Small-cap adventures on the Singapore Exchange

There are times when you just feel like you've found The One.

The vital statistics, at first glance, just seem too good to be true.

A solid balance sheet free of debt, with decent free cash flow? Check.

A double-digit net profit margin? Check.

Wow, look at that ridiculously low price-to-earnings (PE) ratio!

You rub your eyes and apply the margin of safety, but the stock still stands coy, calling out for you to hit its asking price.

Has the company been around for a while? Check.

Can you see its business on the ground? Check.

No red flags in its financial statements at first glance? Check.

The pulse races. Is that . . . a value stock?

It might be yet another illiquid small and medium enterprise (SME) listed on the Singapore Exchange (SGX). It might be a value trap.

But in the first flush of love, you have no idea.

I remember first getting this feeling one night in May 2012, when, as a young(er) investor, I was browsing stocks on the SGX's "company disclosure" page.

I randomly stopped at a name beginning with "K": Kian Ann Engineering.

That, I realised, was a heavy machinery distributor which had just released its third-quarter results, showing a 16 per cent improvement over the nine months to March 31, 2012.

The company's annualised earnings per share was 4.4 Singapore cents, and yet it was trading at just 22 Singapore cents. Its debt was minimal. Its PE ratio? Five times!

Its revenues and profits were still growing, partly due to the mining boom in Indonesia.

The commodity crash was still some years away. Its dividend yield was 5 per cent.

What sorcery was this?

I bought a small amount the following Monday without a second thought.

I always remember that stock because just months later, it was bought out and delisted at double the price!

I wasn't so lucky with another heavy equipment distributor, Sin Heng Heavy Machinery.

I bought into the crane trader near its peak in 2014, lured in by a similarly high dividend yield, a low PE and price-to-book ratio.

But I completely misread its financial statements, debt levels, and near-term business prospects.

A commodity price crash soon caused an oversupply of cranes in the market.

Nothing serious showed up in financial statements yet.

But if I thought Sin Heng was cheap at a 10 per cent discount to book value, that discount widened to 20, 30 per cent.

I bought into the company at various intervals, thinking the discounts seemed unreasonable.

The company eventually made losses and cut its dividend. It traded lower and lower, from a 40, 50, 60, 70, and even ending up at a 75 per cent discount to book.

Regional earnings collapsed. Brokers have long stopped covering the stock, even as liquidity dried up and I could not exit my position without suffering a big discount.

Sin Heng became my single largest unrealised loss.

Their crane assets, for that matter, are also illiquid.

But now, I hope the market is too pessimistic.

I picked up some stock of the big crane boy in town, Tat Hong, which is trying to become leaner so it can be profitable again.

For Sin Heng, I have committed too much, so I just have to sit and wait.

An oil and gas venture

With a lot more battle scars to my net worth, I was browsing the financials of Hai Leck Holdings half a year ago.

Hai Leck provides maintenance and mechanical engineering services to oil and gas majors in Singapore.

The company had just released its 2016 annual report for its financial year ended June 30, 2016.

It was trading at around 38 Singapore cents.

Pre-tax profit was around S$15 million.

Out of that, the core business of project and maintenance services contributed S$11 million, and a call centre business, S$4 million.

Net of tax, we were looking at a S$13 million net profit.

With 205 million issued shares trading at 38 Singapore cents a share, the value of the company was just S$78 million.

Yet oddly, it already had S$51 million in the bank.

This means that even though the company was trading at six times earnings on the surface, it was actually only trading at a little over two times historical earnings when cash is excluded.

Two times! The feeling of having hit upon some treasure was back, even though I know past earnings might not last.

What was also impressive was the firm's high operating profit margins of over 10 per cent.

Higher margins give firms a cushion during downturns as they can stay profitable even if they are forced to lower prices.

So I initiated a position.

The stock looked undervalued.

But you have to wonder.

Is the SGX really such an inefficient market?

Or does the market know something that new investors don't?

Sustainability of earnings

First, I have to evaluate the possibility of earnings collapsing.

Two times earnings is a reasonable price to pay as long as current earnings are not going to drop by two-thirds and stay there for years.

Key questions abound.

Are oil majors going to pull out of Jurong Island anytime soon?

Given that Hai Leck has to survive based on new contracts for engineering and maintenance given out by big firms, will it somehow lose their trust?

Is another competitor taking away market share?

Is there some hidden accounting scandal at the company?

The macroenvironment is challenging, with rising costs and restrictions on foreign labour biting.

Revenues are definitely declining.

But I imagine a widespread collapse in the oil processing and refining sector is unlikely, simply because the oil majors are still in good financial health.

Problems are confined to the leveraged offshore support services firms.

Hai Leck is in rude health by contrast.

Refineries will hopefully still need the scaffolding and corrosion prevention maintenance services that it offers.

There are also no indications of its customers being unwilling to pay up, as happened to customers who wanted Keppel and SembMarine's rigs.

No accident, touch wood, seems to have happened in a way that damaged customers' trust.

With contracted jobs, you never know if they will keep coming.

But I have some confidence that the firm will be around to take advantage of an upturn, when it comes.

After all, it has been around since the early 1970s.

Even 10 years ago, it was making several million dollars a year of profits.

Scouring the balance sheet

Then you have to wonder about the company's balance sheet.

Are there time bombs within it such that huge impairments have to be made?

I went through some standard "red flag" checks.

Is the cash real?

Sometimes, a large amount of cash will be reported as generating an unreasonably low amount of interest income.

At end-June 2016, Hai Leck had S$26 million of cash tied up in fixed deposits, with interest income from there of S$196,000.

This gives a 0.7 per cent interest rate, which is not too low to generate suspicions.

Now, what is the likelihood of most of the company's cash being used for some gigantic, wasteful project?

No such indication of a big ramp-up in spending was apparent in the management discussion in the annual report.

Research and development expenditure since 2009 totalled just over S$20 million.

In fact, S$10 million in the past quarter went back to shareholders in the form of dividends - a 13 per cent yield.

Meanwhile, spending on replacement machines and tools are at levels below cash incoming from operations, after adding back depreciation.

This free cash flow enables the business to sustainably pay profits to shareholders without resorting to borrowing or running down its cash hoard.

There is one Thai joint venture, which is accounted for under non-current assets.

The venture appears to be profitable and in any case, assets far outweigh liabilities, and its book value is still small.

Trade receivables did rise substantially in 2016.

There is a problem if they rise faster than sales, for the company can be unsustainably making sales on credit to pad its financial results without being able to collect the cash.

This is only a worry only if it is a persistent trend.

As it turned out, that wasn't the case.

Circumstantial evidence

So far, so good.

Hai Leck does have other things going for it.

For one thing, it does seem like the government is willing to support its sector by encouraging firms there to be more productive.

Some googling will reveal how the firm, together with SGX-listed peers such as PEC and Hiap Seng Engineering, are contractors of Singapore Refining Company (SRC), which operates an oil refinery on Jurong Island.

The companies were cited in a 2015 press release which mentioned how Spring Singapore, the Economic Development Board and the Association for Process Industry have supported a project for the SRC and its contractors to improve productivity.

There are also mentions of the firm in a government productivity portal, where it set up a productivity centre to embark on initiatives over the next few years.

Meanwhile, it is interesting that the firm's deputy chief executive officer, Cheng Li Hui, is an elected member of parliament with the ruling party.

The company will hopefully be motivated to run a tight ship, simply because the reputational consequences are too big should anything go wrong.

But just because the company seems bona fide does not mean that its business is worth investing in from a value perspective.

One example might be satellite communications firm Addvalue Technologies, which developed hardware carried on satellites launched by Nanyang Technological University.

The company operates in a sector that Minister for Trade and Industry (Industry) S Iswaran said the government was focused on growing.

He paid a visit to the firm last November.

But Addvalue is a stock on the speculative end of the spectrum.

After all these years, the company has accumulated losses on its balance sheet of some US$50 million at end-September, 2016.

Investors have yet to see the light at the end of the tunnel.

Call me, maybe

What is most interesting about Hai Leck today is its call centre business, Tele-centre Services, injected in November 2011 for under S$3 million from vendors consisting of Hai Leck's founder, his wife, and a former CEO.

Revenues are now around S$12 million a year.

Pre-tax profit margins are now well above 30 per cent.

Absolute pre-tax profits have risen from under S$1 million to over S$4 million each of the last two years.

This is an incredible return on investment.

This is in addition to Hai Leck's core business of engineering and maintenance services, which can generate a few million dollars in profit every year at the minimum, and even S$10 million in a good year.

So Hai Leck's ex-cash valuation of S$27 million seemed too low, especially after you average out past earnings and apply a standard small-cap no-growth multiple of five to seven times.

Before I can evaluate it more, the company's share price ran up very quickly.

DBS published a small-cap report, highlighting Hai Leck among other stocks that look intriguing given their low earnings ratios, high net cash per share and dividend yield.

"Hock Lian Seng and Hai Leck Holdings are the most intriguing as they are also trading at just 6.6 times and 6.1 times PE respectively, while trading at 71 per cent and 66 per cent of net cash per share," DBS analyst Paul Yong wrote on Oct 10.

Last Wednesday, Hai Leck reported increased profits and declared a five Singapore cent dividend, which was an 11 per cent yield on its last price.

Even though revenues dropped, the firm was valued significantly higher the next day.

Presumably, investors liked the dividends and the resilience of the firm's call centre business.

Now, at over 50 Singapore cents, it is still not expensive, but it is no longer as clearly cheap as it used to be.

Ultimately, as much as I love hunting for value stocks, I still don't dare to invest too much in SMEs.

Due to their illiquidity, you might only buy a few hundred to a few thousand dollars at a time.

Sometimes, there might be just offers of just a few hundred shares on the "bid" or "ask" side.

Spreads might be wide.

Which means you might be paying your standard S$25 online commission to buy or sell just S$100 or S$200 of stock, and not necessarily at the best price.

You have to sit by your screen the whole day to accumulate shares at a decent price, or input a firm bid price every day, hoping somebody bites.

At one point last Thursday, the "sell" queue even disappeared entirely for Hai Leck.

During tough times, when you really need to sell, it might be likely that there will be no buyers, too.

Meanwhile, there's no telling whether the oil industry will improve anytime soon.

Hai Leck, after all, was trading for cheap because its core business recorded a sharp fall in revenue over the past year.

With digitisation and chat robots, the days of call centres manned by humans might be numbered.

For now, the centre is still hiring.

A job site notes it is a "valuable business partner to renowned multi-national companies and key government organisations".

Long may that last.

So hunting for small-cap value on the SGX is not as easy because companies are illiquid, and business prospects are hard to read.

Nevertheless, if my limited adventures in small-cap investing are anything to go by, there are opportunities still.

There are ignored segments of stocks that don't show up at analyst parties.

Investors who practice value investing have to value these firms based on a conservative estimate of earnings, across a business cycle if possible.

The balance sheet and cash flow statements can help give a better understanding.

And just as there's plenty of fish in the ocean, the market always gives you a chance.

haoxiang@sph.com.sg

This article was first published on February 13, 2017.
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