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Investing in late-cycle earnings growth

SINGAPORE (Feb 25): Positive news flow on the ongoing US-China trade talks continued to buoy sentiment for global stocks over the past week. Following reported progress after days of negotiations in Beijing, further discussions have resumed in the US. Clearly, markets have now priced in some sort of deal to avert another tariff hike or, at the very least, an extension to the March 1 deadline.

Volatility, as measured by the CBOE Volatility Index (VIX), has fallen quite sharply since hitting a high on Christmas Eve last year. That said, many investors remain wary that volatility could return in the near future.

If so, this would not be at all surprising, considering that the global economy is very late in the current upcycle. There are bound to be greater uncertainties over the timing of the turning point. Unemployment rates have fallen far below levels seen in the last recession — US unemployment is near a 50-year low.

Analysts are already talking about an earnings recession. According to estimates collected by data provider FactSet, US corporate earnings are now expected to contract 2.2% in 1Q2019, well off the estimated growth of 4.9% less than three months ago, at end-November.

Currently, earnings are forecast to grow 1% in 2Q2019, but this could easily turn into a second consecutive quarter of decline if analysts continue to pare back earnings estimates.

Of note, revenue is expected to grow at a faster pace of 4.7% and 4.5% for the first two quarters, respectively. In other words, the market is forecasting margins contraction, which is a symptom of late-cycle expansion, when slack has been taken up.

All of the above, I believe, means greater opportunities for stock selection strategies as opposed to beta investing, which had gained increasing popularity in the low-volatility, liquidity- driven rally of recent years.

We can expect a higher degree of late-cycle earnings dispersion and thus, should see more focus given to underlying fundamentals of individual stocks. It is more likely that value — and hence, outsized returns — can be found in smaller companies. Therefore, we are actively looking for fresh stock ideas within these parameters to add to my Global Portfolio.

Granted, many smaller-cap companies have low profiles and are not well researched. Hence, the information available could be limited and, sometimes, in a foreign language. As a result, their share prices too tend to be more volatile.

Case in point, shares in Shanghai Haohai Biological Technology Co, which we sold for a 34% gain, traded as high as HK$59.90 and fell as low as HK$34.05 before rebounding to the current HK$48.50 — all in the past one year.

Similarly, the share price of Sunpower Group has rebounded quite smartly in the past couple of weeks, recovering almost all of its recent losses. Recall that the share price took a sudden dive in October 2018, which was not reflective of the company’s underlying business and earnings.

Inevitably, there are times when we would just be dead wrong. A good example is Towa Corp. Its share price reversed into a persistent downtrend soon after we bought the stock in December 2017. We took a loss of 16% in February 2018 and since then, the stock has fallen another 60%.

We rely heavily on data analytics in the search for stocks globally, which unfortunately does not usually give any nuance on localised issues. There is always a risk of losses. Our aim is to find more winners than losers.

China Sunsine Chemical Holdings and Ausnutria Dairy are performing very well; their share prices are up some 23.4% and 23.2% respectively from our acquisition costs. On the other hand, our investments in DIP Corp and Nine Dragons Paper (Holdings) remain in the red.

I suspect price upside for Nine Dragons could be limited in the near term on muted sentiment despite its valuation attractiveness. Demand for containerboard (for packaging purposes) has weakened, affected by the trade conflict and China’s economic slowdown. There is evidence of destocking activities. The result is lower selling prices, which is also capping the ability to pass on higher costs.

Recently, there was speculation that after tightening impurity requirements for imported scrap paper, the Chinese government is mulling an outright ban in 2020. This would negatively impact margins, given that local scrap prices are trading much higher currently.

In the long run, further industry consolidation would be positive for Nine Dragons, which is the biggest paper-packaging manufacturer in the country. The company has a head start in diversifying its feedstock and recently acquired pulp mills in the US. In other words, its business and longer-term outlook are intact. I am staying invested at the moment. However, I do not rule out disposing of the stock in the near term if there is a better investment alternative.

Elsewhere, DIP’s share price has remained weak despite its upbeat earnings. It is quite perplexing. With low unemployment rate — the labour market is the tightest in four decades — the number of job advertisement listings is on the rise and DIP has been expanding its operations.

Revenue is growing — by 10.2% y-o-y in 1QFYFeb2019, 10.3% in 2QFY2019 and 10.9% in the latest 3QFY2019 — albeit lower than in previous years, owing in part to the larger base effect. Net income for 9MFY2019 is up an outsized 24.9%, reflecting improving margins, despite lower ad rates. In addition to raising headcount, the company is lifting productivity through the use of technology.

The stock is trading at a price/earnings-to-growth ratio of less than 1 time, with an estimated yield of 2.4%. DIP has forecast dividends rising to ¥49 a share for the current financial year, up from ¥43 in FY2018. I like DIP’s business proposition, but admittedly, it has been a drag on the portfolio.

Perhaps the market is anticipating significantly greater competition — in an already fragmented industry — in the future. We are sticking with the stock and believe the market will catch up with our views.

Stocks in the Global Portfolio traded broadly higher last week, paring losses (since inception) to just 3.2%. Although the portfolio continues to underperform the MSCI World Net Return Index, which is up 1.2% over the same period, the gap has been narrowing in recent weeks as global stocks regained investors’ confidence.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore


Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports