In a Pit with a Lion on a Snowy Day: Lessons for Value Investors – Bamboo Innovator Weekly Insight
December 21, 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 | December 21, 2015|
|Bamboo Innovator Insight (Issue 113)
In a Pit with a Lion on a Snowy Day: Lessons for Value Investors
As the year-end Christmas season approaches, we are reminded of of an obscure passage in the Old Testament book and its relevance to value investors in their search for wide-moat compounders in an increasingly uncertain environment following the supposedly “expected” symbolic decision to hike US interest rate for the first time in nearly a decade.
Buried in the Old Testament of 2 Samuel, the 23rd chapter and the 20-21 verses, is the story of Benaiah who chased a lion down into a pit on a snowy day. Encountering a lion in the wild is bad luck. Finding yourself in a pit with a lion on a snowy day qualifies as a horrible, terrible day. The instinct and the prudent thing to do is to run away. Most people would have seen the lion as a five-hundred-pound problem, but not Benaiah, who did not let fear dictate his choices. The Scripture doesn’t describe Benaiah as being prudent. It uses the adjective valiant. He chose to face and fight the lion, and killed it, defying the impossible odds. Fast forward two verses, Benaiah won a place in a bodyguard position in the administration of David, the King of Israel. Benaiah went on to have a brilliant military career, climbing all the way up the chain of command to become commander in chief of Israel’s army. His genealogy of success can be traced all the way back to a life-or-death encounter with a man-eating lion.
In a sense, Benaiah’s heroic acts of courage were unplanned. But don’t think that Benaiah was unprepared. He couldn’t predict when, how, or where the lion encounter would happen, but he had been preparing for it since he was a boy, wrestling with his poor pet cat that doubled as an imaginary lion, practicing his swordsmanship in front of a mirror until it became second nature, staging faux battles with his brothers. So when the lion crossed his path, he didn’t see it as bad luck. He saw it as an stewardship opportunity. Success equals stewardship. Stewardship of how we manage our time, talent, energy, including opportunity.
The story of Benaiah resembles that of companies facing disruptive changes and their response that would determine their destiny. Over the decade plus, we have encountered a number of entrepreneurs who faced disruptive changes and chose to chase the lions in building and deepening the wide moat in their business model.
Shanghai M&G Stationary (Shanghai: 603899) – Stock Price Performance, 2014-2015
One of them include Shanghai M&G Stationary 晨光文具 (603899 CH), which was facing the disruptive digitization and smartphone threat to writing instruments and stationary. When M&G was established in the 1990s by the brothers Chen Huwen and Chen Huxiong and their sister Chen Xueling, they also faced a powerful and bigger incumbent lion TrueColor Stationery (真彩文具) who was the pioneer in introducing gel ink pen in China. In other words, M&G was in a pit with a lion on a snowy day, just like Benaiah.
The Chens responded with designing a unique and extensive win-win distribution partnership and launching a wide-range of high-quality, user-friendly, stylish, and value-for-money products. M&G is also the trend creator for the stationery industry with continuous new product and marketing innovations that include “Confucius Blesses Your Scholarly Success” writing pens designed for exams for the 200-million student population, also a popular gift set during this festive year-end season for school-going children before they start school in the New Year ahead.
M&G now corners the stationery market for students and it is said that three out of every ten stationery shops around the 600,000 schools in China belong to M&G. In addition to its own brand M&G, the company has also established partnerships with Auchan, Disney, Tesco and Walmart. M&G products are also available in over 40 countries and regions, with network covering Asia, Europe and Middle East, and it has sole agent in Malaysia, Singapore, Thailand and Vietnam. All three of the Chen siblings started working in the retail industry as teenagers and endured difficulties. Because they started from the bottom, they understand the difficulties and always will want to help sales people on the ground to do well. The brothers both own about 28% of M&G, now China’s largest stationary maker with a market cap of US$2.72 billion, generating $550m in sales and $64m in operating profits and 19.6% ROE.
The Chen siblings emphasized the need to focus on quality in order to win respect. Like Benaiah who had been preparing himself since young, Chen started running around as a 17 year-old salesman and encountered the stationery industry. Chen chose to focus his time and entrepreneurial energy in the stationery industry as they believe it relates to the child’s growth, learning, and thinking.
They also noticed the opportunity that comes from common misunderstanding that the business of pen has a very low threshold. Because people’s traditional impression stationery industry threshold is low, the industry manufacturing equipment and technology lags behind. Interestingly, China’s Premier Li Keqiang complained at a seminar with a question “Why can’t China make a good ballpoint pen?”, commenting that Chinese pens felt “rough” compared to pens made in Japan, Germany, and Switzerland. Li said China’s manufacturers at the lowest levels should focus on innovating their technology.
The business of pen is an advanced production industry requiring know-how in precision equipment that include precision lathes, the manufacturing equipment of the same level to manufacture luxury watches, with some requiring even higher precision than watch-making. Thus, the core technology of each pen — the stainless steel ball and its casing — is imported as China does not have a machine with the precision required to make the best ballpoint pens. Because the tip is hollow, the intrinsic quality of tolerance cannot be measured with a measuring tool, as compared to watch parts that are solid. A sophisticated infrared microscope is needed to monitor the quality. As Chen explains, “You are now writing with the nib, ball diameter 0.5 mm. If the writing length reaches 1,000 meters, the ball must withstand more than 200,000 times the rotational friction. Keeping the written precision has extremely high requirements as the ball must achieve micron-level precision. The key is the quality of the pen is demanding, but the unit price is very low, which means large-scale production is required to maintain product quality and stability.”
Better quality goods and services ultimately rely on quality and process management in both production and distribution- marketing. While M&G product quality standard is world-class reaching only 15 defects per million, Chen emphasized that this meant that their one-day output yield would mean 1,500 complaints from the customers and from the propagation angle, one negative defect would spread to 7 people and this meant that the problem might spread to 10,000 unhappy customers in one day. Thus, Chen emphasized that “Mass production while controlling a certain quality at the same time is very difficult. A lot of factories are cottage-style with no brand, no quality, and we are up against counterfeit and copycats. The pursuit of excellence, the pursuit of 100% quality, is always our goal, not just that simple goal of achieving few defects per millionth.” Chen added that their company name M&G “adds a layer of deeper meaning: exceed customer expectations to provide products and services to win customer respect and trust – a pursuit of excellence for quality”.
M&G has established a network of provincial distribution centers, with more than 3,000 channel partners, 100,000 retail outlets, and 100% coverage key account stores that include Carrefour , Wal-Mart , Tesco, Rosen, and all other major supermarkets, convenience stores. M&G’s deep and strong marketing network ensures its stationery products can arrive in 3 days in every city in China. M&G also built an informational analytics network to carry out product real-time monitoring to have an accurate understanding of market needs.
Its unique decentralized marketing system resembles Berkshire Hathaway, with the M&G’s HQ having only 50 people who focus on cultivating primary market dealers cultivate into single-brand dealers with dealer training guidance, planning and team building. The primary market dealers foster the secondary market dealers, who in turn build the rural market towns.
The goal of life is not the elimination of fear and risk; the goal is to muster the moral courage to chase lions, the opportunities which often look like insurmountable obstacles. The lion-chaser Benaiah devoted himself to being watchful and thankful. The word watchful is a throwback to the Old Testament watchmen whose job was to sit on the city wall, scan the horizon, and keep watch. They were the first ones to see an attacking army or traveling traders. They see further than others see. They see things before others see them. And they see things that people don’t see.
Chen is watchful of M&G’s progress: “Every year I took our team to study abroad from excellent high-level dealers to help them improve their respective areas and to explore new ideas. In Japan we learned a lot; they are meticulous in their management and in the manufacturing, which should be worth learning. Their cost control, quality assurance, and their pursuit of excellence is worthy of study.” Above all, Chen commented that “An enterprise should always maintain a sense of crisis, to be able to progress; an entrepreneur must maintain a sense of balance and not overestimate oneself and lose control. All the world’s successful brands are not accidental. They have decades, centuries of history. There is no shortcut.”
With the story of Benaiah and M&G, we like to wish our readers a Merry Christmas and a Blessed New Year 2016. Thank you for your support all this while.
The Moat Report Asia
PS1: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:
PS2: We will be back in the week of 4th January in the New Year 2016.
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. 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.
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.