Contrarianism Part 2: Lessons from Templeton. Vote for your stock!

If you like this column, please start voting which stocks you would like them to write on in their next article! This is your chance to interact with them and they will write on the most voted stock of your choice!

How to vote: Comment any of the 4 listed stocks of your choice mentioned in the article (M1, Comfort Delgro, SPH, SIA Engineering). The most number of likes/comments by Monday morning will be chosen. It’s that simple!

Voting starts now and ends on Monday (31st July) when market opens (9am)!

Disclaimer: this article simply provided analysis on stocks from the fundamental perspective, it does not represent any buy/sell recommendation from Investingnote. *All the dollar unit ($) in this article refer to SGD.

This column is written by @j_chou.
–Jay has an interest in global macro trends, financial markets and equity research and enjoys applying a combination of the three in his investments. His eventual investing goal is to manage a risk parity portfolio and achieve true financial freedom.

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With S&P 500 and NASDAQ closing at record highs today and VIX Index at a 23-year low, the timing seems ripe to revisit the contrarian approach!

Besides Dremen, another famous investor whom we can learn the contrarian approach from is Sir John Templeton. Known for his acumen in global stock-picking, Templeton’s principles of purchasing at “maximum pessimism” pushed him towards stocks that had been entirely neglected. His story of profiting off the Great Depression is legendary: in 1939, he purchased $100 worth of every stock which was trading below $1 per share on the New York and American stock exchanges. This totaled about 104 different companies, a whopping 34 of which were bankrupt, and Templeton’s initial investment was $10,400. After four years, he managed to sell those shares for nearly four times the money he had initially invested. His genius proved to be timeless, as yet again in 1999 during the dot com bubble he famously predicted that 90% of the new Internet companies would be bankrupt within five years, and he very publicly shorted the U.S. tech sector.

Let’s look back on some of Templeton’s famous words of wisdom and see if we can gain any new insights into the current market!

“The four most dangerous words in investing are: ‘this time it’s different.'”

Against the calls of caution by some prominent hedge fund managers, there are many who have instead been up in droves to quash any bearish sentiments. Many bull investors view this run as different from the dot com bubble; they believe that this time round stock market appreciation is driven by fundamentals and earnings growth.

In fact, even prominent bears are increasingly turning bullish.

Robert Shiller, famed for creating the Shiller P/E and predicting the dot-com bubble and housing bubble, has frequently warned that the market looks “very expensive” but has recently claimed that several sectors in the market are relatively cheap, including the best performing tech stocks and “stocks could go up 50% from here”.

Three years ago, famous bear investor Jeremy Grantham of GMO was firmly in the camp that the extended post-crisis market rally was due for a correction. However, recently Grantham has decided that U.S. large caps deserve to trade at higher multiples than the past as they have far more earning power.

Even Warren Buffett, once famously averse to technology stocks, is now one of Apple’s (AAPL) biggest shareholders. He pointed out at Berkshire Hathaway’s recent annual meeting that big tech firms are different from traditional companies as they do not require much capital to grow.

Maybe this time it really is different?

“Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

Templeton warns against being too confident of one’s own investing abilities, as “An investor who has all the answers doesn’t even understand the questions.”

The brilliant former Business Times columnist Teh Hooi Ling noted: “Humans are by nature optimistic. When two views are presented, the optimistic and pessimistic ones-we tend to think that the optimistic view will pan out. That is until we are proven so dead wrong that we lose hope entirely and regard any light at the end of the tunnel as an oncoming train. That’s the time we would dismiss any optimistic prognosis.”

It is indeed common sense that one should buy low and sell high. Yet due to human behavior it is hard to go against the herd mentality. As such, it is best to rely on technical indicators to provide a clear outlook of the market.

One such indicator as suggested by Teh Hooi Ling in her article “Spotting A Bubble From Some Distance Away” was to use the equity risk premium(ERP). By analyzing when to hold stocks or cash by setting a buy signal when ERP rises above 4%, and selling when ERP is below 2%, for a period of 15 years, she managed to generate compounded annual return of 10.5%, above STI return of 6.2% for the same period.

Hence, when ERP gets too low it may indicate a bubble forming, and it may be better to hold cash until ERP increases.

“Focus on value because most investors focus on outlooks and trends.”

As InvestingNote members often gripe, being contrarian is easier said than done. How are we to be greedy when others are fearful, when we are at the same time afraid of catching a falling knife? The answer, as surmised by Sir John Templeton, is to focus on intrinsic valuation. It is no coincidence notable contrarian investors are also strong believers of value investing: Graham, Buffet, Klarman, Dreman, Neff, Templeton etc. Instead of panic-searching for news or analyst opinions, assessing a stock based on fundamental analysis and healthy ratios into the long term is probably the safest and surest way to successful contrarian investing. After all, if due diligence was done your investments will be protected by margin of safety.

Contrarian opportunities in SGX?

Recently, there have been some SGX stocks that have seen a plunge in prices and generated negative sentiments in the InvestingNote community. Are these companies a contrarian opportunity or are the fall in prices justified?

Vote in the comments below and let me know which stock you would like me to analyse!

$M1(B2F.SI)

Post by @RetiredOldMan: https://www.investingnote.com/posts/143401

Post by @KallangRiverWoof: https://www.investingnote.com/posts/146351

Post by @Sporeshare: https://www.investingnote.com/posts/146442

$SIA Engineering(S59.SI)

Post by @CASHFLOW: https://www.investingnote.com/posts/145930

Post by @PhilipCapital: https://www.investingnote.com/posts/146289

$ComfortDelGro(C52.SI)

Post by @akwl88: https://www.investingnote.com/posts/145310

Post by @BrennenPak: https://www.investingnote.com/posts/144298

Post by @Jimes: https://www.investingnote.com/posts/145354

$SPH(T39.SI)

Post by @indigo: https://www.investingnote.com/posts/144840

Post by @mlow: https://www.investingnote.com/posts/141963

Post by @Turtle_Investor: https://www.investingnote.com/posts/141131

Please cast your vote on your favourite stock (pick 1 out of 4) in the comments below before the market opens on Monday at 9am!

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$ComfortDelGro(C52.SI): Grow or No Grow?

This column is written by @j_chou from InvestingNote.com.
@J_chou has an interest in global macro trends, financial markets and equity research and enjoys applying a combination of the three in his investments. His eventual investing goal is to manage a risk parity portfolio and achieve true financial freedom.

A component of the STI, Comfort Delgro was once championed as a stable dividend paying stock with a strong economic moat. Recent disruptions in the taxi industry have since changed that view, causing the stock to tumble to its 52-week low despite a relatively muted 1Q17 earnings report. Investors were likely concerned with the falling revenue and operating profits, mostly attributed to the decline from the taxi segment. The share price has since recovered slightly from its 52-week low to $2.310, but there is still an opportunity to capitalize on the negative sentiments towards the company. In this article I will look to determine whether Comfort Delgro is ripe for a contrarian play by assessing its long-term prospects from a bullish, neutral and bearish perspective for the next 5-10 years.

Comfort Delgro: Much more than just a taxi company

The distinct blue and yellow taxis that peppers the streets of Singapore may cause investors to mistake Comfort Delgro as primarily a taxi company.

But a quick look at the company’s financial report will reveal that the taxi segment only contributes 33% of total group revenue; Public transport segment, which comprises of buses and rail, is the largest contributing segment with over 60% of revenue.

By every measurement Comfort’s management has shown that the company is well-run and deserving of its past glory: Since the merger of Comfort and Delgro in 2002 the company has leveraged on its advantages in the Singapore transport industry and successfully expanded overseas. A scan through their annual report will show that Comfort is a leading player in the transport industry: it has a diversified portfolio of transportation services in 35 cities and 7 countries, including Singapore, China, Australia, UK, Ireland, Vietnam and Malaysia, with the overseas segment contributing 36% of total revenue.

Given that the public transport and taxi segments contribute over 90% of total revenue, I will break them down by employing mostly a top-down approach and determine a bullish, neutral and bearish scenario for each.

But before analysing the company itself I will like to discuss about a certain issue that I observed has been widely neglected in the Taxi vs. Uber & Grab saga which will definitively disrupt the transportation industry and form a revolving theme for determining Comfort’s future position in the industry.

The Rise of Autonomous Driving

For decades autonomous driving has always been a hot topic of research in the transportation industry. If fully implemented, autonomous driving will have a massive disruption on urban mobility (one of the many reasons why Tesla’s share price is so expensive!). In recent years, the entry of automotive and AI market players and the combination of three interlocking trends has accelerated the development of autonomous driving technology.



Computer vision: Advances in big data and machine learning have allowed computer vision to finally be good enough to distinguish objects on the road, build 3-D maps of the surrounding area, and be supported by processor speeds powerful enough to be able to operate them natively in a car.

Ride-sharing: The self-driving technology stack is currently still too expensive for the average consumer, but the advent of ride-sharing companies like Uber and Grab has allowed the possibility of distributing the cost over many passengers.

Electrification: Every fully autonomous car company today is planning on an EV platform. This is only secondarily about the environment. Primarily, it is because the cost of maintenance of an EV car is dramatically lower. If a single company owns the car and it has an incredibly high utilization rate, then that lower maintenance cost is easily worth the higher upfront cost.

And the technology is actually not too far away from being implemented. Self-driving cars have already been introduced by Uber in the United States, and companies from Tesla to Baidu have already proven the effectiveness of autonomous driving.

See: Testing Tesla’s Autopilot System At 70mph:https://www.youtube.com/watch?v=tP7VdxVY6UQ
With technology aspect overcome sooner rather than later, the concerns with autonomous driving will lie only with governmental regulations and consumer acceptance.
With Singapore being a densely packed urban city with land scarcity issues, it should come as no surprise that the government is very receptive to implementing an autonomous driving system. According to a report from Singapore’s Land Transport Authority (LTA), the potential benefits of driverless vehicles include improved fuel efficiency, enhanced mobility for the elderly and the disabled, and the reduction of land needed for roads and parking lots.
Tan Kong Hwee, director of transport engineering at Singapore’s Economic Development Board (EDB), noted: “We have a growing population and more than one million vehicles on the road. Being a small and densely populated country, Singapore has a real need for more effective transportation solutions, while optimising our limited resources in space and manpower.” Hence, in the long term, it is clear that the government is aiming to adopt autonomous driving on a large scale to complement the public transport system.

An article on the many benefits autonomous driving will bring to Singapore:
See: Self-Driving Vehicles: Future of Mobility in Singapore: https://www.smartnation.sg/initiatives/Mob...



Therefore, taking into consideration the inevitable adoption of autonomous driving on Singapore roads within the next decade, how will Comfort’s transportation segments fare?

Public Transport
The public transport segment is broken down into two sub-segments, mainly bus and rail. The segment is primarily operated under its subsidiary SBS Transit, which owns a significant fleet of public buses and runs the North East Line (NEL), Punggol and Sengkang LRT as well as the new Downtown line (DTL).

Buses
Comfort operates bus services in Singapore(through subsidiary SBS), UK (through subsidiary Metroline), Ireland and Australia. The overseas bus business actually contributes a significant amount to the public transport segment; It is not specified in 2016 Annual Report but from past data it is highly likely the contribution from overseas bus segment amounts to 2/3 of total bus revenue.
In Singapore, 75% of subsidiary SBS’s total revenue of $1098M in FY16 comes from the public bus segment. The catalyst for this segment going forward will be the change in revenue model given the LTA’s decision to transit to the Bus Contracting Model, which states that the government now bears all fare revenue risk and the capital expenditure for the purchasing and ownership of public buses. Operators such as SBS will be instead paid a fixed amount to operate the buses. This has so far been a positive change for the bus segment, evident by the 0.75% growth in 1Q17. Management has also stated in 1Q17 that the BCM will allow Comfort to enjoy greater revenue intake. Looking forward, this provides a clearer outlook for projected bus income from 2017 until 2025(maximum duration of current BCM contracts) and the substantial reduction in capital expenditure(as the company will not have to purchase buses anymore) will free up cash flow for Comfort.
Not much information is divulged with regards to Australia and UK Bus business but management guidance states revenue from the Australia Bus Business is expected to be higher while revenue from the UK bus business is expected to decrease from the foreign currency translation effect of the weaker £.

Bullish:
Switch to BCM has a net positive effect on profit margins and winning upcoming Bukit Merah Bus Package and maintaining existing 8 bus packages until 2025. Conclusion of Brexit will bring certainty and strengthen the pound, resulting in increased revenue from UK bus business. Australia segment to also maintain its revenue growth. Utilising cash holdings to make more acquisitions and increase overseas revenue.

Neutral:
Renewals for existing bus packages will be more difficult as Increase in competition for tenders will squeeze margins and cancel positive effect of BCM. Revenue contribution from Australia and UK to maintain and grow at rate of inflation. Utilising cash holdings to make more acquisitions and increase overseas revenue.

Bearish:
SBS to lose some of its existing bus packages to competitors as LTA seeks the participation of more competitors to improve operational efficiency. Acquisitions overseas to also become less effective due to disruption from autonomous driving.

Overwhelmingly Bearish:
Government has hinted on occasion in the past that the public transport system may have been over privatised. The switch to the new contract model signals LTA’s intent to wrestle more public control. By taking back ownership of public buses, the introduction of autonomous driving may cause the role of operators to be reduced significantly reduced as drivers and other operating services such as bus depots are no longer required; hence future operator contracts will be awarded at a fraction of current cost thus severely impacting operators’ revenue.

See: LTA inks agreement with ST Kinetics to develop and trial autonomous buses: https://www.lta.gov.sg/apps/news/page.aspx...

Rail
The rail segment has enjoyed positive growth y-o-y. Operating under its subsidiary SBS, rail segment contributed around $250M to total revenue. For FY16, demand for SBS Transit’s rail services grew with over 329 million passenger trips made, which is a 27% increase over the previous year. The spike came from the Downtown Line (DTL), which added on 12 more stations in December 2015. Ridership hit 80.7 million during the year, which almost tripled that of 2015. Average daily ridership on the North East Line (NEL) grew by 5.2% to 564,701, while that of the Sengkang and Punggol Light Rail Transit systems (SPLRT) saw a double-digit growth of 15.3% to 114,094. With the opening of Downtown Line Phase 3 in 2H17, the tender for Thomas-East Coast Line and projected CAGR of 10% for LRT and 5% for MRT ridership, there are multiple catalysts for growth in the rail segment. However, the reduction of 4.2% in fares and the likelihood of further decrease may counteract the positive effects.

Bullish:
SBS wins tender for operating Thomson-East Coast Line, which is a strong possibility as competition is only between them and SMRT. Given the route’s location it is projected to have ridership volume comparable to that of NEL and hence increase daily ridership on SBS rails by 30-40%.

Neutral:
SBS does not win tender for TEL, but increase in ridership volume will still allow rail segment to enjoy stronger revenue growth.

Bearish:
I can’t really think of a bearish scenario in the case of rail.

Taxi
The introduction of ride-sharing companies Uber and Grab has had a swift impact on the taxi segment as the bad reputation, uncompetitive taxi rentals and lower demand for taxis are compelling taxi drivers to abandon the once dominant market leaders, with the unhired rate of taxis hitting 9.1% this quarter, which is double the average unhire rate of 5% in the same period last year. As per LTA, Comfort’s taxi fleet also recorded a decline in numbers of 5.7% YTD to 15,683. Given historical data for the past one year, the decline will look to accelerate given increasing supply of private cars on the road. Furthermore, average daily ridership of taxis was at an eight-year low of 853,000, which is a 12% drop in the same period last year.

Comparison: Jan 2017 vs July 2017

Comfort should be worried about taxi’s future prospects. Uber and Grab are not disrupting the taxi industry simply through introducing a fancy app and artificial pricing. And institutional investors such as SoftBank and BlackRock are definitely not mindlessly dumping money into a loss-making taxi business. The excitement with ride sharing companies is in its potential to radicalize the transportation landscape. Uber and Grab are competing not just on pricing but also technology: It is no secret that the most inefficient component of the taxi business is in its drivers, hence eliminating the need for one will significantly reduce cost, improve trip efficiency and keep pricing competitive. As such, if implemented successfully, which could be as early as within the next decade, it will not bode well for Comfort. The major problem is that Comfort’s current business model is asset heavy; through purchasing a fleet of taxis and relying on rental fees collected from the drivers. In comparison, Uber and Grab’s model is currently asset light as they anticipate to spend massively on driverless cars in the future. Hence, they currently do not own majority of the existing cars and instead generate revenue by taking a 20% cut of ride fares. As you can see, this is a huge problem. On top of Comfort requiring a very large amount of capital expenditure to replace their existing fleet with driverless ones, their lack of R&D in technology will imply that even if they switch business models and implement driverless taxis it is unlikely to be as efficient as the ones introduced by Uber and Grab. Hence one way or the other once driverless is introduced Comfort will soon lack a competitive advantage in the taxi industry. Of course, on a positive note if the technology fails to take off then Uber and Grab’s current model which is unsustainable will lead to their demise and Comfort should again see the light of day. But I would think the former scenario is much more likely and will err on the side of caution.



Investors that are also hoping for some sort of intervention from the authorities to protect local taxi drivers (case in point: Taiwan, Italy, Denmark) may be disappointed to know that in Singapore’s case it is apparent as shown in my previous paragraphs that the government is very open to disruptive technology and highly enthusiastic about the prospects of a driverless system. In fact, the world’s first self-driving taxi was actually implemented right here in Singapore!

See: World’s First Self-Driving Taxis Debut in Singapore
https://www.bloomberg.com/news/articles/20...

Consumer resistance is also in my opinion a non-issue. Uber and Grab can simply offer a cheaper fare for the driverless option and Singaporeans are tech-savvy enough to respond to new technology. Government may even offer incentives to encourage consumers to engage driverless in a bid to implement an autonomous system.

Also to take note, the increasing network of public transport systems may cause cannibalization as increasing accessibility of MRT and buses will imply less commuters willing to travel by taxi. Automotive engineering segment, which contributes around 5% of total revenue will also take a hit as revenue contribution from that segment is highly dependent on servicing of Comfort’s taxis.

Bullish:
Autonomous driving technology takes a lot longer than expected to develop. LTA implements stricter regulations for private car hires. Uber and Grab are unable to further compete on prices and Comfort is able to improve upon their business model and maintain market dominance.

Neutral:
Self-driving cars successfully implemented on the roads. Comfort acquires self-driving car technology such as nuTonomy. gradually transitions to a mixture of drives and driverless business model. Significant decrease in market share but able to engage in healthy competition.

Bearish:
Self-driving cars successfully implemented on the roads. Comfort is unable to adapt and could only maintain minority market share with existing fleet of drivers.

Conclusion
The transportation industry is facing an impending disruption in the next decade, and I fear Comfort is underprepared to face it. Management has hinted from FY16 annual report that they do not think autonomous technology will be disruptive play here; “We will keep a keen eye on the development of electric, hybrid and autonomous technologies and the ensuing changes in legislation, which I suspect will take a while as mindsets and attitudes towards such new innovations slowly change.”
I think that they may have underestimated the technological forces at play here, and that is concerning. Remember the case of Nokia and Blackberry?

Nevertheless, management are not resting on their laurels and have indicated their intent to further expand overseas:

“Our efforts to continue our overseas investments may need to be intensified. A new strategy may need to evolve in light of new changes and challenges.”

Comfort’s main issue currently is that Singapore is small and revenue growth here is limited. Management has already shown they can do a stellar job translating their local expertise into expanding to other geographical regions. With a healthy amount of cash and low gearing levels, It is my guess that moving forward they intend to focus more on inorganic acquisitions and increase revenue contribution of the overseas segment. As such, I believe Comfort will follow in the footsteps of SingPost, hence expect a cut in dividends as the company reverts back to a transitional period and utilize more debt and cash for expansion purposes.

Valuation
I will attempt a simple DCF valuation based on my personal opinion of how the three main segments of buses, rail and taxi will play out.
Bus segment: Neutral
As stated on the LTA website, SBS operates 8 bus route packages from 01 Sep 2016 for a total sum of $5,322M. Given the total number of bus operating years is 58, we can assume each bus operating year will generate around 95M of revenue p.a. If SBS is able to renew its contract for upcoming Bukit Merah Bus Package, revenue should project to 760M p.a. till 2025. For overseas segment, in UK and Australia Comfort enjoys significant market share and is likely to seek growth hence I anticipate 2017 revenue from both UK and Australia bus business to maintain at 1200M and a conservative growth rate of 3%p.a. until 2025. This is of course assuming that autonomous buses has not become a thing within the next decade. Cost efficiencies from transition to BCM should allow operating margin to improve slightly from 7.7% to around 8%.



Rail segment: Bullish
As per LTA projections, with the opening of DTL phase 3 daily ridership should increase by another 100,000 on the existing 1 million SBS riders, hence rail segment revenue of around 300M should see further growth of 10%. Subsequently, it should rise by around 5% year on year given increasing daily ridership for MRT and LRT. Using the DTL contract as a benchmark, which was awarded at $1.6billion for 19 years, translating to a value of around $850million for 9 years, adjusted for different contracting model, for the TEL tender. Given that the government will now bear all revenue risk for the TEL, this should translate to additional fixed revenue stream of around 95million per year for SBS however this can only be realized in parts from 2019 onwards as the line will be opening in 5 stages: Stage 1 in 2019, Stage 2 in 2020, Stage 3 in 2021, Stage 4 in 2023 and Stage 5 in 2024.

Taxi segment: Bearish
I will go out on a limb and predict self-driving system to be fully implemented by 2023. Local taxi fleet contributes around 75% of taxi segment revenue. In between, Comfort should see a decline in taxi fleet of around 5% year on year. Based on 2016 data average revenue generated by each taxi should arrive at around $66,000 p.a. given 5% unhired rate. With a constant 10% unhired rate, each taxi should contribute around $62,500p.a. moving forward. The negative effect should actually be counteracted by more drivers returning back to Comfort as Uber and Grab utilise more driverless cars, though I am unable to determine by how much hence I will not factor that in. However, after 2023 with the implementation of driverless system I expect Comfort’s business to rapidly decline by an extreme 20% year on year. This will leave Comfort with a minority share in the taxi market, to cater to niche consumers who do not wish to use driverless. This is also assuming that Comfort sticks with its current business model and does not implement driverless themselves.

For reasons unknown Comfort stopped reporting breakdown of overseas segment since FY15. Hence, due to lack of information on how their overseas segments will play out, I will simply base this DCF on initial assumption that Comfort’s revenue will maintain at 65% Singapore, 35% overseas. I predict that management will attempt to grow the overseas segment, hence overseas segment will increase by 2 percentage points year on year, playing out to 40% Singapore, 60% overseas in 2026 assuming constant currency. Correspondingly Capital Expenditure should increase to around 500M per year for increase in overseas acquisitions. This is counteracted by less capital expenditure in Singapore due to BCM and decrease in purchase of new taxis.

With that in mind, my breakdown of Singapore segments:



My view is that bus segment with a fixed contract model and limited number of new routes will only enjoy stable growth of 1% p.a. Rail segment to have explosive growth if TEL tender can be secured. Taxi segment to rapidly decline in face of disruptive technology. I have cross checked the table figures until 2018E with that provided by other analysts, and the numbers were similar hence I have confidence that my estimates(at least until 2018) are fairly accurate.

I employed a 10-year two stage FCFF model as I view Comfort to soon undergo a transitional phase ala $SingPost hence stable dividend pay-out will unlikely be maintained. I mainly use this to do a sensitivity analysis on how the extent of decline in the taxi business will impact the overall share price. I calculate total revenue based on how the overseas expansion will play out and determined EBIT margin to be around 10%, which when cross checked with other analysts numbers were again quite similar. However, I project capital expenditure should increase to at least 500M per year given management hint of overseas expansion and technology development, which differs from other analysts who have CAPEX mostly projected at around 300M.

Using a 9% WACC and 2.0% terminal growth, assuming taxi business will decline 5% year on year from 2017 and then 20% year on year after implementation of driverless system in 2023, counteracted by the slight growth for bus segment and huge growth in rail segment, I arrive at a price of $1.57 (34% downside).

Even with a more muted decline of 3% y-o-y from 2017 then 10% decline from 2023 onwards price still arrives at around $1.63 (30% downside).

Hence, my long term view is that taking into account the growth story in Singapore has more or less been maximised, Comfort will have to prove over the next few years that it can further expand overseas, to the point where overseas segment will have to comprise more than 70% of overall revenue for the company to counteract the negative impact of a devastated taxi business in order to maintain and grow its current share price level.

Disclaimer:
All research reports are of the analysts’ personal opinions and do not in any way reflect InvestingNote’s official opinion. InvestingNote does not issue a buy or sell recommendation on any security, and any research paper published by The Signal Blog is purely for informative purposes. This research is based on current public information, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual InvestingNote users. InvestingNote users should consider whether the information in this research is reliable, and suitable for their particular circumstances and, if appropriate, seek professional advice. The price and value of investments referred to in this research and the investment income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.

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Stock Picking Strategy Series: Dreman’s Contrarianism Part 1: Investment Philosophy and Strategy

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This column is written by @j_chou.
-@J_chou has an interest in global macro trends, financial markets and equity research and enjoys applying a combination of the three in his investments. His eventual investing goal is to manage a risk parity portfolio and achieve true financial freedom.

David Dreman is the chairman of Dreman Value Management Inc. and his Dreman’s High Return Fund is one of the all-time highest returning mutual funds in the USA since its introduction in 1988. He is widely knowns for his iconic contrarian investment strategy and has authored a few books that revolves around this theme, including the investing classic and bestseller “Contrarian Investment Strategy: The Psychology of Stock Market Success(1980)”.

When Dreman first entered Wall Street in the 1960s he was caught up with the prevailing optimism in the market where “fashionable” stocks were up twentyfold. Within a couple of years many of those stocks had plummeted. Stung by his experience, Dreman began researching the drivers of investing bubbles. He was perplexed as to why investors hadn’t realised that they’d been swept up in an enormous folly.

Dreman’s Approach

Dreman’s strategy, backed up by years of research and illustrated heavily in his books, is outlined by his approach to both the behavioral and interpretational obstacles of investing. Behavioral obstacles include a tendency toward crowd psychology, while interpretational obstacles include the difficulty of actually estimating future company value. While the price of a stock will ultimately move toward its actual intrinsic value (regression to the mean), mistakes in estimating that value (interpretational obstacles) and market emotions and preferences (behavioral obstacles) will result in periods of undervaluation and overvaluation.

As Dreman observed:

“The failure rate among financial professionals, at times approaching 90%, indicates not only that errors are made, but that under uncertain conditions, there must be systematic and predictable forces working against the unwary investor.”

Dreman especially holds contempt for experts and analysts, whom he has extensively researched on and noticed that their estimates were on average 44% off even when provided with a 5% margin of error. He concluded that in general analysts are no better at stock picking than a flip of a coin! The latter half of his observation stems from the fact that investors pay too much for companies that appear to have the best growth prospects but react too negatively to companies with weak prospects. Hence, astute contrarians can profit by taking a position against the crowd with anticipation that results will be better than expected and an improving trend in return-on-capital will emerge.


Graph from The Economist: Sell-Side Share Analysis is Wrong

With this investing philosophy in mind Dreman surmised his simple yet mechanical strategy of picking stocks:

“I buy stocks when they are battered. I am strict with my discipline. I always buy stocks with low price-to-earnings ratios, low price-to-book value ratios and higher-than-average yield. Academic studies have shown that a strategy of buying out-of-favor stocks with low P/E, price-to-book and price-to-cash flow ratios outperforms the market pretty consistently over long periods of time."

To summarise Dreman’s 5 criterias for picking stocks:

1. Low Price-to-Earnings Ratio
2. Signs of Earnings Growth
3. Medium to Large Company Size
4. Financial Strength
5. Above-Average Dividend Yield

Low Price-To-Earnings Ratio


Source from Dreman.com

Stocks with high PER are often attributed to investor’s overconfidence in the stock. Hence Dreman researched on how earnings surprises, both positive and negative affect the prices of expensive and cheap stocks for a period of 24 years between 1973 and 1996. 95 quarters in all were studied and between 750-1000 companies in each of the 95 quarters of the study.
They ranked stocks into five sets of quintiles ranked by PER, PCR and PBR. The top quintile (quintile = 20% of sample) were the most favoured stocks, the bottom quintile the least favorited. Prices were measured against consensus forecasts every quarter between 1973 and 1996.

Results were as follows:

The bottom (cheap) quintile of stocks responded positively to earnings surprises. Per quarter they averaged 1.5% above market and over the full year beat the market by 4.2% per annum. This means that the combined effect of all surprises, positive and negative, worked in favour for the cheap stocks. Middle quintile stocks performed just below neutral, underperforming by 0.2% per quarter and 0.5% per annum. Top quintile stocks underperformed, returning 1% per quarter less, or 3.5% per year. Stocks with a low price to earnings ratio surprised the market by returning 4.2% per year above the general indexes whilst expensive stocks disappointed by 3.5% per year.

It can be concluded in a longer time frame low PER stocks will outperform stocks with high PER.

Signs of Earnings Growth

Companies that are ripe for contrarian plays often have a good reason for being in that particular position, mostly due to enormous losses and poor business operations. As such, further losses will likely see muted negative impact on share prices. However, if the company makes even a modest profit which may signal a turnaround, the growth in earnings will probably be astronomical.

Hence, for this criteria Dreman has learned to keep an eye out for companies that still have a long way to fall. He will only invest if he can determine if a company has decidedly hit the bottom and is starting to turnaround.

He has a simple approach to determining if a company has bottomed out, which is to look at consensus estimates. Though he has a disdain for analysts and does not follow precise estimates, he does look at Wall Street forecasts to a certain extent, to see if forecasts show huge continued losses. He has observed that when analysts are overwhelmingly convinced that earnings have further to fall then it is best to take heed and avoid the stock.

Medium to Large Company Size

Dreman generally dislikes investing in small cap and penny stocks as he observed that for such stocks survival rates are lower and transaction costs are higher Furthermore, due to the illiquidity of such stocks the spread is big, which may completely offset the much higher theoretical profits of such companies.

Also, Dreman is of the opinion that accounting is a “devilishly tricky subject” as from experience both novice and sophisticated investors have often misinterpreted crucial elements of accounting statements. Hence, medium to large firms that will generally provide a more honest view of accounting are preferred as larger firms with long records are watched more closely by a wider range of investors and regulators.

Another reason to favour medium to large cap companies is that through studies Dreman has found fewer large firms has gone completely out of business. Furthermore, large companies have greater managerial and financial resources to weather a company or industry slowdown or problem. Also, stocks of rebounding large companies tend to be in the public eye and get noticed more quickly when things go better for the company which should result in a higher valuation for a given level of earnings.

Financial Strength

Dreman was a big fan of Benjamin Graham’s work. For added margin of safety, Dreman also believes it is important to consider the financial strength of a company when pursuing a contrarian investment strategy. A strong financial position enables a company to work through periods of operating difficulty commonly experienced by out-of-favor stocks. Financial strength is also a measure of stability and ensures that dividend payout is sustainable.

Both short-term obligations of the company along with long-term liabilities should be considered when testing for financial strength. Ensuring that the company has sufficient reserves and conservative debt levels will mitigate the risk of default in turbulent times.

Sustainable Above-Average Dividend Yield

Lastly, Dreman seeks companies with a high dividend yield that the company can sustain and possibly raise. The yield helps to provide protection against a significant price drop, and also contributes to the total return of the investment. Hence, ensure dividend cover and dividend payout ratios are reasonable, as a cut in dividend will have a negative impact on share price.

Exit Strategy

Dreman also discussed a little about his exit strategy in his books. It mostly boils down to one rule, which is to sell a stock when PER approaches that of the overall market, regardless of how favourable prospects may appear. Hence, sell when the stock has reached the same price as the general market as a new contrarian stock will have better prospects. Also, look to sell it if the stock appears to have a deteriorating outlook, as fundamentals have changed. Dreman warns against applying contrarianism for the sake of contrarianism. The idea of contrarianism is to buy undervalued stocks, not bad stocks.

Dreman also has suggestions on how long to hold onto a stock that has not realized its potential. To him it is all pretty much a matter of choice, but give a period of 2.5 or 3 years for the stock to work out.

To be continued…

In the next post I will look at a few SGX stocks where the contrarian strategy could theoretically be applied. Given the poor performance of some mid to large cap stocks recently there should be some interesting picks! Hint: $M1(B2F.SI) anyone?

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Attachment(s):

Quick Screening Series:$SIA Engineering(S59.SI)



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This column is written by @calvinwee 
-Calvin is a fundamental analyst at heart and an ardent disciple of value investing. He relishes the process of searching for undervalued stocks and enjoys collecting dividends from his stocks.

Company overview:
SIA Engineering Company Ltd (SIAE) specialises in providing aircraft maintenance, repair, and overhaul (MRO) services. SIAE is a subsidiary of Singapore Airlines Ltd (SGX: C6L), counts over 80 international airlines as its customers.

SIAE is split into the following 2 segments:
1. Repair & Overhaul
SIAE offers a one-stop service for virtually all types of airplane issues, ranging from airframe maintenance to component overhaul. SIAE’s primary edge lies in its Joint Ventures and its strategic partnership with Pratt and Whitney and Rolls-Royce and most recently in June, GE Aviation, the top aircraft engine manufacturers in the world. This bestow it with the capabilities to repair major aircraft engines.
2. Line Maintenance
Apart from its operations of checking each plane before the flight in Changi Airport, SIAE have business interests in Hong Kong, Indonesia, Philippines, Australia, USA and Vietnam through its JVs.

Key financial highlights



Data source: SIA Engineering Annual Report

➢ Revenue, at $1,104.1 million, was 0.8% lower than the preceding year.
➢ Revenue from line maintenance increased 11.5% to $513.0 million.
➢ Overall, net profit increased 88.2% to $332.4 million, boosted by divestment gains of $178.0 million.
➢ Excluding the divestment of Hong Kong Aero Engine Services Ltd, net profit declined 2.6% to $172.0 million.
➢ On the bright side, SIAE continues to maintain its strong balance sheet with S$601.7 million cash and equivalents and borrowings of S$25.9 million in FY17
➢ Also, SIAE increased its total dividend for FY17 to 18 cents per share, up from 14 cents in FY16.

Outlook
Upsides

1. Changi Airport Terminal 4
➢ With the completion of T4, which has a planned capacity of 16 million passenger
movements, boosting Changi Airport’s current capacity of from 66 to 82 million
passengers per annum.
➢ With more passengers flying in and out of Singapore, this will potentially translate to
more planes for SIAE to service, since SIAE dominates 90% of the line maintenance market at Changi Airport.

2. Growth prospects of air traffic in Singapore
➢ In a report published by IATA, it is predicted that by 2035, Singapore will handle about 117 million passengers - 87 per cent of the planned capacity, with the completion of T5

3. Strong balance sheet
➢ SIAE has a D/E ratio of 0.02 and a net cash position of more than S$400m of cash and cash equivalents on its balance sheet after accounting for final and special dividends
➢ SIAE is well positioned to capitalise on any attractive opportunities that will bolster long-term growth.

4. Collaboration with upstream and downstream partners
➢ collaboration with established partners such as Boeing (fleet management), Airbus (heavy maintenance), and GE aviation (engine overhaul),
➢ revenue drivers in the long run, with exclusive access to the global OEM markets
➢ New MOUs signed with downstream partners such as Moog and Stratasys
➢ SIE’s strategic tie-ups with OEMs and other related companies are a step in the right direction but will not see results in the short term.

Downsides

1. Airlines cost-cutting measures
➢ Airlines are attempting to cut operational costs amidst the cutthroat environment by using newer engines that require less maintenance,
➢ Places downward pressure on MRO rates, rate cuts is a potential scenario to protect market share
➢ Case in point, SIAE’s revenue for line maintenance grew to a high of S$267m in 2H17 but operating margin shrank to 15%, lower than the historical average of 23%.

2. Poor performance from majority of SIAE’s business segments
➢ Only its line maintenance segment is growing
➢ Insufficient to prevent a10% yo-y decline in core operating profits for FY17.

3. Heavy reliance on SIA for business
➢ Close to 70% of top line is driven by SIA.
➢ The growth and maintenance cycle of SIA's fleet therefore strongly impacts SIAE’s core businesses.
➢ As mentioned, SIAE already captures around 90% of the line maintenance market at Changi Airport, thus market share gains are improbable.

Analyst opinions.
Against the backdrop of the lukewarm economic climate and political developments, the MRO industry remain extremely challenging. With the possibility of weak MRO demand in the near future due to structural changes in the industry. The intense competition in the airline industry will continue to put pressure on the margin front.

However, despite the gloomy forecast, there remains a silver lining for SIAE in terms of growth opportunities. SIAE’s investment in strategic partnerships and advancing innovations provide it with a first-mover advantage. By positioning itself as an OEM partner early in the game, SIAE should benefit in the long term from the territorial exclusivity granted to it as OEM’s total care programmes have been gaining a lot traction with airlines especially in Asia-Pacific. These initiatives will strengthen the SIAE's core competencies and service offerings at its Singapore main base, and position it for long-term and sustainable growth.

Disclaimer
All research reports are of the analysts’ personal opinions and do not in any way reflect InvestingNote’s official opinion. InvestingNote does not issue a buy or sell recommendation on any security, and any research paper published by The Signal Blog is purely for informative purposes. This research is based on current public information, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual InvestingNote users. InvestingNote users should consider whether the information in this research is reliable, and suitable for their particular circumstances and, if appropriate, seek professional advice. The price and value of investments referred to in this research and the investment income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.

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Attachment(s):

3 Recent Developments You Should Know About $StarHub(CC3) and the Telco Industry
$SingTel(Z74) $M1(B2F)

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This article is jointly written by @fayewang, @calvinwee and @gordon_ong.
This is just a summary, please refer to the attachment for the full article.

Executive Summary

In Singapore, with a sky-high mobile penetration rate of 150% and stagnant subscription numbers since 2014, there is literally no room to attract new consumers. With an already saturated market, the Singapore telco industry is fast becoming a zero-sum game. New alternatives such as online services and new entrants will only further fragment the market and capture niche segments at the expense of incumbents’ market share. This applies all of StarHub’s 3 business segments: mobile, broadband and cable TV. We may have to prepare ourselves to enter a new norm of more sluggish top-line growth for incumbents, and valuations that take that into account.

One research article that covers the telco sector has been done by the Research and Education department from NTU Investment Interactive Club @ntuinvestmentclub. Refer to the research here: https://www.investingnote.com/posts/108786.

As such, we will be delving deeper into recent developments involving the sector: namely, TPG’s entrance as the 4th telco, Netflix’s entrance and the collaboration between Starhub and M1 in a bid to counteract their difficulties.

1. TPG’s entrance as the 4th telco

TPG’s entrance into the mobile market does not pose a large threat to Starhub as Starhub can differentiate themselves through providing bundled plans. Starhub’s “Hubbing” product bundle offers all 4 services: cable, broadband, mobile and home tel, at discounted rates. However, if TPG captures only 7% of the market and takes market share proportionally, Starhub’s mobile market share will fall from 26.7% to only 24.8%.

Although TPG’s main line of business within Australia is broadband, it is unlikely that it will enter the broadband arena in Singapore in the near future as its allocated CAPEX resources are currently tied up in establishing nationwide coverage for mobile data in Singapore and Australia

As a new entrant, TPG may not gain traction due to its nonexistent branding and most handphone subscribers prefer to stick to an existing plan since they are rewarded with accompanying loyalty benefits. Moreover, TPG may struggle to develop a network with sufficient quality to challenge the incumbents as its estimated CAPEX of 200-300m is seen by the industry as modest at best. Market research firm Ovum believe that the CAPEX set aside is insufficient to install base stations, data centres and the backend fibre-optic cables.

2. Netflix and the impact on Starhub’s Pay TV business segment

In Singapore, rather than directly disrupting the Pay TV industry, streaming video providers such as Netflix are likely to complement each other and by offering both services as a bundle. The collaboration is necessary as Netflix ride on the Internet infrastructure owned and operated by telcos and Internet service providers (ISPs).

The Pay TV business segment contributed 17% to Starhub’s total revenue for FY 2016, down from 17.6% in FY 2015. With the decline, the Enterprise Fixed segment’s revenue eclipsed Pay TV’s contribution for the first time in 2016.The number of Pay TV customers fell 7.2% yoy to 498,000, Starhub recorded a corresponding drop in revenue of 3.3% yoy to $378 million. In summary, All in all, StarHub’s Pay TV business ended FY2016 with a loss of 47,000 subscribers – or 8.6% of the segment’s subscriber base since 2015.

It seems that as Netflix will eventually ease into the role as a complement to Starhub’s offerings rather than as a direct competitor. Firstly, existing Pay TV customers will still pay for regional and localised content in the local languages. Next, some consumers subscribe to Pay TV is to watch sports content such as EPL and NBA which is not available on OTT services. Lastly, Starhub joined in the OTT fray with their own mobile TV apps which do not charge subscribers for mobile data consumed while watching on the go. Also, StarHub, allows its customers to sign up for Netflix through StarHub's Fibre TV set-top box.

The decline in subscribers does not represent a complete shift towards Netflix as some consumers are merely shifting to a different platform for video consumption. That said, although Netflix might not have fully displaced conventional cable TV, but its hold on the local TV-watching landscape grows stronger every month, thanks to its original or exclusive content.

In conclusion, whether Netflix will continue to convert existing Starhub users to its services depends on one word: content. If Starhub can deliver content that is equally entertaining in addition to its current offerings of Asian TV shows, we will see the numbers of conversion stabilize. Ultimately, Netflix and Starhub have a symbiotic relationship,, collaboration rather than competition will lead to the greater good for both the companies and the consumers.

3. What investors should know about Starhub’s collaboration with M1

In January 2017, Starhub announced a Memorandum of Understanding (MOU) with M1. It stated that the two companies are in negotiations regarding mobile network infrastructure sharing for Radio Access Networks (RANs), backhaul transmission and access assets. Despite this apparent collaboration between Starhub and M1, they are still competitors in the telecommunications industry.The MOU was not the first synergy of Starhub and M1, their collaboration through network infrastructure sharing has been in process for several years, and this includes cooperation on combined antenna systems, in-building fibre and tunnel cables.

According to Starhub’s 1Q17 result that released on 3 May, Starhub’s Capex cash payment has decreased 19% when compared to data of first quarter in 2016, and the percentage of Capex to revenue observed 1.4% drop from 7.1% to 5.7%. Thus, based on this, network infrastructure for RAN indeed help Starhub cut its capital expenditure. However, investors should know that Capex will not be wholly charged as current year’s expense; instead, it will be expensed yearly through depreciation based on the useful life. In a nutshell, Capex reduction affect only small portion of total expenditure, thus will not guarantee less expenses.

Though Starhub’s other operating expenses had drop of 6.7% in 1Q17, the total operating expenses increased 2.6% due to the higher cost of sales. Since Starhub almost earned same revenue as 1Q16, the higher operating expenses became one of the reasons of declining quarterly profit.

From the perspective of cash position, Starhub’s net cash from operating activities was S$18.5 million higher because of the lower working capital needs and income tax paid. Net cash used in investing activities decreased S$9.8 million to S$31.8 million in 1Q2017, which is mainly because of due to lower CAPEX payments and repayment of loan from associate.

We can draw a conclusion that the collaboration between Starhub and M1, has benefited Starhub from the reduction of Capex and partial expenses. Also, share of network allowed Starhub accumulate greater amount of cash because it didn’t need to invest as much as in previous years on infrastructure construction. However, the competition is still fierce and the market is already saturated. This collaboration seems more likely to be for the purpose of maintain rather than boost Starhub’s business, and it failed to save Starhub from the downtrend.
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Please refer to the attachment for the full report.

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Attachment(s):

It’s AGM season. Here are the on-site coverages of the top 5 AGMs that happened this week.

Special thanks and shoutouts to those at the AGM who put in the time and effort to provide other community members with the live news and updates! If we've missed out anyone, please comment below so that we could add you in too. Investors Unite and Huat ahhh!

We will be sending more push notifications to our app to keep you updated, so please download our app on the respective Google or Apple app stores.

Also, we strongly recommend to use the following hashtags #agm and #AGM-live for better archiving!

$Sabana Reit(M1GU): https://www.investingnote.com/posts/99654 @vangogh53

$UOB(U11): https://www.investingnote.com/posts/94414 @MasterLeong

$HPH Trust SGD(P7VU) $HPH Trust USD(NS8U): https://www.investingnote.com/posts/96177 @soonchuan

$ComfortDelGro(C52): https://www.investingnote.com/posts/97680 @JLeong

$DBS(D05): https://www.investingnote.com/posts/98791 @MasterLeong

$OCBC Bank(O39): https://www.investingnote.com/posts/99822 @MasterLeong

-Stay tuned!

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Market Indices

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