Sembcorp Industries Limited: 1 Cheap Blue Chip Stock investors May Want To Worry About

Utilities and marine engineering conglomerate Sembcorp Industries Limited (SGX: U96) is one of the blue chip stocks in Singapore’s market. That’s by virtue of its status as one of the 30 constituents of the local stock market benchmark, the Straits Times Index (SGX: ^STI).

Sembcorp Industries may also be a stock that could attract the attention of bargain hunters at the moment. As Chart 1 below shows, the company’s shares are currently trading at a price (S$2.88) that’s near a five-year low:

Chart 1 - Sembcorp Industries' share price from 12 April 2011 to 12 April 2016
Source: S&P Global Market Intelligence

The share price is not the only thing that’s low with Sembcorp Industries. Some of the conglomerate’s valuation metrics – namely the price-to-sales (PS), price-to-earnings (PE), and price-to-book (PB) ratios – are also near five-year lows. You can see this in the following chart:

Chart 2 - Sembcorp Industries' PS, PE, and PB ratios from 12 April 2011 to 12 April 2016
Source: S&P Global Market Intelligence

Such low valuations may help set the stage for a positive reversion to the mean to occur. A mean reversion is the simple idea that what has moved away from the average will return to it over time. But, it’s crucial to note that a share need not be a bargain just because it currently has a low valuation in relation to its own history. Investor Ric Dillon explains:

“On the behavioural-finance side, one of many inefficiencies comes from people anchoring on the past. People assume something is cheap, say just because it hasn’t traded at such a low valuation for five or ten years. But that doesn’t matter, what matters is what will be.”

There may be some cause for worry with Sembcorp Industries’ business. Chart 3 below illustrates the changes in the conglomerate’s returns on equity and net-debt to equity ratio from 2010 to 2015.

Chart 3 - Sembcorp Industries' returns on equity and net-debt to equity ratios from 2010 to 2015
Source: S&P Global Market Intelligence

What Chart 3 shows is that Sembcorp Industries’ return on equity has steadily declined over the past few years despite its net-debt to equity ratio rising. In general, companies can increase their returns on equity by borrowing more money.

But in Sembcorp Industries’ case, rising borrowings (as alluded to by the increasing net-debt to equity ratio) has come alongside a falling return on equity. This could be a sign that the economics of Sembcorp Industries’ business have been deteriorating.

Mean reversion applies to many areas in life, including a company’s business results. So, there is a chance that what Sembcorp Industries has experienced from 2010 to 2015 may be temporary in nature. But if that’s not the case – meaning to say that the economic characteristics of Sembcorp Industries’ business have weakened permanently – then even Sembcorp Industries’ current low valuations may not make it a bargain.

That’s a risk that current and prospective investors in Sembcorp Industries may want to think about.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.