A few weeks back, we wrote about the structural weakness and resulting chronic underperformance of Bursa Malaysia in recent years. The FBM KLCI fell 12.8% from 2013 to end-2020. The Singapore market has not fared so well either, down 10.2%. Both markets were among the worst performing in the region. By comparison, the Standard & Poor’s 500 index has more than doubled while the Nasdaq has tripled over the same period.
This is a worrying trend. A vibrant and healthy capital market is needed for efficient capital allocation that is supportive of sustainable economic growth over the longer term. Part of the problem lies in weakness in the corporate sector. Total profits for Singapore Exchange (SGX)-listed companies more or less stagnated between 2014 and 2019 (before the Covid-19 pandemic distortions), growing at a compound annual growth rate (CAGR) of just 1.5%.
Malaysia-listed companies did even worse, reporting declining profitability and returns on investment — CAGR for net profits was -3.8% — due to serious, underlying structural problems that must be urgently addressed. We have written fairly extensively on this subject in the past. The other major issue is liquidity — specifically, lacklustre liquidity on the local bourse in the last few years.
Liquidity drives valuations. We do not think there will be much argument over the fact that trading volumes on Bursa have been lacklustre for many years. And while trading activity did pick up strongly in 2020- 2021, after the Covid-19 pandemic broke out, much of it was driven by retail investors and focused on speculative small-cap stocks and certain (narrow) thematic plays.
Poor liquidity usually leads to depressed overall valuations, all else being equal. A capital market that is consistently undervalued is pretty much worthless. If companies believe they cannot get the valuations they deserve and attract a wide spectrum of investors, they will choose other, more vibrant, listing destinations, for instance, Hong Kong and China.
The resulting lack of exciting investment choices and returns prospects, in turn, leads to the exodus of investor money, which only serves to perpetuate the liquidity problem. How do we break this cycle?
Regulators could further liberalise the capital market but, as much as liberalisation can be good, that may not always be the case. Take, for instance, intraday short selling in Malaysia and, specifically, the uneven playing field between proprietary day traders, who do not have to pay a brokerage fee, and the rest of us, for whom the rate can be as high as 0.4%. This disparity causes a price mismatch and is detrimental to the longerterm development of the capital market.
Similarly, we think jumping onto the SPACs (special purpose acquisition companies) bandwagon would be a mistake and not beneficial to market development in the long run. The concept of SPACs is intriguing — as the vehicle for innovative, high-growth start-ups to go public faster and for retail investors to earn “super profits” by buying in early, much like private equity funds and venture capital. But as we explained in depth last week, there are good reasons that regulators should be cautious of SPACs, even if they are all the rage in the US right now. In particular, unsophisticated retail investors may not fully comprehend the risks in these “blank cheque companies”, and their structure of a lopsided payoff for sponsors, which incentivises action over inaction, is detrimental to early SPAC shareholders.
The better route would be for the stock exchange operators to review requirements in existing listing regimes and speed up the process by streamlining the submission and approval process. For example, background research on asset valuations and industry prospects included in prospectuses, undertaken by paid consultants, are time-consuming and usually not very insightful, and in many cases based on management input.
Perhaps the hurdles for the listing of high-growth start-ups can be relaxed. Startups typically would not have the required profit track record for an initial public offering, no matter how promising their value propositions. To ensure that the interests of founding shareholders, promoters and/ or investment bankers remain truly aligned with that of the investors, the former group should be required to retain their equity stakes for a longer period of time, perhaps for up to five years to account for the long gestation typical of start-ups.
More critically, the issue of liquidity needs to be addressed head-on. A major reason for the poor liquidity on Bursa is persistent foreign selling. Foreign investors have been net sellers in six of the last seven years. In each of these years, save for 2020, the benchmark indices registered losses.
The continuous exit of foreign funds means Bursa is becoming increasingly marginalised, compared with rising markets. That led to deterioration in the quality of research and a sharp reduction in divergent viewpoints, particularly contrarian opinions based on strong conviction. This surely does not help restore confidence.
The withdrawal of foreign money is compounded by the aggressive diversification of domestic savings overseas. Case in point: The Employees Provident Fund (EPF) is custodian of the biggest pool of domestic savings, the retirement fund for all private sector workers. EPF has amassed more than RM329 billion ($108 billion) in foreign assets, now accounting for 33% of its total investment value, up from 9.8% a decade ago. The value of overseas investments has grown 7.65 times while domestic investments are only 1.68 times larger than they were at end-2010.
We understand the rationale behind the diversification, and there is no question that the strategy has been successful in boosting overall returns for members. But the savings of Malaysians are the country’s precious and scarce resources — that should be invested in the country to develop the capital markets and support sustainable economic growth in the long run.
In short, the catalyst for better liquidity and valuations must come from within. Clearly, Malaysia cannot depend on inflows from foreign investors to drive growth in the country. Therefore, we must chart our own course.
We are not advocating for a complete reversal of EPF’s diversification strategy. Its merits remain valid. But let’s say EPF repatriates just a quarter of its existing overseas investments over the next five years. That would be equivalent to roughly RM16.5 billion of additional investments annually for Bursa.
This fresh injection of funds will more than offset the liquidity withdrawn by foreign selling and give confidence a big boost. In fact, we suspect the mere articulation of this strategy or intention would suffice to trigger a positive feedback loop — boosting valuations on Bursa and attracting more foreign and domestic capital inflows. Success often begets success.
The situation for Singapore is better in that the country continues to attract strong foreign direct investment (FDI), by virtue of it being viewed as the regional hub. Therefore, it is less dependent on the capital market for funding. According to the World Bank, Singapore ranked third in the world for net inflows of FDI in 2019, after the US and China, with nearly 12 times more in value terms than Malaysia. Nonetheless, the stock market will similarly benefit from increased investments by domestic institutions, including sovereign wealth funds.
In fact, the annual foreign fund outflows from Bursa were not excessively huge — averaging less than RM13 billion a year in the six years when there were net outflows — especially compared with its total market capitalisation of RM1.73 trillion. Yes, the selling hurt investor confidence, but why the outsized impact? This is because company valuations, rightly or wrongly, are based on marginal change in stock prices. In other words, a small change in trade will create a multi-fold valuation effect for all shareholders.
To demonstrate this, we analysed the daily change in market cap compared with traded value for the past three years for the US, Malaysia and Singapore stock markets. We call this ratio the value-traded elasticity (see Chart 1). Every dollar of value traded translates into a nearly fourfold change in market cap on Bursa, 3.4 times for the Singapore Exchange and between 3.3 and 5.8 times in the US.
We repeated the same calculations for a selection of companies, liquid large-caps and less-liquid mid-caps (see Tables 1 to 3). The value-traded elasticity for individual companies varies widely, and is a function, primarily, of their respective underlying valuations and liquidity. Generally, stocks with higher liquidity tend to have lower value-traded elasticity.
This value-traded elasticity is why the relatively “small” foreign outflows have such a negative impact on overall market valuations and why an increase in EPF investments should have a similar and opposite positive impact on Bursa. In 2017, a less than RM11 billion in net foreign inflows helped spur a 9% gain for the FBM KLCI.
Aside from domestic institutional funds, we think corporate share buybacks is another key driver for valuations.
Share buybacks are extremely popular and widely used in the US as the method of choice to reward shareholders. The total amount spent on share buybacks by S&P500 companies in the last 10 years was 3.7 times that spent in the previous decade — and notably, 50% more than what companies paid out as dividends (see Chart 2).
The rise in share buybacks coincided with the longest bull market in US history. For sure, correlation is not causation. But the math in Chart 1 and Tables 1 to 4 firmly supports our belief that it is a major factor. And we believe US companies are very well aware of this.
Berkshire Hathaway — one of the largest, most enduring and successful companies in the world — has not paid a dividend since 1967 because Warren Buffett does not believe dividends is the best use of its cash to enhance shareholder value. Yet, the company spent a record US$24.7 billion ($32.8 billion) on share buybacks last year. In his latest annual newsletter to shareholders, Buffett writes: “We made those purchases because we believed they would both enhance the intrinsic value per share for continuing shareholders and leave Berkshire with more than ample funds for any opportunities or problems it might encounter.” Incidentally, Berkshire shares have a high value-traded elasticity of 45.5 times.
Apple, the single-largest stockholding in Berkshire’s portfolio and the world’s most valuable public listed company, is another huge fan of share buybacks. The company spent almost US$75 billion a year in the past three years on share buybacks, way more than on dividends. Again, the step-up in share buybacks coincided with its sharp share price gains (see Chart 3).
As we have pointed out many times before, the stock market is a market for stocks. In other words, prices are determined by demand-supply dynamics, the same way as in markets for any other goods and services. Not only are share buybacks a source of demand, they also reduce the long-term supply by taking the repurchased shares out of circulation. This gives buybacks a unique and outsized impact on prices and valuations. In effect, share buybacks reward existing shareholders with a bigger slice of a larger pie!
That said, the effectiveness of share buybacks also depends on market belief and perception. It works when the market sees the buyback as a way to reward shareholders using excess cash flow generated by the business. And, importantly, when the market perceives management's belief that the shares are below their intrinsic values. Perception matters, as does management credibility.
This is why the share buyback by Top Glove in Malaysia has the opposite effect. Even though it has a strong cash flow from abnormally high prices for gloves, owing to the pandemic, few genuine analysts believe this is sustainable. And, consequently, the share buyback would not enhance the intrinsic value per share.
A share buyback will be ineffective if the move is seen as market price manipulation, management attempting to artificially support prices for its own benefit or to cash out a major shareholder. The market is usually smarter than we give it credit for!
Despite its popularity in the US, share buybacks have not caught on in Malaysia and Singapore. Perhaps this is due to the negative connotation (real or perceived) that such moves might be seen as an attempt to manipulate share prices. Are managements worried about possible legal ramifications and liability?
Companies undertaking buybacks are not exempt from insider trading rules. And the company is the ultimate insider — it will, at any point in time, always have more information than the public. So, does it mean the act of buying back shares is insider dealing?
For the law to approve of share buybacks, the interpretation of insider dealing when it comes to share buybacks must be less strict than when the shares are bought by major shareholders and management. The board and management can decide if it has material information that needs to be released to the public at the point of the buyback.
Remember, share buybacks are widely accepted in the US as a legitimate way to return cash to shareholders. The fact is that no question was raised on the issue of share manipulation or abuse — not by the regulators and not by any major financial institution or mainstream media. We believe it will be the case here, too, if management articulates a clear and consistent policy on share buybacks, rather than act on an ad hoc basis. Used correctly, share buybacks can convey management’s confidence in the company’s future and the undervaluation of its shares.
Perhaps Malaysian and Singaporean regulators should be more actively supportive of wider share buybacks. Companies operating in more mature industries that generate steady cash flow and/or are sitting on excess cash are best positioned to undertake this exercise.
Table 4 lists some companies that have high historical dividend payouts. For those with high value-traded elasticity, in particular, a share buyback will be a better option than dividends. Allocating a portion of annual dividends to share buybacks, we believe, will boost valuations and shareholder value — for the companies and the stock exchange as a whole. In other words, share buybacks will create a bigger bang for your buck.
Stocks in the Global Portfolio traded broadly lower for the week ended March 3. Total portfolio value was down 2.3%, mirroring the broader market decline. Last week’s losses pared total portfolio returns to 55.7% since inception. Still, this portfolio is outperforming the MSCI World Net Return index, which is up 38% over the same period.
Shares for Singapore Airlines surged 10.1% and it was the best-performing stock in the portfolio. Other gainers were Builders FirstSource (+2%), Geely (+0.9%) and Bank of America (+0.1%). All the other stocks ended in the red, with Okta (-10.6%), Taiwan Semiconductor Manufacturing Co (-7.1%) and Qualcomm (-6.7%) leading the decliners.
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.
