Happy Labor Day!
Below is an early peek into excerpts from our March Year End Letter of our Hidden Champions Fund which we were working on while staying tune to the broadcast of the ever-insightful Berkshire Hathaway AGM 2016.
Hidden Champions: Our North Star Investment Strategy to Navigate Turbulent & Fragile Markets
“Governing with excellence (德) can be compared to being the North Star: The North Star dwells in its place, and the multitude of stars pay it tribute.” – Confucius, Analects 2:1
“Successful CEOs are like gems you find on a beach. There are many pebbles, many beautifully colored ones, but they are all stones. Now and again, you will come across a real precious gem, a real emerald, pick it up, polish it. He must have a set of qualities that fits with the job, has energy, drive, ability to interact with people, ability to get people to work with him in a team… You look at all the successful companies, what is the key? Their brainpower. The thinker, good management, good innovators.” – Lee Kuan Yew, founding Prime Minister of modern Singapore, in Hard Truths to Keep Singapore Going
Your funds in listed Asian equities have achieved a % 12-month rolling return (in SGD terms) against a decline of: 11.3% for the MSCI Asia Pacific index, 11.7% for the Australia All Ord index, 12% for the Nikkei 225 index, and 17.6% for Singapore’s FTSE STI index over the same period.
This outperformance is buttressed by a 7% (est) absolute return (in SGD terms) from our investment cost of the revamped portfolio in the second-half since September 2015, powered by a double-digit gain from our high-conviction top position, ASX-listed Sealink Travel, which comprised around one-third of our portfolio NAV. We are also a Top 15 Shareholder in this world-class wide-moat company with dominant market leadership as the largest provider of nation-wide tourism and transportation services generating record profitability with a visible long runway ahead to compound growth with resilience.
We aim to be a 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. As will be detailed in the tables and descriptions in the below section, we are a Top 20 Shareholder in 7 world-class wide-moat companies, out of the 19 portfolio stocks (we added 5 stocks after the financial year end in April which were up 9.2% as at 29 April) that we look to accumulate more, up to becoming a substantial shareholder with 5% stake, as they continue to deliver in their business fundamentals.
This outperformance is possible because of our multi-manager team-based investment process implemented by since September 2015, led by our analyst team comprising of Kelvin Seetoh, Jackson Yeow, Sim Zhipeng and Joshua Zhang. This teamwork greatly strengthens our ability to invest with high conviction in wide-moat companies, making an architectural shift from time-telling to clockwork with a build-to-last structure for our shareholders. As Jim Collins, author of the Built to Last and Good to Great, puts it aptly: “Imagine you met a remarkable person who could look at the sun or stars at any time and state the exact time and date. But wouldn’t the person be even more amazing if, instead of telling the time, he or she built a clock that could tell the time forever?”
Hidden Champions: Our North Star Investment Strategy to Navigate Turbulent & Fragile Markets
“Explorers depend on the North Star when there are no other landmarks in sight. The same relationship exists between you and your right life, the ultimate realization of your potential for happiness. I believe that a knowledge of that perfect life sits inside you just as the North Star sits in its unaltering spot… Your life follows your attention. Wherever you look, you end up going.”
– Martha Beck, author of Finding Your Own North Star
The clock that we are building together as a team to tell the time forever is the Inner Compass and systematic investment process that leads us to our North Star to navigate increasingly turbulent and fragile markets – to the Hidden Champions.
Our approach to value investing is to invest in the Hidden Champions, agile creatures darting between the legs of multinational monsters who are dominant global players in sophisticated, hard-to-imitate niche products and valuable critical niches that are largely invisible to the average consumer. The Hidden Champions create maximum benefits for a target customer group, solving their most burning problems better than any competitor. This innovation strategy requires a deep knowledge of customer needs, which is generated through direct customer contact. Successfully solving this customer problem would then create a “success spiral”. A key source of their wide-moat is their sustained commitment and even obsession to customer needs, which is only possible in our view when there is a Purpose and values system guiding the firm.
The Hidden Champions had their roots as the esprit de corps of Germany’s Mighty Mittelstand, the more than 3.5 million small and midsize family enterprises that form the backbone of Germany’s resilient export-driven economy, employing more than 78% of workers and contributing more than half of the country’s GDP. The Mittelstand traces its roots to the Middle Ages, when the country that is now Germany was divided into hundreds of states. Competition between them created a number of industrial regions with their own educational institutions, banks and political administrations. The Mittelstand had to export early on with a global-orientation in their business model, given that some German states were smaller than two football fields.
Well-known Mittelstand enterprises that became well-known giants include BMW, Audi, SAP AG, Adidas, Hugo Boss, Robert Bosch, Siemens, consumer giants Beiersdorf and Henkel, dialysis giant Fresenius, pharmaceuticals giant Bayer, chemicals giant BASF, industrial gas specialist Linde AG, truck and engine maker MAN SE, and so on. There are also lesser-known, quiet, resilient, successful compounders, including commercial kitchen equipment company Rational AG, eyewear specialist Fielmann, specialty chemicals specialists Brenntag and Lanxess, high-end cleaning equipment Kärcher, Würth group (the “Fastenal of Europe”), auto gasket maker Elringklinger, flavor and fragrance specialist Symrise, lab solution specialist Sartorius, medical vision technology specialist Carl Zeiss Meditec, packaging and bottling machine maker Krones, wound medical products Paul Hartmann, and so on.
From a value investing perspective, investing at an earlier stage in the long-term growth trajectory path of these Hidden Champions – in Asia – will prove rewarding, as highlighted in an investment case insight into Rational AG, which we also share in 8IH’s inaugural value investing educational program in Shanghai.
The Capital Cycle and Sale of Investments
In the book Capital Returns: Investing Through the Capital Cycle edited by Edward Chancellor, the capital cycle analysis can be adapted to make informed decisions on the sale of stock before problems surfaced. In the intriguing case of Vestas Wind Systems, its capex-to-depreciation had risen from just 1 time in 2005 to nearly 5 times in 2008, contributing to excess capacity in the wind turbine sector. Overinvestment is not a solitary activity; it comes about because several players un an industry have been increasing capacity at the same time. When market participants respond to perceived increases in demand by increasing capacity in an industry, they fail to consider the impact of increasing supply on returns. Subsequently, the share price of Vestas crashed over 90% from the peak.
Following the appointment of a new Swedish chairman in early 2013, significant restructuring was implemented at a time when investor fears about weak industry demand had proved too pessimistic and capex was slashed to 0.4 times depreciation in 2013, boosting cashflow and helping to repair the weak balance sheet, sending share price to rise 360%. The case of Vestas illuminated the investment insight that excess returns can be captured by exploiting the managerial decisions in capital allocation in capex: a low (high) capex-to-depreciation is a buy (sell) signal.
Vesta Wind Systems: Capex-to-Depreciation and Relative Share Price Performance
Source: Capital Returns: Investing Through the Capital Cycle by Edward Chancellor (2016)
During the second-half of the financial year, our notable divestments are Hartalega Holdings Berhad and Major Cineplex Group at an average price of RM 5.86 and THB 32.11 respectively, recording a 96% and 77.4% gains on both companies respectively. We were uncomfortable with the expensive valuations accorded to their growth expansion plans which face increasing headwinds in lower ASP in nitrile gloves due to intense competition from new entrants and balance sheet constraints in taking on more debt to finance capex to increase the number of screens in sub-urban and rural regions and in regional countries, including their highly-geared shopping mall operators-business partners, some of whom have announced plans to slow down in building more malls.
Hartalega: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
From the capital cycle chart on Hartalega, we can observe that capex-to-depreciation had shot up aggressively in FY2015 and for TTM2016, contributing to the industry oversupply situation, while the capex-efficiency (as measured by the EBIT profitability generated per dollar of capex spend) had plunged due to lower ASP and higher operating cost.
The same can be observed in Major Cineplex in which the capex-to-depreciation had spiked up in FY2015 while capex-efficiency had declined precipitously after five golden years of capex-efficiency during FY2010-2014. Subsequently after we sold Major Cineplex, it reported a Bt139m net profit for 4Q15, down 33% YoY and 60% QoQ. Stripping out extra items—a net-of-tax gain from selling shares held in India’s PVR Cinema and trading in Thailand’s SF shares in 4Q14 and 3Q15—core profits dive 26% YoY and 41% QoQ. We also agree with former successful studio Grammy Tai Hub (GTH) chief Visute Poolvoralaks who commented that there is a growing risk that Thai audiences have lost faith in Thai movies simply because film production standards vary so much. Thais pay the same ticket price for every movie, so when ones are not good or worth the money, they lose confidence in Thai films in general and opt instead for Hollywood offerings – and Major is increasingly expanding into film production of Thai movies. Having said that, we find that the wide-moat of Major remains intact and will revisit the stock if the price retreats to Bt20 and below.
Major Cineplex: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
We are also uncomfortable with the growing investor fever for movie & entertainment-related companies and some of them are exploiting investors’ attention to hype up their prospects with box-office ticketing fraud.
Shifang Holdings (1831 HK): Roller-Coaster Share Price
Take the case of HK-listed Shifang Holdings, which owns the rights to the earnings of the blockbuster Ip Man movie. “Ip Man 3” saw ticket sales of 400 million yuan in its first three days of release. Shortly after that big start, however, local news reports raised allegations of box-office ticketing fraud. It turns out that Shifang snapped up tickets worth 56 million yuan, guaranteeing a hot opening week. Chinese authorities have opened a probe into the case. The fraud dealt a severe blow to the share price of Shifang. Shares in Shifang surged to HK$3.75 on Feb. 26, the highest level since it listed in 2010. Then came the box-office scandal. It took only four trading days for the stock to plunge 80% to HK$0.76 on March 10.
We do not engage in market-timing by darting in and out of the markets on a short-term trading basis. After our restructuring, our portfolio turnover ratio is low at 3.1%. The portfolio turnover came from our sale of 6 stocks (3 in India, 2 in Thailand, 1 in Japan) due to some slight concerns on their business model sustainability, of which 4 are at a small profit and 2 with losses, at an overall 0.75% loss from our cost as a percentage of our NAV.
The daily liquidity of our portfolio stocks, if we were to account for one-third of the daily volume traded based on the past 30-day average price, is 25.7% of our portfolio NAV, i.e. we can liquidate one-quarter of our portfolio NAV in one day if need be without destabilizing the stock prices.
Avoiding a “Valeant Situation” In Overconcentration of a Deteriorating Moat
Analyzing the capital cycle has also proven useful in evaluating and avoiding the risk of investing in Valeant Pharmaceuticals, dubbed the “Enron of Pharma”. 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. Valeant’s share price collapsed in Oct 2015, hurting many sophisticated institutional investors with concentrated portfolio bets on the drug firm. Charlie Munger back in March 2015 had criticized Valeant: “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. 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.” Buffett, at the Berkshire Hathaway AGM 2016, said Valeant’s troubles illustrate a principle passed on to him by a friend: “If you’re looking for a manager, find someone who is intelligent, energetic and has integrity. If he doesn’t have the last, make sure he lacks the first two.”
Valeant: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant, and one of them was featured on Apr 22, 2014 in Wall Street Journal titled “Allergan Pursuer Valeant: A Drug Maker With Little Patience for Science”. 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. From the above chart on Valeant, we can see that since Michael Pearson took over as CEO in 2008, capex-to-depreciation had soared, a warning sign to avoid the stock.
Why do investors and corporate managers pay so little attention to the inverse relationship between capital spending and future investment returns? The short answer is that they appear to be infatuated with asset growth. An empirical study by finance researchers Sheridan Titman, John Wei and Xie Feixue in the Journal of Financial And Quantitative Analysis found that the average firm destroys value when they invest substantially and a long-short strategy that goes LONG low-capex firms and SHORT high-capex firms earn an annual compounded 16.9% returns. Why? There is execution risk and investors consistently fail to appreciate managerial motivations to put the best possible spin on their new “growth opportunities” when raising capital to fund their “expenditures”. The aim of the capital cycle analysis is to spot these developments in advance of the market. Thus the capital cycle analysis in capex-to-depreciation and EBIT-to-capex is an informative signal about future firm value creation – and destruction.
Combining Capital Cycle With Marketing & Long-Range Information in the Value Creation Process
Long-term investing works because there is less competition for really valuable bits of information. The real advantage comes from asking more valuable questions. The short-term investor asks questions in the hope of gleaning clues to near-term outcomes: relating typically to operating margins, earnings per share and revenue trends over the next quarter. In order to build a viable, economically important track record, the short-term investor may need to perform this trick many thousands of times in a career or/and employ large amounts of financial leverage to exploit marginal opportunities.
The longer one owns the shares, however, the more important the firm’s underlying economics will be to performance results. Long-term investors therefore seek answers with shelf life. What is relevant today may be relevant in ten years’ time if the investor is to continue owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period.
Take marketing which can be vital to long-term value creation yet if often ignored. An understanding of the economics of line extensions and an advertising strategy would have proved useful to investors in consumer products companies. Colgate Palmolive introduced its first line extension – a blue minty gel – in the early 1980s, and supported this product with a hefty advertising spend. This was Colgate’s first new toothpaste in a new generation, and line extensions, which had been used successfully in other household goods, were novel to the toothpaste market. By advertising heavily, the firm hoped to change the buying habits of a generation of shoppers who would subconsciously think of Colgate as they approached the toothpaste section of a supermarket, and when they got there, would find a product which was new, superior and, because of advertising spend, trusted.
This is an almost worthless piece of information for the short-term investors as they will be thinking along the lines of: what does the rise in advertising spend in the new line extension product mean for profit margins next quarter? Few investors would have understood, and even fewer would have cared, about the transformation that was taking place. In the two decades since its first line extension, Colgate’s share price has risen 25-fold, handsomely beating the market. This shows how important it is for long-term investors to understand a firm’s marketing strategy. Yet, given the annual 100% turnover in Colgate shares, very few of the firm’s shareholders have benefitted fully from its success.
Why did so few Colgate investors stay the course? There is strong social and client pressure to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by.
Portfolio Stock (Global #3 Consumer Healthcare Device Brand): Ad Expense as % OPEX and EBIT as % Ad Expense
We have combined the capital cycle analysis with long-range information such as the marketing expenditure to provide a more informative signal. As an illustration, we observed for one of our portfolio stocks, who is in the consumer healthcare & household lifestyle business, that despite a rise in its advertising spending (as a percentage of total operating expense), EBIT per dollar of advertising has been rising, particularly since FY2014. Furthermore, despite a rising trend of capex investments to expand in response to growing demand for its innovative high-quality products since FY2013, EBIT-to-capex has exceeded capex-to-depreciation for this world-class Hidden Champion who commands a dominant 50-60% domestic market share leadership in its consumer healthcare device and is also the global #3 player and #2 in China (22% market share) where its first China plant in over 80 years is operational in March 2016 after building up strong demand from successful sales in leading online marketplaces JDmall and Alibaba’s Tmall.
ROE of this world-class hidden champion is 14.2% and it trades at EV/EBIT 11.7x, EV/EBITDA 8.8x, EV/Sales 1x, a steep discount to its local consumer goods peers who trade at an average of EV/Sales 2.1x, EV/EBIT 20.2x, EV/EBITDA 14.5x. We think that this steep valuation discount is unjustified given the technical excellence and innovative profile of the company and it deserves to trade at a higher premium once there is greater investor awareness when they continue to deliver quality earnings growth with higher ROE, which has soared from 6.7% in FY13 (YE March) to 14.2% in the latest TTM Dec 2015, and is expected to climb higher from its underappreciated price premiumisation strategy.
This portfolio company, a family business established since 1934 and led by the second-generation business leader, embodies the best of patient sacrifice and stable capital for longer-term profound investments in business and people, with relentless and eternal pursuit of excellence in perfecting its offering, institutionalizing its craftsmanship and codifying the knowledge to pass from one generation to another. We believe it has hit a tipping point in its business model transformation into a complete integrated global producer of innovative rubber and plastic products with long product lifecycle with both engines in household & lifestyle division and industrial division (automotive interior) revving up to compound growth with a visible long runway.
Avoiding our Dark Wood of Errors: Risk of Accounting Irregularities & Tunneling Fraud
Once you have found your North Star, keeping it in view is a fine way to stay on course – as long as the sky remains clear. But what about the cloudy nights and the dark wood of errors? In situations when you feel utterly befogged by the risk of accounting irregularities, we need some help figuring out where our North Star lies. It is helpful to have inner compasses wired into our brain and body to guide us in the search for our true path.
As shared earlier that we are honored and grateful to be able to have the opportunity to share our thoughts on 23 September 2015 with the top management team of the Monetary Authority of Singapore (MAS) about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community, we believe strongly that this potential fintech platform that combines accounting data, especially footnotes, with a wide array of contextual information – including unusual related-party transactions; money-go-round off balance-sheet activities; governance, group structure and ownership analysis; textual and linguistic analysis; analysis of event-based “catalysts” (information-based manipulation) and sensitive market announcements (action-based manipulation in prices and volume) – will provide fresh insights and actionable, dynamic, inter-connected analytical information, as opposed to merely descriptive static data or a loose bag of disparate red flags, on Singapore and Asian companies, for the regulator and the public.
We were quite close to investing an initial investigate stake in an ASX-listed
Caring is an exacting, serious and demanding business, especially when it comes to investing in another person’s financial assets, which are a tangible product of his or her life’s work, a repository of aspirations for the future.
We cannot guarantee success in investment outperformance over the short-term, but we can certainly guarantee one thing: You will be proud to be able to participate positively in the resilient growth of these wide-moat Hidden Champions who are solving real-world problems and have helped to create what the world around you looks like today and tomorrow. You will also be a proud and happy parent for your children when they work in these Hidden Champions. As George Washington puts it aptly, “We cannot guarantee success, but we can at least deserve it”.
Consider some of our portfolio stocks:
Bring your family and loved ones to river cruises in Australia and the Kangaroo Island to experience wildlife and scenery, knowing that you are supporting your holding in Sealink Travel, the quasi-monopoly ferry company and tour operator which has plied the crossing from mainland South Australia to Kangaroo Island since 1989. If your in-laws are visiting, suggest to them to take the natural Capilano Manuka Honey to enjoy both its delicious taste and health benefits, and then thank them for buying from one of your businesses.
For a retail experience perhaps even better than IKEA’s, we would highly recommend you to explore the “Retail Wonderland” home improvement centre as described in the above section and be awestruck by the enchanting assortment of items and the superlative customer service.
When was the last time that you express your appreciation to the people who love you, the people who care for you or the people whom have helped you? In today’s fast paced society, it is easy to neglect the people surrounding you. Instead of texting, harness the power of the pen and experience the positive difference of the act of handwriting. The beauty of a hand written note or letter not only allows you to have a deep connection with the recipient, but it can also be retained and cherished, leaving precious memories that can be re-visited. So grab a top quality pen manufactured by one of our Hidden Champions portfolio stocks and pen your gratitude to acknowledge those who have made a difference in your life today.
We hope this will capture the Hidden Champions Fund investment philosophy of entrepreneurs investing in entrepreneurs. We are of the conviction that the future is created one wide-moat innovator and Hidden Champion at a time and each will flourish from their own wisdom. If you also share in our values and investment process, and support our conscious efforts to promote entrepreneurialism in Asia, we invite you to join us in this uplifting journey to participate in the compounding returns in overlooked and underappreciated wide-moat innovators – and to make a positive difference to society.
Welcome to the exclusive Club of the Hidden Champions.
KEE Koon Boon
Chief Investment Officer
Hidden Champions Fund
PS1: The Monthly report will resume during the last week of May as we will be away on our military reservist training from 4 May. Thank you for your understanding.
PS2: We like to share our presentation slides in Value Investing Shanghai on March 18-20, 2016 where we highlighted high-conviction investment in Hidden Champions to navigate the volatile markets and that such an investment approach has enabled us to outperform with positive absolute returns vs -15% for the MSCI Asia Index, and our highest portfolio-weighted stock at 36% of our portfolio NAV is up more than 16% in SGD:
PS3: 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)
and our Value Investing Summit 2016 presentation “Quietly Innovating Value with Hidden Champions”:
PS4: We had also recently presented in the Asian Investing Summit 2016 as one of the instructors:
The Moat Report Asia
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
In the month of March/April 2016, we investigate an Asian wide-moat innovator who commands a dominant 50-60% domestic market share leadership in a consumer healthcare device and is also the global #3 player and #2 in China (22% market share) where its first China plant in over 80 years is operational in March 2016 after building up strong demand from successful sales in leading online marketplaces JDmall and Alibaba’s Tmall.
Since the launch of its game-changing innovative new consumer healthcare device premium product in April 2015, its TTM Dec 2015 (YE March) sales is up 7.2% and EBIT soared 67.6%. Under the motto of using science to enrich everyday lives, [Company’s name] is a quiet innovator in leveraging upon its accumulated deep material science and chemistry know-how to continuously launch innovative new products, from consumer healthcare device to a pad that helps heal wounds by absorbing moisture, a technology that it adapted from its popular food wrapping film household product, to protective film-coated lining for motorcycle seats where it commands a 90% market share in US.
ROE of this world-class hidden champion is 14.2% and it trades at EV/EBIT 11.7x, EV/EBITDA 8.8x, EV/Sales 1x, a steep discount to its local consumer goods peers who trade at an average of EV/Sales 2.1x, EV/EBIT 20.2x, EV/EBITDA 14.5x, a 64-110% premium over [Company’s name]. Its consumer healthcare device peers trade at an average of EV/Sales 4.36x, EV/EBIT 19.7x, EV/EBITDA 17.2x, a 69-96% premium over [Company’s name]. We think that this steep valuation discount is unjustified given the technical excellence and innovative profile of [Company’s name] and it deserves to trade at a higher premium once there is greater investor awareness when they continue to deliver quality earnings growth with higher ROE which has soared from 6.7% in FY13 (YE March) to 14.2% in the latest TTM Dec 2015 and is expected to climb higher from its underappreciated price premiumisation strategy.
Sales has increased 24% in the past 3-4 years since FY13 and EBIT and OCF (operating cashflow) growth is faster at 168% due to the price premiumisation strategy. With the upcoming China plant operational in March 2016 and the tipping point in its US factory in automotive interior material, we believe [Company’s name] can build on the momentum to generate $120m operating profits and OCF in the next 4-5 years, similar to the profit scale of its domestic consumer goods peers with market cap of $2.2-3.4bn, thus spurring an upward valuation re-rating towards a potential tripling in market cap to cross $2.4bn based on EV/EBIT 20x from its present $850m market cap.
[Company’s name] embodies the best of patient sacrifice and stable capital for longer-term profound investments in business and people, with relentless and eternal pursuit of excellence in perfecting its offering, institutionalizing its craftsmanship and codifying the knowledge to pass from one generation to another. We believe [Company’s name] has hit a tipping point in its business model transformation into a complete integrated global producer of innovative rubber and plastic products with long product lifecycle with both engines in household & lifestyle division and industrial division (automotive interior) revving up to compound growth in a long runway.