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Thursday 13 June 2013

Small cap dogs - screaming buy or value trap?

The Hong Kong Hang Seng Index is down nearly 13% from its recent peak of 23,945 in mid-February 2013.  It is currently trading at a PE 9.6 (adjusted to reflect recent fall in index). Data below courtesy of my stocks investing journey.  I  cannot vouch for the veracity of the data, I have merely presented it to set into context against other indices.

My own rough and ready analysis which weights the PE according to market capitalization works out to be 14.2 which suggest it is trading at slightly less than the major indices (e.g. DJIA, S&P500, FTSE 100, CAC40, DAX).  Nevertheless, directionally it sets the tone that there is some discount when compared to these major indices.

The Hang Seng members are heavily skewed towards the FIRE+C (Financials, Insurance and Real Estate + Conglomerates) sector.  I have included Conglomerates despite their diversity as their businesses contain significant real estate related portfolios.  Together their market capitalization comprise 54% of the index.  Together these trade at a PE of 10.6.  A casual observation might suggest that there is room for share price expansion considering China's growth, although slowed, remains respectable in comparison with the other BRI[C]S nations.  But one must be skeptical and ask some obvious questions.  Is it a screaming buy or value trap? 

These three sectors are facing uncertain headwinds which might explain the current low valuation.  Chinese banks the likes of ICBC, BOC, ABC and CCB are choked full of real estate, state enterprises and local government financing vehicles loans which many market observers believe that it is a train wreck waiting to happen. 

The insurance sector (exclude AIA) is not too smart either, with exposure to wealth management products and investments ultimately tracing back to real estate.

Pure play property developers are trading mostly at between 30% - 40% discount to book value and profitability have been lifted by significant upward revaluations - thanks to HK linking its monetary policies to the US.  Therefore investors are right to exercise circumspect with government cooling measures and talk of the Fed having a sudden change of heart on QE to perpetuity.

At a macro level I do believe these valuations reflect uncertainties.  I would even venture so far as to say that Mr. Market is not exercising enough caution given most asset classes are mispriced due to ZIRP.  Implicit in the share price of course is that the Chinese government would inject capital and bailout its banking and insurance sectors if bad debts starts to proliferate.  Across the pond, there is the Bernanke put, which is to say Mr. Bernanke would not let the stock market unwind violently.  How effective these tools are one can only guess.  But the grave global uncertainty should instruct the careful investor to be extra vigilant.

Which now brings us to the subject of our heading.  There are many small cap stocks particularly the industrial and textiles and apparels manufacture variety that are hanging by their threads - no pun intended.  Recently, I came across a dog of a business, Cosmos Machinery, ambitions name in a lackluster sector. 

Cosmos' main business is the manufacture of plastic injection moulding machines which accounts for 40% of revenues.  The remainder of the businesses include the manufacture and sale of plastic products (16%) and PCBs (26%) and the trading of industrial consumables (18%).  All very old economy.

The Company started operations in 1958 and listed on the HK stock exchange in 1988.  Typical of many Asian businesses, it is essentially run by the founder as a family business with the second generation now involved in some capacity.  Very little heed is paid to outside investors.

Its current share price is HK$51.5cents giving a market capitalization of HK$365m versus net assets of HK$1,378m.  It therefore trades at a 73% discount to book value.  Figures based on 2012 annual results.

In 17 years (that's all the data I have!) it made losses in 3 of those 17 years.  2012 unfortunately being the number 3, reporting a loss of HK$24.2m.  The other loss making years were 1998 (HK$63.3m) - Asian financial crisis and 2001 (HK$89.1m) - 911 terrorist attack / post dotcom bubble.

For share data, I have information going back to 2000.  The shares traded at a low of HK$14cents in September 2002 and a high of HK$1.69 in June 2007 giving a market capitalization of HK$89.7m and HK$1,195.7m respectively.  The net assets were HK$579.6m (2006) and HK$791.6m (2001) respectively in those two periods.  Consequently, in September 2002, it was trading an 85% discount to net assets and by June 2007 it was trading at a 51% premium with a PE ratio of 18.3.

The 2002 low point was probably dragged down by disappointing results in 2001.  The high point?  Well the intervening years from 2002 to 2007 showed a steady profit progression culminating in a HK$100m profit in 2007.  From 2008 - 2012 profit trend seesawed - down, down, up, down, loss.  The skill required to value Cosmos whose recent profitability have been volatile in a more or less stable industry is likely to be challenging.

No one is questioning this tough cookie - it keeps coming back like the Terminator giving you bad dreams if you stayed too long.  Indeed management have to fight for every dollar of sales.  Don't believe me? Well in 1996 revenues were HK$1,169.4m and in 2012, revenues were HK$2,121.6m.  It managed to eke out a compound growth rate of only 3.8% compared to China's compound annual growth rate of 15.2% (measured in US$) in the same period.  No kidding, China as a country was growing 4 times faster than this poodle.

At this stage, should one give up hope or admire the tenacity of the management shareholder?  The fact that it can survive for more than 5 decades is a testament to survival bias / conservatism of this Company.  Saying it is a well run company would be a stretch.

So is there an opportunity here?  Cosmos' loss in 2012 was augmented by restructuring charges of HK$8m in the plastic products division.  2013 will be challenging regardless - but one should be on guard of being overly pessimistic in the investment field.  I suspect prospects for 2014 onwards, with no corporate catalyst, will be pedestrian given the slow growth in China.  Cosmos do not have an encouraging track record 'of beating expectations' in good or bad times.

Early this year, the Company announced the disposal of its associate, a Shenzhen listed associate, Haoningda Meters Co., Ltd.  I will not go into too much detail, essentially, the ownership was disposed at a 9% discount to the market value of Haoningda.  However, Cosmos had never mark-to-market their 48.21% interest in Hoaningda since they invested in 1998.  This resulted in a gain of HK$208m and cash proceeds of HK$554m.  The reconstituted balance sheet is shown below (squint, if you cannot see):

The interesting thing to note is that the Company's net cash (excluding pledged bank deposits) is HK$376m which is HK$11m less than the current market capitalization.

The Company is also trading at 77% to NAV and 62% to net current assets based on the above numbers.  Essentially it is valued at break-up value.  Even if management decides to shut shop tomorrow and assuming if one might only be able to recover 52% of net assets*, it would still be trading a 55% discount to a liquidation scenario or for every dollar you can get an extra HK$55cents.

The wide discounts suggest that price have dislocated from reality and there is an arbitrage opportunity.

*I basically worked down the balance sheet and applied discounts to carrying values conservatively.  So Inventories would be marked down between 30% and 80% whilst creditors would be paid in full.

Classic Ben Graham or value trap?

In terms of value trap, there are a few issues we can dispense with already:

(1) The controlling shareholder will soldier on regardless - that is only what he knows  - so unlikely to shut shop.
(2) The free float of the Company is just over 55%, a vulture might swoop in and demand some changes - unfortunately this is not the West and the Company is too small to be even on the radar of bottom feeding value investors.
(3) Take it off the market?  Unlikely, using cash to buy back shares when shares were cheap were not done.  Management rather hoarded the cash. 
(4) In the 14 years since 1999, this Company had only paid dividends in 6 of those 14 years.  A maximum of HK$0.021cents and a minimum of HK$0.005cents was paid.  Even with the exceptional gains made in 2010 of HK$201m only eked out a dividend payment of HK$0.015cents, mind you, the gain was a non-cash event.  So don't expect this miser to make large distributions anytime soon.
(4) This Company has been around for a long time and it has a network of customers and suppliers - goodwill that is in short supply these days.  However one cannot expect transformation from this base.

So what can you expect if you are considering an investment in Cosmos? 

If you purchased shares in January 2003 a couple of months after the Company's share price hit a nadir of HK$14cents in September 2002 at HK$23cents, by January 2013, 10 years later, you would have almost tripled your money (HK$65cents + HK$8.6cents in total dividends) giving a compound rate of growth of not too shabby 11%.  Incidentally at HK$65cents, it traded at a discount to NAV of 66%.

If you were lucky and ran for the hills in 2007 when the average share price was HK$95cents, including dividends, you would have bagged nearly four times your money and it would still have traded at 27% discount to 2006 NAV.  Not bad when considering you have a margin of safety of the stock trading consistently at below net asset values.

Normally one would on balance pass this opportunity on, however, the recent crystallization of the value of its associate have left it cash rich and widen its financial-moat giving it a safety of margin not normally associated with these kind of businesses. 

Die hard Ben Grahams may balk at my attempt at prophecy but there is a good chance operating profitability might rise to the HK$40m - HK$50m mark in the next 12 months given the restructuring of the plastic products division completed in 2012, newly installed efficient production facilities, good reported progress so far in certain business segments, the introduction of new energy efficient machines (see annual report) and raw material prices have continued to soften in 2013.  It is not inconceivable operational gearing can play a significant part considering profit grew 10 fold between 2009 and 2010 whilst revenues grew 40%.

At a PE of say 10, valuation might hit HK$400m - HK$500m giving a 10% - 37% uplift to the share price.  There might even be a special dividend distribution of say HK$30cents (HK$215m less than half the cash received) lifting returns to 70% - 95%.  Now that would be sweet! One can only hope management would do the sensible thing.

In conclusion, Cosmos is never going to be a ten bagger, but if you buy it cheap enough, even when there are no analyst covering the stock, the price will rise.  I expect it to drop perhaps further down to the HK$40cents - HK$45cents mark in the next couple of months, which then makes a good entry point to park a few lose change. 

Notice: The writer is considering an investment in Cosmos Machinery (0118.HK) which is listed on the Hong Kong Stock Exchange.  This does not constitute investment advice neither should it be construed as such.  

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