“Honor the Past, have Discipline and Hard Work for the Present, have Vision with Passion for the Future” – MoatReport.com Monthly Riddle

Dear Friends,

Can You Guess This Asian Wide-Moat Company?

“Honor the Past, have Discipline and Hard Work for the Present, have Vision with Passion for the Future”

“I believe in three things: Past, present and future. Honor the past, which means honor your parents, for the values they give to you, the experiences they pass down. For the present, you have discipline, hard work, using the talent you have been given. Last, the future, which is vision with passion.”

– Madam Y

Which Asian superbrand is so strong that Italian chocolate and confectionary giant Ferrero SpA and Unilever are compelled to bundle their products to better reach out to win the hearts and wallets of the local consumers? And these giants bear the cost of the superbrand’s product in the co-marketing campaign.

This month in December/January 2017, we investigate the owner behind this Asian superbrand who commands a dominant 90% of the domestic mass market share with its brand. Yet, there is a still a visible long runway to compound growth as the company operates in the segment which contributes to 20% market share of the overall highly fragmented industry with room for growth to consolidate the home/small producers making up 68% of the overall market and boutique producers accounting for 12% of the market. [Company’s name] operates 10 factories that is supported by a vast and efficient distribution network of 61,000 point of sales via modern trade channels and traditional trade channels. Established in 1996 by Madam Y and her father, together with two Japanese giants who later became strategic shareholders and technological and trade partners, [Company’s name] has become one of the country’s most recognizable household brands. [Company’s name] is also far-sighted in cultivating children as long-term consumers as they grow up, just like McDonald’s, by conducting factory visits for school children and opening their brand house at Kidzania, the edutainment centers allowing children to work in adult jobs and earn currency and receiving more than 31 million visitors since its opening, making it one of the fastest growing global edutainment brands in the world.

Due to its strong brand equity and efficient supply chain management, [Company’s name] generates a growing ROE of 34.3% and enjoys low to negative cash conversion cycle, a rare quality for manufacturers. This allows the company to repay its bank loans quickly using idle cash as it expands to grow. This efficiency is enabled by its adoption of the ERP system to integrate all systems and procedures starting from raw material purchase to product distribution. The program can also integrate the real-time conditions of the factories, which is a useful feature considering the different locations of the factories. In addition, [Company’s name] laid foundations for advanced distribution network and market penetration in 2012 with its own program which uses state of the art technology to monitor selling patterns, manage product and drop mix; remapping distribution areas built over the last 20 years and expanding its network of agents and distributors. The development of state-of-the-art tracking systems enabled the company to have a growing distribution network and deeper and wider market coverage. This technology allows the company to not only go to areas with potential demand but it enables them to support their distribution agents to increase sales of its branded products.

There are several listed iconic fast-moving consumer food brands in Asia and we think one of the closest comparables is Thailand’s Taokaenoi. Taokaenoi is Thailand’s market leader in processed seaweed snack products with dominant market share of around 62%. Noteworthy is that while [Company’s name] and Taokaenoi both enjoyed market dominance in their respective categories with comparable EBIT margin at 19-20%, [Company’s name] absolute level of sales and operating profit is around 40% higher than Taokaenoi’s US$127m and US$25.3m respectively and [Company’s name] enjoys a superior cash conversion cycle advantage of only 2 days as compared to Taokaenoi’s 30 days, yet [Company’s name] has a market value that is 44% smaller than Taokaenoi’s US$1bn market cap due to the huge disparity in valuations. [Company’s name] trades at EV/EBIT 17.6x and EV/EBITDA 14.1x, a 56-62% discount to Taokaenoi. We think the valuation gap between [Company’s name] and its comparables should closed over time as it continues to execute with performance. Since FY2012, [Company’s name] sales have grown 105% while operating profit grew faster at 133% and we believe the company can build on the momentum to generate over 50% growth in operating profits in the next 3-5 years, and spur an upward valuation re-rating towards a potential doubling in market cap.

We are impressed by [Company’s name] co-founder & CEO Madam Y for her tenacity in transforming the company to become Asia-ex-Japan’s manufacturer in its product category through making far-sighted and consistent continuous investments in production know-how, brand building, distribution network and IT system to scale up. We like the company’s strong management team and corporate culture to foster the win-together mindset and we think [Company’s name] deserves a valuation premium as it continues to consolidate the fragmented industry and expands its presence in a new market in which operations will commence in 3Q2017.

Below are excerpts of her unique insights on succession to the family business which reflected her strong desire and values to scale the business to greater heights by being grounded in discipline, hard work and a vision with passion:

Q: “You were designated at an early age as the successor to take over and lead the family business. What are your plans for your children in the family business?”

Madam Y: “Looking back, I would not do that to my children [Madam Y has three]. I don’t think bloodline qualifies—it’s got to be based on other things as well. To separate ownership and management is not easy for a parent, especially family companies, coming from the Asian families, because they always want it to be whole, it has to be “my son” or “my daughter” who continues the business. But it’s not necessarily good. My father always said, as an insider, you will guard your family assets, you will run the company very well. To me, both insiders and outsiders can ruin the company. As long as my children carry the vision and have the passion for what I do with the family business, they qualify to start the race, but I will not put them as a leader in that position. I will use professionals. I believe in three things: Past, present and future. Honor the past, which means honor your parents, for the values they give to you, the experiences they pass down. For the present, you have discipline, hard work, using the talent you have been given. Last, the future, which is vision with passion.”

Who is Madam Y and this Asian wide-moat innovator?

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/

“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 | Dec 19, 2016
Bamboo Innovator Insight (Issue 131)

  • 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.

The Five Principles of Success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’ – MoatReport.com Monthly Riddle

Dear Friends,

Can You Guess This Asian Wide-Moat Company?

The Five Principles of Success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’

MUNGER: I think Warren and I can match anybody’s failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed… 

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That’s true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail…a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done. 

What is the investment Achilles heel of Warren Buffett and Charlie Munger?

It appears to be in the “tough, tough” retail industry, from the above CNBC interview in 2014, given that it is “hard to establish a permanent moat that your competitors can’t cross”. Also, their biggest error of omission, as Buffett admitted during Berkshire Hathaway 2004 AGM, had been his “thumb-sucking” reluctance in investing more in Wal-Mart in the 1990s because of one-eighth of a point uptick in the stock price. One of the best investment deals that Warren Buffett considered he has made was ironically in a retailer, a furniture store called Nebraska Furniture Mart (NFM). NFM was founded in 1937 by the late Rose Blumkin, fondly known as “Mrs. B”, a Russian immigrant to America, with $500 she had saved for 16 years selling used clothes. NFM was set up in Omaha with no locational or product advantage and goes up against rich, long-entrenched competition – and grew to become one of the top furniture retailers in the country. Buffett had also tried to assemble a furniture empire since with the purchase of Utah-based RC Wiley in May 1995, Star Furniture in Jun 1997, Jordan’s Furniture in Oct 1999, and rental furniture provider CORT Business Services Corporation in Jan 2000. But none came close to matching NFM’s success. In Jun 2004, Berkshire also invested 9% In home furnishing retailer Pier 1 Imports (NYSE: PIR), an investment that did not work out. In Aug 2007, according to Bloomberg news, Buffett even mentioned about the Swedish-controlled flat-packed furniture retail innovator IKEA as a possible investment target, though the trust foundation setup at IKEA made the acquisition impossible.

Make no mistake: NFM and IKEA are the rare exceptions. Furniture retailers face critical economic hurdles and problems in building a wide moat and scaling up the business. Furniture is a category of product that is difficult for a retailer to handle, because (1) inventory turnover rates are low for durable goods, thus few furniture retailers manufacture their own products because of low purchase frequency and distribution efficiency, (2) unlike consumer electronics, it is rare for a furniture manufacturer to have a well-known brand, and it is hard to alter product features notably over a short period, making it difficult to promote replacement demand, (3) furniture sales usually require direct customer contact and explanations in-store, as well as delivery, which adds to the SG&A cost burden. Those rare few innovators who can overcome these formidable business dynamics like IKEA will enjoy increasing returns to scale and the business gets easier as it gets bigger.

In this month of September/October, we investigate another IKEA-like innovator who is the undisputed dominant specialty chain in furniture and home furnishing in its domestic market with rarity value as the only listed Asian company with a unique integrated manufacturing-logistics-retail business model in the industry with an 90% self-developed private label product ratio to sell low- to mid-priced high-quality functional merchandise to the masses. Whereas most furniture retailers simply sell furniture, [Company’s name] has put effort into offering a complete lineup of “home fashion” products which contribute to 60% of its sales. “Home fashion” products are purchased frequently, and by devoting effort to the development of such products, [Company’s name] has achieved the kind of customer-drawing power that other specialty furniture retailers lack. [Company’s name] develops these products itself for over 80% of its offerings.

[Company’s name] has achieved an astounding 29 consecutive years of growth in sales and profit, converting macroeconomic adversities ranging from consumption tax hike to currency volatility into opportunities to grow further. Despite [Company’s name] market leadership, it is still operating in a fragmented domestic market with around 10% market share in the home and garden market and has a long runway ahead to extend its market leadership, particularly in the urban areas. [Company’s name] has expanded its market share in the low-end category, but it has also been releasing mid-priced products that offer additional value in terms of quality and function since 2012, and this has led to the expansion of its customer base. [Company’s name] currently has a network of domestic stores and 37 overseas stores and targets 1,000 stores by 2022, 3,000 stores by 2032. [Company’s name] was established in in 1967 by founder Mr N.

Furniture and home furnishing business has low inventory turnover and loading efficiency is poor. As a result, controlling procurement and distribution costs is critical to achieving low-cost operations and to coordinate store openings and expansion. [Company’s name] manages the whole process of product planning, materials procurement, production, distribution and sales in order to reduce its intermediary costs, which enables it to offer highly functional quality products at low prices. This source of [Company’s name] wide-moat competitive strength is very much under-appreciated until the value investor understands the business economics of the furniture and home furnishing business. [Company’s name] “returns” benefits gained from lower COGS (on raw material changes, design revisions, and improved production yields at overseas plants) to customers through lower pricing. This policy has generated a virtuous circle of sales expansion from increasing economies of scale, and high customer loyalty is captured.

Powered by its unique integrated manufacturing-logistics-retail business model that is perhaps rivalled by only the unlisted giant IKEA, [Company’s name] is able to enjoy a lasting wide-moat competitive advantage that grows stronger with time with the virtuous cycle of customer returns that generate one of the highest ROE at 23.3% and profit margin relative to all its industry peers. Notably, [Company’s name] present operating profit margin at 16.3% is the highest in the industry, which is a steady structural progress over the years from 6% in 2001 to 13% to 2009, and looks set to improve further with a higher sales mix of higher-margin mid-priced quality functional products that expand its customer base. [Company’s name] has a healthy balance sheet with a 13.3% net cash-to-equity ratio to generate an impressive ROE of 23.3% and it currently trades at EV/EBIT 16.3x. [Company’s name] suffered a short-term 23% correction in share price from its recent high in July due to overall market uncertainty and without any major negative firm-specific news. We believe that once its upcoming earnings are announced on Sep 27, 2016 delivering another record-high results, the share price will rebound strongly.

From Wal-Mart to IKEA, companies with a greater sense of Purpose and insurgency in making available to the masses once expensive products and services that used to be affordable by only the rich, the “10X price disruptors”, are powerful super-compounders delivering superior shareholders’ returns for a long period of time. Motivated by this grand purpose to bring true life affluence to customers following his learning trip to US in 1972, Mr. N resolved to cut the middlemen and dedicated his life mission to building a unique integrated manufacturing-logistics-retail business model to offer quality merchandise at low affordable prices. [Company’s name] grew from 2 stores into a nationwide chain with dominant market leadership. We are highly impressed by the unique business model that gets stronger and easier over time and [Company’s name] still has a long runway to grow its store network in the fragmented furniture and home furnishing market in both domestic and overseas markets. [Company’s name] has also developed a powerful human capital strategy which has been a powerful enabler in supporting store expansion to achieve growth in sales and profit for 30 consecutive years. We think this is very rare for an Asian company and [Company’s name] deserves a valuation premium for its staying power and genuine potential to be one of the rare Asian company to reach the $100bn market cap milestone.

Below are some excerpts with the CEO Mr. N on his entrepreneurial journey to scale up his business into a formidable world-class innovator:

Q: “Chairman, [Company’s name] has achieved phenomenal success since it was established in 1967 to command domestic market share leadership in furniture and home fashion & furnishings. Can you share with us how the wonderful story of [Company’s name] started, including your own journey, especially the tipping point and challenges along the way? What is your personal driving force?”

Mr N: “It all began 49 years ago. The year was 1967 when I opened a small furniture store. My tiny 1,000 square foot store served the local community. Then I married and opened another store of about maybe three times that size. We finally managed to earn a decent living with the stores’ sales. However, a year later, another company opened a store of five times that size which made us go almost bankrupt. These were busy days and uncertain times but I continued to look forward and search for ways to grow my new venture.

In 1972, I was then 27, one study tour organized by an industry association to the United States was all it took to change the course of my struggling furniture store. During a week in California, I witnessed how differently Americans shopped and lived. Obviously, that I was deeply shocked. I was truly astonished, moved and struck. In the US there was no stand-alone furniture. Everything was built on the building, like walk-in closets. Compared to our country’s crowded living spaces, California homes were spacious with separate areas for entertaining and dining where guests would be welcomed, and the further back there would be a family-room. American consumers went to convenient retail stores to buy color-coordinated furniture and accessories to enhance their beautiful homes. In contrast, we had only mismatched offerings to choose from. They even had one bathroom on each floor! Most shocking to me was how inexpensive the high-quality merchandise in the US was compared to similar products back home. American furniture was designed to make life easier for consumers, not simply to pad manufacturers’ bottom lines. I recalled that I was so astonished by the difference in furniture and interior decor products in terms of price, selection, and quality.

It was like a dream world, I was so excited I could barely get any sleep. I wanted to bring the affluence of the US to my country. It was at this moment that I decided to bring back to my country what I had learned in the US. At first, I was pursuing my own sales and profit. Then I realized I was wrong. Ever since I visited the US, I changed my life philosophy, setting up an aim to enrich everyday life of people. I made my mind to develop and provide affordable and full-featured products for people. Furniture had occupied an important position in the lifestyle of the people. I would use my company to help people live as prosperously and comfortably as Americans. That wish and determination have never switched since [Company’s name] was founded, and remains there during every moment of its development. Setting and realizing this goal is our greatest pleasure.

Tracing back to the time when we advanced nationwide, we heard customers that they were surprised to see the numerous choices and the low prices in [Company’s name]. We can’t help but imagine the house we like and the room we desire, after what we saw in [Company’s name]. Not to mention it is the first time that we realize our imagination may come true. Every time we hear this, we are reminded once again, that our unremitting efforts have come to a result. We promise to keep an ear out for our customers as always, to step onto the arena of the whole world, to realize our dream deep inside, and to achieve so, we will do our utmost. We continue to chant the strong and simple words ‘to enrich the people’s life’ and to spread a dream to the customers, build a fire of motivation in the employees, stakeholders and business partners.

My personal driving force has been this ‘romance’ and purpose to help people around the world achieve the richness of living in the true sense by providing products with the appropriate quality and functionality for the customers at affordable price. Pursuing higher goals over a long period of time is critical because otherwise improvement will be superficial.

Looking back and our scale of our company is like a dream. [Company’s name] has been able to create value and grow successfully with tenacity and staying power because there was ‘romance’ and a long-term vision. That’s right, I have repeatedly told employees that to work at [Company’s name], it is important to have this five principles of success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’. ‘Romance’ is a feeling in one to contribute for the people and for the sake of the world over one’s life. Without such a Purpose, life is nothing. Humans were originally born for the people, for the sake of the world. Life is aspiring to become a person useful to the world. This is an ideal to get right from young, and even when one is 50 years old, 60 years old.”

Who is Mr. N and this Asian wide-moat innovator?

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/

“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 | Sep 26, 2016
Bamboo Innovator Insight (Issue 128)

  • 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.

Tooling Up the World With Mastery – 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 | Jaunary 5, 2016
Bamboo Innovator Insight (Issue 114)

  • 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?

Tooling Up the World With Mastery

Do you have the right tools to succeed in your work?

The Scottish historian Thomas Carlyle, who coined the term “the dismal science” for economics, once said famously that “Man is a tool-using animal. Without tools he is nothing, with tools he is all.”

In this month of January 2016, we investigate 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. Yet this world-class innovator trades at PE 7.5x and EV/EBIT 10.8x.

Its 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. Technology ownership of key components raised quality and lower cost at a structural level, with production yield raised to 95% and costs reduced by 15%. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in 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.

This is possible because of the leadership by Mr. L and his brother who have demonstrated grit and foresight in a series of critical business decisions, ranging from (1) building  a vertically integrated ODM business model to invest in developing innovative new products, (2) insisting on 100% ownership of the ODM design and manufacturing know-how by continuously building up its capabilities in tool technology from die-casting, coasting, painting, firing pin heat treatment, mold production, and plastics injection; the know-how accumulated over the years is not easily replicated, thus giving rise to our long-term profitability and a win-win partnership with our customers who stayed loyal; (3) resisting the institutional imperative to focus on designing and producing higher-end products while its peers rushed into China, (4) expanding during the 2007-08 Global Financial Crisis to (5) grooming its own group of talents in design and operations who are able to point out from a systems perspective the detailed continuous improvements needed in each production process.

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.

We like how the L brothers have cultivated a decentralized culture of mastery, empowerment and growth at the company to keep winning loyal customers and innovating new products. On its culture, below are some excerpts of the conversation shared by Mr. L:

Q: “What is the culture like at [Company’s name] and what is your management philosophy and style to guide your leadership?”

Mr. L: “Although [Company’s name] is globally number one in its field, I am the company’s driver. Whenever there are clients coming by to visit us, either my brother or myself will drive the company car to receive them. Our culture is such that everyone at [Company’s name] are familiar with my slogan of exceeding targets, challenge the limits, and stay grounded and pragmatic in executing. Our culture is that we treat our products as important as our lives. 

If the real estate industry has its maxim in ‘it’s all about the location, location, location’, our golden maxim to guide us is ‘it’s all about the product quality, product quality, product quality.’ This is why in our 32 years of establishment, we have not been afraid of losing customers and we have quality customers continuously coming in.

Our culture is aligned to our blue ocean strategy which is simple: to focus on innovation and quality in product and R&D. This strategy has been my unshakeable belief all these years. In order to pursue excellence in quality, as long as it can be changed and improved, I will constantly remind and demand my staff to seek breakthroughs and mastery. Do you know why the word ‘quality’ in the written Chinese is formed by three ‘kous’ ? The reason is because with two kous as the foundation, there is always a higher kou on top or mastery waiting to be reached.

Our management philosophy is ‘Integrity, responsibility, and steadiness in innovating. Constantly demand improvement in product quality, stay focused and loyal to the core business, and never stray and mal-invest.’

As shared, I was in the legal arena for 25 years. When I retired, I was the Chief Judge of…. I have gone past the age of striving for fame and fortune. The most important thing in the jump from the legal scene into entrepreneurship is to recognize oneself, to be self-aware of my role and responsibilities. To operate and manage a business is really tough work. Most of us who pressed on are using our hearts, our entire lives to operate.

Although I am [Company’s name]’s Chairman, I believe very much in empowerment and authorized decision rights to my team, in accordance to the Taoist philosophy of ‘managing with wuwei’ 无为而治 or governing by doing nothing that goes against nature.”

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

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/

In a Pit with a Lion on a Snowy Day: Lessons for Value Investors – 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 | December 21, 2015
Bamboo Innovator Insight (Issue 113)

  • 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,

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

MG

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.

MG2

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.

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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.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

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/20151201/pdf/433hdp24p2twyj.pdf

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:

http://www.moatreport.com/members/

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.

The Swordless Samurai: Lessons for Value Investors from Japan’s Wide-Moat Innovator Cookpad – 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 | December 14, 2015
Bamboo Innovator Insight (Issue 112)

  • 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,

The Swordless Samurai: Lessons for Value Investors from Japan’s Wide-Moat Innovator Cookpad

“Gratitude sparked in me a burning desire to better myself and help others. Contrary to what many think, the essence of leadership lies in serving, not in being served. Those who aspire to motivate followers need to learn the Secret of Gratitude: Leaders must be grateful.”

– From the book “The Swordless Samurai: Leadership Wisdom of Japan’s Sixteenth Century Legend Toyotomi Hideyoshi” by Kitami Masao

“Because I want a happy society. Happiness starts at the family table.”

– Cookpad’s founder Akimitsu Sano

How did a seemingly unknown company surpass illustrious giants such as Yahoo, Ajinomoto, Rakuten, Kikkoman to command an unheard of 90% domestic market share in a lucrative and growing service craved by over 56 million monthly users to generate over $30m in operating profit that is growing with new innovative services?

The rise of Cookpad (Tokyo: 2193), which has compounded 800% since 2009 to a market value of $2.26bn, and its newly-minted low-profile 42-year-old billionaire founder Akimitsu Sano who owns 44% in the company reminded me of the leadership story of Hideyoshi Toyotom (1536-1598), one of the most remarkable – and the most unlikely – leaders in Japan’s history.

Cookpad (Tokyo: 7956) – Stock Price Performance, 2009-2015

Cookpad

Despite his lack of strength and size, clumsiness at martial arts, and unglamorous peasant lineage, the “swordless samurai” Hideyohsi learned to outthink and outmanuever every pedigreed foe to become one of the greatest military and civc leaders Japan has every known, unifying a nation torn apart by more than a hundred years of civil strife, earning his position through hard work and innovation rather than birthright, becoming the ultimate underdog hero.

One of the most interesting and important leadership lessons Hideyoshi teaches us is that the essence of leadership lies in serving others, not in being served, an ethic that seemed increasingly rare these days. Hideyoshi goes on to explain that gratitude is the key esntiment that inspires true leaders to devote themselves to serving others.

Serving others to bring joy to the dinner table has been the philosophical foundation underlying Cookpad’s success. Cookpad was founded in the midst of the Asian Financial Crisis in Oct 1997 by Sano-san immediately after he graduated from Keio University. While at university, Sano worked as a produce retailer together with local farmers. Sano continued pursuing socially-involved entrepreneurship and joined an NGO. Participation in a UN meeting proved fateful. Touched by the smiles of delegates from some of the poorer Caribbean nations, Sano realized that economic prosperity was not necessarily a driver of genuine happiness. That nascent desire to pursue projects which might touch the hearts of those around him brought him to the idea of cooking for pleasure, a concept underpinned by his experience as a reseller of high-quality, appetizing fresh produce from the farm and the desire to bring joy to the dinner table.

It has not been an easy journey for Sano: “I tried to monetize Cookpad from day 1, but it took me 6 years. What did my wife and I eat during those 6 years? My wife’s family are farmers, so they gave us food and our living cost was so damn low.” Kitchen@coin, the predecessor of Cookpad, was launched in 1998 as a recipe site that allowed users to search and comment on recipe submissions. The name Cookpad was adopted in 1999, with the site allowing users to revel in pictures of their culinary creations and helpful feedback from other users about their experience with the recipe. Cookpad began accepting advertising in 2002, including accepting recipes specifically utilizing advertisers’ products as well as holding tie-up promotions like contests designed to feature a specific advertiser’s products. The success of these ads brought substantial benefits for advertisers with increased demand, re-evaluation of existing products, increased recognition of new products, which in turn supported the successful maturation of Cookpad’s business model.

Cookpad2

Every day at around 4 p.m., as schoolchildren make their way home, hordes of people across Japan — predominantly female, predominantly in their 30s — start furiously typing on their PCs and smartphones. They all have one burning question on their minds: “What should I cook for dinner?” Cookpad has penetrated into the daily lifestyle of Japanese housewives and other shoppers purchasing food and dinner ingredients who can often be found clutching smartphones accessing Cookpad as they peruse supermarket aisles. Today, more than 56 million users use Cookpad to share and find 2.1 million recipes to prepare at home. Cookpad has expanded its user base twelve fold in the past seven years, making it the 55th-most-viewed website in Japan; more than half of all Japanese women in their 20s and 30s visit it. Cookpad earns half of its revenue from premium services (1.6m subscription users in Japan), 34% from advertising, and 16% from ecommerce.

The “Tsukurepo” platform is perhaps the most underappreciated wide-moat competitive advantage and intangible asset of Cookpad, as this platform…

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Read more about the business model of Cookpad at the Moat Report Asia: http://www.moatreport.com/updates/

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Like Hideyoshi who has attracted talented leaders and created a brain trust dedicated to the mission such as warfare strategist Hanbei, former monk and organizational leader Mitsunari, etc, Sano has Yoshiteru Akita, the current CEO since May 2012. Akita was the former CEO of Kakaku.com from 2003-2010 during which share price jumped from ¥187 to ¥486 during his tenure. Akita owns 14.76% of Cookpad and is regarded as an internet management pioneer. Like Hideyoshi who looks for passionate and dedicated talents, Sano commented that “We look to see if the candidate codes at home or outside the work place. We look for someone who looks like they cannot help but code at any occasion.”

Above all, Hideyoshi’s clarity and power of the vision in reuniting Japan and ending the Age of Wars connected followers, allies and partners, inspiring them with the force of his vision to fight alongside the cause, empowering them to overcome seemingly impossible odds, sustaining his rise to ultimate leadership.

Sano has ambition to make Cookpad a household name around the world with various overseas acquisitions that include Cucumbertown, a U.S. food-blogging platform. Sano believes the way to increase visitor traffic is to offer more high-quality recipes that can make people happy and for the site to offer such attractive, useful services that all users are willing to pay for them. Sano’s clarity and power of vision that connects follower and allies is that he believes cooking helps keep families united and that happiness starts at the family table:

“Probably, the most important thing for an entrepreneur is to find a problem you’re passionate about. It’s not the size of capital that matter, but whether you’re really solving real customer problem or not. Create something! Create your own category! We wanted to offer free recipes as a contribution to the society. It’s essential to know what you are doing because the market is full of competitors. Do you think my vision is to create recipe site only? No, my vision is diversity in your food! Harmony in Japanese families begins in their table at home; by having diversity in your food, you’re not controlled by only one food resource, which means stability of price. Because I want a happy society. Happiness starts at the family table.”

The word “samurai” originally meant “one who serves”. Hideyoshi would have called Cookpad’s Sano-san the “Cooking Samurai”. Hideyoshi sums up the leadership precepts underlying his success:

“You may be surprised to learn that my successful quest to achieve the epitome of leadership was built on the commonplace notions of devotion, gratitude, hard work, and bold action. These principles appear so simple that you might not consider them “secrets”. But few people comprehend their true power, and still fewer understand that they form the cornerstone of the samurai code, an honoured protocol of conduct handed down for hundreds of years. The samurai code covers far more than the mere use of weapons, which is fortunate for me, since I have a reputation as the worst fighter in Japan’s history! But mu most formidable weapon has always been my mind: You might call me the swordless samurai.”

In essence, value investors could do well when they invest in leaders who focus on the values of devotion, gratitude, hard work, and bold action.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: 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/20151201/pdf/433hdp24p2twyj.pdf

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 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.

The Essence of Pricing Power of Asian Wide-Moat Compounders – 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 | December 7, 2015
Bamboo Innovator Insight (Issue 111)

  • 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,

The Essence of Pricing Power of Asian Wide-Moat Compounders

Having taught cost accounting at the university, I always find that the topic on “pricing” to create, communicate and retain value has been sorely neglected. Management tend to have fear of prices, especially when they need to increase them. The fear has one legitimate source: one can never know with absolute certainty how customers will react to a price change. If we raise prices, will customers remain loyal or will they run in droves to the competition? Will they really buy more, if we cut prices? As a result, managers invariably keep their hands off the pricing lever if they have doubt, turning their attention to something more tangible and more certain: cost management. But what is the underlying business model scalability, wide-moat competitive advantages, cost structure dynamics, and organizational system to support the pricing decision and pricing strategy?

The importance of pricing in investment fundamental analysis cannot be emphasized more. In fact, Warren Buffett once described “pricing power” as the most important factor in evaluating a business: “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business,” he said in 2011. In case of either inflation or deflation, value investors want to own companies that have pricing power — it will protect their earnings. Those companies will be able to pass higher costs to their customers during a time of inflation and maintain their prices during deflation without fear of volume decline or loss of market share.

Charlie Munger, the influential partner to Buffett’s success, also commented on the valuation effect of “untapped pricing power” for wide-moat compounders like Disney and See’s Candy:

“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. You will get a few opportunities to profit from finding underpricing. There are actually people out there who don’t price everything as high as the market will easily stand. And once you figure that out, it’s like finding in the street—if you have the courage of your convictions.”

For instance, Disney’s Magic Kingdom actually saw an increase in attendance in all of the last five years except 2010 despite the fact that the price of admission also went up, even hiking to a 3 figure price tag of $105 for a one-day ticket to Magic Kingdom at Walt Disney World in Orlando. While tourism spending is a consumer discretionary item, consumers are increasingly more interested in spending money on unique and innovative “experiences” rather than on things.

At Costco, one of Munger’s favorite companies, member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. By selling several staples as loss leaders – fresh food and gas -Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon. Becoming “Amazon-proof” is an enviable position for any retailer, as the company’s online dominance has most major retailers such as Target and Walmart playing catchup.

The more conscientious students with intellectual curiosity in my accounting class find the various cases shared to be useful. Some of these cases include how JC Penney, once considered America’s most venerated department store chain, plunged over 80% in market value since Feb 2012 when then-CEO Ron Johnson radically altered its pricing strategy from frequent sales promotions at deep discounts off its higher list prices to an everyday low pricing model that eschewed sales and clearance discounting, dubbed “Fair and Square”. Launched without any consumer testing, the new pricing strategy failed dramatically. Customers voted with their feet, leaving the retailer in droves when they could not get products at the discounted price they had come to expect.

Parker Hannifin, the #1 motion & control company, rose 240% since 2001, outperforming the 55% rise in the S&P 500 index, when Donald Washkewicz introduced “winnovation” in integrating pricing into its innovation process, aiming to pinpoint and develop products that offer the most potential for price premiums. Parker Hannifin build upon basic “cost” information to think deeper about the pricing decision of its over 800,000 seemingly “homogenous” widgets, differentiating them and determining their prices by what its over 470,000 customers are willing to pay rather than what a product costs to make and using the straightforward cost-plus pricing.

Or the case of how Apple changed its pricing structure for songs sold through iTunes from a flat fee of $0.99 to a 3-tier price of $0.69, $0.99 and $1.29. The top 200 songs in any given week which make up more than one-sixth of digital music sales – songs by artists like Adele – are charged at the highest price of $1.29. Six months after Apple implemented the new pricing model, downloads of the top 200 tracks were down by 6%. However, because Apple’s iTunes costs – wholesale song costs, network and transaction fees and other operating costs – do not vary based on the price of each download, the profits from the 30% price increase more than made up for the losses from the 6% decrease in volume. Apple has also applied this new pricing structure to movies available through iTunes, which range from $14.99 for new releases to $9.99 for most other films.

A favorite Asian example is Japan’s Kyocera, the advanced ceramics company, working with the same material used to produce rice bowls.  If a company sells one truckload of rice bowls for ¥1.5m, the profit is about ¥0.1m. However, if that company sells one truckload of IC packs, which are made of the same ceramic material, it can charge ¥50bn, making a profit of ¥15bn. The products are based on the same material, but the difference in profit is obvious. The secret of Kyocera’s success was in its ongoing commitment to resolving any problems of customers while overcoming technical challenges. It also experienced constant price pressure, with customers in effect saying, “If you don’t lower your prices, we won’t place any more orders.” In that situation, the company made all-out efforts to reduce costs, opening up the market for a fierce cost-cutting struggle. The basic requirements for a technology-oriented company to exploit its uniqueness are: (1) Choose a core technology and then improve and then upgrade it; (2) Exchange technical information while positively fostering human relations; and (3) When an obstacle is encountered, start to adopt an attitude of making every attempt cause a positive splash in the market and with customers. The inventions of Kyocera’s founder Dr. Kazuo Inamori, who was the first person in Japan to synthesize Forsterite, a kind of ceramic that played a pivotal role in electronic circuitry for TV sets, helped supported Japan’s global revolution in TV manufacturing in 1950s after WWII. Kyocera’s advanced ceramic materials also fostered the development of the semiconductor industry.

Pigeon Corp (Tokyo: 7956) – Stock Price Performance, 1988-2015

Pigeon

For Japan’s Pigeon Corp

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Read more about the pricing power strategy of Pigeon Corp and 3 other Asian wide-moat companies at the Moat Report Asia: http://www.moatreport.com/updates/

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Pricing also intrigued the late managmenet guru Peter Druckerfrom an economics and also from an ethical perspective. He understood profit to be the “cost of survival” and sufficiently high prices to be a “means for survival”. Above all, he warned against the abuses of market power. He commented on price transparency and advocated fair behavior. The pricing abuse of pharmaceutical drug companies from Michael Person’s Valeant to Martin Shkreli’s Turing Pharmaceuticals has sparked public furore and threathened the going concern of their business. Pricing power to maximize profits become an inflmmatory phrase and lighting rod.

Hedge fund manager Bill Ackman compared “platform stock” Valeant to early-stage Berkshire Hathaway in early 2015; William Thorndike, author of The Outsiders, compared Valeant’s CEO Michael Person to Liberty’s cable billionaire John Malone. When Valeant’s share price collapsed in Oct 2015, many sophisticated institutional investors were hurt. Charlie Munger commented in March 2015 that companies like ITT Corp., made money back in the 1960s in an “evil way” by buying businesses with low-quality earnings then playing accounting games to push valuations higher. “Valeant, the pharmaceutical company, is ITT come back to life,” Munger said. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.” Valeant relied on “gamesmanship” to run up its value and created a “phony growth record.” We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant: Valeant CEO Michael Pearson is known as an aggressive cost cutter. Valeant’s corporate culture is that it does not want to spend money on science and sees no wrong in substantially jacking up prices of drugs after acquiring them, violating the Drucker’s ethical principle on pricing power.

Value investors analysing the pricing power of business need to understand that a sustainable fair game between the seller and consumer in pricing lies in one word: value. Ultimately, the customer is only willing to pay for the value he or she gets. The challenge for any seller is to find out what this perceived value is and then price the product or service accordingly. It leaves the seller or manager/ entrepreneur three tasks which the value investor must know in order to understand the effect of pricing power on value creation: (1) Create value: The quality of materials, performance, and design all drive the perceived value of customers. This is also where innovation comes into play; (2) Communicate value: This is how you influence customers’ perception. It includes how you describe the product, your selling proposition, and the brand. Value communication also covers packaging, product performance, and shelf or online placement; (3) Retain value: What happens post-purchase is decisive in shaping a lasting, positive perception. Expectations about how the value lasts will have a decisive influence on a customers’ willingness to pay. The customer stays loyal only if the exchange with the seller cultivates a lasting sense of fairness. Customer satisfaction and loyalty is the only way to build and deepen wide-moats and compound long-term value.

An ancient Chinese business philosophy sums up best the essence of pricing power and sustainable value creation for value investors:

斯商,不以见利为利,以诚为利;

斯业,不以富贵为贵,以和为贵;

斯买,不以压价为价,以衡为价;

斯卖,不以赚赢为赢,以信为赢;

斯货,不以奇货为货,以需为货;

斯财,不以敛财为财,以均为财;

斯诺,不以应答为答,以真为答;

斯贷,不以牟取为贷,以义为贷;

斯典,不以值念为念,以正为念。

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: 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/20151201/pdf/433hdp24p2twyj.pdf

20151201081907

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 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.

Investor Day Presentation – Our Investment Strategy: 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 | December 1, 2015
Bamboo Innovator Insight (Issue 110)

  • 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,

Investor Day Presentation – Our Investment Strategy: Investing with Conviction to Outperform in Times of Volatility and Uncertainty

This week, 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/20151201/pdf/433hdp24p2twyj.pdf

2015120108522420151201081907

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 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.

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/

What the Best Do Better Than Everyone Else – Asian Wide-Moat Innovators Surpassing Stall Points in Scaling New Heights

“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 19, 2015
Bamboo Innovator Insight (Issue 105)

  • 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,

What the Best Do Better Than Everyone Else – Asian Wide-Moat Innovators Surpassing Stall Points in Scaling New Heights

Training CampCan a small guy with a big heart succeed against all odds?

In the masterful book “Training Camp: What the Best Do Better Than Everyone Else” that was based on interviews with top professionals from a wide variety of fields, author Jon Gordon tells about the tale of Martin Jones, an undrafted rookie trying to make it in the NFL. After spraining his ankle in the preseason, Martin thinks his dream is lost, until he meets a very special coach who shares life-changing lessons that keep his dream alive as he strives for excellence and brings out the best in others every day.

The story of Martin bears some resemblance to the hidden fear and doubt that blighted many SME business owners whom we have interacted over the years. Despite attaining a certain level of success and personal wealth, their hearts are ever more unsettled as time passes, because they have hit a stall point in their core business model and they are unable to unlock the valuation potential of their business. In other words, they failed the acid test that value investors should employ to gain conviction in sizing up the investment bet to outperform in times of volatility and uncertainty, a seemingly simple but profound question: “Does the business get easier as it gets bigger?”

We like to share an article “Surpassing Stall Points in Scaling New Heights” below that we wrote in May 2011 in which we kicked ourselves and asked the tough question: “Is there a “natural limit” or “stall point” in the size of the business by industry and country as the entrepreneur attempts to scale up before he or she faces the challenge of their corporate lives to overcome the start of a secular reversal in fortune?” We had used the story of Ray Kroc to highlight how he and his team scaled McDonald’s with tenacity amidst the thicket of resource-rich incumbents, aggressive competitors under the wings of corporate giants, and copycats.

It has been four years since the article was written and we like to update the question for value investors to address the power of disruption lashing SME business owners and even giants who had hit the stall point in the growth of their core business model. Even seemingly stable wide-moat companies are not spared: McDonald’s is upended by fast casual disruptors such as Chipotle Mexican Grill; big beer firms are forced to merge with consumers switching to craft beer with innovative styles; Coca-Cola challenged by the secular decline of soda consumption as consumer taste change toward healthy and natural beverages. The decay in valuation once accorded to these incumbents and the narrowing of the economic moat had accelerated, posing an incredible dilemma for value investors:

“Should value investors hunt for what seemed to be “bargains” in disrupted business models hitting stall points? Or should they pivot and switch to buying the richly-valued disruptors instead?”

The icon of disruption is epitomized by Travis Kalanick, Uber’s co-founder, who entered and thrived in city after city, despite the opposition of giant taxi companies, lawsuits, strikes, consumer privacy woes, and other controversies from some of its drivers, who are private contractors rather than full-time employees. The question on the minds of value investors is undoubtedly: how do you value a company like Uber, as was asked and updated in Oct 2015 by NYU’s finance professor Aswath Damodaran. Uber was last valued at over $50bn from its last bond term sheet in Jun 2015 revealing $470m in operating losses on $415m in revenue. Even the disruptor Uber was not spared from being disrupted itself – by Google, who could end up undercutting Uber’s revenue by offering a service for free in a free app called “Free Ride” using its Google autonomous cars. Some venture capitalists have called the disruption risk of Google’s Free Ride to be overblown because Google was only trying a carpooling service internally for employees.

Asian Wide-Moat Innovator (Red) vs S&P 500 Index – Stock Price Performance, 1997-2015

WMI

The business of carpooling reminded us of an Asian wide-moat innovator in our Index who is the largest developer and operator of time-rental parking spaces. This innovator had updated the antiquated parking lot business and pioneered 24-hour automated time-rental parking services and became the most well-known brand of unmanned pay-by-the-hour parking lots, pulling itself ahead of its competitors who range from large real estate operators to sole proprietors. In terms of vehicle units managed, this innovator is over twice the size of rivals. The company disrupted itself by starting a car sharing business in June 2009, which was unprofitable for quite due to heavy up-front investment, but it turned profitable in FY14 and becomes an earnings driver to generate ROE of over 18% and this highly profitable world-class innovator is trading at EV/EBITDA 9x. Contrasting with Uber’s $470m in operating losses, this Asian innovator has created possibly the only profitable car-sharing business in the world, owning 60% of all vehicles used for car sharing services in its country.

The second generation leader of this family business has also introduced an innovative system that made it possible for the parking lot operator to…

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Read more at The Moat Report Asia

Importantly, as a result of striving for excellence every day, the low-profile family leaders are able to surpass its stall points in its business model to scale new heights. 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 Bamboo Innovators devoted in their intensive task of building a wide-moat business.

Surpassing Stall Points in Scaling New Heights

BY KEE Koon Boon, 9 May 2011

2011 marks the 50th “anniversary” since Ray Kroc, 59 years old then, bought out McDonald’s for US$2.7 million from the McDonald brothers who were the original pioneers of the fast food restaurant “system”– an expensive valuation then and with no secret recipe for hamburgers, no patents, and no technological breakthroughs. Since fully taking charge of McDonald’s destiny, Kroc, the visionary leader, enlisted the help of a team with Fred Turner as the execution extraordinaire, June Martino as the human resource specialist, and Harry Sonnenborne as the numbers guy who advised him that real estate was the key to a franchise’s financial success.

By 1965, the year when McDonald’s was listed – interestingly, at the same time as Singapore’s independence – the team had scaled the business nationwide with tenacity to more than 700 restaurants amidst the thicket of resource-rich incumbents, aggressive competitors under the wings of corporate giants, and copycats. McDonald’s now has more than 32,000 restaurants worldwide in 117 countries and two-thirds of its sales are now contributed from outside of America. More than 75 percent of McDonald’s restaurants worldwide are owned and operated by independent local men and women. McDonald’s is also one of the largest property companies with US$17.6 billion in self-owned “McProperty” real estate retail assets. The company’s market capitalization has since multiplied 140 times in 45 years to US$88 billion currently.

Why McDonald’s, easily one of the most recognizable brand name in the world, is not a core buy-and-hold stock in the portfolio of Warren Buffett, the world’s greatest value investor, is probably one of the greatest underexplored enigmas in value investing. The non-investment by Buffett’s Berkshire Hathaway is all the more ironic given that McDonald’s is the biggest buyer of Coke – and the Golden Arches was also listed in the same year as Berkshire. Having multiplied his returns by 10-folds after investing in Coca-Cola in a big way in 1988, the ubiquitous beverage brand is arguably the business model that most define Buffett’s philosophy in value investing.

When asked whether he would buy McDonald’s and go away for twenty years, Buffett gave an intriguing reply in a lecture at the Florida School of Business back in October 1998. “It is a tougher business over time“, Buffett said, “People don’t want to be eating – exception to the kids when they are giving away Beanie Babies or something – at McDonald’s every day. If people drink five Cokes a day, they probably will drink five of them tomorrow… I like the products that stand alone absent price promotions or appeals although you can build a very good business based on that.”

Buffett’s Berkshire Hathaway did purchase McDonald’s in 1995/6 when it was probably around US$17 to 20 billion, but he exited in 1997/8 at around US$26 to 30 billion. Although McDonald’s grew to US$50 billion around a year later, it started its precipitous trend to fall to US$13 billion by February 2002 as it posts its first ever quarterly loss. Singapore’s dynamic entrepreneur Robert Kwan, who had a small wholesale toy store, was earlier than Buffett, opening with sharp foresight the first McDonald’s in Singapore in 1979 at Liat Towers, although he sold off his share in the business in 2003. Mr. Kwan carried his experience and insights to rejuvenate the Singapore Zoo, Bird Park and Night Safari, bringing them back into the black in his role as the executive chairman of Wildlife Reserves Singapore in 2003, later stepping down in 2007.

“A tougher business over time”, an all-important axiom for entrepreneurs and value investors.

Coca-Cola itself hit its peak at around US$200 billion in market cap in Jul 1998 before dwindling to US$90 billion by 2005 and recovering to US$165 billion presently. Starbucks, in its 40th “anniversary” this year, poured its heart to scale one cup at a time after Howard Schultz bought over the six Starbucks shops for US$4 million in 1987 to reach US$28 billion in 2006 before hitting the roadblock to tumble to US$7 billion by end 2008 and is now back up again to US$38 billion.

Most businesses are not so fortunate to be able to recover. In 1962, the year IBM turned 50, Tom Watson Jr. – IBM’s chairman and the son of its founder – commented that of the top 25 industrial corporations in the United States in 1900, only two remained on that list by 1961. This year in 2011, as IBM celebrated its centennial, its current CEO Sam Palmisano carried on Watson’s insight and said that of the top 25 companies on the Fortune 500 at the time of Watson’s lecture, only four remained in 2010.

Is there a “natural limit” or “stall point” in the size of the business by industry and country as the entrepreneur attempts to scale up before he or she faces the challenge of their corporate lives to overcome the start of a secular reversal in fortune? After all, if an elephant were larger by a mere 15 percent, its body weight would require such bone and muscle strength in its legs that its weight would make it simply too heavy for the muscles to lift, and the beast, unable to move, would starve.

Yet, elephants can dance, as what Lou Gertsner said in describing how he led IBM to overcome a near-death experience in the early 1990s when he took over as CEO in April 1993. IBM then was at US$10 billion after falling from its 1987 peak at US$50 billion. By reducing the Big Blue’s dependency in mainframe manufacturing, which was supplanted by personal computers and servers, and building the global platform for services to provide higher value to customers, a core business which today accounts for over 40 percent of its overall profits, Lou had multiplied the market cap 10-folds to US$100 billion by the time he passed over the leadership baton in 2002 to Sam Palmisano. Palmisano quadrupled earnings and created another US$120 billion in shareholders’ value in 10 years as he positioned IBM in software and analytics, an area which now contribute more profits than services do.

Understanding the dynamics of this stall point can illuminate important lessons for both the Asian entrepreneur trying to scale his or her enterprise to a greater height and the diligent value investor wanting to generate sustainable compounding returns. In other words, value investing is about investing in the outstanding entrepreneur building the durable economic moat which means the business gets easier, not harder, as it gets bigger.

One key to McDonald’s success is what…

<ARTICLE SNIPPED>

Read more at The Moat Report Asia

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.

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
Bamboo Innovator Insight (Issue 104)

  • 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,

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,

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.

Living the Life That Is Upright and Executing Day By Day to Scale Asia’s Wide-Moat Foodservice Company – 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 | October 7, 2015
Bamboo Innovator Insight (Issue 103)

  • 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,

Living the Life That Is Upright and Executing Day By Day to Scale Asia’s Wide-Moat Foodservice Company 

Can You Guess This Asian Wide-Moat Company?

“Work hard. Deal with people honestly. Always look to improve yourself. Celebrate if we outdo ourselves, not when we outdo others. Enjoy what you are doing. This will help you to deliver the best products and services to your customers. It will also help you to strive to improve until you achieve excellence. Be ready to innovate. And never be afraid to dream big! The advice and motivation comes from one source – my mother. She is steadfast in counselling us, on how to live the life that is upright.”

This is the message that the inspiring Mr. C has for like-minded entrepreneurs and the next generation of leaders.

In the month of October, we investigate a listed Asian family business founded in 1975 by Mr. C and his wife 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.

The company’s flagship brand, which contributed 52% of systemwide sales, has powerful store economics driven by high margin, low cash investment cost per outlet, resulting in cash-on-cash return of 43%, which is significantly higher than the 24% return for the average US peers. Its other domestic brands are leaders in their own categories with market share ranging from 35-91%.

Its international brands in China have broken even in 3Q14 after its initial entry more than 10 years ago; all along, the operations are profitable at the store level, but lack enough scale to cover the corporate and infrastructure overheads in which the management has committed to long-term investments in central kitchens to support the scaling up of the network expansion. In Jan 2015, management also inked a 60:40 JV and master franchise agreement with famous US snack chain in China and commented that they are exploring the opportunity to acquire a US brand with a $1bn market capitalization.

Being born into a poor family, Mr. C has demonstrated far-sightedness, discipline and values to build and scale the company into Asia’s leading foodservice company by “giving our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends.” Below is an excerpt shedding more insights into the inspiring entrepreneurial story of Mr. C:

********

Q: “…Can you share with us the story of how the company started? What are the business and personal challenges that you face along the way? How did you overcome them and what are the lessons that you have learnt?”

Mr. C: “…That was the first lesson – and it is something that [Company’s name] espouses to this day. I believe that we should give our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends. I think that comes from the view that we don’t have to be greedy in our daily lives or business. If we strike the right balance, we share the benefits with whomever we’re dealing…

Saving every dollar we could was our mindset during the early days of [Company’s name] when we had a lone store… We had to do everything by ourselves in the beginning.. My wife and I even cleaned the toilet. When there’s no cashier, you do the cashier.. if there’s no janitor, you clean the toilet. It’s like your neighborhood mom-and-pop store. We also served the customers as waiter and waitress, and then at night, we do the accounting by ourselves. As my wife said wisely, ‘There’s a Chinese saying that says it’s easier for you to save than to earn’. So if you have something and you can save it. Don’t waste it because to earn money, it takes a lot of hard work. We worked hands-on but as the business propels, we noticed they could not do it all so we started to set up an organization hired store managers, and trained people.

During those challenges I continued to have high hopes and optimism that anything is possible. I think I pick up this belief from my mom. Our role is to do what we can as best we can and don’t worry about the outcome. The outcome will take care of itself. This belief has allowed me to sleep well at night. It gives me new hope everyday.

The third lesson is that innovation starts in our minds. Our mindsets determine what we’re able to accomplish. The story of [Company’s name] is a story of finding opportunity amidst difficult times. The main thing is to dream, dream big and not be afraid of it. Dreams are free. Why limit what you are aspiring for? But dreaming is not enough. One must be willing to put in the needed action and hard work to make these dreams come true. If you dream big and put your dreams into action you will indefinitely make mistakes. But don’t be scared to make mistakes. Just be quick to recognize them and learn from them as fast as you can. Learn from each mistake and it will not be a waste of time. If we place no restrictions on ourselves, then we’re capable of doing anything. If we are not greedy, then more things will return to us. If we give more to our fellowmen and to our customers, more than what they expect, they’ll return over and over again…

…The food business is still very basic. It’s still about taste. It’s still about How did you serve me? Is your place nice? Am I treated well? Do I get value? If you think about it, if we’re going out to eat, these are the basic things we look out for, but the execution is the difficult part. It’s not like other businesses where it’s the concept or the knowledge that’s difficult. Here, there’s no secret; it’s very easy, but it’s the execution that’s hard. If you ask a lot of restaurant, they know all these things. Executing day by day is what’s hard.”

********

Historical precedents in Chipotle and Yum Brands show that EBITDA/store growth drives valuation multiple expansion; EBITDA/store and EV/store is not just a linear combination but an exponential one. Thus, companies that successfully increase store profitability in a sustainable manner will see valuation increase by an even greater degree. Market has rewarded the company in the past for productivity improvements but has punished the company lately for the weaker-than-expected FY2014 and 1H15 results. Enterprise Value/store for is now back to 2013 valuation multiple despite expanding store count by 8.6% and sales/store growth increasing 1.5% in the trailing 12 months. If EBITDA/store improves 5% back to 2013 level and the company is able to sustain the improvement as it expands the store count to the target level in the next 3 years, EV/store could rebound and EV could jump, indicating a 36-56% upside potential.

The company’s store economics and return metrics is more like “fast casual” that include Chipotle, Starbucks, Shake Shack, which have higher returns and tend to trade at higher valuation multiples. In terms of EV/EBITDA to the fast casual companies, the company trades at a 37% discount. The Price/Sales ratio of fast casual companies is >5x, as compared to the company’s 2.16x, indicating room for profitability improvement, especially with its China business breaking even in 3Q14, and therefore providing the foundation for further valuation gains. Thus, the company’s business model which is more fast-casual in its superior store economics, is underappreciated and undervalued by 37% to >100%.

We believe that the outstanding leadership provided by the inspiring visionary Mr. C, 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.

Can you guess who is Mr. C and his wide-moat family business?

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,

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 September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

The Scale of Life in Business and Value Investing – 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 | September 28, 2015
Bamboo Innovator Insight (Issue 102)

  • 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,

The Scale of Life in Business and Value Investing

“Basically, when you get to my age, you’ll really measure your success in life by how many of the people you want to have love you actually do love you. I know people who have a lot of money, and they get testimonial dinners and they get hospital wings named after them. But the truth is that nobody in the world loves them. If you get to my age in life and nobody thinks well of you, I don’t care how big your bank account is, your life is a disaster. That’s the ultimate test of how you have lived your life. The trouble with love is that you can’t buy it … The only way to get love is to be lovable … The more you give love away, the more you get.”

– Warren Buffett’s address to the Georgia Tech students on his greatest success and greatest failure

“Americans love Volkswagen, and now even more,” US transportation secretary Ray LaHood enthused when he opened Volkswagen’s plant in Tennessee in May 2011, hailing the company’s efficient “clean diesel” engines as the route to long-term energy security in the US.

The simple yet profound comment – “The trouble with love is that you can’t buy it” – made by Warren Buffett when students at Georgia Tech asked him about his greatest success and greatest failure, seemed particularly apt in the wake of the emissions fraud at Volkswagen which exploded last week.

At least 11 million “clean diesel” VW vehicles were outfitted with sophisticated “defeat device” software designed to cheat strict emission tests for the past six years by cleverly putting a lid on emissions during testing in lab conditions, but spewed up to 40 times the legal limit of nitrogen oxide emissions, which creates smog and has been linked to increased asthma attacks and other respiratory illnesses, when not tested. The scandal has wiped more than €24bn ($26.8bn) off VW’s market value and VW faced a fine of up to $16bn in the US alone and a possible criminal investigation.

The fraud was first uncovered in 2014 by John German, a hardworking automotive research engineer who earns a modest salary at a small non-profit organisation dedicated to helping to reduce vehicle emissions. John German carried out a simple test with results that were handed over to the Environment Protection Agency (EPA): checking the car’s emissions on real roads rather than in lab test conditions. John German commented: “VW had a chance to fix the problem, and they continued to try and cheat and do what they had done. That’s just amazing. Companies should realise they might get away with stuff for a little while, but it will catch up with them.”

MAS Presentation

Last week, we are honoured and grateful to be able to have the opportunity to share our thoughts and to have a sincere and productive conversation with the top management team at the regulatory authority in Singapore 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.

Public disclosure of the List of companies in the highest risk decile by the five fraud categories (tunneling fraud; grand capex fraud; M&A deals potion fraud; all-in-the-family expense and liability shift; consolidation craftiness fraud) on the regulatory websites to inform and educate public (Financial Literacy 2.0) can (a) prevent harm before fraud happens, and (b) spur the potentially fraudulent firms to act to improve their corporate governance, e.g. return back part of the expropriated “missing cash”, to get themselves off the List. This will also bring about greater efficiency in the overall regulatory system given the limited resources in going after so many fraudulent cases which may occur and implode systematically during poor market and economic conditions (e.g. the reverse merger fraud wave in U.S. that was concentrated in 2011).

We were recently asked a question in a light-hearted way on why does Buffett keep growing money if he “measure your success in life by how many of the people you want to have love you actually do love you”.

Essentially, when one commits to an idea larger than oneself to care for and to serve other people, “wealth creation” takes on a Purpose and meaning, as opposed to opportunistic money gathering through complex financial engineering schemes and tunneling fraud that eventually unwind to harm others. For Buffett-Munger, their idea larger than themselves is manifested in the creation of a focused vehicle Berkshire Hathaway, which compounds not only wealth for shareholders but more importantly, compounds values and virtues as an exemplary role model in the way business is conducted and how they live their life in a simple and frugal way. The Berkshire Hathaway Bus carries more passengers and supporters who get positively energized towards the right direction in the journey of Life in the increasingly harsh and pretentious world…

Interestingly, we had written a positive and uplifting story back in March 2011, the year in which accounting frauds imploded systematically, from Sino-Forest to Longtop Financial Technologies, including the reverse merger fraud wave in US, and the emergence of the likes of Muddy Waters/Carson Block and Sahm Adrangi/Kerrisdale.

A particular quote from the article has reminded once again about the importance for value investors to avoid the seemingly profitable companies who take short-cuts to buy love, those who do not care about the Process to Care and Serve others, those who engaged in complex financial engineering schemes and tunneling fraud that eventually unwind to harm others:

“Commerce is not merely about the measurement of the weight of profits collected in multiple clever transactions to build abstract personal wealth. Only in the endeavour to perform first for customers, and serve them with the highest possible integrity and character, can commerce find its foundation for durable business success and create society’s abundance. The secret at Wal-Mart, Amazon and Vanguard to gaining the “Fu, Lu, Shou” (“Good Fortune, Prosperity, Longevity”) wide-moat compounding success is that the less they take, the more the customer and fund investor make. That is why enterprises designed for the public weal are the quintessential Bamboo Innovators – the bigger it is, the easier, not harder, it gets.”

The Scale of Life in Business and Value Investing

By KEE Koon Boon on 5 March 2011

Commerce would not have progress beyond the barter system without the invention of a system of weights and measures. Before there was the traditional Chinese steelyard (“gancheng”, 杆秤), buyers and sellers eye the heap of goods to determine their weight. It is difficult to achieve a fair trade. With the “gancheng”, the object to be weighed hangs at one end of the beam, while the weights at the other end are slided left or right until a perfect balance of the beam is found. Reading of the mark where the weight-string rests is made to determine the weight of the object. There are 16 markings on the arm of a “gancheng”, such that 16 “qian” in weight is equivalent to 1 “liang” and 16 “liang” is equivalent to 1 “jin” (or 604.79 grams). The Chinese unit of measurement was based on the number 16 instead of 10.

But why 16? The wisdom behind this number will help us understand why Bamboo Innovators Sam Walton of Wal-Mart and Amazon Inc grew stronger and more resilient over time like a bamboo, why Vanguard Group is the world’s largest mutual fund manager with $1.6 trillion in assets under management.

16 is the sum of 7, 6 and 3. 7 stands for the “Beidou Seven-Star Constellation”, which symbolizes the need to have the right direction in our heart when we use the measurement tool to make money and not be too greedy. 6 stands for the directions North, South, East, West, Up, and Down, which cautions us to stay centered in our ethical principles when making money. Lastly, 3 stand for Fu (Good Fortune, 福), Lu (Prosperity, 禄), Shou (Longevity, 寿). When we make money by squeezing one “liang” improperly out of others, we lose “Fu” (损福); wrench two “liang” and we lose “Lu” (伤禄); expropriate three “liang” and we lose “Shou” (折寿). Give money back to the customers and society in a sustainable way and we gain “Fu, Lu, Shou”. Thus, the 16-unit scale is not merely a tool to measure and make money, but more importantly, it is a scale to guide and measure our values in life and in business.

The late retail giant Sam Walton, whom the world’s greatest investor Warren Buffett felt was the greatest CEO of all time, saw the anomaly of retailers overcharging the customers. Sam seeks to correct things by being a champion of the customer with Wal-Mart’s “Everyday Low Prices” by passing along cost savings back to the customers to make better things ever more affordable to people of lesser means. This resulted in Wal-Mart gaining “Fu”, “Lu”, “Shou” and its astounding wide-moat compounding success to over S$200 billion in market capitalization from its initial listing size in 1970 of S$40 million.

Jeff Bezos sacrificed the financial comfort and glamor of his investment banking job to establish Amazon in 1994 with the support of his wife and the life savings of $300,000 from his parents. Now, the internet retailer beats its brick-and-mortar giants at their own game by delivering goods cheaper to its customers. Surveys by Morgan Stanley and Wells Fargo found that Amazon sold a broad range of items 6 to 19 percent cheaper than Wal-Mart. By leveraging its scalable infrastructure and virtuosity in analytics in delivering a dependable and enjoyable customer experience, the customer-centric Amazon has grown bigger more quickly than any company in retail history. Wal-Mart took 27 years to hit $30 billion in sales while Amazon did it in 16 years and its market cap multiplied to nearly $80 billion.

Similarly, John Bogle saw the anomaly of mutual funds charging exorbitant fees to investors for professing to beat the market, when in fact most of them lagged the market benchmark. Bogle set up Vanguard in 1974 to pioneer low-cost index mutual funds for retail investors. By passing back savings to the investors from advisory fee reductions and economics of scale, its low-expense model enables Vanguard to deliver competitive returns without chasing complex risk that they did not understand or respect. Bogle estimated that the costs of securities intermediation in the funds management industry in 2007 are $528 billion. These include sales loads, management fees, operating and marketing expenses, transaction and advisory fees, hidden turnover costs, and soft dollars, and they recur year after year at around 2.5 percent of average assets. Vanguard’s Lion Infrastructure allowed it to have around a 1 percentage point savings, which, when applied to $1.6 trillion of assets, produces savings of $16 billion annually.

Commerce is not merely about the measurement of the weight of profits collected in multiple clever transactions to build abstract personal wealth. Only in the endeavour to perform first for customers, and serve them with the highest possible integrity and character, can commerce find its foundation for durable business success and create society’s abundance. The secret at Wal-Mart, Amazon and Vanguard to gaining the “Fu, Lu, Shou” (“Good Fortune, Prosperity, Longevity”) wide-moat compounding success is that the less they take, the more the customer and fund investor make. That is why enterprises designed for the public weal are the quintessential Bamboo Innovators – the bigger it is, the easier, not harder, it gets.

Bogle shared a meaningful story from Reverend Fred Craddock who was known for his conversational preaching. Craddock, when visiting in the home of his niece, strikes up a conversation with an old greyhound dog.

“I said to the dog, are you still racing?”

“No,” he replied.

“Well, what’s the matter? Did you get too old to race?”

“No, I still had some race in me.”

“Well, what then? Did you not win?”

“I won over a million dollars for my owner.”

“Well, what was it? Bad treatment?”

“Oh, no,” the dog said, “they treated us royally when we were racing.”

“Did you get crippled?”

“No.”

“Then why?” Craddock pressed, “Why?”

The dog answered, “I quit.”

“You quit?”

“Yes,” he said, “I quit.”

“Why did you quit?”

At last, the reason: “I just quit. Because after all that running and running and running, I found out that the rabbit I was chasing wasn’t even real.”

Bogle believed that the rabbit that he has been chasing in his career, which is “essentially giving investors a fair shake in their quest to accumulate assets for a secure future”, is real. It is not the illusory rabbit of success – defined by the measured wealth, fame, and power – but rather the real rabbit of meaning – defined by the immeasurable integrity and virtue.

Yet, there seems to be something missing in the long hard chase for the rabbit of meaning in the asset management industry. Stage 1 is epitomized by fairness in Vanguard’s low-cost business model. Stage 2 requires a sense of caring to inspire the extra level of intensity and dedication in performing for investors. Such performance-based caring is an exacting and demanding business that requires the ablest and most dedicated navigators who truly care.

Yes, the pursuit of a mission that honors society as a whole is painful and requires sacrifice, tough-mindedness and discipline. Then, rather than chasing after that rabbit, finding that it is fake, and quitting in dismay, like the greyhound, it is worthwhile to chase the real rabbit of life and business despite the pain and sacrifice, and then keep running, and running, and running, as hard as we possibly can.

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,

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 September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

Stirring the Soup: Lessons for Value Investors in the Nourishing Growth of Brittania Industries – 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 | September 21, 2015
Bamboo Innovator Insight (Issue 101)

  • 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,

Stirring the Soup: Lessons for Value Investors in the Nourishing Growth of Brittania Industries

SoupWho stirs the pot is the most important ingredient in the value creation process of a wide-moat compounder.

This is the illuminating insight in the inspiring book Soup: A Recipe to Nourish Your Team and Culture by Jon Gordon. In the business fable, Nancy, the new CEO of Soup Inc, faced declining sales and low employee morale; the company had lost both flavor and heat and nobody likes lukewarm soup. When Nancy chanced upon the little-known Grandma’s Soup House, she learnt the “stirring” lesson to create a winning culture and team. No matter how carefully different chefs follow the same recipe, the final product always varies a little bit because we can’t separate who stirs the pot from what’s in the pot. As “Grandma” says to Nancy, the one who stirs the pot is the one who impacts the flavor of the soup:

“The love and energy we invest into our life and work determines the quality of it. The love we share in raising our children or developing employees or helping a customer impacts the final product. The love, or lack of love, we give ourselves and share with others will determine whether life is sweet or sour. It determines the fabric and texture of our relationships and how others perceive and receive us. When we love our kids, they feel it. When we stir the pot at work with love, our customers and colleagues notice. Just as soup is a reflection of the soup maker, our lives, careers, and businesses are the reflection of the love and energy that we put forth. Your people are not just a creation of your culture but are creating it every day. They must be encouraged, inspired, and empowered to stir the pot as well, and they must be coached so they are good at it.. If they did it together and poured their heart and soul into making great soup, they would accomplish great things.”

Reading the Soup reminded me of the nourishing growth of Brittania Industries (NSI: BRITTANIA, MV $5.46bn), India’s leading biscuit and confectionery maker who had compounded over 400% since the “soup-stirrer” Varun Berry joined in Jan 2013 as COO and took over the CEO/MD leadership baton from veteran Vinita Bali (2006-13) in Apr 2014. Prior to joining Britannia, Berry was the CEO of Pepsico Foods for South Asia.

Britannia is one of India’s oldest FMCG companies which was set up in Kolkata in 1892 with an initial investment of Rs295. The company started its own distribution network in 1975, taking over from Parry’s. Britannia listed in 1978. After being owned by Nabisco for most of the 1980s, Britannia was acquired by Rajan Pillai towards the end of 1989. In 1921, Britannia imported machinery and becomes the first company East of the Suez to use gas ovens. In 1993, the Nusli Wadia group and Danone became joint owners of the company. After a highly acrimonious ownership tussle in the interim, Danone sold its 25.5% holding for $200m to the Nusli Wadia group in 2009 who now controlled over 51% of Britannia. Britannia also subsequently bought out Fonterra, its joint venture partner in its dairy business. Britannia’s market reach spans 3.5m outlets across India, of which 1m outlets are served directly by the company. Britannia’s major five brands are “Good Day” (premium-priced), “Nutrichoice” (premium-priced), “Marie Gold” (mid-priced), “50:50” (mid-priced), “Tiger” (low-priced) and amongst its portfolio of biscuits (74% of sales, #1 with 35% market share in volume and 28% in value terms vs 30% for Parle), bread (9%, #1 with 50% market share), cake (5%), rusk and a range of dairy products (5%) that include cheese (#2 with 20% market share behind unlisted state cooperative Amul), curd, and specially formulated functional beverage with a dairy base.

Before Britannia was a “hot soup”, it has been struggling under the shadows of unlisted leader Parle, Mondelez/ Kraft, Nestle India who have equally strong, if not better, distribution reach in India and have more iconic brands. Giant ITC had also entered the biscuit market in 2006, proving to be a formidable and serious rival in targeting premium products and eating up the market share of leader Parle, garnering a 15% market share. Britannia’s products have largely been “me-too” versions of global brands.

Britannia Industries (NSI: BRITANNIA) vs Nifty Index – Stock Price Performance, 1994-2015 (top) and Jan 2013-2015 (bottom)

Britannia

According to industry sources, Sunil Alagh was instrumental in strengthening “Brand Brittania”. An expert in marketing, Alagh was focused on investing in brand building and innovation, with his tenure witnessing the launch of Good Day, Tiger, 50:50, Little Hearts and the Treat portfolio. Most of these brands are the key pillars of Brittania’s biscuit portfolio today. Vinita Bali, according to industry sources, was more focused on building operational efficiencies within the company. Bali shifted the emphasis to cost control from building on its investments in branding and gaining in market share. In FY06, Britannia had an approximately 6% point lead over Parle in market share (in value terms). But, Parle had beaten the company in the volumes game with its mass-market glucose biscuit Parle-G. By 2010, the tables had turned with Parle establishing a 6-7% point lead over Britannia in market share in value terms. Under Bali’s tenure, Britannia lost its place as the value market leader in biscuits to Parle. Also, its EBITDA margins contracted from 11.4% in FY04 to 4.3% in FY10, before recovering to 6.8% in FY13 when Varun Berry joined. Britannia achieved 14.3% EBITDA margin in Q1FY16.

Despite its flaws, Brittania is known for its big marketing interventions and programmes. At one point, almost half the Indian cricket team’s players used bats that sported the Britannia logo. Britannia is one of the few brands that continue to have an Indian ethos and flavour.

With Varun Berry stirring the soup at Brittania, the company refocused its energy and Love back into making innovative products and operational improvements were targeted in realizing this Purpose. Brittania has rationalized nearly 100 SKUs (60 in biscuits, 40 in dairy) to drive a sharper focus on a profitable and scalable portfolio. The idea behind this move is to take a longer-term approach across cost lines with a view to making the entire operations more focused and driving manufacturing costs lower. Under Bali, Britannia had a long tail of products although five major brands drive the majority of revenue. Berry brought more focus on key brands and new innovations including premium cookies, capturing 40% of the healthy snack market with its biscuit brand Nutrichoice (with variants such as Oats & Millet based biscuits, sugar-free crackers and diet biscuits). With enhanced nut content and crunchiness in Rs5-pack, rural school kids are observed to be excited by the innovative new Good Day products that they pool money with their friends to pick up larger packs of premium cookies so they can try them. Britannia’s plan is to be present across all villages in India by 2018. Good-Day, which has a 70% share of the premium cookies market, had a new logo resembling a smile and packaging design in Aug 2015, as well as a new ad film that highlights the newness of the cookie brand and urges people to enjoy the small moments in everyday life and to spread optimism and happiness.

A key operational strategy to widen its moat is to…

<ARTICLE SNIPPED>

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

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In the Soup, Nancy, the CEO of Soup Inc, hand out a wooden spoon to every employee and every family member, reminding everyone that to be a great company, they needed everyone in the room to stir the pot. If they did it together and poured their heart and soul into making great soup, they would accomplish amazing things:

“Who stirs the pot is the most ingredient in the soup. Just do your best and stir the pot with love!”

People are hungry for positive change and a fresh sense of purpose and passion. In the story at both the Soup and Brittania, the value investor will find themselves doing well in sensing an important observation: whether the stirrer of the soup pot is able to put the recipe together and bring together the key ingredients to unite, engage, and inspire his or her team and create a culture of engagement and greatness.

Are you able to see the empowered soup-stirrers holding their wooden spoons in Britannia and the wide-moat compounders that you wish to invest in with high conviction?

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 make an upcoming presentation on 23 September to the senior management of the regulatory authorities in Singapore about the fact-based forward-looking fraud detection framework.

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 September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

The Energy Bus: Lessons for Value Investors in the Transformational Story of Ajanta Pharma – 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 | September 14, 2015
Bamboo Innovator Insight (Issue 100)

  • 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,

The Energy Bus: Lessons for Value Investors in the Transformational Story of Ajanta Pharma

“I am not bound to win, I am bound to be true.

I am not bound to succeed, but I am bound to live up to the light that I have.”

– Abraham Lincoln, sixteenth President of the United States of America who saved the Union during the American Civil War and emancipated the slaves

Battling clinical depression. Two bankruptcies. Death of fiancée, son and father.

A seeming failure at the age of 51, one cannot help but marvel at the man who summoned his courage and strength to overcome all these adversities to take on the responsibilities as the President of the United States and unify the country.

Energy BusNo one goes through life untested and the answer to these tests is Energy. In his inspiring book “The Energy Bus”, Jon Gordon shared the story of Abraham Lincoln waiting for Civil War battle reports to come in, not knowing if his country was one step closer to unification or destruction. Gordon likened Lincoln’s feeling of time inching by to that of us wondering and waiting who will board our Energy Bus in the journey of Life and who would stay off it. An important rule, Gordon illustrates, is to “Drive With Purpose”. Purpose is the ultimate fuel for our journey through life. When we drive with purpose we don’t get tired or bored and our engines don’t burn out. Abe’s opening quote “I am bound to be true; I am bound to live up to the light that I have” illuminates his Purpose to emancipate the slaves and unify the country. Rather than vilify people opposed to slave emancipation, Lincoln sought to comprehend their position through empathy; the Purpose was not to defeat his opponents but to heal them of their false beliefs. Purpose is the fuel that energizes himself and the people around him to board his Energy Bus to drive transformation.

Ajanta Pharma (NSI: AJANTHPHARM) vs Nifty – Stock Price Performance, 2000-2015

Ajanta

Reading The Energy Bus obliquely reminded me of the transformational story of India’s Ajanta Pharma (AJP IN, MV $1.87bn). In The Energy Bus, the life of the protagonist George was in shambles: his marriage was at risk, his job was threatened. Similarly, when the Agrawal brothers joined their family firm, it was in shambles, like the life of George. Like Lincoln’s empathy – the ability to put himself in the place of another, to experience what they were feeling and to understand their motives and desires – which gave him the power to forecast with uncanny accuracy what people were likely to do, the value investor will be able to better appreciate the deeper thoughts expressed by Rajesh Agrawal, the second generation leader who joined the family business in 2000 when the company was listed in the same year. Rajesh said, “When I joined Ajanta in 2000, and realised what was going on, I wanted to run away. I thought to myself, ‘Why did I return from the US? I could have had a job there. It was tough in the beginning, especially the situation with creditors and debtors.”

The Mumbai-based Ajanta — set up in 1973 by three brothers, Mannalal, Purushottam and Madhusudan Agrawal — had been incurring huge losses for many years. In 2001-2002, it reported a consolidated loss of Rs 1 crore ($0.15m) and by the following year, it was reeling under a debt burden of Rs 130 crore ($19.6m). Together, Mannalal’s sons Rajesh and his elder brother Yogesh, transformed the debt-laden Ajanta into an extraordinary compounding story that has seen an over 60-fold growth in market value. How the second-generation Agrawal brothers drive transformation by getting everyone on board their Energy Bus offers timeless lessons for value investors to also board the Energy Bus early to participate in the compounding journey.

Before investigating the story of Ajanta, we have the privilege of interacting recently with a thoughtful, low-profile and accomplished Indian value investor Mr. M. Through our conversations, we are able to sense Mr. M’s values towards investing and life and he also provided value investors a powerful thought-provoking insight and a potential structural mispricing opportunity that bears emphasis:

“I have come across quite a few instances, where in initial days, management may have resorted to some not so kosher practices but as it grew in size / found the runway much bigger than it anticipated, grew in confidence, grew in management bandwidth, and gradually became very professional, transparent and dependable.”

Interestingly, Mr. M went on to cite various such examples, including Ajanta Pharma and five other companies in his investing universe. In an earlier Weekly article “Keepers of the Flame: Revisiting the Origins of Compounders in India and Asia”, we had previously discussed about Mr. M’s idea – in the opposite light, in that there are increasingly groups of entrepreneurs who did not start out wanting to be fraudulent, but turned to the dark side as things got tough. This is the opposite scenario of Mr. M’s insight of entrepreneurs emerging from the dark side of Extractors to the warm glow in the land of the Compounders:

“Value investors in Asia cannot look purely at quant “valuation” metrics since many business models and moats are “permanently impaired” and these stocks are the fertile ground for momentum traders and nefarious insiders who have the incentive and power to manipulate prices and volumes. Value investors who attempted to invest in these statistically cheap stocks in Asia have found themselves facing deadweight losses in their portfolio. We observed firsthand how some business owners grew to become either contented with what they have achieved or disillusioned with their core business, straying to seek “growth” for their private interests such as property development, or simply numbing/”exciting” their senses with destructive lifestyle at the casinos while treating both their listed business vehicles as a personal ATM and their employees as disposable expenses rather than as valuable intangible assets. The listed companies belonging to the latter group become dangerous value traps; some even slipped into conniving with “syndicates”. Financial numbers were “propped up” artificially with the prospects of sexy growth projects to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. Western-based accounting fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps. And we have seen how the perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.”

Before we explore the story of Ajanta to sieve for the timeless insights to identify similar compounders, below is a reproduction of some excerpts of our conversation with Mr. M:

—–Original Message—–

From: Kee Koon Boon

To:

Sent: Thursday, 10 September 2015 11:27 PM

There is one word that I have learnt from the Godrej Group management when I visited India (Mumbai/Delhi/Pune) in 2013: Antevasin (अंतेवासिन्). It is a Sanskrit word for “border-dwellers”, a term used at Godrej where the leaders refer to the Group’s position today as “antevasin”, border-dwellers walking the line of trust, integrity and humility on which they have built their credibility. Antevasin is about learning which is far from the safe horizons, a learning which brings you face front to the ground reality. Antevasin is about leaving the bustling center of worldly life to go live at the edge where the Truth dwells closer. That simmering line between your old thinking and new understanding, always in a state of learning. An antevasin is also a scholar who lives in the sight of two worlds, but is looking towards the unknown, just as the value investor is cognizant of the two worlds of the wide-moat Compounders Vs the fraudulent Extractors and is guided by knowledge and teamwork to distinguish between the value creators and destroyers.

Sent: Friday, 11 September 2015 10:37 PM

From:

To: Kee Koon Boon

Wonderful to get your very insightful mail. “Antevasin” is a concept known to me for a long time …. It is a person who is neither fully a family / household / material man nor a fully transcended and self-realised individual, but a person constantly seeking for higher truth, more integrated truth and truth about his “believed and socially conditioned moral codes” with honesty, dedication and hard work. Trust in self, trust in his spiritual teacher and simplicity are the key characters of a true “antevasin”, the dwellers in the border of material and eternal truth.

I am fully aligned to your approach of separating wheat from the “ocean of chaff” prevalent in the Indian equity market. My 18 years of investment experience in Indian market has taught me that Indian market is quite fast in recognising the wheat and value it appropriately in a very short span of time. Conversely, a chaff, however fancied, slowly falls back to the place it actually deserves. But at the same time, I must say, I have come across quite a few instances, where in initial days management may have resorted to some not so kosher practices but as it grew in size / found the runway much bigger than it anticipated, grew in confidence, grew in management bandwidth, and gradually became very professional, transparent and dependable. I can site quite a few examples like Shilpa Medicare (SLPA IN, MV $553m), Welspun India (WLSE IN, MV $1.3bn), IFB Industries (IFBI IN, MV $274m), Avanti Feed (AVNT IN, MV $388m), Suprajit Engineering (SEL IN, MV $243m), Ajanta Pharma (AJP IN, MV $1.87bn) and few more from my own investment universe. One needs to have patience, understanding of the business and feel from the ground to be really successful in Indian market.

And yes, like an “antevasin” one need to remain away from the crowd, clutter and noise but not so far away as to miss the news, developments, changes happening in society, in business, in invested companies and new emerging opportunities.

********

Second-generation leaders Rajesh and Yohesh Agrawal transformed Ajanta by driving with Purpose, adopting a slightly unconventional approach of not following time-tested business models. The Agrawal brothers…

<ARTICLE SNIPPED>

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

********

In The Energy Bus, the life of the protagonist George was in shambles: his marriage was at risk, his job was threatened. When his car had a flat tyre, George was forced to take the bus to work. And he meets with a unique kind of bus driver called Joy and an interesting cast of characters who shared with him the rules for approaching life and work and transform him. As the author Jon Gordon says,

“Everything happens for a reason. Don’t forget that. Every person we meet. Every event in our life.  Every flat tire happens for a reason. You can choose to ignore it or ask what the reason is and try to learn from it. Every problem has a gift for you in its hands as my man Richard Bach says. You can choose to see the curse or the gift. And this one choice will determine if your life is a success story or one big soap opera.”

When the Agrawal brothers joined their family firm, it was in shambles, like the life of George. Perhaps the crisis happens for a reason – it forces change and transformation. The brothers choose to be the driver of their bus, re-energizing Ajanta with a Purpose, adopting a slightly unconventional approach of not following time-tested business models.

Jon Gordon illuminated the insight that for the Energy Bus to keep moving forward and expand so as to always be able to add more people, it is important to “Love Your Passengers”. Love takes time. It’s a process not a goal. Love focuses on bringing out the best in each person on your team. When you love someone you want the best for him. You want him to shine. Gordon shared five ways to love your passengers:

  1. Make time for them
  2. Listen to them.
  3. Recognize them.
  4. Serve them. – A great leader once said, the higher you get in an organization the more it is your duty to serve the people below you rather than having the people below serve you.
  5. Bring out the best in them.

Value investors will do well to identify and invest in wide-moat compounders by hopping on their Energy Bus early to enjoy the ride by evaluating whether the driver drives with a Purpose, that he or she has the desire, vision and focus to move the bus in the right direction and above all, they love their passengers.

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 make an upcoming presentation on 23 September to the senior management of the regulator in Singapore about the fact-based forward-looking fraud detection framework.

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 September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

Mindware: Tools for Smart Thinking – Bamboo Innovator Daily: 12 Sep (Sat)

Life

  • Elon Musk’s first wife explains what it takes to find your passion; it is the value behind our activities, rather than the activities themselves, that compels us and that we can earn a living from in a way that changes lives. BI
  • Why Curious People Are Destined for the C-Suite: HBR
  • Performance Evaluations In A Results-Focused Culture: Techcrunch

Books

  • Mindware: Tools for Smart Thinking: Amazon
  • Resilience: Hard-Won Wisdom for Living a Better Life: Amazon
  • Relentless: From Good to Great to Unstoppable: Amazon
  • The Journeys of Socrates: An Adventure: Amazon
  • Sacred Journey of the Peaceful Warrior: amazon
  • Way of the Peaceful Warrior: A Book That Changes Lives: amazon

Read more of this post

Rising Strong: Lessons for Value Investors in The Turnaround Story of Bata India – 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 | September 7, 2015
Bamboo Innovator Insight (Issue 99)

  • 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,

Rising Strong: Lessons for Value Investors in The Turnaround Story of Bata India

“The truth is that falling hurts. The dare is to keep being brave and feel your way back up.”

– Brené Brown in Rising Strong

Rising StrongFall. Get up. Try again. Rising strong after a fall is how we cultivate wholeheartedness. The process of regaining our footing in the midst of struggle is where our courage is tested and our values are forged. It’s the process that teaches us the most about who we are. This is the inspiring message in the new book “Rising Strong” by Brené Brown, author of “Daring Greatly: How the Courage to Be Vulnerable Transforms the Way We Live, Love, Parent, and Lead”.

As economic conditions in China and emerging markets worsen, more Asian companies turned into the dreaded “earnings torpedo” in investors’ portfolios with weaker than expected results that led to plunges in share prices. How companies can bounce back to turnaround with sustainable performance is of paramount importance to “value investors” who tend to succumb to the disposition effect of riding losers for too long (because firm valuation metrics were thought to be getting “cheaper” as prices fell, but were in fact value traps) and selling winners too early.

The turnaround story of Bata India (NSI: BATAINDIA, MV $997m) after three consecutive years of losses to generate over 1,000% returns when it regained its footings bears timeless lessons for value investors to distinguish between the alluring value traps in which the cheap gets cheaper and the sustainable turnaround story.

Bata India (NSI: BATAINDIA) vs Nifty – Stock Price Performance, 2005-2015

Bata India

Why is Bata India an interesting case? We have received feedback from some institutional investors about our Monthly Riddle article last week in which we investigated a listed Asian family business who is a wide-moat HVAC (heating, ventilation and air-conditioning) specialist that dominates in its domestic market and continuously innovates to “make available to the masses expensive products and services that used to be affordable by only the rich”. Our astute successful subscribers, who care very much about the knowledge and process that generates investment returns, pointed out the compounding power of investing in wide-moat companies that bring a rich man’s lifestyle, products and services affordable to the masses: Wal-Mart, Ford/Toyota, Charles Schwab, etc.

BataBata’s shoe empire and brand heritage dates back to 1894, the year it was founded in Zlín, Moravia, (then the Austro-Hungarian Empire, today the Czech Republic) by Tomáš Baťa, his brother Antonín and his sister Anna, whose family had been cobblers for generations. Bata’s India operations commenced in 1931 and is India’s oldest and largest shoe retailers. Despite its illustrious brand heritage, Bata India struggled to regain its brand relevancy amongst consumers who increasingly find the brand to be stale. Bata India suffered three consecutive years of losses from 2002-04: Rs74m in 2002, Rs261m in 2003, Rs629m in 2004. What used to be a stable ship is sinking.

How did the Bata India management turnaround the company with key initiatives in 2005 to compound over 10-folds to a market value of nearly a billion dollars? During the initial years of Bata India in embarking the turnaround plan, many investment experts say it is a typical case of too little and too late and that the company is doomed. Understanding the fundamental dynamics and assessing the management ability of such “Rising Strong” companies in turnaround situations is important in our journeys to become better value investors. To do so requires traveling back in time to the company’s history to uncover its “Beginner’s Mindset”, which is also the underlying source of the economic moat and the origination power to overcome adversities and bounce back stronger each time round.

The “complete value investor” – a term that Tren Griffin used to describe Charlie Munger in his thought-provoking book “Charlie Munger: The Complete Investor” illustrating how Buffett’s influential partner and Berkshire Hathaway’s visionary vice-chairman utilizes a set of interdisciplinary mental models to avoid the common pitfalls of bad judgment – would discover that the Bata Shoe Company faced multiple challenges and setbacks in its early days and yet it was able to rise stronger each time round. But what exactly was that origination power?

It is the summer of 1895 and Tomáš Bata found himself facing financial difficulties, and debts abounded. To overcome these serious setbacks, Tomáš decided to sew shoes from canvas instead of leather. This type of shoe became very popular and helped the company to grow. Four years later, Bata installed its first steam-driven machines, beginning a period of rapid modernization. In 1904 Tomáš Baťa introduced mechanized production techniques that allowed the Bata Shoe Company to become one of the first mass producers of shoes in Europe. Its first mass product, the “Batovky,” was a leather and textile shoe for working people that was notable for its simplicity, style, light weight and affordable price. Value investors, check the box in the Mungerian mental model: does the company continuously innovate to make available to the masses expensive products and services that used to be affordable by only the rich?

In the global economic slump that followed World War I, the newly created country of Czechoslovakia was particularly hard hit. With its currency devalued by 75%(!), demand for products dropped, production was cut back, and unemployment was at an all-time high. Tomáš Baťa responded to the crisis by cutting the price of Bata shoes in half. The company’s workers agreed to a temporary 40% reduction in wages; in turn, Bata provided food, clothing, and other necessities at half-price. Importantly, he also introduced the industry’s first profit sharing initiatives transforming all employees into associates with a shared interest in the company’s success (today’s equivalent of performance-based incentives and stock options). Consumer response to the price drop was dramatic. While most competitors were forced to close because of the crisis in demand between 1923 and 1925, Bata was expanding as demand for the inexpensive shoes grew rapidly.

Soon Baťa found himself the fourth richest person in Czechoslovakia with his value-for-money shoe empire. In 1932, at the age of 56, Tomáš Baťa died in a plane crash during take off under bad weather conditions at Zlín Airport. Control of the company was passed to his half-brother, Jan, and his son, Thomas John Bata, who would go on to lead the company for much of the twentieth century guided by their father’s moral testament: the Bata Shoe company was to be treated not as a source of private wealth, but as a public trust, a means of improving living standards within the community and providing customers with good value for their money.

Fast forward to 1973 in India. Tomáš visited India in the late 1920s to source rubber and leather for his footwear factories. He saw a number of barefoot Indians and realized there was a huge market in the subcontinent, too. The Indian shoe market in the 1930s was dominated by more expensive Japanese imports. He vowed to make affordable footwear for the masses. So the Bata shoe organization set up a factory in Konnagar, near Calcutta, in 1931, and later moved to Batanagar near Kolkata. The first India-made shoe machine was produced by Bata in 1942. In 1952 it set up one of the largest tanneries in Asia. When Bata listed stock in its India unit in 1973, it was the subcontinent’s market leader, churning out more than 40 million pairs of rubber, canvas and leather shoes and employing 22,000 people, including craftsmen, designers and chemists. The 1973 prospectus proclaimed that Bata’s mass production had brought about “a standardization in size, quality, pricing, etc., which was unique in India. Shoemaking … had become scientific, modern and sophisticated.” It even exported its shoemaking machines. The Indian market was promising. Per capita footwear consumption had soared all the way from 0.35 pairs in 1961 to 0.52 pairs in 1971.

But by the 1990s, as India was finally opening up to the rest of the world, the trusty Bata brand was besieged by labor union troubles, intense competition from smaller players and a misguided strategy to offer higher-priced footwear–took a battering. Reports of nepotism and corruption were rife. Headquarters tried turnarounds to repair an image that by the early 2000s was marred by shortened store business hours (stores closed at 7 p.m. and were not open on Sundays), rude retail staff and sparse merchandising, but Indians walked away. The problems worsened with the “earnings torpedo” and three consecutive years of losses during 2002-04.

Bata India now sells 50 million pairs a year and has doubled revenues in the last five years to $349m through store additions and renovations plus brand extensions to scarves, bags, sunglasses and belts. Last year it opened India’s largest–at 20,000 square feet–footwear store at Mumbai’s upscale Viviana Mall. The quality of retail ambience has upgraded; the stores now look contemporary and the product range has expanded. Bata India also has a strong distribution network with a footprint of nearly 1,300 stores across 500 cities where dealers buy from Bata on cash-and-carry basis and no inventory is owned by the company. Bata has around 8% share in the organised footwear market in India. The organised sector accounts for 30% of the total footwear industry.

India is back among the top three revenue-generators for the $2.5bn-revenue Swiss parent Bata. South Asia, including India, Pakistan, Bangladesh and Sri Lanka makes up more than $600m in total revenues for Bata and accounts for more than 40% of the stores in the Bata universe. While it has 1,300 stores in India it counts up to 410 stores in Pakistan: 264 in Bangladesh and 65 in Sri Lanka. Bata India is currently 53% owned by the privately-held Swiss parent, which runs 5,000 stores across 90 countries. The founder’s grandson–Thomas George Bata–chairs the global corporation.

Bata's Rajeev

Spearheading the growth of Bata India is Rajeev Gopalakrishnan: ”We are making Bata young, fresh, trendy and affordable. I want Bata India to be at $1bn in revenue in the next five years”. This means a tripling in revenues, capitalizing on India’s rapidly growing middle class, the increasing number of women in the workforce and an evolving rural market. Per capita footwear expenditure is expected to go from $6.3 in 2013 to $11.6 by 2017. Bata in India now sells footwear ranging in price from $5 to $160 and Gopalakrishnan also consciously pushing it upscale–practically removing lower-end rubber slippers in favor of leather. Sports shoes is a promising niche in smaller towns, where the first-time buyer is more likely to try on a Power (Bata’s brand) rather than Nike or Adidas. Geographically, too, Bata is filling out its presence in central India after years of strength in the north and south.

So what really happened in 2005 for Bata India? Small outlets and bleeding properties were closed and new remodelled large-format stores were opened. A graded choice of products was offered to diverse consumer segments. And in a major break from the past, it has extended its working hours, and stays open on Sundays. But importantly, in 2005, Bata India went back to its roots to drive entrepreneurial spirit by implementing a unique “K-Scheme”….…

<ARTICLE SNIPPED>

Thus, the K-Scheme fosters meritocracy and creates a strong sense of responsibility and involvement across the retail network with the performance incentive structure and career progression opportunity offered to outperforming retail employees. Bata India’s Gopalakrishnan commented: “The objective of the brand has always been to deliver the contemporary and aspirational range of products to the consumers at a high quality and affordable value. It gives us immense pleasure to welcome new consumers and loyal customers at our stores and offer an enriching experience with great customer service. We aim to deliver better than the best in future as well.”

The “Rising Strong” process for value investors to evaluate the sustainability and scalability of “turnaround stocks” is illuminated by Bata’s entrepreneurial pledge: “Be courageous. The best in the world is not good enough for us. Loyalty gives us prosperity & happiness. Work is a moral necessity!” By revitalizing the entrepreneurial roots of founder Tomáš Baťa who introduced the industry’s first profit sharing initiatives transforming all employees into associates with a shared interest in the company’s success, Bata India is able to rediscover its “Beginner’s Mindset”, the origination power to stay resilient and rebound from adversities and challenges, just like the Bamboo Innovator who bend and not break, even in the wildest of storms that would snap the might resisting oak tree.

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

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 September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

The “SWFF” guide for value investors to identify Asian wide-moat compounders: Making available to the masses products and services that used to be affordable by only the rich – 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 | August 31, 2015
Bamboo Innovator Insight (Issue 98)

  • 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 “SWFF” guide for value investors to identify Asian wide-moat compounders: Making available to the masses products and services that used to be affordable by only the rich

What do you care enough about to risk time, energy, and money to try to make happen?

What if you are operating in an emerging Asian country where the electricity cost is the highest in the region, even ahead of developed Japan and Singapore, due to complex political and regulatory capture reasons, and the high electricity rates have resulted in one of the most under-penetrated markets in household appliances such as air-conditioners and refrigerators as consumers are wary of their energy bills that may comprise as much as one-third of their income? It would be foolhardy and risky to have a business to sell air-conditioners in such a country, isn’t it?

In his thought-provoking book “Taking Smart Risks: How Sharp Leaders Win When Stakes Are High”, Doug Sundheim explains that at the heart of the capacity to take smart risks is genuine passion, or what is called SWFF (“Something Worth Fighting For”). A SWFF must be simple, stir emotions, lend itself to a narrative or story, and inspire action. The idea is simple and powerful: Can the value investor sense, observe and measure the SWFF in the companies and entrepreneurs they invest in, as opposed to pretenders who take short-cuts, using complex financial engineering schemes and accounting tunneling manipulations to opportunistically generate short-term “wow” results that would eventually unwind in massive impairment losses?

In the month of September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Mr. C, the third generation business leader of this family business, commented:

“I’m very proud of the fact that [Company’s name], at its core, is a homegrown business that is dedicated to helping [our countrymen] live, work and play in cool comfort. I am proud that our products are energy efficient, thus helping them save on electricity expenses. But even as more.. are able to purchase high-end air-conditioners, we are still looking to provide energy-saving cooling solutions that the typical [local] can afford and enjoy. After all, we believe that air-conditioning is a necessity, not a luxury—especially in a tropical country such as ours.”

Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

The company has an impressive track record of continuous product innovations adapted to local market conditions supported by 8 self-owned labs, complemented by an engineering and design team of more than 30 engineers who focus on designing and developing solutions for the consumer suitable for the local market, including patented energy-saving fan-plug technology and corrosion-resistant coating, adding value to the consumer experience.

In its commercial business, the company is working with architects and building consultants at design stage to provide customized solutions and creates a sticky partnership. [Company’s name] develop solutions for commercial clients that cover the entire lifecycle of the air-conditioning and refrigeration products, beginning with the design stage and moving through equipment scoping and selection, supply, installation and testing and commissioning and aftermarket services. As a result of providing end-to-end solutions from direct sales relationship with its sticky commercial clients, [Company’s name] has created a resilient recurring income stream in an otherwise cyclical project-based business in which players are competing on prices, discounts and bribes.

The company’s manufacturing facilities in aircon and refrigerators are the largest of their kind in the country. Interestingly, it has an innovative lean manufacturing strategy with entrepreneurial local partners who are former employees. due to its effective cost management and resilient business model integrating distribution reach, logistics and aftersales to produce scale advantages in efficiencies, [Company’s name] has amongst the lowest operating expense (OPEX) as % sales in the industry at 16.7% vs 25-30% for local and global peers.

The company’s strong top-of-mind brand equity has also attracted long-term strategic partners to add value to the customer experience. New businesses include acquiring a 51% effective interest in the local affiliate of a leading American MNC elevator-escalator company in Mar 2014 and forming a 40:60 JV with an Asian MNC giant in Nov 2013.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

[Company’s name] may surprise on the upside with its long-term plans to expand beyond the core into businesses that leverage upon its core competencies and core business infrastructure with potential new strategic partners into kitchen solutions and building management solutions (fire & security, generators, building maintenance, remote monitoring, energy performance contracting). Sales have increased 64% in the past four years and EBIT and EBITDA growth is faster at 85% due to effective cost management. We believe [Company’s name] can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential tripling in market cap based on EV/EBITDA 15x.

During the recent volatility in the emerging markets, [Company’s name] is down 20% since August, more than the 10% decline in the local composite stock Index. [Company’s name] interim result is also decent, with 1H15 sales +11.2%, driven by new business revenue which more than doubled yoy, and operating profit +10.1% on effective cost management (OPEX +2.2% yoy). After the fall, [Company’s name] is now trading at an attractive EV/EBIT 9x and EV/EBITDA 8.6x and we think this is an opportunity to accumulate.

We like how Mr. C has forged a unique entrepreneurial culture and strong corporate governance at [Company’s name]. The dedication and passion in finding ways to better serve customers has opened up [Company’s name] to a future of great possibilities and [Company name]’s next 50 years will be about providing innovative value-added cooling, energy-saving and building management solutions.

Finding SWFF (Something Worth Fighting For) is the process of identifying and clarifying why risk taking and sacrifice is important to you in the first place. From the below conversation, we can also understand a little more about the SWFF factor in the company and Mr. C:

Q: “[Company’s name] has an illustrious business history of over 50 years, having celebrated your jubilee year 3 years ago in 2012. Can you share with us how the success journey of the company started, and importantly, how you got started working at the family business? What are the business and personal challenges that you faced as a third-generation business leader and how did you adjust along the way?”

Mr. C: “[Company’s name] was founded by my grandfather… in 1962.., while my father… developed it into a leading appliance manufacturer… We attribute our growth and success to our unique integrated manufacturing-distribution-aftersales services-solutions model focused on customer satisfaction.

At a young tender age of 7, I spent my extra waking hours working hours working for the family business… But the harsh reality of working in a ‘real office’ struck me hard at the age of 11 as I was sent to the company’s factory to finally get my hands dirty, working alongside plant employees in a hot room with no air-conditioning where we assembled parts, even though our business was making air-conditioners. I had to work with two conditions under my father’s explicit orders: one, I cannot work in an air-conditioned room and second, I cannot eat in the executive floor so I can truly mingle with the factory workers. I think that built my character. That’s when I realized the value of hard work and the humility of hard work. It was there I also realized the value in earning the respect of employees, no matter their pay grade. I also learned to see the perspective of other people, that you see things from the ground level – and I think that gives our organization an advantage. In hindsight, the lesson my father wanted us to learn was the dignity and respect for hard work.

The moniker really given to people like myself is we are COO [children of the owner]. But in my father’s case, you have to earn the title, for you to be a CEO. We all had to work hard and know the company from the bottom up. This was why all my free time in the mornings were spent in the office to learn. It was an unforgettable and enriching experience—my father was firmly against special treatment of the COO, so I really learned what it was like being one of the factory workers. I mingled with them, and ate with them in the cafeteria. Actually, I wasn’t allowed inside the executive rooms at all.

I prefer to work in a manufacturing environment. My father was a huge influence. But even on my own, I was attracted to the idea of people designing and building things that help improve lives, and help make the world a comfortable place. Understanding how things work just fascinates me. And in terms of running a business, that is in my genes, so I had a very strong inclination towards running and growing an enterprise.”

Q: “How about the personal pressures that you face in taking over the reins of the family business?”

Mr. C: “When you join a company and you’re the owner, am I there because of my name or am I there because of what I can do? I think that challenge was more to myself than to the employees. Proving that you know we were worth the position that we carry. That, I tell you, is the biggest challenge faced by companies like ourselves where you have a family corporation, where you tend to tangle up family affairs and business affairs—that’s very critical. I have proven my naysayers and detractors dead wrong.

Being heir to my family’s empire has put a lot of weight on my shoulders. My name is on every product we carry. If you criticize our product, you criticize me. This is one challenge we face every day – proving that we are worth the position we carry. We are so passionate in building solutions worth staking our name on. They say that the third generation will destroy the business that the first generation established, but I think I was able to prove that wrong. Of course, I am proud that we… are able to carry on the legacy of my father and grandfather, and that we were able to make the business flourish even more… We are now a local company with international clout, backed by solid infrastructure and research & development ties that attune the firm to the needs of consumers.

The way I look at it is that I have a goal, that goal is clear, achieving those goals. Working every day to achieve those goals and moving to the next goals. I often tell our people in the plant – we have very big plants – and I ask them, ‘How do you eat an elephant? Piece by piece.’ And that’s what we do with our expectations. It’s not about, ‘hey, I want to be this great guy up here,’ it’s about taking that step at a time. I think humility is very important in that as a person, you are thankful with what you have accomplished. I think being humble as possible is good for this business.

Despite the success of the company, I remain hands-on in the business as I believe in the importance of team work in running the company. And I don’t micro manage. I believe in my team, from the factory workers to the corporate employees, and I trust them to do their tasks well. There is a lot of communication, constituting some 80% of my time, bringing groups together, sharing the vision, helping solve problems. You have to know your staff. If I don’t understand what they are doing, how will I motivate this organization? I’m very easy to relate with. That’s the advantage – people can easily come to me, talk to me and we discuss. But I challenge them and bring out the best in them. Every time, I try to raise the bar, motivate and challenge people to do their best and help them develop their potential.”

Q: “Can you share with us what you believe is [Company name] economic moat and unique competitive edge in garnering a market leadership position..?”

Mr. C: “[Company’s name] market leadership has been built through in-depth knowledge of the end-user and the industry as well as a proven track record which enabled us to build a strong reputation and a solid customer base. We have and continue to offer the widest range of products and the best end-to-end customized cooling solutions and backing this with excellent after sales services to meet the needs of local consumers and businesses… These cooling solutions are defined by individual customer needs and are adapted to [the local] weather conditions and use. We understand the [local] consumer by heart. The company has established its track record by introducing automatic timers into air conditioning units and our patented fan-plug technology, knowing that families switch between air conditioning and fans throughout the night to save on electricity. We also launched refrigerators with larger freezer compartments as many families use them for business. Such intimate knowledge of its target consumers has driven [Company’s name] phenomenal growth.”

Q: “Where do you see [Company’s name] in 2020 and in the next 50 years?”

Mr C: “We see a future of great possibilities… Our next 50 years will be about providing solutions – solutions that will enhance our environment – whether at home, at work, in the place of business or in areas of recreation and leisure. We are not a perfect company, but we have always strived and dedicated all our efforts and are very passionate in finding ways to better serve our customers.“

Who is Mr. C and his wide-moat family business innovator?

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:

https://www.smu.edu.sg/BT_20150819_1.pdf

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/

SuperBetter: A Revolutionary Approach to Getting Stronger, Happier, Braver and More Resilient–Powered by the Science of Games – Bamboo Innovator Daily: 25 Aug (Tues)

Life

  • Making Decisions in a Complex Adaptive System: Farnam
  • How to Stop Overplanning (Even If You’re a Perfectionist): HBR
  • Square Root of Kids’ Math Anxiety: Their Parents’ Help: NYT
  • Starbucks’ CEO sent a memo telling baristas to be nicer because of the stock turmoil; “Let’s be very sensitive to the pressures our customers may be feeling, and do everything we can to individually and collectively exceed their expectations.”: WaPo
  • The world’s top-earning authors: Forbes
  • Being ‘Intensely’ Data Driven Is Not for Everyone; A high-performing culture like Amazon’s is effective, but it also creates winners and losers. And, in some cases, it can quickly go bad. CFO

Books

  • SuperBetter: A Revolutionary Approach to Getting Stronger, Happier, Braver and More Resilient–Powered by the Science of Games: Amazon

Read more of this post

What to Do When Earnings Torpedo Sink Your Portfolio and When You Are Misunderstood? From Bezos and Jobs to “Asia’s Overlooked Amazon”, A Guide for Value Investors – 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 | August 24, 2015
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Dear Friends,

What to Do When Earnings Torpedo Sink Your Portfolio and When You Are Misunderstood? From Bezos and Jobs to “Asia’s Overlooked Amazon”, A Guide for Value Investors 

Don’t let an earnings torpedo sink your portfolio!

This is the metaphor coined by accounting researchers Douglas Skinner and Richard Sloan in their controversial paper describing their evidence that the market overreacts sharply and suddenly to announced earnings that fell just short of the analysts’ consensus earnings forecast (i.e. a torpedo effect), and that the effect is more pronounced for “growth stocks”. Hence, while “growth stocks” outperform during “boom periods” with relatively low frequency of negative earnings surprises, they underperform on average relative to “value stocks”. Fears of the torpedo effect also explained why managers tend to play the earnings game to meet or beat the threshold numbers.

This practical metaphor comes alive for many investors with the recent heightened volatility in the emerging markets reminiscent of the 1997/98 Asian financial crisis. Even Buffett-invested Deere & Co (NYSE: DE) got hit after it announced last Friday on 21 Aug that third quarter earnings tumbled 40% and its net income for the fiscal year through October will be about $1.8bn, less than the $1.9bn that Deere forecast in May and the $1.92bn average of 11 analysts’ estimates, as lower crop prices weakened the farm economy and the energy industry bought less of the company’s construction machinery. Interestingly, its EPS of $1.53 had beaten the $1.44 average estimate. It is also worth noting that since the beginning of its 2012 fiscal year, Deere has beaten the analyst consensus on 12 out of 14 occasions and the last 10 in a row. Yet its shares have actually fallen following 11 of those 14 results. So the bar has been raised from a simple EPS estimate to a composite measure of forward-looking forecasts in revenue, earnings and outlook. This time round, with the lowered full year forecast, Deere was punished – its shares fell the most intraday in six years, plunging 7.9%.

What can value investors do to overcome such painful and frightening earnings torpedo?

  • Should you take a deep breath and don’t do a thing – and wait for market rebounds to bring about a price recovery?
  • Should you sell? Is the deterioration in fundamentals likely to persist? Has the original investment thesis changed? Is the economic moat no longer intact? If so, should you sell immediately after the adverse earnings announcement? Or have you already missed the boat, especially when there is evidence that the inferior performance is concentrated in the 31 days leading up to the quarterly earnings announcements, driven by preemptive earnings disclosure? This problem is made worse in Asia with news leakage to “insiders” and “friendly parties” who have already sold, hiding their identities in different nominee accounts, before the adverse public announcement.
  • Should you buy more? If so, is there a right time period to accumulate? Should you exercise tortured patience and wait when the torpedo effect may be at its maximum pessimism, when the negative post-earnings announcement drift (PEAD) is at its deepest after a certain period, before swooping in to buy more to average down the cost? Or have you underestimated the challenges that the business face? We have shared earlier that Buffett had tried to capitalize on the earnings torpedo effect in Home Depot (NYSE: HD) when Berkshire acquired a stake in the home improvement retailer in 2000. On Oct 12, 2000, Home Depot experienced a 29% drop in its stock price in response to a preannouncement of earnings of $0.28 vs consensus expectations of $0.31. Buffett held Home Depot for a frustrating ten years before selling off the unprofitable investment in mid-2010 (the index was flat during this ten-year period). And mid-2010 was when Home Depot took off to outperform the index: Home Depot tripled versus the doubling in index.

The answer perhaps lies in what the researchers left unanswered: Why did they miss the forecast? How will, and how do, the managers and entrepreneurs react after they announce bad news? A key word to unlock the practical investment puzzle is “misunderstood”. Is the company misunderstood in the eyes of the majority consensus? For instance, is the company missing its revenue and earnings forecast because it is making long-term investments that incur costs to impact short-term earnings or in new project initiatives that do not contribute meaningfully to the bottom-line yet? Or is the miss due to a restructuring in sales and product mix?

Let us consider the cases of Amazon.com, Steve Jobs and “Asia’s Overlooked Amazon” as a general guide for value investors to think deeper about and respond to the frightening earnings torpedo.

Amazon.com (NASDAQ: AMZN) has endured and outlasted critics. The online retail giant has also sunk in multiple earnings torpedo incidents, missing Wall Street forecasts as shown in the table below, and went on to outperform in the longer-term.

Date Headline News Short-term price reaction Longer-term performance
24 Jul 2009 2Q sales grew 14% but came in slightly under Wall Street’s forecast, due to weakness in sales of video-game software and hardware. Down 10% in the next 3 trading days and down 16% till end Aug 2011 +420%

Vs Nasdaq +140%

23 Jul 2010 2Q earnings missed Wall Street’s estimates as the online giant stepped up its investments in fulfilment centers and marketing. Down 13% following results +310%

Vs Nasdaq +105%

25 Oct 2011 3Q EPS of $0.14 missed analyst estimate of $0.24 Down 16% and down 27% till end Dec 2011 +110%

Vs Nasdaq +75%

28 Jan 2012 4Q sales for the typically strong period is weaker than expected, due to higher mix of third-party sales Down 9% following results +160%

Vs Nasdaq +70%

25 Jul 2014 2Q results trailed analysts’ predictions for the second successive quarter as Bezos continue to pump money into new initiatives like warehouses to speed shipments and research on home-delivery drones Down 11% and down 20% by Oct 2014 +40%

Vs Nasdaq +5%

Misunderstood could be the word that plagued Amazon and Bezos throughout its history.

Amazon recently came under fire after a New York Times article Inside Amazon: Wrestling Big Ideas in a Bruising Workplace on 15 Aug 2015 slammed its “thrilling, bruising” workplace environment, describing Amazon as “a soulless, dystopian workplace where no fun is had and no laughter heard” in which people are encouraged to belittle their colleagues, and where leaving work to recover from cancer earns you a demerit.

The NYT writers also described Bezo’s penchant for data-driven management with a story that Bezos himself shared in speech  to Princeton grads: “Jeff Bezos turned to data-driven management very early. He wanted his grandmother to stop smoking, he recalled in a 2010 graduation speech at Princeton. He didn’t beg or appeal to sentiment. He just did the math, calculating that every puff cost her a few minutes. ‘You’ve taken nine years off your life!’ he told her. She burst into tears.”

The NYT ends the story there, drawing a broad conclusion from 10-year-old Bezos’s behavior: “Decades later, he created a technological and retail giant by relying on some of the same impulses: eagerness to tell others how to behave; an instinct for bluntness bordering on confrontation; and an overarching confidence in the power of metrics.”

What the NYT writers fail to mention is that Bezos was using the story to illustrate an important and inspiring humane lesson. Bezos expected to be praised for his math in the offending comment “at two minutes per puff, you’ve taken nine years off your life!” When Bezos’s grandmother “burst into tears,” his grandfather stopped the car on the shoulder of the highway and delivered a line that stayed with Bezos 46 years later. “Jeff, one day you’ll understand that it’s harder to be kind than clever,” his grandfather said. Bezos went on to say that students should not be “seduced” by their gift of intelligence: “Cleverness is a gift, kindness is a choice”. Bezos drew contrasts between choosing “a life of ease” and “a life of service,” and he asked students to consider whether they would “wilt under criticism” or “follow [their] convictions”.

Critics of Amazon abound early on since it was established in 1994. When Amazon was still relatively small, Bezos build five $60M automated fulfilment centres in 1999 against the advice of experts: “for a company that only had $1bn in sales, spending $300m on fulfilment centers is a very big investment.” In 2000, its estimated warehouse capacity was three to five times more than it needed. In 2001, sales had fallen short of expectations, two of its distribution facilities were closing, and Amazon had to lay off 1,300, or 15%, of its employees. Pundits and critics predict the death of Amazon. A breakthrough came in 2002 when Amazon embarked on a strategy of broad discounting and free shipping (for purchases >$25) rather than spending money on marketing ads as advised by experts, dramatically increasing sales, decreasing the operating leverage and risk associated with Amazon’s fixed costs while more fully utilizing its newly-developed distribution network.

Following his convictions led to many people to misunderstand Bezos and also nearly led to the demise of Amazon. Bezos summed up the “willingness to be misunderstood” as the acid test to overcome ongoing volatility and critics:

“Our willingness to be misunderstood, our long-term orientation and our willingness to repeatedly fail are the three parts of our culture that make doing this kind of thing possible”.

We also shared with various Asian entrepreneurs over the years about the story of Amazon and Bezos, including a forgotten tale about the “humane” side of Bezos. In 2004, Bezos was visiting an Amazon fulfillment center with his leadership team. During the visit, he heard about a safety incident when an associate had seriously damaged his finger on a conveyor belt. When Bezos learned of the incident, he walked to the white-board and began to ask five whys to get at the problem’s root cause:

Q1: Why did the associate damage his thumb?

A: Because his thumb got caught in the conveyor.

Q2: Why did his thumb get caught in the conveyor?

A: Because he was chasing his bag, which was on a running conveyor.

Q3: Why was his bag on the conveyor and why was he chasing it?

A: Because he placed his bag on the conveyor, but it then turned on by surprise.

Q4: Why was his bag on the conveyor?

A: Because he used the conveyor as a table for his bag.

Q5: Why did he use the conveyor as a table for his bag?

A: Because there wasn’t any place near his workstation to put his bag or other personal items.

Bezos and his team determined that the likely root cause of the associate’s damaged thumb was needing a place to put his bag but not having one around he used the conveyor as a table. To eliminate further safety incidences, the team provided a portable, lightweight table at the appropriate stations and additional safety training to alert associates about the dangers of conveyor belt work. While this innovation was minor, Amazon member Pete Abilla said it was a transforming experience “that I carry with me to this day.”

The incident showed that:

  • Bezos cared enough about an hourly associate and his family to spend time discussing his situation
  • He properly facilitated the five-why exercise to arrive at a root cause: he did not blame people or groups (no finger pointing allowed)
  • He involved a large group of stakeholders, demonstrated by example, and arrived at a root cause (solution) to prevent the same terrible incident to occur again for any Amazonians
  • He is a billionaire founder and CEO, yet he engaged in the dirt and sweat of his employees’ situation

Bezos wanted Amazon to be a place where people are committed to their work like a vocation and are willing to embrace risk and strengthen ideas by stress test., with leadership principles like “never settle” and “no task is beneath them.” Even relatively junior employees can make major contributions. The new delivery-by-drone project announced in 2013, for example, was co-invented by a low-level engineer named Daniel Buchmueller. In essence, Amazon has provided a platform for those who are fanatics in wanting to build meaningful things as part of a bigger purpose.

Consider another misunderstood case: Steve Jobs and Apple. Like Amazon, Apple had also had its fair share of earnings torpedo over the years and went on to compound over the long-term. However, a qualifier is that we noticed that Apple had missed earnings on 17 Oct 2011 after having beaten forecasts in every quarter since 2004. This was after Steve Jobs passed away on 5 Oct 2011. Since the earnings torpedo and Jobs’ death in Oct 2011, Apple is up around 80%, roughly in line to around 70% for the NASDAQ index.

The story below will give us further insights on why people like Steve Jobs are likely to be misunderstood for their actions.

On a late-October morning in 2010 in the restaurant of the Four Seasons hotel in San Francisco, Steve Jobs and two of his friends were approached by a waitress who asked what they wanted for breakfast. Jobs said he wanted freshly squeezed orange juice.

The waitress returned with a large glass of juice after a few minutes. Jobs took a tiny sip and told her tersely that the drink was not freshly squeezed. He sent the beverage back, demanding another. A few minutes later, the waitress returned with another large glass of juice, this time freshly squeezed. When he took a sip he told her in an aggressive tone that the drink had pulp along the top. He sent that one back, too.

Jobs’ friend asked him, “Steve, why are you being such a jerk?”

This story, told in a New York Times article “What Steve Jobs Taught Me About Being a Son and a Father” by Nick Bilton, who commented that his initial impression was that Jobs is indeed a callous jerk, but added that Jobs had planted an idea in his head that he could shake off after hearing Jobs’ reply.

Jobs replied that if the woman had chosen waitressing as her “Vocation”, “then she should be the best.”

The idea that Jobs believe strongly in is that: No matter what you do for a living, should you do the best work possible? Bilton went on to share a touching tale of how his mother had later contracted terminal cancer with only two weeks to live. That was when the writer learnt that “even if a job is just a job, you can still have a profound impact on someone else’s life. You just may not know it “.

On her final day, Bilton’s mother was craving for shrimps. But they did not have any in the kitchen and the nearest place to get them was a tiny nondescript Thai restaurant a few miles away.

While Bilton stood waiting for his mother’s shrimp, he watched the restaurant staff toiling away and he thought about what Jobs had said about the waitress from a few years earlier: the idea that we should do our best at whatever job we take on. Bilton concluded:

“This should be the case, not because someone else expects it. Rather, as I want to teach my son, we should do it because our jobs, no matter how seemingly small, can have a profound effect on someone else’s life; we just don’t often get to see how we’re touching them. Certainly, the men and women who worked at that little Thai restaurant didn’t know that when they went into work that evening, they would have the privilege of cooking someone’s last meal… It was a meal that would end with my mother smiling for the last time before slipping away from consciousness.”

We can detect the dedication and intensity and sense of urgency that Bezos and Jobs bring towards integrating every aspect of their values into their work and life – and why they are easily and always misunderstood. A key task of the value investor in an earnings torpedo situation is to differentiate the authentic innovators and leaders, from the pretenders who use complex financial engineering schemes to generate short-term results that would eventually unwind in impairment losses.

Thus, the case of Bezos and Jobs highlighted that in order to overcome the earnings torpedo, value investors must assess the element of misunderstanding that creates volatility in results and must ultimately be able to pierce through this misunderstanding with an acid test: Are the entrepreneurs committed to building an idea larger than themselves to serve others? Only if the value investor is able to sense and measure this commitment to a Purpose and assess that the economic moat remains intact, then would the earnings torpedo present an opportunity to buy more.

This brings us to the final case of “Asia’s Overlooked Amazon”…

<ARTICLE SNIPPED>

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

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In her thought-provoking book “No One Understands You and What To Do About It”, author Heidi Grant Halvorson explains why we are often misunderstood and how we can fix that. Halvorson emphasized that this is not about making good impression, but about coming across as you intend to: “It’s about the authenticity we all strive for”.

Two particular “solutions” caught our attention as relevant for value investors to assess the entrepreneurs building the economic moat to last for the long-term but got hit by a short-term earnings torpedo or some other challenges.

One of them is “Demonstrate your strong willpower.” Do they internalize the obstacles and challenges, maintain discipline, exercise self-control and demonstrate willpower in overcoming the problems instead of blaming external environmental factors or people?

Another is “Emphasize what you can do with some concrete specific details, not what you have done.” This allows the value investor to assess the long-term orientation of the entrepreneurs by combining the Elon Musk strategy discussed earlier on delving into details to assess consistency and depth of thoughts in order to sieve out the pretenders. We can observe this in the concrete details provided by “Asia’s Overlooked Amazon” in their long-term investments in the new businesses. There is a sense that they want to get things going, to get things done.

Another common example: Consider the statement that companies involved in alleged accounting irregularities often make, that their accounts comply with the financial reporting standards and Big Four auditors have issued them unqualified opinions, but not addressing the specific allegations in providing more transparency and disclosures behind the “audited” numbers:

“No, you can’t hide behind GAAP. GAAP accounting rules are the ones that we all live by and they are very strict. We had both KPMG and Ernst & Young restate that they are ok with our numbers.”

This was what Computer Associates’ Chairman and CEO Sanjay Kumar said before he was later sentenced to 12 years in prison for his role in the $2.2 billion accounting fraud. Such broad proclamations, that hide under “compliance” or “track record” or “reputation” but do not address the specific issues that people wish to know more to understand the long-term orientation and integrity of the entrepreneurs in generating the numbers, are essentially a signal of defensiveness, impression-management and evasiveness.

To sum up, with Halvorson’s solutions to better understand the context of messages emitted by people in situations of misunderstanding and how the authentic leaders go about fixing them, earnings torpedo present an opportunity to buy more only if the value investor is able to

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

PS1: We have some updates on “Behind the Scene Conversations on Value Investing in Asia” in the Forum: http://www.moatreport.com/forums/topic/behind-the-scene-conversations-on-value-investing-in-asia/. We had a thought-provoking discussion with our existing Institutional Members about stocks that include Singapore-listed Petra Foods; HK-listed Sa Sa International, Great Wall Motor, Sun Art Retail; Taiwan’s Poya, Shin Zu Shing, King Slide, Eclat, Paiho; Indonesia’s AKR, India’s Mayur Uniquoters, Kitex Garments, Page Industries, Mahindra & Mahindra and its listed affiliates, Swiss-listed DKSH vs Li & Fung and its listed affiliates Global Brands Group and Trinity. We believe that for value investing to be productive, there has to be a candid dialogue with a group of people who genuinely care for one another..

Our recent weekly insight article on Mahindra & Mahindra (NSI: M&M, MV $12.6bn) was read by the capable management team at the entrepreneurial company. The Mahindra leaders passed the article to the Mr. Ananda Mahindra himself, who commented that it was “well-written” and “bridges the gap between the investors and the ground realities of managing a business in Asia”, according to the management team whom we had a teleconference with two weeks ago:

http://www.moatreport.com/being-strong-and-resilient-in-a-world-when-things-go-wrong-the-case-of-mahindra-mahindra-a-different-sort-of-indias-berkshire-hathaway/

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 last week:

https://www.smu.edu.sg/BT_20150819_1.pdf

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/

This month of August, we highlight a listed Asian company who is the #1 functional beverage drinks company in its country with around 40% domestic market share by value and the leading functional coffee powder brand in terms of volume (#2 by value). The company is one of few Southeast Asian consumer firms who enjoy success outside of their domestic market, with overseas exports to over 60 countries contributing over 60% of total sales. The company is still in the early growth stage of deepening its channels in the overseas markets with functional beverage as the fastest growing category driving the growth of the global $200 billion nutraceuticals industry. Nutraceuticals is expected to play a central role in the frontline of the battle for consumer health with the rise in lifestyle diseases and consumers are increasingly making health-conscious choices from cutting down on carbonated soft drinks to switching to natural, organic diet.

Gross margin has expanded from 30.3% in 2012 to 39.5% in 2014 with improving production efficiencies and rising higher-margin export sales. EBITDA and EBIT margins stand at 19.8% and 16.6% to generate ROE of 22.8%. The company’s high-capex era has stabilized and will enter into a bigger free cashflow and net cash position going forward. Interest-bearing debt-to-equity has dropped from 1-1.2x in 2012-13 to zero debt and net cash in 2014, with the latest net cash to book equity position at 21.7% in 1Q15, giving it a stronger position to make bolt-on acquisitions of niche nutraceutical companies, including expanding into the functional food category to strengthen its robust portfolio of functional beverage brands. The company trades at historical EV/EBIT 15.9x and EV/EBITDA 13.3x.

Swadeshi Innovators in Asia (Part 2): Who Is The “Precision Castparts” of Asia? – 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 | August 17, 2015
Bamboo Innovator Insight (Issue 96)

  • 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,

Swadeshi Innovators in Asia (Part 2): Who Is The “Precision Castparts” of Asia?

“Brothers and Sisters, I would like to pose a question to my youngsters as to why.. we are forced to import even the smallest of things? My country`s youth can resolve it, they should conduct research, try to find out as to what type of items are imported by India and then each one should resolve that, through may be micro or small industries only, he would manufacture at least one such item so that we need not import the same in future. We should even advance to a situation wherein we are able to export such items. If each one of our millions of youngsters resolves to manufacture at least one such item, India can become a net exporter of goods. I, therefore, urge upon the youth, in particular our small entrepreneurs that they would never compromise.. on.. zero defect. We should manufacture goods in such a way that they carry zero defect, that our exported goods are never returned to us. If we march ahead with the dream of zero defect in the manufacturing sector then, my brothers and sisters, I am confident that we would be able to achieve our goals.”

– Indian PM Modi’s at the country’s 69th Independence Day on Aug 15

“My Swadeshi chiefly centres around the handspun khaddar and extends to everything that can and is produced in India.” – M. Gandhi

“Swadeshi innovators” was a term inspired by Indian PM Modi and coined by us during the last Independence Day speech in which Modi forged the “Made in India” industrial vision.

The word Swadeshi derives from Sanskrit and is a sandhi or conjunction of two Sanskrit words. Swa means “self” or “own” and desh means country. Swadeshi, as a strategy, embodies the principles of self-reliance that stems from a certain deep intangible knowledge, as we have written in our Part 1 article “Swadeshi Innovators in Asia: Fluid, Fast and Nonlinear to Compound Value” on 18 Aug 2014. We commented on the rise of modern facilities in and around Pune in western India – with companies including Germany’s Volkswagen, Indian carmaker Mahindra & Mahindra (MM IN, MV $13.3bn), and autoparts maker Bharat Forge (BHFC IN, MV $2.9bn) helping turn India into a car exporting hub – suggests the industrial success is possible in parts of India. In Gurgaon and Manesar (New Gurgaon), southwest of New Delhi, this industrialization effort is led by Maruti Suzuki (MSIL IN, MV $13.2bn) and wiring harness and auto parts maker Motherson Sumi Systems (MSS IN, MV $5.1bn).

Investing in listed emerging markets affiliates of MNCs has proven to be a winning strategy for shrewd long-term institutional investors such as Aberdeen. Unilever, for example, has listed affiliates in India, Indonesia and Pakistan in which it owns stakes of 37%, 85% and 75% respectively. There were 92 such companies across the emerging world, 24 of them in Asia, 46 in Emea and 22 in Latin America. Aberdeen also supported a research paper “Emerging Market Outperformance: Public-traded Affiliates of Multinational Corporations”. Yale’s finance professor Martijn Cremers found the share price performance of listed affiliates was vastly better than that of both emerging and developed markets broadly, as well as their own local markets, over the 13 years from June 1998 to June 2011. An equally weighted index of the 92 listed affiliates returned 2,229%. This compared with total returns of parents, local markets and parents’ markets of 407%, 1,157% and 147% respectively. The pattern of outperformance was consistent across regions too. Affiliates in Latin America, Emea and Asia outperformed their local indices by 41, 134 and 50 percentage points respectively. Adjusted for volatility the affiliates’ performance was even better, as many of them demonstrated defensive qualities during the 2008-09 financial crisis.

In recent years since the study, there is increasing backlash against MNCs in emerging markets: from Nestle India’s poisoned Maggi noodles incident; Chinese regulators clamping down on MNCs for overcharging in price-collusion; to Korea forcing MNCs to report their detailed governance structure, business transactions and M&A deals to Korean tax authorities annually from 2017. With the backlash and the “Made In India” drive, we see the increasing localization of content driving Swadeshi Innovators in India and Asia.

In Stage 1, Swadeshi Innovators have to forge tie-ups with MNCs to access technology – Maruti has rolled out India’s People’s Car in 1983 after a JV with Japan’s Suzuki Motor (TSE: 7269, MV $20.1bn). With around 40-44% market share supported by a dominant dealer service network, Maruti Suzuki today produces one passenger car every 12 seconds or 1.5 million vehicles a year. Suzuki’s 5.5% royalty stream on all Maruti sales was equivalent to a $500m annual cash dividend and is the recent target of activist investor Dan Loeb. As they grow dominant, they become more powerful than their “masters”, as evident from the split of Hero Motocorp and Honda in Dec 2010 after a 26-year JV partnership that dates back to 1984. However, it could be noted that while Hero Motorcorp survived the crisis and went on to rise around 30% after the split with its MNC partner, it underperformed the Nifty’s 75% climb over the same period.

In Stage 2, Swadeshi Innovators attempt the M&A path or in-house R&D strategy to acquire technology for themselves. These include the success of Eicher Motors (NSE: EICHERMOT, MV $8.6bn) whose iconic Royal Enfield premium motorcycles contribute 40% of turnover and 80% of operating profit. Despite a five-fold increase in capacity in the last four years, the waiting period for a Royal Enfield averages between two and four months, as its distinctively-styled bikes fulfil the customer’s key aspiration of owning differentiated products at a reasonable price. Yet, Eicher group wanted to sell or shut down Royal Enfield back in 2000 due to losses and it was second-generation leader Siddhartha Lal who asked his father Vikram Lal for two years to effect a turnaround. We believe the valuation premium from the Aberdeen-style of investing in listed emerging markets affiliates of MNCs will increasing shift towards the Swadeshi Innovators and their listed affiliates.

Eicher Motors (NSE: EICHERMOT) Stock Price Performance vs Nifty index, 1995-2015

Eicher

However, analyzing these innovators before they become successful is a huge problem for many value investors. Why? Consider the wisdom of Buffett’s candor who admitted in a recent CNBC interview that he had never heard of the Precision Castparts (PCP), Berkshire Hathaway’s biggest-ever acquisition deal(!), until around 3 years ago when his portfolio manager Todd Combs, who manages $9bn, invested in the company: “Three or so years ago, he added Precision to his portfolio. I had never really heard of the company before that.”

Yet, PCP had been founded in 1949 and remains one of the best compounders in American capital history, up over 1,700x in three decades plus, growing from a small metal casting workshop to a global giant in aerospace and oil-and-gas components with a market cap of over $30 bn. In other words, an initial investment of $100,000 compounds to over $170 million, as highlighted in our weekly “Can Asia Produce a Precision Castparts (PCP), a 1,000X Compounder?” on Oct 2013. And Buffett has never heard of PCP until it was up over 1,700-folds. What are the important lessons does Buffett’s candor and the rise of Swadeshi Innovators in Stage 2 hold for value investors?

Let’s understand a little more about why Buffett and most value investors tend to miss the PCPs, before we investigate the “PCP of Asia” and why analyzing their rise has proved more difficult unlike the Aberdeen-style of investing in listed emerging market affiliates of MNCs.

<ARTICLE SNIPPED>

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

********

Inspired by the work of Carol Dweck in her book “Mindsets: The New Psychology of Success” and based on our decade-plus experience of interacting with Asian entrepreneurs, we see parallels in Swadeshi Innovators as having the “growth mindset” as opposed to the “fixed mindset” of the Sexy Pretenders. A growth mindset is the awareness that painful challenges are inevitable in the journey and approaching them as a process with purposeful engagement to get better in developing one’s ability and character, rather than avoiding challenges and failure to maintain the sense of being smart or skilled. Entrepreneurs with a growth mindset understand the success is not an event-based victory based on a peak point, a punctuated moment in time, like concluding a M&A deal. Success is not merely a commitment to a goal, but to a curved-line, constant pursuit. Value investors will do well to understand the story of how entrepreneurs approach and overcome challenges that come from acquisitions or growing in-house its technological know-how.

For instance, when MSS made its breakthrough acquisition in Visiocorp, the world’s largest mirror-making company with its manufacturing facilities largely in Germany, for $21m at the height of the financial crisis, turning around the firm appeared to be an impossible task and the firm was bleeding cash with sales falling off the cliff. It is to be noted that in Germany, if a business runs out of cash, the chief executive is held liable and can even be jailed. At that rather tumultuous stage, Sehgal took a decision that shocked many within the company. He decided to name the then 27-year-old son Vaaman as chief executive. “Of course we would never have allowed him to go to jail but that was the best training I could give him,” says Sehgal. “We saw things going from bad to worse,” recalls Vaaman. “First the lunch stopped, then the tea stopped and then the toilets stopped being cleaned.” For the next four years, Vaaman was put through the fire. He toured Visiocorp’s (since renamed Samvardhana Motherson Reflectec) facilities relentlessly and worked on making processes more efficient. He learnt German. He also made personal calls to his customers – Volkswagen, Audi and Porsche among others- so that orders started flowing in once automobile sales resumed. Within a year, Visiocorp was making a profit and today, it accounts for $1.3nn in sales for MSS. More importantly, with this acquisition, MSS had gained global scale, global customers and global ambition. Overall, between 2002 and 2015, MSS has made 15 acquisitions and compounded market value by over 300X to nearly $7bn.

At the heart of what makes the “growth mindset” so winsome, Dweck found, is that it creates a passion for learning rather than a hunger for approval. Its hallmark is the conviction that human qualities like intelligence and creativity, and even relational capacities like love and friendship, can be cultivated through effort and deliberate practice. Not only are people with this mindset not discouraged by failure, but they don’t actually see themselves as failing in those situations — they see themselves as learning. The growth mindset leads people to more deeply engage with the limits of their skills and emotions at a particular time. We thrive, in part, when we have Purpose, when we still have more to do. Value investors will do well to sense that forward thrust, a reason and Purpose to continue making work, in order to distinguish between the Sexy Pretender opportunistically engaging in short-term financial engineering schemes that usually unwind into eventual impairment losses and the authentic Swadeshi Innovator.

Mindsets

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

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/

This month of August, we highlight a listed Asian company who is the #1 functional beverage drinks company in its country with around 40% domestic market share by value and the leading functional coffee powder brand in terms of volume (#2 by value). The company is one of few Southeast Asian consumer firms who enjoy success outside of their domestic market, with overseas exports to over 60 countries contributing over 60% of total sales. The company is still in the early growth stage of deepening its channels in the overseas markets with functional beverage as the fastest growing category driving the growth of the global $200 billion nutraceuticals industry. Nutraceuticals is expected to play a central role in the frontline of the battle for consumer health with the rise in lifestyle diseases and consumers are increasingly making health-conscious choices from cutting down on carbonated soft drinks to switching to natural, organic diet.

Gross margin has expanded from 30.3% in 2012 to 39.5% in 2014 with improving production efficiencies and rising higher-margin export sales. EBITDA and EBIT margins stand at 19.8% and 16.6% to generate ROE of 22.8%. The company’s high-capex era has stabilized and will enter into a bigger free cashflow and net cash position going forward. Interest-bearing debt-to-equity has dropped from 1-1.2x in 2012-13 to zero debt and net cash in 2014, with the latest net cash to book equity position at 21.7% in 1Q15, giving it a stronger position to make bolt-on acquisitions of niche nutraceutical companies, including expanding into the functional food category to strengthen its robust portfolio of functional beverage brands. The company trades at historical EV/EBIT 15.9x and EV/EBITDA 13.3x.

Warren Buffett, “The Value Investing Carpenter” and the Adapting the Greatest Investing Strategies of All in Asia – 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 | August 10, 2015
Bamboo Innovator Insight (Issue 95)

  • 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,

Warren Buffett, “The Value Investing Carpenter” and the Adapting the Greatest Investing Strategies of All in Asia

Would you use cheap wood for the back of a cabinet, since nobody is going to see it?

A great carpenter won’t. Steve Jobs and Warren Buffett won’t.

Steve Jobs shared the story of how he was inspired by his dad who taught the young Jobs that it was important to craft the back of cabinets and fences properly, even though they were hidden. “He loved doing things right. He even cared about the look of the parts you couldn’t see,” Jobs explained, a motto that has guided him to build Apple with a craftsmanship drive and “process” to make “insanely great” creations that customers love to use and that will “put a dent in the universe”.

In his inspiring book “The Carpenter: A Story About the Greatest Success Strategies of All”, Jon Gordon explained that a carpenter builds things; a great carpenter creates a work of art like a craftsman. While most people approach their work with the mindset that they just want to get it done, craftsmen are more concerned with who they are becoming and what they are creating rather than how fast they finish it. After all, it’s no use finishing something if it’s not a work of art. Craftsmen would pour their hearts and souls and Love into everything they build, knowing that all that they create is a reflection of themselves. When they create art, they feel energized, and they energize all those who experience their work. And with each creation, they become more of the person they were meant to be.

Warren Buffett’s greatest investing strategy of all is having an eye for these “great carpenters”. These great carpenters take the form of outstanding entrepreneurs who put their Love into the work they do. Love isn’t just a feeling. It is a commitment and ongoing action. Choosing to love meant you were choosing to make a commitment that you will love regardless of how you feel and you will put love into action regardless of your circumstances.

Like Nebraska Furniture Mart’s Mrs. B, whose work ethics was phenomenal: “I come home to eat and sleep, and that’s about it. I can’t wait until it gets daylight so I can get back to the business.” She was on the floor until retiring at 103, and died the following year in 1998. She was committed in serving her customers with dedication. Because we Love, we Serve. And when we serve others, we fill up their cup with love and our own as well. As Buffett explained, “One question I always ask myself in appraising a business is… [to identify the] business built upon delivering exceptional value to the customer that in turn translates into exceptional economies for its owners”. Buffett elaborated further that everyone should study Mrs. B: “They would learn the essence of business. They would learn that taking care of customers is what it is all about. Taking care of them… She did and working like crazy she was there day after day. She had a passion for it.” Buffett summed up his value investing philosophy: “When we buy businesses, we are looking for people that will not lose an ounce of passion for the business even after their business is sold.” In essence, Buffett goes beyond the numbers to identify wide-moat innovators by also sensing that an entrepreneur takes care of his or her customers in a deep way and keep delivering exceptional value to them. Even if it means pains and sacrifices. Even if it takes a long time, working crazy day-in-day-out. Even if they grow rich. All possible only because they are committed to an idea larger than themselves to serve others.

When you love and serve, you care about the work you do and show people you care about them, you stand out in a world where most don’t care. The world will flock to people who care and buy products that were made with care and support businesses that care. We can tell whether the person making the products or services cared enough to make it great. When we care, we build things that others care about. When we care, we are craftsmen and craftswomen who are always looking to get better, work harder, and care more.

Who are the businesses that understood the power of caring? Some of these include:

  • The company that provides free shipping and free returns to customers – Amazon (AMZN)
  • The airline that cares about their employees and customers so much that LUV is their stock symbol – Southwest Airlines (LUV)
  • The restaurant that go out of their way to cater to people with food allergies – Chipotle Mexican Grill (CMG)
  • The auto parts and repairs shop who cares about solving the primary problem for customers in parts availability and helps the 4,000 stores keep few inventory and tie up less working capital, so that they have greater agility to respond to and focus on servicing customers’ needs such as fast availability of hard-to-find parts which can be delivered quickly from their system of 23 distribution centers (DCs). Each DC keep 120,000 SKUs (twice the industry average) and yet increasing far higher inventory turn while fulfilling customer requests all the time. Each store inventory is also modeled to match the specific market and customer demographic – O’Reilly Automotive (ORLY)
  • The metal casting compounder that cares about forging unique hands-on relationships with its customers to help improve not only the finished product, but also the engineering process that goes into developing these complex parts for critical applications such as aircraft components. As a result, the dollar content per commercial aircraft platform has grown tremendously. When they turned into short-term opportunistic acquirers of businesses that had very little, if any, contact with the end users of their products, which were primarily sold through distributors and the products themselves were a collection of components brought together from outside sources, then assembled and tested prior to shipment, the problems caught up later on. The company’s share price plunged 60% from the middle of 1998 till end 1999 while the S&P 500 index was up 30% over the same period. The company learnt painfully that selling through distributors does not build close interface relationships with the customers to win critical engineering insights to develop high value-added components that can be bundled into a solution to command pricing power and high “switching cost” – Precision Castparts (PCP), potentially the largest acquisition that Berkshire Hathaway will make in the latest news announcement on 9 Aug in which Berkshire could potentially utilize half of its $60bn cash holdings, dwarfing Buffett’s purchase of 31 bolt-on acquisitions in 2014 for a total of $7.8bn
  • The logistics company that gives the white-glove treatment to their customers such as long-haul truckers whether the shipment is cans of tomatoes or cases of machine parts because it cares about how each container contain promises: “A promise that manufacturers will get what they need to produce their product. A promise that retailers will receive the product by a certain date and have it on the shelves. And ultimately, it’s a promise that consumers will be able to buy that product easily, whenever they need it.” The company operates in the tough LTL (less-than-load) niche with a hub-and-spoke system with 219 shipping centers to do both long-haul loads and short distances and serve over 48,000 direct points in US and Canada. It keeps its focus on employees, giving workers the tools and the time to fit boxes precisely, cushioning them with inflated brown paper pillows. As forklifts pull up with pallets, operators tap their touch screens to enter each step into a mainframe computer. Over time, that information, entered by every person touching a shipment, builds a database that top managers can use to shape the company’s entire system – Old Dominion Freight Line (ODFL)

When you don’t care – whether it is using cheap wood for the back of a cabinet, taking shortcuts, or focusing on opportunistic short-term financial engineering schemes or accounting tunneling manipulations that usually unwind into eventual impairment losses – people can tell.

Un-caring can be manifested in “smaller” simple ways, such as BreadTalk (BREAD SP, MV $271m), Singapore’s largest 46-outlet bakery chain who was under fire by being recently discovered last week for using Yeo’s pre-packaged soya bean milk, labeling the third-party vendor’s soya bean milk as their own branded bottle of “freshly-prepared” soya milk for a number of years. BreadTalk sold the 350ml bottles for a special promotional price of S$1.80 each (its normal selling price is S$3) while Yeo’s soya bean milk is sold at S$1.50 for a one-litre carton.

Usually, when a company engages in financial engineering deals, it could easily forget or be distracted from its original Purpose in Serving and Caring at the day-to-day ground level. Before the recent scandal, Breadtalk had made a joint venture investment to develop Beijing plots in Apr 2013, following up from an investment in various property projects managed by a Singapore retail property trust in Jan 2014, Nov 2011 and Jan 2010. Interestingly, if the sum of capital is allocated to strategic investments in bakery-related wide moat companies since Jan 2010, Breadtalk would have gained handsomely in not only capital gains but more importantly, an opportunity to seek long-term cooperation leveraging off its core competencies. These “could-have” capital allocation include: bakery-café compounder Panera Bread (PNRA) which tripled in value; Japan’s Yamazaki Baking (2212 JP), up over 90%; Taiwan’s bakery equipment specialist Sinmag Equipment (1580 TT), up over 230%; Indonesia’s Nippon Indosari (ROTI IJ), up over 320%; Korea’s Samlip General Food (005610 KS), the listed company supplying to its Paris Baguette bakery chains, up over a staggering 3,800%.

Or un-caring can take the form of bigger complex schemes, such as a Chinese healthcare services firm doing a financial engineering job in soliciting a $966m non-binding bid on 6 Aug 2015 from a Chinese departmental store whose book equity is $219m (tangible book equity is a negative $593m!) and is pummeled by recently reported interim losses while carrying over $950m in interest-bearing debt (excluding undisclosed off-balance sheet debt and a sudden suspicious jump in “other current liabilities” from $40m in FY04 to $207.5m in 1Q15) – and the market value of the Chinese healthcare services firm is around $460m before the “bid”. Share price spiked up after the non-binding bid announcement, saving the day for the insiders who have likely pledged their shares and thus escaping margin calls on the pledged shares. Much of the Chinese healthcare services firm’s supposed cash & cash equivalents held in the balance sheet are raised from $243m in external funds; its cash outflow on “investing activities”, including related-party transactions, amount to $130m, corresponding to the increase in “unearned revenue”, raising the reasonable doubt on the possibility of the cash outflow re-routed back to the firm as “cash equivalents” while generating artificial sales. It is to be noted that the sum of external funds raised and the cash outflow in investments approximates the total cash and cash equivalents. The Chinese healthcare services firm also has inconsistent patterns between its non-financial measure and financial measures, an empirical tool to detect firms with high fraud risk.

In the course of highlighting our monthly Moat Report Asia ideas over the past two years, we have focused on a two-step process to identify wide-moat compounders in the Asian capital jungles:

  • Step 1 in eliminating firms with potential accounting fraud and misgovernance risks, taking away the fear factor of investing in fraudulent stocks with deceptive visual signals that include low price-to-book, low PE ratios, high profit margins and ROE, decent accounts receivables and inventory turnover period, and high net cash as percentage of market cap.
  • Step 2 in analyzing and assessing the business model for its resiliency, innovations and wide-moat characteristics to eliminate the risk of investing in value traps.

We realize that the wide-moat companies in which we have thought deeper about a Step 3 – the story and validated committed actions of how they Love, Serve, and Care with a Purpose larger than themselves – tend to perform better.

Who are the Asian businesses that undertake the committed action to illuminate the power of caring? We highlight some of them below:

Consider Major Cineplex (SET: MAJOR) that we highlight in Sep 2013 and is up about 80% while the SET index is flat over the same period; Major was also down >15% along with the SET index in 4Q13. Major is Thailand’s dominant cinema chain operator with a 80% domestic market share, a “spider-web” lifestyle entertainment business model attracting 25-30m Thai consumers to its “destination to be”. Major’s CEO Vicha Poolvaraluck shared how he cares deeply about the consumer experience, using creativity to fight foreign competition which dominated the local cinema industry. Vicha elaborated that he made “all theatres different, more colourful and invested in interior decoration. Thais are people who are eager to see and experience something new and exciting all the time. In the West, many theatres may use the same style of carpet for three or more years without any renovation. But I cannot do that with my cinema here. If people get bored with the atmosphere of the place, they can instead stay at home and watch a DVD. We have to always make everything fresh [design and concept of the cinema] to draw them go out of home.” Vicha demonstrated his love and care to serve his customers in the committed action to take photos of nice places during his travel trips and send them to his marketing and engineering team to see the possibility of adapting the décor, carpet, toilet, unique objects, welcome drinks, and the services in the cinema.

Major

Consider PChome Online (GreTai: 8044 TT) that we highlight in Aug 2014 and is up around 51% while the TWSE index is down 8% over the same period. PChome is the largest ecommerce group in Taiwan and has complete platform coverage in the Amazon-type of B2C ecommerce of selling directly to end consumers (PChome), Rakuten-type of B2B2C platform (PChomeStore) to support the online SME merchants who in turn sell to the end consumers, and the eBay-type of C2C auction site (Ruten) where individuals buy and sell to one another. PChome’s founder and chairman Jan Hung-tse shared how he describes the obstacles to ecommerce transactions as ‘friction’, and how he care deeply to commit to building a business model that can deliver within 24 hours. Jan showed great foresight in understanding the needs of the consumer in forging the Purpose, the Why:

“First, the why. We can have an asset-light business model and it’s about managing information flow more efficiently and more complete. A body as light as a swallow. I can have online orders from the customers. Then I will go to the suppliers to purchase the goods to deliver to the customers. However, I am now a customer myself and I am dependent on the efficiency of the suppliers. The goods that I ordered from the suppliers may come one day later, two days, three days, maybe not at all. Once I received the goods, I will deliver them to the customer. Another one day, two days, or three days. The key question for the customer is this: How am I going to arrange my life? If I am flying off to Shanghai the day after, and I want to buy one more memory storage card for my digital camera. Do I spend time to go out to buy or do I make the purchase online? If I know that the purchased goods will come the next day, it will be just in time for my flight to Shanghai and I can utilize my time better. The biggest problem is that there is uncertainty in the delivery time. It can arrive tomorrow, the day after, or even longer. If we can have a business model that can deliver within 24 hours, then we have solved the major problem of the customer and provide the maximum benefit of ecommerce: as an enabler to help arrange his or her life better.”

Jan elaborated: “I resolve to take on the Life’s Task to reduce this ‘friction’. I decided to build our own warehouse inventory management and logistics system. Taking on this challenge to sharpen the sword to reduce the friction has taken nearly 10 years. We have reduced the time to delivery from three days to 24 hours.” PChome reap the returns from serving the consumer with love and care: “Through 24-hours delivery, 7 days no-conditions returns policy and various other measures, including the cost of goods returned is borne by PChome and a penalty fee of TWD 100 shopping voucher for late deliveries and free delivery for purchases above TWD 490 ($16.3), we erase the doubts and concerns of consumers. As a result, during the initial launch of the 24h, the average daily transaction value of each customer is around TWD 500 per customer. One year later, it jumped nearly 10-fold to TWD 4,900.”

PChome

Consider Paiho (TSE: 9938 TT) that we highlight in Mar 2014 and is up 75%  while the TWSE index is flat during the same period. Paiho is the world’s largest touch fastener tape maker (1.3m km/yr, >10% market share) with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, inc Nike, Adidas, Reebok, Sketchers, UnderArmor are customers and Paiho has forged long-term “spec-in” partnerships with them. Paiho’s founder and chairman Vergil Cheng shared the insight how he care about the customer and fostering innovation among his employees:

“Paiho is one of the rare few Taiwan and even Asian shoe materials company with proven R&D capabilities and is involved in the design stage with the client before the new product is launched. Our “spec-in” long-term partnerships with all the top 20 athletic sports shoe companies develop new materials/designs and provide better and patented solutions to avoid price competition and maintain stable margin. We send 8,000 pieces of sample products to our clients for them to do their trial tests. Only by doing co-R&D work with the world’s best brands and growing together with them can we provide the best customer service and solution, to master and even lead the industry trend. Our comprehensive product range is also protected by over 110 patents. Some of these patented innovations include our water-resistant tape fastener which can maintain its ‘stickiness’ in the water and is designed for water sports activities. The importance of R&D cannot be emphasized enough; it’s akin to helping the engineers and developers to‘carry books’. At Paiho, all business unit managers and supervisors and above are automatically listed as a R&D personnel and can present their idea proposal.”

Paiho

Consider Kajaria Ceramics (NSE: KARARIACER) that we highlight in Dec 2014 and is up around 28%  while the Nifty index is up around 3% during the same period. Kajaria is the #1 ceramic tiles company in India with a 20% market share in the organized segment of the tiles industry. The company has been able to successfully create a ‘pull’ for its products and currently enjoys the highest brand equity in the industry in quality, innovation, availability. Kajaria is backed by sound management credibility, comprehensive product range, superior design capability, high brand recall, loyal and widespread dealer network, strong marketing capabilities, business policies, giving it a distinct competitive edge over its peers. It has been conferred the ‘Superbrand’ status for consecutive years since 2004, giving Kajaria a price premium and pricing power advantage. Kajaria’s founder Ashok Kajaria pioneered large-format wall tile segment when everyone is selling cheap small-format tiles as he believed in delivering “Tiles that touch your soul” at a value-for-money price point, rather than compete on price and giving consumers a quality they do not deserve. Kajaria care deeply about delivering Aspiration, Affordability, Availability to the Indian consumer, giving them “a house we can be proud of’ and giving them flooring that stamps the character of our home”. As a result, Kajaria “created a brand that would trigger a consumer pull. Over the last 25 years, the biggest transformation at Kajaria is that what started out as a tile manufacturing company is now an aesthetics-led organization.”

Kajaria

To summarize, we realize that we sometimes commit the mistake in trying to fit what we see and learn about the competitiveness of the firm into the “model” of wide-moat characteristics such as “high switching cost”, “network effect”, “low cost advantage”, “efficient scale”, “intangible assets”. This descriptive approach into fitting observations into the model is categorization through analogy – and its #1 flaw is stocks are categorized into moats AFTER they are obvious. Until we go the distance and extra mile in Step 3, the story and validated committed actions of how they Love, Serve, and Care with a Purpose larger than themselves, we could fall into the dangerous trap of overpaying for the moat even if the valuation metrics appear cheaper with seemingly lower downside risks. The table below sums up the need for value investors to delve deeper into the DNA of a Carpenter-Craftsman to understand the origin and source of the wide-moat before it becomes obvious.

Table of Bamboo Innovators

********

Sacrifice is needed for not using cheap wood for the back of the cabinet: The wood was more expensive; the work required more energy, focus, and effort; the process was filled with more sweat and failure; and the years and tears it took to master the craft were greater. Everyone can be a craftsman but not everyone is willing to become one. Too many people want five minutes of fame but they don’t want to spend the thousands of hours it takes to master their craft.

You show up every day. You do the work. You see yourself as an artist dedicated to your craft with a desire to get better every day. You put your heart and soul into your work as you strive for excellence. You desire to create perfection, knowing you’ll never truly achieve it but hoping to get closer to it. You try new things. You fail. You improve. You grow. You face countless challenges and tons of rejection that makes you doubt yourself and cause you to want to quit. But you don’t. You keep working hard, stay positive, and preserver though it all with resilience, determination, and a lot of hope and faith. Then you make it! Everyone wants to work with you. And the world says, ‘Where have you been?’ And you say, ‘I’ve been here all along, and hopefully getting better day by day.’ To the world, you are an overnight success. To you, the journey continues. You’re a craftsman who wants to make your next work of art your best work no matter what you have been accomplished in the past.

You cannot be a craftsman unless you are putting your love into the work you do. After all, if aren’t building it with love it won’t be worth building. As an artist you must be driven by love. Only then will you create something special, magnificent, and compelling. Only through love will you create a masterpiece.

It is also essential to have the right attitude and approach to your life and work. Think of the craftsman beginning a new work. The craftsman is not thinking about failure. The craftsman is only thinking about building his work with love. Because he loves his work so much and creates with love, fear loses its power over the craftsman. And this allows him to do his best work and create with all the love in the universe. In every moment will you choose fear or love? Choose love and:

Love the struggles because it makes you appreciate your accomplishments.

Love challenges because they make you stronger.

Love those who have hurt you because they teach you forgiveness.

Love fear because it makes you more courageous.

Failure serves as a defining moment, a crossroads on the journey of your life. It gives you a test designed to measure your courage, your perseverance, commitment and dedication. Are you a pretender who gives up after adversity or a contender who keeps getting up after getting knocked down? Failure provides you with a great opportunity to decide how much you really want something. Will you give up? Or will you dig deeper, commit more, work harder, learn and get better?

Yes, we will have moments when the last thing you want to do is to love, serve, and care. Loving others is the last thing on our mind when we are stressed. There will be days you don’t want to get out of bed. It is during these times that you need to remember your purpose. The love of what you are building has to be greater than the challenges you face. When you know your why, you will know the how, and you’ll find a way. Your purpose will inspire you to love those you find hard to love, serve when you don’t feel like serving, and care more when you don’t feel very caring. Do everything with gratitude and love. It’s much more powerful this way. And the more you are thankful, the more you will have things to be thankful for.

We have, and will, never forget our original motivation and Purpose to do up the Moat Report Asia in highlighting the overlooked, neglected, misunderstood, underappreciated and undervalued wide-moat Bamboo Innovators in the Asian capital jungle to serve value investors and the public, “to explain, exhort, encourage, inform, educate, advise”, in the spirit of the timeless wise words of the late Dr Goh Keng Swee, one of the founders and chief economic architect of modern Singapore.

Every year on August 9, Singapore celebrates our National Day commemorating our independence in 1965. This year is a special one as Singapore crosses the mark of 50th year. Singapore had the winning founding team of Lee Kuan Yew as the indomitable political visionary, Goh Keng Swee as the economic and financial architect, and Hon Sui Sen as the builder and administrator par excellence. National Day is a time to remind ourselves to remember how our founders and forefathers Serve and Care in crafting Singapore to be a special Home filled with Love and the right values.

Five years ago, we wrote a trilogy series about Berkshire Hathaway and Singapore. We like to share them with you in this Singapore’s National Day special. Happy National Day to all!..

Part 1: The power of vision

The success of Berkshire Hathaway and Singapore can be traced to their visionary leaders who work with winning teams

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/LHZB_20100809_2.pdf

Part 2: Lion Infrastructure and value investing

Both of them are an ongoing team process that demands sacrifice, hard work and soberness to scale new heights

http://www.businesstimes.com.sg/?dlink=/sub/views/story/0,4574,389848,00.html

Part 3: Lion Infrastructure is the way to go

To reach a US$2 trillion GDP in 2065, Singapore must create and build commercial assets with a special quality

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/BT_20101230_1.pdf

The Trilogy in One Document:

http://www.slideshare.net/KeeKoonBoon/lion-trilogy-lion-entrepreneurs-and-lion-infrastructure-media-articles

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

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/

This month of August, we highlight a listed Asian company who is the #1 functional beverage drinks company in its country with around 40% domestic market share by value and the leading functional coffee powder brand in terms of volume (#2 by value). The company is one of few Southeast Asian consumer firms who enjoy success outside of their domestic market, with overseas exports to over 60 countries contributing over 60% of total sales. The company is still in the early growth stage of deepening its channels in the overseas markets with functional beverage as the fastest growing category driving the growth of the global $200 billion nutraceuticals industry. Nutraceuticals is expected to play a central role in the frontline of the battle for consumer health with the rise in lifestyle diseases and consumers are increasingly making health-conscious choices from cutting down on carbonated soft drinks to switching to natural, organic diet.

Gross margin has expanded from 30.3% in 2012 to 39.5% in 2014 with improving production efficiencies and rising higher-margin export sales. EBITDA and EBIT margins stand at 19.8% and 16.6% to generate ROE of 22.8%. The company’s high-capex era has stabilized and will enter into a bigger free cashflow and net cash position going forward. Interest-bearing debt-to-equity has dropped from 1-1.2x in 2012-13 to zero debt and net cash in 2014, with the latest net cash to book equity position at 21.7% in 1Q15, giving it a stronger position to make bolt-on acquisitions of niche nutraceutical companies, including expanding into the functional food category to strengthen its robust portfolio of functional beverage brands. The company trades at historical EV/EBIT 15.9x and EV/EBITDA 13.3x.

Conquering Inner Fear to Build Asia ex-Japan’s Largest Listed Pure-Play Functional Beverage Company – 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 | August 3, 2015
Bamboo Innovator Insight (Issue 94)

  • 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?

Conquering Inner Fear to Build Asia ex-Japan’s Largest Listed Pure-Play Functional Beverage Company

“The doctor of the future will give no medicine, but will interest his patients in the care of the human frame, in a proper diet, and in the cause and prevention of disease.”

When the prescient Thomas Edison said this in 1902, perhaps even he could not have foreseen the enormous growth of the nutraceuticals to become a thriving market that is worth around $200 billion since the word “nutraceutical” was coined in 1989.

Nutraceuticals is expected to play a central role in the frontline of the battle for consumer health with the rise in lifestyle diseases and consumers are increasingly making health-conscious choices from cutting down on carbonated soft drinks to switching to natural, organic diet. This “Take Care of Yourself” global trend of the modern era has sparked dizzying M&A action from Coca Cola acquiring non-carbonated niche innovators from Honest Tea to Fuze vitamin-enriched juice and Zico coconut water to Japan’s Suntory acquiring the iconic nutritional drinks brand Lucozade and Ribena from GSK and Nestle taking over Novartis health science business.

In Asia, second-generation leader Mr. R demonstrated foresight and courage in transforming his family business of traditional cookies into a modern consumer enterprise that pioneered the market trend of functional health beverages and functional coffee powder, the fastest growing category driving nutraceuticals growth, in his domestic market where [Company’s name] is the #1 leader with around 40% market share. [Company’s name] is now Asia ex-Japan’s largest and most valuable listed pure-play functional beverage outside of the energy drinks category, and is also one of the few Southeast Asian consumer firms who carved success outside of its domestic market, with overseas exports to over 60 countries contributing over 60% of total sales, and it is still in the early growth stage of deepening its channels in the overseas markets.

Like the misunderstood Edison who was not brilliant in his academic studies (Edison’s teacher mocked him as “addled”) but discovered his talents as an entrepreneur, Mr. R never thought he would have to return to his family business: “I was not outstanding in my academic studies and I am fearful that the family business will be ruined in my hands.”

Courage

When Mr. R was pursing his post-graduate education in Japan, he was amazed and inspired by the variety of beverages available in the market. The period in Japan broadened his horizon “in terms of learning how this most creative of nations can incorporate the use of high technology into little goodies in our everyday life with regular foods and beverages. Once I saw the opportunity, I collected products and drink tastes such as green tea and juices mixed with different kind of ingredients.”

Nelson Mandela illuminated the wisdom that “courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear.” Mr. R overcame his fear and began the transformative journey since 2001 to master the know-how in nutritional science and solving the problems in R&D and production to continuously launch innovative new products that are also not only tasty and delicious, but also exciting for the consumers to embrace with its creative marketing, staying ahead of the competitive curve to take market leadership.

Despite its #1 domestic market leadership and rising global sales, sceptical views abound on the longevity of the functional beverage trend and products. Read the except to Mr. R’s story to continue to grow [Company’s name] as a lasting brand and business and how he consciously forge a collaborative corporate culture to create creative workers who enjoy their work.

Q: “There is the concern that [Company’s name]’s functional beverage is a faddish trend. And the competition is increasing with new entrants attracted by the higher profit margins and they have bigger marketing budgets and have more resources. What is your plan to continue to grow [Company’s name] as a lasting brand and business?”

Mr R: “By focusing on the needs of the consumer, we will not become a faddish trend… Functional beverages is still a long-term global trend as consumers continue to worry about their health and focus on bettering their lives. Because consumer behavior is focused on health, consumers are ready to spend money to buy products that are innovative. Take care of yourself is the trend of the modern era.. The product has to be an innovative solution to the consumers, otherwise it would have no meaning and is just another something that’s new. We must take advantage of innovation combined with delivering a solution for the consumer.. For urban dwellers, they are people with time limitations who wish to take care of themselves. They can do so conveniently and comfortably and conveniently with [Company’s brand] functional drinks.

Our innovative products are aimed at creating a unique experience to meet the demands of those in the market who want something different. Our creativity can be seen through our many products that have served as pioneers in their own category. Our communication to consumers is simple: give them some opportunities. We aim to become one of the best organizations.. that cater to on-the-go health conscious consumers. We knew we had a long way to go before we could be a recognized brand so we focused on every single detail in production. We wanted all our products to be known for their quality, knowing that quality will market itself. For us, in order to produce a quality product, we must place the most importance on the quality of raw materials and ingredients. We are very meticulous about the materials and ingredients we use..

I hold the conviction that there must be a different and new idea to innovate to create value. I do not want to create a product to compete with rivals already on the market. Because of this unique difference, we will define the market and determine the market price. We have to create people to be creative. That can only be possible when there is an enjoyment in what you do, to love in the creation of thinking of something new all the time whether it is a new product development or new product management, including marketing campaign. It is important to be a company’s thinker rather than focusing solely on product sales.

One of the ideas and philosophy is that I want everyone to have fun at work. The physical and emotional health of all people working happily and enjoy their work. Because everyone is key to drive the organization to success. If everyone works happily and enjoy what they do, we can work out good targets without emphasizing the targets. Our employees continue to learn and hone their expertise in areas of product, research, logistics, and add value to the brand in order to constantly improve the variety of products offered. Our relaxed working atmosphere has molded a company culture that is happy and fun for our employees. We believe that if our employees enjoy their work then they will be able to excel, allowing us to move our company forward together.

We will never stop thinking. To developing something new. To allow consumers to have a better life. To capture the most profitable consumers to be loyal fans. The first priority is the interest of the consumers. To develop quality products consistently that meet their interest. To forge a corporate culture that improve the quality of life of our employees. To enjoy creating creative new products continuously. To be proud of delighting consumers while contributing to the society. To refresh [Company’s brand name] constantly. Combine these things and it connects us to success and sustainability.”

In terms of margins and profitability at EBITDA 19.8% and EBIT margin 16.6%, [Company’s name] is comparable to Carabao (SET: CBG), a pure-play functional beverage maker in energy drinks with 22% market share in Thailand, behind unlisted leader Osotspa who controls around 54% of the market and also competes with Red Bull/ Krating Daeng. [Company’s name] generates higher ROE at 22.8% as compared to Carabao’s 12.9%. [Company’s name] also has a more promising overseas growth potential with its unique products and exports contribute to over 60% of sales as compared to <20% for Carabao whose overseas sales have lower profit margin than its domestic sales. Yet, [Company’s name] trades at a 70% valuation discount in terms of Price/Sales, EV/EBIT (FY04: 15.9x) and EV/EBITDA (FY04: 13.3x) as compared to Carabao. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in the domestic market and strong portfolio of unique innovative functional beverage brands with excellent export growth prospects.

Gross margin has expanded from 30.3% in 2012 to 39.5% in 2014 from improving production efficiencies and rising higher-margin export sales. For instance, its innovative functional fruit juice beverage sells at EUR 3 per bottle in Europe as compared to EUR 0.34 in its home market. Its high-capex era has stabilized and [Company’s name] will enter into a bigger free cashflow and net cash position going forward. Interest-bearing debt-to-equity has dropped from 1-1.2x in 2012-13 to zero debt and net cash in 2014, with the latest net cash to book equity position at 21.7% in 1Q15, giving it a stronger position to make bolt-on acquisitions of niche nutraceutical companies, including expanding into the functional food category to strengthen its robust portfolio of functional beverage brands. Sales has risen 56% in the past three years while EBIT and EBITDA soared 378% and 276% respectively. We believe [Company’s name] can build on the momentum to double its profits in the next 3 years, pointing towards a doubling in market value.

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

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/

Being Strong and Resilient in a World Where Things Go Wrong: The Case of Mahindra & Mahindra, a Different Sort of “India’s Berkshire Hathaway” – 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 | July 27, 2015
Bamboo Innovator Insight (Issue 93)

  • 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,

Being Strong and Resilient in a World Where Things Go Wrong: The Case of Mahindra & Mahindra, a Different Sort of “India’s Berkshire Hathaway”

“Deere John, I have found someone new.”

Deere JohnThis was the caption in a billboard ad featuring a blonde, pony-tailed American woman driving a little red tractor that was produced and sold by an Asian wide-moat innovator. The ad, done so with a humor designed to appeal to Americans,  was a tongue-in-check in response to Deere & Company (NYSE: DE, MV $30.8bn), the largest farm equipment manufacturer in the world, who promised a seemingly short-lived and desperate $1,500 cash rebate to any American farmer who traded in this Asian tractor for a John Deere. Only a handful responded to the offer. And the offer had the unintended effect of further promoting this Asian brand, who had overtaken Deere, New Holland (NYSE: CNHI, MV $12.4bn), AGCO (NYSE: AGCO, MV $4.6bn) and Japan’s Kubota (TSE: 6236 JP, MV $20.7bn) to become the largest tractor maker in the world by sales volume, selling about 234,000 tractors.

Would Buffett’s decision to invest in Deere change if he had known about the story of the Asian wide-moat innovator behind this ad? Buffett had disclosed in March 2015 that he had built up in 2014 a 5% ownership in Deere, which has paid steady or increasing dividends since 1987, giving it a streak of 28 consecutive years without a dividend reduction. Since this 2007 ad and losing the #1 title, Deere is up around 10%, underperforming the 40% rise in the S&P 500 index.

Mahindra & Mahindra (NSI: M&M) Stock Price Performance 1994-2015 Vs Nifty index and Deere

M&M

This Asian innovator is Mahindra & Mahindra (NSE: M&M, MV $12.9bn) who recently acquired a 33% stake in Mitsubishi Agricultural Machinery, a subsidiary of Mitsubishi Heavy Industries (TSE: 7011 JP, MV $19bn), for about $25m in May 2015. The popularity of M&M’s tractors stemmed from producing sturdy low-powered tractors (under-70 horsepower) suited for fragmented landholdings in India and China. M&M realized that there is an underserved market in the United States to which its low-powered tractor is well-suited: hobby farming. Baby boomers are retiring from stressful urban lives in California to places like Arizona where for the price of a luxury condo in San Francisco, they can buy over 15 acres of land, ideally suited to tilting by hobby farmers and suburban lawn masters who don’t need a monster tractor and like M&M’s reliability. Many of M&M’s customers in the United States are women, hence the “Deere John” ad.

Flying under the radar of Deere when it first entered US, M&M built close relationships with small dealerships, particularly family-run operations. Rather than saddle dealers with expensive inventory, M&M allowed them to run on a just-in-time basis, offering to deliver a tractor within 24 to 48 hours of receiving the order. M&M also facilitated financing. In return, Mahindra benefited from the trust the dealers enjoyed in their communities. M&M also built close relationships with customers. Some 10 to 15% of M&M tractor buyers got phone calls from the company’s president, who asked whether they were pleased with the buying experience and their new tractors. M&M also offered special incentives such as horticultural scholarships to neglected market segments such as female hobby farmers. Following the example of Hyundai Motor (KOSPI: 005380), which used especially long product warranties to gain acceptance in the American auto market, Mahindra offers a five-year warranty on its tractors in the US, compared with the standard two years offered by Deere. M&M has also rolled out a military appreciation program providing U.S. and Canadian veterans and their families with $250 rebates, with its website stating: “We appreciate your service and commitment to our country and would like to show our support.”

Anand“I call America our emerging market; they find it very amusing when I said that. Our goal was to say we are second to none in technology. We don’t want to be value for money tractor that is beating out John Deere and all. This product has incorporated auto technology in the tractor. If you look at electronics, suspension, ergonomics. The state-of-the-art knowledge of R&D we had in auto has come in to our tractors,” commented Anand Mahindra, the chief architect of the M&M Group, who describes his country’s malaise using the metaphor of “Star Wars”. Graft and cronyism in India are like an evil Empire that has struck back. His hope is that young Indians become Jedi knights to battle the Dark Side. Anand Mahindra has kept M&M away from industries that require “a competence for lobbying”, and he says he avoids Delhi, India’s capital, like the plague.

M&M was founded as a steel trading company in 1945 by K.C. Mahindra, J.C. Mahindra and Ghulam Mohammed, under the name Mahindra & Mohammed. Mohammed in 1947 migrated to Pakistan to become its first finance minister. M&M entered automotive manufacturing in 1947 to bring the iconic Willys Jeep on to Indian roads. Besides holding the #1 title for tractors, M&M is also the #1 SUV maker in India. Now, M&M is present across the entire automotive spectrum – two-wheelers, commercial vehicles, SUVs and sedans. Whether it is tractor or SUV or two-wheelers, the M&M brand is defined not by horsepower or engines, but instead by the fact that it stands for ruggedness, few frills, no-nonsense performance and an honest price tag. “M&M psychographically is about safe, strong, powerful, rugged vehicles, irrespective of the segments.”

Today, M&M is a diversified conglomerate who employs over 180,000 people around the world and operates in industries such as automobiles, defence, aerospace, information technology and BPOs, financial services, hospitality and retail; the automotive & tractors business continues to be the largest contributor at two-third of group revenue.

“We don’t call it a conglomerate, we call it a federation,” Anand Mahindra says. “If you look at a spectrum between General Electric and Berkshire Hathaway, GE is a conglomerate, one single monolithic company with divisions, Berkshire Hathaway has multiple investments. M&M is more Berkshire Hathaway than GE.” Anand focused on having independent presidents who would focus on their line of business, segmented in six areas: auto, technology, hospitality, retail, defence and aerospace, and steel. “These six new sub-entrepreneurs have made significant gains in their own wealth because they share the business,” Anand says. Anand looks for niches. It’s a contrast to the business strategies followed by some leading business houses in India. Anand cites the example of Reliance Industries – the company wants to dominate competition with its size. This is not M&M’s strategy. Also, there is a central pool of money that can be used in different businesses. In the M&M Group, each company has its own balance sheet and its own cash flow to fund growth. Anand’s mantra is not about winning all the time, but to ensure that failure does not cripple. Anand has the vision to build a live, growing organisation—one that can evaluate, incubate, build and scale up businesses continuously that can escape gravity and transcend boom-bust business cycles, even while the flops fall by the wayside. Each company is ring-fenced from the damage failure elsewhere can do, even while being free to finance its own growth and make its own mistakes, to grow and find its own capital without betting the whole ranch. M&M, the flagship, is the major shareholder and the spine of the structure – the lever that makes things work. Mahindra sees his role as group head to assess risk with a team. “Measured risk-taking is at the heart of entrepreneurship,” Anand says. M&M’s approach is “segmented strategy”. M&M’s annual War Rooms are where crucial go-or-no-go decisions are discussed and decided. These are high-powered forums meant for interaction with individual companies that form the Mahindra federation.

Anand Mahindra is J.C. Mahindra’s grandson. Anand Mahindra joined the group’s Mahindra Ugine in 1981 after finishing his MBA from Harvard. Businesses in India were governed by the licence raj, where the government would select five to six companies to make or sell in any segment. Mahindra Ugine, headed by Anand’s father Harsh, was one of the six players which had licence to make specialised steel products for electric arc furnaces. As Anand recalls, “It was a cosy market, and nobody cared that I had joined”. But suddenly, in 1981, the government gave licences to 36 players to make electric arcs. As a result there was excess competition, something which Indian business houses were not used to. Prices plunged and there was surplus capacity in the sector. Ugine did not cut price and sales plummeted and the company posted its first loss. “When all hell broke loose, it was an opportunity for somebody new,” Anand Mahindra says, who turned around the company gradually by selling inventory and squeezing the supply chain.

Anand went on to take over as head of the group’s flagship vehicle business in 1991, even though his uncle and K.C. Mahindra’s son, Keshub Mahindra, was still the chairman. When India liberalized in 1991 Mahindra was sprawling and flabby like many of its peers—making everything from jeeps to lifts. After liberalisation, there were rumours of M&M businesses winding up. No one thought that Indian automakers would survive with companies like Ford, Daewoo and General Motors coming to India. What Anand found at M&M’s vehicle manufacturing business shocked him: an almost complete lack of integration among the departments and the needs of the customer were completely ignored. In short, everything has gone wrong for M&M during that turbulent period.

the resilience dividendIn her fascinating book “The Resilience Dividend: Being Strong in a World Where Things Go Wrong”, Judith Rodin, president of The Rockefeller Foundation, recounted the well-known story of Anand’s near death experience – and resilience – in the day before the Diwali festival in 1991.

Anand was attempting to turn around the business…

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Interestingly, Anand has his own unique view about innovation as the engine to drive the M&M federation. Anand believed that low-cost innovation is essential for solving many problems facing India. Yet, he believed that the famous concept of “jugaad” should not be confused with frugal innovation:

“India desperately needs big innovations to address large-scale problems and make use of opportunities in the country and not just stick to the now famous concept of `jugaad’. It really bothers me that we have become so smug about `look, how good we are’. `Jugaad’ means you use whatever little resources you have and make something happen. Jugaad does imply a positive ‘can-do’ attitude, but unfortunately, also involves a ‘make-do’ approach. It can, hence, lead to compromises on quality and rarely involves cutting edge or breakthrough technology. ‘Constraint-led Innovation’ is a better approach. It targets the most advanced technology but with a philosophy of ‘more for less’. The time has come for India to move from ‘jugaad’ (somehow) to ‘jhakkas’ (superb).”

Thus, with the “constraint-led innovation” embedded by Anand Mahindra into the company’s culture that propelled M&M forward over the years since the turbulent period of India’s liberalization, this different form of “India’s Berkshire Hathaway” has been able to recover from shocks and stresses and to adapt and grow from disruptive experiences, creating and taking advantage of new opportunities in good times and bad. Just like the values of the Bamboo Innovator, bend not break even in the wildest of storm, staying strong and resilient in a world where things go wrong.

Read more about the story of “India’s Berkshire Hathaway”

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

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/

This month of July, we highlight Asia ex-Japan’s largest maker of a mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, and Autonomous automotive trends. Without this “nervous system”, the various auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

Mickey Vs Mario: Buffett’s Omission Mistake in Disney and Any Magic Character Innovators in Asia? – 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 | July 20, 2015
Bamboo Innovator Insight (Issue 92)

  • 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,

Mickey Vs Mario: Buffett’s Omission Mistake in Disney and Any Magic Character Innovators in Asia?

Walt Disney: “I only hope that we never lose sight of one thing – that it was all started by a mouse.”

Nintendo’s Shigeru Miyamoto, creator of the character Super Mario: “Since we first created Mario, people have compared him to Mickey Mouse. I’ve always said Mickey Mouse evolved with each evolution in animation. From early on, I wanted Mario to be that character in the digital world, so that with each digital evolution, he was there to usher in the next era.”

Buffett: “Well, I made a terrible mistake. We owned a chunk of Cap Cities/ABC and merged with us and we kept the Disney stock for a while and then we sold it. That was before Iger took over. We probably shouldn’t have sold Cap Cities/ABC because ESPN – we owned 80 percent of ESPN and that of course has been the home run asset of all time.. Bob Iger is a home run hitter. I mean he is really, really good. And he’s a great guy on top of that.”

Buffett: “We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirate’s ride had just been put in. It cost $17 million bucks. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back in….in 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the ‘60s. So for $80 million bucks, and you got Walt Disney to work for you. It was incredible. You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. And the reason was, in 1966 people said, ‘Well, Mary Poppins is terrific this year, but they’re not going to have another Mary Poppins next year, so the earnings will be down.’ I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years…I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time…I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said ‘I want you to buy into this’…they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced people that $80 million was an appropriate valuation. Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.”

Warren Buffett missed holding on to and sold out his investment in Disney (DIS, MV $201bn)twice.

What are the important timeless investment lessons that value investors can learn from Buffett’s candid and wise admission of his omission mistake in Disney so as to identify and evaluate the scalability and sustainability of character-based or content business models? In Asia, Nintendo (7974 JP, MV $24.3bn)’s Super Mario and Sanrio (8136 JP, MV $2.5bn)’s Hello Kitty immediately comes to mind as the “Disney of Asia” with their popular characters, including the unlisted publishing giant Hitotsubashi Group-Shogakukan’s bluish robot cat character Doraemon controlled by the secretive Ōga family. Besides Nintendo and Sanrio, are there overlooked character innovators in Asia who have the potential to globalize their characters?

Character-based or content business model is able to reaps gains from the same intangible character asset over and over again and with profit multiplier effect as the character is leveraged into weaving products (merchandise, games) and services (theme parks, movies) around the character. However, the very strength of the intangible character asset is also its biggest weakness as the business model suffers blowup risks when this core key asset becomes stale from neglect, complacency and underinvestment.

First up was in 1966 when Buffett used a sum-of-the-parts (SOTP) valuation analysis to evaluate Disney’s intrinsic value. Disney was assessed to be undervalued at $80m with its hidden assets in the library of 220 films in the vault, the emergent growth of the theme park business with 300 acres in Orange county where the Anaheim park attracted 9 million customers a year, and an innovative owner-operator in Walt Disney running the place. Importantly, Buffett did not commit the common serious mistake made by SOTP in being overly obsessed with the hidden asset value and overlooking the more important aspect of the core content-character business driving Disney’s earnings. While the consensus view the Disney characters, such as “Mary Poppins” that was created in the musical fantasy film which was widely considered to be one of the greatest films of all time and Walt Disney’s “crowning achievement”, as unsustainable in generating blockbuster-like earnings year after year, Buffett believe these characters can be shown to kids the same age seven years later, and that they are “like having an oil well where all the oil seeps back in” and that “you get a new crop every seven years and you get to charge more each time”. Classics such as Sleeping Beauty and Cinderella are still refreshed, remade and retold since they were created more than 60 years ago, reinforcing merchandise and theme park sales and the brand equity of the Magic Kingdom.  However, Buffett was eager to prove his worth to his clients and did not wait till seven years to realize his Disney crop. Buffett sold the stock a year later after it climbed 50% from his investment of $4m for a 5% stake, now worth over $10bn.

Second wasBuffett_Disney nearly 30 years later when Buffett’s 1979 investment in Tom Murphy-Dan Burke’s Capital Cities-ABC was acquired for $19bn by Disney in 1995. Buffett got his payment in Disney shares. At the news conference announcing the deal, Buffett sat on the dais with Disney Chairman Michael Eisner and Cap Cities/ABC Chairman Thomas Murphy, and said: “This deal makes more sense than any other deal I have seen except for the [1986] Cap Cities and ABC deal.  It is a merger of the No. 1 content company [Disney] with the No. 1 distribution company [ABC].” Buffett sold off his Disney shares which went on to compound over 500%.

Why did Buffett sell off his Disney shares for the second time? The decision appears to have something to do with his assessment of the management, “before Iger took over” in 2005. The long-running legal battle in removing Disney president Michael Ovitz in 1996 had resulted in an extraordinary statement in 2006 by the chief judge of the Delaware Chancery Court who wrote that Eisner had “enthroned himself as the omnipotent and infallible monarch of his personal Magic Kingdom” and described Eisner’s behavior as falling “far short of what shareholders expect and demand from those entrusted with a fiduciary position.” The deterioration in the management quality culminated in 2003 when Roy E. Disney, the son of Disney co-founder Roy O. Disney and nephew of Walt Disney, resigned from his positions as Disney vice chairman and chairman of Walt Disney Feature Animation. His reason for resigning was his feeling that there was too much micromanagement within the studio, flops with the ABC television network, the company’s growing timidity in the theme park business, Eisner’s refusal to establish a clear succession plan, the studio releasing a string of box-office movie flops starting in the year 2000, and the Walt Disney Company turning into a “rapacious, soul-less” company.

When the key intangible asset that drives the profit-multiplier business model becomes stale, all the tangible pieces and financial numbers in the Magic Kingdom from merchandise, movies and theme parks start crumbling off, just like Cinderella reduced back to her rags when the spell wears off after midnight. Who could have faulted Buffett for selling off Disney shares for the second time to get off the Cinderella ride before midnight?

So how can value investors better assess the management quality and culture that nurture and harness the profit-multiplier power of the fragile intangible character asset? We like to recap what we wrote in our 23 March 2015 article “The Physics of Music and the Asian Innovators”:

“In our years of interacting and observing entrepreneurs and managers in Asia, we find that there seemed to be two kinds: some who would look for flaws in ideas and people, and then pounce to kill them; and others who started from a place of seeking and promoting good, new and original ideas and people. When the “idea and people promoter” saw flaws, they pointed them out gently, in the spirit of improving them – not eviscerating them. The “idea and people killer” were not aware that they were serving some other agenda, which was often to show others how high their standards are. The innovators understand the difficult, ephemeral process of developing the new. The innovators understand that looking beyond the pretty and rigorous checklist for something original, authentic, something surprising and unproven, are necessary for genuine value creation – and must be a conscious effort.

We also want to observe that the corporate culture are NOT infested with the kind of people that populated Disney in the late 1970s as remarked by Pixar’s founder Ed Catmull in his inspiring and thought-provoking book Creativity, Inc.: Overcoming the Unseen Forces That Stand in the Way of True Inspiration:

“Unbeknownst to me, soon after our meeting at Lucasfilm, John Lasseter would lose his job at Disney. Apparently, his supervisors felt that The Brave Little Toaster was – like him – a little too avant-garde. They listened to his pitch and, immediately afterward, fired him. What John hadn’t realized when he joined Disney Animation, however, was that the studio was going through a rough, fallow period. The animation there had plateaued much earlier – no significant technical advances had been made since 1961’s 101 Dalmatians, and many of its young, talented animators had left the studio, reacting in part to an increasingly hierarchical culture that didn’t value their ideas. When John arrived in 1979, Frank Thomas, Ollie Johnston, and the rest of the Nine Old Men were getting up in years – the youngest was 65 – and had stepped away from day-to-day business of moviemaking, leaving the studio in the hands of a group of lesser artists who had been waiting in the wings for decades. These men felt in was their turn to be in charge but were so insecure about their standing within the company that they clung to their newfound status by stifling – not encouraging – younger talents. Not only were they not interested in the ideas of their fledgling animators, they exercised a sort of punitive power. They were seemingly determined that those beneath them not rise in the ranks any faster than they already had.”

We think this lesson from Disney is poignant for Asia which is at a critical transition phase in succession risk (and opportunity) with the patriarchs and matriarchs handing over the reins of their business empires to the right capital allocators, whether to their heirs or professional managers. Many of the Asian successors are like Disney’s highly experienced and well-qualified men-in-charge in the late 1970s.

Above all, we think a corporate culture focused on KPIs is downright unhealthy as it results in gaming of the performance measurement system and distances people from creating an idea larger than oneself that can involve co-creators in the value creation process.”

The culture to foster – and limit! – innovators can be seen in Nintendo when it hired a student product developer named Shigeru Miyamoto in 1977.

Nintendo PeopleMickey MarioNintendo

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Read more about the stories of the trials and tribulations of Nintendo and Shintaro Tsuji’s Sanrio

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

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DisneyDo you have a good dream?

Value investors will do well in character-content business model by assessing the goodness of the dream, the willingness of the leaders to love the drudgery it involves and not take short-cuts and engage in complex opportunistic financial engineering activities to generate short-term profits that lead to the festering of long-term problems and impairments down the road.

Commitment, attitude, care and dedication have much more to do with character than pay and perks. At the center of character are dreams for life and work. Behind the rational, practical-minded efforts in building a “business”, the Bamboo Innovators like Walt Disney, Yamauchi-Iwata-Miyamoto and Shintaro Tsuji are pursuing their dreams. Walt Disney’s dream popped out from a mouse character to reflect and reveal the human in us in a perturbed world:

“Mickey Mouse popped out of my mind onto a drawing pad 20 years ago on a train ride from Manhattan to Hollywood at a time when business fortunes of my brother Roy and myself were at lowest ebb and disaster seemed right around the corner. We have created characters and animated them in the dimension of depth, revealing through them to our perturbed world that the things we have in common far outnumber and outweigh those that divide us. When people laugh at Mickey Mouse, it’s because he’s so human; and that is the secret of his popularity.”

A good dream is a crucial inner resource for leaders. Great businesses and great ideas usually originate in an individual’s deepest aspirations. A compelling image – of a better world and a best life for themselves – impels them forward through obstacles and hardships and engages the aspirations and dreams of others.

The important test of a good dream can be the willingness to sacrifice other dreams for it. Even the greatest leaders, with all their extraordinary talents, have had to make great sacrifices to pursue what they valued most. Commitment to a dream for life or work usually has real costs. A good dream is a calling, a vocation. Perhaps the unorthodox wisdom for a good dream is as British essayist Logan Pearsall Smith wrote: “The test of a vocation is the love of the drudgery it involves.” Love of drudgery may be a better test of a healthy dream than excitement or inspiration. Good dreams have deep roots in a person’s character and everyday life, not in the images and seductions of the society around them. Bamboo Innovators make a difference in the world by refracting their dreams through an endless series of small and large efforts – over hours, weeks, and years. The journey is long and arduous, with many challenges, temptations, and ordeals along the way. What finally determines success or failure are the hand of fate, the strength of the commitment to one’s dream, and one’s moral code.

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/

This month of July, we highlight Asia ex-Japan’s largest maker of a mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, and Autonomous automotive trends. Without this “nervous system”, the various auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

“A Community First, A Company Second”: Berkshire Hathaway’s Frugal Innovator DaVita and Are There Similar Wide-Moat Companies in Asia? – 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 | July 13, 2015
Bamboo Innovator Insight (Issue 91)

  • 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,“A Community First, A Company Second”: Berkshire Hathaway’s Frugal Innovator DaVita and Are There Similar Wide-Moat Companies in Asia?CNBC’s Becky Quick: “Mark Blakely from Tulsa, Oklahoma, wrote in and said, ‘Would Ted Weschler explain what he likes about DaVita HealthCare Partners and why he finds this company such a great investment? Since Berkshire signed an agreement not to own more than 25% of DaVita, does Ted or Berkshire have any other intentions besides being a large shareholder?’”

Berkshire’s Ted Weschler: “Okay. I followed the dialysis industry for, mmmm 30 years now. Right outta college I started– studying. And so I know the space reasonably well. And I think the broad filters that I apply for healthcare investment in general is: Number one, ‘Does the healthcare company deliver better quality of care than somebody could get anywhere else?’ And DaVita falls into that. Number two, ‘Does it deliver a net savings to the healthcare system?’ In other words, is the total bill for U.S. healthcare cheaper because of the efficiency that the company provided? DaVita checks that box. And lastly, ‘Do you get a high return on capital, predictable growth– and, you know, shareholder-friendly management?’ Absolutely. And all three of those together– you know, you’ve got healthcare is whatever, 17%, 18% of GDP. You got an incredibly talented team running that company. I’m not sure what the stock will do over the next year or the next two years, but very comfortable at five years from now it’ll be a more valuable franchise.”

Does the healthcare company deliver better quality of care than somebody could get anywhere else?

Does it deliver a net savings to the healthcare system?

These are the two great questions asked by Ted Weschler, one of the two stock pickers Buffett hired as part of his succession plan, in assessing Berkshire Hathaway’s investment in Denver-based DaVita (NYSE: DVA, MV $17bn), the second largest operators of kidney dialysis centers with a network of 2,100 outpatient centers serving over 180,000 patients with around 34% market share in the United States, behind leader Fresenius (NYSE: FMS, MV$26.4bn). Berkshire Hathaway had accumulated 27.2m shares, or about 13% of DaVita in 4Q11, a stake increased to 38.5m shares worth $3.1bn, nearly doubling in value from its cost of investment while the S&P index was up around 50% during the same period.

These two questions are the hallmark characteristics of a frugal innovator, which encompasses the ability to do more with less, creating more business and social value because of the business model innovation in the way they operate, build and deliver sustainable solutions with cost-effectiveness, care, integrity and without putting strains on the broader societal system. Exploring further into the business model of Berkshire’s DaVita and frugal innovators will be useful for serious value investors to identify and assess sustainable wide-moat compounders in Asia.

Anyone who has seen a diabetes patient in a kidney dialysis center can immediately feel the morale and emotional commitment that is essential to the long-term health of the patient. Not only do they have to endure the pain of having two thick and long needles stuck in them as they sit hooked up to a machine, but also they had to come to the dialysis center for four hours or more three times a week. These scheduling left the patients feeling they have no control over their lives. Patients become depressed. Patients on dialysis often suffer other diseases such as cardiovascular disease. Patients missed their dialysis appointments because they found the treatment and its logistics unpleasant. And patients chose to end their treatment and therefore end their lives; about one out of five deaths of patients on dialysis was a deliberate decision by the patients.

What if dialysis patients are managed by a patient-centric “membership” plan that coordinates their total healthcare needs at a fixed fee – and the fee is potentially lowered over time as their overall health shows a consistent improvement? Thus, instead of paying for visits, procedures, and tests, patients pay for care per member. The nature of such contracts puts the provider “at-risk” for the costs required to care for each member, thereby creating an incentive to reduce costs through preventive care and improving overall health such that fewer and timely treatments are required. The mindset will be shifted to that of a frugal innovator to provide quality value-add solutions while sharing the benefits of the cost savings to get the best outcome for patients with the lowest consumption of high-cost, low-value inputs, such as unnecessary surgeries and treatment, duplicative tests, etc. For instance, the provider could arrange for the patient to use that four-hour time in dialysis chair on general needs, such as eye and foot exams. Physicians and care providers in the “at-risk” network are also rewarded with bonus based on clinical outcomes, patient satisfaction, and the performance of the larger group or region. This “at-risk” model is the alternative to the existing fee-for-service (FFS) which creates the distorted incentive to maximize the volume of services, as evident from the recent horrifying case of the Michigan cancer doctor who prescribed $35 million worth of unnecessary chemotherapy just so he could bill healthcare companies.

DaVita (NYSE: DVA) Stock Price Performance 1995-2015 Vs S&P 500 Index

DaVita

DaVita controls about $33,000 in Medicare spending for each dialysis patient, but those clients often are very sick with multiple illnesses and cost about $55,000 more each year in other health needs. Kent Thiry, chief executive of DaVita, says the company could manage the entire $88,000 healthcare needs per patient, saving the government money while improving quality at the same time. This coordinated managed care business model is a result of DaVita’s acquisition of HealthCare Partners (HCP), America’s largest operator of medical groups and physician networks with more than 150 medical clinic locations and more than 8,300 independent doctors, in May 2012 for $4.4 billion at the valuation of 8.4 times FY11 EBITDA.

HCP represents one of the few organizations that has actually demonstrated that ability for years via its strong primary care base, emphasis on prevention, integrated healthcare information technology infrastructure, chronic care management and care coordination efforts, performance measurement and reporting, and experience with taking “at-risk” patients. For instance, patient medical records are standardized and shared as part of a data-driven, team-based approach that coordinates the efforts of primary care physicians, specialists, hospitalists, nurses, care managers, and social workers. Patient data are analyzed to develop a best care plan for each patients; automatic intervention alerts help ensure patients take their medication and get proper preventive and follow-up care; home-care teams help keep patients stable in their home – all helping to avoid more costly ER (emergency room) visits and hospital admissions that also put further strains on the healthcare system. HCP’s integrated care management program for inpatient bed days per 1,000 among seniors was half the Medicaid fee-for-service average and the 30-day readmission rate was one-third lower – but with better quality measures. HCP is synergistic to DaVita’s existing VillageHealth which provides advanced care management services to government agencies with non-dialysis cost savings of 15% vs fee-for-service Medicare.

It was hard to imagine that when Kent Thiry took the helm in 1999 as CEO of Total Renal Care (TRC) with its 460 dialysis centers, the former name of DaVita, the company was near bankruptcy. It was losing more than $60m per year, was under investigation for fraud by the federal government, had a 40% staff turnover, exhibited poor clinical outcome measures relative to its peers, and had its bank covenants broken by this performance. Share price had plunged from $23 to $1.71 and was heading even lower. TRC was founded by Victor Chaltiel who tried to do financial engineering and M&A deals at the kidney dialysis centers based on his earlier success in flipping a former company for a good profit using such methods. Senior executives paid scant attention to the dialysis centers themselves, which were seen more as an avenue of corporate growth where patients and caregivers were economic units in a bigger financial structure. This headquarter-centric, financially-oriented operating culture did not win friends among the healthcare practitioners who worked hard in the field to deliver quality care.

Kent Thiry and his management team made a decision that was baffling at that time given that it was a crisis period: they emphasized the importance of the “softer issues” of values and principles, that the company should be a “A community first, a company second”: “Think of a small town where people have to pay taxes, this is OK if people feel they get value, a good police force, roads, parks. Similarly, there is no problem with shareholder profit in return for capital put into the business as long as the right things are done for the patients and teammates. But it must be fair and transparent.” The company was renamed DaVita, the name chosen by employees, meaning “giving life”. DaVita experienced a remarkable turnaround between 2000 and 2005, a transformation based on building a strong values-driven culture, with an emphasis on fact-based decision making (“no brag, just facts”) and the theme of “one for all, all for one” and an emphasis on company as community. From near-bankruptcy status, DaVita went on to become strong enough to acquire its Swiss rival Gambro, make its way onto Fortune’s World Most Admired Companies list, and market cap compounded from $200m to $17bn.

Kent Thiry, affectionately called KT many teammates in the company, reflected on the transformation:

“I realized that many corporations are lifeless, emotionally sterile, and culturally empty despite the fact that people spend a lot of their life in them. This was especially critical to address how decentralized our teammates are, how pressurized their work is helping patients with renal failure, and how easy it is to create a gap between management and the people at the front lines, and that was something I felt had to be addressed to have a sustainable strategy for DaVita. Equally important, it is just a better way to live. We call this the DaVita village, a place where we care for each other, sacrifice for each other, support each other, and together, create meaning in our work and in our lives, as we embarked on a quest to build the greatest dialysis company the world has ever seen.”

The organization was designed to be flatter and Kent Thiry began answering hundreds of emails from employees all over the company, compressing the distance from the CEO to the front line. A big part of the new philosophy was to recognize that the dialysis centers, where patient care was delivered and where most DaVita teammates worked, were key to the company’s success. To emphasize the importance of the centers, Thiry had all senior managers, himself included, “adopt” a center and drop by occasionally. The adopt-a-center program was adapted to “Reality 101” which entailed spending a week in a center helping to do the day-to-day work. Executives participated in activities such as machine set-up prior to dialysis, machine tear-down and disinfection post-treatment, helping with blood pressure monitoring, or whatever tasks they felt comfortable in performing. Thiry believed it was important not to push people to do things they felt uncomfortable or unskilled at doing, but it was important for people to experience what it was like to get up at 4 o’clock in the morning to get to the center at 5.am. so that it could be open for the first patients at 6 a.m. and to see what life in a center was about. Thiry understood that they needed the involvement, cooperation, energy and ideas of the clinic managers, the front-liners who make the centers work. A DaVita University and DaVita Academy were set up to provide training and build friendship and a feeling of team spirit among those who took the class together and to engage people fully in the DaVita spirit and way of relating to each other. The importance and role of DaVita’s values were embedded into the recruiting process.

From the case of Berkshire’s DaVita, value investors can draw a mental model of frugal innovators:

  • Unique business model with a deep domain knowledge that solves a major problem, creates a sustainable, mass-customized personalized solution, and shares in the benefit from the customer’s improved experience
  • Customer involvement throughout lifecycle, shaping customer behavior, using customers to motivate employees, and co-creating value with customers: With its unique total “managed care” business model for the customers, they are more engaged at every stage of the product or service life cycle, and this longer-term engagement can be capitalized into making the operational and innovation process frugal with more market-focused, cost-effective and agile R&D solutions, saving precious time and labor in the process. The business unlearns the insular and costly business practices that have been built on long and linear development cycles with little, or at best arm’s length, customer involvement.
  • Flexing of organizational assets, sharing of resources, “distribution” and “delivery” to the last mile, integration of technology into the business model to bring about an informational advantage in the delivery of customer experience
  • Emphasis that frontliners matter in the value creation process, engaging and empowering them with decision rights and accountability, transferring the deep domain knowledge to frontliners, acknowledging their efforts and potential as a whole person
  • Fostering a unique aspirational culture with Focus, Purpose and bold Commitment
  • NO COMPLEX FINANCIAL ENGINEERING SCHEMES TO GENERATE SHORT-TERM OPPORTUNISTIC PROFITS

In Asia, when we hear frugal innovation, perhaps one of the first images that come to mind could be Tata Motors Nano car, the lowest priced car in the world, which underperformed its massive expectations. Nobody wants to be seen driving the lowest-priced car! Frugality was not crafted into a higher purpose of values that customers aspire towards, akin to the case of Ryohin Keikaku (TSE: 7453 JP), the owner and operator of MUJI, the “no-brand” retailer whom we had written in the earlier article “Brand It Like Buffett in Asian Wide-Moat Consumer-Brand Innovators” in how they made “frugality” and simplicity an aspirational value for its loyal base of hardcore consumers to embrace. Another image that comes to mind is China’s Xiaomi, the low-cost smartphone that was first launched with basic features and then use suggestions from millions of consumers to add new and better functions to their products, which they bring to market within weeks and using their own online distribution platforms to cut out the middleman. Thus, there are astounding success stories in Asia about frugal innovators that value investors and entrepreneurs can learn from. We find that the most outstanding successes are usually organizational-wide business model innovations, like DaVita and MUJI, as opposed to product innovations. Unless of course these product innovators are like the Godrej Group who has fostered a culture of innovation over the decades to create continuous product innovations.

Godrej Consumer (NSI: GODREJCP) Stock Price Performance 2001-2015 Vs Nifty Index

GodrejGodrej2

Godrej’s steel almirah was made in 1923 and built to last, one of Godrej’s guiding philosophies for all its products. It is also a timeless icon of a father’s love for his daughter as her wedding gift that says, Keep my love safe, You are my gold. G. Sunderraman and Sanjay Lonial with the ChotuKool, a low-cost refrigerator designed for India’s poorest households.

We wrote about the frugal innovator Godrej and its low-cost refrigerator ChotuKool targeted at the bottom-of-the-pyramid consumers in an earlier article “Keepers of the Flame: Revisiting the Origins of Compounders in India and Asia” when we visited leading companies in India (Mumbai, Delhi, Pune) in Dec 2013:

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Benjamin Franklin, one of the founding fathers of the United States and the archetypal Bamboo Innovator says it best about frugal innovators:

“The way to wealth is as plain as the way to market. It depends chiefly on two words, industry and frugality: that is, waste neither time nor money, but make the best use of both. Without industry and frugality nothing will do, and with them everything.”

Which are the other three frugal Bamboo Innovators in Asia mentioned in the article?

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

PS: An Announcement…

We have shared our earlier plans to launch a series of innovative and transparent smart-beta indexing products based on the Bamboo Innovator methodology to systematically identify and invest in neglected, overlooked, misunderstood and underappreciated wide-moat resilient business models with a scalable fund capacity build-up.

In order to accelerate this collaborative plan, I will be joining a listed investment holding company, which has a market capitalization value of over S$300 million, with effective from 1 September 2015 as their Chief Investment Officer (CIO) to spearhead this business project, in addition to taking care of the sustainable outperformance of the listed equities investments, and to source for and add value to undervalued high quality private equity opportunities, together with a dedicated team of seven business analysts (including myself). I am very excited and grateful to be joining the team to create value for the supporters; over 200 shareholders turned up at the Annual General Meeting last week asking great questions.

AGM

Back in 1997, Dell CEO and founder Michael Dell had been quoted as saying that he would liquidate Apple and return all the cash to shareholders if he owned the company. This prompted Steve Jobs to get up in front of his team and say the following:

“The world doesn’t need another Dell or HP. It doesn’t need another manufacturer of plain, beige, boring PCs. If that’s all we’re going to do, then we should really pack up now. But we’re lucky, because Apple has a purpose. Unlike anyone in the industry, people want us to make products that they love. In fact, more than love. Our job is to make products that people lust for. That’s what Apple is meant to be.”

To paraphrase Jobs, perhaps the investment world does not need another star fund manager, as opposed to an asset management organization that is able to scale up sustainably because of its process-driven investment know-how. There seems to be something missing in the long hard chase for performance in the asset management and wealth management industry. Stage 1.0 is revolutionized by John Bogle’s passive low-cost index model introduced 40 years ago in 1975 as Vanguard. Stage 2.0 is disrupted by Robert Arnott’s Research Affiliates (RAFI) in 2002 and Jonathan Steinberg’s WisdomTree (WETF) in 2006 with their fundamentals-weighted indexing with quant-based criteria that include sales, earnings, book value, cashflow, dividend yield, and so on. Over $2 trillion in funds have shifted from the conventional fund management business to these indexes. However, fundamentals-indexing has become an overcrowded strategy with everyone copying and chasing the same quant factors generating diminishing marginal risk-adjusted returns and also made unnecessarily complicated with multi-factors thrown into the black box that is increasingly darker.

Importantly, the existing smart indexes are not necessarily adapted to the Asian capital jungles with (1) its distinctive potential accounting tunneling fraud and misgovernance risks with high-net-cash-in-balance-sheet stocks unravelling in accounting scandals, as well as (2) the type of business models that are competitive and increasingly valuable in the Asian business environment.

Imagine if there is a smart-index that can take away the fear factor of investing in Asian accounting fraudulent stocks with deceptive visual signals that include low price-to-book, low PE ratios, high profit margins and ROE, decent accounts receivables and inventory turnover period, and high net cash as percentage of market cap.

The index also goes one more step to eliminate the alluring value traps without a resilient and innovative business model.

This systematic process combines financial data with a wide array of contextual information – including the analysis of governance, group structure and ownership, suspicious related-party transactions, money-go-round off balance-sheet activities, textual/linguistic analysis of news about the company and management, the proprietary Bamboo Innovator business model analysis – and looking through this lens to reach fresh insights in assessing firm value and performance. More than 96% of companies are eliminated in the process – around 30% are those with a higher likelihood of fraud or governance breakdown, and around 60% are potential “value traps”. What’s left is a Watchlist of around 550 companies. This watchlist filters down to 230+ companies, or 1.5% of the original investment universe.

The Asian Bamboo Innovator Index fund will be scalable with a clear and scalable fund capacity buildup of at least $1 billion (an equal-weighted index of 200 stocks meeting liquidity requirements with up to $5 to $20 million in each stock), rebalanced every quarter and periodically in the event of major corporate actions such as spinoffs or corporate restructuring. Related funds using the same scalable know-how, including a concentrated fund that holds 20-30 stocks, will also be offered for investors.

This is what we wrote in our very first issue of the Bamboo Weekly Insight on 6 June 2013:

Intuit’s former Chief Technology Officer and entrepreneur David Murray summed up his years of experience in remarking that we are great at solving problems but less adept in defining the right problems. LinkedIn’s founder Reid Hoffman expounded on this when he said that it’s really asking “How can I help?” and to “fulfill needs, solve problems”. The primary problem for value investors in Asia is that the beautiful macro Siren is alluring but dangerous at the micro or firm-level, leaving even experienced money managers shipwrecked before they reach their target destination for their clients. This Bamboo Innovator research product is meant to solve this problem.

A longer-term plan in the works will be to develop a Bamboo Innovator index product. The self-indexing trend to embed “smart-beta” investment strategies, such as weighting companies by low-volatility or by fundamentals such as dividends or “value” attributes, have proven to be a meaningful displacement to the active fund managers, private bankers and financial advisors who have thrived by shifting client’s assets around according to the “flavor of the month” or some hot popular themes to generate lucrative fees and expenses to the detriment of the investor. Gather assets via attractive middleman/intermediaries/deals and churn the assets. This “people-based” approach has been a contrast to the “know-how”-based management of assets by a resilient investment process to scale up funds to generate sustainable outperformance. The acid test to distinguish between the two approaches is simple: Just ask whether “Is there a larger idea and purpose than the people?” Such “people-based” fund managers and intermediaries have been hit during the global financial crisis as a significant number of Asian fund managers get their “long-term” track record numbers before Oct 2007 while the newer funds are benefiting from the general uptrend from the March 2009 bottom but may not last in the upcoming painful transition phase in Asia for the next five to ten years. Many of them have the mindset to just lure assets in, get the fees, get deals, and cash out.

There is a balance sheet constraint to earnings manipulation both at the country and company level and Asia is in the vortex of this transition phase. Coordinated macro-based and monetary policies – Let’s print and pump together! Let’s all build infrastructure and capacity! – that worked to temporarily overcome the 2007/08 crisis will need to diverge as a result of differences in balance sheet constraints. The pouring in of the thunderous credit growth has not translated into real growth with diminishing returns and even losses from malinvestments.

Interestingly, Rob Arnott’s Research Affiliates who pioneered weighting companies by their fundamentals and economic footprints rather than by market value has resulted in over $100 billion in assets invested or advised by them during the past five years in the aftermath of the crisis. However, perhaps there has been a crowding of assets and most end up pursuing similar quant-based “fundamentals” strategy, resulting in correlated performance and destructive destabilizing price impact in deleveraging crises situations.

Gaining a deeper insight about Asia through the eyes of the innovative resilient compounders and not through the myriad confusing macro, sector and thematic prognosis or even simplistic quant-based “fundamentals” is critical in the next decade as the innovators break apart to outperform in uncertain times. In other words, opportunities will be about identifying and weighting companies by their “moats” and business models, as Morningstar did for its Wide Moat ETF and hopefully the Bamboo Innovator index.

Investing has to be simple in complex times to outperform and compound value, staying clearheaded when we are guided by the Bamboo Innovator as the inner compass in the Asian jungle.

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It is with great sadness that I am bidding farewell to my students in the Singapore Management University (SMU). I am fortunate to have the chance in helping the students to acquire the required technical accounting competencies and sharing with them the importance of sharpening their critical thinking skills and embracing the right values and ethics. Some kind feedback from the students includes:

  • “I am writing to show my gratitude for Prof Kee Koon Boon for his outstanding teaching. As a graduating student in SMU and through my four years education in SMU, Prof Kee is one of the most passionate and knowledgeable lecturers/professors that SMU has.. I cannot emphasize how important is this module to accounting and finance professionals. There have been widespread media reports on accounting fraud scandals in China-based companies. To put it across bluntly, these reports are ex-post and the harm has been done. What the public needs is ex-ante reports to identify these potential accounting frauds. Despite me getting A+ for Financial Accounting module, Management Accounting module and Corporate Reporting & Financial Analysis module, it never occurred to me to judge the accounting numbers beyond their face value. This module has brought great insights to me through the various methods taught to detect accounting fraud. For SMU to continue producing excellent financial professionals, this module on Accounting Fraud should be expanded to take in a larger amount of students genuinely interested in this subject.”
  • “I was moved into writing this letter of appreciation letter for Professor Kee Koon Boon for his work done for the module Accounting Fraud in Asia. This module.. will undeniably be one of the most useful course SMU undergraduates will find themselves taking.. his exemplary teaching quality and methods will continue to help nurture graduates with an edge who will be highly sought after by corporations. What Prof Kee is teaching is vitally important, because most accounting systems today are focused on post-mortem fraud, investors today are not equipped with the vital skill of fraud detection ex-ante.. His constant encouragement.. shows his deep concern for our core growth and maturity, not just in terms of academic development and technical skills, but also in terms of our character development and desire to do good for society. He is truly an educator and a teacher, in every sense.”
  • “I am touched by your spirit and passion, so keep this teaching style spirit going and impact more students! With that, I would like to thank you for the sharing session from interview to fraud class lessons as well as thank you for leading me in finding the energy of myself.”
  • “Besides the technical skills and knowledge, I think there are other aspects of my life that you “value add” to. For example, how to persevere and be positive, how to “hold on together” so that “our dreams will never die”. These are values which other professors will not share. You are one of the most dedicated, hardworking and “on the ball” professors that I have come across.“
  • “I have thoroughly enjoyed your lessons so far. In fact your lessons are something that I look forward to during the week. After working in the hedge fund industry for 8 months last year, I find that it is really rare for someone like you to come out and share your insights and experiences with the world, or even to undergraduates like us without expecting anything in return. I truly admire your spirit and generosity that is similar to that of Benjamin Graham or Bruce Greenwald, reputable masters in their own rights. The learning goes beyond the classroom, and the website is a great tool for students and the general investing public to learn as well. At the end of the day, what really matters is how much value you have added in this world. For that, I believe your work has benefited many of the enthusiastic students in class and have educated investors who are keen to invest in Asia but are looking to arm themselves with background knowledge to finesse their way through the Asian capital jungle.”
  • “Right on the cusp of entering the working world, we are thoroughly grateful to be on this journey with you. And I say this in a continual manner because I’m certain our journey doesn’t end here. Thank you for your generosity in sharing your knowledge with the class. Thank you for your passion in uncovering fraudulent activities for the good of investors and the quest for rightness. Thank you for your being the genuine spirit that you are, truly committing yourself to the noble cause of educating us and leading us along with you in the pursuit wisdom and character.”
  • “There is no thread of doubt that we are learning highly proprietary and beneficial stuff from you and the goodness is beginning to take shape in us slowly. These seeds once sown will grow further with time and I must thank you for showing us to the gates of this new realm and equipping us with the necessary weapons to outlast if not conquer the Asian Capital Jungle eventually. Beyond these, having been through 7.5 semesters with just 5 weeks of SMU life remaining, I must tell you that I count myself really fortunate to have taken your class right before leaving school. I must honestly say that you are the most enthusiastic Prof I’ve met in school and just like the video of the Chinese singer you showed us in class, your great work shines through and has inspired me a lot. Beyond technicalities, it has taught me to be really really thorough in the pursuit for excellence, esp as a young entrant into the financial industry. Your class contains the most practical wisdom compared to other mods in SMU and all this are what ‘true value’ in education really mean.”
  • “Thank you for your passion and guidance during the past 4 months. Through this course, I was able to see the various ways accounting fraud can be perpetuated in Asian society. I indeed have a greater awareness of my own shortcomings and have a clearer sense of direction on which career path I should choose in future – to avoid being swayed towards greed and worldly pleasures but instead lead a life of sufficiency, gratefulness and service.”
  • “Thank you for the effort and dedication in the materials & speakers you have provided for us! I have learnt knowledge that have been picked up from valued experiences from yourself as well as speakers like Mr Hemant Amin, knowledge that I would not be able to amass unless through the course. I am thankful to have taken Accounting Fraud because you have taught us values together with knowledge. A compass that will continue to guide us in our journey.”
  • “The instructor is very dedicated to his job… He also has great experience and insights into current issues and always tries to bring them into context with what we are learning.”
  • “… willing to share his insights into different subject matters and let us think deeper into what is taught to us.”
  • “… a very caring and understanding professor who takes the effort to encourage students – concepts learnt can be readily applicable to the working world”.
  • “… a very responsible and helpful professor who is willing to share his insights to the class. He is also extremely knowledgeable in many aspects and there is a lot to learn from him.”
  • “Prof is very approachable and I’m most impressed by his sincerity and passion in sharing valuable lessons with us.”
  • “Patient, kind, caring and considerate of individual, special needs of students. Always warm and approachable.”
  • “Prof Kee has inspired me with his enthusiasm in learning and the vast knowledge that he possessed. He was very willing to share his wisdom with us and is definitely a great teacher.”
  • “Prof Kee is very friendly prof. He makes an effort to get to know each student and is genuinely interested in the conversations of us students. He is also very knowledgeable and passionate about learning. His sincerity is heartwarming and he is a good role model for students. Thank you Prof Kee!”

We will be continuing our course Accounting Fraud in Asia and Wide-Moat Analysis of Bamboo Innovators periodically for lifelong adult learners, professionals and serious value investors. We are grateful to have the economic crime prosecutors at AGC (Attorney’s General Chambers) and institutional fund houses who have expressed interest in these courses.

We are grateful to have your support all this while. Please rest assured that we will continue to pour forth our dedication and utmost effort to deliver more unique value-added solution to our Members.

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/

This month of July, we highlight Asia ex-Japan’s largest maker of a mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, and Autonomous automotive trends. Without this “nervous system”, the various auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

Buffett’s Machines and the Rise of Asia’s Wide-Moat Machine 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 | July 6, 2015
Bamboo Innovator Insight (Issue 90)

  • 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,

Buffett’s Machines and the Rise of Asia’s Wide-Moat Machine Innovators

“CTB, which operates worldwide in the agriculture equipment field.. since we purchased it in 2002.. again set an earnings record. Vic Mancinelli, its CEO, followed Berkshire-like operating principles long before our arrival. He focuses on blocking and tackling, day by day doing the little things right and never getting off course. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash.”

– Buffett in Berkshire Hathaway 2011 Annual Letter to Shareholders

“I checked with Howie; he told me CTB was an absolute first-class company and he’d heard good things about Vic. Howie would rather spend an evening on a tractor in the field than a date with Angelina Jolie, which is not true of all members of the family, but that’s true of Howie.. I spent a little time talking to Vic and I knew that he was the right guy and CTB was the right company, and, boy, was that a lucky day for Berkshire. Ever since then, the operational results, the acquisitions that you’ve made, everything has exceeded my expectations.. Vic is a manager that could run any company in the Fortune 500. He’s done a wonderful job for us.. CTB has been moving ahead every year since we bought it. We’ll hit a bump in the road every now and then but we’re looking at a superhighway out there in front of us.. You know, this may be a tougher year economically than some we’ve had in the past, but we’re going to own CTB forever. So over the next 100 years we’re going to have some bad farm years, we’re going to have some bad years in the economy, but just look at the progress you’ve made over time, and I hope you keep doing more of the same.”

– Buffett address to CTB employees in a video posted on CTB’s website that he refused an initial proposal to bid for CTB, reversing his decision only after Mancinelli made a trip to Omaha, that his son Howard had recommended CTB and that CTB may produce profits beyond the year 2200.

Warren Buffett learnt about the power and business model of “machines” very early on. There is plenty for value investors to learn from Buffett’s wisdom about the business of “machines” to identify Asian wide-moat machines innovators.

In his senior year of high school, Buffett bought a broken pinball machine that had an original price of $300 for $25, and went to his friend Don Danly to fix it. Together they started Wilson’s Coin-Operated Machine Company, named after a fictitious Mr. Wilson to give the teens an air of credibility and authority. They asked a local barber if they could put the machine in the back of his shop, in exchange for half the money they raised. In just a single day, enough customers at the barbershop played pinball to make four dollars. Within a week Warren had enough money to reinvest to buy more pinball machines, which he negotiated into other barber shops, get it delivered and installed, handle maintenance and repairs, and he had to collect the coins from the machine. In terms of customer service, the boys always told the barbers that they would blamed Mr. Wilson for any unpopular decisions they had to make, such as why they were not able to replace older machines with newer ones. Buffett later sold the business to a War Veteran for $1,200.

As Buffett becomes the world’s most successful value investor, he added more powerful machines into his own acquisitive mega machine Berkshire Hathaway. One of these machines is CTB Inc., a worldwide leader in equipment systems for the poultry, pig, egg production and grain industries which was acquired for $139 million on its 50th anniversary in 2002. Buffett revealed in his 2011 annual letter to shareholders that CTB had performed very well and praised its CEO Victor Mancinelli. The business has – in a decade – distributed well over 100 percent of its purchase price in cash to Berkshire and its pre-tax earnings are roughly the acquisition price.

What accounts for the growing success of CTB?

Outfitting a farm can be a multi-year commitment. Knowing that the company you are buying from has a global network to provide outstanding customer service provides peace of mind to the purchaser. CTB operates from multiple locations in various countries around the world and serves its customers through a worldwide network of independent dealers and distributors. The depth of offering from CTB meant they are able to equip the entire farm to provide a one-stop solution, saving the farmer the trouble of attempting to get disparate systems to operate together. Once a CTB system is installed, switching to another is a highly costly transaction. CTB also undertook at least eight bolt-on acquisitions to expand its product offerings and integrate them into a total solution at a competitive price to outfit the entire farm, enhancing the farmer’s user experience.

Buffett also recently disclosed in March 2015 a 5% ownership in Deere & Company (NYSE: DE, MV $32.2bn), the largest farm equipment manufacturer in the world known for its high quality tractors, construction equipment, mowers, and other farm machinery. Buffett used a special confidentiality rule to delay disclosing the increased position he was building in 2014 in Deere, which has paid steady or increasing dividends since 1987, giving it a streak of 28 consecutive years without a dividend reduction.

Buffett’s experiences from the pinball business to CTB highlight several important axioms for value investors seeking to invest in machines or capital equipment companies. Value investors tend to overly focus on the observable, including the price-to-book valuation ratio, the order book to bill ratio, and the cyclical price-earnings ratio given that capital equipment sales tend to cyclical according to the industry’s business cycle, and overlook the wide-moat business model underlying the generation of the numbers. From the customer’s perspective in their purchase decision of machines, even if a company offers excellent products, they won’t buy from it if it doesn’t offer excellent and speedy repair services, given that breakdown in machines are inevitable which will be disruptive and costly to operations.

Thus, this is the major problem and constraint – and wide-moat opportunity if the problem is solved – in the business model: One Buffett cannot service 100 barber shops customers and “Mr Wilson” cannot be put to blame forever, which limits the scalability of the pinball machine business. In the case of CTB, some of the most important steps that Victor Mancinelli had undertaken since Berkshire acquired it, besides the successful bolt-on acquisitions, was the restructuring into Business Units and introducing the Rapid Customer Response (RCR) to bring “people closer to the customer” so that they have a “better sense of customer challenges” and are “more responsive to changing customer needs” to “continue to provide innovative solutions”. By valuing its employees, enabling their growth through training in lean manufacturing principles and techniques and getting everyone to understand department and business operations in detail, CTB creates employee engagement and ongoing commitment that improves productivity. These actions resulted in winning Buffett’s praise in his 2010 annual letter that sales per employee had more than doubled from $189,365 when they purchased CTB in 2002 to $405,878 in 2010. Thus, understanding the dynamics of this stall point can illuminate important lessons for both the Asian entrepreneur trying to scale his or her enterprise to a greater height and the diligent value investor wanting to generate sustainable compounding returns in machine or capital equipment stock.

With this Buffett wisdom in our pocket, value investors can travel to Asia with greater confidence to identify wide-moat companies beyond the quant screens and checklists. Let’s make the first stop at Mount Fuji in Japan to witness the breath-taking poetry in motion scene of robots making robots at the world’s largest – and most secretive – robot manufacturer. Then we travel to Kyushu, the third largest island of Japan and most southwesterly of its four main islands, to visit its rival who had developed a katana-wielding robot as an example of its capabilities and know-how with robots. Finally we will go back to Tokyo to visit another world-class wide-moat machine innovator that is arguably even better managed than the earlier two global champions and understand its management strategy called Lanchester Strategy that is named after the British aeronautical engineer F.W. Lanchester (1868-1946) who had researched attrition in land, sea and air combat, and developed the “3:1 rule” of Lanchester Laws.

Machines

Interestingly, despite the US producing the first industrial robot in the early 1960s and also having a robust auto sector, there are no US companies that are dominant in industrial robot manufacturing globally. We think one of the reasons why Japan has a robust industrial robot industry is because during the 1980s, Japanese auto manufacturers were early in recognizing the benefits of using robots in their assembly processes, which in turn facilitate the development of the Japanese robot industry.

<ARTICLE SNIPPED>

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

PS: We are grateful to be presenting for the third time as one of the instructors in the 3rd Wide Moat Investing Summit on July 7-8. Instructors include: Thomas A. Russo, Managing Member, Gardner Russo & Gardner LLC, Paul Lountzis, President of Lountzis Asset Management; Todd Sullivan, Managing Partner, Rand Strategic Partners; Robert Deaton, Managing Partner of Fat Pitch Capital; and many more. Do join the global community of ValueConferences attendees, including professionals from Artisan, Baillie Gifford, Baupost, Bestinver, Chieftain, Citadel, Citigroup, Diamond Hill, GAM, Gardner Russo, GMO, GoldenTree, Goldman Sachs, IVA, Invesco, Merrill Lynch, J.P. Morgan, Raymond James, Rothschild, Ruane Cunniff, Schroders, Third Avenue, Tiger Global, Tweedy Browne, and many smaller funds, advisors, analysts, and individuals, to gain access to the best wide-moat investments.

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/

This month of July, we highlight Asia ex-Japan’s largest maker of a mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, and Autonomous automotive trends. Without this “nervous system”, the various auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

Building Asia ex-Japan’s largest maker of the “nervous system” in smart cars with Responsibility – 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 | June 30, 2015
Bamboo Innovator Insight (Issue 89)

  • 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?

Building Asia ex-Japan’s largest maker of the “nervous system” in smart cars with Responsibility

How would you respond when you lose your finger in a workplace accident? We will be depressed, the inevitable and natural response which paralyzes and robs us of the ability to respond to our troubles and setbacks.

For Leonardo Del Vecchio who severed part of his finger in a mold-making factory while working as an apprentice to put himself through design school, he went on to build Luxottica (LUX), the world’s largest eyewear company with a market cap of $32.7 billion and became Italy’s second richest man. Luxottica is one of the world’s most respected companies that is responsible for revolutionizing and dominating the entire eyewear industry, creating a fashion concept out of a functional item and putting luxury glasses on the world.

For Mr. C who lost two of his fingers while manually operating a stamping machine, he went on to build Asia ex-Japan’s largest maker of [Flagship product’s name] in automobiles and motorcycles, a mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. The painful accident made Mr. C “swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line.” Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. “As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.” Mr. C also set his mind to build a sustainable, scalable, wide-moat business model with an “organizational-wide competitive ability and an organizational-wide management information system”.

This month of July, we highlight this Asian wide-moat innovator behind “the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts.” Without this “nervous system”, the auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

Our earlier highlight for the month of May about Asia’s #1 maker of a patented automotive electronics part that is part of the fast-growing multi-billion Advanced Driver Assistance System (ADAS) market and the race towards the autonomous car is up >25% in <2 months.

Read the story of Mr. C below and be inspired about the values of Responsibility – the ability to respond in times of hardship and adversity..

Q: “Chairman C, [Company’s name] has an illustrious business history since its establishment more than 38 years ago in 1977. Can you share with us how it all started, the philosophy and thought process underlying the evolution of the business model, the lessons learnt, and the ups and downs in your personal journey building [Company’s name]?”

Mr. C: “My personal journey in building [Company’s name]? I was poor when I was young and I always wanted to venture into business to give a better life to my family. After my middle school, I wanted to go straight to work but my father insisted that I must continue to study in the night school. So I work in the daytime in the metal stamping division of lighting company.

At that time, metal stamping is still operated manually by hand, with the operator using one hand to hold the metal, another hand to step on the machine’s pedal, stamping the metal piece by piece. However, an incorrect rhythm or a slight neglect will result in a workplace accident. An accident happened to me and I lost two of my fingers as a result. As a result, I swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line. Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.”

Q: “Thank you for sharing such a moving and inspiring personal story behind the impressive production automation commitment at [Company’s name]. Our curiosity is piqued, can you share with us what is so difficult about making these [Flagship product’s name] beyond having more capital and money?”

Mr. C: “Computer and smartphones can malfunction, but can cars afford to malfunction? When consumer electronics products break down, they will cause inconvenience, but they will not cause our lives. When a car is moving and it suddenly malfunctions, what would be the consequences? In terms of safety standards, automakers have far higher requirements for components and parts than those for consumer electronics products. Safety is of paramount importance. When there is an incident of a car engine on fire, a big reason is because of the breakdown of the [Flagship product’s name]. [Flagship product’s name] are first used during the World War II in fighter planes. The [Flagship product’s name] is small and not eye-catching, but it is the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts. Without them, the auto parts cannot start and work. Now, [Flagship product’s name] need to be even smaller and precise than ever before and the supplier has to produce customized parts according to the customer’s diverse requirements. Each car requires around 600 to 3,000 to 6,000 [Flagship product’s name], depending on the ‘smartness’ or electronic content of the model. So the demand is rather sizable in terms of volume and value.

Yet in the early days, no one is interested in this business. The reason is simple. Besides the high barriers to entry and extremely high standards set by the customer, the supplier would have to produce small-lots and multi-items, and this does not make any economic sense from a cost perspective. The time period of investment is long and the payback even longer and uncertain. [Company’s name] has grasped the technical complexity of the functioning of the various auto parts and foresee the change in the shifting profits in the value chain towards high value-add electronic parts.

Hence [Company’s name] focuses on mission-critical [Flagship product’s name] in the safety area. The technical expertise required is much higher and the design and development of the molds requires deep know-how, but the margins are also much higher. There are other auto parts companies who also tried to break into this business but they started in producing the products that will not affect the safety and engine of the car, thinking that it will be a starting point to win more business. However, these companies underestimated the barriers to entry and they have all exited.

Thus, not anyone can enter this business. Because of the extremely high standards for safety and reliability, car makers are very strict in selecting their suppliers. Once the supplier is connected to the automakers’ supply chain, that’s ten-year worth of business at least. With mutual trust as the foundation, this relationship is not easily changed. However, this also means it is very difficult to break into the supply chain of an automaker.”

Q: “We understand the high barriers to entry and stringent quality standards required by the car makers. Still, we are curious – are there any specific production technique or know-how or secret to success that [Company’s name] has mastered over the 38 years that gives it a sustainable wide-moat competitive advantage to generate a relatively high ROE of 20.5% and to keep growing?”

Mr. C: “…. <SNIPPED>”

Q: “Do you have any words of advice for entrepreneurs? What is the best advice you have received that has guided your thinking?”

Mr. C: “I always remember what my parents have taught me since young, ‘Be kind to others’. My mother would also remind me, ‘If you manage to make money, you must treat your workers better.’ Our principles of management include: ‘Co-sharing of fruits reaped through teamwork’, ‘Human-friendly management’, ‘Whole-hearted trust and support’..

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

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

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/

 

Brand It Like Buffett in Asian Wide-Moat Consumer-Brand Innovators – Bamboo Innovator Weekly Insight (Issue 88)

 “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 | June 22, 2015
Bamboo Innovator Insight (Issue 88)

  • 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,Brand It Like Buffett in Asian Wide-Moat Consumer-Brand Innovators

Warren Buffett: “When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness… there’s something in the mind about a brand. I mean, you have something in your mind about Coca-Cola – but you don’t have anything in your mind about RC Cola because they’ve never been, you know.”

Charlie Munger: “We didn’t know the power of a good brand until we bought See’s Candies. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important… How would you try to create a brand that competes with Disney? Coke is a brand associated with people being happy around the world. That is what you want to have in a business. That is the moat. You want that moat to widen.” 

Last week, we discussed the Achilles heel of Buffett and Munger in retail stocks in the article “Buying Furniture with Warren Buffett and Mrs. B at Asia’s Wide-Moat Furniture Innovators” and how value investors can overcome this tough investment hurdle to identify compounders before their wide moats become obvious by the investment community. This week, we examine their greatest investment strength – picking consumer brands – and the case of an unusual wide-moat consumer-brand innovator in Asia.

Imagine if Warren Buffett-Charlie Munger’s See’s Candies, Coca-Cola, Gillette/Pampers (P&G), Heinz and a host of iconic consumer-branded products that they had successfully invested in are stripped of their trademarked name, logo and nice emblazoned packaging design. Would consumers – and Buffett and Munger! – consider them as “brands” and still buy them?

How would Buffett-Munger evaluate Ryohin Keikaku (7453 JP, MV $5.2bn), owner of MUJI? MUJI stands for Mujirushi Ryohin (無印良品), which translates to “No Brand Quality Goods” and “All Value No Frills”. None of MUJI’s 7,500 “minimalist” products, including household products (36.9% of sales, including linen & interior goods, furniture, household appliances, houseware, stationary, cosmetics), apparel (53.5% of sales, including underwear, socks, bags and shoes), and food products (8.2% of sales) have a logo or are wrapped in fancy, distinctive packaging. Plain but not generic, MUJI’s products have a simple aesthetic that appeals to certain customers. In fact, it is the lack of a name brand that many find enticing. With more than 700 stores worldwide (284 directly-managed and 117 licensed stores in Japan), including 301 stores overseas (130 in China), the Japanese retailer has a cult-like following. MUJI seems like a Japanese nazonazo (riddle): one of the most beloved Japanese brands that isn’t a brand.

Ryohin Keikaku (TSE: 7453) Stock Price Performance 1995-2015 Vs Nikkei 225 Index

MUJI1 MUJI2

So what is it about MUJI that accounts for its rising success? Often hidden in the seemingly simple designs are functions that make MUJI’s products stand out. Its toilet brush, for example, has a small cover to protect water from splashing while cleaning. Their summer sheets are made of special linen that absorbs moisture better than cotton. But you might argue that many other companies can copy MUJI’s minimalist product concept. After all, wouldn’t MUJI lose its competitive edge in terms of pricing to the fast-fashion outlets such as apparel giant Uniqlo/Fast Retailing (9983 JP), low-priced furniture giant Nitori (9843 JP), and the myriad 100-yen stores that were features of every new mini-mall? And MUJI’s rising success is all the more amazing when we revisit one of Munger’s fascinating insights about brand-based moats. Munger imparted his wisdom that “informational advantage” enables brands to leverage into advantages of scale:

Munger: “The informational advantage of brands is hard to beat. And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t know and put it in my mouth—which is a pretty personal place, after all, for a lousy dime? So, in effect, Wrigley simply by being so well known, has advantages of scale—which you might call an informational advantage. Everyone is influenced by what others do and approve. Another advantage of scale comes from psychology. The psychologists use the term, ‘social proof’. We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody’s buying something, we think it is better. We don’t like to be the one guy who is out of step. Again, some of this is at a subconscious level and some if it isn’t. Sometimes we consciously and rationally think, ‘I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ The social proof phenomenon which comes right out of psychology gives the huge advantages to scale—for example, with very wide distributions, which of course is hard to get. One advantage of Coca-Cola is that it is available almost everywhere in the world. Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup—which is slowly won by a big enterprise—gets to be a huge advantage….And, if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you. All told, your advantages can add up to one tough moat.”

Thus, the “no-name” MUJI products apparently do not emit the “informational advantage” that Munger described – carrying or using a MUJI product is not observable by others and the “social proof” effect seemingly breaks down.

While the MUJI products have no brand logo to elicit the psychology-based “social proof”, MUJI is actually perceived as a great brand with thoughtful, innovative products. The design and stories around how these new innovative products came to be developed show the seriousness of MUJI to develop a new unique product – continuously. These designs have also come to MUJI winning more than 100 top-tier design and innovation prizes.

Amongst the design “stories” is a pair of “right-angled 90-degree socks” (Chokkaku Kutsuhsita) – the way your foot extends form your leg, rather than a conventional sock at a 120-degree angle. The angle between the heel and sole on the socks is 90 degrees, after research showed that the shape reduced shrinkage and damage. One of the global associates of MUJI sent information that a sock knitted by a grandmother in Czech for her grandchildren has a right angle. MUJI thought it was very MUJI and invited the grandmother to come to Japan. Her knitting was video-recorded and MUJI asked a manufacturer whether it can mass-produce the socks. An immediate response from the manufacturer was, “Please do not joke. We cannot produce such a pair of socks.” The reason dates back to as long as during the Industrial Revolution in England when machines mass-produce socks at 120-degrees, an angle which allows the well-balanced mass-production of socks. MUJI persisted and they found a way to make machines to mass-produce the right-angled sock which was introduced in 2006 and improved in 2011 in partnership with a research center in Nara Prefecture. MUJI also used a more breathable and elastic material in the redesign. MUJI created a hit product selling over 7 million pairs annually.

The wide-moat strength of the MUJI brand is the mission, values and unique philosophy the company founders have identified and carefully cultivated:

  • Affordable, simple,  sleek, durable minimalist products designed well for a specific task and made of natural materials
  • An antithesis to the consumption society and designs created simply for profit-making
  • We leave room for the individuality of the customers to use products as users wish by eliminating commercialism and waste
  • No name, anonymous, not inducing consumers to purchase due to the names of brands and designers
  • We try to take the viewpoint of the purchasers, consumers

Its growing cult-like customers come to identify and associate with the MUJI values, much in the same way Buffett-Munger described the power of association in See’s and Coca-Cola, brands associated with people being happy around the world. MUJI customer is more about the lifestyle of the MUJI brand promise and values. Its core, core customer is really core. They don’t think about which furniture or stationary or household product store they should visit. MUJI is more about regular shopping, lifestyle shopping.

MUJI has also improved its excellent customer service with a revamped store environment offering detailed lifestyle suggestions and the experience of discovery, in which product advisors and specialty sale staff (styling advisors, interior advisors, tasting advisors) help tailor choices for customers, offering suggestions for living, and customers can also see, touch and feel to discover their own original style at the Fragrance Studio, Stamp and Gifts Corner, Wood Environment Play Area. MUJI’s online sales has also been growing steadily and now accounts for around 6.5% of sales.

MUJI was launched in 1980 by the late Seiji Tsutsumi (photo, left), the chairman of the Saison retail group, as an inexpensive house brand and line of merchandise for his Seiyu chain of supermarkets under the slogan “Cheap for a reason” (Wake Atte Yasui). Tsutsumi was the son of Yasujirō Tsutsumi, founder of the Seibu Railway. Following the death of his father in 1964, he led the spin-off of its logistics business to form the Saison Group, which eventually included the Seibu department stores, Seiyu supermarkets, Wave (a music shop), Parco (shopping complex), and the Muji and Loft variety store chains. MUJI no-name products soon garnered a following thanks to its iconoclastic simplicity designed by Ikko Tanaka (photo, right), a leading graphic designer, Kazuko Koike, who was MUJI’s creative director, and three other founding members. Tsutsumi-san and Tanaka-san observed that companies sell their products using highly manipulative marketing techniques and engage in meaningless branding. Tanaka had deep thoughts on how a man should be and live, and found it necessary to concretize his thoughts into products, expressing his antithesis to consumptive society. Thus, MUJI was born with a goal to produce products really valuable to consumers, instead of inducing them to purchase those with valueless brand names.

To concretize these values and concepts into products is not easy, which is why many imitators of MUJI did not go far. MUJI operationalize three processes: (1)…

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The systematic use of external designers and the crowdsourcing projects is an exemplification of the “open innovation” business model that characterized the “Bamboo Innovator”, as explained in earlier articles in how we systematically identify overlooked, underappreciated and misunderstood innovators.

MUJI’s information system also ensures the escalation of management reform. The sophisticated IT system can track with precise accuracy the movement of even a single pen throughout the country. MUJI also introduced an innovative business process support system for better decision-making in relation to customer information, automatic ordering to enable more accurate long-term demand forecasts and product planning. The logistics system was designed to coordinate every aspect of distribution from merchandise procurement to retail outlet supply (to ensure stable support of products), reduction of physical distribution costs, aggregation and transmission of product distribution information, and improvement of stores’ efficiency.

The evolution of MUJI also bears instructive lessons for value investors in looking beyond numbers to assess the erosion or widening of the economic moat. MUJI was very successful in the 1990s and they grew complacent. MUJI started to…

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The rise and fall and rise again of MUJI remind us of what the late American writer Carl Sandburg once said:

“When an institution goes down or a society perishes, one condition may always be found. It forgot where it came from. They lost sight of what had brought them along”

We observe the Sandburg effect in different companies. For instance, whenever McDonald’s was embroiled in controversies that were the result of its neglect of the core values, such as the usage of low-quality or unhealthy ingredients, it flounders. When the Golden Arches went back to rediscover the core values, it rises back up, like it did when it created a healthier and higher-quality image since 2003, although McDonald’s had neglected its core values to stumble again. Without the workable intangible culture and core values, the tangible assets, such as its vast retail property assets, would amount to a dark-cloud-like ominous liability, particularly when leverage is involved.

At MUJI, the innovative designer spirit of the founders that include Tsutsumi-san and Tanaka-san has lived on and endured. Through MUJI, value investors get to experience the role of design and designers in brand-based moats. A designer always approaches his or her work from the viewpoint of the consumer. Designers characteristically begin with the necessities in the life of the typical consumer. Design has the power to show consumers the future in a very tangible way. We believe that companies can use this power to communicate corporate vision, as well as to create new businesses and services that let consumers dream about future lifestyles while creating demand by society. Today, companies need to create new products and services over a shorter lifecycle and we live in a time where companies have to move beyond the question of process efficiency and “branding” through marketing, creating something to sell that is something more to do with commercialism rather than the essential nature of the product itself. The creativity of design can help companies make enormous leaps forward in developing new ideas.

Today, there aren’t many business leaders in the world today who have embraced design as a way to create business. MUJI has embraced and exemplified this idea from its earliest days. The MUJI approach takes design beyond an approach to management, incorporating it into every business and product as an inseparable part of the whole. MUJI was essentially founded by designers, not businessmen with retailing backgrounds. Tsutsumi-san brought Ikko Tanaka and a number of other designers and creators to create MUJI in a single generation.

Ikko Tanaka was the first MUJI art director, and he was famous for saying that they created MUJI as a way to find the best consumers in Japan. Normally, a business says that they want to offer the best products to the consumer. MUJI’s approach was the opposite, which is very refreshing. Retail companies will normally sell anything that the consumer will buy. But, MUJI refuses to sell anything that won’t lead to better living on the part of the consumer. MUJI is looking for the best consumers to offer them a more fulfilled, conscientious lifestyle.

Ikko Tanaka and the other designers-creators believed that design would be able to elevate the lifestyles of Japan’s regular citizens, rather than be something just for Japan’s noble or feudal class. They refused to accept the form and ornamentation of Japan’s traditional authoritarianism.

MUJI communicated the message that living well and enjoying a quality lifestyle didn’t mean buying the expensive brands and luxury items that were so popular. MUJI chose to pioneer a completely new path during a time when the markets were controlled by short-term popular trends. MUJI concept remains valid even as they expand globally. There’s a Japanese culture, spirit, and way of thinking that are inseparably connected with the MUJI philosophy. MUJI’s values meant that they didn’t have to focus on going out and selling products. The instant you focus on selling, you start to resort to flattery. The moment you focus on complex financing engineering schemes to generate short-term profits, you start to neglect the core business of serving customers and value investors can find this salient information in the footnotes on segmental performance that inevitably report the profit erosion in the core business. MUJI is a resilient Bamboo Innovator with a scalable open innovation business model that is embraced by employees, designers and consumers who share the same values and recognize not only the outward design, but also the underlying philosophies.

Above all, MUJI believe that corporate longevity depends on two principles: Flexibility and Conscience. Flexibility to respond to the fast environmental changes. Responding to these changes by asking two questions: “What brings happiness?” and “What will a fulfilled lifestyle look like for people in the future?” The second is the degree to which Japan values the principles of gratitude and service. MUJI does not believe in enriching ourselves at the expense of others. MUJI calls this value their “conscience.”

Flexibility and Conscience. This is the ultimate success factor behind Buffett-Munger when investing in consumer brands, viewing companies beyond the screens, checklist and numbers to assess both supply-side economics (network effect of distribution and IT system to scale up) and demand-side economics (psychology advantage in association with consumer happiness to sustain the competitive advantage period runway) in brand-based moats.

Have you shopped at MUJI to fully appreciate Buffett-Munger’s wisdom of brand-based moat to identify the next consumer-brand compounder? Brand it like Buffett-Munger at MUJI and other Asian innovators with Flexibility and Conscience!

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: The Weekly will be back on 30 June with the Monthly Riddle to the monthly Moat Report Asia for the month of July.

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 June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.

Buying Furniture with Warren Buffett and Mrs. B at Asia’s Wide-Moat Furniture Innovators – Bamboo Innovator Weekly Insight (Issue 87)

 “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 | June 15, 2015
Bamboo Innovator Insight (Issue 87)

  • 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,

Buying Furniture with Warren Buffett and Mrs. B at Asia’s Wide-Moat Furniture Innovators

MUNGER: I think Warren and I can match anybody’s failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed… 

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That’s true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail…a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done. 

BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don’t know, the 50th market in the country? This store does $450 million annually… But there’s no store that remotely can offer the variety. There’s no store that can undersell us.

“Sell cheap and tell the truth.” – Rose Blumkin (Mrs. B) of Nebraska Furniture Mart (NFM)

“I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.” – Buffett

Buffett in the 2004 AGM: “I cost us about $10 billion. I set out to buy 100 million sharers [in Wal-Mart], pre-split, at $23. We bought a little [5 million shares] and it moved up a bit and I stopped buying. Perhaps I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot.”

What is the investment Achilles heel of Warren Buffett and Charlie Munger? How did they overcome this weakness? Are there positive inspiring entrepreneurial stories of wide-moat innovators in Asia in this area of vulnerability and how can value investors use a framework to identify them? We will travel together to Asia to examine the success factors of an Asian wide-moat innovator who still holds the record for the longest continuous sales and profit growth – 28 straight years – of any listed company in its country and its market cap had compounded over 9-folds since 2002 to $8.5bn.

Furniture

First, back to Buffett’s Achilles heel, which appears to be in the “tough, tough” retail industry, from the above CNBC interview in 2014, given that it is “hard to establish a permanent moat that your competitors can’t cross”. Also, their biggest error of omission, as Buffett admitted during Berkshire Hathaway 2004 AGM, had been his “thumb-sucking” reluctance in investing more in Wal-Mart in the 1990s because of one-eighth of a point uptick in the stock price. Buffett’s self-awareness and candor saw him making right his earlier decision in Wal-Mart by building a large position in 2005, according to SEC filings, and now owns 60.385m of its shares, at probably an average price of $51-60 as compared to the current price of $72 per share.

Mrs B

Thus, one of the best investment deals that Warren Buffett considered he has made was ironically in a retailer, a furniture store called Nebraska Furniture Mart (NFM). NFM was founded in 1937 by the late Rose Blumkin, fondly known as “Mrs. B”, a Russian immigrant to America, with $500 she had saved for 16 years selling used clothes. NFM was set up in Omaha with no locational or product advantage and goes up against rich, long-entrenched competition – and grew to become one of the top furniture retailers in the country and into the radar screen of Buffett. After several attempts to buy the business and rebuffed each time Buffett acquired 90% of NFM for $55m on his birthday on Aug 30, 1983 with a purchase proposal just over a page without the involvement of investment bankers or lawyers. Buffett didn’t audit her company, nor did he check her receivables, inventory, and real estate titles. Mrs. B agreed to make a deal with Buffett at the age of 89 because, she figured, if she sold the company before she died, then her children wouldn’t fight over it. After tucking in the cheque, Mrs. B reportedly said: “Mr. Buffett, we’re going to put our competitors through a meat grinder.” Mrs. B work ethics was phenomenal: “I come home to eat and sleep, and that’s about it. I can’t wait until it gets daylight so I can get back to the business.” She was on the floor until retiring at 103, and died the following year in 1998, with the business well taken care of by her capable children. Today, more than 30 years later, the Omaha-based store generated more than $450m in annual sales, with Buffett proclaiming confidently that the store will become “very big” and “will do over $1 billion”.

Buffett had tried to assemble a furniture empire since with the purchase of Utah-based RC Wiley in May 1995, Star Furniture in Jun 1997, Jordan’s Furniture in Oct 1999, and rental furniture provider CORT Business Services Corporation in Jan 2000. But none came close to matching NFM’s success. In Jun 2004, Berkshire also invested 9% In home furnishing retailer Pier 1 Imports (NYSE: PIR), an investment that did not work out. In Aug 2007, according to Bloomberg news, Buffett even mentioned about the Swedish-controlled flat-packed furniture retail innovator IKEA as a possible investment target, though the trust foundation setup at IKEA made the acquisition impossible.

Every year, when undergraduate students from 40 universities compete for a trip to Omaha to spend a day with Buffett, the Oracle would bring students to Mrs. B’s store to show what can result from hard work and sheer will. Buffett has previously told reporters that he would have rather done business with Blumkin over any highly pedigreed MBA in the country. Buffett explained the success factors behind NFM: “I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions falling outside of that area of competence; and (4) unfailingly behave in a high grade manner with everyone they deal with. (Mrs. B boils it down to sell cheap and tell the truth.)” In his 2013 letter to BRK shareholders, Buffett wrote: “Aspiring business managers should look hard at the plain, but rare, attributes that produced Mrs. B’s incredible success. If they absorb Mrs. B’s lessons, they need none from me.”

Make no mistake: NFM and IKEA are the rare exceptions. Furniture retailers face at least two critical economic hurdles and problems in building a wide moat and scaling up its business model. After all, can anyone still remember the once-mighty Heilig-Myers (HM)? HM used to the largest furniture retailer in the United States in the 1990s with over 1,000 stores nationwide – and it filed for Chapter 11 bankruptcy on Aug 17, 2000 and was also embroiled in an accounting fraud scandal.

It was distribution and delivery problems that helped bring down HM when it over-expanded nation-wide in 1993 as it buckled under the costs of operating large distribution centers and sprawling home delivery systems. Thus, the first critical problem to understanding the wisdom of Buffett beyond the usual quant screens, checklist and financial numbers when he commented why it is “hard to establish a permanent moat” in retail: Every furniture retailer hoping to go national must eventually overcome the same economic hurdle: the diminishing returns that kick in when a single distribution center can no longer serve all of a chain’s stores.

The second critical problem: HM, like other furniture retailers, relied on financing customers’ furniture purchases with installment loans, usually of two-year duration. Much like a financial services firm, HM provided its own debt servicing and realized revenue from the interest and fees collected from servicing the installment loans. That revenue accounted for up to one-third of profit in some years. HM lost focus in its core business improvement and dabbled in complex financing engineering transactions to boost short-term profits.

Specifically, HM transferred most of its installment sales to a trust account that issued certificates backed by the collection of the installment loans—asset-backed securities (ABS), and some were held by HM in a special-purpose entity (SPE) which were reported on its balance sheet at fair-market value despite the fact that these securities were never traded in a public market. When consumers with better credit quality began using credit cards for purchases rather than Heilig-Meyers installment loan plans, the loan plans were increasingly issued to consumers with low credit quality who defaulted and HM was awashed in toxic waste. The accounting fraud scandal was that Heilig-Meyers kept two sets of accounting books: the company was basing its loss and delinquency statistics on historical patterns rather than current data based on actual payments and collections which showed that HM was not as profitable as they wanted investors to believe. Heilig-Meyers used a “recency” accounting method rather than the standard “contractual” method, and that actual loss and delinquency rates on the contracts were in fact twice as high as stated by the company. In short, the ABS was based on the overly optimistic figures, which improperly inflated the true collateral behind them.

Thus, making and selling affordable furniture for the end customers is critical to avoid the temptations of financial engineering.

Let’s examine the success factors and business model of Nitori Holdings (TSE: 9843, MV $8.5bn) who still holds the record for the longest continuous sales and profit growth – 28 straight years – of any TSE-listed company.

Nitori is the largest furniture retailer in Japan with a 15% market share with around 300 Nitori stores, 17 Deco Home and 19 overseas stores. Rivals include Shimachu (6% market share), IKEA Japan which entered Japan in 2006 (3%), Otsuka Kagu (2%), GMS (21%) and home centers (5%), department stores (4%) and small specialist mom-and-pop stores (44%). Nitori was established in 1972 by Akio Nitori in Sapporo, Hokkaido in the northern island of Japan. Hokkaido is home to a number of innovative retailers, many of which started out in the early 1990s, when the bubble economy collapsed. Nitori first listed in the Sapporo Stock Exchange in 1989, followed by the listing on TSE in 2002.

Nitori grew by…

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Nitori is also renowned for its tight quality control in which less than 1% of items sold are found to be defective, winning customer’s trust. To achieve this, Nitori hired former Honda engineering specialists, many of whom are in their 60s, and gave them an engineer’s paradise. Theses engineers break chairs to see why they splinter, wash pillow covers with acid to see if their colors bleed, left lightbulbs on for hours to see how hot they get.

Like the legendary Sam Walton who has a penchant for the right analysis of data, Nitori tracks a long list of data: customer traffic; the age of every store and employee; the number of quality complaints; profit and sales area per employee. To each the company assigns a target, most of which Nitori can recite from memory.

Nitori’s motto is: “Our greatest pleasure if offering and achieving ‘true life affluence’ for our Japanese customers.” Yet, like Mrs. B, many people do not know the pains and challenges that Nitori-san had to endure and overcome in order to realize this motto. Interestingly, both Mrs. B and Akio Nitori had the same life experience when they are trying to implement their low-price strategy.

Nitori

For Mrs. B, Buffett wrote that when furniture manufacturers stopped selling directly to her after bigger customers in Omaha complained about her low retail prices, she travelled to Kansas City, Chicago and New York, bought from department stores and still undersold her rivals. Her competitors used fair means and foul, and after pressurising manufacturers to stop supplying her, hauled her into court charging her with violating Fair Trade laws. But “she not only won all the cases….at the end of one case she sold the judge $1,400 worth of carpet.”

In the late 1960s, when Akio Nitori was just starting its business, local furniture wholesalers wielded enormous power, because it was relatively difficult to buy products in Hokkaido, primarily due to geographical and transport-related factors. If a company tried to accelerate its store launches by selling products at low prices, wholesalers would refuse to do business with it, as such firms were seen as troublemakers disrupting the status quo of the industry. For this reason, Nitori started buying products from wholesalers based in Niigata and Gunma prefectures. “But the transactions with them ended quickly, as information was passed on from the Hokkaido-based wholesalers,” Nitori said.

A major life-changing event was when Akio Nitori joined the Pegasus Club in 1972, the year when Nitori was officially established. The Pegasus Club was formed in 1962 to study the US and European chain-store management system and led by distribution consultant Shunichi Atsumi. Young small-business retail executives at that time, such as Daiei’s Isao Nakauchi, Aeon’s Takuya Okada, and 7-Eleven/Ito-Yokaido’s Masatoshi Ito, were among the initial participants. A core principle of the Pegasus Club is “thorough rejection of the current situation and always looking ahead to a better format in 10-30 years.” Akio Nitori’s approach of setting long-term goals and determining the right steps to achieve these goals is heavily influenced by the Pegasus Club.

The Pegasus Club organized a trip to US and Akio Nitori, 27 and the owner of two furniture stores, joined in the trip to learn more about how overseas retailers operate. Nitori spent a week in California, shopping and observing the way Americans lived. He was inspired by the insights gleaned from the US trip and was determined to achieve a “logistics revolution” to grow and scale a national chain store:

“When I visited chain stores in the United States more than 30 years ago, I was overwhelmingly impressed and marveled at the wide disparities with Japan in terms of consumer values such as low prices, merchandise selection and product quality. Creating a home that is enjoyable, relaxing, harmonious and suited to the residents’ lifestyle is a well-established activity in Europe and America, and the reason is the means exist for easily purchasing, at a reasonable price, home products that can be readily coordinated. Nitori has declared its dreams of ‘realization of a society where Japanese can enjoy true life affluence’ and by taking the excitement, stimulation and resolve of that time as its starting point, Nitori is striving to achieve a “logistics revolution” centered on the creation of a national chain store.”

Thus, to the bullying powerful local furniture wholesalers, Nitori found a solution outside the country. The company started…

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Besides Nitori, another wide-moat furniture innovator that we have written earlier in Mar 2014 in the article Willingness to be Misunderstood and the Swedish Corporate Model to Scale an Asian Wide-Moat Compounder: The Story of “Korea’s IKEA” Hanssem is Korea’s Hanssem (009240 KS, MV $5.6bn), whose market cap had since jumped by 270%.

********

In the 1983 annual report, Buffett explains how, at 23, Rose talked her way past a border guard to leave Russia for America. Mrs B had no formal education and knew no English. She learnt the language from her elder daughter who taught her, every evening, the words she learnt in school during the day. Mrs. B had worked in the store at age 6, talking her way into a job as a store clerk when she was 13 and becoming manager with six men working under her three years later. When her initial resources, the $500 savings that took her 16 years to accumulate to establish NFM, ran out, she sold every appliance and piece of furniture in her home to pay off a debt.

So how can value investors identify wide-moat business models and the entrepreneurial owner-operators, like the tough Mrs. B, who run them? Buffett revealed his mental model in the quote below and in a Charlie Rose:

“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business—one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Charlie Rose: How was she able to kill them [the competition]?

Warren Buffett: She cared and she was smart. She knew her limitations of her knowledge and she was confident in the circle of her competence. She didn’t get outside of it and she took care of her customers. She sold cheap and it took her a long time but she built the largest home furnishing store in the country in a town like Omaha, a town of 700,000 people. She was a remarkable woman, and Charlie, she could not read or write and I think every business school should study her.

Charlie Rose: What would they learn?

Buffett: They would learn the essence of business. They would learn that taking care of customers is what it is all about. Taking care of them. I mean by that, giving them good deals, which nobody would touch. She did and working like crazy she was there day after day. She had a passion for it. The truth is, if you took the Fortune 500 CEO’s and I gave you the first draft pick on 10 of them, and I put them in competition with her; she would win.

Buffett compared her to the late Walmart founder Sam Walton:

“One thing that Sam Walton and Mrs. B had in common is they had passion for the business. It isn’t about the money, at all. It was about winning. Passion counts enormously; you have to really be doing it because you love the results, rather than the money. When we buy businesses, we are looking for people that will not lose an ounce of passion for the business even after their business is sold. After all, doing business with someone who is driven by beating the competition by creating a superior company rather than simply finding ways to build a war chest is what it’s all about.”

In essence, Buffett’s mental model beyond the numbers to identify wide-moat innovators is to sense that an entrepreneur takes care of his or her customers in a deep way and keep delivering exceptional value to them. Even if it means pains and sacrifices. Even if there are bullies. Even if it takes a long time, working crazy day-in-day-out. Even if they grow rich. All possible only because they are committed to an idea larger than themselves.

When Nitori returned from California in his life-changing trip in 1972 and inspired to carry out his “logistics revolution” to offer and achieve “true life affluence” for the Japanese customers, he did some quick calculations. It took America 120 years to develop its retail industry, and he guessed it would take him 60 years to catch up. He began crafting a six-decade plan then that he continues to refine today. With his single-minded focus on keeping prices down for customers without disappointing them on quality.

Who are your Mrs. B and Akio Nitori in Asia?

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 June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.

Eating Out with Warren Buffett at Asia’s Wide-Moat Restaurant Innovators – Bamboo Innovator Weekly Insight (Issue 86)

 “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 | June 8, 2015
Bamboo Innovator Insight (Issue 86)

  • 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,

Eating Out with Warren Buffett at Asia’s Wide-Moat Restaurant Innovators

“If you have an enemy, wish upon them a restaurant.”

– An old Chinese curse

“…the more important point even, is that 3G – they’re not buying things to sell. And the other private equity firms.. buy companies with the idea of either IPO-ing them or selling them to competitors, or selling them to another private equity firm. That is not 3G’s strategy. They bought Burger King which is now Restaurant Brands International. They bought that to keep.”

– Buffett in a CNBC interview. In a Berkshire Hathaway (BRK/A) news release dated December 12, 2014, Berkshire revealed that it currently owns 4.18% of the common shares of Restaurant Brands International (QSR), the new parent for Burger King and Tim Hortons fast-food chains. Berkshire also holds $3bn of preferred shares in Restaurant Brands that earns 9% annual interest.

Warren Buffett has defied this old Chinese curse of restaurant business only rarely in his illustrious investments career.

While restaurant chains have been a favorite target for value investors and private equity firms, because their cash-flow makes financing deals easy and brands can benefit from cost-cutting, the business dynamics of a restaurant business is characterized by challenges that makes them “a business that becomes harder as it grows bigger” and over 6 to 8 new restaurants out of 10 fail in the initial years. The deep-seated challenges surface in the form of (1) high fixed costs in operations; (2) the struggle to maintain consistent quality, uniqueness and experience in food and service at the individual outlets as it scales up in expansion – and one bad experience can eradicate three or four great customer experiences; (3) availability of suitable locations; (4) being held hostage by the key personnel that include the chef and restaurant manager and high employee turnover; and (5) low barriers-to-entry with little or no economic moat.

The deep thoughts behind Buffett’s restaurant investments hold important lessons for value investors to uncover inspiring innovators in the restaurant business in Asia. With Buffett’s wisdom, we will better understand the story of how an electrical engineer-turned-billionaire restaurant-prenuer has been able to build a wide-moat in his restaurant chain known for its “dancing staff”, tech innovations and whose market value compounded to $1.47bn in market value after growing from only one outlet prior to 1984 to over 550 restaurants throughout Asia.

However, such positive investment success stories in the restaurant business are uncommon. After all, Yum! Brands (YUM) had to write off $361m in goodwill in Feb 2015 related to the ever shrinking value of the company’s 2012 purchase of Little Sheep Mongolian Hot Pot for $860m from private equity firm 3i, following an earlier impairment charge of $258m in 3Q13. In Mar 2015, CVC Capital had to freeze the assets of the flamboyant Chinese restaurant owner Zhang Lan who sold sold a majority stake in her company South Beauty to the European private equity group last year for $300m, due to accounting tunnelling fraud. In India, there are private equity investment failures in Nirula’s, once the sole symbol of fast food in Delhi, south-Indian food chain Sagar Ratna Restaurant, Bangalore-based food chain Vasudev Adiga, etc.

But first, let’s understand Buffett’s previous restaurant investment 14 years ago before his recent deal in Restaurant Brands International (QSR), the new parent for Burger King and Tim Horton’s fast-food chains.

In 2001, Buffett bought 1.9m shares in OSI Restaurant Partners, owner of Outback Steakhouse, for $48m at around $25 per share. By 4Q06, Buffett completely sold his stake when OSI announced in Nov 2006 that it will be acquired by Bain Capital Partners for $3.18bn with the assumption of $185m in debt, or $40 per share, a 27% premium over its last traded price before the deal. In its final fiscal year (2006) as a public company, its operating profit was $152.3m. In 2008, revenue and profits declined and Bain was forced to take a goodwill impairment charge of $726m, an indication that it had seriously overpaid for Outback and the rest of OSI’s restaurant concepts. Prior to the acquisition, OSI’s debt was less than $200m, and its annual interest expense was just under $15m. After the takeover, debt was $2.6bn with $136m in interest, topping out in 2008 at $197m. OSI was relisted as Bloomin’ Brands Inc (BLMN) in Aug 2012 and it had managed to reduce its debt to $1.8bn and an annual interest bill of $83m. Its present market value at $2.7bn is still below the $3bn valuation nearly nine years when it was taken private. Interestingly, Buffalo’s Wild Wings (BWLD) is up more than 13-fold since its 2004 listing to a market cap of $2.9bn.

OSI is part of the two big waves of PE acquisitions in the restaurant industry in 2005-2006 and 2010-2011. Since 2005, over $21bn in transactions has been recorded. Despite their average EV/EBITDA at acquisition at the decently attractive level of around 7.4x, many have failed and entered into Chapter 11, including Charlie Brown’s, Uno Chicago Grill, Sbarro’s, Bugaboo Creek, etc. OSI former staff and early leaders who inspired Outback commented how with the new private equity owners, the people-first attitude has left and been replaced by a devotion to profits.

What could have attracted Buffett to OSI beyond the financial numbers? Or put in another way, why is Outback able to build a wide-moat in its business model when the general restaurant business has little or no economic moat?

OSI

Outback Steakhouse began as one restaurant in 1988. The founders were two corporate guys and two art majors, Chris Sullivan, Trudy Cooper, Bob Basham and Tim Gannon (photo on left), who established the company because they felt they were not treated fairly by their former employee, Pillsbury, after helping the company grow the Bennigan’s chain. The founders resolve that if they were ever to own a business, they would never make anyone feel the way they were made to feel – underappreciated and under-rewarded.

This was the underlying motivation behind the unique Outback ownership structure, which requires each restaurant manager invest $25,000 in his or her restaurant in exchange for a 10% ownership stake. Outback’s original reason was to create a company that did not take advantage of its employees but that shared the benefits of success with those who make it happen. The Outback’s founders understood people. They knew that (1) People want to be part of something that they can believe in and be proud of, (2) People want to be respected, treated fairly, recognized, and have the opportunity to advance, (3) People want to have control over their destiny.

Outback’s owners believed in decentralized management. “We’ve been in their shoes. We’ve worked for companies and said, “If you guys would just leave us alone and let us do our jobs, we would be so much more efficient.” Each restaurant is a separate entity owned by Outback, a regional partner, and the restaurant’s general manager. Ownership means actual equity ownership – sharing in the annual profits and building equity under a buyout formula of 5x the last 2 years’ average annual cashflow. Other store personnel share in a bonus system on a quarterly and annual basis. People can see career paths and actual ownership at Outback, where the founders take great pride in the fact that they have created more millionaires than any other restaurant company. Every restaurant manager, JV or regional partner, and in some cases, chefs, too, are required to invest $25,000 to $50,000 cash for a 6 to 10% ownership interest in the restaurant depending on the concept. Store managers then are paid a base salary, and they receive stock options and 10% of the restaurant’s profits. They have a 5-year employment agreement and at the end of 5 years, they can resign or sell back their ownership interest based on a formula of 5 times the average cashflow for the last two years. Most managers who work at Outback for 10 years become millionaires. They also care about their restaurant, act like owners (because they are), and are able to engage their employees. Interestingly, Outback has no HR department. In addition, each restaurant has a profit-sharing program for waiters, waitresses, hosts and hostesses that is paid out quarterly.

In addition, the company took steps to maintain positive working conditions for its employees, so that they would provide cheerful service to the restaurant’s patrons. “If you worry about your employees and their environment and their ability to do the job, and you make sure they’re happy, you don’t have to worry about the guest,” Gannon said. Accordingly, wait staff were responsible for only three tables apiece, and the company devoted 40% of the space at each location to the kitchen so food preparers would not be crowded. “We understand from having been managers, waiters, cooks, what they feel like,” Gannon said, “We know what the heat of the kitchen is like — personally.” Outback’s attractive arrangements for restaurant general managers and staff resulted in management turnover of 5% compared to 30 to 40% industrywide.

So who is the wide-moat restaurant innovator in Asia that we mentioned is famous for its “dancing staff” and tech innovations?

MK Restaurant Group PCL (SET: M) Stock Price Performance 2013-2015

MKMK Dance

At family business MK Restaurants Group PCL (SET: M, MV $1.47bn), best known for its popular chain of value-for-money sukiyaki restaurants in Thailand where customers cook their food in hotpots at their tables, managing director Rit Thirakomen explained that the “MK dance” began within the company, as staff were asked to dance after arriving at their restaurants early in the morning, before they began serving customers. The original objective was to create an opportunity for restaurant managers to talk to their staff each day as a means of solving or pre-empting problems. It also helped to “energise” sleepy staff members. The MK dancing also helped staff to overcome shyness and work as a united group. Some diners have found it such fun that they have even formed a club to occasionally join in dancing with the MK staff. MK branches now have dancing shows for customers at noon and in the evening.

MK RitAn electrical engineer, Khun Rit, 63, cofounded the book publisher Se-Education (SET: SEED, MV $69m) in 1974 and worked there until 1986, when he joined in 1984 his wife Yupin’s family restaurant business founded by his late mother-in-law. Khun Rit spearheaded MK’s expansion into sukiyaki and eventually other Japanese food with the Yayoi chain. Despite a slowing economy, Khun Rit opened 55 new restaurants in 2014, taking its total to 557, in line with its target of having 1,000 restaurants by 2018. In March 2015, MK made a splash with London Street, Thailand’s first community food mall in Bangkok on Phatthanakan Road based on the concept of a London-chic design, which houses all 5 of MK’s restaurant brands (photo on right). MK generates $448m in sales and $62m in net profits and  $110m in EBITDA, trading at EV/EBITDA of 13x with a debt-free balance sheet and net cash of $389m.

MK Restaurants has been investing in IT every year for almost a decade. Before the advent of iPad, MK had invested in personal digital assistant (PDA)-based ordering system in 2004, with the aim to improve service time in food ordering. Many people questioned the investment. Not only was the system able to save operating costs and time spent in serving customers, thereby freeing up tables more rapidly, but also a lot of customer satisfaction was created. The investment outlay would be returned in only two years and MK was able to satisfy even more customers. The restaurant chain also invested in GPS installed in all of its trucks to improve its logistics management and save on fuel costs. Khun Rit also planned to enhance the good relationship between MK Restaurants and its customers by issuing RFID-based member cards. In this way, existing customers will immediately be recognised in any branch and details revealed such as their favourite dishes. “With the smarter member cards, we will be able to treat our regular customers with the same standard of service as soon as they come in, even at different branches.”

An engineer by education, Khun Rit said he preferred systematic methods rather than solving problems case by case.  “From a small restaurant growing into over 500 branches, our target has always been to create customer satisfaction. Every customer must feel happy when they visit our restaurants. We don’t overlook even the smallest details. At MK, we design everything – from the smallest to the biggest matters,” Khun Rit explained. In paying attention to the smallest details, MK believes that most problems represent “the tip of the iceberg” and there is a need to discover the real causes. Some examples of MK’s attention to details incorporated into “MK designs” from design of services and extended into recruitment, training, motivation, the organisation’s culture, customer feedback, quality auditing and strategy alignment:

  • MK’s customer-focus strategy includes providing comment cards on every table. To encourage clients to fill in the comment cards, the company created a colour-code scheme. If a customer rates MK’s service very highly, they mark the card in blue. Orange is used for a very poor rating, and red for areas that need improvement. The strategy has been used since 1996. In the first three years, Khun Rit saw red and orange colours being marked more often than blue. These responses helped the company identify and rectify its weaknesses.
  • Instead of expecting each of its suppliers to deliver goods to the company’s restaurants all over the country, requiring more than 20,000 trips each day, MK has the goods delivered to one of its two factories. Here, the goods are processed or materials and ingredients combined and then the company’s own fleet delivers supplies to the restaurants at least once or twice daily, requiring about 300 trips per day.

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Employees work hard for companies where they believe they have a future and where they can have an impact. In the case at OSI, when they see that current top managers started out where they are now, as line employees, a powerful, self-reinforcing system is created. But the attitude and resulting behavior of top management is key. Humbleness is mission-critical. Top managers who have a sense of entitlement or superiority generally do not fit at high-growth companies, where humility is more important than status. Top management receives few perks at these companies. Except for compensation, the companies try to eliminate elitist executive perks.

Like Buffett, the authentic value investors go beyond quant screens, checklists and financial numbers to understand the underlying business model dynamics that in turn is influenced by the motivation and character of the entrepreneurs and owner-managers.

Just as OSI founders were influenced deeply by their experience of unfair treatment at their former employers and wanted to make things right by building an owner-manager environment, MK’s Khun Rit was shaped profoundly by his childhood experience which led him to found his first company called SE Education (SET: SEED). Khun Rit reminisced: “When I was a child, Thailand was still poor. The people were less educated, with no opportunities for them to receive a good education. I was hoping to see everybody allowed to receive a good education. I successfully entered the engineering faculty of the prestigious Chulalongkorn University. Because my long-cherished desire to receive a good education was achieved, I studied even harder at the university. I also helped my friends from time to time by translating their materials into English for them. Many of them were poor at English, so I helped them. This experience led me to establish a company for publishing and selling books. That is the company now called Se-Education. Our company has 300 branches across the country. I launched this company with a few classmates who graduated from the university along with me. This was an achievement of my childhood dream. As the company expanded, my life became gradually wealthy. This made me feel happy about the fact that we are providing less-educated people opportunities to cultivate themselves.”

Besides MK as the role model of a wide-moat innovator in the casual-dining space in Asia, there are two wide-moat innovators in the quick-serve segment: Café de Coral (341 HK, $2.2bn) and…

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Café de Coral (341 HK) Stock Price Performance 1986-2015

Cafe de Coral

Victor LoIn an earlier article in Jul 2014, we had highlighted briefly Café de Coral, the largest fast-food chain in HK with over 580 outlets across its brands all over the world. Café de Coral was started in 1968 by Victor Lo Tang-seong and Lo Kai-muk, the second-generation leaders of the inspiring founder behind Vitasoy (345 HK, MV $1.8bn) – Dr. KS Lo. The spirit of Dr. KS Lo to want to produce a cheap, nutritious, high-protein soya milk after observing severe malnutrition in children caused by diseases in mainland China and HK had inspired the next generation of leaders in Sunny Lo Hoi-kwong (photo) who scaled Café de Coral to greater heights and had passed on the baton to his son-in-law Michael Chan. We wrote:

“Both Shin and KS were inspired by the idea larger than oneself: to bring about kindness and betterment to children and people in ruined lands through food technology and quality products and services. This larger idea has galvanized the trust and support among the community of customers, business partners and suppliers throughout the years. Whenever this core value is diluted, without the accompanying culture of trust and decentralization to empower the people in the pursuit of growth, globalization, size and diversification, chinks in the mighty armour start to appear and can deteriorate quickly into major problems that would bring down the organization.”

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Finally, to the next generation of leaders, MK’s Khun Rit offered the following viewpoint:

Study hard and find what you want to do in life, something you feel passionate about. These cannot be found unless you look for them seriously. If you can find a career that you really aspired to, this should be better than anything else. We are like artists who try to create good works but returning to them again and again and improving them little by little. A beautiful work can be created with a repetition of very careful, not hasty, finishing touches. Entrepreneurs need to have passion in what they are doing and a strong belief that other people will have the same passion for the products and services they deliver.”

BuffettAs we eat out with Warren Buffett at these Asian wide-moat restaurant innovators amidst the multiple restaurant failures with seemingly attractive low EV/EBITDA valuations multiples from the screens and checklist, value investors come out with one important insight to think differently about the way that we “eat” and to stay resilient against the old Chinese curse.

What unites the original OSI, MK, Café de Coral and… is a sense of mission towards their customers and the people around them which inspires the extra level of intensity and dedication for them, forged by enduring dimensions as character, values, beliefs, capabilities, and personality. In a business organization, these enduring characteristics are a firm’s culture – the so-called soft factors that will actually sustain it over many years and through many situations while the hard factors like financial performance all too quickly come and go. These enduring characteristics resonate like the resolute gong of the temple bell because the sound reverberates in our hearts, stirring the everlasting values that matter: Forbearance, Honor, Duty, Hardwork, Fairness, and Humility, the timeless values that epitomize the Warren Buffett and Charlie Munger way of value investing and the core values of the Bamboo Innovator that bend but never break.

Thus, before you start to bite into that restaurant stock based on its seemingly attractive numbers, make sure you are able to go back to the basics to digest this: Do you assess the numbers and valuations to be backed by a wide-moat business model and an enduring corporate culture that promotes owner-operators? Is there an idea larger than oneself underlying the business model? If your answer is a resounding Yes!, then you are able to eat well – and sleep soundly.

Warm regards,

KB

The Moat Report Asia

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In the month of June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.

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