Sunday, 17 November 2019

PART I : TEO SENG WARRANTS. RM46,000 PROFITS IN 1.5 MONTHS. HERE'S HOW WE DID IT.

 
I'm writing this post in the first person, for a change. This will be an extremely long winded account of a trade that went right - so long that we broke this into two parts. 

More than anything, this is a personal account of what this trade represents, for me personally and for the team. I'm not sure if this is written with our readers in mind, and I apologise for that.

You can see from the title itself how much we made - the trading aspect will come in Part II. Somehow, we managed to score a decent (car-sized) profit for once. It's the result of a painstaking preparation process, and sheer effort to maintain a position. I have to admit that our holdings in this trade is far larger than our conviction.

I'd like to think that it's not about the money, but of course that's a factor. This was an important test of our credibility and ability to come up with meaningful insights. We did the research ourselves. I made sure we covered all the bases, and that we would not commit to any dumb decisions. 

Perhaps in a very small way, I felt like we had cracked the code - just a bit. My ambitions are as large as my capacity for risk taking. We all have day jobs, but perhaps with this kind of performance, we can do this full time eventually, at some point.

Hence the importance of this trade as a test case. It was crucial that we took care of both sides of the research equation - fundamentals and technicals. We pored over financial statements. Several annual reports, we tried to read from front to back. We scrutinised the charts. We envisioned about 20 different trading scenarios. There were some sleepless nights.

I call this a test case simply because we are now fully validated in our approach. We had an original insight, and we were certainly early in this trade. I did not see anyone else in the market when this warrant was at five sen, apart from a few souls who were probably smarter than we were. 

We got into this warrant at around 7 sen or so in late September; we bought it all the way to the bottom. Then, in early November, the warrant jumped to 20 sen.

Now we know we have the tools. We can utilise them when a similar opportunity presents itself. In fact, we can scale the trade ten times larger. Maybe. 

It would be neat to achieve financial independence out of this whole business. But to do that, we will have to replicate these kinds of trades another 100 times, perhaps. But I don't think money is the main motivating factor, nor should it ever be.

I'd do all this for free, with a virtual trading account and fake money, if I had no other option. Trading is not a hobby or a side hustle for me. I'm just an obsessive person who is naturally curious about things. Capital markets is my life, and how I define my identity. Maybe that's what it takes to trade this way.

So I'm telling the story of this particular trade - and it's worth reading in full, since I'm sharing everything I know about it - in extensive, painful detail. I do wish you can apply some of these findings in your own trading.

Now let's switch to our usual third person narrative.



A CHICKEN & EGG PROBLEM

We really have to go back to the events surrounding Leong Hup International's IPO and listing in May, which sort of put the brakes on the momentum of the high flying poultry sector.

As an associate company of LHI, Teo Seng Capital, was an earnings contributor and egg producer. LHI is primarily a chicken supplier; in a nutshell (egg shell?), these two are among the best poultry stocks you can buy on Bursa Malaysia. 

LHI, which in itself carries an awesome back story and a long history of entrepreneurial success, was relisted on Bursa Malaysia as a multi-billion ringgit poultry conglomerate. The listing did not result in a pop in LHI's share price; it went the opposite way, actually.

The listing somewhat unfortunately coincided with negative industry fundamentals. Chicken prices, already at four year lows, saw a major fall in the second half of 2019. Indonesia had to resort to mass murder to support selling prices. Small chicken farmers and corporates alike were in a spot of bother.

In August 2019, LHI disclosed that it expects a significant dip in earnings, owing to lower-than-anticipated selling prices for chicken. This of course sent the stock into a tailspin; from its IPO price of RM1.10, LHI's stock fell steeply to a low of 70 sen by the end of August. A 34% decline in barely three and a half months... not a good look. 


There are tons of reasons why the stock fell; this much is obvious. What we were really interested in are the reasons why the stock shouldn't have fallen as hard. It was a telling sign that LHI's stock bottomed out just after it released quarterly earnings to reflect the weaker-than-expected selling prices. Since then, it has exploded upwards. From 70 sen to 90 sen? A very handsome stock.

Without boring you with the technical details, let us describe the simple dynamics of this type of business. Because of the sheer scale of LHI's operations, a marginal shift in selling prices brings overall revenue down. 

This is a firm with huge fixed cost obligations, and huge capacity of production. Let's assume those costs are fixed, and take into account just the drop in revenue, which apparently wasn't enough to be offset by higher demand (because of lower chicken prices, get it?).

Ultimately what happens here is that your bottom line gets hit. So LHI ended up with marginal profits of RM16 million from revenues of RM1.47 billion in 2Q. 

We all watch net profit margins, and in this case the figure was a meek 1%. Of course some investors would up and run: if the company only makes this much, how do you think they are gonna pay the dividends??


We posit an alternative  theory. We think it's fairly awesome that LHI can even make all those profits when chicken prices are at multi-year lows. The economics of scale still makes sense. For net profits to return to their expected levels, chicken prices simply have to normalise, and we're talking about an increment of a few teens in cents here.

And of course, since chicken is clearly an indispensable part of the Southeast Asian diet, think of it as hedging : cheaper chicken, higher demand. Prices can only go down so much.

But you know what else is an indispensable part of our diets? Eggs. This is where the hero of the story comes in.



TEO SENG CAPITAL BHD

This company, in our minds, was a clear cut winner with a capital W. But it seemed to be held back by some exceptional factors. 

Just to rattle off some stats, if this company is to be compared to its listed poultry peers on Bursa Malaysia.

Best net profit margins. 

Strangely low price-earnings ratio. 

A diversified earnings base with reliably profitable exposure in side businesses such as animal feed and care products (which somewhat explains the higher-than-peers net profit margins).

Most other egg producers are nowhere near as profitable; clearly this company was doing something right.

TEOSENG annual performance, from the annual report

None of these are particularly insightful observations. The whole market knew this. Why else would the stock go up 51% between January and May?

Even when it peaked, there were reports suggesting that the stock was still undervalued.


TEOSENG daily chart, from January to 13 May, 2019


TEOSENG's stock was winning - until LHI went to listing.

For better or worse, the market's expectation of the poultry sector was readjusted after LHI came into the market. Of course, being an associate company, TEOSENG's stock was dragged down alongside it.

It went for a nosedive off a steep cliff, with some time to do a flip. Ouch.

TEOSENG's daily chart, 15 May to 28 June 2019

But let's not forget - the egg business is a whole lot different than the chicken business.

LET'S TALK EGGS

We spent about three months doing deep dive analysis on eggs, and everything there is to know about the protein. How to produce them. How to cook them. How to eat them.

We tried to understand the underlying economics, the supply and demand, and all those things.

We also nudged the Department of Veterinary services to update the egg prices for a week in which it came out a bit late. They were prompt with their replies. They are angels.



 Egg prices, Department of Veterinary Services Malaysia. Link here.

And from this we graphed the trajectory, for what it's worth.


  Weekly egg prices, Grade AA


The first thing that struck us was this : weren't egg prices much cheaper last year?

The second thing : why aren't people making a fuss about higher egg prices this year? Perhaps we all just came to terms with it somehow. Or we were all too absorbed (and disillusioned) by the current state of Malaysian politics.

The fact remains that an egg producer like TEOSENG can reasonably expect good earnings with higher egg prices. As a controlled item, the fluctuation in prices shouldn't be too out of whack.

Think of us as complete virgins on the subject of eggs and poultry farming. We are amateur sleuths, and we needed to understand a few things; real money is on the line, after all.

So we learnt about 'All In All Out' and 'Closed House' rearing systems that the company practices. It's a highly regulated industry with extremely tight quality control requirements, all laid out in lush details in their annual report

There is no doubt that their operations are of the highest quality possible : you don't mess around with biological assets. If the (egg laying) chickens die, the business dies.


No, seriously. It's a great site.

We also tested the product from TEOSENG's farms. Yolk is fine, quite tasty fried, or scrambled. We tried a comparison with eggs made by QL and LKH, but a taste test is somewhat useless (as we naively realised just then) since we are not egg taste experts. They all taste like eggs.

Most people go to the supermarket and they get whatever's cheap and available.  Preference is more on whether the egg is Omega-enriched, organic, or else. At the very least, we found out that we can easily get TEOSENG's eggs at any Tesco; as you will see by the end of this story, we are having only these for the next few years.


WHAT TO INVEST IN?

Let's revisit LHI again. Look, we have a personal bias into liking the company. It's a multibillion ringgit chicken empire that's going to continue making billions of ringgit. It also has a dividend payout policy.

And most important of all, we thought the selling in the stock was severely overdone. The lower it goes, the more valuable it becomes. Investors stand to get not just capital gains, but also great dividend yields. The smart money would buy all the way to the bottom.

We did separate research into LHI's business and the price trend for day old chicks prices. We won't bore you with them here, but some interesting charts. You can also read this on how to start your own reban ayam business.

Weekly prices, day old chicks (DOC)

And this little gem:

We didn't question the LHI's stock selldown; we just questioned its severity. DOC and broiler chicken prices clearly had a major dip in the second quarter, but the subsequent recovery was quite significant.

In fact, DOC prices just had to normalise slightly for LHI's net profits to recover. This thinking can be applied to the stock itself - LHI's shares just need to recover slightly for a smart investor to get double digit capital gains. There is a lot of money to be made here.

The first important hint that we received was when the stock did exactly this. After a sustained spell of selling, and more selling, LHI suddenly jumped. It seemed as if the bad stuff had already been priced in.

LHI stock, 29 & 30 August 2019 - a 16% increase in two days

As we have highlighted early on in this blog, in one of our least read articles, we were quite confident that the sector recovery was just beginning. Having done some legwork on the viability of the poultry sector, we narrowed down our stock picks to the market leaders - LHI and TEOSENG.

Both are set to enjoy better earnings in the third quarter as a result of higher average selling prices for DOCs, broiler chickens, and for TEOSENG, eggs. 

Check out this chart: LHI spiked, but TEOSENG hasn't recorded its own (we hope) 16% in gains. The two stocks went down together when LHI went for listing - we figured there is some room for TEOSENG to recover by 3Q, or end of 2019 at the latest.


We waited a bit for this angle to confirm itself; there was still a significant risk that the upside in LHI would be temporary. By mid-September, the stock successfully maintained its value at between 80 and 84 sen.

As specialists in warrants trading, we immediately considered warrant proxies in LHI and TEOSENG. Warrants enable us to leverage and juice up our returns; we like them because we are risk taking cheapskates, that's all.

There was only one viable candidate for LHI, since the other call warrants were priced at IPO price levels; most were useless as a trading device. There was LHI-CM, one of the first call warrants to be issued after LHI's big fall. The benefit of this is that the upside potential is (we think) properly priced into the warrant structure. 

You can see here that the value proposition is clear. If LHI goes back to RM1 levels, the payoff in this call warrant would be huge. At this time (end-September), LHI-CM was priced at around 8 sen.

Note the break even price at expiry.

However, we were even more excited with the second option. It was a high-risk, high return proposition, with an amazing payoff potential if this sector recovery happens the way we think it would.

Presenting our rocket to the stars : TEOSENG-WA.

ACCEPT THE TERMS & CONDITIONS?

From the warrant structure details laid out above, we were presented with an option: accept the terms, and bear the responsibility.

TEOSENG-WA carries with it some major risks. It is not for the faint hearted, and we had to decide whether to commit fully to this angle.

So what are the risks? First, this warrant is nearing expiry in January 2020 - or about four months from the date we had considered an entry. It was listed back in 2015; it went through some up and downs, but at this particular point in time, it has never been cheaper.

Why cheap? It's simply a factor of time decay - warrantholders/the market are simply pricing in TEOSENG-WA's lack of potential. A near term recovery did not seem likely at the time. 

With an exercise price of RM1.35, one-to-one conversion ratio, and with the warrant trading at around six sen, the theoretical value of the stock plus warrant is RM1.41. 

In simple terms, if you got a bunch of warrants that you can convert into TEOSENG shares by paying RM1.35 apiece, the sum (RM1.41 = RM1.35 + RM0.06) would be beneficial to you IF the stock goes above RM1.41 in the future. But of course we had no intention of converting into shares. 

And oh, the warrant needs to hit RM1.41 before it expires - it's a race against time. The prevailing warrant price suggests that the stock did not have a chance in hell of this happening; TEOSENG was trading at around RM1.10 levels when we came in.

The warrant price basically collapsed because the market doesn't expect such a price point to be attainable in the short term, or at least before the warrant expires. Having done our research, we completely disagreed. Now all that's left for us to do is to commit.

But here we encountered a second, potential fatal roadblock: NOBODY WAS TRADING THE WARRANT ANYMORE. 

To give you a sense of how dead this thing is, the warrant had declined by 90% from May to September (!)


Here's one question that we get asked often : how insane do I have to be to contemplate such a trade?

The answer : your money, your call. Don't do dumb shit that you don't understand. Protect your money like your life depends on it, because in some ways it does.

This insane trade is the only way to really achieve insane profits. There aren't a lot of avenues in which you can trade and make 150% profits in under two months. This trade is the culmination of our collective experience trading in the markets. 

We really had to tread carefully by structuring a trade. We understood the payoff potential. We also fully came to terms with possible losses. So here's what we essentially did.

STRUCTURING THE TRADE

We defined our trading parameters first.

Buy range for TEOSENG-WA : Between 5 and 7 sen.

Stop loss point : 4 sen (potential loss of 42% of invested capital)

Target price : 12 sen (potential upside of 70% and beyond)

Then, we incorporated some automatic steps to take. To make this really worth it, we intended to buy as much of the warrants as we can.

Parameter 1 : 
Establish a core position of 200,000 warrants
 (at 7 sen apiece, the maximum cost of capital is RM14,000)

Parameter 2 : 
Add to the core position if it is profitable 
(the 'profit buffer' having been established).

Parameter 3 : 
Only buy more if the chart, price, and volume, suggests upside momentum.

In stark terms, we are investing in a dead warrant with an expectation of it coming back to life.

And if this angle works out even slightly, we knew our profits would be huge. If it doesn't work, we'd end up with the proverbial eggs on our faces.

To skip to the ending a bit, we guess it's not much of a surpirise to diclose the eventual outcome.


In our next post, we will discuss the trade itself: the many days it took to build a position, the nerve-wracking days and weeks with zero progress, the temporary losses, the long and painful validation process, liftoff, and how to really hold on to massive gains.

<Continued in Part II>

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