Portfolio Positioning of Centaur Value Fund

The Fund continues to hold investment securities that we believe represent some combination of good value and reasonable safety. Below we provide a brief review of some of the Fund’s larger investments at the end of Q1:

Alleghany was the Fund’s largest single stock investment at quarter-end, at roughly 5.3% of total portfolio value. Alleghany is primarily an insurance company, but is very flexible in its opportunistic business approach and has in the past two decades owned a variety of industrial, financial, and commodity-based businesses. Despite a strong emphasis on conservatism, Alleghany has managed to grow its per-share book value at a faster rate than the S&P500 Index over the past ten years ending in December 2014.

However, the stock has not kept up with the growth in the business over that period, which is why we consider it a relative bargain today. The stock’s multiple to book value has declined from over 1.2X at year-end 2004 to approximately 1X book value today.

Alleghany management has shown strong instincts in exploiting difficult times in the past, making large acquisitions during times of stress at attractive prices. As a recent example, in early 2015 Alleghany bought an entire oil field from the U.S. government after oil prices fell by over 50% from recent highs. The company also has aggressively repurchased shares during those stretches where the stock has traded below book value in recent years.

We continue to own long-dated TARP warrants on two large U.S. banks, both of which have reported impressive profits and growth despite significant industry headwinds. These headwinds include narrow interest rate spreads and heavy spending increases for regulatory compliance, legal settlements, and needed improvements in cyber security.

We believe that these banks will likely demonstrate improving earnings as the recent heavy spending subsides and particularly if long-date interest rates rise. Due to the warrant structure we are able to get considerable leverage with our investment. At quarter-end, the Fund’s investment in the warrants was about 3% of portfolio assets on a cash basis, which translates into just over 10% exposure on an economic basis.

The Fund also is invested in both of the major NASCAR track operators, with total exposure of approximately 8% of Fund assets at quarter-end. These two companies own and operate the tracks at which the major auto racing events of NASCAR are held, and represent unique and irreplaceable assets with long productive lives. In NASCAR, the venue owners receive the lion’s share of the revenue from the sport’s attendance and broadcast rights, the latter of which was recently renewed for ten years at a solid increase to the prior deal. We believe that after several years of decline in attendance, NASCAR racing is poised for a modest rebound. We believe that the combination of recent improvements at various tracks, increased television exposure, and the recovery of the sport’s core fan base from the recession are likely to result in improved economics for the track owners. As evidence of this improvement becomes more apparent, we expect the shares to be re-rated by the market to better reflect the quality of the underlying assets and the long-term revenue visibility provided by the recent broadcast agreement.

Despite our enthusiasm for the Fund’s holdings, we remain concerned about the elevated valuation levels in the U.S. stock market as a whole, and believe that both stocks and bonds are unattractive generally. We remain intently focused on the concept of having a margin of safety against significant loss across the portfolio, and we hope to find cost-effective hedges or compelling individual short ideas to the portfolio to offset further increases in long exposure in order to protect against an abrupt shift in investor sentiment.

We believe that many risks are not appropriately discounted in today’s low-interest rate environment and that there is an excess of confidence that the world’s central bankers will be as successful in influencing the world’s capital markets in the next five years as they have been in the last five. As value investors, we rely upon occasional volatility and the distressed selling on the part of excessive risk takers in times of falling prices to acquire the bargains that naturally accrue to providers of scarce capital in times of uncertainty. The low volatility and the historically high correlation of stock prices over the past several years has served as a hindrance to us in fully deploying the Fund’s capital, but such periods do not last forever and we expect that 2015 will continue to provide us with opportunities so long as we remain both diligent in our search for ideas and patient in waiting for truly compelling opportunities.

This post has been excerpted from the Centaur Value Fund, Q1 2015 Report to Partners.

This report is being furnished by Centaur Capital Partners (“Centaur”) on a confidential basis and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. This report is being provided to existing limited partners for informational purposes only, and may not be disseminated, communicated or otherwise disclosed by the recipient to any third party without the prior written consent of Centaur.

An investment in the Fund (“CVF”) involves a significant degree of risk, and there can be no assurance that its investment objectives will be achieved or that its investments will be profitable. Certain of the performance information presented in this report are unaudited estimates based upon the information available to Centaur as of the date hereof, and are subject to subsequent revision as a result of the CVF’s audit. The performance results of CVF include the reinvestment of dividends and other earnings. Past performance is not necessarily a reliable indicator of future performance of CVF. An investment in CVF is subject to a wide variety of risks and considerations as detailed in the confidential memorandum of CVF.

References to the S&P 500, NASDAQ Composite and other indices herein are for informational and general comparative purposes only. There are significant differences between such indices and the investment program of CVF. CVF does not invest in all or necessarily any significant portion of the securities, industries or strategies represented by such indices. References to indices do not suggest that CVF will or is likely to achieve returns, volatility or other results similar to such indices.

This presentation and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events.

The information in this presentation is not intended to provide, and should not be relied upon for, accounting, legal, or tax advice or investment recommendations. Each recipient should consult its own tax, legal, accounting, financial, or other advisors about the issues discussed herein.

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Detecting Accounting Fraud in Asia (Part 4): Introducing Six New Measures

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.

Earlier articles in the Accounting Fraud in Asia series:

“What seemed to be wrong with this income statement?” I would ask and engage value investors in a conversation discussing the limitations of western-based screening tools and techniques in financial statement analysis to analyze Asian companies.

“It was generated by a listed Chinese zipper company who claimed to be the ‘YKK of China’ with a diversified customer base of over 900 customers. Its zipper products are used in fashion and sports apparels, camping equipment, shoes, and bags by renowned brands. It also received the ‘PRC Top Ten Famous Zipper Brands’ in China. To perhaps make your job easier, a simple table of financial ratios from profit margins, ROE, cash conversion cycle (CCC) is provided. Interestingly, you might note that it is a company generating a ROE of 20.2% on profit net margin of 22.3% and trading at a modest valuation of Price-Earnings ratio 6.2x and Price-to-Book Value 1.6x, with downside protected by a seemingly healthy ‘net cash’ balance sheet with net cash comprising 27% of the market value of the company.”


“And we would stay on this income statement for whatever time it takes before someone points out the dog that didn’t bark,” I added.

Sometimes, there would be one or two people, often those who are open-minded and intellectually curious in their learning approach, who would point out: “The selling and distribution expense of RMB3m seems awfully low for a company generating RMB882m in sales for truckloads of zippers to be transported to over 900 of their customers’ factories in the different provinces.”

This zipper company is SGX-listed Fuxing Zipper (SES: DC9, Bloomberg: FUXC SP), down over 90% in market value. We will later illustrate how accounting tunneling fraud is carried out and the six new measures for value investors to employ to avoid such statistically-attractive fraudulent stocks. From the case of Fuxing, one of the apparent measures is based on the opportunistic shifting or deferring of operating expenses out of the income statement to boost profits artificially – often into the balance sheet items. But how do we can capture this? A possible measure is that of the “OP/OL ratio”, or “Other Payables/Operating Liabilities ratio” which we will elaborate upon later with the cases that we have observed to be a systematic phenomenon. In essence, we have observed that an OP/OL ratio over 40% leads to subsequent and future acts of accounting tunneling fraud in which corporate wealth and cash is tunneled out.


As we have shared in earlier articles, transportation and logistical cost is a nightmare in China and emerging markets, estimated to account for 15 to 20% of the cost of doing business and of the GDP too by various sources that include World Bank and the Li & Fung group in an insightful presentation. The problem lies not only because of the geographical woes but also due to the regulatory licensing bottlenecks: “China’s logistics system is governed by nine separate ministries and commissions, which prevents the central government from regulating cross-provincial transport across China’s 31 provinces. Instead, local governments manage their transportation systems as provincial fiefdoms, often using local license rules and tolls to raise revenue. Thanks to high transaction costs, no trucking firm has yet established a nationwide network.

The emerging Asian and Chinese companies engaging in accounting fraud often push operating expenses and overheads off the listed entities to related-party companies to boost artificially-high profit margins and ROE. For instance, an Asian consumer “brand” selling its “visible” products in supermarkets would usually shift the substantial expenses related to shelf-space placement to undisclosed related-party “distributors” and “agents” (called “tong lu” 通路in the local language) to achieve the high profit margins and ROE that are attractive to investors. Most value investors focusing on financial ratio analysis do not realize that logistics, distribution and marketing costs in emerging Asian markets is around 15-20% of sales, instead of the 0.34% that this zipper company incurred. Like-minded value investors are often amazed that they have not seen what was now obvious to them. Thus, one simple new measure is to use the “Selling and Distribution expense as % of Sales (Measure #1) as a sanity check on unrealistically low operating expenses that were deferred or shifted out of the income statement.

We wrote something in the article “BNSF + JB Hunt = Buffett + Munger = Lollapalooza! How About Asia?” about how logistical improvement throughout America has enabled the scaling up of retailers and businesses in a cost-effective way:  “The open innovation also enabled American companies such as Petco Animal Supplies, Pepboys Auto, The Container Store, Best Buy, Lowe’s, arts & craft retail chain Michael’s, to scale up their expansion in a cost-effective way.  Petco commented, ‘Despite a 27% growth in stores since 2008 – from 870 to 1,100 – our transportation spend on a cost-per-delivery basis has remained relatively flat. If you had told me we could add that many stores without raising the transportation costs, I wouldn’t have believed you.’”

The above excerpt talking about pet shop Petco highlights one of the important real-world cost concept in doing business: cost-per-delivery or in general, cost-per-activity. Many Asian entrepreneurs whom we have talked to over the past decade plus had lamented their problems in scaling up their business to get a decent valuation beyond the billion-dollar market capitalization barrier. They mentioned how sales might perhaps tripled in five or ten years, but core business profit growth (excluding deal-making trading profits) might remain flat or even decline, and a key reason (from a simple cost perspective) is that Selling, General and Administrative (SG&A) cost, thought by many to be a “fixed” or at least a “semi-fixed” cost, had increased even faster than sales. Rather than SG&A costs being fixed or even variable, these costs had become “super-variable” – increasing faster than sales.

The impatient entrepreneurs seeking their payday resorted to opportunistically manipulating this SG&A cost to improve dramatically their profit margin in the eyes of investors by shifting or deferring this expense item into the balance sheet items that include “Accrued Expenses”, “Other Current Liabilities”, “Other Non-Current Liabilities”, “Deferred Tax Liabilities” and so on, giving the excuse that these expenditures provide long-term payoffs which are unlikely to materialize and hence they should be expensed off. We classify and sum these up as “Other Payables”. A closer examination into the footnote disclosure would reveal these include loans due to directors, amount due to related-parties.

A common IPO fraud ruse by the insiders and investment bankers is for the directors to first borrow some short-term financing from the banks, using part of the borrowed money to create set-up customers to engage in fictitious sales with the IPO company. Once the IPO proceeds are raised, the loans to directors and amount due to related parties are repaid with other people’s money (OPM) – often disguised as under the purpose of “IPO proceeds used for working capital purposes”.

Another is to use the IPO company to buy equipment, goods and services at inflated value from their related companies. Equipment worth $20m is invoiced to the IPO company at $100m from the related company, with the insiders pocketing the “free” $80m profit which they either pump back to the company to boost artificial sales or to convert as “personal” investment into “free” equity into the IPO company in a show of “ownership commitment” in the eyes of the unsuspecting investors. This is often disguised as under the purpose of “IPO proceeds used for PPE, factory expansion and capex investments”. In the case of the accounting tunneling fraud through PPE and capex (we coined it as “Grand Capex Fraud” in our earlier articles), we will elaborate upon this in another future article.

As for deferred tax liabilities, joint-controlled entities and associates are usually set up in which these entities are not required to be consolidated due to the listco having a less than 50% ownership stake in them. However, because the listco has hidden economic control and power over these entities, the listco can shift operating expense and debt liabilities to their <50% entity, and subsequently absorbing them through acquisition with the original operating expenses captured now as deferred tax liability in the balance sheet.

We had discussed briefly in an earlier article “Do investors overvalue firms with bloated balance sheet?” about the “Bloated Balance Sheet” measure, proxied by the Net Operating Asset (NOA). A high NOA provokes excessive investor optimism and a fear of missing out (FOMO). As a result, investors systematically overvalue firms with bloated balance sheet with a failure to discount for the unsustainability of earnings growth. Disappointment and subsequent correction in mispricing result in negative returns in the long-run.

Operating Asset (OA) = Total Asset – Cash and Short-Term Investments
Operating Liabilities (OL) = Total Asset – Shareholders’ Equity – Short-Term Debt – Long-Term Debt
Net Operating Asset (NOA) or Bloated Balance Sheet = (OA – OL)/ Total Asset (Measure #2)

We have observed that companies with bloated balance sheet or NOA measure of over 40% having a higher probability of subsequently engaging in acts of accounting tunneling fraud. In the case of Fuxing Zipper, the NOA measure in 2007 and 2008 is 53% and 64% respectively.

In addition, the OP/OL ratio = Other Payables (OP)/ Operating Liabilities (OL) (Measure #6), a ratio in which we have observed that crossing over the unusually high 40% (as opposed to under 20% for the typical companies) leads to subsequent and future acts of accounting tunneling fraud in which corporate wealth and cash is tunneled out. In the case of Fuxing Zipper, the OP/OL ratio in 2007 and 2008 is 44% and 52% respectively, as opposed to around 19% for YKK for instance.


We will use the following table that illustrates potential accounting tunneling fraud at Fuxing Zipper with three parts (Part A: The Deception, Part B: The Tunneling, Part C: The Tunneling Measures). From the accounting concepts underlying the key features of accounting tunneling fraud, we will operationalize a set of three simple but powerful new measures to detect fraud ahead of the curve:

  • Change in “Other Receivables” (OR) as % of Change in Sales (Measure #3)
  • “Other Receivables” (OR) / Operating Assets (OA), or OR/OA (Measure #4)
  • “Other Receivables” (OR) as % of Cash Raised (IPO, SEO, private placement) (Measure #5)

Fuxing was listed in Sep 2007 in Singapore, raising $53.5m in IPO proceeds, or around RMB364m. From the table, revenue and earnings peaked in FY07 and Fuxing encountered deterioration in its financial performance in FY08 with the onset of the global financial crisis. Share price plunged by more than three-quarter from its peak in FY08. In FY09, the performance worsened with a revenue plunge by RMB370m and earnings fell to RMB30m from FY197m in FY07.

Should this poor fundamental performance be attributed to external macroeconomic conditions or to opportunistic fraud carried out? If we can predict this deterioration in financial numbers ahead of the curve, the nefarious intentions of the insiders and management can be observed.

As observed in Part A: The Deception in the table, the usual western-based financial statement analysis of financial ratios, accruals and cash conversion cycle does not appear to be revealing. Accounts Receivables Day has deteriorated slightly from 121 days in FY07 to 126 days in FY08 and Inventory Turnover Days has improved from 20 days to 18 days. While ROE has declined from 20.2% in FY07 to 12.9% in FY08, the typical bargain value investor armed with their rigorous quantitative screening software will salivate at the prospect of the high net cash as percentage of the market value at over 80% of the market cap, the low single-digit PE and the low price-to-book value of 0.2x! It calls for an all-in no-brainer trade!

However, what’s lurking beneath the deception is a spike in the “Other Receivables” (OR) account in the balance sheet in FY07, the peak year of its financial performance. These OR include: Other Receivables, Prepaid Expenses, Prepayments and Advances, Other Current Assets, Amount Due from Related Parties and Directors, Amount Due from Subsidiaries, Restricted Investments, Bank Deposit Pledged, and so on, which we classify and sum them up as OR. This is typically ignored as an inconvenient and “meaningless” number. What’s more important are the accounts and trade receivables, the inventory, the profitability of the assets in generating high return-on-equity, the high net-cash in the audited balance sheet. Yet, these OR are aggregated in the ROE figures and these accounts are the very reason why there is often the “missing cash” phenomenon when accounting fraud unravels. Let us explain and elaborate this “Roll-Over Tunneling Fraud”, one of the four commonly-used methods used by actual insiders and syndicates to expropriate cash and assets out of the firm as we have shared in our Detecting Accounting Fraud in Asia article series Part 1 and Part 2.

Step 1: Listco engages in “intercorporate loans”
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Cash (raised from IPO, SEO, bank etc)

Step 2: Generates artificial or fraudulent sales via undisclosed related-party transaction disguised as fictitious “customers” (this will show up in Step 3):
DR “Cash” (“cash” or short-term financing loans re-enters the listco)
CR Sales (artificial or fraudulent sales)

Step 3: Check for artificial or fraudulent sales:
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Cash (raised from IPO, SEO, bank etc)
DR “Cash” (“cash” or short-term financing loans re-enters the listco)
CR Sales (artificial or fraudulent sales)

The accounting transgression thumbprint left behind:
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Sales (artificial or fraudulent sales)

Changes in OR are short-term financing schemes that should not – must not! – lead to revenue generated. Only the sale of products or performance of service obligation leads to revenue transactions. If there is a “matching” debit or increase in other receivables and a credit in sales, Step 2 shows up, that is, sales was generated using fictitious customers disguised as undisclosed related party transactions.

When the insider decides not to maintain the scheme, as in the case of the “missing cash” syndrome in the S-Chips and HK-listed P-Chips, the transactions unwind and a plunge in sales correspond to a plunge in these “Other Receivables”, cash equivalents, prepayment, advances and short-term financing accounts.

In the case of Fuxing Zipper, Step #3 of the accounting transgression thumbprint shows up in the crime scene: The increase in revenue in FY07 of RMB167.5m is matched by an approximate sudden increase in the total OR of RMB181.5m. A quick check into the financial footnote disclosure reveal this amount relates to “advances to suppliers” and amount due to related parties which are essentially unsecured and interest-free loans.

image 1image 2

This is essentially short-term money that can be shifted around and “repaid” by the close of financial period and “taken” again without the guarantee of repayment or recoverability and there is no collateral at all to offset this non-repayment risk imposed on the minority shareholders. Importantly, this begs several important additional questions that require proper disclosure for accountability to the minority shareholders given the significance of the sum:

(1) Who is this supplier or sub-contractor? Is this a related-party? If this is an “independent” party, it will be necessary for the auditor to ascertain and verify this material information, including the financial track record of this supplier in the event of default. There should be – must be – proper bad debt provisions if this information are not disclosed and ascertained. Also, if the supplier is incorporated in the offshore haven centers, it will be hard to recover back the amount and the ultimate identity can be easily hidden to escape any asset tracing in the event of non-repayment. What is to stop the non-repayment?? This is an obvious red flag in accounting fraud.

(2) Why is this huge amount “lent out” in the first place? And interest-free and unsecured! What is the nature of the relationship to warrant such terms? Without this loans amount, will “revenue” wax and wane with such short-term financing schemes?

(3) Why does the increase in revenue correspond to this OR amount of around RMB180m? This is particularly worrying and a cause for accounting tunneling risk with these short-term financing routed to related party vehicles posing as fictitious customers to engage in artificial sales in prior periods – and the abrupt decline in the revenue that correspond to the non-repayment risk of this short-term loan highlights that this scheme may be unwound easily, leading to the missing cash and cash equivalents. This casts huge doubt on the revenue recognition policy and revenue reliability of the listco.

In the case of Fuxing, let’s apply the below measures:

  • Bloated Balance Sheet or Net Operating Asset (NOA) = (OA – OL)/ Total Asset (Measure #2)
  • Change in “Other Receivables” (OR) as % of Change in Sales (Measure #3)
  • “Other Receivables” (OR) / Operating Assets (OA), or OR/OA (Measure #4)
  • “Other Receivables” (OR) as % of Cash Raised (IPO, SEO, private placement) (Measure #5)
  • Other Payables (OP)/ Operating Liabilities (OL), or OP/OL (Measure #6)


From the above, we observe that Measure #3 of the accounting transgression thumbprint shows a near-similar match of 108%, i.e. an increase in revenue correspond to that of an increase in OR, which should not and must not be the case as lending money to another company does not lead to the generation of sales, unless that lent money is routed to create fake customers engaging in fictitious sales with the listco. Other related measures include checking the OR/OA and OR as percentage of the cash raised in IPO/SEO. In the case of Fuxing, the OR as % of cash raised is 79% in FY07 before escalating to 130% (possibly from cash raised in IPO used to pay Other Payables to related party entities who rout back this money back to the listco as OR to artificially pump up sales). Note that the sum of the change in OR from FY06-08 is RMB406m, versus the RMB364m raised in IPO. If we take into consideration the sum of the change in OP of RMB5m and the increase in total intangibles of RMB44.2m, the cash outflow from the tunneling act during FY06-08 is RMB367m, corresponding to the IPO cash amount raised.


FY09 is the year of the accounting tunnel fraud act taking place. The sudden plunge in revenue by RMB370m corresponds to the plunge in the OR of RMB387m, or the ratio of Change in OR as % of Change in Sales is 104%. With the global recovery in markets taking place in Feb/Mar 2009, the insiders and management perhaps thought of engaging the fraudulent scheme once again to lure in investors once again. In FY10, there is an increase of RMB205.6m in sales, corresponding to an increase in the OR by RMB161.7m. Indeed, bargain value investors are lured in and the share price more than doubled from its bottom in 1Q09, with the share price staying in the range till Mar 2011 when disastrous FY11 financial results were announced. In FY11, do take note that the decrease in OR of RMB206.8m correspond to the earlier increase in FY10 sales of RMB205.6m. The stock then resumed its plunge, the money grab completed.

Thus, traders and investors using aggregate financial accounting numbers to derive superficial financial ratios (e.g. profit margin, return-on-equity) and valuation metrics (e.g. low price-to-earnings, low price-to-book) without understanding the underlying business model, the related-party transactions artificially inflating the aggregate financial numbers and the data generation process in the financial footnotes can be misled.

We have observed this accounting transgression pattern in a comprehensive list of S-chips, HK-listed P-chips and Asian companies that were involved in actual accounting irregularities and fraud across industries. They include the environmental protection equipment industry that China Environment operates in (Sino-Environment), industrials (China Packaging; FerroChina, Fibrechem, China Sky, China Gaoxian, Hongwei, Sino Techfibre, Falmac, China Zaino, Sinopipe, China Printing; Fushi Copperweld, Rino International, Orient Paper etc), consumer (China Hongxing Sports, Peacemark, Moulin Global, First Natural Foods, Warderly, Zhongguo Jilong, New Lakeside; Deer Consumer, Fuqi International etc), Resources (China’s Sino-Forest, HK’s Chaoda Modern Agriculture, China Green, China XLX, Pan Sino, Asia Aluminum, China Metal Recycling; Le Gaga, Celestial NutriFoods, China Sun Bio-chem, China Milk, China Integrated Energy, China SinoTech Energy, China Natural Gas, China Energy, China Oilfield Technology, etc), tech (Longtop Financial Technologies, China New Century Media, China MediaExpress, China Intelligent Lighting, KXD Entertainment, etc).


Let us illustrate quickly with another case: SGX-listed China Hongxing Sports (SES: BR9, Bloomberg: CHHS SP), a former stock market darling with all the alluring statistics that include high net cash in the balance sheet, high profit margin (>15%), high ROE (>11%), modest Price-to-Book valuation ratio. Market value at its peak in Oct 07 has crossed over a billion dollar. During FY08, share price declined with the onset of the global financial crisis. Notice that in FY08, the increase in revenue of RMB843m correspond to an increase in OR by RMB877m.

Again, a quick check of its financial footnote disclosure revealed that this increase in OR relates to “advances to distributors” which are essentially unsecured and interest-free loans.

image 5

FY09 is the act of the accounting tunneling fraud taking place with a sudden plunge in revenue by RMB890m – and a corresponding plunge in OR by RMB1bn. From FY10-12, the financial performance worsened markedly. In Feb 2011, the shares were suspended with the announcement that the auditor Ernst & Young facing noting irregularities in the cash and bank balances, accounts receivables, accounts payables and other expenses during the course of their audit work of the PRC-incorporated subsidiaries for FY10 accounts. And the stock died.

And again, the set of tunneling measures reveal that lurking beneath the deceptively attractive financial ratios and valuation metrics is the hideous Picture of Dorian Gray with all the sins hidden.


This is what we wrote in Aug 28, 2013 and we still feel very strongly, if not more so, about what we have written since:

“This prevalent situation in Asia is analogous to that of the Picture of Dorian Gray in the novel by Oscar Wilde (1890) – the face of Dorian Gray showed no signs of aging as time passed, whereas the sins of his worldly existence are vivid in the portrait of himself that he kept hidden in the attic. The Dorian Grays of Asia have been able to get away with their accounting frauds and misgovernance transgressions because they are branded as sexy growth companies who charm party-goers with their good looks (quantitative financials) and riding on “The Asian Growth Story”.

At Bamboo Innovator, our task is to support fellow value investors to understand and appreciate the early signs of potential problems and red flags in Asian companies ahead of the market, to see the real attic portrait of the companies’ financial health and economic worth.

We still hold on feverishly to the idealistic hope that a community of like-minded people can come together to spread their knowledge and kindness built around a resilient mental model, a home that everyone can breathe in it and make it their own. We hope that our candid and authentic views about value investing can be shared in our little community. 

Thus, despite self-doubts all the time, this mission to create value for our readers with the Bamboo Innovator analytical framework has pulled us forward to devote nights after nights and squeeze every ounce of our bludgeoned body to do this. This is why we care so much about doing The Moat Report Asia for you.

Having the inner compass of the Bamboo Innovator in our hearts can help us not lose our way in difficult and uncertain times as we journey together in the dangerous Asian capital jungles.”

PS1: We are doing up a Foreword and Introduction to a compiled Special Report of the analysis of 19 accounting tunneling fraud cases in Asia and accounting and governance issues of Asian companies exclusively only for our Moat Report Asia subscribers. Some of the cases include:

  • HK-listed Chinese companies: China Taifeng Bedding (873 HK), Sany Heavy Equipment (631 HK), Fu Shou Yuan (1448 HK), Rongsheng Heavy (1101 HK), Rexlot (555 HK), Beijing Enterprise Water Group (371 HK), Bracell, formerly Sateri (1768 HK), China Nature Home Flooring (2083 HK)
  • US-listed Chinese companies: China XD Plastics (CXDC US), Pingtan Marine (PME US)
  • ASEAN-listed stocks: Muda Holdings Berhad (MUD MK), Silverlake Axis (SILV SP), SIIC Environment (SIIC SP), Dukang Distillers (DKNG SP), Cordlife (CLGL SP), Zhongmin Baihui (ZMBH SP)
  • Bursa Malaysia-listed Transmile Group, SGX-listed China Eratat Sports, Korea’s Celltrion
  • And more

PS2: With the Special Report exclusively for our Moat Report Asia subscribers, this Weekly is a double-issue for April 20 and April 27. We will be back with the Weekly on May 4.

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:


Paid subscribers get:

  • The Monthly Moat Report Asia (20 issues)
  • The Weekly Bamboo Innovator Insight Articles (>70 Issues)
  • Access to the Members’ Forum
  • Videos and Presentations by Thoughts Leaders, Entrepreneurs and Business Leaders in Asia
  • Asian Extractor – Unearthing Accounting Fraud in Asia (asianextractor.com). We are pleased to present the presentation materials exclusively for our Moat Report Asia subscribers:
  • Week 1 – Survival in the Asian Capital Jungle: Who Knows What When? (108 slides)
  • Week 2 – Western Tools to Catch An Asian Snake? (111 slides)
  • Week 3 – The Incentivized Asian “Wedge” Snake to Tunnel Corporate Wealth (105 slides)
  • Week 4-5 – Shedding of the Asian Snake’s Skin, The Opportunistic Tunneling of Corporate Wealth (157 slides)
  • Week 6 – Descend into the Asian Snake’s Lair, Occult Offshore Centers, Tax-Tunneling, and Consolidation Craftiness (89 slides)
  • Week 7-9 – The Asian Snake Charmer and Stock Manipulation Scheme  (112 slides)
  • Week 10 – The Accounting of Words and the Hiss of the Asian Snake (57 slides)

You will also get download access to the presentation by our invited expert guest speakers:

  • Jarrod Baker, the Senior Managing Director at NYSE-listed forensic specialist FTI Consulting Inc (NYSE: FCN, MV $1.5bn).
  • Hemant Amin, Founder, Chairman and CEO of Asiamin Capital, a successful multi-million single family office, and Founder and Chairman of the BRKets investor group (www.brkets.com)
  • Emerging Markets Research. KB is also the co-advisor to the School of Accountancy’s SMU Emerging Markets Club (smuem.com). Carefully-curated presentations are made available for download for our subscribers:
  • Kerry Logistics Network(636 HK) and China’s Transportation & Logistics Industry, by JIANG Lingjun
  • PT Bank Tabungan(BTPN IJ): BTPN’s Successful Business Model, by Daniel IGOR
  • PT Sumber Alfaria Trijaya Tbk (Alfamart)(AMRT IJ): Maintaining Its Stranglehold as Competition Heats Up in Indonesia’s Modern Grocery Retail Industry, by Kelly GOH Wan Jun
  • Mitra Adi Perkasa Tbk PT(MAPI IJ): Still Fashionable in the Fashion Apparel Retail Industry? by Lucas LIM
  • Alibaba: Embracing Its Challenges + China Online Market: Growing with Challenges, by JIANG Lingjun
  • Ulmart: Russia’s Own Amazon, by Christina LIM

Learn more about The Moat Report Asia.

The Equity Holdings of Lountzis Asset Management

ABBOTT LABORATORIES  (ABT)  is a  leading  diversified healthcare company operating in the following areas: pharmaceuticals, diagnostics, nutritionals and medical products.

In 2014, the company generated sales of $20.2 billion from four diverse business units: nutritionals 33%, medical products 26%, established pharmaceuticals 18% and diagnostics 23%.

Abbott has leading market  share positions in several businesses, as shown  in the following table, and, furthermore, in addition to a broad portfolio of products and services, is geographically diverse with 30% of sales in the U.S., 30% in other developed markets and 40% in the more rapidly growing emerging markets. Abbott’s new Hepatitis C drug offers excellent potential in the years ahead with sales estimates rising to over $3.5 billion in the next couple of years.


BANK OF NEW YORK MELLON (BK) is a leading trust bank with assets under custody and management exceeding $28.5 trillion. It is a global leader in several segments in which it operates. Few competitors have their global reach and scale. Approximately 80% of  its revenues are reoccurring and fee-based, focused on institutional services with less reliance on the higher credit risk from lending

In 2014, BK generated operating revenue of $15.7 billion and pre-tax income of $4.3 billion or a 28% pre-tax operating margin. Low interest rates continue to negatively impact results as they have over the past few years, while the bank continues to work diligently on its initiatives to cut expenses and selectively raise prices on many of its products. We believe the bank can earn $2.75 in 2015 representing a multiple of just over 13x earnings, while paying a 2% dividend yield.

BED BATH & BEYOND (BBBY) is the leading home furnishing retailer with just under 1,200 stores. For fiscal year 2015, which ends February 28th, BBBY should generate revenue of just under $12 billion and earnings per share of $5.05.

The company’s solid balance sheet, excellent merchandising capabilities,  improved focus on electronic commerce to better compete with the Amazon threat, will enable the company to continue to prosper as the leading home furnishing retailer in the country. We believe the company remains well positioned to continue its leadership position in the home furnishing industry. The company should earn in excess of $5.55 in fiscal 2015, representing a multiple of 13.5x earnings.

BROWN & BROWN (BRO) is a leading insurance broker with an outstanding corporate culture that helps generate the highest margins in its industry. Total 2014 revenue was $1.6 billion, a 16% increase from 2013, while adjusted earnings rose 14% to $1.63 per share.

After several years showing sparse growth, Brown & Brown has begun to grow organically while continuing to maintain the highest profit margins in the industry. In fact, during the 1997 to 2007 insurance cycle, Brown & Brown grew EPS at 20% per year but, since that 2007 earnings peak, organic growth slowed significantly. In fact, strong earnings growth continued in 2014 from solid growth in 2012 and 2013. We believe earnings growth should continue in the 10-15% range over the next couple of years, helped primarily by acquisitions.

LAB CORP (LH) is the second largest provider of clinical laboratory testing services in the United States. In 2014 the company purchased Covance, a leading contract research organization and together creating a leading global diagnostics company offering a broad range of clinical laboratory services as well as a full suite of capabilities for drug and diagnostics development  and commercialization.  At  closing,  the purchase consideration was valued at $107.19 per Covance share, consisting of $75.76 in cash and 0.2686 LabCorp shares for each Covance share, or an equity value of approximately $6.2 billion and an enterprise value of approximately $5.7 billion. The company believes the deal will be accretive in 2015, with annual synergies of over $100 million in 3 years.

The pro-forma company as of September 30, 2014 will generate revenues of $8.5 billion, adjusted EBITDA of $1.6 billion, a 19.1% operating margin and free cash flow of more than $700 million. The deal significantly diversifies LabCorp’s revenues though the purchase price was certainly a full one and we believe that free cash flow will now be applied to paying down debt rather than stock repurchases which has been a key use of free cash flow over the past several years.

LOWE’S (LOW) is a leading home improvement retailer that should generate revenues of over $58 billion in fiscal 2015 with net income of $2.9 billion. Diluted earnings per share should be $3.35 and we see that rising in 2016 to $3.65/share. The company continues to generate significant free cash flow exceeding $3.7 billion in 2015 providing for a solid dividend yield of just under 2% with continued share repurchases. While Home Depot continues to perform better than Lowe’s, as measured by same store sales and operating margin, we believe that Lowe’s will continue to improve its merchandising operations, raise margins to over 9.5% and continue to buy back significant amounts of stock. Lowe’s stock price appreciated 40% in both 2012 and 2013 and continued to rise in 2014 appreciating 39%.

MARTIN MARIETTA MATERIALS (MLM) is the second largest domestic producer of construction aggregates and a producer of magnesium based chemicals and dolomitic lime. Aggregates refer to the business of selling crushed stone, rocks and sand and is an attractive business. It enjoys significant barriers to entry, including the challenges in gaining permits for new quarries, as well as the low value to weight ratio of aggregates creating local oligopolies that enable solid pricing power. As I mentioned in prior letters, it is one of few businesses I have ever studied that have experienced enormous volume declines yet have been able to continue to raise prices illustrating the power of their business model.

The company purchased Texas Industries in July 2014, which expanded their geographic presence and market share in several markets, and provides additional products; they are on course to generate $100 million in synergies by the end of 2016, an increase of over 40% from their initial projections.

MLM remains well positioned for solid growth in its largest markets, and achieved a 77% increase in 4th quarter earnings from the prior year. While the acquisition accounted for a large portion of the increase the company’s aggregates volumes rose 13.7% and prices rose 4.7% for the year. Revenues rose to $2.7 billion from $1.9 billion and operating income rose to $314.9 million from $218 million in 2013 with earnings per share of $2.71.

With the significant need for rebuilding our bridges and highways we believe that MLM is well positioned to drive strong future growth as our country begins spending the required capital on our rapidly deteriorating infrastructure.

MERCURY GENERAL (MCY) is the largest auto insurer distributing policies through independent agents primarily in California, their largest state representing 80% of premium volumes. The company had a solid year though a disappointing 4th quarter due to reserving for a potential legal settlement.

Net written premiums in 2014 were $2.8 billion, up from $2.7 billion in 2013. In late December as the company’s stock price rose to over $55 per share, an attractive exit point from this long term holding that paid a solid 6% dividend yield for many years. We have enormous respect for George Joseph, an industry legend who is now in his early 90’s, and he, along with his ex-wife, control more than half of the 54.1 million shares outstanding.

MOHAWK INDUSTRIES (MHK) is a leading manufacturer of flooring products whose revenues continue to increase as the economy and, in particular, the housing markets continue to rebound. Sales in 2015 should exceed $8.5 billion with net earnings of just over $800 million or over $10 per share.

The company continues to aggressively make acquisitions, including the 2013 purchases of Marazzi Group, the fifth largest producer by volume in the ceramic tile industry as well as Pergo and Spano. Combining Mohawk’s existing ceramic division Dal Tile with the Marazzi Group creates the largest ceramic tile company in the world on a revenue basis. Currently, about 9% of U.S. flooring consumption in value is made of ceramic tiles, a much lower percentage than in most other nations around the world. In Western Europe, tile represents 30%, and in countries like Italy tile can exceed 55- 60%. In January 201, Mohawk purchased IVC, a European based manufacturer of sheet vinyl, luxury vinyl tile and laminate sold in Europe and the U.S. The purchase price of $1.2 billion is 10x trailing EBITDA and the acquisition should be $.30-.50 accretive in the first 12 months.

We anticipate continued improvement in the housing markets and in the U.S. economy, which bodes well for Mohawk Industries in 2015 and beyond.

PEPSICO (PEP) is the leading global snack and beverage company that manufactures and markets a variety of salt and convenience snacks, carbonated and non-carbonated beverages and foods. The company operates through four segments: Beverages North America, Frito-Lay North America, PepsiCo International and Quaker Foods North America.

PepsiCo’s fourth quarter 2014 earnings were $1.12, an increase of over 6% from 4th quarter 2013 earnings. This was better than expected with stronger than anticipated volume and top-line growth, as it attained its full year performance objectives. Revenues generated in 2014 were $66.7 billion with operating income of $10.3 billion and $4.63 in earnings per share, a 6% increase from 2013.

The company continues its focus on cost reductions with over $1 billion in incremental savings per year over the next 5 years. We believe the company can generate in excess of $10 billion in operating profit in 2015, with over $7 billion in free cash flow, even while facing strong headwinds from the rising dollar, and slowing global economies, as over 50% of company sales are outside the United States. In 2015, with share repurchases of between $4.5-$5 billion and dividends exceeding $4 billion PepsiCo will be returning over $9 billion to shareholders.

PROGRESSIVE (PGR) is the fourth largest auto insurer in the country and generated revenues of $18.7 billion in 2014 with pre-tax operating income of $1.7 billion, or $1.91 per share. We project Progressive’s net premiums written to exceed $19.4 billion in 2015 generating pre-tax operating income of $1.8 billion and operating earnings per share exceeding $2.

UNITEDHEALTH GROUP (UNH) is a leading diversified managed health care company serving 75 million individuals and operating through two segments: UnitedHealth care, and Optum. The UniteHealthcare segment serves employers and individuals, communities, states, Medicare and retirement. The Optum service businesses include Optum Health, Optum Insight and Optum RX. Overall company revenues in 2014 exceeded $115 billion with after tax operating earnings $5.6 billion and earnings per share of $5.70.

The UnitedHealth care Segment has the #1 market position in several areas including: Medicare Advantage, Medicare Supplement, and Medicaid and is #2 in commercial insurance. Furthermore, the company’s geographic and product diversity serve to reduce business risk.

The Optum segment of UnitedHealth Group is a health services business serving the broad health care marketplace, including payers, care providers, employers, government, life sciences companies and consumers.  Using advanced data, analytics and technology, Optum helps improve overall experience and care provider performance. Revenues for the Optum Segments in 2014 were $47 billion with earnings from operations of $3.3 billion. Of the three segments, Optum Insight is a leader in healthcare data analytics and generated revenues of $5.2 billion for the year including 26% growth in the fourth quarter of 2014. The company is projecting 2015 revenues of $140 billion and earnings from operations between $10.7 and $11.2 billion.

US BANCORP (USB) is one of the top 10 largest banks in the country with assets of $357 billion at year end 2013. The company has an outstanding credit culture, resulting in low credit losses and generates substantial fee income providing greater stability and predictability in its earnings. In 2014, the company generated $11 billion in net interest income and $9 billion in fee income. Operating revenues were $20 billion and net income was $5.8 billion or $3.03 per share.

The company’s financial metrics are among the best in the industry with a return on common equity of over 14%, return on tangible common equity exceeding 22% and a return on assets of 1.4%. We believe US Bancorp is well positioned to continue to build upon its outstanding franchise both organically and through selective acquisitions in the years ahead. The company should earn in excess of $3.25 in 2015 representing a price earnings multiple of 13.5x earnings-a favorable valuation for an outstanding diversified financial institution. While interest rates remain low, when they do rise the bank is well positioned to grow its net interest income and margins. Furthermore, with a large fee income stream the bank is better able to weather low interest rate periods than most competitors who lack such a large recurring fee income stream.

WELLS FARGO (WFC) is the fourth largest bank in the country with average assets of $1.6 trillion at year-end 2014. The company generated operating revenues of $85.3 billion in 2013 with net income of $23.6 billion and reported earnings of $4.10 per share.

The company is a diversified financial services company operating in a broad range of markets including the east and west coasts of our country, and through several business segments including, banking, insurance, investments, mortgage, and commercial and consumer finance through over 9,000 locations, 12,000 ATM’s and the Internet. Wells Fargo, like US Bancorp, also generates significant fee revenues providing a more stable and recurring revenue stream less impacted by the declining interest rates that have negatively impacted net interest margins over the past few years. In 2014, the company generated net interest income revenue of $44.4 billion while generating fee revenue of $41 billion.

We believe that Wells Fargo’s diverse business model will continue to thrive in various economic environments and will benefit when interest rates rise, augmenting the net interest margin to once again exceed 4%, a level it has fallen below over the past several quarters. Nevertheless, Wells Fargo remains an outstanding financial services company generating a return on tangible common equity of 17%, and a return on assets of 1.4%. The company also maintains leadership positions in several businesses including a leading originator and servicer of mortgages. In fact, the company originates one of every three mortgages in this country.

Over the next several years in a more normalized interest rate environment, we believe that Wells Fargo can generate in excess of $5 per diluted share in earning power. We estimate the company can earn in excess of $4.20 in 2015 and $4.60 in 2016.

WORLD FUEL SERVICES (INT) is a global leader in fuel logistics, engaged in the marketing, sale, distribution and financing of aviation, marine and land fuel products and related services. The company provides one stop shopping for customers in this highly fragmented industry. World Fuel Services was founded in 1984 and in 2014 generated $43.4 billion in revenue and $221.8 million in net income. We believe the company has a long runway to continue to grow organically by expanding its customer base, geographic reach and additional product and service offerings, as well as through acquisitions.

While a legal issue resulting from a devastating rail accident transporting oil in Canada remains a cloud over the company, we believe the company’s insurance and strong balance sheet will be adequate to satisfy the legal claims. The company should generate earnings of $3.40 in 2015, representing a multiple of 15.5x.

Our entire team at Lountzis Asset Management, LLC appreciates the privilege and opportunity to serve you and we are grateful for the confidence and trust you have placed in us. We will continue to work diligently seeking attractive investment opportunities with a primary focus on capital preservation and a secondary focus on achieving attractive rates of return.  We wish you a delightful springtime filled with warmer days.

The above commentary is excerpted from the Lountzis Asset Management year end letter for 2014. Download the original letter.

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