Tong Kooi Ong
Leverage is fine, if you’re not ignorant
To borrow a quote from Warren Buffett; “When you combine ignorance and leverage, you get some pretty interesting results”.
Followers of this column would recall that I spent the past two weeks discussing prevailing reporting standards for financial statements and how they can at times, make it more difficult to determine the underlying fundamentals of a company.
Most financial statements do contain useful information, though not necessarily all that the company would be willing to provide. But some information, even when they are in compliance with all accounting standards, can be misleading.
Case in point, the situation surrounding financially-troubled Hyflux (listed on the Singapore Exchange), which I discussed in detail last week. To recap, part of its recognised profits does not entail cash flow and certain obligations (perpetual securities classified as equity) are reflected in a way that overstated profits and understated gearing.
If there is one thing to be learnt from the Hyflux saga, where stakeholders are now facing significant losses, it is that even well regarded companies can and do fail under the burden of debt.
This being the case, we undertook an exercise to look at all the companies listed on Bursa Malaysia (excluding financials and real estate investment trusts). Of the 877 companies, there are 319 that reported an increase in net absolute borrowings since FY2013.
We omitted companies with market capitalisation below RM100 million and added several additional filters to the remaining 217 companies.
Firstly, we left out companies where gearing levels are now lower than they were in FY2013, even though the absolute amount of borrowings has increased. Why? These companies have also raised equity (accumulated profits) and increased its assets faster than borrowings.
Next, we eliminated those where cumulative cash flow from operations is higher than net profit over the period FY2013-FY2017. We decided on this filter to remove companies that generate strong cash flow, such as telcos.
Finally, we whittled down the list to only companies where current net gearing is more than 50% to reflect the relatively higher risk profile. The result is shown in Table 1.
We repeated the exact same exercise for companies listed on the Singapore Exchange (see Table 2).
Let me be clear, we are not saying these companies are, or will be, in financial difficulties. Companies necessarily reinvest for the future. These expansions are funded through a combination of internally generated funds, borrowings and cash call. The capital investments then generate future income streams, to pay off the debts and reward shareholders via dividends.
What we do wish to highlight are the risks associated with high gearing and that investors should take a deeper dive into their financials to make the best-informed decision. As in the Hyflux case, one may well have come to a different investment decision with a better appreciation of the accounting behind its reported numbers.
Incidentally, these details are what I meant by useful information companies are willing to disclose, but which are not contained in financial statements – in quadrant 4 of the diagram (which I articulated two weeks back).
The Global Portfolio gained 0.7% last week, which pared total portfolio losses (since inception) to just 1.8%. Nevertheless, this portfolio is still under-performing the benchmark MSCI World Net Return Index, which is up 2.8%, over the same period.
Stocks on the Bursa Malaysia traded broadly lower last week. Selling pressure built up during the week and intensified on Thursday, when the FBM KLCI fell nearly 21 points led by losses from blue chips such as Public Bank, KL Kepong, Maybank and Tenaga Nasional. It was the biggest one-day point loss since the first trading day of this year.
The Malaysian Portfolio fell 0.6%, in line with the benchmark index’s 0.6% loss for the week ended Thursday.
Total portfolio returns now stand at 52.9% since inception. The portfolio continues to outperform the benchmark index, FBM KLCI, which is still down 9.1%, by a long way.
A Note to Readers
It is my pleasure to share with you my Value Investing Portfolio. However, I must emphasize that it is by no means a recommendation or a solicitation or expression of views to influence you to buy or sell any stocks. I am just sharing openly on what I am doing with my stock portfolio.
Further, I like to remind all investors that investing is not just about the profits or returns. You will inevitably suffer stock losses too. You need to understand your own investment objective, risk appetite and the amount of loss you can afford to bear. So, while many investors talk only about absolute returns, I am also sharing the computed risk-weighted returns of my portfolio.
Tong Kooi Ong