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Summary

I have decided to sell out on my positions in both InnoTek and Micro-Mechanics as they appear fairly valued given the risk-reward stand off at this point of time.

All divestments made in 2018 by Author, price includes transaction costs

However, I continue to like both counters and will continue to monitor them closely on my watchlist.

Divestment Rationale - InnoTek

I last wrote about InnoTek after their mid year results were released in August last year (here). Then, I mentioned that InnoTek was facing a difficult time securing demand for their office automation and consumer products, and that the following growth drivers will be key to their performance going forward:

2H'17: Heat sinks for TV and Computers
1H'18: New automotive programs begin
2H'18: Mansfield Thailand to begin operations

Amongst the 3 growth drivers, the new automotive program and Mansfield Thailand are the bigger 2. However, Mr. Market had raised InnoTek's share price by over 30% even though the company had not yet been able to show any results with regards to these 2 key growth drivers.

While I continue to believe that InnoTek is worth far more should they execute their growth plans flawlessly, I consider a 30% return now a decent deal as I will not need to undertake these execution risks. 

With a PE of around 9.2 (5.63 net of cash), InnoTek remains one of the cheaper manufacturing stocks out there. I will keep InnoTek on my watchlist for possible re-entry should execution failures scare investors away.

Divestment Rationale - Micro-Mechanics

At the point of initiation, Micro-Mechanics was trading at a PE below 10 (here). Today, Micro-Mechanics commands an all-time-high PE that exceeds 18 (17.7 net of cash) after displaying strong growth over several quarters. 

I have therefore taken the decision to sell Micro-Mechanics now as I consider it fairly valued in light of weaker growth prospects.

Firstly, growth in net profit is likely to slow down due to high base effect following last year's growth spurt. Instead of growing profits at 20% or 50%, 2Q's net profit growth rate of 14.7% should be the new normal for Micro-Mechanics in the near future.

Source: Compiled by Author

Secondly, the current semiconductor up-cycle is 17 months old. The previous 2 up-cycles have lasted 20 and 26 months. While I am no guru and do not know when the current up-cycle will end, I prefer to exit on the top and leave some money on the table rather than be caught out when the tide had well and truly turned.

Lastly, the fact that Singapore's electronic non-oil domestic exports have declined for 2 consecutive months (here) also points to more potential speed bumps ahead.

That being said, although I have divested my position in Micro-Mechanics, I strongly believe that the fundamentals that attracted me to this stock remain intact - a healthy balance sheet, strong cash flow generating ability, management-shareholder alignment, diversified client base, high returns and tight margin controls are all hallmarks of high-quality companies. I will therefore also keep Micro-Mechanics on my watchlist.

Conclusion

To me, taking profit on "fairly valued" counters is something that is perhaps even more challenging than picking good stocks. While some of my sell decisions have been pretty amazing (like Valuetronics), others have proven outright silly (like DBS). InnoTek and Micro-Mechanics should be good lessons for myself as I look to improve my stock selling skills.

From a portfolio point of view, I am actively looking to utilize my cash hoard and have a slight preference to take up positions in companies that might be more recession-resistant in the current economic climate. (do feel free to throw me any good stock tips from SGX or HKex!)

Happy investing everyone!

This is neither a recommendation to purchase or sell any of the shares, securities or other instruments mentioned in this document or referred to; nor can this blog post be treated as professional advice to buy, sell or take a position in any shares, securities or other instruments. The information contained herein is based on the study and research of Dan O (“the Author”); is merely the written opinions and ideas of the Author, and is as such strictly for educational purposes and/or for study or research only. This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Every investor has different strategies, risk tolerances and time frames. You are advised to perform your own independent checks, research or study; and you should contact a licensed professional before making any investment decisions. The Author make it unequivocally clear that there are no warranties, express or implied, as to the accuracy, completeness, or results obtained from any statement, information and/or data set forth herein. The Author, its related and affiliate companies and/or their directors, executives and employees shall in no event be held liable to any party for any direct, indirect, punitive, special, incidental, or consequential damages arising directly or indirectly from the use of any of this material.
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I wrote about some reasons to be bearish that don't make sense last week. Since then, the Dow Jones Industrial Index had posted its worst week in two years with 2 days of free fall exceeding 1000 points. In fact, had the Dow lost any ground on Friday, it would have been the index's worst week since the financial crisis in October 2008.

I guess this provides the perfect context for discussion on reasons to be bearish that makes economic sense.

1) Treasury Bond yields are rising

10 year treasury bond yields have accelerated since the start of the year and now sits 0.841% more than it's 1-year low in September. While 0.841% itself is rather insignificant on an absolute basis, it is actually quite a big deal due to September's low 2% base.

Source: CNBC

The major question is what has this got to do with equities? 

Bonds are a major alternative investment asset class to equities. Ceteris paribus, rising bond yields makes this asset class more attractive relative to equities. We will therefore see money flow from equities to bonds.

Rises in Treasury bond yields have the greatest impact on overall fixed income as Treasury bonds are seen as the safest investment. Consequently, other fixed income instruments will also see corresponding increases in yields in order to maintain their respective risk premium.

2) Inflation is rising (more than expected)

The US Labor Department reported in early February that wages in January were up 2.9% compared with a year earlier, the best pace since June 2009. Higher wages serve as a leading indicator for higher inflation.

Given the spike in expected inflation, it appears that the pace of wage growth has caught investors out by surprise.

Source: Federal Bank of St Louis

The direct impact of inflation on equities differ between businesses. In general, businesses that can pass on inflation to the consumer tend to fare better. As such, industries where demand is price inelastic might be better placed than industries where demand is price inelastic.

However, the direct impact of inflation is minute compared to its indirect impact. When inflation rises more than expected, so too nominal interest rates:

 π + r
i = nominal interest rates
π = expected inflation
r = real interest rates

Higher nominal interest rates can impact borrowing costs and discount rates. As such, the impact of unexpected fluctuations in inflation on equities can be rather drastic.

3) Margin calls

Definition of 'Margin Call', as quoted from Investopedia -

A margin call is a broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when the account value depresses to a value calculated by the broker's particular formula.

An investor receives a margin call from a broker if one or more of the securities he had bought with borrowed money decreases in value past a certain point. The investor must either deposit more money in the account or sell off some of his assets.

TL;DR - When stocks plunge as suddenly as 10% in a week, investors trading on margins might be forced to sell off assets in order to maintain minimum maintenance margin. This worsens the free fall, which might then trigger another round of margin calls. If widespread, such a vicious cycle is devastating for both affected investors and the entire market.

Bull or Bear

Just as writing about some reasons to be bearish that don't make sense is not to be construed as bullishness, this post is not to be taken as an indication of bearishness. Rather, I advocate understanding the arguments for both Bull and Bear. This will help us remain calm and make rational decisions on investing (and divesting).

For those who wish to hear it from someone with more authority on the subject, here is Mark Cuban:

Mark Cuban: Dow plunge doesn’t make me nervous - YouTube

This is neither a recommendation to purchase or sell any of the shares, securities or other instruments mentioned in this document or referred to; nor can this blog post be treated as professional advice to buy, sell or take a position in any shares, securities or other instruments. The information contained herein is based on the study and research of Dan O (“the Author”); is merely the written opinions and ideas of the Author, and is as such strictly for educational purposes and/or for study or research only. This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Every investor has different strategies, risk tolerances and time frames. You are advised to perform your own independent checks, research or study; and you should contact a licensed professional before making any investment decisions. The Author make it unequivocally clear that there are no warranties, express or implied, as to the accuracy, completeness, or results obtained from any statement, information and/or data set forth herein. The Author, its related and affiliate companies and/or their directors, executives and employees shall in no event be held liable to any party for any direct, indirect, punitive, special, incidental, or consequential damages arising directly or indirectly from the use of any of this material.
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Innotek was brought to my attention by a friend of mine. The story is pretty similar to that of Valuetronics - a turnaround amidst this tech manufacturing bullishness permeating through SGX.

With the purchase of Innotek, I have hit my target of 8 counters and have officially ran out of cash. As such, I do not expect to announce any further portfolio additions for the coming months.

Equity: InnoTek Ltd (SGX: M14)

Business: Electronic Equipments
Markets exposed: Asia Pacific
Stock exchange: SGX
Purchase price: 0.375 (Cum Dividends)
Purchase month: April

10% per annum thesis: 

Innotek is a turnaround similar to Valuetronics. I also consider them undervalued as an asset play.

Introduction:

After two consecutive years of losses, new CEO Lou Yiliang has successfully executed a turnaround plan. Cost of sales, administrative expense, finance costs etc have all fallen significantly as proof of management's increasingly strong control over costs.

Considerations:

1) Good Governance

I will begin with the customary inspection of Innotek's Corporate Governance. 

Innotek ranks at a very respectable 152 on 2016 SGTI Corporate Governance Index.

3/6 of their directors are independent, and a further 2/6 are non-executive. In fact, CEO Lou Yi Liang is the only executive director. The current board has a very good mix of Audit, Law, Banking and relevant business experience.

Chairman Robert Sebastiaan Lette has expressed interest in retiring, so they might be looking to replace him on the board. In an ideal scenario, I would prefer an independent chairman and perhaps a new director with some corporate banking background.

2) The Turnaround is Real

Innotek is a case of a true turnaround - they were actually making significant losses in 2014 and 2015. However, the company has managed to turn in a strong profit for 2016.

Source: InnotTek FY2016 Annual Report

If we zoom in on their bottom line for FY2015 and FY2016, we are able to see that their turnaround is actually accelerating. They showed particularly good results in Q3'16, and encouragingly, managed to sustain the results in Q4'16.

Source: InnoTek Financial Statements

Margins are also increasing and they are well on course for a double digit Return on Equity (ROE) for FY2017.

3) Undervalued Asset Play

Innotek currently trades at a Price-Earnings (PE) ratio of about 7.3 and a Price-Book (PB) ratio of 0.68. For a firm that is on course to generate double digit ROE, they are definitely making economic profit beyond their cost of capital. Based on the Residual Income Theory alone, they should not be trading at a discount to their book value.

From a Balance Sheet point of view, they are in a SGD$30 million net cash position. In other words, about 35% of their market capitalization is backed by cash. Net of Cash, we are paying PE of only 4.9 for Innotek's business!

Now, lets have a look at something I compiled for Valuetronics again.

Source: Various Financial Statements
Compiled with figures from 14/4-17/4 weekend

In comparison to these firms, Innotek is another firm that is clearly undervalued in my opinion.

Risks

I will simply list 2 of my most prominent concerns for interested investors to research more on:

A) Regional Slowdown

Innotek is different from Valuetronics in the sense that they are extremely dependent on the East Asian economies. While manufacturing is clearly on an uptrend in the region, I am particularly cognizant of the fact that the feel-good factor will not last forever.

I find China particularly worrisome as they are in the midst of a domestic debt fueled growth. Innotek has shown a slight increase in impairment for trade receivables, and I will be monitoring these danger signs closely.

Conclusions

As with the case of Valuetronics, I am expecting a strong set of results from Innotek for the coming 2 quarters.

Given that the entire tech manufacturing field is already on an uptrend (technically, Innotek is no exception), I foresee Innotek to successfully test the $0.50 and $0.60 resistances within 6 months as long as they deliver the results expected of them.

On a side note, when considering my portfolio allocation, I realized that a significant portion has been dedicated towards Manufacturing. While I really like my manufacturing stocks, I will consider re-balancing once the companies successfully completes their turnaround in the near future.

This is neither a recommendation to purchase or sell any of the shares, securities or other instruments mentioned in this document or referred to; nor can this blog post be treated as professional advice to buy, sell or take a position in any shares, securities or other instruments. The information contained herein is based on the study and research of Dan O (“the Author”); is merely the written opinions and ideas of the Author, and is as such strictly for educational purposes and/or for study or research only. This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Every investor has different strategies, risk tolerances and time frames. You are advised to perform your own independent checks, research or study; and you should contact a licensed professional before making any investment decisions. The Author make it unequivocally clear that there are no warranties, express or implied, as to the accuracy, completeness, or results obtained from any statement, information and/or data set forth herein. The Author, its related and affiliate companies and/or their directors, executives and employees shall in no event be held liable to any party for any direct, indirect, punitive, special, incidental, or consequential damages arising directly or indirectly from the use of any of this material.
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