Investing In China Hidden Champions: Distinguishing Between Outstanding Capital Allocators and Capital Destroyers – Bamboo Innovator Weekly Insight
November 9, 2015 Leave a comment
|“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)
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%.
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.
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.
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……
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）.
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:
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.
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.