Using “Value-to-Quality” (“VQ”) ratio to determine the health and intrinsic value of the fund portfolio

Jul 10, 2017

One of my favourite investing lessons is from the business biography “It’s Not All About Money: Memoirs of a Private Banker” by the late Hans Julius Baer, the indefatigable owner-operator of the Julius Baer Group who helped to develop it into one of the largest independent wealth managers in Switzerland during his near sixty-year career:

“My grandfather used to say occasionally, ‘What would I do with all the money that I have already lost?’ He always lost money in speculations. From childhood on, he was more interested in his father’s credit business than in the animal skin trade; as I said before, he learned the systematic side of banking from August Gerstle. The Augsburg banker was heavily engaged in financing industrial enterprises; for example, he invested in Maschinenefabrik Augsburg Nurenberg (MAN), a truck manufacturer the size of Freightliner, and Rudolf Diesel, the inventor of the diesel engine.”

Han’s account illuminated that the foundation of long-term wealth creation is to think of investing as financing and owning a piece of resilient compounders, such as Man SE, which has grown from its small business roots to a global champion with a market value of US$15.7 billion, rather than to peddle or speculate in the next big get-rich-quick schemes, or investment products, deals, or trades.

It is not rare in the asset management industry to be sales-driven by launching funds when the market outlook is euphoric or speculative, or launching funds with hot and popular themes to attract fund inflow and gather assets. We believe “noise traders” who “invest” in hot and popular themes almost always find themselves taken advantage of by clever arbitrageurs. As the influential finance researchers Andrei Shleifer, Bradford De Long, Robert Waldman and Lawrence Summers noted in their classic 1990 paper “Noise Trader Risk in Financial Markets” published in the Journal of Political Economy: “When noise traders are optimistic about particular securities, it pays arbitrageurs to create more of them. These securities might be new share issues, penny oil stocks, or junk bonds: anything that is overpriced at the moment.

As CIO and CEO of 8 Capital, I would like to make the commitment that we will never raise capitals based on fads, and will serve our existing and prospective clients to make informed, intelligent decisions based on facts and knowledge. A general rule of thumb: clients should stick to plain funds with understandable, and not “black box”, investing strategies and have a clear sense that the fund manager goes the distance to demonstrate dedication and craftmanship in articulating and implementing the uniqueness and scalability of the investment process to generate returns.

An important metric that we coined and employed in communicating on the health and intrinsic value of the fund portfolio, beyond the current NAV price, is the metric the “Value-to-Quality” (“VQ”) ratio. It has guided our investment thinking to uncover underappreciated investment opportunities. While the principles of value investing – to buy undervalued assets at a margin of safety – appears simple, its complexity lurks beneath in the actual practice. This is because investors tend to commit the investment errors of:

(1) solely focusing on buying statistically cheap stocks while sacrificing or misevaluating “quality”. For instance, screening for high net cash, or high net current asset, as a percentage of market value of the company might be the first step for many “Graham-style net-net value investors” to determine the discount in valuation of certain stocks. However, in Asia, their financial numbers often are revealed to be "propped up" artificially to lure in funds from investors, while the studiously-assessed asset value has already been "tunnelled out" or expropriated in money-go-round tunnelling opportunities via unusual related-party transactions. These seemingly cheaply valued stocks often turn out to be either value traps, or worse, unravel into fraudulent blackholes; and

(2) overpaying for popular “quality” stocks whose growth underwhelms expectations. As recounted by Peter Lynch in his book One Up on Wall Street: “You'll never lose your job losing your client's money on IBM. If IBM goes bad and you bought it, the clients and the bosses will ask: ‘What's wrong with that damn IBM lately?’ But if La Quinta Motor Inns goes bad, they'll ask: ‘What’s wrong with you?’ That’s why security-conscious portfolio managers don’t buy Wal-Mart when the stock sells for $4, and it’s a dinky little store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there’s an outlet in every large population center in America, fifty analysts following the company, and the Chairman of Wal-Mart is featured in People magazine as the eccentric billionaire who drives a pickup truck to work. By then, the stock sells for $40.”

A seemingly valued stock trading at an enterprise value-to-operating earnings (EV/EBIT) ratio of 5x (Company A) is not informative on a stand-alone basis of its cheapness in value if the company generates ROE of 2%; similarly, a stock trading at EV/EBIT of 15x (Company B) is not necessarily expensive if the company generates ROE of 30% and is growing healthily. However, growth can be destructive, as growth can outstrip the capabilities and competencies of a company and its management team, and can stress quality and financial controls, eventually destroying or diluting one’s culture. This is especially so for companies generating low ROEs, who want to grow at a rate faster than their ROE by pursuing supposed new value-creating projects, as they need to tap the external capital markets using debt or equity. Is this good news or bad news for minority shareholders? Building upon Nobel Laureate George Akerlof’s classic research in 1970 on The Market for Lemons, due to the presence of asymmetric information with entrepreneurs knowing more about the private value of their firm than investors, the adverse selection problem is created: if consumers cannot tell the quality of a product, and are willing to pay only an average price for it, then this price is more attractive for sellers who have bad products (“lemons”) than to sellers who have good products. Thus, selling equity is more attractive to owners of bad firms (lemons). This implies that investors should be suspicious if they are offered equity.

The ills and lapses that come with growth is a key reason why many Asian businesses, or over 80% of the 24,000 listed firms in Asia, fail to scale up beyond the billion-dollar market capitalisation mark, and remain statistically cheap value traps whose share price and volume are also often manipulated by syndicates and insiders. Therefore, a VQ ratio matters in overcoming the two investment errors, and separating the winners from losers in the pari-mutuel race between Value and Quality. In the first example of Company A trading at EV/EBIT 5x with ROE of 2%, the VQ ratio is 2.5x while Company B trading at EV/EBIT 15x and ROE of 30% has a VQ ratio of 0.5x. A simplified description is that investors are paying a value of $0.50 per dollar worth of “quality” in Company B as compared to $2.50 for Company A. We usually do not invest in companies with VQ ratio above 1x.

In determining our “Quality”, we incorporate our fact-based, forward-looking fraud detection system that combines accounting data, especially footnotes, with a wide array of contextual information – including unusual related-party transactions; money-go-round off balance-sheet activities; governance, group structure, consolidation accounting and ownership analysis; textual and linguistic analysis; analysis of event-based “catalysts” (information-based manipulation) and sensitive market announcements (action-based manipulation in prices and volume) – to provide fresh insights in equity valuation to support our decision-making process in investments.

To build our investment conviction to size our investments with prudence, we are vigilant to tipping points in business models that could result in a valuation re-rating. We are watchful for longer-term fundamental changes, as opposed to reacting to short-term news “catalysts,” which could be manipulated to create buzz around a stock, monitoring the ratio of the sales contribution from new products/services and markets/customers; overall health of value chain and ecosystem; corporate culture, strategy, innovation, partnerships. We are fervent readers of interview transcripts and articles on the management to gain a better understanding of the management’s (1) desire to cultivate a culture of decentralisation, trust and cooperation to foster innovative experimentations, including investing in a system to cascade decision rights throughout the organisation; (2) discipline in handling power and wealth; (3) focus and sense of urgency to build something with a purpose and commit to an idea larger than themselves to care for, and serve, others with love; (4) skin in the game with aligned performance-based incentives. Our three-step investment process:

  • Eliminating companies with potential accounting tunnelling FRAUD and mis-governance risk prevalent in Asian companies with unusual related-party transactions, which escape the detection by western-based financial tools and techniques, using on our proprietary fact-based, forward-looking fraud detection system. We are grateful to have been invited to present our system to the top management of the Singapore financial regulator;
  • Analysing the business model for QUALITY, including: (1) Resilience to stay profitable and protect market positions through up/downturns in the economy, and to allow companies to better manage rapid, sometimes disruptive, technological change; (2) Strong leading market positions with proven records across business cycles as this enhances pricing power and creates the foundation for sustainable good profitability, as well as an attractive position in the value chain without being dependent on specific suppliers or customers; (3) Continuous innovation and R&D to achieve and ensure strong market positions, create new categories of growth and profitability over time; (4) Long runway and addressable market to compound growth from solving pressing problems for their customers; (5) Exposure to service and after-market sales to improve the understanding of customer needs, building customer loyalty, and also offers attractive profitability, additional growth opportunities and increased product penetration; (6) Prudent stewardship and allocation of capital; (7) Strong balance sheet and robust cash flow generation that can be used for reinvestment into the business, for example in R&D and market expansion, to capture attractive opportunities, as well as steady cash distribution to the investor;
  • Selecting entrepreneurs and owner-operators with VALUES & PASSION for their business. This is seen through their thought leadership and value-add to the community as they serve with integrity, and the corporate culture they build.

We have been following closely a number of entrepreneurs building their enterprises in Asia over the years, observing up close their struggles and their breakthroughs, compiling the progress of their corporate lifecycle stage by Stage 1 to 4 and valuation dynamics according to the VQ ratio, which guided our investment thinking and action to avoid the costly errors of over-emphasizing “value” without regards to “quality” or/and overpaying for “quality”. 

these business models are impaired and stuck in Stage 1. In the past decade, once-successful “Stage 1” entrepreneurs have scaled their companies by multiple-folds to under a billion dollar in market cap. However, as a result of them mishandling risks, or even preventing risks through business model design, an overwhelmingly majority of companies remain in Stage 1, unlike the rare few like Largan Precision who are able to make the successful transition from a billion to $20 billion in market value. Nonetheless, entrepreneurs still push the same, possibly inappropriate, levers for growth, or worse, start to stray as they find it easier to seek growth by engaging in non-core business activities, and private business interests outside of their listed vehicles. These are the value traps to avoid.

Peter Lynch’s Magellan fund makes superb returns over the longer-term but when they dig further into individual unitholder's average returns, the performance results were surprisingly disastrous. This was because they were fleeting investors in the mutual fund who did not stay the course. Through the study, Lynch and Templeton guided a profitable investment strategy for their clients: buy more units of the fund whenever the fund experiences a drawdown, despite the healthy and improving fundamentals of the portfolio.

Table: VQ Ratio of Hidden Champions Fund – 85% Superior Than the Market Comparable

When we compare the weighted profits of our portfolio companies in the Hidden Champions Fund to the 346 Asia Pacific companies with a similar operating profit range of US$40-70 million, our weighted portfolio return on assets (“ROA”) and ROE are around 50% better than the Asian companies of comparable profit scale, yet the valuations in terms of EV/EBIT are around 23% cheaper. With the VQ ratio of our Hidden Champions Fund presently superior by 85% than the market comparable, we believe the Fund is significantly undervalued relative to its intrinsic value and the downside risks are limited to protect investors.

As the current market hype over the “flight to junk” carry trade that is groping for yield subsides and the overall market retreats, we expect our Fund to outperform. We have also taken the opportunity to make some divestments over the period at a significant net absolute gain and our cash level is around 20% in late April/early May 2017. Given the significant undervaluation of our Fund, despite the continued strong fundamentals, we reframe our YTD positive but lagged results as a setback akin to the cutting of a string that reaches between where you are now and your goal; if you make the effort to retie the string, the distance between your position and your goal shrinks. We believe our focused Hidden Champions will continue to monozukuri their way to “retie the string” to outperform with resilience.

We would like to share our video which illustrates our investment philosophy and strategy in Asian Hidden Champions. It features role models such as Adi Godrej of Godrej Consumer, KBS Anand of Asian Paints, Alan Wilson of Australis’s Reece, Scott Lin of Taiwan’s Largan Precision, Akio Nitori of Nitori Holdings, Takemitsu Takizaki of Keyence Corporation and Shigetoshi Sakamoto of Hoshizaki Corp: