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 of
had 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-fold
business strategy in 1992 when its market from “median” to “mean”. Thus, understanding
capitalization was US$130m, that sum would be how business models and their profit patterns
worth $15m today as the market value of this evolve is critical in the context of Asia, given that
environmental and water solutions company the competent entrepreneurs over the past
Ecolab (Ticker: ECL US) multiplied over 150-fold in decade have grown their companies multi-fold to
20 years to over US$20bn. the half-billion to billion dollar mark in market
value during “Stage 1” to “Stage 2”. Yet, as these
Exchange 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 be
Malaysia 46 644 91% 15% 562 their core strength and becoming asset-heavy in
Indonesia 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 to
HK 195 3,445 76% 5% 5,054 grow but the growth is of a lower quality and their
Taiwan 88 577 92% 25% 974
return on capital starts to decline. In other words,
Korea 85 780 91% 15% 1,350
India 52 533 >90% 13% 1,545 they become “bloated” in their balance sheet and
Australia 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 the
investors 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 same
corporate lifecycle. Presently in Asia, the median familiar levers of success that resulted in their
listed company size is around S$50 to 100m, companies to grow multiple times to a billion
somewhat similar to that of pre-1992 Ecolab, and a dollar in market value may find it perplexing why
significant number (>80%) of companies are below their efforts are not helpful in moving the needle
the 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 to
collected at the beginning of Dec 2012 for the create a “bloated” effect.
universe of listed stocks in the various Asian
exchanges. With her “solution-specialist” business In a way, this “bloated” effect is parallel to the
model, water treatment specialist Hyflux (Ticker: developments at the “macro” level as pointed out
HYF SP) is a classic example of a company that has on Dec 21 by the Wall Street Journal article “Asian
shifted gear successfully thus far to “Stage 2” in its rise in borrowings ring some alarms”: “Asia has
corporate lifecycle in the past decade in fast- been able to withstand some of the economic and
growth Asia. Interestingly, the initial and present financial distress felt elsewhere, largely due to the
market cap of Hyflux, S$54m in January 2001 and a sound balance sheets with which local businesses
billion dollar now respectively, is also quite similar entered the crisis. Asia's economic resilience amid
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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 lose
companies and households load up on cheap confidence.” In her FT article “Questioning China’s
credit - rapidly in many areas. By June, Asia's governance” on 29 Oct, MacKenzie commented
credit-to-GDP ratio had climbed to 104% - that “Only recently have many investors realised
surpassing levels seen at the time of the region's that the main reason for China’s resilience – a
financial crisis of the late '90s - from 82% in huge government-directed lending and spending
December 2007. By contrast, the euro zone's ratio spree – cannot and will not continue, at least not
had risen more slowly to 131% from 123%, while without further distorting the economy and risking
the 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 26
In China, the smell of lemon from the “bloated” Dec, “the buying spree by mutual funds has been
effect gets stronger with the default in Dec of the underpinned by one belief: What many companies
wealth management product (WMP) sold by lack in profit and cash flow, they make up for with
Huaxia Bank, following which, CITIC Trust and their close relationship to local-government
China Construction Bank (CCB) also reported authorities that would step in to repay their debts
problems in their WMP. The unregulated sale of if needed.” Reuters reported on 19 Dec that
WMP 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 recent
Academy of Social Sciences. The China Banking deals. Agricultural commodities supply chain
Regulatory Commission caps interest rates offered specialist Olam (Ticker: OLAM SP), which sold
by banks and they have been issuing WMP to get $500m in five-year bonds in Sep, was cited in the
around 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% coupon
investments 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 being
equities, bonds and money-market instruments. fixated by the short-term PE ratio or yield level in
CITIC’s product was based on a loan to a assessing investment opportunities, the long-range
steelmaker, while Huaxia’s product was backed by fundamental question “Is there a balance sheet
revenue from a pawnshop and an automobile and business model constraint to growth and
dealer. Financial Times Kate MacKenzie coined earnings?” is always on the mind of value investors.
WMP as “Weapons of Mass Ponzi”, in reference to
Bank 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
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3. models that value investors should study carefully US$2.5bn in fiscal year 2012, more than doubled
for mutlibagger returns, project complexities in from 2007. Nike aims to “just double it” in the next
replicating the solution to a different set of global four years as Chinese consumers increasingly lose
customers ranging from cost overruns and delivery the taste for domestic brands and quality
delays to financing and receivables risk start to counterfeits while Nike continues its well-crafted
emerge. 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 at
around S$10m in net debt and its market cap was the top-end. Shares of the once-multibagger
around S$1.5bn; now, Hyflux has interest-bearing domestic brands were down by 50 to 80% from
net debt of over S$470m and over S$390m in non- their 2010 peak; Nike’s share is trading at around
convertible perpetual preference shares paying 6% its all-time high.
and its market cap had fallen to a billion. As a
result of mishandling these risks, or preventing Ideally, a portfolio of companies comprising of
them in the first place through business model “Stage 1 to 2” companies growing 10-fold from
design, companies fail to make the successful $100m to $1bn, and “Stage 2 to 3” companies
transition to “Stage 3” from a billion to $10bn in scaling up 10-fold from $1bn to $10bn, will reduce
market value. The investment analysis and volatility, while continuing at the same time to
valuation impact of the moaty “horse” (business generate multibagger returns for the patient
model) 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 to
currently in. At this transitition point in Asia, race towards Stage 3, and (B) the Stage 1 and 2
besides the group of entrepreneurs and managers “jockey” (entrepreneur) is too distracted, too
who are still trying very hard but are pushing the disillusioned or too contented to scale their core
same, possibly inappropriate, levers for growth, business further to Stage 2. Yet, there is plenty of
there is another conspicuous group, particularly in dazzling action and “growth” in Asia although the
the below billion-dollar camp. These are people risk from the “bloated” effect is rising. While the
who find themselves stuck in “Stage 1”. They grow stock prices might correct downwards for both
to either become either disillusioned with their Group (A) and (B) as a result of the earlier
core business or contented with what they have “bloated” effect in the balance sheet and business
achieved. 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” in
find it easier to seek “growth” by engaging in valuations, the careful value investor must also be
private 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 the
However, at the same time, the multinational Globe” strategy that Ecolab employed in 1992 to
corporations have hit their own tipping point in get rid of the “bloated” effect in its balance sheet
their penetration into emerging markets after and business model as it scale up beyond the
years of persistence – and losses. Perhaps a billion dollar cap? Founded in 1923, Ecolab had its
striking 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, and
model Kingdee (Ticker: 268 HK). A multibagger Ecolab subsequently expanded beyond selling
which has grown successfully 36-fold from products by providing cleansing services for
US$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 and
US$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 hospitality
enterprises (SMEs) to SAP AG when the German markets with a market value of $20bn generating
MNC 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, a
highlighted in the “On the Ground” February water purification and environmental process
edition. Another example is the success of Nike in technology company that Warren Buffett’s
China 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 to
cities into the domestic brands’ strongholds in continually expand its portfolio of related products
inland China. Sales in China at Nike surpassed and services for its existing customers, no matter
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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 to
needed to clean a restaurant, especially the increase their global competitiveness in the recent
kitchen. These include the detergents and Towers Watson survey “The Next High-Stakes
computer-controlled dispensing systems that hook Quest: Balancing Employer and Employee
up to the dishwasher and all the other products Priorities”. When the focused strategy was
needed 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 in
items, but also for training the restaurant staff on 1997. From 1997 onwards, Ecolab’s “Circle the
how to use them. They audit results on a monthly Customer” business model continue to gather
basis. They make sure that the dishes are clean momentum with a series of synergistic acquisitions
and recommend ways to minimize dishware that are synonymous and integrative to the “Circle
breakage. They balance the dishwasher and make the Customer” culture to expand into new market
sure 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 market
restaurant’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 central
repository 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 circular
Ecolab products are used to clean more than 250m motion after a good meal feels good - and it also
dishes. Each year, cleaning products sold in the U.S. pays to walk around the neighbourhood sundry
alone stretch 2,150 miles, the length of the Great stores to digest things off. While organized retail in
Wall of China. All of this activity also sets the stage the form of department stores and hypermarkets
for sales-and-service associates to offer the are booming, most parts of emerging Asia and
customer 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 of
pest-elimination products and services and kitchen consumers is still largely served by the small
equipment parts and repair services and they can private operators of these stores. An untapped
sell 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 Asian
drive more than 8m miles, the equivalent of consumers are getting steep upward re-rating in
circling the globe 10 times per day. valuations. When I first started out in the
investments industry a decade ago, I find myself
Thus, the system of over 8,000 solution providers discovering “new” things everyday by simply
and local field experts and 1,300 scientists and looking at the usual with a fresh pair of curious
their knowledge base working consultatively with eyes. I remembered that one such “walking
the end customers is designed right into its around” expedition at my usual neighbourhood
business model, becoming the source of sundry store a decade ago led me to investigate
competitive advantage and economic moat for “Jack n Jill”, the potato chips brand.
Ecolab. The best strategy is always “simple” but
often difficult to really do it. Every employee thus
has the opportunity and incentive to take
ownership in their ideas and initiative and each
one matter in the value creation process of
“circling the customer”, rather than a few
rainmakers. It is far easier to hire high-profiled
dealmakers who may be able to pull in high-dollar
projects or make centralized decisions, but
because of the difficulties in coordinating and
executing large-scale complex projects, these
projects or deals cannot be repeated and the hype Perhaps not many would bother to look behind
associated with big orderbook starts to fade, the packaging to find out which company produces
particularly when cost overruns and delivery the potato chips. They would have missed out
delays start to rear their ugly heads. Ecolab is also finding out the story behind the company
rated 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 companies
majority of Asia-Pacific companies who continue
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5. in the Philippines which pioneered the savoury financial crisis and URC’s market share in the
snacks 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 beverages
in market cap in 2007/08 to over S$5.4bn now. continue to rise, prompting the sharp 6-fold jump
URC 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 RTD
often described as well-read, simple-living and tea beverage brand C2 was not only launched in a
workaholic. The eldest child and breadwinner of record six months in Oct 2004, but it was also the
his family, he learned at an early age how to sell first RTD tea in Philippines, single-handedly driving
food and other goods in the streets of Cebu, growth of the RTD tea market, establishing itself as
competing with men and women who were at the dominant leader with a 73% market share.
least twice his age. In his teenage years,
th
Gokongwei bought his own bicycle so he can go to On Gokongwei’s 86 birthday this August, a
nearby 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 said
that having a good wife like he did is not only good support for
life and career, it’s great to come home daily to good rest. He
revealed that ever since he got married, he has stopped going
out 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 to
save on costs and to better launch new products. JG: Just follow the Chinese immigrants (laughs). It’s
URC 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 immigrants
Mindanao. URC also operates 11 distribution who built fortunes and in the process helped build
centers (DCs) located next to the plants, a Philippine economy.
reduction from 26 previously, following the launch
of 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 the
This extensive network to get closer to the end
consumers has resulted in its resilience post
5

6. then-famous business leaders, they’re gone, not a founder Lee Yang-gu who died in 1989, leaving
single one existing. behind his two daughters and son-in-laws to run
the empire. The Tong Yang Group is one of the
Another Asian “Circle the Customer – Circle the largest chaebol conglomerates in Korea; the 10 top
Globe” example from my neighbourhood sundry chaebol make up more than half the value of the
store 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% of
round layers of cake with marshmallow fillings South Korean exports in 2010, according to
with chocolate covering. Introduced in 1974 by Federation of Korean Industries. The father of
Tong Yang Group’s confectionery spinoff Orion Korea’s newly-elected 18th lady President Park
Corp (Ticker: 001800 KS) after a member of the Geun-hye, was the late military strongman Park
R&D team was inspired by the chocolate-covered Chung Hee until his assassination in 1979, who
sweets in the hotel’s café during a visit to Georgia allowed the chaebol to flourish under his 1962-79
in US, the cake was well-received by many Korean autocratic rule and attain their dominant position
children 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 momentum
President 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 Vanguard
during its 20 years of overseas expansion, with its made a switch in benchmark in Dec for six of its
overseas business now contributing 50% and 43% emerging markets (EM) equities fund from MSCI to
of 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 be
starts to bear fruit, Orion is up more than 7-fold to bumped out of the portfolio. Investors yanked
S$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. will need to boost investment in equities of China, However, there are also negative examples of
India 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, due
in localizing its overseas production facilities and primarily to poor control of channels and pricing
distribution channels. Its Shanghai factory, despite their “brand” and also because of a strong
completed 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 value
Choco Pie achieved KRW 1tr in accumulated sales, investors to understand how the “circling” is
the first snack brand in Korea to achieve this drawn to compound value. Orion’s co-creation of
milestone as a single item. Orion now controls a value with its wholesalers is a simple example of
two-thirds share of the Chinese snack market “value circle” described by Jonathan Sallet, former
which contributes 34% of the group’s sales and the Director of the Office of Policy & Strategic Planning
Choco Pie is a popular wedding gift since it took on of the Department of Commerce under President
the Chinese name “Good Friend” (好朋友). What Clinton. Sallet presented a new way to look at the
differentiates Orion against other foreign value chain. Sallet argued the new value chain is
confectionary/snacks companies in China is that it the “value circle” in which multiple companies add
offers support for merchandising, displaying and value to each others’ products without directly
sales promotions to build strong relationships with competing with each other, as opposed to a
wholesale agents. Wholesalers are willing to take traditional value chain in which each company sells
transportation 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 models
which shows Orion’s strong brand value. Choco Pie embrace the “value chain” strategy in circling the
is 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 value
ancestral rites ceremonies. Choco Pie has also exponentially and enjoy PE re-rating multibagger
become a favorite snack of North Korean workers returns. “Bloated” and “Value Circle” are the Word
and “the 35g diplomat” has come to symbolize of the Year for 2012 and 2013.
capitalism. Orion also maintains a “Choco Pie
Index” created as a parody of The Economist’s Big ********
Mac Index. Another key tipping point was when “Do investors overvalue firms with bloated balance
Orion sold its media entertainment assets sheet?” This is the title of the empirical research
Megabox cinema chain in Jul 2007 and cable paper in the Journal of Accounting & Economics in
operator On*Media in Dec 2009 to CJ Group to 2004 by the US-based Singaporean accounting
focus on its growing confectionery empire. Orion doyen Teoh Siew Hong and her colleagues. Prof
was also able to replicate its success in new Teoh is also the dean at Paul Merage School of
products 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 by
addictives and vegetable oils, Market O are using rules of thumb and by processing only
popular gifts (omiyage) among young women and subsets of available information. An investor who
the product took top seller spot in Japan’s hyper- values a firm based on its earnings performance
competitive 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
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8. investor optimism, followed by disappointment wanted to visit some Australian companies as part
that the high level is a result of an extended of the due-diligence investment process. At that
pattern of earnings management, and the time in Oct 2009, I made a simple observation that
subsequent correction in mispricing result in both Olam (Ticker: OLAM SP) and Graincorp
negative returns in the long-run. For instance, NOA (Ticker: GNC AU) have around the same level of
increases when firm books a sale as a receivable net tangible asset at S$1.7bn, but Olam is trading
before it has received the actual cash inflow, or at S$6.7bn while Graincorp is S$1.9bn in market
when a firm records expenditure as an investment cap. Both are agricultural commodities supply
rather than an expense. In both these cases, chain specialist. Singapore Inc’s Temasek Holdings
current 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 is
accounting 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 of
of problems in the firm’s operations will tend to Olam and Graincorp are moving in tandem to each
increase NOA. For example, high levels of lingering, other until the strucural break in Feb 2012 that
unpaid receivables may contain adverse resulted in the correlation to melt; both
incremental information (beyond that in past companies now trade at roughly the same market
earnings) about future earnings. Therefore, when cap of S$3.6-7bn. In Feb, the MSCI Asian index was
high cumulative working capital accruals increase 448 and retreated 15% in Jun, before climbing
NOA, 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 cash
overvalue the firm. To test for investor bid by Archers Daniel Midland (ADM) on 22 Oct
misperceptions of firms with bloated balance which was subsequently rasied to A$2.8bn; both
sheets, the accounting researchers measure stock offers were rejected. There is a wave of
returns subsequent to the reporting of NOA. The consolidation in the agricultural commodities
level of NOA scaled by beginning total assets is a sector with Toronto-listed Viterra acquired by
strong and robust negative predictor of future Glencore for US$6.1bn, while Marubeni of Japan
stock returns for at least three years after balance swooped on privately held Gavilon in a deal worth
sheet information is released. They call this the US$5.3bn. Australia is the world’s second largest
sustainability effect, because high NOA is an wheat exporter and Graincorp owns seven of the
indicator that past accounting performance has nine bulk grain ports on the east coast of Australia
been good but that equally good performance is and has about 20m metric tonnes of storage at
unlikely 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 on
the sustainability of accounting performance. A Australia’s east coast and moving a third of
trading strategy based upon buying the lowest Australia’s wheat corn. The integrated, strategic
NOA decile and selling short the highest NOA portfolio of assets gives Graincorp ready access to
decile 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 fair
the market in the first, second and third year by value accounting concerns in reporting gains on
14.9%, 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 accounting
During my Sydney trip in Dec 2009 to present my is how extensively and effectively investors use
empirical 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
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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 War
Furthermore, our evidence indicates that investors II it also supplied military trucks for the U.S. Army
do 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 were
business media and policymakers should consider tough, leaving just its truck and engine divisions. In
possible ways to make balance sheet information 1986 it changed its name to Navistar. I
more 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 during
generating 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: the
observation of “I have never seen more people
who talk to themselves than in Jakarta” (Jakarta
Globe, 27 Aug) with “mental disturbances” rising
amongst Jakartans as they struggle to cope with
the rapid changes, chaos, congestion and intense
competition in recent years; violent robberies on
the rise in Jakarta with one crime registered every
minute (JG, 27 Dec); the sex and money scandals
that plagued Singapore’s top elite; the first strike
in 26 years in Singapore by bus workers over low
wages and poor living conditions; the violent gang-
rape of a 26 year-old physiotherapist on a bus in Paccar manufactures and distributes medium- and
Delhi and the ensuing violent protests. heavy-duty trucks under the names of Peterbilt,
Kenworth, Leyland, and DAF. It is third behind
The “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 Pigott
quote in the Forbes article “Death By Hubris: The bought back in 1934. Current CEO since 1997 is 4th
Catastrophic Decision That Could Bankrupt A Great generation Mark Pigott. Since Mark Pigott took
American 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 as
Dan Ulstian was the former CEO of Navistar (Ticker: building a standard truck through its use of a
NAV), one of the great lines of manufacturing DNA robotic assembly. But all of these fancy “tech” will
in U.S. history, a company whose roots date back come to naught if there is no “Value Circle” to
to Cyrus McCormick’s 1831 invention of the circle the customer – the “right” customer. In the
mechanical reaper. In 1902 his McCormick heavy truck industry, many buyers operate large
Harvesting Machine Co. merged with Deering fleets and these “blue-chip” customers are
Harvester Co. to form International Harvester. motivated to drive down truck prices. Trucks are
Until the mid-1980s International Harvester was a built to regulated standards and offer similar
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10. features, so price competition is stiff. Unions practice the deeds of the bodhisattva Goddess of
exercise considerable supplier power and buyers Mercy or Guanyin (观音), which means “Observing
can 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 vision
To create and sustain long-term profitability within
that encourages us to dare greatly: to embrace
this industry, Paccar chose to focus on one
vulnerability and imperfection, to live
customer group where competitive forces are
wholeheartedly, and to courageously engage in
weakest; individual drivers who own their trucks
our lives. Brown, who also gave the blockbuster
and contract directly with suppliers. These
TEDTalks “The Power of Vulnerability”, evoked the
operators have limited clout as buyers and are less
immortal quote by Theodore Roosevelt:
price sensitive because of their emotional ties and
economic dependence on their own trucks. For “It is not the critic who counts; not the man who
these customers, Paccar has developed features as points out how the strong man stumbles, or
luxurious sleeping cabins, plush leather seats, and where the doer of deeds could have done them
sleek exterior styling. Buyers can select from better. The credit belongs to the man who is
thousands of options to put their personal actually in the arena, whose face is marred by
signatures 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 of
has 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 call
center people service is integrated into Paccar’s
And added:
business model in working together as a coherent
whole to circle the right customer to scale up
“When we spend our lives waiting until we’re
sustainably. This interesting quote by Mark Pigott perfect or bulletproof before we walk into the
is also uplifting: “We want to be able to look arena, we ultimately sacrifice relationships and
people right in the eye and say we did it squarely, opportunities that may not be recoverable, we
ethically, and to the best of our ability, and these squander our precious time, and we turn our
are the results. That’s exciting. They don’t teach backs on our gifts, those unique contributions
you 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” in
worded, 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 that
everyone around her report only goods news and KEE Koon Boon
dare not voice out any concerns (“报喜不报忧”). 30 December 2012
Cixi also diverted critical money earmarked for the
navy to pay for her elaborately-carved marble boat
that sat on the tranquil lake in the center of
Beijing’s ancient Summer Palace. The Qing empire
was overthrown after 267 years in power by a
republican revolution in 1911 three years after the
death of Cixi. Perhaps authentic leaders and
serious value investors do their very best to
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