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The Revenge of the Geographical Value Investor in Asia & The Year of the Fishball Snake Or Why a Powerful Dragon Cannot Crush a Snake in its Old Haunts (强龙不压地头蛇)

Dedicated value investors are more likely to see a common fork in the road in the success of 7 Habits author-cum-entrepreneur Stephen Covey and the multibagger genealogical paid-subscription website Ancestry.com as well as the failure of Caterpillar’s revelation on 18 Jan of its massive $580 million goodwill impairment charge and "deliberate, multi-year, coordinated accounting misconduct" in its China unit it acquired last year in June for around $700 million – and map out the future overlooked true-north investment opportunities in the Asian marketplace jungle with its myriad micro microstructure and institutional booby-traps, and not lose their way as a result of the distractions from the “Great Rotation” macro siren shrills. Both Stephen Covey and his NYSE-listed FranklinCovey and Ancestry.com have their start in selling their unique offering to an initial loyal set of audience and customer base from the rocky state of Utah, where Mormons predominate. Ancestry.com got its start years ago in Provo, Utah, partly as an outgrowth of the Mormon church’s interest in genealogy. But it quickly grew into a globe-girdling business and claims more 2 million paid-subscribers, 39 million family trees and 4 billion profiles of individuals to help people track family histories. Ancestry.com is up 130% in two years since its Nov 2009 listing to $1.6 billion in value and bought out by private equity investors in Dec 2012. Covey’s 1989 book on The 7 Habits of Highly Effective People laid the foundation of his multi-million training and consulting business empire and he propagated the ideas initially through lectures amongst the Mormon community. Caterpillar’s acquired unit in China, ERA Mining Machinery, had its start in a reverse merger deal with the injection of the assets of Zhengzhou Siwei into a nearly defunct HK-listed distributor of

Hollywood DVDs. All the macro-related and “rising tide” stars appear aligned for Siwei, which makes safety roof support used in underground coal mining. China's appetite for coal is the largest in the world and accounts for two-thirds of its domestic consumption needs, but its mines are among the world's deadliest, with thousands of workers killed annually in accidents. Based in Zhengzhou, the capital and largest city in the central China province of Henan, where there are large reserves of coal in the surrounding area, Siwei appears well-endowed geographically like Stephen Covey and Ancestry.com to have an established customer base for its mine safety products. And when highly reputable people are involved in the deal, often a short-cut used by investors in assessing the merits of an investment, the company appears to be a sure-winner without the usual “governance risks”. Notwithstanding all the positive “macro” top-down factors, Siwei’s business model was unsustainable at the “micro” firm level. Sales were boosted only by extending credit and better terms to the “middleman” distributors in order to compete with state-owned rivals with deeper “guanxi” relationship in establishing direct sales channels. Working capital at Siwei was stretched to the limit; it took more than 180 days to collect payment, twice the industry average. Improper revenue recognition and cost allocation in inventory also resulted in overstated sales and profits. The multibagger investment opportunities are often undiscovered and overlooked because of local “geographical” specialization in knowledge which is embedded into the business model to translate into a powerful competitive advantage. Hence the ancient Chinese wisdom that a powerful

dragon cannot crush a snake in its old haunts (强

龙不压地头蛇 ). Consider Charoen Pokphand Group (CP) (Ticker: CPF TB), arguably Thailand’s

On the Ground in Asia – January/February 2013

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most powerful business empire. Charoen Pokphand means “commodity development” in Thai and had its beginnings in a small seed company named Chia Tai, founded in 1921 by two Chinese brothers Chia Ekchor and Chia Seow Nooy. It is hard to imagine now given its present success but CP was a struggling business until the 1970s, when Bangkok Bank asked it to assume control of a bankrupt chicken farm. Following this experience, CP began lending money to farmers, providing technical expertise, and selling poultry feed. CP also purchased grown chickens for distribution to grocers and restaurants. This “geographical” penetration into the provincial network of the farmers with value-added services and local expertise worked phenomenally well and CP expanded its operations successfully outside of Thailand as well.

Another classic multibagger case is Thailand’s Dynasty Ceramic (Ticker: DCC TB) which sells ceramic tiles to the middle-to-low-end market and is founded in 1995 by the accountant Roongroj Saengsastra, 63. Its business model is direct sales via its own distribution channel of more than 200 factory outlets covering every province across the country to penetrate to targeted customers, effectively managing its inventory and pricing strategy to establish a dominant market share of over 50% in Thailand, more than double of its closest rivals. Dynasty is able to hold its own even when competing against the royal family’s business unit Siam Cement which has to close down many of its direct outlets as dealers refuse to cooperate. During the Asian Financial Crisis, Roongroj acquired his rival Dynasty for $1 million when it was auctioned off in late 1997 and he merged the firm with his own Tile Top. Inspired by a roadside shoe-seller he had seen on a business trip to Dallas, Roongroj wanted to implement his factory-direct to deepen its geographical penetration but he faced initial ridicule from many

sceptics and experts as everyone in the industry operated on cozy dealer relationships who typically took 2 to 10% of the retail price. Going direct meant that Dynasty was destroying its own distribution channels. Yet by having its own geographical channels, Dynasty can translate the lower inventory and marketing costs into lower prices for the farmer customers who wanted cheap basic home remodelling to express their wealth. The first cash-and-carry warehouse outlet with cheap and quality tiles at Hinkong Sub-District of Saraburi was a big hit amongst the farmers and Roongroj expanded and deepened its geographical network with the capable help of current president Sanchai Janejarat.

Since Roongroj’s son Maruth joined in 2005/07, he has used his skill in computer science picked up from his masters at MIT to turn Dynasty into an integrated computerised company with timely informational advantage on inventory, allowing Dynasty to use pricing strategy by changing its product mix while other manufacturers who rely on dealers are unable to do so, and Dynasty has since catapulted more than 3-folds to S$880 million in value.

Similar “geographical” local expertise penetration has catapulted the value of boring Singer Thailand (Ticker: Singer TB) by 12-fold in the past five years to S$226 million in value. Singer sells boring products (sewing machines and electrical appliances) directly to households in the rural

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areas who have no access to formal banking credit based on a monthly instalment basis which is tailor-made to fit the customer’s income level rather than product prices. Leveraging upon the same business model, Singer has built a new group of SME customers by selling them freezers and beverage coolers for commercial purposes, petro vending machines, motorbike wash vending machines, air-time vending machines (for mobile phones), commercial-sized air cons and also built a lucrative after-sales service maintenance business.

Again, big cap companies with “geographical” local expertise business model to get closer to the end customers have demonstrated similar market outperformance characteristics and PE re-ratings in uncertain macroeconomic conditions. Consider Swiss-listed DKSH (Ticker: DKSH SW) which has risen over 40% to S$6.2 billion in market value in less than a year since its Mar 2012 listing while the Euro Stoxx index and Swiss market index is nearly flat and up 18% in the same period. DKSH is founded in the 1860s by three Swiss entrepreneurs who sailed east to Asia. Over the years, they established flourishing trading houses, which later evolved into major players in South East Asia, China, the eastern Asia Pacific region, and Japan. DKSH handles the full value chain of market expansion services (MES) from marketing, to providing the sales force, distribution and logistics, invoicing and credit control, handling of inventory and returned goods to help emerging and established western and local consumer brands, drugs, scientific instruments etc to penetrate into the domestic market via their comprehensive “capillary network”, particularly important as Asian markets are evolving from being the “extended workbench” of the West to becoming promising domestic markets. Strong increases in consumer demand throughout Asia are driving growth in inner-Asian business. Stagnating Western consumer markets are causing Asia’s export economy to transfer its focus into its own regional markets.

In his provocative book “The Revenge of Geography: What the Map Tells Us About Coming Conflicts and the Battle Against Fate”, Stratfor’s Chief Geopolitical Analyst Robert Kaplan cited the example of the great British geographer Halford Mackinder who gave a singular example in 1890 of how knowledge of “geography” enriches one’s thinking on world affairs:

“Suppose that I am told that a certain sample of wheat comes from Lahore, and that I do not know where Lahore is. I look it out in the gazetteer and ascertain that it is the capital of the Punjab. If I know nothing of geography, I shall get up with the idea that Lahore is in India, and that will be about it. If I have been properly trained in geography, the word Punjab will probably connote to me many things. I shall see Lahore in the northern angle of India. I shall picture it in a great plain, at the foot of a snowy range, in the midst of the rivers of the Indus system. I shall think of the monsoons and the desert, of the water brought from the climate, the seed time, and the harvest. Karachi and the Suez Canal will shine out from my mental map. I shall be able to calculate at what time of the year the cargoes will be delivered in England. Moreover, the Punjab will be to me the equal in size and population of a great European country, a Spain or an Italy, and I shall appreciate the market it offers for English exports.”

The year 2013 is not only the Year of the Snake for companies with the local expertise to outwit the powerful Dragon, but also the year of the Revenge of the Geographical Value Investor. To borrow the description by the Black Swan author Nassim Taleb in his latest book “Antifragile: Things that Gain from Disorder”, it is the dedicated artisans with “soul in the game” and going the extra mile beyond the usual macro reasoning who are able to ferret out the multibaggers with antifragile business models that outperform even in – or because of - volatile, uncertain market conditions. The geographical “snakes” with local expertise that I have mentioned in the previous editions of “On the Ground in Asia” have continued to outperform, such as Madison Square Garden (Ticker: MSG), the Asean-listed Ta-Q-Bin last-mile parcel express delivery carrier whose operations I visited in Feb 2012 and its “comparables” listed elsewhere such as India’s Blue Dart (Ticker: BDE IN), Taiwan’s Kerry TJ Logistics (Ticker: 2608 TT) etc. I have posted the compilation of “On the Ground” on SlideShare for those who are interested to read at leisure. Overlooked and undiscovered multibagger investment opportunities are perhaps akin to the quiet stall selling tasty Foochow fishball noodle

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soup that I often visit during lunchtime to beat the crowd. The place is around ten minutes away from town by the MRT metro train system (require some time in “research”) as compared to the convenient popular eating haunts in the noisy crowded town area with long queues (so called “blue chips”). But some are still able to enjoy their food at these crowded popular eating places because they went in “early” (insider trading on privileged private information or participation into inside news on syndicates buying the shares collaboratively together to ramp up the price?). The fishball stall is perhaps quiet because it is away from town, located in a place where it is harder for those with big cars to drive in (funds with very big AUM who needs to trade “macro” thematic ideas to deploy the assets) and only has a few tables (relatively lower liquidity), though takeouts are frequent amongst loyal customers with 40 fishball at one go (long-horizon investors who buy in relatively concentrated or meaningful-size bets and hold for the longer-term). Opposite the fishball stall is a budget Italian restaurant which serves good food too. I usually go for the cheapest dishes in the menu which are cooked by the “lower-ranked” chefs. If the quality is as good as their top dishes, it is a testimony that there is some human capital development process for the business to scale up and maintain quality earnings without a bloated and blowup effect. Next to the Italian restaurant is a 100 year-old Singapore soy sauce and condiment company with a history older than Singapore itself. It reminds me of HK’s Lee Kum Kee which celebrated 125 years of anniversary with the current 4

th generation

Chairman Eddy Lee (李慧森) scaling the sauce and condiment family company to greater heights with ten consecutive years of double-digit growth in sales and profit based on the ancient sage Lao-

Tzu’s “Invisible Leadership” (自动波领导模式 ) philosophy, a stark contrast to the “Asian Emperor” model prevalent everywhere. And Lee Kum Kee was also rated by Hewitt and Fortune China as Asia’s and China’s Best Employer. In the realm of biological world, scale made organisms slower; in the realm of the durable “moaty” business models, it made them faster in value creation. This is also supposed to be the case even in the realm cities: the bigger the city, the higher the wages, the more patents produced, the more it delivers per capita, but also the greater the number of violent crimes, more traffic, more infrastructure breakdowns, more impersonal interaction, more loneliness in which strangers are many and true friends and family relatively few. The megacity will be at the heart of 21

st century

geography. Crowded megacities, beset by poor living conditions, periodic rises in the prices of commodities, water shortages, and unresponsive municipal services, will be fertile petri dishes for the spread of an invisible and intangible disease that cannot be cured by tangible infrastructure and urbanization buildouts. This invisible disease is what Ibn Khaldun writes in his Muqaddimah, or “Introduction” to a world history, that desert nomads, in aspiring to the physical comforts of sedentary life, create the original dynamic for urbanization that is then captured by powerful rulers and dynasties, which in turn, by providing security, allow cities to flourish. But because authority requires luxury, decay eventually sets in, as group solidarity erodes and individuals, through their accumulation of wealth and influence, weaken executive power. Thus, systems grow brittle and fragment, and are superseded by other formations. For this first time in history, this process is operating on a global scale. Vast cities and megacities have formed as rural dwellers throughout Eurasia, Africa, and South America migrate toward urban centers from the underdeveloped countryside. As a consequence, the mayors and governors of these conurbations can less and less govern them effectively from a central dispatch point, so that these sprawling concentrations informally break up into suburbs and neighbourhood self-help units, whose own local leaders are often motivated by their own self-dealing interests. Cities are large piles of small, very different things – neighbourhoods, networks, innovators, and infrastructure. These tie together different people and groups in loose, informal, ever-shifting affiliations. Until the invisible integration of the clustering of density and diversity is resolved, increasing scale by a single curve – reaping the benefits of a single mode of wealth and capital creation – will ironically speed up the demise and collapse of the robust-yet-fragile system, perhaps a contrast to the optimistic urbanization-led prosperity story for Asia. However, just as markets can stay irrational longer than one can stay solvent, the growth of cities can stay extended on debt and capex-led investment financed by increasingly fragile confidence, as was suggested in a widely-noticed IMF study “Is China Over-Investing and Does It Matter?”. It was also reported by Bloomberg news on 2 Feb that China registered its first capital exit last year, since 1998 when investors deserted China during the Asian financial crisis, with a deficit of $117.3 billion in its capital and financial account. This had followed another news on 1 Feb that China’s M2 money supply increased by RMB 27 trillion to RMB 97.4

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trillion by the end of 2012, making it the largest in the world, accounting for a quarter of the global money supply, 1.5 times the total of M2 in the US, 4.9 times that of UK, 1.7 times more than Japan. The RMB 27 trillion increase in M2 also meant that China accounted for half of the increase in global money supply last year. China’s M2/GDP has surpassed 200%, the highest in the world. A seven-fold jump in December’s lending by China’s trust companies in short-term financing loans as reported by Bloomberg news on 17 Jan is also setting off alarm bells for regulators to guard against the risk of default. A Financial Times article on 27 Jan reported that China’s brokerages have also emerged to become shadow banks, a development that underscores how financial risks are spreading more widely in China. For 2012 as a whole, shadow financing via brokerages appears to have increased almost 600%. Total short- and long-term borrowing by 3,895 publicly traded non-financial companies rose to almost $1.7 trillion in their latest filings, from $604 billion at the end of 2007, data compiled by Bloomberg show. Financing costs, including interest, on all forms of debt climbed to the highest level as a percentage of GDP last year, according to Sanford C. Bernstein & Co. As the prominent economist Yu Yongding noted in his Project Syndicate article “China’s Narrowing Policy Horizon” on 31 Jan, “Though the full implications of this uniquely high ratio for macroeconomic stability need further investigation, it certainly implies financial fragility and a weakening of the PBOC’s ability to control overall liquidity in the economy. If the shadow banking system collapses, the consequences for the financial system will be much graver than the problems caused by underground credit networks and local-government finance platforms, which were much discussed in 2012. No wonder, then, that one influential banker regarded as a possible successor to PBOC Governor Zhou Xiaochuan has warned of the possibility of a “Chinese-style subprime crisis.”

******** It is deliberate that this monthly “On the Ground in Asia” newsletter that I have written since 2012 is not like the usual sell-side market research reports following a certain writing format with charts and figures spewing multiple stock recommendations based on PE/CAPE, DCF or various forms of valuation ratios. Instead, I attempt to discuss about the investment thought process behind the stocks in Asia in a purposeful story-like manner with a central theme and mental model, in a way that is entirely “different” from all these reports to stimulate critical thinking and conversation, or in a way that Harvard Business School Professor

Youngme Moon described of the Nobel laureate physician Richard Feynman in her highly thought-provoking and “similarly”-styled conversational book “Different: Escaping the Competitive Herd”: When I was in college, I remember reading a book by the Nobel Prize–winning physicist Richard Feynman, entitled Surely You’re Joking, Mr. Feynman! What was interesting about the book was that it appeared to be nothing more than a compilation of rambling anecdotes — about his personal life, his teaching, his work. And yet the weight of these anecdotes crept up on you, so that by the time you finished the book it was impossible to regard it as anything less than a finely honed indictment of the scientific discipline. What Feynman seemed to understand was that there are in fact two ways for a scholar to contribute to our understanding of something. The first is to adopt the PowerPoint approach, which is to take a complex phenomenon and attempt to distill it down to its core. The second is to do the reverse: to take a complex phenomenon and attempt to shed new light on it, not by removing information but by layering on unexpected shades of nuance, from unexpected sources. This is what Feynman did: He wove his subject into the broader tapestry of everyday life. He added richness, texture, context. He was a man I wish I could have invited to dinner… All of these works exist across wildly different disciplines, and yet they have something very much in common: They were written by scholars who were able to bring their respective disciplines to life, by humanizing them somehow, without dumbing them down. Their relationship to their work is akin to the one Calvin Trillin has to food, which is to say that they regard their subject—whether it be medicine, or architecture, or technology—as constituting one small piece of a much larger fabric. These are writers who meander, certainly, but only as a means of getting straight to their point. Their books inspire, because although they provide a running commentary of all that is wrong with their respective disciplines, they do not stop there. I have always thought that the way to keep criticism from devolving into cynicism is to make it the starting point rather than the punctuation mark, and that’s what these writers do: They look hard to identify the good amid the bad, and when they find it, they shine a light on it, they celebrate it, they encourage us to learn from it. If scholarship is a conversation, then in my mind these are the ones who make the most compelling conversationalists — the ones braving the unfamiliar dialect, the ones pushing the dialogue forward in unexpected and provocative ways. This will be my last “On the Ground in Asia” piece as I embark on a transition phase in my career. I hope this monthly writing over the past year has pushed the dialogue on value investing in Asia forward and that you have enjoyed reading it. KEE Koon Boon 4 February 2013