Jeremy Chia, Author at The Good Investors : Page 5 of 21

Singapore Airlines Is Redeeming The First Tranche of MCBs – Is That Good For Shareholders?

SIA shareholders were treated to the news that the company was in a position to redeem the first tranche of MCBs. Here’s what that means for shareholders.

Singapore Airlines (SGX: C6L), or SIA, will be redeeming its first tranche of mandatory convertible bonds (MCBs).

These bonds were issued by the airline merely 2.5 years ago in 2020, near the peak of COVID-19 lockdowns. Back then, SIA had to pause most of its operations as passenger air travel was severely restricted due to the pandemic. Cash was short for SIA and it desperately needed to raise money. But things have improved significantly for the company this year as it reported a record profit in the first half of FY23 and free cash flow was also comfortably positive.

With its finances moving in the right direction, SIA’s management has decided that redeeming the airline’s first tranche of MCBs would benefit its shareholders. In this article, I explore whether the airline is making the right decision.

First, is redeeming the MCBs a good use of capital?

In my view, the short answer is yes. The MCBs are a costly source of capital for SIA and redeeming them early will save the company significant money.

The MCBs are zero-coupon bonds but have a set annual yield that starts at 4% before rising to 5%, and then 6% (head here for more detail on the MCBs). What this means is that the longer the MCBs are left unredeemed, the more expensive it becomes for SIA to redeem them in the future.

Moreover, if left unredeemed for 10 years, these MCBs will automatically convert to shares. The conversion price of the shares is S$4.84 at the end of the 10-year mark, which is lower than SIA’s current share price. (A low conversion price is bad for shareholders as it means more shares are issued leading to more heavy dilution.) Bear in mind, the conversion price is not based on the principle paid. It is based on the principle plus the accumulated yield.

If converted to shares, the MCBs will heavily dilute SIA’s current shareholders, leaving them with a smaller stake in the entire company.

All of these lead me to conclude that redeeming the MCBs now seems like an efficient use of capital by SIA on behalf of its shareholders.

But should SIA conserve cash instead?

SIA has a history of producing irregular free cash flow.

I looked at 15 years’ worth of financial data for SIA (starting from 2007) to calculate the total free cash flow generated by the company. In that period, SIA generated a total free cash flow of a negative S$3 billion. Yes, you read that right – negative free cash flow.

In 15 years of operation, instead of generating positive cash flow that can be returned to shareholders, SIA actually expended cash.

This is mostly due to the high capital expense of maintaining its aircraft fleet. Capital expenditure for the expansion of SIA’s business was only S$5.6 billion, meaning the value of its fleet only increased by S$5.6 billion.

I say “only” because even if I exclude the expansion capital expenditure, SIA only generated S$2.6 billion in total free cash flow over 15 years. This is an average free cash flow of just S$174 million per year. Keep in mind that this free cash flow was generated off of a sizeable net PPE (plant, property, and equipment) base of around S$14 billion in 2007. The free cash flow generated is a pretty meagre return on assets.

What this shows is that SIA is a business that struggles to generate cash even if it is not actively expanding its fleet. This said, SIA does have a significant amount of cash on hand now.

With the cash raised over the past two years and the strong rebound in operations, SIA exited the September quarter this year with S$17.5 billion in cash. Redeeming its first tranche of MCBs will cost SIA around S$3.8 billion, around a fifth of its current cash balance.

The airline also has a relatively young fleet of planes now, which means its net capital expenditure requirement for maintenance is going to be relatively low in the near future, which should lead to higher free cash flows in the next few years.

And with the global recovery in air travel as countries around the world get a better handle on COVID-19, SIA’s operating cash flow is also likely to remain positive this year.

As such, I think it is fair to say that SIA does have the resources to retire the first tranche of its MCBs pretty comfortably despite its business’s poor historical ability to generate cash.

Can it retire the 2021 tranche of MCBs?

This brings us to the next question: Can SIA retire the second tranche of its MCBs which were issued in 2021? To recap, besides the S$3.5 billion raised in 2020 via the issuance of MCBs, SIA raised a further S$6.5 billion through this second tranche of MCBs in 2021.

Including interest, the total outlay to redeem the second tranche of MCBs will be slightly more than $6.5 billion (depending on when exactly SIA redeems the MCBs).

After redeeming the first tranche of its MCBs, SIA will be left with S$13.7 billion in cash. But the airline also has S$15.8 billion in debt (including long-term liabilities), which means it will have net debt (more debt than cash) of around $2.1 billion.

Bear in mind that the MCBs are not considered debt according to SIA’s books. Instead, they are considered equity as they have a feature where they are “mandatorily converted” in 10 years. So the debt on SIA’s balance sheet are additional borrowings which will eventually need to be repaid or refinanced. Given the small net cash position, I don’t think SIA should stretch its balance sheet to pay back the second tranche of MCBs yet.

SIA executives should also have wisened up to the fact that the company should keep some cash in its coffers to avoid another situation where they have to raise capital through the issuance of stock at heavily discounted prices (which happened during COVID-19) or through borrowing at usurious terms. A secondary offering or expensive debt in troubled times will be much more costly to shareholders than the MCBs.

The bottom line

All things considered, I think it is a good move by SIA’s management to redeem the first trance of the airline’s MCBs. The MCBs are an expensive source of capital and retiring them early will benefit SIA’s shareholders. The airline is also in a comfortable financial position to do so.

But the second tranche of MCBs is a different story altogether. After redeeming the first trance, and given SIA’s history of lumpy and meagre cash flow generation, I don’t think management will be willing to stretch its balance sheet to redeem the second tranche of MCBs just yet.

It is worth mentioning that SIA also decided to start paying a dividend again. I would have thought that management would prefer to retire the airline’s second tranche of MCBs before dishing out excess cash to shareholders.

One needs to remember that despite its poor cash flow generation in the past 15 years, SIA still paid dividends nearly every year. In hindsight, this was a mistake by management as the distributed cash would have been better off accumulated on the airline’s balance sheet to tide it through tough times such as during the COVID pandemic.

Ultimately, SIA paid dividends in the past 15 years, only to claw back all of the money (and more) from shareholders by issuing shares in 2020. This was certainly a case of one step forward, two steps back, for shareholders. Let’s hope for the sake of shareholders that history doesn’t repeat itself.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Mental Model For Assessing Acquisitions

Are you a shareholder of a company that is acquiring another company? Do you know if the deal is good for you? Here’s how to find out.

Acquisitions often pose an analytical challenge for investors.

Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.

The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.

Here is a short primer on the things to look out for in acquisitions.

Accounting for cash outlay

Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs.

Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.

I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.

If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.

Let’s take Adobe’s acquisition of Figma as an example.

Adobe announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.

As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.

But given that it is a one-off expense, does this mean anything? A resounding, yes.

When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.

Consider dilution when looking at stock-based financing, instead of the current dollar amount

Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.

Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.

Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.

In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.

In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%.

This is the real cost of stock-based financing.

Is the acquirer overstretching its finances?

Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.

Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.

Let’s take a look at the Adobe-Figma deal again.

Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion.

Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.

Analysing the target company

Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?

As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc.

Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.

Second, will the combined entity work well together?

In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.

Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.

Does the price match the value?

Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.

In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.

Final Thoughts

Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.

With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.

If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.

The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Adobe. Holdings are subject to change at any time.

Pocket Aces, Stocks, and Variance

Variance plays a big part in poker. Investing is just like poker in that sense. We may deviate from our long term expected rate of return.

Pocket Aces is the best starting hand in Texas Holdem Poker. Against any other starting-hand combination, Pocket Aces will win approximately 80% of the time.

When facing just one other player, that gives Pocket Aces an expected return of 60%. This expected rate of return includes the times when Pocket Aces loses.

In poker, a profitable bet arises in any situation where your expected return is above 0%. Stock-picking is similar to poker. As stock pickers, we make calculated bets based on the expected rate of return. If the expected rate of return meets our target or exceeds other opportunities, then investing in the stock makes good investment sense.

Expected return for stocks

Like poker, when calculating the expected rate of return for stocks, we should consider all the potential paths a stock can take. In poker there are only two possibilities – you either win or lose. But stock picking is a little more complicated than that. There are numerous potential outcomes that we need to consider when estimating a stock’s expected rate of return.

Stock returns can range widely from -100% (a total loss) to +X,000% (thousands of percent) or more. The expected return for stocks should include an aggregation of all these possible outcomes.

Difference between expected and potential return

The expected rate of return should not be confused with the potential rate of return. The potential rate of return is the upside of investing and does not take into account the other possibilities.

For instance, in poker, when playing Pocket Aces, the potential return is 100% over a single hand played. But the expected return over many hands is 60%.

On the flip side, if you are holding a random starting hand against Pocket Aces, your potential return is still 100% as you still have a 20% chance to win the hand. But the expected rate of return is negative 60%.

Investing in stocks is just like poker. Many stocks may have high potential returns if the company’s management executes perfectly but the actual expected returns may be much lower or even negative as the probability that management executes so perfectly is low.

When investing we are looking for stocks that are just like “Pocket Aces”. These are companies that have high expected returns and not just high potential returns.

Variance and diversification

Another element of poker that transfers well to stock picking is the concept of variance.

If we play just one hand of poker, we are expected to lose with Pocket Aces 20% of the time. In the unfortunate case that Pocket Aces loses over a single hand, our actual returns for that game would be substantially lower than our expected rate of return.

Over two hands, we will break even 32% of the time, lose twice 4% of the time and win twice 64% of the time. In this case, we would now be below our expected return 36% of the time. Poker professionals call this phenomenon variance, which is why small-sample results usually mean nothing for poker players.

However, if we make numerous such bets on Pocket Aces, our rate of return will eventually converge toward 60%.

This is the same when investing in stocks. While we may have put our money in a stock that has a high expected return, the actual outcome may deviate substantially from the expected return.

Final Thoughts

I’ve been fascinated by the game of poker for many years. It is a game of calculation, game theory and exploitation of opponents’ mistakes.

Many elements of poker can also be transferred to investing such as position sizing, return calculations and even portfolio management.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Lessons From The Ongoing Bear Market

Surviving long-term, the importance of cash, and good management teams are some of the key lessons from this bear market.

This year demonstrated the cruel realities of investing in stocks.

Year-to-date, the widely followed US stock market benchmark, the S&P 500, is down 14%. Meanwhile, the NASDAQ Composite, a tech-heavier benchmark for US stocks, has lost 22% of its value.

But that’s just the tip of the iceberg. Many fast-growing companies have had it worse. For instance, the ARK Innovation ETF, an exchange-traded fund that invests in high-growth tech companies, is down by more than 50%.

Multiple stocks that were big winners during the COVID-induced lockdowns have also since returned all their gains; some are even trading well below their pre-COVID prices.

In my nine years as an investor, I’ve never seen such sharp and steep drawdowns across such a wide array of companies. But this likely won’t be the last time either.

With this in mind, I’ve penned down a list of investing thoughts to prepare myself for future downturns.

Don’t celebrate when prices go up

Stock prices gyrate wildly. During the booming market of 2020, there were many investors who celebrated when prices went up. Today, many of the stocks that rose in 2020 have returned all those gains – and then some.

2022 has so far reinforced the fact that stock prices really don’t matter in the short run. If prices run up without fundamentals, they will come back down eventually. Similarly, if stock prices fall below intrinsic values, don’t panic. Prices will eventually return to their underlying values.

As a long-term investor, I have learned to ignore near-term price movements and focus on business fundamentals and valuations.

Cash matters!

When stock prices were rising, companies could raise capital easily by issuing new shares at inflated prices. This increased their cash balances with minimal dilution to existing shareholders.

But now that stock prices have fallen, this source of capital has evaporated. Debt has also become more expensive due to rising interest rates.

It is in times of crisis that companies with strong balance sheets survive, while those with weak financials struggle. Companies that are burning cash and have insufficient cash may end up in a liquidity crisis or end up having to raise more capital at depressed valuations, which could severely impact existing shareholders. If these companies are unable to raise money, their debt holders may end up taking over them, leaving equity holders with scraps.

Invest in strong managers!

With asset prices low, this is a time for companies with the financial muscle to double down on investing for their future. This is a time when prudent managers shine through.

If a company has a great capital allocator at the helm, the company can come out of this bear market stronger than before.

Berkshire, for instance, has started to become more aggressive with its investments in terms of both buybacks and acquiring stakes in other businesses. I believe Warren Buffett’s recent decisions will pay off handsomely for Berkshire shareholders in the future.

Diversify

When stock prices were going up, there was a lot of discussion about concentrating one’s portfolio into just a few stocks.

But this is a risky strategy. Every company has its own set of risks that could result in long-term underperformance of its stock. Companies that are still growing fast and burning cash bear even more risk.

When investing for the long run, we are placing a bet on a company performing well for many years. This doesn’t always pan out. In fact, most companies don’t do well over time and the strong performances of market indexes are driven by just a small handful of companies. When investing, we never deal with absolutes. We are always playing the probability game.

As a long-term investor, survival and long-term steady returns are more important to me than simply maximising earnings. While having a diversified portfolio might reduce my expected returns, it increases my odds of long-term survival and stable returns.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Tencent’s Results Weren’t As Bad As The Headlines Suggest

Tencent’s revenue for the second quarter of 2022 declined by 3%. This may seem bad at first glance, but a look underneath the hood says otherwise.

Tencent released its 2022 second-quarter results last week and the headlines sounded pretty dire.

“Tencent woes mount even after US$560b selloff” – The Business Times

“Tencent’s workforce shrinks for first time in nearly a decade” – Bloomberg

“Tencent, the $370 billion Chinese tech giant, posts first ever revenue decline” – CNBC

If you’re just reading these headlines in isolation, you might think that Tencent is in dire straits. But that’s really not the case. On closer inspection, I think there a number of positives to take away from Tencent’s latest results.

Revenue growth will probably return after China’s lockdowns ease

Tencent’s revenue was down 3% to US$20 billion in the second quarter of 2022. This was the first time Tencent reported a decline in revenue but this shouldn’t have been a surprise. Most of Tencent’s revenue is derived in China and in the bulk of the second quarter of 2022, parts of China were still in COVID lockdowns.

There’s a common misconception that as an internet services company, Tencent will not be impacted by lockdowns. But this is far from the truth.
One of Tencent’s biggest revenue and profit drivers is its payments ecosystem, otherwise known as its Fintech segment. This is highly dependent on commercial activity and also includes offline payments. During lockdowns and when China’s economy is weak, this segment of Tencent’s business suffers. Conversely, when the economy reopens, the growth of Tencent’s payment business should start to reaccelerate.

Tencent also has a huge advertising business. When the economy stalls, advertisers cut back on marketing spending. In the second quarter of 2022, Tencent’s advertising revenue declined by 17%. Again, this should reverse when China’s economy improves.

Margins will get better

Tencent’s operating profit declined 14% during the quarter to US$5.5 billion, excluding exceptional items. Although this may seem alarming on the surface, there are signs that Tencent’s margin will climb in the future.

The company has been actively cutting costs and improving efficiency. In the second quarter of 2022, Tencent’s sales and marketing expenses dropped by around US$300 million. There were other cost-cutting initiatives, such as right-sizing the number of employees, stopping loss-making businesses, outsourcing unprofitable projects, optimising server utilisation, and exercising more prudence with content production in Tencent’s long-form content segment.

All of these cost-saving initiatives should lead to better margins for Tencent from the next quarter onwards.

Management is also confident about its Gaming business

Tencent’s revenues from both the domestic and international games segments were flat. The domestic games business was hampered by regulatory restrictions. For international games, the challenge came from the reopening of economies worldwide.

On the domestic front, the regulatory environment is starting to improve as there has been a resumption of the issuance of licenses for new games. In June this year, it was reported that China had issued 60 licenses to new titles, which is positive news for game developers such as Tencent.

In addition, Tencent’s current gaming franchises still have highly-engaged audiences, with engagement numbers for both domestic and international games being relatively high.

Tencent’s capabilities in digital gaming gives management confidence that the company is well positioned for growth once the challenging environment laps.

Share buybacks good for shareholders

Besides a likely turnaround in its business, Tencent has been using its capital to buy back shares. I think this is a value-accretive initiative given the fact that Tencent’s shares are relatively cheap compared to the value of its business and the potential free cash flow it could generate.

For perspective, Tencent has a market cap of around US$370 billion now. Its investments in public and private companies are worth around US$150 billion. This means the rest of Tencent’s business has a value of around US$220 billion, which is merely 12 times that of Tencent’s annualised operating profit for the second quarter of 2022. With Tencent’s operating profit likely to improve from here, the stock looks undervalued.

But don’t just take my word for it. Tencent’s own management has said its shares are very undervalued. In the latest earnings conference call, Martin Lau, Tencent’s president, said:

“We are very focused on returning capital to shareholders given we believe our share price is very undervalued and also undervalued in the context of our investment portfolio. So if you look at what we’ve done year-to-date, we’ve returned around $17 billion, $18 billion to Tencent shareholders. And we’ve been largely neutral in terms of our investments, divestments in other companies, excluding the substantial JD divestiture. So our focus from a sort of investments perspective has been buying back and dividending to our own stock, and that will likely remain the case going forward for some period of time. “

Bottom line

Headlines don’t always paint the full picture. In Tencent’s case, while the headlines conveyed a story of a company in dire straits, Tencent’s business is actually in a strong position to return to growth. The operating climate is challenging but Tencent’s core businesses remain in a good position.

Its shares are also priced at a low valuation, giving management the perfect opportunity to buy back shares and reduce its share count. This should be a long-term benefit to patient shareholders.

Based on today’s valuation, I think patient shareholders who are willing to hold shares for the long-term will likely be well-rewarded in the future.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Tencent. Holdings are subject to change at any time.

Can You Make Money By Investing in a No-Growth Company?

Should you pay up for a growth stock or look for bargains among stocks that are not growing. Here’s the low down on which investing style works.

We know that investing in high-growth companies can be very rewarding. But there are more ways to make money than investing in growing companies.

A classic example

A great example of a company that has not grown but has still given shareholders sizeable returns is Vicom .

Vicom is a vehicle inspection company based in Singapore. It is mandated by Singapore laws that all cars in the country have to undergo an inspection either annually or once every few years depending on the age of the car. A majority of the vehicle inspection centres in Singapore are run by Vicom, giving the company close to a 75% market share in the sector.

However, because of its relatively high market share, Vicom has limited opportunities to grow. Moreover, in recent years, the Singapore government has targeted zero vehicle growth on the roads to reduce congestion. This has limited the expansion in the addressable market for vehicle inspection in Singapore.

I also suspect that Vicom’s inspection business is regulated by the government, which limits the company’s ability to increase its prices too aggressively.

Because of these reasons, Vicom’s business has been stable but growth has been non-existent. The table below shows Vicom’s revenue and profit since 2012.

The company’s revenue and profit have barely budged for a decade. Yet shareholders who bought Vicom’s shares in 2012 have made a healthy profit.

A decade ago, the company’s share price was S$1.13. Today, they are norht of S$2. As such, Vicom’s shareholders have enjoyed capital appreciation of 82%. In addition, shareholders have collected a total of S$0.751 per share in dividends, which translates to a 66% yield based on the S$1.13 share price.

What’s the catch?

Shareholders who held on to Vicom’s shares for the past 10 years had earned a total return of 148%. And that’s even excluding any potential returns from reinvested dividends.

So why were shareholders so well-compensated despite Vicom not growing in the past decade?

Firstly, Vicom’s shares were trading at a low price a decade ago. At that price, investors could scoop up shares relatively cheaply and earn a decent return simply by collecting dividends.

Secondly, Vicom’s management decided to reward shareholders by paying a much higher dividend per share over time. Vicom had accumulated large amounts of cash on its balance sheet over the years and had little use for it. You can see this play out over the years as Vicom’s dividend payout ratio rose and exceeded 100% in four of the last five years. Management’s decision to pay shareholders a larger dividend caused Vicom’s share price to appreciate as investors were willing to pay a higher price given the higher dividends.

From this, we can see that when investing in no-growth companies, shareholders need to buy at a low valuation and hope for a rerating in the share price to make a capital gain. Oftentimes, a catalyst needs to occur for the share price to appreciate. In Vicom’s case, an important catalyst was management’s change in stance toward its dividend payout ratio.

If you buy Vicom’s shares today, it is unlikely that its share price will appreciate at the rate it did in the past, given the already high valuation of the shares today and the limited opportunity for further dividend growth given the already-high payout ratio.

What to look out for when investing in no-growth companies

Investing in companies that are not growing can still be rewarding. But it is important to know that not all no-growth companies will perform as Vicom did.

When looking at slow-or-no-growth companies, one of the main things to look out for is a low share price. If a company is trading at an unreasonably low multiple, even if its earnings don’t grow, the share price can still appreciate over time.

Next, when investing in slow-or-no-growth companies, it is important to look at the company’s cash position and dividend payout ratio. A company that has more than sufficient cash on its balance sheet is likely to eventually decide to pay that excess cash out as dividends. This provides shareholders with more dividends and can be a catalyst for a re-rating of the share price.

Third, look for a business that is resilient. Vicom’s business has not grown in a decade, but its revenue has not declined either.

If you invest in a company whose profits are declining, the valuation multiple might compress further and what may seem like a value stock will end up as a value trap. On top of that, if profits are declining, management will probably not increase its dividend payout ratio in a bid to use its cash to reaccelerate growth, oftentimes ineffectively.

Lastly, because dividends are a major source of returns when investing in a slow-or-no-growth company, it is important to find companies that are domiciled in places where there is no withholding tax on dividends. For example, if you’re a Singaporean investor, you should not have to pay tax on your dividends. But if you invest in US stocks, there is a 30% tax. As such, it is best to stay away from such companies in the US.

The bottom line

There are many ways to invest in stocks. Although I prefer to pay a higher multiple to invest in growing companies, other investors may prefer to buy no-or-slow-growth companies at a low multiple and wait for valuation re-ratings and/or to collect dividends.

Whichever method you prefer, the main thing is to find a style that you are comfortable with and suits your investing appetite.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time

Why Shareholders Shouldn’t Fret Over Short-term Fluctuations in Business Growth

Businesses can have good years and bad years. But the good ones will eventually keep growing.

As a long-term investor, business fundamentals matter more to me than the near-term fluctuations in stock price. That’s because if a company can grow its free cash flow per share every year, the share price will likely follow suit over the long term.

But this does not mean that a company which has a bad year will be a bad investment.

The truth is that businesses don’t grow in straight lines. Even the fastest growing companies have periods of time when growth decelerated or even turned negative. Business growth depends on a host of factors, some of which are not within the control of companies.

Let’s take Apple for example. Today, Apple is the largest listed company in the world but its business experienced ups and downs along the way.

The table below shows Apple’s revenue and revenue growth from 2007 to 2021

From 2008 to 2021, Apple managed to grow its revenue almost tenfold. But from the right-most column, we can see that the growth rates were very inconsistent. Apple even saw its revenue contract year-on-year in 2016 and 2019. Those declines in revenue did not make Apple a bad company overnight. The iPhone maker managed to bounce back to post much stronger results each time.

As shown, even one of the most innovative companies in the world can experience inconsistent business growth.

Ultimately, a company that has a capable and innovative management team, great products, and a great value proposition to customers will be able to accelerate growth in the future.

This year, in the current challenging economic environment, many companies that previously had stellar records of growth are either growing more slowly or are experiencing contractions in revenue.

Although this is unpleasant to witness, I think shareholders should focus on what’s causing the deceleration in growth and whether the company can post a rebound. A bad year does not make a trend.

It is in times like this that we need to remember what being a long-term shareholder truly is. Your portfolio companies will not always grow at the same rate each year. There will be some good years and some challenging years.

So be patient. Focus on the metrics that matter and the quality of the business. Don’t be too quick to write off a company and don’t get too caught up with Wall Street’s obsession with near-term results.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Apple. Holdings are subject to change at any time

My Observations On Malaysia’s Payment Ecosystem

I spent a few days in Malaysia. Here are some observations on Malaysia’s payment ecosystem and how paying as a traveler has evolved.

Last week, I spent a few days in Malaysia for a friend’s wedding and for a short drive around the country’s western coast. This was my first time in Malaysia since the start of the COVID pandemic.

Although the purpose of my trip was primarily for leisure, I couldn’t help but notice the interesting dynamic of Malaysia’s evolving payment ecosystem.

Card penetration is still low and will likely remain so

The first thing I noticed was that many small merchants still do not accept card payments. Although card payments are convenient for both merchants and consumers, there is a frictional cost involved with card payments for merchants.

The cost of accepting card payments includes a fixed transaction fee per transaction and a variable fee based on the size of the payment which can add up to 3% of the total amount collected. In addition, merchants need to pay for the hardware to be able to accept card payments, which is another extra cost that some merchants may be unwilling to bear.

Card companies trumpet the fact that a large percentage of payments made globally are still done in cash, implying that there’s a vast addressable market to be won. This is true but there are large amounts of cash transactions made today that will likely never transition to card payments.

In Malaysia, there are still a large number of mom-and-pop businesses that depend on low-margin, small-sized transactions. The frictional cost of card payments makes accepting such payments too costly for these merchants. Moreover, as cash is still dominant in Malaysia and with the nature of these businesses dealing with relatively small transactions, cash is still a relatively convenient solution.

I am bullish on the prospects of card payments growing globally. But I believe card penetration for certain types of businesses will remain low for the foreseeable future.

Other digital payment methods gaining steam

Although card payment is not widely accepted at small merchants, I noticed that local or regional digital payment methods such as Grabpay, Shopee Pay, and Touch and Go are much more common.

I believe that merchants are more inclined to adopt these payment solutions as they are cheaper to set up and have lower transaction fees. Grabpay and Shopee Pay, for example, require neither the installation of a card reader nor a dedicated point of sale system. Merchants only need to download the app to start accepting payments.

Besides the low set-up cost, these solutions currently levy merchants a lower fee than cards. Some solutions like Touch and Go are not even charging any transaction fees to smaller merchants. This naturally makes merchants more willing to accept these payment solutions.

At the other end of the transaction, consumers are inclined to use these digital payment methods as they are more convenient than cash and there is occasionally a reward system tied to these payment solutions.

My observations about paying as a traveller

Making payments overseas is becoming increasingly frictionless and cheaper. For my trip to Malaysia, I paid in cash when necessary (which was mostly the case) but when card payment methods were accepted, I used a debit card linked to my Wise account.

Wise is an app that makes sending money overseas or paying money in a foreign currency convenient and cheap.

To set up, all I had to do was top up my Wise account and apply for a debit card. When paying with the Wise debit card in Malaysia, the Wise app would automatically deduct the amount from my Wise balance. Even though I kept the cash in my Wise balance in Singapore dollars, I could still make payments in Malaysian ringgit as the app would automatically deduct the appropriate amount of Singapore dollars at a competitive rate.

Wise markets itself as a company that provides very competitive rates and low commission fees for transfers and payments made using its solutions.

Travellers today can use apps like Wise or Revolut for more competitive foreign exchange rates than standard credit cards.

Final thoughts

The payment ecosystem in each country is unique. Countries such as Malaysia are still highly reliant on cash but are fast transitioning to other forms of digital payment methods.

And with companies such as Wise, travellers are getting cheaper ways to pay for goods overseas. All of these developments are great for merchants and consumers as it decreases the fractional cost of transactions, enabling more commerce to occur seamlessly.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Wise. Holdings are subject to change at any time

What Is a Stock, Really?

When you buy a stock, you are purchasing a small stake in a company. But what does that really mean?

What is a stock? A stock is a small stake in a company. But what does that really mean?

First Principles Thinking

Elon Musk recently popularised the term first principle thinking which in layman’s terms refers to questioning assumptions until you get down to the bare bones of the matter.

This can apply to defining a stock too. A stock represents part-ownership of a company. But what does being a part-owner of a company mean? Let’s dig deeper.

As a part-owner of a company, you are entitled to receive dividends from the company. The company can choose to pay dividends to shareholders when there is excess cash on the balance sheet. As such, we can say that if you own a stock, you are entitled to a stream of future cash based on the profitability of the company.

This is one of the main reasons investors buy stock in a company. But that’s not all. In a well-oiled stock market, investors can buy and sell stocks to each other.

As such, not only are stockholders entitled to future dividends, but they can also sell the stock – or in other words, this “entitlement to future cash” – to other investors in the stock market.

So why do stock prices fluctuate so wildly?

Once we understand what a stock really is, we realise that the value of a stock should be tied to cash that the stock owner can get.

In theory, the value of a stock is all of the stock owner’s future cash flows discounted to the present day. But if stocks have a very easily defined value, which in theory, should not fluctuate on a day-to-day basis, why do stock prices still gyrate wildly?

There are many reasons for this. First, the cash flows of a company may be hard to predict and may depend on many factors. When situations change, the company’s cash flow outlook can change too, which means the present value of the company’s stock can fluctuate.

Also, investors may make different assumptions about a company which also causes market participants to value a company differently. All of which can lead to fluctuations in the stock price as investors are willing to pay different amounts for a stock.

The discount rate that is applied to value a company is also highly dependent on numerous factors such as the inherent risk in the business and the risk-free rate which is set by central banks. Investors may apply different discount rates to future cash flows based on how they perceive the risks to that cash flow materialising.

The discount rate is also affected by the risk-free rate. Usually, central bankers will meet a few times a year to decide on what the risk-free rate will be. When the rate changes, the value of a stock should change too.

There are also investors in the stock market who simply don’t care about value. All they care about is being able to sell a stock at a higher price to someone else.

These traders simply buy and sell a stock in the hopes that the stock price goes in the “correct” direction for them to make a profit.

Even if a stock seems very overvalued compared to the potential future cash flows of the business, these traders are still willing to buy the stock in anticipation that someone else will buy it from them at an even higher price.

The gravitational pull of value

While stock prices can fluctuate wildly, over time they tend to gravitate toward the intrinsic value of a company.

Benjamin Graham, mentor to Warren Buffett and the author of classic investing texts such as The Intelligent Investor, once said that in the short run, the stock market is like a voting machine but in the long run it is like a weighing machine.

This makes sense as eventually, a stock should trade close to the present value of its future cash flows. For instance, if a stock is too cheap, investors can simply buy the stock at a discount and make an outsized profit from the actual cash flows paid to shareholders.

This basic principle should be music to the ears of long-term investors, especially in today’s bear market. Although it may feel unpleasant when your stock price falls, it is important to take a step back and realise the true meaning of being a shareholder.

When you do so, you can properly assess the actual value of your stock.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned.

Themes To Watch This Coming Earnings Season

Earnings season is just round the corner and with so much uncertainty around the economy, this will be an interesting earnings season to say the least.

I find that earnings seasons always provide important insights to investors. This is especially so in today’s climate, when there is so much uncertainty over macroeconomic conditions and stock prices have fallen hard.

With this in mind, here are the key themes I’ll be keeping an eye out for during the upcoming earnings season which will start in a few weeks.

Spending trends

The Federal Reserve’s tightening of monetary policy will likely impact consumer spending and company budgets. I will be keeping an eye on managements’ commentary about the business environment that they are in and the spending trends that they are seeing.

In the first quarter of 2022, it was heartening to see mission-critical software companies continue to post excellent results amid the wider market slowing down. I’ll also be looking for other companies that can come out of this environment stronger than they were before.

If these companies can continue to buck the trend, it will be another sign of their resilience.

Stock-based compensation

Lower stock prices could result in more heavy dilution for companies that depend heavily on stock-based compensation. This is because such companies need to offer employees more shares to make up for the shortfall in stock prices to attract the best talent.

With some companies seeing up to an 80% drop in their stock prices, it will be interesting to watch the dilutive impact of stock-based compensation. While the true impact will likely only be felt much later in the future, I’ll be keeping an eye on managements’ commentary on this subject.

Leadership changes and employee turnover

DocuSign and Pinterest recently reported that their respective CEOs have stepped down from their roles. It is not uncommon to see leadership shuffles in times such as these.

In the coming earnings season, we should also get a better picture of what companies are doing about retaining employees and the employee turnover trends. Investors of companies who have seen the loss of key personnel should also hope to get clarity on the reasons for any C-suite shuffling.

Updates on cost-cutting initiatives

There has also been a host of companies that have tightened their belts for the year. Sea Ltd, Tesla, and Netflix have all announced layoffs. With interest rates rising and capital becoming more expensive, companies will need to be more prudent in their spending.

In the coming earnings reports, I’ll be looking for additional colour on the impact cost-cutting initiatives have on their businesses going forward and how the initiatives have panned out.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Docusign, Tesla, Netflix, and Sea Ltd. Holdings are subject to change at any time