Bullish small-cap players

SINGAPORE'S National Day, celebrated on Aug 9 each year to commemorate the nation's independence from Malaysia in 1965, has always been special to boutique portfolio managers Victor Khoo and Wong Yu Liang, founders of Singapore-based Lumiere Capital, a smallish fund company focusing on small and mid-cap value stocks in Asia.

"My birthday falls on National Day," says Wong, 35, in an interview with Personal Wealth on Aug 6. Having already seen the National Day Parade rehearsal, he was planning to celebrate on Aug 9 over dinner with his girlfriend, followed by a trip to the newly opened Gardens by the Bay.

For Khoo, who has a daughter and another child on the way, National Day is a time for family bonding. "I will have my extended family come to my place for dinner and the fireworks [his high-rise condominium at Tanjong Rhu, near Marina Bay, offers unblocked views of the display.] We will watch the parade over TV and the fireworks live," the 35-year-old says.

Currently managing slightly more than S$30 million (RM75.23 million) in assets, about S$4 million of which is their own money, the two are among a handful of local fund managers who have struck out on their own and succeeded. In October 2007, Wong and Khoo — who were both rookie stock pickers then — boldly launched the Lumiere Value Fund with S$5 million worth of assets under management (AUM).

The former schoolmates at Nanyang Technological University and colleagues at the now-defunct accounting firm Arthur Andersen, each sank S$1.25 million of their wealth (accumulated through astute stock investing) as seed money for the fund. Lumiere Value Fund had around 30 investors at that time, comprising mainly their close friends and relatives. Their aim is to achieve a compounded annual return of 20% for their investors over the long term, by investing in a concentrated portfolio of about 25 core stocks, consisting mainly of undervalued small- and mid-cap counters.

The timing of its launch couldn't have been worse. Hit by the global financial crisis of 2008, the fund lost two-thirds of its value. However, Wong and Khoo didn't throw in the towel during the darkest hours of the credit crunch, when the fund's AUM declined to less than S$3 million. They kept faith with their deep-value investment approach and purchased more of their favourite stocks that were trading at steep discounts to their intrinsic value. That move paid off handsomely, and as the global stock market rebounded sharply in the two years that followed, the Lumiere Value Fund delivered stellar gains of 163.5% and 51.2% (in US dollar terms) in 2009 and 2010, respectively.

But it hasn't been all smooth sailing of late. The fund slumped 22% last year and lost 14.5% of its value over the three months to end-June. Hit by the downturn in global equities, the Straits Times Index and Hang Seng Index dived 17% and 20% respectively last year. Small- and mid-cap companies of Singapore and Hong Kong, the key groups of stocks in Lumiere Value Fund's portfolio, were hit harder than the broader markets during that time.

"In a risk-off environment, it hurts the deep-value, small and mid-cap stocks the most. The stocks that we own tend to be under the radar, and they are not so easily understood by investors and not as well covered by analysts. In times of perceived trouble, investors would dump these stocks much faster than the blue chips," explains Khoo. "Given the situation in the market, we were pretty satisfied with our 2011 performance," says Wong.

Predicting that the downtrend in Asian small-cap stocks is close to an end, they are positioning their fund for a bullish rebound. "If you look at the Asian small-cap cycle over the last 20 to 30 years, you would see there were always one to two years of a bear cycle, followed by an uptrend of more than two years. The end of 2010 marked the start of the bear cycle and now we are approaching the two-year mark," observes Wong. "Things are bound to get better, not worse. What we are doing now is to position ourselves for an upside going forward," says Khoo, The Lumiere Value Fund, which currently has 17% of its assets in cash, was up 4% this year as at end-June.

Betting on Hong Kong small capsWong and Khoo say their job as deep-value fund managers is to look for attractively valued, out-of-favour stocks with good growth prospects in the region. Currently, the most unloved but potentially rewarding group of equities in the small and mid-cap area is those listed in Hong Kong and China.

"We are driven by valuations. Hong Kong small caps have seen their stock price halved from their post-Lehman highs over the past two years," says Wong, citing the Hang Seng Composite Small Cap Index, which has lost 40% of its value since its peak in November 2010. "In terms of valuations, Hong Kong small caps look very cheap. And China has been in a bear market for a few years. Once high-flying stocks, they are now selling at a fraction of their value. Some of the smaller Hong Kong companies are down two-thirds from their highs," he points out.

As at end-June, more than 50% of Lumiere Value Fund's assets were invested in Hong Kong-listed stocks, while Singapore stocks accounted for just a quarter of its portfolio. "Many of the smaller Singapore counters didn't fall as much as their Hong Kong counterparts," explains Khoo, who says the fund has been trimming exposure to Singapore counters such as high-flyer Sarin Technologies to invest in cheaper ones in Hong Kong.

Sarin Technologies, a Singapore-listed Israeli company that manufactures diamond scanners and whose shares have surged more than 85% this year, is currently the best-performing stock in Lumiere Value Fund's portfolio on a YTD basis. "There is some [price] momentum to Sarin. Even though it has gone up a lot this year, it is still some way from its intrinsic value," says Khoo, who reckons the stock still has potential upside of 30% to 40% from its current price.

"Sarin, which is into raw diamonds, is dominating that space. Now, it is using the advantage to gradually move into the polished diamond space. But, in the short term, the company is subject to the capital equipment cycle of the diamond industry and there could be some volatility. Over the long run, however, it could be at the early stages of an inflection point," Khoo adds.

Having trimmed exposure to the stock this year, Khoo says the fund will continue to hold on to its remaining shares in Sarin Technologies, which is trading at a forward price-to-earnings ratio (PER) of 11 times and gives a gross dividend yield of 2.25%, according to Bloomberg data. "Although we wouldn't buy Sarin at today's prices, we don't have the habit of selling stuff irrationally and will continue to hold it.".

Of late, Lumiere Value Fund has also been taking profit in Hong Kong-listed DBA Telecommunication Asia. Shares of this telecoms company, which makes and operates smart payment terminals, have surged more 90% this year.

Stock namesWong and Khoo like to bet on "deep-value companies" with good growth potential that are under the radar of big institutional investors. "There isn't much research coverage on the companies that we buy into. These are smaller companies that have yet to be discovered by other big investors," Wong explains. Their other stock bets include out-of-favour counters that are trading at low valuations owing to some "special situations", he adds.

Doing their own stock analysis and research, the value-oriented fund managers would assign an intrinsic value to each of the stocks their fund owns. To determine a company's intrinsic value, they would estimate its long-term growth rate and put a multiple to it. For example, for a company with 15% or 20% growth over the long term, they would assign a fair PER of 12 times based on current-year earnings, explains Khoo, who doesn't use future earnings in his calculations. "We don't want to pay for future [expectations], we want to see what the company has achieved up-to-date." For a company with one dollar in earnings and has a fair value of S$12, Lumiere would buy its shares at a discount of around 50% to its fair value, which is at S$6.

"We do our own research and we don't rely on brokers to tell us what is good to buy," says Khoo. "We don't have a team of analysts. If we find something worthy of more research, we might ask our intern to do a bit more." Besides the two founders, Lumiere Capital, whose office is at the second floor of Far East Square, currently employs a business development executive, an operational manager and an intern.

During the financial reporting season for listed companies in Singapore and Hong Kong, the fund managers would painstakingly look through most of the reports in search of new investment ideas. It was through this process that they found Fufeng Group, which is the world's largest producer of monosodium glutamate (MSG). "If it is something that is crappy and expensive, we would give it a pass. But Fufeng came about during our search. It has a good track record and good dividend payout. Forty per cent of its profits is being paid out for dividends," says Khoo.

Shares of Hong Kong-listed Fufeng used to trade at 12 to 15 times, but owing to high corn prices in recent years, which created a margin compression for the company, the stock currently trades at a forward PER of just 5.45 times. MSG is produced from corn. Lumiere bought the stock in 2H2011 when its PER slumped below eight times and purchased more when its share price continued to tumble this year because of persistently high corn prices.

"Last year, there was already pressure on Chinese corn prices, which were gradually inching up. But instead of raising prices and passing on the cost, Fufeng kept its selling prices constant and consolidated its position in the industry. It gained market share from the smaller players when it refused to increase its prices. It basically engaged in a price war, which caused many smaller MSG producers to go out of business," says Khoo. But in July, after solidifying its position as the top MSG maker in the world, Fufeng started to increase the prices of its products. Nonetheless, high corn prices — especially that from the US — continue to weigh down the stock, which has fallen almost 30% this year.

Wong says there is a good buying opportunity in the shares of Fufeng, which is more affected by Chinese corn prices than those of the US. He observes that Chinese corn prices aren't as volatile as those in the US, which have been hit by the recent drought in the Midwest. "Now that Fufeng is No 1 in the world by a good margin, it will start to move prices higher going forward, in order to regain that profitability," Wong predicts. The company currently supplies MSG to major sauce makers, retail MSG producers and instant-noodle makers. "At current prices, you are getting five to six times PER for Fufeng, whereas you have to pay 15 to 20 times PER for a noodle chain."

Other Hong Kong-listed small-cap stocks that Lumiere likes are lead-acid motive battery maker Tianneng Power International, which supplies battery packs to electric vehicles such as electric bicycles in China, and Hong Kong watch retailer Oriental Watch. It is also bullish on Singapore oil and gas servicing company MTQ Corp.

"Tianneng is the market leader in China for electric bicycle batteries, with 20% to 25% of market share," says Khoo. Last year, owing to the potentially harmful effects caused by the inherent pollution of lead acid batteries, stricter regulations were introduced and inspections conducted by the Chinese authorities on lead acid battery makers, according to Wong.

As a result, one third of the country's producers were shut down and another third temporarily ceased operations, pending further inspection, he adds. "Therefore, two-thirds of the industry capacity was mothballed. There was a shake-up in the industry and the weaker players were weeded out, especially the smaller ones with lousier environmental standards. Tianneng, being the market leader and with larger capacity and better practices, solidified its market position and gained market share. Now, it has better pricing power due to fewer competitors."

At the same time, the electric bicycle industry in China is growing and that will continue to support Tianneng's revenues, according to Khoo. Electric bicycles are the primary mode of transport, especially in rural China where the transport networks aren't well developed. Each new e-bicycle needs a set of four batteries and the life of the batteries is typically about two years, so there is a natural replacement demand, which will give Tianneng good recurring revenues, Khoo adds. Although Tianneng's share price is up more than 35% this year, the stock is still trading at a low forward PER of 6.3 times. And, it currently has a gross dividend yield of 4.3%.

On Oriental Watch, whose share price has fallen by more than 30% this year, the Lumiere fund managers say it is now trading at an attractive five to six times earnings and pays a decent dividend yield of more than 3%. Furthermore, the Hong Kong watch retailer, which is the distributor of Rolex watches, is currently actively unlocking value.

"Since we bought it, it has fallen a bit. The stock is now below book value. There is insider buying and it pays a decent dividend. The company is actively unlocking value because it owns a few shops in Causeway Bay and it was selling them," Khoo says. "We like it because it has a 50-year track record. It may not be as glamorous as other high-end watch retailers, but it is a sure and steady mover."

Another deep-value counter is MPQ Corp, which provides repairs and spare-part servicing for oil rigs in the oil and gas industry. Wong reckons that its earnings could surprise on the upside going forward. He points out that MPQ's lossmaking Bahrain facility, which was acquired three years ago, could break even this year and start to contribute to profits next year. Another profit catalyst is Premier Group, which MPQ acquired last year. "Premier Group has a similar business with a slightly different product range. MPQ has successfully integrated this business. Looking at its latest financial results, Premier Group is already generating profits and doing better than expected. It could drive earnings for MPQ this year," says Wong, who sees an upside of 50% to 100% for the share price of MPQ.

Better returnsGiven the strong rally in global equity prices since early July, Khoo is confident that the fund, which is only sold to accredited investors in Singapore and has a minimum subscription of S$200,000 plus a lock-up period of one year, will turn in attractive returns for its investors.

"We don't lose sleep over our investment strategy. We are confident we will perform well. Like in February, we were up 16% in one month. We could recover our recent losses in just two months," says Khoo. Lumiere slumped 14.5% over the three months to end-June. "Our performance is volatile both on the upside and downside."

To limit the downside of their fund, Khoo and Wong say they would hold more cash when stocks are overvalued and when there are headwinds in the market. "Our portfolio currently trades at five times PER, one-time NTA [net tangible assets] and gives an average dividend yield of 4.5%. What else can you ask for?" Khoo says.

In recent years, Lumiere Value Fund's investor base has grown from 30 to nearly 100 now, of which the majority are Singaporeans. "There are some professionals like accountants, lawyers, audit partners and bankers. Some of them have access to sensitive information, so they cannot invest in equities on their own. They saw value in what we were doing, and they came and invested with us. There is another segment of business people who own companies. There are also people who manage their family finances on a full-time basis. They are similar to family offices, managing assets of S$20 million to S$100 million," says Khoo.

Despite increased participation from new investors, Wong insists that redemptions for the fund are negligible. "A lot of our investors, who are sophisticated investors themselves, understand our strategies very well. They roughly know how we are going to perform in an up and down market, so they tend to stick with us for the longer term."

Interestingly, redemptions for the fund only tend to occur when a high net worth investor decides to buy a property in Singapore, observes Khoo. "In recent years, property has been a rather hot [asset class] for Singaporeans. Our real competitor isn't other equity funds, but property. When some of our investors want to start a family and buy a house, they would redeem the fund to pay for their down payment."

This story appeared in The Edge Singapore on Aug 13, 2012.