The Importance of Structure

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap. 

This post is about structure and is the last of three main posts that provide insight into my research and investment process.  The two other posts are about people and valuation (see here and here).

Structure is the hardest to write about.  It is boring when compared to writing about people and is not easily quantifiable like valuation.  Nevertheless I think it is extremely important and something that investors don’t pay enough attention to. 

By mapping a business group’s structure investors can identify potential leakages, or situations where controlling shareholders can transfer something from the listed company to their privately owned vehicles.

It is also time consuming.  Mapping corporate structures of large business groups sometimes requires days or weeks of trolling through corporate filings, websites and news articles.  It took two weeks for me to map China’s two largest petrochemical conglomerates, CNPC and Sinopec, for my 2012 report on Chinese conglomerates.  And I could easily have spent more time on both. 

Business Groups

Business groups represent the ownership interests of an individual, family or government entity that controls two or more companies.  The group may or may not be legally defined.  It can be a formal holding company or just a loose collection of friends that co-invest in many projects together.  

They can account for a large role in national economic growth, especially in frontier and emerging economies where they control numerous businesses.  Many times they account for a large portion of economic activity.  In the early 1980s the Salim group’s revenue accounted for about 5% of Indonesia’s GDP (related book review is here). 

Business groups can be large and complex.  Below is partial map of Fosun, one of China’s largest privately-owned business groups, when I attempted to map it in 2014.  At that time the group had over 300 entities.  In one of the group’s more recent filings, it lists economic interests in about 500.  

Based on my experience I guesstimate that 20-40% of the value in most stock markets is controlled by a relatively small number of people – say 5 to 30 well-connected families and individuals.  Another 20-50% is controlled by the government through ministries, sovereign wealth funds or other government-linked companies and entities. The remainder are companies that have a distributed shareholder base, subsidiaries of MNCs or companies that are not part of the larger business groups. 

Taiwan is a good example.  One of the largest business groups in Taiwan is the Formosa Plastics Group which controls ten listed companies.  Together their value is over 10% of the entire value of all the companies trading on the Taiwan stock exchange. 

Governments are also the controlling shareholders of many large listed companies.  In a report I wrote on South East Asian business groups in 2011, I found that about 31% of the large companies listed in ASEAN were controlled by government-linked entities.  The largest was Singapore’s Temasek which controlled companies that accounted for almost 14% of the region’s total value of large investable companies.  In my 2012 book on China’s business groups, I found that the Chinese governments' proportion of control was even higher at about 60%. 

Group Structure Brings Additional Risks

The group structure brings risks to investors.  There is a large incentive for controlling shareholders to transfer assets, cash or something valuable from the entity they own only 51% of to that entity they own 100% of.  “Expropriation of minority shareholders” is the way financial types and corporate governance experts phrase it.  “Screwing over small shareholders”, is more succinct in my view. 

There are many ways for this to happen.  The beauty behind human ingenuity and imagination means that if there is proper incentive, someone will find a way around the existing rules and laws.  Investment bankers, lawyers, and corporate strategists are paid big bucks for devising such structures.

The remainder of this blog illustrates two schemes the controlling shareholder might deploy to take money away from minority shareholders: adverse related party transactions and something I like to call long term pump-and-dump. 

I. Adverse Related Party Transactions

Related party transactions are deals or transfers of some sort between two companies that are both controlled by the same person or group.  They are like moving money from one pocket to the other. It stays with the same person.  However if one of the company’s shares are listed, then moving money from one company to the other hurts small shareholders of the listed company. 

All related party transactions should be at ‘arm’s length’.  This means that the sale from one controlled entity to another is executed at the prevailing market price and that it would make no difference than buying or selling to or from a company inside or outside the group.  However determining market prices can be subjective and open to interpretation by the two companies involved.  The ‘market price’ can be set to benefit one entity at the detriment of the other. 

The following is a hypothetical example of how this works. 

Let’s call the very rich owner of a large business group BIG TYCOON.  BIG TYCOON is the eldest son of the conglomerate’s founder. His father invented and marketed what is now a very popular candy. To increase sales, BIG TYCOON’s father expanded from simple manufacturing into many other related businesses.  These include distribution and logistics (to get the candy to market), convenience stores (to sell the candy), and paper manufacturing (to make candy wrappers).   

Because he’s the eldest son, BIG TYCOON took ownership when his father passed away.  Unlike his father, BIG TYCOON enjoys the money and lifestyle of owning a successful business more than actually running it.  He’s not a bad guy in the sense that he beats his wife or children, but he’s simply not interested in the candy business or running a public company. 

The outline of BIG TYCOON’s conglomerate is shown below.  He owns 51% of Manufacturing Company and 51% of Convenience Store Company.  He also owns 100% of Distribution Company. As their names imply, the Manufacturing Company makes candy. Distribution Company distributes it and Convenience Store Company sells it.  

The Manufacturing Company and Convenience Store Company are both listed on the stock exchange.  The other 49% of both companies is owned by institutional and retail shareholders.  The latter two are called “minority shareholders’, since they own less than 50%. 

With 51% ownership in both public companies, BIG TYCOON has a firm grip on both Manufacturing Company and Convenience Store Company.  Even if all other shareholders get together, they won’t have enough votes to override BIG TYCOON’s decisions.

This structure gives BIG TYCOON near absolute control over all three companies despite owning a little more than half in two of them.  He can make decisions that may or may not be in the interest of the minority shareholders of the two listed companies.  

In fact there is a large incentive for BIG TYCOON to treat minority shareholders badly.  Why settle for 51% of the profits, when he can steer more to the company he owns 100% of?  This transfer can occur in many different ways.  One of the simplest ways is to lower the sales price of the candy produced by his 51% held Manufacturing Company.  

After the price change, BIG TYOON’s 100% owned Distribution Company pays a lower price for the candy, and its sales, margins, profits and cash flow increase.  The lower price causes the opposite at his 51%-owned Manufacturing Company.  Its sales, margins, profits and cash flow decrease. The end result is that minority shareholders suffer at the expense of the controlling shareholder, BIG TYCOON’s decision.

Manufacturing company’s minority shareholders are likely to complain about the poor results. BIG TYCOON has many ways to explain them - consultants telling him to lower prices to gain market share, rising competition, higher distribution prices by other logistics companies, etc.  

II. Long-term Pump-And-Dump

Another way for controlling shareholders to abuse minorities is through something that I call long-term pump-and-dump.  

A long-term pump-and-dump is another form of related party transaction.  In this case the owner transfers profits into the company that he wants to raise money for.  This makes that it appear to be healthier and more valuable than it actually is.  After the money is raised, the scheme is reversed. 

Let’s again use BIG TYCOON’s candy empire as a way to illustrate this scheme.   Let’s assume Big Tycoons’ empire now consists of two companies. He owns 100% of Wrapper Company and 51% of manufacturing company.  Most of these candy wrappers produced are sold to his Manufacturing Company.  

BIG TYCOON decides to monetize his stake in the Wrapper Company.  Instead of selling it outright, he wants to sell 49% through an IPO, collect the cash, and retain control with 51% shareholding.  This has worked well with the other two listed companies and he’s keen to do it again. 

However Wrapper Company is not growing and its future growth prospects do not look very good.  BIG TYCOON’s investment banker says that he can help Wrapper Company sell its shares and list on an exchange, but unless Candy Wrapper shows good growth, its valuation will not be very high. Who wants to invest in an old industry that’s not growing very quickly?

BIG TYCOON wants to get as much as he can for his stake and devises a strategy to make Wrapper Company more attractive to investors.  Firstly Wrapper will expand internationally.  They’ll sell at zero profit or even below cost to quickly ramp up sales in fast growing countries like China and India.  They don’t expect to make much profit out of this, and will likely incur costs as they need to get market share quickly.  This means undercutting their competition with lower prices.  

Secondly they decide that it will look good to have a new product.  They increase R&D spending and ‘invent’ a brand a new wrapper 'technology' that they claim is better and cheaper.  

To pay for all this BIG TYCOON decides to boost candy wrapper sales by increasing the price that Manufacturing pays for the new high-tech wrappers.  Increased revenues will cover the costs of international expansion and R&D.  

All is going according to plan and over the next two years Wrapper Company’s sales, margins and profits increase.  From the outside it appears that Wrapper Company's global expansion and new technology are accepted by the market.  However what is actually happening is that Wrapper Company’s growth comes at the cost of Manufacturing Company. 

BIG TYCOON meets with the investment banker and shows him Wrapper's progress.  The banker is very happy.  Instead of trying to find buyers for a slow growth, old-fashioned candy wrapper manufacturer he now has the technology-based, globally expanding Wrapper Company.  Its increasing sales, margins and profits are ‘proof’ that the global expansion and new technology are successful.  The banker is certain that Wrapper Company can be sold as a growth company at a high valuation. 

The skilled banker does a very good job marketing and selling Wrapper Company.  The IPO is a big hit, with the company valued at $1,050m.  Like his other listed companies, 49% of 
Wrapper Company is sold to minority shareholders who can now trade their shares through the local stock exchange.  

The 49% stake sold to the public raises $490m for the company and existing shareholders.  New shares account for half of this so the company gets cash of $245m.   The remainder are BIG TYCOON’s personal holdings so he pockets $245m.  The investment banker gets a 5% or $50m, fee for his efforts.

This leaves 51% – or a controlling stake – in the hands of BIG TYCOON.  BIG TYCOON retains control, has a lot of more cash, and another listed vehicle to potentially use as he did in our first example.  

The net effect of our fictitious story is that over time the value of Wrapper Company has been pumped-up by transferring profits out of Manufacturing Company.  Once the money is raised through the IPO, rights issue or other capital raising exercise, the whole process can be reversed. 

End Note

This lengthy blog has covered a lot of ground.  It not only introduces the concept of business groups, but it also makes an attempt to illustrate why it’s important to study their structure.  Two examples have been given to emphasize how controlling shareholders can take money from minorities. 

Along with researching key shareholders and valuing companies, structure is something I believe investors should spend considerable time researching.  As stated at the beginning of this blog, it’s not as fun as the other two but, if done properly, it’s essential to understanding the risk minorities take when investing in companies that are part of larger business groups.

Why the US Does Not Have Business Groups

My favorite research projects are analyzing and writing about business conglomerates in Asia.  For me it is an easy way to quickly come-up to speed on a country's key people, capital allocation structure, and power chain.  After completing the reports I feel I know who is actually in control, their background and their relationships with important business and government personalities and entities.  I also get a sense of the who the good groups are and who the not-so-good groups are.  So far I've mostly been correct (see a case study type write-up here).


In the past several years I've been investing my own money using much of the same research methodology I used in writing the reports. The best example is my trip to Greece last year.  Other investments closer to home and based on recent reports have also done well.

So far I've been content doing my bottom-up research and have not really looked into why Asia and the rest of the world's corporations are organized differently than companies in the US and the UK.  The few US and UK companies I've looked at have a very flat corporate structure, and I've been told that neither country has business groups. 

However virtually all of my analysis and investment experience has been outside the US and UK, and the group structure is my base case when looking at companies.  Because of this, my research and investment methodology doesn't really fit with the US and UK's flat corporate structure.

I've always been a bit curious as to why the US and UK are different than the rest of the world.  But like a myopic-race-horse-with-blinders, I've accepted the structure for what it is and concentrated on trying to make good investments and recommendations.  

Thanks to to UC Berkeley PhD candidate Matthew Sargent for turning me onto the very well written, but long-titled, "How To Eliminate Pyramidal Business Groups - The Double Taxation of Inter-Corporate Dividends and Other Incisive Uses of Tax Policy". 

Written by Dr. Randall Morck in 2004, the paper states that a key reason that US corporations do not have the pyramidal business group structure is due to the 1935 imposition of inter-corporate taxes.

Apparently after the 1929 US stock market crash many business groups defaulted on their loans, and the public blamed the large conglomerates for causing the crash and subsequent depression. It sounds like this gave President Roosevelt's administration enough political capital to change how America's corporate sector is taxed and, by extension, organised.

The new tax regulations made dividend payments from a company to all the entities that owned it subject to taxes.  Each layer is subject to pay taxes on the dividends it receives from companies that it has a stake in.  If a conglomerate has many layers, each layer is subject to tax charges.  This makes each additional layer very expensive. This creates a  tax penalty on the pyramidal structure of business groups.  

America's utilities were given special attention.  The Public Utilities Holding Company Act (PUHCA), also passed in 1935, subjected utilities to US federal regulation and did not allow an owner with more than two corporate levels to hold any public utility.

After the two new rules were implemented, the group structure that was so prevalent in the US, was quickly broken up.  According to the paper, stock liquidations surged in 1936.   America has had a flat business structure ever since.

The paper attributes the UK's flat business structure to pressure from British institutional investors who were 'dismayed over corporate governance problems in business groups'.  As a result, the London Stock Exchange Takeover Rule was issued in 1968.  The rule said that any acquisition greater than 30% of a listco needed to be at least a 100% acquisition.  This forced the parent company of a listco to own all 100% of its subsidiaries or less than 30%. 

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What I found very interesting is that the pyramidal business group structure that I'm used to was very common in the United States.

They were so common, that in 1928 the US Federal Trade Commission wrote a report on the abusive nature of business groups.  The report found the same transgressions of business groups that I focus on when investigating corporate structures.  Morck notes that the 1928 report on US business groups said that US conglomerates had '...widespread instances of tunneling, poor governance, and monopolistic practices'.

Other government reports in the 1930s noted that many groups transferred profits between entities to avoid taxes.  "Listed companies in a business group could trade with, finance or insure each other at artificial prices, transferring taxable income from companies with few deductions to companies with many".

In other words, many business groups were ripping off the government as well as minority shareholders.  

This is very similar to what I've seen amongst many, but certainly not all, business conglomerates that I've researched. 

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This is a great paper, and I sincerely appreciate Matt for bringing it to my attention

But most of the thanks and appreciation goes to the author, Dr. Randall Morck, for researching and writing it.

Good Find - Japanese Version of "The Rise of Capital"

Deep in Taiwan University's library last week I was taken aback when I came across a Japanese version of the Rise of Capital.   I did not know it had been translated into other languages.  Given the book's significance, and the great work by Japanese academics such as Kunio Yoshihara, it should not have come as a surprise.

First published in 1986, The Rise of Capital by Richard Robinson is the best emerging markets finance / investment book I've read.  It outlines the emergence of a domestic capital class in post-colonial Indonesia and the confluence of politics and business that nurtured it .  It noted that many of the firms and businesses that did well under Sukarno, had a hard time after Soeharto came to power.  

The book filled in many gaps in my understanding of how business operates in Indonesia. It showed that the Jakarta listed companies I was analyzing were typically a small part of very large conglomerates.  The book highlighted that many of the business group founders were related, did business together and typically had strong political ties.  Later I learned that a similar structure is found in all non-Anglo Saxon economies that I've looked at.   

Ever since reading the book I spend more time looking at the people behind the listed companies, what else they own and how this might affect the listed companies. I've also written several reports on the corporate backgrounds of many of Asia's bigger business groups.  Most of this is targeted to large investors (publication list here: http://michaelmcgaughy.blogspot.hk/2012/02/publication-list.html..).  

In the last couple of years I've been investing my own funds using key leanings from The Rise of Capital and my own bottom-up research.  Results have mostly been better than expected. 

Cut Out the Middle. People = Equity

I am still searching for ways to best explain the philosophy behind my ‘group’ research and why it is important.  My research starts with looking at the background and history of the controlling shareholders, as well as all the companies he/she/it controls.  I do as much research on the listed and unlisted companies and spend as much time on the non-core businesses as the core businesses.

There are likely many different ways to explain what I do depending on the listener’s background. 

My last post was written for financial professionals.  In that article I introduced two expressions – “research beta” and “research alpha”.  I contrasted the type of research used to generate consensus earnings forecasts – ”research beta” – with the more background, people and structure focused research that I emphasize – “research alpha’ (See: http://michaelmcgaughy.blogspot.hk/2013/04/research-alpha-and-research-beta.html). 

After posting this, I thought of another, non-investment-jargon way of explaining the philosophy behind what I do. Here goes….

Firstly, it has been written many times before that business is about people.  The equation can be written: "people = business". 

Secondly, equity represents an investment in a business.   By definition equity represents a legal claim on a business.  It represents the difference between assets and liabilities of that business.  The equation can be written: "business = equity". 

Cut ‘business’ out of the middle and we are left with a direct link between people and equity.   Or rewritten: "people = equity".  Equity is about investing in people.

From this simple equation it becomes clear that equity investors should evaluate the people behind the business’ they own.  However this is rarely done for listed companies.  When was the last time you’ve seen a research report with an objective or even critical assessment of the key family, people or entity that controls a listed company?

Visiting and meeting management is different than objectively evaluating their background and history.  It is a good information point, but a meeting or two does not replace looking at someone’s past actions and background.  Bernie Ebbers (Worldcom) and Eka Tjipta Widjaja (Asia Pulp and Paper) likely charmed the socks off many corporate and investment bankers while building their companies.  At the end of the day they were behind two of the largest corporate defaults before the 2008 meltdown.  

I would also argue that people are more important in emerging markets where the legal system, regulatory agencies, and business infrastructure is not as entrenched as in more developed countries.  

In my experience more emphasis and attention is placed on people in South East Asia, the Indian-subcontinent, and greater China than in the West. In most developed Western countries the emphasis is comparatively more focused on institutions and rules.

Another reason as to why people are more relatively more important in Asian and emerging markets is that many of the largest listed companies are relatively young; they are typically majority owned by their founders and their descendants, and are tightly controlled by the founding family.   Think of Li-Ka Shing and his Cheung Kong group, the Lim family’s Genting group, or Guo Guangcheng’s Fosun International group. 

Luckily there is a lot of publicly available information about most ‘tycoons’.  In many Asian countries wealthy tycoons get as much press coverage as rock and movie stars do in the US and Europe.

There is also a wealth of publicly available data as reporting requirements have increased in most Asian and other markets in the last three decades.  Insider buy-and-sell data can be important trading signals.  Related party transactions provide a window into the tycoons’ non-listed businesses.

Even in the West individuals are important.  Think about Steve Jobs and Apple.  His history as an innovator, businessman and marketing guru were well known when he returned to Apple in 1996.  Betting on him and his background turned out to be of the better investments of all time with Apple's share price increasing from its 1996 range of US$4.50 - US$8.50, to over US$700 in 2012.

People also impart their culture and values on the companies they lead. This can be especially true of the founders.  This initial corporate culture can take a life of its own with older employees reinforcing existing culture and corporate history to newer ones; or only hiring new employees that fit-in. One of my favorite examples is Astra International, which was started by the very honorable Soeradjaya family.  It remains one of the best-managed companies in Indonesia despite the founders having sold their stake over 15 years ago.

Research also bears this out.  I forget the exact reports I read, and I may be rusty on the numbers, however I remember several stating that share prices decline by something like 50% on average within five years of the founder’s death.  (Apple shareholders take note?)

People are important in every occupation, but especially in business.  Decisions have to be made and people are behind each and every one of these decisions.  Understanding the business from the controlling owners' perspective is something that is overlooked by many analysts and should be emphasized more.

Research Alpha and Research Beta

Research Alpha and Research Beta 

I've been researching and writing about Asian conglomerates and business groups off-and-on since 1990.  In the last two years I've started to look at the price performance of companies controlled by 'good' vs, 'not so good' corporate owners.  What is clear is that buying quality at a good price has been a very good strategy.

I'm not the first, nor will I be the last, to make this observation. However my methodology of separating good from bad may be unique.  I've found that the group research methodology I've been using is a fast way (or not too slow way) to weed out the 'not so good', from the 'good'. 

I'm also currently in the process of expanding the work I've been doing on business groups and corporate backgrounds in Asia.  The goal is to get more clients to look at this.  As such I need to better explain what I do and why it adds value.

One way to explain this is to separate investment research into ‘Research Alpha' and ‘Research Beta'.

'Research Beta' I define as that which what is done by most sell-side analysts.  Sell-side research is very much focused on trying to accurately predict next quarter's profit and EPS.  Analysts typically decide if they will be above or below consensus earnings forecasts.  Once done these forecasts get factored into the very same consensus earnings forecasts that was used as benchmark.  These are then compiled by all the main data providers and are likely quickly reflected in stock prices.

Everything else I call 'Research Alpha'.   These are the factors that I focus on in my research.  They include items such as a deep dive into a company's background and structure, spending as much time researching the non-core as the core businesses, looking at both listed and unlisted entities, taking an objective view of owners/management and their background, return of cash and treatment of minority shareholders, scope for adverse transfer pricing, etc.  

These are qualitative factors that the sell-side spends almost no time researching.  They are in my opinion are not reflected in the consensus earnings forecasts that 'the Street' likes so much.  Logically, concentrating on these 'Research Alpha' factors should lead to non-consensus investments and performance. Non-consensus research that should produce non-consensus results.

The argument for not concentrating on these types of factors - at least from my sell-side contacts - is that they don't change much and are already factored into share prices.  

Easy to argue both ways.

However, my perception is that the sell-side can't do, or won’t publish, this type of research for three reasons. Firstly, most sell-side analysts spend a great deal of time marketing.  They don't have enough time to do this type of research.  Secondly, the sell-side, mostly at its client's request, is increasingly short-term oriented.  Thirdly, analysts are under pressure to stay friendly with management. They run the risk of straining the bank’s, or their own relationship, with the company by publishing anything negative or too revealing.  

However concentrating on qualitative factors suits my style of investing - long-term, fact based and evidence driven.  It is also very fun and, so far, rewarding.

I find that after I've done my work I can sleep at night as I feel comfortable with the stewards of my capital and that their interests are aligned with mine.

And what could be more important than a good night's sleep?