Looking at liquidity (short-term financial health) of a company

I have discussed in an earlier post on "cash conversion cycle" as an important determinant of a company's short-term financial health (see http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html).  Cash conversion cycle is an important yet often overlooked metric in assessing a company's short-term liquidity (working capital position). Why is it important to look at a company's short-term liquidity? It tells us the short-term financial health of the company, whether it has a positive working capital position.

Working Capital = Current Assets - Current Liabilities

It is important for a company to have a positive working capital position so that it's current assets can meet it's current liabilities (over a one year short-term period). If the current assets of a company is not able to meet it's current liabilities, a company will have to raise cash (by employing debts or other forms of capital raising) to meet it's current liabilities failing which in most drastic case may mean bankruptcy for the company.

Types of current assets and their amounts held by a company can influence it's liquidity and short-term financial health

There are various items that are considered as current assets that can be converted to cash in a one year short-term period (e.g. cash and cash equivalents, equities held for trading or sometimes called marketable securities or short-term investments, accounts receivables and inventory). The breakdown of all these current assets held by a company can be found under it's balance sheet statement.

It is important to understand how each of these types of current assets can affect the company's short-term financial health. Cash and cash equivalents are the most liquid of all the types of current assets that can be converted readily into cash to pay off current liabilities. Next in order are equities held for trading or any equivalent short-term investments that can be readily converted into cash. Accounts receivables are also fairly liquid depending on the estimated number of days a company needs to wait to receive payments for their goods sold or service rendered. Inventory is the least liquid assets held by a company because the company has to go through the entire process of selling and waiting for payments on the goods sold.

Thus, it is important to evaluate carefully the proportion of each type of current assets held by a company to determine it's short-term liquidity and financial health. A company may have a much higher total current assets than it's total current liabilities. However, if a substantial proportion of the current assets consists of inventory, it maybe quite worrying should a company not be able to sell it's goods under the inventory held. If a company has a trend over the years of high amount of assets held in it's inventory, this maybe a red flag for greater financial problems to come especially if the company also has a poor "cash conversion cycle" (high number of days required for the entire cash conversion cycle). All these may suggest difficulty in selling the company products and the company also has difficulty in collecting payments from products sold if the cash conversion cycle is poor. A high amount of current assets held in inventory may not always necessarily be a bad sign provided the company has an excellent cash conversion cycle.

Based on the order of liquidity of the various types of current assets, it may suggest that a higher amount of current assets held in cash and cash equivalents is best since it can be most readily converted into cash to meet the current liabilities. This is true only to a certain extent. If the company has a trend of having too much assets held in cash and cash equivalents, it may also suggest that the company is unable to deploy it's cash to productive use to grow it's business and make meaningful returns.

Thus, when evaluating any types of current assets, similar to evaluating any single metric of measurement, one has to be careful not to make any sweeping mistakes in judgment by not considering other metrics of measurements together in order to see the big overall picture of a company's investment worthiness. A trend of high amount of current assets held in inventory with a trend of increasing revenue, increasing net income, increasing gross and net margins and increasing positive cashflows may instead paint a good picture instead of a grim outlook based on making a biased judgment on looking at a trend of high amount of assets held in inventory alone.

Financial ratios to evaluate a company's liquidity and short-term financial health

When evaluating liquidity of a company, there are various financial ratios one can consider such as current ratio, quick ratio and cash conversion cycle. I have already discussed cash conversion cycle in my earlier post. I shall discuss current ratio and quick ratio, and then provide a comparison between these different types of financial ratios. All the figures used in the calculations of the financial ratios discussed below can be found under the current assets and current liabilities of the balance sheet statement. 

Current ratio

Current ratio is the simplest financial ratio to determine the liquidity of a company. It is also the most commonly used and stated financial ratio by analysts and investment firms. The current ratio only measures the short-term financial health of a company by considering whether its current assets is able to meet its current liabilities. Thus, a current ratio of more than 1 is preferred so that a company's current assets can meet its current liabilities fully. The shortfall with using this financial ratio is that it does not consider the types of current assets and their amount held as mentioned above. By using this financial ratio, one is assuming that all current assets can be readily converted into cash to meet the current liabilities which often is not the case (e.g. inventory that cannot be sold quickly or accounts receivables that cannot be realised quickly).

Quick ratio

Another financial ratio that considers only the more liquid assets that can be converted into cash to meet the current liabilities is the quick ratio. As seen in the formula above, inventory is not considered in the caculation since it is not easily converted into cash (offers least liquidity). As such, quick ratio is a more conservative financial ratio than current ratio when assessing the short-term liquidity and financial health of a company. A quick ratio of more than 1 is preferred so as to allow the more liquid assets to meet the current liabilities fully.

Cash conversion cycle

Cash conversion cycle is another way to measure a company's liquidity based on considering the days in inventory, days in receivables and days payable outstanding (see my previous post on cash conversion cycle http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is a better measurement of the liquidity and short-term financial health of a company by considering how fast the company sells it's goods held in inventory, how fast it receives payments for goods sold or services rendered and how long it can be able to delay it's payments to suppliers of goods. A company that can sell goods fast, receives payments fast and have sufficient time to pay it's suppliers has a shorter cash conversion cycle (in terms of shorter number of days) and thus a better liquidity and working capital position (ability to raise cash fast from it's operations) to meet it's currrent liabilities.

Thus, cash conversion cycle maybe a better and more critical way to measure a company's liquidity. Most often, it is a poor cash conversion cycle that drags down a company's liquidity and short-term financial health more so than the amounts and types of current assets held.

In conclusion, a careful investor does not base his assessment on any single metric alone. It is the overall assessment of a company based on many factors of consideration that matters because considering any single metric in isolation may result in an inaccurate judgement of a company's investment worthiness.

The Richest Man in Babylon

I recently borrowed an audio book from the library titled "The Richest Man in Babylon". I am currently expanding my research from investment to include financial planning as well. I am looking into financial planning skills as I believe that investment and financial planning (allocation of one's capital to increase productivity and security) go hand in hand. As such, I will seek to provide more research on these two areas of both investment as well as financial planning in my future posts.

In this audio book, I managed to pick up some important financial planning skills. This book presents an interesting look into old financial planning skills from ancient past of Babylon. Of course, the characters and story being told are fictitious. However, the lessons to be learnt are applicable to modern times. It told of a richest man in Babylon who gave a tablet containing important rules on money management to his son. The man also gave some gold to his son and sent him off to the outside world to test his ability to manage and grow the gold.

In two misadventures, the son nearly lost the entire gold given him by his father. The first misadventure spoke of the son believing in some travellers who told him to put a portion of his gold into a sure win gamble of a horse race. The son lost the gold put into the bet and only in the end found out the travellers were con men who were in cahoots with the few other competitors who bet against this son in the horse race. The son found out this from other travellers only when the travellers who swindled his money had left him.

In another second misadventure, the son heard from a travelling merchant that his merchant friend had a business selling pots and wares which is worth investing in. This travelling merchant managed to convince the son to buy over the business which he persuaded the son that it is a good investment on his gold and he would make many times returns over his invested gold. After the son bought over the business did he realise that pots and wares were difficult to sell and he ended up with lots of junk pots and wares that were of little value and use.

After losing almost his entire gold did the son began to look at the tablet that his rich father had gave him. He began to study carefully the words of wisdom carved on the tablet by his father. It contained five important money management rules.

Rule number one said that "one should seek to invest wisely not less than one-tenth of his regular income consistently for compound interest to work".
Rule number two said that "one should always seek profitable employment (investment) for his money in order to grow it".
Rule number three said that "one should seek the advice of wise man who manages and invests money prudently in order to learn from them, and one should also be cautious to never place his money in risky wager or gamble ".
Rule number four said that "one should never make investments that he does not understand or is unfamiliar with so as to protect his principal capital." 
Rule number five said that "one should never be caught by greed to make investments that promise returns that are far beyond any logical thought and should beware of tricksters who promise returns on investments that are unbelievable."

After the son has read the rules carefully and given much thought to them, he realised that only a person that has the right attitude towards money management will be able to grow his money prudently. It does not matter whether how much money he began with. To a prudent person, even a small sum of money can compound into a large amount given the right money management attitudes. To a non-prudent person, even a large sum can be lost through his hands resulting in nothing in the end. As such, the son regretted that he should have read the money management rules his rich father gave him first before even venturing his given money into any investments. He realised that it is the right attitudes in money mangement that really matters and not how much money he begans with.

With regards to the above five rules, it can be summarised into simple take home messages. We are not talking about being greedy in terms of accumulating and hoarding wealth. We are taking about managing our finances prudently so as to make meaningful growth in our savings and in turn using our money or money management skills to help others. Of course, helping others may not be restricted to only monetary means. As in one of my earlier post, one needs to look beyond just wealth as it is a perishable item that one cannot bring to the grave anyway.

Simple take home messages:-
(1) Invest as much dispensable income (portion of income one does not need in short-term) and returns from existing investments regularly to make meaningful growth of one's investments by compounding.
(2) Never gamble one's money. There is no basis for a sound foundation of returns by gambling.
(3) Be humble to learn from wise prudent people who manage their investments and finances well. 
(4) To protect one's capital, one should never invest in any investment that one does not understand the workings of the investment.
(5) One should be realistic about the returns one is getting from an investment. If an investment promises a return too good to be true, think carefully for it may really be "fleeting sweet promise". Invest therefore on a sound foundation of investment knowledge and not seek short-cuts.

To listen is always easy, but it is the discipline and perserverance that will allow only the doer instead of listener to reach his financial goals.

My thoughts on MacarthurCook Industrial REIT's fund raising exercise.....

At last, the EGM for MacarthurCook Industrial REIT (MI-REIT), one of my investments has been convened. I attended the EGM today and this happened to be my first time at an EGM after one year plus of investing journey. It was indeed an eye-opener for me at the EGM where I saw the exchanges between the unitholders and management of MI-REIT. I highly encourage serious investors to attend all AGMs and EGMs of their invested companies to update themselves on the developments of their invested companies,  voice out their constructive opinions on important issues to the management of their invested companies, and also to vote for any important resolutions to be passed during such meetings. Thus, such meetings serve as very important avenues for shareholders to meet the management, and exert shareholder pressure serving as a check to make sure management is still executing strategies that are beneficial to both the business and their shareholders.

There are altogether five resolutions to be passed at the EGM basically as follows.

(1) To approve the AMP Capital Investment
(2) To approve the Cornerstone Investments
(3) To approve the AIMS Investment (as part of the Cornerstone Investments)
(4) To approve the Rights Issue
(5) To approve the Acquisition of the AMP Capital Properties

Based on one of my earlier post, MI-REIT has term loans of S$226 million and JPY 1500 million (S$23.7 million) which needs to be settled by end December. It also has a contractual obligation to purchase an industrial property in Singapore (1A International Business Park) by end December which it requires around S$90 million.

MI-REIT has come out with a fund raising proposal which comes in a package to deal with the refinancing of the loans and purchase of the business park property. In this package, it has invited some institutional investors namely AMP Capital Holdings, a group of investors including AIMS Financial Group together called the Cornerstone Investors, and proposed a rights issue to raise funds to refinance it's debts. All the invited institutional investors will be offered the purchase price of $0.28 per unit for new units in MI-REIT. Rights units under the rights issue will be priced at $0.159 per unit. As part of the proposal, it has also proposed the purchase of 4 industrial properties from AMP Capital Holdings as part of the agreement for AMP Capital Holdings to invest in MI-REIT.

I present below some of the major issues that were raised by unitholders and also responses of MI-REIT to the issues raised. After that, I will present my own thoughts over this whole fund raising episode. Before I continue further, I caution readers that I do not guarantee the completeness or accuracy of my interpretation of the issues raised and responses to the issues by MI-REIT.

Major issues were raised by existing unitholders during the EGM as follows:-

(1) Why did MI-REIT waited so long (almost a year) to come up with a last minute desperate fund raising proposal (when the debts are due soon in December) that leaves existing unitholders with no choice but to accept this proposal or face winding up of MI-REIT?

(2) Is there no other better proposal except this current packaged fund raising proposal?

(3) Why are the invited instituitional investors (AMP Capital, AIMS Financial and other investors under the group of Cornerstone investors) offered new units ($0.28 per unit) at such a significant discount to the NAV of MI-REIT ($0.94 per unit)? Are the invited investors being opportunistic in nature?

(4) Why did MI-REIT not consider the sale of some of it's properties to raise funds to clear it's debts?

(5) Why must MI-REIT purchase the 4 properties from AMP Capital? Is it fair for MI-REIT that AMP Capital should insist the sale of it's 4 properties to MI-REIT as part of the agreement to act as a potential investor in MI-REIT?

(6) Why not consider winding up MI-REIT since it's NAV is high and unitholders may get back a good fair amount of compensation after liquidating MI-REIT's properties and paying down all it's liabilities?

(7) Is such a huge dilution due to the funds raising proposal (theoretical ex-rights price of around $0.22 per unit and ex-rights NAV of $0.32 per unit) justified for the interests of the unitholders?

Management of MI-REIT responded to the above major issues raised as follows:-

(1) MI-REIT has already been actively seeking out funding possibilities since the start of the year. However, all potential lenders or institutional investors require an interest return of 25 to 30% which is too much for MI-REIT to accept as favourable. Basically, under such negative circumstances faced by MI-REIT, it has no bargaining power over it's potential lenders/ investors. As such, the management thinks the current proposal is the best and is not a last minute thing, after much sourcing for funding and consideration.

(2) Mangement thinks there is no other better solution after much sourcing for funding and consideration, except to accept the whole proposed fund raising package for the interests of the unitholders.

(3) Mangement expresses that it is necessary to come with an agreement with the potential investors to offer new units at such attractive price of $0.28 per unit to ensure the fund raising exercise will be successful as the investors will also sub-underwrite the rights units being offered. All in, this ensures the REIT will obtain it's funding to refinance it's debts.

Management thinks the potential investors AIMS Financial Group and AMP Capital Holdings will serve as strong sponsors to MI-REIT once they have a substiantial stake in MI-REIT after acquiring new units in MI-REIT. Both these investors are some of the leading investment companies in Australia and they have exposure and experience in real estate and fund management in China, Japan and Australia. They will be catalysts in helping MI-REIT source for and acquire good industrial properties in such regions out of Singapore which is in-line with MI-REIT's original growth strategy of investing in industrial properties in Asian regions. Thus, management thinks these investors are not opportunistic and on the contrary will benefit MI-REIT to have them as it's future sponsors.

(4) MI-REIT has considered but will not sell any of it's properties as it's total debts and obligations are too large (around $320 million) to be meaningfully met by the sale of some of it's properties (total of it's estimated property value only round $500 million).

(5) MI-REIT thinks that it is necessary to accept the purchase of the 4 properties from AMP Capital as part of the agreement so as to secure AMP Capital as one of it's potential investor and future sponsor which will provide future benefits to MI-REIT and it's unitholders. Somemore, the total purchase price of the 4 properties is fairly priced (according to two independent property valuators) and the properties are also yield accretive.

(6) Management thinks winding up MI-REIT is not a viable option and is disadvantageous for it's unitholders. In the event of winding up, the properties will be in the hands of a receiver (e.g. a bank) and the receiver will try to sell the properties as quickly as possible at firesale prices which means the amount to be returned will be much lower than the total current value of all it's properties. Furthermore, the total debts and liabilites need to be cleared and after clearing all debts and liabilities, it may mean little amount or even no compensation to be returned to it's unitholders. Thus, winding up is never an option at all as it may result in total loss of it's unitholders' investments in MI-REIT.

(7) Such significant dilution due to the fund raising exercise according to management is not good for it's unitholders. However, management expresses that it is necessary to do the fund raising to ensure the continuity of MI-REIT. This will settle all refinancing until year 2012 and will put MI-REIT at better grounds financially for possible expansion (by acquiring properties) into other Asian regions given the support from the new sponsors which have experience and expertise in estate and fund management in other Asian regions.

My thoughts on the whole fund raising episode by MI-REIT

My opinions are mostly aligned to MI-REIT's managment responses to the major issues raised during the EGM. A fund raising exercise like this, though resulting in significant dilution, is necessary to the continuity of MI-REIT.

NAV per share is NOT a guarantee to one's investments

I am not in favour of the winding up of MI-REIT as this may mean total loss of unitholder investments in MI-REIT. Many investors have the misconception that Net Asset Value per share (NAV per share) is like a magical number that guarantees their investment value in a company. In investments, there is nothing guaranteed. In the event of liquidating the assets of a company due to winding up the company, the assets usually sell at ridiculousy low prices over a short-time period so as to raise cash fast to pay the debts due and other forms of liabilities owed by the company. So, NAV per share is just a very rough estimate not to be taken too seriously. Seriously speaking, NAV per share DOES NOT guarantee the investor will get back this NAV per share amount upon liquidating all assets and paying all liabilities. Thus, I learn this big lesson over the MI-REIT's episode. Nothing is guaranteed in equity investment (unless there is any insurance company willing to insure an investor's investments??). Always be very careful when investing. As such, I had partly divested out my investments in MI-REIT to recover back my invested capital in MI-REIT before attending the EGM.  I did this not because I have no faith in the fund raising exercise by MI-REIT. I wanted to protect my capital as anything can happen should unitholders not vote in favour of the resolutions during the EGM. As Warren Buffet's most important investment rule goes, "Never lose money". Preservation of capital is the most important investment rule that all sound investors hang on to carefully.

Most investors are short-term oriented or should I say short-sighted?

With this fund raising episode, I can see that most investors are very much concerned about the dilution effect due to the fund raising exercise. I can understand and emphatise with many investors on the dilution of their investments and reduction of distribution yield. However, should an investor be only concerned about the returns of an investment and ignore anything else including the fundamentals of the invested company. I quite agree with MI-REIT management's viewpoint of getting in AIMS Financial Group and AMP Capital as strategic sponsors to benefit the REIT going forward. Of course, nothing is guaranteed as to the future growth of MI-REIT with these new potential sponsors. However, at least the immediate benefit is that MI-REIT is able to raise funds from these new potential sponsors to clear it's debts and ensure continuity of it's business. I am for the long term growth of a company and if having these sponsors can potentially help MI-REIT in it's future growth, the question is why not? I think as investors, we need to have a long term outlook and not just be caught up with short-term gains. Returns on investments though are important, one also need to consider that returns come from underlying business of an invested company. No good business equals to no good returns. If MI-REIT can strengthen it's balance sheet and have strategic growth plans going forward, why not give it a chance and not quibble over a temporary drop in distribution yield or NAV? I think that even investors sometimes can act like small children quarelling over who gets more and who gets less over a short-term period. Be long term business oriented and not short-sighted money oriented.

Protection of capital by value investing

Again, holding MI-REIT's units at low average price (around $0.30 per unit) substantially lower than it's NAV of $0.94 per unit allowed me the chance to partially divest out of it to recover my capital thus preserving my capital. If I had purchased my units at higher prices, I may have to bear a loss upon divesting out at current market value (which an investor has no choice but to do so should a company is on the road to bankruptcy). Thus, value investing by purchasing equities at undervalued prices again allowed me the chance to protect my capital by divestment upon possible mishaps to a company (I had earlier divested out of another company Jaya Holdings also by virtue of value investing).

Final conclusion

I certainly hope that MI-REIT can survive this ordeal and emerge stronger clearing it's refinancing and also with the new sponsors in it's management. Much leaves to the future of MI-REIT even if it pulls through this ordeal. It still have to prove itself by expanding over the Asian regions if the new sponsors come on board with their regional experiences and networking. If it pulls through, I hope it can learn a good lesson from this episode and be prudent with capital management and risk going forward. Expansion is always good for any company or REIT. However, it will not be good if expansion puts the company/ REIT in a precarious financial situation. I still subscribe to the notion that a business that can enjoy good growth and returns by using mostly retained earnings to reinvest and not employing much debts is the best around. Even better if it's rate of growth and returns is higher than it's competition under such conservative capital management and ideal economics that does not require funding of growth by large amount of debts.

What is financial independence?

I attended a seminar recently which speaks about entreprenuership. I attended the seminar because I wanted to find out more about how to set up businesses as I may be interested to set up my own business in future. The speaker spoke passionately about her experiences with helping many people and organisations set up and run businesses effectively. The speaker also questioned the audience about their reasons for wanting to be an entreprenuer. One common reason given by many on why they would want to set up and run businesses is to reach financial independence.

I managed to reach a better understanding of what is financial independence based on the speaker's explanation. The idea of financial independence to me before hearing from the speaker used to be the ability to receive passive income for living without the need to work. However, my idea of financial independence is partially faulty. Financial independence is the ability to receive consistent recurring passive income that is more than able to cover total personal expenses (including all liabilities and loans), thus allowing the individual the luxury not to work anymore. Thus, the person is in a state of being financially free and working becomes an option and not a necessity for him anymore.

Can a person who has reached financial independence return back to the state of being financially burdened again? Yes. If the passive income is no longer able to meet the total personal expenses anymore, the person returns to the original state of needing to work again to meet his personal expenses. Usually, for ease of discussion, one can look at total monthly passive income versus total monthly expenses. As long as one's total monthly passive income is more than total monthly expenses, and this state is able to be maintained indefinitely, the person has reached a state of financial independence. Assuming there is no change to his amount of passive income and amount of expenses, this state of financial independence will be maintained.

So, financial independence simply means:-
Total recurring monthly passive income greater than or equal to Total recurring monthly expenses

It is not difficult to reach financial independence. Two points must be reached and maintained as follows.

1. There must be a stable consistent passive income source(s).

2. The amount of this monthly passive income must be greater than or equal to the total monthly expenses.

Thus, theoretically speaking, if one is a person whose recurring monthly expenses is little and he has stable recurring monthly passive income source(s) able to meet his total monthly expenses, he would have reached financial independence. The longer this state can be maintained, the longer the person need not be burdened with the necessity to work anymore.

Why is it that not many people can enjoy the luxury of consistent financial independence? 

A few reasons could be possible.

1. The passive income source(s) is/are not stable.

2. The amount of passive income keeps fluctuating, sometimes below and not able to meet the expenses.

3. The amount of monthly expenses keep changing and usually is getting larger and larger so that the monthly passive income can no longer fulfil the increased expenses (possibly with changes in lifestyle and commitments).

Final conclusion

It is many peoples' dream to reach financial independence. There is nothing wrong with aspiring towards this state. However, one must be careful that once he reaches financial independence, what will he do with his freed up time that he no longer need to work anymore. Invest his freed up time to enagage in meaningful actvities to help others or just while it away in meaningless pursuits? This is a question to consider carefully since one has only a lifetime to live and spend his life after which all humans must meet death eventually (whether by natural or unnatural death).

Investment Learning Points

Dear readers,
I am shifting all the investment learning points from the sidebar of my blog into this dedicated post so as not to overcrowd the sidebar of my blog. This is also to allow further updating and expansion of my investment learning points in this post as my investment experience grows. Please return periodically to this post for updates on my investment learning points. I wish all readers a fruitful investing journey!

INVESTMENT LEARNING POINTS

Investment techniques

Focused investing:- Invest heavily in only a few stocks (10 stocks or lesser) that are perceived to be most promising.

Value investing:- Invest in stocks only when their price is below their intrinsic value to pay less than what the shares of a company is worth, and achieve greater returns.

Cut loss:- Short-term investors should adopt a strict cut-loss measure to sell out shares that have decreased by a certain pre-determined amount in price to prevent incurring huge loss.

Emotions kill at investing.  

Never catch a falling knife.

It is difficult if not impossible to accurately time a market bottom.

It is always prudent to analyse business fundamentals underlying a stocks before purchasing the stocks.

Average down only when stock prices are already significantly undervalued. Never average down on a free falling bear market to prevent catching a falling knife.
 
Cheap price may not mean value buy. Always check for any permanent problems with underlying business of stocks to make sure one is not inheriting a failing business.

For a diversified investment approach, an investor can consider exchange traded funds (ETFs).


An investor should live out an investment philosophy suitable to his personality so as to make investment decisions based on his philosophy and not emotions.

Avoid rebalancing of one's portfolio. Have the courage to ride the winners and weed out losers constantly.

Avoid high turnover in trading one's portfolio. Transaction costs is a drag to investment returns.

Value investing provides a protective margin of safety.


An investor may misjudge a company's intrinsic worth, so he should always seek to invest at share prices below the estimated intrinsic value per share of a company to gain a margin of safety to account for possible error in overestimating intrinsic worth of a company.

Buy-and-hold strategy can work well if an investor has applied it properly knowing when to buy, when to hold and when to sell a stock or investment product.

Compounding is an amazing effect that serves to grow an initial investment many times over in value through reinvestments. The higher the compounded annual rate of returns and the longer the time period of compounding, the higher will be the final value of an initial investment.

The stock market is not always efficient. Prices of stocks can be traded at ridiculously low or high valuations at times.

The stock market is random. Stock prices may not always follow through trends and can change suddenly. Make use of market price fluctuations to one's advantage.

Valuation techniques
 
Hunt for stocks with high current and future projected yields on investment:-
Take current EPS divide by current share price and multiply by 100% to calculate current yield. Take future projected EPS (after certain number of years) divide by current share price and multiply by 100% to calculate future yield. That will be the future yield of returns on an investor's investment dollars.

One can estimate the intrinsic value of a company by using the discounted cashflow method (DCF method). This valuation technique assumes that a business is worth the present value of all it's future projected cashflows. A note when using the DCF method is that future cashflows are only estimates and the estimated intrinsic value per share of a company using DCF is ONLY an estimate at best. Thus, value investors should invest at a margin of safety below the estimated intrinsic value per share of a company.

Fundamental Analysis

Free cashflow = Net cash from operating activities - Capital expenditure

Look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and has consistent high return on equity (ROE).

Ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.

Return on equity (ROE) is an important metric for measuring a company's profitability. Consistently high ROE (15% or more) for many years of a company's operating history is desirable. An investor should also take note of a company's financial leverage when using ROE to make sure a company is not risky by taking on excessively high amounts of debts.

It is important to examine trends in the financial statements of companies over a period of time (e.g. last 5 to 10 years) to uncover any consistency or inconsistency in the economics of a business. A one-off recent spectacular performance by a company may not necessarily indicate consistency to perform in future. Similarly, a one-off recent underperformance may not necessarily indicate permanent deterioration in business fundamentals. Be aware of non-recurring exceptional items in any financial statements that may undermine or overestimate a business's true economics. Always look for possible consistency in the business fundamentals and make sure the consistency is still intact.

Net asset value (NAV) per share also known as book value per share or equity value per share is the value of a company's assets less the value of its liabilities.

Net asset value (NAV) = Total assets - Total liabilities
It is a misconception that shareholders of a company should get back the NAV per share worth of compensation upon winding up a company. This is because assets of a company may be sold at lower firesale prices than its carrying price stated in financial statement upon winding up the business. Shareholders may get back lower than NAV per share value of compensation or even no compensation upon winding up of a company after it has paid off all liabilities.

One should consider the liquidity of a company to evaluate it's short-term financial health. To do so, one can consider the types and proportion of current assets held by the company such as cash and cash equivalents, short-term investments (e.g. equities held for trading), account receivables and inventory. Cash and cash equivalents are the most liquid current assets that can be readily converted into cash while inventory are the least liquid current asset that is most difficult to convert into cash. The company that can readily convert it's current assets into cash will be able to meet it's current liabilities ensuring good short-term financial health. 

To assess the short-term financial health of a company whether it has current assets able to meet it's current liabilities, one can look at a few financial ratios and calculations such as current ratio, quick ratio and cash conversion cycle.

REITs investing

When investing in REITs, do not just focus on annualised distribution yield alone which can be misleading since it changes according to the REIT's traded unit price which can fluctuate. Instead focus on core fundamentals such as:-
- performance of trends of growth over the years in the amount of income distribution to unitholders, rental revenue and net property income.
- average income yield of properties in the REIT,
- occupancy rates over the years,
- track record in refinancing loans on time,
- gearing of less than 40 plus %,
- diversified rental income sources from different types of tenants,
- built-in rental escalation,
- security deposits on rental,
- long average rental lease period to expiry,
- no large number of rental leases (expressed as % of gross rental income) expiring over any single year,
- no significant overcontribution from a single tenant,
- honest and capable management that are shareholder friendly,
- interest coverage ratio of more than 1.5,
- low interest rate on borrowings, 
- consistent growth in EPU and DPU (examine carefully the reason if there is a dip in EPU and DPU for a particular year).
Also seek to invest significantly below the NAV of the REIT to gain a margin of safety.

Rights issue

Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares.

Look for rights issues that are supported by full underwritting from an investment bank. This ensures that the company / REIT raising the rights issue can obtain it's funding regardless of whether the rights shares/ units are eventually undersubscribed or oversubscribed.

Theoretical ex-rights price is an estimated stock price after factoring in the effect of the rights issue. One can use the theoretical ex-rights price to compare with one's eventual average holding price after purchasing new shares through the rights issue to make sure one's eventual average holding price is not too steep above the theoretical ex-rights price.

Check carefully whether a rights issue consists of renounceable or non-renounceable rights. Renounceable rights offer existing shareholders the choice to sell their rights entitlement to other investors during the nil-paid rights trading period should they not want to hold the rights to purchase the new offered shares. This is so that existing shareholders that do not want to exercise their rights to purchase new shares can receive some compensation for the eventual dilution of their investment in the company.

To determine how much is the rights entitlement worth, take the difference between the theoretical ex-rights price per share and the rights issue price per share. An existing shareholder (who does not want to purchase new shares) should seek to sell his rights entitlement above this calculated rights entitlement value during the nil-paid rights trading period. On the other hand, a new investor (who wants to purchase new shares) should seek to buy at below the rights entitlement value for a bargain.

Be careful of companies that frequently raise rights issue only for paying down debts. This may signal problems with the financial health of the company. Rights issue is preferred for reasons such as fulfiling acquisition and growth plans. This ensures potentially increased future shareholders' earnings from yield accretive ventures.

Cash conversion cycle

Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).

Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding

Red flags to look at when assessing the cash conversion cycle include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.

One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.

Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.

Industry analysis

There are five competitive forces driving industry competition. These forces drive returns in an industry to a perfectly competitive level, thus constraining any companies in an industry from achieving supernormal returns. These five competitive forces are:-
1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

It is important to check whether a company has both strong bargaining powers as buyers of goods/ services and suppliers of goods/ services before investing in the company. Bargaining powers as buyers and suppliers affect the competitiveness and margins of the company.

To deal with the threat from potential entrants into an industry, existing companies engage in two strategies:
1. Sending clear message to the new entrants that if they cross over a certain tolerance line they will be subjected to strong retaliatory attack until they are driven out of the industry.
2. Putting different types of barriers in the path of new entrants.

An investor has to consider in his assessment of a company whether it is facing much intense competition with rival companies in an industry based on different possible factors promoting competition. Intense competition reduces returns in an industry.

An investor needs to consider any potential threat from substitutes of products or services to an existing company to see whether the company has downside pressure to it's margins due to such threats.

Cash conversion cycle :- important parameter especially for retail businesses to manage!

I come across through my research, one overlooked and seldom discussed but very important metric which is "cash conversion cycle". Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables). Cash conversion cycle is especially important for retail businesses that rely heavily on selling their goods fast and receiving payments fast and being able to delay payment to its suppliers to a suitable time in order to pay them. Cash conversion cycle can also be applicable to other businesses that purchase and hold goods (inventory) to sell to customers.

If cash conversion cycle is not efficient, it may mean significant losses for the business in the end. Inventory pilling up with goods that cannot be sold (even more drastic for perishable goods that cannot be sold that can cause a loss on asset value), customers delaying payments and suppliers chasing for payments; all these can put extreme pressure on the business which may even damage the business permanently if cash conversion cycle is not brought back to an efficient level for a prolonged period of time.

Thus, a business (especially of a retail nature) hope to sell its products as fast as possible (resulting in high inventory turnover), collect payments from its customers as fast as possible for goods sold (resulting in high receivables turnover), but pay suppliers as slowly as possible (resulting in low payables turnover). It is most ideal if a business can sell its goods and collect payments from its customers before it has to pay its suppliers. Most businesses should be able to collect direct payments from its customers unless a business extends credit terms to its customers (of which an investor should be wary since there is a risk that the business may not receive payments from its customers compared to upfront immediate payments for goods sold which has no risk of default on payments since customer payments is immediate upon receipt of goods).

Cash conversion cycle calculation

Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding

This is the basic formula for cash conversion cycle of a business.

Days in inventory, days in receivables and days payable outstanding can be calculated as follows.

Days in Inventory = 365 / Inventory turnover  

           Inventory turnover =
           Cost of sales or Cost of goods sold / Inventory

Days in Receivables = 365 / Receivables turnover

          Receivables turnover = Revenue / Accounts receivable

Days Payable Outstanding = 365 / Payables turnover

         Payables turnover =
         Cost of sales or Cost of goods sold / Accounts payable

As one can see, we need the raw data for Inventory, Cost of sales, Revenue, Accounts receivable and Accounts payable. Figures for Inventory, Accounts receivable and Accounts payable can be found in the Balance Sheet Statement. One should consider using Accounts receivable and Accounts payable both under current assets and current liabilities respectively only since accounts that are current involve assets and liabilities over a one year period (since cash conversion cycle is calculated for a one year period as well). As for revenue and cost of sales, both can be found under the income statement.

One can consider comparing the cash conversion cycle for same company for different years to assess the trend whether a company has decreasing number of days for its cash conversion cycle over the years which is a positive sign or increasing number of days for its cash conversion cycle over the years which may be a negative sign.

Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these happening for prolonged period of time. Such red flags are especially bad for retail businesses that rely heavily on their ability to optimise their cash conversion cycle.

An example on calculation of cash conversion cycle for one of my invested company (Tat Hong Holdings)

All financial figures are taken from the year 2009 annual report.

Inventory turnover = 390622000 / 217686000 = 1.7944

Days in Inventory = 365 / 1.7944 = 203 days

Receivables turnover = 631761000 / 97725000 = 6.4647

Days in Receivables = 365 / 6.4647 = 56 days

Payables turnover = 390622000 / 182325000 = 2.1424

Days in Payable Outstanding = 365 / 2.1424 = 170 days

Cash Conversion Cycle = 203 + 56 - 170 = 89 days

Thus, Tat Hong Holdings has a cash conversion cycle of 89 days. One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors. Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.


Discussion points:- Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).

Cash conversion cycle is especially important for retail businesses that need to optimise their cash conversion cycle. However, it can also be applied to assess any businesses that rely on purchasing goods and holding goods to sell.

Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.

One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.

Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.

Of rights issue and REITs (Part 3 of 3)

After going through a rights issue by one of my investment (CapitaComm Trust) in June this year and a proposed rights issue by another of my investment (MacarthurCook Industrial REIT), I got exposed to the nitty gritty of rights issue.

What is rights issue?

Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares (usually last closing price when rights issue was announced). Rights issue calls by companies are for raising funds for various reasons such as paying down debts, fund acqusition, or other growth plans. Sometimes, rights issue is underwritten by an investment bank. This means that the investment bank agrees to bear the risk of helping the company to raise funds through the rights issue by buying the rights and selling the rights at a marked up offer price to the public. Full underwritting of rights by an investment bank provides assurance that the company will still be able to obtain it's finances through the rights issue (since the investment bank bears the risk of buying and selling the rights for the company).

Theoretical ex-rights price

Rights issue offers shareholders rights to a discount on new shares purchase. However, the trade off is that there will be an increased number of shares of the company thus resulting in dilution of the shareholders' investment in the company. To check whether the rights issue offer is attractive, an existing shareholder needs to consider the theoretical ex-rights price. Theoretical ex-rights price is an estimated price of a stock after the rights issue has been exercised fully.

A typical example of calculation of theoretical ex-rights price:-
Imagine a company is offering 1-for-2 rights issue. This means that for every 2 existing shares held by a shareholder, he has the rights to purchase another 1 more share at the rights issue price. If the shareholder is offered the rights to purchase the new shares at $0.60 per share and the current market price of the stock is $1.00 per share, the calculation is as follows.

Value of existing shares = 2 X $1.00 = $2.00 per share

Value of new offered shares = 1 X $0.60 = $0.60 per share

Total value of existing shares and new offered shares = $2.00 + $0.60 = $2.60 per share

Theoretical ex-rights value per share = $2.60 / (1+2) = $0.867 per share , note that the denominator (1 + 2) consists of total of the number of new offered shares and existing shares in a simplified reduced ratio (1-for-2 rights issue implies a total number of 1 + 2 = 3)

As one can see, the calculation is merely a simple ratio calculation which an upper primary student can also do. Thus, we have the following share prices for comparison.

Last current market price for stock = $1.00 per share

New offered share price (through rights issue) = $0.60 per share

Theoretical ex-rights share price = $0.867 per share

The theoretical ex-rights share price is an estimated price the shares of a company will be traded after completion of the rights issue. An existing shareholder can choose to subscribe fully for the rights by purchasing new shares exercising his rights, renounce the rights, or choose to do nothing. Sometimes, if the shareholder sees no more future in investing in the company offering the rights, he may even sell off all his existing shares upon news of the rights issue.

An existing shareholder can calculate his average holding price after he purchase the new shares and compare his holding price with the theoretical ex-rights price to see whether he is getting a good bargain from the rights issue. For example, an existing shareholder owns 2000 shares of the above-mentioned company at $1.50 per share. He decides to exercise his rights to purchase new shares. He can only purchase 1000 new shares at $0.60 per share based on the terms of the rights issue. His new holding price will be $1.20 per share for 3000 shares after the rights issue. Comparing this with the theoretical ex-rights price of $0.867 per share, his new holding price of $1.20 per share is way above the theoretical ex-rights price and thus he is at a disadvantage by owning shares far above the theoretical ex-rights price. There are ways to overcome this, for example by applying for excess rights or buy rights entitlement from other shareholders during nil-paid rights period and eventually purchase more new shares using the additional rights entitlement.

Determining right response to rights issue

It is always easy to stereotype rights issue as a disadvantage to existing shareholders of a company. It is true that offering new shares to the market results in dilution of existing shareholders' investment in the company. However, rights issue does offer existing shareholders the rights to purchase new shares of a company at a discount price. Thus, existing shareholders receive rights entitlement to purchase new shares. Rights entitlement carries a value to compensate existing shareholders for the dilution of their investments. Existing shareholders can choose to sell their rights to others to exercise this value of compensation (by getting back some amount of money) should they not want to purchase the new shares eventually. As such, there are two types of rights entitlement namely, renounceable or non-renounceable rights.

Renounceable rights and non-renounceable rights

Renounceable rights offers an existing shareholder the choice to sell his rights over the stock market during the nil-paid rights trading period. This means the existing shareholder sold his rights entitlement to another investor. Thus, he has no more rights to purchase the new shares offered by the rights issue.

Non-renounceable rights means rights cannot be sold over the stock market. The existing shareholder is thus faced with the only option to either purchase the offered new shares or not to purchase the new shares eventually.

Usually, rights issue are offered with the means of renounceable rights and the existing shareholder should consider carefully whether to sell his rights entitlement to another investor during the nil-paid rights trading period. If the shareholder has no wish to purchase the new offered shares, then he may sell his rights to at least get a little bit of monetary compensation for the dilution of his investment in the company.

How much should one sell his rights entitlement over the nil-paid rights trading period?

To determine how much should one sell his rights entitlement over the nil-paid rights trading period, one should consider the difference between the theoretical ex-rights price and the rights issue price. In the above example, the difference is $0.867 - $0.60 = $0.267 per share. This means the rights entitlement is estimated to be worth only $0.267 per share. An existing shareholder that does not want to purchase new offered shares should seek to sell his rights entitlement to other investors at above $0.267 per share during the nil-paid rights period when there is usually another traded counter (e.g. company name-R; R represents rights trading counter) for this purpose of selling one's rights entitlement to another investor. Of course, the higher the rights entitlement sold above $0.267 per share, the more an existing shareholder will get back for his compensation for the dilution of his investment in the company. On the other hand, the lower a new investor can pay for the rights entitlement (below $0.267 per share), the more bargain he gets.

It is not difficult to appreciate the reasoning behind calculating rights entitlement value. Assuming as a new investor (not existing shareholder), I pay $0.267 per share for rights entitlement. I need to further pay $0.60 per share (fixed based on rights issue price) to purchase new shares using these rights entitlement I have obtained. I pay in total $0.867 per share for getting new shares in the company which is same as the theoretical ex-rights price (price in which shares of the company is estimated to be worth after rights issue). I thus get no bargain.

If I can pay $0.10 per share for rights entitlement, I will pay in total ($0.10 + $0.60 = $0.70 per share) for the new shares in the company. This now gives me a bargain since I pay less than what the shares should be worth ($0.867 per share) after factoring in the effect of the rights issue.

Similarly, if I pay $0.40 per share for the rights entitlement, I will end up paying a total of $0.40 + $0.60 = $1.00 per share for the new shares. I thus overpaid for the new shares at $1.00 per share which is above the theoretical ex-rights price ($0.867 per share; which is price in which shares of the company is estimated to be worth after rights issue).

Doing nothing is as good as gaining nothing!

Doing nothing at all is the most foolish thing an existing shareholder 'can do' when faced with a renounceable rights issue. If an existing shareholder wishes to purchase the new offered shares, he should keep his rights entitlement and later use all his entitlement to purchase the new shares at discounted price (by the acceptance deadline of payment for the rights issue). If he has no wish to purchase the new shares, he should sell off his rights entitlement during the nil-paid rights trading period to at least get back his compensation for the dilution of his investment in the company.

Doing nothing is often due to lack of understanding of the terms of a rights issue by existing shareholders or some shareholders may not even be aware that their invested company is offering a rights issue at a certain time. This goes to show that as investors, one ought to be serious to find out some basics about equity investment and monitor one's invested company periodically. Warren Buffet has stated an important investment mantra, "Risk comes from not understanding one's investment." If an investor is not serious at all, he may be better off not risking his money in stocks, but instead put his money into simpler investment products such as fixed income deposits offered by banks or just simply leave the money in bank savings account (though the meagre interest rate returns will not be enough to overcome inflation which erodes away the value of money over time). By doing so, at least he is practising the most important investment rule, that is never to lose money (capital preservation).

Is rights issue always a bad thing?

It all depends on the reason for raising funds by a company since they are diluting the investment of their existing shareholders in the company. Usually, it is preferred for a company to raise funds for acquisition and growth opportunities rather than paying down debts. Of course, if paying down debts is important to increase balance sheet health of a company, it may be still a justified cause. However, beware of companies that frequently raise rights issue so much so that it becomes a bad habit, especially that the funds raised from the frequent rights issue is to keep paying off debts. This leaves one thinking why the company is so good at frequently raising cash and then equally good or better at buring away cash for no better reason than just paying off debts upon debts. Sounds much like a ponzi scheme or a black hole suction effect for shareholders' money that goes to no where........

Discussion points:- Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares. 

Look for rights issues that are supported by full underwritting from an investment bank. This ensures that the company / REIT raising the rights issue can obtain it's funding regardless of whether the rights shares/ units are eventually undersubscribed or oversubscribed.

Theoretical ex-rights price is an estimated stock price after factoring in the effect of the rights issue. One can use the theoretical ex-rights price to compare with one's eventual average holding price after purchasing new shares through the rights issue to make sure one's eventual average holding price is not too steep above the theoretical ex-rights price.

Check carefully whether a rights issue consists of renounceable or non-renounceable rights. Renounceable rights offer existing shareholders the choice to sell their rights entitlement to other investors during the nil-paid rights trading period should they not want to hold the rights to purchase the new offered shares. This is so that existing shareholders that do not want to exercise their rights to purchase new shares can receive some compensation for the eventual dilution of their investment in the company. As such, doing nothing is disadvantegous to an existing shareholder since he receives no compensation by not selling his rights to other investors (assuming the rights is renounceable) should he not want to exercise his rights to purchase new shares from the rights issue. 

To determine how much is the rights entitlement worth, take the difference between the theoretical ex-rights price per share and the rights issue price per share. An existing shareholder (who does not want to purchase new shares) should seek to sell his rights entitlement above this calculated rights entitlement value during the nil-paid rights trading period. On the other hand, a new investor (who wants to purchase new shares) should seek to buy at below the rights entitlement value for a bargain.

Be careful of companies that frequently raise rights issue only for paying down debts. This may signal problems with the financial health of the company. Rights issue is preferred for reasons such as fulfiling acquisition and growth plans. This ensures potentially increased future shareholders' earnings from yield accretive ventures.

Of rights issue and REITs (Part 2 of 3)

More points of consideration for REITs

I have discussed some points that an investor can examine when looking at REITs in my previous post. Now, I shall proceed to more points of consideration.

Assessing integrity of management and how unitholder friendly are they?

As with assessing all company managements, be it management of REITs or other companies, it is most important above other forms of measurements to look at integrity and shareholder friendliness. No matter how profitable a company has been managed, as long as the management does not show convincing integrity and shareholder friendliness, it is a matter of time that things may go wrong. We have heard so many times of accounting frauds and bad corporate governance. I will rather look for steady management that show integrity and shareholder friendliness. Such management may not always be the most promising in terms of profitability compared to their competition, but at least I know my invested money is in good hands of an honest and capable management that always considers shareholders' interests in all management decisions they make.

How does one identify such managements? Read what key management figures (chairman, CEO, etc.) say about their company in their annual reports. It is important not just to look at one year's annual report. One should follow through the statements of management figures over a good number of years to get an idea of the management. It is not difficult to judge a management's character if one is patient enough to read what they said over the years. A management that always seems to talk big in their annual reports, praising their performance, even finding ways to talk up their performance and hide their short-comings in a bad financial year may be showing fanfare. Is the company really performing up to what they claim? I always look at annual reports with healthy skepticism. Anyway, as in all human nature, which management will want to report bad things in an annual report to their disadavantage? However, I look out for management that report as honestly as possible their yearly performance. I look out especially for management that is bold to admit mistakes and take actions to correct over their mistakes mentioned in their annual reports. I also look out for managements that mean what they say and always follow up on what they say. Such managements of companies walk their talk and is likely to be dependable and honest in their dealings with not just shareholders but also their customers. Even if they should not carry out a project mentioned in their annual reports, they will state clearly any reasons even if admiting any oversight when planning for a particular project.

In a nutshell, look for candidness in the management that mean what they say and is bold to admit and correct over their mistakes. Such candidness show that the management is sincere and serious about doing their best in running their business. Showy fanfare that does not follow through with practical actions taken are just like wind blowing in the air.

Assessing profitability of a REIT

One can look at trends over a good number of years (e.g. 10 years) on the different figures such as gross revenue, net property income, distributions paid to unitholders to get an idea on the profitability of a REIT. Look for a general rising trend in such metrics over the years to ensure consistency in the profitability of the REIT. Such figures can be found in the annual reports of REITs.

Looking at net asset value per unit of a REIT

Net asset value (NAV) attributable to unitholders = Total assets - Total liabilities

All the above figures of total assets and total liabilities can be found in the balance sheet of the financial statement. Even net asset value per unit ($) is found in the summary financial statement of REITs, so there is no need to go through any calculations. The above mathematical calculation is for reference purposes.

What does NAV per unit ($) tell? It is a theoretical breakup value of a REIT, that is if the REIT were to cease to be viable, and it is completely broken up and after selling all it's assets (mainly made up of properties) and paying all it's liabilities, the net asset value per unit ($) is the amount of money that can potentially be returned to it's unitholders. For example, if NAV per unit of ABC REIT is $0.50 per unit, unitholders can expect to receive back $0.50 per unit upon breaking up of the REIT when it ceases to be viable anymore. When viewing NAV per unit ($), it is not to be taken literally since it is at best only a theoretical estimated value that unitholders can expect to get. Properties may not be sold at their valuations and usually in such drastic situations of dissolving a REIT, properties tend to be sold at drastic discount over a short-term to meet the liability obligations. So, treat NAV per unit with a pinch of salt. Nevertheless, it is always good to hold units at steep discount to their NAV per unit to gain a sufficient margin of safety.

Looking at other metrics of measurement for REITs

Earnings per unit growth and distribution per unit growth

Ideally, earnings per unit (EPU) and distribution per unit (DPU) should see growth over a good number of years. A consistent growth means the REIT is generating growth in earnings and distributions over the years. As an investor of REIT, stabiltity of and growth in distributions is paramount. A thing to note is that EPU and DPU may decrease for a particular year if there is any issuance of rights, private placement of units and other forms of increase in number of units, so an investor should investigate carefully the reason for any dip in a particular year's EPU and DPU.

Gearing or aggregate leverage ratio (%)

I have already discussed in previous post that a gearing of 40 plus % is on the high end for a REIT. One should not dismiss a REIT as an invesment candidate based on high gearing alone. One should also examine whether the loans of a REIT is due anytime soon (e.g. less than a year) which may have added risk and also the potential of a REIT being able to refnance it's loans based on a track record of securing refiancing successfully (sometimes based on having a strong sponsor's backing).

Interest coverage ratio

Interest coverage ratio is a metric to determine how easy a company or REIT can pay interest on outstanding loans/ debts.

It is important for a company or REIT to be able to pay interest on loans outstanding in order to maintain the loan agreement failing which the lender can take legal action against the company or REIT. Inability or delay in paying interest on loans may reflect badly on the company or REIT's credit worthiness, and maybe a red flag for more problems to come. An interest coverage ratio higher than 1.5 is desired (the higher the better).

Interest rate on borrowings/ loans

One may consider the cost of borrowings as a % of the total borrowings to have an estimate of the interest rate on borrowings.

Interest rate on borrowings = (Cost of borrowings / Total borrowings) X 100%

A REIT that can consistently secure lower interest rate than other peers in similar REIT asset class and also lower than market interest rate suggests lesser cost of borrowings and potentially higher distributions to be paid to it's unitholders.

Discussion points:- Always look out for honest and capable management of companies or REITs that are shareholder friendly.

Look for general rising trends over a good number of years (e.g. 10 years) on the different figures such as gross revenue, net property income, distributions paid to unitholders to get an idea on the profitability of a REIT.

Invest at below NAV per unit of a REIT to gain a margin of safety.

Look for consistent growth in EPU and DPU. Examine carefully the reason for a dip in EPU and DPU for any particular year to ensure it is not due to any disadvantegous situation facing a REIT.

Interest coverage ratio is a metric to determine how easy a company or REIT can pay interest on outstanding loans/ debts. An interest coverage ratio higher than 1.5 is desired (the higher the better).



Look for REITs with a low interest rate on borrowings. Lower interest rate on borrowings suggest potential for higher distributions to their unitholders.
 
I shall discuss more on rights issue in future post. To be continued........

Of rights issue and REITs (Part 1 of 3)

My recent encounters with rights issue exercise

I have went through one rights issue exercise raised by one of my investments, CapitaCommercial Trust in June this year. Before I can barely take a breather from such fund raising exercise for retail investors like me who have participated in the exercise, then comes another potential rights issue raised by another of my investments, MacArthurCook Industrial REIT (MI-REIT). Wow, rights issue has become a fashion trend embraced by many local public listed companies so far this year! I am personally not prejudiced against rights issue though we heard of the dilution effects of rights issue to shareholders.

However, it really gets on my nerves as I have to pore through the terms of a rights issue and it means extra time spent for me. If I don't do so, it also means I may not be able to understand and come to an informed decision whether to subscribe to the rights units of a company. Blindly putting my money into a rights issue just in order to purchase more rights at discounted price to current traded share price may not mean a good bargain. It is akin to blindly buying shares of a company that has dropped in it's share price significantly. What makes one think that he is getting a good bargain and not end up instead inheriting a failing company due to permanent deteroriation of a company's fundamentals? There is always a reason why a company's shares are undervalued. Not all cheap stocks are value stocks. Some cheap stocks may be worthless (no worth) stocks!

I view the recent announcement of one of my investments, MacArthurCook Industrial REIT (MI-REIT) that it has proposed plans for refinancing it's debts due in December 2009 through equity fund raising. It's debts consisted of term loans of S$ 226 million and JPY 1500 million (S$23.7 million). Earlier in the year, MI-REIT has already encountered problems refinancing some of these loans which were due in earlier part of the year, and it has managed to extend the loan settlement date to December this year through negotiations with the various lenders. This has at least given it time to plan for a recapitalisation exercise to deal with these loans. In addition to these loans, MI-REIT also has a contractual obligation to purchase an industrial property in Singapore (1A International Business Park) which it requires around S$90 million to complete the purchase also by December 2009. Looking at the debts profile, MI-REIT has a current gearing of 44.7% (on the high side for a REIT investment).

To deal with these few pressing issues at hand, MI-REIT is holding an EGM this month to seek unitholders' approval to a few matters to deal with these debts refinancing and also acquisition of the International Business Park. There are also other additional matters to seek unitholders' approval including further acquisiton of another 4 more Singapore industrial properties etc.

As the EGM has not been convened, I shall not share my opinion about the terms of the equity raising exercise as I do not wish to influence any unitholder's decision. I believe each retail investor has his own investment objectives and his decision may differ from another investor's decision. Even if investment decisions may differ, it may not necessarily mean one investor's decision is better than another (as each may have his own unique investment objectives affecting his investment decisions, and also unique judgments to the fundamentals and terms of a rights issue from another). Thus, I hold the view that investing is both a science and an art. Quantitive measures of a company are obvious (based on financial statements) while qualitative measures of a company (based on perceptions of the business model and competitive strength) are at best anyone's guess. Also, there is nothing absolute. A company that has excellent economics can also turn sour along the way in future.

Some points for consideration when looking at REITs

Though I do not wish to comment on MI-REIT at this moment, such equity raising exercise (e.g. by rights issue) has got me pondering over my investment in REITs of which I have two in my portfolio (MI-REIT and CapitaCommercial Trust).

REITs are leveraged investments with ongoing risk of not being able to refinance it's loans?

Real estate investment trusts also known as REITs operate on purchasing properties and leasing the properties to tenants, and so receive rental income from it's tenants. There are different types of REITs namely commercial, retail, industrial, healthcare, mortgage, residential, infrastructure, etc. As the names suggest, a commercial REIT owns mainly commercial properties, a retail REIT owns mainly retail properties, etc.

No matter which type of REIT, REITs need to purchase properties to grow it's portfolio of properties. This ensures the growth of a REIT through constant growth in it's portfolio size by purchasing properties, apart from other organic means such as rental income escalation. To purchase properties, REITs have to raise funds through loans or equity. Loans and other means of raising funds (e.g. convertible bonds) carry interests that REITs have to pay for. No lenders or investors will provide funds for free to REITs. There is no free lunch in this world. To get loans, a REIT has to pay interests to the lender over the loan period or distributions to investors for their invested equity. In addition, it must not be forgotten that paying interests does not mean paying debts of the loan. The original loan still remains to be settled upon the expiry date of loan.

The way REITs function is unique. It has to provide at least 90% of it's rental income as distribution to it's unitholders in order to receive income tax rebates by regulation. It is not difficult to see that since most of a REIT's income is distributed to unitholders, what remains after paying off it's interests on loans and other expenses is just a palty sum certainly not enough to pay off even a small fraction of it's loans. Thus, there is also regulation to the amount of gearing a REIT can take. A gearing in the 40 plus % range is certainly towards the high end of gearing for REITs considering that it is impossible for REITs to have enough retained cash earnings to pay off loans. If it were to be a normal company, it can decide to retain more of it's earnings as cash reserves since there is no such mandate to disburse 90% of it's earnings to shareholders.

So, constant refinancing of it's loans is always one of the ongoing concern for REIT to remain viable. It is like an owner of credit cards keep borrowing from one credit card to pay off the credit loan of another card and he keeps doing that again and again rotating among different credit cards to clear credit loans that seem forever difficult to clear unless he stops spending on credit (unless a REIT stops acquiring any more properties). Of course, REITs can choose to raise funds through equity from it's unitholders of which there is no interests requirement to pay. However, there is a limit of equity that can be provided by unitholders. Therefore most REITs adopt raising funds through combination of both equity and loans from lenders (e.g. banks or financial institutions).

So, REITs can be highly leveraged operations with a hidden risk that it's loans may not be able to be refinanced. If such problems arise, a REIT can dispose some of it's properties to clear it's loans. However, the problem with properties is that there may not be a ready buyer all the time. So, gearing of a REIT and it's ability to refinance it's loans remain a going concern not just for the REIT, but also it's unitholders.

I learnt this lesson the hard way about REITs being leveraged investments with hidden risk of not being able to refinance it's loans after encountering equity raising exercises (through rights issues) all from two of my investments (both REITs), which are MI-REIT and CapitaCommercial Trust. So, be prepared as unitholders of REITs for more encounters with rights issues from REITs than other companies in general.

Looking at a REIT's portfolio of properties

Another important consideration after assessing the gearing level and track record of the ability to refinance loans by a REIT, is to look at the portfolio of properties of a REIT. Properties are the backbone of a REIT. I will only discuss REITs that function on rental properties here (e.g. commercial, retail and industrial REITs). Properties that are high income yielders benefit a REIT and if the income yields on all properties of a REIT are higher than market rate, the properties are doing well to generate higher income. To identify such high income yielding properties, one may look at the net property income divided by the initial cost of purchase for the particular property as a %. For example, assuming one bought a house for $300k and rent it out at $2k per month. Assuming other expenses and taxes to be paid on the property is negligible, the  income yield is 8% per annum.

As such, income yield depends on the initial cost of purchase for properties in a REIT. The cheaper the cost of purchase for properties in a REIT, the better the income yield. The income yield also depends largely on the amount of rents a property owner gets on the property. So, the ability to secure higher rents than market rate for it's properties is important for a REIT. The amount of rents that can be secured depends on market demand of tenants to rent similar properties in the market. Rents can also be affected by the exact property in question, it's location, age and quality of it's infrastructure. Rents is usually expressed as rents per square foot. So, one can also compare the rents per square foot for individual properties in a REIT compared to the average rents per square foot in the market for similar properties to get an idea of how much rents a REIT is getting from it's properties compared to market.

Another consideration is occupancy rate for individual properties of a REIT. It is good for all properties in a REIT to have 100% occupancy rate. This means all properties are fully leased out to tenants which makes all properties very productive. Any property in a REIT that has low consistent occupancy rate over years may suggest that such property is not productive for the REIT especially when other similar properties in the market have higher occupancy rate over the same time period. Occupancy rate may depend on many factors such as demand and the qualities of the property in question.

In a nutshell, the higher the income yields and occupancy rates for all properties in a REIT, the better the portfolio of properties of a REIT. When looking at any metrics, it is important to examine them over a good number of years to look for consistent trend of high income yields and occupancy rates.

Type of tenants and rental lease period to expiry

The ability of tenants to pay for rents without delay or default is important. Big name tenants that operate large businesses are generally more stable than small name tenants. I am not stereotyping here. Larger businesses that have longer operating history generally have better consistent cashflows and there maybe lesser chance of delay or default in payment of rents. So, the more big name tenants found in a REIT's profile, the better the stability of rental income.

Also, the ability for tenants to accept rental escalation over the rental lease period means a REIT can secure increasing rents over the rental lease period. The longer the average rental lease period to expiry for a REIT the better it will be because the REIT can likely continue to receive rental income for a longer period (especially when rental escalation is built into the rental lease period). The rental lease expiry profile for various properties in a REIT should preferrably not fall significantly at same future year but should be well spread out over various future years. This ensures no potential risk for rental income to fall significantly over any single year should the REIT failed to renew the expired rental leases or secure new rental leases.

Also, it maybe better not to have an over contribution of rental income from any one single tenant. This is because should the tenant pull out from the rental lease, it will dampen the rental income of a REIT too significantly. Over here, balanced contributions of rental income from many tenants may ensure lesser risk to sharp decline in rental income at any time.

Sometimes, there is security deposit required to be paid by tenants. This ensures the landlord is protected against any premature termination or breach of rental lease agreement.

More discussion on REITs and rights issue in future posts....to be continued

Disussion points:- When looking at investing in REITs, consistently rising distribution income received by unitholders over a long period (see financial statement of REITs for amount of distribution income) is more important than the annualised distribution yield per unit (since distribution yield depends on unit price fluctuations which is everchanging and misleading).

Amount of distributions income paid to unitholders depend largely on income yield of properties in a REIT, the higher the average income yield of properties in a REIT, the potential for more distributions to be provided to unitholders. Managers of REITs that can consistently secure low cost of purchase for properties (lower than market valuations) and also higher rents per square foot than market rate is securing better income yields on it's properties for unitholders.

Check for high consistent occupancy rates (best to have 100% occupancy rates) on all properties of a REIT to look out for ability for REIT to fully lease out all it's properties which makes the properties productive.

Check for consistent track record for a REIT to refinance it's loans on time. Be wary of REITs having high gearing in the 40 plus % range.

Check for any big name tenants in a REIT, rental escalation built into rental lease agreement, security deposits received on rental leases, long average rental lease period to expiry, no large number of rental leases expiries falling over any single year, and preferably no overcontribution to rental income from any single tenant.