The following article is extracted from the Bamboo Innovator Insight weekly column about the process of generating investment ideas among wide-moat businesses in Asia. Each month, an in-depth presentation on one such business is featured in The Moat Report Asia.
“Ideals are like stars; you will not succeed in touching them with your hands. But like the seafaring man on the desert of waves, you choose them as your guides, and following them you will reach your destiny.”
– Carl Schutz (1829-1906), German revolutionary and American statesman
We recently came across a thought-provoking and profound Japanese word that captures the essence of value investing in Asia: Hoshin. This unique word connected to us when we were re-evaluating the investment merits of an Asian wide-moat innovator with global market leadership in specialty cutting tools for industrial applications in the aerospace and automotive industry for our Hidden Champions Fund.
Hoshin is a Japanese word and concept translating roughly as Shiny Compass Needle aligned with your Guiding Principle Star (GPS) of Highest Potential. It’s a practice and Way designed to break through apparent chaos to reveal a higher order and direction. Over the past decade past in interacting with Asian entrepreneurs, we find two different groups of entrepreneurs classified by their motivations and inner compass: one that is labeled “Cash is King”—defining success in relation to financial goals, building a business that provides a revenue source in order to capture pleasures elsewhere—and another that is labeled “Make me Whole”—defining success in relation to their commitment to an idea and Purpose larger than themselves to care for and serve others with love. “Make me Whole” entrepreneurs were extremely passionate about their work even if work entails sacrifice and hardship, believing that work impacts, inspires, and changes the lives of those they work with, especially employees. An entrepreneur’s value systems and beliefs can have a strong influence on his/her business decisions, culture, mission, and other important outcomes for his/her organization. We observe in entrepreneurs that having the right Inner Compass of core values is necessary and critical to create value, yet not sufficient to bring about a wide-moat compounder. The Inner Compass must be aligned with the Guiding Principle Star (GPS).
The Guiding Principle Star (GPS) in 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 customer needs, which is generated through direct customer contact. Successfully solving this customer problem would then create a “success spiral”. A key source of their wide-moat is their sustained commitment and even obsession to customer needs, which is only possible in our view when there is a values system guiding the firm.
The key difference between the Hidden Champions or Bamboo Innovators and the atypical Asian firms that determine the scalability of the business models lie in the fact that most Asian firms have an emperor-based culture. One lone emperor cannot possibly serve hundreds and thousands of customers to find out their needs at an intimate level and he or she often does not see the need to grow the people around them and frontliners to solve customer needs. It is far easier for the Asian entrepreneur to be the middleman through deal-making to take orders from a few important anchor clients who have the critical access to the end-customers, take capital risk investing in tangible assets and work hard to produce the required products with quality and efficiency — than to attempt to build business models that have direct ownership of the hundreds and thousands of end-customers. As a result, these Asian entrepreneurs are unwilling to share the rewards with their “undeserving” staff who took neither risk nor sacrifice. They treat employees as expenses and not intangible assets, make most or all of the decisions and hoard most resources and information, running the firm as a “one-man show” or as a “team” of high-profile dealmakers/mercenaries who can bring in the sales orders; the job of “everyone else” is to execute efficiently and “productively”. While short-term profits are achieved, the corporate culture is eroded. Eventually, they may face the challenge of business continuity arising from succession woes. There is no terminal value in the business as time becomes an enemy of the business; without terminal value, the DCF analysis would point towards a well-deserved low PE multiple in the valuation of the business.
Founded in 1938 and now led by the second-generation family business leader, this listed world-class hidden champion in specialty cutting tools generates an ROE of 22.3% with the Gross Profit/Total Assets quality measure at 33.5%, the highest in the industry even when compared with the global #1 leader Sandvik’s 31.2%. It has also been a serial repurchaser that bought back over US$83m in stocks since 2003 and trades at an attractive EV/EBIT 9.4x, EV/EBITDA 6.4x.
Underlying the financial numbers is its wide-moat in mastery in material science and innovation. Aircraft contain many times more parts than automobiles. Because these parts need to be both lightweight and very strong, processing is extremely difficult. Aerospace manufacturers need tools with special coatings to provide increased durability when used to process materials that are difficult to cut, such as carbon fiber reinforced plastics (CFRPs) and titanium alloys, including wings and fuselages, in order to achieve significant improvements in fuel efficiency. Manufacturers process these materials using tools made possible by the company’s diamond coating technology, which is based on their patented ultra-fine diamond crystallization technology.
Furthermore, it is a dominant supplier of over 70% of the tools used by Japanese automotive manufacturers for engine machining processes. Engines require closer machining tolerances and more advanced technology than any other automotive part, and over 1,000 high-performance tools are used. The company attributes this success to their commitment to finding answers to the processing problems and needs of their customers, often by visiting customers’ facilities. They apply this experience to the development of new customers, by building close relationships so that they hear from them whenever they have troubles and by helping them to find solutions to problems that arise at automotive production sites around the world.
Stock Price Performance, 1984-2016, of Asian wide-moat innovator (Red) vs Index (Blue)
On Apr 7, 2016, this listed Asian hidden champion announced the acquisition of 100% ownership in an American tool maker which was founded in 1972 by a master tool maker and missionary “with the desire to spread the gospel of the Lord Jesus Christ” and “built on the ideals of precision, craftsmanship, and integrity”.
When we saw the biblical description of this American firm which supplies precise geometry tools for manufacturers in industries such as aerospace, automotive and marine, from top-tier Boeing and Lockheed to the smallest experimental and prototype builders, and its corporate slogan “cut with integrity”, we were reminded of the word Hoshin and another company that Warren Buffett had acquired – Iscar Metalworking.
Warren Buffett, the world’s greatest investor and the apostle of risk aversion, broke his decades-long record of not buying any foreign company with the purchase of an 80 percent stake in Iscar Metalworking, the world’s second largest maker of cutting tools behind Sandvik, which is founded in 1952 in a wooden garage, for US$4 billion in May 2006 – seemingly vulnerable assets in war-torn Israel. Buffett’s view is that if Iscar’s facilities are bombed, it can go build another plant. The plant does not represent the value of the company. It is the “intangible” – the talent of the management, the international base of loyal customers, and the brand – that constitute Iscar’s value. As Iscar’s founder Stef Wertheimer puts it firmly, “We do not miss a single shipment. For our customers around the world, there was no war.” By responding to threats this way, Wertheimer and his team have transformed the very dangers that may make Israel seem risky into evidence of Israel’s inviolable assets. Israelis, by making their economy and their business reputation both a matter of national pride and a measure of national steadfastness, have created for foreign investors a confidence in Israel’s ability to honor, or even surpass, its commitments.
The same thread that connects Iscar, the Asian wide-moat innovator in specialty tools, and the American tool maker is Hoshin, with the qualities of the human spirit: patience, tolerance, a sense of responsibility, fulfilling a Purpose (a calling) and a connection with others through love and service that originates from deep within, living an integrated life, experiencing an inner life and being in community with others. It is part of a central core or essence where people have a profound sense of who they are, where they come from, and where they are going. Aligning one’s inner compass with one’s GPS provide an enormous source of energy, passion, and direction that gives meaning to life and can provide an empowered feeling of success in work and in life.
In other words, the Hidden Champions, Bamboo Innovators and Hoshin entrepreneurs have a soul. In the same way that each of us has an animating energy often called a soul and a physical body through which this soul acts, a business has body and soul. A business has tangible assets in factories, physical facilities, and a collective of people who are generating ideas and coordinating their ways of creating together. This ‘‘soul’’ of business carries the imprint of all the people who are collaborating in the enterprise: the workers, the stockholders, the owners, and the management. The quality of awareness of those who imprint the business will affect everything the business does.
Hidden Champions approach the business with the highest personal quality of awareness and ask the question, ‘‘How can I encourage everyone connected with this enterprise to work from the highest possible level of awareness?’’ This simple shift in focus in turn transforms every aspect of the business. Quality is not merely a material consideration of a product without mistakes; it is an ‘‘extra-material’’ idea that asks for the most imaginative, well-designed, enjoyable, and sustainable product possible. Ethics is not a book of principles to which one retreats in the event of a lawsuit or recall; it is integral to the standard practices of every aspect of the business, how we deal with all the living beings on which business has an impact. By improving the inner quality of the enterprise, the Hidden Champions, Bamboo Innovators and Hoshin entrepreneurs expand the capacity of the business for innovation, imagination, collaboration, partnership, and wealth creation.
PS1: We like to share our presentation slides in Value Investing Shanghai on March 18-20, 2016 where we highlighted high-conviction investment in Hidden Champions to navigate the volatile markets and that such an investment approach has enabled us to outperform with positive absolute returns vs -15% for the MSCI Asia Index, and our highest portfolio-weighted stock at 36% of our portfolio NAV is up more than 16% in SGD:
PS2: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:
http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)
and our Value Investing Summit 2016 presentation “Quietly Innovating Value with Hidden Champions”:
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
In the month of March/April 2016, we investigate an Asian wide-moat innovator who commands a dominant 50-60% domestic market share leadership in a consumer healthcare device and is also the global #3 player and #2 in China (22% market share) where its first China plant in over 80 years is operational in March 2016 after building up strong demand from successful sales in leading online marketplaces JDmall and Alibaba’s Tmall.
Since the launch of its game-changing innovative new consumer healthcare device premium product in April 2015, its TTM Dec 2015 (YE March) sales is up 7.2% and EBIT soared 67.6%. Under the motto of using science to enrich everyday lives, [Company’s name] is a quiet innovator in leveraging upon its accumulated deep material science and chemistry know-how to continuously launch innovative new products, from consumer healthcare device to a pad that helps heal wounds by absorbing moisture, a technology that it adapted from its popular food wrapping film household product, to protective film-coated lining for motorcycle seats where it commands a 90% market share in US.
ROE of this world-class hidden champion is 14.2% and it trades at EV/EBIT 11.7x, EV/EBITDA 8.8x, EV/Sales 1x, a steep discount to its local consumer goods peers who trade at an average of EV/Sales 2.1x, EV/EBIT 20.2x, EV/EBITDA 14.5x, a 64-110% premium over [Company’s name]. Its consumer healthcare device peers trade at an average of EV/Sales 4.36x, EV/EBIT 19.7x, EV/EBITDA 17.2x, a 69-96% premium over [Company’s name]. We think that this steep valuation discount is unjustified given the technical excellence and innovative profile of [Company’s name] and it deserves to trade at a higher premium once there is greater investor awareness when they continue to deliver quality earnings growth with higher ROE which has soared from 6.7% in FY13 (YE March) to 14.2% in the latest TTM Dec 2015 and is expected to climb higher from its underappreciated price premiumisation strategy.
Sales has increased 24% in the past 3-4 years since FY13 and EBIT and OCF (operating cashflow) growth is faster at 168% due to the price premiumisation strategy. With the upcoming China plant operational in March 2016 and the tipping point in its US factory in automotive interior material, we believe [Company’s name] can build on the momentum to generate $120m operating profits and OCF in the next 4-5 years, similar to the profit scale of its domestic consumer goods peers with market cap of $2.2-3.4bn, thus spurring an upward valuation re-rating towards a potential tripling in market cap to cross $2.4bn based on EV/EBIT 20x from its present $850m market cap.
[Company’s name] embodies the best of patient sacrifice and stable capital for longer-term profound investments in business and people, with relentless and eternal pursuit of excellence in perfecting its offering, institutionalizing its craftsmanship and codifying the knowledge to pass from one generation to another. We believe [Company’s name] has hit a tipping point in its business model transformation into a complete integrated global producer of innovative rubber and plastic products with long product lifecycle with both engines in household & lifestyle division and industrial division (automotive interior) revving up to compound growth in a long runway.