Hidden Champions Fund FY16 Investment Letter: Our North Star Investment Strategy to Navigate Turbulent & Fragile Markets
“ Governing with excellence can be compared to being the North Star: The North Star dwells in its place, and the multitude of stars pay it tribute.” – Confucius, Analects 2:1
Dear Shareholders,
Your funds in listed Asian equities have achieved a -4.7% 12-month rolling return (in SGD terms) against declines of 11.3% for the MSCI Asia Pacific Index, 11.7% for the Australia All Ord Index, 12% for the Nikkei 225 Index, and 17.6% for Singapore’s FTSE STI Index over the same period.
This outperformance is buttressed by an 11.2% absolute positive return (in SGD terms) from our investment cost of the revamped portfolio in the second-half since September 2015 against market index decline, powered by a double-digit gain from our high-conviction top position, ASX-listed Sealink Travel Group, which comprised around one-third of our portfolio NAV. We are also a Top 15 Shareholder in this world-class widemoat company with dominant market leadership as the largest provider of nation-wide tourism and transportation services generating record profitability with a visible long runway ahead to compound growth with resilience.
We aim to be a Top 20 Shareholder disclosed in the Annual Reports of the companies we invest in as a demonstration of our conviction and transparency in the investment process. As detailed in Table 1, we are a Top 20 Shareholder in 7 worldclass wide-moat companies out of the 18 portfolio stocks (we added 4 stocks in April after the Financial Year ended which were up 10.8% as of 29 April). We are looking to accumulate more and becoming a substantial shareholder with a 5% stake as they continue to deliver in their business fundamentals.
This outperformance is possible because of our multi-manager team-based investment process implemented in September 2015, led by our analyst team comprising of Kelvin Seetoh, Jackson Yeow, Sim Zhipeng, and Joshua Zhang. This teamwork greatly strengthens our ability to invest with high conviction in wide-moat companies, making an architectural shift from time telling to clockwork with a build-to-last structure for our shareholders. As Jim Collins, author of the Built to Last and Good to Great, puts it aptly, “Imagine you met a remarkable person who could look at the sun or stars at any time and state the exact time and date. But wouldn’t the person be even more amazing if, instead of telling the time, he or she built a clock that could tell the time forever?”
“ You look at all the successful companies, what is the key? Their brainpower. The thinker, good management, good innovators… Successful CEOs are like gems you find on a beach. There are many pebbles, many beautifully colored ones, but they are all stones. Now and again, you will come across a real precious gem, a real emerald, pick it up, polish it. He must have a set of qualities that fits with the job, has energy, drive, ability to interact with people, ability to get people to work with him in a team.” — Lee Kuan Yew, founding Prime Minister of modern Singapore, in Hard Truths to Keep Singapore Going
We would like to express our heartfelt thanks to our 8IH team as all of us put forth energy when and where it was needed and yet were careful stewards of organisational energy by painting a vision so beguiling and inclusive that it riveted the attention and harnessed the energy of everyone into something exponentially valuable. This teamwork culture resembles the Angklung, a traditional Indonesian musical instrument made from joint pieces of bamboo. The tubes are carefully whittled and cut by a master craftsperson to produce certain notes when the bamboo frame is shaken or tapped. Each tube of the Angklung produces a single note or chord, so several players must collaborate in order to play melodies. It symbolises how humans cannot stand solitary; one needs others in life. Angklung is Harmony in a Bamboo Orchestra.
Hidden Champions: Our North Star Investment Strategy to Navigate Turbulent & Fragile Markets
“Explorers depend on the North Star when there are no other landmarks in sight. The same relationship exists between you and your right life, the ultimate realization of your potential for happiness. I believe that a knowledge of that perfect life sits inside you just as the North Star sits in its unfaltering spot… Your life follows your attention. Wherever you look, you end up going.” — Martha Beck, author of Finding Your Own North Star
The clock that we are building together as a team to tell the time forever is the Inner Compass and systematic investment process that leads us to our North Star to navigate increasingly turbulent and fragile markets to the Hidden Champions.
Our approach to value investing is to invest in the Hidden Champions, agile creatures darting between the legs of multinational monsters who are dominant global players in sophisticated, hard-to-imitate niche products and valuable critical niches that are largely invisible to the average consumer. The Hidden Champions create maximum benefits for a target customer group, solving their most burning problems better than any competitor. This innovation strategy requires a deep knowledge of customers’ needs, which is gathered through direct customer contact. Successfully solving these problems would then create a “success spiral”. A key source of their wide-moat is their sustained commitment and even obsession to customers’ needs, which is only possible in our view when there is a purpose and values system guiding the firm.
The Hidden Champions have their roots in the esprit de corps of Germany’s Mighty Mittelstand, the more than 3.5 million small-and-midsize family enterprises that form the backbone of Germany’s resilient export-driven economy, employing more than 78% of workers and contributing more than half of the country’s GDP. The Mittelstand traces its roots to the Middle Ages when the country that is now Germany was divided into hundreds of states. Competition between them created a number of industrial regions with their own educational institutions, banks, and political administrations. The Mittelstand had to export early on with a global-orientation to their business model, given that some German states were smaller than two football fields.
Mittelstand enterprises that became well-known giants include BMW, Audi, SAP AG, Adidas, Hugo Boss, Robert Bosch, Siemens, consumer giants Beiersdorf and Henkel, dialysis giant Fresenius, pharmaceuticals giant Bayer, chemicals giant BASF, industrial gas specialist Linde AG, truck and engine maker MAN SE, and so on. There are also lesser-known, quiet, resilient, successful compounders, including commercial kitchen equipment company Rational AG, eyewear specialist Fielmann, specialty chemicals specialists Brenntag and Lanxess, high-end cleaning equipment Kärcher, Würth group (the “Fastenal of Europe”), auto gasket maker Elringklinger, flavour and fragrance specialist Symrise, lab solution specialist Sartorius, medical vision technology specialist Carl Zeiss Meditec, packaging and bottling machine maker Krones, wound medical products Paul Hartmann, and so on. From a value investing perspective, investing at an earlier stage in the long-term growth trajectory path of Hidden Champions in Asia will prove rewarding, as highlighted in an investment case insight into Rational AG, which we also shared in 8IH’s inaugural value investing educational programme in Shanghai.
Investment Case Insight into an Archetypal Hidden Champion: Rational AG
Why are Hidden Champions “hidden”? If they are “hidden”, will they become successful companies? Aren’t the successful ones always prominently visible?
An oblique reply: Have you been to a restaurant kitchen? Did you notice what is the brand of the kitchen equipment the professional chefs are using? Would you think a company that makes the equipment produces a good investment?
Often, eyes roll and heads shake until we share with them the inspiring story of Rational AG, which has compounded over 1,200% since 2000 to a market cap of US$5.9bn. Its reclusive billionaire founder, Siegfried Meister, became a trailblazer when he chose to go against the grain, battle conformity, and buck outdated traditions to launch its innovative product that enables most cooking processes to be performed using one device. For instance, the device recognises how big and how cold the chicken pieces are, and adjusts the cooking process accordingly. And all this on a very small floor area – a great step forward in using space economically.
More than 87% of Rational AG’s sales are exports. You can find a Rational AG intelligent cooking system on a Norwegian submarine, a Saudi prince’s yacht, as well as in hospitals and restaurants around the globe. This intelligent cooking equipment system commands a global 54% market leadership in the world’s professional kitchens that include Buckingham Palace and the White House, and is behind the success of such famous culinary names like Gordon Ramsay.
Hidden Champions such as Rational AG aren’t well-known to the public and their existence are often taken for granted, although their target customers (i.e. professional chefs) will swear to only use their innovative products or/and excellent services and nothing else. They are the brand behind the brands and they are essential to the well-being and success of our everyday life.
Everything about Rational AG is focused on the customer, the professional chef. Sales and marketing trainees spend three weeks working directly for customers in hospitals, hotels, and restaurant kitchens. Rational AG employs 300 chefs working in different processes who demonstrate the company’s products and act as “lawyers for the customers”, presenting the customer’s point of view to everyone inside the company. True to the corporate goal of always offering maximum benefits to the customer, in 2004, Rational AG launched another spectacular innovation: the “Self-Cooking Centre“. This new product is designed to reduce the chef’s workload and is selfcleaning, providing him with more time for culinary creativity and his guests.
Siegfried Meister, a qualified electrical engineer who spent many years in the management divisions of several large and medium-sized companies, felt that the immense success of his product concept would have been unthinkable if they had not always paid a great deal of attention to the needs of the customer and the marketplace. Specialisation, yes, but not on a product, but a problem area – in other words, customer benefits. We are inspired by Rational AG’s incredibly high work standards that hang on the factory walls in posters that read: Gut Genug? Der Kunde Entscheidet (Good Enough? The Customer Will Decide).
Rational AG not only created the market, but has always dominated it. Market saturation is relatively low despite the market dominance of Rational AG. The customer potential is estimated at more than 3 million commercial kitchens worldwide – from simple innkeepers and fast-food chains, to hotels, hospitals, and prisons, providing a visibly long runway to compound growth in difficult market conditions.
Adapting the Search for Hidden Champions in Asia
In the Asian capital jungles, outbreaks of accounting frauds, corporate governance lapses, and asset expropriation are erupting on a systematic basis at the firm level. These render elaborate quant screens and valuation metrics increasingly less relevant, and value investors need to go the extra mile beyond the accounting numbers and factors.
Good is not the absence of evil. Even if the investor somehow manages to eliminate the “evil” ones with potential misgovernance and accounting tunnelling fraud to limit the downside risks, we might still neglect and overlook the good resilient compounders. Each time there is a credit crisis punctuating the markets, there is an increasing premium on valuation for wide-moat business models in Asia as the Innovators stand apart from the Imitators and the swarming Incompetents.
Value investors in Asia need to take the leap to become more Munger-like in selecting companies with wide-moats that can generate compounding returns rather than dwell with a false sense of security in the realm of statistically cheap stocks that can turn out to be either fraudulent or value traps as time progresses. Value investors also cannot scale up their position size in these stocks with conviction, especially in the Asian capital jungles. The fund manager that takes on new money “diversifies” into more stocks in hundreds of small bets that melt down with a destructive destabilising price impact in systematic risk and market deleveraging situations. This results in the all-too-common phenomenon in which managing a bigger asset size perils performance to achieve superior long-run investment returns.
Thus, we have focused on a two-step process to identify widemoat compounders in the Asian capital jungles:
Step 1:
Eliminating firms with potential accounting fraud and misgovernance risks, taking away the fear factor of investing in fraudulent stocks with deceptive visual signals that include low price-to-book, low PE ratios, high profit margins and ROE, decent accounts receivables and inventory turnover period, and high net cash or high net current asset value as percentage of market cap. Accounting information can be used to inform or to deceive. In other words, Step 1 eliminates Asian companies which escape the western-based financial tools by intricate “tunnelling” acts via unusual related-party transactions, money-go-round off balance sheet activities, consolidation craftiness fraud, and so on, leaving defiled returns for the minority shareholders;
Step 2:
Analysing and assessing the business model for its resiliency, innovations, and wide-moat characteristics to eliminate the risk of investing in value traps whereby companies appear cheap based on conventional valuation metrics such as Price-Earnings Ratio but their business models have hit a stall point in scaling up further, and cheap gets cheaper. To assess whether companies can overcome a crisis, we systematically evaluate the underlying source of the wide-moat: (1) the “indestructible intangible asset” that stems from having proprietary know-how in product, process, and first-hand knowledge of the ground situation of their focused targeted underserved customer group, and/or the trust and support from its community of suppliers and partners; (2) the “core-periphery network” which is about decentralisation and empowerment of the frontliners, scaling the business with technology as an enabler embedded into the business model design; and (3) the “open innovation model” in working with internal and external partners to codevelop new products.
We believe we are fairly adept in Step 1; we are honoured and grateful to have had the opportunity to share our thoughts and to have a sincere and productive conversation on 23 September 2015 with the top management team of the Monetary Authority of Singapore (MAS) – Mr Paul Yuen, Head of Market Conduct; Ms Gillian Tan, Head of Enforcement Division; Ms Lee King See, Director (Enforcement & Investigations); Mr Ang Eng Seng, Deputy Director; Mr Eric Chia, Deputy Director; and the team at the Secondary Markets & Enforcement Division – about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore as well as the public and investment community.
When it comes to Step 2, it is easy to commit the mistake of fitting what we see and learn about the competitiveness of the firm into the “model” of wide-moat characteristics such as “high switching cost”, “network effect”, “low cost advantage”, “efficient scale”, or “intangible assets”. This descriptive approach into fitting observations into the model is categorisation through analogy, and its #1 flaw is stocks are categorised into moats AFTER they become obvious.
See full PDF below.
