Sold off: infrastructure assets

When I started this blog, I bought shares in three categories: consumer staples, infrastructure-related companies and online portals. Nowadays, I only entertain the first category. First, I sold off all my tech companies during their wild share price movements in early 2023. The volatility made me realize that I don't fully comprehend what drives the valuations of these tech giants. In the case of Alibaba and Tencent, for example, the Chinese government has a particular interest and involvement, which seems impossible to gauge. In the case of Meta Platforms, there were concerns about the costs of its Metaverse, which I found equally impossible to evaluate.

Mid 2023, I also started selling off my infrastructure-related companies and REITs. These types of stocks are easier to understand than tech. However, another reason to avoid this sector emerged: increasing debt burdens. Hard assets are almost always bought with leverage. I believe that interest rates will be higher for longer. I started by selling off particularly vulnerable companies like Ho Bee Land. Over the months, I grew increasingly uncomfortable with leverage, even for my holdings with relatively strong balance sheets. I scrutinized all my infrastructure-related holdings individually and made the following sell decisions.

Sold: Anhui Expressway Co Ltd (HKSE:00995), Qilu Expressway Company Ltd (HKSE:01576), Jiangsu Expressway Co Ltd (HKSE:00177)

The 'higher interest rates for longer' mantra may not apply to China, at least not for now. These toll road operators are not under immediate debt pressure, but I had other concerns. Chinese toll road operators generally do not disclose their concessions' end date. However, we can compare the total yearly amortization of the concession value with the total remaining concession book value. We then realize the average remaining concession is often only 10 - 15 years. After expiration, the toll road operator has no assets left unless it negotiates renewals for its concessions or gets new concessions. It's hard to gauge whether concessions will be renewed and at what price. Consequently, it's hard to establish a valuation for these operators. It's like a discounted cash flow formula with or without a terminal value. As I argued in the industrial S-REITS article, that means a huge difference in the DCF calculation result.  I find the valuation calculations too uncertain to hold on to these toll road operators. 

Sold: Qingdao Port International Co Ltd (HKSE:06198), China Merchants Port Holdings Co Ltd (HKSE:00144) 

Qingdao Port announced a restructuring of its ports in the form of a combination with sister companies. They issued a 32-page document describing the transactions in legal language. Honestly, I could not get the gist of it. Qingdao Port is a Chinese state-owned enterprise (SOE). The transaction may have some political purpose rather than a business optimization goal. But again, I am puzzled about what was going on in the first place. I found that reason enough to sell. In the same light, I sold off China Merchants, also an SOE with investments outside China that I found hard to justify business-wise.

Sold: Suria Capital Holdings Bhd (XKLS:6521) 

Another port operator, but this time in Malaysia. It is also an SOE, majority-owned by the state of Sabah. The holding contains all ports in Sabah and, as a monopoly, is doing well. However, the growth thesis is based on a large development project next to the port of Kota Kinabalu, which will offer residential and commercial properties. I have no particular insights into the Malaysian real estate sector. Frankly, I should have thought of that before buying the share. Suria Capital has no debt and may be an interesting share for investors who do have detailed insights into the sector.

Sold: China Tower Corp Ltd (HKSE:00788)

Back to mainland China. China Tower Corp is a joint venture of the three leading telecom operators within China: China Mobile, China Telecom, and China Unicom. These three operators sold their telecom towers to China Tower and leased them back. This is a standard construction within the telecom industry, but in this case, all four parties involved are SOEs. The construction makes sense, but there are also opportunities for transfer pricing. If not now, then in the future. It's hard to determine whether your interests as a foreign minority investor will always be considered.

Sold: CK Hutchison Holdings Ltd (HKSE:00001)

Well-known Hong Kong-based holding linked to the Li Ka-shing family. I held the share for over five years, during which its price dropped consistently. Thankfully, my overall loss is limited to only a few per cent, thanks to the high dividend payouts. 

The interest coverage ratio (ICR) of the holding is around 4. The debt burden is not an immediate threat. Still, you could calculate a worse ICR depending on how you account for associate companies' income and debts. CK Hutchison's multiple holdings structure is complex. In any case, however you calculate the ICR, it has been dropping recently. It could fall further, considering CK Hutchison was still borrowing at an average interest rate of only 2.7% until recently. The credit ratings from Fitch and Moody's for Hutchison's debt are still solid, resp A- and A2. Even so, at the moment of selling, CK Hutchison had the highest debt levels among my portfolio companies. 

Sold: Hutchison Port Holdings Trust (SGX:NS8U)

Together with CK Hutchison, I also sold its associate Hutchison Port Holdings Trust (HPHT), a business trust listed in Singapore. Its debt burden is increasing. I calculated an ICR of about 3.7 on 30 June 2023, but a lot of debt has to be re-negotiated soon, which will be at higher rates in the current interest rate environment. Profits will increasingly be re-directed from dividends to interest payments and debt repayments. 

Let me also address the assets' life expiry issue for this trust. HPHT indicates that the concessions for its ports expire from 2038 to 2055. They don't provide the details to calculate a weighted average expiry, but in the case of its Hong Kong ports, it is June 2047. (I assume this date is related to the expiry of the Special Administrative Region status of Hong Kong.) On the other hand, HPHT currently offers a dividend yield of more than 10%. The investor seems sufficiently compensated for the risk that the port concession will not be extended to HPHT. The debt burden, rather than the concession expiries, turned me away from the stock.

The low ROIC of infrastructure stocks

To conclude this blog, an observation about another issue: low return-on-invested-capital (ROIC) yields. Almost all infrastructure-related stocks have low ROIC yields; let's take 4% as an example. This does not immediately seem a big issue when you buy the stock at a price-to-book lower than 1. Infrastructure-related stocks are often quoted at P/B < 1, meaning that the return-on-investment of your recently invested dollar is higher than 4%, for example, in the form of a 10% cash dividend yield, like in the case of HPHT.   

So far, so good, until your new company starts making new investments to either expand into new assets or refurbish existing assets. These new investments are most likely again at the typical low 4% yield for infrastructure and real estate. The free cash flows for the high dividends you enjoyed will be redirected to investments with a 4% ROIC, which you probably do not appreciate. In the long term, your low P/B bargain becomes a trap. I believe this is the mechanism Charlie Munger referred to in the following quote.

Over the long term, it is hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you re not going to make much different than a six percent return even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result. So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects. How do you get into these great companies? One method is what I'd call the method of finding them small - get 'em when they're little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it's a very beguiling idea. If I were a young man, I might actually go into it.

(Charlie Munger, Poor Charlies Almanack, 3rd Edition, Page 206. "The art of stock picking")

Disclosure: No positions in Alibaba, Tencent, Meta, Anhui Expressway, Ho Bee Land, Qilu Expressway, Jiangsu Expressway, Qingdao Port, China Merchants Port Holdings, Suria Capital, China Tower, China Mobile, China Telecom, China Unicom, CK Hutchison, Hutchison Port Holdings Trust, and Wal-Mart 

Sold out: Ho Bee Land Ltd (too much debt)

 I liquidated my Ho Bee Land (SGX:H13) position on 18 Apr 2023 for SGD 2.21, realizing a loss of ~20%, including dividends received. Considering the rising interest rates, I fear Ho Bee Land's debt is too high. 

Ho Bee Land is almost a REIT considering the high amount of investment properties compared to the projects they still have in development. Like a REIT, its net debt level is also relatively high at almost 13 times EBITDA. The interest coverage rate is 2.9, which is low but not immediately alarming. However, when you flip through the Ho Bee Land 2022 Annual Report, you learn that it was borrowing at rates of only 1.02 - 1.61 % (page 74) in 2021. Already in 2022, this range expanded to 1.05 - 5.05 %. What would eventually happen if all their loans were charged a 5% interest rate or higher? When your finance costs rise fivefold, the lease payments of the tenants will also have to grow five times just to keep the interest rate coverage stable. 

Raising rents fivefold is highly unlikely, even in an inflationary environment. However, Ho Bee Land has another trump card to play: their borrowings are currently hedged with interest rate derivatives. In 2022, we can already see these derivatives creating value (annual report page 75), and they will keep working for them if interest rates stay high. Unfortunately, we must consider what will happen after these hedges expire. All derivatives are tied to specific loans, which mature from 2023 - 2026 (page 74). These loans will have to be refinanced, and obviously, you can not continue to lock in a 1% interest rate with derivatives when the general interest rate environment is already much higher. Thus, Ho Bee Land can only pray that the interest rates will drop again in the coming years. Here, we arrived at the crux of my fear.

Most of Ho Bee Land's investment properties are in the UK. I could not find a reliable source for historic commercial real estate lending rates. The graph shows the historic Bank of England Bank Rates. It is the interest rate that banks receive for holding money with the BOE. This data will also prove my point.

(Source: excel data from https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp)

We can see three different clusters of interest rate levels.

• Fluctuating around 11% from 1973 till 1993

• Fluctuating around 5% from 1993 till 2009

• Near 0.5% from 2009 till 2022

Apart from the transition years (1993 and 2009) and 1978, for some reason, there are no years where the rate significantly differs from the year before or after.

From observing this pattern, the current 5% rate is unlikely to be followed by a reversal back to the 0.5% regime. Apart from another 1978 type of exception, it is likely that we will see the 5% level sustained over a longer term. In other words, it looks like there is a new regime of mid to high interest rates. This is a bit of an engineering type of pattern recognition. If you have strong economic reasons to disagree that interest rates remain elevated for longer, there is no reason to worry about Ho Bee Land. Their balance sheet is quite strong now. They will gracefully survive a short period of high interest rates. However, if you agree that there might be an interest rate regime change, the coming years look bleak for Ho Bee Land. Not only for them but also for many REITs and other real estate holders facing the same issue: lots of debt with low interest rates, locked in for a few years but expiring in a potentially higher interest rate environment.

One remedy for leveraged property owners is to simply sell off properties and repay the debt until it is no longer a burden. But who is going to buy those properties from them? Even if it is a high-quality office in London? Most other real estate investors are also leveraged and facing the same rising interest rate issue. Adding more fuel to the fire, cap rates generally rise together with interest rates, so estimated values of properties will go down. Ho Bee Land actually started selling off some properties in Singapore. However, I wonder if this strategy can reduce the debt burden enough to stop worrying about it. (NB: Ho Bee Land stated that those property sales are unrelated to debt pressures.)

Disclosures: I am not a real estate professional. Nothing written here is investment advice. I sold off Ho Bee Land and all my REITs except Daiwa House Logistics REIT. I will give more details in future blogs.

Breaking my own checklist rules

Earlier, I revealed my Stock Buy Checklist on this blog. Today, I will review the stock holdings violating this checklist's rules. This gives me a chance to explain some rules in more detail and the reasons for violating them sometimes.

United Plantation Berhad is not in the consumer staples or infrastructure industry.

My most constricting rule is to only buy consumer staples and infrastructure-related companies. United Plantation Berhad is the only real exception to this super rule. It runs oil palm plantations, counting it as a commodity producer. They sell some consumer products like NutroPalm Golden Palm Oil through their associate Unitata, but these activities are minimal. I decided to buy United Plantation shares anyway because its operations are run very efficiently. There are only so many great companies on the Malaysian stock exchange.

Several Malaysian companies have a market cap below 100 mln USD

InNature, Able Global, HAIO/Beshom, Suria Capital, and Spritzer are all flirting with the 100 mln USD market cap threshold. All these companies were well above this threshold when I bought their shares. However, the Malaysian Ringgit has devaluated against the US Dollar since then. That's not enough reason to suddenly remove these companies from my portfolio. The purpose of the market cap rule is to avoid buying a company so small that a black-swan event like a fire, a flood, or a fraudulent employee might threaten the continuity of its operations. In that light, it is not really relevant that a market cap goes from 100 to 98 mln in USD when the actually used currency is the Malaysian Ringgit.

Natural Food International Holding Ltd has a market cap and book value below USD 500 mln.

This company produces cereals and other healthy food products in the Chinese market. The book value is not even 200 mln USD, which is far below my threshold rule for mainland Chinese companies. As I wrote above, the market cap rule is set for my peace of mind regarding the stability of a company. In the case of Natural Food, we have the presence of US food giant PepsiCo as a significant shareholder. PepsiCo is also represented by a board member. I will assume that PepsiCo did due diligence into Natural Food before buying its shares and will continue to keep an eye on developments within the company.

Camellia PLC depends on operations in India and Africa for most of its revenues.

I focus my research on Asia Pacific, Europe, and US-based companies. Although Camellia is based in Kent, United Kingdom, its lands, gardens and plantations are located worldwide. It owns a few brand names, like Jing Tea and Goodricke. However, the bulk of its production should be considered agricultural commodities. Finally, Camellia is a conglomerate. So, here we have three violations of my checklist rules: 1. geography, 2. conglomerate, and 3. commodity-related. I bought Camellia long before I compiled my checklist. Likely, my experience with this company's poor management and its collapsing share price inspired some of the checklist rules. I will sell this share to finance an investment idea that conforms to my checklist better.

Boustead Singapore, CK Hutchison, Saha Pathana, ABF, F&N, and LG H&H are conglomerates.

Talking about conglomerates, I have a few others in my portfolio, although my checklist encourages me to avoid them. Like Camellia, I bought most of these shares before I wrote my checklist. In those days, I still had a value-investing approach where you would calculate the sum-of-the-parts of the different businesses and assets and then compare the grand total with the market cap. You often see a big 'holding company discount' making the share seem like a bargain. Value investing blogs and fora keep pouncing on such 'deep-value bargains'. The problem with this approach is that the discount usually does not close. The management and majority shareholders are simply not interested in closing the discount. You will remain stuck in these poorly performing conglomerate shares until management changes its priorities and reorganises the company's structure and activities, if ever. 

This is not a concern for the six conglomerates mentioned in the title. I gladly hold them for the long term, even if they remain conglomerates. Saha Pathana, Associated British Foods (ABF), and LG H&H are primarily active in consumer staples which is my portfolio focus. The same goes for Fraser and Neave Ltd (F&N), which also has a printing and publishing division, but it is only responsible for 11% of the total revenues within F&N.

CK Hutchison has consumer staples operations through their retail activities (A.S. Watson) and infrastructure-related assets with their ports and mobile telecom operators. This fits within my 'consumer staples and infrastructure' philosophy, although CK Hutchison also has investments in sectors such as utilities, pharmaceuticals, media, and energy, of which I have no knowledge. 

The same goes for Boustead Singapore Ltd, which is active in software, energy, and medical services, besides developing business parks through the listed Boustead Projects subsidiary. This share is also a relic of my deep-value investing days, long gone. The share price has been going nowhere for the last ten years, but the dividend yield is reasonable, and I trust the management. Because of the Boustead Projects activities, the stock fits in my infrastructure bucket. Although Boustead's other activities do not fit my philosophy, they seem stable.

Ho Bee Land and Boustead are developers.

Adding to my Boustead objections: its most significant subsidiary Boustead Projects, is a developer, not a REIT. I typically prefer a REIT over a developer because developers tend to have very cyclical earnings, and it is difficult to get reliable profit projections on the properties still under construction. In contrast, properties in a REIT portfolio are already operational and easier to value. In addition, the various regulations governing a REIT limit the opportunities to abuse minority investors. In fact, Boustead Projects recently initiated a REIT (Boustead Industrial Fund), but unfortunately, it is not publicly listed. 

Ho Bee Land is also a developer, but most revenues come from renting out its existing investment properties. It owns an impressive portfolio of offices in London and Singapore. Shareholders have repeatedly pressured management to divest this portfolio into a REIT. At a minimum, this will yield tax benefits, but it might also benefit the share performance. However, management has yet to honour this request. Ho Bee Land does not have many development projects compared to its portfolio of investment properties, so the company is safe enough for me to keep holding. The company seems significantly undervalued too.

DFI retail group and Imperial Brands have more debt than equity.

Two companies in my current portfolio violate the debt/equity < 1 rule. However, the Interest Coverage ratio in both cases is more than sufficient. Dairy Farm (DFI) runs supermarkets and restaurants. Most of its debt is the liability for its future store leases. According to current account rules, DFI has to list these under 'debt', but store lease liabilities are much safer than actual debts resulting from loans. When a company takes out a regular loan, it is to finance a new factory or some new business activity where the ultimate payoffs can only be guesstimated. In contrast, the expected yields on long-existing retail store rentals are much more certain than a new factory or a new business activity. I don't worry much about these store leases for existing restaurants, convenience stores, and supermarkets.

Imperial Brands is a tobacco company. The balance sheet seems weak at a quick glance, but incoming cash flows from smoking-addicted customers seem reliable and will relieve the debt burden over time. The management sets a "target leverage towards the lower end of our net debt to EBITDA range of 2-2.5 times." They are at 2.4 now and still reducing debt. If they indeed reach a net-debt/EBITDA = 2, that looks pretty safe. Fitch rates their debt as BBB. I am not worried but will keep an eye on debt repayments.

Luckin Coffee pays no dividends.

I prefer my holdings to pay dividends, but it is not a strict requirement. For growing companies, it usually makes sense to skip dividend payments and re-invest profits into the business instead. Luckin Coffee invests in the fast expansion of its coffee shop chain. 

Luckin Coffee is listed as an over-the-counter (OTC) stock.

OTC and Pink Sheet stocks are hardly regulated. I had never bought an OTC stock before Luckin, and I don't plan to do that again. There is a high chance of running into fraudulent companies in these markets. Luckin Coffee had also admitted to committing fraud when I started looking at the stock. My research mainly focussed on whether the fraud could be even bigger, as was exposed already. So far, that has not proven true, and the stock price has been going upward throughout 2022.

When I bought my Luckin stock in May 2022, the fraud-committing people were already removed from management positions. Luckin was entering arrangements to compensate the defrauded parties. My thesis is that Luckin can successfully move on from this dark era. It was a gamble when I took my position, but I considered that the most prominent Chinese coffee shop chain should be in a portfolio called The Coffee Can APAC. As I am writing this in December 2022, we can witness Luckin Coffee solving its legacy fraud issues while growing its operations quickly. I hope Luckin can re-list soon on the Nasdaq, preferably with a secondary listing in Hong Kong.

ABF's Primark is a fashion brand. 

Even worse than being listed as an OTC stock is running a fashion brand. I am not a follower of fashion myself, but I am aware that brands come and go, sometimes very quickly. It is impossible to assess those cycles in advance. Hence, I usually avoid investing in fashion retail companies. Nevertheless, in the case of Associated British Foods (ABF), I got comfortable with their Primark business, which delivers about half the profits for the overall conglomerate.

ABF started the Primark clothing stores initially in Ireland, then Great Brittain, then Europe, and recently jumped over to the United States. I visited several stores myself. Primark sells cheap clothes, packed to the brim in large stores at city-centre, triple-A locations. Customers love it, judging from the Google Map reviews and the consistent queues to pay at the cashier registers. The Primark brand signals a low price level and straightforward buying process rather than style and fashionability. I am confident that Primark customers will keep going to its stores as long as Primark sticks to its approach. It may be successful in Asia and South America too.

Daiwa House Logistics REIT is active in Japan. 

I am still contemplating whether I want to invest in Japanese companies. The demographics in this country predict a terrible economic future. Japanese company managements are often not shareholder friendly at all. Dividend payments are low and charged with a steep 20.42% withholding tax. Japanese stocks are generally priced relatively high from a value-investing perspective.

Daiwa House Logistics REIT seemed reasonably priced at its IPO and has an impressive portfolio of large, modern warehouses. Despite all properties being located in Japan, the REIT is a Singaporean entity. This means there is no dividend withholding tax for individual investors. Also, the Singaporean REIT regime requires the REIT manager to pay out at least 90% of earnings. This restricts the REIT manager from hoarding excessive cash on the balance sheet as many Japanese companies tend to do. For these reasons, I bought the REIT a few months after its IPO. My doubts about Japan's demographics and economic future still stand. Is this a Coffee Can REIT that I can hold for decades while sleeping well?  

Dairy Farm and Hutchison Port have sizeable operations in Hong Kong.

I reduce my portfolio exposure to companies that generate a lot of their profits from within Hong Kong. The city's future has been clouded for a few years already. Let's not get into the political details here, but it looks like the role of Hong Kong as a gateway into China is diminishing. Currently, Hong Kong is still ranked very high on surveys that estimate the cost of living. However, measured over the medium and long term, I wonder if much of this wealth may disappear. 

My holding Dairy Farm derives a lot of income from Hong Kong consumers. The management does not disclose the exact amount, but by combining other metrics, I estimate it to be about a quarter of total earnings. On the other hand, Dairy Farm is also exposed to many retail opportunities in China and South-East Asia. These could balance out deterioration in the Hong Kong market.

Hutchison Port Holdings Trust derives a lot of income from its Hong Kong port. This is obviously based on the geographical location as a deep-sea port which will remain unchanged. Different demographical and political circumstances are unlikely to affect these port operations.

Conclusion

I do not use my checklist blindly. As illustrated in this article, I break my rules when there are good reasons to do so. It is more important to keep an eye on the underlying concerns behind the rules. I felt some of these concerns while preparing and writing this article, for example, in the case of my last remaining Japanese stock, Daiwa House Logistics REIT. In addition, I feel uncomfortable around companies where several rules are broken simultaneously, as with Camellia and Dairy Farm.