On the Ground in Asia – December 2012/January 2013            Word of the Year in Asia for 2012 and 2013: “Bloated” and “V...
the global slowdown masks a disturbing trend - a          saying that “this is fundamentally a Ponzi scheme.swift rise in ...
models that value investors should study carefully      US$2.5bn in fiscal year 2012, more than doubledfor mutlibagger ret...
where they did business around the world. For             to struggle with attracting and retaining the high-instance, one...
in the Philippines which pioneered the savoury                     financial crisis and URC’s market share in thesnacks in...
then-famous business leaders, they’re gone, not a                founder Lee Yang-gu who died in 1989, leavingsingle one e...
will need to boost investment in equities of China,    However, there are also negative examples ofIndia and Taiwan given ...
investor optimism, followed by disappointment           wanted to visit some Australian companies as partthat the high lev...
contains information above and beyond that              diversified manufacturer of farming equipment,contained in the inc...
features, so price competition is stiff. Unions        practice the deeds of the bodhisattva Goddess ofexercise considerab...
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On the Ground in Asia (Dec 2012/Jan 2013)

  1. 1. On the Ground in Asia – December 2012/January 2013 Word of the Year in Asia for 2012 and 2013: “Bloated” and “Value Circle” (1) “Circle the Customer - Circle the Globe” to Rid “Bloat” and Get Asian Multibaggers (2) Do Investors Overvalue Firms With Bloated Balance Sheets?“Circle the Customer - Circle the Globe” - If you to the median and mean value of the universe ofhad invested $100,000 in the company that listed stocks in the Singapore exchange. In 11 years,articulate this tipping point phrase as a core the market value of Hyflux has jumped 12-foldbusiness strategy in 1992 when its market from “median” to “mean”. Thus, understandingcapitalization was US$130m, that sum would be how business models and their profit patternsworth $15m today as the market value of this evolve is critical in the context of Asia, given thatenvironmental and water solutions company the competent entrepreneurs over the pastEcolab (Ticker: ECL US) multiplied over 150-fold in decade have grown their companies multi-fold to20 years to over US$20bn. the half-billion to billion dollar mark in market value during “Stage 1” to “Stage 2”. Yet, as theseExchange Median Mean Mkt Cap <S$1B Total “proven” companies grow, they could be tempted, MC MC % by % by Mkt Cap or under high pressure, to move beyond their (S$M) (S$M) No. Value (S$B)Singapore 78 1,072 88% 11% 735 specialization, taking on activities that may not beMalaysia 46 644 91% 15% 562 their core strength and becoming asset-heavy inIndonesia 172 1,243 80% 13% 512 “balance sheet”, that is, the “income statement”Thailand 109 1,109 84% 13% 616 figures of revenue and profit may continue toHK 195 3,445 76% 5% 5,054 grow but the growth is of a lower quality and theirTaiwan 88 577 92% 25% 974 return on capital starts to decline. In other words,Korea 85 780 91% 15% 1,350India 52 533 >90% 13% 1,545 they become “bloated” in their balance sheet andAustralia 58 1,410 >87% 8% 1,673 business model; the Price-Earnings (PE) ratio, commonly used as a heuristic valuation metric,The Ecolab example is critical for both value does not measure the “bloated” effect in both theinvestors and entrepreneurs in Asia as many balance sheet and the business model. Thus,companies are still stuck in “Stage 1” of their entrepreneurs and managers pushing the samecorporate lifecycle. Presently in Asia, the median familiar levers of success that resulted in theirlisted company size is around S$50 to 100m, companies to grow multiple times to a billionsomewhat similar to that of pre-1992 Ecolab, and a dollar in market value may find it perplexing whysignificant number (>80%) of companies are below their efforts are not helpful in moving the needlethe billion dollar mark in market cap, as tallied in towards “Stage 3”, the ten billion dollar target.the simple table above from Bloomberg data Instead, they might have inadvertently push tocollected at the beginning of Dec 2012 for the create a “bloated” effect.universe of listed stocks in the various Asianexchanges. With her “solution-specialist” business In a way, this “bloated” effect is parallel to themodel, water treatment specialist Hyflux (Ticker: developments at the “macro” level as pointed outHYF SP) is a classic example of a company that has on Dec 21 by the Wall Street Journal article “Asianshifted gear successfully thus far to “Stage 2” in its rise in borrowings ring some alarms”: “Asia hascorporate lifecycle in the past decade in fast- been able to withstand some of the economic andgrowth Asia. Interestingly, the initial and present financial distress felt elsewhere, largely due to themarket cap of Hyflux, S$54m in January 2001 and a sound balance sheets with which local businessesbillion dollar now respectively, is also quite similar entered the crisis. Asias economic resilience amid 1
  2. 2. the global slowdown masks a disturbing trend - a saying that “this is fundamentally a Ponzi scheme.swift rise in debt levels across the region as The music may stop when investors losecompanies and households load up on cheap confidence.” In her FT article “Questioning China’scredit - rapidly in many areas. By June, Asias governance” on 29 Oct, MacKenzie commentedcredit-to-GDP ratio had climbed to 104% - that “Only recently have many investors realisedsurpassing levels seen at the time of the regions that the main reason for China’s resilience – afinancial crisis of the late 90s - from 82% in huge government-directed lending and spendingDecember 2007. By contrast, the euro zones ratio spree – cannot and will not continue, at least nothad risen more slowly to 131% from 123%, while without further distorting the economy and riskingthe U.S. ratio had ticked down to 62% from 63%.” a bigger crash in future.” While “Bloated” might be disputed as the Word of the Year in Asia for 2012, “Bond” would not, notwithstanding scores of companies have attempted to cure the “bloated” effect in balance sheet using bond financing. Asian companies have borrowed more via the bond market than through syndicated bank loans this year for the first time ever, having raised $133.4bn this year, up ten-fold a decade ago. The sub-investment high-yield grade bonds favoured by private wealth clients returned over 20% this year, while the MSCI Asia-Pacific ex- Japan index of stocks returned 18.7%. Private- banking clients accounted for 16% of corporate bond purchases in the region this year, up from 6% in 2008. Chinese companies are also raising money in their own domestic bond market at a record pace as Chinese banks scale back lending. $327bn worth of bonds issued by non-financials has been sold almost exclusively to domestic investors this year, led by mutual funds. As WSJ reported on 26In China, the smell of lemon from the “bloated” Dec, “the buying spree by mutual funds has beeneffect gets stronger with the default in Dec of the underpinned by one belief: What many companieswealth management product (WMP) sold by lack in profit and cash flow, they make up for withHuaxia Bank, following which, CITIC Trust and their close relationship to local-governmentChina Construction Bank (CCB) also reported authorities that would step in to repay their debtsproblems in their WMP. The unregulated sale of if needed.” Reuters reported on 19 Dec thatWMP has racked up a staggering RMB20tr wealthy Asian investors may lose their appetite for(US$3.2tr) in China, estimated by the Chinese corporate bonds after getting burned in recentAcademy of Social Sciences. The China Banking deals. Agricultural commodities supply chainRegulatory Commission caps interest rates offered specialist Olam (Ticker: OLAM SP), which soldby banks and they have been issuing WMP to get $500m in five-year bonds in Sep, was cited in thearound the restrictions. They typically offer yields report for its high debt levels and unrated bonds.of 4 to 5%, about 1% higher than the ceiling on Olam was also targeted by an attack from short-deposit rates. To obtain the higher returns, banks seller Muddy Waters for its accounting practices.funnel the savers’ money into riskier The price of Olam bonds, whose 5.75% couponinvestments that are largely held off-balance attracted private-wealth clients to buy $350m,sheets. CCB’s product was backed by a mixture of were knocked as much as 17%. Rather than beingequities, bonds and money-market instruments. fixated by the short-term PE ratio or yield level inCITIC’s product was based on a loan to a assessing investment opportunities, the long-rangesteelmaker, while Huaxia’s product was backed by fundamental question “Is there a balance sheetrevenue from a pawnshop and an automobile and business model constraint to growth anddealer. Financial Times Kate MacKenzie coined earnings?” is always on the mind of value investors.WMP as “Weapons of Mass Ponzi”, in reference toBank of China’s Chairman Xiao Gang’s op-ed in At the “firm” level, for “solutions-specialist”China Daily on 12 Oct prescient warning of shadow business model such as Hyflux and Ecolab,banking risks in the proliferation of off-book WMP, amongst the twelve different types of business 2
  3. 3. models that value investors should study carefully US$2.5bn in fiscal year 2012, more than doubledfor mutlibagger returns, project complexities in from 2007. Nike aims to “just double it” in the nextreplicating the solution to a different set of global four years as Chinese consumers increasingly losecustomers ranging from cost overruns and delivery the taste for domestic brands and qualitydelays to financing and receivables risk start to counterfeits while Nike continues its well-craftedemerge. For instance, in 2005, Hyflux was asset- marketing campaigns in introducing more lower-light and lowly-geared in its business model with priced products and cultivating its brand cachet ataround S$10m in net debt and its market cap was the top-end. Shares of the once-multibaggeraround S$1.5bn; now, Hyflux has interest-bearing domestic brands were down by 50 to 80% fromnet debt of over S$470m and over S$390m in non- their 2010 peak; Nike’s share is trading at aroundconvertible perpetual preference shares paying 6% its all-time high.and its market cap had fallen to a billion. As aresult of mishandling these risks, or preventing Ideally, a portfolio of companies comprising ofthem in the first place through business model “Stage 1 to 2” companies growing 10-fold fromdesign, companies fail to make the successful $100m to $1bn, and “Stage 2 to 3” companiestransition to “Stage 3” from a billion to $10bn in scaling up 10-fold from $1bn to $10bn, will reducemarket value. The investment analysis and volatility, while continuing at the same time tovaluation impact of the moaty “horse” (business generate multibagger returns for the patientmodel) matters more than the “jockey” capital. Thus, the key investment risks for value(entrepreneur) in the transition from “Stage 2” to investing in Asia are twofold: (A) the Stage 2“Stage 3”, the transition period which Asia is “horse” (business model) is not moaty enough tocurrently in. At this transitition point in Asia, race towards Stage 3, and (B) the Stage 1 and 2besides the group of entrepreneurs and managers “jockey” (entrepreneur) is too distracted, toowho are still trying very hard but are pushing the disillusioned or too contented to scale their coresame, possibly inappropriate, levers for growth, business further to Stage 2. Yet, there is plenty ofthere is another conspicuous group, particularly in dazzling action and “growth” in Asia although thethe below billion-dollar camp. These are people risk from the “bloated” effect is rising. While thewho find themselves stuck in “Stage 1”. They grow stock prices might correct downwards for bothto either become either disillusioned with their Group (A) and (B) as a result of the earliercore business or contented with what they have “bloated” effect in the balance sheet and businessachieved. Often, these successful, achievement- model, like Kingdee or the Chinese sports retailers,oriented entrepreneurs start to “stray” as they making them “cheaper” and more “attractive” infind it easier to seek “growth” by engaging in valuations, the careful value investor must also beprivate business interests outside of the listed aware of the risks of catching a falling knife.vehicles, particularly in property development. So what is this “Circle the Customer – Circle theHowever, at the same time, the multinational Globe” strategy that Ecolab employed in 1992 tocorporations have hit their own tipping point in get rid of the “bloated” effect in its balance sheettheir penetration into emerging markets after and business model as it scale up beyond theyears of persistence – and losses. Perhaps a billion dollar cap? Founded in 1923, Ecolab had itsstriking example is enterprise resource planning foundation from a single product, Soilax, which is a(ERP) software and solution-specialist business cleanser designed for mechanical dishwashers, andmodel Kingdee (Ticker: 268 HK). A multibagger Ecolab subsequently expanded beyond sellingwhich has grown successfully 36-fold from products by providing cleansing services forUS$13m in market cap in 2001, Kingdee is down institutional customers such as restaurateurs. Now,over two-thirds from US$1.6bn since 2011 to Ecolab is a global provider of water, hygiene andUS$470m on in market value currently after losing energy technologies and services to the food,its core customer base of small and medium energy, healthcare, industrial and hospitalityenterprises (SMEs) to SAP AG when the German markets with a market value of $20bn generatingMNC rival introduced a local and price-competitive over $500m in profits from $7bn in revenue.version of an ERP software, Business One, as was Ecolab also merged in July 2011 with Nalco, ahighlighted in the “On the Ground” February water purification and environmental processedition. Another example is the success of Nike in technology company that Warren Buffett’sChina who has been active in the Chinese market Berkshire Hathaway invested in 2008. This “Circle”for 30 years as it ventures beyond the Tier 1 and 2 strategy is simple: the company would seek tocities into the domestic brands’ strongholds in continually expand its portfolio of related productsinland China. Sales in China at Nike surpassed and services for its existing customers, no matter 3
  4. 4. where they did business around the world. For to struggle with attracting and retaining the high-instance, one of the divisions sells all the products potential and critical-skill employees needed toneeded to clean a restaurant, especially the increase their global competitiveness in the recentkitchen. These include the detergents and Towers Watson survey “The Next High-Stakescomputer-controlled dispensing systems that hook Quest: Balancing Employer and Employeeup to the dishwasher and all the other products Priorities”. When the focused strategy wasneeded to clean and sanitize a restaurant. The unveiled in 1992, Ecolab’s market cap soared 7-sales force is not only responsible for selling these fold over the next five years to a billion dollar initems, but also for training the restaurant staff on 1997. From 1997 onwards, Ecolab’s “Circle thehow to use them. They audit results on a monthly Customer” business model continue to gatherbasis. They make sure that the dishes are clean momentum with a series of synergistic acquisitionsand recommend ways to minimize dishware that are synonymous and integrative to the “Circlebreakage. They balance the dishwasher and make the Customer” culture to expand into new marketsure it is operating correctly. They capture all this and new customers and market value climbed 20-information on a tablet PC and share it with the fold in 15 years from $1bn to $20bn in marketrestaurant’s manager. If the restaurant is part of a value during the “Stage 2” to “Stage 3” transition.chain, they download the information to a centralrepository so that the chain’s headquarters can ********see what is going on in all their units. Every day, Rubbing around a “bloated” stomach in a circularEcolab products are used to clean more than 250m motion after a good meal feels good - and it alsodishes. Each year, cleaning products sold in the U.S. pays to walk around the neighbourhood sundryalone stretch 2,150 miles, the length of the Great stores to digest things off. While organized retail inWall of China. All of this activity also sets the stage the form of department stores and hypermarketsfor sales-and-service associates to offer the are booming, most parts of emerging Asia andcustomer Ecolab products and service solutions in particularly Asean are still dotted with the mom-adjoining categories. They can sell that restaurant and-pop sundry stores and a large group ofpest-elimination products and services and kitchen consumers is still largely served by the smallequipment parts and repair services and they can private operators of these stores. An untappedsell water-purification products and services and treasure, business models which “get horizontal”audit services. Each month, Ecolab sales force to reach closer to and “circle” the end Asiandrive more than 8m miles, the equivalent of consumers are getting steep upward re-rating incircling the globe 10 times per day. valuations. When I first started out in the investments industry a decade ago, I find myselfThus, the system of over 8,000 solution providers discovering “new” things everyday by simplyand local field experts and 1,300 scientists and looking at the usual with a fresh pair of curioustheir knowledge base working consultatively with eyes. I remembered that one such “walkingthe end customers is designed right into its around” expedition at my usual neighbourhoodbusiness model, becoming the source of sundry store a decade ago led me to investigatecompetitive advantage and economic moat for “Jack n Jill”, the potato chips brand.Ecolab. The best strategy is always “simple” butoften difficult to really do it. Every employee thushas the opportunity and incentive to takeownership in their ideas and initiative and eachone matter in the value creation process of“circling the customer”, rather than a fewrainmakers. It is far easier to hire high-profileddealmakers who may be able to pull in high-dollarprojects or make centralized decisions, butbecause of the difficulties in coordinating andexecuting large-scale complex projects, theseprojects or deals cannot be repeated and the hype Perhaps not many would bother to look behindassociated with big orderbook starts to fade, the packaging to find out which company producesparticularly when cost overruns and delivery the potato chips. They would have missed outdelays start to rear their ugly heads. Ecolab is also finding out the story behind the companyrated consistently by its employees as one of the Universal Robina Corp (URC) (Ticker: URC PM),Best Places to Work. This contrast with the vast one of the largest brand food product companiesmajority of Asia-Pacific companies who continue 4
  5. 5. in the Philippines which pioneered the savoury financial crisis and URC’s market share in thesnacks industry since 1966 and has grown more various product categories from biscuits, snacks,than 6-fold in the past 5 years from under a billion candies to Ready-To-Drink (RTD) tea beveragesin market cap in 2007/08 to over S$5.4bn now. continue to rise, prompting the sharp 6-fold jumpURC is started in 1954 by the 86 year-old Chinese in market cap in the past 5 years as investors re-Hokkien Filipino tycoon John Gokongwei (吴奕辉), rate its business model. In particular, URC’s RTDoften described as well-read, simple-living and tea beverage brand C2 was not only launched in aworkaholic. The eldest child and breadwinner of record six months in Oct 2004, but it was also thehis family, he learned at an early age how to sell first RTD tea in Philippines, single-handedly drivingfood and other goods in the streets of Cebu, growth of the RTD tea market, establishing itself ascompeting with men and women who were at the dominant leader with a 73% market share.least twice his age. In his teenage years, thGokongwei bought his own bicycle so he can go to On Gokongwei’s 86 birthday this August, anearby towns and barrios to sell soap, thread, children’s book on his life story entitled “Big John”candles and other things that people need. is launched, part of a “Dream Big Books” series of inspirational children’s books with personal sagas. Gokongwei also gave an interesting interview with PhilSTAR, with excerpts below:John Gokongwei and wife Elizabeth Yu. Gokongwei has saidthat having a good wife like he did is not only good support forlife and career, it’s great to come home daily to good rest. Herevealed that ever since he got married, he has stopped goingout to parties and stayed at home every night with his wife(PhilStar, 14 Aug 2011). Q: Since it’s almost your birthday, it’s good for you to share some wisdom, especially with the youth.Philippines is a country with 7,000 islands and What’s your advice to young people on success?decentralizing production and distribution helps tosave on costs and to better launch new products. JG: Just follow the Chinese immigrants (laughs). It’sURC has 11 plants – 9 in the main island Luzon, true, just follow their values and work ethic.including 3 in Manila, and 1 each in Cebu and Throughout Philippine history, it’s the immigrantsMindanao. URC also operates 11 distribution who built fortunes and in the process helped buildcenters (DCs) located next to the plants, a Philippine economy.reduction from 26 previously, following the launchof Project Geometry in 2005 to realign its Q: What has changed in the Philippines since?distribution system. JG: I observed that every 50 years, there’s a cycle of change, new business leaders rise. Even us the present-day business leaders, if we and our families are not vigilant, others will rise to the top. This is true not only here, even in the US, look at the Rockefellers before; they’ve been overtaken by modern-day business leaders like Warren Buffett, Bill Gates, the late Steve Jobs of Apple and others. Before over a century ago, there were tycoons like John D. Rockefeller, Edward Henry Harriman, etc. I think, there’s a cycle of change, every 50 years. When I first came here to Manila in 1949, all theThis extensive network to get closer to the endconsumers has resulted in its resilience post 5
  6. 6. then-famous business leaders, they’re gone, not a founder Lee Yang-gu who died in 1989, leavingsingle one existing. behind his two daughters and son-in-laws to run the empire. The Tong Yang Group is one of theAnother Asian “Circle the Customer – Circle the largest chaebol conglomerates in Korea; the 10 topGlobe” example from my neighbourhood sundry chaebol make up more than half the value of thestore which I started to notice in 2005 is the Orion 1,800 companies on the Korea Stock Exchange.Choco Pie, a snack cake consisting of two small The 30 largest chaebols accounted for 84% ofround layers of cake with marshmallow fillings South Korean exports in 2010, according towith chocolate covering. Introduced in 1974 by Federation of Korean Industries. The father ofTong Yang Group’s confectionery spinoff Orion Korea’s newly-elected 18th lady President ParkCorp (Ticker: 001800 KS) after a member of the Geun-hye, was the late military strongman ParkR&D team was inspired by the chocolate-covered Chung Hee until his assassination in 1979, whosweets in the hotel’s café during a visit to Georgia allowed the chaebol to flourish under his 1962-79in US, the cake was well-received by many Korean autocratic rule and attain their dominant positionchildren and senior citizens because of its in the national economy, now Asia’s fourth-largest.inexpensive price and good taste. President Park is set to take a relatively restrained line in dealing with the powerful chaebols, particularly the complex “circular shareholding” structures that allow the groups’ founding families to retain control, as she believe abolishing the structures would undermine the companies and leave them vulnerable to hostile takeovers. Failing to do so may reinforce concerns about the nation’s corporate governance that contribute to the widely-known Korea Discount in the stock market. Charles Lee, North Asia research director for the Asian Corporate Governance Association,Orion Choco Pie sharing the spotlight in Sep 2011 with Russian commented that: “Korea’s renewed momentumPresident Dimitry Medvedev during his midday tea. on corporate governance may lack conviction and could fade once this year’s election passes. We sense a widely shared fatalism among most Koreans that the reform process can only go so far, because certain features of the current system - such as the chaebol structure - are simply accepted as the Korean way of doing business.”Orion has seen its market value rising sharply Interestingly, investment indexing giant Vanguardduring its 20 years of overseas expansion, with its made a switch in benchmark in Dec for six of itsoverseas business now contributing 50% and 43% emerging markets (EM) equities fund from MSCI toof 2012 sales and operating profit respectively. FTSE to lower its licensing fees, resulting in Korea,Since 2005 when its overseas business expansion classified by FTSE as “developed market”, to bestarts to bear fruit, Orion is up more than 7-fold to bumped out of the portfolio. Investors yankedS$7.3bn, boosting the family fortune of Tong Yang $900m from Vanguard’s popular EM ETF in Nov,Group which was founded in 1956 by the late even as other EM ETFs had inflows. The $67bn ETF 6
  7. 7. will need to boost investment in equities of China, However, there are also negative examples ofIndia and Taiwan given their higher weights. Korean companies which failed to “circle” the customer, such as Nongshim (Ticker: 004370 KS,A key tipping point happened when Orion invested market cap S$1.8bn) ramen business in China, duein localizing its overseas production facilities and primarily to poor control of channels and pricingdistribution channels. Its Shanghai factory, despite their “brand” and also because of a strongcompleted in Sep 2002, became the growth engine rival Master Kong owned by Tingyi (Ticker: 322 HK,for Orion in China and Asean. By Sep 2003, Orion market cap S$18.7bn). So it is important for valueChoco Pie achieved KRW 1tr in accumulated sales, investors to understand how the “circling” isthe first snack brand in Korea to achieve this drawn to compound value. Orion’s co-creation ofmilestone as a single item. Orion now controls a value with its wholesalers is a simple example oftwo-thirds share of the Chinese snack market “value circle” described by Jonathan Sallet, formerwhich contributes 34% of the group’s sales and the Director of the Office of Policy & Strategic PlanningChoco Pie is a popular wedding gift since it took on of the Department of Commerce under Presidentthe Chinese name “Good Friend” (好朋友). What Clinton. Sallet presented a new way to look at thedifferentiates Orion against other foreign value chain. Sallet argued the new value chain isconfectionary/snacks companies in China is that it the “value circle” in which multiple companies addoffers support for merchandising, displaying and value to each others’ products without directlysales promotions to build strong relationships with competing with each other, as opposed to awholesale agents. Wholesalers are willing to take traditional value chain in which each company sellstransportation cost and pay cash upfront in a its goods to another or directly to the consumer.country in which the use of credit has become king, Thus Asian companies whose business modelswhich shows Orion’s strong brand value. Choco Pie embrace the “value chain” strategy in circling theis also popular in Vietnam, in which it has over customers will not only get rid of the “bloated”60% market share, and it is even served for effect as they scale up, but also compound valueancestral rites ceremonies. Choco Pie has also exponentially and enjoy PE re-rating multibaggerbecome a favorite snack of North Korean workers returns. “Bloated” and “Value Circle” are the Wordand “the 35g diplomat” has come to symbolize of the Year for 2012 and 2013.capitalism. Orion also maintains a “Choco PieIndex” created as a parody of The Economist’s Big ********Mac Index. Another key tipping point was when “Do investors overvalue firms with bloated balanceOrion sold its media entertainment assets sheet?” This is the title of the empirical researchMegabox cinema chain in Jul 2007 and cable paper in the Journal of Accounting & Economics inoperator On*Media in Dec 2009 to CJ Group to 2004 by the US-based Singaporean accountingfocus on its growing confectionery empire. Orion doyen Teoh Siew Hong and her colleagues. Profwas also able to replicate its success in new Teoh is also the dean at Paul Merage School ofproducts in tough markets, such as Market O Real Business, University of California, Irvine (UCI).Brownies which debuted in Japan in 2010. Given limited attention and vast information,Marketed as a specialty product free of artificial investors simplify their judgment and decisions byaddictives and vegetable oils, Market O are using rules of thumb and by processing onlypopular gifts (omiyage) among young women and subsets of available information. An investor whothe product took top seller spot in Japan’s hyper- values a firm based on its earnings performancecompetitive cookie and biscuit market. rather than a complete analysis of financial variables is following such a strategy. Teoh et al argued that investors fail to discount for the unsustainability of earnings growth and are unaware of “balance sheet bloat”, proxied by net operating assets (NOA), a cumulative measure of the deviation between accounting value-added and cash value-added. An accumulation of accounting earnings without a commensurate accumulation of free cash flows raises doubts about future profitability. Investors with limited attention overvalue in the short-term firms with high NOA which provoked excessive 7
  8. 8. investor optimism, followed by disappointment wanted to visit some Australian companies as partthat the high level is a result of an extended of the due-diligence investment process. At thatpattern of earnings management, and the time in Oct 2009, I made a simple observation thatsubsequent correction in mispricing result in both Olam (Ticker: OLAM SP) and Graincorpnegative returns in the long-run. For instance, NOA (Ticker: GNC AU) have around the same level ofincreases when firm books a sale as a receivable net tangible asset at S$1.7bn, but Olam is tradingbefore it has received the actual cash inflow, or at S$6.7bn while Graincorp is S$1.9bn in marketwhen a firm records expenditure as an investment cap. Both are agricultural commodities supplyrather than an expense. In both these cases, chain specialist. Singapore Inc’s Temasek Holdingscurrent accounting profitability may not be had invested in Olam in Jun 2009. Three years later,sustained in the future, so investors who focus on Olam is down over 40% to S$3.7bn; Graincorp isaccounting income may overvalue the firm. Even if up 90% to S$3.6bn. The interesting Bloomberg 5-managers do not manage earnings, certain types year chart above shows how the share prices ofof problems in the firm’s operations will tend to Olam and Graincorp are moving in tandem to eachincrease NOA. For example, high levels of lingering, other until the strucural break in Feb 2012 thatunpaid receivables may contain adverse resulted in the correlation to melt; bothincremental information (beyond that in past companies now trade at roughly the same marketearnings) about future earnings. Therefore, when cap of S$3.6-7bn. In Feb, the MSCI Asian index washigh cumulative working capital accruals increase 448 and retreated 15% in Jun, before climbingNOA, an investor who fails to discount for adverse back up to above 460 to be up 18% for the year.information about low quality receivables will Graincorp also received a A$2.7bn takeover cashovervalue the firm. To test for investor bid by Archers Daniel Midland (ADM) on 22 Octmisperceptions of firms with bloated balance which was subsequently rasied to A$2.8bn; bothsheets, the accounting researchers measure stock offers were rejected. There is a wave ofreturns subsequent to the reporting of NOA. The consolidation in the agricultural commoditieslevel of NOA scaled by beginning total assets is a sector with Toronto-listed Viterra acquired bystrong and robust negative predictor of future Glencore for US$6.1bn, while Marubeni of Japanstock returns for at least three years after balance swooped on privately held Gavilon in a deal worthsheet information is released. They call this the US$5.3bn. Australia is the world’s second largestsustainability effect, because high NOA is an wheat exporter and Graincorp owns seven of theindicator that past accounting performance has nine bulk grain ports on the east coast of Australiabeen good but that equally good performance is and has about 20m metric tonnes of storage atunlikely to be sustained in the future; and that more than 280 inland grain handling sites,investors with limited attention will overestimate handling more than 75% of annual production onthe sustainability of accounting performance. A Australia’s east coast and moving a third oftrading strategy based upon buying the lowest Australia’s wheat corn. The integrated, strategicNOA decile and selling short the highest NOA portfolio of assets gives Graincorp ready access todecile is profitable in 35 out of the 38 years in the the growing Asian and east African markets.sample, and averages annual returns in excess of Interestingly, Graincorp does not have the fairthe market in the first, second and third year by value accounting concerns in reporting gains on14.9%, 10% and 6.8%, or 32% for the 3-year period. the biological assets of plantations, crops or cattle, nor the opaque business model that plagued Olam. Teoh et al concluded in her study that “An important scientific and policy issue in accountingDuring my Sydney trip in Dec 2009 to present my is how extensively and effectively investors useempirical research paper findings at the 23rd different kinds of reported accounting information.Australian Banking and Finance Conference, I Our findings indicate that the balance sheet 8
  9. 9. contains information above and beyond that diversified manufacturer of farming equipment,contained in the income statement that is useful construction equipment, gas turbines, trucks,for evaluating the financial prospects of the firm. buses and related components. During World WarFurthermore, our evidence indicates that investors II it also supplied military trucks for the U.S. Armydo not make full use of this balance sheet and Navy. The company sold many of its farming-information. These findings suggest that firms, the related assets in the late 1980s, when times werebusiness media and policymakers should consider tough, leaving just its truck and engine divisions. Inpossible ways to make balance sheet information 1986 it changed its name to Navistar. Imore salient and transparent to investors.” remembered Navistar because it competes with Volvo and Paccar (Ticker: PCAR) and Paccar was a ******** case study that I shared with CEOs, entrepreneurs,If intangible human capital were also counted as institutional clients and high net-worth individuals.part of the asset in the “balance sheet” in I also shared this story last month in Nov duringgenerating the income statement figure of GDP the productive trip to HK to a group of top“earnings”, the broader zeitgeist and socio-cultural management team of a listed company in the I.T.climate now in Asia can be understood better as a industry on how SMEs scale to become“bloated” effect in the balance sheet in generating multibagger MNCs.earnings and coping with growth. Signals of a“balance sheet” breakdown include: theobservation of “I have never seen more peoplewho talk to themselves than in Jakarta” (JakartaGlobe, 27 Aug) with “mental disturbances” risingamongst Jakartans as they struggle to cope withthe rapid changes, chaos, congestion and intensecompetition in recent years; violent robberies onthe rise in Jakarta with one crime registered everyminute (JG, 27 Dec); the sex and money scandalsthat plagued Singapore’s top elite; the first strikein 26 years in Singapore by bus workers over lowwages and poor living conditions; the violent gang-rape of a 26 year-old physiotherapist on a bus in Paccar manufactures and distributes medium- andDelhi and the ensuing violent protests. heavy-duty trucks under the names of Peterbilt, Kenworth, Leyland, and DAF. It is third behindThe “bloated” effect in the balance sheet of a Daimler AG and Volvo. William Pigott founded“leader” can also be seen in his or her “attitude”. A Paccar in 1905; sold it in 1924 but son Paul Pigottquote in the Forbes article “Death By Hubris: The bought back in 1934. Current CEO since 1997 is 4thCatastrophic Decision That Could Bankrupt A Great generation Mark Pigott. Since Mark Pigott tookAmerican Manufacturer” on 2 Aug caught by eye: over as CEO in Jan 1997, Paccar is up over 66-fold from US$230m to US$15.7bn in market cap, nearly “Dan is telling his technical people, ‘You’ve got ten times larger than Navistar at US$1.6bn. So to deliver,’ and they’re saying, ‘We don’t know what exactly did Paccar, led by Mark Pigott, do how, but we’ll try,’” says the former executive. since 1997? A key tipping point that year was that “There was a lot of tension in the technical Paccar calls itself a technology company, not a community, from the scientists on up to the managers, about whether we should be truck company or manufacturing company; it agreeing to something we don’t know how to do. technology-enabled its entire supply-chain, its Dan didn’t want to hear any of it. ‘You’re going manufacturing process, and its dealer chain and to get it done.’ He’s a positive thinker. He built a world-class call center for truckers. It has doesn’t like negative thinking.” the capacity to let each customer build his or her own custom truck as efficiently and as fast asDan Ulstian was the former CEO of Navistar (Ticker: building a standard truck through its use of aNAV), one of the great lines of manufacturing DNA robotic assembly. But all of these fancy “tech” willin U.S. history, a company whose roots date back come to naught if there is no “Value Circle” toto Cyrus McCormick’s 1831 invention of the circle the customer – the “right” customer. In themechanical reaper. In 1902 his McCormick heavy truck industry, many buyers operate largeHarvesting Machine Co. merged with Deering fleets and these “blue-chip” customers areHarvester Co. to form International Harvester. motivated to drive down truck prices. Trucks areUntil the mid-1980s International Harvester was a built to regulated standards and offer similar 9
  10. 10. features, so price competition is stiff. Unions practice the deeds of the bodhisattva Goddess ofexercise considerable supplier power and buyers Mercy or Guanyin (观音), which means “Observingcan use substitutes such as cargo delivery by rail. the Sounds (or Cries) of the World”, who goes all out to hear and see the pains and sorrows and negative things to help with her thousand hands and eyes (“即发誓言,若我当来堪能利益安乐一 切众生者,令我即时身千手千眼具足.” 《千手 千眼 观 世音 菩萨 广 大圆 满 无碍 大 悲心 陀罗 尼 经》). Seeking to hear and see the negative things and acknowledging sadness and failures is perhaps the first step into the “Value Circle”. And the energy to step in comes from “Vulnerability”. In her extremely enlightening book, “Daring Greatly: How the Courage to Be Vulnerable Transforms the Way We Live, Love, Parent, and Lead”, thought leader Brene Brown offers a powerful new visionTo create and sustain long-term profitability within that encourages us to dare greatly: to embracethis industry, Paccar chose to focus on one vulnerability and imperfection, to livecustomer group where competitive forces are wholeheartedly, and to courageously engage inweakest; individual drivers who own their trucks our lives. Brown, who also gave the blockbusterand contract directly with suppliers. These TEDTalks “The Power of Vulnerability”, evoked theoperators have limited clout as buyers and are less immortal quote by Theodore Roosevelt:price sensitive because of their emotional ties andeconomic dependence on their own trucks. For “It is not the critic who counts; not the man whothese customers, Paccar has developed features as points out how the strong man stumbles, orluxurious sleeping cabins, plush leather seats, and where the doer of deeds could have done themsleek exterior styling. Buyers can select from better. The credit belongs to the man who isthousands of options to put their personal actually in the arena, whose face is marred bysignatures on these built-to-order trucks. dust and sweat and blood; who strives valiantly;Customers pay Paccar a price premium and Paccar who at best knows in the end the triumph ofhas been able to earn a long-run return on equity high achievement, and who at worst, if he fails, at least fails while daring greatly.”above 16%. The technology and world-class callcenter people service is integrated into Paccar’s And added:business model in working together as a coherentwhole to circle the right customer to scale up “When we spend our lives waiting until we’resustainably. This interesting quote by Mark Pigott perfect or bulletproof before we walk into theis also uplifting: “We want to be able to look arena, we ultimately sacrifice relationships andpeople right in the eye and say we did it squarely, opportunities that may not be recoverable, weethically, and to the best of our ability, and these squander our precious time, and we turn ourare the results. That’s exciting. They don’t teach backs on our gifts, those unique contributionsyou that in business school.” that only we can make.”Compared to Mark Pigott, Dan Ulstian and “Vulnerability” is also the thought-provoking Word“positive thinker” leaders are, perhaps harshly- behind the Word of the Year 2013 “Value Circle” inworded, like Cixi, the empress dowager in the Qing observing and investing in the multibaggers in Asia.Dynasty who was known to only want to hear Happy New Year 2013.positive news, so much so to the extent thateveryone around her report only goods news and KEE Koon Boondare not voice out any concerns (“报喜不报忧”). 30 December 2012Cixi also diverted critical money earmarked for thenavy to pay for her elaborately-carved marble boatthat sat on the tranquil lake in the center ofBeijing’s ancient Summer Palace. The Qing empirewas overthrown after 267 years in power by arepublican revolution in 1911 three years after thedeath of Cixi. Perhaps authentic leaders andserious value investors do their very best to 10