IPO opportunity – HC Surgical Specialists Limited

A micro-cap IPO is being launched in Singapore and is expected to be listed on 3 November 2016. The company in question is HC Surgical Specialists Limited (“HCSS”). As I have mentioned previously in a post on Advancer Global’s IPO, I almost always avoid IPOs but HCSS’ pricing gives a lot to pause for. The valuation seems undemanding, especially when compared to its peers in the healthcare sector listed on the SGX, which are trading at obscene multiples.

The key details extracted from the Offer Document, which can be found on here, are as per below, which would paint a picture of why I believe it is rather undervalued and represents a good opportunity to mop up some shares. That is if I can even get my hands on it on the day of trading, given that the IPO is a full placement – no shares offered to the general public via balloting and there is a strong likelihood the share price will shoot up so quickly at the opening bell it won’t make sense to buy at an elevated valuation.

Below is a quick and dirty assessment of the IPO, the business and its valuation.

About the business

Placement price per shareMarket capitalisation and number of shares outstanding

 

Normalisation

Past 3 years’ results and pro forma numbers for FY2016

Tax rates, government grants and FY2014’s and FY2015’s profit

The tax rates for FY2014 and FY2015 were abnormally low due to tax incentives which may not accrue going forward. To be conservative, I would adjust the profit for both years by the normalised and standard statutory corporate tax rate of 17%.

In addition, government grants under ‘Other income’ may not be a guarantee going forward, and  as such, should be deducted to normalise historical earnings.

Deducting the government grants and applying the 17% tax rate would mean that FY2014’s and FY2015’s net profit would have been S$3,168,974 and S$2,792,090 respectively.

Normalising FY2016’s figures

The company incurred listing expenses of S$430,000 which will not be repeated in future years (other than in FY2017 as the IPO crosses over the time period). It also generated fair value gain on derivative financial instruments of S$366,049 and finance costs of S$444,029 arising from its redeemable convertible loan which are non-recurring (other than in FY2017 as the IPO crosses over the time period).

By normalising the above 3 components, deducting government grants of S$52,683 and applying a 17% tax rate, we would arrive at FY2016’s normalised profit of S$3,153,694.

To summarise, normalised net profit for the last 3 financial years are:

FY2014: S$3,168,974

FY2015: S$2,792,090

FY2016: S$3,153,694

Estimated profit for FY2017

To have a rough gauge of how the numbers are going to look like going forward, I take the pro forma numbers up till the profit before tax line of S$4,032,259. This figure assumes acquisitions done after the FY2016 year end (31 May 2016) were taken into account, among other line items as per the adjustments above.

Some figures that need to be adjusted include the total fair value gain on derivative financial instruments, finance costs, listing expenses, government grants as mentioned in the previous section’s ‘Normalising FY2016’s figures’.

In addition, there will be expenses incurred in relation of HCSS being a publicly-listed company. These include director fees, Catalist sponsor fees, fees payable to SGX, etc. For larger businesses, there is often sufficient buffer to take on those costs, but since HCSS is in the micro-cap space, let’s have a quick look as to whether it will create a large enough dent in earnings to warrant attention.

• Directors’ fees – There are 3 additional directors, excluding Dr Heah Sieu Min and Dr. Chia Kok Hoong who are part of management. The 3 are non-executive directors and are expected to be paid between S$0 up to S$250,000 per annum as per the Offer Document. That is a little too vague and would probably be better represented by Hay Group’s study in 2015 on non-executive directors’ average remuneration of S$60,000 per annum for Singapore-listed companies. With 3 directors, that adds up to an estimated S$180,000 of expenses estimated to be incurred by HCSS for FY2017
• Sponsor fees – There does not seem to be publicly available information on fees paid to continuing sponsors for Catalist-listed companies. I believe it should be safe to assume S$15,000 per month which totals S$180,000 per annum
• Fees payable to SGX – As per SGX’s website, “Catalist listed equity securities are subject to a minimum fee of S$15,000 and a maximum fee of S$50,000 based on S$25 per million dollars or part thereof of the market value.” Since the market cap of S$39.5m translates to just S$987.5, it is safe to assume the fee it will be paying to SGX will be S$15,000 per annum for the foreseeable future

There will definitely be additional costs involved such as the printing of fanciful glossy annual reports and booking of function rooms and catering for EGMS and AGMs. I assume setting aside S$50,000 per annum should be sufficient. Adding all the items up, we have ongoing costs of about S$425,000 per annum.

Assuming all other revenue and costs stay the same for FY2017 and adjusting for all the line items mentioned above, we get a profit before tax of S$3,704,918 while net profit based on a 17% tax rate gets us to S$3,075,082 or 2.10 cents per share (based on post-Placement shares of 146,311,530).

Cash flows

There doesn’t seem to be much of accounting gimmicks, given that operating cash flows have exceeded net profit in FY2014 and FY2015 out of the last 3 financial years. The reason it dipped below net profit in FY2016 is due to changes in working capital which isn’t much of a concern in this case (specifically payment of trade and other payables).

Capital expenditures are rather reasonable at S$337,357, S$406,005 and S$192,501 respectively for FY2014, FY2015 and FY2016 respectively compared to close to 10x the operating cash flows the business generates.

The average free cash flows across the 3 past financial years match very closely to that of the average net profit – a good sign of investors’ ability to rely on the income statement.

ROIC

My initial guess is that the nature of the medical business is such that it doesn’t have to employ much capital to generate good returns since most of the work done or value stems from the intangible skills and reputation of the doctor. The quality of tangible equipment definitely plays a part but I would argue that the importance of the person utilising the machines ranks higher.

Going deeper into the numbers, invested capital  (equity + debt, redeemable convertible loans, derivative financial instruments – cash) for the financial years are:

FY2014: S$421,775

FY2015: -S$123,312

FY2016: -S$1,557,687

Clearly, HCSS is a superior business given that it doesn’t need much invested capital and runs on negative invested capital in FY2015 and FY2016 to operate and churn cash out. That pretty much leaves ROIC (normalised net profit) for FY2014 as a ridiculous 751% while not being applicable for FY2015 and FY2016.

Moats

The moat appears to be intangibles – brand, which is pretty much dependent on the doctors’ skills and reputation. I don’t exactly like the idea of the main moat being dependent on the persons running the show, which in this case appears to be Dr Heah and Dr Chia. If they get hit by a bus, would that effectively mean game over for the business? The good news is, there are 2 other surgeons within the group, 4 external surgeons who run their own practices with fee-sharing arrangements and 2 other general practitioners.  I wouldn’t say the moat isn’t strong for now, not until they have created a brand name for the practice that will outlive the reputation of the individual doctors (think the Mayo Clinic, Q&M and Raffles Medical).

The Offer Document listed ‘we have multiple clinics located in highly accessible locations’ as one of its competitive advantages. I personally think it is a nice to have but would not represent a strong advantage. Granted, the operating costs are lowered given the cheaper rental in the heartlands where HCSS has a presence but it represents just 3 (Hougang, Bukit Batok and Tampines) out of 11 facilities on hand. The rest of the facilities are in the usual higher rent central hospitals like Mount Elizabeth and Gleneagles. In addition, my opinion is most people will view specialists located in top notch and well-known medical centres as much more reputable and are willing to pay the premium that comes with it. After all, medical expenses are not exactly line items you would want to cut down on when it concerns your health. I would even argue that having a specialist clinic located in the suburb may lower the brand equity of the overall group.

Growth

The Offer Document talks about the company’s prospects and strategy towards growth as per below:

I generally agree with the prospects and growth plans wise, in most cases I discount it a fair bit, particularly on overseas expansion in Vietnam since that also brings a whole set of risks.

I would say for businesses such as this where it’s practice-based rather than owning a hospital outright which provides a certain untapped capacity to grow the business, more often than not, a rollup strategy to acquire other practices is likely to be the name of the game. There are only so many patients a doctor can perform on a procedure a day. In other words, it doesn’t quite have the economies of scale in the sense of the scalability that allows software companies make money. Granted, the roll up strategy is riskier than organic growth, it isn’t too bad a strategy and the nature of the business sort of forces the dynamics of a rollup strategy. After all, with all the gushing operating cash flow generated by each practice and nominal maintenance capex requirements, the only logical way to grow the business is to deploy capital to acquire other practices and using the currency of its stock to attract targets.

Valuation

Based on the market capitalisation of S$39.5m and assuming revenue and costs stay constant while HCSS incurs expenses as a listed company – net adjusted profit of S$3,075,082 or 2.1 cents per share (based on post-Placement shares of 146,311,530), the price to earnings (P/E) ratio would be 12.8x.

Enterprise value (EV) based on the pro forma balance sheet which has S$5,194,000 of cash and net cash proceeds raised from the IPO of S$6,147,000, equates to S$28,159,000. On an EBITDA basis, HCSS generated S$3,971,983 or 2.7 cents per share which gives rise to an EV/EBITDA ratio of 7.1x.

With S$4m or 65% of the net cash proceeds earmarked for expansion, HCSS’ business will most certainly grow over the short-to-medium-term, though I am not taking it into account at this point.

If we look at HCSS’ peers as per below, based on the figures as at 30 Oct 2016, we can see that HCSS compares very favourably in terms of the valuation multiples.

Peer comparison

The above peer valuation chart was extracted from KGI Frasers’ initiation report on Health Management International, dated 20 July 2016. Although it is slightly dated, it serves as a quick and good-enough comparison of HCSS’ peers and their valuation. This is since most of its peers’ stock prices have been stable (+/- 5%), sans Health Management International, Singapore O&G and Healthway Medical Corp which have risen much higher in price (which means the multiples are higher), while Cordlife was the only one that declined more than 5%.

As can be seen from the table, the average P/E and EV/EBITDA ratio for the peers, both on a historical (28.0x and 28.6x respectively) and forward (29.2x and 19.7x) basis are miles higher than HCSS’. The direct comparison isn’t exactly accurate since there could be parts of each company’s financials that should be normalised like how my calculations for HCSS was normalised, different capital structure and ROICs generated. Nevertheless, it gives a pretty good gauge of how underpriced HCSS is for the impending IPO when the averages are compared to HCSS’ P/E and EV/EBITDA of 12.8x and 7.1x respectively.

Price to purchase

Some of the peers’ multiples are relatively high and I would be more comfortable taking the average of the 3 lowest peers’ multiple to perform a quick and dirty price calculation to purchase HCSS, without going into a detailed DCF valuation.

On an average forward P/E and EV/EBITDA ratios basis, the average of the 3 peers’ with the lowest multiples are 19.6x and 14.5 respectively. When applied to the HCSS’ adjusted earnings and adjusted EBITDA per share, it would translate to 41.2 cents and 39.2 cents respectively.

Given the clean balance sheet, high ROICs, zero debt, and the simple nature of the business, I would be comfortable with a lower margin of safety of 10%. In other words, my assigned buy price would be about 37.1 / 35.3 cents and below.

 

Other points

Dividend policy

Management’s stake

Following the IPO, the management team will continue to hold a substantial stake, representing nearly 70% of shares outstanding.

Pricing power and business’ susceptibility to technological change

Health-related fields have a certain degree of pricing power, although from time to time, excessive fees charged by doctors and surgeons scrutinised by the regulators. It’s not something I am excessively worried about. My opinion is surgeons’ skills are highly specialised and regulated, and the chances of their livelihood being disrupted by technological change are much lesser than a typical pencil pusher sitting behind a desk. The relatively low capital expenditures on medical equipment as compared to the revenue and operating cash flows generated appears to be a good gauge of this.

Why is HCSS lowballing themselves with a low valuation

HCSS isn’t the first medical-related company to go to IPO with such low valuation. Singapore O&G Ltd, a medial group specialising in obstetrics and gynaecology, was one such IPO. With an IPO price of S$0.25 backed by a low P/E ratio of 9.9x then, it surged 156% to S$0.64 by the end of the first trading day on 4 Jun 2016. Separately, a recent underpriced IPO, Advancer Global which I wrote about prior to their listing and had a P/E ratio of 7.2x, jumped 77% from S$0.22 to S$0.39 on the first day.

Having discussed with several friends, the reasons as to why the bankers and issuer likely leave quite a fair bit of money on the table for IPOs are in my opinion:

• Shares are placed out to friends, staff and family – Issuer would not want to risk damaging relationships and would want them to make money. In any case, if the majority is held by family who owns shares through the placement, the original owners aren’t exactly losing out
• Small stakes placed out – By selling relatively small stakes to the ‘public’, there isn’t much risk of dilution anyway as compared to benefits such as goodwill accrued

The following reasons are more of why they are going for an IPO than why the shares are underpriced.

• Using shares as currency for acquisitions – By IPOing and the strong likelihood of the stock price rising, given the public’s obsession at placing a high multiple on such companies, management can use ‘expensive’ shares in the future for acquisitions and expansion. As such, the dilution by placing out underpriced shares at IPO is probably a small price to pay for such a benefit
• Publicity – They may believe the higher profile of being a listed company provides more clout in attracting talent and customers, which then lead to more business

Conclusion

While on an optical basis, profits have been declining over the past 3 years (without normalisation), it is still a reasonably good business with profit margins in excess of 40%, in a relatively resilient industry. While I am not too psyched up about its growth, the underpricing makes it an attractive opportunity to accumulate shares below 37.1 / 35.3 cents cents per share, providing a margin of safety of 10%. The only thing left to do now is to await for 3 Nov 2016 and see how things go at the opening bell at 9am, to see if the price range is within reasonable limits to purchase some shares. I certainly expect a sharp price increase but will be keeping my fingers crossed nevertheless.

Progress of watchlist 3

As a follow up post to ‘Progress of watchlist‘ and ‘Progress of watchlist 2‘, I have set up the email alert system some time ago by adding the code into Google Sheets. I surfed around the web for the code and finally found a rudimentary one which worked well enough.

For those who are keen, all that needs to be done is to open up the script editor and go into Tools > Script editor. Thereafter, paste the code below and change the variables in red (without having the brackets).

function [anyNameToIdentifyFunction]()
{
var ss = SpreadsheetApp.getActive();
var sheet = ss.getSheetByName(“[sheetname]“);

var valueToCheck = sheet.getRange(“[cell]“).getValue();
if(valueToCheck > [3])
{
MailApp.sendEmail(“[youremailaddress@gmail.com]“, “[email title]“, “[content]“);
}
}

Where:

• [anyNameToIdentifyFunction] – Give it a name without having spacings. This will be needed to identify the function when activating the trigger
• [sheetname] – Name of the sheet/tab
• [cell] – The cell in which the number would change to trigger an alert eg. E7, G6
• [3] – Number in [cell] to exceed to trigger an email alert
• [youremailaddress@gmail.com] – The email which you want the alert to be sent to
• [email title] – Literally what you want the email’s subject to say
• [content] – Email content

Thereafter, click on the icon in the screenshot below to set the triggers.

In my case, I prefer to have the alerts come in just once a day at a certain timing and thus, I have set it as such in the screenshot below.

There are some limitations to it, or rather some hassles involved. For each stock in the watchlist, the code and triggers have to be repeatedly copied and pasted as each function code. It would of course be much better if I could have the coding crafted for a single column so that I could just add on to the watchlist sheet without any further opening up of the script editor and creating a new trigger. However, since I am not much of a programmer, my hands are pretty tied and it’s a small hassle for timely updates when a certain stock crosses the risk-reward ratio I have set.

One of the key question that readers may be – why not just set a stock price alert using some other services such as those brokerages? That is because I try to centralise the running of the calculations of intrinsic values in a single location and in this case, through Google Sheets. By centralising the calculations and alerts in a single place, I would not then have to worry about forgetting to login to a separate service just to change the threshold of the stock price alert each time I had to update the financials of each stock. There will also be greater flexibility in terms of the types of alerts I may want to set in the future, such as thresholds, that I may not be able to do through other simple stock price alert services.

With this, the watchlist’s core functionality is pretty much completed though I’ll definitely be tweaking it along the way from time to time.

Checklist for QVG opportunities

Under my Investment Philosophy, I spoke about the QGV (Quality, Growth, Value) framework which I adhere to when investing. Below is a 14-point checklist which I use on a DO-CONFIRM basis when assessing ‘compounder’ opportunities.

It certainly is not exhaustive and there are a number of other factors I look out for in a company. However, I wasn’t comfortable having an excessively long checklist since that would be off-putting and defeat the purpose of a checklist if I end up loathing to use it. Instead, the points below are the key ones which I have identified over the years, made the most sense to me and which have served me well.

Just as I have tweaked the checklist over the years, I am sure I’ll continue to adjust, add and remove points in the checklist over time.

Quality

1. Any risk of accounting gimmicks? (Operating cash flow > net profit)
2. Any risk of obsolescence or collectability? (Inventory and accounts receivables < Sales growth?)
3. Does the business have ability to reinvest at high rates of return on capital? (examine incremental ROIC over last 5-10 years)
4. Are high ROICs due to excessive debt? (Dupont analysis)
5. How high is the pricing power? (Can it at least beat inflation?)
6. Can rapidly changing technology damage the business significantly? (moat types and strength of it)
7. Does management own a substantial stake in the business?
8. What are the potential reasons the stock price may drop 50% tomorrow (pre-mortem)

Growth

1. Have revenue and operating cash flow grown in 7 of last 10 years?
2. Are there ample opportunities for the business to reinvest capital?

Value

1. Is EV / Maintenance FCF reasonable?
2. Can I see the stock price doubling in the next 3 years?
3. Are there any other positions in my portfolio that are more favourable on an overall basis than this?
4. If the stock price drops 50% tomorrow, will I buy more?

Sapiens – Follow up on licensing revenue

I wrote a post on Sapiens International Corporation N.V. in August 2016, on the company being an investment opportunity. In the post’s closing remarks I mentioned that I was in the midst of finding out why licensing revenue was declining.

In my mind, licensing revenue was supposed to be paid on an annual basis for as long as a customer uses it. If the licensing revenue segment was declining, that should cause some concern, particularly on whether it is a sign that it’s customers are leaving by the droves.

Sapiens’ licensing model is based on a perpetual model. In truth, I misunderstood the term and I should have dug deeper.

To explain the terms, the 2 main licensing models that exist for software companies are ‘perpetual’ and ‘term’. Perpetual meaning that a customer pays the fee once and it is then entitled to use the software forever. Term means that customers pay for the period it uses. In other words, perpetual licenses are non-recurring while term licenses are recurring.

This explains why licensing revenue declined – because customers pay them once and the rate of signing on new customers was slower than the past or the apportioning of new customers’ contracts for licensing and services were tilted towards licensing.

I was told that revenue should be taken in totality in considering Sapiens’ growth since there is certain leeway in apportioning the percentage between services and licensing at the onset of a customer signing on with Sapiens.

While the level of licensing revenue is part of the equation of how fast the business will grow, it is not the entire story. Even without new customers, Sapiens can still grow its revenue through the services segment which does maintenance and additional features/modules for existing customers. Not to mention that the revenue streams from the services segment is highly recurring and sticky, given that relationships between Sapiens and its customers typically last for 10-15 years.

That said, it is definitely prudent to keep an eye on licensing revenue and on announcements of new customers being signed on. If it falls too far below its currently levels, that is something definitely worth factoring into whether the original investment thesis and growth assumptions are sound. Ultimately, the fact of the matter is that Sapiens must replenish its revenue streams to counter the rate of its relationships with existing customers running out.

Pricing power – The rocket fuel to any investment thesis

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” – Warren Buffett

I added a column within the Google Spreadsheet Watchlist for “Pricing power”, with the ranking system of 1 to 5 – 1 being weakest and 5 being strongest. This provides an important reminder for myself when evaluating companies, that sufficient pricing power itself can be a margin of safety and may invite unexpected upside.

The beauty of true pricing power acts in such a way that a company can raise its prices (revenue) without a corresponding increase in its cost base (expenses). In other words, the extra boost in revenue falls directly to the bottomline and provides a magical boost to profits without lifting much of a finger. As a simplified example, a company that makes $100 in revenue by selling widgets currently has a cost base of $95. This translate to a net profit of $5. Assuming that it has a significant amount of pricing power so much so that it is able to raise the price of its widget by 20% without losing a single customer, its revenue is now $120 for the same volume of products sold. The cost of manufacturing its widgets and other miscellaneous costs continue to be $95. Instead of earning a net profit of $5, the company now earns $25 ($120 – $95). This effectively means that profits multiplied by 400% (from $5 to $25) even though revenue only increased by 20%.

Imagine now that the company is publicly-listed and was trading at a P/E multiple of 10 times. When it initially earned $5 in net profit, the stock price was $50 ($5 x 10). After flexing its pricing power muscle and assuming its P/E multiple remained at 10 times, its net profit of $25 now translates to a stock price of $250 or a 4 times gain if you sell the stock at this point. If the market decides that it previously overlooked the “hidden” pricing power the company has, that perhaps a 10 times multiple is too low for such a strong business, and that a 15 times P/E multiple is probably more fitting (multiple re-rating), the stock price goes up to $375. From the initial stock price of $50 to $375, one would have made 6.5 times his money from the benefit of a company’s pricing power and the market’s recognition of it.

In the real world of course, the perfect situation of a company as described above is probably rarer than a unicorn, given that most people would have easily recognised the strength of such a business, so much so that the multiple would be way higher than 10 times. Even though it is an extreme example, I hope it clearly illustrates the extra rocket fuel an investment can provide if the underlying business has sufficient pricing power, and given the skewed positive returns it can provide, paying up for quality businesses even at higher multiples can sometimes be very worth it.

The most recent types of businesses or more specifically, a company that has been in the limelight for all the wrong reasons by taking pricing power to the extreme is none other than the pharmaceutical company, Valeant. It worked well for awhile before it all came crashing down when enough people decided Valeant had gone too far in raising its products’ prices. The underlying lesson is that to build a sustainable business, a company that is able to raise its prices above the rate of inflation with such ease without losing a single unit volume, should probably use this privilege sparingly to avoid alienating its customers and risk damaging its long-term viability.

Turning away from Hanwell

This is a followup post on Hanwell, a Singapore-listed stock I wrote about as a potential deep value investment opportunity in an earlier post – A basket case of Graham-type stocks.

I was having dinner with a bunch of friends just the other day and I shared some of my findings on Hanwell. It turned out that one of them, a deep value guy, did extensive work on the other companies that Hanwell’s chairman effectively controls. My friend actually did alot more than just pull the numbers apart. To cut the long story short, based on his findings, he eventually invested a sum of money in those companies. Those companies were trading at such a deep discount to their liquidation value that it was in many orders the magnitude of what Hanwell presently trades at – I estimated Hanwell to have about a 40% margin of safety. He invested, knowing full well of the troubling corporate governance issues that the companies face. At such deep discounts, he found the opportunities hard to resist.

What happened was that he then proceeded to lose his shirt after a series of massive rights issue which made no apparent sense other than perhaps diluting minority shareholders to death.

The underlying lesson he learnt was that there is just no margin of safety that can be applied to bad corporate governance, especially if the perpetrator is the majority shareholder and is part of the senior management team and worse still, a director on the board.

In Hanwell’s case, the chairman is the second largest shareholder. That provides some comfort in that he alone would unlikely he able to pull some massive stunts without the approval of other large shareholders, or at least the largest shareholder. However, the largest shareholder is pretty mysterious and I could not seem to dig up a shred of information on him/her.

To be honest, I am a little torn between pulling the trigger on this as an investment and pulling away from this altogether. One part of me says the conditions in Hanwell’s case are slightly different from the rest of those companies that blew up while the other part says “You can’t make a good deal with a bad person”.

In the end, I decided to give this a miss until a time when conditions point to improvements in corporate governance practices or if event-driven situations arise, such as a tender offer, sale of the chairman’s stake, chairman steps down, initiation of dividend payout, etc.

A basket case of Graham-type stocks

I ran a screen on Singapore-listed stocks on 22 Sep 2016 for deep value stocks, with some simple criteria below and the sub-bullet points being the criteria’s rationale:

1. Enterprise value < market cap
   • So that cash outstrips debt. This provides greater operational cushion even if the core business falters down the road
2. Price to tangible book value < 0.7
   • Higher possibility of total residual liquidation value exceeding market cap
3. Market cap > S$50m
   • Provides higher liquidity for the purposes of stock purchases and  exits
4. Trailing-12-months operating cash flow > S$0.1m
   • Higher possibility of operationally sound business
5. Trailing-12-months free cash flow > S$0.1m
   • Indication of higher possibility of cash pilling up over time. This raises the margin of safety as intrinsic value builds up even if the market fails to recognise the value over the short run
6. Singapore-domiciled
   • Not including this would throw up a good number of Chinese companies, most of which may have financial and operational issues

Deep value stocks are not usually known to be cash generative from the onset. As such, to get the best of both worlds, I added criteria 4 and 5 for additional kickers to the equation. Correspondingly, these provide another layer of margin of safety for the potential investment to work out over time.

Not surprisingly, the screen resulted in just a handful of names – 5 to be exact:

1. Dyna-Mac Holdings Ltd
2. Hanwell Holdings
3. Hai Leck Holdings
4. Metro Holdings
5. PEC Ltd

This then calls for the rolling up of sleeves to do a liquidation value analysis on each of the stocks to see if they are viable investments. I have done a very quick back of the envelope calculations for all 5 but in this post, I’ll start with what appears to be the most interesting of the lot. The “undervaluedness” of this stock seems to be the deepest among all the candidates, but it is by no means a shoo-in as an investment. This stock ended up throwing up more questions than answers as I dug deeper.

Hanwell – Money for nothing and your subsis for free

Liquidation value table

The liquidation percentages largely follow that of Graham’s conservative teachings. The rationale behind the company level liquidation percentages that move the needle in the calculations are as follows:

• Cash – Cash levels have been rising over the years. As such, likely to be able to be fully extracted almost without much fuss. Applied a small discount in event of miscellaneous payouts or small working capital requirements
• Trade and other receivables – Typical Graham application of 75% liquidation value
• Property, plant and equipment (“PPE”) – The bulk of the cost and net book value relate to items other than higher-value buildings. They are mostly leasehold improvements, renovations and computers which are likely to fetch a much lower value if sold off. As such, applied larger and conservative discount to PPE

Thesis

On the company level, the residual liquidation value is S$121m, out of which over 80% is made up of highly liquid cash holdings. The residual liquidation value matches almost that of the market cap of S$119m as at 24 Sep 2016. This residual liquidation value does not account for the subsidiaries which it holds. This essentially and theoretically means that the subsidiaries are available for free. A high-value subsidiary and assets held for sale are what I term as kickers as explained below.

Kicker 1

Hanwell owns about 63.9% or S$40m in market value of Tat Seng (“Tat Seng”), a publicly-listed corrugated paper packaging products manufacturer on the Singapore Exchange. Tat Seng’s stock price has marched upwards over the years as opposed to Hanwell’s declining stock price. To be conservative, applying a 15% discount to the stake in the event of a liquidation gives us S$34m. The stake is held under the group level as a subsidiary.

Just as quick points, Tat Seng’s market cap as at 24 Sep 2016 is S$63m while its trailing-12-months free cash flow is S$16m. In the last 2 years, it generated positive free cash flow. On a quick and dirty liquidation value analysis, we get a residual liquidation value of S$41m. While it is not as severely undervalued from a balance sheet perspective, it is a clearly viable business that is cash generative and the stock price should not have immense room to fall.

Kicker 2

Through a web of direct/indirect ownership, Hanwell is selling a 49% stake in Million Cube Limited which holds a property development project of a golf club in Hainan, China – Sanya Yalong Bay Sun Valley Golf Club. Talks to sell it to Kang Cheng Holdings Limited (“Kang Cheng”) (unknown party) for HK$307m (c.S$54m) has been held since March 2014. While the deal has not been completed, Kang Cheng has paid non-refundable tranche deposits of HK$150m (S$26m) over the past 2 years+, with the most recent tranche amounting to HK$50m (S$9m) paid in Apr 2016. Although there is no absolute certainty of the deal ultimately materialising, the S$26m in deposits collected raise the chances of the sale completing (sunk cost fallacy on the buyer’s end) and even if it doesn’t, Hanwell has the S$26m in the bag, along with the golf course intact. Applying a 25% discount on the remaining unpaid amount gives a total liquidation amount (including deposits collected) of S$47m for kicker 2. The stake is held under the group level as assets held for sale.

On a side note, one could be forgiven for wondering why a consumer goods company is holding stakes in a golf course. I wonder that too, and part of the answer or at least its origins can be found in the last point of “Risks and red flags” below.

Risks and red flags

• Mounting cash levels to an obscene level close to its market cap beg the question of what is going to be done with the cash and more importantly, is it really there – no dividends paid since 2012
• Value of Tat Seng stake may decline if packaging business slides
• Risk of loss-making subsidiaries burning through cash as holding company loans them more money or impairs the loans
  • Gross non-trade amounts due from subsidiaries (under receivables) stood at a whopping S$68.1m as at 31 Dec 2015. While a good S$8.2m appears to be converted to cash in 2015 from 2014, the impairments rose from S$14.9m in 2014 to S$23.0m in 2015. This signifies the deteriorating business of the subsidiaries. That said, Hanwell, on the company level has been able to convert much of its receivables successfully over the last few years into cash so the immediate risk of cash burn appears mitigated
• Perceived lack of corporate governance
  • The chairman, who is Hanwell’s 2^nd largest shareholder and holds a stake of 17.9%, is part of senior management/chairman of several other listed companies, including Hanwell’s subsidiary, Tat Seng; Hanny Holdings (insider trading cases more than 10 years ago); China Enterprises Limited (penny stock hammered to near-death, which very curiously appears to have indirectly sold the golf course described in kicker 2 to Hanwell in 2012! Why it ended up in Hanwell, I’ll leave it to the readers’ speculation). Most of the mentioned companies’ stock prices, other  than Tat Seng, have not been doing well. To top it off, the chairman’s reputation among netizens in online forums hasn’t been too ideal.

Mitigating factors

• Dr John Chen, who was a former Member of Parliament of Singapore is on the Board. Having a reputable (former) public figure on the Board is never a silver bullet to governance ills but it does provide a slight slight tinge of comfort. At the very least, I suspect he would not risk being associated with a company that is outright fraudulent – think veracity of S$104m in cash on the company level
• Sam Goi, a billionaire in Singapore who is supposedly a shrewd businessman, particularly in the consumer goods sector, has a 15.1% stake in Hanwell. He also has his son, Goi  Kok Meng, on the Board of Hanwell since 2012

Catalyst

Completion of the sale of the golf club which would raise the group’s cash levels by about another S$28m, thus, increasing the pressure to further unlock value for shareholders.

Valuation

The 2 kickers add an additional S$81m to the existing residual liquidation value (company level) of S$121m, to reach a total adjusted residual liquidation value of S$202m. This compares very favourably with the market cap of S$119m, which provides a margin of safety of 41% and a corresponding potential upside of 70%.

The adjusted residual liquidation value does not account for Hanwell’s other subsidiaries such as Topseller Pte Ltd, Tipex Pte Ltd and Fortune Food Manufacturing which manufactures and/or distributes popular consumer products stocked in Singapore’s supermarkets. These brands include Royal Umbrella (rice), Beautex (tissue paper) and Fortune (tofu). These businesses are likely suffering from operating cash outflows, given that Hanwell’s consolidated group operating cash flows are lower than that of Tat Seng’s standalone numbers. Nevertheless, given the established mentioned-brands in Singapore, they are likely be worth much more than zero if they are liquidated.

At the group level, consolidated current and non-current debt as at 30 Jun 2016 for both Hanwell’s and Tat Seng’s group level balance sheets match precisely. This points to an absence of debt held by Hanwell’s other subsidiaries, thus, increasing the attractiveness of the stock.

Conclusion

The crux of the thesis hinges on 2 issues:

1. Is the cash real?
2. Can management be trusted not to squander the cash pile?

On cash, I am inclined to think it is real since Hanwell operates out of Singapore, at least at the company level. While the same can’t be said for the overseas subsidiaries, in this case, it doesn’t really factor into the thesis anyway with kicker 1. As for Kicker 2, Googling led to at least some sources (Tripadvisor and Raffles Hainan) pointing to the golf course being a real development. Continuing on cash levels, KPMG, the auditors, would have to have sent bank confirmation letters locally to Hanwell’s 3 principal bankers – DBS, UOB and Standard Chartered – and in my opinion, being top-tier/Singapore banks, it provides less leeway for hanky panky. I would be more concerned if they were smaller and/or are less well-known banks based outside of Singapore. Also, more than 90% of the cash at the company level is tied up in fixed deposit accounts. This makes it slightly harder to use tricks such as last minute bank deposits from some other unrelated bank accounts to create the illusion of cash on the balance sheet. Lastly, interest income amounting to S$1.3m in FY2015 or an interest rate of 1.4% adds up to the story of fixed deposits being S$91.1m as at 31 Dec 2016.

On whether management can be trusted, my opinion is: not really. I suppose the 41% margin of safety is where it is going to be applied – on management screwing up – mitigated by a leap of faith that Sam Goi and Dr John Chen keep a close watch to protect their reputation and monetary interests.

I will end by saying I will likely invest in Hanwell, starting with a small stake, but it will be in conjunction with a basket of other deep value stocks for diversification.

Thoughts on position sizing

For me, position sizing has been somewhat haphazard and based on non-quantitative intuition of how much risk I am willing to take on a particular position given its potential upside and downside. Having put this on the back burner for a long time, it is at least somewhat of a framework now although it is still a little rudimentary. The right approach should be the utilisation of the Kelly Criterion which would provide a sounder mathematical basis to allocation.

I first came across the Kelly Criterion a few years ago, after reading the book, Hedge Fund Wizards by Jack D. Schwager but have never quite utilised it. By incorporating the Kelly Criterion into my portfolio, I will be able to determine how much each position should be sized in accordance with the probability of an investment working out and the payoff ratio. The formula goes like this:

Kelly % = W – [(1 – W) / R]

where
W = Winning probability
R = Win/loss ratio

Plenty has been written about the Kelly Criterion so I shan’t go into the details. To read more about the origins of the formula and how it should be used, Investopedia has a quick introduction to it. The Kelly Criterion is not without caveats – the most important being that the 2 variables of W and R must be correctly assessed.

In a typical casinos game, the odds of the game can be accurately determined and payoffs are fixed beforehand. As such, the W and R variables can be plugged into the Kelly Criterion. It works well theoretically and in practice under such clear cut situations.

On the other hand, for equities and correspondingly, the underlying businesses, these are inherently complex and there are many interlocking sub-variables and situations that are out of management’s control. This ultimately means W and R are really just estimations based on imperfect information. Without a crystal ball, these assessments are at best approximately right and even then, are subjected to each assessor’s individual biases that will lead to skewed inputs – risk of garbage-in-garbage-out.

That said, I still think it is better to be approximately right than precisely wrong, and that is why I will still be utilising the Kelly Criterion to manage my portfolio. Some tweaks will of course be needed to reduce the risk of overconfidence (I think I am a natural optimist and tempering the bull in me will be most ideal) and portfolio blowups from unexpected market declines. Below are some that come to mind which I will be implementing.

• Instead of a full Kelly, utilise half Kelly (half of whatever the percentage the Kelly Criterion spits out)
• No single position to take up more than 15% of the portfolio

Do I have an obsession with tech-related companies?

I came to the realisation that my last few investment opportunities writeups have been on tech-related companies – Sapiens, YouGov, VeriSign and Ebix.

Truth be told, I have always been skeptical about tech as an area ripe for investing, simply because the pace of change is so fast and you never know where and which direction the next wave of competitive disruption is going to come from. Think MySpace, Friendster and WebVan which have all gone the way of the dinosaurs,  and all the Ubers of the world which have burned through billions of capital without generating a dollar in profits. Warren Buffett has been known to absolutely shun the notion of investing in tech companies.

That said, I would hesitate to paint all tech-related businesses with the same broad stroke. The irony with Buffett is the fact that Berkshire has stakes in IBM, VeriSign and most recently, Apple, although Berkshire’s positions in VeriSign and Apple were most likely initiated by his deputies.

My investment theses of Sapiens, YouGov, Verisign and Ebix are not so much based on the tech theme being all the rage now with investors. I will be the first to admit that technology in itself is not a moat. Rather, these companies happened to be tech-related; and by leveraging on technology, they created relatively strong moats such as network effects, switching costs and Intangible brands, for themselves within the space they are in. These have made it hard to dislodge their competitive positions, paradoxically, because of technology as an enabler in creating those moats mentioned. Ultimately, these qualities will come to nought if it does not translate to the most crucial metric – cash flow. In these 3 businesses, they generate copious amounts of cash and will likely continue to do so for many more years to come.

Cash flow generation is the core reason why I like Sapiens, YouGov, VeriSign and Ebix as investments. They just happen to be tech-related.

Grabbing life by the horns

“Remembering that I’ll be dead soon is the most important tool I’ve ever encountered to help me make the big choices in life. Because almost everything – all external expectations, all pride, all fear of embarrassment or failure – these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart.” – Steve Jobs