Saturday 31 October 2015

Does Oxley's 5% Bond Have Sufficient Margin of Safety?

Bonds are typically boring investment with very little news. However, for the past week, it seems that the market could not get enough of news about bonds. First, there was the start of trading of Perennial's 4.65% bond on the SGX. Next, the second tranche of Singapore Savings Bonds closed with barely more than 20% of the total amount subscribed. Following that, OCBC announced that it would be redeeming its 4.2% preference shares listed on the SGX. Finally, we also have Oxley launching its 4-year, 5% bonds for subscription. Does Oxley's 5% bond have sufficient margin of safety according Benjamin Graham's criteria of minimum earnings coverage and minimum stock value ratio as described in The Lost Art of Bond Investment? Below are the ratios computed based on Oxley's latest financial statements in Jun 2015.

Earnings Coverage

Profit before tax = $142.7M
Adjusted for:
- Add: Non-recurring loss (forex, revaluation, impairment) = $23.3M
- Add: Finance cost = $41.0M
Total earnings available for covering fixed charges = $207.0M


Current finance cost = $41.0M
Add: Interest of proposed bond = 5.00% x $125.0M

= $6.25M
Total finance cost = $47.3M


Earnings Coverage = $207.0M / $47.3M

= 4.38

The earnings coverage of 4.38 times is above the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares = 2,9448.2M
Share price = $0.42
Market value of shares = $1,238.3M


Current amount of borrowings = $2,406.0M
- Add: Loan advances = $81.9M
- Add: Proposed bond size = $125.0M
Total bond value = $2,612.9M


Stock value ratio = $1,238.3M / $2,612.9M

= 0.474

The stock value ratio of 0.474 is lower than the minimum stock value ratio of 1 for industrial companies.

Thus, Oxley's bond meets the earnings coverage criterion but does not meet the stock value ratio criterion. Based on Benjamin Graham's criteria, Oxley's 4-year, 5% bond does not have sufficient margin of safety. Having said that, this does not mean that Oxley will definitely default on this bond, it just means that the risk is higher.


Sunday 25 October 2015

The Day US Entered The Gulf War

It is the time of the year again as the world awaits US Federal Reserve (Fed)'s decision on Wed whether to raise interest rates. Although the majority view is that Fed would not raise interest rates at this meeting, the consensus was not so clear this time last month. I was busy wondering whether the economic implications of an interest rate rise would hold (i.e. stocks would fall) or the investor psychology of buying after a bad news would happen (i.e. stocks would rise). You can refer to A Jittery September for the thinking going on prior to the last Fed meeting. In the end, an event that happened 25 years ago settled the argument in favour of the latter.

It was 2 Aug 1990. Iraq had just invaded Kuwait, its oil-rich neighbour to the south. Oil prices promptly shot up from US$17 per barrel in Jul until it reached US$36 per barrel in Oct. Stocks fell correspondingly. The Straits Times Index (STI) fell from 1,557.80 points the day before the invasion and reached a low of 1,079.50 in mid Oct, for a loss of 31% in a short span of 2.5 months. Iraq had just emerged battle-hardened from an 8-year war with Iran and boasted an army of 1 million men with 5,000 tanks. It was the fourth largest army in the world. Throughout the second half of the year, people were worried about US going into a prolonged war with Iraq, with dire consequences for oil prices and the world economy. 

On 15 Jan 1991, US declared war on Iraq, codenamed as Operation Desert Storm. 2 days later, the war that people feared started with aerial assaults on Iraq. Yet, contrary to all expectations, stocks did not fall. Instead, they rose. STI rose 5.4% on the very day the war started. It was not an initial, knee-jerk reaction; stocks continued to rise until US ground troops liberated Kuwait and ended the war 6 weeks later on 28 Feb 1991. By the time the war ended, stocks had recovered almost to their initial levels prior to the war. The figure below shows the performance of STI during the period of the war.

STI Performance During Gulf War

If you had watched the 1992 Hong Kong drama "The Greed of Man" (“大时代”) starring Lau Ching Wan and Amy Kwok, this was the event that gave rise to the climax turnaround in fortune for the male protagonist.

Coming back to our time, on the one hand, my mind tells me about the economic implications of an interest rate rise, as described in Getting Ready for US Interest Rate Rises. On the other hand, my gut feel tells me that expectations for a fall in stock prices in the event of an interest rate rise had been heavily priced in and a counter-intuitive rally in stocks was possible. After recalling the above-mentioned event just before the Fed meeting in Sep, I decided to buy stocks in favour of an interest rate rise. As you know, the interest rate rise did not happen. Nevertheless, it resolved the last major consideration in deciding whether the "big bad bear" was coming. I thought I had another one month until the next Fed meeting in Oct to continue adding stocks slowly, but stocks went up unexpectedly in early Oct, thus ending my buying spree a little too early.

So, now, the world awaits Fed's decision again. Would the announcement of an interest rate rise (assuming it happens) set off a decline in regional currencies, gold, oil and stocks, or would it spark off a short-term rise in the very assets that are affected by interest rate rises, until the economic implications start to take effect in the medium-term? I am quietly believing in the latter. Having said the above, the recent stock rally has ended any further buying activity. Essentially, I do not buy stocks because I think they are rising; I buy stocks because I think they are undervalued, and at no risk of falling significantly. And in case I am wrong, there is still a warchest to rely on.


Sunday 18 October 2015

Does Perennial's 4.65% Bond Have Sufficient Margin of Safety?

It has been getting more interesting for retail bond investors recently, with the launch of Aspial's 5.25% bond in Aug, Singapore Savings Bonds in Sep and now Perennial's 4.65% bond. Does Perennial's 3-year, 4.65% bond have sufficient margin of safety according to Benjamin Graham's criteria of minimum earnings coverage and minimum stock value ratio as described in The Lost Art of Bond Investment?

Perennial was listed following the reverse takeover of St James Holdings in Oct 2014. Hence, it did not have financial statement for a full financial year. Based on Perennial's latest financial statement for the year ended Jun 2015, the minimum earnings coverage and minimum stock value ratio are computed as follow.

Earnings Coverage

Profit before tax = $57.1M
Adjusted for:
- Deduct: Non-recurring fair value gain on investment properties = $46.0M
- Deduct: Other non-recurring gains (earn-out, forex) = $11.0M
- Deduct: Share of results of associates = $13.8M
- Add: Finance cost = $37.8M
Total earnings available for covering fixed charges = $24.1M


Current finance cost = $37.8M
Add: Interest of proposed bond = 4.65% x $150.0M

= $7.0M
Total finance cost = $44.8M


Earnings Coverage = $24.1M / $44.8M

= 0.54

The earnings coverage of 0.54 times is way below the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares = 1,652.5M
Share price = $0.975
Market value of shares = $1,611.2M


Current amount of borrowings = $1,678.5M
- Add: Proposed bond size = $150.0M
Total bond value = $1,828.5M


Stock value ratio = $1,611.2M / $1,828.5M

= 0.881

The stock value ratio of 0.881 is lower than the minimum stock value ratio of 1 for industrial companies.

Thus, Perennial's bond does not meet both the earnings coverage criterion as well as the stock value ratio criterion. Based on Benjamin Graham's criteria, Perennial's 3-year, 4.65% bond does not have sufficient margin of safety. Having said that, this does not mean that Perennial will definitely default on this bond, it just means that the risk is higher.


Sunday 11 October 2015

A Jittery September

It looks like the recent "bear" market is over before it has barely begun! Having said that, September was a very jittery month for me, not because stocks had fallen rapidly, but because I was trying to figure out whether and when to buy stocks. Stocks had already fallen sharply in mid August when China devalued its currency, but a look at the calendar for September showed there were several more events that could cause nervous moments for the stock market, with Singapore's General Election (GE) on 11 Sep, US Federal Reserve's interest rate decision on 17 Sep and finally Greece's GE on 20 Sep. Including the renminbi devaluation and US' announcement of higher GDP growth in Q2 in August, there were 5 events to digest in quick succession in order to conclude whether the "bear" was coming or just pretending.

Among these 5 events, 3 have economic significance, meaning they have an impact on the economics of companies and how stocks are likely perform in the medium term. These events help to determine whether stocks should be bought or sold. The other events merely affect the volatility of the stock market, meaning they only determine the timing of any buying or selling decision. The 3 events that have economic significance were China's renminbi devaluation, US higher Q2 GDP growth and US Fed interest rate decision. The events that have volatility implication were Singapore's GE, Greece's GE and, again, US Fed interest rate decision. Let us consider the events with economic significance first.

The reason why China's renminbi devaluation sparked off a global stock market sell-off was because it suggested that China's slowdown was larger than expected. In the absence of any other economic news, this is going to be very dismal for the stock market for months, because every month, there are economic statistics coming out of China and you could expect most of them to be negative. On the other hand, US announced a positive set of GDP growth rates for Q2, which were much higher than that for Q1. The big question is this: Is the world's No. 1 economy going to pull up the world's No. 2 economy (and the rest of the world), or is the world's No. 2 economy going to drag down the world's No. 1 economy (and the rest of the world)? It is easier to answer the second question first, so let me start with that one. Nevertheless, I have to admit that economics is one of my weaker subjects and I do not profess that my answers are correct.

To answer the second question, it is worthwhile to consider the answer to another related question: did China pull up US in the first place? Because if China did not pull up US significantly in the first place, then it is unlikely to drag down US significantly in the near future. As an example, the fate of resource-exporting economies such as Australia is very much tied to that of China. When China boomed or slowed, so did these economies. Unlike resource-exporting economies, the main source of US growth was not China. A look at the US GDP Q2 report revealed that the main source of growth was domestic. Hence, it would take more than China's slowdown to knock the wind out of US growth. Now, back to the first question, would US pull up China, the world's factory, with its domestic demand? There are several reasons for China's slowdown, such as over-capacity and over-leverage, etc. Such issues take time to work through, so it will take a lot more than US demand to pull up China. Thus, the conclusion is that neither China would drag down US nor US would pull up China in any significant manner. The world's No. 1 and No. 2 economies will go about their separate ways in the near future. The other economies will be in-between these 2 economies depending on the relative exposure they have to each of them. The key conclusion is this: the world is not going into a synchronised global recession.

By the time I figured the above out, it was early Sep. Sentiments were very fragile then. While I did not mind buying, say, Keppel Corp at the $6.80 price range, I mind a lot if it were to drop $0.30 the day after I bought it. It was not improbable for Keppel Corp to rise or fall by $0.30 in a single day during those days. So, I decided to wait until Singapore's GE was over. Surprisingly, stocks did not move much the following Monday after the GE, despite a landslide win for the governing party. That week was also the week of the Fed meeting and Grecee's GE. Let's talk about Greece's GE first. The key issue about it was whether there would be a replay of the Grexit drama in July, when Greece nearly exited the Euro zone because of opposition to austerity measures imposed by the EU as conditions for bailing out its debts. I managed to figure out beforehand that neither the anti-austerity governing party nor the pro-EU opposition party would oppose the debt bailout package, so Greece's GE was not a key event to consider. The final event left was Fed's interest rate decision on 17 Sep.

US Fed interest rate decision has both economic significance and volatility implications. The economic significance was discussed in Getting Ready for US Interest Rate Rises in Jun. To recap the key points from that discussion, interest rates are not going to rise significantly. However, regional currencies and US dollar-denominated assets like gold, oil and other commodities are in for a rough ride. Volatility in these assets will likely lead to volatility for the stock market. This conclusion is based on economic considerations. However, given the fact that interest rate rises have been discussed for a very long time already, I have a gut feeling that expectations for a drop in regional currencies and USD-denominated assets have been priced in already. There is a possibility of a counter-intuitive rally in the very assets that are supposed to fall when Fed announces a rise in interest rates!

To summarise, these are my conclusion of the key events of the past month that determine whether and when to buy stocks:
  • US vs China: The world is not going into a synchronised global recession
  • US Fed interest rate decision: Economically negative for regional currencies and USD-denominated assets, but possibility for a counter-intuitive rally in the same assets
  • Singapore's GE: Turned out to be a landslide win for the governing party
  • Greece's GE: No replay of Grexit

My key conclusion is that the "big bad bear" is not coming and I began to pick up stocks. Nevertheless, I remain wary of stocks with exposure to regional currencies and my warchest is still intact should my analysis be wrong and the bear returns.


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Sunday 4 October 2015

The Big Picture During Bear Markets

Bear markets can be very frightening. They can cause stocks to drop by 40% to 60% and stay there for a fairly long period of time. It can be quite stressful to go through a bear market, especially for young investors. However, it is helpful to look at the big picture, which is this: even though the prevailing bear market might look very frightening, most young investors are still working, and there are 20 to 30 years of income still to be earned. If you include these unearned income in your total wealth, you will find that the prevailing bear market actually only eats up a small fraction of your total wealth. Let us consider the following example.

Starting Salary  $      3,000
Annual Salary Growth 5%
Salary Ceiling  $    10,000
Investment Allocation 10%
Asset Returns 7%
Max. Drawdown 50%

A fresh graduate aged 25 is able to earn a starting salary of $3,000 per month. This salary grows at a rate of 5% annually. Let's further assume that his salary does not grow forever, and his salary ceiling is $10,000 per month. He is able to set aside 10% of his monthly salary for investment, which grows at a long-term average rate of 7% per year. During a bear market, he loses up to 50% of his invested capital in unrealised losses, which can be quite painful for a young investor.

At the age of 30, 5 years after working, he would have accumulated an investment capital of $22,729, comprising the $300 he set aside every month which grows at the long-term average rate of 7% per year. At the depth of the bear market, he would have lost 50% or $11,364 of his investment capital that he has so painstakingly built up over the last 5 years. Although the losses are significant, he still has 35 years of working life in front of him. Assuming that he continues to set aside 10% of his future monthly salary for investment, he would have an unearned present-value capital of $100,457 (discounted using the 7% long-term annualised asset return), or 4.4 times his earned capital. The unrealised losses just make up 9% of his total wealth, which is a lot more comfortable than the 50% unrealised losses. The figure below shows the amount of earned capital and unearned capital at age of 30, 35, 40 and 45 for the same person.

Total Capital for Different Age Group

As the person increases in age, his unearned capital will reduce as it is progressively transformed into earned capital. At age 35, the unearned capital is still 65% of his total capital, which is equivalent to 1.8 times of his earned capital. The unrealised losses just make up 17% of his total wealth. At age 40, the unearned capital is 50% of his total capital and the unrealised losses make up 25% of the total wealth. Only after the age of 40 would the unearned capital fall below 50% of the total capital and the unrealised losses make up a significant portion of the total wealth. By this time, he would need to take less risk to reduce the amount of potential losses.

The point is, if you are a young investor, the prevailing bear market might look very frightening as you sustain heavy losses in percentage terms. However, if you consider the big picture of future cashflows, the amount of unrealised losses is considerably smaller. I would even say that a few years after you have gone through this difficult period and accumulated more capital, you might look back at this period and realised that the "signficant" unrealised losses that caused so much pain is actually fairly insignificant. As an example, at the depth of the 2000-2003 bear market, my unrealised losses were $50,000, which was equivalent to 50% of my invested capital. It was a very significant loss and very depressing. But by the time I got to the depth of the Global Financial Crisis (GFC) 5 years later, the amount of unrealised loss was around $175,000 to $200,000. The $50,000 unrealised loss sustained during the 2000-2003 bear market that seemed so significant then had paled in comparison. You might not believe me now as you go through his difficult period, but in a few years' time, you will realise that this is true. What is important now is not how much money you have lost, but how many lessons have you gained in investing, so that in a few years' time, as your investment capital grows, you will not make similar mistakes again, which are going to cost you a lot more since your investment capital has increased.


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