The Covid-19 pandemic was without question one of the most disruptive events in recent history, due to the geographical scale of its impact and the fact that practically everyone was flying blind.
There was no precedent from our lifetime. No one knew how bad things would get or for how long. The sudden enforced changes to people’s lifestyles also brought about unexpected consequences. Businesses scrambled to respond to all the resulting uncertainties. Some saw massive windfall profits as demand for their products surged to historic highs while others struggled to meet demand amid severe supply shortages, due to production disruptions and logistic snarls. Yet others had to grapple with cliff-like plunges in sales practically overnight. Testing times. Also times when the investor could best assess the capability, integrity and fortitude of management and controlling share holders, people who would ultimately drive shareholder value in the long run.
Over the next couple of weeks, we are going to take a look at some of the big winners during the early days of the pandemic — how much of a windfall, how the companies spent the sudden surge in profits and cash flows, their share price performance since then and how they are doing today, and their outlook in the post-pandemic years.
The glove makers were, without question, the single biggest winner of all on Bursa Malaysia. When the pandemic broke out, there was a sharp spike in global demand for personal protective equipment, including masks and gloves. Given the short-term supply constraints, selling prices soared — leading to outsized margins and supernormal profits for glove makers.
We did a quick tabulation of select financial metrics for the seven glove makers listed on Bursa (see Table 1). Total net profit increased by more than 10 times, from a combined RM2.38 billion (pre-pandemic 2018-2019) to RM26.3 billion during the height of the pandemic (2020-2021).
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The sharp jump in profits, when most businesses were being negatively affected by lock downs, drove investor interest and share prices went sky high. The rally was fuelled by massive liquidity and speculation. And yes, the frenzy was also fanned by analysts, who kept rais ing their target prices — by applying historical price-earnings ratios (PERs) to the supernormal profits and coming up with mind-boggling val uations for the stocks.
At the peak, in October 2020, the combined market capitalisation for the seven Malaysian glove stocks reached nearly RM200 billion, more than 12% of the total market cap for all stocks listed on Bursa. Top Glove Corp’s market cap hit a high of RM78.2 billion on Oct 19, way larger than Public Bank’s (RM61.5 billion on that same day). If ever you need an example of foolishness, this is it. Any company announcing a venture into gloves — for instance, Mah Sing Group on Bursa and Aspen (Group) Holdings Ltd on the Singapore Exchange S68 — was given a huge valuation boost by the analyst community.
To reiterate, the intrinsic value for a stock is the sum of its discounted future cash flows. Applying a historical average PE multiple to peak earnings assumes that this supernormal profitability is sustainable in the long run. As we have explained multiple times, as far back as in July 2020, it is impossible for such an abnormal profit margin to persist for long in any competitive, free-market environment. Gloves are commodity-like, the industry is low skilled, has low barriers to entry and little to no proprietary intellectual properties. There are ample and easily accessible raw materials and plenty of cheap land and empty factories for rent. Practically any company — within or without the industry — can set up a glove manufacturing facility in as short as six months’ time. And this is exactly what happened.
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Production capacity surged in Malaysia, Thailand and, especially, China — by an estimated 65% in total between 2019 and 2021 (see Table 2 and Chart 1). The resulting supply glut — estimated to be some 50% above prevailing demand — sent selling prices for gloves tumbling. Utilisation rates for glove makers plunged. So did margins and profits. All the seven Bursa-listed glove makers reported losses in the latest quarter.
The huge pandemic windfall has turned into a curse for the glove makers. Shares for the three biggest glove makers by market cap, Top Glove, Hartalega Holdings and Kossan Rubber Industries, are now trading 28%, 54% and 15% respectively below their prices at end-2019 (after adjusting for dividends). That’s right — shareholders are now worse off compared to pre-pandemic. Their valuations are lower be cause the expected future cash flows are now less than they were before the pandemic.
That said, we think Malaysian glove makers are competitive in the global market. Hence, there should be a gradual recovery in utilisation, selling prices, margins, profits and cash flows. But it will likely take about three years for the glove market to normalise, when demand catches up with the pandemic-induced supply explosion. It is likely a few of these stocks are now undervalued, just as they were overvalued in 2020-2021. And that is one of the intentions of this article.
The pandemic is a learning experience for businesses, small and large. The winners and losers may not be as clear cut as it first appears. What seemed like a blessing could also turn into a curse. Whether that curse inflicts permanent damage is very much a reflection of manage ment foresight, integrity, capability and professionalism, especially in how they spent the windfall profits.
As they say, money burns a hole in your pocket. Flush with cash, did management choose to reward shareholders by returning the excess cash through dividends, retain the cash to strengthen its balance sheet which would serve it well during this current downcycle, buy back its own shares at high valuations to support falling prices or spend it on ill-timed capacity expansion and worse, non-productive assets to the detriment of shareholder values? For investors, this may be the better judge for a winning or losing stock over the longer term.
For more stories about where money flows, click here for Capital Section
We ranked the performance of management of the Malaysian glove companies in the table, where Hartalega and Kossan came out tops. In the final analysis, it is always about management and controlling shareholders that drive value. It is better to be a shareholder of a coal mine with capable managers of high integrity than to be a shareholder of a gold mine that is not well managed.
The Malaysian Portfolio fell 0.4% last week, paring total portfolio returns to 155.2% since inception. We added 20,500 shares of Hartalega to the portfolio this week. We did a simplistic calculation to determine the marginal costs (operating cost before depreciation) for some of the major glove makers (see Chart 2). The figures are not precise, due to incomplete available data — for instance, we assumed industry benchmark selling prices (without taking into account product differences) — but we believe they are sufficiently useful. Based on the exercise, Hartalega is the most cost-efficient producer among the local glove makers. This portfolio continues to outperform the benchmark FBM KLCI, which is down 24.1%, by a long, long way.
Sidebar Article: What ChatGPT says …
In view of the heightened interest in the capability of generative artificial intelligence (AI), and growing concerns that it will eventually replace human jobs, we asked the same question of ChatGPT. Here is the answer.
Why can windfall profits be a curse to shareholders?
ChatGPT: Windfall profits, which are unexpected and significant gains in a company’s earnings, can indeed be a curse to shareholders under certain circumstances. Here are a few reasons why windfall profits can have negative implications for shareholders:
1. Distorted financial performance: Windfall profits can create a distorted perception of a company’s true financial performance. When a company experiences an unusually high level of profits due to factors beyond its control (such as a sudden surge in demand or favourable market conditions), it may lead shareholders to overestimate the company’s long term earning potential. This can result in inflated stock prices, creating a bubble that may eventually burst when the windfall profits subside.
2. Misallocation of resources: Windfall profits can lead to misallocation of resources within a company. When a company experiences a sudden influx of cash, management might be tempted to invest in projects or ventures that are not aligned with the company’s core business strategy. This can divert resources from more viable long-term investments, negatively impacting shareholder value in the future.
3. Reduced focus on efficiency and innovation: Windfall profits can create complacency within a company. If shareholders and management become overly focused on enjoying the short-term financial gains, there is a risk of losing sight of the need for continuous efficiency improvements and innovation. This lack of focus can hinder a company’s ability to adapt to changing market conditions and sustain long-term profitability, which can ultimately harm shareholder returns.
4. Increased expectations: When a company experiences windfall profits, shareholders often develop higher expectations for future performance. Meeting or surpassing these inflated expectations becomes challenging, especially if the windfall profits were a one-time event. Failing to meet these expectations can lead to disappointment among shareholders, resulting in a decline in stock prices and a loss of confidence in the company.
5. Negative external perceptions: Windfall profits can also attract negative attention from stakeholders outside the company, such as regulators, competitors, or the public. Excessive profits can give rise to accusations of price gouging, unfair competition, or monopolistic practices, leading to increased scrutiny, potential legal issues, and damage to the company’s reputation. These factors can negatively impact shareholder value over the long term. While windfall profits can initially seem beneficial to shareholders, it is essential for both management and shareholders to approach them with caution. It is crucial to consider the long-term implications, maintain a focus on sustainable growth, and avoid making rash decisions based solely on short-term gains.
We will write a more in-depth article on what we think of generative AI, its strengths and limitations sometime in the near future. But it is obvious from this small exercise that we did, comparing its answers to what we had written prior, that the answers are good, much better than many analysts’. Will it replace us?
We followed up with the next logical question. Now that the negative implications of windfall profits have come to pass for the glove makers, is there any stock that is worth buying and if so, why? Here is the answer.
Would you invest in any of the listed rubber glove manufacturers, and why?
ChatGPT: As an AI language model, I cannot provide real-time financial advice or make specific investment recommendations. Market conditions and the performance of individual companies can change rapidly, so it’s essential to conduct thorough research and analysis before making any investment decisions.
If you’re considering investing in rubber glove manufacturers, it’s important to evaluate several factors, including financial performance, competitive positioning, market trends and overall industry conditions. Consider factors such as the company’s revenue growth, profitability, market share, product quality, customer base, and geographic diversification.
Additionally, it’s crucial to stay informed about any regulatory changes, industry developments, and potential risks that may affect the glove manufacturing sector. For example, the Covid-19 pandemic significantly increased demand for gloves, but as the situation evolves, the demand may fluctuate.
To make an informed investment decision, it’s advisable to consult with a financial adviser or conduct thorough research using reliable sources such as financial statements, industry reports, and market analyses. These sources can provide valuable insights into the specific companies you are considering and help you assess their investment potential based on your individual investment goals and risk tolerance.
What this little experiment tells us is that ChatGPT (generative AI) is very informational and far more efficient than Google search in terms of trawling the internet. It can be a very good “research assistant” for background information, if you ask the right questions. But it is not prescriptive — it cannot analyse the information gathered, perform follow-up analysis and give you an actionable answer. This is its limitation, and key difference from humans, at least for the current generation of AI.
— Sidebar Article Ends —
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.
