Growth at All Costs? (Part 2)

Increasing Interest Rates

Meanwhile, in separate reports by western media, strong U.S. data, rising commodity prices, increasing wage pressures and aggressive monetary-tightening policies combined to push treasury yields to cycle-highs, and global bonds are sold down significantly. A chief economist puts it neatly: “Interest-rate risk hits all high-quality bonds. Higher growth means higher nominal and real rates.”

The Bloomberg report go on to suggest that investors are betting the era of ever-looser monetary policy is firmly over.

QUESTION: Supposed a group of portfolio managers decide that it’s time to rotate out of bonds (amidst increasing interest rates) and emerging market equities (where supposed corporate governance are unable to encourage appropriate financial discipline, yet) or at least reduce both positions, and they start selling these positions – now where will they park that “fresh cash”? Where should they park those freed up cash?

We believe this is the perfect concoction for a sustained flight to quality/ growth where money and portfolios will be rotated to favour companies that are able to grow revenue and profit sustainably amidst rising interest rates, and hopefully for the appropriate core reasons as follows:

1) Ability to raise price and pass costs to consumers/ clients due to their market leadership and superior products or services.

2) Ability to innovate new products or services that increasingly discerning and cash-tight consumers are willing to pay for.

3) Ability to increase volume; sell more and further increase their economies of scale; includes doing business in new markets.

4) Ability to reduce costs and remain lean and green.

Flight to Quality & Growth

Consider this business, a second-generation family owned business in Asia Pacific, it is the largest of its kind in the regions that it operates, where it is about 50% larger than its closest peer. While its foreign peers had been expanding aggressively in the Greater China region for the sake of being bigger, but not necessarily better, and unfortunately stumbled and fell flat on their faces, this management had instead chose to keep lean and green, allowing their cash position to build up over the past 5 years while they maintained sales, managed inventory turnover, and selectively traveled south where there were less competition and more real consumption where they grew in peace and quiet.

Such is the character of the management that they never want to be engaged in a wet-market, loud-hailer style shouting competition as to “who has more money to throw?”. Instead they chose to quietly do their thing and grew in resilience, only allowing their on-the-ground operations, customer experience, and results to speak for themselves.

In fact, they were so persistent and focused in their approach that their net cash position grew almost 350% over the past 3 years, it grew so much that it now accounts for about 30% of their entire market capitalisation.

We wish to emphasise that it is not the cash that amounts to 30% of their market capitalisation that matters, but the increasingly rare character of the management who intended for such an organic occurrence that stands out.

It is financially dangerous to be filtering companies simply based on this simple metric without ascertaining the qualities of management.

One can make money on the basis of return on equity (mathematically sound to invest in cheap), but the investor might lose the castle on the basis of return of equity (realistically unsound to invest in corrupt), where the money might be “re-routed” out of shareholders’ reach.

Any financial magician can conjure a way for such numbers to appear as intended on balance sheets and on spreadsheets, and for savvy investors to then go on and label them as “undervalued” and maybe even invest in them. But when such facades are not backed by real, on-the-ground operations, they tend to fall apart within 3-5 years, likely because the math no longer adds up and the balance sheet literally blows up, or simply because the humans involved can no longer take that kind of mental and moral stress.

Back to our company in discussion, in their recent quarterly report, this company reported sustained growth in revenue and organic earnings due to a mixture of improved inventory supply-demand, and improved operating leverage. That revenue finally grew after years of industry consolidation was a sign of relief, the growth in organic earnings was icing on the cake.

Subsequently after these recent announcements, the founder went on to acquire the company’s shares in a transparent and above-board manner on several occasions, where the total shares acquired amounted to almost two years’ worth of dividends collected by the founder by virtue of his significant shareholding in the company. Back in our Investment Research Lab, we quipped that this is the founder’s idea of a personal “Dividend Reinvestment Plan”.

The amount in value was equivalent to 10 years’ worth of his salary, and a total 8 figure amount in US dollars term.

When was the last time you invested 10 years’ worth of salary (not savings) into one company?

Where will you put your money if you rotated your funds out of bonds & emerging markets equities?

Thank you for reading.

~ The most important journey is the one within