Monday 3 March 2014

Small caps at irrational values

Last week, we wrote about the return of retail investors to the stock market, as indicated by the larger share of small cap stocks to the total value of transactions on Bursa Malaysia, and their net buying activities on the local bourse.

Retail investors have done well since January 2013. The FBM SCAP index of small cap stocks on Bursa Malaysia has risen by 47%, compared with the FBM KLCI’s gain of only 8.6% for the same period.

The biggest single monthly gain for the FBM SCAP Index was in May 2013, when it surged by 24%. For February 2014 so far, this index has appreciated by 7.5%.  Since our report last week, where we had advised caution, the FBM SCAP Index has lost 1.6% in the last five trading days.

This week, we explain further why we believe the rise in the FBM SCAP is not rational and, therefore, unsustainable.

Since January 2013, the price-to-earnings (P/E) ratio for the FBM KLCI Index has increased from 15.1 times to 17.3 times. In contrast, the P/E ratio for the FBM SCAP Index has almost tripled from 9 times to 25 times.

Similarly, the price-to-book for the FBM KLCI has risen marginally from 2.25 times to 2.33 times. However, the price-to-book ratio for the FBM SCAP Index increased from 0.75 times to 1.10 times.

Chart 1 tells the story. Since January 2013, the gains in the stock prices for the small cap stocks were due entirely to higher valuations. In fact, during this period, earnings and dividend growth were both negative.

This explains why the P/E ratio for FBM SCAP Index went up by a significant 179%, much more than the gain in the index of 47%.

Please let me repeat. Prices for small cap stocks have risen by 47% since January 2013 at a time when the earnings and dividends of these same companies have fallen. 

Is that reasonable? Yes, if the starting valuations were low. This was true in January 2013 when the P/E ratio was 9 times and price-to-book ratio was 0.75 times for the FBM SCAP Index.

Is it still rational now? The P/E multiple today for the small caps is 25 times and the price-to-book ratio is 1.10 times. Even if you believe in the stock market, it is better to switch to the FBM KLCI stocks.

It should be noted that the FBM SCAP price to book is almost always below one time (please see Chart 2). The reason for this is simple. Why would you buy a small cap, illiquid – and sometimes risky -- stock above its asset value? 


The last time it traded at above one time book was during the period from Feb 2007 to Feb 2008. What happened to the FBM SCAP Index subsequently? It crashed from 12,261 to 6,319 by March 2009!

Finally, Chart 3 shows the historical P/E valuations for the FBM KLCI and the FBM SCAP Indices. It is normal for the KLCI stocks to trade at a premium to the small cap stocks. Smaller and less liquid stocks trade at a discount due to higher risks, which are not just operational or governance-related. Investors are always prepared to pay a premium for liquidity – to be able to buy in and get out quickly. 


Since June 2013, the P/E ratio of the FBM SCAP Index has been higher than that of the FBM KLCI Index. This is not entirely attributable to rising prices for the small cap stocks, and has as much to do with falling earnings.

We believe the institutional investors are factoring in the rising risk bandwidth. Consequently, the FBM KLCI Index is trading more cautiously. On the other hand, we think retail investors remain too exuberant, driven by the strong performance of small cap stocks over the past year. Such irrationality may last for months before a major correction.

Note that our analysis above is for the stock market as a whole and our discussions on the FBM KLCI and the small cap stocks are in general terms. In other words, it relates to the overall indices.

Obviously, there will always be specific opportunities where great values can be found. If you do find them, we will be happy to hear from you.

“Those who don’t know history are destined to repeat it” -   Edmund Burke

Saturday 1 March 2014

1MDB. Time to be transparent.

Two weeks ago, The Edge wrote about the power assets 1MDB acquired for RM10.85b. Based on the estimated original IRR (internal rate of return) of these power plants, The Edge estimated that 1MDB may have overpaid in excess of RM2b. Consequently, the IRR of the power assets acquired by 1MDB are in single digit, close to 4%. These are also old power plants.

As a result, The Edge had predicted two weeks ago that 1MDB will be given Project 3B, the RM11b, 2000 MW, coal-fired power plant to be built in Negeri Sembilan. 

This is necessary to raise the overall IRR of 1MDB power assets to facilitate an IPO. A cash raising exercise for 1MDB is paramount as this sovereign wealth fund (yes, it belongs to all Malaysians) has already accumulated over RM30b in debts over a short 5 years of existence. 

Yesterday, the Energy Commission announced that 1MDB has been awarded Project 3B. Surprise, surprise!

In this week's Edge, Kay Tat responded to the comments made by 1MDB in relation to The Edge's article two weeks ago. He also raised more questions. Three external auditors in five years?
"Where is the beef" (US$2.32 billion of cash purportedly managed offshore)?

Read more in The Edge.
This is a sovereign wealth fund. It is time to be transparent, please.

Wednesday 26 February 2014

A Tribute to Wan Abdullah

This is a tribute to my friend, Dato’ Wan Abdullah Wan Ibrahim, the former Chief Executive Officer and Managing Director of UEM Sunrise Bhd who passed away on February 26, 2014.

I got to know Wan since end of 2010 when UEM Land Holdings Bhd acquired Sunrise Bhd and I subsequently joined the board of UEM Land. I am not his close or family friend, nor am I his golfing buddy. I am sure many of his friends can write far better tributes to a man who was genuinely warm, fair, honest, humble and hard-working.

There is one very positive aspect of Wan that I know well, and I feel it will be a loss if I do not share. He is genuinely inclusive and not egocentric. This is a trait not often found in corporate Malaysia.

Post-acquisition of Sunrise Bhd, Wan warmly embraced the staff, the processes and the values of Sunrise into the enlarged entity. So much so that UEM Land Holdings Bhd is now renamed UEM Sunrise Bhd. Of course, this is also made possible by a majority of the board members who are equally inclusive and open-minded.

Operationally, many of the senior staff of UEM Sunrise were from the former Sunrise, including both the current Chief Operating Officers. Unlike some other acquisitions we are familiar with, most of the staff of Sunrise stayed on, years after the completion of the acquisition.

If you ask any of the senior staff, there is no question that the main contributing factor was Wan Abdullah.

The fact that he accepted me as the Chairman of the Development Committee, even as I was the previous CEO of the acquired company, speaks volume of his humility. Wan is a man with a big heart rather than a big ego.

What does this mean to the company Wan led? By any financial measurements, it has been a success. Pre-tax profit rose from RM129 million in 2006 (when he joined UEM Land as CEO) to RM686 million in 2013. Total assets now stand at almost RM10 billion, up from just RM3.5 billion in 2006.

Wan coined the term “tipping point” and predicted rightly that 2012 will be the year when the developments in Iskandar Malaysia, Johor, will accelerate from dreams and ideas, to real investments and activities.
He led UEM Land into some of the most successful projects in Iskandar Malaysia, as catalysts to bring in more investments, employment and homes. These projects include Puteri Harbour, Mall of Medini, Bio-XCell, Horizon Hills and Motorsports City among many others. He helped to oversee the transformation of Iskandar Malaysia from a vast barren land into a thriving property hotspot.

As my colleague on the board of M+S Pte Ltd, he proved to be also willing to listen and learn, just as he is ever willing to lead.

While some may see Wan as fairly impatient at times, my own impression of him is quite the opposite. So very often, I saw some people putting his patience to the test. Yet, Wan always came through. He was always willing to be tolerant, to be patient and to slowly win over his detractors. I would have blown my top many times over.

I have a few fond memories of Wan as a friend. Together with his family, they visited me in Vancouver, Canada. In England on a business trip, we managed to watch a couple of football matches, including the game between Manchester United and Arsenal, and the game between Chelsea and Tottenham Hotspur.

Wan led a good life. He left many legacies too, including the success of UEM Sunrise and his many contributions to Iskandar Malaysia and the M+S projects in Singapore. These are only those I am personally aware, and I am sure there are plenty more.

More than anything else, in the few occasions I shared with him as a friend, I believe he is first and foremost a family man. To his family, I pray that God will continue to bless all of you and that his life’s story will be the light that shines your future path.

To the rest of us, it’s a reminder that life is short. Go do something great this year. Do something kind this week. Go hug your kids today.

Tuesday 25 February 2014

Fried sweet potato starch

My dinner last night was at an interesting restaurant in Old Klang Road. Pu Yuan's address is 112, Batu 4 ½, Jalan Klang Lama.

Looking for the place is an adventure in itself. Coming from Mid Valley, look out for SJK (C) Choong Wen on your left and turn left immediately.

The fried sweet potato starch is unique and very good. A meal of five dishes, including deep fried wheat chicken, vegetables and noodles cost RM40 in total. I thought it was rather good value.

You need to walk a short distance of a narrow back lane to get to the front door. And it does not look much of a front door, nor a back door. A bit scary actually. But once inside, it is surprisingly clean, comfortable and air-conditioned.

Well worth the effort… good food, comfortable and value for money.

Saturday 22 February 2014

Turbulence in the skies — the options left for MAS

Malaysian Airline System Bhd’s (MAS) latest earnings results for the last quarter of 2013 underscore our previous opinion that simply boosting capacity and load factor without a concurrent — and huge — cut in operating costs would not be sufficient to turn the company around.

MAS reported a net loss of RM343 million in 4Q2013 and a cumulative loss of RM1.17 billion for the whole of 2013, compared with a net loss of RM432.6 million in the previous year.

This is despite the company raising the available seat kilometres (ASK) and revenue passenger kilometres (RPK) by 17% and 27% respectively. Its load factor also increased to 81% from 74.7%.

These statistics show that MAS flew more flights and passengers, and filled more of its seats. And yet, it lost money big time.

So, what needs to be done for MAS to break even?

We analysed its latest earnings results, ran the numbers and came up with three options, including one that is rather interesting, plausible and, most certainly, controversial.

Option 1: Boosting load factor to 96.7% on current capacity

For all our scenarios, we assumed a consistent 40:60 fixed-to-variable cost structure (excluding interest expense), and average yield based on total revenue per RPK for the sake of simplicity.

In the first scenario, we conclude that MAS can achieve breakeven at the pre-tax level if it boosts its load factor to 96.7% on its existing capacity (ASK) of 58,381 million seat kilometres.

Casting aside the practical impossibility for any airline to maintain such a high load factor, this scenario also requires that the average revenue or yield remains unchanged at 31.74 sen per RPK. This is highly doubtful.

Consider this — MAS’ yield fell from 36.87 sen per RPK in 2012 to 31.74 sen last year in order to lift its load factor from 74.7% to 81%. That is a load factor increase of 6.3%.

To raise the load factor further to 96.7% means another hefty increase of 15.7%. It is safe to say that to attract this many more customers, MAS would have to reduce its pricing. But as prices (yield) fall, even a load factor of 96.7% would not return the company to the black.

More importantly, AirAsia Bhd, one of MAS’ biggest competitors, has a much lower cost structure. Its operating cost per RPK is almost half that of MAS’ — about 17.5 sen compared with MAS’ 33.3 sen. Thus, even if MAS decides to reduce prices, AirAsia could well match it — and still come out ahead.

Option 2: Cut cost by RM1.1 billion

A more viable option is to cut cost. To be fair, MAS has been doing this over the past year, except that it was just not deep and fast enough to outpace the even steeper decline in yields. The average operating cost per RPK fell 12% while average yield fell an outsized 14% in 2013. In absolute terms, total operating costs rose by RM1.7 billion or 11.7%.

Based on last year’s earnings results, the company would need to shave off another RM1.1 billion in total operating cost (excluding interest expense) — equivalent to a roughly 7% reduction across the board — to break even.

While the figure does not appear too daunting, it should be noted that a good portion of its costs is beyond its control. This includes fuel costs, and handling and landing charges. Others such as depreciation and amortisation are, by and large, fixed. For those costs that are somewhat more flexible, we did a back-of-the- envelope calculation of the quantum of reduction required for one possible combination.

To save RM1.1 billion, MAS could cut staff and aircraft maintenance costs by an average of 11%, and commission and all other expenses by an average of 25%.

To say this is a tough task would be putting it mildly. The quantum of cost cutting required is certainly not impossible but the political will to execute and see through such a painful exercise is highly questionable. Indeed, this option has been articulated in the past but never fully implemented.

To be sure, there are many other possible permutations to lower costs. For the current year, MAS is focusing on increasing assets utilisation (reducing the aircraft downtime) and swapping older planes for more fuel-efficient ones. But these are longer-term solutions that would require time before any material impact is felt.

Another option would be to reduce net interest expense — which totalled RM323 million in 2013 — either by refinancing its loans at a lower rate or raising equity through another cash call. Both alternatives appear unlikely. Globally, interest rates are on the rise and MAS had just raised some RM3.1 billion in rights issue in July last year.

Option 3: Dumping the competition out of the skies

MAS’ latest results underscore the fact that boosting the load factor without any major new investments is not a solution.

Our calculations show that it would have to raise its load factor all the way to 96.7% just to break even. This is practically impossible and yields will keep falling anyway as competitors such as AirAsia have lower cost structures. Slashing cost deeply may work but if history is any guide, the political will to execute such a plan is weak.

This leaves us with one last possible scenario — dumping the competitors out of the skies, for good.

MAS could go on an expansion binge. Armed with the increased capacity, it could then move aggressively to capture market share by throwing prices. It would suffer greatly in the near term as losses would balloon — although the average cost will drop with expenses spread over a larger capacity, yields will fall even faster.

But it would outlast its competitors in the bloodshed because it is funded by cheap government money. After it has finished off its main competitors, the company would be free to raise prices again and start making money.

By any definition, this option will qualify as an anti-competitive practice subsidised by the government. But it is nonetheless, a plausible move.

Extreme measures in extreme circumstances, when all else have failed?

We can already hear Tony Fernandes screaming his head off!