Friday, 9 February 2018

Bargain stocks in HK/China; no-brainer investing; and Dongfeng Motor

Despite the putative universal overvaluation of global equity markets at present (although the current correction, which Jim Grant would describe as the 'value restoration project', is starting to mitigate that), there are still in fact a large number of extraordinary bargains to be had for the industrious stock-picker. One just has to be prepared to look a little harder for them, in unusual and out-of-favour corners of the market. Obvious bargains have disappeared; non-obvious bargains have not.

Indeed, it is arguable that because we are likely moving into tougher times for the broader indices (high valuations of index-heavy large caps will mean lower returns moving forward), this will be a genuine opportunity for talented stock-pickers to shine. Over the past decade, you could have made good money owning just about anything in the US. Why pay for stockpickers? You could have loaded up on blue chip dividend-proxies and rode the wave of multiple expansion, and it was hard for a lot of stockpickers to do a whole lot better. That will not be the case moving forward in my opinion. ETFs are likely to provide disappointing returns over the next decade, and genuine stock pickers are therefore likely to be in a position to add a significantly increased amount of value.

One of the advantages of buying very cheap stocks is that you don't have to be very smart. The more expensive a stock is, the smarter you need to be, and the more important it is that you are able to predict the future, and predict it correctly. Is Amazon still a buy at US$1,400/share? That's a difficult question to answer. Maybe, maybe not. It depends on a lot of things. You could spend an entire year doing nothing but studying all the relevant issues, and still be unable to form a bankably-accurate conclusion, because no amount of research will resolve genuine uncertainties. At the other end of the spectrum, some stocks are so obviously cheap that you sometimes need an hour or less to determine that to be the case. That is what I call 'no-brainer' investing, and is what I try to do. I prefer to stick to things that are obvious and where I don't need to be that smart: all that I needed is diligence (primarily sifting through large numbers of stocks), patience, and discipline. 

One such place to look for off-the-beaten-path bargains at present is HK/China, and in particular, amongst balance-sheet stories in low growth areas of the market. The opportunity arises for three reasons: (1) global markets have been generally inclined towards a bearish view of China's economic prospects over the past five years or so, on account of the country's rapid build up in debt (although that bearishness moderated throughout 2017), which has left a lot of stocks discarded (many global investors hold the blanket view that 'I want no exposure to China' and so they are not even prepared to look); (2) the Chinese names and operations of many of these companies are unfamiliar to Western investors, and this lack of intuitive understanding of the companies acts as a deterrent to look/invest; and (3) markets are less efficient in Asia, and most investors in the region are preoccupied with 'growth', and have little interest in cheap stocks with lackluster growth trajectories - particularly ones lacking a catalyst where patience might be required. This creates a significant opportunity for value-oriented investors with a longer term time horizon, that are prepared to do the work, and wait.

One area of broadbased neglect is the lack of attention paid to the balance sheet. Generally speaking, markets are 'earning obsessed' and tend to neglect the balance sheet/book value, but this is particularly the case in Asia, where markets are all about earnings and earnings growth. This approach doesn't make a great deal of sense to me. After all, earnings are merely the change in a company's book value (dividend and capital action adjusted) from period to period. The expected delta of the change in shareholders' equity during one rotation of the earth around the sun is given far more primacy than what a company already owns. At the same price, people would rather own a stock expected to make $0.20/year for 10 years than own a stock that already has US$2.00 in cash, but no current earnings. In some cases that might make sense (for instance where the governance is poor and the cash is unlikely to be paid out, or wasted), but in a lot of cases it doesn't.

A great example at the moment are the shares of Dongfeng Motor (489 HK), which at the time of writing, are changing hands for HK$9.44/share. Dongfeng owns stakes (typically 50%) in a number of automotive OEM JVs in China, in partnership with global players such as Honda, Nissan, and Peugeot, and is also a large principle producer of commercial vehicles in China as well. Through its various associate interests, the company commands an approximate 11% share of the Chinese automobile market (the world's largest), producing more than 3m vehicles a year, and has a presence in every major Chinese automobile segment. It could well be one of the largest global car producers you have never heard of.

Dongfeng has 8,616m shares on issue, yielding a market capitalisation of HK$81.3bn, or CNY 65.7bn at the current 0.808 HKD/CNY cross (the company's functional and reporting currency is Chinese Yuan). For those that think in USD, that is a market capitalisation of slightly more than US$10bn (i.e. this is far from an obscure small cap).

A simple examination of the balance sheet yields some interesting insights. Firstly, the company, as at 1H17, had a consolidated net cash position of CNY 24.0bn, or 36.6% of its current market capitalisation. In addition, the majority of the company's assets, earnings, and value lies within a host of joint ventures with foreign automakers, which are associate accounted rather than consolidated. A close examination of the notes to the company's accounts in its annual report (these disclosures are not available in the company's interim reports) highlights that the company's major JVs are also in large net cash positions. Summing up Dongfeng's proportionate share of the cash held by its major JVs yields another CNY 21.6bn (another 32.9% of its market cap).

Lastly, the company also owns a 12.86% stake in Peugeot (UG FP, listed in France), which it acquired in 2014 for 800m Euros. At Peugeot's last traded price of E 17.98, that stake is now worth 2.1bn Euros, and at the current 7.74 EUR/CNY cross, that is worth another CNY 16.2bn, or 24.6% of the company's market cap. Summing up these three sources of value alone yields CNY 61.9bn, or 94.1% of the company's current market cap. Basically the stock's current valuation is already underwritten by existing cash and liquid assets, before considering any of the sources of current, recurring earnings, the company is still reporting.

How much are those earnings? In 2014, 2015 and 2016, Dongfeng earned CNY 1.49, CNY 1.34 and CNY 1.55 per share, and earned another CNY 0.82 in the first half of fiscal 2017 (the company is yet to report its full-year 2017 results). This includes only very trivial amounts of interest income and associate Peugeot income deriving from the itemised sources referenced above. You are buying these earnings at about a 5.0x PE multiple, but a less than 1x PE multiple backing out cash and Dongfeng's Peugeot stake.

I have read a handful of broker notes on Dongfeng. In all cases, they completely ignore the balance sheet, and focused only on the outlook for Chinese auto sales; Dongfeng's market share and model launch slate; and the outlook for Dongfeng's margins and earnings growth. Most conclude that given that earnings have stagnated; China's auto industry is maturing; and competition is increasing, that the prospects for earnings growth are lacklustre and hence a low PE multiple is justified on account of the poor and uncertain earnings outlook. In my view, this makes little sense, given that the company's share price is already underwritten by past earnings (that is where all the cash came from).

The truth is, at the current valuation level, none of those issues that the brokers are writing long reports about really matter. Those issues would matter a great deal if Dongfeng were trading at 10x earnings ex cash, because the question of whether the stock was trading at a fair, too high, or too low a valuation would hinge on the outcome to these issues. However, at its current price, under almost any realistic scenario for the company from an operational standpoint, Dongfeng is cheap. So why waste the time spending considerable analytical resources trying to figure out those (largely unknowable) questions? I would rather commit the time to sifting through more stocks to find more bargains.

True, Dongfeng - like many Chinese/HK companies - likes to sit on an unnecessarily large cash pile for an indeterminately long period of time, and pays out far less of its earnings than it could (and should). Some discount is warranted on account of this reality. However, the current discount level is extreme - particularly because Dongfeng does pay a dividend, and a growing dividend to boot. Dongfeng has paid a dividend every single year since its 2006 listing (including through the GFC), and has increased its dividend steadily from CNY 0.04 per share in 2007, to CNY 0.23 in 2016, and in 2017, declared an inaugural interim dividend of CNY 0.10. Expectations are for CNY 0.33 in total dividends for 2017 (including the upcoming final dividend), which represents a dividend yield of 4.07% at Dongfeng's current share price.*

Futhermore, the company has tremendous latent capacity to either increase its dividend payout, and/or pay a significant special dividend, and at some point it may well consider doing so - particularly as China's auto market matures, and new capacity expansion capex requirements moderate. The notes to its accounts show that its JVs are now paying out a significant fraction of their earnings to their owners (Dongfeng and its JV partners), so this cash is already being upstreamed to the Dongfeng parent and will thus be increasingly available to pay parent dividends. If Dongfeng ever announced a significant increase in its dividend payout ratio and/or a special dividend, the stock would soar, and in the meantime, you're paid a 4% yield to wait - well in excess of what most bank accounts pay. And if they do not increase the dividend further then, well, that is already in the price.

This is a no brainer. However, importantly, it does not mean you will immediately make money after you buy the stock, or will not have to endure significant volatility or mark-to-market (or even actual) losses. Given the nature of markets, it is likely that if the Chinese economy has a downturn/recession, and Dongfeng's auto sales drop by say 20%, Dongfeng's share price will probably still go down by 50% (indeed, it has dropped 5-10% over the past week or so on the back of the US market rout). The stock could also merely drift sideways for years and years (this is another key reason why the opportunity exists; most investors are not prepared to wait or hold a stock with an indefinitely-long payoff profile). Being cheap does not stop a stock going down, or guaranty a good outcome. The stock might drop 50% and then be taken over by an opportunistic bidder and you might still end up losing money.

However, the important thing in markets is expectancy of returns, not individual outcomes. I firmly believe (and decades of market history also backs this up), that if you can buy a diversified basket of Dongfeng Motor type stocks, and hold them through multiple market cycles, overall you will end up with significantly better-than-market returns, delivered with lower-than-market levels of risk, and for a long term investor, that is the outcome that is important - not the outcome on individual stock positions.

Focusing on process rather than outcome is also a great way to guard against the psychological pitfalls that the market's repeated ups and downs can entail, which often corrodes investors' discipline and poise. If you get the process right, the outcomes will inevitably follow over time. Portfolios I manage have an approximate 1.0% portfolio weighting in Dongfeng Motor.


LT3000
  

*Note that the dividends are CNY denominated, whereas the shares are denominated in HKD. The HK$9.44 share price is equivalent to CNY 7.63 at current exchange rates. Equivalently, the 0.33 CNY dividend is equivalent to HK$0.41.





10 comments:

  1. Hi Lyall,

    Love the tempo and content of your posts, very insightful, am i glad i stumbled upon your blog,as happy as can be when finding a cheap stock.
    Not sure if you have come across iqgroup in your stock trawling,a lighting co, was trading very cheaply at 6x, oem just moved into own brand manufacturing, n sitting on a boatload of cash and generous with payouts, stock came down more than 50% of its peak but still i didnt buy because i tot it was in a competitive industry and recently recorded quarterly loss due to slowdown in throughput...boy do i regret it when it rebounded more than 15% in a day...curious to hear your views on this stock and did i just turn away from a no brainer?

    Trying to improve my investment process and thinking.
    Thanks in advance

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    1. Thanks for your comment & glad you're enjoying the blog. I haven't encountered IQgroup yet tbh - I'll take a look. Thanks for flagging. I might revert with some comments at a latter time. Cheers, LT

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  2. Thanks, looking forward =)

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  3. IQ Group started as an OEM for smart lighting systems for commercial, resdiential and industrial segments. They make most of their revenue outside Malaysia. Lately, they tried to create their own brands and devoted R&D employees to it. Due to new business, the stable business of OEM suffered since IQ Group wasn't able to come out with new products for their clients. It is a turnaround stock that I am watching closely as well.

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  4. Excellent synthesis of process and instructive case study of thinking through value. I would love a post on how you think about bet sizing and process... I would have thought 1% allocation to an idea like this is trivially low.

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    1. Hi Jonathan. Thanks - I would agree with you if there weren't literally hundreds of stocks as cheap as this in places like HK/China, as well as many other emerging markets at the moment. In addition, as fate would have it, the stock has in fact fallen 20% since this post was written - deep value stocks very often simply persist in getting cheaper, often for very long periods. I've taken the weighting up to 1.3-1.4% as the stock has continued to fall. There is no shortage of cheap stocks out there at the moment - value investors are spoilt for choice. Cheers

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  5. I got a few more for you.
    Goldpac, makes 7% of the world's bank cards. Trading 7-8x earnings, with entire market cap in net cash and a 7% dividend
    Asia Orient, owns high quality real estate, You get a 51% of Asia Standard for almost free (which is also cheap in itself)
    Baoye Group, Real estate company that has repurchased almost 20% of its shares in past 4 years. Trades at <4x PE with lot's of cash, and earnings upside due to their housing industrialization initiative.
    Consun Pharma, less than 10x 2018 earnings will amazing growth prospects in a largely untapped market. Very cheap compounder. Repurchased lot's of shares with large insider purchases in the past year.
    Texhong, Compounder at <10x earnings with above average management (even for Western standards)
    Hopefluent, real estate broker at 5x earnings with a lot of cash on balance sheet, large insider purchases and 5% divvy.

    I own all of these :)

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  6. The Dongfeng dividend yield now exceeds 5% according to Yahoo Finance.

    https://finance.yahoo.com/quote/0489.HK/

    Is this stock in the category of 'net net' deep value as per Benjamin Graham?

    Yahoo reports (end of 2017) CNY114B current assets and CNY96B total liabilities so the net net is 114 - 96 = 20. Market cap is currently CNY72B so that is a lot more than CNY20B.

    I am probably not doing this right. I'm a complete beginner at valuing stocks. I read a book and now I'm trying it out.

    Are the Peugeot shares a 'current asset'? If not do we add them to current assets? About CNY17B extra.

    Is further adjustment required to recognise the JVs?

    Are there any unrecognised liabilities like pension obligations or long leases that need to be added?

    If the author or readers can help me value Dongfeng in some conventional way I'd be grateful.

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  7. Hi Lyall,

    I've looked at Dongfeng and i'm not as confident as you on this. In fact all the state owned auto manufactures are trading very cheap - and justly so.

    In April 2017, the Chinese government established a medium and long-term development plan for the automotive industry.

    You can read it here: http://miit.gov.cn/n1146295/n1146562/n1146650/c5600446/content.html

    Essentially, these state owned companies exists because of Chinese regulations that forces foreign automakers to establish 50/50 JV agreements with state owned enterprises or be subject to significant import taxes.

    If you read the Chinese government's long-term plan, within the scope of 10 years -- their goal is to eventually release these JV conditions. Once independent Chinese car makers are capable of completing on a global scale with significant technological capabilities -- these JV structures will be gone, along with the revenue that DongFeng generates from it.

    This is a huge problem for a company like Dongfeng which generates 80%+ of it's revenue from JVs. regardless of whether it will happen in the next 10 years as proposed or in the next 20 years.

    Why?

    let's say a hypothetical company will grow 15% for 10 years and 5% for the remaining live of company. Let's say cost of capital is 9% per year.

    The sum of PV of earnings during the first 10 years is $3,731 and sum of PV from year 10 until it's demise is $12,324

    This means that 76.8% of the true intrinsic value of the company today is the company's earning after 10 years.

    If for Dongfeng - it's existence 10 years from now is in limbo -- then it's multiples should be heavily discounted.

    Perhaps you can bet on a tail side event?

    As you once said "And yet it is changes of opinion, driven by unexpected events, which drives the vast majority of the big moves (and returns/losses) in markets."

    I've thought about 2 possible events:


    1 . What if JV structures don't get changed by the Chinese government? Note that something like this would have to completely remove the possibility instead of postponing the inevitable to provide a meaningful return --- the recent removal of the 40% import tax on cars by Chinese gov upon pressure from trump doesnt help in the short run in terms of catalysts

    2. DongFeng can build up its own local brands -- unfortunately the auto industry in china is currently in the midst of a pricing war -- lots of competitors and very hard to establish a strong brand over the well known foreign companies --- lots of execution risks as this is very hard to do

    maybe there's an another tail event that i can't predict, and that's fine.

    Regardless, i think buying dongfeng is like betting against the chains of capitalism.

    Li Lu (he manages charlie munger's money) talked about modernization as it relates to china, and china being on the path to a free market society.

    If there's anything wrong about my thought process here, please let me know.

    Thanks

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    1. One more thing:

      another possible event is that the JV partners might become reliant on Dongfeng, such that even if they aren't sanctioned to use them...they might still rely on them for the manufacturing.

      I can't possibly know what the probability of this is...but i don't think it's 0%.

      Maybe this is not being priced in as a tail side event at 1x p/e ex.cash

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