Annual Letter to Partners
26 December 2017
Dear Partners,
For the financial year 2017, our portfolio gained 19.67%. The FBMKLCI gained approximately 9.2% including dividends during this time.
I neither sold nor purchased any stock in 2017. Dividends were retained and added to our cash holding. I did not find the right investment idea yet.
I spent most of my time studying, consolidating, and most important of all, reviewing our portfolio through in-depth analyses on various aspects of businesses that we owned.
One company that I reviewed immensely is Public Packages Holdings Bhd (PPHB). Although my research outputs are published on valueveins.blogspot.my, allow me to consolidate those important takeaways to help you understand our core investing approach better.
Our investing approach
We look for five things in an investment:
· Simple businesses
· Durable strategies and competitive advantages
· Competent, honest and shareholder-oriented management;
· High quality balance sheet and cash flow
· Priced at 30% (or more) discount to its value
The first four is related to how safe an investment is. The fifth relates to how cheap the stock is. “Safe” is more important than “cheap”.
Simple businesses
The first thing we want is a “safe” business. Its core products or services should experience little change, and would still be in high demand after decades.
PPHB is mainly involved in manufacturing corrugated boxes, which are used as packaging for protecting goods. PPHB also manufactures niche paper-based packages.
Manufacturing industry and e-commerce will continue to rise in Malaysia over time. PPHB is expected to capitalize on these extremely powerful economic trends.
Durable strategies and competitive advantages
Warren Buffett stressed the importance of competitive advantages. However, I see competitive advantage as the end-state. It is equally or perhaps more important to understand how strategies are designed and implemented to achieve the desired state.
A blogger recently contacted me and wrote a good piece on PPHB’s strategies. Her work concluded that PPHB does “short runs”. The phrase “short runs” ties the company’s focus to the essential problem faced by other manufacturers in the industry – the very high costs of switching a production line from making one product to another, or even printing one label and then setting up to print another. The runs may be shorter because the customers are smaller, because the products are newer or sophisticated, because they are low volume-high-value products, or because it is a rush order to cover seasonal or other unexpected demand, and so on.
The strategy above is very much similar to the early days of Crown Cork & Seal, which was a favourite of superinvestor Peter Lynch.
The “short runs” enable PPHB to exercise its pricing power. Despite escalating production (not just paper) costs, PPHB has demonstrated increasing gross and net profit margins year after year. I consider this as an impressive performance given the intense competition in its industry. The management humbly attributed the success to improved efficiency, which is equally right from the perspective of cost control.
Importantly, the “short runs” strategy strengthens the competitive advantage of PPHB in offering total (complete) packaging solutions, encompassing creative design, manufacturing, printing, packaging, goods storage, and delivery. Such a one-off package is most appealing to SMEs and big companies producing niche or high-value products. Other manufacturers only offer partial packaging solutions.
Competent, honest and shareholder-oriented management
I look for reasonably competent, honest managing or controlling groups that do not reap investors off. Capital allocation is always a key challenge facing the management.
The competency of PPHB’s management can be evidenced from a number of quantitative metrics: (1) pricing power, (2) increasing margins, (3) quality cash flow, and (4) increasing return on equity (although still a high single digit).
In particular, capital expenditure at the expense of dividends was well thought: the return on incremental invested capital of PPHB has consistently been above its weighted average cost of capital. That means the management created more shareholder value through retained earnings.
I am also document-driven. The management did what they promised in quarterly and annual reports. They paid themselves consistently at an approximate of 10% each year regardless of improved financial performance.
To review our stock holding better, I even travelled to attend PPHB’s Annual Meeting 2016 in Penang. The management was generous in offering their time to help me understand their businesses in relation to the industry.
Through the meeting, I was assured that PPHB is merit driven. Accordingly, new shares under the Employee Grant Scheme were largely issued to core personnel (non-managemet).
High quality balance sheet and cash flow
A “safe” balance sheet featuring high quality assets is what I regard as the defence line. I hone my easy way of measuring value through financial position of companies. Earnings and earnings power are fickle. They are also vastly overrated.
Through positive free cash flow, PPHB has recently become a net cash company.
Beyond the close look, it is easier to look at the quantity and quality of the properties that PPHB has than to forecast its earnings. PPHB is presently developing a boutique hotel on its 3 pieces of land in the Georgetown World Heritage Site. These lands could be valued RM56.5 million compared to their RM21.1 million book value.
Priced at 30% (or more) discount to its value
After scrutinizing the assets, I make sure that I place my buy orders at a big discount to the private market values of those quality assets – that is, to the net asset value (NAV) per share. Over 80% of our portfolio companies were acquired at a substantial discount to “readily ascertainable net asset values”.
In 2014, without any asset revaluation, net tangible assets of PPHB were appraised at approximately RM1.50 per share. But we bought all the shares we wanted for below RM0.70 apiece. One could say that our purchase was made at 53% discount of its net tangible assets value.
We are distressed-growth investors
Traditional growth investing is essentially paying up for widely recognized growth with the hope that the growth will continue.
While I like distressed investing, we buy into the kind of growth that is not generally recognized while most growth investors buy into generally recognized growth and they have to pay up for that.
During our first acquisition in 2014, PPHB already entered a growth stage. We, however, paid nothing for its growth. Instead we were offered 53% discount of its net tangible assets value.
The growth of PPHB has continued, even at the time of writing.
I will continue to seek out investment opportunities in distressed-growth companies.
I would like to end this annual letter with my sincere wishes for your health and prosperity.
Managing Partner,
Yeong Sheng Tey (PhD)
tyeong.sheng@gmail.com
http://valueveins.blogspot.my/2017/12/annual-letter-2017.html
