Sustainable, proven businesses with reasonable yields

25 Feb 2019

Source: The Edge



To say that 2018 was a terrible year for stocks on Bursa Malaysia is an understatement. The bellwether FBM KLCI fell 5.9% for the year — its biggest loss since the 2008 global financial crisis. Even then, the number flatters. The index comprises the 30 largest companies on the local bourse, most of which have strong domestic institutional support.

By comparison, the broader-based FBM Emas Index was down 10.9% for the year while the FBM Small Cap Index lost a whopping 36.2%. In fact, four of every five stocks on Bursa ended in negative territory last year.

Part of the weakness was due to external events. We have already written about how and why the global markets performed poorly in our "Review of 2018 " article.

The other reason was, without doubt, the historic May 9 general election. In the long run, the toppling of the coalition that had ruled the country since independence must be positive, given the degree of erosion in public institutions, legal system and government administration as well as the investing environment and public finances. Again, we have written a fair bit on this subject in our main piece, "Reviving growth through technology and digitalisation".

But the unexpected election results is negative on the economy and stock market in the short term, if only due to the significant policy changes and greater transparency on the damage that have been done. Case in point, construction and related stocks went from being the most sought-after to the biggest losers overnight. To a large extent, this highlights the fact that stock markets take a very short-term outlook.

As a result of both external and domestic events, corporate earnings were a massive disappointment last year — on track for the biggest contraction since 2010. We discussed at length the worrying trend of consistently falling profitability and return on equity for Corporate Malaysia in our main piece.

To quote our prime minister, 'The struggle to win was tough, rebuilding Malaysia will be even tougher". Against this backdrop, we have modest expectations for our economy and the broader stock market in 2019.



Events in the US and President Donald Trump's policies will continue to wield outsized influence on global markets. The country's relationship with China, the world's second largest economy and the key driver of growth in the past three decades, clearly will have significant impact on the rest of the world. Smaller emerging markets, including ours, will be little more than collateral damage.

The financial markets started the New Year on a steadier footing, following the bruising selloff in December. Investors are reassessing the health of the global economy and whether fears of an imminent recession have been overplayed.

Reassuring statements from the US Federal Reserve and apparent progress in the US-China trade talks have lured some investors to bargain-hunt. Still, volatility could return in view of the prevailing uncertainties or rather, the unpredictability of key risk factors.



Certainly, downside risks have risen and economic growth around the world is showing clear signs of slowing. Nevertheless, the current data on the global economy does not indicate an imminent recession, at least not in 2019 .


In fact, according to the latest World Bank Global Economic Prospects report, GDP growth is estimated at a pretty healthy clip of 2.9% this year, just slightly slower than the 3% to 3.1% in 2017/18 .

The US economy, even though in late cycle, remains on solid footing and is forecast to expand by an above-potential pace of 2.5% this year. A strong job market with positive momentum on wage growth and unemployment near 50-year lows should underpin consumer spending, which accounts for two-thirds of economic activity. Consumer confidence remains near its highest levels since 2000 .

Similarly, while corporate earnings growth may have peaked in 2018, forecast growth for this year is still above average compared with the past decade. According to data provider FactSet, earnings for S&P 500 companies will expand by 7.4% on the back of 6% revenue growth in 2019.



Of course, there are potential pitfalls that could derail growth. One of the biggest threats is the unpredictability of Trump.

We think that he will make a trade deal with China, perhaps on a limited scope basis, but one where he can claim victory. A full-blown trade war — and negative implications for the economy and stock markets — would not play out well for his re-election bid in 2020. Furthermore, domestic policies now look likely to get jammed up in a Democrat-controlled Congress.

Sales weakness at Apple is a harbinger of how US companies will be affected by prolonged trade tensions, and especially when tariffs are raised to 25% on the US$200 billion worth - or potentially more — of Chinese goods, if a deal is not secured by March 2. The latest slew of statistics underscores the threat, with US business investments and manufacturing activities slowing on the back of tariff uncertainties and rising costs.

Therefore, it is not irrational for Trump to kick the can of thornier issues such as intellectual property and China's technological ambitions further down the road. In any case, a quick resolution is nearly impossible. The world's two largest economies will continue to jostle for dominance in technology and geopolitics for years to come.

Honestly though, no one knows how Trump will act, not even his own Cabinet. And this is precisely the source of investor angst.

China has as much, if not more, reasons to strike a deal with the US, even if it means ceding ground in the short term. Without the trade war overhang, Beijing can focus on domestic policies to ensure a soft landing for its economy.




The Chinese economy has been decelerating as Beijing's deleveraging measures and crackdown on environmental pollution start to bite. Manufacturing activities were on a downtrend for the better part of last year as trade tensions affected business confidence.

The government wants to shift the economy from one that is driven by exports and investments to one that is more reliant on domestic consumption. But worries over the economy are putting a dent in consumer confidence and spending, especially for big-ticket items.

Case in point, vehicle sales fell 6% last year, ending the industry's 20-year growth cycle while smartphone sales are weakening, as underscored by Apple Inc's revenue warning. The property market is losing momentum, with modest expectations on sales and prices — some are even predicting a drop — this year.

Beijing reduced bank reserve requirements several times last year to boost liquidity and credit, especially for the private sector. As there is usually a time lag for monetary policy to filter through, we hope to see some improvements later this year. The government most recently announced additional tax breaks for small firms. The market expects further easing measures and stimulus in 2019 , including possibly more tax cuts for consumers.

How the Chinese economy fares will have material spillover effects on closely interwoven Asian economies, including ours.



Rising interest rates and tightening liquidity could weigh on asset prices worldwide. The volatility we saw last year may just be the beginning as the reversal of a decade of extremely loose monetary policies hits the markets.

In the years of quantitative easing (QE), cheap and massive liquidity lifted the prices of almost all asset classes, including stocks and properties. Therefore, it bears to reason that a reversal would have the opposite effect. In reality, no one knows how significant or otherwise that impact would be, given that the policy measures were unprecedented.

Globally, property markets are weakening under the strain of higher mortgage rates, among other reasons. And market observers have pointed to the uncanny correlation between tighter liquidity and increased market volatility last year.

The Fed was the first major central bank to start quantitative tightening (QT) in October 2017, allowing a monthly fixed amount on its US$4.5 trillion balance sheet to run off (mature without reinvesting proceeds). It started with US$10 billion a month and rose every three months to US$50 billion monthly by October 2018. Hence, we will see the maximum impact this year. At the current pace, its balance sheet will shrink below US$3 trillion by 4Q2020 , which is still well above the US$900 billion or so pre-QE.

The European Central Bank (ECB) had been reducing its bond purchases through 2018, which stopped altogether this year. Unlike the Fed, it plans to reinvest proceeds, thus keeping accumulated bonds on its balance sheet at around US$5.3 trillion "for an extended period of time". There is no timetable on when exactly it intends to start QT.

The Bank of Japan too has kept up its asset purchases — to keep interest rates pegged near zero — but at a slower pace. There is no indication of when it will stop. As inflation has remained stubbornly below target and growth is weakening, the central bank may not have a choice even if it is currently holding a whopping US$5 trillion worth of bonds, exchange-traded funds and other assets on its balance sheet. That is about the size of the country's annual GDP.

The three central banks acquired a combined US$2.06 trillion worth of assets in 2017. This amount turned marginally negative last year, due mainly to Fed actions, which will grow larger in 2019. In short, the world is looking at years of gradual liquidity tightening (see Charts 1 and 2).

The Fed has pencilled in two rate hikes for 2019. But it has also, of late, reassured markets that any future decisions will remain data dependent.

Meanwhile, deposit rates in Europe remain in negative territory. The ECB has indicated that it may start raising rates in 2H2019, at the earliest, though markets do not expect one until 2020 .

All these suggest higher cost of borrowing in the future — albeit tempered if inflation stays subdued — at a time when the world is never more indebted. Higher funding costs risk exposing fault lines where companies have invested foolishly with cheap money that is now getting more expensive, in assets with poor quality returns.

Investors, in their desperate search for yields, too may have lent money foolishly as well — that is, many could have mispriced the risks undertaken. Added together, we could have a recipe for the next financial disaster.



Much has been written about the inversion of the US Treasury yield curve — that is when long-dated bond yields fall below short-dated ones — and how it portends recession.


To be sure, the yield curve has been flattening throughout the past year, as the Fed raised short-term rates faster than market-driven yields at the long end. At the moment, there is a small segment of the curve that is inverted, though not the whole (see Chart 3).

The most commonly used inversion indicator is the gap between the two-year and 10-year yields. This was falling steadily throughout 2018 , but has rebounded slightly at the beginning of this year (see Chart 4).

Historically, recessions in the US have been preceded by this gap falling below zero (inversion). We are very close to zero right now. Does that mean a recession is imminent?


Notably though, not every inversion is necessarily followed by a recession (see Chart 5). There have been periods where growth slowed but did not contract. At this point, the underlying fundamentals of the US economy are still fairly robust, in terms of jobs and inflation, even if growth has peaked.


Furthermore, some have argued that unprecedented QE has distorted yields at the longer end. Even when a recession does follow inversion, the time lag could be as long as two years. Plus, history shows that stocks can go up even when yields invert (see Charts 6.1 and 6.2). Where does that leave us?

We think all these just mean that predicting the economy, and especially stock market movements, is a nearly impossible task. It is easiest to decipher chart patterns in the rear-view mirror.

As value investors, we should look at the underlying business, earnings, cash flows and balance sheets instead of trying to time the market. Ultimately, it will be earnings that drive share prices in the long run.




We do not see any specific standout themes for the local bourse this year. There is no clear-cut sector that is expected to outperform. Investors could turn more risk averse as the year progresses if issues such as trade remain unresolved or, worse, deteriorate.

There will be outsized influence from external events that are beyond our control. Slower global trade and economic growth will translate into lower exports — we are already seeing this in recent data weakness — as well as commodity prices, especially oil and gas.

It is hazardous to forecast oil prices, given the huge (and unpredictable) geopolitical factor. Trump could extend or let import exemptions on Iran oil lapse come April. Tensions in the Middle East could flare up and disrupt supply. Saudi Arabia may or may not stick to its plan to take big output cuts to support (and lift) prices.

Domestic economic growth will decelerate as new policies take shape during this transition period. Much will depend on the pace of reforms and improvements (or deterioration) in public finances. These could, in turn, affect our sovereign credit rating, borrowing costs and strength of the ringgit. Big changes in any of these key metrics will affect the broader market sentiment, though the impact on individual stocks will differ.

Global property markets are showing signs of weakness, including Hong Kong, China and Singapore. The domestic property sector is expected to stay downbeat, pressured by persistent excess supply, while home ownership is constrained by rising unaffordability.

There were valid fundamental reasons for the local market selloff last year. Corporate earnings were abysmal, contracting at the fastest pace since 2010 and reversing the nascent improvement we saw in 2017, which came after consecutive years of decline.

However, there was evidence that the selling had turned indiscriminate as sentiment deteriorated sharply towards the end of the year, when the share prices of companies that delivered good earnings also came under severe pressure. Smallercap stocks, in particular, were battered.

Thus, we see good opportunities for value investors, especially in quality companies that were dragged down by a sentiment-driven market.

Our stock picks in 2018 performed poorly on average. The biggest losers were, unsurprisingly, stocks related to the embattled construction sector. This is quite ironic since they were chosen as the "safer" picks at the start of the year.

Nevertheless, we are confident that careful stock selection remains the best investing strategy. Indeed, alpha investing should do better than passive beta and momentum investing when liquidity no longer lifts all boats.

Our Top 10 Stocks for 2019 is relatively defensive as a whole in view of the prevailing uncertainties. Most are in net cash positions with track records of steady dividends. This could be especially crucial in the expected environment of rising funding costs. As always, our main focus is on the underlying businesses and their longer term sustainability, growth prospects and earnings as well as balance sheet strength.



Incorporated in 1961, Ajinomoto is an established manufacturer of monosodium glutamate (MSG) and a household brand in Malaysia. Its products are sold to more than 36 countries, with export markets contributing 40% of the total revenue.

Under the consumer business segment (which accounts for 72% of revenue), the company manufactures MSG and related products such as pepper, chicken stock and sweetener under the brands of Aji-No-Moto, Tumix, Seri-Aji and Aji-Shio. It also produces a wide range of savoury seasoning products (28% of revenue), which are used by industrial producers of instant noodles, seasoning, snack foods, sauces and processed food.

Despite difficult operating conditions and the stronger ringgit (which translates into lower export revenue), sales expanded by 3.9% y-o-y to RM436.3 million in FYMar18 and 0.6% y-o-y in 1HFY2019

Ajinomoto acquired a piece of freehold land in Techpark @ Enstek for RM81.2 million last year for capacity expansions. Management will continue to focus on enhancing efficiency as well as developing new products to mitigate cost pressures.

The stock is trading at reasonable forward price-earnings ratio (PER) of about 20 times and 16 times ex-cash. The company is currently sitting on cash of RM297 million, equivalent to 26% of its market capitalisation, with zero borrowings. Ajinomoto has distributed some 50% of its earnings to shareholders over the past few years. Assuming a similar payout level, we expect a yield of 2.5% for investors.



Superlon is Malaysia's leading manufacturer of thermal insulation materials for heat and cooling systems used in industrial, commercial and residential buildings as well as for corrosion insulation protection. The company recently introduced a new product called Acoustec, used in vehicles, music studios and buildings as well as construction for noise reduction and heat resistance.

Superlon has a production capacity of 9,000 tonnes per annum and exports to more than 70 countries worldwide. India and Vietnam are its largest export markets, accounting for about 40% of total volume sold.

Superlon's revenue grew at an eight-year compound annual growth rate (CAGR) of 7.4% to RM109.4 million between FYApr 10 and FY2018. Earnings were badly hit by high butadiene prices in FY2018 — Ebitda margin slumped to 18% from 31% in FY2017. Positively, profits have turned around since hitting a low in 4QFY2018. Ebitda margin recovered to 25% in the latest 2QFY2019.

We believe the earnings turnaround is sustainable. Butadiene prices are coming off their highs. Construction of its Vietnam plant is completed. This will bring total capacity to 10,500 tonnes per annum. Production trial run is ongoing and we expect it to commence operations by 4QFY2019. The new factory will allow the company to further strengthen its position in the fast-growing Vietnam market as well as neighbouring countries.

The stock is currently trading at roughly 12 times estimated FY2019 earnings. Valuations are expected to narrow to 10 or 11 times in FY2020. It has net cash of RM6.5 million. Assuming the company maintains a payout level of 45%, we estimate net yield to rise to 4% for investors.



Incorporated in 1984, SCGM is the leading thermo-vacuum formed food and beverage packaging manufacturer in Malaysia. It produces a wide range of food containers such as clamshell, tray blister and lunchboxes under the brand names of Benxon, TempScan and Kingtex.

SCGM derives about one-third of its sales from exports to more than 20 countries across a wide range of sectors. Its newly completed state-of-the-art facility (+65% capacity) commenced operations this year and is expected to increase operational efficiencies by streamlining production flow, which is also less labour-intensive.

SCGM's top line has grown consistently since FYApr10, at a commendable CAGR of 15% from RM67.7 million to RM207.4 million in FY2018. For 1HFY2019, revenue was up 7% y-o-y due to rising demand from local and export markets. We expect its revenue to grow by 13% and 21% for FY2019 and FY2020 respectively as a result of continuing efforts to increase local market share and secure new over seas customers, especially from Asean, Australia, New Zealand and the US.

Ebitda margin should benefit from economies of scale and gradually recover from 12% in 1HFY2019 to 15% in FY2020. Additionally, prices for resin, which accounts for 60% to 65% of production costs, peaked in October last year, dropping by an average of 10% to 15%. Lower resin cost should be reflected in its 4QFY2019 earnings, assuming a slight lagging effect.

Valuations are decent relative to its growth prospect. PER is expected to drop to about 11 times by FY2020. We estimate yields of around 2.5% to 3.5% in FY2019/20.



Kawan Food is a producer of frozen Asian food delicacies, including paratha, chapatti, naan, spring roll pastry, buns, bakery products, frozen vegetables and desserts. The company markets its products under the brand names Kawan, KG Pastry, Veat, PassionBake and Aman. Exports — mainly to North America, Asia, Europe and Oceania — account for 61% of its total revenue.

Rising demand for frozen bakery products has underpinned the company's growth. Revenue expanded at a CAGR of 11.4% from 2010 to 2017. Paratha is its most saleable product, contributing 46% of total revenue.

Kawan Food recently commissioned the new RM200 million state-of-the-art manufacturing facility in Pulau Indah. The potential revenue, assuming full utilisation of current capacity, is estimated at RM600 million. Management is in talks with potential overseas partners to ramp up utilisation levels. There is still significant space for future expansion.

The company intends to expand into the food service industry, which will provide a good balance to its retail business vis-a-vis economic cycles. We forecast revenue to grow at a CAGR of 20% for 2019/20 .

The stronger ringgit and higher marketing and promotional expenses hurt earnings in 9M2018 . Positively, prices for raw materials (crude palm oil and flour) are softening. We forecast Ebitda margin to improve from 16% in 9M2018 to 18.5% and 20% for 2019 and 2020 on the back of economies of scale, lower raw material costs and stronger US dollar. On the other hand, higher depreciation will offset part of these gains in the near term.

Nevertheless, valuations — PER of about 25 times — are decent for a consumer stock with strong growth prospects that is supported by capacity expansion, increasing popularity of convenience food, continuous product development as well as the strength of its branding and network.



Dialog is strategically exposed to the upstream, midstream and downstream oil and gas value chain, which will buffer volatility in crude oil prices. For instance, when oil prices are strong, it enjoys higher demand for its upstream-related specialised products and better production margin from oilfields. When crude oil prices slump, demand for downstream products and services pick up, offsetting the decline in the upstream businesses.

Crucially, the midstream business of tank terminals provides steady recurring income. The demand for storage capacity is relatively stable.

The company's expertise in constructing and maintaining tank terminals has been a key growth driver, particularly in the development of Pengerang Deepwater Terminals.

Dialog has exclusive rights to 680 acres of reclaimable land, of which only 307 acres have been developed for Phases 1 and 2 of Pengerang Deepwater Terminals. Additionally, it owns 650 acres of buffer land and industrial estate in Pengerang. Only 123 acres are currently utilised for its fabrication workshop.

Dialog is in discussions with potential customers to develop Phase 3, which will cover 300 acres with an indicative initial investment cost of RM2.5 billion.

With the construction of Phase 2 nearing completion, revenue from engineering, construction and fabrication works is set to decline. However, the drop in earnings will be offset by income from leasing and tank maintenance, which is more profitable. Dialog is a fundamentally strong company with solid long-term prospects.



FPI is one of the leading original equipment manufacturers of high-quality sound systems in Malaysia, including conventional speaker systems, smart audio systems and musical instrument components.

Revenue grew at a CAGR of 22% from RM252 million in 2014 to RM461 million in 2017, thanks to the rapid growth of the new musical instrument segment and resilient demand for its audio systems and components.

Growth prospects for the musical instrument segment is underpinned by its strategic alliance with Roland, a leading Japanese manufacturer of electronic musical instruments. Roland's factory, its regional hub, is located next to FPI's plant in Port Klang.

The outlook for the audio system segment too is bright with the increasing popularity of smart speakers. Smart speakers are essentially wireless speakers with an inbuilt voice assistant. They can receive voice commands from users and perform tasks such as selecting playlists, adjusting the temperature of air conditioning, switching on lights and checking the weather forecast.

As the adoption of smart speakers in regular households is still low at the moment, the growth potential from the largely untapped market is huge.

FPI is sitting on net cash of RM139 million, about one-third of its market cap. Valuations are undemanding at a forward PER of nine times and yields of 4.6%, at least.



While the US-China trade war has clouded the outlook for most industries, it appears to benefit the local furniture manufacturers. To recap, furniture products are included in the latest round of US tariffs, which involves US$200 billion worth of Chinese goods. Existing 10% tariffs (since end-September 2018) is set to rise to 25% should ongoing negotiations between the two countries fail.

As a result, US importers have started to shift their orders from China to Asean countries, driving up sales for furniture manufacturers in the region. Positive impact was already visible in Poh Huat's latest quarterly results, where both revenue and profit expanded by double digits.

On top of better efficiency and economies of scale, stronger demand makes it easier for the company to roll out new models that better reflect prevailing costs to replace older, less profitable ones.

Poh Huat is a net beneficiary of a stronger greenback as the bulk of sales are exports (denominated in US dollars) while most of its costs are in the local currency. It will also benefit from a softening of particleboard prices, due to industry oversupply. Its plant in Malaysia manufactures panel-based furniture.

With a forward PER of only six times and estimated yield of 5.3%, the stock is inexpensive relative to the favourable industry outlook and its growth prospects.



YSP is involved in the manufacturing and trading of prescription pharmaceutical, non-prescription pharmaceutical and veterinary drugs as well as miscellaneous medical equipment. Its manufacturing facilities are located in Malaysia, Vietnam and Indonesia.

We like YSP because it has a lot of room for growth in the export markets, which currently contribute about 26% to total revenue. It is actively securing licences in various markets to produce or sell products in the highly regulated pharmaceutical industry. The company is in possession of 1,142 export licences for its products.

For instance, with the accreditation from Japan's Ministry of Health, Labour and Welfare for its manufacturing facility, YSP will be able to commence product registration and expand into the Japanese market. The company has also applied for CE Mark for its medical devices segment to penetrate European countries and New Zealand.

Following the acquisition of Alpha Active Industries Sdn Bhd, YSP now possesses halal certification from the Department of Islamic Development Malaysia (Jakim) for 29 Islamic permissible products, which opens up opportunities in Asean, the Middle East and Africa.

Domestically, pharmaceutical players will be beneficiaries of increased government spending in healthcare under Budget 2019.

Revenue grew 9.9% in 9M2018 to RM212.7 million while pre-tax profit increased an outsized 52.3% to RM32.9 million, largely due to lower cost of goods sold, higher production and productivity. We are optimistic that YSP will be able to maintain such growth. Valuations are attractive with a forward PER of 11 times and a trailing EV/Ebitda of less than 6.5 times.



Panamy manufactures electrical home appliances and other related components, broadly categorised into home appliances, fans and others. About 46% of sales are currently derived from the domestic market with the rest coming from exports to Asia-Pacific, the Middle East, Japan and other countries.

Revenue was up 1.5% y-o-y to RM614.4 million in 1HFYMar19 , with growth in domestic sales mostly offset by a decrease in exports (due to the weaker US dollar). Increased domestic sales were attributed to the tax holiday. However, net profit fell 6.3% y-o-y to RM59.3 million due to derivative losses.

The company is in the midst of streamlining its administrative and manufacturing operations at its two factories in Shah Alam to expand production capacity. Panamy plans to increase in-house production for parts and reduce its reliance on third-party manufacturers.

Looking ahead, exports to the Middle East markets could remain volatile due to political uncertainties in the Gulf region, which will affect the economic outlook. On the other hand, emerging markets such as Vietnam are potential growth areas. Contributions from the domestic market are expected to remain resilient.

Panamy is attractive for its relatively resilient business, albeit moderate growth potential, and strong fundamentals. Dividend yield is estimated at 4% and the company is sitting on RM575 million cash. Valuations are decent at about 18 times estimated earnings and 13 times ex-cash for a company with a strong recognisable brand in the region.



We like SAM because its aerospace division is in position to take full advantage of the growth and backlog in the global aircraft market. Its aerospace division is currently manufacturing parts for aircraft with the highest backlog and demand. Plus, most of the models are in the early stages of their lifecycles. This division will be the major growth driver in FYMar19 and going forward.

While it is undeniable that the HDD market is declining, we are confident that SAM's equipment division is capable of compensating for the loss of revenue from growth in the semiconductor testing equipment segment as well as aerospace division. Furthermore, the longer-term outlook for semiconductor equipment remains strong as the consumption of semiconductors will rise with the growing adoption of the Internet of Things, smart sensors and cloud computing.

Current order backlog for aerospace, worth RM3.1 billion, will keep SAM's current production facility fully utilised for the foreseeable future. An additional facility for LEAP-X engine casing manufacturing in Singapore, starting with 14 machines and 2 FMS lines, will begin contribution in FY2020.

We remain confident in management's ability to complete The Crossover Project, which entails crossing the RM1 billion revenue threshold, of which 80% will come from aerospace.

Current valuations of about 13 times forward earnings is reasonable given its growth prospects and healthy balance sheet. We expect SAM to maintain a 50% dividend payout, which translates into a yield of 3.6%.