Category Archives: Mental Model

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

 

 

2016 ANNUAL PERFORMANCE REVIEW

 

While the annual performance review is somewhat arbitrary, it is good to review you investment process on a regular basis to find improvements.

 

In 2016, the average local currency return of our recommendations was -3.1% with the average US dollar return not far off at -3.0%. Relative performance was -5.3% as the Emerging Market Small Cap Index as measured by iShares MSCI Emerging Market Small Cap ETF (EEMS) was up 2.3% compared to our average US dollar return of -3.0%.

 

The major drag on the performance of recommendations was Miko International and Universal Health. Universal Health saw a significant decline after its founder and majority took a loan against the company’s shares leading to forced selling in the stock. Subsequently, the company’s operational performance deteriorated drastically leading us to question the validity of the company’s initial financial statements. Miko International saw a number of independent directors resign followed by its auditor resigning due to disagreements over accounts in the company’s financial statements. It hired an auditor of last resort known to work with many Chinese frauds. We also saw poor performance at another Chinese company Honworld as management’s poor capital allocation inhibits its ability to grow without raising external funds. The poor performance of the Chinese small and mid caps leads us to question the financial statements in many Chinese small and mid cap companies. Given the inability to have any conviction, we are taking a smaller position if we invest in Chinese companies. Our other Chinese investments in Peak Sports Products and Anta Sports Products were our second and third best performing stocks in 2017 making us not totally write off investing in Chinese companies. Interestingly, the poorly performing Chinese companies all recently went public and therefore we have implemented a rule of not purchasing any stock that went public in the last three years.

 

The poor performance of Universal Health and Miko International highlighted the limits to our knowledge leading us to be less aggressive with our position sizing. Our new position sizing philosophy is 1-2% for high quality watch list stocks like Credit Analysis and Research and Anta Sports, 2.0% for deep value, 2.0% for Chinese companies, and from 2.0% to 8.0% for high quality companies depending on the strength of the business and attractiveness of returns. The goal is to get 25-35 holdings. The smaller position sizes do not match with the depth of our research. Our research was deep dive taking up to a month. The depth of research clearly required the ability to take larger position sizes as you can research only 12 ideas in a year. Assuming, half that are fully researched reach our investment standard leads to a maximum of six recommendations per year. There is no way we could ever be fully invested with our new position size philosophy, therefore, we are decreasing the depth of the research so we can hopefully one day get close to fully invested. We will focus on the crucial elements of every investment but not as much in depth. Hopefully, this will also increase the value of the blog for readers as we are trying generating more ideas by researching more companies. As mentioned, we will also be looking at high quality stocks that may be slightly more expensive than our typical investment but meets all other requirements. These will be formally placed on the watch list and placed in the portfolio at a smaller position size. Credit Analysis and Research and Anta Sports fall into this category. The hope is these positions will eventual become more attractive on valuations. The side benefit is highlighting more high quality companies.

 

Since May 2014, we have made 10 recommendations generating an average outperformance of 30.9%, with three recommendations having negative absolute performance. The average time from recommendation to sale is 459 days with four of the 10 recommendations still being held.

 

Overall, 2016 was not the best year for stock selection with underperformance of 5.3%. More importantly, we feel the mistakes made have allowed us to strength our process. Despite the bad year, our recommendations are up 30.9% since May 2014.

 

The table above illustrates position sizes at the end of each half since the end of the first half of 2014.

 

In 2016, our portfolio fell be 12.8% on the back of poor performance and large positions in Universal Health, Miko International, and Honworld. Despite the poor performance in 2016, our portfolio is up 12.3% in absolute terms since inception and 24.4% relative to EEMS, while averaging 67.9% of the portfolio in cash. The large cash position is a function of our high threshold for investment and the time required in our in depth research process. Hopefully, our shorter reports will allow us to be more efficient at finding ideas allowing us to put the cash to work.

 

While 2016 was not the best year in terms of performance, the improvements made to our process due to the mistakes made should more than make up for it in the future.

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

Mrs. Kusum Jain, a non-Executive Director, resigned from PC Jeweller’s board, with effect December 30, 2016. This is the first director resignation at PC Jeweller for some time, but it is worth monitoring in case there are additional resignations from independent directors.

 

On December 21, 2016, Zensar Technologies announced it appointed Manoj Jaiswal as Chief Financial Officer. Manoj Jaiswal was Chief Financial Officer for CEAT, another RPG Enterprises company. Before joining CEAT, Manoj had spent 17 years in Wipro in different roles.

 

Zensar also changed its auditor to Deloitte from PricewaterhouseCooper. Under Section 139(2) of the Companies Act, 2013, all listed companies and certain categories of unlisted public companies and private companies are mandated to rotate their auditors after 10 or more consecutive years.

 

On January 7, 2017, CARE announced that it was shutting down its Maldives operations after its license expired and decided not to renew. The Maldives operations were insignificant.

 

 

INTERESTING LINKS

 

 

Horsehead Holdings (Aquamarine Fund)

 

Guy Spier, a noted value investor, and portfolio manager of Aquamarine Fund looks back at his investment in Horsehead Holdings. It is a very good template for looking back and learning from your investment mistakes. (link)

 

Looking For the Easy Game (Credit Suisse)

 

Credit Suisse’s Michael Mauboussin discusses passive and active investing. (link)

 

A Bird in Hand is Worth More Than (Forecasted) Eggs in the Future (Latticework)

 

This is a very good article by Amit Wadhwaney of Moerus Capital Management discussing his investment philosophy. (link)

 

The Future of Retail 2016 (Business Insider)

 

Business Insider’s BI Intelligence unit created an interesting slide deck on the future of retail. The slide on the article illustrates the share of digital in different categories. Useful for understanding what segments of retail are most impacted by the internet. (link)

 

Patagonia’s Philosopher King (New Yorker)

 

The New Yorker wrote an article on Yvon Chouinard, the co-founder of the outdoor-apparel company Patagonia. (link)

 

The Irrationality Within Us (Scientific American)

 

Scientific American discusses our irrationality. (link)

 

Charlie Munger on the Paradox in Hold vs. Buy Decisions in Long Term Investing (Fundoo Professor)

 

Professor Sanjay Bakshi discusses Charlie Munger’s thoughts on the decision to continue to hold a stock vs. the decision to buy a stock. (link) The comment section should be read as well as there are many insightful comments. As illustrated by the changing of our positions sizes, we do not subscribe to the buy and hold regardless of valuation. By saying that you would continue to hold an asset at a particular price but you would not buy the same amount if you did not hold it, you are ascribing more value to the asset you hold, which is a bit irrational and is known as the endowment effect. Endowment effect is valuing an item you own more than an identical item you do not own. We try to look at all companies the same way, whether we hold them or not. First, a high percentage of companies can be ruled out as a potential investment due to poor financial health, poor management, or poor business quality. We may compromise on business quality if the company is a deep value investment but there is a limit on this compromise. Once companies pass the first investment hurdle, we assess the attractiveness of the company based on its business quality, management, growth outlook, and risk. Future returns are estimated based on scenarios giving a range of potential returns. If the market values a company so highly that very aggressive assumptions are required to meet the market’s expectations, we would not buy a company or hold a position. If on the other hand, if the market was valuing that same company so cheaply that the most conservative assumptions pointed to significant upside and there was sufficient business quality, we would take our maximum position of 8%. In between the two extremes is a spectrum of potential returns leading to a spectrum of position sizes between 0% and 8%. The decision of the position size is based on the attractiveness of the returns of a business not whether we hold a stock or not.

 

Valuation and Investment Analysis (Bronte Capital)

 

Bronte Capital wrote an article discussing how they do not use valuations in their investment process. (link) Again, please read the comments as there are some useful comments.  Clearly, we do not agree with Bronte Capital’s view.  We agree that valuation is difficult and does not provide a point estimate that is why ranges and scenario analysis needs to be used in the valuation process or reverse engineering a DCF or Residual Income model to find out the market’s expectations of key value driver assumptions. These market assumptions can be tested for reasonableness. We believe it is very difficult for anyone to call themselves an investor if they do not have some estimate of what is the value of potential investment. Investing requires understanding the fundamentals of the business, and the valuations of the business. Value investing requires an additional margin of safety to ensure you are not buying a business with sufficiently attractive returns. Not having an estimate of the potential returns of an investment is pure speculation. Bronte Capital focus on operational momentum to ensure the business will continue to grow for a long time. The problem is growth stocks often do not meet the growth expectations of the market and this is precisely why you should have an understanding of what type of growth the market is expecting. Within the Emerging Markets small cap universe, the MSCI Emerging Markets Small Cap Growth Index has underperformed the MSCI Emerging Markets Small Cap Value Index by 141.34% over the past 16 years or 5.66% per annum. Similar to Bronte Capital, growth investors are more concerned with growth than valuation leading to missing a big piece of the puzzle in understanding a business.

 

Value vs. Growth in Emerging Markets

 

Given the past two articles, we thought it be interesting to review the performance of various Emerging Market indices to see how each style has performed.

 

The table above illustrates the performance of MSCI Emerging Market indices across size and style biases. Indices have various inception dates so the longest time period with performance for all indices is 10 years. Over that period, the best performing index is Emerging Markets Quality index followed by Small Cap Value and the Small Cap Index. Over the past 20 years within the large and mid cap universe, value outperformed growth by 1.00% per annum. Quality seems to be the best performing index outperforming the overall index by 1.95% per annum since 06/30/1994 compared to only 0.44% per annum outperformance of value over the past 20 years, and -0.57% underperformance by growth over 20 years. There is a one and a half year difference in the long term performance figures if quality and value and growth, but given the length of the track record there would need to be a drastic underperformance of quality (roughly 35%) over that one and half years for quality’s performance to fall back to the value index’s level of performance. With some confidence, we can say quality has been the best style among the Emerging Markets large and mid cap universe.

 

Small Cap outperformed the large and mid cap index by 1.24% per annum illustrating a persistence of the size premium in Emerging Markets. Within the Emerging Markets small cap universe, value outperformed growth by 5.66% per annum over the past 16 years. The 5.66% growth translates into 141.34% additional performance over the period. There is no small cap quality index to compare the quality style.

 

Value outperforms growth in Emerging Markets with significant outperformance vs. the benchmark and growth in the Emerging Market small cap universe. Brandes Institute of Brandes Investment Partners did a study on style bias in Emerging Markets, which can be found here.

 

Alexa: Amazon’s Operating System (Stratechery)

 

Ben Thompson always writes great articles on technology therefore is a must read. We tend not to invest in technology as short product life cycles leading to disruption leading to difficulty valuing these companies. Despite the difficulties in technology, Silicon Valley and start-ups are very good at understanding all aspects of business models and therefore reading some of the best writers in the industry helps increase understanding of business models in more investable industries. In this particular article, Mr. Thompson writes the business model of operating systems. (link)

 

Tren’s Advice for Twitter (25iq)

 

Like Stratechery, 25iq is a must read. Tren Griffin works in the technology industry but is a value investor. Mr. Griffin gives his advice to Twitter. His advice is relevant for all companies. Understand your competitive advantage and continue to strengthen it while being as operationally efficient as possible. There is not much more to strategy. Understand your competitive advantage.  If it is unique advantage,  strengthen it as much as possible. If it is a shared competitive advantage, try to cooperate with competitors as much as possible to distribute fairly the benefits of the value created by the shared competitive advantage. If there are no competitive advantages, operational efficiency is the most important thing. Due to institutional imperative, which prevents firms from acting as rational as they can, operational efficiency can allow one firm to persist with excess profits for a long time. The importance to barriers to entry on strategy and profitability illustrates why the identification of competitive advantages, also known as barriers to entry, are so crucial to Reperio’s investment process. (link)

 

Amazon’s 2004 Shareholder Letter

 

Amazon’s 2004 Shareholder Letter stresses the importance of free cash flow not earnings the main metric followed by most market participants as earnings does not take into working capital and fixed capital investments required to generate additional earnings, while free cash flow accounts for the necessary investments. (link)

WEEKLY COMMENTARY 12/13/16 – 12/19/16

WEEKLY COMMENTARY 12/13/16 – 12/19/16

 

 

POSITIONING

 

 

 

 

COMPANY NEWS

 

Grendene changed its auditor from PWC to E&Y due its requirement to change its auditor every five years.

 

We were thinking about PC Jeweller and the potential evolution of the jewelry retail industry in India. When think about industry evolution in Emerging Markets, we often look to developed markets for roadmaps. Each market has idiosyncrasies but strategic logic should hold from industry to industry across geographies. For example, the retail market structure in India should eventually look like retail market structure in the US as the industry develops. Retailing is fiercely competitive in all markets with no barriers to entry therefore all industries should have many competitors with very few if any generating significant sustained excess profits.

 

Our main reference point for the following information on the US Jewelry market is Edahn Golan Diamond Research & Data’s 2015 US Jewelry State of the Market report. You can download the report here. According to the Jewelers Board of Trade, there were 21,463 specialty jewelry retailers accounting for 43% of the US jewelry and watch retail market. The vast majority of these specialty stores are independent with Signet Jewelers being the largest retailer accounting for 4.3% of overall jewelry sales in the US and 9.8% of specialty jewelry sales. Signet Jewelers had roughly 3,000 stores at the end of 2015.  Despite market development and industry maturation, the US jewelry market remains fragmented with thousands of players illustrating a lack of barriers to entry and continued competitive pressures.

 

The lack of barriers to entry puts a cap on Signet’s and Tiffany’s ability generate excess profits with their average ROIC over the last five years below 15%.

 

Looking at the United States jewelry retail industry as a roadmap leads one to believe that fragmentation will persist within the Indian jewelry retail industry.

 

Another use of the roadmap is the potential multiple the market gives a company during maturity.  Signet’s EV/IC has ranged from 1.69 in 2012 to 2.89 at the end of 2015, while Tiffany’s EV/IC ranged from 2.54 at the end of 2016 to 3.55 at the end of 2015.

 

Signet’s EV/EBIT ranged from 6.86 in 2012 to 18.94 in 2015. Tiffany’s EV/EBIT ranged from 11.84 in 2016 to 37.19 in 2014, with operating Income in 2014 was depressed. Accounting for the depressed operating income, EV/EBIT ranged from 11.84 to 14.49.

 

We have included similar analysis on Honworld (condiments) and Universal Health (pharmacies/pharmaceutical distribution) that we did in the past at the end of the weekly commentary.

 

 

INTERESTING LINKS

 

Deep Dive into China’s Apparel Market (Fung Business Intelligence)

Fung Business Intelligence freely provide a lot of good information on China. In this multi-part report, Fung Business Intelligence provides detail on China’s Apparel Market. (Part 1) (Part 2)

 

Asahi to Buy SABMiller’s Eastern European Beers in $7.8 Billion Deal (Bloomberg)

Acquisition news is always interesting as a knowledgeable player in the market puts a value on an assets based on a detailed analysis. The problem is we do not know the assumptions the acquirer is using, which are crucial, but it gives an idea of an appropriate valuation multiple in an industry. The paragraph below is from the Bloomberg article.

 

The offer values the SABMiller assets at about 15 times Ebitda of 493.8 million euros for the year ended March 2016, according to Bloomberg calculations. That compared with the median of about 11.5 times trailing twelve-month Ebitda for 9 brewery acquisitions announced worldwide in the past five years, according to data compiled by Bloomberg.

 

We extended the sample size of acquisitions back to 1999 and the median acquisition multiple was 11.7 times not far off the 11.5 times paid over the last twelve months.

 

 

 

The table below shows the upside to the 11.7 times multiple for various brewers in Emerging Markets.

 

 

 

Median Buyout EV/EBITDA Ratios Rising (PitchBook via ValueWalk)

 

The PitchBook examines the median buyout multiple for private value investors.  (link)  What we find interesting is the disconnect between what business owners are willing to pay and the valuations public market investors are willing to pay for companies.

 

 

The Undoing Project: A Friendship That Changed Our Minds (The Rational Walk)

 

The Rational Walk discusses Michael Lewis’ new book about pioneers in Behavioural Finance and how it relates to investing. (link)

 

 

The Story of How McDonald’s First Got Its Start (Smithsonian)
The story of the history of the McDonald brothers before McDonald’s became a multi-chain restaurant. (link)

 

 

What is Your Edge? (Base Hit Investing)

 

An article discussing three types of edges in investing. (link)  We view our biggest edge over other market participants is a time horizon edge as we are looking for stocks for the next three to five years.  This also brings an analytical edge as we are analyzing business from the view point of a business owner rather than trying to figure out if the company will beat next quarter’s expectations.

 

 

Buffett’s Three Categories of Returns on Capital (Base Hit Investing)

 

An older post discussing how Buffett categorizes businesses (link)

 

 

HONWORLD DEVELOPED MARKET ROADMAP

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out but when it does it leads to a national market similar to many developed market like the US. The cultural convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.

 

The significant fixed costs in the form of advertising and distribution allows a brand to be built by larger competitors as more customers can be reached and educated. A brand is particularly important in an industry with a low priced product as the brand decreases search costs for customers leading to potential habit forming behavior. For example in the US, customers have acquired a taste for Heinz Ketchup.  When a customer goes to the store given Heinz may cost as little $2.50 a bottle and the Heinz brand represent a known and liked product that customer is not going to spend anytime even thinking about another brand given very little benefit.

In addition, retailers only have so much shelf space and are unlikely to place 15 to 20 different cooking wines on the shelf as a good number of the 15 or 20 cooking wines will not sell leading to waste shelf space.  The biggest players have a tremendous advantage as retailers now they will sell.

 

The table below shows the market structure of the five largest condiment markets in the US.

 

The US condiment industry is a great example of industry consolidation in a more developed market and a good roadmap for the Chinese Cooking Wine industry. The lowest concentration ratio among the largest five US condiment markets is the Hot Sauce market with a 52.2% four firm concentration ratio, while the highest is Ketchup with a 78.6% three firm concentration ratio. The four firm concentration ratio in the Chinese Cooking Wine segment is only 26.8% so there is potential for significant consolidation. The low four firm concentration ratio reiterates the fragmented regional nature of the market.

 

 

UNIVERSAL HEALTH DEVELOPED MARKET ROADMAP

 

Market Structure

 

The pharmaceutical retail segment in China is fragmented. According to the China Food and Drug Administration, in November 2013, there were 433,873 chain and individual drug stores in China, 10,150 more stores than 2012. There are 3,376 enterprises with multiple locations in China. Enterprises with multiple locations are more likely to manage the business for profitability and close down unprofitable stores. All though the market is fragmented, market consolidation is underway with Universal Health and Sinopharm leading the way. Retail competition comes in the form of target customer bases, business models, and product portfolios.

 

At the time of its IPO, Universal Health was the largest pharmaceutical retailer in Northeast China with 794 self operated outlets.  There is not sufficient information to get a sense of the efficiency of each store as competitors with higher revenue per store maybe a function of bigger stores, but it seems Universal Health’s may not be as efficient as competitors. This poor efficiency may be due to acquiring less efficient stores and improving operations. The pharmacy market in Northeast China has low level of concentration with a 2012 five firm concentration ratio of 44.2%.  This only tells part of the story as there could be a large number of smaller independent stores.  Universal Health has increased its estimated market share in Northeast China retail from 5.7% in 2012 to an estimated 8.8% in 2014.

 

The largest distributors in Northeast China at the time of the IPO are listed below. Universal Health is the largest private pharmaceutical distributor in Northeast China.

 

 

The largest retail pharmacy chains in China are listed below.  In 2012, the largest pharmacy operator had a 2.1% market share.  The 2012 five firm concentration ratio was 9.4%, while the ten firm concentration ratio was 16.0% indicating a very fragmented market. At the end of 2012, Universal Health’s China retail market share was 40bps.

 

The Chinese pharmaceutical distribution market is less fragmented than the retail market but still exhibits low concentration with the leading player accounting for 16.8% of the overall market.  The five firm concentration ratio is 36.5% and the ten firm concentration ratio is 44.9%. Universal Health garnered 16 bps of the total Chinese pharmaceutical distribution market.

 

While each individual country has its own idiosyncrasies leading to different development paths, the market structure of more developed markets may give a roadmap for developing countries.

 

The US pharmacy market shows moderate levels of concentration with a five firm concentration ratio of 64.4%.  There is some fragmentation but there are a significant number of small players still operating in the market.

 

According to Canada’s Office of Consumer Affairs, the Canadian pharmacy market has a 2012 four firm concentration ratio of 68.6%. The largest company is Shoppers Drug Mart with a 31.8% market share followed by Katz Group with a 16.7% market share, Jean Coutu with a 12.2% market share, and McKesson with a 7.9% market share.

 

According to the Pharmaceutical Journal, in the UK, there are 14,361 pharmacies with 4,201 independent owners, owning up to five pharmacies, operating 5,590 pharmacies and 174 multiple owners, owning six or more pharmacies, operating 8,771 pharmacies.  Large owners and supermarkets account for 52% of the overall market.

 

The US’s, Canada’s, and UK’s pharmacy market structures point to a much more consolidated market than the Chinese market but not the oligopolistic market structure you would expect if there was a significant benefit from economies of scales.  There seems to be economies of scale in purchasing but only to a point. Another reason for the fragmentation and large number of small independent operators may be that independent operators do the job for something other than profit maximization.  Just like optometrists or dentists, the ability to be your own boss and make a decent living trumps the desire to sell to a larger chain or exit when faced with a competitive disadvantage.

 

Pharmaceutical distribution markets are far more concentrated in developed countries than China with a three firm concentration ratio ranging from 43% to 85%.  Developed pharmaceutical distributors, economies of scale manifest themselves in high capital efficiency as operating margins often struggle to reach 2%.   The high fixed costs associated with upfront investments and low marginal cost for selling an additional unit leads to very high competitive rivalry among distributors and the need to utilize fixed costs as much as possible leading to greater profitability.

 

 

Weekly Commentary 10/31/2016-11/6/2016

Weekly Commentary 10/31/2016-11/6/2016

We are starting a weekly commentary to provide more consistent updates.  It will contain the news from the companies we cover, random investment thoughts, and the top articles of the week.  Let us know what you think.

 

Company News

 

On November 2, 2016, Zensar Technologies announced the acquisition of Foolproof. Foolproof is one of Europe’s leading experience design agencies, headquartered in London with other offices in Norwich and Singapore. The company helps global brands design better digital products and services for customers based on a deep understanding of consumer behavior, their clients’ business and new technology. It has many Global500 firms amongst its clients. LTM revenue = GBP8.5 million with a mid-single digit GBP million EBITDA with expectations for continued growth rate of 10-15% post acquisition. Zensar’s digital revenue now is 30% of total revenue.

 

From a strategic standpoint, the Foolproof acquisition makes sense. Foolproof adds knowledge in a fast growing industry strengthening Zensar’s digital services business. It strengthens Zensar’s client list adding relationship with a number of Global 500 allowing Zensar to cross-sell other services. It is also a smaller bolt on acquisition making it easier to integrate into existing operations. Unfortunately, the lack of price disclosure eliminates the ability to evaluate the transaction fully.

 

We will maintain Zensar’s current 3.5% position in our model portfolio. The company is trading at roughly 6% NOPAT yield with expected growth between 5-15% over the next five years. It continues to generate strong profitability and its executing on its strategy to increase revenue from digital services. It continues to win larger and larger contracts allowing for greater profitability. Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and/or some switching costs. Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers. The Indian IT services sector is based on low cost labor or price competition. There is no sustainably differentiation on knowledge as employees hold the knowledge of the organization and employees can take this knowledge to another company.

 

Why are we maintaining Zensar Technologies 3.5% position size while decreasing PC Jeweller’s position size to 2.0%? Zensar and PC Jeweller’s both offer a NOPAT yield of roughly 6.0% and both offer growth between 5-15% over the next five years. Zensar’s business seems slightly better to us. Both industry have significant competition, but Zensar’s industry generates much higher average returns on invested capital than PC Jeweller’s, due to the asset light nature of the business. The jewelry business is very working capital intensive. Additionally, Zensar has a long history of steady growth while PC Jeweller has grown rapidly; it is in a much more cyclical industry.

 

On November 3, 2016, Miko International announced the resignation of Mr. Zhu Wenxin, an Independent Director at the company with Mr. Chan Wai Wong replacing him. The resignation is the latest in a series of director resignations. Below is a list of previous resignations.

  • On June 30, 2016, Gu Jishi resigned as Executive Director being replaced by Ms. Ding Lizhen, a member of the founder’s family.
  • On March 14, 2016, Mr. Wong Heng Choon resigned as Independent Director less than a month after being appointed.
  • On February 19, 2016, Mr. Leung Wai Yip resigned as Independent Director.
  • On September 8, 2016, Mr. Ng Cheuk Him resigned as Chief Financial Officer.

 

All the resignations follow the resignation of KPMG on April 21, 2016 and appointment of HLB Hodgson Impey Cheng Limited, an auditor of last resort for many Chinese frauds. The signs of fraud are piling up.

 

On November 4, 2016, Miko announced it signed a Memorandum of Understanding to set up a Joint Venture in the factoring business, an industry far removed from the current operations, which does not make much sense. We are already in the process of selling our position in Miko International.

 

On November 4, 2016, Credit Analysis and Research (CARE) reported first half results. Revenues grew 9% and operating profit grew 20%. The company also grew its client base by 8.5% from June 2016. It also signed a Memorandum of Understanding to start a credit rating agency in Nepal. The company also designated the first “SMART CITY” credit rating. Overall, the earnings report does nothing to move the needle either way. CARE is trading on a NOPAT yield of 3.0% but it is the most profitable company in an oligopolistic industry with significant barriers to entry and a very long runway for growth requiring no capital to grow. We entered with a 2.0% position in hopes that we could increase our position size at a cheaper price. We will maintain the current position given the barriers to entry in the industry, the runway for growth, and the lack of capital required to grow.

 

 

Random Thoughts

 

A recent FT Alphaville article discussed Sanford Berstein’s shift away from valuing companies by discounting cash flows. Bernstein argued in a zero rate world the risk free rate and the over weighted average cost of capital (WACC) is so low the importance of distant cash flows in the intrinsic value is much higher. Given an inability of analysts to forecast cash flows in the distant future, this increasing importance of the terminal value places a significant weight on highly uncertain cash flows. The following exhibits from the FT article illustrate the importance of the terminal value in Berstein’s estimation. Bernstein uses a discounted cash flow model with a five-year forecast period followed by a fade to a terminal value in year 10. Bernstein’s first charts assume a 10% growth rate for the next five years followed by a fade to a terminal growth rate of 3.5% in year 10. The second chart assumes a 5% growth rate for the five-year forecast period followed by a fade to a similar terminal growth rate.

importance-of-terminal-value-ft

 

Under the scenarios mentioned, Bernstein estimates the terminal value accounts for 55% at a 10% WACC increasing to 99% for a 3.6% WACC. WACC or discount rate is one of the many factors determining the importance of terminal value in a discounted cash flow valuation. We believe Bernstein, like many other market participants, is overlooking many other crucial factors in determining the importance of terminal value. We will discuss our view on the discount rate as well as other factors overlooked by Bernstein. We will also discuss another valuation method to overcome the shortfall of increased importance of terminal values in the discounted cash flow valuation. Whenever we value companies at Reperio, we use a similar discounted cash flow model with a five-year forecast period fading to terminal assumptions in year 10.

 

In the article, Bernstein’s main concern was lower interest rates lead to a lower discount rate leading to a lower WACC. Given the value of a corporation is driven by cash flows well into the future, the main assumption in lowering a company’s WACC is interest rates will remain low for a very long period of time. The chart below is the yield on a US 1 year treasury rate since 1953 illustrating the current rate of interest is the lowest on record.

1-yr-treasury-rate

We are bottom up investors but to assume market participants will accept 64 basis points forever in compensation for lending the US government money for one year seems aggressive, particularly, when one-year interest rates were over 1600 basis points in the early 1980s.  .

 

The treasury rate is a key input into the Capital Asset Pricing Model (CAPM) used by Bernstein and many other investors in determining a company’s WACC or discount rate. CAPM like many models in economics and finance is built with assumptions completely detached from reality. The biggest flaw in the CAPM is price equals risk. When calculating the cost of equity to determine the cost of equity, beta is multiplied by the equity risk premium. Beta is the volatility in a stock relative to a stocks benchmark meaning if a company’s share price is more volatile than its benchmark, it is assumed to be a more risky investment and therefore have a higher cost of capital. Putting aside the potential errors in measure a stock beta, a volatile stock does not equate to risk for the investor. This logic would lead you to believe a private business with the exact same characteristics of a public company listed on a stock exchange is a much safer investment, as there is not daily price volatility associated with being listed. At Reperio Capital, we view permanent loss of capital as the true risk of any investment. Permanent loss of capital comes from three risks: business risk, financial risk, and valuation risk. Business risk is the permanent loss of capital due to a permanent impairment of cash flows from competition or mismanagement. Valuation risk comes from overpaying for a security. Financial risk is when a company is has significant financial leverage that may lead to bankruptcy.

 

Another significant problem with CAPM is measuring a stock’s beta. The measurement of beta lends to significant estimation errors. Using Zensar Technologies as an example, if you calculate the company’s beta on a weekly basis since its listed in July 2002, its beta is relative to the SENSEX is -1.19. If you change the time period used in calculating beta to the last 10 years, Zenar’s beta changes to 0.77 illustrating the potential issues calculating beta.

 

Instead of calculating the weighted average cost of capital, we have used a constant discount rate as we assume there is an opportunity cost associated with making any investment. We are increasing our discount rate to 12.5% discount rate (from 10%) for all companies, roughly the average annualized return generated by the MSCI Emerging Market Index since inception and slightly more than the S&P 500 average annualized return is 9.5% since inception. If we can generate 12.5% annual return elsewhere then cash flows from any potential investment should discounted at that particular rate regardless of what the cost of capital is for each individual company. A constant discount rate also eliminates some of the subjectivity in valuation.

 

Other than lower interest rates and faulty measures of risk, Bernstein’s assumptions seem very optimistic. The FT article only mentioned growth and discount rate assumptions meaning the other important value drivers of operating margin and capital efficiency must have remained constant assuming no competitive pressures over the life of the company. The vast majority of companies succumb to competitive pressures leading to a fall in profitability and/or capital efficiency eliminating any excess returns. If excess returns are eliminated, growth does not add value making it an irrelevant discounted cash flow assumption. A small number of companies can hold off competitive pressures making profitability and capital efficiency irrelevant assumptions. The FT has a great free equity screener. In its universe, there are 13,799 stocks with a market capitalization above USD100 million and a 5-year average return on investment. Of the 13,799 stocks, only 2,001 stocks or 14.5% of the universe averaged a 15% return on investment over the past five years, which a very, very crude approximation of a company with a competitive advantage illustrating the difficulty in fending off competitive pressures and maintaining excess returns. Given the vast majority of companies face competitive pressures the assumption of constant operating margin and capital efficiency and any growth in terminal cash flows is very optimistic. An example is PC Jeweller, the company is operating efficiently generating excess returns but jewelry retailing is a fiercely competitive industry with thousands of competitors with little ability to sustain differentiation. We assume a 10% growth over the first five-year forecast period with growth fading to 0% in year 10 and competition eliminating excess profits.

1-scenario-terminal-value-total-value

 

As illustrated, at a 5% discount rate, the cash flows in the terminal value account for 51.0% total value. At a 15% discount rate, cash flows in the terminal value account for 31.6%. At a 5.0% WACC, Bernstein estimated 91% of a firm’ value is in the terminal value, while our estimate is much lower at 51.0% as we are more conservative on our assumptions for the vast majority of companies. The failure to account for competition makes terminal value a much larger percentage of total value.

 

Changing our initial assumptions to view PC Jeweller as competitive advantaged with sustainable margins and capital efficiency but with no growth in the terminal value, at a 5% discount rate, the cash flows in the terminal value account for 73.6% total firm value. At a 15% discount rate cash flows in the terminal value account for 39.1% of the total firm value still well below Bernstein’s estimates.

3-scenario-terminal-value-total-value

 

Being competitively advantaged and adding terminal value growth of 3.5% similar to Bernstein’s calculations further increases the importance of the terminal value assumptions. Again, growth in the terminal value is aggressive, as the vast majority of companies do not generate excess returns. Assuming a competitive advantage and 3.5% terminal growth, at a 5% discount rate the importance of cash flows in the terminal value increases to 90.5% of total firm value, while at a 15% discount rate 46.1% of the of the total firm value is derived from the cash flows in the terminal value.

 

The assumption of permanent low interest rates, no competitive pressures, and perpetual growth are all flaws in Bernstein’s assumptions that increase the importance of terminal value in a discounted cash flow valuation and probably are over aggressive. Like Bernstein, many investors make the same mistakes in their discount cash flow assumptions, which leads to the question why? The biggest reason is institutional constraints and the focus on asset gathering rather than performance making the vast majority of investors short term oriented and trying to outperform every quarter and every year. This short-term orientation leads to focus on next quarter’s earnings and whether a company will beat earnings estimates rather than focusing on a company’s competitive environment, management, financial health and valuation. The charts below from Andrew Haldane’s Patience and Finance illustrate the short-term orientation of market participants with the average holding period of a stock on the many different stock exchanges decreasing.

nyse-lse-holding-period

other-exchange-holding-periods

 

In the US, the average holding period of equities dropped from 7 years in 1940 to 7 months in 2007. In the UK, the average holding period of equities dropped from 5 years in the mid-1960s to 7.5 months in 2007. Looking at stock exchanges around the world the average holding period of equities has dropped to under 1 year on all exchanges with the exception of the Toronto Stock Exchange and Euronext. It seems evident that equity investors have a shorter and shorter investment horizon leading to focusing on the next few quarters making the discounted cash flow a useless tool for many investors. For long-term investors, a discounted cash flow with conservative assumptions it is still very useful. Another use for a discounted cash flow is to reverse engineer the market’s expectations of key value drivers, which eliminates the need for forecasting and makes judgment of the assumptions of key value drivers, the main determinant of the margin of safety associated with an investment.

 

If the use of a discounted cash flow still concerns you, a residual income model provides the same valuation while eliminating the importance of cash flow forecasts in the distant future. At Reperio Capital Research, we also use a residual income model with a five-year forecast period followed by a fade to the terminal value in year 10, with the current invested capital as the book value and return on invested capital and the discount rate as other key inputs. Residual income = (ROIC – discount rate) * invested capital. The residual income stream is then discounted back and added to the beginning of the year’s invested capital. The theory is every company has an asset base to generated returns. The asset base comes with an opportunity cost as the money invested in the asset base can be allocated elsewhere. If the company cannot generate its discount rate, it is destroying value and the company will be valued at less than its asset base. If the company generates excess profit, it will be valued above its asset base. Revisiting PC Jeweller using a residual income valuation and the same three scenarios illustrated above, we can see the residual income valuation method relies less on the discounted cash flows from the terminal. Under a scenario of no competitive advantage, no excess returns are generated in the terminal value assumptions therefore; the terminal value adds no value. Under the scenario of a competitive advantage but no growth, at a 5% discount rate, the terminal value accounted for 57.1% of the total firm value while a 15% discount rate 14.6% of the total firm value is derived from the terminal value. Finally, under the scenario of competitive advantage and terminal value growth, at a 5% discount rate, the terminal value accounts 83.4% of the terminal value and 21.0% of the total value at a 15% discount rate.

residual-income-terminal-value

 

The residual income method does a much better job at decreasing the reliance on terminal value calculations, but provides the same valuation outcome.

 

Discounting cash flows to value companies is still a valuable for any investor with a long-term orientation. Unfortunately, a model is only as good as its inputs. In a world with increasing short term thinking, garbage in will lead to garbage out.

 

 

Other Interesting Links

 

Jim Chanos’ and Kyle Bass’ views on China (link)

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

  • They talk about a potentially interesting idea within the Emerging Market Small Cap space: ABS CBN in the Philippines.
  • They also discuss other ideas First Pacific Holdings in Hong Kong and Rallye SA in France. Both are based on management track records.

 

Apple Should Buy Netflix (link)

A very interesting post at Stratechery discussing the media value chain.

 

Competitive Advantage of Owner Operators (link)

Base Hit Investing goes into detail into the advantages of owner operators.

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

Value Investing using Enterprise Multiples — Is the Premium Due to Risk and/or Mispricing? (link)

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

Investment Process: Competitive Advantage vs No Competitive Advantage

Investment Process: Competitive Advantage vs No Competitive Advantage

One of the most important models we use is the idea that a company either has a competitive advantage or does not. Whether a company has a competitive advantage or not determines the valuation methodology we use in arriving at an estimate of the company’s intrinsic value. Unless proven otherwise, a company is assumed to have no competitive advantage and returns will revert to its cost of capital.
We view a competitive advantage as a barrier to entry inhibiting supply.  It is an activity that is not easily replicated by competitors. Competitive advantages are rare but come in many forms. A discussion of the types of competitive advantages and the evidence we look for to identify whether a company is competitively advantaged will be left for next month. The existence of a competitive advantage leads to more predictable profitability, excess profits, and value creation in the case of growth opportunities.

 

A lack of competitive advantage means competition will eventually lead to the erosion of any excess profit as competitors envy the company’s excess profits and deploy capital in an attempt to generate similar returns. Capital continues to be deployed until excess profits are competed away.  Often if there is a long lead time to build supply, a long lead time to shut down supply, if exit barriers exist, or if demand is difficult to predict, supply will come on stream and surpass required capacity for demand leading to average industry profitability falling below the cost of capital eventually leading to the highest cost capacity will be taken off stream until supply moves back in line with demand bringing profitability back in line with the cost of capital.  Despite a lack of a competitive advantage, excess profitability can be sustained in the medium term if demand growth continues to outpace supply growth leading to a continued mismatch in demand and supply, which typically occurs early in an industry’s life cycle.

 

The short term nature of financial market participants creates an environment where many publicly listed companies are valued as if they are competitively advantaged despite the rarity of competitive advantages. This is particularly evident during the strongest parts of the business cycle when companies without a superior competitive position report abnormally high profits.  These high profits in the strongest part of the business cycle are followed by low profitability during weaker parts of the business cycle. As Benjamin Graham stated in Chapter 20 of The Intelligent Investor “The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.” These losses come from a combination of elevated profits and investor sentiment during favorable business conditions along with unsustainable elevated profits from a lack of protection from competition illustrating the importance of being able to identify if a company is competitively advantaged or not.

 

Given a competitive advantage shields a company from competition and the erosion of profitability typically associated with competition leading to more predictable earnings, it is more appropriate to value companies with a competitive advantage on earnings.  Our preferred method is the internal rate of return estimate as it eliminates forecasting and the errors that come with it.  If the company does not have a competitive advantage, estimating the cost to reproduce the company’s competitive position is the best valuation methodology as profitability is eventually squeezed towards the cost of capital eliminating any value created from the company’s investments making it worth no more than the capital required to reproduce its assets.