The Hong Kong protests have carried on for about 6 months at this point in writing.
- Many commercial property operators are feeling the heat with office transactions at their lowest level since 1996 exacerbated by a sharp fall in tourism and retail sales.
- Property stocks are among the hardest hit, with the Hang Seng Mainland Properties Index falling 14.2% since mid-April.
A point on the psychology of value investing
The optics certainly look bad. This is often the case when you are buying undervalued stocks.
- Investors who wish to buy a severely undervalued stock must be willing to look at zones where there are trouble.
- They must be able to sift out the treasure among the trash and they must be comfortable doing it.
- They must also understand that what they buy can obviously dip lower, but they must know the turnaround situation (in this case HK protests lifting or abating and business cycle resuming) – which is where the money is made.
Fundamentally, deep-value investing, as we are going to talk about in this article is about identifying good stocks which have been unfairly or unreasonably dragged down (in terms of share prices), buy them, and wait for the situations to recover.
The Strategy: Conservative Net Asset Valuation
We will utilize a strategy called Conservative Net Asset Valuation1 (CNAV1), which is used especially for property counters.
Let me start by giving a quick summary of this strategy.
Built on the back of Benjamin Graham’s investment concept, the Conservative Net Asset Valuation Strategy specifically seeks to buy companies which are undervalued compared to their Assets. The CNAV1 value is always lower than the Net Asset Value (NAV) of the company since it excludes or otherwise reduces the emphasis on certain assets found on the company’s balance sheet.
We cover the strategy in greater academic detail under our Factor-Based Investing Guide.
Running this strategy in tandem with our proprietary stock screener, we found 3 companies which have immense profit potentials while still delivering relatively decent yields.
Let’s take a quick look at each of them.
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#1 – Hongkong Land (Property) / Yield: 3.49%
Founded in 1889, Hongkong Land (SGX: H78) is a leading property investment, management and development group. It owns and manages more than 850,000 square meters of premium commercial and residential property across Asia.
Out of this, some 450,000 square meters form up the company’s Central Hong Kong portfolio with the remaining of Hongkong Land’s portfolio spread across prime locations in Singapore, Beijing and Jakarta etc. With such a high exposure to Hong Kong, the impact of the protests has led to a 22.4% drop in share price over the last six months.
With that, we found out that Hongkong Land is trading with a NAV of US$16.428 and CNAV1 Value of US$12.41 upon running our convenient proprietary screener. In this instance, where there is a discrepancy between CNAV1 and NAV, it is best to opt for the conservative valuation approach – CNAV1.
Even when we adopt the more conservative approach, HongKong Land’s CNAV1 US$12.31 target still offers an upside of 125% from its share price of US$5.51, which would suggest that the stock is significantly undervalued.
Let’s zoom into the other 2 stocks we identified.
#2 – Langham Hospitality (Hotel) / Yield: 6.72%
Langham Hospitality Investments (HKSE: 1270) is an investment holding company with ownership and investment in hotels across Asia. The company’s property portfolio currently consists of three premium hotels within Hong Kong.
Given its hotel rates and occupancy levels have fallen from direct exposure to a decrease in tourism, as well as the overall instability on the streets of Hong Kong, it is unsurprising to see the share price has plummeted 34.5% since mid-April.
Once again, if we run the Conservative Net Asset Valuation Strategy, we can see that Langham Hospitality Investments has a potential upside of 188% when we compare to its CNAV1 of HK$6.09.
Unlike the last example, the company’s CNAV1 value is pretty similar to its NAV. This suggests that almost all of its assets are either property or cash and cash equivalents. It also means that the price targets and potential profits for the stock are about the same.
Last but not least, we check out the 3rd stock in our list.
#3 – Wing On (Retail) / Yield: 2.77%
Wing On Company International is another investment holding company, based in Hong Kong. Its focus is somewhat different to that of its peers, as it owns and operates department stores sharing the same name. The company also has an investment segment, where it leases commercial properties in Hong Kong, Australia and the US.
Retail sales in Hong Kong have been plummeting in recent months, including the worst monthly decline on record. Recent data shows that department store sales are down 30% year-on-year. This goes some length to explain the share price slide for Wing On, which is down 18% across the last six months.
In this example, the NAV for Wing On has a modest premium over the CNAV1 Value, so it is prudent to use the latter conservative approach. Its CNAV1 value of HK$59.97 indicates a potential profit of 198% when compared with its share price of HK$21.80.
By now, many readers would probably have a mind-boggling question on how to calculate CNAV1 value of a stock. With that, we dive right into the calculation using one of our examples, Hongkong Land (SGX: H78).
Calculations: How do we know that Hongkong Land is undervalued?
As per the screening above, we have established that Hongkong Land is massively undervalued based on our CNAV1 calculations. To show you how the CNAV1 calculation works, let’s do a step by step walkthrough for HK Land as a case study.
Let’s dive into the calculations:
The first step is to calculate what assets the company holds. You can also check out our past writeup here.
However, it is important to recognize that we filter out any poor quality or unreliable assets. For property counters, we tend to only focus on investment properties, as well as cash and cash equivalents.
With this in mind, this is how its CNAV1 is calculated:
- Investment properties: US$33,712.1 mil
- Bank balances (cash): US$1,874.4 mil
The total of these Conservative Assets = US$35,586.5m
Next, we need to calculate our Total Liabilities.
The annual report from Hongkong Land does not list a total value, rather it itemizes current and non-current liabilities.
Nonetheless, Total Liabilities = USD$6,593.5m
To determine CNAV1, we need to deduct Total liabilities from our Conservative Assets.
When we do this, we are left with CNAV1 = USD$28,993m
To determine CNAV1 per share, we must retrieve the number of shares on issue. You will find this under note 19 accompanying the financial statements in the 2018 Annual Report -> 2,333.9 million shares.
Finally, divide the conservative assets by the number of shares, and you will get a CNAV1 per share of around US$12.42. Hongkong Land is currently trading at a price of US$5.51, which is a 56% discount to CNAV1 per share.
Barring some minor rounding differences, our calculated CNAV1 is the same as the figure automatically calculated if you employ our proprietary platform, as shown above.
Once again, the reason for this is because our investment here is a strategic one. We are investing in the company as an asset play, where we want to own the assets for cheap and the business for free.
Further Stress Tests
Is it sufficient to simply rely on this one measure to assess whether you can buy this undervalued stock?
Of course not.
In fact, the company still has to go through the following 3-step stress test (albeit these will not be covered in detail in today’s article) which we have termed as POF Score:
While we emphasized an asset-based valuation, we look into earnings as well because the company should be making profits with its assets. As you may have realized by now, if we pay a fraction for its valuable assets, the future earnings all come to us for ‘free’.
- Operating Efficiency
Next, we also have to look at the company’s cash flow to ensure the profits declared are received in cash. Positive operating cash flow will ensure the company is not bleeding cash while running its business. If it does, the CNAV will decline as the company seeks to raise cash by selling assets and / or borrowing money.
- Financial Position
Lastly, we will look at the gearing of the company. We do not want the company to have to repay a mountain of debt going forward, especially if interest rates rise since it may eat into their operating cash flow, or worse, deplete their assets.
On top of the above, there are also more things to consider like knowing when to take profits and assessing the company’s economic moats, management team, insider ownership, business effects and more. –> this is also likely to take the longest for most people. We take an average of 15 minutes to 1 hour to do this.
In short, what seems to look like a long exercise of calculating a particular company’s CNAV1 value can be done in mere seconds; leaving you plenty of time to go through the qualitative side of the company.
The fundamental point of this article has been to deliver to you two simple learnings.
#1 – Deep value is found in places of conflict or stressors or bear markets or otherwise deemed trashy areas, where institutions don’t really look, where analysts don’t really cover and where it is almost universally avoided. You must learn to lean against the herd and stop following it in order to truly find stocks which have been unfairly and unreasonably lowered in value. The money is made whenever there is a logical break between reality and stock market prices. Your job is to find that break and exploit it. And you must be able to identify the turn around points and/or otherwise be rewarded for holding the stock and risking your capital. The stocks above all pay above 2.5% yields, which means you at least beat inflation (somewhat, if not, at least you match your ordinary account gains) while your money is tied up in the stocks. All three companies are also undervalued primarily because of Hong Kong’s current situation, which could correct in our 3 years waiting time. Can a protest go on for 1 year? Maybe. Can it go on for 3 years? That’s a much marginally reduced chance of it lasting that long. And that is my turn around (or if the stock price appreciates to NAV).
#2 – Having a formula to calculate the value of a stock with three simple steps as well as a simple checklist to identify if the company is in good health can help you invest with better peace of mind. Why is this so? Because you know where the real value of the company is! If you know the share price is worth $10 and you bought for $2, why should you care when the share price fluctuates up and down everyday? Just check to know when the share price climbs and check to see if fundamentals have deteriorated. In other words, when you know what you pay for, you have nothing to fear beyond bad luck, or in the case of Saudi Araco, a missile strike –> which is also beyond your ability to predict.
I hope this has been a valuable read for you. And I sincerely hope that our method of valuation allows you to invest better knowing what the price you should be paying is and isn’t.
If you are interested in how we use these fundamentals to further hunt stocks that can deliver truly life-changing capital gains, you can register for a seat here to see a live demonstration.
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Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.