Tuesday, November 11, 2008

Cooking a recipe for an excellent investment opportunity

This article builds upon what was addressed in Investment Methodology. All the articles should neatly sum up what I believe defines an excellent investment opportunity from a business perspective. For the uninitiated, this series of articles are probably useful as a start read, but for the seasoned value investors, perhaps you can look elsewhere (or share your thoughts via comments/shoutbox)

Disclaimer: The belowmentioned recipe cooks a soup not for the faint-hearted or the ordinary man on the street.

Reference material: The Intelligent Investor by Benjamin Graham, Common Stocks Uncommon Profits by Philip Fisher, Built to Last by Jim Collins

The First Ingredient of an excellent investment opportunity: Outstanding Management

The directors own a significant stake in the company, increase their stakeholdings over time and never sell out any single stock.

The intent of going public listing must be to purely raise capital and still retain control to expand the business further. It must never be a case of a shrewd businessman who desires to sell-off the business and start washing his hands off for retirement with millions of dollars from the equity issuance. Knowing that a director has a significant vested interest gives the retail investor an added assurance that the directors take complete ownership in ensuring the company's profitability. Also, it is desirable to know that the directors never sell down his stakes and instead continues to buy in when prices are depressed.

The management stays within its circle of competency and does not diversify into areas of business that they are not familiar with.

If the company is good at producing bubble gum and has been doing so profitably for the last 20 years, that is their circle of competency. I would not expect them to diversify into unfamiliar industries. This dilutes their area of focus and it is also much more difficult to perform valuation and business analysis. A company that produces soft drinks and also invest in investment property clouds the financial statements too much for a valuation on ROE to be accurately measured. Likewise, a company that is adept at producing beer should continue to develop to eventually achieve world domination in the beer industry.

The directors are humble people who stay out of the media limelight

Based on a whole spate of scandals of directors in listed companies, it has been quite obvious that CEOs that bask in the media limelight, with so many public interviews and constant stream of over-promising news have been correlated to an issue with integrity. Hence, this theory of good directors stay out of media limelight has a certain element of truth in it.

The directors are prudent people who avoid using derivatives and complicated financial instruments, and are very transparent in their financial records

This is very arguable. But given the difficulties where accounting methods and standards were not originally designed to accurately reflect such derivative instruments and coupled with the risk arising from internal control and possible abuse, I would prefer corporations that stay away from such financial instruments.

Financial records tell a million tales. Directors who accord a high degree of transparency in the accounts allow the retail investor greater insights of the business. We may be informed that the company has grown it's revenue 20+% for the last year, but for a good investment valuation we would also like to know how the various market segments and different product ranges have performed. Some companies provide good resolution, while some do not as it is not a requirement in Singapore's Financial Reporting Standards.

The company grows the leaders from internal succession planning, not through a 'musical chair' change of white knights

There are many case studies of how the descent of white knights bring about a turning point in the companies, like how Carlos, who serves on both Renault and Nissan as CEO, manages to turn Nissan around in a matter of years with his visionary ideas. But I would prefer that the management team are the ones that grew up together with the company. Such people are the ones who knows what works and has been working well to bring in profits; they are the ones who have a closer rapport with the entire company crew.

(This is an interesting trait that Jim Collins concluded in his empirical study of all the NYSE companies, as written in
Built to Last. He and 60 graduates performed a thorough study that sifted through all NYSE companies to identify the winning traits of a 100-years-old corporation. It was concluded that corporations that last beyond a lifetime of profitability promote the CEOs through internal succession and growth. Corporations that rely on a white knight usually rise fast but vanish into oblivion like fireworks.)

The Second Ingredient for an excellent investment opportunity: Outstanding Business

When Warren Buffett acquired Berkshire Hathaway, it was an almost-drowning textile company. But he repeatedly injected fresh capital in a bid to revive the flagging business before finally arriving at a neat conclusion that is subsequently widely termed as "flogging a dead horse" - you can change the management team of any business, but you will not be able change a business with poor economics and prospects. Having an outstanding business is another ingredient for an excellent investment opportunity.

High barriers to entry; high returns on equity, high profit margin for the last 5 years

A good business must be one that possesses a strong moat to prevent an erosion of its profitability. It must be sufficiently difficult to break into the market either because of the complexity of the business or the brand and reputation of the incumbents are immensely strong. Companies that own rubber plantations are also ruled out here because the barriers to entry are so low and the companies have to compete on being the lowest cost producer.

Large corporations which are blue chips generally produce lower returns on equity by virtue of their size. As an investor, I will prefer a company that is at its growth stage and have a very high returns on equity for the last 5 years.

Asset light, conservatively financed, powerful cashflow generators

Companies that are heavy in assets require an immense amount of capital to generate revenue. An example is airline companies that own million dollar jets. And usually, such companies have a comparatively low holding in cash type assets. This makes them immensely vulnerable in times of economic recession. What is happening to US airline companies now is self-evident: where they are seeking for mergers or takeovers to survive declining revenue due to declining passengers; without which business continuity is in question.

Companies that are powerful cashflow generators are the ones that can grow organically with minimal debt or necessity to raise capital through issuing capital. They are either providers or high value services like event management or creative designs, or they can be those that rely on a few machinery that run 24-hours a day to generate a disproportionately large amount of revenue.

A case in point

Have you not forgotten the days in the recent past where we hear of U.S. airlines failing and seeking mergers? It's the same thing. The airline industry heavily rely on high cost fixed assets to expand their capacity and grow revenue, with low operating cashflows. This inevitably makes then immensely vulnerable in bad times.

The Third Ingredient of an excellent investment opportunity: Outstanding Value

Significant margin of safety, extreme market pessimism

You can elect to own a part of an outstanding business run by an outstanding management at a fair price and it is still a sound investment decision. But being able to own it a significant discount in terms of price to intrinsic value makes it an outstanding investment decision. You have a good margin of safety for provision of errors in estimates, and you can sleep soundly at night.

Such moments of good value will only emerge when the market is extremely pessimistic about the future outlook of the economy.

Measuring value using a summation of free cash flow discounted to present day

Buffett and various value investing thinkers have conceptualised the measurement of value as such: the company's intrinsic value is basically a summation of estimated cashflow that will be generated over a period of years and discounted to present day prices by factoring in risk-free rates and inflation.

The components of this cashflow or free cashflow is basically: operating cashflow - estimated annual capital expenditure - estimated depreciation expense.

Why the presence of the annual capital expenditure and depreciation expenses? Machines break down over time to a point of beyond economic repair, and capital has to be continuously injected over time to replenish the production capability. Also, such machines are usually capitalised as an asset on the balance sheet and the cost is slowly expended off from the books using accounting depreciation methods; an accurate measure of incoming cashflow has to account for this.

What about company operating in the red?

For companies that are operating in the red for the short run with negative cashflows, the discounted cash flow model cannot be applied to obtain a quantifiable measure of the value of the company.

Under such situations, discerning true business value from a bad business operating model requires astute judgment. It requires the investor to examine the existing business and market conditions. A qualitative assessment has to be made: (a) Are the losses accrued to a weakening in business fundamentals of shifting market demands, profitability, cost-push reasons, leadership capability, or other hidden reasons? (b) Or are the losses a temporal condition due to rapid expansion or internal restructuring and the effects are not likely to persist in the longer run. And given time, the business will surge forward?

Such kind of investments are only for the stout-hearted investors who are able to see value that is beyond apparent value.

Concluding Remarks

All three elements are crucial in identifying an excellent investment opportunity - the Man, the Machine, the Moment. No single element stands on its own. When rigorously applied, one should be able to seek out conservative, and yet excellent investment opportunities.

As usual, your mileage may vary (YMMV).

Sunday, October 19, 2008

A Cursory Study of Derivatives and Financial Accounting

The Sage of Omaha dubbed derivatives as the weapons of mass destruction (read:
Warren Buffet on derivatives). In fact, derivatives, specifically credit default swaps, are the instruments that are responsible for the recent financial crisis that vaporised billions of dollars from the global financial system.

And as I read more and more annual reports of companies, I repeatedly encounter derivative financial instruments that were accounted for in the balance sheet. The point to note here is that it is not unusual to notice that a small amount is reflected in the balance sheet under 'Fair Value adjustment of derivative financial instruments', but if you dig deeper into the financial footnotes (which is buried deep within the annual report), you will notice that the contract notional amount dwarfs what is stated on the balance sheet by many times. e.g. a fair value adjustment of S$10mil, but the notional contract amount is S$300mil. To the lay investor, such large variance in declared numbers versus 'buried' data does makes one wonder if the company has been cooking the accounts a la Enron style.

Derivatives: What are they?

The intent of derivatives is to reduce the risk of one party and "eliminate bumps for one party", as how Buffett coined it. The value of such instruments are dependent (or derived from) on the underlying value of other financial instruments, hence the name derivatives.

There are three major classifications for derivatives: options, forwards/futures, swaps. In modern day economics, all three elements feature in a company's financial statements. Options (or rights to buy) are given out to employees as part of their Employee Share Option Scheme (ESOS). Forwards/futures are employed by companies to derive some form of stability and predictability in commodity or currency prices for the next few years. Swaps are used on interest bearing loans so that the companies can swap floating interest rates with another party in return for a fixed interest rate.

Futures/forwards and swaps marry the demands of two different groups of investors: one who desires stability, and another who desires to profit from the speculative movements. But in any case, as a whole, it's a zero sum game in the transfer of wealth between both parties.

Such derivatives are either traded over-the-counter (OTC), i.e. private deals that are executed by market makers, or through an organised exchange like NYMEX. In over-the-counter contracts, it's basically a legal agreement between two parties without going through any intermediary. For swaps, over-the-counter deals are the most common method of transaction. For organised exchanges, typically a margin account is opened and a collateral is placed as a form of guarantee.

Forward/Futures contracts

Here's why companies will consider futures/forwards: currency rates and commodity prices (e.g. steel) fluctuate significantly. If a company frequently have to deal with foreign currencies or buy commodities in its day-to-day operations, it makes sense for the company to have some form of stability and predictability in its income sources by entering a forward contract with another party. In this way, risks in price movements are removed and the company does not have to constantly worry about costs increase over the short run.

Basically, two parties will arrange to come together and agree on a price of the currency/commodity to be exercised at certain time in the future. As a form of mutual assurance, an asset is placed under collateral by both parties, i.e. in the event of default by one party, the collateralised asset will be seized to fulfill the original promise.

Interest Rate Swaps

Companies take loans, which banks offer at floating interest rates, dependent on the monetary policy of the central bank and the market conditions. However, if the company also desires to enjoy some form of stability and predictability in its interest payments, they can enter into a contract with another party where their floating rates are swapped for a fixed interest rate.

Points to note about derivatives

Counter-party risk

Transactions executed over-the-counter have an underlying assumption: both parties are able to honour their financial obligations as stated in the contract. However, in the event that either party is unable the service it's obligations, then such a mechanism will have failed as a risk management tool and the affected party will then have to pay at the existing market rates.

Collateral and creditworthiness

Forwards/futures are based on an underlying collateral asset as well as the creditworthiness of the company. This meant that the company is exposed to additional risks: in the event that the underlying collateral asset loses value significantly, or the company's credit rating is downgraded, it may be enforced upon the company to "top up" its collateral within a short span of time. Without which, the company will face liquidity problems; assets will then be placed on fire sale prices, and the company may face bankruptcy.

Preclusion of any favourable fluctuations

Since a certain fixed value is locked in, engaging in swaps or forwards/futures also meant that the companies are precluded from enjoying any favourable fluctuations. And such are clocked as "potential loss" or "net negative gain on fair value adjustment'

Financial loopholes

Such derivatives can be buried and made invisible in the financial statements. What the company simply has to do is to create an associate company or subsidiary and hide the accounts for such derivatives within. Large amounts of assets can be placed as collateral for derivative trading, and what only appears is a change in the net asset value of the associate company with no mention of derivatives at all in the entire annual report. In fact, this is how a lot of companies in US went under in the recent past, and the public is kept in the dark all the while.

Potential Pandora's Box

In the wrong hands, derivatives can be very dangerous tools. If there are insufficient controls in place, a rogue trader in the company who is overly empowered to leverage and make decisions for selfish reasons can easily bring a company down to its knees overnight. Take a look at this latest piece of news, look at how 3 rogue traders vapourised US$81 million from the company and made attempts to cover it up.

Derivatives gains and losses as a distraction

Gains or losses of derivatives are mandated to be reported on the financial statements and are subject to public scrutiny. Such gains/losses can grow to become a very major distraction to the company management. Instead of focusing on growing profits from operations, what is feared is that the management will direct more attention at at growing their accounting profits from derivatives trading.

Valuation of derivatives

Singapore follows the standards, word for word, as set by International Accounting Standards Boards (IASB) (read here). Under the accounting rules as stated in IAS39, the companies are required to measure the value of the contracts based on the prices in the market at that point in time, and this is also known as fair value and mark-to-market accounting. The net change in the value of the contract is then reported on the balance sheet as "net fair value adjustment of derivative financial instruments".

The profits or losses accruing from this realisation of fair value are then reported on the statements. However, in reality, such losses are just opportunity cost as a result of the company's decision to hedge against fluctuations, while the one time extraordinary gains are pure luck due to market movements of currency or commodity prices.

What to take note of

For an accurate measure of intrinsic value, businesses must be valued based on their operating profits, such one time extraordinary gains arising from derivatives sales are not to be taken into consideration. Conversely, when a company reports losses, the keen-eyed investor must be sharp enough to discern these "potential losses" from actual losses accruing from operations.

My final comments on derivatives: Beware, Beware, Beware

Swaps and futures/forwards are double-edged swords: the outcome of the use of it hinges a lot on the person who wields it. Companies that employ such derivative financial instruments must use it only for risk hedging. However, this is very difficult to ascertain and such companies are deemed to be more risky. It's never a comforting thought that an internal rogue trader can bring about the collapse of the entire company overnight through derivative trading. So, to avoid having any sleepless nights, one should refrain from investing in such companies. It is little wonder that Warren Buffett shut down an arm of derivatives trading in one of his businesses.

So, to invest? Or not to?

On this point, I hold a different view from the Sage. All investment decisions are made based on a simple baseline of risk-reward: such companies should be considered for as a worthwhile investment when the value proposition in terms of risk-reward spread provides an extremely compelling argument. The marginal increase in risk has a corresponding large increase in potential returns.

1. there is an impressive profitability of more than 20% sustained growth
2. high margin of safety in the comparison of price/intrinsic value and Book Value
3. sustainable competitive advantages and barriers to entry are high

To mitigate investor's risks arising from the presence of derivatives to an acceptable level, the companies must fulfill the below conditions, over and above all the other criteria for a high quality company:

1.The directors hold very significant stakes in the company, in excess of 50%.
2.The directors have sufficiently demonstrated that a robust system of controls and check-and-balance is well in place to prevent systemic abuse of derivatives.
3.An esteemed chartered accountant sits on the independent board of directors to provide for check-and-balance.

As usual, YMMV.

(For further reading on derivatives, check out this wikipedia link)

Thursday, October 9, 2008

A Cursory Study of Real Estate Investment Trusts (REITs)

As the global financial crisis continues to deepen, I continue to dig deeper into my wallet to do some shopping. What struck me is that there are many SGX-listed stocks that are trading below their Net Asset Value, and many of such stocks belong to the category of REITs.

Disclaimer: the author is not vested in any REITs

A short synopsis on REITS

Real Estate Investment Trust (REIT) is basically a collective investment scheme where funds are raised through an equity fund raising, and the money is then placed in the hands of managers to invest in high quality real estate. The rental income and returns from such real estate investments are then distributed back by a certain mandatory percentage to all the investors in the form of dividends. In essence, for the retail investor, investing in REITs is like investing your money in a small part of a large property like Suntec City mall.

Key Characteristics of REITs

REITs allow the general public to enjoy all the benefits of owning a property at a small cost, and at the same time, enjoy the liquidity of a listed stock.

In a way, REITs are like mutual funds – a large pool of investors concentrate a pool of money in the hands of a few managers who will invest in real estate on their behalf. However, the key difference is a much higher level of transparency and accountability: (1) all transactions of the REITs are made known publicly, but transactions of the mutual fund managers are not made known to the public (2) the management of the REIT is made known and any changes in key appointment holders are to be made known publicly, but for mutual funds, the managers are faceless and nameless.

Funding Model of REITs

Companies are either funded by equity or by debt. For REITs, it is not unusual to find that they have a very high debt leverage i.e. REITs use large sums of short term borrowings mixed with funds raised through equity to purchase high quality assets and generate cashflow through rental income.

As almost 90% of the rental income is mandated by law to be distributed back, and 10% and less is retained, it is impossible for REITs to grow organically through internal cashflow generation. Therefore, REITs are only constrained to raise funds in a few ways:

of properties that have appreciated in value

(2) Borrow through either long term of short term debt

(3) Issue new shares and raise funds from the public

Each of these options have their own disadvantages and limitations. As the retail investor, you have to be savvy about REIT’s funding model.

For (1), sale of properties that have appreciated in value means that the management must have identified other real estate opportunities to invest the excess cash, or else it will be distributed back to the shareholders in the form of dividend. This will mean that the asset base of the REIT is drawn down.

For (2), increasing the borrowing means that the risk free rate (or opportunity cost) per share correspondingly increases. Also, a greater sum of interest payments are made to the bank regularly. However, if the management is able to use the leverage to increase the dividend per share and net asset value, then this is a good option.

For (3), I view it as the least desirable of all the options. Suppose when the stock market and economy is having a downturn, opportunities for bargains abound and it is perhaps the best time to buy properties. But because share prices then are depressed, a lot more shares have to be issued to raise the same amount of capital, this in turn, brings about a greater dilution to existing shareholders’ holdings.

If you are a retail investor who is not keen to continually increase your investment holdings, equity fund raising is the greatest bane of them all. For you to participate and maintain your percentage holdings and the dividend rate, you will have to invest more money by subscribing to the new shares. If you choose not to participate, your per share asset worth is diluted, and your dividend rate is reduced. To the layman this can just mean, “Just put more money in, I will return you with a higher dividend. But if you don’t, your dividend rate will naturally have to decline due to dilution”

Therefore, for this option, the management should have a very compelling reason to raise such funds to purchase these assets.

From my perspective as a retail investor, the more desirable options are (1) and (2).

Debt Structure

One point to note about REITs is the debt structure. This is a critical determination factor on whether the REIT will face cashflow or financing problems in the next few years. Typically, the REITs will take up long term debts that are due after several years. The area of concern is whether, the REITs target for a 'bullet repayment', or a gradual instalment repayment. If it is a bullet repayment, which normally is a very large sum that the REIT cannot afford to pay down, the REIT will be faced with three options again: (1) raise funds through equity issuance, (2) sell off one key asset to pay off the loan, (3) extend the debt with the bank. 

Further to what was raised in the previous paragraphs, (1) and (2) are heavily dependent on the economic conditions during that point in time where we know it's uncertain. If the industry is doing very badly, the REITs may have problems selling off their assets at good prices to pay off the loans. 

Another critical factor for REITs is the credit rating by external agencies. This is because banks use the credit rating to determine if they have to tighten or loosen the loans to the REIT. Due to the high debt leverage of REITs, and low level of current assets, in the event that banks lose confidence on the REIT manager, what we will witness is a 'run on the REIT' and the REIT will have to bankrupt itself by quickly selling off all its long term assets to pay off the bank liabilities.

Valuation of REITs

In light of the characteristics of REITs, the dimensions in valuation and areas of focus in carrying out analysis varies slightly from that of the usual publicly listed stock. This is primarily because directors of REITs are paid a management fee and normally do not have a significant vested interest in the REIT itself.

Without this comforting factor of “directors will swim and sink with the rest of us”, there is ample room for them to mess around the financial regulations to their own selfish interest and at the expense of the trust of the retail investor. For example, if the cashflow generation from the assets are detected to be weak, the management may decide on a stopgap measure like issuing more shares on the pretext of raising funds for acquisition, but the funds are then used to be distributed back to shareholders in the form of dividends.

The valuation of REITs will have to place a strong emphasis on measuring the quality of the management, and detecting any incoherence in policies.

Over and above existing financial indicators like Net Asset Value (NAV) per share, Distribution Per Unit (DPU), dividend yield, Leverage Ratio, Debt structure, Cashflow, we have to examine the track record of the managers in the following aspects:

(a) The number of times management sought to raise capital through issuance of shares or increment of debt, and has this over time translated to higher DPU and higher NAV. Also, take particular notice of whether the assets purchased through equity issuance are contributing significantly to the asset worth and DPU with high occupancy rates.

(b) The ability of the management to identify good property investements, and to convert them into profits by selling off, and then using the money to buy into other properties.

Variations of REITs

One interesting variant of REITs are shipping trusts. The key difference is that the funds raised are used to purchased ships for chartering, instead of buying land and property. Likewise, the rental earned from chartering are then distributed back to the shareholders. 

But there are a few primary differences: (1) the ships bought by the shipping trusts have a fixed service life of 20~30 years. This means that the ships are subjected to depreciation in value over time, until it becomes scrap. This has to be factored in the valuation (2) do not expect the asset value of the ships to appreciate significantly in the secondary market. Unless there is a dire demand for ships, I do not expect that these ships can always be sold off at a profit to other shipping firms. (Perhaps locally listed shipping trusts like Rickmers Marine and First Ship List Trust may prove me wrong)

Concluding remarks

REITs can be good alternative investment vehicle, what really matters is that one must have performed your due diligence to discern a high quality REIT from a low quality and dubious entity. With the convenience of the stock market, the value investor can exploit the wild gyrations of the stock market to his advantage by buying in at low prices. At low prices, the corresponding dividend rate is increased.

For further reading on REITs, do check out

As usual, YMMV.

Friday, September 26, 2008

Three Signs of A Market Soaking in fear

Times have been extremely chaotic. There are some glaring signs of immense fear that signals for the value investor to awaken from hibernation and pick up some bargains:

1. Long queues outside financial institutions

When the sub-prime crisis brought about a possible collapse of AIG, the local policyholders started surrendering their insurance policies despite repeated calls from MAS that everyone's money is safe. Investors started dumping their holdings in the stock market for fear of greater implications to come. We read of news where policyholders said that they felt "safer in having cold hard cash from AIA." This a definite sign of mass panic and investors riddled with immense fear.

2. A wildly gyrating stock market that fluctuates +/- 10% or 1000+ points over 5 days

Dow Jones Industrial Average swung by a difference of 1000+ points over a short period of 5 days, driven by a mere piece of news of a possible US$700b bailout plan by the US government. This is a colossal move of 10+% in a matter of days and is purely irrational behaviour.

3. Do you also feel the fear and stampeding tremors too?

The fear of a financial meltdown and currency fallout was so prevalent and real that at a point in time even I, an ardent impassioned and rational person, was influenced to think that it might be a wiser choice to stay by the sidelines and do nothing but hold on to cash.

Fear is such a powerful weapon, where there was once I started doubting my own judgments. It was an immense internal struggle on whether to-act or not-to-act. However, the better half of me eventually won: I decided to make a move now.

Be greedy when everyone is fearful

The greater the fear is, the greater courage the value investor must have to act in a rational manner that will go in the opposite direction of the stampeding herd; only then will he be able to reap gains when the time comes.

This reminds me of how Warren Buffet recently acted to acquire a US$5b stake in Goldman Sachs.

As long as (1) the financials of the company have been evaluated to be sound, and (2) there is a significant margin of safety in the price to intrinsic value, and (3) there are good prospects and growth drivers for the company to grow continuously even in recessionary years, the value investor must trust in my own independent judgment and make decisions based on that.

I have started to do my shopping. Have you?

Sunday, September 21, 2008

A Cursory Study of Eu Yan Sang

Eu Yan Sang strikes me as a very interesting business proposition. Apparently, in the entire Traditional Chinese Medicine industry in Singapore (and probably the region as well), the only well-known brand is Eu Yang Sang. This definitely warrants a further investigation into the entire business.

Disclaimer: The author is not vested. YMMV.

Industry Overview

When Traditional Chinese Medicine (TCM) was introduced, it was initially not well received by the masses and the medical fraternity. It was then believed to be 'alternative medicine', where the effects of the medication are hard to measure and difficult to draw correlative conclusions. But in recent years, as scientific methods of measurement advanced and studies were conducted on various aspects of TCM, the medical fraternity grew to recognize the benefits of acupuncture, traditional chinese herbs, and 'tieh ta'. We are witnessing a tectonic shift in perspectives of TCM; the paradigm shift is slow but definite.

The traditional chinese medicine industry worldwide is highly fragmented with so many small and unknown players, countless unknown brands of Chinese medicine. Besides Eu Yan Sang, there are no other brands that I can associate TCM with at the moment.

Company Synopsis

Eu Yan Sang's business proliferates all aspects of TCM ranging from clinics to products and herbs distributorship. The company has created a strong retail brand, incorporated scientific methods of measurement to ensure products are of high quality and consistency, established trained general practitioner clinics. In addition, the company has established distributor and retail channels to sell their TCM products which include Bak Foong pills for pregnant ladies and bird's nest drink.

Over the last couple years, Eu Yan Sang made efforts to tap into the growing numbers of health-conscious people by setting up a large concept store of Red-White-Pure, like a one-stop hub for all things related to TCM, ranging from dining to therapy and retail galleries. However, this endeavour failed miserably. A simple google on "red white pure" and instantly I got to read so many yucky reviews on the restaurant food.

Competitive Advantages

1. A strong brand in retail products

Eu Yan Sang has a very good brand in their retail products. Ask any shopper what products/brands they associate with TCM, and Eu Yan Sang naturally comes to one's mind. The other customer touchpoints of clinics and herb distributorship further reinforce the brand of Eu Yan Sang.

2. Sole distributorship for world's finest ginseng - Wisconsin Ginseng

Wisconsin ginseng is famous for being the world's finest form of ginseng with the highest concentration of gisenocides, a chemical that makes consumption of ginseng highly beneficial to the health of human beings. In 2006, Eu Yan Sang managed to secure from the Board of Wisconsin Ginseng a right to exclusively manage, distribute and sell Wisconsin Ginseng.

This is a Buffett classic type of toll bridge economics, or sustainable competitive advantage, that will help the company generate enduring profits for a very long time to come.

3. Differentiated products - high in quality and consistency

The general retailers use arbitrary methods of visual, touch and smells to identify the herbs. The probabilities and occurrences of mis-prescription, and product quality problems are significantly higher, as the method of identification will then rests on the skill of the individual staff.

What sets Eu Yan Sang apart from the rest is that it leverages on scientific methods to ensure the quality and consistency of all the retail products. They employ modern methods that are equivalent to DNA fingerprinting to check and ensure products are consistent and correct.

My Final Comments

On cost controls, revenue expansion

Eu Yan Sang has been making losses for the last few financial quarters; although there's a growing revenue base, costs are spiraling and chewing off the profit margin. Despite the multiple competitive advantages possessed by Eu Yan Sang, it is very disappointing to know that that management has somehow not been able to effectively capitalise on them and generate enduring profits.

On business strategy

Proliferation of Eu Yan Sang products in South East Asia countries is not significant, and much less in China. There remains a huge latent market in South East Asia that is untapped. However, Eu Yan Sang has taken the direction to 'educate' the westerners on the benefits of TCM; they have been expanding their presence in Australia and the United States. Is this business strategy successful? I guess the financial numbers will have to speak for themselves.

Everytime I pass by Eu Yan Sang retail stores, what consistently struck me are the vast retail space and the lack of customers, mostly a few at any one time. While I agree that it is important to strengthen the consumer brand through establishing shopfronts, the management must be conigzant that not a lot of consumers buy health products every day, and must less so for TCM products. Spawning shopfronts at expensive shopping malls and incurring high rental costs may not be a very wise and prudent move.

On transparency

When key appointment holders resign and are replaced just weeks (or was it days?) prior to the the results release,
it doesn't reflect well on the company and leaves one's imagination to run wild, was there a serious conflict of opinion that made the CFO decide to leave?

On attractiveness as an investment

Eu Yan Sang was successful at the initial years of public listing; but it made some costly mistakes too. It is only in recent months that they have finally completed cleaning up their balance sheet and restructured the company. As to whether it has potential to become a great investment opportunity, there is still much to be seen.

Friday, September 19, 2008

The Lurking Dangers behind Structured Investment Products

I read with great interest, when Straits Times posted the article on how a certain structured product of High Notes 5 in DBS is currently facing the problem of an imminent dissolution due to the collapse of Lehman Brothers. To understand more about structured products, you may read http://www.askdrmoney.com/Analysis_Structured_Explained.htm

Brilliant marketing + investment products = Beware of the devil in the fine print

I do not deny the benefits of leaving your money in the care of professionals and experts, but the biggest gripe is most if not all structured products use clever marketing words to mislead and imply statements that are not true, and the disclaimers are always written in the smallest font in the last line of the brochure. Words like "9% payout on 1st year..." does not necessarily mean you will receive an investment return of 9%, but rather 9% is tapped from your initial investment and repaid to you.

Sadly, so many people take things at face value, make uninformed decisions and always end up on the losing side of the deal.

There's a brilliant website that read and analyzed several structured products of Singapore Banks. You may want to read them at http://www.askdrmoney.com/Analysis_Structured_Bank_Products.htm

So, if you ever want to consider investing in structured products, think again.

Friday, September 5, 2008

Analysis of Adampak (Part III - An Interview with the CEO)

I was invited by nextinsight.com.sg to publish this article at 

I had the great honour to meet up with Adampak CEO Mr Chua on 29th August at Adampak's office at Loyang Way. Prior to this meetup, I had submitted the analysis and list of queries lock-stock-and-barrel, to him via his secretary. He had already read through everything and gave me very interesting observations about Adampak and its business. I did not make any recordings, as it will be too rude; everything existed as just a verbal discussion that flowed for 90 mins.

I have summarized and properly categorised my takeaways from my conversation with him, as below. In all my analyses, as more information is acquired, it is only natural that the perceptions evolve and are refined to greater accuracy. Penned in this blog will be the observations and corrections to past erroneous perceptions. Please do not be alarmed as you encounter conflicting propositions as compared to earlier research reports.

Disclaimer: The author is vested in Adampak. YMMV.

On business strategy:

1. Gun
for the big deals from the MNCs in any available sector

Mr Chua revealed that Adampak's business strategy is to focus on securing contracts from big time multi-national corporations and making their name known amongst them. Business from other MNCs will then automatically come through referrals etc. Gunning for deals from MNCs is a good strategy and there are two key benefits: firstly, Adampak can ride along on the bustling growth of the MNCs; secondly, increased resilience to regional economic impact. In 1997 when Asian was struck with the financial crisis, sales of Adampak continued to increase at double digit growth, simply because a bulk of Adampak's sales went to US, European MNCs.

The fact that 90% of Adampak's sales derives from the electronic sector is an outcome that is just somehow generated as Adampak just grew it's portfolio over the years; there was no deliberated or active efforts on a particular market focus.

2. Establishing a localised presence as a proximity advantage

In Mr Chua's words, "In this competitive industry, the first one in, wins." In the manufacturing industry, for customer companies to engage a manufacturer, they have to first go through a lengthy qualification process to assess whether the manufacturer is up to standards and can match their requirements. It is after the qualification process that the manufacturer will stand a chance at gaining a part of the contract. A localised presence has helped Adampak obtain more customers who have qualified their plant.

The best exemplification is China. Adampak set up a factory in Suzhou Industrial Park geographically sited alongside many MNCs and the company has an added proximity advantage over other non-local label suppliers based in South-East Asia. In many ways, this move has helped to increase the list of customers who qualified Adampak's plant. In recent months, the number of suppliers based in China has increased sufficiently for a break even point to be achieved at Adampak Suzhou. And it is expected for the number of qualified suppliers to continue to grow

3. Building strong relationships with suppliers to achieve a preferred label converter status and increase revenue streams

Over the years, Adampak has forged strong relations with their suppliers. Today, Adampak is a preferred label converter to 3M, which will recommend their clients to adopt Adampak's services. This further lends credence to Adampak's reputation and opens up an additional revenue stream.

4. Building a strong reputation of quality, reliability, consistency in service delivery

At first glance, it does appear that anyone can do the job of printing labels. But to be able to do the job, consistently, every time is an immense challenge. This is a critical success factor: over the last 20+ years, Adampak has built a strong brand of being able to consistently deliver high quality products on schedule. The brand is there, and the big corporations like HP, FedEx, Seagate, P&G, major telcos, etc. all know Adampak for its ability to consistently deliver at the lowest cost. It was also revealed that HP has been using Adampak's services for the last 20 years since the Adampak was founded. How amazing for a little factory that started in Loyang Avenue!

On growth drivers

"RFID faces a chicken and egg problem. No one wants to take the lead in adoption; everyone just want to be the follower of a tried, tested technology". Those were words of Mr Chua. The history of barcode labels is a very good case study. It used to be very expensive in the early phases of industry adoption, every company only started to catch on the wave when major players started using it and costs concurrently went down. Likewise, RFID in 3rd Party Logistics will definitely come as the next big wave, as it greatly simplifies inventory management, let's wait patiently to see this sector blossom.

On competitors

According to Mr Chua, it is hard to claim that Adampak is the industry leader in South-East Asia because the coverage is just too difficult to ascertain. There are so many companies operating in a similar fashion in the region, and all are covering different scopes with different strategies. Just to name a few, like Brady, Zephyr (these I know) and ITW, etc. I would estimate there are 10 odd competitors in this industry.

Nonetheless, Adampak is certainly no small player here. Mr Chua shared that a lot of MNCs know Adampak when it comes to die-cut products and high end labels, and companies acknowledge Adampak's reputation for a consistent delivery of quality products. This is a good sign of a company that probably counts as the top few of the list.

He also revealed that Zephyr did make an attempt to break into China many years back, but the venture failed miserably and never materialised, and this made Zephyr's management adopt a more conservative approach of keeping to local confines of Malaysia and China.

On production capacity and scaling up capabilities rapidly

Adampak's factories run 24 hours shift. Mr Chua shared, "in this industry, there's no way you can survive if you work only on 1 shift". The plants run at full capacity for 5 full working days, and during peak periods, the staff work overtime. Clearly, Adampak is running at maximum operating capacity, with little evidence of any excesses.

One of the critical success factors for the manufacturing business is the ability to flex and scale up production capacity rapidly within a very short notice. If a company does not have strong processes in place, achieving a rapid scaling up will not be possible. Mr Chua shared that Adampak has the ability to set up new plants, new factories and get them up and running in a matter of 2~3 months.

On financial management

The sense of financial prudence

Mr Chua shared that the management closely watches the returns on equity. In addition, the company practises a good sense of financial prudence because the management is always fully cognizant of the risks involved in credit calls when banks face a liquidity crunch. Adampak has consistently maintained a high current ratio (current assets over current liabilities), whereby the short term borrowings and liabilities are well within the company's capabilities to repay within 1 year.

Good cashflow management

He also mentioned that Adampak happens to be doing well in this area and is very fortunate because "the customers see the company not as bankers", and their clients have been very prompt and regular with their payments. This is another sign of a well managed business where the company has a very strong relationship of trust and goodwill with their clients.

On process re-engineering and cost rationalization

Adampak does not have a specific department on this. But what they have are a few key staff trained in Six-Sigma (a qualification in process streamlining to reduce costs). Initiatives on cost rationalization are always on-going. For quality checks, computerised imaging was employed a few years back, but there are problems with obtaining a consistent output. Hence the idea was shelved and manual labour is retained. "Nothing beats a visual check", he says.

Putting the money at where there are greatest cost savings/avoidance

If there are any projects ongoing, Mr Chua cited that the company will generally invest more resources to refine the key processes that are potential show-stoppers in the entire manufacturing process. For example, one of the showstoppers in the label manufacturing chain is the punching of label holes and unwarranted retention of debris that causes clogging. This was mentioned by Mr Chua to be a real problem where resources in engineering were diverted to improve the process because of the immense costs of failure in the entire chain.

On Aident
Mr Chua shared that the original plans for Aident was to secure a public listing on the Malaysian Stock Exchange. However, for some reasons, this did not materialise.

I vaguely recalled that in one of my conversations with a Malaysian factory businessman, he mentioned that for anyone to go on a public listing in M'sia, 50% of the company shares will have to go to the government. That is why, there are so many companies that do not want to go public listing to raise funds, because by doing so, they will have lost control of the company and will be reduced to doing the bidding of the government. This is anecdotal evidence, and has yet to be verified. But this might just be one of the reasons that Aident's listing never materialised and Adampak decided to acquire Aident.

On dilution of earnings post-consolidation with Aident
Mr Chua enlightened that the gross profit margin dilution is primarily due to a consolidation with Aident. For 1H07, profits from the associate company Aident were accounted for, but not the revenue. Whereas for 1H08, post-consolidation, the revenue is now included, hence this accounts for the decline.

On impact of inflation and cost increases

I further asked Mr Chua on the impact of inflation on Adampak's business. He gave a very straightforward reply that these are factors that are not within Adampak's control, and when raw material costs increases, Adampak just transfer the cost increases to the customer. This also meant that Adampak should be insulated from damaging effects on cost increases in raw material

On employees

Giving where credit is due, and striving to reduce employee turnover to a minimum

Adampak's management strongly believes in the principle of rewarding the employees for their efforts. This could probably explain why admin expenses generally rose in a 1:1 ratio to revenue, while maintaining a very strong ROE. And this principle has done Adampak a lot of good. Mr Chua shared that it's a well known fact that "Adampak has one of the lowest employee turnover rates around"

This is comforting, because with a HR policy that focuses on rewarding good managers for their efforts, I do not have to worry about excellent managers being poached by other companies.

On management succession planning

I asked him on the plans for management succession planning, he mentioned that this has already put in place - all the managers running different segments of the company. As for the question of importing foreign talent to helm the ship, like many Singapore companeies, Mr Chua said that the issue is not on foreign talent, but on finding the right man for the right job. He is confident that if he is not around, his managers can step up and run the company as well as he does.

On the board of directors

A strong representation of independent directors with experience across multiple industries

Mr Chua also shared that the representation of solid independent directors who hold concurrent appointments on other companies' board helped a lot. The executive management has received good advice from these people who are able to draw on their industry experience.

My final remarks

I think Adampak is a very good company, that is well worth the money I put in as investment. From a financial perspective: the intrinsic value is much higher than the current share price of S$0.22, and there's a very significant margin of safety. Moreover, the net asset value approximates S$0.18 cents per share. Their current significant exposure to the electronics industry will also mean that they may ride along the economic cycles, but I do not expect their ardent clients like HP and Fed-Ex to go out of business, so I am not really worried.

(A sidenote, I realised that HDD are dirt-cheap now. Now, don't you think that developing nations will be very hungry over the next few years for such low-cost storage?)

From a people perspective: it is well managed by a strong team, and this is validated by every single touch point I have with Adampak. From asking of AGM minutes, to requesting for a meetup with the CEO, to posing as a customer to test the sales staff competency, to warm customer service officers who gladly brought me around the factory floor to see a group of workers who are going about their tasks professionally. The team has not failed my expectations thus far. The management is financially prudent, and people like Mr Chua comes across as a forthcoming person an astute businessman.

Does it really bother me if there will be a recessionary year ahead and that electronics industry may be affected? Not at all. Even if the stock market shuts down for the next 12 months, I can continue to sleep well, knowing that the company will continue running and my money will be in good hands. I have done my due diligence to the best of my abilities, and the entire study tells me that the odds are in my favour. Let's wait to see if this gem will really shimmer and shine so brightly that the market cannot ignore anymore.

For Adampak, I have done more than sufficient as an analyst and part owner. It's time to move on to understand other businesses, while keeping this in view.

(P.S. Mr Chua was visibly impressed when he knew that all the written analyst reports I submitted to him came from an engineer. "Not many engineers I know write as well", he said. What a compliment! I guess I was just short of submitting my resume to seek employment in Adampak. :P )

Wednesday, August 27, 2008

How to Start Investing

I have frequently been approached by my friends and colleagues on what stocks to buy and how to start investing. Then I realised that an element is missing in this blog that has not been addressed: that is, how to start investing in businesses via the Stock Exchange.


1. Go for the low lying fruits lying just above and around you

Start by looking around you and keeping a keen eye to identify which products and services are provided by companies that are listed in Singapore's Stock Exchange. Perhaps it will never occur to you that so many products and services you experience in your daily life all belong to listed companies:
- a can of green tea from Pokka, or canned drinks from F&N
- massage chairs by OSIM
- traditional chinese medicine by Eu Yan Sang
- nice Jap restaurants like Sakae Sushi that are operated by Apex Pal
- famous brands like Raoul managed by a company called FJ Benjamin
- niche watchshops like Hour Glass that sell watches that are horological art
- our favourite family bookstores like MPH and Popular
- Singapore's newspaper monopoly by Singapore Press Holdings
- our favourite 1st Class, World Class Singapore Airlines
- "Eng Seng" sprayed on some temporary roadblocks come from the construction company Chip Eng Seng
- banks like OCBC, DBS, UOB, etc.

(The mention of these listed companies does not constitute a recommendation from me...)

And the list goes on.

2.  Target businesses that have a geographical proximity to you

There's always this question: what about companies listed on New York Stock Exchange like Intel, Dell, Microsoft - why not consider them too? You could, but do you remember what sages like Sun Tze and Clausewitz said about the principles of conducting a warfare? Always fight a battle on grounds where you have a good grasp on the terrain. Likewise, companies listed on New York Stock Exchange are geographically very far from home ground and this also meant that the information sources are confined to the internet. If I have to invest my money, like how I will wage a war, the entire operation will be conducted on grounds that I am most familiar with. Risks are lower, and my confidence of success is much higher.

(For more info on how Sun Tze's war principles can apply to investing, read the following articles written by another fellow investment blogger, Sun Tze: Chapter 1 - Deliberation, Chapter 2 - Planning, Chapter 4 - Tactics.)

3. Doing your due diligence: Performing the different levels of business analysis

After looking around you, pick one area that you have a specific interest, it is best if is a product that you can relate to tangibly and you have an active interest to find out more. Then read up on it from reports and announcements found on
http://www.sgx.com/, sift through posts in forums in http://www.wallstraits.com/, www.wookup.com/huatopedia. Talk to your friends - ask what they think of Sakae Sushi (as an example) food and service quality. Ask employees or ex-staff about how they find their bosses. Make your research as exhaustive and complete as possible. All these will give you a pretty good idea on the nature of the business and the prospects of the industry.

The framework for analysing the business is clearly laid out in the various articles I have written on investment methodology.

4. "Inactivity strikes as intelligent behaviour" - Warren Buffett

The next step after conducting all analysis is to take one step back. Briefly sense what the stock market climate is like and observe. Is there an immense sense of euphoria where people believe that the market will be shooting through the roofs tomorrow? Do you read of articles about university students are suddenly all investing, and aunties throwing in their life savings into the market? These are signs, but never act base on them. What you have to do is to take note of all these observations and remain inactive in trading activity, and continue reading up and finding out more about your companies. Inactivity is intelligent behaviour.

When the time comes where you can take advantage of bargain prices of listed companies, act swiftly and decisively to swoop in, because such opportunities are rare.

Monday, August 25, 2008

Gold: Insurance for your wealth

Investment in gold deserves a mention in this blog, because gold is an important asset class from the perspective of a wealth insurance, but usually this is not known and not considered by people generally.

Disclaimer: This article merely expresses the authors views and are not recommendations for action by the reader. YMMV.

Concept of money as a medium of exchange
Before we talk about gold investment, allow me to talk a little on background of money. Some explain money as "Money is what money does", which means that money is a medium of exchange. In the good old days, money notes is designated to be a promissory note of guarantee and as a means of convenience to replace physical gold as the currency. It was a medium of exchange that allows one to trade between different items using a common denominator of value, and over time, the entire world economy grew to depend on money as its lifeblood.

The Bretton Woods system
As the world progressed into modern times and global trade and commerce started to bloom, it was recognised that there's a need to establish a common policy for international monetary management. The Bretton Woods system was established in 1944 as a set of rules of commercial and financial relations among the major industrial nations. It was also in the same time period that an international regulatory financial body like International Monetary Fund (IMF) was established. The primary feature of the Bretton Woods system is that the nations are obliged to peg their currency at a certain fixed rate to gold with a 1% spread between the buy and sell rates. It was a good and stable system that is in a way backed by physical gold. For the world's dominant leader, the US dollar was pegged at USD35 per ounce of gold.

However, by early 1970s, US's participation in the Vietnam war accelerated inflation, and for the first time in modern history, the nation as a whole began running a trade deficit. The reasons for an accelerated inflation can be attributed to a massive consumption of resources and the government began to finance this consumption by printing more money notes. As this war went on, people started to swap their dollars for physical gold. Because of excess printing of money by the US government, nations began demanding US to fulfil its promise to pay, by a conversion of dollars into gold. This came to a tipping point where US's gold coverage deteriorates from 55% to 22% and it represented the point where holders of the dollar lost faith in US's ability to cut it's budget and trade deficits.

Collapse of the Bretton Woods system and emergence of the floating currency
In 1971, the United States devalued its currency from USD35 per ounce of gold, to USD38 per ounce of gold. In 1972, it reached USD70 per ounce. In 1973, the Bretton Woods currency markets closed and subsequently reopened as a floating currency regime where the dollar is no longer pegged at a fixed rate to gold. Today, the exchange rate stands at startling rate of USD823 per ounce of gold and this is expected to rise further.

Fiat money and the risks of hyperinflation
As United States grew to became the modern day economic powerhouse, the dollar became the de facto currency that many countries view as gold. The dollars became a favourite denomination for countries to keep in their vaults as foreign currency deposits.

And as the circumstances in the world evolved, it somehow becomes apparent to me that our world's economy now hinges on fiat money - money is designated as a medium of exchange because the government said so. It runs purely on the confidence in the government, and holds no intrinsic value. For the world's economy to fall apart, all it takes is for a critical mass of people to lose faith in their government's currency and began collectively raising prices mindlessly. Humans have the herd instinct, once the confidence is shaken, things can spiral out beyond control like what happened in Zimbabwe, where money completely loses its effectiveness as a medium of exchange. (read here)

Gold: insurance of wealth against runaway inflation
Gold is an asset class that will not lose its effectiveness as a medium of exchange because of the underlying intrinsic value and limited global supply. It is an excellent form of liquid asset class that can help insure us against a currency fallout. The risk of a currency fallout is remote, but it is there and as a rational human being, I will want to guard against such a catastrophic situation. Let me draw an analogy: we buy life insurance even though the risks of death and critical illness are statistically remote - for the simple reason that we want to preserve our state of wealth and minimise impact on our loved ones if something unfortunate strikes. Likewise, buying some gold can help to preserve our hard earned wealth and standard of living should an unfortunate case of currency fallout strikes. Although very unlikely, I do not completely rule out that possibility. And if ever a currency fallout does happen, I want to know that I can still use ounces of physical gold to sustain my daily needs.

Buying how much gold is enough then?
Historically, when hyperinflation occurs and prices rise beyond 1000%, gold prices will also rise more than 1000%. A good rule of thumb to start with is that we should probably strive to build 10% of our net worth in gold. So in the event of hyperinflation, gold price can be expected to rise such that we can still retain 100% of our current net worth.

Methods on investing in gold
We can invest in gold in basically 3 different forms. Either physical bullion, paper gold certificates, or Exchange Traded Funds. If you think of buying gold, it can be acquired in the form of physical bullion from official websites like http://www.kitco.com/. The online market also allows one to sell off gold. Just a comment on physical bullion: the bigger the gold bar, the cheaper it is in terms of per ounce, but also less liquid. Gold is much more liquid in forms of widely recognised coins like the Canadian Mapleleaf coin (see picture above)

A fellow forumer, who is incidentally my brother, has written excellent articles on gold investing. (Read How to Invest in Gold, History and going forward, Investing in Gold)

For further information and open forums on investments in gold, you can go to http://www.goldclubasia.com/

Other interesting points about gold:
Market movements have shown that crude oil prices and gold are in many ways correlated. It has been widely recognised that oil and gold have one of the strongest historical commodities relationship. It is even more interesting to note that back in 1975, oil was pegged at USD75 per barrel, as compared today's prices of USD113 per barrel. Now, compare that against the gold exchange rates: in 1975, USD40 per ounce of gold. Today, it is USD823 per ounce of gold.

I shall leave you at this thought. For further reading, see here.

Saturday, August 16, 2008

Analysis of Adampak (Part II)

Comments on 1HFY08 Results Released on 15th August

(Updated as at 19 August 08, after a release of new information found in 1H08 briefing slides)

(Following a few valid points raised by a fellow investment blogger donmihaihai, I relooked and amended to reflect greater clarity.)

Revenue at US$28m for 1H08 as compared to earlier year (1H07) grew by 49%, cost of sales grew by 57.8%, reducing the gross profit margin by 4 percentage points (as compared to 1H07). Given an estimated inventory turnover ratio (cost of sales = US$19m / Inventory = US$7m) of 2.7, the raw material inventory (est. to take up 62% of all inventory, from FY07 AR) is not expected to last beyond 3 months. From this, it can be infered that inflationary pressure on material prices over the last 6 months have been factored into the rise in cost of sales.

(Effects of exchange rate between USD and SGD on profit margin are more fuzzy here to draw direct relations, so I shall not comment on it)

The administrative/distribution expenses rose in tandem (approx. 49%) with the revenue growth - this is reasonable from a retrospective point of view because historical trends have shown that Adampak's admin/distribution expenses growth correlates to revenue growth on a 1:1 ratio. Balance sheet is healthy with a current ratio of (46mil/12mil) of 3.8.

Comparatively, Brady, the global market leader for labelling, is doing much worse and has only registered a 1% growth in revenue for Apr 08 in the Asia-Pacific region (as compared to similar quarter in 2007), and 10% overall sales growth.

Revenue Structure

Examining the revenue structure reveals that Adampak has an inherent business vulnerability that must be addressed in the longer run. i.e. over-dependence on the HDD market. The management acknowledged that efforts must be made to expand their scope of business into other sectors like pharmaceuticals, telecommunications, etc. But it remains to be seen if Adampak can achieve diversification into other sectors and reduce its exposure in the HDD industry. For 1H08, 45% (compared to 49% in 1H07) of the revenue was derived from sales to HDD manufacturers like Seagate.

n overly focused revenue structure is a double edged sword: on one hand, the company is able to ride on the rapid expansion of the HDD industry; but on the other hand, it is definitely not healthy in the long run as Adampak's performance will be half (literally) dependent on the HDD industry.

For RFID sales, revenue registered a growth of 57% from US$0.5m to US$0.8m. By absolute figures, this is a modest figure but definitely not sluggish. While there are serious challenges for RFID to achieve a ubiquitous status, it will definitely come. Let's maintain a close watch on this.

Pre-Aident consolidation versus Post-Aident merger
From the 1H08 results briefing slides, if we assume that Aident was already fully merged with Adampak in 1H07 as a single entity, then compare the sales against that of 1H08 when they have fully merged, we see that sales to telecom products fell by 46% from US$4.2m to US$2.3m. Sales to other electronics sector shrunk by 6% from US$9.7m to US$9.1m. Are this as a result of slowing demand in the electronics products? Does this imply that there were some inherent inefficiencies in Aident's business that brought about the decision of the management to shut down their plant in Shanghai?

It is also noteworthy that it was mentioned that Adampak accrued the lower net profit margin due to the consolidation of Aident's results, as compared to the earlier year which was based on a 1 month equity accounting (i.e. apportioning the results of Aident by the percentage of Adampak's ownership). Such a statement necessarily implies that management acquired Aident, which is a company that is less profitable.

There are many questions that needs answers. But I believe that Adampak's management made this strategic acquisition for good reasons of expanding fast to rapidly penetrate Asian markets like Malaysia and China by leveraging on the established processes and infrastructure of Aident. And all the time, the management is fully aware of the need to restructure and streamline Aident's operations for greater efficiency.

A financially prudent and candid management
The management has also demonstrated financial prudence by curtailing their purchases on plant and equipment (1H08 US$0.2m compared to 1H07 US$1.2m) to conserve cash holdings, brace for a slowdown in global demand, and prevent built up of excess production capacity.

What consistently struck me in my entire analysis was the candid nature of the management about areas of their business that was not doing so well.

Final remarks
Adampak has so far done extremely well in light of the inflationary pressures and slowdown in global demand. Profit margins may be slightly squeezed in view of rough times ahead, but given an efficient cost structure and strong balance sheet, the company will definitely be able to continue to inch forward and expand their market share. Also, management and the business development personnel must continue to aggressively expand sales to other industry sectors to minimise their risk exposure.

Let's wait and see if this gem will ultimately shine in time to come. In the meantime, I will just enjoy the generous dividends. YMMV.