Hidden Champions Fund Newsletters: March 2019 Updates // FINANCIAL GARBAGE IN, FINANCIAL GARBAGE OUT: How Reliable Are The Ratios We Use?

18th March 2019

Dear Valued Clients and Partners,


Share Price Movements & My View of China-US Trade War

Markets and share price movements have always been part of the deal in investing. Benjamin Graham’s unforgettable analogy of the market (Mr. Market) definitely provides some level of guidance when prices move. However, price movements, particularly massive ones, should not be ignored but instead thoroughly investigated to ascertain the cause and whether the market has overreacted, be it on the upside or downside. Where gyrations are to be expected as part and parcel of a marketplace (where free trade occurs), it is the big movements and long term price trends that an investor should pay attention to. The tendency for markets (which is made up of many human beings) to overreact either way is important for us to know so that we can take appropriate actions. However, we must not believe that (due to the Mr. Market analogy) the market is always wrong; in fact, in my opinion, the market is more often right.  We need to ascertain the facts and likely impact, taking into account the sentiments of the market and ourselves.

At this juncture, we are in the midst of a China-US Trade war. There have been many differing views on how this will pan out. As this will inevitably affect our strategy and decisions, and hence investment returns, I think it is perhaps important for me to articulate my opinion and perspective on the situation so that all fund investors are aware of the risks involved if my views are wrong. Do drop me an email as well if you beg to differ!

I believe that there will be plenty of tensions and Tit-for-Tat actions from both countries in the next few years or even a decade. And being an emerging Superpower, China will modernise and upgrade her military capabilities. The United States will feel that China is a threat for a while despite China’s assurances. But despite all these, it would be hard for both Superpowers to go to a military war directly. Proxy wars are a possibility, where the damage of war is suffered in other countries, rather than their own.

Going to war is no longer profitable in the modern era. Even though one can obtain physical land and resources when a country conquers new territories, the most important economic resource today is the people and talent pool. How do you win a war and at the same time win the hearts and minds of the people conquered? That is a near impossibility in my mind. And because of that, whilst the armed forces of the world are still around, we are living (according to many accounts) in the most peaceful of times on Earth. In today’s interconnected world, where we have too much connectivity especially among the economically developed and developing countries, it is hard to imagine that countries developing well economically will want to go to war with each other and suffer the inevitable karmic impact and suffer military and economic losses due to that aggression.

Despite this, humans often act unpredictably (I dared not write off Donald Trump when he was running for President during the elections) and there is always a possibility of a military war, as an investor, I envision that the higher possibility scenario is most likely one which despite the tensions and “tit for tat” actions, peace between the Superpowers prevail and those economically well-developed countries will continue to stay the course to uplift their population economically.  The wealthier nations of the world must also stay the course of promoting economic well-being and have it spread to all countries of the world. Just like the Wealth inequality gap between the rich and the poor breeds unhappiness, a gap too wide between countries may prove to be a catalyst for war.

Having said that, I am optimistic about the mid to long term future of the Asia Pacific region, in particular China.

Recently, there was a big market upswing for many companies involved in China’s 5G and the relevant sectors, including Hikvision (mentioned in our previous issue). While it is emotionally comforting to have our stock picks “endorsed” by the market via a positive price action, there is always a mixed feeling wondering if the market has moved too fast ahead. But over the mid to long term, the regression to the mean tend to occur and we should not be too bothered by this movement so long as the businesses that we have invested in are fundamentally sound and growing.

Prologue to next segment of Newsletter:

In contrast to our previous issue, we will be focusing our attention to some of the more commonly used financial ratios in investing. Financial ratios are commonly used tools in an investor’s toolkit but how well an investor is able to use them is really very much a matter of judgement and mastery. Many ratios capture the meaning on the surface but it is often important to delve into the details or the breakdown of the ratios to enable us to go deeper into what the actual situation is in the company.  Unusual financial ratios are often tell-tale signs for further investigations and to go deeper. Even for healthy looking financials and ratios, one must not be complacent but be vigilant to look into the details, which we will be doing so in the next section.

I hope you enjoy this issue of our Newsletter.

Warm regards,
Clive Tan | CEO
Hidden Champions Capital Management


Return On Equity (ROE), Return On Asset (ROA), Net Profit Margin (NPM), Current Ratio, Debt-to-Equity, Price-to-Earnings Ratio (P/E), Discounted Earnings Model (DEM), Discounted Future Earnings (DFE).

Any fundamental investor would be reasonably familiar in using most of these profitability, liquidity, solvency ratios and valuation models to analyze companies. These data points are available in many paid and even free financial data providers servicing the retail investor.

But as we confidently check-off our target companies to these ratios, project its earnings, arrive at our estimate of the intrinsic value and plough in our hard-earned money, did we pause to wonder just how reliable these ratios are and what they exactly represent?

Here we will look at a couple of these ratios, the danger of taking action based on some commonly used financial ratios and how we substitute some of these ratios at the Hidden Champions Capital Management to better uncover the true value of our Hidden Champions.


The commonly used P/E ratio evaluates the price the market is willing to pay per dollar of earnings. Simply take the current stock price, divided by the company’s most recent per share Net Income. Seem too easy a process to capture the entire company’s business value? That’s because it really is. While the ratio’s simplicity is its biggest benefit, we believe it is also its largest flaw if wrongly applied.

Problem With Price

P does not consider debt and cash – Price represents market capitalization or share price and only considers the price paid for the equity. However, if the company is purchased, the price paid would only reflect the cost to acquire its outstanding equity and the buyer would still be responsible for paying back all its outstanding debt or deployment of available cash in the company for dividend payment or future growth.

At Hidden Champions Capital Management, we prefer to look at a company’s ‘Enterprise Value’ as opposed to its ‘Market Capitalization’ where:

Enterprise Value = Market Capitalization + Total Debt – Total Cash & Equivalent

As an example, let’s take a look at three companies, ‘Normal’, ‘Debt’ and ‘Cash’. Assuming all three companies generate the same $10 million in earnings except for the following differences:

  • ‘Company Debt’ borrowed money to fund its operations and no cash
  • ‘Company Cash’ has spare money waiting to be deployed and no debt
  • ‘Company Normal’ did not borrow, nor do they have spare cash


The conventional P/E ratio would value all companies at the same 10 times earnings while ‘Enterprise Value’ correctly price in borrowings made by ‘Company Debt’ resulting in a more expensive valuation.

‘Enterprise Value’ would also price in the spare cash available for growth initiatives or dividend payouts by ‘Company Cash’, rewarding it with a cheaper valuation.

Problem With Earnings

Oversimplification – Net Income is an important measure of how profitable the company is for that financial year and involves tabulating all accounting inflows (e.g. revenues and gains etc.) and accounting outflows (e.g. expenses and losses etc.).

As shown in Figure 2, the journey from top-line to bottom-line involves walking through multiple segments which we will attempt to simplify into 2 broad categories:

  • Main Recurring Business Operations – The main business operation which we want to purchase and assign an intrinsic value by projecting its earnings into the future.
  • Non-Core or Non-Recurring Operations – The “other stuff” which are either lumpy and non-recurring or has nothing to do with its core business operations.


Valuation models are straight-line projection of the company’s earnings into the future with assumption that it will continue to grow at a steady rate. In the Figure 3 example, an investor would have overpaid by over 100%!

This is due to:

  • Wrong Growth Rate – Earnings Per Share increases from $1.00 to $1.30 or 30% if one-off items are included, resulting in increased valuation projection.
  • Wrong Earnings Per Share Starting Point – Year 0 is the point an investor start considering the stock. Projections starting from $1.00 vs $1.30 will likewise result in increased valuation projection.


The compounded effect of wrongly projecting a company’s unadjusted earnings and wrongly inflated growth rate would be disastrous.

At the Hidden Champions Capital Management, we “clean” every net income figure we use from one-off items and normalize many other aggressive accounting estimates used to calculate price multiples or valuations.

Figure 4 is an example of Starbucks’s financial statement showing earnings before and after one-off adjustments. For the unsuspecting investor looking purely at accounting earnings to calculate P/E ratio, they would have reacted during these periods:

  • Fear on 12 Nov’15 – Q4’2014 from “losses” due to one-time legal settlements
  • Greed on 29 Jan’19 – Q1’2018 from a 47% “increase” in earnings due to one-time gains on investment & asset sale


However, when we adjust for these one-off items, we can see that these legal settlements in 2014 and gains in sale of asset and investments in 2018 has nothing to do with Starbucks selling coffee and will never occur every year.

Check the share price for market reactions during those periods!

Where the Starbucks example are cases of genuine one-off items, our team have encountered far too many cases where upper management, on realizing earnings for the next few quarters will dip below analyst expectations, would create one-off items to prop up earnings and its underlying valuation. What is going on? Are the management out to deceive?

A 1995 speech by legendary investor Charlie Munger titled “The Psychology of Human Misjudgment” opened my eyes to how useful behavioral psychology can be in business, problem-solving and how incentives shape behavior. Incentive is a powerful tool to facilitate or prevent certain behaviors in people. We would have experienced Granny’s Rule,  “Dessert comes after carrot”.

“Never, ever, think about something else when you should be thinking about the power of incentives.”
— Charlie Munger

Misaligned incentive structures are partially to blame for the recent Wells Fargo scandal. Even if Wells Fargo established incentive arrangements with the best of intentions, it tied a substantial percentage of employee compensation to uncontrolled sales targets.

This compelled employees to open millions of bogus accounts and credit cards in customers’ names, infringing on their trust, and costing them millions of dollars in fees for services they did not willingly sign-up for. This case makes it obvious that incentives intended to stimulate people to do their best can sometimes push them to do their worst.

When the remuneration committee ties the upper management’s bonuses to share price performances, revenue and accounting earnings as opposed to economic value add (EVA), it is no surprise why propping earnings via one-off items and other financial shenanigans are a common infestation in the capital markets.

This brings us to the next reason why earnings usually cannot be trusted at face-value.

Quality of earnings are not considered – Income statement earnings are made up of cash earnings and accrual earnings (i.e. profits booked but hanging on a paper promise that they will be paid by their clients). In fact, many companies can earn no cash despite reporting huge paper profits and end up writing off those profits in the future or end up bankrupt. Earnings can also be boosted by delaying payments to their suppliers to report a higher profit.

Many companies are able to snowball paper profits for years because investors were taking the reported earnings at face value and thought they were great buys. If investors were more aware and understood the other parts of the balance sheet, they may have spotted inflated earnings as a real issue and avoid the company.

The amount of paper profit or expense pending payment by the company can be found on the balance sheet, accounts receivables and accounts payable, a separate topic which we would leave for another session.

The Combined Problem Of The P/E Ratio

If up to this point I have yet to convince you on the fallacies of plucking price and earnings from the financial statement at face value, here are a couple more situations where if combined, we arrive at a situation of financial garbage-in, financial garbage-out.

Backward looking – The P/E ratio is a backward-looking indicator if you use the company’s most recent full year earnings number and project it forward. The problem of looking at the rear-view mirror and driving forward is very dangerous during periods where economic conditions have changed significantly in a short period of time.

Imagine the danger if the car in front suddenly breaks or accelerates.

At times a low P/E ratio does not mean that a company is undervalued. The market is usually efficient and have priced in the necessary risk such as financial trouble in the near future. Stocks that go down in price and stay down usually do so for a reason.

Buying into a company with low P/E over a prolonged period of time usually leads to a value trap. And as an example, I would like to introduce you to 4 types of companies, Mr Value Trap, Mr Fair Value, Mr Under Value and Mr Quality Growth.

Doesn’t account for growth – P/E ratio doesn’t account for any growth and has the common misconception that 10 times earnings is cheaper than 20 times earnings. However, when we take growth into consideration and are willing to pay up for quality growth companies, which we systemically hunt at Hidden Champions Capital management, we find that compounding does it magic over time.

Figure 6 shown above shows us 4 different types of companies an investor could have included in their portfolio:
  • Mr Value Trap – A ‘very cheap’ stock bought at 5x P/E but of very low quality and an uncertain future.
    • At time of purchase (Year 0), it would appear cheap.
    • As time goes by, earnings drop and the investor pays the price from the lack of earnings. Holding this stock on the 10th year would mean 46 years to break even or 1/46.6 = 2.1% p.a. returns and dropping.
  • Mr Fair Value – Paying fair price for a mediocre company.
    • Base rate example. Nothing much to be said.
  • Mr Under Value – Paying a very cheap price for mediocre company
    • Another popular investing style which Warren Buffett employed in his early years to immediately arbitrage on market mis-pricing.
    • Misjudging the quality of the company may result in a Value Trap situation.
    • This strategy requires the investor to be fairly active in trades. If the style is to hold the company over a long time, this would not generate the best returns as seen by the P/E ratio after the 5th year.
  • Mr Quality Growth – Conventionally ‘expensive’ stock bought at 20x P/E but of high business quality, growth and a long business runway.
    • At time of purchase (Year 0), it would appear very expensive.
    • Misjudging the quality & growth of the company may result overpaying for the company and a poor return on investments.
    • As time goes by, earnings compound and the investor reaps the benefits from its increased earnings. Holding this stock on the 10th year would mean making back your initial capital every 1.5 years or 1/1.5 = 67% p.a. returns and increasing.
    • At year 10, it would take a severe black swan event to be able to purchase this company at its Year 0 Price.
“Time is the friend of the wonderful business, the enemy of the mediocre.”
— Warren Buffett

Relative valuation ratios still has its place in valuing stocks, but investors should never use it as the sole reason for investing in a company. At Hidden Champions Capital Management, we use relative valuation tools not as a pricing tool but as a comparison tools among peers.

Adjusting the market capitalization to reflect cash and debt (example shown in Figure 1), we use the company’s Enterprise Value (EV).

Avoiding the one-off items and taking only earnings from a company’s main recurring business operations (example shown in Figure 2), we use the company’s Operating Profits aka Earnings Before Interest And Tax (EBIT).

As EBIT does not consider one-off items, Interest payment and Tax, we can compare companies in similar industries across various geographic boundaries with differing tax rates, with differing capital structure and interest payments and without the fuzziness of one-off items.

For banks and financial institutions where interest payments/expenses are critical, other adjustments would be needed.


We hope what with this issue, readers will be more aware when using common ratios involving accounting earnings such as Return On Equity (ROE), Return On Asset (ROA), Net Profit Margin (NPM), Price-to-Earnings Ratio (P/E) and Discounted Future Earnings (DFE) etc.

In the next newsletter, we will explore major fallacies of taking balance sheet ratios at face value like Return On Asset (ROA), Current Ratio, Debt-to-Equity ratios and how we systemize our investment process to adjust for these fallacies to uncover Hidden Champions.

Joshua Zhang | Investment Manager
Hidden Champions Capital Management