31 Dec Hidden Champions Fund Newsletters: December 2019 // Happy New Year!
Dear Valued Clients and Partners,
We would like to take this opportunity to wish all our readers a happy and most prosperous New Year!
May all your Wishes and Desires be fulfilled in the coming year!
And for our Chinese readers, wishing you an early and Happy CNY ahead!
A Reflection of 2019 and Looking ahead for 2020
Based on my own experience and conversations with others around me some time back, I have this perception that time tends to pass faster as we get older. Rationally, that would not make sense as every second is scientifically the same based on the measurement methodology* of using the atomic clock. So, between the reality and the perception, our own human mind and judgement is shaping our reality. In fact, according to Scientific American**, from childhood to early adulthood, we have plenty of new experiences and learning, hence our early years tend to be overrepresented in our autobiographical memory and on reflection, last longer. However, as our lives become more routine, we will experience fewer unfamiliar moments, thus time seems to pass faster. This means that to slow time down, we need to alter our perceptions by continually learning new skills and ideas and exploring new places (now we know why many of us like to learn new skills, attend courses & seminars and travel!)
In investing, our minds tend to shape our perception of the companies that we have invested in. One common phenomenon in investing is known as confirmation bias, where the data we gather tends to confirm our conclusion. This is done typically unknowingly on the individual’s part. Besides being self-aware of this bias, it is best to encourage every team member to speak their mind without fear of being wrong. Obviously, this is where unconsidered viewpoints may surface, but this is better than not raising the potential issues so as to reduce the potential blind spots.
2019 has been a bullish year for the world’s major markets amidst the volatility. Being conservative in our allocation has caused us to underperform the market. Many of the largest companies (by market capitalization) continue to appreciate in terms of their price. My opinion is that the stock prices of many of these index stocks may have been pushed up by the influx of funds from ETFs and Index funds to these index stocks. These can continue for a long time so I wouldn’t bet against the trend.
Prologue to next segment of Newsletter:
In this issue Richard will continue to share his perspective on assessing different types of management.
He will provide a few examples of our favourite kind of management , the owner-operator. Many may not realise it but the odds of having a management that can bring a company to great heights are few and far in between, particularly if you look at it from a percentage point of view.
I hope you enjoy this issue of our Newsletter.
*one second is defined in 1967 as “the duration of 9,192,631,770 periods of the radiation corresponding to the transition between the two hyperfine levels of the ground state of the caesium-133 atom.”
Clive Tan | CEO
Hidden Champions Capital Management
What is the Right Management and Why They Are Important (Part 3 of 3)
Recapping from the previous newsletter – There are 3 different types of leaders: (1) From the extreme left are the Owner-operators (OO), typically founders of the business; (2) in the middle of the continuum (LT) are long-tenured managers or those who have worked in the same industry for at least 3 to 10 years; (3) and the extreme right are the Hired Hands (HH) who have limited experience (<3 years) dealing with clients. In the last section of this three-part topic, we will delve into our favourite type of management, the owner-operator.
Owner- Operator 1 (OO1)
These are the ideal managers to partner with in a business. An owner-operator is a manager who has genuine passion for their particular business and is typically the founder of that business.
These passionate leaders run the business for key stakeholders such as clients, employees, and shareholders alike. They are usually paid modestly and have high ownership interests in the business. A stellar example for this would be Warren Buffett. If we refer to Berkshire Hathaway 2010 proxy statement, Warren Buffett earns a meagre $100,000 in salary (he was running a close to US$300billion market cap company in 2010!) and directly owns 37.1 percent of the stock. These managers typically take a long-term perspective when making business decisions and tend to tie their personal achievements with the survival and growth of their businesses.
In Sunny Optical, we have another example of an ideal manager we would love to work with. Sunny Optical started out in 1984 manufacturing optical components and optical instruments, and has been listed in Hongkong Stock Exchange since 2007. The founder, Mr. Wang Wenjian, set up the school-supported factory (Yuyao No.2 Optical Instrument Manufacturing) with just 8 fresh graduates from senior high school, a loan of just RMB60,000, and 4 workshops.
With his passion in optics, Mr Wang has overcome obstacles, transforming Sunny Optical from a low-end lens maker into an innovative lens-solutions provider. The company has blossomed and become one of the largest handset camera module suppliers in China, serving tier-one smartphone OEMs such as Huawei, Vivo, Oppo, Xiaomi and Meizu.
Despite his achievements in transforming the company into a billion-dollar market capitalization company, Mr Wang was paid relatively modestly. Apart from a one-time retirement bonus in 2014, he averaged USD$250,000 a year in compensation from FY06-FY13.
In addition, Mr Wang wrote a quote in a book on Sunny Optical’s history published in 2017 which touched us greatly: “When money gathers, people will be apart; when money is scattered, people will gather.”. True to this, at Sunny, Wang took the rare step of distributing stakes beyond top management when Sunny Optical restructured from a so-called village and township enterprise into a joint-stock company in the 1990s. This decision to hand stakes out to early employees, regardless of their position, has turned hundereds of them into millionaires, despite them having jobs such as factory workers, janitors and cafeteria chefs.
“In our firm, a helper handing food to you in the canteen may as well be a billionaire” in yuan terms, Wang said. “We did one thing well — building a team and keeping them growing.”
Today, together with the founding employees, key management owns about 38.74% of the company.
The management’s high ownership in the company ensures alignment with shareholders, willingness to accept a lower compensation in order to allow the company to grow, and his generosity and willingness to reward employees to grow together with the business is something we admire greatly.
Owner- Operator 2 (OO2)
This is an owner-operator who is passionate about running the business but is in between the two extremes of being completely stakeholder oriented and operating the business for his or her own personal benefit. These managers typically receive higher compensation packages than OO1 managers.
For example, Stephen Kaufer, the co-founder and CEO of Needham-based travel review site TripAdvisor Inc., received total compensation worth nearly $48 million in 2017. To put it into perspective, the company was loss-making that very year, and this was also 481 times as much money as TripAdvisor’s median employee, who had a salary of $99,643, according to TripAdvisor’s proxy filing.
Kaufer’s sky-high compensation in 2017 was largely the result stock options and restricted stock units he was awarded in Nov. 2017, which were part of a long-term incentive compensation plan laid out back in 2011 when TripAdvisor held its initial public offering. However, the pay out was hard to justify given that over the past years, TripAdvisor’s stock price has dropped more than 66 percent from an all-time peak of $109.18 to a current level of around $30.
Owner- Operator 3 (OO3)
OO3 managers are owner-operators who are not passionate about the business and primarily run the business for their own benefit. Their focus is more on building to sell rather than building to last. They think short term, do not take shareholder interests into consideration, and sometimes siphon off profits to themselves through egregiously large compensation packages.
One such example was a beauty company that is one of the leading retailers of cosmetics and skincare products in South East Asia. It offers a variety of beauty products under several brands with more than 7,000 stock keeping units (SKUs), focusing on the concept of offering excellent quality and premium design at an affordable price.
At its peak, the company was worth US$2 billion, which is quite rare in South East Asia context for companies to make it past US$1 billion dollars. But today, it is only worth less than one tenth of its value at its peak. So what happened?
Over the years, the business grew tremendously at a very fast pace. During this period, instead of thinking about the long-term sustainability of the business, or how to build a moat around the business in a low barrier of entry and competitive environment, the management just relied on what made them successful instead of thinking out of the box.
Furthermore, the management were busy selling out of the business to institutional and retail shareholders, making huge amount of profits and cashing out into their account. Research suggests that the CEO is an avid collector of antiques or vintages (apparent in his home collection) and a car guy (which he collectively owns approx. 30 ranging from classic to super cars).
Over a period of 6 years, key management holdings decreased by almost 50%, to just slightly above the 20% strategic shareholder threshold. If you were partnering such a management to grow your business, would you be concerned?
Hence, when we look at the management, although we get excited when owner-operators are leading a good business, we are wary of the type of owners operators they are. Having an aligned management leading our business will bode well for us.
Richard Sim Zhipeng | CFA, CA
Hidden Champions Capital Management