Beaten, Not Broken: Construction Companies | Analysis & Opinion

The local market has experienced an incredible blast off this year, with the Straits Times Index up by around 9% YTD. Valuations have generally risen across the board, with stocks in formerly depressed industries like banking (eg. UOB) and property development (eg. Capitaland) turning around remarkably. However, in a quiet corner of the market reside a group of depressed counters that have been neglected – construction companies. A few things are ubiquitous in the world of local construction – Hokkien company names, low P/E ratios and lacklustre business outlooks. Sounds like a place where one might start a value hunt.

Their plight is unsurprising, as the government’s property cooling measures in full force since 2013 (until recently) has crimped demand for newly built homes, combined with a weaker local economy.  This has left many construction companies trading at low valuations, although the prices of a few have started picking up in recent months. While not trying to pick a bottom, I believe there could be better days ahead for the sector in the coming years. 

The Building and Construction Authority (BCA) expects the value of construction contracts to be awarded this year to be between $28 and $35 billion, with the bulk ($20-24 billion) stemming from public sector works. This is higher than $15.8 billion in public sector demand in 2016, and $13.3 billion in 2015. However, private sector construction is expected to remain depressed. [BCA Release] Annual demand is further projected to be $26-35 billion in 2018-2019, and $26-37 billion in 2020-2021.

Looking ahead, with many public sector projects in the pipeline (eg. new MRT lines), it seems reasonable to expect that any industry turnaround would be led by the public sector. Private sector demand may also pick up, and already early signs are showing with news of aggressive bidders for new residential sites [article], signalling confidence and a potential turnaround for the industry. While they are mostly property developers, construction companies would get a reprieve from the property market picking up. 

Sieving Out Firms

I ran a search on SGX’s Stock Screener for the construction industry, in attempt to search for potentially undervalued counters. Based on my selected criteria, and the following 7 companies were filtered out.

I then did some fact-finding and complied the relevant data.

All data sourced from SGX’s website.

Most of the metrics I’ve chosen are rather self-explanatory, and so I shall not waste time elaborating on those, but proceed to further eliminate counters and narrow down further.

Elimination Round

For ease of comparison, I’ve colour-coded some figures in red and green, representing either the largest or smallest figures in that category, both which can be good or bad depending on context. 

First up, the price-to-something ratios. We see that all have P/Bs of less than 1, and P/Es of less than 10 (with the exception of PEC). Price-to-sales ratios also fall below 1 (with Low Keng Huat standing out). EV/EBITDA values are rather thin, except for LKH (again). 

All the counters pay decent dividends, with yields exceeding 3%, going as high as 8% (Keong Hong). Dividend payout ratios give us a rough idea about the sustainability of future dividend payments, and LKH stands out once again (3^rd time) with the highest ratio. Lian Beng’s is kept low at 9.8%, which could signal the potential for dividend increases down the line.

Moving over to financial health and creditworthiness, LKH (4^th time!) has the highest debt/equity ratio at 62%, while the rest are moderately geared (40-50%). However, when measured by the ability to quickly pay down their debts (debt/EBITDA), Lian Beng fares the worst at 13.5x Debt/EBITDA, hinting that its moderate gearing ratio could be more lethal than expected. LKH’s debt/EBITDA of 8.6x is slightly concerning as well. KH, KSH and PEC are standouts for having much better ability to repay their debts. In fact, all 3 of them are in a net cash position. 

Stripping out the (very likely) anomaly of LKH’s 141% net profit margin, Lian Beng handily managed a net profit margin of a respectable 22%. Worth mentioning are also KH and KSH, for managing double digit margins. On the other end of the spectrum is Tiong Seng, which only managed a meagre 2% NPM and 5% ROE. 

Looking at return on equity (ROE), Keong Hong fared best in its last fiscal year, at nearly 25%, nearly double of the next highest (KSH) at 13%. The firm also managed to grow its revenue (albeit only slightly) in these difficult recent years, which most of its peers did not. Lian Beng seemed to have suffered the most from this downturn revenue wise.

Lastly, I tried to find data on each firm’s total order book as of the end of its most recent quarter and listed are those which I managed to look up. Tiong Seng boasts the most impressive order book at about a billion dollars, and not far behind is Lian Beng at $644M, following its latest contract win. Note the size of each firm’s order book relative to its total revenue and market cap. Also note that the order book size may not accurately reflect immediate revenue as revenue is usually booked progressively in stages.

Verdict

Unsurprisingly, I’ve decided to eliminate Low Keng Huat first, owing to it having the highest leverage, and being the most expensive based on EV/EBITDA and P/S ratio.

Now the selection process becomes a lot harder. None of the firms stand out particularly – what area it excels in, it compensates for in another. 

PEC looks very promising, given its low gearing, big pile of cash and extremely low EV/EBITDA. However, the company is mainly involved in construction and engineering for the oil & gas and petrochemical industries, which links it to volatile O&G. Its order book is not very large, and my guess is that the firm is loading up on cash to cushion it from downturns in the O&G industry.

Tiong Seng’s last-12-months revenue surpasses all at $774 million, and its order book looks impressive at a billion dollars, but with profit margins so low, and assuming they do not improve, not much is going to be made from it. This explains the very low price/sales ratio. Nonetheless, the firm maintained respectable growth in the years prior and its conservative dividend payout ratio gives headroom for dividend increases in future.

Lian Beng looks very promising, except for its debt/EBITDA ratio of 13.5. Simply put, the firm has to continue making money at its current rate for at least 13.5 years, to completely pay off its current debt! Being in a net debt position of $421m (more than 150% its market cap!) means that business has to markedly pick up in coming years and profit margins cannot deteriorate, for the business to remain financially sound. Should the industry be hit by another downturn again, Lian Beng could face financial pressure. Its share price may have advanced lately on news of its contract wins, but investors should stay cautious.

It is hard to criticise the final 3, Keong Hong, KSH and Lum Chang, but they are of course, far from perfect. In a low-growth and saturated environment that is construction, share price upside is rather limited and daily stock trading volumes are lacklustre. Therefore I believe one should choose higher dividend paying stocks to compensate for the opportunity cost of holding such counters. Not only do high dividends cushion a stock’s fall, it also gives the investor income while waiting for an industry recovery to materialise. 

Keong Hong’s 8% dividend yield very mouth-watering. The dividend payout ratio is fairly conservative and the firm is in a net cash position, ensuring the stability of dividends in the near future. It also has decent profit margins and return on equity, and even managed to achieve revenue growth in the past 3 years.

Through a little research, I discovered that KSH is labelled as the government’s “preferred” contractor for civil construction works. This does somewhat give it an economic “moat”, or an advantage over competitors. Their portfolio is a litany of public contracts (eg. NUS) and so is their order book. Besides benefitting from the uplift in public construction spending, public contracts tend to be more stable than private ones as the risk of a counterparty default is minimal (speaking of which, just look at the mess in Singapore’s O&M sector). KSH’s 5% dividend yield is far from shabby, providing the investor with decent income while sitting out the downturn. 

The Final Word

Based solely on the above, I personally have 2 picks for exposure to the construction industry – Keong Hong and KSH, the rationale being collecting dividends while waiting out the industry downturn. 

Of course, this does not mean that one immediately goes out and buys them. More due diligence has to be conducted on these two stocks and I hope to review them in greater depth soon.

Just my two cents.

Happy 8th Birthday to the Bull Market? | Analysis & Opinion

As the relentless bull charges onward into its 8th year, I believe this is a good time to take a step back and examine the larger picture. It has been 8 years since the bulls wrestled control from the bears in the depths of the Great Recession in 2009, ever since the Dow Jones Industrial Average bottomed out on 9 March 2009. Through these 8 years we have witnessed numerous events that threatened to halt the bull on its upward charge [Story]. Yet through all the turmoil, the S&P500 managed to post a stunning >250% gain from that low point struck in 2009. On hindsight, the market has indeed come a long way from the tumult of the past, but the question of concern now is, how far and for how long more can the bull continue soldiering on?

Of course, the answer to this question would be anyone's guess, but we can evaluate empirical data from the past to draw parallels and perhaps come to certain conclusions. Nobody can tell precisely when the bulls will throw in the towel, but it is without doubt that the markets move in cycles and the bears will take charge again one day in future. Rather than trying to pinpoint an end to this bull market, I attempt to gauge where we could be in the current cycle and what we could possibly look out for.

Patching Together Parallels

Perhaps we could start by examining the charts of notable bull markets since the 70s (or about as far back as Tradingview allows me to go). I know there are plenty of people who scoff at the idea of looking at charts (hindsight is always clearer than foresight, confirmation bias etc) and I respect that view, but charts do paint pictures of the past like a history book. It is up to us (the historians) to interpret. Nonetheless, as the modern economy and stock markets only go back so far in time, we may not possess a large enough sample size for comparisons.

All the charts were indexed at 0% at the beginning of their time period, for ease of comparison.

The Late-70s Bull:

The 80s Bull:

The Legendary 90s Bull:

The 00s Bull: (we all know what happened after that)

Several Observations: (could be due to confirmation bias)

-  All the bulls have witnessed at least one big decline in its lifetime, which could have led many people to think that "it's over", but the bull ultimately regained its footing and trudged higher (may not be the case for the 00s)

-  Strong rallies tended to follow these sharp, deep declines

-  The final years of a bull market tend to return more than the early years, usually cumulating in one final big surge before putting in a top (1980, 1987, 1999, 2006)

-  They tend to range rather widely at their tops before the eventual decline (with the exception of Black Monday 1987)

- The topping out action tends to foreshadow a looming recession ahead, even when the GDP growth numbers have not yet turned negative. However, a market crash does not necessarily signal a recession, as was the case in 1987

Looking at the current bull market in this context, we appear to have just emerged from another "it's over" phase from 2015 to 2016, the previous one dating back to 2011. The sharp spike higher since the 2016 lows then seems to follow the trend of strong rallies after a sharp decline. Are returns then, going to accelerate, cumulating in one big final surge? Or could this just be the start of another leg up before a long consolidation phase?

Either could be the case, but taking into account the typical length of bull markets (see graphic below), we see that this bull has very likely already surpassed the halfway mark of its lifespan and could now be in its final dash. If that is the case, then the bull probably has anywhere between 6 to 24 months left in this cycle.

Source: Mackenzie Investments website

Again, all these judgements are solely based on empirical data, without using any other indicators or techniques (eg. Elliot waves). Market forecasting is more of an art than an actual science, after all.

The Ominous Signal of Looming Trouble

However, one rather reliable indicator shows that the bulls have no intention of laying down yet. While more of an economic indicator itself, the constant maturity spread between 10 and 2 year US government bond yields (2y-10y spread for short) has been remarkably accurate at foreshadowing recessions ever since the 1970s. Notice than when the spread dips below the zero-line (when the sovereign yield curve inverts), a recessionary period (marked out in grey) follows not long afterwards. The spread then widens again throughout the recession.

Source: Federal Reserve Bank of St Louis website

While the 2y-10y spread better reflects the credit cycle in the USA (and the rest of the developed world which follows not far behind), the credit cycle is very similar to the economic cycle, to put things simply. The stock market tends to lead the economic cycle. Thus, an inverted yield curve could be a warning sign signalling a market top. Then again, the data set may be too small to form a statistically sound argument for this ominous signal. But since history tends to repeat itself, it pays to keep an eye on the yield curve.

As the 2y-10y spread currently hovers around 1%, the "clear" signal is still flashing strong, but note that it is considerably lower than the 2.5% levels seen earlier in the decade. Based on this data alone, a market top or a recession does not appear to be around the corner.

Looking Ahead: Possible Strategies (Investing)

- Do not chase the rally, wait to buy on pullbacks. However, one should bear in mind the risk of that pullback in particular turning into the start of the next bear market

- For investors, it is perhaps prudent to trim positions and take some profits off the table following big surges. Alternatively, those with sizable US equity portfolios could employ strategies to hedge downside (more on that later)

- US stocks look pricey based on valuations, but could have more room to run à US corporate profits easily beat lowered expectations in 2016, and the most recent earnings season hinted at a possible rebound in corporate earnings, which could provide catalyst for more upside. But with the market rather pricey now, stock selection is of crucial importance.

- Now is not the best time to enter into passive index-tracking funds/ETFs for the long term, when we are in a late stage bull market

- Low-beta dividend stocks may seem boring, but those offer a cushion against market volatility when periodic shocks occur

- The local market (Straits Times Index) -- Singapore is the best performing market in Asia year-to-date in 2017, roaring back to life by decisively breaking above 3000 and then 3100 points, surprising many people (myself included). This is a possible "revaluation" trade as many counters which have been bogged down for many years (eg. property developers) are coming back to life again. We are still way short of the 2015 highs in the 3500 range but it would be a huge surprise if the STI manages to reach that level within a single year. Trading at around 14 times price-to earnings, the STI is still relatively cheap compared to other markets and could have more room to run. Perhaps the best course of action is to seek out undervalued and overlooked counters that have potential to be the "next big movers".

- The bond markets could see some radical changes this year as US interest rate hikes may happen at a quicker than expected pace. This marks a drastic reversal from an era of low rates the world has gotten hooked on. Long-dated sovereign bond yields have risen sharply since bottoming out in 1H16. Should economic conditions pick up, the European Central Bank and Bank of Japan could quickly cut their Quantitative Easing programmes and raise interest rates back above zero -- now is not the best time to invest in bonds. That said however, local corporate bonds with shorter durations may be less sensitive to interest rate movements, and individual bonds are affected by corporate yield spreads (above the risk-free rate) as well as individual company credit conditions.

- Investors with net-long equity exposure in the US markets could consider hedging their portfolios through what is known as a "collar" options strategy, which can be executed for net zero cost (excluding fees). This involves buying put options at a strike price below current market price, and selling call options at strike prices above market current price. If both the put and call option here have the same value, the trade does not entail any cost. While it protects the portfolio to the downside, the investor gives up potential upside above the higher strike price in return.

Looking Ahead: Possible Strategies (Trading)

- Low volatility environment at present, with 103 consecutive days (and counting) since a 1% decline in the S&P500, coupled with low VIX readings. The market has rewarded those who caught the "Trump Trade" or "Reflation Trade" early on in Dec 2016. Betting against the market rally outright has been a painful strategy for traders.

- There could be a (overdue) correction or consolidation in the near term (next 3-4 months), which is ultimately vital and healthy for the continuation of the current bull. 

- The continued spread between implied and realised volatility -- buying volatility has been a poor trade lately, especially through VIX-linked ETFs, as the steep contango of the VIX futures curve has led to big losses on such products. [More Info] But selling volatility outright is risky as well, exposing oneself to sudden shocks that could jerk the market and cause a spike in volatility. As equities now show some signs of near-term consolidation or range-bound trading, selling covered calls or call spreads could be a viable strategy for traders.

- Equity put options are reasonably priced, with at-the-money implied volatility hovering around 12.5 for put options on the S&P500 ETF (SPY) expiring a couple of months out, but buying them outright entails a net cost. Buying puts essentially bets on a spike in volatility and a falling market in the coming months. The trade would be a losing one should such an outcome not materialise, as time decay eats away at option values.

- Trading opportunities in gold (my thoughts on gold), which is also likely to soar should any black swan event happen this year (keep an eye on the European elections). Rate hikes may not dampen gold prices for long periods, as long as the "reflation trade" and expectations for higher inflation under the Trump administration persist.

The Final Word

For all we know, the bears could return as soon as next month or as late as the end of the decade. The reality is that life is uncertain and there are far too many factors and variables that influence the markets. Since nobody knows for certain what is going to happen in future, we can at best make informed and educated forecasts, and adjust them accordingly as conditions change. Whether they turn out to be true or not... only time will tell.

Just my two cents.