In Defense of REITs

While surfing on WallStraits Forum, I came across a post criticising REITs:

Originally posted by ocean21
During an economy downturn, i believe REITs will have the hardest impact, because:

1) Its fundamental business is very narrow and specific. When times are bad, pple spend less $$. Shops will not have business and cannot afford the high rental and they will go bust. Once REITs cannot continue to have their regular flow of high rental, they will not meet their expected yield. Its gonna have downward spiral effect.

2) Most REITs acquired their properties at pretty high prices (and at premium) from their "owners". When times are bad, valuation of these properties will fall and their NTA will be greatly affected since properties account for almost their entire balance sheet.

While these may sound like valid points to stay away from REITs, I feel they stem from a misunderstanding of how to invest.

These 2 reasons are insufficient by themselves to stay away from REITs. Every investment has its own pros and cons and advantages and risks.

What is important is to have a good understanding of the business and never to pay too much for it. Purchasing a REIT at a suitable margin of safety will mitigate against the risk of loss during an economic downturn.

with regards to point (1), this criticism can be made of the entire consumer brands sector as a whole. Every retail outlet and consumer brand has a particular niche and focus in their respective markets. Quality commercial REITs acquire shopping centers in good locations and fill them with quality tenants.

While this does not gaurantee that every tenant will stay in business during a downturn, a quality selection of tenants will still attract a reasonable clientele during a recession. Furthermore, REITs are at liberty to negotiate lower rents during times of economic difficulty - this prevents unnecessarily high rates during recessions and keeps their tenants in business.

With regards to criticism (2), again, this could be made of the entire property sector as a whole. Every investor who buys real estate will see market valuations of their property fall during a time of economic downturn. The trick is not to stay away from property, but to purchase assets only at reasonable valuations. If you look at the market now, you can find REITs that are priced very reasonably after the stock market pullback.

Like any investment, REITs should be evaluated while taking into consideration the business risks involved while remembering never to pay too much. If an investor keeps these factors in mind, he can profit by purchasing REITs when the market underprices them and selling when the market overvalues them. The solution is not to make a blanket condemnation of any asset class.

Parkway Life REIT

Well Positioned Industry

The Singapore medical services industry is well positioned for continued growth in the years ahead. Singapore’s strong supporting infrastructure and regulatory environment encourages the industry to flourish. In addition, the medical services industry is part of the larger drive to shape Singapore into a knowledge-driven services economy, and this will allow the country to continue to attract medical tourists from abroad. Singapore will benefit from wealthy patients coming in from the emerging economies in the region such as India, China and Indonesia.

Strong Competitive Position & Management Track Record

Parkway has a strong reputation and track record within the hospital management industry. Two of the three hospital assets that the REIT will start out with, Mount Elizabeth and Gleneagles, are premier hospitals with a strong supporting specialist base which uses the facilities. The large pool of medical specialists housed in the neighbouring medical centres to the hospitals more or less guarantees a steady flow of patients and utilization of the hospitals. I cannot say the same for East Shore hospital as less is known about it. By inference, however, we shall assume that there is at least a sufficient level of medical care provided in the hospital to attract patients to it as well.

Capital Structure

The debt-to-asset ratio of the REIT is currently 4.6%. It has a lot of room to take on debt, unlike comparative REITs which are much more highly leveraged, with anywhere from 20-40% gearing ratios. Higher gearing will enable the REIT to achieve higher returns on unitholder's funds.

Valuation

The main issue to be considered is the valuation of the REIT. At the issue price of $1.28, the REIT is projected to yield around 4.77% in FY2007, with low debt. Considering that REITs as an asset class are expected to yield 7-8% (leveraged) on average over the long term, this valuation is still not cheap. Some of the premium is made up by the fact that Parkway REIT has quality properties under its management and that it is a strong business. However, even factoring this into the picture, we should not expect outsized gains from the original IPO price.

Evaluation

Investors in Parkway REIT should hold the stock and not panic if the price of the stock falls. The business is fundamentally sound. However, given the premium valuation, investors should not expect outsized gains. The REIT will make a sensible long term investment with reasonable dividend yield and should be treated as such.

If the price of the REIT falls further, investors may like to consider buying more of the stock, perhaps somewhere in the region of $0.90-$1.00.

The Importance of Learning Mandarin in Singapore: An Economic Perspective

When I was younger, I did rather poorly in my Mandarin classes in school. I got a D7 for my Chinese at AO-level in my first year in junior college. In the second year, I gave up trying to pass the subject and dropped it. I just could not see the relevance of putting effort into learning a language which I did not use at home, in my other subjects, or in any practical way other than in Mandarin language class. In short, I was studying Mandarin in a vacuum.

Nowadays, I know that some students in Singapore schools face a similar difficulty and lack of motivation towards putting their hearts into learning the language. For many years the education system has been constructed primarily around getting grades rather than learning for learning's sake. It is thus understandable that students might be unmotivated when learning the subject; it is extremely difficult to study Chinese just for the sake of passing exams.

The thing about learning a language is that a language never exists in a vacuum. It is a medium of communication, a tool used by people to exchange ideas, to record thoughts and knowledge, and to express oneself. It is thus natural that without an environment within which to regularly use the language, or without a purpose which includes learning Mandarin as a part, students are naturally unmotivated to study the language at school.

Personally, I have since moved on from those times when I was unmotivated to learn the language. My experience studying in Australia and my deepening understanding of global economics and business have given me a personal impetus to improve my Mandarin.

Here are examples of the things I have seen:

A. China's economy is large (3rd largest) and is the fastest growing of any of the major economies in the world. In time to come, it will exert an global economic influence that businesses, politicans and employees cannot ignore. Indeed, the global economic center of gravity has begun to shift across the Pacific Ocean away from the USA. Those with a grasp of the Chinese language will be in an advantageous position to benefit from the ascension of the Chinese economy.

As a case in point, let us take the economy of Australia. Australia is one of the most resilient economies in the world. It has shown positive or flat economic growth for the last 15 consecutive years. In most of those 15 years, Australia's economy experienced expansion, and it is still going strong. This is unprecedented for a developed economy. A deeper examination into the roots of Australia's economic growth will reveal that it has been driven by the global natural resources boom of which China has been the engine. As a country rich in natural resources, Australia has seen a surge in natural resource exports to China, and this has had a persistent multiplier effect throughout the Aussie economy. Needless to say, the Australians who have some sort of understanding of Mandarin have been able to capitalise on the business opportunities presented by China's insatiable thirst for natural resources.

B. Not too long ago, a certain individual was passed over for the top job at Goldman Sachs China because his mandarin was not good enough:

"Goldman's Ong misses China CEO job on language hitch (Bloomberg)
Updated: 2007-07-12 16:33

Goldman Sachs Group Inc, the world's most profitable investment bank, couldn't name the co-head of investment banking in Asia as chief executive officer of its Beijing joint venture because his knowledge of Chinese was too weak, three bankers at the firm said.

Richard Ong, an ethnic Chinese born in Malaysia, didn't write Chinese well enough to take a mandatory test for senior managers, said the bankers, declining to be identified as the matter is private. New York-based Goldman instead promoted Zha Xiangyang, deputy CEO of its China joint venture, Goldman Sachs Gao Hua Securities Co, in May."

See here for the entire article.

Indeed, it is no trivial matter that a senior banker at one of the world's top banks was unable to land the top job in the world's fastest growing securities market. A firm grasp of the Chinese language is so critical to doing business in the country that even those with less experience and ability may be promoted to top positions over those who are technically more capable but linguistically less so.

C. For many years, Las Vegas has taken pride in being the gaming and entertainment capital of the world. Yet since the liberalisation of the gaming market in Macau not too long ago, Las Vegas has already been supplanted from its perch by the former portuguese economy. Macau in 2006 over took Las Vegas in gaming revenues; in time to come it will far and away outstrip Las Vegas and make it look like a small fish. All the big players in the gaming market, including Americans, Australians and Europeans have been rushing to get a foothold in Macau market.

Read this to get a sense of the scale of the Chinese market.

D. In the world of entertainment, we are seeing a conscious decision on the parts of movie executives to try to penetrate the Chinese market. Pirates of the Caribbean 3, for instance, starred Chow Yun Fatt and a few other Chinese actors. Oceans 13, for the first time, included a Chinese actor in its cast, who only spoke Mandarin throughout the movie. In short, Hollywood is beginning to realise that the Chinese market is just too large to ignore.

E. Closer to home in Singapore, the government has made a push to expand industries such as the integrated resorts, private banking, and digital media. I have absolutely no doubt that the Chinese market will be a major contributing factor to the growth of these industries in Singapore. Those seeking for jobs in these areas will definitely have an advantage over their peers if they are fluent in Mandarin.

Conclusion

As we can see, China will exert its influence far and wide on the global economy in almost every field of business and in every part of the world, particularly in Asia. These examples that I have listed are only the tip of the iceberg, a simple enquiry into the Chinese influence on the global economy will make its importance apparent. Ethnic Singaporean Chinese who ignore the Chinese language only do so to their personal disadvantage.

As for me, the difficulties of finding motivations to improve my Mandarin are long gone. I now try to watch Mandarin movies, interact with Chinese people, and put myself in situations where I can be exposed to the language. I hope that in time I will be able to have a fluent grasp of the language.

How about you?

GMG Global - A Play on the Weather

I know that certain investors are extremely enthusiastic about a stock called GMG Global:


As can be GMG Global's stock price has fallen in half since its highs earlier this year. Some investors are seeing this as an opportunity to pick up a "bargain" and have been snapping up the stock at its current perceived low price.

Analysis

As a rubber seller, GMG Global operates in a commoditised market. It has no pricing power and the only way for GMG to increase its profitability is by lowering its cost structure. However, cost structures are only flexible to a certain extent. The primary factor affecting the business is thus the revenues that GMG Global derives from selling its rubber.

A glance at GMG's financial statements will reveal that in the first half of 2007, there was a sharp decline in revenue year-on-year while the company's cost structure remained the same. This resulted in a sharp drop in profits from $18m to $8.5m in the corresponding financial periods.

The company claims that this was primarily the result of poor weather conditions:

"Lower yield, and field production caused by extremely bad weather conditions prevailing in the first half ended 30 June 2007 which had adversely affected sales and revenue;"

Taking this statement at face value, a bet on GMG Global is essentially a bet on the weather conditions in Cameroon and Ivory Coast. Now, we all know that nobody knows where the weather is going to go in the next one month, let alone the next half year. Hence, no investor can possibly be certain that the weather in Cameroon and Ivory Coast will much better than the conditions that prevailed 1H07. The weather might improve, however we have no idea how much it will improve. This is the first element of uncertainty regarding GMG.

The second issue regarding GMG is its current valuation. The stock is currently trading below book value of $0.126 per share at about $0.105. However, the EPS of 1H07 is 0.31 cents. Even if we give an optimistic full year EPS of 1 cent per share, this is a sub-par 8% return on equity - this is a business that is generating very low returns on capital employed.

The third issue regarding GMG is that it seems to be a company operating with a high operating leverage. Any significant fluctuation in revenues will result in a significant impact on the bottom line. This acts as a double-edged sword, but in the event that the weather moves adversely against the company, this could effectively wipe out most of GMG Global's profits.

Evaluation

At the price of $0.105, this puts GMG into the net-net category for Benjamin Graham. However, I feel that there is a possibility for more value in this stock. The high operating leverage and the magnitude of an impact of a further adverse move in the weather may push GMG into deeper value territory, in the region of 8.5-9.5c per share.

I am putting this stock on my watchlist with buy signal at 9c per share.

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Update: Just some information about GMG I found on the net

Cameroon Rubber

Rubber is produced primarily in the forested region of Niete, north of Yaoundé, by 3 agro-industrial companies, CDC, Hevecam and Safacam. The rubber yield plummeted from 58,000 metric tons in 1998-1999 to 32,000 metric tons in 1999-2000. The main producer, Hevecam, was purchased in 1996 by the GMG Group based in Singapore. Most of Cameroon's rubber is exported to the European Union. With average annual rubber exports valued at CFA20 billion (US$30 million), this industry provides 2 percent of Cameroon's export revenue.

From here

More on Hevecam Rubber

The Subprime Debacle and the Singapore Fallout

As the above chart reveals, the STI has been extremely volatile over the last couple of months. The index has rocked back and forth as events surrounding the US subprime squeeze unfolded. The US indexes fell and so did markets around the region, including Singapore.

What are the implications of this recent volatility?

A. Some think that the market is entering an extremely volatile phase. The prices of some stocks are violently fluctuating up and down, sometimes losing 50% in a day and gaining a similar amount back in another day. So because of this extreme volatility, one school of thought argues that it is better to stay on the sideline in cash or in a conservative position, until the market regains its composure and there is a better risk/reward situation available.

Because there is uncertainty surrounding whether the subprime fallout will have further implications on other sectors of the US economy, there is still a chance that the volatility in markets will continue as events continue to unfold. For such investors who would rather refrain from taking the risk, it is better to stay out of the market.

B. Another group of investors has simply been stopped out by the recent steep fall in stock prices. Margin calls have forced these investors to liquidate their positions at prices much lower than a couple of months ago.

C. A group of investors have found buying opportunities. They think that the damage has been confined to the subprime sector of the credit market and that the Federal Reserve has taken adequate actions to prevent the ripples from spreading throughout the economy. For these investors, the overall US economy is strong, and Asian economies are still in a position to deliver significant growth in the future.

For these investors, the sharp drop in prices in some stocks has presented a buying opportunity as they believe that the dip is only temporary and that prices will resume once the subprime issue passes and strong corporate earnings push stock prices to their previous highs and beyond.

I personally fall into category C, which category do you fall into?

Temasek & Barclays

Earlier today, it was reported in many news sources that Temasek is taking approximately a 3% stake in Barclays, and that this injection of capital will allow Barclays to raise its bid in its acquisition battle with the Royal Bank of Scotland for ABN Amro. Well, I don't have the exact details of the transaction and I haven't done an exact valuation of ABN Amro, but intuitively, this doesn't look like a particularly good investment.

a. Firstly, there is no gaurantee that a Barclays - ABN combination will generate significant shareholder value over and above hurdle rates as a combined entity, than apart. Many mega-mergers have turned out to be big destroyers of shareholder value, think AOL-Time Warner or Daimler-Chrysler, see this post for more. Temasek is betting that 1. Barclays will be successful in its bid for ABN, and 2. an ABN - Barclays merger will go smoothly and transcend all the corporate culture and other execution issues that often plague mega-mergers.

b. Secondly, Temasek is injecting capital to fuel the 3rd bid in the Barclays-RBS bidding war. Thus, i think it would not be unfair to say that the bid is probably very close to the intrinsic value of ABN to Barclays, and there is quite a bit of a chance that Barclays is paying a sizeable premium. If that is the case, then not only does the Barclays-ABN combination not have to fail, it has to succeed wildly, with a very very narrow margin for error.

Put the two factors together, and intuitively Temasek's injection of capital into Barclays does not make sense to me. Of course I could be wrong, as I haven't done the actual number crunching. But this deal smells awfully foul.

Insurance & Reinsurance

Berkshire Hathaway, Warren Buffett's company, has a significant insurance and reinsurance business, Berkshire Hathaway Re. Reinsurance is insurance that is underwritten by a reinsurer to insure the risks of the primary insurance companies themselves. The risks that reinsurance companies take on are usually called catastrophe risks - so called because they are contracts written to protect the insurance companies from major disasters, such as hurricanes, tsunamis, and terrorist attacks where the damage to life and property is of a very great magnitude.

Reinsurance companies need to be very well capitalised - Berkshire Hathaway easily falls into this category (Mr Buffett has about $40 billion in cash sitting around doing nothing). Without adequate capitalisation, the reinsurance contracts would be of low quality since the reinsurers would be close to insolvency in the event that a catastrophe materialised.

In the case that a single reinsurer is unable to take on all the risk, reinsurance intermediaries, such as Benfield, help to place the treaty contract to multiple reinsurers in order to spread the entire risk amongst several companies, rather than just a single one.

All the major reinsurance intermediaries have a presence in Singapore; I managed to have a chat with a guy at Benfield Asia during a career fair and it was a very pleasant experience.