An update on Equity Risk Premium for STI

As of 30 Jun 2016, Straits Times Index closed at 2,840.93. The implied equity risk premium (ERP) that I calculate through a Discounted Cash Flow model is 4.42%. Compared to 18 Jan 2016 when STI is at 2,580 with the implied ERP at 5.56%, STI has recovered 10% and it has moved from a highly undervalued market to a modestly undervalued one.  To support this slight undervalued market notion, the 12-month forward PE ratio is at 11.98x, still hovering below STI’s 12-month forward PE -1SD at 12.2x.

The 12-month forward PE is lower due to Earnings per share (EPS) growth for 2016 has been revised down from 5%, Jan 2016, to 2% as of Jun 2016. Risk free rate has also dropped to about 2% but dividend yield for STI is still a decent 3.9%. Bargain stocks will be harder to find in this market. With market rallying in the first half of July, ERP has further fallen to 4.29% with the index at 2,925 on 15 Jul 2016. This means that investors are expecting a total return of 6.29% by investing in the market, fallen from 8.02% in Jan 2016.

As seen in my first post, Prof Damodaran’s compilation of implied ERP on the US equity market (a good proxy for Singapore’s historical ERP), the 75^th percentile of US Equity Market implied ERP from 1960-2015 is 4.93%. This means that Singapore’s current implied ERP of 4.29% signify a more cautious optimism for STI in the near to medium term.

An interesting observation is also that the payout ratio of companies has fallen from 60% to 52.8% and on a rolling 12-month basis, share buybacks conducted by STI constituents have been lower by 8%. In the near term, shareholders’ return that focuses on dividends will definitely be impacted given slower growth in earnings and thus lower payout ratio by companies. In addition, this is enforced by a relatively lower yield environment where investors hunt for dividend yield stocks - prices go up and yield goes lower.

QAF

QAF may be unfamiliar to many but its brands, Gardenia and Cowhead certainly aren’t. Gardenia is the leading brand in the pre-packed bread market in Singapore, Malaysia and Philippines. Bakery business is the cash cow for QAF as it is 50.5% of total revenue and 80% of operating profit in 2015. Though QAF’s overall operating margin is mid-single digit, its bakery business is consistently between 10-15% over the past 6 years. This exhibits the profitability and importance of QAF’s bakery business.

QAF’s next biggest revenue generator is its Australia primary production (36%) under Rivalea which produces pork for the domestic market and exports to Singapore, Japan, New Zealand and other Asian countries. Rivalea also own its stockfeed mills thus able to reduce the costs of feeds for its livestock. Revenue from this segment tends to be more volatile due to the volatile exchange rate in recent years of a strengthening Singapore dollar against the Australia dollar.

The last segment of QAF’s business is the trading and logistics business. Ben Foods is the company that owns the proprietary brands Cowhead (milk, dairy products and confectionery) and Farmland (meat, potato snacks, cooking oil). Ben Foods also distribute Emmi yogurts and Campbell’s Food Service such as frozen and canned soup in Asia. This revenue segment has consistently increased over the past 6 years from $84 million in 2010 to $104 million in 2016.

The number one strength of QAF is its positive free cash flow for the past 8 years after accounting for dividends being paid out. Strong free cash flow is the number one metric to look for in businesses and companies. I foresee that this positive free cash flow will be maintained due to QAF’s economic moat in its bakery business, from the Gardenia brand.

QAF’s investment track record is also impressive. Its ROIC is consistently above 10% since 2009 and ROE is approximately 10% since 2009 except for 2013 at 7.6%. It has also a low debt to equity ratio and has a healthy cash balance at $100 million, ready to acquire businesses or for expansion into other markets. One area to keep a look out for is Gardenia’s expansion into China. Valuation wise is also healthy, trading at 11.5x P/E and P/B at 1.41x. Enterprise value over operating income is also at 6x which is a decent multiple. Dividend yield is at 4.5% based on the current share price (13/07/2016) of $1.12.

QAF is financially strong as a group as compared to its competitors like Auric Pacific which produces Sunshine bread. On the contrary, Auric Pacific’s manufacturing business of Sunshine bread is much stronger than QAF’s Gardenia as the former’s operating margin almost doubled at 20.7% as compared to QAF’s at 11.65%. One reason is that QAF’s bakery business is more diversified in terms of geographic (Singapore, Malaysia, Australia, Philippines and China vs Sunshine manufactured only in Singapore and distributed locally and to Malaysia) and variety (Bakers’ Maison in Australia which serves French style bread). QAF also suffers foreign exchange losses when profit is repatriated back to SGD especially so in 2015 when RM and AUD falls against SGD. Thus, one risk of QAF is its currency exposure to Australia, Philippines and Malaysia as evidenced in the 2015 results which has foreign exchange losses of $2.8 million as compared to $1.9 million in 2014.

Another plus point for QAF’s bakery businesses is the relatively lower price of wheat which is a key raw material for bread. Wheat prices have been coming down over the past 3 years. This could be attributed to the supply side which technology assisted in improving wheat yield and the demand side which global economy is slowing down. Wheat prices like many agricultural commodities should stay in the doldrums over the next few years as I believe the commodities market will be in a down cycle. Thus low prices for its raw material will contribute positively to QAF’s bottomline.

I employed the discounted cash flow model and the assumed terminal growth rate and operating margins assumption is conservative at 2.5% and 6% respectively. The discount factor (i.e. the weighted average cost of capital) is where I account for QAF’s geographical risk at 8%. Discounting QAF’s cash flows to present value, adding back cash and investments and less out debt, the value per share comes to $1.30. QAF has strong economic moat in its bakery business and its current price of $1.12 as of 13/7/2016 is quite attractive, a potential 16% increase. However I will wait till when its price is close to $1. My target price of $1.30 is also close to OCBC Securities’.

The catalyst for QAF to reach its target price will be its growth in China and investors aiming for solid companies that gives out sustainable dividends, its dividend yield at 4.5%. In this sluggish economic growth climate where investors are hungry for yield, defensive companies with solid business model will be attractive. I am optimistic that QAF will be a solid investment.

From the time I written this article in late June 2016, QAF’s share price has been steadily climbing from lowest of $1.03 to current price of $1.12. Will this rally in the global markets continue? I will update my equity risk premium on the next post.

Singapore Banks

The fundamental working of a bank is to attract deposits (savings and deposits) by offering a certain interest rate and thereafter lending out the funds as loans (housing loans, corporate loans etc) at a higher interest rate earning a spread termed as net interest margin.

Banks have to do their due diligence on borrowers to price their loans competitively and ensure that the probability of default on the whole is kept to a minimum. Banks are also required to have capital buffer to cover for these loan losses in times of recession and for daily operation needs such as to meet withdrawal requests or to do investments. Thus, regulators will need to step in and ensure that banks are solvent as banks are considered important institutions to ensure that thee gears of the economy is running. The importance of banks can be seen in the last global financial crisis in 2008.

In Singapore, the Monetary Authority of Singapore has a strong grasp on the banking sector as exhibited in their stricter requirements as compared to Basel III on capital requirements on Singapore incorporated banks. The capital conservation buffer on top of the Common Equity Tier 1 Capital Adequacy Ratio (CET 1 CAR) is estimated to be at least 12.5% by 1 Jan 2019.

Therefore, what is important when looking to invest in a bank is its net interest income growth, loans growth, net interest margin, non-performing loans rate, capital buffer and lastly return on equity, driven by the factors mentioned. As a diversification, non-interest income has also been increasing as a percentage of total income with wealth management seeing strong growth over the past few years among the 3 local bank with DBS having the largest share of wealth management income at $599 million and biggest non-interest income at $3.69 billion. However, DBS is still preliminary dependent on interest income as it represented 65% ($7.1 billion) of total income, compared to OCBC at 59.5% and UOB at 62%. DBS has seen strong growth rates in its loans and net interest income over the past few years as compared to the rest as seen in the table below. All figures are in S$ million. OCBC acquired Wing Hang bank in 2014 and that is why there is a huge increase of loans and net interest income.

How to value financial services firms?

Typically, free cash flows are computed after netting out reinvestment in the form of capital expenditure and changes in working capital. Capital expenditure by financial services firm is difficult to tabulate as banks invest mainly in intangible items such as human capital and brand name. The investments are also treated as operating expenses rather than capital expenses therefore it is difficult to measure capital expenditure for future investing needs. Free cash flow to equity holders also require us to know the change in composition of debt by firms but debt is also being used by banks as a raw material rather than capital as the funds raised can be used to lend out. In regulators’ eyes, equity is the capital which is why we have the CET 1 CAR. That is why we need to have a new definition of reinvestment needs by banks.

Credit to Prof Aswath Damodaran, he defined reinvestment by banks as the reinvestment in regulatory capital. By deducting reinvestment in regulatory capital from net income, we obtain the free cash flow to equity for financial services firms. The Singapore banking sector’s asset will grow at 2.5% and net income close to 2% over the next few years, both relatively conservative estimates given the dim outlook (CEOs of the banks are expecting low single digit loans growth in 2016). Given that regulatory capital for Singapore banks are currently between 13 - 14%, much buffer has been in place and will remain constant over the next few years and target at 15% at year 5. Free Cash Flow to Equity (FCFE) for each year is obtained by deducting reinvestment in regulatory capital from net income. FCFE is then discounted at the cost of equity calculated based on the risk free rate of 2.78%, equity risk premium of 5.75% and the regression beta of various banks, 1.1 for UOB & DBS and 1.04 for OCBC .

We have now come to the crucial terminal value which I will take year 5’s net income and let it grow 2%, a stable growth period. The stable payout ratio is assumed to be 50%. Banks in Singapore typically payout 35-45% of earnings in the form of dividends and buybacks. The cost of equity at stable period will also be assumed to be 8.76% for OCBC, a premium of 6% over existing risk free rate and 9.11% for UOB and DBS. Typically, the cost of equity of mature firms should fall but on a conservative note, we assume it remains for the stable period. Do note that the terminal value is about 70% of total equity value therefore we have to be conservative in estimates. The FCFE model generates the value of equity per share for OCBC to be $7.36, DBS $12.83 and UOB $15.06.

All estimated values are below current share prices which means that there are room for share prices to go down. The market is pricing UOB at the highest premium potentially due to its relatively smaller exposure to China and Oil and Gas (O&G) segment

Bank	Greater China Gross Loans exposure	Greater China Non-performing loans (NPLs)	Total Cumulative Allowances for Greater China NPLs
UOB	12.2% ($ 25 billion)	0.86%	not disclosed
DBS	33.5% ($ 96 billion)	0.85%	not disclosed (230% in 2013)
OCBC	26.8% ($ 56 billion)	0.43%	241%

O&G segment lending is also on the spotlight.

UOB - 3.6% ($7.7 billion)

DBS - 5.9% ($17 billion)

OCBC - 6% ($12.4 billion)

Overall NPLs

UOB - 1.48%

DBS - 0.98%

OCBC - 0.93%

CEOs from UOB and DBS sounded more positive in their latest earnings observation and said that the risk in their loan books is manageable. Meanwhile, OCBC Chief Samuel Tsien raised some concerns on the outlook on their loan books from the oil and gas segment. UOB’s optimistic outlook is understandable due to its relatively smaller exposure to China and O&G while DBS’ outlook could be due to its 148% cumulative allowances as of total NPLs. Comparing to UOB’s at 130% and OCBC’s at 120%, DBS might be the safer bet if things do not turn out as rosy as they expected since they have already set out almost 150% of allowances based on NPLs. Prices move when unexpected things happen and that is why lowering of risk is of utmost importance.

On relative valuation, DBS is the cheapest in terms of Price to Book ratio and Price to Earnings (trailing twelve months) ratio. The price is as of 2 March 2016.

Bank	P/B	P/E
UOB	0.92x	8.81x
DBS	0.89x	8.04x
OCBC	0.99x	8.78x

Based on UBS’ calculation of a 10 year average from Feb 2016 (UBS report Feb 2016) in the table  below, we can see that the banks are trading very much below the mean. Of course, mean reversion need not happen in the short to medium term. What I’m trying to imply is that if your horizon is long enough, the probability of mean reversion is higher.

Bank	Long term average P/B	Long term average P/E
UOB	1.45x	12.4x
DBS	1.33x	12.9x
OCBC	1.54x	14x

To conclude, DBS is my top pick amongst the banks as allowances is one of the better buffered against NPLs, high net interest margin at 1.77% and strong CET 1 CAR at 13.5%. Most importantly, its relative valuation and FCFE model (least premium compared to market value) is also most attractive amongst the banks. Concerns about China’s slowing growth and O&G segment should be less serious at the moment as the banks have mainly lent to strong state-owned enterprises and some allowances for O&G segment have been set. There could still be headwinds in the near future especially if China’s slowing growth problem exacerbated. I foresee prices of bank stocks to be beaten down due to a lack of positive catalyst and negative global sentiment. Positive catalysts that can trigger bank stocks to go up are rising oil prices, strong company earnings in 2016-2017, coordinated effort on fiscal policies and structural reforms among nations and lastly China’s success in the medium term to transit into a sustainable economy.

Till these events happen, I will strongly advise to accumulate DBS bank at around $13, 4.6% dividend yield, on a long term horizon. If we adjust our valuation model to 0% growth over the next 4 years and a stable growth period of 2% from year 5, the value comes out to be $11.17. 5% growth over the next 4 years will amount to $14.52. My scenario here is in the mid-range of 2-3% growth over the next 5 years and a stable growth period of 2%. The growth I assigned is not overly optimistic as can be seen during the 08-09 global financial crisis period, net income is still at low single digit growth. This explains my base case scenario to start accumulating at $13. DBS is also giving out $0.30 dividends, XD on 5 May 2016, so practically, you can accumulate at $13.30.

A side note: DBS CEO Piyush Gupta bought $2.8m in own company’s stock on 22 Feb 2016, a signal of confidence in DBS.

Vicom

Vicom provides vehicle and non-vehicle inspection and testing services in sectors including mechanical, biochemical and civil engineering. Vicom is also a subsidiary of ComfortDelgro, a substantial shareholder of Vicom at 67%.

Vehicle inspection and testing services revenue accounts for 30% of Vicom’s total revenue while non-vehicle accounts for 60%. However, both vehicle and non-vehicle inspection and testing services account for 35% of operating profit which implies a higher margin from the vehicle segment, an impressive 37.6%. The operating margin of non-vehicle segment is 19.1%. Do note that the above figures are from 2011 as Vicom stopped reporting segmental results from 2012 onwards. It is however safe to assume that these % should not deviate much in recent years. This means that vehicle inspection is equally strong in contributing to the bottom line even though its revenue share is smaller relative to non-vehicle segments. 

Vicom’s strong margins in the vehicle segment can be attributed to:

1. 74% market share of Singapore vehicle testing and inspection (520,000 inspections out of 702,000 total vehicles inspected.
   
   
2. Most vehicles on the road will have to be inspected at least once every 2 years.
3. Strong growth rate of vehicle population at 2.4% CAGR over the past 10 years, from 754,992 in 2005 to 957,246 in 2015.

At the existing price of $5.85 on 12 Feb 2016, the PE ratio is at 16.26 and PBV ratio is at 3.54. The payout ratio as of the latest dividend is about 75%. It might seem expensive at first glance but it is expensive for reasons. Vicom’s ROE is at 23% and ROIC is at 60%. ROIC has been increasing since 2006 at 20%. This is due to the minimal capital expenditure required once the basic machineries have been in place. Vicom’s net capital expenditure in recent years is mainly to cover its depreciation. Due to its business model, Vicom does not really need to acquire new technology to attract business. Cars will also have to be inspected due to safety regulations. Free Cash Flow to the Firm has also been positive after payment for dividends, averaging $10 million each year over the past 4 years. It also has no debt therefore it is less susceptible to rising interest rates and it has built up a decent sum of cash in recent years standing at $100 million. What are the risks and what price should I buy Vicom at then?

Risk

Vicom’s share price has been down beaten from its high of $6.78 on Apr 2015 to current levels. This could be mainly attributed to the aging profile of Singapore’s car population (accounting for 40% of vehicle inspections in 2015).

As seen in the table above, we can see that Singapore’s car population shot up during 2005-2010 period due to the government stance to encourage car ownership. Growth rate is set at 3% + de-registrations for at least a decade till 2009. From then on it staggered downwards and from Feb 2015 onwards, it is set at 0.25% growth rate + de-registrations. The age profile of 8-10 years is also the bulk, accounting for 51% of car population. By 2018, about half of the car population will most likely be renewed into new cars. Fortunately, with a lower growth rate of COE supply, some people might be considering holding onto their cars longer than 10 years as it is unlikely that COE prices will reach to previous lows. This is evident as you can see that there is a huge jump of cars older than 10 years of age in 2014 and 2015.

For the gloomy years ahead, Vicom has built up cash to prepare for the storm in the vehicle segment over the next 3-5 years as vehicles less than 3 years of age need not be inspected. Although we do not have colour to non-vehicle segment sales in recent years, what I see from recent annual report is that they have started to expand their range of services in Setsco. Hopefully this will mitigate the fall in revenue from vehicle segments even though the management is expecting slowdown in non-vehicle testing services. 

Valuation

I will assume that Vicom will have -5% growth in revenue over the next 3 years and 0% growth from 4th to 5th year. From year 6 to year 10, I will allow it to grow at a decreasing rate from 5% to 2% and the terminal growth rate set at 0.5%. There have to be a cap on growth of vehicles in land-scarce Singapore therefore a 0.5% growth rate is considered appropriate. Operating margins will also be decreased from the current 34.7% to 28% in the terminal year. I have adjusted the regression beta of Vicom’s from 0.5 to 0.72 due to the nature of its higher operating leverage business which has higher fixed cost. After accounting for reinvestment needs, the free cash flow over the next 10 years and the terminal value is discounted at the weighted average cost of capital of 6.93% and 7.8% in the terminal year respectively. Adding back cash and accounting for operating lease as debt, the estimated value per share is $4.83. I have to admit that this is a rather conservative estimate. By assuming 0% growth over the next few years instead, the estimated value per share is $5.35.

Conclusion

Based on current price, the market is over-valuing Vicom 21% above its intrinsic value. The current yield is at 4.87% (FY 2015 dividend of 28.5 cents) and at the intrinsic value, 5.9%. With the current market sentiment, Vicom will be a conservative play in one’s portfolio with stable dividends and strong economic moat in the long term. The vehicle population is a 10 year cycle and I do not foresee vehicles being displaced from Singaporeans’ life over the next 30 years. Right now, Vicom is nearing the end of the 10-year cycle which many cars will be deregistered. The share price has been affected and the downward pressure will continue to persist in the near term. But be sure to catch it when Vicom offers itself at a discount and you will be in for a ride of decent dividend yield if your investment horizon is at least 10 years.

What to expect of the market in 2016?

Based on 31 Dec 2015 Straits Times Index (STI) closing of 2882.73, I have calculated that the implied equity risk premium (ERP) is 4.98%. This means that for investors whom want to invest in the market, the market must be returning at least 4.98% above the risk free rate. The risk free rate which I used is 2.50% based on the Singapore Government Bond 10 year yield. How did I calculate the ERP? I simply treat the problem as a discounted cash flow model. The price of the index is simply the net present value of future cash flows. Cash flows here is in dividends and share buybacks done by the 30 companies of STI in 2015 and I assume this cash flow will grow at 5% for the next 4 years and a terminal growth rate of 2.5% (equals the risk free rate). Thereafter I apply a discount rate to these cash flows to derive the price i.e. the index level. Deducting the risk free rate out of the discount rate, I will obtain the ERP. 

The cash payout of earnings done by STI companies in 2015 is 60% and I assume that this stays constant. Interesting to note is that for S&P 500, the cash payout in 2015 is 101.5% of earnings, which is unsustainable over the long run. Potentially we could see S&P 500 correcting in the near term. With this information, we will only need to solve for the discount rate. This discount rate is the total return that investors are expecting. Implied ERP is then obtained by deducting the risk free rate. Therefore for investors based on the start of 2016, they are expecting a total return of 7.5% by investing into the stock market.

As of 31 Dec 2015, the trailing twelve months (TTM) price-earnings (PE) ratio of 13.78x and a forward PE ratio of 13.1x, this represents a good opportunity to start accumulating at the market.

Moving two weeks into 2016, the STI ended at 2630 on 15 Jan 2016. ERP at this level has increased to 5.46% and PE ratio has gone to 11.98x. This means that comparing to PE ratios over the past 8 years, a DBS report, the average 12 month forward PE is at 13.74x and as of 15 Jan 2016, the forward PE ratio of 11.98x has crossed 12.2x (-1SD) FY 16F PE. In statistics, this means that we are about 68% confident that the true PE ratio lies between the upper (15.25x) and lower limit (12.2x) of PE ratios. The implied forward ERP of 5.46% is also in the similar statistical range of PE ratio as the earnings are similarly used. This means that STI is getting more undervalued as of 15 Jan 2016. If you are still not convinced, one can compare a longer period by using the historical ERP over the past 20 to 30 years and decide a fair ERP. I do not have the longer history data on hand, probably a Bloomberg terminal might help getting the information easily. Also to note, ERP is a key to calculate the cost of capital thus a higher ERP tends to undervalue stocks.

An interesting insight to note here is that the 2SD away from the average 12-month forward PE is between 16.71x and 10.66x. This means we are 95% confident that the true PE ratio lies in this range. At PE 10.66x, the implied forward ERP is 6.12% and the index will be 2340. This is about 11% drop from 15 Jan 2016 closing of 2630. I do not foresee that we will be heading to this level this time, but if we really do, it will be one of the rare chances to buy stocks at a bargain.

To give you some comparison, the US implied equity risk premium is pretty comparable to Singapore’s due to both countries sharing the same currency sovereign rating of Aaa. Therefore some analysts and practitioners have interchangeably used both ERPs. 

Referencing the above to Prof Damodaran’s compilation of implied ERP on the US equity market posted on his blog, the US ERP as of 2015 is about 6%. S&P 500’s 2015 cash payout is 101.5% of earnings therefore it makes sense that US’ ERP is higher than what I have calculated for Singapore’s.

What I would like to note is that the 75^th percentile of US Equity Market implied ERP from 1960-2015 is 4.93%. This means that Singapore’s current implied forward ERP of 5.46% does signify optimism for STI in the near to medium term and supports my call to start accumulating Singapore stocks.

On a side note, I have also read some recent Howard Marks' memo and on his latest on 19 Jan 2016. I agree with him that the market is a compilation of all investors’ (from your big institutions to men on the street) actions. And these actions are based on predictions going forward and these predictions tend to be swayed by emotions which affect the market strongly in the short term. In the long term, the fundamentals should prevail.

Markets can be right at times and wrong at others. It is always best to take action when the market is wrong. I think now is the time.