The focus of most analyses on stocks tends to be on profit forecast and financial ratios as the basis of their valuations. Less frequently mentioned are qualitative factors such as the integrity and governance of management and controlling shareholders — factors that are equally, if not more, important in driving shareholder value in the long run. Last week, we wrote about how the Covid-19 pandemic was testing times for businesses, given the high degree of uncertainties — but also times when investors could best assess management capabilities, mettle and professionalism (see “Windfall profits can also be a curse to shareholders”, July 3). Windfall profits during the pandemic can turn into a curse — and nowhere is this more apparent than at integrated pharmaceutical group Pharmaniaga.
The company was widely perceived as a winner at the outset of the pandemic, its share price surging (around mid-2020) after it was identified to undertake the “fill and finish” process for China’s Sinovac vaccine once available. It subsequently signed a contract to supply 12 million doses to the Malaysian Ministry of Health, which it delivered by July 2021. At this point, the government announced that it would stop administering Sinovac vaccines once its existing supply was depleted, as it had secured enough vaccines for its vaccination programme. The number of vaccines administered daily in the country peaked in August 2021 and was falling rapidly. Pharmaniaga, however, was still purchasing-producing and, even though the government took another eight million doses off its hands, inventory continued to rise until end- 2021. The company took a massive RM552.3 million ($160.32 million) write-down of its vaccine stockpile in 4Q2022, completely wiping out its shareholders’ equity (see Chart 1).
Pharmaniaga is now classified as a PN17 company, one that is financially distressed. The debacle speaks not only of poor judgement but also extreme imprudence on the part of management — in its decision to finance the vaccine venture primarily with borrowings. Net debt increased from RM539 million at end-2019 to the current RM1.2 billion. Gearing had risen to 259% by September 2022, before its equity was wiped out in 4Q2022.
Not all that glitters is gold. The management of some companies tends to chase the latest hype, jumping on the bandwagon of the moment, whether it is gloves, vaccines or durian farms, to the detriment of shareholders. As we have said before, it is better to be a shareholder of a coal mine with capable managers of high integrity than to be a shareholder of a gold mine that is not well managed. Incompetent management and dishonest controlling shareholders will eventually destroy shareholder value. We think this is true for many companies that jumped on the glove bandwagon during the pandemic. The sharp reversal in fortunes for the glove sector is totally predictable, given that glove manufacturing has low to no barriers to entry and a short time-to-market.
By comparison, two other sectors that reported windfall profits during the pandemic — electronics and electrical (E&E) and plantation — have fared better. We tabulated the same set of financial metrics as we did for the glove makers last week for the two sectors. Owing to space constraints, we have listed only the five largest companies (by market capitalisation) on Bursa Malaysia for each sector (see Tables 1 and 2).
The combined net profit of the five largest plantation stocks increased from RM838 million in 2018/19 (pre-pandemic) to RM9.8 billion in 2020/21 — driven by crude palm oil (CPO) price increases that more than offset volume production decline. Margins widened, as a big component of their costs is fixed. CPO prices rose steadily after falling at the beginning of the pandemic — rebounding from the lows of around RM2,000 per tonne in May 2020 to as high as RM7,757 per tonne in April 2022. Prices were driven by a confluence of factors, including supply shortage and logistic disruptions.
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Labour shortage as a result pandemic lockdowns had a negative impact on the production of palm oil in Malaysia. Output of other edible oils was also affected by unfavourable harvests because of the effects of weather, particularly in Latin America, which was worsened by the war between Russia and Ukraine. The latter two countries are significant exporters of soybean oil, rapeseed oil and sunflower oil. Meanwhile, the growth in palm oil supply has been modest in recent years, especially from large plantations, limited by tightening regulations on deforestation and peatland development.
CPO prices are also closely correlated to oil prices, as CPO is a viable alternative fuel in biofuel blends. Indonesia, for instance, has been raising its mandatory blend of palm oil in biodiesel — mostly recently to 35% (in February 2023) — used in the country. Oil prices have rebounded smartly after plunging in the first few months of 2020. The shock of WTI oil (the benchmark in the US) prices briefly falling below zero in April 2020, pressure from climate change activism and the current clean energy transition sharply curtailed funding and investments in the oil and gas sector. OPEC+ made the largest production cuts in its history back in June/July 2020, to support prices, and has since kept a tight lid on output.
Unlike the glove companies, however, their share prices did not significantly outperform, as the market did not believe the record-high CPO prices were sustainable. Investors in plantation companies are more institutional and longer-term — unlike the retail punters in the glove companies then. Sure enough, CPO prices have since fallen back from the peak. Prices are currently still higher than pre-pandemic levels, partly on account of higher costs. But their share prices have not collapsed along with falling CPO prices.
For one, there was no big surge in planted acreage because the industry has substantially higher barriers to entry. There are land constraints, high upfront costs and long time-to-market (oil palm reaches maturity only after four years and it is eight to 10 years before yields hit prime levels).
Managements have been prudent with the windfall profits, raising dividends to shareholders and retaining cash. All the companies in Table 1 reported lower net debts compared with end-2019 levels, save for Kuala Lumpur Kepong, which successfully expanded its plantation acreage by acquiring IJM Plantations. Another sector that benefited from the pandemic was E&E. Global demand for goods surged as widespread lockdowns shifted consumer spending patterns, away from in-person services such as travel, experiences, entertainment and restaurants. The semiconductor industry, especially, saw bumper demand, thanks to a confluence of factors.
The switch to e-commerce and work-from-home drove sales for servers, PCs, laptops and smartphones sharply higher. People were buying furniture and electrical appliances for homes during the lockdown. And demand for cars soared as many avoided public transport. Severe logistics disruptions also prompted manufacturers along the supply chain to stockpile components, including chips, further driving up demand. All of which led to higher volume sales and selling prices, boosting profits for domestic E&E companies. The five largest E&E stocks by market cap on Bursa saw a near doubling of their combined net profits from 2018/19 to 2020/21 (see Table 2) — though this is also partly due to higher value-added products — while their share prices surged even higher (on valuations expansion).
Interestingly, their share prices remain far higher than pre-pandemic levels, despite the current industry downturn, which could last for a few more quarters. The pandemic period saw a fair bit of pull-forward demand — durable goods have longer replacement cycles — and with consumers now switching their spending back from goods to services, there is aggressive cutback in inventories, from retailers and all the way up the supply chain. The outsized contraction we are now seeing is effectively a reversal of the magnified pandemic demand.
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Stock prices are staying high partly because, like the plantation sector, the semiconductor industry has relatively high barriers to entry, including intellectual properties (to varying degrees) and relationships. Unlike gloves, which are commodity-like with a large end-market, it is difficult for a newcomer to become part of the existing global supply chain. Thus, there is probably limited additional capacity from new players to exacerbate the drop in demand.
In addition, investors generally have upbeat expectations on the prospects for the tech sector, fuelled by the hype surrounding generative artificial intelligence. Most expect the current semiconductor downcycle to be short- lived and chips demand to rebound once the excess inventories are worked off. Remember, the intrinsic value of a stock is equal to the sum of its discounted future cash flows. So, it is less about current short-term earnings dip than expected future earnings growth (whether or not they actually materialise).
Similarly, plantation stocks are not faring as well as current earnings (which are still generally higher than pre-pandemic) would suggest. We suspect this is due to, at least in part, the expectations of limits on future growth as well as higher perceived risks — the increasing focus on climate change activism — which raise the discount rate (the denominator in the valuation equation). This would explain the general lack of investor enthusiasm for plantation stocks.
In short, there are distinct structural differences between the gloves, plantation and E&E sectors, which determine whether pandemic blessings turn into curses. And investors would want to stick with management that has demonstrated the capability to navigate in uncertain times and responded with integrity to sudden windfall profits.
The Malaysian Portfolio gained 0.3% for the week ended July 5, outperforming the benchmark FBM KLCI, which gained 0.1%. Hartalega Holdings, which we acquired the previous week, gained 6.3%. Sentiment for the stock remains broadly negative in the analyst community, with 80% of prevailing recommendations being “hold” and “sell”. This is usually a good signal to do the exact opposite. Elsewhere, KUB Malaysia was up 5.2% while Star Media Group (-1.2%) and ABF SG Bond Index Fund ETF (-1.1%) ended in the red. Total portfolio returns now stand at 155.9% since inception. This portfolio is outperforming the FBM KLCI, which is down 24%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
