Prelude: This article aims purely to share some finance and investment knowledge. It is not a post to peddle any stock, which I have no interest nor any motivation and have never done that before. If you detest seeing my name or the subject matter, just don’t read it and waste your time. But if you open up your mind and choose to read it, you may learn something interesting in a very important concept in finance and investing. It is your choice folks. Your comments, good or bad, purely on the subject matter, is appreciated.
Deep value asset investing strategy
When it comes to investing in stocks, many cannot distinguish the difference between a great company and a good investment. A great company may not be a good investment if the price is grossly overvalued and vice versa. Those who are in the know also place greater emphasis on earnings of company as earnings in general drive the value and growth of a company and the price of its stock. Often, the company's balance sheet is ignored, even though it has huge amount of hard and marked to market assets way above the market cap of the company. Therefore, asset-rich companies occasionally trade well below its intrinsic value.
Deep asset bargain investing is about having a very conservative measure of intrinsic value, essentially liquidation value, and a large margin of safety, in order to try to buy a stock worth RM1 for, say, 50 sen. Some of the world’s most legendary investors like Ben Graham, Walter Schloss, John Neff, Marty Whitman and many others have made a mint out of this investment approach. In fact, I don’t think there is anyone else who has beaten the record of Walter Schloss who was one of the most influential investors based on his 5 decade long performance from 1955 to 2005, returning a CAGR of 21.3%, almost three times the 7% return of the S&P during the same period. $1000 invested with Walter Schloss with his deep value asset investing in a diversified portfolio would have become $17 million in the 25 years.
Quality of assets
It must be pointed out here that not all assets are the same. In fact, the difference can be vast ranging “from earth to heaven”. Take for example, in my previous article on “Any return flight from Holland to London?” in this link below,
https://klse.i3investor.com/blogs/kcchongnz/214995.jsp
I have demonstrated that although London Biscuits has a net asset per share of RM1.54. At the price of 16.5 sen now, it is traded at just a tenth of its book value, the mother of all deep value asset investing. However, as it is under PN17 and if it failed to regularize its operation, the shareholders are unlikely to get back any money upon the liquidation of the company as its assets are poor quality assets which made up mostly by the plant and equipment which are of not much use for others and receivables which have not been collected for long time and unlikely to be able to collect most of them. These are poor quality assets. Sendai is the same if not worse. There are many more.
What about the quality of the assets of Insas? We will use the latest financial statement of Insas Berhad for the quarter ended 30th March 2019 as examples.
Assets of Insas
Column 1 in Table 1 in the Appendix summarizes the assets of Insas as on 31st March 2019.
The net asset (Total assets-total liabilities) of Insas is RM1717m. With 663m shares outstanding, net asset backing per share is RM2.59. At the closing price of 80 sen on 19th July 2019, Insas is trading at less than a third of its book value. It would be of no use if the assets of Insas are made up of mainly plant and equipment and money owed by others, like what happens to London Biscuits above.
Two thirds of Insas’s assets are made up of cash in banks, money market fund, share investment mainly in public listed companies. These assets are high quality liquid assets which can readily be converted to cash.
Column 2 in Table 1 shows the weightage given to each category of assets and their net value calculated and shown in column 3. Cash and cash equivalent are given full weightage whereas Receivables and Investment in properties were given 25% discount. In the case of Associated companies, as there are market values for these assets such as shares of Inary at RM1.61, Ho Hup at 56.5 sen etc., the market value of approximately RM1b is used instead of the book value of RM429m. Inventories, Intangible and other assets are totally discounted. Even Property, plant and equipment are totally discounted too even though there is considerable value in the land and building and the rental cars it owns. The net value for each asset category is listed in column 4 in Table 1.
This analysis gives a total asset value of RM2523m and after subtracting the total liabilities of RM641m, the market value of the net asset is RM1882m, or RM2.84 per share. At a price of 80 sen, Insas is trading at more than RM2.00 below its conservative net asset value, or a discount of 72%. This means Insas is trading at 28 sen for a Ringgit of its conservative and mostly marked-to-market assets. Hence at least for the risk aspect, the downside risk is taken care of.
Insas at 80 sen, or a market cap of RM530m, with a total debt of RM411m, and RM130m in Preference shares, is trading below its cash and cash equivalent and marketable securities, or a negative enterprise value company. This provides an arbitrage opportunity for astute and rich investors.
Theoretically someone can borrow RM530m from banks to buy up all the shares in the open market at 80 sen, and after gaining control of the company, sell off Inari, Ho Hup and other shares, the and money market funds, strip off the cash in banks, payoff company loan of RM411m and RM130m to holders of Preference shares, and pay the bank loans of RM530m borrowed for this purpose, pocket RM870m cash left over, and still own the business for free.
This arbitrage opportunity as shown in Table 2 in the Appendix is used as a theoretical illustration purpose only. In practice, it is easier said than done though as there are problems in a hostile takeover attempt. At present, the major shareholders control just short of 33% of the outstanding shares of Insas. With another close to 100m warrants and a large portion of Preference shares which can be used as conversion price for the warrants, the major shareholders have a firm grip of the company. However, it would be interesting if the warrants are left to expire worthless in early 2020. If this hostile takeover can be done later by someone with deep pocket, huge reward is awaiting. Even if there is a takeover war going on, share price would also rise and benefit the existing minority shareholders.
Conclusions
Deep value investing is not easy. It requires patience, and a lot of patience. It is not for the faint hearted. Insas has been undervalued for a long time. A catalyst may be required to unlock the value. Fund managers and institutional investors will not be able to endure it as they will be long fired by their investors before value is unlocked due to their temporary under-performance. Most individual investors also have no stomach for it. They will be laughed at by others embarking in this strategy as it does look stupid at times. But if a stock is way undervalued, not only by 10%, 20%, or even 50%, but a much larger discount such as 72% as that of Insas, the probability of success is higher. Of course, nothing is certain in this world. But at least the chance of losing money is very slim as the extreme cheapness and quality assets would have taken care of this. Insas has also been providing satisfactory return over the years, and it is likely continue to do so even if the deep value is not unlocked.
Take care of the downside, let the upside takes care of itself.
What we are afraid of is if the value takes a long time to unlock, value may erode, such as in a business with persistence huge losses, burning cash in its operations, or management embarking on overvalued acquisitions, or squander away the cash it has, failed business ventures, or other shareholder value destroying activities. I my opinion, Insas does not belong to this category. Having different stocks with different return drivers in a diversified portfolio is also a smart strategy in investing.
KC Chong
Appendix
|
Table 2: Arbitrage opportunity |
RM million
|
|
Borrow from bank and buy all Insas shares, million |
530
|
|
Pay for shares |
-530
|
|
Sell all shares of associated companies |
1000
|
|
Liquidate all other financial assets |
273
|
|
Strip off all Cash in banks |
668
|
|
Total cash available |
1941
|
|
Pay personal bank loan |
-530
|
|
Pay Preference shareholders |
-130
|
|
Pay all company debts |
-411
|
|
Total liabilities paid |
-1071
|
|
Pocket money |
870
|
https://klse.i3investor.com/blogs/kcchongnz/216003.jsp
