In my previous post, I’ve highlighted that the current property market in Malaysia is in a downturn and there are no signs of recovery yet. This could mean that most of the property stocks in Bursa Malaysia are not favored by investors and its share price are suffering from selling pressures. As a contrarian, it could only mean one thing… Is there an opportunity to take advantage of the current property downturn and profit from it?

Let’s face it, you can only get an undervalued company when the overall market outlook is bad. You can never get both good price and positive outlook. Below are top 10 property companies that has been beaten down the most since year 2016:

At the time of writing, there are a total of 94 property stocks in Bursa Malaysia. So how do we find the right one? Here are the FOUR criteria I used to find property stocks that are worth investing in it.

#1: Asset Quality

There are many factors that determines the quality of a property. One of it being the location of the property situated. You can have as many property development projects as you would prefer, if the location of the asset is in a place which is not strategic you would still fail to sell it. Second is the developer’s track record. In investors’ point of view, I prefer to find out how successful the company’s past project is. So, I would want to know their past project’s take-up rate, the design, pricing of the property against the demand. Ultimately, what you want to know is whether the company has the ability to sell its developed property.

For example, in my previous post on KSL Holdings Bhd I highlighted that there is a mismatch between their properties pricing (i.e. average at RM500,000) against the current demand which is more towards RM300,000 and below. As such, it is difficult for them to sell and this explains why its inventory rises significantly. Usually, this is not a good sign for a property development companies. This brings me to my next criteria, “Liquidity”.

#2: Liquidity

This refers to the company’s ability to turn its asset into cash as and when the need arises. In my opinion, this is a very important criteria that you should not ignore it. As you know from my previous post that property cycle usually takes a very long time to recover (around 2 to 3 years or more), companies that are not liquid could risk itself going bust. This is because property is an extremely illiquid asset, you can’t sell and turn it into cash immediately. Normally, you will have to go through all sorts of paper work (e.g. from applying bank loans to signing of sales & purchase agreement) in order to sell the said property and these takes time.

Consequently, companies that focus only on property development would not be able to finance its working capital as they are suffering from lower income due to not being able to sell its developed property. Eventually, they would need to take on more debt to resolve its cash flow problems and they continue to do so until it no longer able to service its debt. So what happens then? They will have no choice but to request money from shareholders (i.e. rights issue, private placement, etc.) despite the company continue to make losses and burn cash. This is a typical example of companies that focused on a cyclical industry.

So how to resolve this liquidity problem? In my opinion, you need another source of income that is stable and recurring in nature. The only way to do this is by leasing out properties and collect rental income. Companies that have a stable source of income tend to be more liquid as they have a stable stream of cash inflows that could help them to either finance its property development segment or service its debt. Thus, ensuring the company operates without any cash flow problem and still has the ability to pay its borrowing. In other words, they are more prepared to survive the hard times of property cycle than others.

In Malaysia, you are likely to find that most property stocks have investment properties that collect recurring income but only contributes less than 20% of total revenue while some have unrelated businesses (e.g. trading, plantation, engineering, etc.) which the income generated are not recurring in nature. Peter Lynch calls this “diworsification” and true enough, their financial performance are mediocre. Some even made losses for few years. Below table is a list of property stocks that have recurring income that are more than 40%.

As you can see, their share price performance are much better despite the weak property market since 2016.

#3: Solvency

The third criteria refers to a company’s ability to pay its debt. When looking for property stocks, I prefer to look for companies that do not take on more debt than they are able to service it. This is not to say that property companies should not take on debt, don’t get me wrong. In a capital intensive business like property development, debt financing is unavoidable. In fact, property companies that do not take on debt is like going to a fight naked. It is a sure lose outcome.

For property companies, they need a significant fund for its land banking activities and property development projects. As such, debt financing is a must because it is cheaper than equity. However, I prefer companies that do not take on debt until a level that servicing it becomes a trouble. My personal rule-of-thumb, a property company should have debt servicing ratio of less than 30%. Anything more, could be regard as risky.

#4: Valuation

This is the final and most important criteria among the other 3 criteria explained above. This is because a fundamentally weak assets can be a good investment if bought at a significantly cheap price to its value. The opposite is also true, a fundamentally strong assets can be a bad investment if bought at significantly high price relative to its value. Whatever the case is, you do not want to overpay a property stock.

So, how do we value a property stock? Generally, you should use price-to-book (“PB”) ratio. The reason being that property stocks are asset heavy (most of it are land and investment properties) and it probably have been subjected to independent valuation. As such, we should assume that property stocks’ intrinsic value should reflect its asset valuation less all its liabilities (this is known as “net assets”).

In determining whether a property stock is overvalued or undervalued, some subjectivity is required and you should really incorporate any risks into your valuation. There are no rule-of-thumb here rather it should be compared against the property industry average PB ratio and take into consideration all the result of your assessments in the above 3 criteria explained (i.e. Asset quality, Liquidity & Solvency).

My Insights

These are the 4 criteria I use when researching for the right property stocks to invest in while it is a general rule, it should be able to protect you from any downside risks. After all, investing is all about controlling your risk of losing money. Only when your downside risk is protected, your upside potential will take care of itself. Hopefully, you learn something new from this post. My next post will be a case study on property stock, stay tuned by subscribing to this website.

This article is taken from http://www.stocksinsights.com/. If you would like to receive more Investing 101 article, do subscribe to this website. You can also check out some of my past articles on REITs or get some investment ideas by browsing through my articles on companies Analysis.