Follow the herd! Win or lose?

It’s been a while since I last posted on My Views. I was attracted to a very interesting stock this time, Hayleys Fibre PLC (HEXP). HEXP is a subsidiary of diversified holdings, HayleysPLC. HEXP is an exporter of coir fibre. However, they generate approx. 15% - 20% of its revenue from the local market. They manufacture a variety of products which fall under five main categories, Erosion control, growing media, horticulture, bedding and upholstery and industrial fibre. In terms of revenue Asia (I assume Russia is also categorized under this by the company) and Europe account for about 75% of their export revenue while the balance is split between Japan and USA. (refer below Sale by region graph, Sourced from Company’s latest published Annual Report).

Company going forward

As per the latest annual report, the management intend to focus on the following in order to grow revenue and increase profitability from the business:

• -       More focus on erosion control, specifically to focus and rationalize the product portfolio and consolidate business with more emphasis on value added products (I hope it the most profitable product category and they will stop producing loss making products);
• -       Invest in new technologies (hope they will increase efficiency and also reduce operating costs);
• -       A backward integration project (this should help reduce raw material costs);
• -       Energy saving initiatives; and
• -       Aggressive marketing at the Joint Venture company level.

With this in mind it is good to look at historical performance to get an idea about how they have performed. (refer below for profitability ratios of HEXP). The performance numbers says the story that HEXP is operating in a very competitive market (globally competing) and are a price taker when it comes to sourcing raw materials.

As a result, returns on capital has been shockingly low. (refer the ROIC chart below). 

Recent explosive growth

At the beginning of this month, REXP was at LKR44.90 (6 October 2015) and as of my writing the stock appreciated rapidly to reach LKR88.40 as 97% return in less than a month. (refer the graph below).

As far as I know, there was no any significant news about the company which should trigger this type of appreciation. (as usual, may be market possesses some information which I’m not privy to).

However, I was interested to find out a reason for this. From what I understand, one reason may be the recent drastic depreciation in the Sri Lankan Rupee. Hence, technically, HEXP being an export company become price competitive in the market and their foreign currency earnings are now converted to higher LKR value. To see how this plays, I ran a correlation analysis in to HEXP’s revenue and LKR/USD to see if they are correlated. However, I was surprised to see that they show a negative .0.8240 correlation.

Alternatively, it is merely due to excessive retail participation due to some market rumour and subsequent herd behavior where everyone else jumped in to enjoy the rally.   

HEXP valuation

In order to value the shares of HEXP, I conducted a discounted cash flow valuation, as I usually do. As always, the valuation is based on assumptions made by me and I certainly do not possess expert knowledge as to how this business operate (but I think my assumption here are more generous than in any other case). However, I have used assumptions that I believe are reasonable and I would be glad to change them and see the impact on valuation if you can come up with more robust assumptions.

My cost of capital calculation is based on few parameters like beta of 1.17 (against All Share Index) for the stock which was taken from Colombo Stock Exchange, risk free rate of 9.85% (current 10 year Sri Lanka treasury bond rate in the market), Equity Risk Premium of 8.00% (my subjective judgment as I currently don’t have a scientific method to calculate, I will soon rectify this), pre-tax cost of debt of 9.50% and a tax rate of 15.31%.

On the tax rate I want to specifically mention that the company’s export earnings are only taxed at 12% concessionary rate while other earnings are taxed at normal 28% rate. Hence, I used a weighted average tax rate for cash flow calculations. Equity and debt weights of 79.59% and 20.41% were used respectively. Using these assumptions I derived a cost of capital for the firm of 16.93%.

The other assumptions are as per the below calculations.

Based on all these, I derived an equity value of c. LKR367.67 of which about 88% is coming from non-operating assets. These non-operating assets consist of Investment Property (property in Ekala that is rented), investment in joint venture company (carrying value of 50% ownership in Bonterra Lanka Ltd, which is equivalent to 50% of the net assets value of the entity) and other financial assets (investment in unquoted shares of Toyo Cushion Lanka Pvt Ltd and Rileys Pvt Ltd which are valued by them based on DCF method).

The derived value gives a per share value of LKR45.96 per share of REXP. The market price as of my writing of the share was LKR88.40 which is 92% higher than my valuation.

Bottomline

As I always say, I’m a very bad trader and every time I try to profit from this type of stock rallies, I end up buying in at the peak. So, now I tend not to join the bandwagon. But, if you are good at trading please go ahead and do it. But, if you are not, please be careful as the stock is currently heavily overvalued as per my valuation (you are welcome to argue with me on my valuation). If you are a believer in technicals, then be mindful as it is now in the overbought territory and a similar fashion drop is also all possible.