Hidden Champions Fund Newsletters: April 2019 Updates // Financial Garbage In, Financial Garbage Out: The Un-Balanced Sheet

17th April 2019

Think Smart Cities

“The 19th century was a century of empires, 20th century was a century of nation states and the 21st century will be a century of cities.” – Former Denver Mayor W. Webb

The above quote ties in with how cities have grown over the centuries on Earth. Whereas only 3% of the world’s population live in cities in 1800, 50% of the world’s population live in cities in 2008, and that percentage is set to rise in the coming decades. More importantly to an investor, most economic growth occur in cities.

With the advancement in technology and its applications, cities are set to become smarter. There will be positive impact to the environment, safety, transportation, utilities and buildings of smart cities. However, in many cities in the developing world, there are more and more slums being formed due to increasing migration to the urban areas from the rural areas. If the cities are not well planned and the inflow managed improperly, this could lead to a heavy strain on the existing infrastructure.

One observation that I made during my trip to India was that many people, even the rural “poor” have mobile phones. This, to me, is an encouraging sign and can serve as an “equalizer” of the income disparity between the rich and the poor. When even the poor has access to mobile phones, this allows more people to access information online, enabling people to have better assessments and decision making for the human population as a whole. This, I believe, will support in increasing social mobility, and this is an important aspect to help in balancing the income disparity.

The above brief description is my perception of the world’s development thus far. That’s why I like businesses that are involved in Smart Cities and mobile devices. While cities and mobiles (devices facilitating information access) will encounter their Ups and Downs, I believe that in the long run, these are irreversible macro trends. On top of that, there are plenty of data collected and the insights gained (and increasingly employing more Artificial Intelligence) will result in more effective and efficient use of resources and at the same time, fulfilling more human needs and wants.

With this, I hope that human civilization will not have to come to a point where we need to take a “Thanos” perspective that to save the world, we need to eliminate a significant percentage of the population. While I cannot condone what is done (as depicted in the Marvel movie series “Avengers”), it makes me more aware of the importance of demographics and the harnessing of that talent pool.

Prologue to next segment of Newsletter:

In this issue, we will be focusing our attention again to some of the more commonly used financial ratios in investing. Joshua will run through some of his insights when it comes to reading and understanding a balance sheet. And while the balance sheet is a snapshot, it does provide us with an understanding of a company’s current financial strength (or weakness!). While not everyone of us enjoys pouring through the details, it is important for us to know at least where to look.

I hope you enjoy this issue of our Newsletter.

Warm regards,
Clive Tan | CEO
Hidden Champions Capital Management


In the previous newsletter we looked at reasons we should never take ‘Net Profit’ at face value and how its derived ratios (ROE, ROIC, NPM etc.) and valuation models (P/E, PEG, Discounted Future Earnings (DFE), etc.) can show results skewed against our favor as investors.

In this newsletter, we will look at how at Hidden Champions Capital Management (HCCM), we take special care to adjust for ratios and likewise avoid taking the balance sheet line items at face value to unearth the true value of our Hidden Champions.

The main issues revolve around the flexibility GAAP allows. Fueled by short-term incentives like earnings performance (bonuses), stock price (stock options) or the pressure to raise funds for their cash-strapped companies, executives have an array of accounting choices to “game the system”, usually to increase earnings or create the appearance of a strong financial condition. Since they are within GAAP, they will most likely will be signed off by the auditors.


The balance sheet is supposed to represent fair values of its assets and its source of funding (from liabilities and ownership interests). Some assets and liabilities are marked to its market value, but many are based on historical costs like most inventory and property, plant and equipment (PPE).

Our team came across many ‘puffer-fish companies’, where executives have every incentive to show that the company is backed by as large an asset-base as possible but is inflated by air.

This allows for a better credit rating which then enables them to easily issue debt (bank financing or bonds) at lower interest rates or increase the amount of debt they can issue. The balance sheet can even be used to “store earnings” for future periods by utilizing aggressive accounting to overstate assets or understate its liabilities.

It is no surprise that many known cases of accounting fraud involves inflated assets. The last time Enron filed its quarterly statement, it listed assets of about $62bn. After filing for bankruptcy and investigations into potential financial and accounting fraud at the company, Enron pegged the value of its assets closer to $38 billion. Value of its assets was overstated by as much as $24 billion due to ‘accounting errors’.

Enron and other high-profile cases were made an example by the regulators because they were caught. However, these cases are the tip of the iceberg with many firms playing ‘within the rules’ and often escape undetected. While most would probably not amount to a violation of the law in letter, many are breaches of the law in spirit.

Inflated Inventory

Inventory represents goods manufactured but not yet sold. Once sold, they are reported in the income statement as Cost of Goods Sold (COGS). COGS is equal to beginning inventory plus inventory purchases minus ending inventory.

If the ending inventory is overstated, a firm’s COGS will be understated, resulting in a form of earnings management. An inflated inventory can also come about when executives refuse to write-off obsolete inventory resulting in a higher asset base.

In the case of Laribee Wires, they employed a mixture of non-existent and overvalued inventory which was then used as collateral borrow $130mn from various banks. With the bloated inventory and understated COGS, the company reported a net profit of $3mn when it was subsequently discovered to be a $6.5mn loss.

(LINK: Inventory Manipulation What You See Is Not Always What You Get)

At HCCM, we always keep a keen eye on wild fluctuations in inventory with respect to its revenue and total assets, unexplainable changes to a firm’s COGS as a percentage of its revenue and Days Inventory Outstanding (DIO), which is the average number of days the company holds its inventory before it is being sold.

Inflated Receivables and Reserves / Allowances

Overstated receivables affect not only the balance sheet but also reported income through uncollectible accounts receivable, overstated carrying value, understated bad debt and manipulation of reserve in doubtful accounts. It plays a key role in detecting fabricated revenues or inflated earnings by allowance for doubtful receivables.

Part of our screening and monitoring process involves keeping a close watch on the deterioration of earnings quality, especially when receivables are growing faster than sales or when Days Sales Outstanding (DSO) fluctuates wildly.

Pension Liabilities

Pension liability represent the amount of money a company must account for in order to fulfil a future pension payment. Since the liabilities occur in the future, the company estimates the value of pensions to account for them and this is a potential playground for manipulation by public companies.

Aggressive estimates can be used to improve earnings and create the appearance of stronger financial positions by changing assumptions to reduce the pension obligation like discount rate or artificially changing the net benefit cost or expected return on pension plan assets.

Inflated Goodwill

As we enter into the age of the intangible digital economy, it is understandable that our accounting system still lags behind in valuing digital assets.

However, goodwill also represents a subjective overpaying for an acquisition or the off–balance sheet shenanigan of using equity method to “hide” unconsolidated affiliates. Failure to write-off worthless goodwill from a bad acquisitions have been used to portray a larger than actual asset base.

Our team is always on the look-out for acquisition binges, especially where goodwill is the largest asset composition and when past acquisitions have been a disasters.


Leverage is one of investor’s key concern and our team have seen many financial statements where executives utilized creative ways to understate its debt, boost its assets and under-report its debt obligations.

Operating Leases 

A form of rental, operating lease is a contract that allows the company to use an asset without the need to own its assets or liabilities in its balance sheet. However, this form of asset ‘renting’ without ownership presents various issues.

Conventionally, a company borrows to buy an equipment. Paying off its interest and depreciation of assets will reflect as cost in the income statement and eat into profits while liabilities in its balance sheet will increase due to its borrowings.

With an operating lease, depreciation and interest payment will appear as an expense incurred to rent the asset in the income statement. However, the balance sheet will not record the assets and liabilities, hence giving the impression that the company’s ratio of debt to equity low.

The misleading part is that in both cases, the company cannot continue its daily operations without the asset, be it land or equipment, and require the same long-term financial commitment. Historically, operating leases have enabled firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets.

Under a new Financial Accounting Standards Board (FASB) rule effective Dec. 15, 2018, public companies will be forced to recognize all operating lease commitments on the balance sheet as part of their reported debt obligations unless they are shorter than 12 months. The accounting change on operating leases would add $3 trillion in debt to corporate balance sheets.

Perpetual Securities – Debt disguised as Equity 

Heated discussions surround perpetual securities in Singapore recently due to the Hyflux (SGX:600) saga, where a total of $900 million worth of debt ($400m preferred stock and $500m perpetual bonds) was raised from over 34,000 retail investors raised over a period:

  • $392 million at 6.00% p.a., issued on 13 April 2011 (Perpetual preference shares)
  • $300 million at 5.75% p.a., issued on 23 January 2014 (Perpetual Capital Securities / Bonds)
  • $175 million at 4.80% p.a., issued on 29 July 2014 (Perpetual Capital Securities / Bonds)
  • $500 million at 6.00% p.a., issued on 27 May 2016 (Perpetual Capital Securities / Bonds)
  • $175 million at 4.80% p.a., redeemed in July 2016 (Perpetual Capital Securities / Bonds)

The amazing part however is that none of these appeared as Hyflux’s liabilities even though numbers at that time already suggested that the company’s capital structure was hardly sustainable with its balance sheet laden with expensive debt that could not be serviced by its lack of earnings.
These preferred securities stays on Hyflux’s equity side of the balance sheet rather than showing as debt because the justification used by all companies to recognize perpetual securities as equity references IAS 32 (MFRS 132) where:

  • There is no contractual obligation for the securities to be redeemable and the option to redeem is at the company’s discretion.
  • Distributions/dividends are at the discretion of the company.

By classifying perpetual securities as equity, company executives aims to strengthen the balance sheet by reducing its gearing ratios and credit metrics.

However as investors looking into the financial situation and risk of a company, substance is more important than form and the substance of perpetual securities tells us otherwise where:

  • Usually five year time period where the principal should be redeemed by the issuer and in the event it is not redeemed, the coupon rate is stepped-up rate effectively forcing a repayment.
  • Interest or dividend rate is specified with a time interval to pay, usually semi-annually or if company has discretion to delay payment, it is cumulative and interest bearing;
  • Some perpetual securities are secured against the company’s assets.
  • If dividends of perpetual securities are not paid, some stop the entity from paying dividends to original shareholders.

Figure 4 Hyflux FY2016 (31 Dec’16)


As seen in figure 5, with perpetual securities recognized as equity, the gearing of Hyflux is 1.0, giving the impression that its debts is high but still within control. In reality, after adjusting for commitments from perpetual securities, gearing leaped to almost double at 1.8x debt to equity.

In the income statement, had perpetual securities be counted as debt, it would also deduct another $60 million (~5%) in interest expense from its already dwindling $10 million Net Profit in FY2016, and reported an after-tax loss of $50 million.

Special Purpose Entities (SPEs)

Special-purpose entities (SPEs) have become common financing techniques over the last 25 years and have extraordinary flexibility to keep liabilities off the balance sheet via undisclosed related party transactions.

Some of these hidden debt can be hard to detect in the financial statements. We simply avoid company we come across that has a spider web-like holdings with plenty of shell companies.

Figure 7 The Enigma Network: 50 stocks not to own (David Webb – www.webb-site.com)

Guarantees & Contingent Liabilities

Contingent liabilities are potential liability that may occur in the future, depending on the outcome of an uncertain future event. These can range from things like warranty obligations, anticipated lawsuit compensations or acting as guarantor for the bank loan of another company.

Any possible occurrence of these events can pose as a huge investment liability risk though it does not show in the conventional debt ratios.

Companies can also creatively account for these liabilities by underestimating their materiality. Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income or shareholders’ equity.

Investors can avoid these problems by carefully reading a company’s footnotes, which contain information about these obligations.

At HCCM, we have been prudent in adding not only operating leases but also other forms of hidden debt we feel are not classified according to its risk to investors such as pension liabilities and perpetual securities to a firm’s total borrowings.

We are also allergic to contingent liabilities and companies utilizing Special-Purpose Entities (SPEs) entangled in a confusing web of shell companies and cross-holdings which we will discuss below.


Net Debt / Net Tangible Asset (NTA)

In light of all the above investor’s risk discussed, traditional solvency ratios cannot be directly taken at face value. Take the commonly used Debt to Equity ratio as an example.

The fundamental reason why we look at debt ratios is to access the company’s risk of bankruptcy. We have discussed how companies are increasingly overstating goodwill to inflate its assets.

The conventional measure of equity is suitable when measuring a company’s profit generating ability per invested capital. However when measuring the risk of default and a company’s ability to service its debt with its assets, goodwill would run the risk of almost little or no monetary value.

Goodwill is a premium paid over the valuation of the company for brand name, distribution networks build, client database etc. Imagine a bank accepting a company’s distribution network built or software code as collateral for loans anytime soon.

  • Total Equity = Total Asset – Total Liability
  • Net Tangible Asset = Total Asset – Total Liability – Total Intangible Asset

Net Debt to NTA thus excludes intangible assets from solvency ratios, presenting a more conservative gearing ratio and is able to surface companies with true solvency issues.

At HCCM, we are consciously conservative and painstakingly detailed in our financial analysis to avoid potential risk and unearth hidden champions to compound our wealth. We believe that when we take care of our downside and focus on the process, our upside will naturally take care of itself over the long term.

Joshua Zhang | Investment Manager
Hidden Champions Capital Management