Dear Fund Investors/IOU Holders,
Firstly, a brief update on the key matters that occurred during the year.
As all of you are aware, on the 7th of March, we have adopted the “Fund Unit” method of tracking returns. Working backwards from that date, the extrapolated value of the fund units at each milestone is as per the table below.
Inception of Fund – 21 March 2017: RM1.007
End of first year – 3 January 2018: RM1.130
Today – 30 June 2018: RM0.966
In addition to the above, moving forward, the fund will be using the FBMEMAS Index instead of the KLSE Index to track performance.
Why the change?
As some of you may be aware, the KLSE Index only tracks the prices of the top 30 largest listed companies in Malaysia. As the Malaysian stock market consist of more than 950 companies, it’s scarcely a fair representative of the class of assets invested by the fund, which do not include these 30 companies.
Personally, the fund tends to swim in the waters populated by the small to mid-sized companies. This is not due to an aversion to the top 30 companies, nor a proclivity to the small and medium sized companies.
It just so happens that the lack of coverage by analyst as well as institutional funds in these areas, statistically ensured a greater probability for obtaining value, and thus far, investments that have meet the fund’s investment criteria have come solely from this area.
The FBMEMAS Index however, represents 98% of the market capitalisation of all listed companies in Malaysia, and is thus a much more accurate representation. Having said that, the top 30 companies still contribute roughly RM1.05 trillion, or 58% of the market capitalisation of all listed companies in Malaysia, which is roughly RM1.8 trillion. And thus KLSE index, by extension still have a weighting of about 58%-60% in the FBMEMAS Index.
First the facts.
Since our last update on 3rd January 2018, we have officially lost our virginity, and recorded our first loss. A drop of RM0.164 or 14.52% per fund unit from RM1.130 to RM0.966. During the same period, the FBMEMAS Index have fallen from 12,930 to 11,961. This represents a smaller drop of 7.5%, and a negative 7.52% performance on our part.
However, delving deeper into the numbers, during this period, the KLSE index which constitutes 58% of the FBMEMAS Index fell by a mere 5.58%. On the other hand, the Malaysian Small and ACE Index, which represents the remaining 42% of the FBMEMAS Index, and also 100% of the fund’s investments have fallen 18.88% and 24.91% respectively, far higher than the drop in value of the fund, and thus an over performance on our part.
Having said that, I am aware that in times of under-performance, providing explanations (however reasonable), sound uncannily similar to making excuses. In addition, negative returns is negative returns. Using the Japanese stock market for the last 20 years as reference, one can actually outperform the market every single year and still lose money.
At the end of the day, as investors, we expect not just outperformance, but a positive return on our capital over the long term. And as your fund manager and largest unsecured investor in the fund, I intend to provide it.
For our IOU holders, regardless of performance, at minium, the protection of your capital and interest of 4.4% (0.4% higher than the highest FD rate in Malaysia) is guaranteed.
There are a few factors that contributed to the drop in value this year and they are as follows:
The fall in value of our export related stocks.
In the previous year, yours truly, built up a roughly 10% position in Lii Hen Industries Bhd (“Liihen”) and Latitude Tree Holdings Berhad (“Latitude”). The initial investment thesis was as follows:
Liihen is actually a pretty good business, at least in the context of cost based business.It had a tight control over their manufacturing, is highly efficient with factories being located near to each other and with suppliers and its products have great reputation as well as strong demand from its customers.
The management is honest and competent, the business had low capital expenditure requirements, and they had a natural in built moat in having access to large amounts of rubber wood in Malaysia (one of the key materials for making furniture). The government’s ban on the export of rubberwood also basically ensured that they will always have supply at a reasonable price.
As for Latitude, I liked it as it was much cheaper valuations wise than the already cheap Liihen, and as it was also based in Vietnam, it had a much lower cost base as the per capita income in Vietnam is about 35% of Malaysia’s.
I also expected the USD to continued gaining against the RM, as I figured Najib would be around, and the resulting slow deterioration of our economy will devalue the RM. The cheaper the RM, the higher the demand for our export goods.
I also expected the USD to gain, due to,
Lower corporate tax rate implemented in the US resulting in higher investment there.
One off reduced tax holiday implemented for repatriation of cash held overseas in the US for US Corporations, which should result in roughly USD 1 Trillion held overseas being repatriated back.
Increased interest rates by the US Federal Reserve in order to unwind their bloated balance sheets
And subsequently, increased repayments of USD denominated loans worldwide due to rise in interest rates as well as USD.
The economy in the US was booming, and still is booming. As the hurricanes just occurred, I expected demand for furniture to increase.
For the most part, I was correct. However, the USD fell against the RM initially, before strengthening again, resulting in a drop in profit for both companies for one or two quarters.
In addition, the companies had problems finding enough workers due to labour constraints (ironically, a result of our lower currency, resulting in lower immigration, as well as crackdown on illegal workers) resulting in increased labour cost, which further compressed margins. The drop in profit, resulted in the drop in stock prices of 26% to 37%. However, as the investment is only 10% of the fund, net effect was only a 2-3% drop in value.
Moving forward, I now no longer expect a deterioration of the Malaysian economy over the long term, however, Rome is not built in a day, we still have some way to go before the turnaround, and the factors previously raised that will result in a higher USD is just starting to take hold.
In addition, both companies are still very well managed and its fundamentals remain intact. After all, there is more to export businesses than just foreign exchange fluctuations.
Valuations wise, the companies are also of pretty good value and therefore the fund will continue to hold these stocks.
The fall in value of petroleum refinery companies.
In 2017, a significant portion of our gains was due to a run up in the value of petroleum refinery companies, of which the fund had a significant stake of roughly 10%. The name of the companies are Petron Marketing Berhad (“Petron”) and Hengyuan Refinery Berhad (“Hengyuan”). On a cost basis, roughly 8% was held in the first and 2% was held in the second.
At one point, our unrealised gain in Petron was in excess of 88%, while our gain in Hengyuan was almost 100%. It has since fallen, and on a net basis we are currently at a small profit.
In the previous year, the crack spread (difference in price between crude oil and its refined products) hit an all-time high of USD6 per barrel. This contributed to extraordinary profits during the year for both companies and a run up in the stock prices.
For Petron, they also have a Marketing arm, ie, they also sell petrol. Petrol stations in general, make about 5% margin on RON95 and Diesel, 10% on RON97 and roughly 20% on RON100. For Petron, as they own most of their stations, this allows them to earn this retail income.
And, if one were to look more deeply into the accounts, other than the widening crack spread, a significant portion of the additional profits during the year was due to its expansion into rural or underserved areas.
In addition, Petron is also a preference for the middle to low income group as they allow you to pre-set the amount payable when making payment via debit or credit card. Every other petrol station charges an automatic RM200, with the balance being reversed after 2 days. A very significant amount for the average household. The alternative is of course to pay cash up front, get back your change after pumping your petrol, a very tedious affair.
In addition, Petron also places a strong focus on its membership cards, which unlike other stations, allow you to convert the points directly to cash or petrol, a much more useful mechanism compared to other merchants which will only allow conversion to other goods such as vacuums etc. This indirectly ensures that its customers remain stickier than most when it comes to where they would want to pump their petrol.
For Hengyuan, it’s a pure petroleum refinery outfit. Previously it was owned by Shell, before being sold to a Chinese GLC. The company is expected to have its refineries upgraded and subsequently supply refined petroleum products at market price to the Chinese market.
So where did things go wrong?
Well, for Petron, your fund manager was not as disciplined when it came to selling the stock when its fair value was achieved.
The main reason being that Petron was and still is a pretty good business. At its peak, it was selling at roughly 12 times earnings, whilst its direct competitor which did not have the same growth potential was selling at roughly 20 times earnings.
As for Hengyuan, your fund manager did sell them at close to peak prices. But rebought the company when prices dropped 30%. However, when the repurchase was made, I failed to perform a deeper analysis of its true earning power (after discount this extraordinary event of high crack prices), and thus overpaid. It subsequently fell 55%. However, netting off against the profit previously realized, we are still in a small profit position.
It would however be remiss of me to not acknowledge that my emotion did get the better of me when it comes to both companies. It was a bull market. And bull markets are like sex. It feels best just before it ends.
Having said that, due to both localised as well as general sentiment, both companies are currently trading at ludicrously low valuations, with Petron currently selling at roughly 5.3 times earnings, and Hengyuan 2.62 (normalised its about 8 times). And as your fund manager, I am personally glad to be given an opportunity to purchase more!
A drop in market value for TIMECOM
As stated in the funds previous letter, our largest investment then was TIMECOM at 31% of the fund. It is currently at a more reasonable 22.5%. This is largely due to additional deposits placed into the fund that was invested in other equities.
Here is a brief recap on the company.
TIMECOM is a provider of fixed line internet services in Malaysia, which is also expanding to Thailand and Singapore. It is the provider of the best, fastest and cheapest internet connection in Malaysia.
Comparing its base package to TM’s, it provides 10 times more value for the money.
The company is also the owner of the only pure fibre optic cable backbone and network in Malaysia, thus giving them a competitive advantage that cannot be easily taken away unless significant investment, and more importantly time is given.
Due to the essential nature of its service, internet connection, its earnings are also highly resilient. In addition, due to the sheer demand of its service, given its incredible value, its strong growth also happens to be highly resilient.
The retail division grew roughly 102% year on year from 2016 to 2017, for a net effect of roughly 18% growth in recurring operating earnings and revenue for the whole company.
I almost could not ask for more in terms of business performance from this company.
So why did the price fall?
Well, in the previous years, its earnings was bolstered by the gains on the disposal of its shares in Digi. And in the more recent quarters, there was a reduction in one off sales of bandwidth, foreign exchange losses due to the gain in the USD(some of its bonds and one off bandwidth sales is denominated in USD), and they also incurred higher initial depreciation cost on its newly completed undersea fibre optic cables
In addition, with the election of our new PH government, some investors were scared off by their election manifesto to double speeds for half the price.
Double the speed? TIMECOM is 10 times the speed.
For the sake of discussion, let’s assume the new government forces TM to do that (I doubt it can, that company’s net margin is only 7% to begin with, and they owe RM8 billion to the banks), that is 20MB at RM75 (Cheapest TM plan now 10MB, RM149) or 100MB at RM375 (extrapolated).
TIMECOM is RM149 for 100MB or 60% cheaper. Even when compare to TM’s best plan, 100MB for RM329. TIMECOM is still 55% cheaper!
Given the short term nature of most investors, this has caused the price to fall roughly 20% from our cost.
As your fund manager, my only regret was buying too much too soon. It’s a great company, but valuations were not cheap to begin with, but merely fair.
However, like Public Bank, when one finds a fantastic company, the key thing is to own some and to hold for a long period of time. The mistake here is to not buy any to begin with or only hold it for a short period. Given the fund’s long term perspective, we are quite optimistic on our investment in the company and look forward for an opportunity to buy more.
The new kid on the block
During the year, the fund have opened a new and significant position in RCE Capital Berhad. As of today, our investment in this company consist of 29% of the fund and it is by far our largest position. Here’s why.
RCE Capital Berhad is a non-deposit taking financial institution, whose main business consist of running the money lending operations on behalf of “Co-operations” (similar to what we had in secondary school, ask Soon Huat!). They currently run the money lending operations for Yayasan Ihsan Rakyat (“YIR”) and Yayasan Dewan Perniagaan Melayu Perlis Berhad (“YYP”).
So what do these Co-Operations do? Their business consist of giving out personal loans to government servants. And their focus is on the B40 (Bottom 40% Earners) population and government servants who often cannot get loans from conventional banks.
However, this risk is mitigated by the nature of its repayment process and higher interest rates. Unlike other loans, as these are loaned to government servants, this allows the company to make direct deductions on the salary. Every month, RCE Capital gets paid before the borrowers even sees their salary.
In addition, as the guarantors are also often government servants, in the event the original borrower cannot make the payment, the Company will simply deduct the salary of the guarantor, providing a second layer of safety.
They literally cannot run. Legalized ah longs at its best.
The company borrows money at 4.5% -6% (via loans from banks, bond issuances, or securitisation of the loan book) and loans them out to the government servants at roughly 15% to 20%. Net of impairments, the company makes roughly 6.5% return on assets. The highest in Malaysia
As they are a financial institution, they are also able to leverage up safely, as long as cashflow is properly managed. The company is currently leveraged 2.5 times. Giving them return on equity (return on every additional dollar invested) of roughly 16.5%.
Except, here’s the best part, most non deposit taking financial institutions can leverage safely up to 5 times. Which means, the potential for RCE is roughly 33% return on equity which is utterly incredible.
One of the best things about financial institutions is that, as long as the company is properly managed, it can be very hard for things to go wrong.
First off, the income is recurring. As long as you manage your cashflow, loan requirements, risk models and actuarial tables, in addition to not overleveraging or get greedy. Money will be coming in like clockwork, every single day, on the dot.
In addition, as the product is cash and well, everything in the business is basically cash. It is very unlikely that bad allocation of capital will be done. You will not see capital expenditure that turn out to be just a waste of money, or money being spent to buy assets that are not being used and just held in the books.
The only thing a management need to do is be conservative, check twice and don’t be greedy, and for a bank to be able to do this, its owners need to have significant skin in game (most banks are owned by institutions, not private individuals) and RCE Capital Berhad have more than 50% of its shares owned by a private individual/company.
The other bank with a similar ownership structure is Public Bank and Hong Leong Bank. They are the number one and two when it comes to return on asset by a deposit taking financial institution. Elk-Desa Berhad is also mainly owned by the owners and have one of the highest return on assets, but as they do not leverage, Return on Equity is therefore unattractive.
Another thing about financial institutions, is that they are essentially perpetual growth engines. Banks generally grow in line with the economy, and when people get richer, they don’t borrow less, they borrow more!
The low end civil servant borrows to buy a Proton, the mid end engineer, borrows to buy a Honda and the manager borrows to buy a BMW!
They are also a few benefits to borrowing exclusively to the Bottom 40 Earning group and government servants as they have certain characteristics that make them very lucrative customers.
- They have low financial knowledge and education. More often than not, when taking out a loan, they fail to differentiate between nominal interest rates and effective interest rates.
Often times, they don’t even take interest rates into consideration! Instead, they just look at the monthly repayment amount. This allows you to structure the loan to charge high interest over a very long period of time.
And often, almost all of them never get out of debt, as allowing you to make money at 15-20% per annum off them almost permanently.
- A bottom 40% earning individual as well as a government servant have certain characteristics.
They often have a low level of education and bad working habits or attitude, making them unemployable in the private sector.
In addition, chances are they will also be too addicted to that 1 hour breakfast, 2 hour lunch break and 1 hour tea break work life, as well as needing to work 30-35 years to get the maximum pension. If they leave sooner, they get significantly less.
These people will usually never leave the government and therefore their salaries will always be deducted.
- Often, the bottom 40 group are also the last to get fired. When PH won the government, they said publicly that 17,000 government servants/political appointees will be let go. And, the vast majority of those people are high earners. Net effect to RCE Capital Berhad is less than 0.5% of loan book.
In addition, in a democratic society, no government ever won a re-election after cutting down the civil service. With Malaysia having roughly 1.5 million civil servants, that is a big group of people who are guaranteed to vote. You simply cannot lose their votes.
At worst, a government can freeze hiring, firing is simply not an answer at all, especially since they are on pension/ defined benefits retirement schemes. Even Mahathir, said low income earners will be spared. The average loan size in RCE Capital Berhad is RM15,000.
And the absolute best part? In terms of valuations, this company is only selling at 5.5 times earnings! With the loan book having an average duration of 7-8 years. The market is valuing it as if the company has shut down and is only collecting on the remaining loan book.
Great business at a cheap price. Sign me up!
General and Macro Overview
Well, what an incredible few months. PH won the elections and threw markets into a turmoil.
Coupled with the following factors,
- Rise in interest rates in the US, causing flight of capital from emerging markets
- Flight from overvalued stocks to cash in US and China
- The general negative sentiment regarding the overly high housing prices in Canada and Australia
- The incredible public debt levels in Canada, China, Europe and the US
- The unwinding of incredible bloated central bank balance sheet of Bank of Japan, Europe Central Banks, Bank Of China and the Federal Reserve.
- Geopolitical turmoil in South East Asia, especially Malaysia
This has caused the KLSE market to turn into a bear market, with equity prices now trading 10-20% below 200 days moving average prices.
Since the last 8 weeks, starting from just before the elections, almost Rm10 billion have been pulled out from the Malaysian equity markets by foreign investors. With a few hundred million being taken out every single day for the last 6-8 weeks.
However, long term wise, the future has never been brighter in Malaysia. It will take some time, but the long term prospects is just incredible. We are the only country in South East Asia, whose people can speak 3 languages well, and connect both high value chains like Singapore, with lower value chains like Indonesia, Thailand and Vietnam. In addition, we are also large enough to have a proper industrial base unlike Singapore.
With this renewed optimism in Malaysia, I think the listed Property Development companies in Malaysia will soon start to see higher earnings and thus and expansion valuations and higher market capitalisations.
With this renewed optimism and a brighter future, I expect two things.
- A significant portion of Malaysians currently overseas will migrate back
- Malaysians, the Chinese in particular, who were previously considering migration, will now consider staying back.
Both of the above groups are of the higher income levels, will this renewed optimism in Malaysia, will start spending and investing in Malaysia again. And being an Asian country, most of us love buying property.
Currently, most property development companies are selling at liquidation value despite still being profitable! The highest gains are made when investments that were once valued at liquidation value is now being valued as business again, especially one with a bright future!
Having said that, in terms of where we are now in the credit and economic cycle, a recession within the next two years is definitely in the cards.
However, given the long term nature of the fund, our zero leverage policy, our discipline in only investing in companies that meet our increasingly strict and refined criteriass, and ensuring that our investments are generally good to great businesses with good capital structure that won’t go bust in the trough and bounce back fantastically when things turn around. It makes us optimistic for the years and years ahead.
Overall, as your fund manager, I remain grateful for your support, and will continue working hard to continue to merit your confidence.
The current shareholding of the fund is as follows.
Fund Performance to date
|Period||Fund Returns||FBMEMAS Index||Alpha|