Crash stocks: The Plastics Stocks 9 comments

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I highlight the plastics sector in this article to illustrate the folly of long-term buy-and-hold without regular monitoring and assessment of industry dynamics, or even the simpler approach of cutting loss or taking profit at certain cut-off points. The failure to identify the cyclical nature inherent in a particular sector, coupled to a stubbornness in refusing to exit before it is too late, can lead to heavy underperformance in a bull market and hence great frustration.

This is a convenient sector to track because I follow the sector through my self-created Plastics Sector Index started in mid-2006. By then the sector was already accelerating into its declining stage. But even then, from a starting index of 100, the sector has plunged another 40% through the 2007 market bull and the subsequent bear to hit just above 60 today. For comparison, the STI was up ~35% over the same period, while outperforming sectors/themes like oil&gas and China are up over 60% (according to two other tracking indices I created). Be a patient buy-and-hold investor in the wrong sector and you will be disgusted at the stock market and more justifiably, at yourself.

The boom in the plastics sector started in mid-2003 and lasted till early 2005. That they were among the first stocks to charge up in the bull run gives credence to the sector timing view that technology stocks are among the early movers in an economic recovery.

Indeed, the plastics sector had been growing revenues and profits consistently even as early as from 2002 onwards, which probably caught fund attention when the global rebound began in earnest in mid-2003. They were riding on the trend of electronics manufacturing being outsourced to Asia, a structural shift which had already seen a major wave of re-ratings on SGX-listed EMS (electronics manufacturing services) companies in 1999/2000 along with major M&A deals; the action moved to plastics moulders in 2003-05.

The main sector leaders were Fu Yu, Meiban, Sunningdale, Hi-P, First Engineering. Fu Yu made plastic parts for HP and also Chinese handset companies; Meiban served HP and Dyson; Sunningdale made plastic automotive parts; Hi-P moulded for a diversified customer set and also did downstream contract manufacturing; First Engineering did high-precision components for HP, hard-disk drive OEMs and automotive suppliers. Over 1.5 years from mid-2003 to end-2004, these companies doubled or tripled in price as institutional funds piled in.

I have this plastics sector report from Kim Eng in August 2004 at the height of the boom, and its views were typical of bullish brokerage views of the sector at that time. I quote: "Despite rising uncertainty in the electronics industry" (yes, the industry was already stagnating then), Kim Eng was positive because (1) the outsourcing trend; (2) "it is the material of choice in many products, replacing others such as metal and glass"; (3) "Plastic is playing a more important part in product differentiation" (whatever that means); (4) "Plastic component makers are becoming contract manufacturers and capturing the additional value added in the manufacturing process". Generally, it then set price targets of 15-20X trailing, or even forward PE, on these companies. Typical of brokers to fan the flames of bullishness when the going is smooth.

How, then, to explain the collapse since mid-2005? Obviously, the fundamentals in the form of earnings drove the collapse. Examining one layer deeper, and consolidating the reasons offered by the various plastics companies since then explaining their profit drops, we find that there was a simultaneous confluence of: drop in demand leading to pricing pressure from customers, buildup in plastics manufacturing capacity leading to excess, and a rise in raw material costs due to continually rising oil prices (plastics is a petrochemical product). Individual companies faced further company-specific problems that exacerbated the dire industry plight for them: for example, Fu Yu faced a meltdown of the domestic China handset makers which were some of its main customers, and later ran into management problems; Hi-P's main customer Motorola went downhill after failing to follow up on the success of its Razr handphone; Sunningdale merged with another moulder Omni Mould and then found it hard to cope with integration and excess capacity.

The developments described above lend credence to the view that when it rains, it pours, and thus we should never try to catch a falling knife where sectors or individual companies are concerned (but markets are another matter). Capacity excesses take a long time to work themselves out, and the markets can punish the sector leaders mercilessly in a death spiral: first a PE de-rating as institutional funds sense that the sector has peaked and start to exit, then further price fall as earnings drop continuously, finally a fall below NTA (net tangible assets) as the slide continues (a stock trades justifiably below NTA if its return on equity is too low).

Today Fu Yu is trading at sub-20 cents, a fifth of its peak, and faces investigations for management indiscretions. Hi-P is also trading at about a fifth of its peak as profit margins have halved over each of the last two years. Meiban seems to have recovered in earnings but due to sector PE de-rating remains at a third of its peak. Sunningdale trades at half its NTA; at its peak it was trading at 2-3 times NTA. First Engineering had the best ending: it got acquired at $1.00, just a third off its peak at ~$1.40. There is still no respite for the sector: even if the excess moulding capacity has resolved itself or if individual company managements have embarked on new and more effective positioning strategies, the end demand from the Western economies does not look like picking up anytime soon as the sub-prime crisis continues to exact its toll.

References:
(1) Kim Eng report Aug 04: Plastic Rules