Value Investing Summit 2016: Quietly Innovating Value with Hidden Champions – Bamboo Innovator Weekly Insight
January 27, 2016 Leave a comment
|“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)
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.
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.
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).
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.
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.
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.
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.
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”.
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:
The Moat Report Asia
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
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.