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 my last remaining REIT: Daiwa House Logistics Trust (DHLU)

In my 21 June post, I list all the REITs I sold. In the final paragraphs, I explained why I kept Daiwa House Logistics Trust (SGX:DHLU) in my portfolio. However, after some thinking, I also sold this last remaining REIT.   

On 3 August 2023, Daiwa House Logistics Trust presented its financial results for the first half-year of 2023. Link to the PDF of their presentation. The REIT is doing well, with 100% occupancy of its properties reached. The income growth looks satisfactory in Japanese yen terms, while the already low leverage has dropped even more. We can almost conclude that DHLU is a worry-free REIT until we reach the last part of the presentation. Management presents 28 pipeline properties suitable for inclusion into the REIT: 16 in Japan, 12 in Vietnam, Malaysia and Indonesia. These properties are all built by the REIT sponsor Daiwa House Industry Co., Ltd. This is the first time management included such a detailed list of potential acquisitions in its presentation. The message is clear: we can expect acquisitions from this pipeline shortly. This realization made me reconsider my holding. 

As we know, REITs have to finance new acquisitions by issuing new debt or equity. I am not excited about the idea of a rights issue. The share is currently priced at P/B = 0.74, which means a rights issue near the current stock price will be dilutive for the existing shareholders. Let's start with a general observation about P/B ratios. The book value of equity is often prone to manipulation by management, for example, by not writing down goodwill or inventory entries to reflect reality. However, DHLU's assets are modern, fully tenanted warehouses with straightforward valuations. Therefore, I consider DHLU's book value per share a good estimation of the value per share. 

Consequently, when DHLU would issue new shares at P/B = 0.74, it essentially sells a dollar for 74 cents. Warren Buffett buys back shares of Berkshire Hathaway when they are below his estimation of intrinsic value in order to create value for the company. Issuing shares below intrinsic value is the exact opposite and destroys value. Of course, I could participate in a DHLU rights issue to profit myself. However, my existing shares will still be diluted in value. My net benefit will be negative unless I buy a whole bunch of new shares. That would equate to doubling down, a dangerous psychological rabbit hole which I always avoid.

Will management wait until P/B = 1 before expanding the REIT? I doubt it. DHLU was initiated by its sponsor, Daiwa House Industry Co., Ltd., a prominent Japanese developer. The latter's incentive is creating a vehicle to purchase the warehouses it builds. The developer can then use the sales proceeds to build more properties, which is its primary business. The sponsor is not in the business of offering an optimal financial product for third-party investors. Of course, this observation applies to most REITs, and legal restrictions are in place to regulate the resulting conflicts of interest. However, it's good to be clear about the sponsor's incentives. Daiwa House Industry Co., Ltd has a stake of only 12.5% in the DHLU. The Related Parties Shareholding is one of the few weaknesses REIT-TIREMENT flags in its analysis.

Lastly, I have some concerns about this REIT's momentum. The REIT is among the last to be listed during a long Singaporean REIT glory period. The overall sentiment around REITs has turned more negative lately. DHLU's investors are mainly Singaporean private retail investors. We know this from the Annual Report 2022, in which a list of the Twenty Largest Unitholders are mostly nominees connected to retail brokers in Singapore. Private retail investors generally don't hedge currency risks. This means DHLU's share price is susceptible to the JPY/SGD exchange rate. Exchange rates are impossible to predict.

Adding to its fragility, DHLU has a modest SGD 400 million market cap. It's hard to see how DHLU would leap to the premier league of large REITs suitable for institutional investors other than by issuing shares and acquiring warehouses. Lots of them. Perhaps all the 28 pipeline properties. However, as explained, I do not support such rights issues. Not to even talk about issuing debt, which can be even more risky considering the current interest rate environment. 

In summary, we have a paradox. DHLU needs to grow, but I don't want them to expand. Damned if they do, damned if they don't. I chose to step aside.

Disclosure: Sold out Daiwa House Logistics Trust (DHLU)

More cosmetics: bought Creightons PLC (LSE:CRL)

My journey into micro-caps has started. Creightons could even be called a nano-cap with a market cap of only 22 million GBP. My market cap rule is not to buy companies below 100 million USD. I am scared that an incident such as a flood, a fire, theft, or a fraudulent employee would disrupt a small business too much and damage it permanently, even with proper insurance in place.

I decided to take a chance with Creightons anyway. The company has been under sensible and conservative management for at least 20 years. If you want to get an impression, YouTube provides an online presentation delivered by the current management. Financially, the company offers everything a value investor could wish for: insider ownership, high ROIC, free cash flow, little debt and consistent growth. The company is too small to be investable for professional funds. That may be the reason why the stock valuation seems low. I bought at an average of 0.32 GBP between June and August 2023, during which I accumulated a 4% position in my portfolio. Based on my DCF calculation, I estimate the stock's fair value to be 0.55 GBP.

Creightons invents, produces and distributes cosmetics and personal care items. They supply British supermarkets like Tesco, Sainsbury's and Boots with their house brands in these categories. They also do contract manufacturing, which means they can deliver one-off inventory orders placed by third-party personal care brands. For a detailed description of Creightons, I refer to this blog of Eddie Lloyd. A year later, Eddie wrote an update which includes a valuation model.

Another long-term shareholder is Adrian Ford of the Overlooked and Undervalued substack. Adrian highlights an important change in Creighton's strategy. The company bought and developed several own brands: Feather and Down, The Curl Company, Balance Active and Emma Hardie. These brands have the potential to grow.

Especially Emma Hardie is interesting. I did a quick and informal online review of this premium skincare brand. Emma Hardie's presence on TikTok is small compared to large brands like L'Occitane, but there are still a few dozen reviews, instruction clips and promotional clips. Emma Hardie has 63,000 followers on Instagram. The Amazon user reviews of their top-selling products are overall good. Creightons understands it has to work with these new media channels. It is nothing like the cases of HAI-O and Able Global, where the lack of presence on social platforms is unsettling.

I am betting that Emma Hardie or one of the other brands will break through internationally and drive Creightons' revenues upwards. Should the team fail, the house brand and contract manufacturing business will still be there. Heads, I Win; Tails, I Don't Lose Much.

Disclaimer: This investment is risky because of Creightons' small market cap and illiquidity. Do not invest without doing your own research first. The share trades under the SETSqx trading system of the LSE. This means there is only trading at 8am, 9am, 11am, 2pm and 4:35pm UK time. 

Disclosure: Long Creightons. Sold HAI-O and Able Global earlier this year.