Saturday, July 11, 2015

Stress Test For Small Cap Stocks

Before you continue to read the rest of the article, I have to warn that it's going to be another piece of pessimistic view which follows from the previous article. This article is written since we are in the midst of a global rebound from the turmoil of the recent Chinese and US market, so I thought it might come in handy and practical. For others, I'll promise to write some happier views in my next post at best.

Small Cap stocks have been one of my personal favorite in recent years. These stocks have some of the best earnings potential and balance sheet we've ever seen compared to others and valuations are not unreasonable. Fellow blogger, Investment Moat, has written an article about small stocks (Link Here) and he mentioned that not all picks of these small cap stocks will work out. There will be a couple which will propel multi-bagger returns for the portfolio while the rest are probably value traps. It is the responsibility of the investors to dish out the value play from the value trap and some luck probably plays a part more than skills. This is vastly different from picking some of the blue chip names we are more familiar with because the latter are usually backed by more powerful institutional and sovereign funds, compensated by a much more expensive valuations.

For the purpose of this exercise, I am going to pick up some of the small cap stocks which interest me and conduct a stress test tolerance on these stocks. I will also be using the most recent 2008 GFC and 2011 Euro Crisis as part of the stress test trough period to see how these stocks are doing back then and now.

  • China Merchant Pacific
  • Riverstone
  • Silverlake Axis
  • UMS
  • Sarine Tech
  • Nam Lee Metals
  • Second Chance
  • Boustead
  • Kingsmen

Balance Sheet Strength

The first stress test is to check on the strength of their balance sheet.

On the overall, it looks like most companies have a much stronger balance sheet now as compared to back then in 2008 and 2011. Companies which are visibly in the net cash position for years have grown their cash position to even more in 2015, with Riverstone, Silverlake and Kingsmen leading the pack. I've previously mentioned that while keeping cash increases the strength of the balance sheet in general, hoarding too much cash may not be the best decision as it erodes the long term roe of the company.

Companies which are in the net gearing position such as China Merchant Pacific, Second Chance and Boustead are usually asset heavy, with mostly PPE or properties development consisting the majority part of their assets. This does not immediately discount them as being inferior from the rest, it just simply means that they are not as liquid as the rest who are in the net cash position.

Balance Sheet Stress Test

Net Cash as a percentage of market cap %

Earnings Valuation

The second stress test is on their respective earnings valuation.

Given the overall general market trend, it's not surprising to see that most, if not all current earnings valuation are much higher now as compared to the low of 2008 and 2011. Most of these counters have a much stronger balance sheet now as compared to the past, but that doesn't mean that the low of 2008 and 2011 will not be repeated. We just need to know that it CAN happen to allow us to prepare for more room for unexpected things.

I've also included below the implied potential downside risk based on the latest earnings should we revisit again the magnitude of 2008. They are not the holy grail methodology to compute the implied downside, but they are definitely an important mitigation risk that investors need to consider should the world goes into extreme turmoil once again.

Earnings Valuation Stress Test

Implied Potential Downside Risk

Final Thoughts

There's plenty of local investors and friends who have expressed their interests in awaiting for the correction to come and that is a good sign because I'm basing on the assumption that they are ready to stomach the downside and take the opportunities given, either through having sufficient warchest to deploy or having the right mentality to approach them.

The investors from the 2008, 2011 and 2015 will tell you different stories because they have walked and experienced the different walks of life, given the different magnitude of their investing experience in the market. Those who have experienced the magnitude downturn of 2008 will have expanded their mentality of how much they can afford to stomach, including dealing with the less certainty of job security, lesser salary increment, bonus and the noise coming in from all over the media.

If you think just by investing in blue chips you are spared, you may want to revisit those time when Creatives and NOL are still blue chips or read this post I've written earlier about blue chips (Link Here).

For myself, even though I am currently holding a warchest of around 35% in the overall portfolio, I would be a liar if I tell you that severe market downturn does not totally affect me mentally. Take existing investors of Silverlake (vested myself) for instance. We invest in the business because we are determined and confident in their business moat, financials and management, but whoever tell you that they are not affected mentally when the implied share price potential downside is $0.12 (see table above) will be lying straight through their pants. When you see your share price goes down from the high to the extreme low, you'll be asking a lot of questions, including your ability to prospect the company in a logical and efficient manner.

Let me give you another analogy in more layman terms. I am a sucker for eating Salmon fish. Whenever I go to the supermarket, I would check for discounts on the Salmon they are offering on that day. Salmon is an expensive dish, so I'm most likely to buy when they are offering discounts, given the certain limitations that I would have to eat them within the next 2 days since it's probably not the freshest around. I love such deals because there are compromises between myself and the supermarket. They can get rid of the stock while I can get cheap Salmon that I like. However, should the day comes when I see Salmon is offering at $0.01 (extreme discounts), I'll be up on my feet and be very wary because I would be asking if my prospecting of the expiry date was wrong or in fact if they have already expired. I think you get the idea.

I'm not trying to scare the hell out of investors out there but you can't deny that in the stock market, anything is possible and probable. Even given the best preparation you have made out there, you still need to constantly review your prospecting of the business, your asset allocation, your job security, your downside tolerance level and your ability to survive and prosper during a severe market downturn.

Thanks for reading,

Vested in China Merchant Pacific, Silverlake Axis, Nam Lee Metals and Kingsmen as of writing.


  1. HI B,

    I guess the key trick is to know your salmon REALLY well and know when it smells fishy and cheap or when it is smelling fresh and cheap!

    It pays to eat some smelly cheap salmon before and get a real tummy ache, so that next time you can recognise (hopefully!) the bad ones from the good ones.

    1. Hi LP

      Hahaha, I guess once bitten twice shy. The inherent problem with this one that I see is that firstly the choosing of the cheap salmon and get food poisoning is an unintentional process and secondly some people may not learnt from the first mistakes they made. Human errors somehow are always repeated. But it's always good to learn from the early mistake.


  2. At supermarket, we can still verify the fish fresh or not before paying and leaving the supermarket; but not at some stalls with special light effect at wet market. :-)

    1. Hi Uncle CW

      Can touch touch press press but not buy?? :D

  3. We don't panic until everyday we read that it is going to be Global Depression 2.0 and it is going to last at least 10 years and we are in our 40s, 50s or 60s. LOL!

    1. Hi Uncle CW

      Yeah that's true. The media tried to boil up the recent China selldown but they managed a rebound after that. They will come again and the media will again blow things out of proportion once again ;)

    2. Hi B,

      If u invest with the right mindset from start, u do not panic. U sigh only...

      If I am Greek now, staying in Greece, do I panic? No!!! Panic or no panic end result still the same.

      Better to stay calm and think of the next step. A what happened happened, cannot be reverse. We can only change the route ahead..

  4. Good blog. I haven't experienced major financial crisis yet but this helps simulate of the extreme that could happen. I think the best we can do is believe in the company we are invested on.

    Btw, what do you think of Riverstone? Just wondering why you are not vested. I am a fan of this company and has been vested for over a year now. My best performer so far and with the growth visibility of the next 3-4 years.

    1. Hi CM

      Thanks for your kind words.

      If you are investing for the long term, there's no doubt that there will come a day when you will meet the beast. It's just a matter of time if not when.

      Riverstone has been in my watchlist for a number of years now. I like the company's fundamentals but doesn't quite like the valuation that they are offering right now. When the opportunities arise, I will want to relook at the company again.

  5. Good post, timely.

    The good things for you and me - our age!

    Even we "accidentally" bought at the historical high, it will only go higher in the longer run, if you can buy a "good fundamental" company. We wouldn't know how long we will live, but living longer also mean more money needed for Financial Independence. It is a proportionate problem, so it is fine. :)

    1. Hi Frugal Daddy

      Thanks for your kind words.

      I agree with your take in general that the overall market will trend up over the long run, but I'd be wary to consider that during my buying thought process, which can mislead investors to think that it's okay to buy high, hold and still do fine over the long run. They are true in a certain sense but the long term return will severely underperform those who can buy at a fair or undervalued valuation, which is what I think we should be aiming if we are going for early FI :)

    2. Hi B

      That why I am on intensive learning mode and read your blog daily. Haha. Buy low sell high is still the way to go.

    3. Hi Frugal Daddy

      I hope I don't mislead ^^ but I am hardly the ideal choice for buy low sell high. lolx :)

  6. Hi B,

    As a blogger, some readers might think of us as "experts".

    Having crossed the reader/blogger divide not long ago (I am obviously still a reader), I beg to differ that we are "all-knowing experts."

    Good of you to point out that we do feel upset when our buys turn against us by 10-20% immediately after we buy it.

    But the key is, how much do our emotions affect our behaviour? =)

    1. Hi 15hww

      Thanks for your comment :)

      I'd agree that hardly anyone out there is an expert right now because everyone seems to have differing views of their own, which I think they have the right to think so.

      Hmm, I feel like emotions will impact our behaviors to a large extent, It takes a very strong mind and conviction to think of someone who are able to separate emotions from actions a full hundred percent. I think you would agree that humans are driven by emotional and so it's quite common that we act in a certain manner :)

  7. I saw CMP hitting below $1 recently. I guess the recent massive correction in China stock market has something to do with it. Looks tempting to add due to the potential 7% dividend yield.

    1. Hi Betta man

      Yeah, if i do not have already such a huge position in the portfolio, I'll be tempted to add them. But for the moment, I'll just remain vested with what I already have.

      They are likely to remain with the 7 cents/share dividends for this year, which translates to about 7% yield.

  8. "Even given the best preparation you have made out there, you still need to constantly review your prospecting of the business, your asset allocation, your job security, your downside tolerance level and your ability to survive and prosper during a severe market downturn." I think it's one of the best advice ever! people need to take responsibility for themselves.

    1. Hi Vivianne

      Thanks for your kind words as always :)

  9. Hi B

    I am thinking of investing UMS share but do not know what price to enter, it has been under my watch list for very long.
    What do you think about this high dividend stock.

    1. Hi Joey

      From a financial figures point of view, UMS financials look extremely fantastic. High FCF, great earnings yield, fantastic dividend yield, solid balance sheet.

      The only reason stopping me from investing in them is my lack of understanding in the semicon business. Perhaps when I had studied and understand them enough, I will be vested in them one day.

  10. Hi B,

    Wonderful article that serves as a reminder for both novice and seasoned investors. Not everyone has can stomach the very depressed share prices in times of crisis even with emotional discipline.

    By the way, I see that you have a large portion of 20% of your portfolio in CMP. CMP has attractive dividend yield, steady payout ratio and strong earning margins with their business capable of churning recurring income. However, as it is a S-chip, do you have concerns, if any, that investors should be concerned about?

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