The following article is extracted from the Bamboo Innovator Insight weekly column about the process of generating investment ideas among wide-moat businesses in Asia. Each month, an in-depth presentation on one such business is featured in The Moat Report Asia.
“Mr Murthy, if we have black-and-white values like yourself, how can we live in the real world that is grey?” This brilliant question to Infosys Chairman Narayana Murthy was posed by Hemant Amin, the Singapore-based value investor who compounded his investment in Infosys by 60-folds, amongst his other concentrated portfolio holdings in his multi-million single family office. Last Thursday was the second time that the Bamboo Innovator has met over lunch with Hemant, also the head of the BRKets (www.brkets.com), after our rendezvous at the Singapore Cricket Club on 7 Nov. We also wanted to catch up before the Bamboo Innovator flies over to India on a work trip from 7 to 17 December.
The Bamboo Innovator is grateful to have the experience to have met with people from all walks of life during the past decade plus in the Asian capital jungles. They range from competent pioneering intra-preneurs such as Tong Chong Hong who nurtured Singapore’s Keppel FELS (KEP SP, MV $16.3B); gritty entrepreneurs such as Lim Hock Chee who built Singapore’s supermarket chain Sheng Siong (SSG SP, MV $672M) against the odds of competing with the Davids of state-owned FairPrice and giant Jardine Group’s Dairy Farm, China’s natural gas pipeline and equipment baron Wang Yusuo of ENN Energy (2688 HK, $7.6B) and spinoff Enric (3899 HK, MV $3.2B) and many more; kind and wise professors from the School of Accounting at Singapore Management University; to exposing the accounting frauds of billionaire imposters such as Eddy Groves of Australia’s ABC Learning and the “extractor” CEOs of S-chips and P-chips. Perhaps the Bamboo has acquired some sensitivity in differentiating between the “Compounders” and the “Extractors” in a harsh and cruel world over the years. Hence, we are always excited to meet with a super value investor or/and outstanding entrepreneur with upright values and Hemant is amongst them.
The answer by Narayana Murthy was equally brilliant and profound. “You have to be able to live with the consequences of your values system. You have to be comfortable under your own skin.” An example would be how Murthy would rather acquire plots of land to expand his business at three times the price than he would otherwise pay for if he had gone through the “grey market” of middlemen who would most probably bully and rape the rural poor residents and force them into “illegal” eviction.
Besides Infosys, another concentrated compounding bets that returned multiple-fold for Hemant include HDFC (HDFC IN, MV $20.6B) and its subsidiary spinoff GRUH Finance (GRHF IN, MV $671M). As Asia slows down, many tycoons have been considering spinoffs as part of their corporate restructuring efforts to battle sluggishness and improve managerial efficiency. As explained in our earlier articles, not all spinoffs are value-creating opportunities. Heavily-indebted firms are in deleveraging mode to dispose highly-geared businesses to investors in spinoffs. The upcoming spinoff events in Asia need to be examined carefully for their business fundamentals (whether they have a wide moat and a unique scalable business model) and their motivation. In India, one of the more useful accounting clues to separate the Compounders vs the Extractors in India has been the Indian Accounting Standards 18 (IAS 18), which we will elaborate in a short while after understanding the (hidden) debt problem in India and Asia.
Reserve Bank of India (RBI) Governor Raghuram Rajan singled-out “willful defaulters” on his first day in office in September and rising bad loans at Indian lenders remain “a major challenge”. Company owners “do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor do they have the right to use the banking system to recapitalize their failed ventures”, Rajan said. Frustration among lenders over rich company owners defaulting on debts grew during last year’s collapse of Kingfisher Airlines. Controlling shareholder Vijay Mallya, a liquor baron who has not been named a “willful defaulter” by his banks, drew criticism for his flamboyant lifestyle even as the airline was unable to pay salaries for over seven months. Mallya, who has been unsuccessful in his efforts to find new investors for Kingfisher, has said that it is the company, not him personally, that owes money – over $1.4 billion in debt. Shortly after the wife of one of the unpaid staff members committed suicide in Oct 2012, Mallya’s young son posted on Twitter that he was playing “volleyball with bikini-clad models.” Two of the highest-profile recent cases of alleged willful default involve Winsome Diamonds and Jewellery and Deccan Chronicle Holdings, which between them defaulted on $2 billion and are being investigated for fraud by the federal police. Rajiv Takru, the top official in the government’s financial services department, said the Central Bureau of Investigation was scrutinizing the 30 biggest defaults at Indian banks for any evidence that borrowers colluded with bankers for personal gain. Indian state banks hold 86% of the system’s bad loans while accounting for 75% of the lending market. Bad loans larger than Rs 2.5million ($40,000) at state banks and classified by the RBI as “willful” totalled Rs 1.2 trillion ($19 billion) at the end of June, up 18 times from June 2008. Over the same period, total bad loans at state banks rose five times to nearly Rs 2 trillion. Stressed loans in India – those categorized as bad or restructured – total $100 billion, or about 10% of all loans. Fitch Ratings expects that to rise to 15% by March 2016.
And the woes of big Indian family business groups are not yet reflected in the numbers. The ten most indebted of them account for 13% of all bank loans at more than $100 billion, according to the Credit Suisse report “House of Debt – Revisited” in Aug. Much of this debt — the highest leverage since the late 1990s — is denominated in foreign currency. A weakened rupee has only increased the size of the debt in local terms. Almost all their debts are still classed as performing, despite their weak state. 34% of India’s stock of corporate debt is owed by firms with operating profits too small to pay their interest costs. The latest entries to this list included Jaypee Group (a conglomerate that has businesses in cement, power plants and built India’s first Formula One racing track), real estate giant DLF owned by billionaire K.P. Singh, and Hindustan Construction. 80% of the loans were with companies that had not be able to pay the interest on their debt for four quarters in the last two years and 26% of the loans were with companies that had not paid their interest for eight consecutive quarters. Amongst the large corporates, 23 of the top 50 companies (by debt) have not paid interest on their loans in seven or more quarters in the past two years, and 38 companies have been incurring net losses. The biggest losers include wind turbine supplier Suzlon, Tata Communications and telecom infrastructure company GTL Infrastructure Ltd. Amongst those who have been piling on debt during this period, the leaders of the pack include Lanco Infratech whose debt levels have shot up 134% in the last two financial years, followed by Essar Oil (debt up 85% at this company part of billionaire brothers Shashi & Ravi Ruia’s group), Electrosteel Castings (debt up 78%) and Adani Power (up 71%), owned by billionaire Gautam Adani. According to Credit Suisse, the moment of reckoning will come early next year, in the fiscal period ending March 31. By then, slowing growth will have seriously affected the ability of these corporations to make profits and service their debts, repayments for which will be much higher in fiscal 2014. Perhaps this situation could be why the venerable Tata Sons recently withdraws its application for banking license in India.
A senior executive speaking to the Financial Times likened the Indian corporate scene to a “Ponzi scheme”, in which large corporations making overambitious investments when the going was good were able to repeatedly restructure loans from state-backed banks, which the government faithfully recapitalized with its own money. Such collaborative capitalism with Indian characteristics resulted in an extraordinary degree of corporate leverage and frothy asset markets. In 2009, a taped conversation between lobbyists quoted Mukesh Ambani as boasting that the ruling Congress party was now his dukaan, or shop. Responding to a demand from Reliance, the government doubled domestic natural gas prices from April next year. The increase will affect SMEs and farmers, not to mention ordinary middle-class Indians. And the decision was almost entirely unchallenged by the political opposition and the mainstream media. As Bloomberg columnist Pankaj Mishra pointed out, photographs from a lavish birthday party for Mukesh Ambani’s wife in Nov – held in a royal palace in Rajasthan rather than the Ambanis’ 27-story Mumbai private residence — show a loyal and gratified Indian elite in attendance, including the union minister for heavy industries and cricketing legend Sachin Tendulkar. Guests, flown in on 32 chartered planes, included a maker of socially conscious cinema, Aamir Khan, as well as the new Bollywood teen icon Ranbir Kapoor. The large Indian corporates were also beneficiaries of a culture in which “the lives of the rich are discussed admiringly, and every act of indulgence greeted with applause,” according to political commentator Santosh Desai. This encourages them “to live on an island of delusion, aided by media and feted by the public that is visible to them.”
“It’s very difficult to find Indian companies that don’t want to become conglomerates,” says Vallabh Bhanshali, co-founder of brokerage major Enam. Most business families in India are ambitious about expanding their empire. Often, that means using group companies as ATMs to fund new ventures or even loss-making ventures, which ends up destroying value. “Capital allocation and respect for equity can be a lot better in India. There are many companies that are continuing without thinking what return they get from marginal investment, that is, the return on incremental capital employed,” says Bhanshali. HDFC Mutual’s chief investment officer Prashant Jain commented, “The problem is that there are few management who have the real desire to excel. Mostly, they would like to increase their sphere of influence by expanding, making acquisitions and so on.” Indeed, there are the classic cases of debt-financed M&As impairing the balance sheets and haunting companies such as Tata Steel, Hindalco and Bharti Airtel today. Tata Steel recently announced an impairment charge of $1.6 billion. Shares of Tata Steel are down 30% since the Corus acquisition, against a 55% rise in the Sensex. Bharti shares have been stagnant while the index rose 16% since March 2010 when it acquired Zain. Hindalco, again, is down 21% when the index had gained 46% after its Novelis announcement. Not very long ago, all these were great companies; Tata Steel and Hindalco were counted among the world’s lowest-cost producers of steel and aluminium, respectively, and Bharti Airtel was one of the most profitable mobile operators in India.
As shared earlier, in India, one of the more useful accounting clues to separate the Compounders vs the Extractors has been the Indian Accounting Standards 18 (IAS 18). The IAS 18 covers the disclosure requirements of RPTs (related-party transactions). Parties are considered to be related if one party has the ability to control the other in making financial and/or operating decisions in a particular reporting period. Companies often indulge in RPTs to manage their earnings or to siphon off the assets of listed companies to other affiliated firms. Other RPTs include granting loans, writing off loans and dues, selling assets to a related entity for a price significantly below the market price. Such RPTs are usually carried out by dominant shareholders, who have significant control rights compared to their cashflow rights, creating a strong incentive to expropriate the minority shareholders. In a study carried out by finance researcher Padmini Srinivasan from the Indian Institute of Management on the companies in the BSE 200 index, the total value of the RPT was Rs 613,761 crore ($98 billion) and the three major RPT transactions that account for over 60% of the total value were income, expenses, and loans and deposits. It has been found that Indian companies with higher RPTs have lower ROA and firm performance.
Total value of RPTs (in INR crore)
Value of transactions with each related party (in INR crore)
Despite the entrenched problems in India, both Hemant and the Bamboo Innovator share the same investment insight that India is a unique vibrant and versatile hub for “frugal innovations”: cost-effective and affordable solutions of various varieties that cater to price-sensitive consumers. Like the three sources of wide-moat in Bamboo Innovators to separate the resilient compounders vs the extractors, India’s Frugal Innovators are those with the:
- Indestructible intangible know-how in proprietary know-how in the system to scale up or know-how in unique products or trust and support in the community of customers and suppliers, such as Tata Consultancy Services TCS; NBFCs such as HDFC and its subsidiary GRUH with their accumulated knowledge base in assessing the credit quality of its borrowers which cultivates and snowballs trust and support from its customer base; the “unique” products of Bosch India, Pidilite Industries, Britannia, Jyothy, Eicher, Emami;
- Core-periphery network with the strong touch-points and periphery network eg Asian Paints, Godrej Consumer, Mahindra & Mahindra;
- Open innovation in co-creating value with external partners, such as the MNCs Nestle India etc, Amara Raja vs Exide, Hero Motocorp.
Reputational advantage in a shaky business environment is useful to separate the Compounders from the Extractors. Deepak Parekh, chairman of HDFC, commented on their early struggles, “It is never a cakewalk. In the first 10 years, the retail saver never trusted us. Everyone came to us for loans, but they did not trust us to deposit their money. Now, they do. Trust is built over time”. In the toughest times during 2008-09, when wholesale money became dear, HDFC managed to raise retail deposits worth Rs 8,124 crore ($1.3 billion), accounting for 54% of the total funds raised in 2008-09. Parekh said, “Indian companies tend to over-leverage because promoters don’t want to dilute their holdings. Promoters tend to think their shares are undervalued. Industrialists these days believe their status depends on the debt they take, not their market-cap.” An admirer of Buffett’s philosophy, Parekh elaborated, “The biggest takeaway from Buffett is how you can create value for shareholders with such great consistency. HDFC has done nothing dramatic — it has just bettered its processes and stuck to its knitting. But that has yielded magical results. Other companies, such as the Shriram group, Asian Paints and Bosch, too have unleashed the power of compounding for shareholders by sticking to their competencies.”
Avalokiteśvara or Guanyin, sitting in the lotus position
One prominent Buddhist story according to Mahāyāna doctrine tells of Avalokiteśvara (Sanskrit: अवलोकितेश्वर lit. “Lord who looks down”), the bodhisattva vowing never to rest until he had freed all sentient beings from samsara. Despite strenuous effort, he realizes that still many unhappy beings were yet to be saved. After struggling to comprehend the needs of so many, his head splits into eleven pieces. Amitabha Buddha, seeing his plight, gives him eleven heads with which to hear the cries of the suffering. Upon hearing these cries and comprehending them, Avalokiteśvara attempts to reach out to all those who needed aid, but found that his two arms shattered into pieces. Once more, Amitabha Buddha comes to his aid and invests him with a thousand arms with which to aid the suffering multitudes. The Chinese name of Avalokiteśvara is Guanyin (观音菩萨), which means “Observing the Sounds or Cries of the World. The Goddess of Mercy goes all out to hear and see the pains and sorrows and negative things to help with her thousand hands and eyes (“即发誓言，若我当来堪能利益安乐一切众生者，令我即时身千手千眼具足.” 《千手千眼观世音菩萨广大圆满无碍大悲心陀罗尼经》). In their own ways, Frugal Innovators attempt to design cost-effective, “good enough” solutions that can reach out to meet the aspirations and solve the problems of millions of consumers with the indestructible intangible asset in the form of their first-hand knowledge of the ground situation of targeted customer group. Seeking to hear and see the negative things and acknowledging sadness and failures is perhaps the first step to becoming a Bamboo Innovator and resilient compounder.
In an addendum to Narayana Murthy’s profound reply to Hemant’s thought-provoking question, a kind and wise person commented that perhaps it is those who are in a position of strength can claim to have “black-and-white” values and it takes an even stronger character to embrace the flaws of another and to bring about positive change. Thus, whether grey, or black and white, the color of the inner self and the world in the eyes of the Bamboo Innovator is… (ever)green, like that of the evergreen bamboo with a growth mindset of positive change: when covered in snow, will patiently wait for the snow to melt down and then rise up. A system is something we do on a regular basis that increases our odds of happiness in the long run. If we’re waiting to achieve it someday in the future, it’s a goal. Running a marathon in under four hours is a goal; exercising thrice a week is a system. Aiming to retire by 40 or 50 is a goal. As Scott Adams, the creator of Dilbert, illuminates with his wisdom in his latest autobiography How to Fail at Almost Everything and Still Win Big,
If you achieve your goal, you celebrate and feel terrific, but only until you realize you just lost the tong that gave you purpose and direction. Your options are to feel empty and useless, perhaps enjoying the spoils of your success until they bore you, or set new goals and re-enter the cycle of permanent pre-success failure. Goal-oriented people exist in a state of continuous pre-success failure at best, and permanent failure at worst if things never work out. Systems people succeed every time they apply their systems, in the sense that they did what they intended to do. The goals people are fighting the feeling of discouragement at each turn. The systems people are feeling good every time they apply their system. That’s a big difference in terms of maintaining your personal energy in the right direction. Warren Buffett’s system for investing involves buying undervalued companies and holding them forever or at least until something major changes. That system has been a winner for decades. Compare that with individual investors who buy a stock because they expect it to go up 20 percent in the coming year; that’s a goal, not a system.
PS: The Bamboo Innovator will be away to India on a work trip from 7 to 17 December and will resume the weekly Bamboo Innovator Insight article in the last week of December. We are grateful for your support and understanding all this while.
There are many paths to success in investing. So it may not come as a surprise that investors often get confronted with the question: “What’s your investment style?” But as much as it may be intuitive for some investors to check a certain style box, for other investors the answer will always float somewhere around the various arbitrary style boxes. The latter investors are often the best investors.
Chris Crawford, chief investment officer of Crawford Fund Management, is a great example of an investor who employs an opportunistic approach to investing, rather than being constrained by one approach only. However, while mastering multiple investment approaches can give an investor an advantage, the trick is to stay disciplined in the application of each one approach. Below is an excerpt from my conversation with Chris Crawford in which he describes some of the different investment opportunities, what it takes to master each as an investor, and the associated benefits to an investment portfolio. The full conversation is available in The Manual of Ideas Members Area.
Chris Crawford on the Advantage of Being Opportunistic
Chris Crawford (transcript): “There are a number of different approaches to investing. There are a lot of different ways to succeed in this business. If you just look out at the successful investors, there are many different ways that it’s done. One of the key things is, there’s a page in a great baseball book by Ted Williams called The Science of Hitting where he has a picture of his strike zone broken down into his batting average in different points in the strike zone. The concept is knowing what you’re good at and what you’re not good at, and not swinging at the pitches that come in areas where you don’t have a history of success, and going after the things where you have a history of success.
The main thing is to know what you’re good at and what you’re not good at. Once you’ve done that, if you can be good at multiple things, then you’re going to have more opportunities available to you. The market rewards different types of investing, different styles at different times. Sometimes it rewards deep value investing, sometimes it rewards momentum investing, sometimes growth investing.
If you can be able to recognize different types of opportunities, you’re going to be able to have more stability in your portfolio because you’ll have a balance of different ideas. You’ll be able to arbitrage between different types of opportunities because as some are fully recognized, others may be not recognized and you can recycle capital between these types of ideas. It’s important to be good at a few things. In terms of developing that expertise, it just takes a lot of time, of going out, researching ideas, investing in ideas, seeing the results, both the successes and the failures, and learning from them, and focusing in on those areas where your probabilities are higher.
So for me the types of ideas I like to look at, my favorite type of long investment is what I would call a wealth compounder. It’s a business that you find young in its life cycle that has a large, long growth opportunity in front of it where it can grow its top line, it can scale its operating structure, scale its margins and create value at an increasing rate over time, and finding it when it’s a small company. Those businesses are great because you can grow with it. You don’t have to spend as much labor finding new ideas and it’s very tax-efficient because you’re compounding the value and not paying taxes until far into the future.
There’s a whole series of key things you need to know in recognizing those types of businesses and avoiding the pitfalls in those types of companies as well. The key things being the internal reinvestment opportunities of the business, it takes a lot of work to understand those opportunities. That’s one type of investment, the wealth compounder.
Another type of investment I would call the margin of safety value investment. This is finding maybe a more mature business that’s trading at a steep discount to its intrinsic value. Franchise companies that have a solid market position, they might dominate a niche or even be a bigger company but they have a protected moat around their business and they can generate free cash flows year after year. At various times, these companies come in and out of favor. They might have business-specific issues, a temporary setback in their business that is causing the market to be temporarily pessimistic. It’s identifying those businesses at a time when the markets cast them aside. That’s another type.
The other type I like to look at is what I call sum-of-the-parts or hidden value type of investments where you’ve got a business that’s a rather complex company that has several different things it’s doing. It might own a cash-generating business but it might also have other assets that are not immediately obvious. It could be a money-losing division that they’ve been investing in that is actually burdening their earnings but the business has positive value. If you’re just superficially looking at the company on traditional metrics, P/E ratios and the like, you may not see this value sitting inside the company. Another type of company might be someone with a large NOL built up, a tax asset that can be monetized or utilized – so identifying those hidden values.
On the short side, the hedging side of investing, there are also different thesis-types that you should focus on. For us, one is finding a flawed business model. You have these waves of IPOs that come. A couple of times every decade, there’s a big IPO wave. Each time, it’s a different series of hot themes or hot industries that Wall Street promotes. It’s usually a germ of a good idea that gets taken to excess. And over the years, back in the internet bubble you had the B2B companies, the business to consumer internet companies, the e-tailers, and you had a big boom in telecom equipment companies, there was a micro-brewery fad.
There’s always a hot theme being played. Today, it is things like cloud computing. Five years ago, it was E&P gas drilling companies. There’s always a series of companies that get taken public and within these hot themes, you tend to find the lower quality merchandise comes to market later and there’s flawed business models, unproven business models, many of which don’t end up being successful. Something like 20% of all companies that are taken public are delisted within five years.
There’s a lot of failure that’s out there in the market. Having a keen eye towards business models that are not going to work is one short thesis type. Another one is extreme overvaluation. You also get markets like 1999 where you get extreme valuations that are mathematically impossible. These are tricky because nothing limits how overvalued these businesses can get in the near term. It may be inevitable that the valuation can’t be supported or that the insiders keep selling more stock.
There are forces that ultimately correct these valuations, but those can be trickier and more treacherous. But that is an area where you hone a skill of identifying extreme overvaluation and trying to time when the life cycle of the thesis plays out, when the market finally comes to realize how overvalued it is. Those are some areas.”
Chris Crawford is one of the instructors at Best Ideas 2014, the fully online investment conference taking place live on January 7-8, 2014.
“Fire is catching! And if we burn, you burn with us!”
― Katniss Everdeen in Mockingjay, series #3 of The Hunger Games
“When you’re in the arena … you just remember who the enemy is.”
― Haymitch in Catching Fire, series #2 of The Hunger Games
Audit firms that show up year after year to express their “true and fair” opinion on the financial statements to be free of material misstatements run the risk of getting complacent and, worse still, be in cahoots with their clients in their chemical dependence on the comfortable audit fees — like the victors of previous Hunger Games who show up annually at the event and spend the rest of their time in the relative comfort of the Victor’s Village in each district. Last week on Nov 19, an arrow struck into the client-auditor nexus that perpetuates frauds in Asia: The Seoul Central District Court ordered Samil-PwC, the largest auditor in Korea, to pay a $13 million fine to a group of 137 shareholders for failing to conduct its audit in Kosdaq-delisted software firm Forhuman with due care. The shareholders filed the lawsuit to claim compensation for their losses after the company was delisted from the Kosdaq exchange over embezzlement and accounting fraud scandals. Lee Yong-hee, the company’s CEO, was ordered to pay more than $23 million on charges of embezzling $9.4 million. Forhuman was listed on the Kosdaq market in 2002. From 2008 to 2010 it recorded $15.5 million of net losses. However, the software developer forged its accounting records, recording $39 million of net profit instead. During that period, Samil-PwC consistently gave Forhuman high evaluation scores.
This is the first time that a court has ruled to hold big accounting firms such as Samil-PwC responsible for poor auditing, whether in Korea or in Asia. And this ruling came despite the financial regulator defending Samil-PwC, arguing that it would be wrong if an auditor should assume responsibility for what was perpetrated by a client company. Both retail and institutional investors in Asia have frequently fallen prey to the negligence of auditors in terms of their duties or collusion with companies, as has been seen in the savings banks and Tongyang Group scandals which prompted the unprecedented ruling in Korea. Over the last three years in Korea, accounting firms had to pay a total of only $3.2 million for partial responsibility and settlements in accounting scandal cases. Incorporated accounting companies also came up with clever ways to escape responsibility over charged of negligence. The ruling against Samil PricewaterhouseCoopers was the second decision made by the same court in the same month that an accounting firm is responsible for negligence. The Seoul Central District Court ruled on Nov 9 that BDO-Daejoo is partially responsible for compensating investors of the failed Samhwa Mutual Savings Bank.
Accounting fraud has long been a prevalent and deep-seated problem. There had been various measures to tackle it, but fraudulent practices continue. In Hunger Games, the mockingjay bird becomes a symbol of rebellion in the second series Catching Fire. Hopefully, the Forhuman is the “mockingjay” symbol that can spread throughout Asia to unravel more accounting frauds with the various colluders from auditors to financial advisors/dealmakers with the company’s insiders. The S-chip (or Singapore-listed Chinese companies) scandals have also cases of auditor partners directly or indirectly involved.
For instance, there is the case of chemical maker Ziwo (SGX: ZIWO SP), a “bulletproof” Chinese company touted with great growth prospects when it was listed in Oct 2009 given that its chemical product is used in diversified applications from diver suits, mouse pads, laptop bags to bulletproof vests. The partner at Deloitte Singapore was advertised to have invested in the company as one of the largest shareholders. Analysts and fund managers were flown in all-expense-paid trips in Nov 2010. Net cash stands at S$0.14 per share as at Sep 2010 with zero debt and healthy operating cashflow of $13 million were generated in the first nine months of 2010. The IR of the firm is also attractive-looking. Longtime value investors in Asia would also have noticed that firms with attractive-looking IR personnel can be like the poisonous Nightlock berries in Hunger Games (a slight digression: HK-listed Prince Frog International (HKSE: 1259 HK), the Chinese personal care brand under attack by short-seller Glaucus, also has an attractive-looking IR). In Jan 2011, the sell-side research house issue a bullish “reiterate BUY” note and looked to raise the target price – and as usual, there’s a volume spike before the bullish research piece.
As explained in our series on Detecting Accounting Frauds (Part 1 and Part 2), Ziwo is a typical case in employing the capex inflation (“Grand Capex”) and consolidation trick in accounting by using balance-sheet items in the “Subsidiary”, “Amount Due from Subsidiary” and “Prepayment/Advances” accounts (“Roll-Away Loans or Advances”) to generate artificial sales and mask possible acts of tunneling and expropriation of cash and assets. Since the media blitz, the all-expense-paid IR trip and bullish sell-side research piece, share price is down nearly 90% from S$0.42 to S$0.05. Worse still, sophisticated institutional value investors lured by their quant assessment of high net cash and high net working capital in Ziwo were hurt in the “bargain-hunting” process. As usual, while the “tributes” of investors from various “districts” (retail and institutional) slugged it out in the Hunger Games (or Charles Ellis’ apt investment metaphor of the “Losers’ Game”) arena trying to bargain-hunt a cheap quant stock, the nefarious insiders and syndicates have already emerged victorious winners after doing their usual pump-and-dump machination and watching the spectacle of the tributes killing one another and eventually dying themselves – and the brutal Hunger Game repeats for these shell vehicles with sexy thematic growth stories.
Like Ziwo, the fraudulent accounts of Korea’s Forhuman are detected via their affiliate business partners in Japan. These are all part of the related-party transactions atypical of Asian firms. Noteworthy for Forhuman, Ziwo and Prince Frog is that if their hidden “related-party” entities (subsidiaries, associates, SPEs/VIEs (special purpose entities/ variable interest entities), JVs, pool arrangements, financial assets/instruments) are consolidated into the balance sheet as they ought to be, a far clearer picture on the financial health, particularly the hidden liabilities and debt, of the group (of companies) can be analyzed and evaluated. Value investors would be able to observe the explosion in the hidden debt and liabilities for Korea’s Forhuman at the group level once the Japanese affiliated entities are consolidated into their balance sheet and not be misled by the nice quant numbers of just the listed vehicle at the company level.
The new IFRS 10 Consolidated Financial Statements (the outgoing IAS 27) is effective for annual periods beginning on or after Jan 1, 2013 will significantly change the entities consolidated into the group’s consolidated financial statements. Singapore is one of the prominent jurisdictions which have incorporated IFRS into its local accounting standard which has delayed the initial adoption of IFRS 10/FRS 110 in order to allow more time for implementation. Thus, FRS 110 will be effective for annual periods beginning on or after Jan 1, 2014. The power of control is one of the most difficult questions to answer in accounting since it involves subjective judgment, leading to diversity in practice related to consolidation. Under the old FRS 27, control is the power to govern the financial and operating policies of an entity so as to obtain economic benefits from its activities, typically assessed based on the 50% voting rights ownership control. Under the new FRS 110, it is more complex, and an investor has control over an entity if all three elements are met: (1) power over the investee, exposure to variable returns and (3) ability to use power to affect the investors’ returns. For example, does a company with shares of less than 50% voting rights control another company when the former is by far the largest shareholder or has power over the board or other forms of special relationships and decision-making authority that exist to give rise to informal power?
Take the case of India’s listed business groups which have multiple affiliates that are not consolidated, thus hiding the total hidden debt liabilities and guarantees made at the listed company level. As the rupee tanks, the dollar debt servicing becomes significantly more expensive, resulting in. These problems include Jindal, Jaypee/Jaiprakash, Essar, Adani, JSW, GMR, Lanco, Videocon, and GVK. In Korea, as we have discussed briefly in the earlier weekly Bamboo Innovator insight All-in-the-Family Earnings Management and Misgovernance in Asia and Can Asia Produce a Precision Castparts, a 1,000x Compounder?, these listed business groups or chaebols which have gone bust include Woongjin, STX, Tongyang, Kumho-Asiana and the potential ones in danger include Doosan, Dongbu, Hanjin and Kolon.
The IFRS 10/FRS 110 has far-reaching impact since it involves a range of entities from subsidiaries, associates to SPEs/VIEs, JVs, pool arrangements and financial assets/instruments. For instance, the REIT/real estate/construction industry will be affected, as does the shipping industry, because it is common to operate through pool arrangements, SPEs and JVs to undertake large contracts. For instance, the strategy of an administration-controlled pool may be to build up a fleet comprising many different ship owners to enjoy economies of scale, to become visible to charterers, and through its diversification and risk-sharing, enable it to give its members an adequate return on their investment. SPEs have been used by shipping entities as a means of securitization, financing, risk-sharing, asset transfers, financial engineering, or raising capital for vessel owners. The underlying assets of vessels are purchased by SPEs to meet credit risk preferences of a wide range of investors. Many SPEs are set up as offshore “orphan companies” with their shares settled in a trust and with professional directors provided by an administration company. Substitute ships for property and other forms of investments. REITs, business trust structures and asset managers need to exercise judgment in determining if they are principal or agent to the structure. The new standards require an investor to reassess its existing structure and arrangements, especially the off-balance sheet and hidden vehicles, which could result in consolidation or deconsolidation of its investee. The parent company or investor needs to continually assess if it controls an investee when facts and circumstances indicate there are changes to the elements of control defined by the standard.
What are the implications for value investors? Hopefully, the more intense scrutiny of the group will result in the iniquitous insiders and syndicates to decide that, hey, it’s too risky and not worthwhile to prop up artificially the financial numbers of the listed (shell) vehicle with the objective of raising capital and subsequently tunneling out the cash and assets. Thus, when the artificial propping of financial numbers stop with the exit of the insiders/syndicates, we could see a wave of accounting fraud revelation in 2014 in Asia.
Yet, all these accounting standard changes are not impactful if the auditors are not held accountable for any material misstatements and fraud revelation. It will be similar to the case of goodwill hunting in which the NPV impairment test of goodwill – the excess of the acquirer’s purchase price over the value of the target’s assets – becomes a tomfoolery. An example is Tata Steel writing off $1.6 billion impairment losses in May 2013 for its $13 billion takeover of British Corus Steel six years ago. That the acquisition was a financial disaster was clear at least four years ago but the losses were written off only this year despite yearly impairment test of the balance sheet by the auditor for fair value measurement. Valuations are subjection and executives can twist their arms over the auditors. Hence the importance of the mockingjay symbolized by the court ruling case for delisted Kosdaq tech firm Forhuman last week. The auditors are now in the fire. Katniss Everdeen, the heroine in The Hunger Games, provides hope and leads the rebellion as they fought into the Capitol. Haymitch provided Katniss the crucial bit of advice to “remember who the true enemy is”, the idea that The Capitol is the true source of corruption, no matter what cruel occurrences may happen in the districts or the arena. As a result, Katniss finally takes a stand and leads the rebellion. Remembering who the true enemy is makes her the powerful character we all love. “Fire is catching! And if we burn, you burn with us!”
Key Bamboo Takeaways
- Asian listed companies employ the consolidation trick in accounting by using balance-sheet items in the “Subsidiary”, “Amount Due from Subsidiary” and “Prepayment/Advances” accounts (“Roll-Away Loans or Advances”) to generate artificial sales and mask acts of tunneling and expropriation of cash and assets.
- Value investors would be able to observe the explosion in the hidden debt and liabilities for Korea’s Forhuman at the group level once the Japanese affiliated entities are consolidated into their balance sheet and not be misled by the nice quant numbers of just the listed vehicle at the company level. The same goes for many business groups in Asia when the hidden “related-party” entities (subsidiaries, associates, SPEs/VIEs (special purpose entities/ variable interest entities), JVs, pool arrangements, financial assets/instruments) are consolidated into the balance sheet as they ought to be, presenting a far clearer picture on the financial health, particularly the hidden liabilities and debt, of the group (of companies) that can be analyzed and evaluated.
- The IFRS 10/FRS 110 has far-reaching impact since it involves a range of entities from subsidiaries, associates to SPEs/VIEs, JVs, pool arrangements and financial assets/instruments. For instance, the REIT/real estate/construction industry will be affected, as does the shipping industry.
- Hopefully, the more intense scrutiny of the group will result in the iniquitous insiders and syndicates to decide that, hey, it’s too risky and not worthwhile to prop up artificially the financial numbers of the listed (shell) vehicle with the objective of raising capital and subsequently tunneling out the cash and assets. Thus, when the artificial propping of financial numbers stop with the exit of the insiders/syndicates, we could see a wave of accounting fraud revelation in 2014 in Asia.
TransDigm (TDG) is a leading designer, producer and supplier of highly engineered components that are used on over 70,000 commercial and military aircraft currently in service in the world. Through its subsidiaries, TDG offers a broad range of products that include: mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices, specialized AC/DC electric motors and generators, NiCad batteries and chargers, engineered latching and locking devices, cockpit security components and systems, specialized cockpit displays, seatbelts and safety restraints, and engineered interior surfaces, among many other items. The company was formed in 1993 by current CEO Nick Howley and is based in Cleveland, Ohio. TDG became a public company in 2006.
TDG is a very attractive company. It’s earned high returns on equity and invested capital. Sales and EBITDA have grown at annualized rates of 21% and 22% respectively over the last decade. Although the company seems expensive when looking at various valuation multiples (EV/EBITDA is in the low teens and the free cash flow multiple is in the 20s), when adjusting for its wide moat, a strong management, and the likelihood of future, accretive acquisitions or returns of capital, we think the long-term investor can still earn a generous rate of return by paying up for this high quality company.
Several factors have contributed to TDG’s success. First is their dominant positions in numerous product niches due to the fact they own the intellectual property or are the sole source provider. Second is that sales to the aftermarket, which is highly profitable and recurring in nature, account for 55% of revenues. Third, the company operates on a “private equity-like” business model. This means a focus on acquisitions that meet their strict return requirements, aggressive capital management, and paying managers for performance.
Because of its performance history, more and more people have started paying attention to this company. TDG was also even mentioned briefly in The Outsiders by William Thorndike, a book about how eight different CEOs (including the likes of John Malone, Warren Buffett, and Henry Singleton) created enormous returns for themselves and their shareholders. We certainly believe TransDigm and Nick Howley deserve a place next to “The Outsiders” and although the shares are not as attractively priced as they were just a few years ago, we expect investors will continue to experience good returns over the long-run.
Operates in an industry with a strong tailwind
One of the many attractive attributes of TDG is that it’s part of an industry that grows more or less in tandem with growth in air traffic. Since 1970, worldwide revenue passenger miles (i.e., one passenger paying to fly one mile) has increased almost every year. This metric has doubled about every 15 years since 1970 for a compound annual growth rate of 6%. The current growth rate is a little over 5% and companies like Boeing are expecting a 5% CAGR over the next twenty years. Furthermore, over this same time frame, Boeing expects demand for over 35,200 new commercial airplanes valued at $4.8 trillion.
Significant barriers to entry
There are four major barriers to entry to TDG’s business. The first is the extensive design and qualification procedures the OEMs undertake when they design a new airplane. In the vast majority of situations, the OEMs pick one supplier to work with and design a particular component for the plane. After this process is complete, it’s tough to reverse course. Next is the FAA certification process, where the FAA must certify each plane with a type certificate (i.e., a design approval issued by the FAA after the applicant has demonstrated that a product complies with appropriate regulations) and a bill of material. The FAA has to approve any variation of the bill of material for the plane to be legal to fly in the U.S., and by proxy most places in the world. There is a process to change the specs of a plane, but this is expensive and time-consuming.
The third entry barrier is the limited size of the markets, the dispersed customer base, and the large number of relatively low-price part numbers TDG sells. The benefits of changing to a second source supplier rarely justifies the switching cost. Finally, there is the end-user’s risk and reward thought process. TDG sells relatively low-dollar items to be used in a product with a high perceived risk (e.g., a plane not being able to take off or a plane crash). Thus, TDG is able to raise prices every year.
With more than 90% of sales coming from proprietary products for which they own the design and approximately 75% of sales from products for which they are the sole source supplier, TDG has limited or no competition. Furthermore, competition is unlikely to encroach on their products because of the expensive and time-consuming process of receiving FAA approval.
Majority of sales are from the aftermarket
The chart to the right is a visual illustration of the lifecycle of an airframe and how the profitability of parts change as time progresses. During the development phase of a new plane, TDG will lose some money as they give away engineering, parts, and testing for free. After about five years, the plane will go into production for 25 to 30 years with very few variations. After the planes start to fly, TDG will start to see demand in the aftermarket. When production of the plane model stops, it takes another 30 years for the last plane to run out of a fleet. The key take away for this general process is the aftermarket is huge, long-lived, and profitable, which gives it an annuity-like quality. With about 57% of sales coming from the aftermarket, TDG is able to take on significant debt in order to lever returns and drive value for shareholders.
Decentralized and incentivized management
TDG operates under a decentralized management structure. The central office only controls the value generation strategies of each of their operating units. In order to run one of TDG’s businesses, a manager must be comfortable with local autonomy and minimal corporate interference and bureaucracy. In regards to management incentives and compensation, TDG underpays on salary and overpays via an options program that is 100% performance-vested. In order for all options to vest every year, a manager must achieve 17.5% intrinsic value growth of the business for which they are responsible. If a manager does not achieve at least 10% growth, then no options vest at all.
Strong acquisition program and capital management
In addition to a fantastic core business, management has an impressive acquisition program. There are hundreds of targets with small, monopoly product lines that have not reached their full profitability potential. These companies typically have 15% to 20% margins and TDG acquires them at multiples in the range of 9x to 11x EBITDA. Post-acquisition, TDG brings the margins up to 40% to 50%, effectively reducing the multiple at which they purchased the business. TDG increases margins by instituting price increases, cutting costs, and consolidating operations.
TDG has acquired over 40 businesses since 1993, including over 25 since its 2006 IPO. We think TDG will continue to use their acquisition program to add value to a much greater extent than the sell-side expects. Furthermore, if the company is not able to find acquisitions that meet their return requirements, they will return capital to shareholders to maintain an optimal capital structure. In just the past year, the company has returned $2 billion to shareholders via special dividends as a result of not being able to use capital for acquisitions.
Finally, TDG does not have to use a lot of cash on capital expenditures. Capex as a percent of gross profits has averaged 3% at the company. Low capex requirements are generally a sign of a more attractive business with higher margins and limited competition.
We value TDG by discounting its estimated future cash flows to their present value. We start with TDG’s “EBITDA as defined” as it excludes many one-time charges (e.g., M&A expenses, public offering expenses, non-cash compensation costs, and refinancing costs) and then subtract the required expenses to keep the business running (capital expenditures, interest expenses, and taxes) to arrive at an estimate of the free cash flows that are left over to shareholders. By this definition, free cash flows have grown at an average annual rate of 24% over the past six years. We assume a drastically lower average growth rate of 14% over the coming years.
Using a discount rate of 10% and an ending multiple of 17, we find the company has an intrinsic value of about $173 per share. With the stock trading at $147 per share, this is a 15% discount to fair value. Using slightly more pessimistic and slightly more optimistic assumptions would yield a fair value range of $168 per share to $195 per share, or a discount range of 12% to 25%.
Forward Rate of Return
Given the sensitivity of a DCF valuation to its several important input variables, a simpler way of looking at TDG would be to take a “Don Yacktman approach” and estimate a forward rate of return. This year we expect TDG will easily generate $600 million in free cash flow, or about $10.55 per share. At a price of $147 per share, this is roughly a 7% yield. Add an organic growth rate of about 4.5% (assumes no more acquisitions) and an inflation rate of 2.5% and we come up with a forward rate of return of 14%. Not bad at all.
Sales to the military
Given that 25% of total sales are to the military, this introduces an element of uncertainty regarding these revenues. Government spending on the military has declined and will likely continue to decline in the future. We expect military sales to be flat or slightly negative going forward.
In general, one should always be wary of companies with high levels of debt. However, there are always exceptions. What might be too much debt for one company might be just the right amount for a different company. Given that TDG has a large amount of recurring and predictable sales, strong pricing power, and dominates in its many product niches, it can take on a significant amount of debt for the benefit of shareholders. Since 2000, TDG’s Total Debt / EBITDA ratio has ranged from 3.5x to 6.0x. Net debt / EBITDA is currently 5.7x and will likely decline to 4.7x in one year assuming no additional acquisitions or special dividends. Given the strength of its business and the decades of experience management has in aggressively managing the company’s capital, we think leverage is not a large risk to this investment.
With the company already trading at high multiples because of excellent past performance and expectations that this will continue, if the growth of TDG slows or if TDG does not perform in line with sell-side estimates, the multiple on the company’s earnings and free cash flows will decline. Because this is a realistic possibility, we feel we have already protected ourselves by assuming the current multiple of 24x FCF declines to 17x by year 2020 in our discounted cash flow analysis of TDG’s intrinsic value.
Even if the company is merely fairly valued right now, the company is still capable of growing shareholder value at a good rate. Looking at the experience of Danaher (DHR), a company in a different industry, but with similar profitability, run in a similar way, and a similar record of outstanding value creation) when it was of a similar size to TransDigm, Danaher traded at EBITDA multiples ranging from 11x to 19x as it grew from a $3 billion enterprise value company to an $18 billion enterprise value company. Purchasing Danaher in the middle or even towards the top of this range would have produced good investment returns over the long-run. We think the same is possible with TransDigm.
TransDigm is one of the rare companies with the right management, in the right industry, executing on the right strategy. The management is incentivized to increase the intrinsic value of the business at high-teens rates and they’re in an industry that easily allows them to grow at double-digit rates at high margins through a combination of organic growth and a disciplined M&A strategy that produces high returns on capital. Because the company focuses on lines of business where they either own the intellectual property or are the sole source provider, this affords them incredible pricing power for over 50 years, which in turn allows them to use leverage to enhance returns for shareholders. In summary, this all translates into a company that will still give shareholders a double-digit rate of return over the long run.
For more information on TransDigm, please contact Douglas Ott at Andvari Associates.
The following commentary is taken from Vol. I, No. 10 of The Misbehaving Investor, provided by Triad Investment Management.
Scientists use complex equations to describe the surface of a simple soap bubble. Fancy math to describe a rather simple object. Social bubbles are the opposite. Complex systems with simple explanations. No equations necessary.
I recently searched our 3,500 public company database, looking for investor hope and promise. In other words, highly-valued companies. I wasn’t disappointed. I searched for companies with current stock market valuations over 10 times their annual sales. By comparison, most businesses sell for less than 3 times sales. Much promise. Even more hope. To exclude small, startup-type companies I restricted my search to companies with annual sales over $25 million and market values above $100 million. Of the remaining 2,800 companies, 114 made the final cut. Many are pharmaceutical and biotechnology companies, where real homerun potential exists. For that reason I won’t pick on the biotech sector; it’s far out of my league to be evaluating some PhD’s science project. Some of these may hit the proverbial grand slam.
But, there were plenty of companies in very competitive industries, selling for what I’d suggest are gargantuan valuations. A sign of the times? Yes, robust times. One thing seems certain–we are no longer in a financial crisis, judging by the valuations that investors are putting on some of these businesses. Many of these highly valued companies are in up and coming, high-growth areas. Solar and Alternative energy. Electric vehicles. Cloud-based technology. Big data. 3D printing. Internet-based businesses.
For instance, Splunk. What, never heard of Splunk? Neither had I, until recently. Still not sure exactly what Splunk does. And I’m guessing that goes for some Splunk investors. Never mind, investors today value Splunk around $6.3 billion. Yes billion. According to Value Line, Splunk “provides an innovative software platform that enables organizations to gain real-time operational intelligence by harnessing the value of their data. Its software collects and indexes data at massive scale, regardless of format or source and enables users to quickly and easily search, correlate, analyze, monitor and report on this data, all in real time…the software addresses the risks, challenges, and opportunities organizations face with increasingly large and diverse data sets, commonly referred to as big data.”
Huh? I don’t know about you, but now my head hurts. I don’t know much about big data, but I do know about big valuations. Splunk has a big valuation. Roughly $6.3 billion for less than $200 million of 2012 sales. That’s over 30 times sales. Of course, Splunk speculators are betting on years, no make that decades, of growth. Which may or may not happen. Did I mention Splunk is still losing money?
Now ask yourself: self, if someone dropped $6.3 billion in my lap, would I buy Splunk? Probably not. But then again, many professional investors who bought Splunk aren’t playing with their own money. No, they’re rolling dice backed with someone else’s dollars, and are perhaps less concerned with elevated valuations, and more concerned with beating the market and earning big bonuses. And many feel they can sell before the bubble pops.
Our advice? Don’t succumb to the “greater fool” theory that another sucker will come along and buy at an even higher price. When the next IPO storms out of the gate, be careful with your wallet. Don’t bet the farm. Remember, bubbles usually inflate slowly, but like a soap bubble, when they burst, all that’s left is air.