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.