Riverstone 2017 AGM – 8 Key Takeaways

Riverstone 2017 AGM
Riverstone 2017 AGM at Raffles City Convention Center

Recently, I attended Riverstone’s 2017 AGM on 23 April 2018 at Raffles City Convention Center. I have been a shareholder of the company since September 2016 but this is my first time attending its AGM (finally got to meet the good management in person). It’s held in a relatively small room, with about 60-70 shareholders attending I think.

Riverstone is one of the good companies in my portfolio that I feel very comfortable about holding long-term (and accumulating if the prices are fair), due to various reasons  – high ROE, very conservative capital structure, good industry tailwind, good management with high stakes in the company, reasonably solid moat, well paved expansion plans for the next few years, etc.

Aloysius from the Little Snowball did a very good job covering the company, so I would recommend reading it here (although I have slightly more conservative assumptions than his), especially if you are not familiar with this company.

Before I attended the AGM, I have already intended to hold it for at least another two-three years, unless the fundamentals, the industry dynamics or operating environment changes. After the AGM, I felt even more comfortable with my shareholdings in it, as I feel that the management is honest and down-to-earth and will be there working diligently and smartly to protect the business and our money in it (I was a little bit surprised at how soft spoken and humble Mr Wong Teek Son, the executive chairman and CEO, is, which is quite different from what I expected).

Here are 8 things I took away from the AGM!

1. Riverstone has strong moats in certain cleanroom gloves (especially Class 100)

Cleanroom segment has performed well and better than healthcare last year, and will continue to be the focus for the next few years, given the higher margins and strong demand. Overall market demand for cleanroom gloves is expected to grow at 10% per year, but as the market continue to switch from natural rubber to nitrile rubber gloves (which Riverstone is in), the expected market growth would be higher than 10%. Riverstone’s plan is to grow cleanroom volume by 20% per year steadily, which means taking some market share from both natural and nitrile rubber players. Although the sales volume side should not face much pressure, Mr Wong expects there would be some pressure on both pricing squeeze (2%-3% per year) and costs.

According to management, Riverstone among the few strongest players in cleanroom, with the biggest competitor being Ansell and Kimberly Clark (but one of them focus more on the U.S. and the other on Europe, and less on SE Asia). Within cleanroom, there are many sub-categories, in terms of material (latex, nitrile, PVC coated) and class. Riverstone is especially strong, or probably the best, in Class 100 gloves, with about 50% market share worldwide in terms of volume. These Class 100 cleanroom gloves made up about 20% of total revenue last year. According to Mr Wong, within Class 100, Riverstone has the best technology in the world, where its gloves emit only a certain low amount of electrostatic particles (something like that), and the next best competitor is still very far behind in technology in terms of that measurement. In terms of competition in Malaysia, there are very limited players in Malaysia in cleanroom. Besides that, a barrier of entry for new competitors is that the process to become a cleanroom vendor is longer than healthcare gloves, as the criteria is much stricter.

Riverstone’s cleanroom gloves are also highly customised. We can’t really put a % to how much of its gloves are actually customised for certain customers, and how much % are non-customised standard gloves/ solutions. This is because almost the entire solution/process/product is sort of customised, where Riverstone’s team engages with and work closely with the customers’ engineers in their production sites, for long periods, figuring out the specifications/ solutions that best fit the customers’ situation/demands. Some of their customers have been with them for decades, and they are always constantly working together to continue customising the best solution. Every customer is different, for e.g. each requires gloves that can withstand certain chemicals differently, and therefore it is not a simple standard process. These are the reasons why its customers are very sticky, according to Mr Wong. Furthermore, Riverstone deals directly with most of these customers (instead of going through distributors), which is time and energy intensive, but resulting in a very close relationship with the customers, which Mr Wong sees is one of the competitive advantages Riverstone has over its competitors in the cleanroom segment.

Overall, Mr Wong thinks that the key issue that decides whether Riverstone can perform well in cleanroom in the long run is whether it can constantly catch up in terms of technology, and not capacity/demand issues, as technology is really important in this field.

A side point on cleanroom expansion plan is that Riverstone has set up new service centers in Shenzhen and will set up centers too in Vietnam soon.

2. Healthcare overall demand is still strong

Overall demand for healthcare gloves is now 270 billion units and is expected to be 8% per annum (i.e. about 20 billion units per year). Riverstone is expanding 1.0-1.5 billion units every year, so it’s only a small portion of the total market increase.

According to Mr Wong, it is not easy to develop good and cheap healthcare gloves. The management running the company are very important, and training to personnel is very important too. Given that Riverstone has executed well and is now well recognised by the customers, Mr Wong is confident that this business segment will be consistent, as long as he and the team manage it well.

In terms of distribution strategy, Riverstone relies on distributors for big orders for large companies, which comprise a large portion of its sales. At the same time, Riverstone also specifically allocate some of its sales to small customers, in which it deals with them directly to establish a direct relationship (like its cleanroom segment) and performs some customisation solutions to build the business together with the customers. In short, Riverstone is trying to use its advantage of being a relatively smaller company and craft out some niche and competitive advantage here, instead of just mainly competing on costs and quality.

On issue of potential over-supply and excess capacities in the market, Mr Wong said that he is not concerned. He said that what you hear in the market is only companies/people telling you how much new capacities are coming in, but what you don’t hear is that how much of the existing capacities are old capacities that have to be retired or not being used.

On the recent problems faced by Chinese healthcare glove players due to pollution issues, the extra demand provided to non-Chinese players were taken up by Riverstone competitors, which is why we see Top Glove, etc doing very well in the last quarter. However, given that Riverstone has always been operating at almost full capacity (~90%), it does not have excess capacity to benefit from this situation.

And on R&D, the 20-strong R&D team used to be all doing R&D on cleanroom gloves, but now some of them are working on healthcare gloves to work on innovative products and some upgrading of existing products.

3. Continued efforts in automation will help to drive operating costs down

Mr Wong shared that although they have been implementing automation in the production processes for a few years, there are still much more room for automation. This is because the technology is always changing, and there are always new and better machines/technology that they can adopt. For e.g. two main areas with automation opportunities are stripping and packing, where the expected financial benefits of those automation are to drive the unit costs of that activity (per glove) down by almost 50%.

4. The current expansion plans will last until 2019

The current expansion plans entail building dipping lines (which are interchangeable between cleanroom and healthcare) of 1-1.2b units per year. The expansion plans are until 2019 only, because after that, the company will run out of land and has to find new land.

5. China sales are still doing well

The company has been getting more sales from China, but are not reflected as such in the annual report. This is because when the China orders become big, they would ship the orders from Malaysia instead of from China for various reasons (e.g. tax). Thus, they would be captured under Malaysia’s sales.

6. Mr Wong thinks that the greatest risks/concerns are not on the demand/revenue side, but on the cost side

Mr Wong mentioned that the next few years should be stable growing business, but the key risks (including for the long-term) would not be on the demand/revenue side, but on the cost side. In particular, two points, i.e.:

  • the supply of latex raw material, where the suppliers (like companies XX and XX – I forgot the name, but I mentioned Synthomer which Mr Wong acknowledged too) may not be able to supply sufficient volume (which will also result in increasing prices); and
  •  the supply of resources, in particular water (and electric), as the gloves production processes consume massive amounts of water, and any shortage/disruption of water supply can be quite detrimental to the operations.

7. Other points

  • The recent take-up of borrowing is for Ecomedical Gloves for expansion into Vietnam (which is easier in terms of cash management across different geographies).
  • Receivable days for cleanroom are generally longer, at around 90 days, versus 0-60 days for healthcare.
  • Lim Sing Poew, who joined Riverstone as Group general manager in 2017, is actually the company’s ex-CFO last time. He went to work for a competitor Top Glove for 1.5 years, but came back in the end. (Note: I personally think that this shows something).
  • The company hedges 50% of its sales revenue every month (by selling forwards), and won’t change this hedging strategy because it’s hard to predict the changes. It prefers to focus on the business side, instead of the FX side.
  • The company’s remuneration is highly performance based, both for management and also for all employees to some extent. The staff costs in FY2017 increased by 20%, from RM80m to RM97m, due partly to increase in base salary (which happens every year) and partly to higher incentives for the year (all the employees, including general workers, got a 1-week incentive as the company achieved 10% growth in terms of profit over the previous year). Besides that, the management’s remuneration has a large portion based on performance too, where there is a minimum hurdle in terms of net profit to cross to start getting the profit sharing component, which increases as it crosses higher tier hurdles.

8. Last but not least, Mr Wong will still be here to run the business for the foreseeable future

Mr Wong thinks that the overall outlook for the company is still looking good. When asked whether he would sell out if approached by interested parties (e.g. the bigger glove companies which can benefit from its strong cleanroom segment), his answer for now is no. He said that his health conditions are still okay (although it’s very energy-intensive to run a glove company, due to the high level of focus needed – a disruption or an issue in operations for a few hours can lose a lot of production volumes), he is not in need of those finances too, and he is still passionate about the business, and therefore he wants to continue to run it as long as health conditions permit.

Riverstone 2017 AGM - With Mr Wong
With Mr Wong Teek Son, Executive Chairman and CEO, who doesn’t pay himself any Director’s fees.

I personally am very reassured by this, by his passion/energy for the company (while adopting a conservative approach to grow the business – which protects the downside), which makes me feel comfortable handing my money to these diligent, honest and down-to-earth management for them to take care of it and compound it well (together with the growth of the business).


Book Review – The Manual of Ideas (by John Mihaljevic)

Book - Manual of Ideas

The Manual of Ideas (2013), by John Mihaljevic, is quite a good and different read. It is different because it covers a wide diversity of value ideas (nine categories of value ideas, as follows), and it focuses on a few key points within each value idea, i.e. the approach, uses and misuses, screening methods, methods beyond screening and the right questions to ask:

  1. Graham-style deep value
  2. Greeblatt-style magic formula
  3. Small-cap value
  4. Sum-of-the-parts or hidden value
  5. Superinvestor favourites
  6. Jockey stocks
  7. Special situations
  8. Equity stubs
  9. International value investments

Personally, reading this cross diversity of value ideas/approaches allows me to examine the core value investing principles (ultimately all of them are value investing to a large extent) and ideas from various different perspectives. Even though I might focus on a few of the categories that suit my style/preference, I believe the ideas and knowledge from the other categories would be helpful at times and improve my cross-disciplinary and lateral thinking. As Charlie Munger always likes to say, ‘To a man with a hammer, everything looks like a nail”, and I will prefer not to be one such man.

This book also introduces me to a lot other investors whom I haven’t heard of and makes me learn more about some of the investors whom I don’t know well enough before this.

The key points that I got from each chapter are listed below.

Chapter 1 – A Highly Personal Endeavour

  • If I directed the allocation of the world’s capital, I would not be able to rely on the market to bail me out of bad decisions. The greater fool theory of someone buying my shares at a higher price breaks down if the buck stops with me. Successful long-term investors believe their return will come from the investee company’s return on equity rather than from sales of stock.
  • Thinking like a capital allocator goes hand in hand with thinking like an owner. Investors who view themselves as owners rather than traders look to the business rather than the market for their return on investment. They do not expect others to bail them out of bad decisions. (Note: Imagine myself as the CEO of Berkshire Hathaway, e.g. Warren Buffett, monitoring my (private) businesses’ operating earnings over time, and allocating more capital to the better ones, and in the end look to earn returns from the growth in those companies, not from the change in valuation/market sentiment.)
  • The old own-a-stock industry could hardly afford to take for granted effective corporate governance in the interest of shareholders; the new rent-a-stock industry has little reason to care.
  • Losses have a perverse impact on long-term capital appreciation, as a greater percentage gain is required to get us back to even. For example, a 20 percent drop in book value requires a 25 percent subsequent increase to offset the decline. (Note: This applies not just to my own investments, but also to the investments/ decisions made by the companies I am looking at or own too.)

Chapter 2 – Deep Value: Ben Graham-Style Bargains

  • “The problem is to distinguish between being contrary to a misguided consensus and merely being stubborn” – Robert Arnott and Robert Lovell Jr.
  • Finally, they came with considerably less opportunity to meet someone cool of the opposite sex while browsing, unless one was looking for a date who wouldn’t mind being taken to a meal at McDonald’s. You see, it took a certain type of person to enjoy bargain bin shopping – and it is no different with Graham-style equity investing.
  • Several years ago, Buffett was reported to have invested some of his personal portfolio into South Korean net nets – companies trading for less than their current assets minus total liabilities. The investment approach of Zeke Ashton, managing partner of Centaur Capital Partners, has evolved similarly. “We very much prefer our ideas to take the form of high quality businesses with excellent management that can grow value over the longer term, but we will buy mediocre assets if the price is right.”
  • Ben Graham, Walter Schloss, John Neff and Marty Whitman are just a few names that came to mind.
  • A holy grail of value investing might be uncovering opportunities that both provide asset protection on the balance sheet and include businesses with high returns on capital.
  • The truism that over the long term an investor in a business will earn a return closely matching the return on capital of the business is only partly true. If the business dividends out all free cash flow, a long-term shareholder will earn a return equal to the free cash flow yield implied in the original purchase price… As the payout ratio declines, the economics of the business becomes increasingly important.
  • States Nick Kirrage, fund manager of Specialist UK Equities at Schroders: “Staffing business… have big fixed overheads and quite volatile top lines, and profits can be quite volatile. Typically, the staffing industry understands this, and they therefore run with balance sheets that are either heavily net cash or very lowly geared. But the market becomes very focused on short-term profits, so once per cycle, the share prices collapse very, very strongly, and people just assume that profits either won’t recover or it will take too long for them to recover – and they can’t really be bothered to wait. For people who are willing to wait for three to five years, that’s wonderful, because you’re not taking balance sheet risk. Therefore, the chance of you permanently losing money is very low. The chance of you making quite a lot of money, because the operating leverage works both ways, is very high“.
  • Scott Barbee, portfolio manager of Aegies Value Fund, says “we generally like to buy companies trading at significant discount to their asset values and at mid to low single-digit multiples of normalised earnings two to three years out”.
  • Comfort can be expensive in investing. Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations. (Note: This applies to all investing – Take advantage of it!)
  • Investors typically do worst when they enter situations in which they lack staying power, whether due to financial or other reasons.
  • Perhaps this is why many investors either adopt an approach and stick with it or evolve from one approach to the other. Few investors apply both approaches (Buffett-style and Graham-style) successfully at the same time in the same investment vehicle.
  • When we attempt to extract value from poor businesses with valuable assets, impatience becomes a virtue. We are not referring to impatience with the stock price – quite to the contrary… Instead, we refer to impatience with regard to the course of the business itself.
  • We find it difficult to argue against Marc’s conclusions, and denial is never a recipe for success, whether in investing or in life. If we accept that creative destruction will continue at least at the pace experienced throughout recent history, then it becomes obvious that businesses trading at deep value prices are likely to be among those that are creatively destroyed… It seems unwise to allocate a large portion of investable capital to any one deep value opportunity, even if the latter promises a large expected return.
  • With smart investors eager to invest in Graham-style bargains, any remaining net nets are likely to possess disqualifying risks (note: this, to me, is second level thinking). As a result, investors may want to keep track of the historical proportion of net nets in various markets around the world. When the proportion exceeds the average, conditions may be ripe for successful deep value investing.
  • According to Whitman, some long-term assets may be more readily marketable than certain short-term assets. For example, a Class A office building in Manhattan may be easier to sell without impairment than the inventory of a failing retailer.
  • Value creation via buybacks – Share repurchases tend to be particularly accretive in the case of companies generating cash from operations while trading below tangible book value. If such companies apply free cash flow toward buying back stock, they accrete tangible book value per share, widening the gap between the market price and accounting net worth… When the stock price of Sears Holdings declined below book value a couple of years ago, Bruce Berkowitz argued that the game would be over for short sellers of Sears stock if Eddie Lampert simply kept buying back stock. Berkowitz appeared to refer to the per-share accretion dynamic described here.
  • We know that the mood of insiders generally swings in close concert with that of other market participants – this is why we see more merger and acquisition activity when prices are high rather than low. When insiders act against the psychological tendency to simply hunker down and not throw good money after bad into a stock that has underperformed, they express a view that the market has overreacted on the downside. Most insiders, by virtue of being businesspeople rather than investors, may weigh operating performance more heavily than the equity valuation in their stock purchase decisions. As a result, it may be rare for insiders to buy stock unless they believe the fundamentals of the business are at least okay.
  • When a business with high working capital requirements hits a speed bump or enters a permanent period of stagnation, working capital needs decline, freeing up cash. In addition, lower capital expenditure (capex) requirements typically mean that the depreciation recorded on existing plant and equipment exceeds maintenance capex. This dynamic causes slow-growth businesses to report free cash flow well in excess of net income. If the market is overly focused on sales declines or the income statement, an opportunity may exist to acquire a business at a high free cash flow yield.
  • Jeroen Bos stresses the importance of a strong top line, as sales restoration might be more difficult to achieve than margin improvement: “I like to see a company that has huge volumes but is not making money… than a company where sales are just completely evaporated, and it has to earn those back.”
  • In his context, it makes sense to start with the quotation the market is putting on a company, although we might normally prefer to appraise an equity security before learning of the market’s appraisal. When we confront an equity that is undeniably cheap (though perhaps not undervalued), we gain insight by extracting the key question embedded in the market price – and answering that question correctly.
  • Such a negative development is not farfetched, as businesses with low capital intensity tends to be most susceptible to competitive threats. When something other than capital employed drives the profits of a business, that something can change quite easily unless the business has a sustainable moat. Businesses with low capital intensity may be more likely to exhibit winner-take-all dynamics, as capital is not a barrier to scale. Consider how quickly Apple crushed well-established companies Nokia, Research in Motion, and even Sony. This was only possible as Apple did not need to scale capital employed alongside market share. Investors who considered investing in beaten-down equity of Nokia too early because the Finnish company seemed to have a capital-light business in addition to large net cash holdings might have been surprised by the degree to which the profitability of the capital-light business would be affected by competition.
  • We like to think about value in these types of situations as follows: If the primary valuation ratio remains constant, will the stock price increase or decrease over time? … Mohnish Pabrai states in a similar context: “I value [consistency of earnings] more than the absolute cheapest business, because then we know there is some sustainability to the cheap business getting even cheaper, and eventually gravity takes over”. Robert Robotti, president of Robotti & Company, also looks for deep value situations in which intrinsic value grows over time. (Note: This applies to both deep value investing and moat investing too (a form of margin of safety)!)
  • According to Toby Carlisle, “The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case outcome. In my experience, most ‘net net’ companies have been turned around, rather than liquidated”.
  • Economists Eugene Fama and Kenneth French have studied the relationship between stock performance and book-to-market ratios. They have consistently found that equities with high book-to-market ratios outperform those with low ratios.
  • When we invest in an asset-rich but low-return business, time may be working against us. As long as management can hold on to the assets and keep reinvesting at low returns, shareholders may earn unimpressive returns despite a bargain purchase price. As a result, catalysts become a relevant consideration.

Chapter 3 – Sum-of-the-parts Value (Investing in companies with excess or hidden assets)

  • Investors usually analyse a company as a monolithic whole, appraising value based on overall book value, earnings or cash flow. However, many companies can be appraised most accurately by analysing each of their distinct businesses or assets separately and then adding up those components of value to arrive at an estimate of overall enterprise or equity value.
  • Sometimes investors, in their zeal to create a sum-of-the-parts opportunity, slice a company into too many parts, creating an attractive investment thesis in theory but not in reality… However, when the services business is built largely around hardware, the former could evaporate if the hardware business becomes obsolete. In such a scenario, a sum-of-the-parts valuation of interconnected hardware, software, and services units might trigger too optimistic an appraisal of value. (Note: Look out for the inter-dependency and interaction of the different business segments, especially when they have different margins)
  • Stephen Roseman, a portfolio manager of Thesis Fund Management, has made catalysts a key component of his investment approach. “One of the non-negotiable requirements I have with respect to committing capital – on the long side – is a tangible catalyst I can point to within the ensuing six to twelve months. Capital has a cost, and this discipline helps to improve returns in two distinct ways: it helps to avoid value traps, a common foible of value investing; and it helps to improve IRR as capital is deployed closer to events that might help realise value”. (Note: I can apply this catalyst thinking to my own investing style (wonderful companies) too, only if appropriate)
  • In the case of a sum-of-the-parts situation like Berkshire Hathaway, the whole may be greater than the sum of the parts due to Warren Buffett’s ability to create value through capital allocation. In the case of most other conglomerates, a discount to the sum of the parts may be appropriate.
  • Intersegment sales frequently indicate the degree to which the various segments depend on each other. (Note: Check the amount of intersegment sales)
  • The value of sum-of-the-parts valuation exercise grows when the various business segments demand distinct approaches to valuation… Promising ideas include companies with businesses in more than one industry, businesses with vastly different returns on capital, and companies with unexpectedly large businesses in fast-growing geographies.
  • Finally, in the case of an apparently undervalued equity, the perception that some assets are hidden from the view of most investors may explain why the company is undervalued. Seth Klarman has argued that we strengthen an investment case when we understand why the market may have missed, misjudged, or even created an investment opportunity. For example, if we uncover an apparently undervalued company whose stock price has plummeted, the investment thesis will be strengthened by knowledge that a large institutional shareholder was forced to sell shares due to a need to satisfy redemptions of capital by the shareholder’s clients.
  • We have also identified smart investors who appear focused on unusual situations, including equities with overlooked sources of value. We list 10 such investors – Bill Ackman (Pershing Square Capital Management), David Einhorn (Greenlight Capital), Carl Icahn (Icahn Associates), Daniel Loeb (Third Point), Mick McGuire (Marcato Capital Management), Lloyd I. Miller III (private investor), John Paulson (Paulson & Co), Michael Price (MFP Investors), Wilbur Ross (WL Ross & Co), and Marty Whitman and Amit Wadhwaney (Third Avenue Management).
  • Investors may indeed become patsies by failing to realise how many other smart investors have bought into the same story of hidden value. If the perceived discount to fair value does not exist or is later eliminated due to new developments, the outcome might be made more painful because many like-minded investors head for the exits at the same time.
  • By falsely concluding that the market is ignoring the noncore assets, we may overpay for the core business and end up with a value trap… It rarely pays to invest in perceived hidden value unless we like the core business as well.
  • It matters tremendously whether the offer is “buy one, get one free,” or “buy 10, get one free”. As shoppers, we recognise the former as a more compelling offer. As investors, we often overlook this important distinction.

Chapter 4 – Greenblatt’s Magic Search for Good and Cheap Stocks

  • Joel Greenblatt’s track record of 50 percent annualised returns during the 10 years he ran a hedge fund, Gotham Partners, was virtually unmatched in the industry.
  • The longer the holding period, the smaller the role of the exit multiple in determining the investor’s annualised return.
  • To normalise for different tax rates, we use operating income as the numerator of the equation. To normalise for the effects of financial leverage, we use capital employed as the denominator. Greenblatt defines capital employed as current assets excluding cash, minus current liabilities excluding debt, plus net fixed assets, typically consisting of the property, plant and equipment line item on the balance sheet.
  • A few years ago, Joel Greenblatt and Blake Darcy launched Formula Investing…
  • While the market is pretty good at valuing high-return businesses that have reached a steady-state phase of limited reinvestment opportunities, Mr. Market makes two mistakes with some consistency: It overvalues high-return businesses whose returns on capital derive from explosive but ultimately transitory trends or fads… On the flip side, the market may undervalue unhyped quality businesses with sustainable high-return reinvestment opportunities.
  • Similarly, capital-intensive businesses near the top of the cycle have unsustainably high returns on capital employed.
  • As a result, a crucial determination when evaluating magic formula selections is whether they exhibit above-average returns on capital for transitory reasons or for reasons they have some permanence. Warren Buffett calls this moat; others may know it as sustainable competitive advantage. (Note: Be careful not to be just a data analyst – Remember to think about qualitative and think forward-looking (and the business model)!)
  • Adds Josh Tarasoff, general partner of Greenlea Lane Capital Partners: “One of the most powerful ideas I have ever encountered is the one-decision stock: a company you can simply hold for a decade or two and receive an outstanding outcome”.
  • Durability of competitive advantage relates quite closely to a firm’s ability to raise prices in excess of inflation… According to Tarasoff, only real pricing power, that is, the ability to raise prices in excess of inflation, should be regarded as special… When and to what degree a company chooses to exercise its pricing power depends on a number of factors, but the key consideration for investors is whether a firm could raise prices without materially impacting unit sales.
  • High returns on existing capital – the capital already employed in a business – are almost meaningless without an ability to invest new capital at above-average returns. Returns on existing capital, whether high or low, are already reflected in a company’s operating income. In a static scenario, the driver of return to equity investors is the earnings yield – or free cash flow yield, to be more precise.
  • Estimating the extent of the reinvestment opportunity available to a business is no small feat. Josh Tarasoff sheds light on this issue: “For a significant reinvestment opportunity to exist, there must be the potential for long-term unit growth. So, a large addressable market relative to current business is desirable…”

From here on, the points will become much less, as I am becoming lazy… LOL

Chapter 5 – Jockey Stocks (Making money alongside great managers)

  • Chief executives can distinguish themselves in two major ways: business value creation and smart capital allocation.
  • Mr Market has a tendency to deify certain executives, sending their companies’ stock prices into the stratosphere and condemning new purchases of stock to likely underperformance. As investors, our goal should be to identify chief executives who are themselves underappreciated.
  • Times change; human nature apparently doesn’t.
  • A chief executive should own stock (not options) with a market value equal to at least several years of annual cash compensation. Anything less may make the CEO more interested in maximising the pay package than per-share value.
  • Tom Gayner points to an often overlooked check – leverage. “One of the great investors I’ve tired to learn from is Shelby Davis [founder of Davis Selected Advisers]. Shelby said that you almost never come across frauds at companies with little or no debt… If a bad person is going to try and steal some money, they will logically want to steal as much as possible.
  • Daniel Gladis points to incentives as a key reason for investing in family-controlled businesses: “If a family has half or three-quarters of its assets invested in this particular business, they’re probably going to take care of it better than a management for hire that comes and goes in three or four years”.
  • Many business school graduates aspire to be great business leaders. Few aspire to be great capital allocators.
  • Charlie Munger’s advise to invert serves us well when analysing managers – not in identifying the greatest jockeys but rather in eliminating the bad actors, even when those individuals are esteemed by the business establishment. An acid test is compensation.
  • Between the extremes of excellent and poor capital allocators is a world of mediocrity, in which managements often view reinvestment of capital as the default option, giving little consideration to the alternatives.

Chapter 6 – Follow the Leaders (Finding opportunity in superinvestor portfolios)

  • In a review of Youngme Moon’s book Different, Guy Spier writes, “… In saying “no” to the vast majority of people, these businesses ensure that the only people who become customers are those who will value and appreciate the specific configuration the company is set up to provide.” (Note: Ask, is the company in my portfolio saying no to anything? And am I, as a capital allocator, saying no to anything?)
  • Most superinvestors view themselves as employers of management, and they are generally not shy about voicing their views on how existing equity value can be unlocked or new value created.
  • Superinvestors are neither heroes nor infallible. The specific idea we might be copying could turn out to be one investment that becomes a complete write-off.
  • The first step in setting up a superinvestor tracking system is deciding which investors to track. Several factors figure into this decision, including the concentration of an investor’s portfolio, average portfolio turnover, propensity to employ short selling, and the congruence between one’s own investment approach and that of a superinvestor.
  • Turnover is an important consideration because as outside observers we receive only delayed notice of other investors’ buy-and-sell activity.
  • Context is important when assessing the purchase and sale activity of superinvestors.

This chapter also includes a long list of superinvestors in the following categories – Large-cap value, Mid-cap value, Small-cap value, Graham-style deep value, Buffett/Greenblatt-style quality value, Highly concentrated portfolios, Industry specialists, and a few hard-to-follow superinvestors.

Chapter 7 – Small Stocks, Big Returns? (The opportunity in underfollowed small- and micro-caps)

  • Several key developments have created opportunities for small-stock investors, including an increase in the size of institutional portfolios, an escalation of compensation expectations, exclusion of small stocks from major market indices, and scant research coverage by sell-side firms.
  • Even if small caps as a group stop outperforming large caps, the differential between top and bottom performers should continue to be greater in the case of smaller stocks, providing opportunities for research-driven investors.
  • One well-known drawback of small-stock investing is the, at times, severely constrained trading liquidity of smaller companies. Wider bid-ask spreads, greater market impact, and perhaps greater trading commissions conspire to make entering and exiting the equity of small companies a costly affair.

Chapter 8 – Special Situations (Uncovering opportunity in event-driven investments)

  • In markets that exhibit informational inefficiency (Note: Look out for e.g. different segments, with different growth rates, and different profitability (masked), which are not captured by standard financial databases), rewards may accrue to those who make the effort to obtain timely, accurate and relevant information.
  • Investing rules, as distinct from laws, need to be broken occasionally in the pursuit of investment excellence. In this context, rules include the financial formulas (Note: e.g. calculation of EV, when other items like prepaid liabilities may need to be considered and adjusted for) we have memorised along the way.
  • Special situations are one of the few investment areas in which it makes sense to pay at least as much attention to the time component of annualised return as to the absolute return expected in a particular situation.
  • In the absence of identifiable drivers of inefficiency, the probability may be higher that our appraisal of value contains an oversight or flaw. If we can identify a non-fundamental factor that explains the low valuation, we gain confidence in an estimate of value that differs from the market price.

Chapter 9 – Equity Stubs (Investing (or speculating?) in leveraged companies)

  • We need to be careful not to overrreach when our judgment turns out to have been correct. The payoffs in equity stubs may exert an intoxicating effect on the successful investor.
  • The tendency of investors to think about the likely outcome rather than the range of possible outcomes represents a key stumbling block to success in leveraged equities.
  • Our experience suggests that industry-wide sell-offs represent better hunting grounds for potential opportunities than do company-specific crises. A single company may stumble in a way that makes recovery of value impossible, but entire industries disappear rarely.
  • The market sometimes ignores the nonrecourse nature of a company’s debt, perceiving the equity as riskier than it actually is. This creates opportunity for research-driven investors.

Chapter 10 – International Value Investments (Searching for value beyond home country borders)

  • “See the investment world as an ocean and buy where you get the most value for your money” – Sir John Templeton (Note: Fish where the fish are!)
  • In the interviews we conducted with leading investment managers around the globe, most of them expressed a view that the commonalities of international markets outweigh the differences.
  • Numerous studies confirm that adding international equities to a portfolio improves the risk-reward profile, either by boosting expected returns for a given level of volatility or by lowering the volatility for a given level of return.
  • Many investors appear to make the mistake of expecting foreign markets to mirror their domestic market in every material way. This may be particularly true in the area of corporate governance.
  • We avoid much trouble in international investing when we accept that some levers, such as corporate governance, are harder to pull than others, such as the price we are willing to pay.
  • When we go global in the search for investments, we give ourselves a free option to pay a lower price than might be possible in our home market. While no two equities are the same, similar companies frequently trade at materially different valuations across geographies.
  • Buffett’s concept of circle of competence, while typically used in the context of different industries, may also have applicability to different countries. Due to the many unifying features of global equity investing, we may falsely assume that our competence extends to investing in all geographies.
  • One of the biggest drivers of disappointment for investors who venture globally might be an unrealistic view of the promise of emerging markets. In the rush toward growth, many investors readily ignore the return-on-capital prospects of fast-growing but highly competitive and capital-intensive industries.
  • The issue of challenging demographic trends confirms the importance of calibrating fundamentals versus expectations, perhaps best explained in Alfred Rappaport and Michael Mauboussin’s Expectations Investing. When the expectations implied in stock prices fall materially short of the likely fundamentals (Note: e.g. negative demographic headwinds overly price in in the market), a buying opportunity may be at hand.

This chapter also includes a list of 50 international investors who may be considered value investing thought leaders in their respective countries, for example:

  • Kerr Neilson; Platinum; Australia
  • Richard Lawrence; Overlook; Hong Kong
  • V-Nee Yeh, Cheng Hye Cheah; Value Partners; Hong Kong
  • Chris Swasbrook; Elevation; New Zealand
  • Ngiek Lian Teng; Target; Singapore
  • Richard Chandler; Richard Chandler; Singapore

Lessons from Value Investing Summit 2018

VIS - Participant

Over the last weekend (27-28 January), I attended the Value Investing Summit (VIS) 2018 at Expo. I bought the ticket at S$150 from someone who couldn’t make it after buying the ticket. Overall, it’s a good event (depending on the line-up of speakers) and well worth attending if you have the time.

There are quite many learning points for me, and quite some that reinforce (and shed slightly new perspectives on) what I already know (which is a good thing too). And it’s quite inspiriting to see so many Charlie Munger and Warren Buffet (‘s thinkings and wisdom) in the speakers in the room, in fact more so on the former, whom I have recently demonstrated a newfound appreciation for. And even more encouraging to know that most of them (especially Vishal and Hemant Amin, who compounded the capital that he manages at >30% annually for more than 14 years with a 10-stock concentrated portfolio) have very similar investing philosophies, strategies and processes as mine (which I found only after 2 years of investing and lots of readings), although of course, I am still way behind them.

I shall list down the more major learning points here, viewed in my own lens (and very drowsy eyes and practically nonfunctional brain on the first morning due to a late night (2am+) out prior).

VIS 2018

Day 1 (27 January)

Kee Koon Boon – Hidden Champions and Value Investing

  • I have been following his articles for some time and so I have already appreciated quite some of his thinking and wisdom
  • But it’s good to finally see him in person, and understand more of his personality (he was more gentle than I thought, and very knowledgeable and well-read) and the things that drive him (including intellectual pursuit and value-adding to society)
  • Also, think resilience

Hermann Simon – Hidden Champions – The Vanguard of Globeria: Success Strategies of Unknown World Market Leaders

VIS - Hermann Simon

  • Hermann is the one who created the “Hidden Champion” concept. He is a German Professor (Doctor), author and business leader. He is also the chairman of Simon-Kucher & Partners, which specialises in strategy, marketing and pricing (he himself is a hidden champion to me, who has run his firm for more than 30 years)
  • Hidden champion is all around us, creating products/services that we use all the time, often unnoticed and hidden behind, which is why they have the potential to appreciate in value and compound its value for a lot of times
  • Listening to his talk prompts me to think whether the companies that I own or am looking at has the traits/characteristics of the hidden champions, which are good ones to have
  • Germany’s Hidden Champions of the Mittelstand – which refers to world-class, export-oriented small and medium-sized enterprises (SMEs)
  • He is here to talk about businesses (and not investing), but because investing requires understanding of businesses, therefore it helps. It also reinforces to me the idea that I should be focusing on understanding businesses (and the business model), not equities, thus the term business analyst instead of equity analyst as said by Warren Buffett
  • Examples of Hidden Champions that struck with me include: Wanzl (trolley), Flexi (leash), Essilor (optic lens), Paiho Group (velcro fastener), Wirecard (payment processing)
  • Laser focus in a niche (that’s how you produce superior value), but still replicate and scale globally (within that niche area), therefore providing avenue for growth. And mono-maniac (leader)
  • On digitalisation – For B2C is already very advanced; For B2B there’s still much room to go, therefore providing opportunities to businesses and we investors. This is because B2B digitalisation is usually more complex and hard to integrate/implement. For us, as investors, look out for companies that are in the space of, or would benefit from, B2B digitalisation – they provide stable (sticky) cash flows and are associated with high switching costs. In my mind, I run through the companies in my portfolio, and I can only think of Silverlake as more of playing in this area. I shall hunt for more such companies

Joshua Zhang – Case Study

  • Joshua is an analyst with the Hidden Champion Fund I believe. His presentation was good and solid, with very organised thought and thesis flow and good slides and presentation skills, and I still have a long way to catch up to that type of level
  • He presented on Kadoya Sesame Mills (JP: 2612), which is a hidden champion
  • Laser focus on sesame oil; strong moats – culture, know-how (160 years of experience and knowledge)
  • Interesting company and maybe I would examine at some point if the materials in English are not inadequate

周贵银 (Zhou Gui Yin) – The Power of ROE (in Mandarin – interpreted)

VIS - 周贵银

  • One of my two favourites (together with Vishal)
  • 周老师 is from China and he is a super Charlie Munger (lateral and multidisciplinary thinking), and presented on his 觉悟智慧 (and/or 融道智慧), which discusses the integration of the Chinese philosophies and ancient thinking (佛家思想,,易经,道家,儒家,佛家,兵家,老子,孙子,etc etc) with investing
  • Overall, I think these points are very good in shaping and building up one’s character, emotional control, temperament, life philosophies, which are at least as important as, if not more than, diligence, IQ, analytical work and number crunching, etc.
  • These are very high level and more philosophical, and somehow I appreciate it a lot. But I think I am still not at a stage to start studying those Chinese philosophies and teachings to really master the points, and shall leave them to a later stage when I build up more of the other areas first
  • Some of the points that I like/connect more are:
    • 佛家思想 – 三大境界/领悟:看山是山,看山不是山,看山还是山 – Static dynamism (and in another perspective (in my own words), one can see it as the zoom-in-zoom-out approach/mental model which is very useful in investing)
    • 内圣外王 – 行者 – 无,空 – 只拿不给的话,会导致欲望越来越大,导致我们不能客观 – Be very wary of this, which I think is very true –
    • 道家 – 无,为 – 不要过意的去干悟它 – Time is the best friend of a good business
    • 泰来否极 (always be on the look-out for any potential downfall or disaster – humility and constant cautiousness (like Howard Marks)),而不是否极泰来 (please don’t bet on this – in real life it doesn’t work like this)
    • 长久 – Not short term profiteering/compounding, but permanent compounding
    • 兵家 – 未战先胜 – I win (or make money) the instant I bought the stock, just like what Warren Buffett says, because I have done my homework/diligence and know the value of the company (that I am buying)
    • See my notes and more points in the pictures below

VIS - Notes - Zhou Gui Yin.JPG

Panel Discussion – Hemant Amin; Francois Badelon; Hermann Simon; Kee Koon Boon; Judy Goh; Clive Tan

VIS - Panel discussion

On Circle of Competence:

  • Hermann Simon
    • Slightly irrelevant topic – The less known a CEO is in the public, the more successful the company becomes
  • Hemant Amin
    • It’s not competence if you don’t know the extent of the circle of your competence.
    • We use a bit too much IQ (exploring intellectual challenging and complex areas/companies/business models) than we need
    • It’s okay not to have an opinion on things you don’t know (we use, or fall back, too little on the “too-difficult box”
    • Define what you know, and stick with it
  • Kee Koon Boon (some points are on different topics)
    • Charlie’s mental model – multidisciplinary thinking
    • Idea of resilience
    • He likes learning knowledge and likes to know what makes people rise and fall, and that partly leads him to examine company leaders and then businesses and investing
    • Investing is a multidisciplinary area
    • He first developed accounting skills, then psychology to understand CEO’s or human’s mind
    • Duality of a leader (note: duality mental model at play here) – Needs to be tech savvy, and also needs to always have customers’ needs in mind

On screening criteria and habits to develop

  • Hemant Amin
    • Let’s look at what not to screen for (note: inverse thinking mental model at play) – Not growing well, not scalable, not good management
    • Is there a temporary problem? That’s where the opportunities lie
    • Idea sources: Reading, reading, reading (this is what this business is about); Connecting the dots (this inevitably leads us to insights)
    • Habits – Reading across diverse sections
  • Hermann Simon
    • Personal visit of companies is the most valuable information source
  • Kee Koon Boon
    • I’m a mono-maniac. I keep working and adding value to society, because I believe in my work (and that it adds value to society). This is the habit I work on

Day 2

Vishal Khandelwal – In Search of Value in an Irrational World

Finally got to meet Vishal (or rather I would prefer to call him the Safal Niveshak (the successful investor), after following his website and (epic and wisdom-filled) articles for more than two years. So, of course, I have to take a photo with him (such a rare chance)! The Warren Buffett of India!

Anyway, coming back to more serious topic, he presented very well (even though he kept saying that he hasn’t spoken to such large crowds before (he said so too for his previous video interviews)) and presented very useful concepts (more on the high level and strategic points, and temperament). Although I have known most of the concepts/points (mainly through his writings), it’s good to hear them again right out from him and get reminded of those lessons again.

And it’s also good to have met him in person, heard him spoke in person, talked to him and asked him the questions that I have (casually after his session on-stage) in person, and just have a feel of him as a person and understand his personality and the way he speaks/talks/holds himself. Because with these, the next time I read his writings, I would be able to picture him talking to me (note: thought experiment mental model in some way) and therefore able to learn and absorb/internalise those lessons better.

Also, it’s also surprising + lightening to see that (in my own view) he is very much Charlie Munger (or at least uses more of Charlie’s thinking skills in his own thinking) than Warren Buffett (although he learned a lot from Warren too, especially on investing), which proves to me that Charlie’s thinking models and skills are so wonderful that so many successful investors copy and practise them constantly and proactively, and makes me want to learn + implement + practise more of Charlie’s thinking (I am glad that I have read Poor Charlie’s Almanack and learned more about Charlie (‘s thinking and personality) before I heard from and met the speakers in VIS). Just to illustrate, within my first few minutes of conversation with Vishal, he already brought out two mental models (of Charlie’s) – inversion and pre-mortem – which I shall allude to below.

I really want to just list down the most important points that I got from him (note: focus), so here they are (see the more detailed notes in the pictures below):

  • We are not rational. We make an argument first. Then we try to rationalise it. (Be very aware and wary of this, making sure that you don’t fall into this)
  • Learning to say NO! (to various info sources, to noises, to (bad, unaligned, or even aligned but decent only) investment opportunities) is one of the most difficult, but important thing to do. Learn to say NO (time is one of your greatest resources/capital that you should allocate well as a good capital allocator)!
  • Think LONG TERM and have a LONG VIEW! The long view (and long term focus) is an edge that we retail investors have. Look at seasons, not quarters, and one season is maybe 5 years or so (depending on the industry)
  • Focus on the PROCESS, not the outcome. Also, focus on what we have control over (risk, cost, time, behaviour) (which we rarely focus on), not what we don’t (outcome, stock price) (which we only focus on)
  • Investing is 51% ART, 49% science – I base my thesis and purchase decisions on what my GUT tells me after I’ve done all the research and absorbed all the info (the science).
  • Beware of over-focusing on and be careful when using valuation, as all valuation is wrong, and all valuation is biased (since we have already spent a lot of time looking at it) (note: consider the importance of, and use of, margin of safety here)
  • To avoid confirmation bias, especially when you are holding for long term, and leveraging up, a solution is to write down your thesis in an investment pad (you should have one), not on computer. Write down why you buy, and why you sell.
  • His answers/points on the personal questions that I asked him:
    • Be patient and keep doing the work
    • If you can find only companies with high ROIC but little reinvestment opportunities (note: I think Vishal sees this type of company just like another cheap (value) company, which I think he doesn’t want to focus on), but not companies with high ROIC and much reinvestment opportunities (or if you are not willing to pay for them after you find them, either due to the really high or over- valuation currently, or because of your own psychological/mental barrier), then do these two:
      • (1) keep finding, keep doing the work, keep flipping the stones (if the thesis for no. 1 doesn’t work out now (maybe because it’s expensive), go down the rung, look at no. 2, no. 3 in the market (in terms of market leadership (note: which is different from market share)), but don’t go further than that; and
      • (2) be patient and wait for market crash (or correction is also good enough) if it is really overpriced (note: the same thesis might work out in the future too as time passes, not just from the decrease in price, but probably be due to the improvement of business and increase in earnings too – remember, there are two factors, not just one); or be more willing and ready to pay for quality, which requires you to really understand and appreciate Quality – compounding quality gives you a lot of ROI, so learn to understand and appreciate the value of quality (which is not easy, but work on it)
    • And to help understanding and conceptualising the value of quality (and (probably non-linear) growth), Vishal uses/considers an expected return model as one of his tools (note: I believe he has not just hammers, so he doesn’t see everything as nails) (note: the far-out earnings and corresponding valuation can be used to understand/estimate a business better, but not as the main basis for investment/justification for a high purchase price).
      • First, estimate the earnings of the company 10 years down the road (have a long view, and this helps to take into account non-linear/ exponential dynamics).
      • Second, apply a multiple. He personally uses a P/E multiple, and not EV/operating earnings. The important point is to be consistent, applying the same type of multiple across companies consistently – and in response to my follow-up question, he says that difference in or issues on interest expense, capital structure, etc should be taken into account in the estimated earnings (to go with the P/E multiple), and not taken into account by the tool (it is a tool!) (the type of multiple).
      • Third, see whether the implied valuation range (remember, never have one single valuation number – always a range) gives you an annual return of 15%-20% (or whatever your number is), based on today’s price
    • In estimating the long-term earnings of the company, use inverse thinking (e.g. think about what would make the company not achieve that level of earnings, etc; or what level of earnings would the company not achieve). Use Charlie’s pre-mortem concept too
    • Also, force yourself to think about and imagine the long term potential growth. When thinking on this, think about per capita consumption now. E.g. If there is 1 out of 100 people consuming the product/service now, in the future if 5 out of 100 consume, then it’s a 5x growth, just in volume.

Hemant Amin – Value Investing in an Exponential World

VIS - Vishal and Hermant

Hemant is a local fund manager that manages a family fund of more than S$100M with a concentrated portfolio of 10 stocks, fundamental long. And a track record of >30% IRR for ~14 years – Impressive (with a good process)!

  • He focuses mainly on (owner-managed) companies with high quality and high growth (best case), followed by companies with high quality and less growth.
  • Understand business models! Then you won’t say the valuation (EV/EBIT) is high
  • Largest position is in Bajaj Financial Ltd
  • Business models + Technology + Scalability = Exponential Growth! (see picture below)
    • Exponential growth – You have to think NON-LINEAR in this linear worldThe rate of change itself is acceleratingSpot the slow boiling water, and make sure that you are on the other side
    • Think about when does a company moves on the exponential curve (low marginal costs, etc)
    • Understanding business model allows you to understand where the value is (value investing)
  • Warren Buffet: “Investing is simple, but not easy”. Simple is deceptive
  • Be wary of conveniently extrapolating historical results/data – Else librarians will be the best investors
  • Investing is about connecting the dots, and finance is just one tiny dot
  • Business models are on steroids in the exponential world (see picture below)
  • Fish where the fish are – Decide where you want to fish (whether you want to fish only the high quality high growth fish)
  • Management is not a moat, but his actions affect the moat
  • Invest in “technology” (not necessarily technology companies), and your circle of competence on it – Ask how will technology scale your company or destroy your company
  • Elephants (e.g. Google, Amazon, Visa, Microsoft, Adobe, Salesforce) can dance – Size can be a big advantage; Competition is for losers – Wait for good market opportunities for these dancing elephants
  • Portfolio composition is key – Hemant’s top 5 positions take up 7%, top 10 positions take up 95%
  • The zoom in, zoom out perspective/approach – E.g. Ask, can this business double in 3 years (24% p.a.) or 5 years (15% p.a.)?
  • You need to have the discipline to be comfortable with LOW ACTIVITY, HIGH LEARNING, SIMPLICITY (read, read, read and do nothing else)
    • Charlie Munger: “Simplicity is a hugely underestimated edge in investing and in life”
  • Q&A: How do you control risks with a concentrated portfolio? (I personally this question, or rather the answer to this question, is very good and useful for me)
    • Hermann: We do not go out and buy 20% position in a company straight (by doing this, you’re saying that you’re GOD and know everything). We buy <5% every time (start small), then as time goes, we know better and better and more about the company (and the industry), then we accumulate more to a bigger position
    • Side point: Mohnish Pabrai has a concentrated portfolio too, and sometimes he got burned
    • Vishal: Think like a parent (borrowing from Phillip Fischer) – only manage the amount that you can
  • Q&A: Valuation method
    • Vishal: Warren Buffett talks about DCF, but Charlie Munger says he has never seen Warren done one – ROFL. I personally use multiples (note: good to know that I am on the same page with Vishal here)
    • Hemant: Even the CEO of the company can’t predict 10 years cash flow, how can you? Remember, our world is dynamic and businesses react
  • Q&A: Timing the market?
    • Hemant: Crash is relative to your understanding of the business – see it as owning a private house. We are stuck in the psychology of portfolio management (note: I can’t really recollect the essence of this point now)
    • Vishal: Quality is in itself a margin of safety – The longer you hold, the better off you are. Conversely, the longer you hold bad businesses, the worse off you are (note: water the flowers, not the weeds)

Hermann Simon – Hidden Champions – Role Model for Leadership in the 21st Century

  • This is Hermann’s second part
  • Best bottling company – Kronos (America) – It was achieved by the fearlessness of the founder – with courage (a trait of hidden champions), not with strategy
  • To internationalise and be a global leader, you need long term perspective, long-term orientation, and have the orientation, stamina and perseverance to run the marathon – Strategy is not a short term mater
  • Look out for CEOs with long tenures (note: ask, what’s the CEO tenure for your company?) – What can a CEO build in only a few years?
    • Average tenure of large corporations: 6 years
    • Average tenure of hidden champions: 20 years
    • Average tenure of records – Hans Riegel (Haribo bears): 67 years
  • Employees: Look for high productivity in hidden champions
    • High productivity indicators: High qualification (uni degree) – Knowledge > Cheap labour in this world of globalisation
    • Employee turnover rate – Hidden champion has 2.7% turnover
  • Hidden champions have deep value chain
    • Total quality control – E.g. Wanzl trolleys
    • Faber Castell – We grow our own wood in our own plantations – Consistency in quality
    • No outsourcing of core competences
    • Uniqueness can only be created internally – If you buy from others, your competitors can do the same too

Intervarsity Stock Research Challenge Presentation Finals – Judge Panel: Hemant Amin; Hermann Simon; Kee Koon Boon; Francois Badelon

5 companies were presented. I only managed to hear the first 3 and had to leave. Overall, I felt that they had done a lot of homework and research, but the companies all have some certain negative points that made them not compelling.

  • Hamamatsu Photonics (TSE: 6965) – World leader in PMTs, with dominant market share. But low margins, low ROE and low growth rates – Maybe problem lies in sales and marketing front (low asset turnover)
  • Time Technoplast Limited (BSE: 532856) – Polymer drums – Be careful that high market share does not necessarily translate to high market leadership (for high-value products)
  • Nihon Kohden (TSE: 6849) – EEG market – electronic medical equipment. Has broad product range for hospitals that are compatible and integrate with each other (including hardware and software). Recurring consumables. But, low historical growth and sub-par gross margins compared to Johnson & Johnson and others (e.g. Medtronic). Suggestion: Look at its Japanese competitors, Sysmex, which has high export %, better margins and high % of consumables

Ending thoughts

That’s all for Value Investing Summit 2018. I am glad that I attended it, with the most valuable part being able to meet the few great investors from the world and learning from them.

VIS 2019 will be held in Kuala Lumpur, Malaysia on 19 and 20 January 2019. I shall consider attending if it has a good line-up of speakers (good value investors, like this time), so I shall wait for more details first.

Book Review – Poor Charlie’s Almanack (Traditional Chinese version)

Poor Charlies Almanack - Authorized Chinese translation
Source: www.poorcharliesalmanack.com

Today, I finally finished this book – Poor Charlie’s Almanack – after 3 months (I also finished another book – Morningstar’s Why moat matters – during this period).

Although this book is not easy to read (partly because of the nature of the content, and partly because I am reading the traditional Chinese version, instead of the English one), and at first I was having second thoughts on how much would I actually get out from this book, I managed to finish it in the end and I would say it is actually very worth it.

Overall, this book allows me to understand Charlie Munger as a person, and (take a peek at) what’s going on inside his mind, better, just like how the other two books (The Essays of Warren Buffett, and Tap Dancing to Work) that I have read helped me to really get into Warren Buffett’s mind and get to know him better and understand his thoughts better, and have some glimpse of his personal life. Charlie is really a very different guy from Warren, is an impressive thinker, a lateral and multi-disciplinary thinker, with diverse interests and powerful mental models ready on hand anytime.

There are many useful points that I learned from this book, but I would just list down the few that are more important to me (to really appreciate the ideas/concepts, you would have to read the book, or at least, articles discussing them in detail):

  • Inverse thinking – Inverse. Always inverse. Thinking in an inverse way will help you to cover more grounds, and at times give you answers that you cant obtain by not thinking inverse.
  • Thinking and mental models – Learning how to think is at least equally important, if not more, than thinking itself. And mental models would help us much in thinking, in terms of organising our thinking well and retaining and linking knowledge better.
  • Checklists – For god’s sake, have checklists and use them as a tool to aid our thinking. Our human brain is just not powerful enough to remember everything and help us to cover all the important points, when we are processing information or making decisions, especially when human are very susceptible to all sorts of cognitive/behavioural biases ingrained in our genes (which hit us without even ourselves being aware of them). Having and using a checklist will help us greatly in life, and save us from a lot of troubles and help us in making less mistakes. Pilots use checklists to help them, so why shouldn’t we. And Charlie Munger has his own checklists too (since then, I have developed my own checklist of around 140 questions as it stands now (which will, of course, evolve over time), that I shall go through and ponder about before I make my investments in any company).
  • Study psychology, and learn and master the various cognitive biases that we are susceptible to – The good thing about Charlie is that he manages to show us how we can use psychology theories and ideas in our near life (instead of just theories that matter in academia or in clinics), and how important they are. The 25 cognitive biases that he discusses in Chapter 11 of the book are so invaluable and useful in our daily lives (not just investing, although they matter a lot and are very useful in investing too), that I shall list them down here (which itself is a checklist that we (or at least I) should use):
    1. Reward and punishment superresponse tendency 奖励和惩罚 超级反应倾向
    2. Liking/loving tendency 喜欢、热爱倾向
    3. Disliking/hating tendency 讨厌、憎恨倾向
    4. Doubt-avoidance tendency 避免怀疑倾向 – (法官)必须让自己习惯带上客观的面具
    5. Inconsistency-avoidance tendency 避免不一致性倾向 – 在做出决定前,先考虑反方意见 , 来避免第一结论偏见 (first conclusion bias); 处在巅峰期的爱因斯坦非常善于摧毁自己的思想 ; 确认偏见(confirmation bias),这是一个贬义词; 要避免不一致性倾向造成的【维持现状偏见】
    6. Curiosity tendency 好奇心倾向
    7. Kantian fairness tendency 康德式公平倾向
    8. Envy/jealousy tendency 艳羡、妒忌倾向 – 许多大型律师事务所担心这种效应会造成混乱,所以给资深合伙人的薪酬一向都差不都…【驱动这个世界的不是贪婪,而是妒忌】
    9. Reciprocation tendency 回馈倾向
    10. Influence-from-mere-association tendency 受简单联想影响的倾向 – 在这种条件反射中,创造出新习惯的反射行为,是由以前得到的奖励直接引起的; 但条件反射还有另外一种,其反射行为单纯是由联想引发的。例如人会根据以前的经验得到这种结论: 同样商品中,价格最高的,品质最好
    11. Simple, pain-avoiding psychological denial 简单的避痛苦的心理否认 – 现实太过痛苦,令人无法承受,所以人会扭曲各种事实,知道它们变得可以承受
    12. Excessive self-regard tendency 自视过高的倾向 – 禀赋效应 (endowment effect) – 人做出决定之后,就会觉得自己的决定很好,甚至比做决定之前还要好; 当你评价自己…和你过去及未来的行为时,要强逼自己更加客观
    13. Overoptimism tendency 过度乐观倾向 – “一个人想要什么,就会相信什么” —得摩斯梯尼
    14. Deprival-superreaction tendency 被剥夺超级反应倾向
    15. Social-proof tendency 社会认同倾向 – 学会忽略别人的错误示范,因为很少有比这个更值得掌握的技能
    16. Contrast-misreaction tendency 对比错误反应倾向 – 如果把青蛙丢到热水里…; 【小小漏洞,能沉大船】这句格言的功效是很大的,因为大脑经常会错失能沉大船的小漏洞
    17. Stress-influence tendency 压力影响倾向
    18. Availability-misweighing tendency 错误衡量易得性倾向 – 避免这的主要对策,通常是按程序办事,包括使用总是很有帮助的检查清单; 另一种对策就是模仿达尔文那种特别重视反面证据的做法; 记住这个伟大的原理: 别因为一样事实或一个点子很容易取得,就以为特别重要
    19. Use-it-or-lost-it tendency 不用就忘倾向 – 如果他减少练习的项目,因而减少了能掌握的技能,就会陷入【铁锤人倾向】的错误。他的学习能力也会下降,因为他需要用来理解新经验的理论框架,已经出现了缺口
    20. Drug-misinfluence tendency 化学物质错误影响倾向
    21. Senescence-misinfluence tendency 衰老—错误影响倾向
    22. Authority-misinfluence tendency 权威—错误影响倾向 – 把鱼竿丢进大海的这个例子证明,跟随权威人物的心理倾向是很强大的,能够使人的脑袋变成浆糊
    23. Twadle tendency 废话倾向 – 小心废话让你不敢正经事
    24. Reason-respecting tendency 重视理由倾向 – 不幸的是,重视理由倾向是如此强大,乃至一个人随便给出毫无意义或不正确的理由,也能使他的命令和要求更容易被遵从
    25. Lollapalooza tendency 鲁拉帕路萨倾向 – 数种心理倾向共同作用造成极端后果
25 Cognitive Biases - The Psychology of Human Misjudgement - Charlie Munger-page-001
Source: http://www.25cognitivebiases.com

Lastly, I really respect and admire Charlie’s dedication, hardworking and lead-a-simple-life attributes, as brought out by William H. Borthwick’s commentaries on Charlie (as quoted below), which I think is the way to go in life.

-威廉。波斯伟克(William H. Borthwick)

P.S. Much appreciation to Daniel from 10% per annum for being kind enough to provide me with this wonderful gift. Thanks Daniel! 🙂

Is There Money in Capilano Honey (ASX: CZZ)? [Part 3]

In the previous post, we talked about the five reasons why I think Capilano is worth looking at. Today, we will discuss what are the risks and how much I think Capilano is worth.

What are the risks?

Now that we have looked at all the positive points about Capilano, let’s consider the risks that Capilano faces:

  • Honey production risks: The amount of honey crop is highly exposed to weather factors that are uncontrollable by the beekeepers. Bad weather conditions – too cold (the honey bees might die, or they need to consume more of their own honey to generate heat during cold winter), little rain or dry conditions (means less amount of nectar around for the pollinators), strong winds/cyclone (flowers and buds would be knocked off plants, resulting in less nectar available), El Nino, and warm winter (this is cited by an analyst report, to which I don’t understand why) – and pest/diseases can seriously jeopardise the honey crop for that year, and affect both the amount of honey stock (an important ingredient to ensure a smooth business operations) and the level of sales and profits.In my opinion, this is the biggest risk that Capilano, and all other honey packers/producers, face. However, I see this risk as affecting more of the short term business performance (which does not concern me with a long-term view that much), and less of the long term. This is because the stronger players with better cash flows and balance sheets would be able to hold out until the honey season turns better, and still perform reasonably well on average in the long run, unless the bad weather is prolonged over many many years. In fact, the big players might actually end up benefiting in some form. For example, in FY2015, where honey crop was really bad, Capilano took advantage of the situation of lack of honey supply in the market to procure honey and push its market share from 50% to 70% in the Australian market. Overall, I would monitor this risk by keeping an eye on the weather developments and the honey stakeholders’ (Capilano’s, its competitors’ and bee associations’) commentaries on honey production and seasons over time;
  • Strong competition and expansion risks in overseas markets: Although Capilano is very strong in the Australian market, it is less so in the other markets, which it intends to expand its activities. For example, China, a strategic market which Capilano chooses to focus on, has already seen the New Zealand players, for example Comvita, developing and solidifying their bases there for some time, setting out distribution channels and partnerships with local firms. Although the overseas markets are still big enough, I would expect strong competition and retaliation/activities by the competitors, and therefore Capilano would have to plan and execute well in order to establish itself well and expand in those markets;
  • Pricing power in Australia: Beekeeping and honey farming are very labour-intensive activities, especially for Manuka honey, and increasing labour costs would exert pressure on Capilano’s profitability. If Capilano is not able to pass on all the costs increase down to the distributor/retailer that sells to the end consumers, Capilano’s margins would suffer. In this regard, Capilano mainly sells to the big supermarkets in Australia (e.g. Coles and Woolworths) that have great bargaining power, so Capilano would face some pressure from this side too. Earlier, we have already seen Capilano’s gross profit margin declining from 46.3% in FY2013 to 41.5% in FY2016, although it started to stabilise and recover to 42.3% in FY2017. I think that this ties in to some extent with the first risk (honey production risk) too, as a bad season would see the beekeepers producing less honey and therefore demanding higher prices for them (which means higher costs to Capilano) to stay in business, which is probably what’s in play to a certain extent on Capilano’s declining GPM in the past few years (despite its switches in product mixes to higher margin products);
  • Other risks, which include stronger competition in the Australian domestic market (which I think the risk is relatively lower given its stronghold), economic slowdown impacting honey demand, in Australia and/or the export markets (honey, especially Manuka honey, is more of a premium product, which people might consume less during economic downturns), acquisition risks (Capilano’s inability to manage and integrate its future acquisitions, including beekeeping operations, well) and overall development of the Australian Manuka honey industry (for e.g. the Kiwis are currently trying to trademark the use of the word “Manuka” to restrict to only honey produced in New Zealand, which of course, the Aussies stood up to fight against, and challenges on the scientific evidence of the superiority of health benefits of Australian and Manuka honey).

How much is Capilano worth?

And finally, the golden question – How much is Capilano worth? Or rather, how much am I comfortable with considering a position in Capilano (as valuation is an art, and there is no single right answer), as a good company can make a bad investment given the wrong price, and a bad company can make a good investment given the right price. Thus, value investing (value vs price).

Given that Capilano’s debt is minimal (considering its past capital structure) and I expect that its maintenance capex should be close to its existing D&A, to keep things simple, I would value Capilano using a multiples approach (which I commonly use), and in particular just a simple P/E ratio, instead of a EV/operating profit ratio.

Before I discuss my valuation, let’s recap some of the important items that would affect the valuation:

  • in terms of growth, the CAGR from FY2013-2017 for honey sales volume, revenue, gross profit and PAT is 12.6%, 16.5%, 13.9% and 31.6% respectively;
  • In terms of return on capital, the ROE in the past two years (FY2016 and FY2017) is around 17%, with the most recent 16.6% of ROE in FY2017 achieved with the lowest equity multiplier (of 155%) compared with the past few years. The incremental return on capital, based on the CAGR from FY2013-2017, is between 17% to 24% (16.5% for RONA, 19.5% for RONE, and 23.6% for RONIC (remember RONE is, in my view slightly depressed, and lower than this RONIC due to the pare-down of debt)) during a period in which it deleveraged its balance sheet (i.e. reducing the equity multiplier) and building up its inventory (which increases asset base, thereby reducing asset turnover), which means that there is room for potential improvements for its incremental returns on capital;
  • in terms of capital allocation, its past dividend payout ratio has been around 35% – 40% since IPO;
  • in terms of balance sheet, as at the end of FY2017, it had a net debt of AUD 7.8m (AUD 9.0m of debt and AUD 1.2m of cash), receivables (AUD 24m) that were greater than its payables (AUD 21m), and an inventory of AUD 44m.

And here’s how I value Capilano:

  • I value Capilano under three scenarios, which is normally what I do, being a conservative scenario, a reasonable scenario, and an optimistic scenario;
  • I start off with Capilano’s latest PAT in FY2017, of AUD 10.3m;
    1. This FY2017 PAT, based on just accounting numbers, was overstated by one-off net gain of AUD 0.74m (gain on sale of beekeepers assets of AUD 2.07m, minus the downward revaluation of honey stock due to low honeyprice of AUD 1.33m);
    2. However, in my opinion, there are a few other factors that suppressed the FY2017 PAT – (i) losses from its two JVs totalling AUD 0.37m (loss of AUD 0.12m and AUD 0.25m for WA and Medibee respectively) due to start-up phase and bad honey season for WA, (ii) temporary issues for overseas sales, with FY2017 overseas sales declining by AUD 5.2m compared to the previous year, mainly due to tough international market (which is recovering now) and exiting of less profitable markets and products (which is more of one-off nature, and that the company can focus instead on sales of its honey stock in more profitable markets), and (iii) the increased spending of marketing costs for new products (Beeotic) of AUD 2.2m, of which either the costs would taper down after a few years (the company currently still wants to push this product a lot), or these marketing activities, if successful, would result in higher revenue which pulls up the PAT; and
    3. Therefore, I choose to make a net uplift to the FY2017 PAT of between 0% to 10% for the three scenarios, to arrive at a sustainable/normalised level of PAT going forward, for me to apply my assumed P/E on. I consider this 10% max net uplift (of around AUD 1m) to be reasonable, given the substantial decline in overseas sales of AUD 5m which could potentially recover (either soon or in one or two years’ time). This would be something that I would monitor in Capilano’s FY2018 H1 and full year report, to see whether my assumption is reasonable and whether any adjustment is needed;
  • For P/E multiple, I use a range of 15x to 18x for my three scenarios, with the mid-point of 16.5x for my reasonable case.
    1. For my conservative scenario, I see it as a worst case scenario where Capilano does not garner any substantial growth in the future, and merely keeping up with inflation or rise in costs. In this case, given Capilano’s strong ability to convert profits into cash flows and low capex needs, I deem a 15x P/E, or 6.7% earnings yield, to be sufficient for my appetite, since it can almost distribute all of the 6.7% earnings yield as dividends, although this scenario is highly unlikely given the short term growth opportunities still available to Capilano;
    2. For my aggressive scenario, I choose a P/E of 18x, which is lower than its CAGR (FY2013-2017) for profits of 31.6% (which is artificially boosted by enlarged equity base) and closer to its CAGR for revenue of 16.5%.Now, let’s try to put the returns on capital into the equation. I would say I would expect Capilano to be able to achieve incremental return on capital of between 19.5% (based on its past RONE) and 23.6% (based on its past RONIC). To be conservative, I would use a lower number of 20% for my valuation. This means that my assumed P/E of 18x is still reasonable as it is lower than the 20% incremental return on capital (which, in most cases, sets the upper limit of the level of earnings growth). This also means that if I want a PEG of 1x, my assumed P/E of 18x would entail the company reinvesting about 90% of its earnings, which is possible, but unlikely.As a side point, if Capilano takes on slightly more leverage (than its current net-debt-to-equity of 13%) and can manage its working capital, especially inventory, better, there are still rooms for improvements for its incremental returns on capital;
    3. For my reasonable scenario, I take the mid-point of the two P/Es above, resulting in an assumed P/E of 16.5x, which I consider quite reasonable. If not for the high exposure risk of honey production to weather conditions, I would be more comfortable with paying a higher P/E.In addition, to achieve a PEG of 1x, or earnings growth rate of 16.5x, this means that the company has to either reinvest 83% of its earnings, which is unlikely (but still possible if there are sufficient reinvestment opportunities) as it is higher than its past reinvestment rates of 60% – 65%, or take on more leverage to boost its equity returns, or achieve an incremental return on capital of 25.5% (assuming 65% reinvestment rate), which is slightly higher than its past RONIC of 23.6%, and is possible.At a reinvestment rate of 65%, the growth in earnings of Capilano would be around 13% (= 20% * 65%). Also, at a P/E of 16.5x and an assumed dividend payout of 35%, this would mean that my dividend yield would be around 2% (= 1 / 0.165 * 0.35).
  • I deduct a net debt of AUD 7.8m from my valuation, to be conservative (although this is theoretically wrong given that I have used P/E, instead of EV/operating earnings, in the first place). I would say this is quite conservative, given that if we look at Capilano’s last working capital position, its receivables is higher than its payables (by a few millions) and it had a closing inventory of AUD 44m, which it had paid in cash for and could use to generate revenues and profits without incurring any cash costs (although acknowledging that it would require a reasonable level to inventory to run its operations, which in FY2014 and FY2015, it was surviving at about half of the current inventory (AUD 14m and AUD 23m respectively, although it has a much larger operations now with more JVs and acquired companies).

Based on these assumptions, I value Capilano (see table below), in today’s terms, at around AUD 180m to AUD 200m, or around AUD 18 to AUD 21 per share, based on my reasonable and optimistic scenarios. In my conservative scenario, which I consider to be a very unlikely worst scenario, Capilano would still be worth around AUD 155m (or AUD 15.50 per share) as a floor.

Capilano - Valuation (Jan 2018)

Going with my reasonable valuation scenario, I would expect my returns from being a partial owner in Capilano, based on a 35% dividend payout, to come from a 2% annual dividend yield and the capital appreciation of Capilano arising from an increase of its operating earnings by around 13% per annum, giving me a total return of approximately 15% per year. This 15% total return is purely a guide, and of course, would be affected by both positive and negative fundamental developments over the years, and the lack of adequacy of my analysis. Hopefully, I would see more positive developments (e.g. a recovery to a higher level of normalised/sustainable earnings, and/or higher RONIC, arising from either better pricing power, better asset turnover, switch to higher-margin products, more efficient operations, good honey seasons, etc).

On the last point, Charlie Munger always likes to say that “all I want to know is where I’m going to die so I’ll never go there”. Putting myself in this shoes and thinking what could kill my investment in Capilano, I see the worst worst case scenario as one where there are:

  1. prolonged bad honey seasons (due to bad weather/diseases/crazy human acts resulting in bad crops and/or death of honey bees);
  2. worsening of Capilano’s performances in its export markets (due to increasingly stronger competition) and probably its local market too (declining gross profit margins, or if competitors decide to scale up or undertake price cuts in good honey seasons);
  3. strong retaliation from competitors in the China market (in which it intends to strategically invest in (which requires capital)), resulting in prolonged price wars;
  4. cock-ups in its two JVs (maybe due to inexperience in bee farming);
  5. sabotage of Capilano’s branding in Australia (we have seen one in 2016, in which Victorian apiarist Simon Mulvany waged a social media campaign against Capilano, accusing it of selling “toxic”, imported honey and of using misleading labelling);
  6. departures of key senior management, including Ben McKee who has been appointed as CEO in 2012 and MD in 2013; and
  7. New Zealand winning its bid to trademark “Manuka” honey, which would create a mess for the worldwide Manuka honey market.

In a simulated quite awful and unfortunate case, with probably up to four of the factors above happening at the same time, I see Capilano’s profits dropping to around AUD 7.5m (about 73% of its FY2017 profits), and at a P/E of 15x, it would be worth around AUD 110m, i.e. ~35% less than my reasonable valuation of AUD 170m. Hopefully, I won’t get to validate the accuracy of such a valuation. In any way, forcing myself to think about these disasters, or where I would die, would make me more alert to which are the most important factors to monitor and stop me from going there (hopefully, in time).


Note: This is not a recommendation to buy or sell. As with all (value) investments, it’s of utmost importance to do your own due diligence. And as Peter Lynch puts it, “know what you own, and know why you own it”.

Disclosure: The author has long position in Capilano as at the time of writing.

P.S. If you want to receive updates on my future posts, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 2]

In an earlier post, I wrote that, in my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Today, we will visit these points in turn.

Why I think Capilano is worth looking at?

1. Good business economics of Capilano’s honey packing business

Capilano’s honey packing business has good business economics, reflected by its strong financials. When it comes to business economics and financials, the most important thing that I look for is strong returns on capital (ROA, ROE and ROIC).

Capilano has excelled in this area, for a packing/distributor business model, with strong ROA (around 9%-11%), ROE (16%-23%) and ROIC (12%-18%), and crazy ROPPE (24%-49%) in FY2014-17, while not employing moderate leverage (net-debt-to-equity of 13%-27%) during the same period.

Capilano - Returns on capitalCapilano - Leverage

To understand why Capilano is able to achieve such strong returns of capital, it is important to understand its business model and the assets that drive its returns and growth first.

In terms of business model, a honey packer, like Capilano, basically just purchase raw honey from the beekeepers families/enterprises at a reasonable price, filter them, pack them into nice containers or glass jars in its high-tech factories with a high level of automation (it has just over 120 employees who oversee the honey packing process in its head office, implying almost AUD 1m of annual revenue per packing employee), give them some branding labels and pushes the products into domestic retail channels (supermarkets/ pharmacies/ health food stores and grocery stores) and overseas markets (either as retail or industrial products).

In simple terms, it means Capilano is almost just a middleman who consolidate the honey and sell them. Therefore, Capilano’s most important asset is not its fixed assets (to be more specific, its PPE), but its inventory, i.e. raw honey stock.

A quick look at its balance sheet explain this. As at the end of FY2017, its total assets of AUD 96m is mainly made up of inventories (46% or AUD 44m), followed by receivables (25% or AUD 24m) and PPE (22% or AUD 21m).

Capilano - Assets

This makes logical sense, because to pack and sell honey to increase sales, you need honey in the first place. Since Capilano mainly sources its honey from others, it doesn’t require as much PPE (or biological assets, aka bees) to generate those honey. Therefore, inventory, and the ability to purchase and stock up sufficient inventory, is crucial for Capilano’s business. Fortunately, Capilano is good in this – it has a very strong access to honey supply, which is one of the factors I think Capilano is worth looking at, which I will touch on shortly.

Now that we understand Capilano’s business model and asset components, let’s go back to revisit its returns on capital and understand its components. To keep things simple and focused, let’s focus on just ROE.

Capilano - Returns on capital (short)As seen in the table above, Capilano’s ROE started at 16% in FY2014, went up to 23% in FY2015, before coming down to 17% in FY2017. Although the ROE in FY2017 sort of went back to its original level three years ago, its individual Du Pont components have changed quite some extent:

  • Equity multiplier has come down from 174% to 155%, which to me is a good thing, since the current returns are achieved on a less leveraged capital base (which also mean that future ROE can increase if the company can take on and manage more liabilities carefully – a large part of its liabilities is mainly payables (61%), followed by debt (26%));
  • Asset turnover has come down from 173% to 138%, which is not a positive thing to me, but the comforting part is it has started to stabilise and hopefully it would go up in the future. My take on the declining asset turnover is probably that the company has been acquiring many different companies/assets (which I will touch on later) which disrupts/changes the mix of the asset turnover, coupled with quite bad honey production seasons in the past few years (which I will also touch on later);
  • NPM has gone up by 45%, from 5.4% of revenue to 7.8% of revenue, which is a very positive thing. This indicates improving operating efficiency (even on the back of declining GPM) and Capilano’s ability to compete with competitors successful and still increases its profitability (by spending much marketing expenses in terms of % of revenue), which I attribute partly to Capilano’s strong brand (which is one of its moats, which I will touch on later).

The good part is that it is not just its existing returns on capital that are strong. Its incremental returns on capital are solid too, at north of 16% up to 24% depending on which returns on capital we look at (see table below – focus on the CAGR and not the yearly incremental returns which are quite volatile). One point to note is that Capilano’s RONE is lower than its RONIC, and is in my view slightly depressed, mainly due to the use of its retained earnings to pare down long-term debt during that period (resulting in a greater increase in the equity base than the invested capital base).

Capilano - Incremental returns on capital

These strong RONIC (and RONE) would ensure that our shareholder money is well spent and generate good returns when the company grows (which I call good growth – not all growth are good and value-accretive for shareholders).

These are all positive indicators, but remember, as we have just discussed, no matter how good the returns on capital are, the most important capital/asset that the company needs to grow is not the fixed assets which the company can build easily, but a strong and sustainable (and even better, increasing) supply of good raw honey at reasonable prices, which I will touch on next.

At this point of time, some of you might be also thinking if the ROIC and RONIC are so good, why aren’t other players coming in and taking a piece of the cake? The answer is it is difficult, as Capilano is protected partly by the difficult nature of beekeeping (it is much more difficult compared to other primary agricultural industries) and partly by its strong moats (intangible assets and efficient scale), which I will touch on shortly.

2. Strong access to honey supply

Capilano has very strong access to one of the most important ingredient to be successful in this honey packing business, i.e. good honey supply (at reasonable prices).

The first question to answer is what’s so difficult about procuring honey supplies, especially the Manuka honeys? The answer is that rearing bees and farming honey (especially Manuka honey, which requires beekeepers ensuring that the bees only pollinate from the Manuka plants) are not easy. I think OTC Adventures explains this very well, so I will just quote him.

I think Capilano is somewhat sheltered from competition by barriers to entry that honey suppliers face. First, adding honey-making capacity is a lot more complicated than, say, increasing corn or wheat acreage. A field can be planted with whatever crop offers the best prospective return at the moment, but increasing honey output requires building infrastructure that can only be used to produce honey. For bee-keepers to justify adding capacity, they must be confident that higher prices will last. Essentially, the honey price cycle moves much more slowly than those of easier to produce agricultural products.

Therefore, due to the difficult nature of beekeeping business, the supply of raw honey in Australia is limited and if we talk about Manuka honey, there is a strong under-supply due to strong and growing demand for this health product, especially increasingly from emerging markets (think China).

Based on Australian Honey Bee Industry Council (AHBIC), as of August 2017, there were around 21k beekeepers and 647k bee hives in the whole of Australia, with 85% of the total bee hives owned by 8% of the beekeepers (the larger producers with more 50 hives or more), and most of the bee hives located in New South Wales, followed by Queensland, Victoria, SA and WA (Capilano sources from all these five territories/states).

Capilano - No of beekeepers

So how does Capilano manage to get this strong access to honey supply in Australia? Capilano got a strong and lucky hand, due to its origin as a bee-keeper cooperative in 1953, which allows it to develop strong and lasting relationships with many beekeepers for many decades (it currently sources from more than 600 beekeepers, on top of its wholly-owned beekeeping enterprises). Furthermore, in the past, the bee-keepers are required to own a certain number of shares in Capilano for each bee hive in operation (this has been discontinued), which gave them incentive to supply their honey to Capilano but not others.

Besides this natural advantage, Capilano has also been making it a priority to take good care of the beekeepers and paying them good prices for their raw honey, so that the bee-keepers will choose to sell their honey to Capilano and have confidence that Capilano would continue to procure from them at good prices even in difficult market conditions, as it knows that it needs these beekeepers to stay in business so that it would continue to get sufficient honey supply.

Capilano is able to do so (i.e. pay the bee-keepers good prices) as it is able to pass on some of the price increase to the end consumers due to its strong branding, with a >70% market share (which is one of its moats, falling under the intangibles category) and it has lower fixed costs per product unit due to its large business size.

Besides that, Capilano also spent a great deal of efforts to help the beekeepers. For example, Capilano undertook two initiatives in FY2015 – producing a Pest Management Pack for Varroa, a potentially serious pest of bees if or when it arrives in Australia, and a Manuka Information Pack, for the beekeepers.

The outcome of Capilano’s efforts in developing good relationships with a large network of bee-keepers (currently more than 600 bee-keepers) is the development of a strong moat, i.e. intangibles, relating to its strong and long-lasting relationship with bee-keepers, that allows it to gain access to sustainable supply of honey and protect its high returns on capital.

This limited supply market of honey also creates another moat (efficient scale) for Capilano, as the market is not large enough, from the supply side, to support more new entrants (which have to incur large capital costs that can be spread over less scale at the beginning), thus setting up high barriers of entry to new entrants.

Despite having a strong supply network of bee-keepers to source its honey from, getting sufficient honey supply (to ensure an efficient packing process and sufficient stock for sales) is still a difficult feat for Capilano, as the honey production season is highly affected by weather conditions. A bad season, like very cold weather or little rain (the plants grow less and flowers bloom less), can result in bad honey crops.

These bad honey seasons happened in the past few years, in FY2014 and FY2015, with some improvements seen in FY2016 and FY2017, as seen in the chart below (sourced from Capilano’s FY2017 AGM presentation).

Capilano - Honey supply security

To further ensure supply security of honey, Capilano has recently gone upstream into the bee-keeping business, which to me is a positive development since honey supply is such crucial in this business. In particular, Capilano invested in three entities (Kirksbee Honey in July 2015, Medibee Apiaries in July 2016, and Western Honey Supplies, also in July 2016):

  • Kirksbee Honey: On 30 July 2015, Capilano acquired 100% of the share capital in Kirksbees Honey Pty Ltd, a beekeeping enterprise, for AUD 5.3m (made up of AUD 3.2m of plant and equipment + AUD 0.13m of biological assets + AUD 2m of intangibles). Capilano also purchased the land and buildings associated with the business for AUD 0.75m, therefore paying a total of AUD 6m for the deal.This beekeeping enterprise is one of Australia’s largest active Manuka honey producers, which is located in Evans Head, New South Wales. The acquisition included the assets required to operate the business including bee hives, apiary sites, vehicles, related property, sheds and honey extraction equipment. In FY 2015, the beekeeping enterprise produced over AUD 2m worth of bee products, which implied that Capilano paid a P/S of around 3.0x for the deal (= AUD 6m/ AUD 2m). According to the company, Kirskbee was attractive to Capilano as a consequence of:
    – the notable Manuka floral apiary sites the business has access to;
    – the provision of future assurances in its supply chain with regard to high value Manuka honey supply;
    – the potential to grow production over time; and
    – the ability to train and foster new industry entrants to the beekeeping industry.A news article in March 2016 states that “[l]ast year Capilano bought the country’s largest Manuka beekeeping operation at Evans Heads in NSW for $6 million, in the hope it would cash in on the China-Australia free-trade agreement. Health-conscious Chinese are interested in the purported medicinal benefits of Manuka honey, which is produced by bees that feed on the flowers of the scrub-type tree species of the same name, native to Australia and New Zealand, well known for its antibacterial qualities. With China’s demand for Manuka honey increasing, Capilano Honey is ready to reap the FTA’s rewards, aiming to get ahead of its New Zealand competitors. Under the agreement between China and Australia, the 15 per cent tariff on natural honey and the up to 25 per cent tariff on honey-related products will be removed for Australian honey exports to China”.

    Given that the acquisition price was around AUD 6m (although the most part was for PPE and intangibles), which was about 77% of Capilano’s profits of AUD 7.8m in FY2015, and that Kirksbee seems to be one of the then largest Manuka operation in Australia, I would expect Capilano’s honey supplies to grow significantly after its acquisition. However, Capilano’s domestic honey receival in FY 2016 was only 11%, or 1,235 tonnes greater than the previous year (see table below), although I have limited information on these data and there may be other factors affecting the honey crop that year too. Overall, with Kirskbee, Capilano should have stronger and better access to Manuka honey supplies, although all these should have been reflected in the financials in the past two years (FY2016 and FY2017).
    Capilano - Honey stock

  • Medibee Apiaries: In July 2016, Capilano and New Zealand based Manuka specialist Comvita (CVT.NZ) formed a 50:50 JV, called Medibee Apiaries, to secure greater manuka honey volumes in Australia and to develop medical and natural health products. On 29 July 2016, Capilano sold its manuka beekeeping assets into the JV for AUD 9.225m. AUD 2m of these proceeds were redeployed as a loan to the JV to fund its growth.The FY2016 annual report describes this as “[i]n a significant departure from our previous dependence on the purchase of honey and bee products from other beekeeping enterprises, Capilano has begun to vertically integrate by investing in selected beekeeping enterprises, primarily in the production of high value Leptospermum honey used in our premium range of medical and natural health products. These operations will be managed by Medibee, a 50/50 Joint Venture with Comvita who are a New Zealand company that have extensive production and marketing expertise from their own operations in New Zealand and who currently operate in Australia in a sales and marketing capacity. We expect this new joint venture to assist our business by increasing the security of supply and by expanding our involvement in the international value chain for Leptospermum or Manuka honeys”.In FY2017 H1, Medibee has been focusing on growing the number of bee hives organically first, before focusing on the honey production. As stated in the FY2017 H1 report, “[t]his financial year we started two primary production joint-ventures, one a Manuka focussed operation in northern New South Wales and the other based in highly productive regions of Western Australia. In both cases we have organically grown beehive numbers to minimise disease risk, which requires splitting existing hives and initially reducing honey production. This work has increased hive numbers that will improve our production performance in coming seasons”.

    And in FY2017 overall, Medibee is still in the midst of developing the beekeepers’ skills and acquiring additional flora resources, and at the same time, increasing hive numbers to fully utilise current floral resources. In FY2017, after a full year of operations, Medibee incurred a net loss of AUD 246k (with a revenue of AUD 1.58m and total expenses of AUD 1.83m). Even though Medibee is still loss-making and is still building up its foundation, the honey production has already been quite promising. In particular, the management states that “[o]ur two primary production joint ventures have now completed a full year of operations and while the focus has been on expanding the hive numbers to allow them to fully utilize the resources they have access to, they have also produced a reasonable crop of honey. Most pleasingly, they have been able to match and in some cases exceed the production of other similar businesses that operate in the same geographic regions in a below average season” and “[d]espite a low production season this year that impacted profitability we remain confident of the future positive earnings potential of this venture, in addition to the benefits of improved supply security”.

    Overall, I am very positive about this development for a few reasons.

    First, this joint venture and move to upstream activities would allow Capilano to have more control and management over its honey supply base, on top of providing it with more honey supply to fulfil the market demand (over the years, Capilano has been importing honey from overseas (especially Argentina), which it blends with its Australian honey and sells under its Allowrie brand, to fulfil market demand. To get an idea of how big this issue is, in FY2015, Capilano bought 9,265 tonnes of domestic honey and 6,000 tonnes of imported honey, although I suspect the amount of imports has decreased since as the domestic honey production improves).

    Second, this is a joint venture with Comvita, the world and New Zealand largest Manuka player, with its more than double Capilano’s size in terms of market capitalisation, and has extensive experiences and skills in producing Manuka honey in New Zealand, and therefore Capilano would be able to leverage off Comvita’s experiences while Comvita benefits from Capilano’s Australian base. I suspect that Comvita wanted to come into Australia for honey production,because of the more difficult and volatile operating environment for honey production in New Zealand, compared to Australia (Watson & Son New Zealand, a popular Manuka honey brand, was put into liquidation in September 2016, due to the worst honey season in 35 years which affected Watson & Son’s cash flows).

    Third, this joint venture is already showing some results. In FY2017, Medibee was the single largest supplier of Manuka honey to Capilano, providing it with AUD 1.2m worth of honey, and it has around 3,600 hives as at October 2017 (according to Comvita’s data; Comvita had around 30,000 bee hives in New Zealand in June 2016). As Capilano gets from Medibee more and more Manuka honey, which commands higher margins, to sell them, I expect that Capilano’s gross margins would go up, in line with its strategic focus to switch to more premium high-margin products.

    Last, an analyst report states that “[i]n addition to the JV earnings, CZZ will also earn revenue from packing and supplying Comvita’s products in Australia”. This arrangement seems positive to me, but I have been unable to get more information on this.

  • Western Honey Supplies: Unlike Medibee, this is a joint venture that focuses on the supply of normal honey (and not Manuka honey). On 7 July 2016, Capilano Honey Limited acquired 50% of the share capital in Western Honey Supplies Pty Ltd for a cash consideration of AUD 2.5 million and established a 50/50 Joint Venture with Western Australia honey producer, Spurge Apiaries, to provide geographic diversity, secure supply and grow production. On 26 August 2016, Capilano Honey Limited sold 77 apiary site licenses to Western Honey Supplies Pty Ltd for AUD 363,116.Based on the FY2016 and FY2017 reports, “Capilano has entered a joint venture with an existing contracted honey supplier in Western Australia to assist the expansion of this already large honey producing enterprise. While these enterprises will help to secure Capilano’s supply base they will also give us a platform to train and assist potential new entrants into honey production either as employees or ultimately in their own right. We will endeavour to use them to assist rather than compete with our existing contracted supplier base who are mostly very efficient family based businesses” and “Western Honey Supplies is a Joint Venture with a large existing supplier based in Western Australia (WA). Its main focus is increasing supply security of premium floral and organic honey from WA. This venture has also made strategic acquisitions to increase floral resources and invested in increasing hive numbers. One of WA’s worst production seasons last year also impacted profitability, but enabled efforts to focus on hive number expansion and beekeeper skills development for the future betterment of the business. Western Honey Supplies was the single largest supplier of WA honey to Capilano this financial year and is one of our top five suppliers nationally”.
    Although Western Honey Supplies also made a net loss of AUD 122k (with a revenue of AUD 1.0m and total expenses of AUD 1.1m) in FY2017, I see it as a long-term strategic investment which is incurring start-up phase costs, where it was increasing the number of bee hives and floral resources. As with Medibee, the management said that “We are confident of the future positive earnings potential of these ventures, in addition to the benefits of improved supply security. A low production season over FY17 impacted profitability in both ventures”. Overall, I see this development as positive and crucial for Capilano’s strategic plan for its procurement of honey supplies in the future.

At the same time, besides focusing on the bees for its future sustainable access to honey supplies, Capilano has also been focusing on the long-run development of beekeepers and the apicultural industry. It instigated a “Keeping Futures Program” to provide the next generation of beekeepers with career paths and training, whilst protecting the world’s healthiest population of honey bees found in Australia. In addition, in collaboration with Medibee Apiaries, it has also implemented a traineeship program that has just employed three new enthusiastic beekeepers that will be educated with a sponsored practical and theory component. These activities show that the company and management are willing to take the long-view, to ensure its long-term success, instead of just focusing on its short term performance, which to me is good because it is in line with my investing style of holding a good company for long (of course, assuming it is still good over time).

Now that we have looked at Capilano’s strong and sustainable access to honey supplies, the next question I would like to answer is is now a good time to look at Capilano? Which business development cycle is it in now?

3. Reaping rewards after a period of investing and consolidation phases

Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history.

The table below, on Capilano’s generation and use of cash over the past few years, explains everything.

Capilano - Past use of cash

In FY2014 to FY2017:

  • Capilano generated profits of AUD 32m and operating cash flows before WC changes of AUD 39m;
  • Capilano spent those AUD 39m of OCF before WC and its existing cash balances on building up its WC (AUD 25m, of which AUD 26m relates to build-up of inventory) and investments in capex (AUD 19m for investments in PPE and associates, and acquisitions); and
  • in terms of financing, Capilano got AUD 17m of cash from share issuances (mainly in FY2016 which it said would be used to retire debt, fund acquisitions, new product development and capital equipment), which it used to retire AUD 7m of debt and pay out AUD 10m of dividends.

This means that, despite the enlarged share capital base (but with a more solid balance sheet due to retirement of debt), Capilano basically reinvested all of its operating cash flows (before WC of AUD 39m) in the past four years in either:

  • building up its honey stock, by a whopping AUD 26m to AUD 44m (an amount >4x its PAT in FY2017 of AUD 10m); or
  • investing in PPE (AUD 14m, mainly for upgrade of its second major packing line in FY2014; and production efficiency upgrades, installation of several new packing lines at its Maryborough site, replacement of temporary hotrooms at Richlands (QLD) and acquisitions of more beekeeping assets in FY2016) and entities (AUD 2.7m for acquisition of Kirksbee’s intangibles in FY2016, and AUD 2.5m for Western Honey in FY2017).

In my view, Capilano’s investing and consolidating activities have been established, and these investments are now ready to put Capilano in a good position to secure more honey supplies and grow its operations, sales and margins over the next few years.

First, with a better honey stock of almost 6k tonnes (and more beekeeping assets and enterprises) now, Capilano can run its operations in a smoother and more efficient manner, compared to few years ago in FY2015 where it had only a honey stock of 2.9k tonnes and it had to pack about 1k tonne of honey per month, which would put a strain on operation and distribution management. With a stronger honey stock now, Capilano is also in a better position to plan for and fulfil more sales both overseas and domestic, therefore improving its chances of increasing sales in the future.

Second, Capilano’s investments in the two JVs in FY2017, Medibee and Western Honey, are ready to bear fruit. Both the JVs made losses of AUD 0.25m and AUD 0.12m respectively, due to their investments in the foundations (securing more floral resources, developing beekeepers’ skills, and building more bee hives, instead of focusing on the actual honey production) and a moderate/bad honey season (especially in WA). The management is positive over the future positive earnings potential of these two JVs and expect production performance to improve soon. Given that these two JVs form large portions of Capilano’s existing honey supply, where they are the largest Manuka honey and WA honey individual supplier respectively, when their honey production improves over the long run, I expect them to contribute positively to both Capilano’s honey supply (which can improve its sales) and earnings (through switches in product mix to higher-margin Manuka honey, and more operating efficiency and operating leverage).

Third, with the stronger (and more normal) level of honey stock now, after the worst honey seasons few years ago, an improving honey season would fare well for Capilano’s business. The company is expecting a better season in FY2018. In the FY2017 annual report released on 7 August 2017, TR Morgan (the chairman) said that “[h]oney production has improved this season and with reasonable prospects for next season in most regions we hope to be able to take advantage of this additional honey to further expand sales into profitable overseas opportunities”, and Ben Mckee (the MD) said that “[t]he improved rain patterns in key production areas has led to a notable increase in honey supply in recent months, with our largest ever winter honey supply for many, many, years. Weather permitting, we remain very optimistic of the potential for increased honey production in the coming season from spring 2017”. During the AGM presentation on 17 November 2017, the company reiterated that “FY18 crop prospects are looking promising, with an above average crop forecast”. Therefore, it seems that Capilano is on track to secure a decent, if not a good, supply of honey and performance in FY2018.

Last, Capilano has been using its cash from operations to significantly “repair” and de-leverage its balance sheet, paring down its debt-to-equity (and its net-debt-to-equity) from 61% (and 60%) in FY2013 to 14% (and 13%) in FY2017, with strong interest cover too. This puts Capilano in a strong balance sheet and cash flows position (recall the big New Zealand player, Watson & Son that was put into liquidation in 2016, due to cash flow problems arising from bad honey seasons) to take up any future opportunities for expansions or acquisitions. I guess the management has learned from their lessons of not using excessive leverage, which dragged down the company’s profits and cash flows, during the years leading to FY2010 (with a debt-to-equity and net-debt-to-equity of 101% and 43%), and is now more careful of the capital management of the company, and has finally de-leveraged to a comfortable level after many years of efforts.

Capilano - Leverage

4. Strong sustainable cash flows to fund dividends and growth

Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).

As Capilano is not a capital-intensive business (in terms of PPE), its earnings power has been strong. As seen in the table below, its OCF before WC changes has been consistently above 100% of PAT, except for FY2017 at 90% (but that was depressed due to some one-off non-cash gain).

Capilano - Cash flows

Capilano’s WC changes have exerted a large drag on its free cash flow generation capability, but that’s due to the need and intention to rebuild its inventory base over the past few years, which I think would not happen at the same magnitude again going into the future. Its latest capex on PPE in FY2017 was lower than previous years (which saw more capex due to the investments in new packing lines and replacement of temporary hotrooms due to the fire at Richlands in 2012), at about AUD 1.4m (as it pursued a disciplined approach to capital investment and capital was deployed for select production efficiency upgrades and expense improvement projects), slightly lower than its D&A of AUD 1.6m, and I expect that its maintenance (plus a bit of growth) capex going forward would not deviate much from its D&A, and would in the region of AUD 1.5m – AUD 2m.

In my opinion, Capilano is able to achieve such strong and steady (profits and) cash flows due to its strong branding and strong base in Australia, where it commands an impressive 70% (and still growing) market share since FY2015, which it increased from slightly less than 50% in FY2014 (by smartly exploiting the lack of supply to its advantage in FY2015 – a whopping 20% market share jump (based on the information that I am aware of)). A large market share conveys Capilano with much benefits – for e.g. with its products occupying more shelf spaces in more supermarkets in more locations, consumers become more and more exposed to and familiar with its brand over time, and is more likely to choose its products on average. Bigger size also means that Capilano can spread its marketing costs over a much larger base, thus having an edge on profitability and pricing power than its competitors. As at FY2017, Capilano also commands about 30% of repeat customers. In addition, Capilano’s new products (for e.g. Beeotic) would also help it to gain more customers in the future, by either attracting new consumers to the honey category (who would be exposed to its existing honey products too), or by attracting existing honey consumers to switch to its brand in trying out its new products.

This stronghold of cash flows in its domestic base is an important point which makes me prefer to look at Capilano more than its New Zealand competitors, as the strong market share leadership really entrenches Capilano’s ability to continue to extract significant amounts of cash flows, with less uncertainty, from its domestic business, which made up of a large chunk (83% in terms of revenue) of its business.

With these strong sustainable cash flows from its domestic business, Capilano would be able to return some value to shareholders by distributing some of them as dividends (the company doesn’t appear to have any fixed dividend policy, but its dividend payout has been stable at around 35%-40% since IPO), and use the remaining funds to reinvest in its business at high returns on capital (as we have previously examined, its CAGR from FY2013-17 of return on incremental capital ranges between 17%-24%, depending on which asset base you consider).

The near-term growth areas/opportunities that Capilano can/is reinvesting its capital in includes:

  • Expansion of the sales of its new products, in particular its new innovative healthy prebiotic honey, Beeotic®, which was launched in late September 2016 in Australia (and launched in Singapore in around November 2017 with free sampling events). Beeotic is the world’s first clinically-tested prebiotic honey, and is 100% Australian honey. This product has been developed on the back of extensive industry research over several years, has been listed with the Therapeutic Goods Administration (TGA) and is exclusive to Capilano. It sells for more than double the price of normal honey. In Singapore, its Beeotic honey (500gm) is selling for SGD 22, i.e. about 265% of the price of its normal honey (SGD 8.25) (see pictures below, taken on 6 January 2018).

    The company states that “[m]ore advertising, product development and strategic marketing is planned to support the product and further educate consumers. Beeotic has brought new honey consumers to the honey category and the product is awaiting regulatory approvals in a range of key export markets, noting we are currently selling into China as a priority establishment market”.

    According to an analyst report, “[p]ositively, Beeotic is attracting new, health-conscious consumers, upgrading CZZ’s existing customers and growing the overall honey category. The product has good distribution in Australia”. Another article states that “[i]mportantly, for the first time in many years, CZZ will actively market this new product”. Indeed, Capilano’s spent a significant AUD 2.2m in FY2017 on the marketing of new products (which should largely be attributable to the Beeotic product), which took up about 14% of its total marketing and promotion expenses (of AUD 15.3m in FY2017). If this product takes off well and gets sold in more markets after the relevant regulatory approvals, it should contribute much to Capilano’s revenues and, more importantly, its earnings given the better margins for the Beeotic product;

  • Expansion of overseas market, focusing on high returns market, especially China. China is a lucrative market for natural honey, especially Manuka honey, given its people’s strong demand for natural and overseas high quality food. According to an article by Alizila (the news hub for Alibaba Group that runs TaoaBao and TMall), “[the majority of Tmall’s customers’] spending habits are reflected in types of products that sell on Tmall Global. The platform’s best-sellers include Victoria’s Secret lingerie, Swisse cranberry capsule (health supplements) from Australia, Manuka honey from New Zealand, skincare products sold by Japan’s Matsumoto Kiyoshi, milk sold by German supermarket chain Metro, olive oil sold by British retailer Sainsbury’s and other name-brand items from abroad”. The China market has been buying a lot of Manuka honey from New Zealand, with Comvita’s honey being a very popular brand in the China market.Although Capilano is not as strong as its New Zealand competitors in the China market, with wide distributions and local partners there, Capilano has expressed much intention in proactively investing in this market (see its FY2017 AGM slide below). Historical revenue data on its exports to China has been limited, but what I can gather indicates that Capilano’s sales to the China market has grown by 57% and 39% in FY2016 and FY2017 respectively, albeit from a smaller revenue base.According to an analyst report in August 2017, “[c]entral to the company’s target of growing its premium and higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar) is increasing export sales, with China identified as a key market. CZZ has tripled its export department to achieve its export led growth strategy. The company currently sells into China through pharmacy and grocery channels. It is in about 2,000 Chinese pharmacies and is hoping to increase this to 3,000 in the short term. The company is looking to increase its brand awareness in China by training staff and increasing online marketing. CZZ launched its China TMall e-commerce site earlier this year. CZZ will also look to expand into additional export markets in the future”.
    Capilano - China expansion
    In addition to the China market, there are also bright sides to the other export markets in the near future. In FY2017, Capilano’s total revenue decreased slightly by 0.4% from AUD 134m to AUD 133m, mainly due to a significant decrease in export revenue of AUD 5.2m (from AUD 27.7m to AUD 22.5m). This was because of lower international honey prices and greater competition, mostly notably in lower margin industrial segments, and that its export sales that year were impacted by a now resolved trade restriction to one of our biggest markets in the Middle East.

    In relation to this underperformance, the company said that the “[i]nternational bulk honey markets have been relatively stable following the softening in price we saw last year, with competition remaining strong in most overseas markets. Capilano has reluctantly ceased supply to some international industrial segments due to unsustainable prices and insufficient margin”. In November 2017, during the AGM, the company stated that “[i]nternational prices for Manuka have been rising and the market is changing”, implying a potentially brighter FY2018 for export sales.

  • Ramp up of the two joint ventures. As discussed earlier, Capilano is still investing in its two joint ventures (Medibee and Western Honey), which it started at the beginning of FY2017. As these two joint ventures stabilise and increase honey production, they should drive Capilano’s sales and profits.
  • Driving of more sales volume. As and when the honey production season turns better, Capilano would get to procure more raw honey (both normal and Manuka), which it can spend efforts on driving the packing, sales and distribution of more honey sales.

5. Strong and growing moats, with runways for growth opportunities

Last but probably most importantly, I see Capilano as being able to grow and deepen its moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Ultimately, high returns on capital would eventually attract returns-seeking capitalists, which eventually push down the returns on capital to moderate rates, which is why it’s of utmost importance for a wonderful company to have strong moats to protect itself against any impending competition. I see Capilano as having two strong moats that help reduce the attacks by its enemies, i.e. intangible assets (strong branding and relationship with a network of beekeeper suppliers) and efficient scale, which we have discussed earlier.

What I think is even more powerful is that I see Capilano as having a positive moat trend (a concept devised and used by Morningstar) too. This means that I see Capilano as being able to deepen its moat more and more over time. The reasoning goes like this:

  • Capilano has strong moats now and currently has the largest market share and size in Australia;
  • This allows Capilano to spread its fixed costs (packing machines and factories overheads, distribution costs, and marketing costs) more, thus commanding lower fixed costs per unit, and has stronger balance sheets;
  • This in turn allows Capilano to achieve better profitability than the competitors, and thus more able to pay more competitive prices, if necessary (especially during bad times), to the beekeepers in Australia for their raw honey, and continue to source continuously from them even during tough times;
  • This begets trust and confidence from the beekeeper suppliers, resulting in stronger relationships between Capilano and the beekeepers;
  • This results in Capilano having better and more sustainable access to more honey supplies, which in turn allows it to achieve higher sales and grow bigger in size; and
  • The whole cycle continues again and again, strengthening Capilano’s moats over time, and at the same time setting up stronger barriers for impending competition.

In addition, I also see Capilano as having sufficient runways for it to reinvest its capital for the long term, in areas like:

  • new product development (which the company has listed as one of the few key strategic priorities for its 2020 strategy), ideally on products that incorporate more value-add (and thus higher margins) than raw honey, for example the recent Beeotic product;
  • expansion of honey production, either through increasing activities in its two joint ventures, or new ventures including M&A activities;
  • additional marketing and sales activities, especially for higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar), enhancing its branding more and making more advances in the various distribution channels (supermarkets, pharmacies, groceries and health food channels);
  • expansion into overseas markets, especially Asian markets where Manuka demand would still exceed supply for some time

Warren Buffett says in his 1992 letter that “[l]eaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”. Hopefully, Capilano would have sufficiently long enough period and opportunities for it to reinvest its capital at high returns (supported by its moats and pricing power), and produce considerable value for its shareholders.

Now that we have looked at all the positive things about Capilano, we shall discuss the risks that Capilano faces in my next post, so stay tuned.

Disclosure: The author has long position in Capilano as at the time of writing.

P.S. If you want to receive updates on my future post, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 1]

Executive summary

Capilano Honey logo

Capilano Honey (ASX: CZZ) is Australia’s largest honey packer that sells honey products (both normal honey and premium Manuka honey) in both Australia and overseas markets, with a market capitalisation (in January 2018) of around AUD 175m. It was listed on ASX in July 2012, and thereafter from FY2013 (ending June 2013) to FY2017, it has almost doubled its revenue (AUD 73m to AUD 133m), tripled its net profits (AUD 3.4m to AUD 10.3m), while increasing its honey sales volume by more than 40% (from 9,800 tonnes in FY2013 to 14,000 tonnes in FY2016) and expanding its number of outstanding shares by 11% only. In my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

This will be a long post and therefore I am splitting it into three parts:

  1. Introduction to Capilano Honey;
  2. Why I think Capilano is worth looking at; and
  3. What are the risks, and how much is Capilano worth?

Introduction to Capilano Honey

Capilano Honey was founded in 1953 as the co-operative Honey Corporation of Australia to help protect the interests of beekeepers, by purchasing honey from them and helping them to be price-setters instead of price-takers.

It was initially listed on the Bendigo Stock Exchange in 2004 following legislative changes that deemed Capilano ineligible to operate an internal market for trading shares between beekeepers in the co-operative (the beekeepers have to hold a certain number of shares per hive owned). It was subsequently forced to move to ASX in 2012, because BSX was changing the nature of its exchange to make it a clean energy exchange.

Capilano - Product range

It currently sells mainly (about 95%) honey products (both normal honey and premium Manuka honey (Manuka honey is produced from the Leptospermum species of plants that are native to Australia and New Zealand, and this honey is recognised for its scarcity and unique clinically proven antibacterial qualities and consequential premium price) and some (about 5%) non-honey products (apple cider vinegar and beeswax). It is a very popular brand in Australia with a market share of more than 70%. The Australian market contributes to 83% of its revenue in FY2016, with the remainder coming from more than 30 countries (as of 2016) in Asia, Middle East, America, Europe and other countries.

The video below provides a good introduction into Capilano Honey and the beekeeping and honey packing businesses.

In terms of operations:

  • its head office and main packing plant are in Brisbane, with two other packing plants in Perth and Maryborough;
  • it has just over 120 employees who oversee the honey packing process in its head office;
  • it carries a few honey brands that target different market segments, i.e. Capilano Honey, Allowrie, Barnes Natural Brand, Wescobee and Beevital Manuka honey;
  • it has a honey market share of >70% in Australia, and Manuka honey market share of around 11% worldwide;
  • it sources its honey mainly from more than 600 beekeepers in Australia, and has also gone upstream into its beekeeping businesses since mid-2015. In terms of Capilano’s honey suppliers, they vary greatly in size, including “hobbyist/amateur” beekeepers with 100 hives, medium producers with 600-700 hives, and large producers with more than 5,000 hives, where the big commercial guys would produce 100 tonnes of honey a season for Capilano;
  • it purchases, subject to the amount of available supply, around 10k-11k tonnes of honey from beekeepers annually (in FY2016 and FY2017), and imports honey from other countries (e.g. Argentina) to make up the shortfall;
  • it packs more than 1,200 tonnes of honey per month (with a total of 15k tonnes packed in FY2017);
  • it sold about 14k tonnes of honey in FY2016 (no data on FY2017); and
  • it had a honey stock of around 6k tonnes at the end of FY2017 (Jun 2017).

As seen in the figure below, Capilano sources its honey from various areas in Australia, with some of them being more premium honey.

Capilano - Honey sourcing regions

Capilano’s competitors include other honey brands in Australia, New Zealand and other countries. In terms of Manuka honey, which is produced only in Australia and New Zealand, Capilano faces competition mainly from the popular New Zealand brands, which include Comvita, Watson & Son, Nature’s Way, Pure Honey New Zealand, Ora Honey, Streamland, and Arataki Honey.

In terms of financials, let’s have a look at its revenue and profitability over the past few years. As seen in the tables below, from FY2013 to FY2017:

  • revenue has been growing at (0.4)% to 40.5% per year, with a CAGR of 16.5%. These growths are mainly driven by mainly increase in average selling price (ASP), followed by sales volume (CAGR of 12.6% from FY2013-16); and
  • gross profit has been growing at a CAGR of 13.9%, driven mainly by revenue growth, offset by a decline in GPM from 46% to 42%. The decline in GPM was due to increasing costs of raw honey supply due to lack of honey supply (with Capilano passing on some of these costs hike to the consumers, but not fully), offset to an extent by Capilano’s switch to higher-margin products to help improve GPM, although the end result was still a decline in GPM; and
  • net profit has been growing significantly at a CAGR of 31.6%, driven mainly by revenue growth and improvements in operating margins as the business scales up in size (with NPM increasing from 4.8% to 7.8%). The increase in NPM was driven mainly by declining marketing expenses (from 16.0% to 11.5%), declining depreciation expenses (from 2.5% to 1.2%) and declining interest expense (from 1.5% to 0.3%).

Capilano - Revenue and profitsCapilano - Costs

In the next post, I will talk about why I think Capilano Honey is worth looking at for a value investor. Do subscribe to my blog to make sure that you receive the updates.