AMA, #asklbs01, Next Take over target in the sgx?

(I am running a AMA session that you can access via https://app.sli.do/event/jir8c2dq. This will last till 30-Nov)

Question: Next Take over target in the sgx?

(take over, I assume, refers to a party taking over a publicly-listed company in SGX, or what we call going-private transation. It usually involves offering a share price higher than what is last transacted in the market, hence an opportunity for profit)

 

Couple of caveats:

a)     This is not investment advice, and the following is for educational purposes only.

b)    And since this is education, it is going to be a longgggg post.

 

TLDR: There are many reasons why a company privatize. You can statistically find those companies but there are pitfalls. Read on to understand

 

It is anyone’s guess. Even if you have made the right guess on which company to bet on, you might not make money, as it is contingent on the offer price. You could possibly enter the company too early, experienced a general market sell-down and the going-private offer is scarcely any more than your purchase price.

 

Before I go on this subject, companies often get funding from two main sources—debt or equity. Debt would… refer to either bank debt, or bonds. Equity is simply shares, what we call fractional ownership of the company.

 

Getting listed in the stock exchange is one way a company get funds. For some, it is actually the end game. Imagine a tech company that goes through many series of funding, getting seed investments from private equity investors. Eventually, the company might get listed, or what we call an IPO. Usually this IPO price is at a huge premium as compare to what the private equity (PE) investor put in over the years, which enable them to finally realize the profits, i.e. selling the shares in the market.

 

Of course, there are companies like McDonalds, who in the early days secure funding from the stock market in order to grow. But not many companies in SGX are like that. You could tell when they distribute a hefty dividend to the owners, just before they get listed. Sometimes, we call this “cashing out.”

 

So back to funding—which source, debt or equity, should the company owners choose? The cheaper one. They got a nice term for this… “cost of capital.” A sound management should choose a lower cost of capital—that is capitalism.

 

When it is cheaper to borrow money, debt is the better choice. When the owners decided that listing fees, paying dividends, reporting finances to regulators and shareholders is getting too costly, a low interest rate environment is very conducive for de-listing from the exchange.

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There are 3 main reasons why a company will go private.

 

1)    The share price has become too cheap in the eyes of management.
 

2)    A bigger entity might seek to own tangible or intangible assets in the target, such as a patent, a process, or even establish logistical supply lines. Sometimes these companies (who got took over) aren’t even priced cheaply, and neither are the value of their assets glaringly obvious. It takes an industry insider to spot this.

3)    Oddball reasons, such as:
politics, such as regulation by government (SMRT for example. It wasn’t attractively priced then, and how quickly it happen means only insiders could benefit from the deal); 

fending off hostile take overs, or due to pressure from activist investors;

impending, significant positive changes to the company.
Again, it takes an insider to spot this.

 

Of all these 3 options, a common man on the street could possibly only hit on (1). 

There is a huge problem with finding cheap companies in SGX. By and large, markets are efficient… by that, the market usually price the companies close to fair value.  Any company that is statistically cheap could be under some problems or obstacles 

 

These could include
a) management withholding dividends, or paying a much lower dividend than it is capable of, and henceforth suppressing the stock price indirectly. This can be frustrating, given that most of the smaller companies in Singapore are family-owned, and their majority shareholding prevented anyone from buying up share to wrestle control from them.

Personally, I avoid any companies where management is the root of the problem. It is best to avoid a war.

b) potential law suits

c) unstable political environment

 

You could potentially spend many heart-wrenching years waiting out for a potential take-over, while the share price declines (as the management pays themselves a high salary). And you woke up to news that the company has decided to go private… at a price that is lower than your purchased price.

 

***

Having said that, I would still venture on a short, shortlisting exercise to show you what the cheap companies are:

 

There are a few ways to look for cheap companies

a)     based on earnings

b)    based on assets

The first step is to calculate enterprise value 

For example, if a company has:

 

Number of stocks: 20 million
Stock price: last transacting at $2 a share.

Total market capitalization: $40 million

This company could have cash and debt. So let’s say:
            Amount of cash inside the company: 5 million
            Debt owe to others: 10 million

For someone to take over this company, he/she would have to buy over all the shares
            Market capitalization: $40 million
Pays the debt of 10 million,
            Market Capitalization + Debt: $40 mllion + $10 million = $50 million
Takes the cash inside the company,
            Market Capitalization + Debt – Cash: $50 milllion – 5 million = $45 million.

 

The result is known as enterprise value. This company cost $45 million for someone to take over.

 

Now if the company has been consistently earning $1 million, pre-tax, before paying interest, yearly, this would give it a multiple of 45. In reality, it is hard to find companies that consistently earn a certain sum. This multiple, is what we call enterprise value over earnings before interest and tax (EBIT), or EV/EBIT.

 

A multiple of 45 is not attractive. This means I need 45 years to recoup the cost.

Assuming this company earns $9 million a year, that gives it an EV/EBIT multiple of 5, or five years to recoup cost, which is very attractive.

 

Ideally, I like this figure to be about 5 years or less. 

 

Using a computer screener from Stocks.cafe, this gives me 60 companies.

 

What I would do next is to go through the list and remove the ones with a poor dividend-paying record. I found that this halved the results. Next, I subtract the amount of cash by the amount of debt and compared it to the market capitalization as a percentage. There are a few caveats here: 
1) you have to trust the data. Sometimes, data aggregation services get it wrong. I would follow up with the figures in the annual report. Or, the currency used for financial reporting isn’t the same as the market cap’s.

2) sometimes the cash isn’t real, i.e. there is a fraud going on in the company. 

3) Certain companies require a huge hoard of cash as working capital. For instance, HRNETGroup.

 

Dividend Yield: The last reported dividend yield as provided by Stocks.Cafe

Market Cap: Market Capitalization (number of shares multiply by last known stock price)

Net Cash: Cash subtracted by debt

Net Cash % to Mcap: Net cash expressed as a percentage to market capitalization.

 

There are a few issues with this approach:

a)     Earnings could be inconsistent (volatile, cyclical) and the figure used was the last known earnings.

b)    Most of these companies are micro-cap or small companies. This means they potentially have very low trading volume day to day. This results in a huge spread. 

A scenario: Assuming Company ABC is last transacting at 0.360$. The maximum bid price (price that someone willing to buy) could be $0.32, and the lowest sell price could be $0.39. 

c)     Micro-cap companies are usually family-controlled, which can be difficult to take over (unless they are doing it themselves), and potentially aren’t share-holder friendly (pay little dividends, unwilling to disclose information, etc)

 

Again, this is a quantitative exercise which I enjoyed doing and I hoped you learnt a little from this process.