Financial Adviser: 5 Reasons Why Billionaire Lucio Co's Cosco Capital Is the Most Undervalued Holding Company and How to Profit from It

Holding companies, which are also known as conglomerates, own equity stakes in various businesses. Theoretically, the combined valuation of all its businesses should equal its total market value.

But market history has shown that conglomerate stocks have always underperformed the stock market because of the perception of lower expected returns brought about by diversification.

Based on historical data, the market value of a holding company is positively influenced by its return on equity (ROE) 73.9 percent of the time.

This means that when the ROE of a holding company falls, there is a strong probability that its stock price will also fall, and vice versa.

Since 2018, the average ROE of conglomerate stocks has fallen from 9.4 percent to 7.6 percent today, resulting in a deterioration in their share prices.

The fall in market values has caused the average earnings multiple of conglomerate stocks to trade at only 4.86 times today, which is roughly half the average Price-to-Earnings (PE) ratio of the PSE Index.

Lower returns also caused the share prices of conglomerate stocks to fall below their net worth. The average holding company today is trading at a huge bargain of 51 percent discount to their book value.

But amidst the decline in the conglomerate sector, there is always opportunity to find stocks that offer good value.

One of these stocks is Cosco Capital, Inc (PSE: COSCO), which may have been priced too low by the market compared to other conglomerate stocks despite its promising fundamentals.

COSCO offers a compelling value investing opportunity as its current share price does not correspond to its long-term fundamentals.

As a value investor, no matter how low the stock has fallen, it is always wise to look at the fundamentals of the stock. When you understand the intrinsic value of the company, you will have more confidence in investing in the stock.  

Here are the five reasons why COSCO may be the most undervalued holding company today and how we can profit from it:

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1| Recession-proof businesses

Cosco Capital, Inc (PSE: COSCO) is majority owned and controlled by a group of business tycoon Lucio Co. It is one of the fastest-growing conglomerates in the country with significant interests in recession-proof businesses such as retail and liquor distribution.

In a recessionary environment where inflation is high, people tend to shift their consumption pattern from dining at restaurants to preparing food at home.

Demand for packaged food and beverage, as well as personal household products tend to be stable during a recession, making the grocery and liquor business highly recession resistant.

COSCO owns 49 percent of the country’s leading supermarket chain, Puregold Price Club, Inc (PSE: PGOLD) and 78 percent of The Keepers Holdings (PSE: KEEPER), the largest distributor of imported spirits and beverages in the country, with a market share of 74 percent based on volume.

Both PGOLD and KEEPER contribute about 98 percent of COSCO’s total revenues with PGOLD comprising about 64 percent of COSCO’s core earnings while KEEPER is at 23 percent.

COSCO’s stock price has been declining consistently over the past years from a high of P18.90 in 2013 to as low as P3.80 per share this year.

But COSCO’s total revenues have been growing strongly by a compounded growth rate of 17 percent per annum since 2013 from P48.9 billion to P174.45 billion in 2021.

COSCO’s consistent revenue growth translated to an annual earnings growth of 12 percent from P2.5 billion in 2013 to P6.3 billion last year.

This year, COSCO’s total revenue for the first six months grew by 8.5 percent to P87.4 billion from P80.6 billion in the same period last year. This increased COSCO’s net income by 9.4 percent to P3.2 billion for the first half from P2.96 billion last year.

If we annualize COSCO’s earnings based on its first half results, we can expect its total earnings for the year to reach P6.89 billion on a projected total revenue base of P189 billion, the highest in its corporate history.

2| Robust cash flows and high quality of earnings

Earnings are an important drivers of share prices. Investors use earnings updates as basis to project how stocks are likely to be valued in the coming months.

The problem is that not all earnings share the same quality.

If you have two stocks that have similar businesses and earnings growth outlook, you should always choose the one with higher cash flows because the risk is lower.

The cash flows of a company can be broken down into three components: operating, investing, and financing activities.

Among the three, the operating cash flow is considered the most important because it indicates the capacity of a company to generate cash from the business.

If a company cannot produce adequate cash flows from operations, it will not be able to finance its expansion activities unless it secures funding from outside either by borrowing or capital raising.

The operating cash flow is seen as a safer alternative to net income because there is less room for management to manipulate the figures.

If operating cash flow is greater than the reported earnings, it means the company has a high earnings quality that may merit a long-term premium on valuation.

The higher the ratio of operating cash flow to net income, the higher the earnings quality of the company, hence the greater the earnings predictability.

COSCO’s operating cash flow has been growing by an average of 18 percent per annum, from P4.6 billion in 2013 to P16.9 billion last year. It represents more than twice its reported net income, indicating high quality of earnings. Its operating cash flow to net income before pandemic was 1.52 in 2019 before it increased to 3.2 during 2020.

Last year, COSCO’s operating cash flow to net income ratio settled at 2.69, still better than the market average of 1.5 times.

3| Strong balance sheet to weather crisis

Every financial crisis can be traced back to a weak balance sheet. In times of economic slowdown, having a strong balance sheet can put the company in a better position to endure an economic crisis.

COSCO’s current ratio, which measures its ability to pay its short-term payables is 6.57 times as June 2022, higher than the 5.82 times it reported in the same period last year.

A company with a current ratio of less than 1.00 does not have the capital on hand to meet its short-term obligations if they were all to become due at once, but a current ratio that is greater than 1.00 means that the company has the financial resources to remain solvent in the short term.

In the case of COSCO, its current assets, which is composed of its cash, receivables and inventory, are more than six times the amount of its total short-term liabilities. COSCO also has low debt-to-equity ratio of only 9 percent of its total equity. If the cash reserve of COSCO at P52 billion is included in the computation of net debt, its financial position will transform into net cash, making company almost debt-free.

With robust cash flows and strong balance sheet, COSCO can thrive even the toughest of times in the economy.

4| Priced below its book value 

For many years, the Price-to-Book Value (PBV) ratio has been associated with value investing. There is a common notion that when a stock trades below its book value, it is considered a bargain.

The book value of a stock, which is historical costs of its total assets and total liabilities, does not reflect the earnings power of its assets. A company can have large book value of fixed assets but if its earnings are not enough to justify its investments, it will have a lower intrinsic value.

The recent fall in the stock market has increased the number of stocks in the Philippine Stock Exchange (PSE) that trade below their book values, especially the conglomerates.

COSCO’s 12-month trailing ROE is estimated at 7.8 percent, which is a little bit higher than the sector’s average of 7.6 percent. However, the copany’s PBV is only 0.34 compared to sector average of 0.49. If we price COSCO’s PBV ratio equal to sector’s average of 0.49, COSCO’s share price eventually appreciate to P5.70 per share, or 44 percent gain.

Moreover, if we compare COSCO’s PBV ratio to its historical ratios, we will find that the stock has an average PBV ratio of 0.57 in the past three years.

Given the quality of its earnings and growth prospects, COSCO’s long-term valuation should appreciate towards at least half its historical book value.

5| Trading at deep value discount

Benjamin Graham, the father of value investing, believes that one way to find the intrinsic value of a stock is by computing its current asset per share, net of all its liabilities. He says that if you find significant discount between its market price and its “net net” value, the stock is considered to be trading at a huge discount because the stock is selling only at liquidation value while giving away its fixed assets for free.

In this case, lets take the total current assets of COSCO, which stands at P93.5 billion. If we deduct all its liabilities, current and non-current, amounting to P58.7 billion, we will have net liquidation value for COSCO at P34.8 billion.

If we compute this liquidation value at per share basis, we will get COSCO’s net asset value at P4.85, which gives an 18.7 percent discount to its current market price of P3.94.

Buying COSCO at this price means that you are only paying for its net current assets, minus all its liabilities and taking the assets of the company for free.

COSCO is the only conglomerate stock that earns at least P6 billion a year with a market that trades below its “net net” value. Almost all the conglomerates in the market have negative net current assets because they have total liabilities greater than their current assets.

The only two other conglomerates with positive “net net” values are A. Soriano Corp (PSE: ANS) and DMCI Holdings (PSE: DMC) but both ANS and DMC are already trading way above their liquidation values.

COSCO is trading at a discount of 18.7 percent for the first time. Previously, the company has traded above its “net net” value. For example, in 2021, COSCO’s market price was 19.6 percent premium its “net net” value.

In 2020, COSCO was priced at a premium of 106 percent of its “net net value” and 317 percent premium in 2019.

If we price COSCO at least at one is to one pricing to its “net net” value per share, the stock should appreciate by at least 23 percent at P4.85 per share. And if we price COSCO at the same premium it enjoyed in 2021 at 19.6 percent, the stock should appreciate by 47 percent to P5.80 per share.

Henry Ong, RFP, is an entrepreneur, financial planning advocate and business advisor. Email Henry for business advice [email protected] or follow him on Twitter @henryong888