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Falling margins will hold back stock price gains

Tong Kooi Ong
Tong Kooi Ong3/4/2019 07:30 AM GMT+08  • 6 min read
Falling margins will hold back stock price gains
(Mar 4): Stocks around the world chalked up a second straight month of gains in February. This means that after having suffered one of the worst losses since the end of the global financial crisis in late 2018, markets are now enjoying some of the stronge
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(Mar 4): Stocks around the world chalked up a second straight month of gains in February. This means that after having suffered one of the worst losses since the end of the global financial crisis in late 2018, markets are now enjoying some of the strongest starts to a new year. The world’s most closely watched bellwether, the Dow Jones Industrial Average has rebounded some 20% from last year’s lows and is now less than 4% off its record high.

Late last year, markets were driven by extreme pessimism over the global economy. That has since been dialled back after the US Federal Reserve adopted a more dovish stance on future interest rate hikes. Indeed, many have now turned bullish, especially for emerging markets.

Chinese stocks, the worst-performing market in 2018, led the rally, with the Shanghai Composite index up almost 18% year to date. The gains were accompanied by a surge in trading volumes as well as margin loans as progress on the US-China trade talks bolstered investor confidence. President Donald Trump extended the March 1 deadline for a trade deal, delaying the previously announced tariff hike (from the prevailing 10% to 25%) on US$200 billion ($269.7 billion) worth of Chinese goods.

Optimistic investors are also betting the Chinese government will loosen its credit crackdown, including on shadow financing, and announce more stimulus measures to buffer the economic slowdown. Nevertheless, some are sounding a note of caution, as the current rally brings back memories of the last market bubble in 2015.

Indeed, while fear has receded and stocks have rebounded, the outlook remains uncertain. We suspect continuation of the rally will require validation from improvements in corporate earnings, which is far from convincing at the moment. In the US, analysts are still paring back their earnings forecasts, now expected to contract 2.7% y-o-y in 1Q2019 and grow just 0.7% in 2Q2019.

As we mentioned last week, slower (but still-positive) sales growth and narrowing margins are symptoms of late-cycle earnings. That could translate into a tight trading range for stocks from hereon. The challenge is to identify companies that will buck this trend.

Shares in Sunpower Group continued to rally prior to its 4QFY2018 earnings results, which were released after market close on Feb 27. We are now making returns totalling 10.1% on this investment.

The company reported a strong 66% growth in revenue, attributed mainly to its manufacturing and services arm, where sales expanded from RMB1.8 billion in FY2017 to RMB2.5 billion ($504.3 million) (77.4% of total) in FY2018. Its order book increased to RMB2.5 billion as at February 2019, up from RMB1.1 billion two years ago.

More importantly, though, is the growth in the green investments (GI) segment, which is recurring income and carries significantly higher margins. Revenue totalled RMB737 million in the first full-year of operations for the business — 4QFY2018 results were bolstered by the acquisition of the Yongxing plant. Earnings before interest, taxes, depreciation and amortisation from GI rose to RMB276 million in 2018, about 56% of the company’s total for the year.

The company will continue to expand its GI portfolio, ramping up utilisation and adding capacity to existing projects, completing two new projects under construction as well as evaluating pipeline projects. Sunpower has so far invested-committed RMB1.34 billion in equity investments, which are expected to total RMB2.5 billion by 2021. As such, we expect to see revenue and earnings growth, plus rising average margin over time, as GI account for a larger share of total earnings.

On the other hand, the share price of Nine Dragons fell after it reported sharply lower profits y-o-y for 1HFY2019 ended Dec 31, 2018. Net profit fell to RMB2.26 billion, almost half of the RMB4.33 billion in the previous corresponding period.

The results were not wholly unexpected, as profit margins normalised. Recall that margins in 2018 shot up because of a shortage of domestic old corrugated cardboard (OCC), after the government tightened purity requirements for imported scrap and cracked down on small polluting paper plants.

Nine Dragons also reported higher operating costs, including those related to newly acquired pulp mills in the US. It was unable to pass on these costs amid demand weakness, owing to de-stocking activities and China’s economic slowdown. Upside gains for Nine Dragons could be limited in the near term, although valuations remain attractive for the leading containerboard manufacturer in China.

Meanwhile, there were some solid 4QFY2018 results for Malaysian companies, including for those in my portfolio: Dialog Group, Hong Leong Industries, Ajinomoto

(Malaysia) and SAM Engineering & Equipment (M). Generally, however, it was another weak quarter of earnings and we are seeing quite a few cutbacks in market earnings forecasts. It could get worse.

That said, expectations have been lowered going into this latest reporting season. So, the disappointment was less severe. The FBM KLCI fell 0.8% for the week ended Feb 28.

Earnings for consumer companies remain relatively resilient and car assemblers are recovering, aided by last year’s tax-free months. But the downturn in infrastructure activities and property sales is filtering through earnings for construction, materials and property companies. Margins are dropping on the back of lower utilisation, with rising risks of impairments for assets and receivables.

Falling margins on the back of rising costs remain a key issue for most of the companies. Among the index heavyweights, telcos are reporting dismal profits while plantation earnings are weighed down by rising stockpile and weak prices. The nation’s biggest bank, Malayan Banking, reported record earnings for 2018 but was cautious on future loans growth and expects net interest margin to narrow this year.

The Global Portfolio was up 1.6% last week, boosted by gains from Sunpower and Alibaba Group Holding. This pared total portfolio losses (since inception) to just 1.7%. Over the same period, the MSCI World Net Return Index was up 1.7%.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

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.

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