Takeaways from the Berkshire Hathaway AGM 2014 and the Pearl River Delta (PRD) Trip

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”

Dear Friends and All,

Takeaways from the Berkshire Hathaway AGM 2014 and the Pearl River Delta (PRD) Trip

Q: “How does management factor into valuing intrinsic value?”

Warren Buffett at the Berkshire Hathaway AGM 2014:“Actually, Ben Graham didn’t get too specific about intrinsic value in terms of calculations. Now it is equated rightly with private business value. Aesop was the first who came up with it. It is intrinsic value if you can foresee the future, the present value of all cash that will be distributed between now and Judgment Day. You put money in and you take money out. One in hand is worth two in bush. The question is: how sure are you that two are in the bush; how far away is the bush; what are the interest rates – Aesop wanted to leave us something to play with over the next two thousand years so he didn’t spell it all out. In calculating it, Ben would say he wanted two dollars of cash in the bush and pay a dollar and emphasized financial factors for those birds in the bush. Fischer would use qualitative and business quality factors to estimate the number of birds in the bush. I started out very much influenced by Graham, so it’s more quantitative, but Charlie came along and said to look more at qualitative factors.”

Come every April-May, the world congregates not only in Omaha to immerse in the wise teachings of Buffett-Munger at the Berkshire Hathaway AGM, but also in Guangzhou, the capital of Guangdong province with its trillion-dollar GDP, for the Canton Fair. Held bi-annually since 1957, the year when Buffett bought his house on Farnam Street after creating Buffett Associates the year before, the Canton Fair is the world’s longest-running trade shows, a monument to China’s industrial versatility and export prowess, connecting foreign buyers with the Chinese factories that have been anonymously manufacturing their products for decades. Occupying 1.1m square metres, the equivalent of 880 Olympic swimming pools, the Fair houses everything from Segway knockoffs to a giant McDonald’s and a mosque for Muslim visitors to bring about the dating of nearly 200,000 buyers from more than 200 countries with roughly 25,000 Chinese manufacturers. The value of total deals in 1957 was $87m and had risen dramatically after Deng launched his economic reforms in 1978/79, peaking at $75bn in 2011. The Fair acts as a barometer for the health of Chinese trade.

While the crowd in Omaha has gotten stronger over the years, those in the Canton Fair have quietened down. In the recently concluded Canton Fair, companies signed $31bn in deals, down by more than half since its 2011 peak and a 13% decline from last spring. The sluggish performance was a result of rising wage pressures that hurt the cost competitiveness of the ubiquitous low-end manufacturers and OEMs, and trade flows moving to Southeast Asia and the ecommerce platform, such as e-Cantonfair.com created by Alibaba, the world’s largest ecommerce company who filed its IPO last week. We believe that the sharp slowdown risk in China is still underestimated by the market. As we have noted in the February and May 2011 monthly editions of On the Ground in Asia, the predecessor of theBamboo Innovator Insight and the Moat Report Asia, we had highlighted how the weak emperors in China and Asia would attempt to consolidate and take back power from the powerful local warlords by flattening the leverage in the system so as to weaken the warlords’ grip in local provinces through controlling the finances. It was an unconventional opinion back then when Asia had rebounded strongly for almost two years from the bottom in March 2009.

During our trip from 4 to 13 May to the Pearl River Delta (PRD) where we had visited the factories and facilities of diverse industries and interacted with the management and government officials to hopefully bring the financial data alive, we continue to find some possible pockets of competitive “Made in China” strengths. Mobile phones and tablets are increasingly made in China with China’s supply of sophisticated handset components growing to over 60% of total global supply, up from under 10% in 2000. Leading companies include the acoustic suppliers to the iPhone, Samsung, Lenovo such as HK-listed and Shenzhen-headquartered AAC Technologies (2018 HK, MV $6.8bn) and Shenzhen-listed and Shandong-based Goertek (002241 CH, MV $6.7bn). AAC is founded in 1993 and listed on the HK Stock Exchange in Aug 2005. The secretive billionaires Benjamin Pan Zhengmin (below photo on the left) and his wife Ingrid Wu are the co-founders of AAC. Goertek is established in Jun 2001, listed in May 2008 and controlled by Chinese billionaire Jiang Bin (photo on the right). Both AAC and Goertek compete with Knowles Electronics, part of Dover Corp (DOV US, MV $14.4bn) and the world’s largest supplier of micro-electrical-mechanical systems (MEMS) microphones which are widely used in smartphones.

AAC Technologies (2018 HK) and Goertek (002241 CH) Vs Apple and the Hang Seng Index – Stock Price Performance, 2009-2014

Acoustic components account for…

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We also paid a visit to a hidden Chinese export champion based in Zhongshan, Guangzhou with a market value of $460m (PE14e 12.3x, EV/EBIT 11.9x, P/BV 2.1x, P/Sales 0.7x, dividend yield 1.3%). Established in 2002 and listed in…

Amongst the many companies that we saw on the trip include an update on Tencent (2988 HK, MV $128bn), the most valuable Chinese internet giant company.

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With no time to waste, we pounded the streets of Huaqiangbei – 1.45 square kilometres in the heart of Shenzhen, which, for the past two decades, was the city’s most prosperous area. The latest gadgets – genuine, smuggled or knockoffs – could be found there and shipped all over the world. Since the early 2000s, Huaqiangbei has been the center of China’s shanzhai industry, which churns out electronic goods that imitate well-known brands, mostly mobile phones. Many shops in the biggest electronic components market in China – possibly the world – were now closed, with lease and sale signs hanging on their premises. During its peak in 2009/10, the area had more than 20 malls, many of them boasting a floor space of more than 10,000 square meters, and a district-wide employee count of more than 130,000. At that time, more than one million people visited these shops every day, bringing business worth RMB120bn a year to the business center. Worries about Huaqiangbei’s decline have spread quickly throughout the Delta, especially among the digital product traders and manufacturers who have made the place globally famous.

We had also met with the management and chief economist from the Shenzhen Stock Exchange (SSE) to find out more about the institutional dynamics and governance framework underlying the quoted stocks, including the upcoming cross-border sharing trading plan in…

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Long-time value investors in Asia are familiar with how management would show the investors-in-suit the “good stuff” while hiding skeletons in the attic. When visiting the Chinese factories, foreign investors are often impressed by being put through the rigmarole of careful hand washing, the donning of sterile scrubs and caps, and so forth, before going on to the bustling factory floor. It is all very impressive, professional looking, and confidence-inducing. Once the funds are transferred and invested (with the transaction executed by the brokers, sell-side analysts and investment bankers who had arranged the trip and later informed the management), these rituals fall by the wayside and are no longer practiced, and the busy activity quiet down. Throughout the visit, it is not uncommon to be showered with the Chinese elaborate art of courtesy or keqi. When cocooned in such hospitality, it would make the issue of raising meaningful and tough questions seem awkward, with the visitors feeling the onus not to spoil things by embarrassing the hosts. Until of course the painful realization that what goes on is façade.

Yet, beneath the façade, institutional and behavioral patterns do not change much. Without intellectual curiosity and a critical mind, visiting companies and meeting with people will be a futile exercise. The enduring art of questioning according to the culture and context will always prove relevant, as Buffett and Munger had shared in their illuminating reply during the Q&A session in the recent Berkshire Hathaway AGM 2014:

Q: “If you are 23 years old and not a software/tech engineer, what would you do with your entrepreneurial instincts – what are would you go into?

Warren Buffett: “I would do what I did at 23 years old and go into the investment business. And I would look at lots of securities and talk to lots of people. I would see CEOs of 8 or 10 coal companies. I often didn’t make appointments, but they almost always would see me. I would ask them, if they had to put all of their money into any coal company except their own, and go away for 10 years, which one would it be? And which would they sell short over 10 years and why? If I did that, I would know more about the coal companies than any manager would.. You need real curiosity about it, it has to turn you on.. If you are open to things and keep learning things, you’ll find something.”

Charlie Munger: “You should do like Larry Bird, who asked a lot of agents who would be their number two choice – and when they all said the same person, Bird hired him and negotiated the best contract of all time.”

Above all, in our decade-plus journey applying value investing principles in Asia, we find that it is critical for diligent value investors to have a balanced perspective, for Truth lie somewhere between glory and disaster. Most importantly, value investors need to have the same heartbeat as the wide-moat compounding Bamboo Innovators: value investors cannot see the elusive Bamboo Innovators as some dragons to slay; we got to look at them with soft eyes until everything – us and them – becomes one.

To read the exclusive article in full to find out more about the wide-moat factors behind AAC and Goertek and the highlights of the various visits at the Pearl River Delta region; please visit:

• Takeaways from the Berkshire Hathaway AGM 2014 and the Pearl River Delta (PRD) Trip, May 19, 2014(Moat Report Asia, BeyondProxy)

“In business, I look for economic castles protected by unbreachable ‘moats’.”

– Warren Buffett

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy and The Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produce The Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equitiesand savvy private individual investors who are lifelong learners in the art of value investing.

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Our latest monthly issue for the month of May investigates the Home Depot of Asia which has the largest market share in its home country and now seeks to expand regionally. It is one of the few home improvement retailers in the world which is able to achieve a structural negative cash conversion cycle (CCC) at -39 days for resilient, recurring and sustainable operating cashflow to enable the expansion of its store network while keeping a healthy balance sheet. It is hard to achieve negative cash conversion cycle (CCC) as a home retailer as compared to a supermarket retailer as the product nature is more durable. Even Home Depot, Lowe’s and Bed Bath & Beyond (BBBY) are not able to achieve a negative CCC. Led by the capable owner-operators since 1995, the company is a pioneer in proactively creating awareness and demand in the minds of consumers that upgrading your home can be fun and in incremental affordable steps. Its creative branding has resulted in the firm to become the “first on customers’ mind”, or what Charlie Munger elucidated as the “psychological wide-moat” advantage. 80% of sales are generated customers looking for home improvement and renovation ideas and solutions.  Growth is supported by the management’s proven ability to identify and cater to dynamic changes in customer preferences. The firm’s comprehensive pre and aftersales service creates brand loyalty and sustains long-term sales. The merchandizing management is tailored to the peculiarities of customer preferences in each area to drive same store sales growth with creative customization by store, location, season and events. Its key strategy to expand its profit margin is to increase its higher-margin house brands and product-mix management. Its EBITDA/sqm of $400/sqm was higher than Home Depot until Home Depot experienced a rebound last year to $500/sqm. The firm’s resilient sales are supported by its unrivalled network of diverse locations throughout the country. Its bold vision and successful “Blue Ocean” execution in the highly fragmented second-tier markets has created a powerful wide-moat advantage that will last for many years to come. In short, the management have proven their ability to execute in difficult market and industry conditions especially in the past 5 to 7 years during the 2007/09 global financial crisis with the firm emerging much stronger. The Illinois Institute of Technology engineering graduate and quiet billionaire owner behind the home retailer is one of the few Asian business tycoons who has the thirst to scale up the business in a sustainable way, as opposed to opportunistic ventures, having been largely influenced by his early years experience observing the success of American wide-moat firms. If we can adjust the EV/EBITDA valuation metric to reflect the CCC, the company’s EV/EBITDA of 18.5x will be lower at 10-11x, while Home Depot’s EV/EBITDA 11x will be higher at 13x. Noteworthy is that Home Depot has a negative free cashflow throughout FY1989-2001 (13 consecutive years!) and yet market cap has climbed from $1.5bn to $103bn. Home Depot compounded despite the ugly valuations during the capex ramp-up. This once again highlights that the power of wide-moat is often underappreciated, misunderstood and overlooked. When Home Depot generated $180m in operating cashflow in FY1992, quite similar to this Asian firm now, Home Depot is valued at $5bn (vs $3bn). Store network is expected to double in the next 4-5 years, representing a potential doubling in market value.

Our past monthly issues examine:

• The Northeast Asian-listed company who is the world’s largest maker of an essential component with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, including Nike, Adidas, Reebok, Sketchers, UnderArmor are customers and this Asian innovator with R&D capabilities has forged long-term “spec-in” partnerships with them. Its broad product offering is protected by over 110 patents. By locating its Pan-Asian production plant network in China, Taiwan, Vietnam and Indonesia close to its major clients, including sales/customer service centers and warehouses in US and Europe, the firm is better positioned to understand their requirements, deliver fast and meet their needs. While top 10 athletic shoe brands account 40% of its revenue, the firm has a diversified clientele base of over 10,000 customers, giving it resilience and growth with both the established and emerging brands as clients. The company is trading at PE14e 12x, EV/EBITDA 7.1x and EV/EBIT 10.6x with a dividend yield of 3.9%. Interestingly, its EBITDA margin is double that of Adidas and its 8.7% net margin is higher than Adidas’ 5.4%, though below Nike’s 9.8%. Given the tipping point of its Pan-Asian production network and contributions from its new products and as capex tapers off in the next few years, free cashflow could be around $50-60m and applying a P/FCF of 15x would yield a market value of $750-900m,, representing apotential upside of 100-150%. Thus, the firm offers a similar quality growth trajectory to Nike/Adidas with its unique knowledge-based business model and yet trades at a more attractive valuation and higher dividend yield as downside protection.
• The Middleby of Asia commanding a dominant market share of over 80% in hypermarkets, 50% in chain outlets, 30% in 4- to 5-star hotels in China and an overall 30% in its home market. Yet, no single customer accounts for more than 5% of its revenue. Just to recall for value investors, NYSE-listed Middleby, with its sleepy and boring business, has compounded 100-fold from around $50m to $5.7bn since its tipping point in 1999. The founders of this Asian family business demonstrated clear dedication in building up the company with its wide-moat business model backed by a strong and unique distribution/marketing network in finding, winning and binding new customers to build massive brand equity and long-lasting relationships with clients over time. Their devotion to its core product for nearly 20 years results in maximum problem-solving skills, innovative strength and product leadership and hence, to ever greater customer benefit that will protect the company to consolidate the fragmented market and provide ample opportunities to continue its profitable growth. The company is currently trading at PE13e 15.8x and an undemanding EV/EBIT 10.1x and EV/EBITDA 9.5x and its growth potential based on its unique business model is not priced in. There is a structural re-rerating of niche business models with (1) diversified client base, (2) steady revenue streams, (3) lean capex requirements that creates ample free cashflow and defensive growth. Based on PE, P/CFO and EV/EBIT, the company is trading at a 40-50% discount to the foreign listed comparables despite more efficient use of assets in generating profits and cashflow. It has an attractive 7% earnings yield growing at 20% over the next 3-5 years and a 3.8% dividend yield that is supported by its strong cashflow generation ability, steady revenue stream and lean capex requirements to limit downside risks in valuation. Based on the growth plans to penetrate new product and customer segments; build its third plant in India in addition to the ones in its home market and in China; and potential bolt-on acquisition opportunities with its healthy balance sheet in net-cash position, it has the potential to double its operating cashflow in the next 3-5 years and market value could double, representing an upside potential of 100-140%.
• An emerging Asian Walgreens which is a top 3 community pharmacy operator in its home market. Walgreens is a classic neglected American compounder up over 272-fold to $54 billion from under $200m as it quietly consolidates the market. Over the decade, we observed that it is difficult to scale services-based businesses without an entrepreneurial mindset, committment and execution and the bold and unique management system of the company since 2000 allowed the pharmacists to be part-owner of the business which will lead to increased level of commitment and an owner’s mindset in growing the business for the long-term in the community. The firm has strong cash generation ability due to its negative cash conversion cycle (CCC) in the business model to help the business stay resilient during difficult times and to fund capex needs internally without straining the business model scalability as the network expands. The centralized logistics system provide regular deliveries to all of its community pharmacies enables the outlets to maximize retail space without the need to have space to keep stocks. This also enables the community pharmacies to optimize retail space to carry a wide range of products which is important as consumers increasingly have top-of-mind recall for the company as the destination to go to for their healthcare needs. Like Walgreens, the company believed in the power of embedding technology into the business model to better compete and its financial and warehousing/inventory management systems are integrated with its in-house POS (point-of-sale) system which is linked among all its community pharmacies and head office via virtual private network. The company is founded by five college friends who were somewhat frustrated that their pharmacy degrees were underappreciated and under-rewarded as compared to their medical degree counterparts even though they had studied hard for 4-5 years and had in-depth medical knowledge. They were eager to prove themselves that they are as capable, if not more so. This restless spirit to prove their capabilities resulted in them coming together to be entrepreneurs and they wish to provide the platform for similar restless pharmacists to apply their hard-earned knowledge acquired in the university. We find that this common purpose and camaraderie spirit is rare in Asian companies and makes the company unique to scale up sustainably. The company is currently trading at a EV/EBIT of 13.9x and EB/EBITDA 12.6%. In the next two to three years as the company expands its network of outlets, operating cashflow (CFO) could increase 50-60% and a re-rerating could result in a doubling in market value.
• An Asian-listed pharmaceutical company which has a dominant franchise in a neglected but growing disease and is a leader with a domestic market share of 49% in this niche segment and is the only fully-integrated player amongst the few pre-qualified WHO firms, giving it >30% EBITDA margin, better pricing power compared to the competition, and significant advantage over other players in ramping up the global business from the current 30% market share in the most-common treatment drug (vs Novartis 50%). Furthermore, the pharma company has the second-highest GP/TA (gross profit/ total asset) ratio in the industry at 56.3% and the most conservative accounting practice in the industry which “depresses” earnings relative to its peers i.e. it is the only domestic firm which expenses, and does not capitalize, all R&D. With the new plant for formulations export to US, the deepening of the niche drug franchise, growing wins in chronic pain and other niche areas and the commercialization of the potential blockbuster product of blood thinner by FY16/17, EBITDA could potentially double to $200m in the next 4-5 years, triggering a valuation re-rating to a market value of $3.4bn, a 130% upside.
• An Australian-listed company with market value $405m, EV/EBITDA 7.5x, EV/EBIT 10x, div 3%, 70% domestic market share whose management made the controversial bold decision to stop overseas exports in order to focus on cultivating the higher-margin domestic market with innovative marketing strategy and new products and is potentially doubling its supply in the next 3-5 years. It is in its 10^th year of listing after piling the foundation in consolidation, investment, rationalization for its next stage. It has an all-time low debt-equity position 18.6% with healthy balance sheet. “Buffett of Nordic” recently increased position between Apr-Sep this year in the peer comparable of the company and the billionaire investor announced in Nov an acquisition of a rival in a wave of global consolidation and with the view on a sustained recovery in product prices.
• A Northeast Asia-listed company with global #1 market share leadership in 4 different products, including making the components for an innovative consumer product whose sales have climbed from $90 million to $526 million in the recent three years. The company is a hidden global consolidator with underappreciated growth. The stock is trading at PE 11.5x, EV/EBITDA 9x and generates a sustainable dividend yield 5.75%.
• A Taiwan and Southeast-Asian-listed entrepreneurial company, both with a dominant 80% domestic market share and have innovative business models to generate substantial cashflow to support both expansion and a 4-5% dividend yield.
• There is also a behind-the-scene conversation with the CEOs of the companies to understand their thinking process in building up the business.

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers.Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Land acquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singapore spinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideas in which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 7^th run of the series of workshop From the Fund Management Jungles: Value Investing Exposed and Explored – (Part 1) Moat Analysis, (Part 2) Tipping Point Analysis and (Part 3) Detecting Accounting Fraud – on 8 Mar 2014 has been well-received with serious value investors, professionals, and serious lifelong learners attending.

Our 8th workshop on Tipping Point Analysis will be held in June 14; we are taking a short break as our business partner Linda is delivering her new baby!

Thank you for your support all this while!

http://www.eventbrite.sg/e/in-search-of-compounding-stocks-in-uncertain-times-tickets-10057477185?aff=eorg

Thank you so much for reading as always.

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia