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.
“Work hard. Deal with people honestly. Always look to improve yourself. Celebrate if we outdo ourselves, not when we outdo others. Enjoy what you are doing. This will help you to deliver the best products and services to your customers. It will also help you to strive to improve until you achieve excellence. Be ready to innovate. And never be afraid to dream big! The advice and motivation comes from one source – my mother. She is steadfast in counselling us, on how to live the life that is upright.”
This is the message that the inspiring Mr. C has for like-minded entrepreneurs and the next generation of leaders.
In the month of September, we investigate a listed Asian family business founded in 1975 by Mr. C and his wife that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer.
The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.
The company’s flagship brand, which contributed 52% of systemwide sales, has powerful store economics driven by high margin, low cash investment cost per outlet, resulting in cash-on-cash return of 43%, which is significantly higher than the 24% return for the average US peers. Its other domestic brands are leaders in their own categories with market share ranging from 35-91%.
Its international brands in China have broken even in 3Q14 after its initial entry more than 10 years ago; all along, the operations are profitable at the store level, but lack enough scale to cover the corporate and infrastructure overheads in which the management has committed to long-term investments in central kitchens to support the scaling up of the network expansion. In Jan 2015, management also inked a 60:40 JV and master franchise agreement with famous US snack chain in China and commented that they are exploring the opportunity to acquire a US brand with a $1bn market capitalization.
Being born into a poor family, Mr. C has demonstrated far-sightedness, discipline and values to build and scale the company into Asia’s leading foodservice company by “giving our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends.” Below is an excerpt shedding more insights into the inspiring entrepreneurial story of Mr. C:
Q: “…Can you share with us the story of how the company started? What are the business and personal challenges that you face along the way? How did you overcome them and what are the lessons that you have learnt?”
Mr. C: “…That was the first lesson – and it is something that [Company’s name] espouses to this day. I believe that we should give our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends. I think that comes from the view that we don’t have to be greedy in our daily lives or business. If we strike the right balance, we share the benefits with whomever we’re dealing…
Saving every dollar we could was our mindset during the early days of [Company’s name] when we had a lone store… We had to do everything by ourselves in the beginning.. My wife and I even cleaned the toilet. When there’s no cashier, you do the cashier.. if there’s no janitor, you clean the toilet. It’s like your neighborhood mom-and-pop store. We also served the customers as waiter and waitress, and then at night, we do the accounting by ourselves. As my wife said wisely, ‘There’s a Chinese saying that says it’s easier for you to save than to earn’. So if you have something and you can save it. Don’t waste it because to earn money, it takes a lot of hard work. We worked hands-on but as the business propels, we noticed they could not do it all so we started to set up an organization hired store managers, and trained people.
During those challenges I continued to have high hopes and optimism that anything is possible. I think I pick up this belief from my mom. Our role is to do what we can as best we can and don’t worry about the outcome. The outcome will take care of itself. This belief has allowed me to sleep well at night. It gives me new hope everyday.
The third lesson is that innovation starts in our minds. Our mindsets determine what we’re able to accomplish. The story of [Company’s name] is a story of finding opportunity amidst difficult times. The main thing is to dream, dream big and not be afraid of it. Dreams are free. Why limit what you are aspiring for? But dreaming is not enough. One must be willing to put in the needed action and hard work to make these dreams come true. If you dream big and put your dreams into action you will indefinitely make mistakes. But don’t be scared to make mistakes. Just be quick to recognize them and learn from them as fast as you can. Learn from each mistake and it will not be a waste of time. If we place no restrictions on ourselves, then we’re capable of doing anything. If we are not greedy, then more things will return to us. If we give more to our fellowmen and to our customers, more than what they expect, they’ll return over and over again…
…The food business is still very basic. It’s still about taste. It’s still about How did you serve me? Is your place nice? Am I treated well? Do I get value? If you think about it, if we’re going out to eat, these are the basic things we look out for, but the execution is the difficult part. It’s not like other businesses where it’s the concept or the knowledge that’s difficult. Here, there’s no secret; it’s very easy, but it’s the execution that’s hard. If you ask a lot of restaurant, they know all these things. Executing day by day is what’s hard.”
Historical precedents in Chipotle and Yum Brands show that EBITDA/store growth drives valuation multiple expansion; EBITDA/store and EV/store is not just a linear combination but an exponential one. Thus, companies that successfully increase store profitability in a sustainable manner will see valuation increase by an even greater degree. Market has rewarded the company in the past for productivity improvements but has punished the company lately for the weaker-than-expected FY2014 and 1H15 results. Enterprise Value/store for is now back to 2013 valuation multiple despite expanding store count by 8.6% and sales/store growth increasing 1.5% in the trailing 12 months. If EBITDA/store improves 5% back to 2013 level and the company is able to sustain the improvement as it expands the store count to the target level in the next 3 years, EV/store could rebound and EV could jump, indicating a 36-56% upside potential.
The company’s store economics and return metrics is more like “fast casual” that include Chipotle, Starbucks, Shake Shack, which have higher returns and tend to trade at higher valuation multiples. In terms of EV/EBITDA to the fast casual companies, the company trades at a 37% discount. The Price/Sales ratio of fast casual companies is >5x, as compared to the company’s 2.16x, indicating room for profitability improvement, especially with its China business breaking even in 3Q14, and therefore providing the foundation for further valuation gains. Thus, the company’s business model which is more fast-casual in its superior store economics, is underappreciated and undervalued by 37% to >100%.
We believe that the outstanding leadership provided by the inspiring visionary Mr. C, and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.
Can you guess who is Mr. C and his wide-moat family business?
PS: We also like to share with you an article “Scouring Accounting Footnotes to Prevent Tunneling” which we penned for our local newspaper Business Times Singapore that was published on 19 Aug 2015: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the regulatory authorities in Singapore about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.
A new monthly issue of The Moat Report Asia is now available!
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Our previous letter to shareholders evoked a great deal of reader response. We are having a small debate concerning the cause. I, of course, believe it was because the letter was a beautifully written investment classic. However, my colleague Jan Žák claims it was just because the letter’s title included the word sex. To settle the matter, I have decided to title this letter entirely sexlessly “Risk-Free Stocks”.
Properly defining risk
At first sight, the connection of “risk-free” and “stock” seems like an oxymoron. Most people even consider the word “stock” as almost synonymous with risk. In general, however, stocks are much less risky in comparison not only to the ideas in investors’ heads but also to other asset classes. Shares in certain companies can even be considered risk free by definition.
Now, I will attempt to explain step by step how we reached this conclusion. Let us begin with a quote from Warren Buffett:
“We … [define] investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.”
This definition leads to several important conclusions. First, the investor’s greatest enemy and at the same time his or her motivation is inflation. If over the long term inflation were zero, or even negative, we would not need to invest because money would not lose its value. Inflation is positive over the long term, however, and even at current low rates money will lose half its value over two generations. Even just a slightly higher annual rate of 2.5% would destroy three-quarters of that value.
Second, Buffett’s definition clearly shows that investing is a long-term matter. The investor’s objectives must also be long-term. Investing is not about weeks or months but rather the next decade or two.
Third, what is main risk for the investor? It is that he or she fails to achieve his or her objective, which is to increase the real value of his or her money over the long term.
The effort to achieve this objective can be blocked essentially by two things: selecting an investment asset class with a low probability of achieving the objective and permanent loss of capital, which could occur within the selected asset class. Therefore, if we accept Buffett’s definition of investing and the objective which follows from it, the greatest investment risk comes from poor choice of investment asset class and poor choice of individual investments within the selected asset class.
This risk definition of ours is not customary, and it represents by far a minority view. We nevertheless regard it to be correct. Mainstream theory defines risk otherwise, namely as volatility. Simply said, the less an investment asset’s price fluctuates the less risky it is. There undoubtedly exists a certain relationship between risk and returns. The more risk an investor takes, the greater the compensation in the form of returns he or she requires. This is entirely logical. The opposite relationship would make no sense. If we equate risk with volatility, however, this should mean that investors seek more volatility in order to obtain more profit. Have any of you ever met such an investor? I have not.
When risk is defined as price volatility, the assets considered the least risky will be those for which prices fluctuate the least – cash, bank deposits, treasury bills, short-term government bonds. The problem, however, is that in practice these assets prevent the investor from achieving his or her objective – to increase the real value of his or her money over the long term. What good does investments’ low volatility do an investor if they do not enable him or her to achieve his or her objective? Are such investments not rather too risky?
Defining risk as volatility is wrong. It deforms investment considerations and leads investors to poor asset choices. In the long term, volatility is practically irrelevant. Over the past 30 years, shares in Buffett’s Berkshire Hathaway recorded four big drops in the range of 37–51%. For many investors, this is unacceptable volatility which would prevent them from investing into this equity. For a long-term investor, however, it is an entirely usual phenomenon affecting even the highestquality shares. Whoever bought Berkshire shares for $1,300 in 1985 and holds them today at a price of $200,000 is certainly not complaining about the temporary volatility they needed to wait out.
I am aware that the long-term returns on Berkshire shares are exceptionally high and that this is not typical for common equities. However, I want to use this example to demonstrate something else. Buffett is one of the best CEOs in history. He minimises the errors he makes, allocates capital in an exemplary fashion, and acts completely in shareholders’ interest. However, all this cannot prevent the shares of the company he manages from undergoing considerable price fluctuation from time to time. That is simply how it goes. It is important truly to understand that this is not a source of risk.
Returns on individual asset classes
A glance at the following graph makes it clear that not only are stocks the asset with the highest returns over the long term, but they also have the least deviations from their longterm trend.
If we accept the initial assumptions that
- the investor’s objective is to increase the real value of his or her money over the long term,
- the investment horizon is long,
- volatility is not only not considered to be a source of risk but is essentially ignored (in the ideal case it can even be used to the investor’s benefit), and
- equities hold the greatest hope for positive real returns and so also the lowest risk of not achieving the investor’s goal,
then it is evident that stocks must form the basis of every investment portfolio.
Investing in equities does entail risk, of course. It is not risk of price fluctuations, however, but rather risk related to individual companies’ operations. These risks can be divided into several categories:
Among the many companies whose shares are traded on the markets, some can be found which minimise such risks. We therefore consider their stocks to be risk free. First, they are in the class of assets the high returns of which over the long term minimise the risk that the investor will not achieve his or her goal. Second, they also minimise the second greatest risk, namely permanent loss of capital. A portfolio comprised of stocks of such companies can be considered risk free. It will very probably produce positive real returns over the long term and with minimal risk of permanent loss of capital. As investors, of course, we need not limit ourselves when assembling a portfolio to only risk-free stocks. These provide only a starting point. Our task is to study individual companies, form an understanding of the amount of their business risk and possible investment returns, and then select the best combination of risk and returns. Most investors strive for an ideal combination of risk and returns, but the alpha and omega of such efforts is the correct definition of risk.
Imagine two identical companies. They are absolutely the same and differ only in the fact that the shares of one are traded on an exchange while those of the other are not. No one would be likely to assess the risk of the company not traded on an exchange according to its price volatility because its price is not available. Its risk would clearly be assessed according to the aforementioned categories related to the company’s operations. Well, risk of the company traded on an exchange should be assessed in exactly the same manner. The definition of risk cannot simply change based solely on whether stocks are traded on an exchange or not. Trading on an exchange is only an additional advantage that enables us to respond to extreme market moods and potentially achieve higher returns.
Changes in the portfolio
Shares in Precision Castparts (PCP) are on their way out of the portfolio. PCP makes special metal products and components, in particular for the aviation and energy industries. We have been watching the company for several years, but it always seemed expensive to us. We were eventually rewarded in spring by seeing its price drop by about one-quarter from its previous high. We therefore began building our position. We were pleased when about one month later it became apparent that Buffett had also begun buying PCP in the first quarter. Given that neither equity markets as a whole nor PCP share prices in particular were rising, we gradually bought more and more PCP shares for increasingly better prices. It seemed there was no reason to rush. But one Sunday morning in August, we discovered that Buffett’s Berkshire Hathaway was purchasing PCP as a whole. At that time, about 5% of our portfolio was in PCP and we had built approximately two-thirds of our intended position. Our feelings are therefore mixed. On the one hand, we are pleased that Buffett sees value where we see it, and of course we are pleased by the quick gain of about 17%. On the other hand, we like PCP a lot and we had assumed that over the long term it would become one of our main positions and would make us a great deal more money over time. We can find small comfort in the fact that we will continue to own PCP through our shares in Berkshire.
We bought two positions. One in Canada and one in the US. The Canadian company is one of our old acquaintances. We owned it during 2004–2006. We sold it then because we had reservations about the actions of the main shareholder of the time, the founder and director in a single individual. That person left several years ago, however, and we are quite partial to the current management. It is a big, global, and financially strong company, currently available for less than nine times earnings.
Our second new purchase is from the financial sector. We systematically endeavoured to find a relatively young company with an established and, in particular, expandable business model. We eventually succeeded in finding such a company, and we believe it will one day grow to many times its current size. We therefore expect many years of high growth, and at its current price we need not pay for that upfront.
We were relatively active this quarter, including in expanding several existing positions. Prices are falling, and after a long time we have more good investment opportunities than we can use. That is a very nice problem to have. The influx of new money into the fund and the sale of PCP have provided us cash enough for further purchases, and all we can do is wish for prices to become even more advantageous than they are already.
P.S. I would like to thank my friend Alex Rauchenstein from Strategic Investment Advisors. During a recent breakfast, we discovered that our thinking about the concept of “risk-free stocks” is similar and Alex was a partial inspiration for my writing this letter. Alex and his colleagues are also the source of the division of business risk into individual categories.
Note: The above commentary is taken from the recent Vltava Fund Letter to Shareholders.
Our estimates and projections concerning the future can and probably will be incorrect. You should not rely upon them solely but use also your own best judgment in making your investment decisions.The information contained in this letter to shareholders may include statements that, to the extent they are not recitations of historical fact, constitute “forward-looking statements” within the meaning of applicable foreign securities legislation. Forward-looking statements may include financial and other projections, as well as statements regarding our future plans, objectives or financial performance, or the estimates underlying any of the foregoing. Any such forward-looking statements are based on assumptions and analyses made by the fund in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors we believe are appropriate in the given circumstances. However, whether actual results and developments will conform to our expectations and predictions is subject to a number of risks, assumptions and uncertainties. In evaluating forward-looking statements, readers should specifically consider the various factors which could cause actual events or results to differ materially from those contained in such forward-looking statements. Unless otherwise required by applicable securities laws, we do not intend, nor do we undertake any obligation, to update or revise any forward-looking statements to reflect subsequent information, events, results or circumstances or otherwise. This letter to shareholders does not constitute or form part of, and should not be construed as, any offer for sale or subscription of, or any invitation to offer to buy or subscribe for, the securities of the fund. Before subscribing, prospective investors are urged to seek independent professional advice as regards both Maltese and any foreign legislation applicable to the acquisition, holding and repurchase of shares in the fund as well as payments to the shareholders. The shares of the fund have not been and will not be registered under the United States Securities Act of 1933, as amended (the “1933 Act”) or under any state securities law. The fund is not a registered investment company under the United States Investment Company Act of 1940 (the “1940 Act”). The shares in the fund shall not be offered to investors in the Czech Republic on the basis of a public offer (veřejná nabídka) as defined in Section 34 (1) of Act No. 256/2004 Coll., on Capital Market Undertakings. Historical performance over any particular period will not necessarily be indicative of the results that may be expected in future periods.
Here’s a message from the #investing channel in the #valueinvestors online community:
Coming up at 5:00 AM ET: Massimo Fuggetta at European Investing Summit 2015. Here’s an idea snapshot from Massimo: “Tamburi Investment Partners (TIP) is the Italian equivalent of Fairfax, Markel, Leucadia or indeed Berkshire Hathaway. Much smaller in size (500m euro market cap), it has accumulated an excellent track record buying minority stakes in Italian mid and small cap quoted and unquoted companies in the industrial, tech and consumer sector. As a result, the stock price has almost tripled in the last 5 years, but I believe it will continue to do very well, as more investment opportunities are seized. On top of that, it comes at a discount to NAV.”
Not yet a member? Here’s how to join: The #valueinvestors community on Slack was founded for the benefit of subscribers to The Manual of Ideas. However, even if you are not a member of The Manual of Ideas, you may join the community on a trial basis. In order to remain in the community, non-members are expected to add value through their active participation. Apply to join (we will email you when approved).