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.


*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.