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The Asian Innovator’s DNA Powering Robots, Drones, Automobiles, Medical Equipment, Smart Grid and Green Energy – Bamboo Innovator Monthly Riddle

“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 | November 23, 2015
Bamboo Innovator Insight (Issue 109)

  • 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.
Dear Friends,

Can You Guess This Asian Wide-Moat Company?

The Asian Innovator’s DNA Powering Robots, Drones, Automobiles, Medical Equipment, Smart Grid and Green Energy

Amazon’s mobile army of KIVA cargo-carrying robots cruising in the complex automated warehouses need this product inside them in order to function. So too for Amazon’s hordes of unmanned aerial vehicle (UAV) or drones to deliver packages – without this product, airplanes, spaceships cannot fly, the best electronic device cannot function.

This month of November/December, we investigate an Asian-listed wide-moat innovator who is the leading designer and maker of this product that is critical for Amazon’s robots and drones, and wide-range of high-value-add end-applications, from medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things, to function properly.

Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier.

Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba. The company was founded in 1989 by Mr. W who was a former math teacher and had honed his skills as a sales manager for the American MNC who is the world’s largest maker of this product.

The company offers a one-stop solution for R&D, design, vertically-integrated manufacturing capabilities in molding, in-house tooling, component sourcing and assembly of finished goods, similar to giant Hon Hai’s famous eCMMS model. It is capable of taking orders for customized products, turnkey projects and a total solution from international brand-name clients and its flexible production facilities and know-how offer customers high-mix & low-volume services.

The company’s industrial business has received notable orders and long-term contracts from a major US client for FY2016-17 for power-saving equipment and will start shipping smart-grid monitoring module application orders in FY2016. [Company’s name]’s smart-grid devices enable distribution feeder voltage regulation control and power-saving mode, detecting user’s utilization of electronic energy, and help them save about 20% of electricity use per year, taking power from low-use clients and supplying more to higher users. The system saves on power waste for the end-users too; for example, in a shopping mall, the equipment detects where there are fewer people and can adjust air-conditioner temperatures automatically. Overall, the electronic power-saving system saves energy for both the power company and the end-user, and also provides electronic data for analysis, part of the Internet-of-Things (IoT) concept. As the systems will be installed outdoors, devices are deigned to prevent water and dust ingress and offering erosion protection, allowing operation in harsh environments.  This client has signed contracts with power companies in the US, India, Saudi Arabia, and the Philippines, and is looking for new companies to break into, boosting strong prospects for long-term business development due to the need for growing energy-efficiency.

The company plans to enter the supply chain of aerospace electronic components in the Asia-Pacific region with an joint investment in Aug 2015 with a European firm with Boeing, Airbus and GE Aviation being its major customers. It has received the AS 9100 certification for its manufacturing facilities in China for aerospace applications and the construction of the factory started in 2H15 and is scheduled for production in 2016.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

Led by founder and chairman Mr. W and his team of 500 R&D talent out of around 5,000 employees, the company has transformed its business model three times successfully. Mr. W attributed the success of the company’s continued renewal and transformation to the “Innovator’s DNA” and his role as the “teacher, not the boss” in cultivating a corporate culture that fosters innovation. Below are some excerpts of the conversation with Mr. W:

Q: “Chairman W, you mention about that having an ‘Innovator’s DNA’ is the key factor that determine whether the business model transformation succeeds or fails. Can you elaborate more on how you cultivates and develops this ‘Innovator’s DNA’ and corporate culture in [Company’s name]? What personal role do you play in fostering the innovative corporate culture?”

Mr. W: “[Company’s name] has actively nurtured and cultivated organizational innovation, decentralizing the central HQ power and cascading the decision rights throughout the organization in groups. We are not stingy at all in putting down ‘power’, coordinating a performance-based way of approaching and doing things, giving every talent the platform to perform to their best potential.

Every business unit have the autonomy and power to pursue and choose their own customers, to possess the ultimate decision right to develop new markets or carry out R&D. Because [Company’s name] is willing to share, because [Company’s name] treasures talents, our small but closely-knitted team of talents are able to fully make good use of their decision rights, authority and power entrusted upon them, accelerating the speed of development in [Company’s name]’s ‘nervous system’ in intelligence to react and respond to market challenges and opportunities with speed. With the friendly internal competition, [Company’s name] is forever renewing itself and keeping itself dynamic, youthful, vibrant and energetic.

With the ‘Innovator’s DNA’ flowing through [Company’s name], we are able to make a third business model transformation in 2012 onwards, entering into the higher-margin, higher value-add product applications.. In this Industrial Age 4.0, our integrated design-manufacturing-integrated service business model ensures that we are able to innovate new products that include robotic applications for Amazon’s automatic warehouses and win the trust of our customers to foster long-term customer loyalty.

We know that our wide-moat competitive strength does not lie in mass production of standardized items. We need to be more sensitive, we need to be faster. Our focus in the higher value-add niche markets enable us to maintain and grow profit margins and growth. We believe that choosing and deepening our roots in the right niche markets and having the right strategy and risk management will result in [Company’s name] to grow steadily one-step at a time.

Tech business guru Geoffrey Moore commented: ‘The biggest trap that successful enterprises face is that they were kidnapped by their past success. Maturing companies face their stall point in growth from their core business.’

The ‘Innovator’s DNA’ enabled [Company’s name] to be courageous and meticulous in doing the right things right at the right time, to combine innovative strategy with product lifecycle management, rapidly locking in the market and ensuring customer stickiness, continuously and consistently improving the solution to ensure steady and resilient growth, making prudent capital allocation in R&D investments in new fields to seek a new trajectory growth path to strive for the best profitability and efficient use of capital resources.

Notably, by successfully transforming our business model three times over our lifecycle, this has created an intangible advantage and quality in our organizational culture and united our team towards a sense of purpose and common objective.

When our team is familiar with the footsteps of transformation, we can always keep a proactive mindset to coordinate with the market strategy, the IT system, and continuously renew our ‘Innovator’s DNA’ through the process, refine our operating model and adapt to the ever-changing environment.

Importantly, we have to change and innovate before crisis arrives, having the determination to open up new paths of growth. [Company’s name] is like a sponge, constantly sucking in various information from the external business environment, transforming them into new product innovation and new business model breakthrough, and the footsteps to our business renewal and transformation will never cease.

My personal role in [Company’s name] with regards to fostering an innovative corporate culture would be that of a teacher.

As shared, I was formerly a math teacher and the soul of a teacher never diminishes. I am the teacher at [Company’s name], not the boss. A good teacher has to teach according to the different aptitude of the student to unleash their greatest potential. It is the same principle when treating our employees. Everyone has different views on doing things. A leader has to keep an open mind and must listen to the views and feedback of our team and to encourage the team to develop their strengths and perform their best.

We [Company’s name]-ites are not afraid of setbacks and mistakes and also possess the courage to take responsibility and accountability in their work. Even during the difficult periods throughout our corporate history when we were having intense cost pressure, we never retrench any workers and we kept the M plant. We started off our business in M and we will never forsake our root and foundation.”

Who is Mr. W and this wide-moat Bamboo Innovator?

PS1: We will be doing a double issue of the Monthly Moat Report Asia in the week of 4th January. Thank you for your kind understanding and support. We will be back with the weekly on 1 December with presentation slides of our Investor Day – we will be sharing insights on our investment strategy of our listed Asian equities portfolio.

PS2: 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 Monetary Authority of Singapore (MAS) 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/

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Investing In China Hidden Champions: Distinguishing Between Outstanding Capital Allocators and Capital Destroyers – 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 | November 9, 2015
Bamboo Innovator Insight (Issue 108)

  • 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.
Dear Friends,

Investing In China Hidden Champions: Distinguishing Between Outstanding Capital Allocators and Capital Destroyers

Over the past week, I am grateful to have the opportunity to share some insights about value investing in “hidden champions” (隐形冠军) to a group of 50 Chinese entrepreneurs, business owners and investors from China, Hong Kong and Taiwan together with my wonderful colleagues who did most of the heavy lifting and work in the intensive sharing session.

Through interacting with and monitoring Chinese entrepreneurs over the past decade, we had accumulated reasonable knowledge to assess the consistency in their capital allocation decisions to create (or destroy) value. Applying this knowledge and investment process, we built up an equal-weighted portfolio of 30 A-share-listed wide-moat innovators who have unique scalable business models, outstanding cash conversion cycle dynamics and return-on-capital, and linguistic analysis of their corporate culture and we found that they generated returns of over 1,500% since 2006, outperforming the Shanghai Composite Index which was up 200%.

MIPC

One of the 30 hidden champions and case studies that we shared is the second largest domestic elevator maker in China with increasing recurring income generated from both its superior 24-hour after-sales service, repair and maintenance network and component replacement and is set to gain market share from tougher safety rules, a replacement wave of aging equipment and consolidation of weaker low-quality opportunistic competitors.  With its strong commitment to R&D and product innovation and control of the core technology for developing the components, its products are used in IKEA, Carrefour, Wal-Mart, Sun Art Retail’s Auchan, B&Q, Suning, etc. Higher-margin and higher-value-add products such as moving walkways and escalators account for 35% of its total new installation sales that include installations in high-speed train stations. Luxury brand owners LVMH and Burberry have also specifically asked for its escalators and moving walkways products. Its high-speed elevator product is able to achieve the operational speed of 8-meters per second, comparable to global MNCs. Interestingly, the lift density per 1,000 population in first-tier cities Shanghai, Beijing, Tianjin, Chongqing is still below that in Hong Kong and Singapore, pointing towards a long runway for reinvesting in widening its moat to expand growth in its domestic market. Growing overseas exports to over 80 countries that include US, Europe, Australia, Middle East and rest of Asia contributed to around 30% of its total sales.

Hidden Champion

Noteworthy of its capital allocation competencies is that dividend and share repurchases have amounted to over 90% of its IPO proceeds. Management compensation is less than 2% of PBT (profit before tax) and the company had also implemented a share-based incentive plan in 2013 to align with shareholders’ interest and foster a owner-operator mindset, granting 3.6% of total shares to 68 key management and key R&D staff to drive product innovation and retain core talent. The company generates ROE of 16-17% on a debt-free, net-cash balance sheet and trades at EV/EBIT 17x.

Interestingly, the second-generation leader of this family business shared that employees who worked for 4 consecutive hours are required to take a mandatory break. Staff are allowed an hour to rest, read books, and conversing with one another to foster closer workplace relationship. As shared earlier, we are insistent on going beyond the numbers to identify the wide-moat innovators and hidden champions by gaining an understanding on (1) the management desire to cultivating a culture of decentralization, trust and cooperation to foster innovative experimentations, including investing in a system to cascade decision rights throughout the organization; (2) the management skin in the game with aligned performance-based incentives, (3) the management discipline in handling power and wealth; and (4) the management focus and sense of urgency to build something with a Purpose and commit to an idea larger than themselves to care for and serve others with love.

We also share with the participants that 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”. Specifically, a long-short portfolio to buy the group of companies with the lowest capex and short those with the highest capex will generate a compounded excess return of 16.8% (4.2% on the long side, 12.7% on the short side) over the period of 23 years in the researchers’ study.

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.

We shared several real-world cases of value destruction and accounting fraud when fast growth is combined with high capex without Buffett’s mentor Philip Fisher’s “discipline required for growth”. One of them includes the capex fraud case and former stock market darling Fu Ji Food & Catering listed in Hong Kong.

We also shared the fallacy of “free cash flow” analysis without an understanding of the deeper purpose behind the capital allocation in capex investments with the positive cases of Taiwan’s contract manufacturer Hon Hai (2317 TT), which has compounded over 10,000%, tissue paper, diapers and sanitary pad maker Hengan (1044 HK), and Home Depot. We asked:

Q: Why didn’t Buffett and most value investors buy Home Depot (HD) when its market cap scaled 35-fold from $2.8bn to $100bn during 1990 to 2001?

A: Because HD was a much hated stock with negative free cashflow throughout 1990-2001 (11 consecutive years!) and average EV/EBITDA and PE were 23x and 40x respectively.

Home Depot

During the “ugly” period (FY1990-2001), Home Depot was reinvesting its profits into widening its moat with capex investments in expanding its store network, thus resulting in negative free cashflow for 11 consecutive years and accounting profits were depressed. During this period, average EV/EBITDA 23x (Range: 15-36x) and average PE 40x (Range: 25-55x). But boy did it compound in value despite the ugly valuations during the capex ramp-up as the power of wide-moat was underappreciated.

Intrigued and provoked by the difference in value outcome from capex investments in different companies, the participants blasted the tough question: how can value investors have foreknowledge in whether the capex investments will translate to value creation like Home Depot or value destruction like Fu Ji Food & Catering?

We shared with them a simple and practical metric……

<ARTICLE SNIPPED>

Read more at the Moat Report Asia: http://www.moatreport.com/updates/

Capital investments will need to be examined on whether it is for long-term commitment to build a wide moat for longer-term value creation or for earnings manipulation. Thus, value investors can apply this metric to assess whether the management has gained mastery in their capex execution to lower the risk in their investing decision. If the metric has improved but the share price has not been reacting, it is a good signal to accumulate the stock.

Above all, we shared that beyond financial statement and valuation analysis and business model analysis and developing the temperament edge in developing one’s character and economic virtues, value investors need to acquire and immerse in outstanding entrepreneurs’ mindset, sense of stewardship, integrity and noble purpose (使命感).

Three Stages

I ended off with a Chinese poem that I am particularly fond of, which talks about the three stages of knowledge which everyone has to go through, much like the different stages that a company needs to go through to master capital allocation to create value:

  • The first stage is our response to adversity and difficult environment: When the west wind is howling and shearing at the bark of the jaded tree, we have to climb up the building to see what others cannot see, to focus and not be distracted by the haze, to understand ourselves and our confusions, and set out with determination.
  • The second stage is our commitment to love learning: The shirt sleeve gets bigger and yet there’s no regret. For love I have become haggard and sallow. The shirt sleeve gets bigger because we have grown thinner and yet we commit to invest in learning, to love learning, to love creating, to love serving, and we forget about ourselves.
  • The third stage is after many ordeals and decades of hard work, one becomes gradually mature and has hit the tipping point to acquire mastery and to innovate to serve others, to water the beautiful flowers with our blood and sweat. It is also the phrase that inspired the naming of Baidu, the Chinese internet search giant.

And I said finally to the group of lifelong learners of value investing that I am still in the second stage, growing thinner and getting haggard, but never regretting the commitment to inform and educate, to serve with care and love…

PS1: We had been away on an intense overseas business trip from 22 October till 6 November. Our Monthly Moat Report will be back in the week of 13-17 November. Thank you for your kind understanding and support.

PS2: 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 Monetary Authority of Singapore (MAS) 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.

Investing with Conviction to Outperform in Times of Volatility and Uncertainty – 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 | November 2, 2015
Bamboo Innovator Insight (Issue 107)

  • 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.
Dear Friends,

Investing with Conviction to Outperform in Times of Volatility and Uncertainty

This week, we like to share the investment strategy piece from the listed 8I Holdings Limited Interim Report that I wrote:

Our Investment Strategy

“Charlie and I decided long ago that in an investment lifetime, it’s too hard to make hundreds of smart decisions. We adopted a strategy that required our being smart only a very few times.. If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: Too much of a good thing can be wonderful.”

– Warren Buffett in Berkshire Hathaway’s Annual Letter to Shareholders in 1993

“Too much of a good thing can be wonderful”. This penetrating comment by Warren Buffett captures the essence of our investment strategy going forward to make ongoing market volatility and uncertainty our friend in generating long-term outperformance.

Investing with Conviction to Overcome “Disposition Effect” and Make Market Volatility Our Friend

The disposition of the typical investor in selling winners too early and keeping losers for too long is a reflexive choice under uncertainty and reflects an aversion to loss realization. In our view, investors ride losers far too long to postpone regret, hoping for a rebound in prices, and sell winners too quickly because they want to hasten the feeling of pride at having chosen correctly in the past.

Market volatility and chaos, mania and panic – they would be our friend if we have the willpower quotient to overcome this harmful disposition effect. This willpower comes from anchoring ourselves with knowledge in identifying and investing in misunderstood, neglected, overlooked and underappreciated wide-moat companies and sizing up the portfolio bets with conviction when the management continues to deliver in their long-term business plans. Such conviction requires intensive analysis and monitoring of companies and entrepreneurs. This is akin to the investment decision process when Buffett invested 42% of Berkshire Hathaway’s funds in America Express in 1974, whose share price has since compounded over 3,000%. In essence, position size can be more important than entry prices.

To align ourselves with this investment approach which allows for 8IH to protect, to preserve, and to guard our shareholders’ funds in difficult times, we have made an extensive review and restructuring of our investment portfolio in the month of September, whereby we sold off 11 companies because of (1) the narrowing or deterioration in their economic moats; (2) the inability to reinvest profits back into core business to widen the moat; (3) management integrity and corporate governance issues. The heartening thing is that our investment returns were buttressed in investments in wide-moat innovators as our current portfolio is up 6.7% in the rolling 12-months, outperforming the Straits Times Index which is down 14.8% over the same period.

Identifying the Underappreciated Wide-Moat Businesses and Sizing Up Our Portfolio Bets

To illustrate how we can and will improve our investment performance going forward, we will briefly highlight the thought process in some of our winners in our current investment portfolio – Thailand’s Major Cineplex and Malaysia’s largest synthetic nitrile glove-maker Hartalega. Our 12-month rolling returns (in SGD terms) from Major and Hartalega are 32.1% and 11.8% respectively, overcoming the performance drag from the sharp depreciation of the Baht and Ringgit currencies and trouncing the negative 14.8% decline in the Straits Times Index. Our average annualized returns since we initiated the purchase of Major Cineplex and Hartalega is 46.3% and 28.3% respectively.

To gain conviction in sizing up the investment bet, we apply the acid test for our stocks with a seemingly simple but profound question: “Does the business get easier as it gets bigger?”

CEO Khun Vicha Poolvaraluck, a proven innovator with an eye for detail in operations and execution, has built Major Cineplex into a lifestyle entertainment business model attracting 30 million Thai consumers to its “destination to be”, resulting in a dominant 80% market share with strong operating cashflow generation ability to support dividend yield and expansion plans. An underappreciated wide moat factor is its advertising services business segment, which is the crown jewel of the group despite contributing only 13% to group sales. A full-range of advertising services are provided to advertisers and media agencies, ranging from simple cinema screen advertising to fully-integrated below-the-line media solutions in the Cineplex network. This include VDO walls, tri-vision, LED/marquee boards, plasma screens, poll signs, bowling masking units, outdoor media (billboard). This is additional revenue generated on existing assets with high gross profit margin of 86-88% with minimal capex investments.

Thus, as Major Cineplex expands its screen penetration into upmarket and provincial areas outside the Bangkok metropolitan area, advertisers will pay even more for the consumer reach. The business gets easier as it gets bigger. This is akin to the old newspaper model in which ad revenue climbs exponentially with greater readership reach. That’s how Rupert Murdoch scaled up News Corp by buying up newspaper regionally and globally and consolidating them as a bundle with a greater readership reach to pitch to advertisers. Yet, when Murdoch was building this business model before its categorization into a “wide-moat” business becomes obvious, investors underappreciated the tipping point dynamics of the business model once the network grows to a certain critical mass to generate exponential returns subsequently.

For Hartalega, its rivals Top Glove, Kossan, Supermax can also produce nitrile gloves, but not to its scale and focus; in other words, the businesses of its competitors do not get easier as it gets bigger. The tipping point in the business model was when founder Kuan Kam Hon and his son Kuan Mun Leong launched the world’s thinnest 4.7g nitrile glove in 2005 and subsequently an even thinner 3.7g nitrile glove in 2007, creating a pull-based market in which the nitrile gloves can be used by healthcare professionals and patients who are allergic to rubber protein. Before Hartalega, nitrile gloves were chiefly used in industrial applications and not in the medical sector due to their heavy weight and thickness, which was a hindrance for medical practitioners in the examination of patients. The Kuans demonstrated far-sightedness when they invested in automated mechanical stripping system that mimics the human hand motion of stripping gloves off and industrial bar code tech system to scale up to 45,000 gloves an hour at a lower cost, accumulating intangible know-how that gets stronger as they grow bigger.

Stock % Weight of Stock in Portfolio
Original Sizing Scenario 1 Sizing Scenario 2 Sizing Scenario 3
Major Cineplex 3.9% 20% 25% 30%
Hartalega 1.6% 20% 15% 10%
Other Stocks 94.5% 60% 60% 60%
12 month rolling return

(in SGD)

6.7% 13.7% 15.6% 17.4%
vs STI –ve 14.8%

The above table illustrates the 12-month rolling return of our investment portfolio under 3 different scenarios when the portfolio bet size in Major Cineplex and Hartalega is increased. In the original situation, the return is 6.7% when the actual weight of Major Cineplex and Hartalega is 3.9% and 1.6% respectively based on the investment cost. When the portfolio weight is increased to 20% for each stock, portfolio returns doubled to 13.7%. In the scenario when the weight in Major Cineplex and Hartalega is increased to 30% and 10% respectively, portfolio returns jumped to 17.4%. Noteworthy is that the portfolio returns are in SGD, outperforming the Straits Times Index which is down 14.8%.

Staying Vigilant for Tipping Point in Business Model to Lower Valuation Risk

Thus, to build our investment conviction in order to size our bets with prudence, we are vigilant to tipping points in business models that will result in a valuation re-rating and potential index inclusion if they are not yet in the index. We are watchful for longer-term fundamental changes, as opposed to reacting to short-term news “catalysts” which could be manipulated to create buzz around a stock. Some of these include:

  • New products or services, and new markets and customers: We employ textual analysis of the companies with relevant keywords using linguistic databases on a bi-weekly to monthly basis that include “new product(s)”, “new development”, “patents”, “research and development”, “innovation”, etc. We monitor the ratio of the sales contribution from new products/services and markets/customers.
  • Robust improvements in capex execution efficiency and cash conversion cycle (CCC):  We monitor the capex efficiency ratio in capex as a percentage of new sales, gross profitability, EBITDA and operating profit; widening of the CCC advantage on an absolute and relative basis to its rivals.
  • Significant corporate event in spin-offs, M&As, restructuring.
  • Overall health of value chain and ecosystem: We like to invest in quiet resilient consolidators in fragmented industries and we monitor news of strengths in the companies’ customers, weaknesses in their rivals, and harmonious relationship with their suppliers and stakeholders.
  • Corporate culture, strategy, innovation, partnerships: We are fervent readers of interview transcripts and articles on the management to gain an understanding on (1) the management desire to cultivating a culture of decentralization, trust and cooperation to foster innovative experimentations, including investing in a system to cascade decision rights throughout the organization; (2) the management discipline in handling power and wealth; (3) the management focus and sense of urgency to build something with a Purpose and commit to an idea larger than themselves to care for and serve others with love; (4) the management skin in the game with aligned performance-based incentives. We monitor the sales, EBITDA and EBIT per employee. Our textual analysis of relevant keywords include: “culture”, “empowerment”, “trust”, “support”, “decisions”.

Structuring the Investment Process and Team to Scale Up

We have structured our research and decision-making process to foster vigilance, collaboration, and engagement and to leverage off the strengths of one another in our investment team of 7 (5 in Singapore and 2 in Malaysia) to win together. Our target portfolio weighting by business model and by geographical region is as follow, based on our assessment of the prospects of the country, and the kind of wide-moat businesses that we like and the prevalence of these potential compounders listed in the respective countries and regions:

Business Model Weight %
Wide-moat companies – Stalwarts 30-40%
Wide-moat companies – Fast-growers 30-40%
Asset plays and dividend-yield businesses 10%
Cash 10-30%
Country Weight %
Australia and New Zealand 30-40%
India 20-30%
Greater China (HK, Taiwan) 10-20%
ASEAN1 – Thailand, Philippines, Vietnam 15%
ASEAN 2 – Singapore, Malaysia 5%
Japan and Korea 10%

We Are Cognizant of the Macroeconomic Risks in the Horizon

Besides the uncertainty surrounding the US Fed rate hike decision, we are cognizant of the following macroeconomic developments and risks that signal potential market dislocations ahead:

  • Sharp devaluation of EM/ Asian currencies X Highly-geared Asian companies loaded on dollar-based loans = Recipe for disaster for wave of corporate default and profit warnings.
  • Fragility of China’s financial sector. The RMB36 billion default of Fanya Metals Exchange, once the world’s biggest rare metals trading platform has been the tip of the iceberg of China’s bad debt problems. On 13 Oct 2015, Hebei Financing Investment Guarantee Group, one of China’s largest state-backed guarantors, had failed to honour guarantees on loan defaults by five companies worth RMB 227 million and affecting 660 investors in high-yielding Global Wealth products. Financial news agency Caixin said the amount owed to Global Wealth by the guarantor is now RMB 620 million. A disgruntled Chinese investor has stabbed the chief executive of this Hebei guarantor, the latest sign of escalating tension in the country’s financial system amid rising defaults. CLSA uncovered on 13 Oct 2015 that a quarter of Chinese firms with debt are unable to cover their annual interest expense currently. According to CLSA estimates, Chinese banks’ bad debts ratio could be as high as 8.1%, a whopping 6 times higher than the official 1.5% NPL level reported by China’s banking regulator. With total Chinese bank assets at roughly $30 trillion, if one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 8% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $1 trillion, amounting to 10% of China’s GDP. In early Oct, it is reported that emerging markets are set for the first annual net capital outflow in 27 years since 1988. Investors are estimated to pull $540 billion from developing markets in 2015, led by China.
  • Demise of petrodollar flows into equities and the capital markets. According to Financial Times on 28 Sep 2015, Saudi Arabia has pulled out $50-$70 billion of funds over the past six months. In addition, as Norway announced on 6 Oct 2015 that it experienced the first negative global petrodollar export balance in 18 years, resulting in the world’s largest sovereign wealth fund being forced to liquidate assets.
  • Commodities bust and its impact on the financial sector, led by Glencore. When Aussie mining giant Pasminco went bankrupt in 2001 with debts of over $1 billion, it posed systemic risk to both the commodities sector and Aussie banks with huge exposure to Pasminco’s debt. According to market estimates, Glencore is at least 50-100X bigger at $50-100 billion, with counterparty risks in derivatives liabilities and debt.
  • Internet sector correction led by the collapse of Alibaba below its IPO price and the cooling of VC investment environment has taken its toll on startups.
  • Harvard University endowment fund warns of market “froth” in Sep 2015 and is looking to allocate funds into investment managers with expertise as short-sellers.

More Actionable Stock Ideas than Funds – Allocating Capital Thoughfully In Our “Watchlist”

“Float like a butterfly sting like a bee” is the catchphrase that epitomizes the highly unconventional boxing style of the legendary world-class boxer Muhammad Ali. Never an overpowering puncher, Ali relied early in his career on his superior hand speed, superb reflexes and constant movement, dancing and circling opponents for most of the fight, holding his hands low and lashing out with a quick, cutting left jab that he threw from unpredictable angles. His footwork was so strong that it was extremely difficult for opponents to cut down the ring and corner Ali against the ropes.

We have been following closely a number of entrepreneurs building their enterprises in Asia over the years, observing up close their struggles and their breakthroughs, compiling the progress of their corporate lifecycle dynamics by “Stage 1”, “Stage 2”, “Stage 3” in our “Watchlist”:

Corporate Lifecycle Stage Valuation Dynamics Business Model % Weight in Portfolio
Stage 1: Emerging growth industry companies started by wide-moat innovator At several points in time, the financial market holds back in according a proper price on the company, as the company grew in market cap too fast despite the strong fundamentals and growth; market panics and PEG falls Wide-moat companies – Fast-growers: 30-40%
Stage 2: Rides the rising tide, niche potential transforms to mass market scalability As company continues to deliver, there is positive re-appraisal of the company and PE re-rating; PEG climbs back up again
Stage 3: Milks the cow and consolidator PEG remains relatively steady as company “milks the cow” for cashflow – or company gets complacent with size and falters Wide-moat companies – Stalwarts: 30-40%
Stage 4: Dominance/ Legacy/ Built-to-Last Growth slows down, but PEG climbed due to “dominance” or “winners-take-most” factor, resulting in steady market cap Asset plays and dividend-yield businesses: 10%

To lower our risk that comes from investing in new stock ideas, we float around like butterflies in our “Watchlist”, obsessively gathering relevant information about the business model dynamics, value creation levers and critical success factors, management and corporate governance quality.

Before we sting like a bee to jab in a stock inclusion, to guard against the risk of confirmation bias, we insist on every investment team member to voice out and write down their “Top 3 Dislikes” about the company – and we make a critical and calculated evaluation on whether the positives still overwhelm these “dislikes”.

We are honoured and grateful to be able to have the opportunity to share our thoughts and to have a sincere and productive conversation on 23 September 2015 with the top management team of the Monetary Authority of Singapore (MAS) – Mr. Paul Yuen, Head of Market Conduct; Ms. Gillian Tan, Head of Enforcement Division; Ms. Lee King See, Director (Enforcement & Investigations); Mr. Ang Eng Seng, Deputy Director; Mr. Eric Chia, Deputy Director; and the team at the Secondary Markets & Enforcement Division – 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.

Accounting information can be used to inform – or to deceive. 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.

Sting Like A Bee When There’s Informational and Temperament Edge and Valuation Odds in Favor

We have deployed some of our funds in several new wide-moat companies in our “Watchlist” after the portfolio restructuring, and we are targeting concentrated portfolio bets in two companies with dominant market leadership in their respective fields and are on the verge of strong quality core earnings trajectory in the next 12-18 months. Another new stock inclusion is a key crown jewel asset of an Asian tycoon after the restructuring of his family business empire and has potential for index inclusion and importantly, is a powerful consolidator in its domain with a proven track record in execution.

Currently, we have the problem of having more actionable stock ideas than funds to fully execute our investment process to deliver potentially greater returns to our shareholders. We are exploring the setting up of an offshore Mauritius-based fund structure to house our investments to tap funds from potential external institutional investors.

We are confident that distinct efforts to master the investment formula in identifying the right stock, and investing with conviction in the right amount when we have a commitment and informational edge in the assessment of how that business would perform in the decades ahead, and when the valuation odds are in our favour, would overcome these macroeconomic headwinds and generate sustained investment performance.

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 do not believe in painting rosy pictures or beautifying ourselves. We tell cold, hard truths – with a warm and devoted heart. We hope this will capture the 8IH investment philosophy of entrepreneurs investing in entrepreneurs. We are of the conviction that the future is created one wide-moat innovator 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.

PS1: We are away on an intense overseas business trip in Malaysia till 6 November as we are involved in helping to conduct our value investing program in Chinese to a group of Chinese business owners who are flying in to Malaysia.. Our Monthly Moat Report will be back in the week of 13 November. Thank you for your kind understanding and support.

PS2: 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 Monetary Authority of Singapore (MAS) 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.

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