Can this penny stock double in value this year?

The act of investment is a constant hunt for value. And yet, there are much value, or potential that had yet been undermined by investors in Bursa Malaysia, especially this specific counter that we will be discussing today.

First, let’s list out the key criteria in our hunt in value.

1.  Business Model.

We must understand that behind every stock lies an actual running company. Thus, identifying a business that is not under the sunset industry is very important. It is also important to note that cyclical businesses, such as steel, plantation, oil & gas, property, and construction have its ups and downs from time to time. It is not easy for investor to tap into these sectors unless you yourself are involved in it.  For beginners, you should look into sectors that are “futuristic”.

For the next 5 years, we can assure that semiconductor, automotive, telecommunication and software aspects – such as cloud, IoT, omnichannel development and ERP will show enormous growth. This is why these companies are enjoying premium in valuation, and it is exactly our next discussion point.

2.  Revenue and Earnings Growth.

Despite being in the right sector, not or companies thrive. Yes, a rising tide lifts all boats – but when the tides goes out, we know who are the ones that are swimming nakedly. In economical sense, we know who are just putting up a front but do not really brings in value for shareholder. My personal preference on businesses is for them to show at least – 5-year CAGR revenue of 15% per annum, and net profit CAGR of 10% per annum.

Why is this important? Inflation rate is generally 5% per annum, and any growth lower than that does not provide value to shareholder – a 5% inflation rate means that prices are increasing by 5% on average per annum (might not increase on every single year, hence why the concept of CAGR is introduced), any lower than that and your assets are losing value.

3.  Adequate Cash Flow to Support Growth.

“Cash is king”. This is one saying that never go wrong. During good times, company may expand rapidly without having to rely on debts to increase the gearing. During bad times, company with additional cash could stay in the industry with better cash proposition and engage in aggressive M&A to not only maintain – but outperform their peers in the longer run.

That being said, in the capital market, fund raising is also an important aspect of any listing entity.  I personally think that company with acceptable level of shareholding rights dilution could raise higher cash – this should be accepted.

This concept might be new for investors, but don’t forget stock market exists because companies want access to funding. And the ability to continuously fund – especially when the market is giving premium pricing on the company is exceptionally important in our market.

To adhere with our 3 key pillars of investment, I had identified an interesting case study that fits the 3 of our criteria. You might heard of this company before, whether its good or bad, fundamental statistics still shows this company is a very good investment prospect.

This company is ARB Berhad (Stock Code:7181), it was also previously known as Aturmaju Resources Berhad.

Aturmaju Resources Berhad was engaged in timber activities few years before, however due to several new restriction and regulations set by the government to reduce deforestation activities, timber and lumber sector had faced a severe downturn (our first investment philosophy – skip cyclical companies). The company, had been losing money for more than 5 years. Since financial year 2011 to financial year 2017, the company is constantly losing money – but that is until the new management joined the company – Au Yee Boon and Datuk Sri Liew Kok Leong, they had successfully turned the company around.

No, they did not enhance the group’s timber business – but to completely cease it and change it to IT related business.

The company had since then involved in the business of ERP & IoT – and remember what we mentioned in the first criteria of successful investment? Business model. The company is mainly providing ERP software to small & medium enterprises without a huge startup costs, but a share of their revenue and earnings. On the other hand, they also provide IoT solutions such as smart home appliances and integration system for construction businesses. If you are aware with China’s “TIANMAO” ability to use voice control to control the home appliances, yes, ARBB is providing the hardware and software solutions to businesses.

Based on my industrial knowledge in the sector, ERP had been known for high investment costs – especially for small & medium enterprise. A saving in initial investment costs could benefit them handsomely and establish growth room for both parties in the long run. This is why I love ARB’s business model so much.

Let’s talk numbers.

The 5-year CAGR for revenue of ARB is 58.2003% by using financial year 2016 to financial year 2020. The net profit however, were not able to be calculated due to the company’s money-losing nature in 2016 in the timber business. Meanwhile, since the turnaround of the company in financial year 2018 to financial year 2020, the net profit CAGR for these 3 years were 218.276% - a crazily high growth number. How many Malaysian companies could achieve this figure?

I believe the number would be minimal. The business model is attractive, and the earnings (or numbers) had proved ARBB the be one of the highest growth company in Malaysia. This is despite the impact of COVID-19!

But what about their cash flow?

Based on my observation, ARB’s cash flow is weaker by comparison. As we all know, there are never “perfect companies” that could fulfil all investment criteria. If there is one – the valuation should be sky high. But we should also note that ARB had the ability to finance their growth – without increasing their debt. How does that work?

The company had introduced a financial instrument named “Irredeemable Convertible Preference Share” or “ICPS”. This instrument acts similar like convertible bonds – but with no seniority to the claim of assets upon winding up. The ICPS also does not carry interest, but only the ability to convert it into the mother share of the company. What does this mean?

Upon the issuance of ICPS, investors would need to pay to acquire the right to purchase ICPS. This is kind of similar to warrants – but ICPS could be issued in a much larger based as compared to warrants. On the first level, the company had successfully raised cash from investors but did not immediately carry the dilutive impact onto the company. Even when the unitholder of ICPS decides to convert, he or she would need to folk up additional cash of RM 0.200 per share to convert the ICPS into mother share.

Some investors might have concern on the dilutive nature of this issuance, but lets do some simple math on it.

Prior to the issuance of ICPS, ARB had 67,210,000 share base. The company had announced to issue 15 to 1 for the ICPS – which means the company issued 1,008,150,000 warrant-like instrument onto the market. They had collected the cash, but not all investors converted the ICPS into mother share, hence the dilutive effect is delayed.

As of today, the number of share of ARB is approximately 606,162,162, which means 53.4595% of the ICPS had been converted. It is important to note that the net profit for the company is financial year 2018 is RM4.232 million and RM42.870 In financial year 2020. In financial year 2018, the EPS for the company is 0.06297 and in financial year 2020, the EPS is 0.07072. Do you see despite the dilutive effect, the company is still having a positive CAGR growth in EPS?

In my personal investment thesis, valuation also plays a key role. The P/E for ARBB is currently standing at the astonishingly low level of 5.16 times – this is trailing 4 quarter P/E! Could you find any similar company with higher growth, better prospect but with such low valuation? I doubt so.

Thus, ARBB is truly one-of-a-kind, or I should say rare gem to be found. Back to our topic, could this penny stock double in value this year? I strongly believe so!