Honworld H1 2016 Report Review and Position Sizing October 9, 2016
Honworld recently released its H1 2016 report. In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.
Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.
The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.
Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.
The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else. It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.
Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.
We are moving to a new approach for position sizing. There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base. Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.
Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.
Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.
High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation. Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.
The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies. Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential bad investments while still offer enough concentration to take advantage of upside from good investments.