Capital Allocation in Asian Wide-Moat Innovators: The Story of the Jin and Hui Merchants – Bamboo Innovator Weekly Insight

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | October 12, 2015
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Dear Friends,

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,


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 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.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team 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. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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