50 cents on the dollar: Hyundai Motors Preferred Stock

“Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.” – Warren Buffett

For most of us that are used to investing in relatively efficient markets, the following may seem too good to be true.

I have to thank one of our analysts in the Copenhagen Investment Club, Jon for bringing this opportunity to the attention of the group.

Hyundai Motors: The Common Stock

Hyundai Motors was originally part of Hyundai Group, a multinational chaebol headquarted in Seoul, South Korea. The group was founded in 1947 as a construction firm, but expanded into a diverse array of over 60 different subsidiaries that spanned everything from ship building to financial services. However following the 1997 East Asian Financial Crisis the group underwent a major restructuring and split off in to several different companies that each focused on one business area such as heavy industry or property development. Hyundai Motor Group was one of these entities. Although it was initially painful, the split has been good for Hyundai, as it forced the firm to stand on its own two feet. In 2012 Hyundai Motor Group sold 4.41m vehicles. This makes up just over 5% of the global total of 81.8m units. However it is a very fragmented market, and the market leader, Toyota, only produced 9.75m units in the same period.

Since 2009 Hyundai has grown its international sales at a compounded rate of 16% per year compared with 7% for the global market.

Image  

(Source: Hyundai)

Hyundai’s management has made a lot of being named the ‘fastest growing automobile brand since 2005’ by Interbrand. But it does underscore the impressive transformation that the company undertaken from the ‘low-quality affordable’ positioning of the 1990s to the ‘high quality affordable’ segment that it operates in today. Management focus a lot on elevating the brand and consumer perception of the company as a means to continue its international growth.

Hyundai Interbrand

(Source: Hyundai)

Perhaps even more impressive is the company’s operating performance throughout this growth. While its major competitors (Ford, Toyota, Nissan, GM etc.) all report operating margins of in the range of 5-6%, Hyundai has over the past few years reported operating margins that are consistently around 10%. Likewise the company’s net profit margins have clocked in at 8-9%, around 3% above its major rivals.

Hyundaimargins

(Source: Hyundai)

A quick DuPont analysis illustrates how the company has pulled itself up since the global financial crisis and improved margins while paring back leverage.

HYUdupont

    So, here we have a company from an emerging economy that:

  • has transformed itself by moving up value chain,
  • is growing faster than its peers,
  • is more profitable than its peers,
  • and whose management is focused on elevating the company to be the top global auto brand.

If this story sounds familiar then it is for good reason. Hyundai have very clearly sought to emulate the success of Toyota by adopting the ‘Toyota Production System’ but tweaking it to focus relentlessly on speed to market.

HYUpe

Yet with all that it has going for it Hyundai currently trades at a PE of only 8.31 compared with a market cap weighted average for the industry of 13.92.

But I know what you are thinking, this is still an auto company. So lets assume for the sake of argument that the common stock of Hyundai Motors is completely fairly priced as its current 8.31 PE multiple, which is a price per common share of 257,500 Korean Won. http://www.reuters.com/finance/stocks/financialHighlights?symbol=005380.KS

The Preferred Stock: A 52% Discount

So why do the 1st Class Preferred Shares currently trade at only 124,000 Korean Won? http://www.reuters.com/finance/stocks/financialHighlights?symbol=005385.KS

This is where it gets interesting. Hyundai Motor company currently has 220m common shares and 65m preferred shares on issue.

The characteristics of the preferred shares are as follows:

Preferred

The only point I would clarify from the above is that the 1st class preferred shares guarantee a dividend higher than the common of +1%. Whereas the 2nd and 3rd Class preferred shares don’t guarantee a specific value of the extra dividend. From what I can read they instead just guarantee that the extra dividend will be no less than 2% of the par value of the preferred. However in practice it seems that they do apply exactly as listed above e.g. +1% or +2%.

From the Investor relations section of the Hyundai Motors website:

The series 1 preferred shares pay dividends in cash in the amount which is the sum of 1% per annum of par value which is KRW5,000 and the amount of dividends declared on the common shares. The series 2 preferred share pay dividends as declared by the Board of Directors which may not be less than 2% per annum of par value. The series 3 preferred shares pay dividends as declared by the Board of Directors which may not be less than 1% per annum of par value. The option for conversion of preferred share to common share is not included in the series 1, 2 and 3 preferred share.

But in any case, one thing is clear, the preferred shares participate in normal dividends just like their common counterparts and they receive an extra dividend on top.

The dividend calculation for last year is below. Clearly the preferred shares receive a higher dividend. But because the extra % relates to the face value of the shares at issue its important to note that this is not the same as boosting your current yield by 1% since it is now 12 years after issue and they trade well above face value. In 2012 the value of the +1% bonus on Tier 1 Preferred is that the dividend cheque you receive in the mail would be 3% bigger per share held than a common shareholder got (1950KRW compared with 1900KRW).

Preferred2

So we have established that the preferred shares have higher dividends, what else do we know about them?

The preferred shares are:

  • Participating
  • Non-cumulative
  • Non-convertible
  • Non-voting

In other words, they have the same right to profits as a common share and are in substance the same as a normal common share with the added bonus that they pay an extra dividend. The only downside is that they are non-voting.

In a family controlled company such as Hyundai, how much value should we really put on voting rights? In the US non-voting vs. voting preferreds can trade at a discount of around 10%. However with the added bonus of a higher dividend it is also common for these types of preferred shares to trade at a premium to the common stock. We can see an example with the Volkswagen preferred shares.

Summary:

To conclude, the Tier 1 Preferred Shares pay an extra dividend and are currently trading at a 52% discount to the common. This works out to a PE ratio of only 3.98.

You could easily argue that the common stock of Hyundai Motors is already trading at a discount of around 33% just to bring it in line with the multiples of its less profitable, slower growing peers.

Yet here is an opportunity to buy a profitable well managed company that is outperforming its peers, at a 52% discount to an already cheap price.

In the next update I will talk about:

  • Some theories on why this could be so cheap (e.g. liquidity, war fears, fund restrictions, is there anything I could be missing?)
  • What catalysts are there to narrow the valuation gap over time? (& what has happened in other similar situations elsewhere)
  • Who else is talking about this now (there is not much public discussion available out there on this, but some highly respected value investors have started talking about the issue – and taking action – earlier this year)
  • How you actually buy the preferred shares (it is not straightforward or transparent for a normal investor – but it is possible for most)

Start with the A’s

One of my favourite Buffett quotes comes from a 1993 interview with Supermoney author Adam Smith:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

This isn’t hyperbole from the Sage of Omaha.  Warren Buffett would literally read through the financials of tens of thousands of stocks to understand the entire market.  Forget genetics, this is the stuff that genius is really made out of: focused  passionate, back-breaking repetition (for a brilliant book on the topic check out ‘The Talent Code‘ by Daniel Coyle).

Inspired by this I set out to do the same for the Australian small cap market.  This is a much easier task since the market is that much smaller.  The process was straightforward, my investment partner and I would review the entire small cap market (Sub AUD250m) one at a time.  From this list we would cull those with a history of under-performance, or in an industry outside our circle of competence, to arrive at a list of ‘potentials’ for further analysis.  These ‘potentials’ would also be classified into 3 tiers.

We undertook this review in mid 2012 and will be updating the task again shortly (with a little time saving by removing a couple of industries that we don’t look at)

Methodology:

We followed a very similar methodology to that Adam over at Value Uncovered posted in 2011: http://www.valueuncovered.com/a-journey-through-the-pink-sheets-3698-stocks-later. (Actually, we started this in the middle of 2012, long after reading Adam’s post. It was now only after going back to find the link to Adam’s article to reference it that I realised just how similar our method was)

We started with a list of 1,537 <250m market cap companies listed on the ASX.

We classified the companies as follows:

Exploration & Mining: Outside our circle of competence, so an immediate pass.

Finance Industry: Likewise, not within our circle of competence, so pass.

Property Trust: We are looking for operating businesses, so excluded these property investment vehicles

No business: No listed business to be found at the ticker e.g. due to bankruptcy etc.

Governance risk: This was a little subjective – this group was intended to include those companies where we believed we could not trust management due to news from recent filings, corporate structure, or the region where they based their business.

Dilutionary: Businesses with substantial repeated dilution. Doing this review again we may remove this category as most of these companies were also repeatedly loss making as you would expect.

Low returns: We actually killed this category shortly after starting, but I have left it in this summary. It was intended to seperate out companies making profits but which were marginal when compared with the level of capital employed. However we found that: A) these businesses could typically be cut through one of the other filters and B) the level of analysis needed to properly measure ROIC was more than we wanted to do in a first run through.

Loss making: If the company has had a history of losing money consistently for the last 3-5 years we ruled it out. We could always come back to this list if we needed to. There is no doubt that by filtering these out we would have missed some turnarounds. But as we soon found, there were so many terrible businesses that we had to find a way to filter them out. Also it is easy for turnarounds to not turn, and start-ups that have been losing money to continue, regardless of the narrative of success that management are pitching.

The above was mostly ruling companies out, now for the interesting part.

Value Potential: Companies which appeared compelling as value investments in the traditional sense.

Growth Potential: Companies which had the potential for high growth and which appeared at first glance to possibly be within a moat. These ratings were less focused on valuation. The idea being that we keep the best on our watchlist for when they may be undervalued in future. We were basically trying to find a classic ‘Buffett’ company with a strong competitive advantage but which was still a small cap.

Further review: Ok some of these small companies were just too damn interesting. This group was for those companies we couldn’t justify considering as investments but where we just had to read more about them later. A small-cap that wants to launch a satellite and a weapons manufacturer that developed a gun which fires a hail of 500 rounds from a battery 50 barrels simultaneously.

Within Value and Growth we had three tiers of quality as outlined below. We also made some notes on the company’s earnings, share count development, and finally anything else we found interesting.

Value Potential Potential for further analysis as a value investment. Although there was no hard and fast rules here, these companies typically had low PEs, low P/B and high NTA as a % of share price – aka the standard symptoms of undervaluation
Tier 1 Star – a consistent performer that is undervalued or with an intrinsic valuation clearly above market
Tier 2 Stable value – without significant financial distress that appears underpriced
Tier 3 Deep value – may just be beginning to turnaround or which otherwise warrants further analysis
Growth Potential Potential for further analysis as a ‘growth’ style investment
Tier 1 Star – a fast growing company with high potential that should be analysed further
Tier 2 Stable growth – reliable quick growing company which appears fair to moderately undervalued
Tier 3 ‘Dirty growth’ – strong growth potential but may have a current or historical reason for low valuation – warrants further analysis
Earnings Current earnings status
Growing Steadily growing earnings past 3-5 years
Stable Stable earnings
Turnaround Recently returned to profit after making losses
Decline Declining profits
Share count Has this been stable last 5 years or has there been dilution?
Other Other notes or thoughts on the company in order to prompt the further analysis

The Results

First off wow – there are a lot of tiny exploration companies in Australia with nothing but a drilling rig and a dream. This survey was undertaken in mid-2012 when the mining boom was just starting to tail off. So it is possible that some of these companies have now died off. But I wouldn’t be surprised if most are still limping on. We also saw some bizarre (and terrible) businesses that had used mining as some kind of last gamble. You would find a failed company with a business description of fish farming, and which was now prospecting for uranium in West Africa.

There were also as you would expect a heap of just plain bad businesses. The tail end of the small cap space is largely just a graveyard of failed small and mid-caps. The walking dead, just one more dilutionary equity raise away from oblivion. Some others had never really recovered from the weaknesses that the financial crisis exposed.

We did however find a fair chunk of companies, approx. 11% that were interesting from either a pure value standpoint, or which appeared to have the potential for significant growth within a franchise.

The breakdown:

Classification pie chart

Classification Percent
Exploration 49%
Loss Making 21%
Finance Industry 8%
Value potential 6%
No business 5%
Growth potential 5%
Dilutionary 2%
Governance concern 2%
Property Trust 1%
Further review 1%
Low return 0%

Follow up

These quick reviews were just the starting point for more diligent analysis, but were a great screen. By looking at all companies, rather than just those that show up on an automatic stock screen you gain a much better understanding of your market. You begin to quickly appreciate good companies and learn what to steer clear from in others. I highly recommend it.

All of the companies we purchased in the past year were from the value or growth potential groups. We recently purchased one Tier 2 company where a special circumstance drove down the price. Because we had down our homework ahead of time this company was already on our watchlist and we were able to buy a great little company at a discount.

Market Status:Update

I don’t intend to use this platform to prognosticate on the markets next swings, but I want to post a quick follow up on the market status.  Two weeks ago, Howard Marks, co-founder of Oaktree Capital released an excellent memo which concluded with a discussion of the current state of US Equities.  It puts a similar conclusion in better terms than I did.

A few of the key points from the conclusion:

“In the mid-1970s I was fortunate to happen upon one of the first of the time-worn pearls of wisdom that contributed so much to my education as an investor.  It described the three stages of a bull market:

  • the first, when a few forward-looking people begin to believe things will get better,

  • the second, when most investors realize improvement is actually underway, and

  • the third, when everyone’s sure things will get better forever.”

“But the study of market history only makes us better investors if it teaches us how to assess conditions as they are, rather than in retrospect.”

“So now we have a somewhat improved fundamental environment, a generally more optimistic group of investors, and stock prices that are a fair bit higher.  No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one.  I think that existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone.  Thus I’d say we’re somewhere in the first half of stage two.  Pessimists no longer control market prices, but certainly neither have carefree optimists taken over.”

This analysis could just as well describe the Australian market and puts in better terms the sentiment that I described in the last post.  The market is definitely heating up, but does not yet look to be into ‘irrational exuberance’ territory.  The somnolent Bull has stirred, but hasn’t begun its charge. There are objective coincident/leading indicators such as margin lending, or average analyst estimates that we can use to support this view.  However, since ‘market sentiment’ is by its nature a psychological phenomenon many of the best gauges will be subjective, based on a reading of prevailing news/analyst reports/cocktail party banter.

If Stage II of a bull market is the current situation then the best response for investors is to be cautious of being swept up in the rising tide which will lift all boats.  We must maintain the same rigorous standards for investment selection and guard ourselves against any thoughts that ‘this time its different’.  It almost never is.

This is a brilliant memo that is best read in its entirety, and can be found here:

http://www.oaktreecapital.com/MemoTree/The%20Outlook%20for%20Equities_03_13_13.pdf 

The Beginning of the End, or the End of the Beginning?

bullinpamplona

I primarily invest in the ASX market and there has been a lot of talk recently about whether we are in the early phases of a new bull run – or already at the peak.  Is the bull stomping its feet ready for a charge, or have the gains already been made?

I don’t pretend to have any special powers when it comes to predicting the swings of the market.  As a value investor my concern is more about how any gains will impact the ability to buy stocks cheap, or conversely if there is a decline coming, which companies could be about to go on sale.

Over the past 6-9 months I have noticed the difficulty of finding these diamonds in the rough (or cigar butts in the street) has increased.  In mid 2012 my investing partner and I reviewed all ASX listings with a market cap below 250m.  At the time it was relatively easy to find small caps with modest PEs, solid balance sheets, and growth potential.  Looking back on this same list today the ‘top 5%’ small caps we identified at the time have already increased an average of 28%.  The ASX 200 in the same time has also increased 21%.  No matter which way you look at it – the opportunities for a value investor are getting thinner on the ground.  It is enough to make some very astute investors consider sitting this one out.  The market after all is already up almost 60% from its 2009 lows.

ASX200 1999-2013

But having to put in more work to find undervalued stocks is quite different from moving completely to cash and battening down the hatches.

What gives pause to conservative investors is when it appears that the lunatics have overrun the asylum and the bull is about to jump out the window.  There are some signs that the ‘unsophisticated money’ is waking up and wanting a piece of the action:

This from the Wall Street Journal:

“Individual investors are doing more stock trading. Mutual-fund companies are seeing money being put to work in both stocks and bonds. Advisers say they are hearing from investors who had been hunkered down for years but now are feeling more comfortable that another big meltdown isn’t lurking around the corner.

That doesn’t mean greed has completely replaced fear. But as the worries that have dogged investors since the financial crisis finally begin to ease”

Or, put more directly here:

“This is when all the people who have been reluctant and hesitant to invest in the stock market start realizing this isn’t the New York City subway system,” said Birinyi, president of research and money management firm Birinyi Associates. “There’s not going to be another train coming so they better get on board.”

“When we see that everyone is bullish and is able to articulate it, we know the top is near,” said Birinyi. “People are positive, but not quite bullish yet. Wall Street is forecasting a gain of 8% or 9% this year, not 15% or 20%.”

Last week The Australian ran an article “Margin Lending Soars as Stocks Lift” that indicated the bull may be getting started.  Margin lending has is the past often been a coincident or slightly leading indicator of stock market performance.  So lets take a closer look at the current margin lending numbers to put them in perspective.  The Reserve Bank has helpfully kept quarterly figures on the level of margin lending activity in Australia since 1999.  Below we can see that the growth in the total margin lending amount closely mirrored the ASX increases that we saw in the chart above.  The first decline in margin lending in Q3 2007 could have given pause for thought.  But by March 2008 margin calls per thousand customers per day had more than quadrupled, while the total amount of margin lending had fallen by $6bn AUD from one quarter to the next.

Margin Lending Australia v1

In this context the December quarter does not look so precarious.  To be fair, the article in The Australian is talking about activity in the new year, and we won’t see the quarterly numbers for a while.  But if margin lending volume is a somewhat reliable proxy for market sentiment then it does not appear that we are facing a feverish market place just yet.

If we should, as Warren Buffett says, “Be greedy when others are fearful and fearful when others are greedy” then perhaps right now a slightly understated version is apt.  Be brave when others are cautious, and cautious when others are brave.

As usual, we should let the best opportunities decide when and where to invest.  A disciplined value investor will naturally be less exposed to an overvalued market as less opportunities are found.  On the other hand, if you find an investment that is already excellent value, waiting a couple of weeks or months ‘until the market falls’ to purchase is a dangerous game.  You may soon find that the march of progress has left you behind.