Value Investing Summit 2016: Quietly Innovating Value with Hidden Champions – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | Jaunary 26, 2016
Bamboo Innovator Insight (Issue 117)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

Value Investing Summit 2016: Quietly Innovating Value with Hidden Champions

“Why is 2011 the Year of Accounting Fraud with cases from Sino-Forest to Longtop Financial Technologies all concentrated in the year? What if similar conditions in 2011 were to surface to result in the redux of 2016 as the Year of Accounting Fraud?”

This is a question that I pose to the audience of 1,600 lifelong learners at the 5th Annual Value Investing Summit (VIS) held in Singapore in which I have also invited friends from the MIT University Endowment Fund as VIP guests to given their feedback and accomplished value investor Hemant Amin, the Founder and Managing Director of Asiamin Group of single-family office, to be one of the distinguished speakers.

Eliminating potential frauds and misgovernance is a necessary step that many value investors fail to adjust for in their western-based screening and financial statement analytical tools to identify seemingly statistically “cheap” stocks with high net-cash or high net current asset value (NCAV) as a percentage of their market cap.

CHS

Most were intrigued when the case of China Hongxing Sports was dissected to illustrate how a typical value stock with healthy financial fundamentals generating high profit margin (>15%) and high ROE (>11%), and cheap valuations with PE 3.5x, P/Book 0.4x with downside protection with cash as percentage of market cap at 110% during 2008 in the Global Financial Crisis, unravelled as a fraudulent stock in an audit failure with “missing cash” on Feb 2011.

Subsequently in the next few slides, when they were shown that the accounting fraud can be detected from the footnotes in 2008 before the implosion in 2011, they were somewhat stunned. The use of short-term financing schemes – unsecured related-party loans, loan guarantees, promissory notes, investments and “other receivables” – propping up artificial sales in money-go-round transactions to give an illusion of a value stock is one of the five commonly-used tunnelling opportunity used by actual syndicates and insiders to expropriate corporate wealth when the fraud perpetuators discontinue with the scheme.

This systematic fact-based framework can also be used to not only detect and prevent accounting fraud, but also to spur corporate reforms, especially in flushing out the lemons in the Singapore capital markets to restore trust and credibility with the investors. A personal belief is that the capital markets should serve the grand purpose of “藏富于民”, as a vault for common folks to protect, to preserve, and to compound their wealth in outstanding wide-moat innovators. Until the lemons problem has been resolved, getting retail investors to “invest” their hard-earned savings or/and CPF in the Singapore capital markets is an irresponsible initiative.

Framework

2011 is the year of the shadow banking crisis rearing its ugly head, leading to a tightening in credit conditions and greater regulatory scrutiny in March 2011 to curtail short-term financing schemes that had fuelled the opportunistic use of the roll-away “other receivables” to expropriate cash and subsequently the Big-Four audited healthy companies implode in accounting fraud scandals. Since the onset of this tunneling fraud wave in 1Q 2011, Shanghai Composite Index went on to collapse more than 30% over the next two years.

2016 could see the repeat as the Year of Accounting Fraud with the recent eerie news on January 22 that Chinese banks are curtail short-term financing schemes in bill financing after the case of Agricultural Bank of China swapping “bankers’ acceptance note” (BAN) for newspaper in the one of China’s largest bank’s strongbox to tunnel and embezzle Rmb3.8bn ($578m).

BAN1

BAN2

Western-based accounting fraud detection techniques and tools in abnormal accruals or financial ratios analysis break down when it comes to Asian companies. The overconfident value investor who neglected the footnotes and relied primarily on machine-aggregated numbers to churn out financial statement analysis based on value investing principles would have missed out critical information on tunneling that would enable them to avoid the pitfalls in the Asian capital jungles. This Jan 22 announcement hitting the market microstructure and corporate balance sheet’s ability to engage in roll-over tunneling sins could mean that Shanghai has a potential 30% downside to 1,900-2,000 over the next two years.

Shanghai

In Part 2 of my presentation, i share the philosophy of “Good is not the absence of evil”: how the value investor can only eliminate the “evil” ones with potential misgovernance and accounting tunneling fraud to limit downside risks – and still neglect and overlook the “good” compounders. And each time round there is a credit crisis punctuating the markets, there is an increasing premium on valuation for wide-moat business models in Asia as the Innovators stood apart from the Imitators and the swarming Incompetents. Value investors in Asia need to take the leap to become more Munger-like in selecting companies with wide moats that can generate compounding returns rather than dwell with a false sense of security in the realm of statistically cheap stocks that turn out to be either fraudulent or value traps as time progresses.

Enhanced

I also shared how our enhanced systematic team-based investment process since Sep 2015 to identify and invest with conviction in “Hidden Champions” has resulted in our portfolio to outperform the Asian market indexes by double-digits (as at 26 Jan 2016) in turbulent and difficult times. Conviction matter and our top positon in the portfolio (36% of our invested portfolio) has generated positive absolute returns when the overall market is down 10-20%. We aim to be the Top 20 Shareholder disclosed in the Annual Report of the companies we invest in as a demonstration of our conviction and transparency in the investment process – and our Hidden Champions Fund is a Top 20 Shareholder in 5 world-class wide-moat companies, which we share some of them as case studies in the VIS.

VIS1VIS2

I feel extremely blessed to have the opportunity to be involved as a family member of the ASX-listed 8IH team in organizing the VIS event, a meaningful learning platform that brings together like-minded value investors to have a sincere sharing and interaction session, with the objective to enable every one of the 1,600 participants to have an inner compass crafted in the value investing fire to guide us through stormy weathers and compound wealth with resiliency.

VIS3

I am also grateful to have the opportunity to share some of my insights on the systematic fact-based framework to detect accounting fraud in an interview by ChannelNewsAsia’s MoneyMind at the VIS and I would like to thank the CNA MoneyMind team. I also like to express my heartfelt thanks to Mr Hemant Amin who has wowed the audience with his deep thoughts and experience on “The Quest for a Positive Lollapalooza: Great Businesses & Focus Investing”.

 

Hemant

I like to share Hemant’s 68-slides presentation and my 119-slidedeck at the VIS with our Moat Report Asia Members. We look forward to interact with more like-minded value investors at the VIS in the many years to come!

PS1: We will be back on 8 February with our Monthly Moat Report. We will also be issuing an additional Monthly Moat Report Asia in 1Q16.

PS2: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for January 2016 investigates an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly.

This deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in pneumatic tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%. The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.

Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.

The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.

Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.

Asia’s Wide-Moat Winners in China’s Yuan and “Quality Fade” Meltdown – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | Jaunary 18, 2016
Bamboo Innovator Insight (Issue 116)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

Asia’s Wide-Moat Winners in China’s Yuan and “Quality Fade” Meltdown

福兮祸所伏 祸兮福所倚” – 《老子》第五十八章

“Good fortune lies within bad, and bad fortune lurks within good.” – Lao Tzu 

“At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it’s going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.”

– Warren Buffett

Should the devaluation risk of the Chinese Yuan becoming the next Ringgit materializes, and capital flight outflow accelerates into a flood that overwhelms the forex reserves and triggers non-performing loans (NPLs), how can value investors position their portfolio in stock picks that are long-term winners in this trend?

China2 China1

While the weaker yuan appears to temporarily benefit Chinese exporters of commodities, such as steel, which are facing an overproduction and overcapacity situation contributing to a glut in inventories and artificially propping up employment for social purposes, we think that a weak yuan has negative overall impact on Chinese companies who are reliant on USD-denominated debt and are dependent on importing specialty materials and high-tech components to “manufacture” the products. The typical Chinese companies do not possess these know-how and technologies since they are opportunistic traders-dealers-distributors and have been indulging in non-core business activities to generate non-operating and investment income from riding the yield curve impact of a strengthening yuan since 2007.

On the ground conversations with local Chinese companies have indicated that core profit margins have compressed severely. According to the official data before the devaluation in August and December 2015/January 2016, 97% of the increase in profits earned by Chinese manufacturers came from securities investment income. A recent report by Financial Times on Jan 11, 2016 pointed that China banks could require up to US$7.7 trillion of new capital and funding over the next three years with the rise in NPLs which have been doubling annually since 2012 to become a “neutron bomb”. “China Merchants Bank, China Everbright and ICBC are seen as among the most troubled,” and “State bailouts could send the government debt to GDP ratio spiralling from 22% to 122%.”

This well-hidden messy situation has also exacerbated and accelerated the problem of “quality fade”, the deliberate and secretive habit of widening profit margins through cutting corners and a reduction in the quality of materials.

We think an underappreciated opportunity lies in this “quality fade” problem which has reached a tipping point in triggering Chinese middle-class consumers to switch and flock to using quality products in their daily lives by Japan, Korea and Australia/New Zealand.

In Japan, the hunger of Chinese consumers for quality led to the phenomenon of “bakugai”, or “explosive buying” by Chinese tourists of Japanese goods from rice cookers, electronic toilet seats, air purifiers, watches, infant milk, baby shoes, biscuits, high-end apparels and shoes, diapers, cosmetics, perfumes, spirits, cigarettes, bicycle parts, and condoms to toothbrushes. In the China online marketplaces Taobao, Tmall, JDmall, Japanese goods dominate. For instance, the disposable diapers of Unicharm, Lion Corp, Kao and Daio Paper have become smashing hits. Lion’s high-end Systema toothbrushes, sold for about $1.60-$2.40 in China, two to three times more than a typical local brand, made its online debut in China in 2011 on Alibaba’s Taobao and by the year ended December 2014, sales had rocketed fifteen-fold, and Lion became No. 1 in China’s e-commerce market for toothbrushes within just three years. Ryohin Keikaku, operator of Muji stores, has seen increasing popularity and sales of its “no-brand” quality products amongst Chinese consumers despite the apparent overall economic slowdown and has opened its largest Muji apparel and household goods store in downtown Shanghai in December last year.

While there are reasonable concerns that the weaker yuan would result in Chinese consumers to cut back on their spending on such foreign goods, we think that the “quality fade” problem would provide a rising floor for such purchases, especially when the perceived and actual value for money had become part of the lifestyle habit of the Chinese over the past few years.

As highlighted in last week’s article “Bending Adversity with Low-Volatility Wide-Moat Innovators”, we are positive on overlooked and undervalued Hidden Champions in Asia with market leadership and unique business models. One of them, whom we have highlighted last week, is a winner in this hunger for quality by Chinese consumers, a Japanese-listed consumer healthcare/lifestyle innovator who enjoys a dominant 50% domestic market share leadership to provide healthy recurring cashflow.

Due to exceptionally strong demand from selling its consumer healthcare/lifestyle high-end products on online platforms to Chinese middle-class consumers over the past few years, especially in its innovative super-premium product that was launched in April 2015 and is priced double that of the premium product of its UK-listed global rival, this innovator has stepped out of its comfort zone to build its first plant in China for the past eight decades in Guangzhou which will be operational by March 2016. Now the second-largest brand in the China market with a 14% market share, this Japanese innovator is set to close the gap with the UK-listed leader whose product quality and innovation lagged behind. This Japanese innovator will be converting an existing factory to focus production of its innovative super-premium product which has doubled its overall interim results profits (year end March to 1st half September) since it was launched only in April 2015. It has also leveraged its material science technology and know-how to build a 90% market share in its industrial business niche.

This low-profile family business innovator was established in 1934 under the motto of using science to enrich everyday lives and has avidly pursued high product quality and sought to build its brand. It has made consistent dividend payout and share buyback over the last ten years. The company has also issued a positive profit alert on Nov 5, 2015.

Consumer Healthcare1

Consumer Healthcare2

This innovator trades at a decent EV/EBIT 13.7x and a EV/Sales of 1x and has a healthy net-cash balance sheet with a long runway to compound value.

This innovator reminds us of two Japanese ancient proverbs that we find particularly relevant for value investors in this challenging times. The first proverb is “雨降って地固まる” (Ame futte ji katamaru), which means that “after the rain, the earth hardens”. In other words, adversity builds character and opportunities.

The second is “能ある鷹は爪を隠す” (No aru taka-wa tsume-wo kakusu), which means a skilled falcon hides its talons. Now, after hiding its talons for the past decades, and when most manufacturers are retreating from China due to the erosion of their cost competitiveness in largely commoditized goods, this Japanese innovator is using them to its advantage when no one expects it after building strong demand for its innovative high-end consumer lifestyle products using the China online marketplaces and it is carrying out low-risk capex investments to cater to Chinese consumers who are hungry for quality.

We will reveal the names of some of these Hidden Champions in the 5th Annual Value Investing Summit (VIS) on 23-24 January 2016 in Singapore. Do stay tune as we bend adversity together by investing in Asia’s wide-moat winners that are beneficiaries of China’s “quality fade” meltdown.

PS1: We will be back on 26 January with the slides in the 5th Value Investing Summit (VIS).

PS2: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS3: We will issue an additional Monthly Moat Report Asia in 1Q16.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for January 2016 investigates an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly.

This deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in pneumatic tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%. The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.

Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.

The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.

Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.

Bending Adversity with Low-Volatility Wide-Moat Innovators – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | Jaunary 11, 2016
Bamboo Innovator Insight (Issue 115)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

Bending Adversity with Low-Volatility Wide-Moat Innovators

With markets ravaged by fears over the adverse impact on continued Chinese yuan devaluation (possibly even by another 10-20%), the accelerating capital outflows and depletion of the forex reserves in China, and fears over the hard landing risk of the Chinese economy, it is worthwhile to keep in mind the Japanese proverb: Wazawai wo tenjite fuku to nasu (災いを転じて福となす). This wise ancient proverb literally translates to bending adversity and transforming it into happiness and fortune.

The low volatility anomaly, or the tendency for low-volatility or low-beta portfolios to outperform market averages, has been the subject of intense academic and practitioners’ research and lead to rapid growth in low-risk equity investing in recent years. Finance researchers Baker, Bradley and Wurgler (2011) argued that “the outperformance of low-volatility portfolios is perhaps the greatest anomaly in finance.”

Limit to arbitrage has discouraged “smart money” in low-volatility stocks, some of which tend to be relatively less liquid in daily trades. Empirical research by Jason Karceski has shown that institutional investors whose mandate is to beat a fixed benchmark tend to chase returns over time, making fund managers care more about outperforming during bull markets than underperforming during bear markets, increasing their demand for high-beta stocks which creates over-valuation and underperformance when they sell the high-beta stocks.

The results for the low-vol phenomenon also hold for international and Asian stocks. Some notable recent examples include Chinese rice cracker giant Want Want China (151 HK) and instant noodle giant Tingyi (322 HK) which corrected over 40-50% in the past one to two years.

Want Want China (151 HK) – Stock Price Performance, 2008-2016

Want Want China

TIngyi (322 HK) – Stock Price Performance, 2006-2016

Tingyi

In a study published in 2014 in the International Review of Finance by finance researchers Seiichiro Iwasawa and Tomonori Uchiyama, the low-vol phenomenon in outperformance is found to hold true in the Japanese stock market and that it is attributable to foreign institutional investors who over-weight high-beta stocks, as captured in the two charts that were extracted from the article below. In the first chart, the stock portfolio with the lowest-decile low-volatility outperforms the most, while the stock portfolio with the highest volatility underperforms the most.

Japan1

In the second chart, the black line captures the difference in cumulative excess returns between the highest volatility portfolio and the lowest volatility portfolio; the difference is negative and while it is donward trending, when foreign investors’ net purchases of Japanese stocks are strongly positive, the trend either weakens or even reverses.

Japan2

A notable recent example of a high-beta or high-volatility stock is Fast Retailing (9983 JP), the owner and operator of apparel brand Uniqlo. A low-volatility stock is Ryohin Keikaku (7453 JP), the owner and operator of Muji.

Fast Retailing (9983 HK) – Stock Price Performance, 2013-2016

Uniqlo

Ryohin Keikaku (7453 HK) – Stock Price Performance, 2013-2016

Muji

We believe that serious value investors can bend adversity with a distinctive class of low-volatility wide-moat innovators, which we like to call them “Hidden Champions”, a term coined by German business leader Hermann Simon, chairman of Simon-Kucher & Partners, Strategy & Marketing Consultant. We adapted the philosophy of the “Hidden Champions” to apply in value investing and these low-volatility wide-moat innovators have the following characteristics to avoid overcrowded trades:

  1. Leading domestic market share in its area of core competencies, preferably a lead of more than 3X over its next rival, with the ability to widen the cash conversion cycle advantage on an absolute and relative basis to its rivals, and with the potential to globalize its business and to expand into new markets and customers, such as through the pursuit of a premium strategy to extend its pricing power leadership. Value investors can monitor the percentage contribution to sales of new products/services or markets to evaluate the tipping point potential of the further scaling of its business model to enjoy an upward re-rating in its valuations.
  2. Resilient fundamental performance in difficult business environment, with growth in 3-year and trailing 12 months EBIT or core operating profit.
  1. Relatively low share float, combined with the founding family or/and management having a substantial equity stake in the company to provide long-term shareholding stability. Over time, as the company delivers in fundamentals, there will be more long-term buyers than short-term sellers with the low float, and each share owned by the patient value investor will become increasingly valuable.
  1. Potential de-correlated returns to the market and lower exposure to the market risk factor due to firm-specific corporate developments or/and actions not linked to economic conditions, including having a good track record of executing and integrating M&As into the business model to compete more effectively or spinoffs of a division; and prudent capital allocation to prevent mal-investments due to governance risks (self-dealings and tunneling, egoistic empire-building), such as capital reduction program or demonstrating discipline and mastery in executing each dollar of capex investments to generate consistently higher EBIT over time.
  1. Reasonable valuations backed by strong ROE to prevent overcrowded trades in low-volatility stocks by other funds employing seemingly similar broad-based quant strategy without going the extra mile in assessing the scalability of the business model and the quality of the management. For instance, a low EV/EBIT of 5x does not appear cheap when the valuation metric is overlaid with a ROE of 2%. An EV/EBIT of 15x does not appear exorbitant if the business generates consistent and growing ROE of 30%. We construct our own corporate lifecycle valuation ratio to factor in valuation and quality: EV/EBIT divide ROE. This ratio is akin to a “fundamental-based” PEG ratio as growth higher than the ROE requires external financing needs which may over-leveraged the balance sheet. We prefer this ratio to be under 1x.

Some of these overlooked and undervalued Hidden Champions in Asia with market leadership and unique business model include:

Data1Data2Natural1Natural2Tourism1Tourism2 Consumer Healthcare1

Consumer Healthcare2

We will reveal the names of some of these Hidden Champions in the 5th Annual Value Investing Summit (VIS) on 23-24 January 2016 in Singapore. Do stay tune as we bend adversity together!

PS1: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will issue an additional Monthly Moat Report Asia in 1Q16.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for January 2016 investigates an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly.

This deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in pneumatic tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%. The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.

Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.

The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.

Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.

Tooling Up the World With Mastery – Bamboo Innovator Monthly Riddle

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | Jaunary 5, 2016
Bamboo Innovator Insight (Issue 114)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

Can You Guess This Asian Wide-Moat Company?

Tooling Up the World With Mastery

Do you have the right tools to succeed in your work?

The Scottish historian Thomas Carlyle, who coined the term “the dismal science” for economics, once said famously that “Man is a tool-using animal. Without tools he is nothing, with tools he is all.”

In this month of January 2016, we investigate an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly. Yet this world-class innovator trades at PE 7.5x and EV/EBIT 10.8x.

Its deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Technology ownership of key components raised quality and lower cost at a structural level, with production yield raised to 95% and costs reduced by 15%. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%.

The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.

Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.

This is possible because of the leadership by Mr. L and his brother who have demonstrated grit and foresight in a series of critical business decisions, ranging from (1) building  a vertically integrated ODM business model to invest in developing innovative new products, (2) insisting on 100% ownership of the ODM design and manufacturing know-how by continuously building up its capabilities in tool technology from die-casting, coasting, painting, firing pin heat treatment, mold production, and plastics injection; the know-how accumulated over the years is not easily replicated, thus giving rise to our long-term profitability and a win-win partnership with our customers who stayed loyal; (3) resisting the institutional imperative to focus on designing and producing higher-end products while its peers rushed into China, (4) expanding during the 2007-08 Global Financial Crisis to (5) grooming its own group of talents in design and operations who are able to point out from a systems perspective the detailed continuous improvements needed in each production process.

The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.

Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.

We like how the L brothers have cultivated a decentralized culture of mastery, empowerment and growth at the company to keep winning loyal customers and innovating new products. On its culture, below are some excerpts of the conversation shared by Mr. L:

Q: “What is the culture like at [Company’s name] and what is your management philosophy and style to guide your leadership?”

Mr. L: “Although [Company’s name] is globally number one in its field, I am the company’s driver. Whenever there are clients coming by to visit us, either my brother or myself will drive the company car to receive them. Our culture is such that everyone at [Company’s name] are familiar with my slogan of exceeding targets, challenge the limits, and stay grounded and pragmatic in executing. Our culture is that we treat our products as important as our lives. 

If the real estate industry has its maxim in ‘it’s all about the location, location, location’, our golden maxim to guide us is ‘it’s all about the product quality, product quality, product quality.’ This is why in our 32 years of establishment, we have not been afraid of losing customers and we have quality customers continuously coming in.

Our culture is aligned to our blue ocean strategy which is simple: to focus on innovation and quality in product and R&D. This strategy has been my unshakeable belief all these years. In order to pursue excellence in quality, as long as it can be changed and improved, I will constantly remind and demand my staff to seek breakthroughs and mastery. Do you know why the word ‘quality’ in the written Chinese is formed by three ‘kous’ ? The reason is because with two kous as the foundation, there is always a higher kou on top or mastery waiting to be reached.

Our management philosophy is ‘Integrity, responsibility, and steadiness in innovating. Constantly demand improvement in product quality, stay focused and loyal to the core business, and never stray and mal-invest.’

As shared, I was in the legal arena for 25 years. When I retired, I was the Chief Judge of…. I have gone past the age of striving for fame and fortune. The most important thing in the jump from the legal scene into entrepreneurship is to recognize oneself, to be self-aware of my role and responsibilities. To operate and manage a business is really tough work. Most of us who pressed on are using our hearts, our entire lives to operate.

Although I am [Company’s name]’s Chairman, I believe very much in empowerment and authorized decision rights to my team, in accordance to the Taoist philosophy of ‘managing with wuwei’ 无为而治 or governing by doing nothing that goes against nature.”

Who is Mr. L and this wide-moat Bamboo Innovator?

PS1: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will issue an additional Monthly Moat Report Asia in 1Q16.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

In a Pit with a Lion on a Snowy Day: Lessons for Value Investors – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | December 21, 2015
Bamboo Innovator Insight (Issue 113)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

In a Pit with a Lion on a Snowy Day: Lessons for Value Investors

As the year-end Christmas season approaches, we are reminded of of an obscure passage in the Old Testament book and its relevance to value investors in their search for wide-moat compounders in an increasingly uncertain environment following the supposedly “expected” symbolic decision to hike US interest rate for the first time in nearly a decade.

Buried in the Old Testament of 2 Samuel, the 23rd chapter and the 20-21 verses, is the story of Benaiah who chased a lion down into a pit on a snowy day. Encountering a lion in the wild is bad luck. Finding yourself in a pit with a lion on a snowy day qualifies as a horrible, terrible day. The instinct and the prudent thing to do is to run away. Most people would have seen the lion as a five-hundred-pound problem, but not Benaiah, who did not let fear dictate his choices. The Scripture doesn’t describe Benaiah as being prudent. It uses the adjective valiant. He chose to face and fight the lion, and killed it, defying the impossible odds. Fast forward two verses, Benaiah won a place in a bodyguard position in the administration of David, the King of Israel. Benaiah went on to have a brilliant military career, climbing all the way up the chain of command to become commander in chief of Israel’s army. His genealogy of success can be traced all the way back to a life-or-death encounter with a man-eating lion.

In a sense, Benaiah’s heroic acts of courage were unplanned. But don’t think that Benaiah was unprepared. He couldn’t predict when, how, or where the lion encounter would happen, but he had been preparing for it since he was a boy, wrestling with his poor pet cat that doubled as an imaginary lion, practicing his swordsmanship in front of a mirror until it became second nature, staging faux battles with his brothers. So when the lion crossed his path, he didn’t see it as bad luck. He saw it as an stewardship opportunity. Success equals stewardship. Stewardship of how we manage our time, talent, energy, including opportunity.

The story of Benaiah resembles that of companies facing disruptive changes and their response that would determine their destiny. Over the decade plus, we have encountered a number of entrepreneurs who faced disruptive changes and chose to chase the lions in building and deepening the wide moat in their business model.

Shanghai M&G Stationary (Shanghai: 603899) – Stock Price Performance, 2014-2015

MG

One of them include Shanghai M&G Stationary 晨光文具 (603899 CH), which was facing the disruptive digitization and smartphone threat to writing instruments and stationary. When M&G was established in the 1990s by the brothers Chen Huwen and Chen Huxiong and their sister Chen Xueling, they also faced a powerful and bigger incumbent lion TrueColor Stationery (真彩文具) who was the pioneer in introducing gel ink pen in China. In other words, M&G was in a pit with a lion on a snowy day, just like Benaiah.

MG2

The Chens responded with designing a unique and extensive win-win distribution partnership and launching a wide-range of high-quality, user-friendly, stylish, and value-for-money products. M&G is also the trend creator for the stationery industry with continuous new product and marketing innovations that include “Confucius Blesses Your Scholarly Success” writing pens designed for exams for the 200-million student population, also a popular gift set during this festive year-end season for school-going children before they start school in the New Year ahead.

M&G now corners the stationery market for students and it is said that three out of every ten stationery shops around the 600,000 schools in China belong to M&G. In addition to its own brand M&G, the company has also established partnerships with Auchan, Disney, Tesco and Walmart. M&G products are also available in over 40 countries and regions, with network covering Asia, Europe and Middle East, and it has sole agent in Malaysia, Singapore, Thailand and Vietnam. All three of the Chen siblings started working in the retail industry as teenagers and endured difficulties. Because they started from the bottom, they understand the difficulties and always will want to help sales people on the ground to do well. The brothers both own about 28% of M&G, now China’s largest stationary maker with a market cap of US$2.72 billion, generating $550m in sales and $64m in operating profits and 19.6% ROE.

The Chen siblings emphasized the need to focus on quality in order to win respect. Like Benaiah who had been preparing himself since young, Chen started running around as a 17 year-old salesman and encountered the stationery industry. Chen chose to focus his time and entrepreneurial energy in the stationery industry as they believe it relates to the child’s growth, learning, and thinking.

They also noticed the opportunity that comes from common misunderstanding that the business of pen has a very low threshold. Because people’s traditional impression stationery industry threshold is low, the industry manufacturing equipment and technology lags behind. Interestingly, China’s Premier Li Keqiang complained at a seminar with a question “Why can’t China make a good ballpoint pen?”, commenting that Chinese pens felt “rough” compared to pens made in Japan, Germany, and Switzerland. Li said China’s manufacturers at the lowest levels should focus on innovating their technology.

The business of pen is an advanced production industry requiring know-how in precision equipment that include precision lathes, the manufacturing equipment of the same level to manufacture luxury watches, with some requiring even higher precision than watch-making. Thus, the core technology of each pen — the stainless steel ball and its casing — is imported as China does not have a machine with the precision required to make the best ballpoint pens. Because the tip is hollow, the intrinsic quality of tolerance cannot be measured with a measuring tool, as compared to watch parts that are solid. A sophisticated infrared microscope is needed to monitor the quality. As Chen explains, “You are now writing with the nib, ball diameter 0.5 mm. If the writing length reaches 1,000 meters, the ball must withstand more than 200,000 times the rotational friction. Keeping the written precision has extremely high requirements as the ball must achieve micron-level precision. The key is the quality of the pen is demanding, but the unit price is very low, which means large-scale production is required to maintain product quality and stability.”

Better quality goods and services ultimately rely on quality and process management in both production and distribution- marketing. While M&G product quality standard is world-class reaching only 15 defects per million, Chen emphasized that this meant that their one-day output yield would mean 1,500 complaints from the customers and from the propagation angle, one negative defect would spread to 7 people and this meant that the problem might spread to 10,000 unhappy customers in one day. Thus, Chen emphasized that “Mass production while controlling a certain quality at the same time is very difficult. A lot of factories are cottage-style with no brand, no quality, and we are up against counterfeit and copycats. The pursuit of excellence, the pursuit of 100% quality, is always our goal, not just that simple goal of achieving few defects per millionth.” Chen added that their company name M&G “adds a layer of deeper meaning: exceed customer expectations to provide products and services to win customer respect and trust – a pursuit of excellence for quality”.

M&G has established a network of provincial distribution centers, with more than 3,000 channel partners, 100,000 retail outlets, and 100% coverage key account stores that include Carrefour , Wal-Mart , Tesco, Rosen, and all other major supermarkets, convenience stores. M&G’s deep and strong marketing network ensures its stationery products can arrive in 3 days in every city in China. M&G also built an informational analytics network to carry out product real-time monitoring to have an accurate understanding of market needs.

Its unique decentralized marketing system resembles Berkshire Hathaway, with the M&G’s HQ having only 50 people who focus on cultivating primary market dealers cultivate into single-brand dealers with dealer training guidance, planning and team building. The primary market dealers foster the secondary market dealers, who in turn build the rural market towns.

********

The goal of life is not the elimination of fear and risk; the goal is to muster the moral courage to chase lions, the opportunities which often look like insurmountable obstacles. The lion-chaser Benaiah devoted himself to being watchful and thankful. The word watchful is a throwback to the Old Testament watchmen whose job was to sit on the city wall, scan the horizon, and keep watch. They were the first ones to see an attacking army or traveling traders. They see further than others see. They see things before others see them. And they see things that people don’t see.

Chen is watchful of M&G’s progress: “Every year I took our team to study abroad from excellent high-level dealers to help them improve their respective areas and to explore new ideas. In Japan we learned a lot; they are meticulous in their management and in the manufacturing, which should be worth learning. Their cost control, quality assurance, and their pursuit of excellence is worthy of study.” Above all, Chen commented that “An enterprise should always maintain a sense of crisis, to be able to progress; an entrepreneur must maintain a sense of balance and not overestimate oneself and lose control. All the world’s successful brands are not accidental. They have decades, centuries of history. There is no shortcut.”

With the story of Benaiah and M&G, we like to wish our readers a Merry Christmas and a Blessed New Year 2016. Thank you for your support all this while.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS1: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will be back in the week of 4th January in the New Year 2016.

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

The Swordless Samurai: Lessons for Value Investors from Japan’s Wide-Moat Innovator Cookpad – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | December 14, 2015
Bamboo Innovator Insight (Issue 112)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

The Swordless Samurai: Lessons for Value Investors from Japan’s Wide-Moat Innovator Cookpad

“Gratitude sparked in me a burning desire to better myself and help others. Contrary to what many think, the essence of leadership lies in serving, not in being served. Those who aspire to motivate followers need to learn the Secret of Gratitude: Leaders must be grateful.”

– From the book “The Swordless Samurai: Leadership Wisdom of Japan’s Sixteenth Century Legend Toyotomi Hideyoshi” by Kitami Masao

“Because I want a happy society. Happiness starts at the family table.”

– Cookpad’s founder Akimitsu Sano

How did a seemingly unknown company surpass illustrious giants such as Yahoo, Ajinomoto, Rakuten, Kikkoman to command an unheard of 90% domestic market share in a lucrative and growing service craved by over 56 million monthly users to generate over $30m in operating profit that is growing with new innovative services?

The rise of Cookpad (Tokyo: 2193), which has compounded 800% since 2009 to a market value of $2.26bn, and its newly-minted low-profile 42-year-old billionaire founder Akimitsu Sano who owns 44% in the company reminded me of the leadership story of Hideyoshi Toyotom (1536-1598), one of the most remarkable – and the most unlikely – leaders in Japan’s history.

Cookpad (Tokyo: 7956) – Stock Price Performance, 2009-2015

Cookpad

Despite his lack of strength and size, clumsiness at martial arts, and unglamorous peasant lineage, the “swordless samurai” Hideyohsi learned to outthink and outmanuever every pedigreed foe to become one of the greatest military and civc leaders Japan has every known, unifying a nation torn apart by more than a hundred years of civil strife, earning his position through hard work and innovation rather than birthright, becoming the ultimate underdog hero.

One of the most interesting and important leadership lessons Hideyoshi teaches us is that the essence of leadership lies in serving others, not in being served, an ethic that seemed increasingly rare these days. Hideyoshi goes on to explain that gratitude is the key esntiment that inspires true leaders to devote themselves to serving others.

Serving others to bring joy to the dinner table has been the philosophical foundation underlying Cookpad’s success. Cookpad was founded in the midst of the Asian Financial Crisis in Oct 1997 by Sano-san immediately after he graduated from Keio University. While at university, Sano worked as a produce retailer together with local farmers. Sano continued pursuing socially-involved entrepreneurship and joined an NGO. Participation in a UN meeting proved fateful. Touched by the smiles of delegates from some of the poorer Caribbean nations, Sano realized that economic prosperity was not necessarily a driver of genuine happiness. That nascent desire to pursue projects which might touch the hearts of those around him brought him to the idea of cooking for pleasure, a concept underpinned by his experience as a reseller of high-quality, appetizing fresh produce from the farm and the desire to bring joy to the dinner table.

It has not been an easy journey for Sano: “I tried to monetize Cookpad from day 1, but it took me 6 years. What did my wife and I eat during those 6 years? My wife’s family are farmers, so they gave us food and our living cost was so damn low.” Kitchen@coin, the predecessor of Cookpad, was launched in 1998 as a recipe site that allowed users to search and comment on recipe submissions. The name Cookpad was adopted in 1999, with the site allowing users to revel in pictures of their culinary creations and helpful feedback from other users about their experience with the recipe. Cookpad began accepting advertising in 2002, including accepting recipes specifically utilizing advertisers’ products as well as holding tie-up promotions like contests designed to feature a specific advertiser’s products. The success of these ads brought substantial benefits for advertisers with increased demand, re-evaluation of existing products, increased recognition of new products, which in turn supported the successful maturation of Cookpad’s business model.

Cookpad2

Every day at around 4 p.m., as schoolchildren make their way home, hordes of people across Japan — predominantly female, predominantly in their 30s — start furiously typing on their PCs and smartphones. They all have one burning question on their minds: “What should I cook for dinner?” Cookpad has penetrated into the daily lifestyle of Japanese housewives and other shoppers purchasing food and dinner ingredients who can often be found clutching smartphones accessing Cookpad as they peruse supermarket aisles. Today, more than 56 million users use Cookpad to share and find 2.1 million recipes to prepare at home. Cookpad has expanded its user base twelve fold in the past seven years, making it the 55th-most-viewed website in Japan; more than half of all Japanese women in their 20s and 30s visit it. Cookpad earns half of its revenue from premium services (1.6m subscription users in Japan), 34% from advertising, and 16% from ecommerce.

The “Tsukurepo” platform is perhaps the most underappreciated wide-moat competitive advantage and intangible asset of Cookpad, as this platform…

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Read more about the business model of Cookpad at the Moat Report Asia: http://www.moatreport.com/updates/

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Like Hideyoshi who has attracted talented leaders and created a brain trust dedicated to the mission such as warfare strategist Hanbei, former monk and organizational leader Mitsunari, etc, Sano has Yoshiteru Akita, the current CEO since May 2012. Akita was the former CEO of Kakaku.com from 2003-2010 during which share price jumped from ¥187 to ¥486 during his tenure. Akita owns 14.76% of Cookpad and is regarded as an internet management pioneer. Like Hideyoshi who looks for passionate and dedicated talents, Sano commented that “We look to see if the candidate codes at home or outside the work place. We look for someone who looks like they cannot help but code at any occasion.”

Above all, Hideyoshi’s clarity and power of the vision in reuniting Japan and ending the Age of Wars connected followers, allies and partners, inspiring them with the force of his vision to fight alongside the cause, empowering them to overcome seemingly impossible odds, sustaining his rise to ultimate leadership.

Sano has ambition to make Cookpad a household name around the world with various overseas acquisitions that include Cucumbertown, a U.S. food-blogging platform. Sano believes the way to increase visitor traffic is to offer more high-quality recipes that can make people happy and for the site to offer such attractive, useful services that all users are willing to pay for them. Sano’s clarity and power of vision that connects follower and allies is that he believes cooking helps keep families united and that happiness starts at the family table:

“Probably, the most important thing for an entrepreneur is to find a problem you’re passionate about. It’s not the size of capital that matter, but whether you’re really solving real customer problem or not. Create something! Create your own category! We wanted to offer free recipes as a contribution to the society. It’s essential to know what you are doing because the market is full of competitors. Do you think my vision is to create recipe site only? No, my vision is diversity in your food! Harmony in Japanese families begins in their table at home; by having diversity in your food, you’re not controlled by only one food resource, which means stability of price. Because I want a happy society. Happiness starts at the family table.”

The word “samurai” originally meant “one who serves”. Hideyoshi would have called Cookpad’s Sano-san the “Cooking Samurai”. Hideyoshi sums up the leadership precepts underlying his success:

“You may be surprised to learn that my successful quest to achieve the epitome of leadership was built on the commonplace notions of devotion, gratitude, hard work, and bold action. These principles appear so simple that you might not consider them “secrets”. But few people comprehend their true power, and still fewer understand that they form the cornerstone of the samurai code, an honoured protocol of conduct handed down for hundreds of years. The samurai code covers far more than the mere use of weapons, which is fortunate for me, since I have a reputation as the worst fighter in Japan’s history! But mu most formidable weapon has always been my mind: You might call me the swordless samurai.”

In essence, value investors could do well when they invest in leaders who focus on the values of devotion, gratitude, hard work, and bold action.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

The Essence of Pricing Power of Asian Wide-Moat Compounders – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | December 7, 2015
Bamboo Innovator Insight (Issue 111)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
  • Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
  • Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
Dear Friends,

The Essence of Pricing Power of Asian Wide-Moat Compounders

Having taught cost accounting at the university, I always find that the topic on “pricing” to create, communicate and retain value has been sorely neglected. Management tend to have fear of prices, especially when they need to increase them. The fear has one legitimate source: one can never know with absolute certainty how customers will react to a price change. If we raise prices, will customers remain loyal or will they run in droves to the competition? Will they really buy more, if we cut prices? As a result, managers invariably keep their hands off the pricing lever if they have doubt, turning their attention to something more tangible and more certain: cost management. But what is the underlying business model scalability, wide-moat competitive advantages, cost structure dynamics, and organizational system to support the pricing decision and pricing strategy?

The importance of pricing in investment fundamental analysis cannot be emphasized more. In fact, Warren Buffett once described “pricing power” as the most important factor in evaluating a business: “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business,” he said in 2011. In case of either inflation or deflation, value investors want to own companies that have pricing power — it will protect their earnings. Those companies will be able to pass higher costs to their customers during a time of inflation and maintain their prices during deflation without fear of volume decline or loss of market share.

Charlie Munger, the influential partner to Buffett’s success, also commented on the valuation effect of “untapped pricing power” for wide-moat compounders like Disney and See’s Candy:

“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. You will get a few opportunities to profit from finding underpricing. There are actually people out there who don’t price everything as high as the market will easily stand. And once you figure that out, it’s like finding in the street—if you have the courage of your convictions.”

For instance, Disney’s Magic Kingdom actually saw an increase in attendance in all of the last five years except 2010 despite the fact that the price of admission also went up, even hiking to a 3 figure price tag of $105 for a one-day ticket to Magic Kingdom at Walt Disney World in Orlando. While tourism spending is a consumer discretionary item, consumers are increasingly more interested in spending money on unique and innovative “experiences” rather than on things.

At Costco, one of Munger’s favorite companies, member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. By selling several staples as loss leaders – fresh food and gas -Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon. Becoming “Amazon-proof” is an enviable position for any retailer, as the company’s online dominance has most major retailers such as Target and Walmart playing catchup.

The more conscientious students with intellectual curiosity in my accounting class find the various cases shared to be useful. Some of these cases include how JC Penney, once considered America’s most venerated department store chain, plunged over 80% in market value since Feb 2012 when then-CEO Ron Johnson radically altered its pricing strategy from frequent sales promotions at deep discounts off its higher list prices to an everyday low pricing model that eschewed sales and clearance discounting, dubbed “Fair and Square”. Launched without any consumer testing, the new pricing strategy failed dramatically. Customers voted with their feet, leaving the retailer in droves when they could not get products at the discounted price they had come to expect.

Parker Hannifin, the #1 motion & control company, rose 240% since 2001, outperforming the 55% rise in the S&P 500 index, when Donald Washkewicz introduced “winnovation” in integrating pricing into its innovation process, aiming to pinpoint and develop products that offer the most potential for price premiums. Parker Hannifin build upon basic “cost” information to think deeper about the pricing decision of its over 800,000 seemingly “homogenous” widgets, differentiating them and determining their prices by what its over 470,000 customers are willing to pay rather than what a product costs to make and using the straightforward cost-plus pricing.

Or the case of how Apple changed its pricing structure for songs sold through iTunes from a flat fee of $0.99 to a 3-tier price of $0.69, $0.99 and $1.29. The top 200 songs in any given week which make up more than one-sixth of digital music sales – songs by artists like Adele – are charged at the highest price of $1.29. Six months after Apple implemented the new pricing model, downloads of the top 200 tracks were down by 6%. However, because Apple’s iTunes costs – wholesale song costs, network and transaction fees and other operating costs – do not vary based on the price of each download, the profits from the 30% price increase more than made up for the losses from the 6% decrease in volume. Apple has also applied this new pricing structure to movies available through iTunes, which range from $14.99 for new releases to $9.99 for most other films.

A favorite Asian example is Japan’s Kyocera, the advanced ceramics company, working with the same material used to produce rice bowls.  If a company sells one truckload of rice bowls for ¥1.5m, the profit is about ¥0.1m. However, if that company sells one truckload of IC packs, which are made of the same ceramic material, it can charge ¥50bn, making a profit of ¥15bn. The products are based on the same material, but the difference in profit is obvious. The secret of Kyocera’s success was in its ongoing commitment to resolving any problems of customers while overcoming technical challenges. It also experienced constant price pressure, with customers in effect saying, “If you don’t lower your prices, we won’t place any more orders.” In that situation, the company made all-out efforts to reduce costs, opening up the market for a fierce cost-cutting struggle. The basic requirements for a technology-oriented company to exploit its uniqueness are: (1) Choose a core technology and then improve and then upgrade it; (2) Exchange technical information while positively fostering human relations; and (3) When an obstacle is encountered, start to adopt an attitude of making every attempt cause a positive splash in the market and with customers. The inventions of Kyocera’s founder Dr. Kazuo Inamori, who was the first person in Japan to synthesize Forsterite, a kind of ceramic that played a pivotal role in electronic circuitry for TV sets, helped supported Japan’s global revolution in TV manufacturing in 1950s after WWII. Kyocera’s advanced ceramic materials also fostered the development of the semiconductor industry.

Pigeon Corp (Tokyo: 7956) – Stock Price Performance, 1988-2015

Pigeon

For Japan’s Pigeon Corp

<ARTICLE SNIPPED>

Read more about the pricing power strategy of Pigeon Corp and 3 other Asian wide-moat companies at the Moat Report Asia: http://www.moatreport.com/updates/

*******

Pricing also intrigued the late managmenet guru Peter Druckerfrom an economics and also from an ethical perspective. He understood profit to be the “cost of survival” and sufficiently high prices to be a “means for survival”. Above all, he warned against the abuses of market power. He commented on price transparency and advocated fair behavior. The pricing abuse of pharmaceutical drug companies from Michael Person’s Valeant to Martin Shkreli’s Turing Pharmaceuticals has sparked public furore and threathened the going concern of their business. Pricing power to maximize profits become an inflmmatory phrase and lighting rod.

Hedge fund manager Bill Ackman compared “platform stock” Valeant to early-stage Berkshire Hathaway in early 2015; William Thorndike, author of The Outsiders, compared Valeant’s CEO Michael Person to Liberty’s cable billionaire John Malone. When Valeant’s share price collapsed in Oct 2015, many sophisticated institutional investors were hurt. Charlie Munger commented in March 2015 that companies like ITT Corp., made money back in the 1960s in an “evil way” by buying businesses with low-quality earnings then playing accounting games to push valuations higher. “Valeant, the pharmaceutical company, is ITT come back to life,” Munger said. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.” Valeant relied on “gamesmanship” to run up its value and created a “phony growth record.” We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant: Valeant CEO Michael Pearson is known as an aggressive cost cutter. Valeant’s corporate culture is that it does not want to spend money on science and sees no wrong in substantially jacking up prices of drugs after acquiring them, violating the Drucker’s ethical principle on pricing power.

Value investors analysing the pricing power of business need to understand that a sustainable fair game between the seller and consumer in pricing lies in one word: value. Ultimately, the customer is only willing to pay for the value he or she gets. The challenge for any seller is to find out what this perceived value is and then price the product or service accordingly. It leaves the seller or manager/ entrepreneur three tasks which the value investor must know in order to understand the effect of pricing power on value creation: (1) Create value: The quality of materials, performance, and design all drive the perceived value of customers. This is also where innovation comes into play; (2) Communicate value: This is how you influence customers’ perception. It includes how you describe the product, your selling proposition, and the brand. Value communication also covers packaging, product performance, and shelf or online placement; (3) Retain value: What happens post-purchase is decisive in shaping a lasting, positive perception. Expectations about how the value lasts will have a decisive influence on a customers’ willingness to pay. The customer stays loyal only if the exchange with the seller cultivates a lasting sense of fairness. Customer satisfaction and loyalty is the only way to build and deepen wide-moats and compound long-term value.

An ancient Chinese business philosophy sums up best the essence of pricing power and sustainable value creation for value investors:

斯商,不以见利为利,以诚为利;

斯业,不以富贵为贵,以和为贵;

斯买,不以压价为价,以衡为价;

斯卖,不以赚赢为赢,以信为赢;

斯货,不以奇货为货,以需为货;

斯财,不以敛财为财,以均为财;

斯诺,不以应答为答,以真为答;

斯贷,不以牟取为贷,以义为贷;

斯典,不以值念为念,以正为念。

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

20151201081907

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

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