• 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.

Capital Allocation in Asian Wide-Moat Innovators: The Story of the Jin and Hui Merchants

“…the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve. The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

– Warren Buffett

Intelligent capital allocation is possibly the most important skill that entrepreneurs need to master to cross the chasm to “Stage 2” to become a true wide-moat compounder. It requires understanding the long-term value of an array of opportunities to reinvest back into widening the economic moat of the business; sourcing and using money prudently and sagaciously in capital expenditures, R&D, M&As; having a sharp analytical framework and independence of mind to avoid “institutional imperative” and the illusory comfort of equating “busyness” in embarking different projects and multiple activities as “productive”.

Having recently visited the facilities and interacted with the top management team of one of Singapore’s most beloved consumer brands last week, we are confident that with the right capital allocation capabilities, selected Asian entrepreneurial companies can build upon their strong foundation, brand heritage and brand equity to scale to greater heights and create and compound value in a sustainable way.

Michael Mauboussin and his colleagues have written a great guide to capital allocation for investors: Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance. The authors shared a Checklist for Assessing Capital Allocation Skills, reproduced below:

Past Spending Patterns

• Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
• How has the company funded its investments?
• Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
• Have there been shifts in the pattern of spending?
• If there is new management, has spending changed?
• Who makes which capital allocation decision?
• How does the company conduct its budgeting process?

 Calculate ROIC and ROIIC

• Have you calculated ROIC over time and observed a trend?
• Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
• Have you compared the company’s results to those of its peers?
• Have you calculated ROIIC for one year and rolling three- and five-year periods?

Incentives and Governance

• How is the company’s incentive compensation structured?
• How much stock does senior management own?
• Is total shareholder return calculated on a relative basis?
• Have you examined the company’s incentive score?
• Are the measures in place to encourage management to think for the long term?

 Five Principles of Capital Allocation

• Does the company use zero-based capital allocation or is it dominated by spending inertia?
• Is the company focused on funding strategies or projects?
• Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
• Does the company prune businesses with poor prospects for creating value?
• Does the company know how to calculate the value of its assets and does it act accordingly?

We like to share a story that we had written back in February 2011 about Hengan (1044 HK) to illustrate thoughtful capital allocation during 2004-2009; Hengan invested heavily to move up the value chain in higher-end products and to distinguish itself from the hundreds of low-end producers, becoming the largest producer of personal hygiene products such as tissue paper, sanitary napkins, pantiliners and baby diapers and compounding its market cap from a billion to $12 billion in the process.

Importantly, to complement the checklist approach, we explore why the once-powerful Jin and Hui merchant groups in China did not manage to cross the chasm to “Stage 2” to become true wide-moat compounders and blew up because they did not understand thoughtful capital allocation; while the Ningbo entrepreneurs “were more far-sighted, reinvesting their profits into building sustainable industrial businesses rather than making speculative asset transactions that yield transient profits, making the successful transition to Stage 2.”

We hope the story of the eclipse of the Jin and Hui merchants will provide positive and uplifting lessons for entrepreneurs and value investors: the compounding power of capital allocation when mastered properly.

Eclipse of the Jin and Hui Merchants: Lessons for Entrepreneurs and Value Investors

By KEE Koon Boon, 20 Feb 2011

Pinnacle to pits. Such is the tragic and thought-provoking path of the powerful Shanxi-based “Jin Merchants” (晋商) and Anhui-based “Hui Merchants” (徽商) during China’s Ming Dynasty till their demise in the late-Qing Dynasty as they could not cross the chasm to “Stage 2”.

They were richer than the emperor and their business empires stretched as far as to Asia, Russia and Europe. The powerful Shanxi “banks” (piaohao 票号) offered a full array of financial services, establishing the remote inland Shanxi province’s Pingyao and the nearby Qixian and Taigu counties as the premier financial centers or China’s Wall Street then; the first and largest of them, Sunrise Provident (Rishengchang 日升昌), was the modern equivalent of JPMorgan.

They were extremely hardworking; the Hui Merchants were also called “Hui Camels” as camels symbolize their propensity to tolerate hardwork and overcome adversity in harsh conditions. They were highly educated and cultured; the Hui Merchants were also called “Confucius merchants” and one in five imperial scholars came from the Anhui province then. They worked in “teams”; family groups and clan members collaborate to dominate geographies and industries ranging from tea, timber to textile.

So why and how did these two powerful business empires went into oblivion?

Both the Jin and Hui Merchants, for all their vast accumulated wealth, did not invest for growth in building an economic moat, a unique durable business model.

Take the case of Dashengkui (大盛魁), one of the largest business empires established by three “Jin Merchants” then. It had 20,000 camels, dominating the logistics business in China, particularly in the transport of tea to Mongolia, Xinjiang and Russia. Its assets were said to be so vast that they can be converted into enough 50-liang tael to lay a road that stretches from Ulan Bator (the capital and largest city of Mongolia) to Beijing.

Despite the advent of steamship as a low-cost and efficient transportation means, Dashengkui failed to invest any of its profits or reserves in upgrading its logistics assets. Also, the Jin Merchants who dominated the tea trade and became very rich, used the profits and cashflow from the businesses to fund their lavish lifestyles and indulge in asset speculation, purchase land and rebuilt their houses.

In 1866, without the burden of tariffs, the Russians started to transport tea from China via the sea route and subsequently exported the tea to Europe and Middle-East. They established modern processing and manufacturing facilities in places such as Hankou, Jiujiang, Fuzhou, making use of coal-based steam turbine technology and machines rather than the manually-driven turbines and labor-intensive manufacturing methods used by the Chinese Jin Merchants.

The Russians produced high quality and low-cost tea bricks in huge quantities and had the added advantage of transporting via the cheaper sea route instead of the conventional land-based path dominated by Dashengkui. The fortunes of the Jin Merchants started to take a sharp deterioration. They were contented to rely on their core business of piaohao and pawnshops for the cashflow to speculate in property and to fund their lavish lifestyles. As a result, they missed the opportunity to convert their piaohao into banks, including declining the invitation to invest in the current HSBC.

Hu Xueyan胡雪岩 (1823-1885), dubbed the richest-ever Chinese entrepreneur and known as the “Red-Topped Merchant” (hongding shangren 红顶商人) after the scarlet tasselled hat which reflected his position as a first-grade imperial official and awarded the “yellow mandarin jacket”, was probably the most celebrated Hui Merchant.

Despite the realities of the Industrial Revolution exposing the weaknesses of the labor-intensive manufacturing methods employed by most of the Chinese merchants as compared with the modern machines which western companies invested heavily in, Hu, a veteran in the silk business, insisted on using labor to process raw silk. At that time, the western companies had the upper hand and deliberately depressed the price of raw silk in China.

In May 1882, Hu purchased raw silk in bulk, hoping to monopolize the supply in order to force the cartel of western companies to buy at higher prices. Hu was an accomplished opportunistic trader all his life and he was highly confident that his Fukang “Bank” was “rock-solid” in providing the financing to fight the battle with the western companies.

Unfortunately, after two consecutive years of drought in Europe prior to Hu’s purchase, Italy had a good silk crop harvest. Raw silk prices plummet and Hu’s unsold inventory depressed the silk market further. A French navy fleet also arrived at Shanghai, threatening to attack China.

With the prospects of a Sino-French war breaking out, cash became king and banks withdrew their short-term loans. Trade halted and there were massive property and asset disposals in Shanghai. Bank runs erupted, impacting Hu’s “rock-solid” Fukang Bank. By December 1883, Hu was bankrupt. Hu died in 1885 in the same year as did General Zuo Zongtang 左宗棠, who provided Hu protection and patronage, enabling Hu to get and stay rich.

Their neighbors, the Ningbo Entrepreneurs, were more far-sighted, reinvesting their profits into building sustainable industrial businesses rather than making speculative asset transactions that yield transient profits, making the successful transition to Stage 2.

While investing for growth is critical, it is important for value investors to note that making capital investments without allocating them to build a team and an economic moat is likely to be an inefficient and value-destroying exercise. They will fall into the general category of firms described by finance researchers Sheridan Titman, John Wei and Xie Feixue in their 2004 JFQA paper. These firms that increase capital investments substantially destroy future firm value in the long-run because 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”.

In addition, value investors need to be discerning in understanding that investing to build an economic moat to build up the intangibles and core competencies for sustainable and scalable growth could depress short-term cashflow. Thus, the financial numbers may not look appealing from a historical snapshot perspective.

Established by Mr. Sze Man Bok and Mr. Hui Chit Lin in 1985, Hengan grew over 20-fold from US$480 million to US$11 billion since its HK listing in 1998 to become the largest producer of personal hygiene products such as tissue paper, sanitary napkins, pantiliners and baby diapers.

Interestingly, Hengan was below a billion market cap post listing until 2004. From 1998 to 2003, Hengan invested a total of around S$140 million in capital expenditures and conserved cash. The capex figure scaled six-folds to a total of S$830 million from 2004 to 2009 as Hengan invested heavily to move up the value chain in higher-end products and to distinguish itself from the hundreds of low-end producers. Annual profits grew six-folds from a size of S$57 million in 2003 to S$400 million in 2009, creating S$12 billion in firm value in the process.

Long-term entrepreneurs need to appreciate that generating profits via collecting transactions will not lead to sustained compounding returns. Hu Xueyan, the consummate trader in accruing multiple profitable transactions all his life, witnessed the horror of not building a durable economic moat when he opened his warehouses that were stockpiled with unsold silkworm pupae. The silkworms had metamorphosed into moths and Hu literally watched his fortunes flutter away.

Profits need to emanate from, housed and reinvested in an economic moat to be rejuvenated, propelling the enterprise to scale new heights and generate sustained compounding returns. Without doing so, they risk blowing up in Stage 1 like the Jin and Hui Merchants.

It is the task of value investors to dive through the rumpus and bustle of cabal in poignantly troubled times in a vigilant watch for outstanding entrepreneurs devoted in their intensive task of building an economic moat.

PS: We also like to share with you an article “Scouring Accounting Footnotes to Prevent Tunneling” which we penned for our local newspaper Business Times Singapore that was published on 19 Aug 2015: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the regulatory authorities in Singapore about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.

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 the month of October, we investigate a listed Asian family business founded in 1975 that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer. The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.

We believe that the outstanding leadership provided by the inspiring visionary founder and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.

• 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.

Living the Life That Is Upright and Executing Day By Day to Scale Asia’s Wide-Moat Foodservice Company 

Can You Guess This Asian Wide-Moat Company?

“Work hard. Deal with people honestly. Always look to improve yourself. Celebrate if we outdo ourselves, not when we outdo others. Enjoy what you are doing. This will help you to deliver the best products and services to your customers. It will also help you to strive to improve until you achieve excellence. Be ready to innovate. And never be afraid to dream big! The advice and motivation comes from one source – my mother. She is steadfast in counselling us, on how to live the life that is upright.”

This is the message that the inspiring Mr. C has for like-minded entrepreneurs and the next generation of leaders.

In the month of October, we investigate a listed Asian family business founded in 1975 by Mr. C and his wife that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer.

The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.

The company’s flagship brand, which contributed 52% of systemwide sales, has powerful store economics driven by high margin, low cash investment cost per outlet, resulting in cash-on-cash return of 43%, which is significantly higher than the 24% return for the average US peers. Its other domestic brands are leaders in their own categories with market share ranging from 35-91%.

Its international brands in China have broken even in 3Q14 after its initial entry more than 10 years ago; all along, the operations are profitable at the store level, but lack enough scale to cover the corporate and infrastructure overheads in which the management has committed to long-term investments in central kitchens to support the scaling up of the network expansion. In Jan 2015, management also inked a 60:40 JV and master franchise agreement with famous US snack chain in China and commented that they are exploring the opportunity to acquire a US brand with a $1bn market capitalization.

Being born into a poor family, Mr. C has demonstrated far-sightedness, discipline and values to build and scale the company into Asia’s leading foodservice company by “giving our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends.” Below is an excerpt shedding more insights into the inspiring entrepreneurial story of Mr. C:

********

Q: “…Can you share with us the story of how the company started? What are the business and personal challenges that you face along the way? How did you overcome them and what are the lessons that you have learnt?”

Mr. C: “…That was the first lesson – and it is something that [Company’s name] espouses to this day. I believe that we should give our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends. I think that comes from the view that we don’t have to be greedy in our daily lives or business. If we strike the right balance, we share the benefits with whomever we’re dealing…

Saving every dollar we could was our mindset during the early days of [Company’s name] when we had a lone store… We had to do everything by ourselves in the beginning.. My wife and I even cleaned the toilet. When there’s no cashier, you do the cashier.. if there’s no janitor, you clean the toilet. It’s like your neighborhood mom-and-pop store. We also served the customers as waiter and waitress, and then at night, we do the accounting by ourselves. As my wife said wisely, ‘There’s a Chinese saying that says it’s easier for you to save than to earn’. So if you have something and you can save it. Don’t waste it because to earn money, it takes a lot of hard work. We worked hands-on but as the business propels, we noticed they could not do it all so we started to set up an organization hired store managers, and trained people.

During those challenges I continued to have high hopes and optimism that anything is possible. I think I pick up this belief from my mom. Our role is to do what we can as best we can and don’t worry about the outcome. The outcome will take care of itself. This belief has allowed me to sleep well at night. It gives me new hope everyday.

The third lesson is that innovation starts in our minds. Our mindsets determine what we’re able to accomplish. The story of [Company’s name] is a story of finding opportunity amidst difficult times. The main thing is to dream, dream big and not be afraid of it. Dreams are free. Why limit what you are aspiring for? But dreaming is not enough. One must be willing to put in the needed action and hard work to make these dreams come true. If you dream big and put your dreams into action you will indefinitely make mistakes. But don’t be scared to make mistakes. Just be quick to recognize them and learn from them as fast as you can. Learn from each mistake and it will not be a waste of time. If we place no restrictions on ourselves, then we’re capable of doing anything. If we are not greedy, then more things will return to us. If we give more to our fellowmen and to our customers, more than what they expect, they’ll return over and over again…

…The food business is still very basic. It’s still about taste. It’s still about How did you serve me? Is your place nice? Am I treated well? Do I get value? If you think about it, if we’re going out to eat, these are the basic things we look out for, but the execution is the difficult part. It’s not like other businesses where it’s the concept or the knowledge that’s difficult. Here, there’s no secret; it’s very easy, but it’s the execution that’s hard. If you ask a lot of restaurant, they know all these things. Executing day by day is what’s hard.”

********

Historical precedents in Chipotle and Yum Brands show that EBITDA/store growth drives valuation multiple expansion; EBITDA/store and EV/store is not just a linear combination but an exponential one. Thus, companies that successfully increase store profitability in a sustainable manner will see valuation increase by an even greater degree. Market has rewarded the company in the past for productivity improvements but has punished the company lately for the weaker-than-expected FY2014 and 1H15 results. Enterprise Value/store for is now back to 2013 valuation multiple despite expanding store count by 8.6% and sales/store growth increasing 1.5% in the trailing 12 months. If EBITDA/store improves 5% back to 2013 level and the company is able to sustain the improvement as it expands the store count to the target level in the next 3 years, EV/store could rebound and EV could jump, indicating a 36-56% upside potential.

The company’s store economics and return metrics is more like “fast casual” that include Chipotle, Starbucks, Shake Shack, which have higher returns and tend to trade at higher valuation multiples. In terms of EV/EBITDA to the fast casual companies, the company trades at a 37% discount. The Price/Sales ratio of fast casual companies is >5x, as compared to the company’s 2.16x, indicating room for profitability improvement, especially with its China business breaking even in 3Q14, and therefore providing the foundation for further valuation gains. Thus, the company’s business model which is more fast-casual in its superior store economics, is underappreciated and undervalued by 37% to >100%.

We believe that the outstanding leadership provided by the inspiring visionary Mr. C, and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.

Can you guess who is Mr. C and his wide-moat family business?

PS: We also like to share with you an article “Scouring Accounting Footnotes to Prevent Tunneling” which we penned for our local newspaper Business Times Singapore that was published on 19 Aug 2015: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the regulatory authorities in Singapore about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.

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 the month of September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.