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Bending Adversity with Low-Volatility Wide-Moat Innovators – 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 | Jaunary 11, 2016
Bamboo Innovator Insight (Issue 115)

  • The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
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Dear Friends,

Bending Adversity with Low-Volatility Wide-Moat Innovators

With markets ravaged by fears over the adverse impact on continued Chinese yuan devaluation (possibly even by another 10-20%), the accelerating capital outflows and depletion of the forex reserves in China, and fears over the hard landing risk of the Chinese economy, it is worthwhile to keep in mind the Japanese proverb: Wazawai wo tenjite fuku to nasu (災いを転じて福となす). This wise ancient proverb literally translates to bending adversity and transforming it into happiness and fortune.

The low volatility anomaly, or the tendency for low-volatility or low-beta portfolios to outperform market averages, has been the subject of intense academic and practitioners’ research and lead to rapid growth in low-risk equity investing in recent years. Finance researchers Baker, Bradley and Wurgler (2011) argued that “the outperformance of low-volatility portfolios is perhaps the greatest anomaly in finance.”

Limit to arbitrage has discouraged “smart money” in low-volatility stocks, some of which tend to be relatively less liquid in daily trades. Empirical research by Jason Karceski has shown that institutional investors whose mandate is to beat a fixed benchmark tend to chase returns over time, making fund managers care more about outperforming during bull markets than underperforming during bear markets, increasing their demand for high-beta stocks which creates over-valuation and underperformance when they sell the high-beta stocks.

The results for the low-vol phenomenon also hold for international and Asian stocks. Some notable recent examples include Chinese rice cracker giant Want Want China (151 HK) and instant noodle giant Tingyi (322 HK) which corrected over 40-50% in the past one to two years.

Want Want China (151 HK) – Stock Price Performance, 2008-2016

Want Want China

TIngyi (322 HK) – Stock Price Performance, 2006-2016

Tingyi

In a study published in 2014 in the International Review of Finance by finance researchers Seiichiro Iwasawa and Tomonori Uchiyama, the low-vol phenomenon in outperformance is found to hold true in the Japanese stock market and that it is attributable to foreign institutional investors who over-weight high-beta stocks, as captured in the two charts that were extracted from the article below. In the first chart, the stock portfolio with the lowest-decile low-volatility outperforms the most, while the stock portfolio with the highest volatility underperforms the most.

Japan1

In the second chart, the black line captures the difference in cumulative excess returns between the highest volatility portfolio and the lowest volatility portfolio; the difference is negative and while it is donward trending, when foreign investors’ net purchases of Japanese stocks are strongly positive, the trend either weakens or even reverses.

Japan2

A notable recent example of a high-beta or high-volatility stock is Fast Retailing (9983 JP), the owner and operator of apparel brand Uniqlo. A low-volatility stock is Ryohin Keikaku (7453 JP), the owner and operator of Muji.

Fast Retailing (9983 HK) – Stock Price Performance, 2013-2016

Uniqlo

Ryohin Keikaku (7453 HK) – Stock Price Performance, 2013-2016

Muji

We believe that serious value investors can bend adversity with a distinctive class of low-volatility wide-moat innovators, which we like to call them “Hidden Champions”, a term coined by German business leader Hermann Simon, chairman of Simon-Kucher & Partners, Strategy & Marketing Consultant. We adapted the philosophy of the “Hidden Champions” to apply in value investing and these low-volatility wide-moat innovators have the following characteristics to avoid overcrowded trades:

  1. Leading domestic market share in its area of core competencies, preferably a lead of more than 3X over its next rival, with the ability to widen the cash conversion cycle advantage on an absolute and relative basis to its rivals, and with the potential to globalize its business and to expand into new markets and customers, such as through the pursuit of a premium strategy to extend its pricing power leadership. Value investors can monitor the percentage contribution to sales of new products/services or markets to evaluate the tipping point potential of the further scaling of its business model to enjoy an upward re-rating in its valuations.
  2. Resilient fundamental performance in difficult business environment, with growth in 3-year and trailing 12 months EBIT or core operating profit.
  1. Relatively low share float, combined with the founding family or/and management having a substantial equity stake in the company to provide long-term shareholding stability. Over time, as the company delivers in fundamentals, there will be more long-term buyers than short-term sellers with the low float, and each share owned by the patient value investor will become increasingly valuable.
  1. Potential de-correlated returns to the market and lower exposure to the market risk factor due to firm-specific corporate developments or/and actions not linked to economic conditions, including having a good track record of executing and integrating M&As into the business model to compete more effectively or spinoffs of a division; and prudent capital allocation to prevent mal-investments due to governance risks (self-dealings and tunneling, egoistic empire-building), such as capital reduction program or demonstrating discipline and mastery in executing each dollar of capex investments to generate consistently higher EBIT over time.
  1. Reasonable valuations backed by strong ROE to prevent overcrowded trades in low-volatility stocks by other funds employing seemingly similar broad-based quant strategy without going the extra mile in assessing the scalability of the business model and the quality of the management. For instance, a low EV/EBIT of 5x does not appear cheap when the valuation metric is overlaid with a ROE of 2%. An EV/EBIT of 15x does not appear exorbitant if the business generates consistent and growing ROE of 30%. We construct our own corporate lifecycle valuation ratio to factor in valuation and quality: EV/EBIT divide ROE. This ratio is akin to a “fundamental-based” PEG ratio as growth higher than the ROE requires external financing needs which may over-leveraged the balance sheet. We prefer this ratio to be under 1x.

Some of these overlooked and undervalued Hidden Champions in Asia with market leadership and unique business model include:

Data1Data2Natural1Natural2Tourism1Tourism2 Consumer Healthcare1

Consumer Healthcare2

We will reveal the names of some of these Hidden Champions in the 5th Annual Value Investing Summit (VIS) on 23-24 January 2016 in Singapore. Do stay tune as we bend adversity together!

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:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will issue an additional Monthly Moat Report Asia in 1Q16.

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/

Our latest monthly Moat Report Asia for January 2016 investigates an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly.

This deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in pneumatic tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%. The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.

Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.

The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.

Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers 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. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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