01 Jul HCF Newsletter- June 2020 Updates: Portfolio Overview & Our Investment Updates
Dear Valued Clients and Partners,
I would like to thank our clients who set aside your commitments to join us for the teleconference meeting on 3 June 2020 (Wednesday). By joining us on the call, we hope that you have a further understanding and clarity as to how we are able to achieve our results over this COVID-19 period and the stock picks and portfolio allocation that we have done in order to achieve that.
For those of you who were unfortunately not able to do so, I hope that the information provided through our newsletters and communication is sufficient for you to understand our current performance. As with all things in life worthy of our endeavours, they require plenty of brain-work, heart-work and hard work. While it has taken time to show some results, I would like to acknowledge the team for working tirelessly behind the scenes. It is first and foremost a team effort, with individuals playinåg to their strengths and having faith and trust in their team members’ work. I would like to make a special mention of Richard Sim, the investment manager in charge of HCF Class 1 portfolio, for working through this challenging times with the team – particularly when one of our core stock holdings (Ausnustria) was under plenty of scrutiny and a short-seller attack.
In the past two months, we have seen significant improvements in the performance of our fund despite indexes around the world dipping. In this newsletter, we will include a special portfolio performance review segment (written by Richard Sim) below, and a deeper look at one of our core holdings. Please do note that HCF Asia (HCF Class 1) is a fully operational fund open for investment, while HCF USA is currently under our fund product development stage.
I will also be sharing some of my perspectives on the dichotomy of competition and cooperation existing in leadership and management. This newsletter will include a new segment of 3 of the most interesting things since we last spoke, and will likely be included in future newsletters to capture more of our team’s views. I hope you enjoy this issue of our Newsletter.
Clive Tan | CEO
Hidden Champions Capital Management
HCF Asia’s Fund Performance Chart as of 30 June 2020
For our Asia fund, we are delighted to inform our investors that our fund is continuing to fire on all fronts, outperforming all the various Asia indexes we are benchmarking against. MSCI Asia Pacific Index’s YTD return is -8.3% vs HCF’s 28.1%, while the two months’ returns are 6.0% vs 21.6% respectively.
While we recognise that we have undertaken a conservative and slow approach last year (we took a full year to fully deploy the funds to reach our targeted 10% cash level), we are seeing some results from this approach. This is in line with our philosophy of capital preservation with extraordinary growth, where we refrain from acting aggressively unless we see value screaming at us.
Most recently, there was a case where we felt that such an opportunity was present. At first glance, it is not a conventional investment. We had a huge debate and convinced ourselves to take a stake in a company that is currently trading at 100x PE. Yes, 100x PE in Asia. This company is in the Malaysia glove industry, which we will cover briefly below.
In a conventional sense, investing in a 100x PE company may seem crazy, and the team thought so too. However, as always at HCF, we will not let first impressions or feelings cloud our judgement but will always refute or debate our points with quantitative proof and further groundwork.
Through financial modelling and more thorough on-the-ground research by speaking with the management of various glove companies, we came to realise that the expected increase in Average Selling Price (ASP) of gloves will potentially double or even triple their profit! With this information, we arrive at a forward PE of around 30x. Coupled with the future growth potential and the doubling of production capacity in years to come, we believe that this company has a long runway to go and presents value in the investment.
What about future potential threats from China? Glove makers in Malaysia have cost and quality advantage compared to their peers in other countries. Besides having higher labour costs, natural gas prices are higher in China compared to Malaysia. In addition, their Chinese peers require a higher rate of consumption of natural gas to manufacture gloves (10% of total cost) due to their need to adjust for weather conditions (there are four seasons).
In our existing portfolio, we have a comfortable stake in a Malaysia glove company that is currently sitting on 170% returns in less than two years. This new company is one that we are familiar with for the longest time, and this investment will increase our exposure in this industry and diversify the risk across companies at the same time.
While we are quietly positive with the industry, we will continue to be wary of the various uncertainties ahead which might affect the ASP and long-term profitability of the company. We will seek to actively rebalance whenever necessary.
PE chart of the new company.
HCF US (Stocks Only)
If the stock market’s sharp drop in March came as a shock, the subsequent recovery has been far more surprising.
It was not hard to understand why share prices plummeted as the world went into lockdown to slow the spread of COVID-19, but the rebound was harder to explain. It has been described by some as the most hated rally in history, and is probably the least expected too. At HCF, while we were preparing to apply our strategies in the US markets, we thought that the recovery would come much later too. Hence, the later events that transpired caught the team by total surprise.
It seems the old adage of “Don’t fight the Fed” still holds true. The Fed Chairman Powell’s assurances of “we will not run out of ammunition”, seemed to have a very positive effect and achieved its goal of keeping the markets liquid and capital flowing freely to the companies that need it. The flywheel effect where the higher the market went, the more people believed that the Fed will be able to support the market, results in a Fear Of Missing Out (FOMO) mentality. In our opinion, this creates a situation where we see investors/speculators in the market bidding up assets, disregarding the underlying value of the companies.
When the market sentiments moved into the FOMO mindset over the prior fear of losing money, fundamentals and valuations appeared to be of limited relevance. Some examples are the stock prices of beneficiaries of the virus such as digital service providers and on-line merchants approaching the “no-price-too-high” proportions.
With the new US portfolio we are developing to apply our investment strategy into the US markets, we initiated investigative stakes in 15 companies in the US on the 21st April 2020. To date, ALL 15 of them have generated positive results with an average return of a whopping 60.4% of invested money at the time of writing. This is in comparison to the S&P 500 which generated only 18.1%. We will not deny that this situation is beyond our wildest imaginations.
However, we must be grounded and cautious moving forward. Despite the fundamental outlook appearing positive with the support from the Fed, at the current valuations of listed companies where they are, the odds are not in the investors’ favour. As we continue to build this US portfolio, we are wary of all the potential issues/potholes in the road ahead and will continue to exercise caution in our deployment of the funds.
Investing Lessons from Life Experiences
The COVID-19 situation in Singapore has been brought to a level comfortable enough for the country to be out of our imposed “Circuit Breaker”, while official figures from Malaysia has indicated that the COVID-19 situation at their side has been brought under control. However, this is not the case in many parts of the world, where the few nations (South Korea, Germany, China etc.) which seemed to have overcome their first wave are seeing the initial embers of a second wave. In fact, the number of infections and deaths from COVID-19 throughout the world is still increasing, albeit at a slower percentage rate as the base of infected people have increased. I hope you are in great health and safe in the midst of the pandemic, and hope that you are able to take the necessary precautions for COVID-19 as it seems that this will be with us for quite a while longer.
As I am writing this, our Government in Singapore have called for a General Election on the 10th of July 2020. As the various political parties were listing their potential candidates to contest in the elections, there was a particular candidate who shot to “fame” due to certain issues surfacing from his past. Whilst I am not here to provide political commentary, and neither will I as I do not know the person directly and will not judge a person based off feedback on various online channels, it does trigger my thoughts about the importance of having good leadership and management in the businesses that we are investing in.
How exactly do we assess management? If leaders display integrity and compassion, does it mean they would succeed? Frankly, more often than not, I often observe that the top leaders in many businesses (Eg: Steve Jobs from Apple, Elon Musk from Tesla, Larry Ellison from Cisco etc.) are often not known to be compassionate but more competitive in nature. Due to their competitive nature, they tend to ruffle quite a few feathers along the way. However, they may become more compassionate as they age with wisdom. (Just look at Bill Gates!)
This makes business sense. To succeed in business, the dichotomy of competition and cooperation is necessary. If the leadership is overly competitive, it may lead to infighting and present challenges to scale. From my own experience and observations, I feel that more damage is typically done by internal factors rather than external factors. However, if the leaders are very cooperative, I feel that it lacks the competitive edge essential for the survival of businesses when pitted against other businesses. It is rare to meet a business leader who has a good balance of both, with the ability to build up and scale up in a sustainable manner. More often than not, it requires opposing yet complementary personalities within a team to provide such edges. This then provides another question, as to where the limit is on how hard the leader can be on his team members, but yet retain the level of respect needed for the team to still follow willingly? One of the key things for any leadership for me is that they must command the respect of the rank and file of the company so that they can lead the company effectively in an aligned direction going forward.
I would like to draw an analogy to the sports of road cycling. This is one sport that I feel comprises both the cooperative and competitive elements. For those of you not familiar with the sport, the competitive edge is present as there is only one winner, either through passing the designated line first (finish line) or have the shortest cumulative timing over the many stages of cycling. Yet you’ll find even the most competitive and strongest cyclists among the peloton cooperating with other cyclists along the routes to gain the benefits of drafting (by cycling behind a cyclist or in a group of cyclists, the wind resistance and amount of energy required to pedal are reduced, hence increasing the average speed of every cyclist in the group with less energy). These actions tend to support and benefit them in conserving their energy as much as they can towards the end, where it is typically an all-out sprint towards the finish line. It is not uncommon to find competing teams actually cooperate with each other along the way.
In a way, I love this sport because of this dichotomy. When assessing leadership and management, striking a balance between these two seemingly opposite characteristics is what makes it interesting and challenging at the same time.
Moving forward, we would like to include a little segment of “3 of the Most Interesting Things That We Have Read” covering events that happened in the past 2 months since we last wrote. This segment may include anything under the sun that grabbed our attention, and might or might not have relevance to companies or the global economy.
3 of the Most Interesting Things That We Have Read
COVID-19 definitely has to be the top issue in the world right now that is affecting every single person. The ongoing pandemic has already seen more than 500,000 deaths worldwide, and infections surging past 10 million people with signs of a second wave all over the world. These numbers are a strong reminder that the deadliest pandemic of the modern era is stronger than ever.
Now, although we know that you must have heard or read these points thousands of times, we feel that this is the time to reinforce this point more than ever: Despite many countries emerging from their respective lockdowns, we must exercise caution and acclimatise to the new “normal” of practicing social distancing and increased hygiene practices in public to avoid a second wave hitting our countries and economies. We must be aware that there are proven asymptomatic carriers that allows the virus to spread silently for weeks, or even months, creating viral reservoirs that can remain hidden until someone becomes sick enough to warrant testing.
In fact, in Beijing, all it took was a 52-year-old man with fever and chills to test positive on 11 June to show us how the pandemic can come roaring back from apparent obscurity. Beijing’s first reported case after nearly two months shattered hopes that months of painful physical distancing, meticulous testing and quarantining had driven COVID-19 to extinction within the city. Now, more than 200 people have tested positive across Beijing, schools are shut and thousands of domestic flights cancelled. This resurgence offers a stark warning to countries that appear to have cut chains of transmission not to be complacent.
Other regions from Tokyo to Seoul and Australia’s Victoria state are also seeing cases bubble back up. In the United States, states such as Texas, Arizona and Florida are seeing an overwhelming increase in cases, forcing them to reverse plans to open their economies.
The situation may worsen towards the end of the year, where various countries will need to prepare for the annual flu season which will complicate the coronavirus containment efforts given their similar symptoms, and thus adding more stress on already stretched health-care systems.
Economic-wise, the International Monetary Fund has downgraded its outlook for the coronavirus-ravaged world economy, and is expecting the global Gross Domestic Product (GDP) to shrink 4.9% this year, far worse than the 3% predicted in April, projecting expectations of a significantly deeper recession and slower recovery than it anticipated just two months ago.
With the knowledge that a lingering threat of a resurgence in the virus cases will be present in the near future, we are of a similar opinion that the global economy will be in for a rough ride ahead, which makes selecting great companies that are resilient of paramount importance to the team.
2. Malaysia Glove Suppliers Says Shortage To Drag On
Malaysia is the world’s leading manufacturer in the Global Medical Gloves market with 65% of the market share, boosted by natural geographical factors lending a natural moat to their global dominance.
Back in the 1870s, rubber trees native to Brazil were brought into the present-day Malaysia by British colonists and they took to the hot, humid climate quickly. The rubber plantations brought about easy access to latex, a core material in rubber gloves. Malaysia’s large oil and gas industry also provides local glove manufacturers with an additional advantage in accessing an abundance of supplies needed to manufacture synthetic gloves. These natural factors add up to give Malaysian gloves manufacturers the edge over their overseas peers.
Malaysia became the gloves powerhouse as they are known today from a situation similar to now: The AIDS epidemic in the 1980s created a surge in demand for gloves for the front-liners in the war against the virus in the U.S. and Europe. When the Western manufacturers couldn’t keep up with their local demand, Malaysian entrepreneurs, benefitting from relatively lower labour costs, stepped up to grab the opportunity. Even though AIDS proved less transmissible, this incident provided Malaysia with the opportunity to gain a foothold in the gloves industry.
Similar to the situation back then, wearing protective equipment has become the norm with the virus pandemic that has already killed more half a million people worldwide. Malaysia’s Rubber Glove Manufacturers Association estimates that the world’s consumption of Personal Protective Equipment is estimated to jump more than 11 per cent to 330 billion pieces this year, with two thirds likely to be supplied by Malaysia.
With the estimated demand, we are seeing that the global shortage of medical gloves due to a coronavirus-driven surge in demand will carry over into next year. Presently, many countries have depleted their stores and is currently holding insufficient glove inventories for their requirements. Therefore, future growth in 2021 will be underpinned by organic growth, as well as stock replenishment requirements.
Upon further investigations by us, we found that the average Average Selling Prices (ASP) of the gloves have been increasing at an exponential rate quarter on quarter, and may peak at the end of the year by an average increase of at least 30% in ASP. This will result in the various gloves manufacturers doubling or even tripling their operating profit in a year time due to operating leverage.
However, we must be aware of potential risks that the Malaysian glove manufacturers may face due to various uncertainties ahead.
First, should the COVID-19 crisis start easing as a result of better control processes, or if a vaccine is found, the ASP and operating profit margins of these manufacturers are bound to come under pressure due to a drop in demand and the following oversupply as a result of high production.
Secondly, fellow China glove makers like Blue Sail Medical and Intco Medical, have announced ambitious plans to ramp up their nitrile glove production capacity. Blue Sail aims to raise its nitrile glove production capacity to 36.1 billion by end-2023, up from 4.3 billion at end-2019, while Intco plans to expand its nitrile glove capacity to 59.2 billion per annum by end-2023 from 5 billion at end-2019.
However, although it is noted that there is an incoming China nitrile glove capacity of 86 billion pieces, only 7.7 billion are slated to be ready by the fourth quarter of 2020, assuming no delays. It is a known fact in the industry that China had issues with a natural gas shortage in the past, which may lead to quality issues and production disruption. We are of the view that the new capacity produced will be absorbed with the increase in domestic and overall demand over time.
3. Singapore Retains Top Spot As World’s Most Competitive Economy
In the latest edition of the IMD World Competitiveness Ranking, Singapore has retained its top spot as the world’s most competitive economy for a second straight year in the annual list of 63 economies, which analyses the ability to generate prosperity.
Including Singapore, Denmark, Switzerland, the Netherlands and Hong Kong completes the top five list. As a group, they illustrate the strength of many small economies amid the disruption caused by the coronavirus pandemic.
On the other hand, both the world’s largest economies fell in the rankings. The trade war between the United States and China damaged both the economies, reversing their positive growth trajectories. The US fell seven spots to 10th place, while China slipped to 20th from 14th in 2019.
The factors behind Singapore’s success is attributed to its strong economic performance, which stems from robust international trade and investment, employment and labour market measures. Stable performances in both Singapore’s education system and technological infrastructure – telecommunications, Internet bandwidth speed and high-tech exports, also played key roles.
Despite not being as sensational as the first two points, we have still decided to share this point with you. Being Singaporeans, we should be very proud of how this tiny red dot is able to stand its ground in the world and everything it achieved against all odds!
In these volatile yet interesting times, we are confident that our current investment principles and strategies of picking financially strong companies which experiences little or no impact to their operations and growth in the current climate will serve our portfolio well. However, we will continue to be vigilant and stand ready to adapt as the current situation plays out, and will not be afraid to adjust if necessary.
Richard Sim Zhipeng | CFA, CA
Hidden Champions Capital Management