01 Sep The Capital Cycle and Sale of Investments
In the book Capital Returns: Investing Through the Capital Cycle edited by Edward Chancellor, the capital cycle analysis can be adapted to make informed decisions on the sale of stock before problems surface.
In the intriguing case of Vestas Wind Systems, its capex-to-depreciation had risen from just 1 time in 2005 to nearly 5 times in 2008, contributing to excess capacity in the wind turbine sector. Over-investment is not a solitary activity; it comes about because several players in an industry increase capacity at the same time.
When market participants respond to perceived increases in demand by increasing capacity in an industry, they fail to consider the impact of increasing supply on returns. Subsequently, the share price of Vestas crashed over 90% from its peak.
Following the appointment of a new Swedish chairman in early 2013, significant restructuring was implemented at a time when investor fears about weak industry demand had proved too pessimistic and capex was slashed to 0.4 times depreciation in 2013. This boosted cash-flow and helped repair the weak balance sheet, sending the share price to rise 360%.
The case of Vestas illuminated the investment insight that excess returns can be captured by exploiting the managerial decisions in capital allocation in capex: a low (high) capex-to-depreciation is a buy (sell) signal.
Vestas Wind Systems: Capex-to-Depreciation and Relative Share Price Performance
Source: Capital Returns: Investing Through the Capital Cycle by Edward Chancellor (2016)
During the second half of the Financial Year, our notable divestments were Hartalega Holdings Berhad and Major Cineplex Group at an average price of RM 5.86 and THB 32.11, with both recording a 96% and 77.4% gain on both companies respectively.
We were uncomfortable with the expensive valuations accorded to their growth expansion plans which faced increasing headwinds in lower ASP in nitrile gloves due to intense competition from new entrants for Hartalega.
For Major, it was balance sheet constraints in taking on more debt to finance capex in order to increase the number of screens in sub-urban, rural regions and in regional countries. This included their highly-geared shopping mall operators-business partners, some of whom had announced plans to slow down building more malls.
Hartalega: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
From the capital cycle chart on Hartalega, we can observe that capex-to-depreciation had shot up aggressively in FY2015 and for TTM2016, it contributed to the industry oversupply situation while the capex-efficiency (as measured by the EBIT profitability generated per dollar of capex spent) had plunged due to lower ASP and higher operating costs.
The same can be observed in Major Cineplex in which the capex-to-depreciation had spiked in FY2015 while capex-efficiency had declined precipitously after five golden years of capex-efficiency during FY2010-2014. Subsequently, after we sold Major Cineplex, it reported a Bt139m net profit for 4Q15, down 33% YoY and 60% QoQ.
Stripping out extra items – a net-of-tax gain from selling shares held in India’s PVR Cinema and trading in Thailand’s SF shares in 4Q14 and 3Q15 – core profits dived 26% YoY and 41% QoQ.
We also agree with former successful studio Grammy Tai Hub (GTH) chief, Visute Poolvoralaks, who commented that there is a growing risk that Thai audiences have lost faith in Thai movies simply because film production standards vary so much.
Thais pay the same ticket price for every movie, so when a few are not good or worth the money, they lose confidence in Thai films in general and opt instead for Hollywood offerings – and Major is increasingly expanding into Thai movie production.
Having said that, we find that the wide-moat of Major still remains intact and will revisit the stock at appropriate valuations.
Major Cineplex: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
We are also uncomfortable with the growing investor fever for movie & entertainment-related companies. Some of them are exploiting investors’ attention to hype up their prospects with box-office ticketing fraud.
Shifang Holdings (1831 HK): Roller-Coaster Share Price
Take the case of HK-listed Shifang Holdings, which owns the rights to the earnings of the blockbuster Ip Man movies. “Ip Man 3” saw ticket sales of 400 million yuan in its first three days of release.
Shortly after that big start, however, local news reports raised allegations of box-office ticketing fraud. It turns out Shifang snapped up tickets worth 56 million yuan, guaranteeing a hot opening week. Chinese authorities have opened a probe into the case.
The fraud dealt a severe blow to the share price of Shifang. Shares in Shifang surged to HK$3.75 on 26 February, the highest level since it listed in 2010. Then came the box-office scandal. It took only four trading days for the stock to plunge 80% to HK$0.76 on 10 March.
We do not engage in market-timing by darting in and out of the markets on a short-term trading basis. After our restructuring, our portfolio turnover ratio is low at 3.1%. The portfolio turnover came from our sale of 6 stocks (3 in India, 2 in Thailand, 1 in Japan) due to some slight concerns about their business model sustainability, of which 4 are at a small profit and 2 with losses, at an overall 0.75% loss from our cost as a percentage of our NAV.
The daily liquidity of our portfolio stocks, if we were to account for one-third of the daily volume traded based on the past 30-day average price, is 25.7% of our portfolio NAV i.e. we can liquidate one-quarter of our portfolio NAV in one day if need be without destabilising the stock prices.
Avoiding a “Valeant Situation” In Overconcentration of a Deteriorating Moat
Analysing the capital cycle has also proven useful in evaluating and avoiding the risk of investing in Valeant Pharmaceuticals, dubbed the “Enron of Pharma”.
Hedge fund manager Bill Ackman compared “platform stock” Valeant to early-stage Berkshire Hathaway in early 2015; William Thorndike, author of The Outsiders, compared Valeant’s CEO Michael Person to Liberty’s cable billionaire John Malone.
Valeant’s share price collapsed in October 2015, hurting many sophisticated institutional investors with concentrated portfolio bets on the drug firm.
Charlie Munger back in March 2015 had criticised Valeant: “Companies like ITT Corp., made money back in the 1960s in an ‘evil way’ by buying businesses with low-quality earnings then playing accounting games to push valuations higher.
Valeant, the pharmaceutical company, is ITT come back to life. It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.” Valeant relied on “gamesmanship” to run up its value and create a “phony growth record.”
Buffett, at the Berkshire Hathaway AGM 2016, said Valeant’s troubles illustrate a principle passed on to him by a friend: “If you’re looking for a manager, find someone who is intelligent, energetic and has integrity. If he doesn’t have the last, make sure he lacks the first two.”
Valeant: Capex-to-Depreciation, EBIT-to-Capex and Relative Share Price Performance
We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant, and one of them was featured on 22 April 2014 in the Wall Street Journal titled “Allergan Pursuer Valeant: A Drug Maker with Little Patience for Science”.
Valeant CEO, Michael Pearson, is known as an aggressive cost cutter. Valeant’s corporate culture is that it does not want to spend money on science and sees no wrong in substantially jacking up prices of drugs after acquiring them.
From the above chart on Valeant, we can see that since Michael Pearson took over as CEO in 2008, capex-to-depreciation had soared due to frenzied pursuit of M&A deeds while R&D efforts declined – a warning sign to avoid the stock.
Why do investors and corporate managers pay so little attention to the inverse relationship between capital spending and future investment returns? The short answer is that they appear to be infatuated with asset growth.
An empirical study by finance researchers Sheridan Titman, John Wei, and Xie Feixue published in the Journal of Financial and Quantitative Analysis found that the average firm destroys value when they invest substantially and a long-short strategy that goes LONG low-capex firms and SHORT high-capex firms.
The strategy earns an annual compounded 16.9% returns. Why? There is execution risk and investors consistently fail to appreciate managerial motivations to put the best possible spin on their new “growth opportunities” when raising capital to fund their “expenditures”.
The aim of the capital cycle analysis is to spot these developments in advance of the market. Thus, the capital cycle analysis in capex-to-depreciation and EBIT-to-capex is an informative signal about future firm value creation and destruction.
Combining Capital Cycle with Marketing & Long-Range Information in the Value Creation Process
Long-term investing works because there is less competition for really valuable bits of information. The real advantage comes from asking more valuable questions.
The short-term investor hopes to glean clues to near-term outcomes by asking questions typically relating to operating margins, earnings per share, and revenue trends over the next quarter.
In order to build a viable, economically important track record, the short-term investor may need to perform this trick many thousands of times in a career or/and employ large amounts of financial leverage to exploit marginal opportunities. The longer one owns the shares, however, the more important the firm’s underlying economics will be to performance results.
Long-term investors therefore seek answers with shelf life. What is relevant today may be relevant in ten years’ time if the investor continues owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period.
Take marketing, which can be vital to long-term value creation yet is often ignored. An understanding of the economics of line extensions and an advertising strategy has proved useful to investors in consumer products companies.
Colgate Palmolive introduced its first line extension – a blue minty gel – in the early 1980s, and supported this product with a hefty advertising spend. This was Colgate’s first new toothpaste in a generation, and line extensions, which had been used successfully in other household goods, were novel to the toothpaste market.
By advertising heavily, the firm hoped to change the buying habits of a generation of shoppers who would subconsciously think of Colgate as they approached the toothpaste section of a supermarket, and when they got there, would find a product which was new, superior and, because of advertising spending, trusted.
This is an almost worthless piece of information for short-term investors as they will be thinking along the lines of “What does the rise in advertising spend in the new line extension product mean for profit margins next quarter?” Few investors would have understood, and even fewer would have cared, about the transformation that was taking place.
In the two decades since its first line extension, Colgate’s share price has risen 25-fold, handsomely beating the market. This shows how important it is for long-term investors to understand a firm’s marketing strategy. Yet, given the annual 100% turnover in Colgate shares, very few of the firm’s shareholders have benefited fully from its success.
Why did so few Colgate investors stay the course? There is strong social and client pressure to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by.
Portfolio Stock (Global #3 Consumer Healthcare Device Brand): Ad Expense as % OPEX and EBIT as % Ad Expense
We have combined the capital cycle analysis with long-range information such as marketing expenditure to provide a more informative signal.
As an illustration, we observed for one of our portfolio stocks in the consumer healthcare & household lifestyle business, that despite a rise in its advertising spending (as a percentage of total operating expense), EBIT per dollar of advertising has been rising, particularly since FY2014.
Furthermore, despite a rising trend of capex investments to expand in response to growing demand for its innovative high-quality products since FY2013, EBIT-to-capex has exceeded capex-to-depreciation for this world-class Hidden Champion.
It now commands a dominant 50-60% domestic market share leadership in its consumer healthcare device and is also the global #3 player and #2 in China (22% market share). Its first China plant in over 80 years became operational in March 2016 after building up strong demand from successful sales in leading online marketplaces JDmall and Alibaba’s Tmall.
ROE of this world-class Hidden Champion is 14.2% and it trades at EV/EBIT 10.1x, EV/EBITDA 7.8x, EV/Sales 1x, a steep discount from its local consumer goods peers who trade at an average of EV/Sales 2.1x, EV/EBIT 20.2x, EV/EBITDA 14.5x.
We think this steep valuation discount is unjustified given the technical excellence and innovative profile of the company. It deserves to trade at a higher premium once there is greater investor awareness when they continue to deliver quality earnings growth with higher ROE. It has soared from 6.7% in FY13 (YE March) to 14.2% in the latest TTM Dec 2015, and is expected to climb higher from its underappreciated price premiumisation strategy.
This portfolio company, a family business established in 1934 and led by the second-generation business leader, embodies the best of patient sacrifice and stable capital for longer-term profound investments in business and people.
Coupled with relentless and eternal pursuit of excellence in perfecting its offering, it institutionalises its craftsmanship and codify the knowledge to pass from one generation to another.
We believe it has hit a tipping point in its business model transformation into a complete integrated global producer of innovative long life-cycle rubber and plastic products with engines in both household & lifestyle division and industrial division (automotive interior) revving up to compound growth with a visible long runway.