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Investors question penny rally but speculation will always have a place in the equity jungle

The Edge Singapore
The Edge Singapore • 9 min read
Investors question penny rally but speculation will always have a place in the equity jungle
As the adage of the trading community goes: high risk, high returns. And that's why speculative penny stocks have a place in the market.
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On Aug 13, clean-room equipment provider Eindec Corporation reported that losses for the six months to June 30 doubled from a year earlier, on a 44% drop in revenue. The company notes that Covid-19 has disrupted construction projects, to which its business is closely tied, and therefore “adversely affected”. It also warns of “heightened credit risk” and “increased pressure on margins”, and as such, an “adverse effect” on the 12 months ahead.

Typically, such a report card will not inspire investors to jump in. Yet, this past month, amid a wider rally of small cap stocks, Eindec has become the top performer on the SGX, with a gain of 383% between the end of July till Sept 2.

The answer might lie in the company’s very brief and perhaps deliberately vague Aug 24 announcement after market hours that it is exploring an acquisition of a China-based company, although there is no assurance of anything definitive or binding for the moment. The company’s share price, which had already doubled earlier that day, doubled again by the end of the week.

Eindec is not alone. A growing clutch of small caps have made handsome gains in the past month. With the exception of Medtecs International Corporation, International Cement Group and Vicplas International, none of these top gainers have yet hit a market value of $250 million.

Terence Wong, CEO of Azure Capital, describes this penny rally as fitting into an established pattern of the euphoria from the big to the small. “Some of the jumps are justified, as they’ve suffered a major sell-down and the stock prices have been languishing for a long time. Others are just erratic. And there are also those that are playing into a certain trend.”

Samuel Wong, trading strategist at OCBC Securities, observes that with the “aggressive” market rally since March, from a risk-reward premium angle, it is no surprise to see market momentum switch from the over-bought blue chips and cyclical sectors to the more attractive penny stocks.

He calls this an ecological balance, the co-existence of institutional and retail interests. “Basically, the law of the jungle (when it comes to the equity market) is always looking for higher yields and better returns. When the pasture of blue chips gets saturated, the focus would turn to the next better interests of play. In this case, investors look at the second tier of the market,” says Samuel.

On the other hand, Anson Sng, CEO and chief investment officer of Raintree Asset Management, disagrees that it is the rotational play from big caps to small caps. “Usually the blue chips run before the small cap, but in this case our blue chips didn’t really run — if fact they were quite feeble,” he points out.

To be sure, there are some small caps that are indeed direct beneficiaries of the pandemic and they have higher earnings to drive home the point. Medtecs International Corporation, especially, made a spectacular gain of more than 3,000% year-to-date, valuing the provider of medical consumables at $840.6 million as of Sept 2. For 1HFY20, it reported earnings of US$38.9 million ($53 million), up 9,975.9% y-o-y.

The glove-makers such as Top Glove, UG Healthcare and Riverstone Holdings enjoyed handsome gains too. “They didn’t just benefit, they are insanely benefiting,” says Terence. When they reported solid gains in their Q2 earnings, that’s what investors see as a further reason to push the prices higher. “You see their bottom lines multiplying, and you see their PE ratio multiplying too,” he adds.

The surge has inspired non-glove-makers to join the fun. Aspen Group Holdings, which focuses on property development in Penang, on Aug 12 announced plans to diversify into glove manufacturing. Its share price shot from six cents to as high as 34 cents before closing at 24.5 cents on Sept 2, marking a gain of 354% over the past month.

Unlimber the lumber

The market seems quite happy to jump on to new ideas. Several stocks in a previously unloved sector, timber, for example, hit 52-weekhighs recently. Avarga, an investment holding company that controls 70% of a Canada-based building materials supplier, saw its share price surge more than 40% on Monday, Aug 24. Avarga’s executive chairman is Tong Kooi Ong, who is also chairman of The Edge Media Group, parent company of the publisher of The Edge Singapore, while Ian Tong, executive director of The Edge Media Group, wears another hat as CEO of Avarga.

Following a trading query sent by SGX, Ian explained in an interview with The Edge Singapore, published last week, that lumber prices in North America more than doubled year to date because of an unexpected divergence between supply and demand, and that he does not expect such abnormal margins to be sustainable.

Two other timber-related companies enjoyed heightened gains and interest as well. Thanks to higher revaluation gains of its trees, Indonesia-based Samko Timber reported 7% y-o-y growth in earnings to IDR8.1 billion ($746,664), even though sales dropped by 23% y-o-y. While domestic sales slumped by 36% in 1HFY20, export sales, which accounted for a slightly large proportion of its total revenue, increased by 9%. “The demand from our export market has not been too adversely affected by the outbreak. The group is closely monitoring the impact on the group’s business and operations,” says Samko Timber in its earnings commentary on Aug 7.

On Aug 13, Sitra Holdings, which focuses more on furniture making, reported revenue of $7.2 million, down 24.1% y-o-y, as the pandemic hurts consumption in its main markets of Australia, New Zealand and Europe. Losses in the same period widened 131.6% y-o-y to $649,000. The company expects demand to remain weak.

Indeed, companies that enjoyed gains in the past month come from other sectors such as chemicals (Jiutian Chemical Group, Abundance International); maid agency Advancer Global; offshore and marine (ES Group, BH Global) and even retail, SK Jewellery Group, although the spike was triggered by a 15 cents per share offer made on Sept 2 by its controlling shareholders to privatise the company.

A fund manager who declined to be named, struggles to buy into the reasons put out to explain the spurt in trading activities of some of the small caps. “I think they are inspired by some of the moves in China stocks in A and H shares,” he says, referring to the post-Covid-19 boom enjoyed by the Chinese markets. “But seriously I can’t see the resemblance nor relevance. More like imagination — and very stretched imagination, for that matter,” he says.

Not yet 2007 ‘crazy’

Terence warns that the euphoria, if not backed by earnings, will be painfully felt and that’s what happened often enough where the multi-fold ride up tempted many investors to jump in — usually around the peak — and when the dust eventually settles, the fall can be as steep as 90% or more. “While you can go with the flow, you’d better be very, very cautious,” he says.

However, from Terence’s perspective, the current penny rally is, in the historical context of the market, relatively mild. “The crazy doesn’t match up to the craziness in 2007, when the whole index doubled,” he recalls, where several stocks enjoyed their day in the sun before falling by retreating back to oblivion.

In one notable deal that year, Rowsley, Peter Lim, attempted a $2.7 billion reverse takeover of a China-based solar cell maker Perfect Field. Media reports then said the former “remisier king” was planning to become the “sun king”. The share price surged from three cents to around 30 cents in just three months. The deal was eventually spiked after certain conditions such as production targets could not be firmed up. Rowsley, still controlled by Lim, eventually turned into Thomson Medical Group.

In another memorable episode, Jade Technologies, was one of those former high-flying small caps whose former boss was later convicted of insider trading and market rigging. The company’s name was changed first to China Titanium in January 2011, and then to Cedar Strategic in December 2012. Since February 2017, it has been known by Emerging Towns & Cities Singapore.

Some stocks may have been beaten down badly to the point that, for example, its cash balance is worth more than the market capitalisation. So, there are some fundamental reasons to justify the heightened trading interest as more investors become aware of this fact, says Terence. “But, if you haven’t heard of this stock, then do some research, look at numbers coming through and see if there’s a real story. Even if there’s really something, even if mildly benefitting, but if stock price has really gone up, then, maybe something is amiss,” he says.

Extreme decoupling

However, there seems to be new market norms emerging in the fallout of Covid-19. Samuel of OCBC Securities points out that markets are driven by the flush of liquidity in the financial system. For example, US 2Q earnings were down by 35.7% — the largest y-o-y decline since 4Q2008, during the Global Financial Crisis. Yet, traders are still loading up whenever they sense price weakness. They are in effect, buying beyond current concerns. “You simply don’t jam the brakes on a speeding train,” he says.

He warns of an “extreme decoupling” between fundamentals and trading interest. “Earnings are expected to worsen with fundamentals set to deteriorate further before they can get better. The market is always right and it seems they have established the new law of the jungle — which is, ‘bad news can be good news’,” he says.

Still, there are investors such as Goh Tee Leng, fund manager at Heritage Global Capital Fund, who prefer to stick to blue chips for better assurances of sustainable returns. He acknowledges that valuations of small caps may look more appealing.

However, they suffer some inherent limitations. “In countries with huge markets, such as the US and China, their small companies can keep growing by moving from one city to the next. Unfortunately, where can Singapore small caps really move to? We are very different legally, politically and culturally as compared to our neighbours,” he says.

Goh cites the example of Challenger Technologies, which runs a chain of retail stores specialising in IT products. “While the company is a great quality company, with a good management and strong business moat, it is only able to dominate the Singapore market.”

In contrast, the big local banks have the muscle to make substantial and almost transformational acquisitions outside Singapore. For example, OCBC bought Wing Hang Bank and DBS Group Holdings bought Dao Heng Bank, giving them a meaningful foothold into the Hong Kong and China markets, says Goh.

Samuel agrees that the fundamentals of penny stocks are not as intact as blue chips. Naturally, there are additional risks. Yet, as the adage — not limited to the trading community — goes: high risk, high returns. “That is one key reason why the speculative penny stocks would still have a place in the market,” he says.

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