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ComfortDelgro (C52) – My Comprehensive Analysis

October 10, 2017 by Kyith 10 Comments

ComfortDelgro (CDG) is a Singapore private transport company with a wide geographical foot print. It provides a long term average earnings yield of 6.22%. Currently, its historical dividend yield is 5%.

CDG has been in the news due to increased competition from disruptive ride sharing companies such as Uber and Grab. These companies have large capital backing, was able to provide a lot of incentives for taxi drivers to switch over to driving private cars to pick up passengers instead of the traditional taxi.

As such, the market took down CDG’s stock price.  When I started researching into CDG it was at $2.50. Many say it was cheap for a business of this profile. Then it dropped to $2.30. People say its cheaper.

There are a lot of voices that say CDG is done for.

At the time of writing the share price is $2.04.

Its been sometime since I worked my thinking muscle, after 1.5 years of my own “disruptions”, so I thought why not take a neutral view and see what this business is about. So that I can work some muscle. If you don’t work it, you lose it. I almost abandon it as I was not invested but realize some folks I know are invested and have a rather large position in it.

The summary is that at this price, I think we have priced in much downside in a conservative way. It is fair. Many are clamoring for a return to the $2.60 hey days. A lot will depend on how you see this black box that is CDG going forward. Your view of this box can be very different from me.  However, it does seem that if the discount rate is 7.5% and with the same growth rate as in the past of 3%/yr, $2.60 is not impossible.

From here on is the 8900 words expanded version.

ComfortDelgro Group is a Diversified Transport Business

CDG is not only a taxi company. It is essentially a diversified business that deals with public and private transportation and support services.

The table above shows the amount of services that CDG deals with, and when they started in various countries.

They have not been expanding to new segments of the business. A lot of the business have been around in 2004, in the same geographical location.

If we were to name one foray that happened during this period we profile , it has to be their push into developed nation Australia in 2005.

With so much talk on the taxi business, taxi business account for 36% odds of CDG’s EBIT. The big contributors is still taxi and bus with rail being the third contributor.

The significance of this is that if you believe CDG is going to lose their taxi business, it is akin to a 36% fall in EBIT. It is big but you can see from a high level, the diversified business streams is actually a quality situation.

We could talk about a 50% reduction in EBIT from taxi here, and it is a 18% impact to last earnings.

If we know that, we can adjust the free cash flow and earnings accordingly.

The figure above shows the break down of CDG’s EBIT by country. Note that the taxi segment accounted for 27% of the 60% Singapore region.

What made up the other 9% of Taxi that is not in Singapore? Based on the narrative, this would be China.

This further changes the picture that, if CDG’s Singapore taxi business is wiped out, CDG will see a 27% plunge in earnings here.

If we are not expecting such a drastic fall in business but a 50% one, we will see a 14% impact.

Again the situation might not be as bad.

The caveat here is: Is China’s Taxi situation is in a similar state?

If it is, and it is a sector secular shift, then we need to priced in more profit reduction accordingly.

China’s country analysis will be carried out further below.

Return on Asset of Various Business Segments

Gaining an appreciation of the return of assets of the various transport services segment allows us to know how lucrative the business is.

Return on assets gives us an idea of the leveraged return over time.

It also allows us to measure up against the cost of debt of around 4% and cost of equity of around 8-12%.

To manage your expectations, in the past in the 2000s, infrastructure assets such as properties, utilities, toll roads that are not leveraged would yield around 6%.

The public transport service in Singapore is made up of rail, bus and taxi.

In the early days in 2004 to 2005, Singapore was able to garnered above 14% ROA.  Since then, the ROA have went down to a stable 8%.

Much of the reason can be attributed to the increase in capital expenditure required for the bus service and earnings not being able to scale accordingly.

The taxi margins have been stable. The average ROA for taxi over the 13 years is 11.6%.

The table above shows the ROA based on country.

Singapore is a combination of majority in Rail, Bus and Taxi as well ass Vehicle Inspection and Engineering. Its got a very good ROA on an average of 13.50%.

China is predominately Taxi. The ROA have improved over time from 10% to 14%. The average of 12% is quite close to CDG average ROA of 11.6% for Taxi.

UK/Ireland is predominately bus contracting. The ROA is damn good at 17.6%, primarily due to the asset light model.

Australia is also in bus contracting but their average ROA is lower at 7.7%.

Vietnam is in the business of taxi and they average a 7.7% ROA.

Malaysia is in the rental and leasing of car business. Its average margin is 10.7%. This is lower than the taxi business but pretty comparable.

Public Transport

This segment used to be separate as rail and bus.

A Primer to the Rail Business

In 2003, SBS Transit, a 75% own subsidiary of ComfortDelgro started operating the north east line (NEL). Since 2004, CDG have added bus services overseas through expansion and acquisition.

They have also take on the Seng Kang Punggol LRT and the downtown line (DTL). DTL is broken up into 3 phases which the last phase suppose to go online later this year.

  • NEL Operation since 2003
  • DTL Phase 1 December 2013
  • DTL Phase 2 December 2015

The way the rail operations work is different for each line due to the contractual terms define at inception. NEL is under the old framework.

While they do not own the assets, they bear the cost of maintenance capital expenditure. They also earn the revenue of what they earn. This means that if there are greater ridership, they earn more revenue.

Since they bear the cost of maintenance capex, this pose a big problem in that with the recent deficiency we see in our rail network, greater capex is needed, and this cost is borne by SBS.

This is different for the DTL which is under the license model. Under the license model, SBS will be responsible for the maintenance while the assets are owned by Land Transport Authority (LTA).

If there is a need for capex, this is funded by LTA.

In all models, the staff and fuel costs are borne by the operator.

For NEL and DTL, the revenue is still from fares and ridership.  So it is dependent on regulation of prices and population growth, not to mention the urban development of Singapore.

For DTL is a bit murky, in that it is the NRFF model. This likely means they earn someone close to a 5% operating margin, but they bare the revenue risk. I wonder how that works out. Evidence of this is that DTL is operating right now and currently facing losses. If they are earning a true fee based model, shouldn’t they be not having losses? The only explanation is that it has higher start up cost, where the return will come in later in the contract.

In initial stage there will be losses, but as ridership increases, the profit will take off as most of the investments are in fixed investments, so the rail business enjoys the operating leverage (refer to the NEL snapshot below)

A Primer to the Bus Business

CDG operates a fleet of 3,448 buses under SBS in Singapore. They also operate bus network overseas.

In the local context, SBS is able to earn the revenue it collects from fare prices (fare prices are controlled by authority). They also bear the costs and capex.

The operating profit used to be great in the past, until huge capex starts making bus owning look mediocre (we will see this later)

In May 2014, LTA announced a change in model to the GCM model.

Under GCM Model, the bus operators will operated on a cost-plus contract.

Basically, the operators will earn an operating margin (which is unknown as of this year, possibly between 5%-10%) and performance fee.

This model is better for the bus operators because it allows them to focus on providing services.

The revenue and capex risks will be borne by LTA.  This means that should the fare prices increase, SBS do not earn extra. If we require 1000 more buses, SBS does not bear that risk. They are still subject to operational costs (but indexed to inflation)

Out of the 12 bus contracts, 3 are given out for tender and the other 9 is operated by SMRT and SBS. The tenure of each contracts differs.

This model shift is significant.

The table above let us compare 13 years of capex requirements between CDG’s public transport service and taxi segments. For simplicity, trust me that the capex for the public transport service, majority belongs to the buses and not the rail (since rail’s capex does not jack up like that and operating in a license model)

Capex – Dep shows the excess that CDG/SBS invested in the segment on top of its depreciation. A higher number shows more investment then depreciation.

The public transportation service shows after 2004, there is a consistent excess investment.

While we do see excess investment in Taxi, there are some years where it tapered off, and some years where its higher (04,05,15,16).

This extra cost is evident if you look at the bus EBIT Margins over time.

Here are the details of the future GCM packages:

Note that the number of operating years are also different!

A Look at the Financials of Public Transport Segment

The table above summarizes 13 years of segmental data of the public transport service. This is made up of CDG’s bus, and rail business in Singapore and in other countries.

We have a good sense of the growth of this segment.

The revenue grew at 5.7%/yr for the past 13 years.

The operating profit grew at 4.9%/yr for the past 13 years.

If you are looking for some baseline growth rate this is some figures to get started.

Revenue have been increasing every year, except the period of 2008-2009 by way of organic and acquisitions.

In the past 13 years, net of depreciation, CDG have put in $1,750 mil in net investment. This is pretty close to the difference in assets value during the period ($1,655 mil). This is an average of $134 mil a year.

The main attribution of this is perhaps less of overseas acquisitions but large capital expenditure by SBS. If someone mentions to you that these transport company are earning good money from you, this may not be the case.

The operating profit margins decline but it was a slow decline from 8.4% to 7.7%. This should be a blended margin between the high of 15-17% for the rail business and the lower margins of 5-7% for the bus business.

The return on assets (ROA) was damn good in the past (2004-2007) which was above 10%. What is not reflected in the data is that, for the year 2004, the bus division have an ROA of 19%!

This is even more remarkable considering that from 2004 to 2005, the rail business have been making losses (refer to the NEL snapshot below).

Since then ROA have come down to 8%.

In my opinion, this ROA at 8% is pretty good, as during the times when risk free rate is higher, infrastructure assets, utilities that are unlever earns an average ROA of 5-6%.

To me this was an above average business.

Snapshot of NEL Profitability

The rail business for a long time for SBS and CDG is based on NEL. They been operating it since 2003.

It starts of bleeding and eventually becomes more profitable as business picks up.

In the midst of this, it went through a period where inflation is so called “higher”

There is also a period of  higher oil prices which means higher fuel charges.

Here is its profit change

  • 2003: -33 mil
  • 2004:  -17.3 mil
  • 2005: -6.3 mil
  • 2006: 0.6 mil
  • 2007: 9.3 mil
  • 2008: 16.7 mil
  • 2009: 20.5 mil
  • 2010: 25.6 mil
  • 2011: 27.7 mil
  • 2012: 14.3 mil
  • 2013: 4.8 mil
  • 2014: 7.6 mil
  • 2015: 3.2 mil
  • 2016: no more rail data (combined into public transport services)

The dip in profit from 2011 to 2012 is likely due to the start up cost for DTL 1 which commence operation in 2013.

I would say in the face of inflation and high oil prices, they do pretty well.

If we take a look at 2011, where the NEL profitability is easily shown as the highest, the overall public transport profit is $172 mil.

NEL makes up 16% of the overall profit.

NEL took like 3-4 years to reach from negative to positive profitability.

Over time, we have to consider that some of the ridership of NEL is likely to be dissipated as more rail lines come into the picture.  (profit for NEL still based on fares and ridership)

This means that profit growth will moderate down.

In a 2016 report, Nomura hold the same view, but they also helped me calibrate some of the operating margin expectations.

In a Sep 2016 UOB Kay Hian report on the configuration of potential move of NEL to a NRFF like contract model, they highlighted the historical profit margin of SMRT. It looks damn delicious.

Downtown Line (DTL) Profitability

Revisiting the rail profitability figures:

  • 2011: 27.7 mil
  • 2012: 14.3 mil
  • 2013: 4.8 mil
  • 2014: 7.6 mil
  • 2015: 3.2 mil

DTL 1 started operations in 2013 but likely the business started accounting for losses in 2012. There is profitability recovery in 2014.

DTL 2 commerce operations in 2015 so i would assume from the figures they started accounting the costs in 2015.

CDG have given guidance that DTL 2 should break even by the time DTL 3 commence operation, which gives it around 2 years to be positive

While we cannot see the rail profit figures from 2016 onwards (WTF CDG), I do expect 2016 to show a dip in profitability due to DTL 3 and then a similar low figure in 2017 before a  2-5 mil profit growth in 2018.

This will not make a big different to the $178 operating profit of the public transport service in 2016 (estimate to be a 2.9% growth)

Will DTL as a whole, have significant growth as NEL?

It is likely not as the DTL, under the NRFF, will see CDG getting more moderate income growth.

Estimating the Cash Flow of the Local Bus Business

Based on the cost plus contract model, it is likely the profitability of the local bus business is driven by the contract value and the operating margins.

The operating margins will depend on the amount of staff and other operation cost they hire. A certain part of the costs are linked to inflation.

It is a question of how much operating margins that can be earned.

If Tower Transit and  Go Ahead is coming in to compete, you expect them to have a certain expectation how much they can earn.

If the cash flow and margins is not there, why spend so much effort to come in and compete?

However, as I have said, the government will not give great operating margins.

My suspect is closer to 6-7%.

This is the margins that the foreign operators are looking to earn.

Based on Macquarie research the contract fee per package is about $92 mil.

The contract length is different, but on average they are about 7.25 years.

So the per year contract fee can be 7.25 x 92 = $667 mil.

Here is the operating profit, based on different profit margin sensitivity:

  1. 5%: $33.35 mil
  2. 6%: $40.02 mil
  3. 7%: $46.70 mil
  4. 8%: $53.36 mil
  5. 9%: $60.03 mil
  6. 10%: $66.7 mil

Speculation of the Future Cash Flow in the Public Transport Segment

To speculate on the future, we need to understand the past.

SBS’s result is a mixture of

  1. relatively medium term (bus) and long term (rail) operating contracts
  2. overseas contract likely based on cost plus contracts with a certain operating margins that can be earned
  3. NEL that is operating below baseline ridership, that started off at losses before become profitable
  4. 2 phases of DTL that is operating below baseline, and is still not profitable (DTL phase 1 have become positive)
  5. A move from normal operation for Singapore bus service to the government contracting model that is capital expenditure light but only earning a possible operating profit margin between 5%-9%

The attractiveness of this segment is that this is a business segment that is not going away. The government need providers to operate these service and regulated in some ways.

Even with autonomous vehicles, the business model will shift but likely be around in some ways.

New ways will sought to disrupt but likely augment or replace particular segment of the business. The decline will reach a terminal stage in some ways.

These contracts are a service to the people, and there is a regulation and cap on the growth rate.

Fare prices are capped and cannot increase. However do note, this is in the past.

In the future, their NEL business profitability will still be based on how they manage costs and how much ridership. So is the DTL.

However, the bus segment under GCM is based on earning an operating margin and so are the overseas investments. In the future, if they win rail lines such as TEL, it will be under the NRFF model, which is also based on a operating margin.

This means that the future is asset light, but earning an operating margin. The public is not going to be happy to learn SBS or their local bus and rail company earning a above 10% operating margin. So there is a limit there.

The advantage is that the government can set fares at $0.10 per trip and the rail and bus business will not drop into huge losses because they earn a fixed revenue fee for it (except for current NEL and DTL). They do not borne capex costs (except probably for NEL)

The rail business, only NEL is profitable but not DTL. DTL will eventually reach there. The revenue is dependent on fares, but also dependent on population growth in Singapore. The profitability will depend on cost control.

The new GCM contract is between 5-7 years and it is not a given SBS can win them in the past, so if they do not win, less business, less profitability.

However the rail contract still have 46 years and 15 years to run. (this is like a long real estate tenant lease)

Do note, the operating margin is based on a particular contract value and NOT based on current ridership and fare revenue. This means that estimating based on the data above can reach drastically bad outcomes.

You can only get a better handle in the next year when GCM operates for a year (capex is likely going to be much lower, revenue level will change). We will then find the true operating margin.

The operating margin of public transport is a pull between NEL and DTL improving (better) and bus business model improving (better) but lower operating margins (worse). If they fail to provide satisfactory service (locally or overseas) they would lose the contracts (worse). If they win additional contracts such as the TEL, they get to earn a possible 5% operating margin.

The net effect is the downside profitability risk is drastically reduced for CDG.

But you might not get the great growth rate. Growth rate is likely to be organically 2-3%/yr + investments overseas at 8% ROA x % of retained earnings that is not paid out.

Certainly, in the next 2-3 years, GCM will see better profitability but this will offset the losses in DTL, thus the growth will work out better after this 2-3 years.

SBS Transit Did Not Win the Thomson East Coast Line

The upcoming Thomson East Coast Line (TEL) was won by rival SMRT.

SMRT Wins Thomson East Coast Line TEL and CDG share price did not react well to this

This seem to be much anticipated by the analyst, and the share price did not react well to it. Shortly after the announcement, the share price fall on the next trading day.

CDG Share Price falls after the announcement

SBS Transit's Share Price Movement to the News

SBS Transit’s Share Price Movement to the News

I was surprised by the sell down not because they failed to win but that in recent analyst reports written, the TEL line wasn’t mentioned in a big way.

Despite that, the bus business of SBS Transit with the GCM model will be more volatile and shorter in duration. This is not good for SBS and CDG.

The better revenue contract is the rail contracts.

Even if CDG Won TEL, it doesn’t Guarantee Exceptional Profits

From what we see so far of how the DTL is panning out, missing out on TEL operation might not be that big of a disaster.

Many investors were still expecting the kind of profit figures of NEL. However, we have to remember that DTL runs a different contract.

I expect that the break even period to be faster, but there will be a cap on operating margins.

The contract should not be far off from the kind of contract for SMRT’s NSRFF. After all, why is there a need for different contract standards.

The focus on these contracts looks to be to tie operators to service level agreements.

Due to the political heat of the transport issue, it is likely that the contract allows the operators to be profitable, but won’t be so profitable that it draws critique from the public.

Future Contracts Might not Be Lucrative

The bidding of TEL also put some questions into how profitable the future contracts will be.

Daiwa’s analysts highlight that CDG lost out on the TEL as the competitors SMRT priced their bids 30% below theirs.

SMRT have been nationalized and thus profitability is not the main aim here.

This is a challenging competitor to bid against because if profitability is not the main driver, and there is little focus on the operator’s ability to deliver a good service, even if you get the contract, it means you will do a lot of work for inadequate margins.

Taxi Business

Other than Rail and Bus segment, the Taxi Segment is a major profit contributor.

And this is the segment that is currently facing a challenging situation.

The taxi business is predominately made up of Singapore and China.

Taxi business makes up 36% of CDG’s EBIT.  Out of this, China makes up 25% of this, while 75% belongs to Singapore.

Nature of Business

The nature of the taxi business is similar to property management.

A taxi company purchases vehicles on the market. Then they attract prospective customers (who are the taxi drivers) to lease the taxi from them at a particular daily rate. Different taxi companies may have different payment schemes. Some have a monthly salary instead of rental provided the taxi driver satisfy a particular amount of trips per month.

There are allowances and incentives to attract taxi drivers to continue to lease from them.

There is a very strong network effect in this business.

As a consumer looking for taxi during peak hours, I would try to book a cab from the company that I have the greatest chance of getting a taxi. This will be the largest network.

As a client of the taxi company (the taxi driver), I will go with the taxi company that can reach the largest pool of customers.

Taxi drivers need to apply for a Taxi driver vocation license (TDVL) in order to be a taxi driver. The taxi drivers used to need to clock 250km per day. This is to prevent clients from renting the taxi but not using it for the purpose of taxi.

Taxi’s are given the right to take passengers who flagged off on the side of the road and also enter places where taxi are the official pick up points. Private cars were not allowed.

The taxi company also provide the client with intangible and tangible benefits.

The biggest being able to take bookings from consumers who called in to book cabs.

Each taxi purchased is leased to a taxi driver for 8 years and depreciate accordingly.

The taxi company is just like a financing company. A client do not have the capacity to purchase a vehicle for business.  So the taxi company does it for him.

The client then pays a rental fee, which includes the interest payment, principal repayment and residual profits for the value the taxi company provides. The Return on Asset is impressive.

The rental rate increased if demand for taxi outstrips supply. If supply outstrips demand the rental rate falls. There are also inflationary element to the rental rate.

The margin gets cut if the vehicle cost is more expensive. This means a larger portion of the rental goes towards depreciation.

Historical Profitability

The table below shows the 13 year historical figures for the taxi portion of the business. This should be a combined of local and overseas.

In short revenue for taxi division is very good over the 13 years. You do not see the kind of weakness like the other division. Taxi rental looks to be good business.

In terms of profitability there is a dip from $160 mil to $105 mil in 2009.

We can appreciate the results better if we include a snapshot of China’s profit contribution. China have a increase in profits from 2005 to 2008, follow by a gradual stabilization of profit contribution of 45 mil.

In 2008 almost 55% of the contribution seem to come from China. Today it is closer to 27%.

CDG’s success in China contrast against the drop in profits from 2004 to 2008. The poor profit performance very much could be attributed to the Singapore situation.

The Singapore local taxi scene in the past 10 years have been strong. The most recent dip? NOW.

Prior to that, the dip was during 2004 to 2009. Let us look at some other metrics.

Changes in Local Taxi Supply – Competition is not Good

CDG, with Comfort and CityCab have been the dominant taxi operator in Singapore.

While CityCab have shown weakness from 2005 to 2010, Comfort have shown a gradual growth, with the occasional spike in number of taxi.

In recent times, we have seen a fall off in the number of taxis for Comfort and CityCab. Both taxis dip to the 2011 levels.

In 2003, there was a proliferation of new private taxi operators.

We see many companies jump into the fray. SMRT, Transcab, Smart and Premier were the new entrants. This coincide with the drop off in CDG’s taxi profitability we observe from 2004 to 2008 results.

CityCab lost about 1000 cab by 2008 while Comfort gain 1000 cab.

In this period, Transcab added 2000, SMRT 3000, Premier 2000.

The competition from private hires did not affect Prime, Premier much but SMRT and Transcab was also affected as CDG.

Here is a more microscopic look at the number of taxis from each company from Jun 2016.

Competition in an environment where the demand and supply is matured will shrink the pie. It also constrains the taxi daily rental rate for each company.

While fleet was still increasing for CDG from 2004 to 2009, profitability was not rising.

If profitability is mainly determined by the amount of vehicles rented out, then CDG’s profitability should be much better in 2004 to 2009.

How Private Ride Sharing Companies GRAB and Uber changed the Landscape

Private ride sharing companies have been disrupting traditional taxi business in a very big way.

Removal of Exclusivity. Taxi Companies have always have the exclusivity to gain access to people looking for premium transportation through their call service, taxi stand and ability to take passengers flagging off. With an application that is on everyone’s phones and people familiar with getting cab this way, that exclusivity is gone.

Removal of the network effect. CDG’s strength is that they have a lot of taxi and thus consumers will naturally think about them first. What Uber and Grab did was to create a consumer taxi driver matching system independent of taxi company. This remove a big advantage of CDG. Their competitive edge was tore down overnight.

Increase the Supply. The application of Uber and Grab have allowed private cars to be able to moonlight and pick up passengers. This increased the supply of taxi like service.

Increase competition for drivers through incentives and flexibility. To build up the network of taxi drivers and  consumers, Uber and Grab have been providing incentives for both sides to use their service. Because they do not need to answer to their shareholders by providing payments in the form of share price rises and dividends for the time being, they can greatly increase the incentives to disrupt CDG.

This affects the expenses of CDG and in turn affects their margins.

Oversupply of Vehicles have pushed Rental Rates Down

The government have mandated that those drivers who would like to operate for ride sharing would need to apply for a Private Hire Car Driver Vocational License (PDVL)

There is a cost to this, not to mention time spent securing this license.

This reduce the number of people applying for PDVL. When demand reduced, there are more cars that less eligible people can drive.

This becomes a free for all fight for eligible drivers.

Macquarie reckons that there are lot of shortage of eligible drivers fighting for cars that needed to be leased out.

Competition increases Costs

And this means CDG’s margins for taxi segment will go down.

The maintenance of the corporate overheads, the book system and other incentives work better when there are economies of scale.

These things are fixed costs, while the vehicles, to me are variable.

If you increase from 11,000 vehicles to 15,000 vehicles, the costs do not scale up proportionately.  The gross profit go straight to the net profit.

In the opposite scenario, cost for CDG do not scale down proportionately as well.

To make matters worst, CDG have to increase their marketing expenses to be competitive.

Uber and Grab have breached the vast gap to tear down the traditional CDG’s network effect by using incentives.

They are front loaded with capital and deploying it as marketing expenses to acquire the network effect,

Look at it this way, CDG incur the fixed and variable costs, by owning the assets.

But Uber and Grab do have their costs. Because they are asset light, they incur larger than normal marketing expenses. That is their running capital.

The promotion above lets consumers take Grab without having to bother about the $2.xx booking fee. This promotion can take place from 3 days to 1 week.

In the past CDG do not need to provide incentives like this.

Now they have to come up with promotions like this. The cab drivers that I spoken to told me in recent weeks, there have been more efforts to provide consumers with incentive to book through comfort.

However, because they have fixed costs, they can’t go all the way.

The biggest incentives that CDG are unwilling to give is the incentives Uber and Grab gave to the drivers.

If a Grab or Uber driver makes a particular number of trips, they get to earn these incentives. These incentives does change.

For reference, the average daily number of trips made by Taxi drivers (not Grab or Uber) is 17.7. In a 7 day week period, they would have made 119 trips and earn 225 in the above.

But I suspect people will aim for the $450, which forces them to make 25 trips per day.

This driving incentives, according to what I read up, makes up 25% of the Grab drivers earnings.

If this incentive goes away, you will wonder if the Grab drivers will stick with Grab.

It is Easier for a Prospective Driver to get a Private Car Hiring License

Comparatively, getting a PDVL is easier than getting a Taxi one.

And in the above section, we can see that the total number of valid TDVL holders looks to be going down.

This picture is rather grim if you look at how much number of TDVL was issued (2016 Jan to Dec) versus now (2017 Jan to Aug).

Given the choice, and lower rental, people might just settled for a license which is a lower hurdle.

This does not bode well for CDG.

Car Rental without Being a Taxi is Still a Rather High ROA Business

The overheads if CDG operate as a Taxi business is likely more than that of a traditional car leasing business.

CDG does have segmental on Car Rental and Leasing.

If you look at their ROA, it is above 10% unleveraged.

Compare this to the average Taxi ROA of 12%.

A car rental company purchases the car as most of us do through the same COE bidding process and all.

Suppose they secured a car for $110,000. This car depreciates over 10 years, thereafter you can redeem some value.

The car rental company rents out for $50-$65/day.

If fully utilized, or when we say no vacancy, and rented out for a year, this is $55 x 30 x 12 = $19,800. There are some overhead cost, spread out by the number of cars leased out.

The costs do not go up proportionately as the number of cars leased out.

Even if you factor in $833/mth depreciation, it is still very lucrative.

And CDG have been renting them out at above $100 so you can imagine how lucrative this is.

However, in recent cases more of these are in idle state, and this means higher vacancy.

CDG Could Drastically Cut Down on its Capital Expenditure

Analyst expect CDG to not have to spend capital expenditure in the future.

The 2016 Capital Expenditure on Taxi is $326 mil. In 2015 it is $339 mil.

That is almost worth CDG’s entire dividend.

However, we are losing operating cash flow due to lower Taxi rental rates, operating leverage working against them, and higher vacancy.

Net net all these might just balance out.

CDG’s Taxi Segment Revenue in 2016 is $1340 mil. About 75% of this revenue is attributable to Singapore Taxi.

If we assume a fall of 11% fleet, this equates to a loss of $110 mil. The forward revenue for Singapore Taxi could be $895 mil.

If we take a 27% cut in rental rate from $110/day to $80/day, CDG will lose a further $241 mil.

In total they might lose $351 mil.

Net Net, CDG might end up with the savings from capital expenditure cancelling out the loss in vacancy and slash in margins in this scenario. If part of the capital expenditure is attributable to their China ops, and capital expenditure cannot be cut, net net, CDG should be suffering some $100 mil in Singapore Taxi Losses.

Country Segmental Analysis

It might be beneficial to take a snapshot of CDG’s international business.

This may let us have a better understanding about the nature of the business.

The table above breaks down the type of business that CDG have investments in.

Initially, I thought that it is over the past years that CDG manage to spread their footprint all over the world.

Not so. Since 2003, they have been in China, UK, Ireland, Australia, Vietnam and Malaysia.

The core business in these countries stay the same.

For example, UK/Ireland have been mainly doing bus public transport with less in taxi. This is the same for Australia, which they entered in 2005 and only added on private taxi business via acquisitions in 2010.

China in contrast, have a high proportion in taxi business.

This makes our job easier as we can tag Australia and UK/Ireland to appreciate the overseas bus business and China as a proxy to appreciate the overseas taxi business.

In terms of profit, Singapore is still the main contributor at 60% of the operating profit. China’s Taxi, UK/Ireland and Australia buses are significant contributors to the profit. Their business in Vietnam and Malaysia is less significant.

China

CDG have expanded into China over the years. In my notes on its acquisitions, it has been replenishing its taxi fleet, acquiring more taxi licenses.

 

From 2005-2007 there are more investments into capital expenditures, since the capital expenditure have been reduced. We can see a more consistent S$25 mil maintenance rate.

Capex as a % of revenue also went down dramatically since early investments.

Given this, we have seen revenue rising to 2009 before going down.

I wanted to see if there are any currency effect that would cause this. Based on the RMB to SGD movement, there seem to be some effect.

From 2009 to 2011, RMB weaken against the SGD, the revenue seems to weaken during this period as well.

From 2011 to end 2015, RMB strengthened against the SGD, the revenue seems to have stabilized.

After 2015, RMB weaken again, which coincide with the drop off in revenue.

I would think we cannot attribute every  revenue changes to currency movements. In recent times, the reports have indicate stiff competition from ride-share companies.

Given the revenue profile, it is somewhat surprising that after 2011, we do see some improvement or stabilization in operating profit. Capital expenditure since the early days have kept low (except in 2011) and the profit can grow despite the investment.

Initially, I do have the pre-conceived notion that a lot of the profit growth was due to business pumping in more money. Without money flowing in, there will be no growth.

This seems less of a case here.

Profit margin recovered after 2009 to a very healthy level.  The margins is where we think greater private hires or competitive taxi companies could bring it down, but CDG’s China business seems to be doing very well, despite the recent narrative about the stiff competition over there.

Due to the reduction in capex over time, seems return on assets do show some improvement.

On an average, CDG’s China business have an average of 12.2% ROA.

UK/Ireland

Next to Singapore, CDG’s UK business have been its biggest contributor to the bottomline.

Of note is the acquisition of radio meter cabs in 2008 and the acquisition of First PLC Group’s West London Bus Operations.

In terms of Capex, the biggest jump was the 2013 acquisition. Excluding that, the capital expenditure have been very stable at around $50 mil. The capex to revenue ratio is very low averaging 6%.

CDG’s UK business have not been doing very well in terms of revenue. The acquisition of First PLC’s West London business did improve its top line but looks to be decreasing as well.

If we take a look at the currency changes over the past 10 years, we can see a correlation of revenue with currency changes. GBP have been on a consistent weakening trend against the Singapore dollar.

This seem to coincide with the revenue movement.

Given the revenue movement, the operating profit looks much controlled. While revenue fell from 2008 to 2012, the profit is quite consistent.

I believe the reason for the better bottom line was due to better cost controls. You can see here that since 2008, profit margin have improved tremendously.

Prior to the purchase of First PLC’s West London business the profit margin is 7%. Since then its even higher.

CDG’s UK Bus business comes with a great 17% average return on assets. And it seems the acquisition in 2003 improve CDG’s UK business in terms of quality versus its existing business.

Australia

Since 2005, CDG sought to build up their Australia business by way of numerous acquisitions.

The big one was the joint venture in 2005 to purchase New South Wales largest bus operator Westbus together with CabCharge, which owns 49% stake.

In 2016, CDG purchased the rest of the 49% stake of CabCharge in this joint venture..

Due to the acquisitions, the CDG Australia’s capital expenditure stayed high above S$100 mil from 2005 to 2012.

After that the amount of capital expenditure went down.

In terms of capital expenditure to revenue, we can’t see clearly from the chart as a large part of the capital expenditure before 2012 was above that of the revenue.

If we take a look at the actual figures, after 2011, the capital expenditure stabilized and started to declined. In the last 2 years, its capex to revenue is quite similar to that of CDG’s UK business.

As the capital expenditure taper off in 2012, the growth in revenue for the Australian business also tapered off.

The moderation in revenue also coincide with the weakening of the Australian Dollar from 2012 onwards till 2016.

In all 3 cases, currency weakness against SGD have been a consistent story.

In contrast to China and UK/Ireland, CDG Australia’s operating profit did not stabilized after the send of their acquisition spree in 2012. Perhaps cost control was not done very well.

CDG’s Australia over the past years have enjoyed much higher operating margins of greater than 10% to as high as 20% versus UK’s 7% operating margins.

I believe the difference is that CDG operated more private buses in Australia, which means a better margins.

The analysts are estimating between 5-10% operating margins for the Singapore GCM contracts so this is not so far off from CDG’s UK margins.

While operating margins look good, the return on assets look much worse than the China and UK business.

Indeed, UK business has a lower profit margin, higher revenue, lower assets while the Australia business have a higher profit margin, half the revenue and much higher assets.

The full purchase of CabCharge’s 49% stake in their Australia Joint Venture will result in some cash flow going back to the shareholders.

Capital Expenditure Summary

From the segmental look, we can see the business needs to replenish existing vehicles and also there are the occasional investment capital expenditure for new licences.

Over time, after the initial acquisition, capital expenditure was stabilized. This is evident in UK and China.

When it comes to acquisitions, there is no major capital outlay that their retain earnings cannot handle.

On average CDG retain 38% of its net profit from 2005-2017. Based on a profit of $300 mil, that amounts to $114 mil.

Major overseas capex includes:

  1. 2005 China: $111 mil
  2. 2006 China: $111 mil
  3. 2011 China: $90 mil
  4. 2013 UK: $166 mil
  5. 2005 Aust: $142 mil
  6. 2007 Aust: $121 mil
  7. 2009 Aust: $359 mil
  8. 2010 Aust: $117 mil
  9. 2012 Aust: $109 mil
  10. 2016 Aust: $196 mil

There can be concurrent overseas acquisitions, but it is viable for acquisition to take place out from retained earnings and not through leverage (which is an additional lever to pull)

Currency Devaluation a Constant Theme

The issue with venturing overseas is that you need to contend with currency fluctuation. From the revenue profiles versus the currency movement historically, there is strong correlation that currency have a big effect on 40% of CDG’s profits.

Return on Assets Summary

From the review of the segmentals, we have a greater appreciation of the kind of return on assets we get.

This can be used in the future for estimation of future acquisitions.

Singapore is split of 50% bus, 50% taxi, China is mainly taxi. Getting 12% ROA in the last 6 years is not unheard of.

Australia and UK are mainly buses. Australia in recent years have a 7% ROA while UK enjoy a whopping 17% ROA.

Malaysia’s car rental business enjoy 10% ROA.

Overall, the ROA for any of the business on average, equals that to the cost of capital of equities (1o%)

Compare this to properties where CAP Rates (net rental income / value of property) tends to be between 3.5% – 8%.

These look like good businesses.

A Guess of CDG’s Future Cash Flow Profile

CDG has a diversified stream of income and they could move in different direction.

I think this fact was lost in the narrative.

For the folks reading this article, they might lose that as well because not may would read until so deep in HA HA!

Comfort Delgro Many Streams of Income

ComfortDelgro Many Streams of Income

If I were to do a rough break down of CDG’s EBIT it will be something like the above. Singapore Taxi is a big component, but it is still near a quarter of the EBIT.

If we are to invest for a 10 year horizon, we should be reviewing CDG’s baseline over 10 years and not 2-3 years. There might be pain. But how would CDG look in 10 years time.

China Taxi figures looks sturdy but we are under no illusion that there might be some pressure. The baseline in the future is that it will be affected by currency movement and competition.

Australia and UK bus business are affected by currency and their profits can be volatile.

The Singapore Bus and Rail business should do OK. While not winning TEL is not good because the contract for rail is longer. I doubt TEL and Downtown line is under a contracting model that will be as lucrative than the NEL. And this might be missed by many.

The Bus GCM Model will return lots of cash flow from the government, but will go down to paying debts. This segment will be cash flow positive and SBS Transit will try to return as much of the cash flow to the parent CDG. Downtown line will likely still bleed for 1 year but the growth of it will be “controlled”.

I am of the view the government will not give a lucrative contract with high operating profit margin that the operator can earn from due to the fire that they would drew from the public. It is likely something that will be close to what SMRT got which is a 5% operating margin that is capped pretty well.

The inspection business will be around because while there may be less taxi, there is a controlled supply of vehicles. This is unless the secular direction is for public transport to be so efficient that the number of vehicles will go down. This scenario is possible but not likely in the near term base case.

The lucrative aspect could be that with private hires, government may mandate a semi annual test of vehicles, or an annual test. This might be lucrative for VICOM.

The outlook seems to be more grey for VICOM’s testing division, whether they could stem the rot, whether the oil and gas testing is in some form of longer term rot.

The Automotive & Engineering segment is made up of both Singapore and China. While they do many other repairs, it is mainly to serve the CDG taxi fleet. In the future they may have to venture out and do business with the rest. My guess is that they already did but gain less traction.

Finally, the Singapore Taxi segment is facing challenges. The number of taxi will be cut. And the margins will be shaved.

If we revisit the Taxi Segment ROA, you will realize despite the change in number of taxis rented out over time the ROA hovers around 9% to 12.6%. On the average it is 11.5%.

China, which predominately does the taxi business have an average ROA of 12% so its not much different.

We can try to be conservative and take it that the ROA becomes 8%.

In 2016, CDG has the following Taxi Fleet:

They have 16851 taxi.

We are coming near the end of the challenging year and the Taxi Fleet for CDG is as follows:

So that is 15127 taxi. We can see a clear down trend.

So lets be conservative and guess that the future baseline number of taxi they will have is 12,000 and they earn a 8% ROA.

We assume each taxi earns $1 and if we have 17,000, the revenue is $17,000. There is a step down of ROA from 12% to 8%. The net effect is a -53% shave in EBIT.

So what if the situation isn’t that bad that the baseline taxi fell to 13000?

The net effect is not much to be honest.

What if the ROA isn’t that bad but similar to the low of 2009 at 9%?

Ah there is a difference. The margins is more important!  The eventual baseline will be more competitive hiring landscape.

That is the secular trend.

So let’s take all this add figure out the net EBIT change in the future.

comfort delgro profit change

We take it that due to the competitive landscape of the other country, and the currency fluctuations those would not change much. The other businesses are not affected.

The main change is the reduction in number of taxi and the impact to the automotive and engineering. This segment constitutes  38% of EBIT.

The net effect is a -17.35% impact on the bottom line.

However, what if, in the base case, the other segment does grow a respectable 3%?

The net effect is a 2% improvement. I suppose given 7 years of general country, market growth, CDG can get back to its current profitability.

So we have a -17% effect to profit growth to think about.

Valuation

When we reach this point, we have worked out this black box that is CDG.

Now we try to look at the valuation.

CDG is a multi cash flow stream business and usually we will do a discounted cash flow of each segment than do a sum of parts to add them together. We will then deduct off the net debt (total debt minus cash).

Discounted Cash Flow

But…. because I am tired I will not do this at 4 am in the morning. So you can do this and tell me what you get.

So I will do a discounted cash flow where the profit fell by -17% overall.

The FY 2016 EPS is about $0.15.

Assuming no growth, and a discounted rate of 10%, the intrinsic value of CDG is $1.245.

But what if we have a baseline growth of 3% after this?

We take it that CDG after a 17% fall in profit, enjoy a normal 3%/yr growth for 19 years, with the terminal growth rate to be 0%. The intrinsic value we get is $1.615.

Reverse Discounted Cash Flow

So I decide to take the first case of 0%/yr growth and see what is the discount rate CDG is currently trading at.

This is similar to doing the XIRR for CDG.

CDG now trades at around $2.04. So we try to make the intrinsic value to be $2.04 by changing the discounted rate.

The discounted rate is 6.09%.

We look at this as the interest rate of holding this volatile bond called CDG over the long run. I think its rather fair. If we reach a discount rate of 10% we got some value.

While they are different animals, you can compare how does this XIRR of 6.09% look versus some recurring cash flow business such as REITs (learn about them here):

There might be better investments around, with less of a baggage.

Of course this is filled with so much assumptions:

  1. is it only going to be a 17% fall in profit?
  2. in the future shouldn’t there be some inflationary growth of 3%?

All these affect the valuation. That is why its not always a straight forward decision.

Can the share price return to $2.50? What kind of Growth Rate are We Expecting?

Suppose that after this discounted cash flow analysis and reverse discounted cash flow/XIRR, we sort of think that the fair value discount rate, or required rate of return for the risk we are taking is 7.5%.

This can be subjective, depending on how you and I differ in seeing how risky or less risky CDG is.

But let us assume we agree, and its 7.5%.

If we want CDG to be at $2.50 so that we can break even, what kind of profile are we expecting?

If we fixed the discount rate at 7.5%, and the growth for 19 years to be 3%/yr, the intrinsic value is $2.60.

From 2004 to 2016, the Earnings per share of CDG grew from $0.10 to $0.15. The annualized growth rate is 3.1% during this period.  It is not impossible.

Price Earnings / Earnings Yield

So let us take a look at 13 years of CDG Earnings Yield:

I listed out the earnings per share and the free cash flow (which is based on operating cash flow without working capital). They are rather similar. The free cash flow for CDG in general have been slightly weaker than its earnings.

I listed out for each year, the share price that is 1 year later in March. That is usually the end of the financial work year where the financial results come out. For example, in 2015 Mar we will get the full year results of FY2014.

We can then compute the earnings yield. If we invert the earnings yield we get the price earnings.

CDG’s earnings yield have been rather high. Over the 13 years it average around 6.22%.

If we take 2004 to 2010, the average is 6.55%.  In the crisis (GFC) it was 7.23%.

It is only in recent years that we see some yield compression to an average of 5%. During this period the EPS went up 50%.

So where are we? Assuming a -17% growth in EPS of $0.15 to $0.125, at a share price of $2.00, the earnings yield is 6.25%.

That is about fair.

What could change this CDG Value Model?

Well a lot of things let me try to summarize them:

  1. The situation is not as bad as we made out: higher intrinsic value
  2. Automation and self driving cars reduces cost and bring synergistic business to Vicom, engineering services: higher intrinsic value
  3. Australia, UK and China business in the past, have been buffered by a strong Singapore Taxi. Now that situation has changed: could be lower
  4. Currency movement: could be higher and lower

Summary

Nothing much is left to say at this point. I think at $2.04 its a rather fair price to pay.

I tried to use 3 ways of valuing it and the numbers look quite close (because the assumptions are quite close haha)

The devil is always in the details. How differently do you see each business segment headed? That will affect the intrinsic value of CDG.

At one point the data shows the situation to be not too bad.

And this is because CDG have the public transport and testing segment that is unaffected by this.

Still, I feel i build in adequate buffer in my assumptions.

The likely XIRR if we want to even buffer in more negativity is 6.5%.

The growth rate will be important because if we can achieve the old 3%/yr growth rate, we have something there. However, if we look through that 13 year history, its been one where the Singapore public transport division have been suffering, Singapore taxi being very durable, and various growth from Australia, China and UK.

For that 3% to happen, you need the region to grow well, and for CDG to increase its overseas market share.

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Filed Under: Value Investing

Relooking M1 Limited – What has changed? Nothing Much

July 23, 2017 by Kyith 2 Comments

7 months ago, I did a piece on whether M1 and Starhub is a value opportunity or a value trap.

Back then the price is trading at $1.90. Today, we are not so far off.

Had you purchase M1, you would have gotten some good gains. That is, before the recent results were published.

Was my thesis wrong?

My thesis has always been fundamental and that thesis changes as more information is revealed and the environment changes.

This piece is about my reflection on what I see in the first quarter results. Subsequently after the announcement, M1 share price gapped down. I am struggling to see where is the strong double bottom my friend B talked about. If you manage to spot it do let me know.

I only see a huge gap that will be quite a challenge to fill up.

The valuation at this point is not much different from my previous article. The environment, from what I understand became more competitive, and M1’s result is reflective of that.

Reason for the lower profitability

The following table is taken from M1’s 1Q17 financial statements:

The nature of the business is such that M1 is largely profitable. However, what is of note is that operating expenses, out pace that of revenue growth.

On the right, I have pasted the 1Q16/17 results. We can see something similar, higher revenue but the operating expenses outpacing the revenue.

M1 provided further break down of the revenue and market share:

Mobile and International Call Services is down. Based on my last article, one of the reason given is a shift towards a plan where the subscriber do not overspend on data and international call.

Overspending on data have become the saving grace for the telecom operators for the past 3-4 years.

Back when I was reviewing the telecom operators, I couldn’t find how to grow, foreign labor migration have been stamp down since 2011.

Turns out, data revenue is good!

Number of customers is up and so is market share, so they are not losing market share.

However, all this comes at a price. If number of subscribers is up, yet total revenue is down, it is likely the overall plans are becoming more competitive. ARPU will have to go down.

My question is that does ARPU factor in cost normally, since it is Average revenue per user?

This is because acquisition cost per customer is much higher, rising from $329 to $379.

The data points to the telecom trying to be preemptive, to be competitive before the real competition comes. Plans are set more competitive with lower rates. At the same time handset discounts are getting larger.

A Glimpse at the Cash Flow

We have 2 quarters of results in, and we can see how well M1 have done.

The following is the cash flow statement for M1 in Q2:

There are some changes to the working capital, but depreciation year on year is largely similar and that operating cash flow before working capital shows a decrease but nothing to be worried about.

Here my computation of free cash flow takes: operating cash flows before working capital changes – interest paid – tax paid – purchase of fixed assets. I leave out spectrum rights as that to me feels more like an investment capital expenditure than a maintenance capital expenditure.

We get $30 mil in 2Q16 and $31 mil in 2Q17.

As a form of tracking, 2Q16 EBITDA is $77 mil and 2Q17 EBITDA is $67.5 mil

This is largely consistent. The notable difference was the purchase of spectrum which is likely one off.

I am interest to refresh my memory and see how it is versus that of Q1.

The following is the cash flow statement for M1 in Q1:

1Q16 Free Cash Flow is $47 mil and 1Q17 Free Cash Flow is $29 mil.

There is a large decrease, mainly due to higher capital expenditure. I won’t read much into this because capital expenditure is likely not going to be uniform quarter by quarter.

As a form of tracking, 1Q16 EBITDA is $78.5 mil and 1Q17 EBITDA is $73.5 mil

EBITDA wise, both quarter of results show a noticeable fall from 2016. We wonder whether this is going to be a trend.

Q2 EBITDA from Q1 shows some fall as well.

EBITDA margins according to M1 report have fallen from 40% to 35%.

The 1H16 FCF is $77 mil and 1H17 is $60 mil. Remember this excludes the $20 mil spectrum purchase, so 1H FCF could be lower. This may explain why they cut the dividend.

The 1H16 EBITDA is $155.5 mil and 1H17 is $141 mil

How much capital expenditure for the full year?

Telecom companies usually give guidance for capital expenditure as a percentage of revenue.

In my last article, I gave an estimate of $130 mil in total capital expenditure. Based on current $100 mil spending we are almost there.

If we based capex on 13% of its $1157 mil in revenue, the capital expenditure is about $150 mil. So its about an average of $140 mil.

Full Year FCF Estimation

Given this, the second half EBITDA could be $140 mil, the  capital expenditure $45 mil, the interest and tax to be $15 mil and interest expense $4 mil.

This will add a FCF of $76 mil.

This is estimated to bring full year FCF to $60 + $76 = $136 mil.

M1 Ability to pay dividends

In the past, M1’s dividend payout ratio ranges around 80% excluding the special dividends.

M1 Cut its Interim dividend from $0.07 to $0.052.

Facing a falling ARPU, EBITDA and higher capital expenditure that is the prudent thing to do.

Much of whether M1 could stabilize its dividend depends on its future cash flow.

M1 annualized dividend for the year works out to be $0.111

M1 have 930 mil shares. This means they will be paying out $0.111 x 930 = $103 mil.

Based on the estimated FCF minus the $20 mil spectrum cost, it works out to be quite close to this.

The question is whether M1 have stabilized or not. The competition have not come out yet.

Valuation

M1 have long term debt of $350 mil and short term debt of $76.6 mil. They have cash on hand of $6.1 mil.

Thus, net debt is $420 mil.

M1 total assets amount to $1189 mil.

The net debt to asset is 35%. This has edge up a fair bit from the $250 mil long term debt it used to own. However, telecom operators, due to their strong cash flow, and conservative gearing, can usually gear up a little for capital expenditure spending.

M1 current trades at $1.88. With the 930 mil shares outstanding, this bring their market capitalization to $1748 mil.

The Enterprise Value (EV), or Market Capitalization + Net Debt = $1748 + $420 = $2,168 mil.

Telecom companies are not asset based business, but businesses known for its stream of cash flows that can be volatile at times, but generally predictable.

A standard measure would be to use EV/ EBITDA.  This is to see how many times we are paying for the company and its debts, with the cash flow of the telecom.

If we annualized 1H17 EBITDA of $141 mil, we get $282 mil.

The EV/EBITDA works out to be 7.7 times.

7.7 times is quite fair in my dictionary. Usually, telecom at 8 times are fair, 6 times is attractive.

The dividend at 5.9% certainly looks attractive, however, I could have remember M1 trading at much higher (7%) dividends.

Summary

If I were to describe the business of telecommunications, they seem to go through periods of game theory like equilibrium. Then they compete further with each other and each of them end up with a smaller pie.

Still, despite the competition, the free cash flow is still commendable. This is as long as they do not require extremely large capital expenditure.

Part of the challenges of the current environment is that they require expenditure in spectrum and other forms of software investments.

5G is very fast, but it demands that you have adequate spectrum.  Thus they do not have a choice but to do something about it.

That is not to say the telecom operators can only compete on price. The next evolution of telecom operators is the set of application layer that resides on top of the data. So its from voice -> data -> application.

The problem is at the application layer, the telecom operators not only compete amongst themselves but other software companies.

If whatever M1 management say comes to fruition, then at this price its not a bad purchase.

You get a fair EV/EBITDA but a business that is predictable, cash flow generating, with economies of scope.

M1 is competing with Starhub and Singtel now, before TPG comes into the picture and I believe when TPG comes in they are ready.

However, we always go back to the base case. If you have a pie that is already saturated and you have some new entrants, everyone’s pie shrinks. They become more competitive.

If we purchase M1 because its 6% dividend is sustainable, recurring, what happens when their EBITDA that they can earn from the pie shrinks?

They look more expensive. The value point is definitely during the hay days when EV/EBITDA is like 6-7 times for Starhub and M1 WITH THE UPCOMING ISSUES LAID OUT IN THE OPEN.

The current situation is as such.

Again, I repeat, this is a good purchase if they manage to make use of their economies of scope.

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Filed Under: Value Investing

Rickmers Martime Winds Down. My thoughts on Position Sizing, the True Value of Ships and Prospect Theory

April 22, 2017 by Kyith 11 Comments

As human beings we tend to be risk seeking(gungho in taking on risks) when we should be risk adverse (afraid of taking risk) and vice versa, often at the wrong time.

In the case of Rickmers Maritime, I am not sure which is the case.

Rickmers Maritime is a business trust that I wrote about in the past that operates a collection of container ships. They were charter out during the good times at rates of US$25,000/day and now that the charter is coming to an end, the prevailing charter rates is closer to US$5,000/day.

This resulted in a plunge in cash flow, and the repercussion is that they are suppose to repay $200 mil in loan in 2017 and couldn’t get the debts to be refinance because the discounted cash flow of the ships are much less than in the past, and to the potential lenders, it does not warrant to lend them that much.

Rickmers stopped paying dividends, then Rickmers Maritime wanted to restructure their existing debts, where the bond holders would take on new restructure facilities and take on losses outright, prolonging the repayment.

This deal was a no no for the Rickmers Maritime Bond Holders and thus they do not wish to restructure this deal and take the losses.

This week, Rickmers Maritime ran out of means to get themselves out of the situation and would be winding down the trust.

Usually in this situation, the most senior bond holders would get their first take on the trusts assets (which usually are put to liquidation), then the more junior bond holders and then the equity holders.

Straits Times announced that they have found a buyer for the entire fleet of container ships at US$113 mil. Other than the ships, the trust do not have much assets of note, this means that many of the more junior bond holders and all the equity holders are wiped out.

The alluring thing about Rickmers Maritime is that, had you based on what the asset is worth on paper, you would think that the debt to asset ratio is safe.

The vessel values are based on historical cost and some how there was no impairment, if the true future value of the ships are much less.

The vulture deal to purchase the fleet at US$113 mil shows us how much the ships are actually worth.

Second level thinking is important here, when looking at financial statements in asking questions about the financial line item. One good one is whether these items on assets are valued at cost and what is the real value? What are the assets value based upon?

Ships are Commodities, just like General Industrial Properties

Ships by itself, unless very uniquely spec, in my opinion are not worth much without a charter contract.

This is the same as general industrial properties without some demanding specifications.

My friend likes to say industrial properties are just 4 walls.

What gives this and ships value is the quality of the tenants/charterers, the duration and terms of the contract.

Without the contract the ships are worth much less.

This is why I grew tired of this debate by the Sabana shareholders that state that the sponsors are selling the properties into the trusts at an expensive price and this disadvantaged the shareholders.

My question is: why can’t this property sell much higher than the properties around it?

Suppose I have this industrial property in Changi that Amazon are interested in, and they can pay for it. They decide to rent it from me at 3 times the prevailing market rent, and rent it for 10 years with 2% annual escalation.

I decided to sell this whole property and contract to my friend. Do you think I would sell it at the prevailing market rent?

This example, might sound extreme, but where does this stop? Does that mean that after this episode all the REITs should not take any sale and lease back? What is your solution to find properties that rent well, not sale and leaseback, are downright bargains when there are so many REITs, private equity funds and listed businesses looking for good deals?

If there is one good thing that came out of this exercise, at least I know how much is the market value of these 4250 TEU container ships (for my FSL review)

Prospect Theory

We all have the psychological deficiency that losses affect us more than winnings. This is asymmetrical.

In this case, the bond holders would rather cling on that they have 5% chance they would not lose 100% of their money and be more risk seeking about it.

They hope that:

  1. A white knight comes along and save them
  2. The container rates suddenly turn up to $15,000-$20,000/day

In my latest research, the container rates did turned up from $5,000 to $10,000/day. This came probably too late, and I am not sure whether the lenders are ok with that.

The right thing to do perhaps is to be Risk Adverse and take the deal, since to save Rickmers Maritime is to let it run longer, in the hopes that container rate does turned.

Diversification and Concentration of your Portfolio and its Relation to Risk Assessment Level

Many people are invested in Rickmers Maritime and their results would differ.

However, what we should think about is our levels of diversification and concentration in a single stock as such.

If Rickmers Maritime is a winner, you would want to concentrate 10% of your portfolio in it.

However, most likely it is not, and right now it is at the other end of the spectrum. Had you have 10% of your capital deployed, this would be wiped out.

Are you ok with 10% of $10,000 being wiped out? how about 10% of $100,000? or 10% of $700,000?

What is the significance of that absolute amount of money?

This is an aspect to think about.

Diversification is the solution to minimize these blow ups. However, that is sometimes the wrong way to think of things.

Many would go with the frame of mind that to minimize blow ups, I will buy small positions and be very diversified.

There are some mitigating actions. I talked about how I prospect businesses and determine my position sizing in my Expected Return Model.

If you do not diversify, you can have better focus on each of your position, and carry out better and more in-depth risk assessment.

You might be able to determine at an early stage you got it wrong, take the loss or the small profit and run away with it.

Diversification nowadays seem to equate to “I don’t need to know things in depth” and that is dangerous.

The better frame work is understand how much you could possibly lose in a position, are you ok with it, be diversified enough so that in the event the position really blows up, it doesn’t affect the overall objective (often wealth accumulation or financial security) all that much. Build better competency in assessing the business especially the scenarios that could likely go wrong.

Thinks will blow up in your face. You need to figure out the system that takes care of blow up regardless of your confidence in the situation.

To get started with dividend investing, start by bookmarking my Dividend Stock Tracker which shows the prevailing yields of blue chip dividend stocks, utilities, REITs updated nightly.
Make use of the free Stock Portfolio Tracker to track your dividend stock by transactions to show your total returns.
For my best articles on investing, growing money check out the resources section.

Filed Under: Value Investing

The Expected Return Model – How You can Refine Investment Decisions, Prospect Stocks Clearly, and Sleep Better at Night

March 26, 2017 by Kyith 4 Comments

Back when I was still figuring out all these investment stuff, I always have some questions that I couldn’t find in books or the people I listened to.

Some of the questions that often bugs me was:

  1. Should I buy and hold investments for a long time?
  2. When some event happen, that affects my investments, how should my plan deviate? Should I still hold on? Should I sell or buy more?
  3. How should I size my positions in an investment portfolio, such that I do not get a large part of my capital impaired, yet not be too diversified and make my effort not worth it?

Overtime, I found a metric to aggregate most of the quantitative and qualitative part of actively managed individual stock investing that allow me to answer the above questions.

And when I prospect investments, all the information are aggregated to this metric for me to evaluate should I purchase, sell, hold on. It allows me to compare against other prospective investment.

This metric is the Expected Return on an Investment.

This article is dealing more with actively managed individual stock investing, but I think this metric is applicable to other forms of financial assets as well.

Total Return on a Financial Asset

Before we dive into understanding Expected Return Model, it is better I explain briefly on Total Return.

In most financial assets you can invest in, your average return in a single year, most of the time is made up of 2 components:

  1. Cash Flow Yield of a Financial Asset – this can be an investment assets earnings yield, free cash flow yield, or dividend yield (if it pays out majority of its cash flow as dividends) (to learn more about differentiating the cash flows and earnings, you can read my write up here)
  2. The Average Capital Appreciation or Growth of the Financial Asset in a year – suppose the asset grow x% over 5 years, we could work out what is the compounded average growth for a single year in those 5 years.

Both are expressed as a percentage.

When you add these 2 together, you will get the total return for the investment in a single year.

Here are some examples:

  1. Average cash flow on an investment property is 1.5%/yr, the capital appreciation per year over the past 5 years is -3%/yr. The total return over this period is thus 1.5% – 3% = -1.5%/yr
  2. A REIT proves an average cash flow of 7%/yr for the past 10 years based on current purchase price. Over the past 10 years, the REIT’s value grew by 2%/yr. The total return over this period is thus 7% + 2% = 9%/yr
  3. Gold does not prove a cash flow, thus its cash flow yield is 0%/yr. Over the past 10 years, gold provides a capital appreciation of 4%/yr. The total return over this period is thus 0% + 4% = 4%/yr

When you see the Total Return in the examples in the article, I am referring to an aggregation of the cash flow yield plus the average annual capital appreciation of an investment asset.

What is Expected Return?

The metric that I use to guide many of my final investment decision is expected return.

If you have studied higher maths or statistics at some point in school, you might heard of it.

The Expected Return is the amount of profit or loss on a single investment based on the returns of various investment scenarios that single investment could undergo.

We multiply the potential outcomes of each investment scenarios with the chances of that investment scenario occurring, aggregate them up, to come up with an expected return.

Chances or Probability of each investment scenario happening, when add up must equal to 100% or 1.

The expected return is usually express in percentage.

The SIA Engineering Case Study

It will be rather dry and hard to understand if we talked about the definition, so here is an example.

SIA Engineering is one of the reliable company listed on the Singapore Straits Times Index.  It carries out Maintenance, Repair and Overhaul (MRO)  mainly for SIA, but also some airlines that make a pit stop in Singapore.

For some time, it was known as a reliable business with a competitive edge.

While it has a competitive edge, you are paying a rather dear price for it. For some time, it has been trading at 20 times PE, or it has an earnings yield of 5%. Organically, the growth of SIA Engineering should be pretty similar to GDP growth of 3%.  This gives it a total return of 8%.

This is the core baseline scenario.

Another scenario that could be possible is that, Changi Airport develops further, more airlines stop over and more potential contracts for SIA Engineering. In this case while earnings yield is still 5% at this price, the growth rate could be 5%/yr. This gives a total return of 10%.

The last scenario that could happen is that, the OEM companies are interested in this lucrative business and competes with SIA Engineering. Since SIA Engineering have particular dependency to the OEM in their existing work, the OEM could come up with very unfavorable terms such that SIA Engineering is always at the losing end. In this case, the business might be adversely affected. The realistic cash flow yield is reduced to 3%. The growth rate over the next 10 years is -2%/yr. The total return, under this scenario is 1%.

Based on our qualitative work, we determine particular probability each of these 3 scenarios will occur.

We can then come up with a rough expected return, from what we understand of SIA Engineering:

The Expected Return on SIA Engineering is computed as  (8% x 0.80) + (10% x 0.10) + (1% x 0.10) =  7.5%/yr.

This expected return is more than zero, which means it is a positive expected return. By this point, you should have figure out mathematically how to compute expected return.

When you have computed an Expected Return this way:

  1. You have think through the total returns profile of the stock you are evaluating
  2. You have think through the business model, and what kind of scenarios that will affect this investments
  3. You have made a risk assessment of the likelihood of the scenarios happening
  4. You have come up with a figure that you could use to compare to something

Scenarios are a form of Risk Assessment

I wrote about risk in investment and wealth management in the past. You can read my mammoth article on it here.

Risk, in short are deviation from the original intended outcome.

The outcome in investing is that you have a particular expectation of the total return.

The alternate scenarios, can be seen as positive deviation (risk) or negative deviation (risk) from this particular expectation. Many of us associate risk with negative outcomes. There are positive outcomes that you have not think of as well.

By factoring the various scenarios, we hope to cover, to a good extend what could happen to our investment return.

Evaluating between Different Investments and Opportunity Costs

When you have worked out the Expected Return for an investment, you have something that can compare this investment, at this point in time of evaluation to something else.

When we evaluate a stock, we are comparing where and how best to deploy our capital.

Thus, it is an evaluation between:

  1. Adding on an existing stock versus purchasing a new stock
  2. Buying this stock versus staying in cash capital
  3. Buying this stock versus Investing in Risk Free Asset such as Government Bonds

Comparing between 2 Investments

#1 could look something like the example below:

Comparing SIA Engineering Expected Return to Frasers Logistic and Industrial Trust Expected Return

Comparing SIA Engineering Expected Return to Frasers Logistic and Industrial Trust Expected Return

SIA Engineering and Frasers Logistics and Industrial Trust (FLT) are very different monsters.

Despite that, as an investor, we are evaluating where best to deploy our money. A sound evaluation of the scenarios and the return outcome of each stock allows us to come up with an expected return.

We will be able to compare, factoring the potential growth, potential decline possible for each stock, which one is a better deployment for our capital.

SIA Engineering do look like a good investment if we look at it on its own, but when we put it against FLT, a current investment holding, it might not look as appealing.

It might in turn tell you that your capital is better, staying (or even adding on) to your existing FLT.

Your evaluation is not just constrain to 2 stocks. It can be between a stock, a REIT versus another investment assets such as an investment property.

Comparing the Expected Return of SIA Engineering versus an Investment Property

Comparing the Expected Return of SIA Engineering versus an Investment Property

In the table above, an investor compares his decision to plonk down $300,000 into SIA Engineering, versus putting the $300,000 into a residential investment property on leveraged.

For simplicity there are 3 scenarios, the baseline, where the growth rate is moderate at 3%, and the owner services its mortgage in full by rental. There is the more sanguine scenario 2 and the pessimistic scenario 3. The probability of each scenario occurring will depend on the investor’s purchase price versus value, climate, and future outlook.

The Expected Return is 4.3%. When put against SIA Engineering’s 7.5%, SIA Engineering looks a better place to deploy the capital.

Comparing Between an Investment and Staying in Cash

This is a straight up evaluation of whether we should buy or sell.

You might find it strange because cash expected return should be rather low.

It could be 0.25%, or if you put your cash in short term savings instruments that I introduced here, your expected return may bump up to 1% to 2.5%.

A lot of financial assets could beat this handily.

Comparing the Expected Return of an Investment Asset versus Cash Asset

Comparing the Expected Return of an Investment Asset versus Cash Asset

This is not always the case. Depending on your purchase price versus the intrinsic value, the future outlook, your expected return could be negative.

In the table above, the cash asset have an expected return of 1.5%. The investment asset that the investor wants to purchase have a baseline outlook, a more positive and negative outlook. The devil is in the probability each scenario will happen. A mistimed purchase may result in the expected return to be negative. In this case, this turned out to be a bad investment.

I will elaborate more on this in a section below.

Comparing Between an Investment and Risk Free Government Bonds

Comparing against cash most of the time look more extreme. In most cases, investors compare against the risk free rate, which we normally use a certain 3 year or 10 year duration government bonds.

Comparing Expected Return of SIA Engineering with 10 Yr Risk Free Government Bonds

Comparing Expected Return of SIA Engineering with 10 Yr Risk Free Government Bonds

Particularly, we could identify the current spread between our investment asset and the risk free asset.

Overtime, we would be able to know whether this expected return is higher or lower than historical spread. This form of evaluation is more useful for interest rate sensitive assets such as bonds, REITs and business trusts, telecom stocks.

Comparing Between Investments and Cost of Equity

As stock investors, when we invest, we would want to ensure that we get a decent return versus the opportunity costs of putting our money elsewhere.

And that can be putting our capital in other stocks. Thus one measure is against the cost of equity, or how much equity in general cost elsewhere.

While there is a mathematical formula to compute weighted average cost of capital (WACC), I tend to use a rule of thumb:

  1. 8% for less risky assets
  2. 10% for standard assets
  3. 12% for more risky assets

When we work out our expected return, together with our profile of this stock, we can determine if this stock is attractive versus the opportunity cost of not investing in this stock.

What do you need in your Stock Prospecting Tool Box to work out the Expected Return?

Since the expected return is an important part of my evaluation process, we need to be able to put the figures into the tables you see in the example.

You will need to work out:

  1. What are the various scenarios that could affect the investment assets over time
  2. What are the total return for those scenarios
  3. What is the probability of each scenarios happening

The short answer here is that you need to have or to acquire knowledge in this field (which is why 1 of the key success criteria to build sustainable wealth is knowledge and wisdom)

To work out the various scenarios, you need to have a certain degree of understanding of the business or the nature of the investment asset.

The majority of the work I do here is to read through the underlying business of the stock, or the asset class to understand how they work to a particular level.  This is the qualitative part of the work required.

Then we review the financials of the business or if it is not available, we compile the financials gain an insight how have the business perform in the past, and the nature of the business from the numbers perspective. This is the quantitative part of the work required.

Doing both the qualitative and quantitative part, allows us to form a picture of the business and during this process we would be able to ask questions that forms these scenarios. We will also be able to figure out some of the cash flow yield, growth rates that we can expect in the various scenarios

A 9 years compilation of Micro Mechanics financials

A 9 years compilation of Micro Mechanics financials

For example, the financial snapshot above is of a listed company in Singapore. The financials gives us a picture of the nature of its revenue, expenses and profit.

It manages our expectation whether recent good profit is something out of the ordinary. Good businesses or business with good managers over a long period should show its quality in its net profit.  In this case, a review of the result would show that there are some years in 2009 to 2013 where net profit dipped from a high of 8.8 mil in 2008 before returning to the same levels in 2014.

This may tell you that earnings are not so consistent, and going forward what are the possible scenarios. Is the profit we are seeing this year high in a very cyclical industry? Or is this profit going to be consistent due to a change in dynamics of the company or the industry.

For this, you would need to understand more of the nature of the business and industry.

This qualitative aspect can be done through:

  1. Reading through all its historical annual report, focusing on the change in its industry and the company’s reaction to the changes
  2. Spend 1 to 2 days focusing on digging into all things about this industry
  3. Reading through competitor’s annual reports
  4. Reading brokers analyst reports, with the sole focus on the qualitative and quantitative things and not the target prices

The deeper you do the qualitative and quantitative work, the better picture you form. You can come up with more possible trajectory for this stock, and identify its total return better.

Probability of each scenario happening can be subjective and its also a function of your feel of your work.

When there is an Absence of Scenarios. What do I not know!

If you do not do the work, or have not form a good picture, you might not come up with many deviating outcomes.

In some businesses, no matter how much work you do, you will feel like there is much about this area that you are not sure about.

This is normal (provided you know you are rather competent in investing, and have done the prospecting work required).

Known Unknown

Knowledge in various areas can usually be group into the above 4 groups. The first group are the information, data, knowledge that people know and that you know as well. The second group are the common information, data, knowledge that most people know they have a difficulty to find out and you are aware of that.

The third group is the information, data and knowledge people are aware of, but not to you (for some reason due to yourself or high search costs). The fourth and last group is the information that nobody knows at all.

A deep qualitative and quantitative prospecting work will suss out the first and second area.

The challenging part is the third and fourth area.

The fourth area is something that is tough to see. However, you can control this by either staying away, or be diversified enough so that this single collapse do not impede your current and future living conditions.

The third group is the subjective one, depending on whether you have prospect well enough, or whether information is readily available.

Expected Return for Too much unknowns

Expected Return for Too much unknowns

The translation to expected return for SIA Engineering is as above. Your expected return becomes more volatile because it could end up as a good outcome or a bad outcome. For each the total return and the probability of them happening is unknown.

Why do We Lose Money?

We often lose money when:

  1. We couldn’t define the scenarios well
  2. The scenarios we define we were too over-optimistic about the total return (most often the growth rate) and the probability of the scenario playing out
  3. There are too much Unknown Knowns

For example, we have a stock whose business cash flow profile looks like this:

People Know but You didn’t See:

  • 2007: $15 mil
  • 2008: $1 mil
  • 2009:  -$4 mil
  • 2010: $2 mil
  • 2011:  $8 mil
  • 2012: $1 mil

What you know:

  • 2013: $8 mil
  • 2014: $14 mil

We are at the tail end of 2014.

Upon seeing the growth of cash flow announced from $8 mil to $14 mil, the share price of this stock surprises on the upside.

Based on the $14 mil cash flow earned by the stock, the share price is not expensive at all.

This is the cash flows in the future 3 years:

  • 2015: $6 mil
  • 2016: $-3 mil
  • 2017: $2 mil

When the result shows that future cash flow is not going to grow upwards above $14 mil, the share price will plunge accordingly. The future cash flows shows a return to the 2008 to 2011  period.

The investor fell into a valuation trap because of unknown knowns. Inadequate information, due to his or her competency, results him in having a distorted expected return model.

He or she has the view that the cash flow profile will stay at this range or higher.

The total return is expected to be 2% cash flow yield + 23% capital appreciation. Since there is no alternate scenario, his thinking is that his expected return is 25%.

Could we have Averted this Loss of Capital with more Prospecting Competency?

In this particular example, we could.

More quality prospecting would have identified that:

  1. Cash Flow profile in the past is erratic
  2. Qualitatively, the business has not changed much that more consistent cash flow will be the case in the future
  3. Business is very order-book based and 2 to 3 years of good results is common. Longer than that is hard to predict.

The expected return that you could then come up with will be very different. You would realize the great growth scenario’s probability is much lower. There could still be a possibility of a bigger upside (scenario 3), but in all likelihood scenario 2 is the dominant outcome.

High Conviction versus Low Conviction – Viewed from the Expected Return Angle

Conviction refers to the belief that we have. In investing context, it is how high or low of a belief in our investment thesis.

I can honestly tell you, conviction shifts.

Conviction changes the more we reflect on our investments, and the more prospecting work we do. It also changes when new information and knowledge comes about.

When conviction level changes our Expected Return Model also changes.

Evaluating between an Investment at Different Time Period

One realization investors that started their journey may not realize is that the nature of the business and its interaction with the environment changes, and so the value of the business also changes as well.

They wanted some valuation metrics to let them know if a particular stock/business is good to buy or not.

How they view these metrics is that the metrics are static. That is not the case. Stocks shift from cheap to expensive, stay expensive, then becomes cheap. Intrinsic value is volatile.

If we view it from the Expected Return Model perspective, the following parameters would change:

  • Probability of Outcome Changes
  • Total Return for each Scenario Changes
  • More scenarios
  • Unknown Knowns get Reduced

This might present actions to :

  1. Buy in small quantitites
  2. Buy in huge quantities
  3. Sell and Exit an Investment that we thought its good, but actually isn’t
  4. Hold in relax position
  5. Hold but keeping an eye on the door to rush for exit any time

The evolution of prospecting a stock/business that is first unknown to you usually go like this.

I first invested in Straco, which is a small company listed on the SGX at $0.17. When its price almost doubled, I added a bigger chunk of my money. Then when it doubles again I added more but in lesser quantities. The share price rose hit $1, and now its languishing at the price that I last added at $0.76.

What guided my decision is not only the price, but the intrinsic value of the business, and my understanding that forms the view of the intrinsic value of the business. The latter will shift as you delve deeper and reflect more on the stock (which means you need to devote enough time to think)

At the start, I wasn’t as competent as an investor compare to now. That is one factor.

While I did a lot of the quantitative and  qualitative work, there is much I still do not know about Straco to form a better picture.  The total returns look good at 10% but because there are much unknowns, with an emphasis on negative unknowns, the expected return model actually shows slightly positive.

When the share price reaches $0.30, more information is revealed to me. Some of the past uncertainties, or potential negative and positive outcomes become clearer. I also reached a stage as an investor where I was better then in the past.

While Straco’s share price have doubled,  which makes the total return based on historical less (scenario 1), I also gain an understanding that the cash flow growth rate are stronger than I expect when I first look at it at $0.17.

I also got an opportunity to attend AGM, talk to the CFO and did more research on my own to realize there are much competitive advantage to its current business but also more opportunities.

The result of this is that scenarios 2,3 and 4 appeared. They are both positive and negative. Even the negative scenarios would likely affect the business in the short term.

As more scenarios are uncovered, the probability of Unknown Knowns ( scenario 5 and 6) went down from 60% to 13% relatively.

The expected return in this case is near 9% which is more compelling then the original amount of nearer to 0%. It makes a more compelling purchase.

At this point of $0.76, which is the price that I last added, is it as compelling a purchase to add compared to last time?

If we look at how the total return and the scenarios, organic growth have slowed down for the aquariums. Thus the total return for the baseline (scenario 1) is less than previous. This is based on some past recent growth rates from financial reports.

We also realize that the cash flow build up, needs to replenish the Shanghai Aquarium, whose lease ran out in 2035. So the cash flow will go towards replenishing this asset. The return on invested capital on new projects now won’t be as rock  solid than Shanghai Aquarium or Xiamen Underwater. So the potential replacement also slows down. Changes to China’s migration policy have largely factor into the baseline scenario, so the probability is zero percent.

The expected return is 4.7%, much less than last time.

However, expected return is still positive.

My evaluation would be to look at this versus some other stocks and their expected return.

However, the upside of reinvesting into Straco is that I know it better now, and there are less uncertainties versus an investment that looks good on paper a tremendous upside but with more unknown outcomes.

How do you Size Each Position in your Portfolio?

Building on to the case study for Straco, your conviction for an investment will shift. Your knowledge on the investment will also improve, if you delve deeper into it.

The expected returns will also shift.

The basic idea is:

  1. High Expected Return – Add More
  2. Low Expected Return when many Unknown Knowns – Add Less

This sounds good on paper, but as I have illustrated, most work will be in the background where you are drawing a picture of the investment.

If you add more while there are more uncertainties, you are doing some dangerous gambling. Could turn out very well or very bad.

Some peers with high conviction could dare to put 50-75% of their portfolio into a single stock, because they make that stock their whole world. They spend like 80% of their maintenance and recurring investing efforts daily or weekly thinking about the scenarios and perspective on that one stock.

They are basically work as close to the owners as possible.

How do you Sleep more Soundly at Night?

You sleep more soundly:

  1. When you know you have an adequate level of prospecting competency
  2. You have done enough work on the stocks or investments you hold, working out the scenarios (positive and negative outcomes) and are comfortable with it
  3. You have identified that if you were to lose 80-100% of each single investment in your portfolio, life can still go on

Many people say sell down to your sleeping point. I feel this is not wrong.

However, your sleeping point will shift due to the level of clarity you have in stock prospecting and the investment.

The overall idea is that:

  1. You know the Wealthy Formula that holds true regardless of which way you build wealth
  2. You know the Formula to get you to achieve Financial Security or Independence
  3. You are critical about your competency in building wealth this way
  4. You are diversified to an adequate level

Feeling Anxious is Not a Bad thing. Yes it affects your health. However, it is that voice inside that asks the question: Have you done the adequate work required?

Why do People like to Invest in a Bear Market?

I know there are investors who are waiting for the bear market. Then they will plonk down all their money. They are waiting for 8 years almost.

Why is it so good to invest in the bear market?

The Expected Return Model explains this well.

When stocks goes through a bear market:

  1. Good companies, bad companies, mediocre companies go through price corrections
  2. Credit to companies tightened. Those companies that doesn’t manage well will be revealed for all to see
  3. Those companies who doesn’t have a plan for a challenging period will be revealed for all to see
  4. Uncertainties that previously we weren’t aware about will be revealed for all to see
  5. Those companies who have their shxt together will be available for all to see.
A stock that is prospected in the bear market

A stock that is prospected in the bear market

While the stock price has fallen, and so does the underlying earnings or cash flow, you would be able to find stocks with a combination of good cash flow yield and good future appreciation. This is a function of how cheap the price is.

More importantly, for most of these businesses, if you have doubts about their survivability as a business, much will be answered in a tightened operating environment. The Unknown Knowns to you, becomes much less.

The expected return is higher. And it is why stocks that are prospected well are like fixed deposits in the future.

The emphasis is on prospected well, because there are many stocks that have their price fallen, but showed bleak future.

What you should watch out for in a Bull Market?

In a bull market, or in a latter stage. The inverse of the bear market case will happen.

For those with competency, they will still be able to find good businesses to invest in, or special situations. However, in a market that is optimistic, there are likely to be much uncertainty how well the company does when credit tightens and operating environment becomes challenging.

This is more so for those companies that were recently listed with very short open operating history.

Thus in the bull market, tamper with your expectations. You have to sense how much uncertainty you have considered and the impact to the business.

You might be better not investing, or to put in a smaller position.

Much of the stocks will look like Straco in my early stage, where there are much unknown knowns.

The game plan then… is perhaps to be ready to sell when fundamentally it does not look right. Pull the trigger faster with more unknowns and observe on the side lines.

The Exact Maths is Subjective

You might be thinking, do I have to do this for all the investments that I am considering?

The answer is yes and no.

Calculating probability of the outcome is subjective. I mean, how do you attached a figure to some events? In project risk management planning, we typically use rounded up digits such as 10%, 25%, 35%, 70%. However, we are still basing the tangible figure on our gut feel of how likely that outcome will happen. We could draw upon the frequency of past incidence of the business we are prospecting.

However, the awareness that there are multiple scenarios, and that some scenarios you may not see if you do not do enough work, and the need to work out the returns that you will get are important.

Going through this process moves the investment to some closer to whether you owned a golden goose, or a normal goose masquerading as one.

What am I thinking in My Brain

For myself, this model is ingrained in how I see things:

  1. I constantly ask whether I know enough of this domain at this point that I am comfortable with
  2. What are the few scenarios we should be considering
  3. There are some baseline scenarios, operating in normal conditions, in challenging conditions
  4. Based on the nature of the business, the manager’s records, the owner’s motivation, what are the probabilities of positive and negative outcomes happening (positive outcome leads to catalyst for privatization, special dividends, acquisition while negative outcomes may mean minority shareholders getting short end of the stick)
  5. How is the valuations and the total returns on a potential investment now? Am I buying leaning towards expensive, cheap or rather fair?

How does Valuation Matters in the Expected Return Model?

Valuation matters very much.

Working through various scenarios let’s me know how much uncertainty at certain point. If there are more uncertainties than we are comfortable, we hope that the potential return is at least high enough to compensate for not knowing so much.

When we work out the total return, we could then compare against the returns for the business that have a similar profile. Businesses with better quality profiles we can afford to pay a higher multiple (but also not too high), while businesses that are volatile we have to be more vigilant with our holding period and the price we pay.

There are many forms of valuation metrics such as Price Earnings Ratio (PE), Enterprise Value/EBITDA, Enterprise Value/Sales, Price to Book (PTB).

Inverting some of these metrics gives us an idea how much earnings yield / free cash flow yield we get for the business versus historical, other prospecting stocks, cost of capital. If the yield is low, we often inserts in scenarios where the earnings currently are at peak and likely to be lower for the next 5 years. That will lower the eventual expected return and affect our investment decision.

The Take Away

The Expected Return Model is not for everyone. It is more so of an explanation of how I look at investments in general.

This is applicable whether it is REITs, investment property, stocks, managing a passive portfolio.

We are always looking for a positive expected return in anything that you invest in.

I mean, that is why most people want to put their money in fixed deposits isn’t it? The expected return you know is positive.

We invest in stocks, properties expecting that our returns are at least positive.

However, as I have shown, when you move above the risk free assets, there are uncertainties in investment.

Not doing adequate work lets you fall into the trap that you have a lemon masquerading as a sure thing.

I should also add, it doesn’t mean that you do all the work and you can weed away the lemons. This process I believe is proven to work, however there will be the odd blow ups. You have to trust the process.

If this is confusing for you, may I refer you to the thought process used by my peer B, who have a much simpler X + Y + Z = Total Returns model.

Let me know if your thought process is vastly different from this or somewhere along the same lines.

To get started with dividend investing, start by bookmarking my Dividend Stock Tracker which shows the prevailing yields of blue chip dividend stocks, utilities, REITs updated nightly.
Make use of the free Stock Portfolio Tracker to track your dividend stock by transactions to show your total returns.
For my best articles on investing, growing money check out the resources section.

Filed Under: Value Investing

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Kyith Ng is the founder of Investment Moats, which mentors you on wealth management towards Financial Independence

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