Regular readers of Financial Horse know that there is this exercise I like to run.
And it goes like this.
Imagine you’re a new Fund Manager who is raising a new fund. You’ve gone on a bunch of roadshows, called your loyal clients, and just raised $100 million.
You’re feeling pretty good about yourself now.
Then comes the hard part.
How do you deploy that $100 million into the market over the next 3 to 6 months?
The holding period you have in mind is approximately 5 to 10 years, but if a stock / REIT goes up significantly before that, you have no problems exiting the position early.
You have no existing positions since the fund is brand new. What stocks would you buy?
I love this exercise because it forces us to look at the market as it is, not as how we want it to be.
Too often in investing we get attached to a stock that we bought a while back, and it clouds our judgment. This exercise removes all that.
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1. DBS Bank D05 (SGX)
I think the key to DBS Bank in this market is (1) what price do you buy it at, and (2) what is your holding period.
Over the next 3 to 6 months, I think we’ll see an Emerging Market crisis, we’ll see a wave of corporate bankruptcies, we’ll see widespread unemployment globally.
Singapore is surrounded by EM nations who are dependent on commodities, so it’s fair to say we’ll not be immune.
At the same time, the Federal Reserve has cut rates to 0%, and history shows us that whenever they do this, rates stay down for at least 3 years. For a bank that makes money by lending to others, this is bad news.
So short term, DBS will be hit via a double whammy of:
Increasing Non-Performing Loans (NPL):
Expect more Hin Leongs, multiplied across the economy. I could be wrong of course, but the way I see it, Hin Leong is the canary in the gold mine. It was the first to fall, but it will by no means be the last.
Banks are highly leveraged by design. They take in $1 of deposits and loan out $10. So if $1 of their loan book defaults, the bank is effectively insolvent.
So yes, I agree that DBS looks very well capitalized now (as do all the Singapore and US banks – Europe is an exception). But if this crisis plays out over 1 to 2 years, and more companies start to default, even a fortress balance sheet can go bad really fast – that was the lesson from the Great Depression.
Falling Net Interest Income
DBS’s core business model is not rocket science. They borrow money at low rates (from depositors), and they lend it out at higher rates (to companies). The profit is the spread between the two.
This business model is as old as time itself.
The competitive advantage of a bank like DBS is the cheap cost of funding, because of all the mom and pop (ie. Us) that deposit our money with them at low rates.
So when interest rates are high, this is great for DBS – they borrow cheap, and they lend out high.
When interest rates start to fall like right now, DBS is in trouble. Think about it this way, the mortgage you took 2 years ago was financed at 1.8%. When it comes due at the end of this year, you’re probably going to refinance it maybe at 1%+.
That’s a lot of net interest income for DBS going up in smoke. So this dynamic will play out in the coming quarters, impacting DBS’s profits.
So at what price is DBS attractive?
The book value of DBS is about $20. The lowest it traded in 2008 was 0.7 times book value.
2008 was a financial crisis, whereas this time isn’t, so I don’t think we’ll see DBS hit GFC troughs. I think as a ballpark, 0.8 to 0.9 times book value looks pretty interesting, which is about $16 to $18+ range.
We’re still early in this crisis, and I think as 2020 plays out we’ll probably get a chance to pick it up at that price.
2. SBS Transit S61 (SGX)
When I look at SBS Transit, I’m reminded a lot of this other monopoly stock in a regulated industry that I really like: Netlink Trust.
I still like Netlink a lot, but at its current price, I’m less sure if I want to open a big position in it.
SBS Transit on the other hand, offers an interesting value proposition.
They basically operate a bulk of the bus services in Singapore, as well as North East Line and Downtown Line.
Prices are heavily regulated by the government no doubt about that, which places them in a similar position to Netlink in terms of ability to raise prices.
But at the same time, it’s also hard to imagine a competitor coming in to disrupt them. Just like how Netlink’s monopoly comes from the cost of building an entirely new Fibre network, SBS’s monopoly comes from the impossibility of building a new MRT line. Maybe the bus networks can be more easily disrupted, but it still requires regulatory approval, and Singapore is a pretty small market.
Earnings will drop in 2020 no doubt about that, as people travel less. Dividend has also been cut and will probably stay that way this year.
But mid to longer term, this is a monopoly business with strong cash flow, and a business model that likely remains resilient post COVID. And there’s a lot to like about that.
Received a great comment on SBS Transit that I thought was well worth the share. Extracted it below in its entirety, for your consideration:
SBS Transit has negative free cashflow (FCF) from 2008 to 2015.
FCF becomes positive from 2016 to 2019 since the introduction of bus contracting model (BCM) in 2016. FCF ranges from about $41-131 mil between 2016 to 2019. Assuming BCM is here to stay and a perpetual stabilised cash from operations of $83mil (close to 2019 cash from operations, lower than the average of $100 mil over the past 4 years) and average capex at about $29mil, that would generate about $54mil FCF. Based on the latter, it translates to about 10% FCF yield against 2019 equity. $54mil/10% (NPV of future FCF)+ 2019 equity of $526.741 mil would give a revised equity of about a billion. Dividing this figure by the shares outstanding would arrive at about $3.42/share. Against the closing share price of $2.94 on 5 May, this represents a 14% discount.
If I were to acquire the entire company at $2.94/share, based on the long term expected free cashflow from operations of $54mil/year, this would translate to a yield of slightly below 6%.
In the long run, this yield is likely to compress as investors move funds towards stable companies with higher yields and away from say 10-year government bonds. A lower yield expectation would translate to higher share price. Assuming 2020 profits at $55 mil (about 32% lesser than 2019 profits) based on 50% dividend payout ratio, it would translate to a dividend of 8.82 cents (2019 dividend is 13.05 cents) Against the closing of $2.94/share, this would be about 3% dividend yield.
Is this an acceptable return for a bus operator with a market share of 61.1% in 2019? How would this compare to another investment say a REIT that delivers at least 6% dividend yield and they are expected to pay at least 90% of their taxable income. Considering that 2020 FCF is likely to be lower than $54 mil due to lower ridership, should I still buy at $2.94/share? Interestingly, reference to page 120 of 2019 annual report, 8 bus captains commenced legal proceedings against the company. No provision is provided against the lawsuits. Trust that the compensation if any would be minimal impact to the balance sheet if the dispute is just over rest day and over time. Would more bus captains commence legal actions against the firm? Just my two cents worth.
3. Mapletree Commercial Trust N2IU (SGX)
I was pretty amused by the recent run up in Mapletree Commercial Trust (MCT).
I bought a pretty big position in MCT back when the circuit breaker was first announced at the 1.5x range, and the fact that I’m sitting on a ~30% gain just a few weeks later is pretty ridiculous.
For the record, I think the market is a tad too optimistic right now, because I really don’t see retail recovering for most of 2020, and probably a big part of 2021.
Think about it this way – May and June rentals have been waived by retail landlords, so that’s 2 whole months of rental gone. Even after the circuit breaker is removed, demand probably doesn’t bounce back to 100% immediately, and there’ll be a few tenants who rely on the COVID19 bill to postpone rental. And for any leases that come due in 2020, good luck renewing them at the exiting rentals. Any tenant that chooses to renew will be negotiating hard for lower rents, and no way you’re getting a new tenant to sign at 2019 prices.
I think the outlook for retail this year is pretty bleak, and how bleak will depend on how demand bounces back in the second half of the year.
My personal thinking? I think that we may get a short period of pent up spending as people rush out against post-lockdown, but this may not be sustained. COVID19 probably stays with us globally for most of 2020. And eventually recession and layoff fears will catch up, so consumers will also watch their spending. Things like cinemas and gyms are probably going to stay down for a while too.
About 40% of MCT’s portfolio is Vivocity, which is retail, and which is a popular tourist spot (Sentosa). So MCT is not going to have an amazing year too.
That said, I still think there’s a lot of promise in retail, in Singapore. Singapore isn’t like the US where I think retail malls are genuinely in big trouble. In Singapore, I think if you stick with great malls at amazing locations, they’ll still remain relevant 10 years out.
So the only question is price, and right now, the market still looks a bit optimistic.
I still think that before this year is out, we’ll probably see an opportunity to buy at an attractive price, so I’ll wait.
4. Mapletree Industrial Trust ME8U (SGX)
Mapletree Industrial Trust (MIT) is another counter that I bought back earlier in April at the low $2s range.
And again, for the record, I thought it was pretty pricey even at that price, so you have an idea of how I feel after the rally to $2.55 now.
I like MIT because I love the sponsor, I love the portfolio, and I love the exposure to US data centers.
But I don’t love the price.
MIT at a 4.8% trailing yield looks on the pricey side, especially when I don’t expect industrial space to be immune this year.
I think that as 2020 drags on, we’ll start seeing the effect of the global recession kick in, which will cause a fall in global demand, and corporate bankruptcies coming into play. Singapore companies are not going to be immune, and I think same story as retail will play out for the lease renewals.
Existing tenants will ask for lower rents or waivers, and new tenants are not signing at 2019 prices. This will be a headwind for industrial space in 2020 and 2021.
But again, we’re only at 1 May now. The global recession has barely even started.
5. Exxon Mobil XOM (NYSE)
So for the final stock, I wanted to pick something with big upside potential. Something that could juice the gains for the other 4, which are relatively conservative picks.
And I decided to go with the oil industry.
Oil is a tricky one. Personally, I bought some Exxon Mobil earlier in April, but I exited the position after the recent rally.
I think the bull case for Exxon Mobil is that the price oil will eventually recover. No doubt about that right, all the planes and cars operate on oil, so when the world restarts oil price will recover eventually.
But in stocks, how we get there matters. And short term, I still think there are structural problems with the industry. Namely, production is too high relative to the drop in demand, the production cuts from OPEC+ help but are not sufficient, and storage space may fill up very soon.
Oh, and I also think that the restart is going to be a lot tougher than we expect, with many EM nations struggling with COVID19 well into 2020.
And don’t forget the US Dollar. My base case is for a strong dollar in 2020, and this will wreak havoc on all the EM oil nations who borrowed in dollars. Are they going to pump more to balance their budget? Who knows?
Exxon Mobil will probably survive all that though. They’re the 100 pound gorilla in the room, so if there’s a company who get’s through this, it’s Exxon Mobil (the ex Standard Oil, the one Rockefeller founded).
But the short term could be painful. Royal Dutch Shell yesterday cut its dividend, the first time ever since World War II.
Yep you read that right. World War II, when Nazi Germany was invading Europe, was the last time this happened.
That gives you an idea of how massive COVID19 is for the oil industry, so this is definitely one to tread with care.
I get that not everyone likes XOM, so any other oil major or midstream oil player works too. Just do stick with the bigger ones with fortress balance sheets. Oh and I’ll probably also stay away from oil service providers for now.
Bonus Mention: Gold
So the rule I set for myself was on 5 stocks / REITs to buy.
But with where things are, I don’t think this portfolio above would be complete without some allocation to gold.
My base case thinking is that we have a deflationary cycle into an inflationary one, very similar to how 2008 / 1930s played out. So short term gold price goes down, and mid term it goes up.
The problem is that I don’t know how short is short term. If Trump decides to do a $10 trillion stimulus tomorrow and the ECB follows suit, the short term could be tomorrow.
What I do know though, is that based on my holding period for this exercise, there is a fair chance that gold goes higher from here – even though short term it may go down.
So the risk reward looks pretty compelling to me.
Now as always, this article is written on 1 May 2020, and will not be updated going forward. You can find my updated thoughts, together with my personal stock watch and portfolio, on Patron.
After writing this article, it’s just occurred to me that this portfolio is quite skewed towards the inflationary part of this cycle.
So this portfolio will do well in the inflation / reflationary phase, but less so in the deflationary phase. So to counter that, I think some tactical positioning is necessary.
I have a 3 to 6 month period to deploy the $100 million (based on the rules at the start), so short term, I’ll park the funds in Treasuries, USD, or SGD. This gives me some flexibility on timing of deployment, and ability to benefit from the deflationary part of the cycle. Heck I may even long the USD against certain EM currencies (or maybe the Euro?) just to juice some returns. But that’s a discussion for another time.
Share your comments below!
Reminder: We’re running a Labour Day Promotion for the FH Course and the REITs MasterClass. You get a big discount off the usual price, and a 3 month access to Patron thrown in.
A great way to make good use of your extended circuit breaker!
Find out more here!