Month: June 2014

Penny Stocks

Ever heard of the phrase, “never judge the book by its cover”? Well, the same goes for investing in stocks, especially penny stocks. Recently, I read an article on fifthperson regarding the dangers of penny stocks. While I do agree with their points brought up, however, I feel that there is this stigma attached to the term “penny stock” especially how they associate it with speculation. Every time I bring up buying penny stocks to more seasoned investors, their initial response would always be how risky it is.

In SEC terms, any stock that has a value of less than 5 dollars per share and also which is not exchanged on the major exchanges (like NYSE or NASDAQ) is called a penny stock. These types of stocks are traded over the counter and they are listed in exchange boards such as Pink Sheets or in the OTCBB. In the context of Singapore, they are just stocks trading under a dollar.

There is this misconception that penny stocks are priced so low due to reasons such as consistent poor performance, the company usually reporting a net loss or reasons to believe that there is accounting fraud. They aren’t wrong as we do see such cases such as Scintronix (T20.SI) trading at 0.1 cents due to consistent poor performance or s-chips like China Fibretech (F6D.SI) due to the public’s fear of accounting fraud. However, to just throw the baby out with the bathwater is not very fair. There are many other unloved penny stocks that are hidden gems waiting to be discovered. As long as we do proper research, we will realize that many of these penny stocks are undervalued, offering us a large margin of safety and huge potential gains. As one would observe, I owe my portfolio’s performance largely to such penny stocks. One of my darling penny stocks would be Silverlake Axis (5CP.SI) purchased at SGD0.35 and giving me a total return of over 170% including dividends within a time frame of about 1.5 years. Furthermore, if one were to actually hold the stock till now, it would translate to a total return of 237%!

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To sum it up, I hope this post will help alleviate investor’s fear of penny stocks and to some extent their view towards penny stocks being riskier than blue chips. Honestly, what is risk? Imagine, Person A buys a penny stock offering 50% margin of safety compared to Person B who buys a blue chip that is 50% overvalued. To me, Person B is actually at a greater risk as he is overpaying for a stock and in the event that the share price normalizes in the long term, he is actually facing a potential loss of 50%.

Disclaimer: The authors have no vested interest in 5CP.SI, T20.SI, F6D.SI

How to Value Property

As fundamental investors, the art of valuation is our main weapon against the irrationality. In a land-scarce country like Singapore, property holdings are a common and significant source of value, even for companies not in the property business. Today, I would like to share my method of valuing properties. It may not be the most accurate, but as always, the objective here is to broaden perspectives.

I categorise property valuation under two categories – Earnings and Asset Value.  Earnings is derived mainly from rental income while Asset Value refers to the fair value of the land and building if it were sold. At a deeper level, the two are actually converge as you can convert earnings into a pseudo-Asset Value using a DCF or rental yield model.

Before we jump into the nitty gritty of the two categories, there are a few key terms that you should know when it comes to property valuation.

Gross Floor Area (GFA)

When you buy a plot of land, you do not just simply build a one-storey house. By building more than one-storey, you are able to increase the gross floor area even though your land area remains unchanged.

Gross Floor Area ratio (GFA Ratio)

The GFA ratio is simply the ratio of your gross floor area to your land area. The higher the ratio, the greater number of floors you can build for a unit area. Everything held constant, a plot of land with a higher GFA ratio will be worth more than one with a lower GFA ratio. This GFA ratio is set by URA.

Net Lettable Area (NLA)

A building will not be able to rent 100% of its GFA. Out of the entire GFA, some of it would have to be used for common areas like lifts, corridors, toilets etc. Such areas do not earn rental income for landlords. Therefore, adjustments would have to be made to the GFA to obtain the NLA for which rental income would be charged. While the exact adjustment would be hard to determine, I usually apply a discount of about 20% to the GFA, after all, every owner would want to maximise the NLA so I think 20% is a sufficiently conservative amount.

Now we move on to the actual valuation in terms of Earnings and Asset Value which are actually very similar.

1. Determine land area

If it is a new acquisition, this will be disclosed in the announcements. Otherwise, you can find the information in the notes of Annual Reports.

2. Find the gross floor area

To do this, you first need to know the GFA area. This information can be obtained from URA’s Master Plan. Simply search for the address of the land and it will zoom in and display its corresponding GFA ratio. Once you have that figure its simple arithmetic to find the GFA. Make the necessary adjustments and you would have your NLA.

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3. Average rental/price per unit area

This is usually the most challenging and the most critical part of the research. My general principle is to base it on recent transactions in the vicinity (the nearer the better).  To find such information, you can use sites like propertyguru or commercialguru which property owners use to advertise their properties for sale or rent. While this isn’t exactly a recent transaction, it does give a flavour to what the market rate is for properties in the area. However, one disadvantage is that new property launches may not use such platforms for their marketing so you may not be able to find timely information in such scenarios. There are ways around this; if you are loaded (the subscription fee isn’t cheap) you can subscribe to URA’s REALIS where you will be able to find records of all recent transactions.  Squarefoot Research is a much cheaper alternative – the free account provides sufficient information about transaction prices and there’s always the option of a paid subscription. I’m not paid to advertise for them by the way.

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Depending on the situation, choose the appropriate valuation method based either on rental or sale price, multiply it by the net lettable area and you will arrive at your final figure. The method of valuation depends largely on management intention – do they intend to dispose of the property to unlock shareholder value or to retain it as a source of income? In scenario A, if the company owns the land and is sitting on the premises as an office or factory space, asset value would be the way to go. In scenario B, if it is redeveloping a land and intend to rent the units out as an additional source of income, I would go with earnings.

It seems pretty straightforward at this point but it won’t always be that easy. When it comes to Asset Value, the valuation described above is based on Sale Price x Net Lettable Area.  There are times where the sale price is for per land area rather than per net lettable area depending on where you get the information from, therefore caution would have to be exercised in multiplying by the correct denominator.  In any case, I think using either would be fine as value from building (net lettable area) and land (land area) are mutually exclusive since they are just linked by the GFA ratio (for a large part).

I would like to end with a warning against converting asset value to earnings for example, in the case where a company (like a property developer) develops a condo and sells the units. Upon conversion, asset value becomes merely a top line in your income statement, so remember to account for margins.

China Residential Market

From the latest results from the National Bureau of Statistics of China, we can observe that in terms of supply of real estate, the Central Government’s policy is working. China’s real estate sector slowed in May where investments in real estate rose 14.7% during the first five months of 2014, slowing from the overall rate of 16.4% recorded during the period from January to April 2014. Furthermore, we see new construction starts decreasing 18.6% during the period of January to May compared to that of last year.

However, if one were to look deeper, the government’s policy may not be working that well. Looking at demand, we see home sales for May alone to be down 11% compared to that of last year. This translates to an 8.5% slowdown in property sales from the period of January to May 2014, compared to that of last year. Furthermore, Soufun reported earlier this month that 62% of China’s cities recording falling home prices for the month of May. A survey by China Index Academy, a unit of Soufun.com, saw average home prices dropping 0.3% in May compared to April. Furthermore, it was previously reported that only home prices in smaller towns in China saw home prices falling. However, we see home prices in first tier cities, where homes in Shanghai Commercial Centre saw prices fall by 0.4% compared to last month. Among China’s 10 largest cities, Nanjing saw the biggest drop in May of approximately 1.4% and only 2 cities recorded increases in home prices – Bejing and Tianjin.

While we see the slowdown in supply of real estate, this is partly attributable to problems developers are facing. Developers are facing the problem of tighter cash flows, where housing brokers complain about unpaid commissions.


A third of all developers that we are helping sell projects have not paid us commission fees according to the payment schedule

Director of Hopefluent Group Holdings, Fu Wai-Chung commented. The firm operates 280 branches across the Mainland, and was marketing about 600-700 property projects.


Developers are deferring their payment from 90 to 120 days as credit tightening and a decline in property sales hurt their cash flow

Furthermore, Head of Residential Sector at DTZ Greater China, Alan Chiang Sheung-Lai agreed that their company was in the same boat.


Small developers are not only the ones that owe us money, but also major players

Chairman of Centaline China’s parent Centaline Group, said. Developers owed the firm RMB1bn in unpaid commissions for this year, lifting its accounts receivable to RMB2bn. Furthermore, one such developer, Huizhou-based Guang Group had paid Centaline commissions in the form of several flats, and they had sell them at below-market prices.

Despite it all, an official from China’s think tank said that the current real estate market correction is under control and that the country’s economy is strong enough to manage its impact.


Based on our research, risks for the property market still controllable

Vice President of the China Academy of Social Sciences, Li Yang commented. Furthermore, given how the value of properties held by individuals is still much higher than their mortgage obligations, this limits the risk of panic selling.

I attended a happy hour for professionals within the real estate industry yesterday night. The surprising thing was that I actually met other professionals from other sectors such as someone from uber, the hospitality sector etc, which was really interesting. One could actually see how interconnected industries are, where I even saw someone from the carpet industry attending this social event to network with property developers. Anyway all that aside, after talking to the industry’s professionals, it is their view that it is unlikely that China would enter into a recession, where the property bubble will not have repercussions as bad as that of USA. Furthermore, the Chinese government has more fiscal might to bail companies out in the event of such a scenario. That said, I won’t be better against this from happening.

The Value Edge

Thanks to all the support and encouragement from you readers out there, we have decided to register for our own blog domain. After much deliberation, we have decided to name this blog, The Value Edge – a platform we hope that investors will be able to gain a better advantage over markets through the sharing and discussing of value investing.

A couple of user interface changes have been made, namely the ‘Portfolio‘ and ‘Contact Us‘ tab in case readers have a question/comment that they would like to ask/leave with us privately.

More importantly, our investing methodology has constantly been evolving and developing over the years. Currently, we are in the midst of liquidating some positions made in the earlier years to better synchronise the entire portfolio’s investment strategy. That said, fund performance would still be updated every quarterly, while stock positions would be updated monthly.

Memtech International

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Memtech International is a leading component solutions provider for the mobile phone, consumer digital and automotive industries. Over the recent years, we see the company transforming itself to better suit the changing environment of the technological sector. As of late, the company has two business divisions – keypads and plastics divisions, with major clients from both the mobile communications and automotive industry (e.g. Lenovo, Huawei, Alcatel, GM, VW and Tesla). The company has shut down its loss making touch screen division after the fire incident in 2012.

In this analysis, all figures are in USD and data from FY2004 to FY2007 were obtained from company’s website and not cross-referenced with the annual report. Through research, some of Memtech’s competitors would be Scintronix Corporation, Juken Technology and Fischer Tech all listed on SGX (Juken Technology was delisted in 2012, Scintronix Corporation is in the midst of getting delisted).

Fundamental Analysis:

(I)              Earnings:

Screen Shot 2014-06-15 at 1.57.39 pm

Looking at Memtech’s earnings, we would see how volatile and inconsistent it is, and may immediately strike it out of our consideration. However, to get a better feel of these numbers, we have to understand how the business has been transforming over the years. First off, the huge decline of 48.3% and 95.9% in gross profit margins and net profit margins (NPM) respectively in FY2007 was due to the Global Financial Crisis. During this period, there was much weaker demand during the last two quarters of 2008, resulting in lower selling prices, increases in raw material cost and sales & marketing expenses. Following that, as we see the economy improving, margins begin improving in tandem. Despite markets recovering in FY2011, the blip in NPM was attributable to exchange rate losses.

Subsequently, in the technological sector, 2012 was a year we see increase dominance of the smart phones. If I were to remember correctly, 2012 was the year I witness an increasing number of people around me carrying iPhones. Before, that it was still the good old days of using the indestructible Nokia phones (I remembered using the N95, which to date I still have and it is still workingJ). That aside, to put some figures to this, the global market for mobile phones grew 1.2% on shipments of more than 1.7bn units shipped, of which 712.6mn were smart phones, indicating an increase of 44.1% compared to 2011. Memtech recognizing this trend, made the strategic decision to switch their manufacturing capabilities from that of resistive to capacitive touch screens in 2011 (pretty technical here, however in layman terms, before the touch screens we are so used today, touch screens back then weren’t that smooth scrolling).

Therefore, in FY2012, we see margins declining due to the lower demand for mobile phone keypads (Memtech’s main division). Another point to note would be before FY2013, Memtech never supplied to the automotive and consumer digital sectors but only to the mobile communications sectors. Hence, with the growth in smart phones, we see a huge decline in demand for keypads in the mobile communications sector. We observe revenue contracting by 38.2% and that accounted for two-thirds of their total revenue, showing how the keypad division is Memtech’s main business segment. With regards to the plastics division, it was growing steadily, reporting a 9.5% growth in revenue and 33% rise in net profits. Due to operational issues, the touch screen division reported net losses. While I am no expert in this area, my observation is that Memtech did not have the expertise within this business segment. Given a fire incident in the touch screen factory, management decided to shut down this loss making division. In some ways, this fire might have been a fortunate event for the company and shareholders alike.

In FY2013, with management diversifying their clientele, making inroads to the automotive, industrials & medical and consumer digital products, we see a huge improvement in gross profits. However, in that year, we still net losses due to exchange rate differences. It is my view that management has been pretty successful in this regard, having just started venturing into the automotive industry and been able to bag major clients like GM, VW and Tesla. Furthermore, the increase in gross profits was partially due to their restructuring efforts in FY2012 of their Huzhou operations. Management initiated a restructuring exercise of their keypad division production facilities, transferring their operations in Huzhou to the Dongguan and Nantong plants, consolidating group’s total production capabilities.

Going forward, we see in their 1Q2014 results, revenue was up 30.9%, gross profits up a whopping 292.6% and the company has reported a net profit. Revenue has been up mainly due to the automotive sector resulting in increase in sales figures and the company now offering a better product mix.

Overall, I would say given how volatile the mobile communications is, it has resulted in the volatility in the company’s earnings. However, given how the management has started to get a mix of industries such as exposing themselves to the automotives, consumer digitals and industrials & medical sectors, we should be able to see less of this. However, the major concern for me would be exchange rate differences, as this alone seems to be able to affect the company’s overall profitability.

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Comparing Memtech to her competitors, one would observe that in this industry, how inconsistent the gross profit and net profit margins are. While to better understand why the margins are changing every year, we would have to understand how the business has been evolving every year, I did not conduct studies with regards to this.

Some common trends we can observe would be that during the Global Financial Crisis, none of the companies were spared from the decline in demand. However, Memtech fared much better where their decrease in net profits was much lesser. In FY2012, where there was a huge change in demand and increase in raw materials costs, none of the companies were prepared for this, resulting in their net profits decreasing. In this aspect, I would say Memtech fared much better again, due to the smaller decline in net profits and Scintronix Corp having started to discontinue most of their operations. In terms of margins, it can be seen how small the margins are within this industry and is not just something Memtech faces.

Something that Memtech is better than the other companies would be how Fischer Tech and Scintronix faced more than 2 years of negative net profits.

(II)             Balance Sheet & Cash Flows:

memtech_bs

As we can see, the company’s cash levels have been constantly fluctuating given the inconsistency in company’s profitability. However, a good point to note would be that management has been paying down their debts over the years, though they did take on a debt of USD10.2mn in FY2011. I deduce that the debt was taken on to finance their increase in capital expenditures as you would see that in these two years, capital expenditures have increased significantly. Furthermore, looking at their footnotes, one would observe that in these two years, additions to leasable land & buildings and plant & equipments was significantly high. In 2011 it was approximately USD15.7mn and 2012 approximately USD9mn. In 1Q2014, we see cash levels increasing to USD44.7mn, which is a definite good sign. While short term loans still remains at USD1.11mn, it is not something the company is unable to handle while long term loans have decreased slightly to USD3.055mn.

Looking at their cash conversion cycle, I have nothing much to comment. Moreover, given how most of their clients are major players in the world, I do not see many problems in that. However, their cash flow is definitely inconsistent. We can see how in some years there is positive free cash flow (FCF), while in some negative. Once again, this is attributable to the business nature of the company. One major thing I would like to add here would be my calculation for FCF. In the past, I have always just taken net cash from operating activities minus capital expenditure. While it does not make a huge difference because the companies I look at mainly have minimal debt, however, it would be quite significant for companies with higher debt levels. In this new calculation, I have excluded the adjustments made for interest expenses and income. The reason being FCF being the money attributable to equity holders, interest expenses should be attributable to debt holders instead of us equity holders.

(III)            Financial Ratios:

memtech_ratios

Again, I have nothing much to add to the ratios. While the current ratios have started to hit slightly above 3, I feel it is fine and still indicated that Memtech is a healthy business and able to meet short term obligations. ROE and ROA figures have been rocky; however, this is attributable to the rough patches the company has been through.

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Compared to Memtech’s competitors, we would observe that on all ratios, Memtech could be considered the better of the three.

Qualitative Analysis:

(I)              Management:

Qualitatively, I find the way management runs the company ideal. Looking back at the balance sheet, one would note that the total outstanding shares have been decreasing every year from FY2008 onwards. There are no data on that for years before 2008 due to me being unable to obtain the ARs. However, if one were to do a backward calculations based on total NAV and NAV per share, we can see that the number of outstanding shares those few years have been fluctuating as well. From some digging, I know the company did raise capital during those periods by issuing new shares and all. Hence, the fluctuation in number of total outstanding shares you would observe if one tries calculating. This decrease in shares is a good sign as the company has constantly been buying back shares, increasing shareholder’s value. Such as in FY2013, we see the company buying back 3 million shares at the price range of SGD0.70. In FY2012 1.5 million shares was bought back and in FY2011 1.7 million shares at the range of SGD0.095 – SGD0.13. This signifies that at this price range, management feels that the company is still trading at price lower than the company’s fair value.

Furthermore, we can see that management is prudent with respect to dividend payouts. When the company is not performing well, management still maintains paying out a dividend but lesser such as in FY2008 and FY2012. However, when the company starts improving again, management would reward shareholders by increasing the dividends paid such as in FY2010, FY2011 and FY2014.

(II)             Economic Moat:

From Memtech’s margins, it can be seen that they do not have much of an economic moat. However, compared to her competitors it can be said the same. In terms of business, Fischer Tech is most similar to that of Memtech. Also, upon further digging, we would observe that the clients that Fischer Tech has are mostly different from that of Memtech. It can be seen despite what may seem to be a lack of economic moat within this industry, the companies do not really have the same clients.

Valuation:

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At the price of SGD0.09, which translates to USD0.072, based on our usual indicators of P/E, FCF Yield and EV/EBITDA we would be unable to get a true feel of the company. This is because earnings and free cash flow levels have not reverted back to normalized levels. However, one thing to point out would be that Memtech is a pure net-net company. However, this would really be subjective to what net-net formula one uses. Using a more conservative net-net formula, we would derive with a liquidation value of USD0.065.

Conclusion:

Having to come to a conclusion, I would say that it took me quite a while. Eliminating Scintronix was easy, even if it were not going to be delisted soon. Qualitatively I had quite a few doubts that I would have eliminated the company without looking into its financials deeper (however, for the purpose of comparison, I still did it). However, for Fischer Tech it was definitely a more difficult case. It was a company whose earnings have normalized yet still trading at cheap valuations – P/E of 3.93x, EV/EBITDA of 2.4x and FCF Yield of 14.1%. If it was just a case of investing in the best of the three, I would not have faced such a headache and it would definitely be Memtech, net-net being the deal breaker. However, what I was pondering about was if I just wanted to accumulate a basket of undervalued stocks, would Fischer Tech make it inside. After close to 2 hours of pondering, I came to the conclusion of no, especially after looking at the 10-year data for Fischer Tech.

To those who do not understand the point of net-net, I would explain it now. Net-net companies are companies that are trading at or below liquidation value. Essentially, no company should be trading at such valuations, and given time, would normalize back to near its NAV. This is because, if we were to do a research on the market, most companies trade near its NAV. One may read up on Ben Graham’s research for more information about this. Assuming we take the more conservative net-net formula, at a price of USD0.072 vis-à-vis the liquidation value of USD0.065, our downside would be we lose 9.72% of our capital. However, our upside is when it normalizes back to near or more than it’s NAV, our returns are approximately 100%. Given how Memtech is now supplying to the automotive sector whose landscape is not changing as quickly as the mobile communications, the probability of the company producing positive results going forward is quite high. With such odds, I would say that the odds are largely in our favor. Honestly, investing is like poker, where we only play our hand if the odds are in our favor.

Disclosure: The authors are long M26.SI

Circle of Competence

Circle of Competence


I’m no genius. I’m smart in spots – but I stay around these spots.

Tom Watson Snr, Founder of IBM

Followers of Warren Buffett, myself included, would be familiar with the concept of “Circle of Competence”. They key to his philosophy is to encourage investors to stick to what they know best, evident from his Shareholder’s Letter.


What an investor needs is the ability to correctly evaluate selected businesses. Note the word “selected”: You don’t have to be an expert at every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

The concept is simple. To invest successfully, one need not bother themselves with technical, such as beta, capital asset pricing models, modern portfolio theory or option pricing. As an investor, one should simply purchase a company that we understand at a reasonable price. Hence, what many investors should know is how to value a business and market psychology.

Last year, I strayed from this theory, buying Vard (then called STX OSV) and sold off my stake at a 30% loss. I had no one to blame but myself for trying to buy a business that I was completely clueless of. When news of the company having delays in the Brazilian market resulting in profit guidances, I did not know how to react especially with the stock price in free fall. That said, everyone makes mistakes, even Berkshire. In 1960s, they too wandered off from their circle by purchasing departmental stores. Also, Dexter Shoes is another example of failing to stick with their circle of competence resulting in Berkshire getting badly burnt.

It is important to stick within our circle because it gives us an extra edge over others. With that additional information of the business, it allows us to make better, more informed decisions and reduces the mistakes that we would commit. Outside of this circle, we are complete amateurs. In times of uncertainty, it would result in us panicking like the other 99% of the market, selling the stock before analysing the facts laid out before us.

Furthermore, we must never confuse familiarity with competence. Someone who may constantly be flying on the airplane does not mean that he is competent enough to be investing into the airline industry. Whilst many of us may use Facebook, YouTube or Twitter every day, this does not mean that we are able to understand how social media should be successfully managed.

What separate what we do know and what we think we know is a very fine line. It is crucial for us to define our circle’s boundaries, enabling us to improve our odds of success in stock pickings and actually in almost all other aspects of our life. This circle can be widened, however, it is not something achievable overnight and requires constant reading and talking to people whose competence lies in such other areas.

Sinarmas Land – Lessons on Consolidation

I’ve been having the hardest of times piecing together an analysis on Sinarmas Land. Unfortunately, I am unable to overcome my various apprehensions and doubts about the company to produce a complete analysis. This is solely due to my (lack of) depth of knowledge; it certainly does not reflect anything negative about the company but through the course of my attempted analysis, I did learn a few vital lessons which I would like to share.

I’ll start by what analysis I have of the company and draw out the lessons from there.

Sinarmas Land

Description:

Sinarmas Land Limited is engaged in the property business through its operations in Indonesia, China, Malaysia and Singapore. It combines two big developers: Bumi Serpong Damai Tbk (BDSE) and Duta Pertiwi Tbk (DUTI) that are both listed on the Indonesian stock exchange.

Fundamental Analysis:

BDSE and DUTI comprise a large part of the Sinarmas entity. We focus our attention first on determining a fair value for these two subsidiaries.

As of 16/5/2014 and assuming an exchange rate of 0.0011, BSDE has a market capitalisation of SGD3232.8m and is 49.87% owned by Sinarmas. Similarly, DUTI has a market capitalisation of 402.2SGDm and is 44.16% owned by Sinarmas. Using an equity weighted approach, they constitute a market value of SGD1789.8m in total. This actually exceeds Sinarmas’ current market capitalisation of SGD1719m. Considering that Sinarmas has substantial assets besides the two, it seems that the counter is severely undervalued, at face value. It is certainly tempting to conclude as such, but if we do believe that price will converge to its true value in the long term, then the risk in such a conclusion would be that the true value of BDSE and DUTI is actually less than it currently is. We therefore have to ascertain the fair value of BDSE and DUTI, i.e. are they currently overpriced?

A quick snapshot of the Balance Sheet of the 3 companies:

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BDSE – Market cap of SGD3232.8m vs equity of SGD1475.7m.

Paying 2.19x BV is very steep for a developer; most developers in the Singapore market trade below book value. From a value perspective, the only reason to do such a thing would be if the RNAV is significantly higher. Personally, I feel that a price of 0.8-1.0 times of RNAV would be a comfortable range for a fair value. In this case, this would require the RNAV to be at least double of BDSE’s current BV. Typically, the bulk of asset revaluation lies in a company’s non-current asset which, for BDSE, comprises largely of its Land for Development account.

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Unfortunately, imperfect information is often a bane of retail investors and particularly so when it comes to dealing with foreign companies.  The only information I could get out my secondary research in terms of market pricing was the news about BDSE selling up to 95 hectares of land for RP 2 trillion to joint ventures. This translates to RP 2,105,263 per sqm of land in BSD City versus RP 120,221 per sqm (amount divided by land area) in the book. That’s 20 times more.

This is where I ran into my first roadblock. If you choose to believe such reasoning, this counter would be severely undervalued. However, looking at the historical values of the various lands in the account, I notice that the amounts have been revised even when the land area has remained the same. This points to the likelihood that the book value is actually revised yearly which contradicts the purpose of our revaluation exercise and this is only the tip of the iceberg.  My next roadblock is due to the consolidation of subsidiaries and it provided me with the most important revelation I have had in a long time.

Pitfalls of Consolidation

Based on common accounting practices, a parent company is required to consolidate its reports with its subsidiaries. This is why there is often a ‘Profits due to non-controlling interests’ line in the income statement. While most would only focus at the bottom number, this is something you should adjust for (or I would anyway).

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As can be seen in Sinarmas’ case, there is a substantial difference between both numbers which will drastically affect your valuations.

In terms of balance sheet at the parent level, the balance sheet of the subsidiaries is always fully consolidated, regardless of the percentage of ownership by the parent. The rationale is that as long as a parent has a majority stake, it will have full control over the subsidiary’s assets. We investors should know better that this does not equate to full ownership over all of the subsidiary’s assets, therefore, adjustments would have to be made to reflect the percentage of ownership.

Sharp-eyed readers will notice that the sum of BDSE’s and DUTI’s accounts exceeds that of Sinarmas which might seem to refute the point I just made. For example, total current asset for BDSE and DUTI is around SGD1700m vs Sinarmas SGD1300m. This is because when consolidation is done by the parent, adjustments are made to remove intra-group transactions; you cannot earn money by selling to yourself. Therefore, the equity value of a parent should always be less than the sum of its subsidiary’s book value, assuming they are not fully owned and that there are not other assets owned by the parent company. The same concept applies when calculating fair value.

To deal with this, common practise is to apply a holding company’s discount of 20-30%. A better method would be to subtract the value of the company’s books from the group’s (for the various accounts), and then compare this value to the sum of the subsidaries’ books to approximate the percentage discount, but that’s only if they are listed. Caution will also have to be exercised when valuing the ‘Associated Companies’ account of the parent because there might not be a conspicuous distinction between associates of subsidiaries and associates of the parent company. If you are not careful, you might end up valuing the same entity twice.

It gets more complicated when it comes to the cash flow statement because cash flow statements are always consolidated at a group level and is unadjusted for subsidiary contributions. If the subsidiaries were all from similar industries, we might be able to assume that their cost make-up are similar (same percentage of depreciation etc.), then we can adjust the cash flows based on a percentage of ownership basis as well. Nevertheless, it is still a rather stretched assumption because the sizes of the subsidiaries may still differ. It’s even worse when the subsidiaries are in vastly different industries, and unfortunately in this instance I do not have the slightest clue. I admit this is an area I have yet to seriously contemplate but it is definitely something I will explore deeper so till then, all that I have said about cash flow statement might be just gibberish.

The implications are dire and clear; how often have we taken a group-level cash flow value to calculate free cash flow? And when we did that, did we even consider the degree of subsidiary contribution? For parents with fully owned subsidiaries, we would have dodged a bullet. But for companies like Sinarmas which considers 49.87% and 44.16% owned companies as subsidiaries, the difference would be far, far too huge.

With that and after so much deliberation on how to analyse Sinarmas Land, I suddenly recall a very wise man’s analogy about baseball and investing.

“What’s nice about investing is you don’t have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel and you don’t have to swing. No umpire is going to call you out. You can wait for the pitch you want.”

Disclosure: The authors have no vested interest in A26.SI