I have a small position in Hung Hing Printing (HHP) as part of a diversified basket of stocks that trade cheaply relative to their assets. Such companies typically have one or more of the following characteristics, which explains their cheap valuation:
- Poor business results and future outlook
- Poor capital allocation decisions
- Unfriendly treatment of minority shareholders
- Questionable accounting practices
HHP’s business is book and package printing, the consumer product packaging, the corrugated box and the trading of paper. In my opinion, this is a poor, commodity-like business and their results reflect it.
In the past 5 financial years, HHP averaged annual revenues of around 3b HKD and profits of 50k HKD, while employing net assets of 2.8b HKD. Despite not earning an adequate return on capital, HHP still deploys additional capital into the business, averaging around 100m HKD in fixed asset purchases annually.
As of 26 Feb 2017, HHP traded at a price of 1.3 HKD per share for a valuation of 1.1b HKD. This compares to their total net asset value of around 2.8b HKD and their total net current asset value of around 1.3b HKD.
On 27 Feb 2017, HHP announced the disposal of a wholly owned subsidiary:
Click to access LTN20170227630.pdf
The estimated net proceeds of the sale is 960m HKD, compared to the subsidiary’s net asset value was 55m HKD. This represents a gain in book value terms for HHP of about 905m HKD (1 HKD per share), which is almost as much as HHP was being valued by the market before the announcement. However, HHP’s price only went up from 1.3 HKD to around 1.55 HKD per share for a valuation of 1.4b HKD.
From this, there are a few things we can learn about buying stocks which trade cheaply relative to their assets. Such stocks can remain “cheap” for sustained periods of time for as long as their problems (discussed above) remain. For their prices to appreciate, I think that it can either happen when the general market sentiment becomes more optimistic (during which prices of all stocks in general appreciate) or when there is a “catalyst” that unlocks the value in a particular stock.
Catalysts are events which immediately increase the value of a stock by putting cash which was previously “stuck” in the company earning lousy returns in the shareholder’s hands, or changes in the underlying characteristics of the company’s business or management such that capital in the company earns better future returns.
Examples of catalysts are declaring significant dividends and/or stock repurchases, sale of an underperforming/undervalued subsidiary, privatisation bid for the company, change in management, an improvement in the company’s business prospects and so on.
Given the nature of catalysts, we are unable to predict when and what kind of catalyst will occur in the future. This forces us to maintain a diversified porfolio of such stocks in order to maximise our chances in realising gains when catalysts occur in the future.
I think that there are only two scenarios in which you can consider putting a substantial percentage of your portfolio into a single such stock. The first is when you know that a catalyst is going to happen AND the market has not priced it in properly. The second is when the stock itself is so cheap that the cheapness itself may very well become its own catalyst to realise its value.
I bought HHP at 0.96 HKD per share, when it was trading at around two thirds of its net current asset value, expecting to sell it when its valuation went up to its net current asset value (1.43 HKD per share).
In HHP’s case, I was fortunate that a subsidiary which was recorded at only 55m HKD in their books was sold for 960m HKD. This big gain on sale of a subsidiary is a great catalyst for unlocking value. As the subsidiary’s business is a break even one, the huge discrepancy in sale price and book value is probably due to the subsidiary owning some land that was bought decades ago (which has now appreciated considerably) recorded at historical cost in the books. When valuing a company, this is not information we can gather by just looking at their consolidated balance sheet. We can only imagine the huge amount of hidden value that could be extracted from a company’s assets.
A fine example of how much value can be unlocked from a catalyst is that of Luen Thai 0311.HK, which I wrote about in Dec 2016. Prior to the announcements (in Oct 2016) of the sale of some of their businesses, a special dividend payout, and a general takeover offer from a third party, their shares traded at around 1.80 HKD versus a book value per share of around 2.96 HKD. Today, less than 6 months later, after paying 1.57 HKD in dividends, their shares trade at 1.78 HKD.
But, as we will examine in HHP’s case, the big gain on sale of their subsidiary did not immediately translate into a big increase in the share price. The reason is because most of the gain is not immediately put into shareholders’ hands, which leads us back to the same problems why the stock trades cheaply to assets in the first place. In the same announcement on 27 Feb 2017, management also said that of the 960m HKD, it plans to plough 70% of the proceeds (672m HKD) into the business, 20% of the proceeds (192m HKD) for enhancing shareholder return in the next few years, and 10% of the proceeds (96m HKD) as working capital.
I assign zero value to the proceeds that will be reinvested into the business because I think that this capital is unlikely to see any returns for shareholders. The 192m HKD for enhancing shareholder return will be fully valued, as it is likely to be paid out as dividends. The 96m HKD for working capital will given a value of two thirds, as I would do when I value net current asset value. On a per share basis, this adds up to about 0.27 HKD. Hence, I raise my sell price target from 1.43 HKD to 1.70 HKD.
C is for Compounding 