Wednesday, December 30, 2015

Music - A Different Investing Analogy

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 mostly about people and the beautiful music we make.

There is a host of famous investors that compare investing to American baseball.  Both have lots of statistics, and involve strategy, skill and patience.  One good write-up by world famous financial author Michael Lewis can be found here.

While baseball is fine, the analogy that resonates with me most is music. Especially the process of looking for and discovering new bands and music before others, or raw old rare-gems that others did not see value in.

I also love to introduce friends to new bands and genres.  I picture myself as being cool and hip by knowing obscure Japanese hip-hop bands and forgotten jazz greats that others don’t.  There’s not any money in all this, but the music itself is enjoyable and it gives me something to talk about besides small cap Jamaican stocks which not many of my Asia-based friend can relate to.

R.I.P. Don Cornelius
Process.  Finding good investments and new music is a process.  Although I’ve never written it down, when I was younger I had a procedure for sampling and finding new bands.  I read Rolling Stone and other magazines, hung out at independent record stores, watched Soul Train and American Bandstand, and sat through many live performances.   I’d stay up late to tape full albums that were played midnight to six on the radio, talked to other geeky music lovers and trade albums and CDs.  Anything to try new stuff at a cheap price.  If nobody had what I wanted, I’d bite the bullet and spend money on an album or CD that I just had to have. 

It wasn’t work, but looking back it took time away from other worthwhile pursuits.  Like watching baseball.

My investment process is more formalized than my music exploration ever was.  It involves searching globally for undervalued companies, thinking of new financial ratios to backtest, and making deep-dives into corporate structure and controlling shareholders.  This involves lots of reading, travel and talking.  Instead of listening to a lot of different bands, I now sift through lots of corporate data and reports to find the few that make sense to spend more time on and eventually invest.  
F Street's Minor Threat
(Washington, DC, USA)

It doesn’t feel like work, but it takes time away from other ways to earn a living.

Technology.  Music changes with technology. What would jazz be without the saxophone (invented in 1840)?  Could rock exist without electric guitar (1931)? How many modern genres owe their life to computers, synthesizers and other electronic instruments? Musicians are typically at the forefront of utilizing new technology.

Investing and finance are the same.  Investors quickly adopt new technologies.  Before Internet trading and ‘robo-advisors’, there were carrier pigeons, the telephone, ticker tape, and the non-stop rise of computing power.
When Digital Was Analog

Technology is a double-edged sword.  It underpins much of my favorite music styles such as house and hip-hop, as well as ground breaking and multi-genre pioneers such as Kraftwerk.  But it’s also what drives techno, which I detest. 

Technology allows me to invest in Eastern European and Jamaican stock markets from my Hong Kong base.  Something that was virtually impossible 20 years ago.  But it’s also what drives high-frequency trading which is basically front-running.  Something that is certainly immoral and should be illegal.

Importance of luck.  Luck is a big factor.  Just like I can’t predict which stocks will increase, I really don’t know why one band will do well commercially and another doesn’t. 

Many undervalued stocks stay inexpensive before others see value and bid up prices. It can happen quickly or may not happen for a long time.

Overlooked Value
This is similar to ground breaking albums.  The Velvet Underground and Nico only sold 30,000 copies after its 1967 release.  But in 2003 Rolling Stone called it the ‘most prophetic rock album ever made’.  A six CD box set based on that one album alone was released.  Whoever had the foresight to buy the album’s rights must have made a bundle.

I could likely fill many pages with bands and singers that did not make it as big commercially as I originally expected.  Troublefunk, Chuck Brown, the Knack, Wreckless Eric, Altered Images, the (English) Beat, Biz Markie, the Feelies, Love Tractor, Kool DJ Red Alert, are but a small sample of bands that I thought were as good as or even better than those that became much more popular.

Open-mind and independent thought.  Most of my best investments have been from original ideas.  I’ve made money from others’ recommendations, but the majority of my multi-baggers have been due to my own research and analysis.  

This is similar to most of my favorite music.  I’ve been fortunate to have friends who like music as much or more than myself.  Many of their recommendations have been fantastic. But most of my favorite stuff has come from just keeping an open mind and ears. 

HK's Best
Khalil Fong / 方大同
I first heard my favorite Hong Kong singer when I was wandering through Causeway Bay one late rainy evening and Khalil Fong’s (方大同) video was playing at the record store. My introduction to the Indian subcontinent’s great and varied musical traditions came from a jet-lagged meander into a record store in Delhi’s Connaught Circle.  I discovered my favorite Taiwanese band, Soft Lipa (蛋堡) from the try-before-you-buy listening station at Eslite bookstore. Listening stations at Tower Records in Tokyo and Osaka yielded many great finds including one of my all-time favorites, Small Circle of Friends.

Age and experience help.  Being older means knowing what you like and what you don't.  I now rarely spend much time and expense on music and shows that I don’t like.  I still enjoy trying new stuff but am more discerning.  I love Taylor Swift’s latest single - “Shake If Off” is as catchy as they come – but also know that it’s not for me.  It's catchy but without some sort of edge I doubt I’ll be listening to it in a year or so. 
Early Small Circle of Friends

This is true of investing.  I know what style works for my temperament and holding pattern.  I've a process that I’m comfortable with and I know what has a good chance of working.  There is lots of room for improvement, but I’m adding very few new diamonds to my decision tree these days.

Personal/Lonely.  Music and investing are also very personal.  We all like different sounds at different times.  A great investment for a long-term investor can be a money loser to the short-term speculator. 

Both can be lonely.  In most of my better investments, I rarely know of any peers that have also invested in the same companies.  Many times I’m going against the advice from others. This can be lonely.  But mostly it’s been profitable. As I wrote in a previous post, it’s good to look where others don’t (see here).

It’s only in rare circumstances that I’ve gone with others on company visits. Three weeks in a very foreign Eastern Europe and Moscow was a great learning experience, but it made me homesick for family, friends and Asian and Chinese food.

Bragging Rights – Putting It All Together

I got lucky seeing REM as the opening act in a small 200 person punk/new wave club when I was 15 or 16. They were incredible and the next day I rushed out to buy their first single, “Radio Free Europe/Sitting Still”, which was put out on the wonderfully named “Hip-Tone” label. In the next few years REM’s popularity grew very fast.  Record contracts, concerts in larger and larger venues and making the cover of magazines.  It was a like a ‘hundred-bagger’ and I still brag about it. 
REM's Murky First

Like a value investor that sells too soon, my interest moved to other bands and types of music after REM’s second or third LP.  They got way more popular and stayed popular for a long time. I still listen to their songs and still brag about seeing them so early when they were raw, hungry, and passionate.  It was a personal and somewhat lonely experience as friends and parents questioned why I became so enamored with an unknown band from down south.  Looking back it was all worth it as many blissful moments were spent listening and dancing to their music, and tracking the band’s progress.

Investments are similar.  I’ve seen many bad shows and bought albums and CDs that I’ve barely played.  I’m happy with most of what I’ve seen and bought, and the few brilliant performances make all the time spent on the poor ones worthwhile.  This is similar to stocks. In the last few years I’ve made some bad investments, but also some good ones.

2016 Recommendation 

It’s been a while since I’ve seen a live rock/punk/funk performance and I’ve never been to a rave.  Jazz is my musical drug of choice these days.  Instead of searching for new music, most of my time and energy is now spent looking for good companies that have been overlooked, beaten down or for one reason or another trade at a price lower than what it should be.

Last Year's Logo
Which brings this blog to its first ever recommendation.  Perhaps the best value for money is the annual Jakarta Jazz Festival.  A 3-day pass costs about USD 60 and gives one access over 100 performances.  Shows are concurrent and one can’t take it all in, but seeing 20-30 shows over 3 days will likely be more than enough for even the most passionate music aficionado. The Indonesian Rupiah has been weak compared to the USD, HKD, CNY, the Euro and other currencies so now is an even better year to give it a try (reviews of past festivals can be found here and here).  Website of the Jakarta Jazz Festival is here.


Baseball analogies seem to be the most popular, but there are others.  Ken Fisher, who runs one of America’s largest financial advisers, compares investing to hunting wild lions in America – it takes patience, effort and thinking two steps ahead to bag a wild lion (see here).  Howard Marks, a famous American investor, compares it to playing tennis (see here).  Others compare it to running a marathon and even buying avocados (see here and here)   

These are all valid comparisons and there are certainly many more.  

With a song in my heart, tapping feat and a few more dance moves left in my shoes, I’ll stick to my music analogy.  See you in Jakarta.

Investment Strategy
Music Comparison
Great musicians overlooked for some reason.  Comeback acts.  Bill Laswell, Lonnie Smith, Jimmy Cliff, Mike Stern, Christian McBride, Kelly Rowland, Maxwell, M-People, George Clinton/Parliament/-Funkadelic, etc,
Deep Value / Small Caps
Live local music.  Many cities have numerous free/low-priced and high-quality live performance by local musicians, singers and bands.  Check local papers.  Experiment.  In Hong Kong try Full Cup Cafe, Orange Peel, Hidden Agenda, and the Wanch.   Washington DCs 9:30 club is now in a bigger building
Up-and-coming artists and genres.  Check the music magazines.  See a show. Surf the web
Large Cap Growth
Trendy ‘stars’.  They may be good, but it could just be the hype and group think that makes you like them.  Taylor Swift, Justin Beiber, the Weekend
Large Cap Value
Headliners that seem to get better with age.  Herbie Hancock, U2, Faye Wang (王菲), Tonny Bennet, Kreaftwerk, Mariah Carey, Allman Brothers
K- and J-Pop; Brit pop, rock etc, Swedish Pop, Eurotrash, German / Danish / Europe EDM, Cantopop, Indonesian pop
Emerging and Frontier Markets
Huge variation.  Dangdut, Gamelan, Reggae, Bossa Nova, Soca, Qawwali, Tabla, West African, etc.
Technology – Good
House (Happy, Deep, etc.), Drum and Bass, Kraftwerk, Cabaret Voltaire, Switched on Bach
Technology – Bad

Sunday, November 22, 2015

BRICs, PITs, and PIGS: Go Ugly

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 blog is mostly about valuation and yet another example of how investing in beaten down, unpopular and ugly markets can lead to better returns. 

Usually valuations are low in markets that are not very attractive.   But who knows when the news can get even worse? Uncertainty and negative news flow keep most of us out of markets just when we should be buying. 

And it can take even greater will power to stay invested when nobody around you sees your point of view, friends and peers are calling you crazy, and well-educated, respected and slick investment bank analysts and traders are negative.    

It is psychologically easier to invest in markets when there is a lot of good news and the future looks very bright.  The problem is that these markets tend to be expensive and future returns tend not to be as good.

To contrast these two points let’s look at two acronyms that surfaced about the same time.

BRIC stands for Brazil, Russia, India and China. The acronym is attributed to Jim O’Neill in a paper he wrote for Goldman Sachs in November 2001 (found here).  In it he argued that these four countries should be included in high-level government groupings such as the “G7” because their size and growth would make them increasingly influential.

The acronym came out not long after the tech crash. Wall Street was ripe for a new story and over the next few years the term became more popular.  Goldman Sachs and many others launched BRIC funds and ETFs.  There are now over 200 of them according to a very expensive database.

The term took on a life of its own.  Leaders of the four appear to like the grouping.  Just a few months ago they and South Africa formally launched the BRICS Development Bank (link here).

About the same time BRICs was coined, traders and analysts who survived the late 1990s Asian financial crisis were referring to the ASEAN countries as PITs.  The term stood for Philippines, Indonesia and Thailand.  These were three of the hardest hit economies and markets.  Unlike BRICs I don’t think anybody has come forward to claim responsibility for it.  Calling your home market a degrading term soon after clients lost money would not likely make one popular.

Investing in the four BRIC countries when the phrase was coined until now would have generated decent returns.  The four countries' headline indexes are up an average of 302% since late 2001 for a CAGR of 10.5% (this and other return figures in this article are based on the average return of each country's headline index, in USD, dividends not included). 

In contrast, and despite the acronym’s negative connotation, one would have done considerably better by investing in the three PITs markets.  An equally weighted investment in the three grew by 675% over the same time period, which means the PITs investor would have made more than double the money of the BRIC investor.  Even the worst PIT outperformed the best BRIC.  Thailand, the worst performing PITs country, rose by 629%, a bit more than India, the best performing BRIC country, which increased by 611% from November 2001 to November 2015. 

In addition to being weary of investment fads, investors should also be skeptical of what the big banks are pushing. In July 2006 Goldman Sachs launched its BRIC fund.  From launch to close, the fund’s performance was just under 20%.  Over the same time period the three PITs indexes increased on average by 157%, meaning that one would have made almost eight times more money by investing in the markets that were unloved rather than the ones that the big banks were marketing.

Are PIGS Today’s PITs?

PIGS stands for Portugal, Italy, Greece, and Spain.  These are some the world’s worst performing economies and equity markets since the 2008 global financial crisis.  Like PITs it is not a flattering grouping and member countries have reportedly renounced the term (link here).

I suspect PIGS could be an up-to-date version of PITs.  The origins of both are the same and they describe markets that are having problems and are out of favor.  

Also like PITs the countries in the grouping are geographically close and have a lot in common in terms of economic integration, language, and culture. This is a stronger grouping than the BRICs. Except for the large country size, I don’t really see much that binds them like the PITs and PIGS.

Back to BRICs

Ironically now may be a good time to consider investing in BRIC equities. 

Russia has some of the world’s least expensive large companies and very impressive management.  Brazil is starting to look interesting with its currency down some 40% in the last two years.  There are some exciting and inexpensive companies in China and at 7x PE the Hang Seng China Enterprise Index does not seem very expensive. Weren’t US equities trading at the same level in the early 1980s just before that market’s long bull run?

There’s also a good contrarian signal.  Goldman Sachs recently closed the above mentioned BRIC fund.  Big banks have a habit of closing operations and products just when things start turning around. HSBC closed its South East Asian equity research offices in 2001 – just before those markets went on a multi-year bull run. Goldman’s closing of its BRIC’s fund may be a similar signal (more here). 

Go Ugly

This short piece is meant to show that going against the grain and doing what is uncomfortable and unconventional many times leads to higher returns.  The best place to find value is typically in ugly geographies and sectors.   

Are there other places that appear to be ugly and warrant catchy phrases such as PIGS?

How about “RUKs”, for Russia, Ukraine and Kazakhstan, three ex-Soviet countries whose currencies have fallen and have some of the highest interest rates in the world.   Or “PCB”, for Peru, Columbia and Brazil, three of the worst performing equity markets this year for US-dollar investors  Or “JOBQES”, for Jordan, Oman, Bahrain, Qatar, Egypt and Saudi Arabia which are among the world’s least expensive equity markets likely due Middle East uncertainty.  Or "GETOUt" for gold, energy, telcos, oil and utilities, five out-of-favor sectors that dominate my global value screens.


Making Ugly Fun

"Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them", wrote Howard Marks in his very good book, The Most Important Thing.

Psychologically it is hard to put one's hard-earned money into unattractive and out-of-favor stocks and markets.   It's not easy or very enjoyable to try and catch a falling knife.  But buying quality companies at knock-down prices is likely a good way to limit downside and hopefully generate superior long-term returns. 

To help ease the way, I silently sing the chorus of a song from my youth.  Perhaps it will help you also.  It's sexist, corny and elementary, but with a catchy pop-hook its also very memorable, so make sure to click on the link below.  I've changed some lyrics in the second version to make it a little more investment specific.  

If you want to be happy for the rest of your life,
Never make a pretty woman your wife,
So from my personal point of view,
Get an ugly girl to marry you.


If you want to be happy for the rest of your time,
Never make a pretty stock your life,
So from my personal point of view,
Get an ugly market to carry you.

"If You Want to Be Happy", by Jimmy Soul (link here), 
(Based on "Ugly Woman", by Roaring Lion (link here)  

Friday, October 30, 2015

Jamaican Twofer: Book Review and Notes

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 mostly about people and a bit about value. 

Let’s get value out of the way.  My interest in Jamaica was spurred close to two years ago when it came up on my screens as having some of the world’s least expensive listed companies.  Stocks were cheap, but what about their value?  To answer this question I started to research the country and its listed companies.  Most of what I learned seems positive for investors and 'cheap' quickly became 'value'. 

Part of that learning process included reading Jamaican Entrepreneurship: A review of the characteristics, traits and ideas of some of the island’s most accomplished entrepreneurs”.  It is simply one of the best books I’ve read for a while and near perfect for my type of research and investing.

Positive Vibrations

Before reviewing the book, below are some interesting and lesser-known information about Jamaica that I came across.  Most of news flow has been positive in the short time I've been looking at the country.  Consider the following:
  • Investors are bullish about Jamaica’s future. If stocks markets make indicators of future growth, the Jamaican economy should do well in the next few years. The JSE All Jamaican Composite recently hit its all time high this month and is up 72% so far this year in Jamaican dollars and 65% in US dollars. 
  • Sovereign borrowing resumed.  Jamaica issued its first sovereign bond in three years in July 2014.  It was way oversubscribed (related article here). 
  • SME support. According to the 2015 Doing Business Report by the World Bank, Jamaica has the best laws for small and medium-sized businesses in the Caribbean.  It ranks as the 58th best place for small businesses in the world, jumping 27 places from last year (article here).
  • Reinvigorated bauxite exports.  Despite the price of aluminum falling close to its 2009 low, bauxite production appears to be increasing with Russia’s Rusal expanding production.  Bauxite is an importance source of foreign exchange for Jamaica (article here). 
  • Social openness.  Judging from the number of women in powerful positions and the racial smorgasbord of corporate directors’ names and pictures, Jamaicans appear to focus on ability rather than gender or color.   Women in powerful positions include Jamaica's prime minister, Portia Simpson-Miller and Kingston's mayor Angela Brown Burke. Almost 20% of Jamaica’s listed companies have female CEOs.  This includes Jamaica's largest bank (Scotiabank, headed by Jacqueline Sharp) and Jamaica's sole electricity supplier (JPS, headed by Kelly Tomlin) (article here).
  • Expanding financial markets. Another female leader is the head of the Jamaican Stock Exchange, Marlene Street Forrest.  Since becoming General Manager, the exchange introduced online trading, and currency and bond markets.  She's also promoting the exchange as a place for companies to raise money as proudly proclaimed on its Facebook and Twitter feeds (article here).
  • Urban redevelopment.  Jamaican conglomerate Grace Kennedy plans to move its headquarters to downtown Kingston’s waterfront thanks to the Urban Renewal Act.  The development may be available to investors through a REIT in the future (article here).
  • Laws coming in-line with reality.  Along with many Western Hemisphere jurisdictions, Jamaica decriminalized medical marijuana in Apr 2015 (article here).   Just recently a Jamaican living in Canada has proposed investing US$100m in a marijuana growing initiative (article here). 

Book Review
“Jamaican Entrepreneurship” is my kinda book.  It is heavy on facts and very people-centric.  Its 239 well-organized and easy-to-read pages profile 15 Jamaican entrepreneurs from different segments of society, provides a short history of the island’s economy and business environment, and reviews policies that favor entrepreneurship.  

The profiles form the bulk of the book.  They include the entrepreneurs’ background, family connections, education level, and business accomplishments.  Most books such as this focus on the subjects' business backgrounds and typically provide just cursory background information.  Bravo to the author for including a full view.

Some of my favorite profiles are Audrey Marks, the founder and CEO of Paymaster Jamaica, the island’s first multi-payment agency; and Norman Wright, the Founder of Perishables Jamaica, who is helping to revitalize Jamaican farming by packaging, branding and exporting locally-grown herbal teas. Others are Rita Humphries-Lewin who founded and chairs the Barita Group of Companies, one of Jamaica’s largest investment banks; and high school dropout Gordon ‘Butch’ Stewart who started the Sandals hotel chain and revitalized tourism on the island.

Having written about many South East Asia-based Chinese business groups I found the profiles of Jamaican Chinese entrepreneurs to be the most interesting.  Many trace their roots to Fujian and Guangdong provinces – the same home provinces of many of the richest families in South East Asia.  Their stories parallel those of many South East Asian entrepreneurs such as Soedono Salim (blog post here).  Many started as traders before moving into manufacturing or services. The profile of Vincent Chang, who started a chain of fast food restaurants, is very similar to the history of some of South-East Asia's richest families. 

The book also includes a short and concise background to Jamaica’s history and economy.  Its ‘discovery’ by Columbus and the enslavement of indigenous people under the Spanish. The rise of, and dependence on sugar plantations based on imported slave labor. Independence in 1962 with a few good years before socialism, corporate nationalization and subsequent economic decline in the 1970s.  The 1990’s financial meltdown and the lost decade that began the new millennium.

Coming In From the Cold

It’s almost 20 years since the island’s financial crisis, and the country still has a lot of problems.  National debt is high at 132% GDP.  The book notes that interest on it accounted for about 50% of government expenditure in 2013.  There is a concern that this high debt level does not include that owed to China (article here).

Jamaica’s diaspora is a double-edged sword.  The book notes that it has the fifth highest rate of remittances in the world, which account for nearly 15% of GDP.  These are maintained by the high rate of migration with 85% of tertiary graduates leaving Jamaica – one of the highest rates in the world.  Every year 20% of Jamaica’s specialist nurses and 8% of its registered nurses leave the island. 

However Jamaica has a good shot at moving forward.  It can educate its citizens.  It has a young population.  Political transitions have been peaceful since independence.  Its financial infrastructure appears to be improving.  Laws and regulations are changing to support its business sector.

Jamaica punches far above its small size in a wide variety of fields.  Its citizens prove time and again they can compete with the best in the world.  With its progressive government, talented people, and a bit of hard work, there’s a real possibility that the next decade will see Jamaican businesses do as well at home as it’s citizens have abroad.

The book’s introduction logically points out that, “Jamaicans have already shown that they can have an impact on the world stage in areas such as sports, music, food and culture.  Now it’s time to make a mark on the global economy”.

My thanks to Dr. Laman for researching and writing such an insightful and easy to read guide to Jamaica’s other talent pool. It can be purchased at his website which is here.


I'll end this blog with a link to one of my favorite Jamaican songs. George Faith's "To Be a Lover", remixed by Lee 'Scratch' Perry, can be found here.

Sunday, October 18, 2015

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.