Happy Diwali! The Inner Light of Asian Compounders 

Dear Clients and Partners, 

Wishing you all a very happy Diwali! May this festival of lights awaken the Inner Light in all of us and bring with it inner joy and peace.

A Diwali-related business story that we find inspiring is from the fascinating book “The Resilience Dividend: Being Strong in a World Where Things Go Wrong”, in which Judith Rodin, president of The Rockefeller Foundation, recounted the well-known story of billionaire Anand Mahindra’s near death experience – and resilience – in the day before the Diwali festival in 1991.

Anand Mahindra was attempting to turn around the business with productivity improvements and broke down the barriers between the silos of manufacturing, marketing and sales, and finance in the company. On the day before Diwali, Anand Mahindra made an announcement to the factory floor that the traditional holiday bonus would be awarded differently than it had in the past. For the first time, it would be linked to the achievement of performance targets and negotiated through the labor unions. Not long after making the announcement, Anand Mahindra looked out of his window and saw a line of angry workers charging into the factory floor. Anand Mahindra and a group of union leaders he was with scrambled into Anand Mahindra’s inner office and locked the door. A four-hour standoff ensured. The union leaders advised Anand Mahindra to stay put until the workers left, but Anand Mahindra at last decided it would be best to have a direct conversation.

Anand Mahindra walked out of his office to the factory floor and asked everyone to sit down. “If you want to throw me over the railing, you can. But that won’t change anything. The world is changing and there’s not going to be a free lunch anymore.” The workers did not throw Anand Mahindra over the railing. The mood completely changed. They calmed down and waited to hear what he has to say. At the end of the “conversation”, there is a sense that “we’re-all-in-this-together” mentality and one of the workers even asked for Anand’s autograph!

We like to also share another Diwali-related article that we have written earlier: “The Inner Light of Asian Compounders: The Reborn of India’s Hero Motocorp”, also a tribute and remembrance to the wise leader Brijmohan Lall Munjal, the late billionaire founder of Hero Motocorp.

Warm regards,
KB & the team at Hidden Champions Fund
KEE Koon Boon | Chief Investment Officer & CEO
Hidden Champions Fund

The Inner Light of Asian Compounders: The Reborn of India’s Hero Motocorp

A Hero lights up this Diwali festival: Hero Motocorp (HMCL IN, MV $6.8 billion), the world’s largest two-wheeler manufacturer (by volume), announced on Nov 1, the first day of Diwali, that they achieved the highest-ever retail sales (625,420 units, +18.2% yoy) for any month in October in India. This is also the first time that any two-wheeler manufacturer has exceeded the landmark 6 lakh unit sales in a month. Hero sold 6.23 million units in the year ended March 31, and has a capacity to produce 7 million annually. Hero’s performance stood in contrast to the four-wheeler market in which the automakers from Maruti Suzuki, Tata Motor and Mahindra & Mahindra reported lower or nearly flat sales with the Indian economy growing at its slowest pace in a decade and accelerating inflation (onion prices has surged from Rs 16 a kg in Jun to Rs 100) leading the central bank to raise its lending rate twice in as many months. Interestingly, just three years ago on Dec 21, 2010, Hero hit a crisis and was thought to have problems surviving in India. Yet, Hero has emerged stronger from the crisis because of its “Inner Light”, just like the spiritual significance of Diwali.

Diwali, also called Deepavali or the “festival of lights”, is a five-day Hindu festival to celebrate the slaying of the evil demon Narakasura by Lord Krishna, the incarnation of Vishnu (the supreme god of Hinduism), signifying the victory of good over evil and light over darkness. The deeper spiritual meaning of Diwali celebrates the belief that there is something beyond the physical body and mind which is pure, infinite, and eternal, called the Atman or the Inner Light. With this awakening of the Inner Light comes compassion and the awareness of the oneness of higher knowledge which brings ananda (joy or peace).

Hero Motocorp (HMCL IN) – Stock Price Performance, 1995-2013

Hero Motocorp is an incarnation of Hero Honda, the JV formed between founder Brijmohan Lall Munjal and Japan’s Honda Motor (7267 JP) in 1984 in a country that did not think beyond scooters back then. By 2001, Hero Honda beat Bajaj Auto (BJAUT IN) to become India’s largest two-wheeler manufacturer – and also the world’s largest for 12 consecutive years. In the years between March 2000 and March 2011, Hero Honda’s revenue grew from Rs 2,118 crore to Rs 20,787 crore ($3.4 billion); profits increased from Rs 192 crore to Rs 1,927 crore ($314 million).

On Dec 21, 2010, Honda announced a bitter split up and Hero bought over their 26% stake for Rs 3,842 crore ($622 million), ending the 26 year-old JV which started with equity of Rs 16 crore, of which Honda contributed Rs 4 crore. Worse, Honda will be competing with Hero in India and Hero has to drop the Honda name from its brands, products, and distribution outlets after March 2014. How would customers know that the Hero bike is not Honda nad that the quality has not gone down? Dealers are thought to be stampeding out of Hero to join Honda. Prior to the termination of the joint venture, Honda supplies technology for products which Hero marketed in India and Hero’s right to use Honda’s new technology for Hero’s new products will end in 2017, though they can continue to use the existing technology. The 90 year-old Munjal commented, “They didn’t tell us that they want to leave. We told them that if they, themselves, are here to make motorcycles, then they become competitors. How can a competitor and principal be the same?” Since the split, Honda, the world’s biggest motorcycle maker, overtook Bajaj Auto to become India’s second biggest two-wheeler seller with around a 20% market share and vowed to overtake former partner Hero’s 43% leadership by 2020. “We want to be number one in every market we are in, it’s unacceptable at the company to not be number one,” said Tatsuhiro Oyama, senior managing officer in charge of Honda’s motorcycle operations.


The main reason for the split is the typical principal-agent case in Asia: Success. As Hero Honda grew enormously successful, it increased the aspirations of Hero to export and develop the products in-house with its own R&D. Honda, of course, refused any exports though they later modified the agreement to allow exports of limited products to a few countries, namely Sri Lanka, Bangladesh, Nepal, and Columbia. The second contentious issue was that of board representation. Hero felt that the four Honda representatives on the board had access to its plans and strategies, while they had access to none of Honda’s plans. This, Hero Honda had felt amounted to a conflict of interests when Honda decided to launch a 110cc motorcycle, the segment that formed over 70% of Hero Honda’s sales. The third issue was related to Hero Honda wanting to do its own independent R&D and manufacturing its own products. When it asked Honda to be allowed to do so, Honda’s response was “R&D is our heart and we can’t give our heart to anyone”. Honda in turn was unhappy with the Indian family for not injecting the lucrative spare parts business into the listed JV. When the split was announced, the share price fell from Rs 2,000 to Rs 1,500, which subsequently rebounded to over Rs 2,000. During the recent emerging market crunch with the sharp decline in rupee, share price again fell from Rs 2,000 to Rs 1,500 before rebounding to Rs 2,000. Even now, of the 66 analysts who track the stock, 27 rate it a sell, while 19 advise buying it, according to data compiled by Bloomberg.

So how did Hero survive the crisis? What are the lessons for value investors in assessing stocks in Asia beyond the quantitative financial numbers?

Munjal’s journey at Hero is an extraordinary story of entrepreneurship in the face of adversity. Importantly, it is the tale of a man who has lived his life on the principle that if you work hard and be good to people around you, success in business will, inevitably, follow. Munjal started off by manufacturing bicycle parts in 1944, travelling “across India carrying bicycle parts in a bag” and showing dealers the samples. In the initial phase, the dealers simply shoo off Munjal: ‘Sir, you’ll show something and send something completely different. This won’t work’.” Munjal never lose heart. Over a long chat, he would convince the dealer to place just one order; if it didn’t turn out to be as promised then the dealer was free to never order again. “Because we did that, our reputation, right from the first day, was very good. And then people stopped asking for samples. They would directly place the orders.” Munjal decided to manufacture bicycles, recalling that the bicycle-makers Raleigh, Hercules and Atlas mocked him, “They said they had got the technology from England, loans from banks and then started making bicycles. They would say, ‘Will you do it just like that?’ Within six months of us starting operations, they were all taken aback”.
What worked for Hero was simple – whatever was promised was delivered, and there was no attempt at profiteering. “Other people would show something and deliver something completely different. Or after one consignment, if sales were good, they would tell the dealer that the price of raw materials had gone up and then increase the prices. We never did anything like that, unless the Government of India announced that price of raw materials had gone up,” says Munjal. During his bicycle manufacturing days, while in search of machines, Munjal found inspiration from Germany. “People used to be surprised at why I would go to Germany so much. But I got the best technology, met such nice people and was very impressed with their working style,” he says. “I saw that if a person committed to something, even if it is a loss-making proposition for the company, he would go out of his way to keep his commitment. And the Germans would never do an incomplete or inferior job. That influenced me… that whatever I do, I should do it perfectly.” Those were the days of the ‘Licence Raj’. It was easy to get tempted and make money through a licence for a commodity in short supply, such as steel sheets, oil or even power. These could be traded in the market for a handsome profit. “We had a licence to buy steel sheets and if we were to just sell that, there would have been no need to make bicycles. But, with God’s grace, we never ever thought like that,” says Munjal.

These values helped Hero build a reputation where dealers and suppliers had unflinching trust in the company. Building a pan-India dealer and distribution network to reach out the rural consumers is critical for the business model to scale up sustainably. And reach is not just in terms of the sales touchpoint but importantly it’s about service and it is ultimately what determines how much one can sell. From day one, Munhal adopted a very personalized approach towards dealers. The final interview and selection of every dealer that the company has appointed in the last 30 years has been done by Munjal himself. At Hero, there are many such stories about Munjal – be it knowing the company’s thousands of dealers on a first-name basis or personally calling suppliers on their birthdays. But Munjal doesn’t find any of this surprising. “Wouldn’t you do that if it was your family?” he says. So people feel connected and engaged with the company. As a result, from December 2010, when the split happened to January 2012, only two dealers out of its vast network of 5,500 across the country have left Hero. This intangible quality in the trust and support from its community of customers, suppliers, employees, and partners is the Inner Light that helped Hero bend not break in the crisis like the bamboo.

Data from the Society of Indian Automobile Manufacturers show that sales of two-wheelers in India rose an astonishing 85% between 2007-2008 and 2011-2012, to 13.4 million units a year. Much of the growth was driven by demand for fuel-efficient transport in rural areas — where public transport is often poor or nonexistent — and from specific segments of the urban population such as students, office workers and working women. India’s rural spending was $67.57 billion between 2009-10 and 2011-12, compared to urban consumption of $53.95 billion in the same period, according to a November 2012 note by India Brand Equity Foundation. Rising incomes and low penetration of consumer durables are the reasons cited for the growth in spending. Nearly half of Hero’s sales come from rural markets where it has deep-rooted brand equity. Through its vast network of dealers, Hero organizes free vehicle servicing and free health checkups in medical camps in over 100,000 villages around the country to bolster its presence and attract new customers. Hero also has creative marketing campaigns over the years that have entered into the hearts of millions of consumers, ranging from “Fill It, Shut It, Forget It” emphasizing the low-maintenance fuel efficiency to “Why should boys have all the fun?” featuring the Bollywood film-star Priyanka Chopra to “Hum Main Hai Hero” (There is a hero in each one of us).

The company is still relying on technology from Honda for its best sellers, the 100-cc Splendor and Passion, and is struggling to introduce new independent models. Hero and Honda have signed a new licensing agreement under which Hero will pay Honda 45 billion yen ($458 million) or an annual royalty of $228 million till 2014. Since going solo, Hero has developed new engines of 100cc, 110cc and 250cc capacity with technical partners that include Austrian engine-developer AVL and Italian design firm Engines Engineering. Apart from the new engines, Hero is set to commercially launch its first motorcycle without the technology of Honda in the year ended March 31, 2014. “Our ultimate aim is to have our partners as an extended R&D arm for Hero MotoCorp. These partners have huge specifications available and we want to be known as a full-fledged global two-wheeler brand eventually,” Munjal has said. The company is investing Rs 450 crore ($73 million) to set up a R&D centre near Jaipur in Rajasthan. The facility would be commissioned in the first quarter of 2015. In July 2013, Hero acquired a 49.2% stake in US-based Erik Buell Racing (EBR) for $25 million after entering into a technology sourcing pact last year. The investment is part of the strategy to enhance its own technological prowess and have multiple technology sources for different segments. Erik Buell is one of the most revered names in the motorcycle industry Erik Buell has been instrumental in developing some highly advanced technologies for motorcycles over the years and is the only American sportbike maker in the world. Erik F. Buell (in photo with Hero’s Pawan Munjal) commented: “EBR is delighted to partner with a company as iconic as Hero MotoCorp. Both HMCL and EBR share the common commitment to manufacturing world-class two-wheelers with technology of the future. I have personally been deeply impressed with and inspired by Pawan’s vision. He has given us a challenging brief, and our highly-motivated team is working towards giving shape to that dream. We look forward to designing technology solutions which are in line with contemporary global standards and also futuristic in their appeal and utility.”

Hero also looked to expand in global markets to make up for lost time. In August this year, it had announced plans to enter 50 new markets by 2020 with a target of 20 manufacturing facilities across the globe and an overall annual turnover of Rs 60,000 crore ($9.8 billion). Hero currently exports about 200,000 two-wheelers annually while rival Bajaj sells more than 1 million, making significant progress in reaching out to emerging markets in the years Hero was restricted to South Asia. For instance, in Nigeria, Bajaj is the market leader and Bajaj has a significant presence in many Latin American markets and exports make up 35% of its two-wheeler revenue as compared to around 3% at Hero. Hero expects to export nearly 75% more (350,000 units) in 2013-14. Hero and EBR would also promote selling and marketing of motorcycles in the Western Countries, namely North America and Europe and Hero also plan to set up an assembly line for EBR.

The biggest challenge for Hero will be to allocate resources and capital. There is unprecedented demand for capital for initiatives ranging from R&D, spare parts capacity enhancement, developing exports markets, manufacturing capacity expansion, tying up with technology vendors and re-branding. These costs will put pressure on profitability as initiatives such as R&D and exports do not yield results immediately. However, it helps that Hero possess the three sources of “emptiness” in Bamboo Innovators: the indestructible intangible of the trust and support from its community of suppliers, dealers and partners; the core-periphery network of the 5,500-strong dealers, particularly in the rural areas; and the open innovation model that it now adopts in working with external technological partners such as EBR to co-develop new products. With this Inner Light lit up, value investors can see more clearly the uncertain path ahead for Hero in the face of the formidable partner-turned-rival Honda, just like how the lights of the oil lamps during the moonless night of Diwali are turned on to invite the blessings of Lakshmi, the goddess of prosperity and well-being.

Without the Inner Light to guide the path, it is easy for value investors relying on quant financials to always get overconfident and pick up “cheap”-stocks-turned-value-traps such as China’s largest two-wheeler Lifan Industries (601777 CH, MV $1.08 billion) or Vietnam Manufacturing and Export Processing (VMEP) (422 HK, MV $61 million), the third-largest manufacturer of scooters and motorbikes in Vietnam and 67% owned by Sanyang Industry (2006 TT, MV $884 million), not realizing that while the listed vehicles have some “net-net” tangible manufacturing assets, the lucrative intangible assets in distribution and spare parts are not injected into the listed companies which are just front vehicles to raise funds and pledge assets to finance the unlisted businesses in the group.

Even at 90, Munjal still clocks at least six hours in office every day. Ask him why and he informs you that everybody asks him the same question. And he doesn’t see the point of it. “When I am still on duty, what is the point of not coming to office? What will I do at home the whole day? You are being paid for this,” he points out. “What right do you have to not do a full day’s work and still draw a full salary? The biggest thing is that I enjoy working. I enjoy coming to the office and I look forward to the day. Till the time that I am capable of work, I will not think about retirement”. Munjal summed up:

“This company is going to last for a long, long time. Because it is neither in my heart nor my children’s hearts to become rich quickly. If we keep satisfying the customer, who pays money to purchase our products, there is no reason for us to fall behind. Our culture is not to overcommit and underdeliver. First, prove your capability and then talk. Not the other way around. I am very grateful to God that my kids Pawan and Sunil talk only about what they have accomplished or what they have the capability to deliver.”

Key Bamboo Takeaways:

  1. In emerging Asia, the growing rural consumer market is often overlooked because it is difficult to reach out to this group without the right business model.
  2. To assess whether companies can overcome a crisis, value investors would find it helpful to look for the three sources of “emptiness” in Bamboo Innovators: the indestructible intangible of the trust and support from its community of suppliers, dealers and partners; the core-periphery network; and the open innovation model in working with external partners to co-develop new products.
  3. The case of China’s Lifan and Vietnam’s VMEP highlights the extreme dangers of using the net-net approach in investing in “cheap” stocks that (usually) turn out to be scary value traps. While these listed vehicles have some “net-net” tangible manufacturing assets, the lucrative intangible assets in distribution/financing and spare parts are not injected into the listed companies which are just front vehicles to raise funds and pledge assets to finance the unlisted businesses in the group.
  4. In Asia, it is very likely that we will see more cases of the principal taking back their powers from their local partners and compete alongside. Other ways for MNCs to leverage their power include increasing the royalty payments. It is possible that some of the outperforming Asian-listed units of MNCs could start to reverse their earlier massive gains.
  5. The case of Hero also highlights that there is no perfect stock and value investors often commit the error of omission because of nitpicking the grains of sand. Confirmation bias can distort the view of focusing on the trees or “chess pieces” but missing the forest or the “chess board”. Investors need to keep away from the emotion of having to be right in spotting the negatives. The red flags include (1) the lucrative spare parts and financing business residing outside the listed vehicle and in the private pockets of the Munjal family – Hero Honda before the split and Hero Motocorp after the separation; (2) the Munjals, like almost all Indian business family, are also active in their private business interests ranging from renewable energy, financial services, education to retail in chocolate and clothing. However, the core intangible asset of the distribution and marketing that drives the value creation process is housed inside the listco. Often, only one or two questions really matter to the investment case.