Tuesday, January 02, 2007

Priced to Perfection

As we usher in the new year, financial magazines, TV programmes, and brokers are all falling over each other to share their top (ten) picks for this calendar year. However, the mood at Margin of Safety (MOS) is considerably more somber as we are folks who are very much focused on the downside risk of every trade. Hence, the first security featured this year is one which we feel investors should exercise caution with.

CapitaRetail China Trust (CRCT) is a Singapore-domiciled REIT established with the aim of investing into a diversified portfolio of income-producing real estate used for retail purposes that are located primarily in China, Hong Kong and Macau. CRCT's initial portfolio of seven retail malls - Jinyu Mall, Zhengzhou Mall, Anzhen Mall, Jiulong Mall, Wanjing Mall, Xinwu Mall and Qibao Mall, are located in five major cities across China.

CrCT was initially offered at S$1.13 and started trading on 8 Dec 06. It closed on the first trading day at S$1.80 and has since run up to over S$2.00. Investors piling up into CrCT are buying into the growth story of China consumerism and the familiar, but what we crudely consider to be the balderdash of Chinese over-hype. Of course, CrCT is backed by a strong sponsor in CapitaLand Limited (SIN:C31) who has promised to inject properties into the REIT from its incubator funds. Capitaland is a seasoned operator with a stellar track record of managing REITs in Singapore and lately, in Malaysia in the form of Quill Capita Trust. Readers will also recall that in early 2005, CapitaLand had entered into an agreement with state-owned Shenzhen International Trust & Investment Co Ltd to build 21 shopping centres in China with an option for a further 14. These malls will be anchored by US retail giant WalMart Stores Inc.

But at its current price of S$2.10, we like to point out that CrCT is yielding a paltry 2.91%. Paltry because one can receive a yield of more than 3% by purchasing risk free "AAA" Singapore government sovereign gilts (albeit its unglamorous factor). So accumulators at this price have to ask themselves whether they are being sufficiently compensated for assuming the risk of investing into an emerging economy like China? Or risks that competing malls may mushroom adjacent to CrCT's current one in the vast country, changes in legislation, or even a slowdown in Chinese demand?

To compensate for the low yield, investors are probably expecting strong rental growth or an increase in capital value in the years ahead. So exactly how much growth in NAV are we looking at for it to catch up with prevailing prices? It is specifically a 114% increase for its NAV of $0.98 to narrow the gap for CrCT is trading at 2.14x of NAV.

For illustration purposes, we assume that a fair yield for Chinese mall exposure is 6%. A 6% yield at S$2.10 implies CrCT has to make a distribution per unit (DPU) of $0.105. This is approximately a 70% increase over the current DPU from future rental step-ups and asset enhancements. If its DPU were to grow at 10% per year, CrCT will then take about 6 years to grow its DPU to the requisite level. So today's investors have to decide whether they want to pay up for this possibility 6 years in advance!

Another quick way to look at it is that any cent above the NAV backing of $0.98 which one forks out is essentially for the hope of growth. Or for, if you are to excuse our "un-investment bank like" plain speak - Chinese air (which quality may not be the best around if recent reports are to be believed) until the growth materialises.

As a rule of thumb, prices of stocks in a market can gyrate between three states: (a) underpriced, (b) fairly priced, (c) overpriced. Category (b) is for upholders of the efficient market theory. If you fall in this group, it suggests that no mortal can beat the market and hence, one should be better off investing into an index fund (and spending time with your kids) and not CrCT. MOS folks do not fall in this camp. It is stocks in category (a) that we relish and would back up the truck for. At current prices, we are of the view that CrCT is more likely to fall in (c) where the probability of sustaining a loss far exceeds that of making a gain. We tend to stay clear of such a situation where capital impairment is a distinct possibility.

Obviously, one man's poison is another's caviar. So if there is a takeaway in this opening post of 2007, it is that one should tread carefully in the stock market minefield, especially when considering a buy of CrCT at current prices.

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