A Day in Cost Accounting 101: The Case of 21Vianet

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.

The following is an email excerpt sent by KB Kee, Managing Editor of The Moat Report Asia, to his students in his cost accounting 101 class at the Singapore Management University (SMU) to discuss briefly about the recent alleged accounting fraud case of 21Vianet (VNET US, MV $1.3bn).

From: KEE Koon Boon
Sent: Thursday, September 11, 2014 10:56 AM
Subject: ACCT 102 – Fraud Overhead: Cost accounting system of data centers? Alleged massive accounting fraud at 21Vianet (VNET)

Dear All,

21Vianet, dubbed the “Rackspace of China”, has been involved in an alleged accounting fraud yesterday in a 121-page report by a short-seller.

This is another interesting perspective on “cost allocation” of “service department costs”, the topic which we covered yesterday, including the article on “Fraud Overhead” that talks about indirect costs that are hard to allocate to individual “jobs”, manifested in the other article about billionaire Elon Musk’s SolarCity (SCTY US, MV $6.9bn) embroiled in accounting woes from the cost overhead allocation problem.

Companies have been outsourcing their IT service department costs, including data center costs, to reduce capex investments and cost allocation problems – but how about the other side, the data center operator that is taking on such business? What is their cost and financial accounting system like in the revenue and expense recognition as they take on different “jobs” with the “shared” infrastructure at different usage and capacity utilization?

21Vianet could have potentially employed two or three of the four basic related-party transaction (RPT) ideas that are prevalently used by many listed Asian companies to engage in the “propping” and “tunneling” of assets and escape western-based fraud detection techniques such as the abnormal accruals analysis used by both institutional investors and auditors; it’s part of the framework and proposed course elective on Accounting Fraud in Asia that I hope to launch and share in SMU. One of these used by the actual “syndicates” and “manipulators” is the “Deals Potion” to extinguish fake receivables that were used to book artificial sales when the receivables are cancelled and the set-off are booked as Goodwill, Intangible Asset and Other Long-Term Assets that inflate the balance sheet. The accounting transgression thumbprint left behind via these related-party transactions usually correspond to the artificial sales created and can serve as a value-added predictive tool to highlight potential accounting fraud.

In the 121-page report on 21Vianet, you can also find that it talks about cost behavior and Operating Leverage (what we covered in Week 2 Cost Behavior and CVP Cost Volume Profitability Analysis) on Pages 20-21 etc. Hopefully, through 21Vianet, we get to see how cost and financial accounting interact to help us understand the problem of cost allocation (in the case of 21Vianet, the indirect cost overheads are likely improperly “capitalized” and shifted into the balance sheet to inflate income) and capex investment (capital budgeting in Week 11) in building a business.

The accounting for costs associated with cloud computing is also more complex that it seems and those who are interested can go on to read more in this interesting article by Deloitte. SEC’s investigation on IBM’s cloud computing accounting in May last year is also a harbinger of the potential accounting fraud problems and a good summary is provided on the accounting impact on business valuation:

“Cloud computing gives rise to two overarching accounting considerations. First, with respect to revenues, how does one appropriately recognize revenue and expenses on service contracts that have “multiple elements,” such as platform development, data migration and hosting, training, and support services?… Important for potential accounting fraud, the effect of premature recognition could be to record revenue before it is earned or realized, artificially inflating revenues in current periods. One area of revenue accounting that is especially tricky and subject to significant judgment is determining the “Best Estimate of Selling Price” or BESP. That occurs when one element of a multiple-element transaction cannot be objectively verified based on internal or external evidence of value and must be estimated using management’s “best judgment.”

Second, with respect to costs, which costs should be capitalized and amortized over the life of the service and which costs should be expensed in the year incurred?… Were costs improperly capitalized, the effect could be to reduce costs and increase income in a given period, although the offsetting capitalization may lower return on assets.

More articles about SEC’s investigation of IBM’s cloud computing accounting can be found here:

  • IBM Defends Cloud-Computing Accounting Amid SEC Probe (Bloomberg)
  • IBM and others facing the cloudy business of accounting for the cloud (Fortune)

An old email excerpt (edited) that triggered my memory about the company 21Vianet in Jun 2013, when I was also in HK doing up a one-day workshop for the top management team of an Asian-listed tech company about tech business models and innovation:

From: Bamboo Innovator [mailto:bambooinnovator@gmail.com]

Sent: Thursday, 27 June, 2013 11:34 AM

Subject: RE: Bamboo Innovator Letter – Uprising in HK + Institutional Imperative and Differentiating Between the Tech Innovators, the Imitators and the Swarming Incompetents in Asia

One of the stocks – 21Vianet – in the article was mentioned by Straits Times last week in the Cover Page Story(!)… the accounting looks funny..

Have a good week ahead and all the best to your Test 1 next week.

Warm regards,
KB

School of Accountancy
Singapore Management University
DID: + 65 6808 5116
Website: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

Apple Watch and the Digital Pulse From Asia

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.

What can the Apple Watch do that the iPhone can’t?

The most “wow” that Tim Cook elicited in his launch of the Apple Watch last Tuesday was a Starwood app that will let you bypass the check-in queues and check into a hotel room by just waving your Apple Watch to open the door of the properties which include the Westin, Sheraton, W and so on.

Read more at The Moat Report Asia.

My Investment Thesis on Darling Ingredients

Darling Ingredients (“DAR” or the “Company”) has undergone a series of recent acquisitions that have significantly improved its financial profile, but at the same time muddled the financial picture and created a significant disconnect between price and value. Two acquisitions (VION on 1/7/14 and Rothsay on 10/28/13) have doubled DAR’s size and transformed it from a regional rendering business with high commodity price exposure (40% of input costs) to a global food processing and ingredients company with more specialized products (higher margin, more pricing power, higher ROIC, less cyclical) and less sensitivity to commodity prices (15% and declining). These acquisitions also provide DAR with processing capabilities that can be implemented in its legacy business. The Company’s successful integration of Griffin in 2010 serves as a precedent for management’s ability to effectively create value in a large acquisition. Despite its more attractive pro forma financial profile, DAR still trades below its historical multiple range. At 10x LTM cash EPS, DAR is mispriced on an absolute basis absent any incremental merger-related gains or cost savings. The stock should move +50% higher as this reality becomes clearer.

Catalysts

The recent transactions are obscuring Darling’s current cap structure and pro forma valuation. Near-term catalysts to value realization include: 1) reporting of clean, post-acquisition financials; 2) re-rating once the business profile is better understood (recent investor day and pending JPM and potentially Jefferies initiation) and 3) restart of the DGD facility and RFS ruling. The adoption of the VION and Rothsay capabilities should benefit growth, margins and returns in the core Darling business – upside you are getting for free at the current price.

Background

Prior to 2010, Darling was a Midwest renderer of beef, pork and grease. Renderers are essentially waste management companies for the meat processing industry. Darling sources its fats, hides and other proteins from the meat processors. Historically Darling then renders (sterilizes) these byproducts into animal feeds, products that are functionally substitutes for ag commodities (soybean and corn). This was a lower return, waste management business that also had high commodity exposure (in 2005 only 50% of DAR’s contracts were based on fixed margins). In 2010 Darling acquired Griffin Industries, a poultry byproduct renderer. From this acquisition DAR became the largest and only national US operator, but much more significantly, DAR was able to apply many of Griffin’s value-added practices to its other animal processing types (adding 400bps of operating margin) and began adopting Griffin’s fixed-margin pricing structure within it existing contracts (finished product prices indexed to raw material costs, thus ensuring DAR generates a fixed gross margin per unit of input).

Subsequent to the recent Rothsay and VION acquisitions, 80% of DAR input costs are based on fixed margin contracts – so now less than 20% business is directly exposed to commodity fluctuations versus 40-50% before. Darling’s new renewable diesel JV (Diamond Green Diesel) effectively hedges ~50% of the remaining commodity price exposure (from cooking oil linked to corn prices), further mitigating this previous challenge. DAR should be able to integrate Rothsay and VION’s specialized capabilities to its US plants in the same fashion it did those of Griffin (VION yields 30-40% higher in some plants). This will enable it to sell higher margin products into faster growing, more attractive end-markets and industries, spread R&D over twice the revenue and provide it a broader base of sources to procure input materials. The net result is a less cyclical, higher return business with low commodity exposure and significant growth prospects.

(click to enlarge)

DAR_Writeup 9.14 (1)

Segments

Darling Legacy (41% of pro forma EBITDA):

  • Largest renderer in US with 120 processing and transfer facilities (all US)
  • Fats: Process animal by-products and used cooking oil into fats (primarily BFT, PG and YG)
  • Protein: feed grade, pet food and hides (primarily MBM and PM)
  • Bakery: leftover bread, cookies, and other grain-based food products
    • Processed into cookie meal (animal food additive), correlated to corn prices
  • Value-add: blend end byproducts together to produce premium products with specific mixes that typically have higher protein and energy content
  • Entry barriers: requires special use permit from EPA, so relatively high
  • Regional economies of scale for lower-end rendering
  • Input sourcing:
    • Protein: meat processors
    • Oils: from food service and grocery stores
    • Across many regions a strength/ mitigant again supply interruptions
    • Top 10 raw material suppliers accounted for approximately 25% of its raw material supply in 2012

VION (37% of pro forma EBITDA):

  • Closed 1/7/14, $2.2B cash, 7.8x EV/EBITDA from private VION NV; 40% of parent revenue, financially stressed, sold to focus on consumer food products vs ingredients
  • 67 facilities in Europe (65% of rev), Asia (20%), NA and SA (10%)
  • Production of specialty ingredients from animal origin for applications in food, pharmaceuticals, pet food, feed, fuel, bioenergy and fertilizer (18-20% EBITDA margins ex-casings and hides).
    • Rousselot: gelatin for the food, pharmaceuticals and technical industries; no commodity exposure
    • Rendac: rendering; fee based revenue
    • Sonac (similar to Darling legacy): proteins, fats, edible fats and blood products; pricing determined quarterly based on prevailing forward prices
    • CTH: sausage casings; limited commodity exposure (high-volume, low-margin)
    • Ecoson: bioenergy
    • Best Hides: hides and skins (high-volume, low-margin)
  • IR: “Huge potential of exchange of ideas and practices” and “bring US products to Europe, SA, China”

Rothsay (11% of pro forma EBITDA):

  • Closed 10/28/13, $612M cash, 7.6x EV/EBITDA from Maple Leaf Foods (TSX: MFI); sold/ selling various non-core segments to shore-up balance sheet and focus on CPG
  • 5 rendering plants in Ontario, Manitoba, Nova Scotia (largest in Canada, monopoly in Ont.); 1 biodiesel plant
  • More specialized, higher value-add products (similar profile to DAR’s new Jackson plant)
  • Supply composition: 50% based on agreed quarterly forward rate based on costs, 50% margin formula
  • Similar to 2010 Griffin deal – complimentary footprint, overlapping core suppliers and customers (no plant closings near-term, but more efficient shipping)
  • CEO: “Significant integration opportunity in admin, marketing and operations”

DGD (Diamond Green Diesel) JV (8% of pro forma EBITDA):

  • Norco, Louisiana plant co-located w Valero refiner (JV 50/50 w Valero)
  • Capacity: 1B lbs of fat (corn oil, protein oil and animal fat) into 136M gs of renewable diesel per year
    • Consumes ~10% of the US supply of waste fats at capacity
    • 50% of fat supplied by DAR, rest sourced at lowest cost source in the market
  • Lower feedstock cost than soy oil plants (60% of existing US capacity)
  • Provides a hedge against corn prices in core business
  • Producing at capacity since mid-Nov; contributes $15M in EBITDA per quarter at current commodity price levels
  • The facility has been down since August due to a fire (limited damage and cost), restarting later this month
  • Blenders Tax Credit reinstatement being proposed, would add $68M in EBITDA per year

Terra Renewal Services (3% of PF EBITDA):

  • Closed 8/26/13, $120M cash, 5.5x EV/EBITDA from PE
  • Food and processing byproduct waste management in US
  • 9 sites closed, accounts transferred to core business
  • $22M EBITDA contribution w/ growth through cross-selling
  • Overshadowed by larger deals, adds to DAR platform (can solve more waste problems for meat processors)

DAR_Writeup 9.14 (1)(2)

Valuation

DAR consistently generates mid-20s ROIC, the future business should push returns into the high 20s. This is an industry with high barriers to entry due to very rigid environmental permitting for new plants, complex supply chains and processing specialization. At the current price you are getting a value-added processor at a commodity-exposed, waste disposal company valuation (10x pro forma EV/EBITDA-mcapex, 10% pro forma FCF yield) while also getting any incremental revenue and margin upside from the acquisitions for free. Implied stock price at 15x cash EPS and 14x EV/EBITDA-mcapex is $30-$33 per share (50-65% upside).

DAR_Writeup 9.14 (1)(2)

Investment Considerations and Risks

Management:

Randy Stuewe has been CEO since 2003. During that time the stock price has increased 7x, ROIC has averaged 25%. Previously at Cargill and ConAgra. Disciplined capital allocator as demonstrated by the average 7.6x EV/EBITDA multiple paid for Griffin, Rothsay and VION (all 100% cash). Stuewe noted he had been pursuing VION for 1.5 years before the final price was reached. He also indicated he seeks a +20% IRR from any use of capital. Management owns 1.6% of shares outstanding.

Risks/ Considerations:

  • Cattle herd down from draught and hog viruses may limit input availability
  • Corn and soybean price declines given Chinese and Brazil crop yields may be a more pronounced headwind
  • Further consolidation in supply base, meat processing industry has reached a level of concentration that limits further M&A; captive rendering likely already played-out, processors get higher ROIC investing in end-product improvement
  • Reduction in RFS quota would challenge DGD margins
  • Environmental/ food safety (regulated by FDA, EPA)
  • Integration risk; ongoing roll-out of CRM

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Understanding Accounting Fraud in Asia: The Cost Accounting Whale Curve

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.

“It struck me as a business I didn’t know anything about initially. You know, you’re talking about petroleum additives… Are there competitive moats, is there ease of entry, all that sort of thing. I did not have any understanding of that at all initially. And I talked to Charlie a few days later…and Charlie says, ‘I don’t understand it either.’ I decided there’s probably a good size moat on this. They’ve got lots and lots of patents, but more than that they have a connection with customers… Lubrizol is exactly the sort of company with which we love to partner—the global leader in several market applications run by a talented CEO, James Hambrick.” –Warren Buffett on Lubrizol, the $9.7 billion oil additives, lubricants and specialty chemicals company that Berkshire Hathaway bought into in March 2011

“It’s hard to imagine that three years after the fall of Sino-Forest, a fraud twice its size could navigate through a sea of regulators, investment bankers, and auditors to list on a global stock exchange.” –Anonymous Analytics on Tianhe Chemicals, the “Lubrizol of China” in their 67-page report

Information may be used to inform or deceive. Accounting is at the heart of the information system in economies and companies, providing information to lubricate the market and internal working parts of an organization, thus contributing to their smooth functioning.

When accounting frauds and financial failures pop up as what appear to be rather sudden surprise while the most recent financial statements indicate a sound condition, accounting loses their legitimacy and effectiveness. Where were the accountants and auditors?

We were left asking this question last week when HK-listed Tianhe Chemicals (1619 HK, MV $7.6bn) was suspended on Tuesday after Anonymous Analytics (AA) issued a report detailing how the chemicals company, who raised $650 million in its June IPO deal brought to the market by sponsors Morgan Stanley, Bank of America Merrill Lynch and UBS, massively inflate its revenue and profits and “is one of the largest stock market frauds ever conceived.”

whalecurve1

The role of two independent experts have come into the spotlight: the auditor verifying the accounting numbers, and the market research firm Frost & Sullivan producing industry and market share data which was heavily relied upon by analysts and investors. Tianhe is audited by Hong Kong’s Deloitte. According to data compiled by ChinaRAI in May 2013, Deloitte has more “occurrences” of fraud and other accounting issues in China than the other Big 4 firms combined (table above). AA said that original filings made by Tianhe’s main Chinese operating subsidiaries to the SAIC (State Administration for Industry and Commerce) showed revenue and profit that were 85 to nearly 100% less than what the company declared in its filings to investors in its HK IPO.

In another alleged accounting fraud, Emerson Analytics detailed how the sausage-casing maker Shenguan (829 HK, MV $1.1bn) inflated revenue (selling price to its largest customer was over 40% higher than what it charged others on average in the same standardized product) and concealed high cost of raw materials (cattle skin). Ernst & Young’s audit coverage excluded the BVI and PRC subsidiaries were audited by local firm Shenzhen Pengcheng, which had its securities business permit revoked by the CSRC in May 2013 for its failure to perform due diligence in the IPO of Yunnan Green-Land Biological Technology (002200 CH).

whalecurve2

Tianhe claims to be a top five player in the world in terms of lubricant additive sales, behind Lubrizol of the US, the number-one manufacturer, and also number two behind DuPont of the US in speciality fluorochemicals (SFC). Tianhe’s lubricant additive make up 40% of sales with margins at 27% while its SFC clocks in a breath-taking 85% margin. Tianhe, with a market value of $7.6bn, is relatively large as compared to Buffett’s Lubrizol at $9.7bn. So what is the difference in the business model between Lubrizol and Tianhe?

whalecurve3

Both Buffett and Munger initially did not understand about the competitive dynamics of this seemingly-commoditized business and wonder whether it has an economic moat and pricing power. After all, around two-thirds of Lubrizol’s sales come from oil lubricants and additives, which are oil-based and the company must purchase some heavy hydrocarbons such as crude to make them. That means that Lubrizol is exposed to fluctuations in the volatile oil market. When the price of base oil is high and keeps rising, a key question is whether Lubrizol can effectively passed that higher price on to consumers in a cost-plus pricing model based on volume.

Buffett gave us the all-important clue to assessing the moat of true compounders and Bamboo Innovators such as Lubrizol or Huchems Fine Chemical (069260 KS, MV $943m), Korea’s sole supplier of polyurethane (PU) intermediate materials: “They have a connection with customers”. A close customer relationship minimizes earnings volatility inherent in the petrochemical business.

For instance, one of the secrets for Huchems steady margins are the conclusion of long-term supply contracts (about 70% of overall sales) and the pursuit of less-risky capex projects (capacity additions when domestic clients increase their capacity). Worldwide, Huchems is the only company that sells PU intermediates outwardly at its nitric acid plant which is Asia’s largest. In general, the production of nitric acid to DNT and MNB to TDI, MDI is vertically integrated. But in Korea, Huchems has the exclusive presence in the front-end process for PU production backed by lesser material production costs from economies of scale and location advantages. As a sole supplier of PU intermediates in Korea, Huchems has stronger pricing power over its customers such as OCI (010060 KS, $3.4bn), KPX Chemical (025000 KS, MV $278m) than other firms in the value chain and the resulting stable margins.

whalecurve4

In the case of Tianhe, 65 to 90% of its high-margin SFC sales between 2011 and 2013 as reported in the IPO prospectus were to customers who are “trading companies”. AA analyzed them to be fake intermediaries that were related-party entities, “customers” who share office buildings, overlapping management and have limited business operations. In the case of Shenguan, one of its top five customers Zhongshan Defu was owned by a connected person He Xiangji at the time of IPO.

whalecurve5Cost Accounting 101 tells us that the Activity-Based Costing (ABC) cost hierarchy of order-related, channel and customer-specific costs gives companies a clear and accurate picture of the gross margins and cost-to-serve components that aggregate into individual customer profitability. The output from ABC customer analysis is often portrayed as a whale curve (chart on right), plotting cumulative profitability versus customers. While cumulative sales usually follow the normal 20-80 rule (20% of the customers provide 80% of the sales), the whale curve for cumulative profitability typically reveals that the most profitable 20% of customers generate between 150-300% of profits, the middle 70% about break-even, and the least profitable 10% of customers lose 50-200% of total profits, leaving the company with its 100% of total profits. We can identify the behavior that causes some customers to be low-cost-to serve who fall on the profitable (left-hand) side of the whale curve, and the behavior of the high-cost-to-serve customers who, if not fully priced, end up on the falling (right-hand) side of the whale curve. The table below indicates several dimensions that lead to diversity in costs-to-serve individual customers.

whalecurve6

The key idea for value investors is this: For standardized products such as oil lubricant additives, the companies typically uses a cost-plus pricing system and smart customers increasingly buy them direct from manufacturers, bypassing “distributors” and “trading companies”. To handle these direct customers, a sophisticated EDI information system, often integrated with the customers, is critical to improve responsive and create long-term relationships with the customers. Other customers will ask for special services. Since the company typically uses a cost-plus pricing system, these services were not priced, and customers begin to demand much higher quantities of them. As customers’ demand for unpriced services increase, the company incurs lower margins or even losses in serving these customers as the company expands operations and attempts to scale up. For higher-end specialty chemicals, it takes a specialized sales force to provide value-added service to the customers, including providing material management program, supply chain and logistics management, and this service is the competitive advantage that is typically not outsourced to distributors or trading companies.

All along, Tianhe and Shenguan have focus on their industry growth prospects to drive volume growth of their largely standardized products, without much discussion on their customer management and information system. In the case of Tianhe, it attempts to focus on its high growth and high profits in anti-mar agents, the downstream speciality SFC products that contribute 20% of revenue with 90% gross margins. For the reasons described above, the selling and distribution costs of Tianhe are unusually low ($14.2m, or 1.7% of sales). What was also not pointed out by AA is that the “Other Receivables” in Tianhe’s accounts has soared from $33m to $167m from 2011-13, an opportunity to create set-up companies to potentially tunnel out cash via related party transactions and generate artificial sales through these entities. Intangible and other long-term assets of Tianhe also totalled $530m, over 30% of total assets. In the case of Shenguan, the controlling shareholders have potentially tunnelled out RMB1.94bn in cash: by selling a 3% stake in the key operating subsidiary (RMB0.37bn, one-third of the IPO proceeds) that belongs to the controlling shareholder in a related party transaction, disposing listco shares (RMB0.52bn) and dividends payout (RMB1.05bn).

Companies with a system in place to handle both the high and low cost-to-serve customers and keep them in the left-hand side of the whale curve are able to gain a clear advantage in scaling up and enhancing their long-term profitability. They are able to recover costs that their competitors are absorbing, change customers’ behavior to lower the cost of serving them, gain market share by offering lower prices to customers who with just the basic level of services, and shed customers who are not willing to change their behavior to allow a minimum level of supplier profitability.

As the late management accounting pioneer Dr Charles Horngren puts it aptly, “You need to understand the business first, before you can understand the accounting of the business.” Accounting is not just about reporting numbers but is also about structuring incentives, generating information that guides decisions, providing disciplinary feedback on decisions, and inspiring innovations. The accounting way of thinking gives us a language to analyze in a systematic manner and help us reach informed opinions. The accounting way of thinking requires logic and interpretation, an ability to grasp problems and offer solutions, and an ability to ponder deeper questions and offer tentative answers in an ongoing conversation and learning by inquiry. By expanding the accounting way of thinking to the cost accounting of whale curve to understand more about customer profitability and the business model in serving customers, value investors can better understand tunneling and expropriation acts by companies via related party transactions to generate artificial sales.

Investment Process, Idea Generation and Human Biases

“Narcissus does not fall in love with his reflection because it is beautiful, but because it is his.” –W.H. Auden

We’ve had many conversations with investors of late, about idea generation, process and why culture matters. It is our view that these three concepts are inextricably tied together if you are to succeed as an investment manager. We routinely make the point that many large and well-known investment managers may appear to be seamless engines, but their “franchise” masks the dysfunctional ways that ideas are identified, processed, find their way into portfolio and cause compensation to investment professionals. Accepting that any manager may argue that their particular methodology is proprietary and distinctive (ours is BRACE)1, then I would maintain that it is firm culture and sensitivity to human biases that can be the difference between mediocrity and out-performance. Put less dramatically, given a manager’s plausibly effective process, it is culture and the wringing out of human biases that allows a manager to demonstrate the differentiation of their methodology.

Culture and Drinking the Kool-Aid

Culture often evolves from day-to-day behaviors in an investment firm, with little forethought by founders/principals about what kind of place they want to work in, create and be known for. I care about this and have given a lot of thought to the lasting legacy that I hope is Tiburon Capital Management. However, in money management, to my thinking, culture is first and foremost about fostering an environment that will yield the best risk-adjusted investment decisions for the firm’s investors.

If you were to ask any CEO of an investment firm about the ideal culture, I am sure that all discussions would include: high energy, professionalism, and healthy internal competition. Some more enlightened might talk of harnessing the skills of the many throughout their diverse organization. These platitudes are great, but frankly it is much simpler (on paper) than all this (assuming you don’t suck):

  1. Get buy-in to firm culture, mandate and process; and
  2. Wire compensation into effective output (research product) and performance adequately and fairly.

Biases Driving Rot From the Bottom and Rot From the Top

Research, themes and the portfolio allocation decisions that are the consequence, are the investment firm’s form of innovation. Idea generation in investing, as with any corporate product innovation, can fall prone to Not Invented Here and Proudly Found Elsewhere biases. This is seemingly never discussed with clients. Let’s define and discuss these biases.

NIH Bias

The Not Invented Here (“NIH”) bias is a human social phenomenon that describes the unwillingness to adopt an idea or a product because of its origin. In this context, already existing ideas, for our purposes, investment ideas, are avoided/ignored by a persistent social, corporate or institutional culture. If those investment ideas (proposed or enacted by others outside the firm – buyside or sellside) were worthwhile, we (ourselves) would have already thought of them. Thus, if it is “not invented here”, it is not worthwhile.

In general, one’s own ideas are valued higher and are more appreciated than those of others. Accordingly, other sources than one’s own are seen as hostile or inferior. This often leads to a dismissive and pejorative attitude towards other outsider-driven ideas.

NIH bias in investment firms can occur for two reasons: 1) the firm has done a great job of winning the hearts and minds of personnel regarding culture, mandate and process and now has a team that is Drinking the firm-served Kool-Aid. The danger, of course, is more about missed opportunities – as there is an active decision to ignore ideas developed elsewhere; and/or (and more insidiously); 2) an individual within the professional investment team devalues the work of anyone else on the team. Effectively the individual has an internal culture and firm (ego, personality, ambition-driven) and their NIH bias manifests in valuing their personal work higher or to the exclusion of colleagues. NIH bias needs to be wrung out or subsumed to the greater good – best risk-adjusted investment decisions for the firm’s investors. Tinkering here by thinking of the war fought in markets as guerilla in nature, rather than regimental helps. Such thinking can allow some impurity (outside ideas) to enter the otherwise pristine process. And if it’s a problem with an individual (as in point 2 above) – they have to go.

Edison – An Historical Example

The danger of people become obsessively attached to their own ideas is that they fail to objectively evaluate ideas from other sources. Thomas Edison fell into this trap when he tried to dismiss and discredit alternating current (“AC”) as a substitute for direct current (“DC”) which he had invented. Ironically the inventor of AC, Nikola Tesla,2 was working for Edison when he developed it. This meant Edison could have taken the patent (and credit) for AC. However, Edison was so protective of his own creation that he failed to see that only AC could provide the scale and scope needed for the extensive development and use of electricity in the modern age.

Your Aunt Sadie’s Paintings – Why She Proudly Displays Her Awful Artwork

So, as Auden said about Narcissus in the quote at the start of this paper, he looked lovingly at his own image Is. This is at the root of the NIH bias, whether institutional (point 1 above) or individual (point 2 above). Let’s focus on the individual. We are human. Regardless of buy-in of culture, mandate and process, the investment research conducted is accomplished by human beings with their biases and foibles. So why can’t Aunt Sadie see how terrible her artwork is; how narcissistic it appears to rational people, that she displays her work in her home? Because it’s her work!

The behavioral economist Dan Ariely3 conducted experiments to understand why this occurs. His tests and studies suggested that:

  • People appreciate their own ideas a lot more than those of others.
  • When they have created something themselves, they become much more attached to it and can greatly overvalue the potential importance of the idea.
  • We sometimes discover ideas ourselves that may have been invented elsewhere. If we adopt the idea we soon overvalue the usefulness of the idea as if we had invented it ourselves.
  • NIH bias encourages a high level of commitment and determination to see our own ideas through to the end.

To recognize these biases in ourselves is the first step toward wringing out the risks and fallacies in our own logic about an investment idea or any work’s value. The last point regarding commitment to seeing our own ideas through can explain why it is so hard to convince ourselves that we might overvalue an idea. It surely explains why it is so hard to convince others. Ariely’s findings also support the logic behind the theoretical dispassion of a Portfolio Manager and/or committee/investment team in evaluating another individual’s proposed investment ideas.

Finally, it also explains why it is so important to praise and compensate for work done well and recommendations and decisions rendered dispassionately, as the behavior is in conflict with our human coding. More on this later.

PFE Bias

I refuse to join any club that would have me as a member – Groucho Marx

The Proudly Found Elsewhere (“PFE”) bias (with regard to investment ideas)4 signifies the fact that ideas and innovation outside the investment firm are considered more worthwhile than expertise and ideas generated by the firm’s investment staff. This “rot” can occur from top down, so to speak, as it suggests that either managers or colleagues seemingly prefer sourcing ideas via the work of sellside or other buyside firms, and in so doing, tacitly devalue internally generated work.

PFE bias in investment firms can occur for two reasons: 1) the firm has done a poor job of achieving buy-in by staff regarding culture, mandate and process. This could occur if the culture, mandate and process aren’t well articulated, explicit and served in a reasonably strong Kool-Aid laced cocktail. Further, it may be that the process, per se, doesn’t hang together or make sense to the investment staff, and rings false. PFE bias may also arise due to 2) rot at the top, i.e., senior personnel and/or Portfolio Manager(s), other analysts actively devalue or discount the internally generated research while praising the work of others (from outside the firm). I have seen this (and all these dysfunctional behaviors discussed) in my career and this is usually ultimately about money. The senior personnel, once they have wooed and cultivated the investment team, beat on them, their work, their skills and ego in various ways in part, in order to early on establish the basis for their own disproportionate compensation at year-end. This could and should really be read by staff to say, “if you’d work here/for me, you must suck.”

The Healthy Balance

So why is it so hard for investment professionals to consider and concede that meaningful ideas and themes could also be originated elsewhere? What stands in the way of this, typically, is ego. No analyst really wants to admit that they are reusing an idea from a colleague, sellside or a competitor. Institutionally we want to believe we have created something unique and distinctive. Individually, we want to believe we are the reason for our institutional uniqueness and distinctiveness.

As discussed, we all have a natural attachment to our own ideas – but the greatest missed opportunities might just come from those ideas that we dismiss simply because they aren’t ours.

In most industries other than money management, there is a changing perspective on innovation. PFE in industries such as healthcare, consumer products and technology, is coming to mean taking the best ideas from one part of the world and helping migrate them to another. In some of these organizations, people may be specifically responsible for being definitively in charge of finding things elsewhere and articulating, disarming (diluting the angst about its source) and disseminating the best ideas across an organization. This could easily be a clearing house role for either the Chief Investment Officer or member of an investment team less tied to specific portfolio positions or research (if given human frailties, PFE inquiry is hard for a team to accept).

Alignment of Interests to Insure Ubiquity of Ideas

We eat our own cooking – Marty Whitman

A remaining important component to insure a sense of the ubiquity of good ideas, forming investment theses and positions that benefit clients, is the adequate and fair wiring in of compensation to derive effective output (research product).

Culture Sets the Table

So are investment personnel paid by the performance of their ideas in the portfolio or by the overall performance of the portfolio (consisting of the many ideas, generated by a team)? I have worked in places with both sorts of cultures. In the first instance, there is such direct payoff for individual ideas that highly dysfunctional outcomes are prevalent. Here are some observations of such firms:

  1. Ideas in the fund often come from the boss/Portfolio Manager primarily, so that he/she can garner or argue for the majority of compensation.
  2. Portfolio positions often come from the most eloquent, best liked, the closest friend of the PM, to the exclusion of those proffered by the less eloquent or meeker analysts.
  3. Such a culture, like lawyers whose code of ethics requires them to zealously represent a client regardless of guilt or innocence, can drive analysts to put the best case forward on a trade idea, regardless of personal concerns, damaging data or risks uncovered by them. There can be a tacit caveat emptor – let the buyer beware – that exists between the Portfolio Manager and the analysts, and could translate into unforeseen risks for the client.
  4. A portfolio could be conceived, then, that doesn’t harness the full strength of an investment team, and is, in fact, skewed in ways that either may miss magnificent returns or introduce mammoth new risks.
  5. Is it ego? Perhaps money is only one part, and pride of authorship and direct impact (NIH) drives the one-dimensional and zealous presentation of an investment idea. Such work might be done with career upside/organization downside in mind. That is, “if my ideas work, I can lay claim to them (for compensation)”, for aggrandizement – “I want to be a PM, I want to start my own firm, and this will help.” Or “If I am wrong, well, the Fund underperforms and I can hide behind the ‘team’ approach.”

Our view at Tiburon is that investment professionals do not “own their names”, i.e., the work done researching a prospective investment is “as a steward for the team and the firm’s investors”. Each analyst, then, is a fiduciary for their colleagues and clients. This reduces much of the potential dysfunction discussed above. If you are part of our team, it means you are valuable. At Tiburon, value is added by processing ideas but also actively (and civilly and professionally) participating in the discussions of other’s ideas as well. Whether trade ideas ultimately wind up in the portfolio and how they perform does not drive compensation for any individual, but for the team.

So how best to reduce human biases and dysfunctional behaviors, to achieve robust idea generation and adherence to a proprietary process? There are no easy answers to this. The simplest palliatives are: personnel that clearly adopt the culture and shared vision, paying the team on portfolio performance, and active participation in the discussions of all work presented at portfolio meetings. We eat our own cooking, and this helps too: we make sure that not less than 20% of investment personnel’s annual performance compensation is rolled in the Fund and tied up two years.

People/Culture: The Right People

So there is this fine balance that a properly operating team have some coherent, unifying process and objectives, but they need to be the kind of people that recognize their own human biases and do what they can internally, to keep them in check.

If It Matters to You, Make Sure People Know

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The Drumbeat of the New

We do event-driven investing. What a terrific and exciting mandate! I tell you, there is always something to do regardless of markets, liquidity, cycles, etc. Like the shark, Tiburon in Spanish, our namesake – we do not stay still. Move or die. Put more poetically, there is the drumbeat of the new. A sound culture, mandate and process advanced by able investment professionals with buy-in makes the difference in being at the forefront of themes and proving differentiation in our BRACE Methodology.

Where the next big idea comes from should not be important. The risk-adjusted return of our investor’s portfolio is. Flexibility to accept ideas generated internally or Proudly Found Elsewhere (and then reviewed via proprietary methodology and expressed in one’s own institutional way) is the Healthy Balance called for in order to prove out a differentiated methodology.

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The above article contains general information about, and the opinions of, Tiburon Capital Management. This article is not intended to be an offer or any form of solicitation and does not, and is not intended to, constitute any investment advice.