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Thursday, 5 April 2018

ANALYSIS : AS THE MARKET FALLS, GABUNGAN AQRS IS THE BEST GENERAL ELECTION STOCK PLAY

It's just a matter of time now - the 14th General Election is upon us. Coincidentally, the market is reeling from a series of severe shocks. So naturally these questions are getting thrown around a lot now: What to make of the latest market crash? Stay in cash or buy some shares? Should I wait until the election's over to buy shares? Should I buy MYEG?


Here's a ghastly vision of things to come. Image link.


I'll address these questions one by one.

WHAT TO MAKE OF THE LATEST MARKET CRASH?


Answer : The trade war rhetoric is intensifying. It does not have immediate economic ramifications yet the selldown on April 4 was bloodcurdling. Just remember one thing; we've had a very good run from September last year to February. Momentum stocks are the first to get destroyed when momentum stops. Stock prices do not move up in a linear, orderly manner. It is likely that if you're still holding a position in momentum stocks, you were the last to join the party.


By understanding this - the fact that the market responds to short term fears, marking the end of momentum strategies - it is time to remind ourselves that real quality counters will survive the wreckage. Their prices will recover sooner than you might think, and they will lead the broader market rebound.


When this will happen is anybody's guess, but you'd do well by disregarding the entirety of the price and volume activity (and the charts) during the momentum period (September to February). Momentum is defined by its finite nature - it eventually stops, so why would you keep your money in stocks that exhibit such a characteristic?



STAY IN CASH OR BUY SOME SHARES?

Answer : If you're in a profit taking position, do it and stay in cash. Markets are historically volatile during the following, very specific period; the time between the dissolution of Parliament and the first trading day after the GE results. Hence wild swings are to be expected. Externally things don't look so hot either, so any massive overnight declines in the US will likely tear apart the KLCI in the morning.


But if you're looking for a once-in-five years opportunity to derive gains exceeding 30% from a single short term trade, buy some shares ahead of the GE outcome. Take a calculated risk; if you're a big believer in event driven trading opportunities (as I am), this is possibly the biggest market event in years to capitalize on.



SHOULD I WAIT UNTIL THE ELECTION'S OVER TO BUY SHARES?


Answer : If you're asking this question, it means you're well aware that the GE period will be dominated by sentiment, not fundamentals. If you find trading distasteful, stay away until the market stabilizes. If you have a value investor's mindset, you'd do one of two things : 1) stay invested regardless of the silliness of the GE period or 2) wait for value stocks to become cheaper in the event of a market crash or downside volatility. At any rate your hand must not be pushed; you dictate your own investment decisions at your own time.



SHOULD I BUY MYEG?


Answer : Sure, go ahead and buy some, though from a valuations perspective things remain fuzzy. You can certainly put a premium on a monopolistic, government controlled business, but it is not known if the premium can be sustained (say, for example, if a global market crash were to happen. Maybe it's happening now). 


As it so happens with such companies, your investment is essentially a bet on the following : 1) for the market to continue pricing the stock at a forward PE of more than 20 times, 2) on new investments/projects to sustain past business growth successes, and 3) your reliance on the stock as the most politically sensitive counter there is. There is little value proposition here, at least in the conventional sense.


But here's a sobering fact; it is possibly the most obvious election/crony counter play in the universe. You're not part of the 'smart money', you're at the tail end of it. The stock's already up 35% this year and you're thinking about buying it now? All the best!


Really, I'm not trying to knock on MYEG here. I'm just saying that from a relative valuation standpoint, there are other, better stocks to pursue right now. 


WHAT GENERAL ELECTION TRADING IS ALL ABOUT 


To start with, here's a relative comparison of how the KLCI fares versus the world in past election cycles. It's not particularly helpful, unless if you're in the business of predicting election dates.


From my notes




The way I look at it, the GE trading period (again, I'd roughly define this as the time between the dissolution of Parliament and the GE itself) is the mother of all event driven trading opportunities. The upside potential is vast enough that you should take a higher risk than normal to derive outsized returns.


KLCI component counters - supposedly the most sane of all counters on Bursa Malaysia - can rally by 15-20% in a span of days. You'd have done very well if you have a gutsy position like say, a margin account exposure in hundreds of thousands of GAMUDA shares in 2013. But it was equally probable that you'd be destroyed if things moved the other way.


Essentially, my approach here is to look for the cheapest, absolute best bargain opportunities with the highest trough-to-peak upside potential.


But first, try and accept these hard truths:


1) Your GLC bet means you have a vested interest in the status quo. You can vote Pakatan but your GLC stock purchase is essentially a BN vote. An opposition victory could potentially bring about political strife, potential social unrest, the unwinding of certain monopolistic conglomerates, and serious economic ramifications. Guess how the stock market will react?


2) Your GLC bet is a proxy on the KLCI itself. There is no new fundamentals angle here. It is not about the expectation of new contracts; these have already been priced in by the analyst reports as well as the stock itself. The cause and effect is not ambiguous; a 50-point increase in the KLCI will move GLCs up, even if they're not part of the 30 main component stocks. 


3) If the KLCI moves up 50, 80, 100 points right after GE results, it is mostly down to sentiment and short covering. Sure, you can attribute the rise to an influx of fresh capital now that the uncertainty's over. It can also be a vote on status quo and economic stability. But nobody talks about short covering.


Prior to pivotal events such as a general election, institutions or aggressive trading firms will make an outright directional bet on the direction of the market itself. The most cost effective way to do this (for a trader) is to use KLCI index futures, or the FKLI. Go here if you want to learn the basics, but the main point is that index futures can directly lead to a shock in the cash (equity) markets if a massive short covering occurs.


Essentially what this means is that those who bet on a decline in the KLCI prior to the GE would take up massive short positions (remember that a futures contract is always a zero sum game; there are two opposing views for each one). Look at what happened in 2013 (GE13) for a clear demonstration of how this works.


From The Star, 6 May, 2013 (the first trading day after GE13 results):

"Malaysia's FBM KLCI surged to an all-time high of 1,826 early Monday, while the ringgit advanced to the highest since 1997 against the US dollar, after the Barisan Nasional won 133 parliamentary seats at the 13th General Elections to continue to rule the country.

The relief rally broke past all technical indicators, surging 131.45 points or 7.75%.... "

That was the actual index. On May 2, the May index futures contract closed at 1,705. On May 6, it hit a peak of 1,834 from a low of 1,720 in the first hour of trading - a mind boggling 6% increase in an hour.

The FBM KLCI - first day after the 2013 elections. Source

The rapid rise was all well and good as new capital comes in. But at the same time the move upwards was exacerbated by short sellers being forced to cover their positions by buying back futures contracts. 

At the time, the index futures market was very illiquid, so desperate traders were forced to cover their position at any price. And if they can't buy back futures, they have to hedge their losses by buying up shares in the cash market - this essentially means the KLCI component stocks that make up the index. This self reinforcing cycle pushes prices to its peak and explains much of the volatility on that fateful day. The PM even tried to take credit for it.

My point in explaining all this is that you have to understand what you're getting into. From here on, the task is in pinpointing a reasonably priced GLC proxy with a very high upside potential. It also helps if the market is largely ignoring the company's potential, and so far that seems to be very much the case. If such a swing is too much for you to stomach - that 6% one-day move can also happen in the opposite direction - stay away from the market at all costs.

Gabungan AQRS is my top pick for the GE season with a potential conservative upside of 30% in the short term (typically defined as a period of three months). It will very likely receive a huge capital boost post-GE as part of the main pool of politically sensitive counters. It is a sentiment proxy as much as it is a construction, political, or KLCI proxy. So any upside volatility will benefit them the most.


But more specifically, this post focuses on GBGAQRS-WA, a company warrant that expires in July this year, but just enough time to serve as a very valuable proxy to the mother share itself.


Note that the warrant pick amplifies the profit (and loss potential). The following analysis is equally applicable to the mother share - just buy them instead if you prefer.



Get to know everything relevant about the company in one minute with this screengrab.



A GLC PROXY FALLS 30% THIS YEAR AND NO ONE'S PICKING IT UP YET


Gabungan AQRS presents an interesting case : a clear government proxy with multiple exposures in infrastructure projects - we're talking about both Peninsular Malaysia as well as East Malaysia. It has had modest success with previous commitments in rail projects, though it's clear that now the company's targeting far bigger game than just building viaducts.


Research houses have already factored in some of these contracts, with current 12-month target prices of as high as RM2.25 - an upside of about 40% from the current stock price. As recently as 11 January, 2018, the stock hit a peak of RM2.15 but since then it quickly fell by a third. Now why is that?


I had a few ongoing theories in my mind; one of them is that the stock is being driven down by the dumping of GBGAQRS-WA, a company issued warrant that expires in July. It carries an exercise price of RM1.30 and a one-to-one conversion ratio. The warrant itself endured a far worse decline as it fell from 77 sen to a low of 18 sen on 26 March - a whopping 76% decline in two months.


This is where the value emerges. GBGAQRS-WA is technically worthless if the mother share dips below RM1.30 - a possibility which could have influenced the selldown recently - but it will always be worth something due to its time value and convertibility, even if it will expire in three months' time.


These are three of my most important principles : 1) having the best value proposition, 2) having the right thematic angle and 3) having the right instrument to trade.


PART I : THE BEST VALUE PROPOSITION?


Note : I'll use Affin Hwang's target price for AQRS as a baseline for the following analysis. The full report can be found here.


Always think in relative terms; how did the fall of AQRS stock compare to its peers, the sector, and the broader market? Was the selldown overdone? Is the stock responding the same way as its peers, particularly those who share the same catalysts?


Relative comparison is the easiest way to look at this. Construct a table comprising Bursa's leading lights in the construction sector and companies with direct exposure in the bigger infra projects. To get more breadth, include companies in different construction subsegments - engineering companies, construction materials suppliers, etc - as well as important market benchmarks.


Below is a simplified table of what I usually look at. I'm only including two major indicators here - price activity and historical price-earnings ratio. It can be far more comprehensive and easier to compile if you have a Bloomberg terminal.



Companies/Benchmarks
YTD Price Performance, April 2 (%)
 Historical PE (times), YTD share price
HSS Engineers
 +5.8
 30.4
George Kent
 +17
 18.4
Lafarge Cement
 -29
 N/A (loss making)
Ahmad Zaki Resources
 -21
 13.6
KL Construction Index
-7.8
 22 (end-Dec 2017)
FBM KLCI
 +4.5
 17 (end-Feb 2018)
Gabungan AQRS
 -17
 14


Source : Company filings, Bloomberg. Historical PE is based on the latest share price and the latest full financial year earnings per share. I'm fully aware that by April 4 the figures in this table would have shifted drastically but things would still look comparatively favourable for AQRS.


There's a lot of information that can be derived from this. It's clear that AQRS's share price has underperformed its peers and the sector. From a PE standpoint it looks reasonably attractive. It's a company that has some degree of control over its profit margins (around 10% now. For context, AZRB's is 3%). It is unclear if the expectation of future contracts are imputed into the stock price; it would have been when it was above RM2, but not anymore.


It is reasonable to assume that the broad-based selldown was partly due to profit taking activity ahead of the GE; politically sensitive counters will be the most volatile, after all. But how do we measure the sensitivity of AQRS's stock price relative to its financial performance?


One way is to measure the quarter-to-quarter PE. From this we can determine if the price component has overstretched beyond its earnings trajectory. I apply this method for companies that have demonstrated reasonable earnings growth over the long term; for construction firms, it's clear that the growth is due to revenue increase from new projects being delivered. On a year-on-year basis, AQRS's net profit margins have improved slightly from 7% to 10%.




These are useful info; you can interpret it many ways. I'll use indexing - starting from the same base - to visualize the share price-to-PE ratio relationship over this period, plus the year-to-date data.

YTD is the current state of this linkage : it's the YTD price over the latest FY17 historical PE.


This might look confusing, but it essentially means this : this chart shows that the PE has gone down since its peak despite EPS growth. You're getting higher EPS now but the stock's PE (YTD) is similar to 1Q, when the EPS was 23% lower. So the 'current' PE (14 times) is a reflection of the current share price.


Simply put : the valuation HAS NOT STRETCHED. You can get the stock at last year's valuations despite the huge improvement in net profit and profit margins. Or, put another way, you can buy into a stock with 4Q17's EPS at 3Q17's price levels in 2Q18.


Plus, its valuations are still below peers, profit margins have improved, and right now the share price minimally reflects the company's exposure to new projects(remember that the research house estimate factors in new contract wins of up to RM1.5 billion in FY18, hence the RM2.25 target price). So the stock currently offers an excellent value proposition relative to its peers.


PART II : THE RIGHT THEMATIC ANGLE


AQRS clearly has a good story behind it - most people already knows this. The company is ambitious in its expansion plans, and with the CEO as a major shareholder, his and the company's financial interests are clearly aligned. Its past price performance likely reflects this.


It is already involved in LRT Line 3, and its links to Sabah is fairly well known. I'm not trying to impute its future stock value if it wins a Pan Borneo Sabah construction package, for example - my point is that the company is an excellent GE proxy and construction proxy stock.


 From Affin Hwang's report.

Again, I'm looking for value here instead of catching the momentum. You can easily buy HSSEB, GKENT, or MYEG for a high-momentum GE proxy play, but I have no idea how high these stocks can go. I can't trade what I can't plan for, even if that means missing out on easy profits. (Note: those three stocks fell between 5% and 11% on April 4 alone. AQRS? A mere 1.22% decline)


The GE thesis assumes that at the upon its conclusion (and you have no choice but to assume a BN win), the earnings potential from the government contracts will be imputed into the stock prices again. This alone represents a 25% upside from the current stock price.


PART III : HAVING THE RIGHT INSTRUMENT TO TRADE


For profit maximisation, it's simple: buy GBGAQRS-WA as a short to medium term trade. Between now and July, the warrant is likely to closely track the mother share IF it does not fall below the RM1.30 mark. Another big IF is the state of the global markets over the next few weeks - there is a real possibility that it can drive the warrant to near worthlessness as investors stay away and liquidity dries up.


It is even trading at a slight discount to the mother share after factoring in the exercise price; in other words the long term shareholders (and particularly the major shareholder) may find it appealing to convert the warrants into actual shares at below prevailing market prices.


This whole post is not merely a thought exercise as I've been targeting GBGAQRS-WA over the past two weeks. At 20 sen per warrant as at last week (March 26 to 30), it was a fantastic opportunity to gain exposure cheaply. The stock was trading at around RM1.50 at the time, but a very conservative assumption of a 10 sen increase (a 6% rise) would result in a 10 sen increase in the warrant itself (a 50% rise).


With this in mind, I built up a fairly large position. A week later this was the immediate payoff (RGL stands for realized gain/loss) :




And this is just the first round. The market has just hit a reset button but this does not threaten the  earnings prospects of companies like GBGAQRS. Once the volatility subsides, what you'll end up with is an incredibly undervalued stock with the fundamentals intact.


I should mention that the warrant was absolutely destroyed on April 4 in part due to the panic selling. It closed at 24 sen, or a steep discount to the underlying (inclusive of the exercise price, the conversion will get you a share at RM1.54, or an eight sen discount to the mother share's April 4 closing price). This can mean two things - either the mother share will fall rapidly or the warrant is artificially mispriced as panic grips the market.


I'm 100% in cash and ready for Round 2. My advice? Ignore the short term noise, forget momentum, focus on value, and buy on panics.












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