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Tuesday, 6 March 2018

STORY TIME : LOTTE CHEMICAL TITAN AND THE PERILS OF SHORTSIGHTEDNESS

The events described below occurred from July 2017 onwards. It was a while back but there were a lot of valuable lessons, including the perils of a panicky market, the ignorance of fundamentals, and how to profitably trade off of these two things. When the same thing happens again, you'll know what to do.



Not this one.




Let's look at the background of Company A and the situation it found itself in :


1) Company A is a petrochemical giant. It is a solid, cash flow positive, margins busting firm. It gives out 50% of its annual earnings as dividends. Its annual earnings are in the hundreds of millions of ringgit per year.


2) Company A had a lousy bookbuilding exercise and was forced to lower the asking price for its IPO. Nonetheless it had cornerstone investors who were salivating at the prospect of a %3.3 annual dividend yield.


3) Company A achieves listing. But surprise! An earnings shock causes an immediate collapse in the share price.


4) The company's market cap falls by 25% within weeks. Yet with a lower share price its dividend yields become more attractive. Aside from the one-quarter earnings surprise, the company is in no immediate danger of lower profits over the long term.


5) The share price decline wipes about RM5 billion from the company's capitalisation. It even falls below book value!


Now that all this has happened, who looks silly? It's the investment bankers (who overestimated the market demand for the IPO), the cornerstone investors (who were trapped during the immense price decline), and the company's management (who had no excuses for not foreseeing the one-time surprise and not disclosing them as a potential risk in the prospectus). A lot of people were left embarrassed by this ordeal, but there was no malice intended. It's just a normal screw-up, but the overreaction was intense.


But other than that, did anything change? Did this company suddenly lost its earnings potential and competitive advantages? You already know Company A is Lotte Chemical Titan. It's a petrochemical giant with the backing of an even bigger international group.


Petronas Chemicals is also a petrochemical giant with the backing of an equally big parent. What if PetChem was Company A? Do you think those guys would have experienced what Lotte did under similar circumstances? Surely not.


So who benefits from this decline? It's the fund managers (who can enter the stock at much more attractive prices), the analysts [who can easily initiate coverage on the stock with a target price near the IPO price of RM6.50 - low downside risk. The business hardly requires sophisticated analysis ;) ], and last but not least, retail investors.


The last group can max out their margin accounts to hold a long term position with great dividend prospects. Short term punters can buy the stock with the expectation of a quick upside recovery (a 25% decline in two weeks? Too much). And then there are the call warrant traders who are aware of the apparent existence of an artificial mispricing in the company's stock (me among them).


The shocking decline in Lotte's share price presented a good trading opportunity because the immediacy of the selloff points to some kind of panicked trading activity (possibly disposal of shares at any price). Plus, the punitive financial punishment (loss of billions in market cap) does not match the crime (a one time negative earnings surprise).


This imbalance causes the company to be valued at much less than it's arguably worth, even though the underlying fundamentals remain exactly the same.


THE STARS ALIGN.... IN A BAD WAY


Before we get into the trading process let's have a closer look as to what exactly happened in July-August 2017.


There were clues abound that the IPO was botched. Expectations were too high, the market's sentiment was tepid, and investors no longer put a premium on the upside potential of sizeable IPOs on Bursa Malaysia (you can thank ASTRO, AAX, and FGV for that).




In a sucks-to-be-you moment, Lotte's cornerstone investors were appalled that the stock only traded at the RM6.50 level on the first day - it never returned there since. When a stock struggles immediately after listing, its bankers step up to 'stabilise' the share price in what is known as a 'greenshoe'. The investment bank does this by simply buying up millions of shares to mitigate price shocks. But there's a catch : they can only do this within 30 days of the stock's listing. You know where this story leads; during the greenshoe period, Lotte's stock still fell 6%.


So you have a struggling stock and bankers trying to assure the market that the struggle is not so real. Your 30 days is up. The next thing that comes up is the stuff of ( Lotte's IPO subscribers' ) nightmares - the company reports a 72% year-on-year fall in net profits. Needless to say this was unexpected. The stock falls 25% in two days. If there's a time to pity investment bankers, this was it.



Waiiit a minute... this is a petrochemical product.



A botched IPO, a steadily declining stock, and a negative earnings surprise. But this is where it's important to think rationally.


Here's a list of what caused the net profit decline. The actual numbers are : RM113.62mil for Q2FY17 versus RM404.03mil in Q2FY16 :


1) Lower output due to an unplanned water interruption by Syarikat Air Johor during the quarter.
2) Sales dip due to the festive holiday period in June 2017.
3) Fair value losses on derivatives of RM22mil.
4) Write-offs and share of losses from associates amounting to RM36mil.


The summary of my analysis of these reasons - so what ? These are not systemic risks. These do not affect Lotte's earnings potential over the next 10 years. It's a bit of an overreaction to cut RM5 billion off of the company's market value just because you didn't like a one-quarter unpleasant surprise. Yet it happens all the time in the market.


I'd put a premium on the following : Lotte's profit margins are in the double digits.  It ended up earning RM1 billion in net profit last year - half of that to be paid out as dividends. By several key measures, it remains the cheapest petrochemical stock in the continent. But let's go back to August 2017 when the stock price hit a low of RM4.14.


A series of unfortunately events resulted in volatility and mispricing of the stock. This created an event driven opportunity - so it's time to trade.


TRADING THE UPSIDE VOLATILITY


Lotte's share price decline coincided with the issuance and price collapse of its accompanying call warrants. The volatility meant that upon issuance, some of the call warrants lost up to 70% of their value in three trading days. It is worth noting that their exercise price was reasonable enough - some are close to RM7, or just an 8% premium to the IPO price. The company was expected to be a safe, boring petrochemical play. No such volatility was expected.




So what do you get when you have a supposedly boring stock that's trading like Bitcoin? You get a chance to capitalize on the downside volatility with a favourable risk-reward proposition. It doesn't matter if you'd bought the mother share or the call warrants - both were set for a strong and immediate recovery, at least according to my trading thesis at the time.





Trading volatility requires some specific rules. For example, I will construct a trading angle when a company loses more than a quarter of its market cap in a short period.


Chances of profiting from a recovery is good when the activity clearly points to panic selling. It's even better when the entire decline itself is overdone. And even better yet when there's a warrant to amplify the earnings potential of this trade.


In a volatile situation, a recovery occurs about as quickly as the decline. There will be a period of bargain hunting and accumulation at recent lows, also known as setting the floor.


LEFT - Here's what the floor looks like. The consolidation period lasted eight trading days or so. There was initial volatility amid the bargain hunting, and this occurred in the call warrants as well.




 









I got this little souvenir while attempting to accumulate a call warrant position.




What happened was that the call warrants continued to fall despite the stock achieving some stabilisation. This wasn't exactly a surprise - a call warrant's volatility is amplified relative to the mother share's. I was pushed out of my position, but it didn't mean my trading thesis was wrong.


The next step was to try again. My analysis of the trade points to a limited downside - among other justifications, the stock was trading at a shocking 10% discount to book value. It's like paying Fiat prices for a BMW.


From August 14 onwards, the stock skyrocketed by 25% in just four trading days. I had another position which I exited from too early, so I didn't benefit from the majority of the price rally. But the payoff was decent.








This may be a low return figure for some of you high rollers. But that's a 24% payoff from a single trade lasting all of five days. The best part - this trade can be replicated the next time another botched IPO causes the stock to collapse for silly reasons. Developing and executing the game plan was the real reward.


FIVE MONTHS LATER.... DISCOVERING VALUE AND TRADING SHORT TERM VOLATILITY


And now for something completely different, other than the fact it's the same stock and the same trading philosophy (event driven).



I've written previously on how to choose a call warrant out of many by putting a premium on certain aspects of their characteristics. In January 2018, Lotte's call warrant flips the argument - the market puts a premium on the call warrant by simply existing.


Here's a different type of mispricing and premium. LCTITAN-CG was the only call warrant available to trade at this point. Forget the call warrant's terms - it has done nothing since issuance and was trading at 4 sen as at 12:30PM on January 30th.


During the afternoon market break, Lotte released its 4QFY17 figures. It reported a net profit of RM378mil versus RM290.86mil in 4QFY16. Disregard the company's fundamentals outlook, the fact that the bump was due to higher non-operating income, etc. The most important kicker here is the 23 sen dividend that it announced.


This shouldn't come as a surprise given that it's a clearly stated dividend policy. But it validates prior assumptions that the stock has been trading below its real value. If you like your charts, you may also notice that the stock has been rallying since December, so there was a reasonable level of accumulation activity and anticipation of positive earnings.


                                                                 Boom - January 30th




This trade is described in further detail here. The payoff:




PRESENT DAY...

Fast forward a little bit and guess what? This was from last week:

Via Bloomberg.


So again, in the grand scheme of things, that one-quarter earnings blip is totally insignificant. In fact, it was a blessing for those who were able to get in near the bottom of the market. An investor who bought the shares at August 1, 2017 would have enjoyed a 34% gain as of March 2, 2018. That's the reward for ignoring market panics.