Wednesday, February 28, 2007

The Chinese Contagion

Global markets were all roundly routed today after Chinese stocks sold off by 9% yesterday. Asian markets such as Japan, Korea, Malaysia, India and Singapore all tumbled more than 2% in its worst slide since the Sept 11 attacks in 2001. Markets further away in India, Canada and South America were not spared either.

Volatility returned to the market when the VIX spiked to 19 in early morning trade. The VIX was up almost 50% from the day before. MOS last described VIX in our last posting. As evident from recent posts, MOS has been preaching the theme of cautious investing of late. The choppiness of the market today underscores our warning.


Saturday, February 24, 2007

The Sun Always Shines (only on TV)

On Tuesday, MOS had alerted investors that we should exercise "especial caution" in the market. With the festive boozing getting to our cranium, we had inevitably failed to explain our case. That, as a result, drew several mails from irate readers who suggested that MOS is attempting to talk the market down.

Hence, we would like to take the opportunity to present our case today. We consider this to be a period of unprecedented bullishness across many asset classes. From memory, the current PER of the local market is about 19x, only a shade off the high of 22x registered in the technology bubble. This same sentiment is observed in international markets, may it be the US or emerging countries. The recent returns of the Dow, S&P 500, TSX are very strong. Emerging market equities such as Vietnam, China, India and Latin American countries are also trading at extremely extended levels too.

We also understand that junk bonds and highly leveraged debt instruments are abound in the market today and they continue to proliferate. In addition, REITs, which are a hybrid between equities and debt, are yielding less than their ten year government bond benchmarks.

For some reason unknown to us, fear has virtually vanished from the market. The VIX, aka the Fear Index of US, is languishing near record lows, ranging around 9 - 10 when highs of 20 - 30 were registered only as recently as 2002. Even the volatilities of major currencies, an asset class synonymous with volatility, are below normalized (ten year) levels.

These record setting highs are engineered by the substantial liquidity that has been sloshing around for over a year. The combination of petro-dollars and the wealth of the rising Chinese are plausible causes for this liquidity glut. But it will take only a quick and rude shock to the global financial system to bring about the withdrawal of the hot money.

The strains are starting to show. In January, the sub-prime mortgage market in the US tanked. The industry benchmark, the ABX, nosedived after several lenders reported higher loan losses, delinquencies and defaults. MOS does not think that issues in the housing market will be contained within the sector. The housing slowdown is likely to have knock-on effects on the broader US economy. And should the world's largest economy go into a tail spin, the other nations are unlikely to fare any better.

It is always difficult to play the party pooper. And it’s never going to be easy to convince Noah to build the ark when rain is not in evident in the horizon. But, the sun always shines, unfortunately, only on TV.

Credits: The title is a play on A-ha's smash hit from the 1985 album, "Hunting High and Low" - "The Sun Always Shines on TV".


Tuesday, February 20, 2007

A Time for Especial Caution

Frequent readers of this site will know how averse the MOS folks are to capital loss. We see our first and foremost mission as capital preservation, not capital appreciation. A Mandarin proverb, loosely translated underscores our objective - "with the lush mountain intact, one should not be afraid that there will be insufficient wood for a fire".

Over the long weekend, the talk dominating cocktail parties here is "Singapore 4000". It is not a catchy phrase of a new government campaign. But it refers to the optimism that the benchmark Straits Times Index will hit a high of 4000 points and luxury apartment prices will reach S$4000 per square foot soon. And there would bound to be someone sharing how fast bucks were made flipping the numerous initial public offerings which trebled within days of their listing.

In fact, as this stellar run in the equity market and property prices continue, more and more cautious investors are throwing in the towel - "to heck with valuations" and succumbing to the temptation of hitching a ride on this "relentless" bull. For the last few holding out, let us suggest that it may be more worthwhile to pack up for a getaway to Phuket to enjoy the Andaman Sea breeze and sun instead. There, you are assured not be to bombarded with news of market highs if your Blackberry is left behind.

With prices escalating more than before, we argue that the danger now of sustaining a capital loss with an indiscriminate purchase is higher than ever. Indiscriminate to the extent that the business quality is actually poor, or possess cyclical earnings but is masked by the current buoyant economic conditions. The foregoing caution is not novel; but one that has been expounded by Mr Benjamin Graham. We end this post by quoting several paragraphs written by the superinvestor.

In the 1951 edition of "Security Analysis", Mr. Graham offered the following - "When the general market is high there are always a number of individual issues that appear definitely undervalued by objective standards, and consequently even more attractive in contrast to the inflated level of other stocks... But that is a time that calls for especial caution. Not only may the 'neglected security' continue neglected for the remainder of the bull market, but when the downturn comes it is likely to decline in price along with the general market and to fully as great an extent. In a word, beware of 'bargains' when most stocks seem very high."

Mr. Graham went on to elaborate on the above in "The Intelligent Investor" - "The risk of paying too high a price for good quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume prosperity is synonymous with safety... It is then, also, that common stocks of obscure companies can be floated far above tangible investment, on the strength of two or three years of excellent growth." Mr. Graham continued, "These securities do not offer an adequate margin of safety in any admissible sense of the term... Thus it follows that most of the fair weather investments, acquired at fair weather prices, are destined to suffer disturbing price declines when the horizon clouds over - and often sooner than that".


Tuesday, February 06, 2007

Defying Gravity

Gravity defying - that's been the path for which the share price of Micro-Mechanics (Holdings) Ltd (MMH SP) (SIN: 5DD) (MMH) has been taking in the last few months. Since MMH was last featured on Margin of Safety (MOS) on August 2006 (S$0.48), investors in the semiconductor consumables supplier would have pocketed a 70% gain. Whilst the run up may partly have been attributed to the buoyant market sentiment, its management led by Christopher Borch, has also continued to deliver the results and reward shareholders.

The latter was evident in the 1H FY07 results unveiled yesterday. MMH managed to grow its revenue by 15% (vs 1H06) to S$17.7 million despite the loss of a customer in Singapore. This was due to the group's increased penetration into Taiwan and Europe. More significantly, net profit margin increased further to 25%. MOS believes that the custom machining and assembly (CMA) business which MMH has diversified into may be the reason behind this margin expansion. The growth of the CMA business from an insignificant share to 7.3% of total revenue also serves to help MMH diversify beyond the semiconductor industry. With the increasing net profit margin and top line growth, its EPS grew by 21% to 3.2 cents per share.

To foster share ownership amongst its employees, MMH has also announced a unique share offer cum gift scheme. Employees (or a family member) who meet certain pre-requisites are allowed to purchase shares from Mr and Mrs Borch at a sharp discount to the reference price of S$0.78. MOS views this as a refreshing move by the management when they clearly could have sanctioned a share option scheme which may potentially be dilutive to current shareholders in future. Should these purchasers subsequently sell their entitlements on the open market, the available free float also increases for this relatively illiquid counter. Whilst liquidity isn't a factor for the patient folks at MMH, it may well put the counter on the radar of the bigger and more established fund houses; thereby spurring added activity on the counter.

To reward shareholders, MMH is also declaring an interim dividend of 1.5 cents per share. This puts it on track to equal or best the total dividend of 3.5 cents per share paid in FY2006. Furthermore, the balance sheet of MMH remains debt free and its ROE remains high at 25.2% on an annualized basis.

Going forward, it is unclear how the fortunes of the global semiconductor industry will pan out. In fact, research consultancy Gartner has forecasted that growth is likely to slow. However, MOS remains confident that MMH's management will take all measures to keep the company on even keel.

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