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Building a Core China Portfolio – Part 6, Cash is King; How To Spend It!

13 Sep

The table below (Click to enlarge) highlights VTech’s historical free cash flow (FCF), outlines how the cash is allocated, and contains just a couple of basic ratios that stress test the balance sheet.

I’ve calculated FCF by taking the company’s cash flow from operations, and deducting the CAPEX, investments and other investments. Some might argue not to use the ‘other’ line item, as it generally connotes non-recurring items. When analyzing a single year or a few years I would agree that it makes sense to exclude non-recurring items, and check whether such items are indeed included in this line.

Benjamin Graham discusses non-recurring items in his famous Security Analysis. His example of a refund for over paid taxes illustrates the difference between the treatment of non-recurring items by an analyst in a single or a multi year analysis:

“Most of the non-recurrent items play a double and contradictory role in security analysis. They should be excluded in arriving at the results for a single year, but they should be included in the overall results for a period of years. A substantial refund of overpaid taxes for example has nothing to do with the year’s operating profit, and it is a misuse of language to call it part of the “earnings” of the year in which it was received… Yet, in a seven or ten year analysis of average earnings, a tax refund pertaining to the period belongs in the picture jus as much as the profits or losses against which it was accrued.” (Graham and Dodd, 1956)

Either way, apart from 2000-1 the company has been cash generative every single year.  We already flagged those years in a previous blog entry, and assumed they were the result of the tech bubble bursting – we will still have to find out what actually happened. Yet I am satisfied with the level of cash generation. I also note that apart from outlier years, the FCF as a percentage of net income has been around 75-80% on average for over 15 years. In other words, the earnings on the P&L have a high level of cash conversion – they are quality earnings.

Looking below at the allocations, this data is also mostly positive. There are essentially three types of allocation:

1.      Dividends and buybacks (to the equity holders)

2.      Payment of debt and interest / coupons (to the providers of debt)

3.      CAPEX and acquisitions (potential company growth – or value destruction if it goes wrong!)

As potential equity holders we should be interested to see that the lion’s share of the FCF has been allocated as dividends and share buybacks to shareholder. Firstly, this should come as no surprise, as we’ve seen previously that VTech has no debt on its books. In fact, if one looks at the bottom line of the table, we see that on average 75% of FCF has been allocated in dividends and buybacks since 1992. On the one hand this is good, as the company is not making use of funds for acquisitions. Acquisitions are often a risk and can be value destructive. Unless a company already has a record of successful value creating acquisitions I would not a priori look favorably on the use of cash for such endeavors. However, with a sustainable ROE of high 30%’s (see – I would like to find out whether there are any other organic growth opportunities VTech could be spending its cash on. Think about it – where else am I going to get a 35%+ return in the market so easily?!  There might not be such an opportunity out there, but I’d ask the question when we get to that stage.

Finally, there are the ratios at the bottom of the table. These basic ratios are a basic and initial stress test on the balance sheet. Though we know these guys have basically no debt on the books, so I’m not too worried.

So in conclusion, I am still positive about VTech, and will continue dedicate time to my investigation. This analysis has highlighted VTech as a company with high quality earnings historically, a history of strong capital allocation to equity holders, a seeming avoidance of risky acquisitions, and as we already knew no debt burden. The only question that arises is whether I would prefer them to plough cash into growth opportunities, but we will ask more about such opportunities in a later blog entry.

Until now we’ve been looking in the rear view mirror. Next time I will begin looking at the business itself, and then we will use that information to look forward and derive a fair value range.

Building a Core China Portfolio – Part 5, The Equivalence

7 Sep

Before we move onto analysing Vtech’s balance sheet strengths and risks allow me to digress for one blog entry…

Every company has a replacement value; that is the amount it would cost to set up the company from scratch and get it to its current state of returns.

The market cap of a company is a theoretical takeover price.  The difference between the market cap and the replacement value represents the premium (or discount – a discussion for another time) that investors will pay for a company over its replacement cost. By way of an example, if the replacement cost of a company is $1bn, and the market cap of the company is $2bn, then the ratio is 2x. In other words, investors are willing to pay twice the value of the price tag to set up the company from scratch and nurture it to current state.  But why would someone be foolish enough to pay twice the price for an asset?

Put simply, investors believe that the present value of all the future returns of the company is currently worth the replacement cost of the company. Add those future returns present valued ($1bn) to the current value of $1bn, and you get a company value of $2bn, hence the 2x price/replacement cost ratio.

It should be possible to derive the same figure by finding the ratio of a company’s return (ROE) to its cost of equity.  This ratio will tell you the excess return a company will create over the cost of investing in such a return.

If one assumes that over the long-term the fundamentals of the market and prices must coincide (i.e. the arbitrage opportunity for a good buy will be removed over time), then using both these ratios together one can see whether the market is currently pricing an arbitrage situation, i.e. is the current price a good entry point. Let’s put it another way:

Over the long-term there must be equivalence between our two ratios:

[Market Cap] / [Common Equity] = ROE / [Cost of Equity]

As a one man band I am forced to make a number of simplifications when using the above principals.  Firstly, I’m sure you noticed that I substitute replacement cost with book value (i.e. common equity). Secondly, I replace a real cash return for an accounting based ROE.  In reality, a cash based return on an economic replacement cost – i.e. an economic profit version of the numbers – would yield a cleaner and more reliable set of results.

Let me digress a little more before I bring us back to VTech. These ideas are not my own. They come from a book called Cash Return on Capital Invested (CROCI), written by Pascal Costantini.  Using an economic profit adjusted model, and accounting for growth (amongst other things) Deutsche Bank currently value companies using this method, with a high degree of accuracy.

Anyway, back to VTech.  I would normally focus on the balance sheet, capital allocation and cash conversion of a company before paying too much attention to the valuation side of our work.  However, I was struck by the price/book consensus valuation on Bloomberg of 4.7x 2011e (note the company has a March year end), and 4.3x for 2012e. These numbers seemed very large to me, so I decided to investigate earlier than usual in my process, based on the equivalence of the two ratios presented above. Costantini in fact calls it The Equivalence.

In the 2010 VTech annual results, they have HK$4bn of common equity. The market cap of the company is HK$19.4bn. Dividing the Market Cap by the common equity gives a ratio of 4.85x. In other words investors are willing to pay 4.85x my approximation of the replacement cost of the company.

That’s all well and good if we assume that the company can make that residual return over its cost of equity consistently.  The data presented in my previous blog entries highlights VTech to have a sustainable ROE of around 40%. Not only is that great, but it compares favorably with both peer groups (as we’ve seen).

Nonetheless, using our two ratios, we can divide 40% by 4.85x, which means the market is assuming this company has a cost of equity of 8.25%. I’m not going to calculate a cost of equity for this company as it’s beyond the scope of our discussion. But I will stress test this level with a common sense assumption that a cost of equity below 8.25% is unlikely, so at best the company is at fair value. I note that Citi Bank’s DCF on Vtech uses a 9.1% WACC – now this company has no long term debt, so that ‘s effectively a cost of equity.

So if we just assume for a minute that VTech’s cost of equity is 9%, then the current share price is 9% overvalued. (i.e. [[40%*4bn]/9%/19.4bn]-1).

But hang on a minute… there are other plausible alternatives to this interpretation of the data…

Perhaps the book value used in the equation is below the actual replacement costs (i.e. you really need economic profit data to make The Equivalence work). Maybe  the cost of equity is either lower or expected to get lower in the future, and my common sense feel is incorrect (I’m willing to accept that!). In addition, the market might be saying that the sustainable ROE is going to increase in the coming periods. In other words all 4 parts of this equation have elements of dynamism.  The data alone does not give us the answers as to whether VTech is over, under or fairly valued. The data is agnostic.  But it gives us a prism through which to digest the company and ask relevant questions in our analysis, and to bear in mind that this might be a chink in the armor.

I am not going to write for over a week now, but in my next blog entry I will be looking at the strength of VTech’s balance sheet, capital allocation, and quality of earnings.

Stay tuned….

Zai Jian

Building a Core China Portfolio – Part 4, Let’s Start Digging!

5 Sep

In my previous blog entry ( we discussed the notion that a lot can be understood about a company by its numbers, before we even know the details of its business model and drivers, let alone speak to the company’s representatives. We are using VTech Holdings as our first example based on the 100 companies delineated in my shortlist to be found at the following URL:

To reach a deeper understanding we will compare the ROE of VTech with its main competitors, as well as the components of said ROE with that of main competitors.  But that leads us to the following question: who are VTech’s main competitors?

The company reports 3 main segments:

  • Manufacture and supply of corded phones (TEL)
  • Electronic Learning Products (ELP)
  • Contract Manufacturing Services (CMS)

Over the past 5 years the TEL segment has contributed to about 45% of the company’s top-line, and the ELP segment to just shy of 40%. As such, I consider 2 peer groups to be useful:

  • Phone manufacturers
  • (Electronic) toy manufacturers
  • [One could potentially look at VTech in the context of Hong Kong exporters as about 55% of revenues come from the US, and 35% from the EU]

Before we start digging into the toy manufacturers, let me just remind you of the components of ROE so you can understand why I am performing the decomposition below, ans see the influence each component has over the final return figure:

ROE = [EBIT%]  x [Asset Turnover] x [1-Tax Rate] x [Leverage]

Toy Manufacturer Data

Figure 1 – Historical ROE vs. Toy Peers

Figure 2 – Historical EBIT Margin vs. Toy Peers

Figure 3 – Historical Asset Turnover vs. Toy Peers

Figure 4 – Historical Leverage vs. Toy Peers

Now let’s move onto the phone manufacturers:

Figure 5 – Historical ROE vs. Phone Peers

Figure 6 – Historical EBIT Margin vs. Phone Peers

Figure 7 – Historical Asset Turnover vs. Phone Peers

Figure 8 – Historical Leverage vs. Phone Peers


For most of the past 2 decades VTech has been the best in class performer in terms of ROE in both peer groups. This is evident from figures 1 and 5. That’s no simple accomplishment. Let me assure you, that this is a live investigation – I’d not seen this data up until this point. Let me also remind you that consistency and sustainability of strong results are they key element we are looking for.

Figures 3 and 7 show that the asset turnover (sales/total assets) at VTech is simply world class, and has contributed heavily over 20 years to the company’s impressive returns. In a coming blog, if we decide to stick with VTech we will want to break this down and see what is contributing to the strong asset turnover (e.g. is it heavily influenced by fixed asset turnover, net working capital turnover, and are there any weak links).

Normally one finds that companies with high asset turnover have lower EBIT margins, and vice-versa.  It’s normally a reflection of whether the company’s strategy is more focused on volumes (i.e. high asset turnover) or high pricing (i.e. high EBIT%). With that in mind we can perhaps understand why VTech’s margins have been historically lower than its toy peer group (see figures 2 and 6).

In fact looking at these figures we see that it was a negative EBIT margin in 2001 that significantly contributed to the poor ROE in that year (it was exacerbated by a slightly lower leverage in 2000-2002).  If we continue beyond today’s blog entry with VTech, we will want to understand what happened that year and ask questions such as the following: Is the company more prone to cyclical risks than its competitors in both peer groups? If so why? Has this changed? How? Is it simply more operationally leveraged? Again why? Etc… Was this a one off?

Despite this weaker long-term margin history, I am very encouraged to see that EBIT margins performed very strongly in both absolute terms and relatively compared with both peer groups (see figures 2 and 6) since 2006. Is this sustainable, and if so how? What changed? Was it simply mix? Geography? Etc… We will want to find this out.


This is a quality company. It is worth understanding the business model, drivers, and future sustainability.

  • Strong sustainable ROE (both relatively and on an absolute basis) of about 40%
  • driven mainly by very high asset turnover
  • and good EBIT margins in recent years.
  • Leverage is within the peer group ranges and at very acceptable level historically.

Next I will be asking questions to dig into qualitative elements of the firm in order to judge its sustainable profit levels, provide an upside / downside valuation range.

With such a value range we will be able to understand a good entry point for VTech and judge whether the current risk reward posits a buying opportunity.


One point at this stage – I notice that the company does not report product segments below the revenue line. I do not like this as I am unable to ascertain the strengths, returns, and sustainability of each part of the business, and to know whether one is dragging the other up or down. I will look more at this.

Zai Jian

Building a Core China Portfolio – Part 3, Assessing Quality

2 Sep

Our aim is to find companies that fit the following bill:

  • high quality
  • low balance sheet risk
  • no-left field risk
  • quality of earnings (i.e. cash conversion)
  • favourable capital allocation vis-a-vis equity holders
  • strong competitive position
  • solid drivers

If a company does not fit our profile, we reject it and move onto the next one. If it does meet our profile, we can move onto estimating sustainable income and putting an upside/downside value range on the firm. With comfort about the quality and risks, and a fair value range (with a high margin of safety) one can decide whether now is the right time to purchase the stock, or whether to keep monitoring (and amending with new information), and waiting for the right moment to pounce.

Now, time is our most precious commodity.  With that in mind I start my list above with an assessment of quality and balance sheet risk. It is fairly easy to get a quick assessment of these 2 criteria, and know whether it’s worth spending further time on a deep understanding of the company’s business model and working on a valuation.

The measure of quality is returns. As a potential equity investor one must ensure that the company has a good track record of returns on its equity (ROE).

Yet how does one define quality. The first basic benchmark is to look for companies with an ROE of at least 15%. This is not fool proof, and will often be industry dependent. However, on average the market is returning around 12%, and with many companies beating that average, below 15% represents a healthy level at which to reject a company with comfort in the knowledge that there’s still a huge universe to choose from.

(Note – It usually yields greater rewards to find quality and wait for a good entry price rather than go for low quality at a very discounted price. It’s just common sense that sustained low quality is less likely to improve than a discount opportunity is likely to close on a company with sustained quality).

The second thing to ensure is that a company exhibits a sustained (or growing above the benchmark) return over a period of many years. A track record is important for obvious reasons. I will add though, the success of a company is clearly heavily dependent on management. With one of managements’ primary task being the successful allocation of capital in a firm (in order to create value i.e. grow its returns above the cost of said capital),  a good track record of sustainable returns is a great yardstick for the competence of a management team, and with all other things being equal, is a good indicator of future success of the teams execution (this naturally has its caveats and should not be relied upon in isolation).

The next thing to do is chose a number of peer companies and compare how our company under analysis has performed compared with the competition. If the company has severely underperformed I suggest rejecting it at this early stage and moving on.

If the company has:

  • had only a couple of poor years
  • had a sudden jump or drop
  • performs relatively well compared with peers
  • or has even performed well or very well

…then it is worth breaking down the components of its ROE to understand what’s driving that performance and or blips, what’s causing the differences etc… and then making an initial decision about the company’s quality.

What are the components of the ROE?:

ROE = [EBIT%]  x [Asset Turnover] x [1-Tax Rate] x [Leverage]

(Note – this is ROIC x leverage)

Anyway, this blog entry has been very theoretical. In the next entry we will apply these ideas, present and have a close look at some of the data.

I want to leave you though with something more concrete.  In my last entry on building a core China portfolio ( I presented a short list of 100 companies that deserve further inspection (

We decided to start looking at VTech Holdings (HK 303). Below is a graph of VTech’s ROE between 1993 and 2010.

On first inspection it looks great. It increased steadily from 1993 to 1998 to high 30%’s (easily above our benchmark 15%). Then it collapsed when the tech bubble burst (will need further investigation). Subsequently, the company has posted returns sustainably in the high 30%’s, reaching 50% for a couple of years. Even 2009/10 was very strong.

Conclusions thus far – let’s keep looking at Vtech!

Building a Core China Portfolio – Part 2, The Shortlist

25 Aug

The table below contains the top one-hundred companies shortlisted according to the criteria outlined in part 1 of my “Building a Core China Portfolio” series, ranked by best return over a ten year period.  (Find part 1 at –

Before I explain some of the details, I know that the table is too small to read. All you need to do is click on it and it will open as a stand alone table in your browser. Next simply enlarge the table (clicking on the table itself is one way to zoom in) to a readable size. Alternatively you can right click on the table to open it in a new tab or window and similarly enlarge.  Either way, I am happy to be contacted and email you the table in excel format.  Send requests to

It will take me a little time to clean up, but I am planning to set up the table for users to be able to open a dynamic excel spreadsheet with their bloomberg terminal. If you would like a copy of the dynamic table when I’ve fixed it up, please contact me at the same email address.

Anyway, back to the table itself.  The table contains the top 100 companies ranked by 10-year returns. In addition, I excluded all companies with a maket cap below 5bn in local currency in order to reduce and element of trading-liquidity risk a this stage.

The table contains the following data points:

1. Company name

2. Bloomberg Company ticker

3. Market Cap in local currency (HK$s or CNS)

4. p/e for current and next year (so we can see whether we are getting a good price for the quality we’ve identified in the company’s returns – a lot more on this in coming blog entries).

5. Capital employed (i.e. increase in common equity and net debt), increase in net income, and return over 5, 10, and 15 years.

So what comes next?

Remember, I’ve said that this is a live investigation, and I’ve no idea where is will lead or end. Well next I simply plan to work my way through the list from the top to bottom, choosing which companies are worth expending my time on a thorough investigation.  Time is afterall our most precious commodity.

Let’s look at the top three companies to begin with. Clearly Vtech Holdings is the place to start an investigation.  Not only does it have a 15 year record, but it also had very strong returns over all three periods. In addition, the p/e of 9.4x 2011e bloomberg consensus earnings is a good price for a company with such strong returns.

So, in part 3 of this series I will take a closer look at Vtech. The discussion on Vtech will also present an opportunity to talk about some methodology.

Zai Jian – Jon

再见 -乔恩

Building a Core China Portfolio – Part 1

22 Aug

I’ve wanted to build a China portfolio for a while.  But I’m not (yet!) an expert on Chinese stocks.  So in order to make an educated decision (and improve mine and your expertise along the way), I’ve decided to apply the same principles I’ve learned and used in other markets.  My goal is to discern which companies should form the core of my portfolio. I’m not sure where my investigation will take me, but I invite you along for the ride.

The ultimate goal is to look for quality investments (sustainable high returns) with no balance sheet or left-field risk, and a competitive edge.  This must all come at a reasonable price with a wide margin of safety.  These are the kind of names one holds for the long term i.e. investments, not speculation.  And yes… such companies do exist!

The first step is often the most difficult.  With 1000’s of mainland and Hong Kong listed companies, where does one start?  Well I decided to apply a basic return heuristic to the entirety of the Shanghai and HK stock exchanges, and rank for the best performers – i.e. create a shortlist for deeper analysis and investigation. I admit that it’s not a fool proof system, and I know quality companies will fall by the wayside at this early stage, and that low quality might slip through the safety net. But the logic is fairly sound, which should lead to a fairly sound short list of 10’s of stocks.

I’m going to take every listed company and compute a form of return over a series of different length periods. The reason to take different periods (5, 10 and 15 years in this study) is to test how robust the returns of the company are historically. Sustainable returns are important as returns are the most important indicator of quality to a stock analyst.  If we understand the environment (both internal and external) that contributed to said returns, and can qualitatively assess how likely those factors are to continue in the coming years, that combination of solid facts and common sense is as close to science as stock picking comes.

In addition, the primary job of management from our perspective is to allocate capital effectively within their company and create value for stockholders. In other words, their job is to consistently deliver returns greater than their cost of capital.  Many analysts will meet management and declare whether or not they are good or bad.  Now my first degree is in psychology, but it didn’t make me a mind reader. How can an analyst jump to such conclusions, often using them as a basis for his or her investment decision? I don’t know how. But the return data does not lie, and solid returns over an extended period (note – solid depends on many things, and will vary according to sector – though as a rule of thumb, the developed market is returning about 12% return on book equity) is a good indicator that management knows what its doing. This data point should not be used in isolation to judge management, but the importance of capital allocation and returns to the shareholder, along with the dependence of returns on management decisions, makes good management golden.

Anyway, back to creating our shortlist.  The return heuristic I am going to calculate is the following:

Increase in net income over the period / (Increase in common equity + increase in net debt)

In other words, this tells me over a certain period of time how much capital a company employed to create additional income over that same period. The higher the return sustainably, the better the company has been at using its additional capital to create value for its shareholders. Granted it uses P&L data which is itself riddled with caveats, (not to mention that the system does not account at this stage for capital structure) but ranking such returns over different periods and assessing sustainability is a good way to create a short list of 10’s of companies for close inspection from a universe of 1000’s.

I will use Bloomberg data, again not fool proof, and I caution against making a final decision to buy (or short) without reading or modeling from numbers taken from actual annual reports. But I’m happy using their data as part of an exclusion exercise, as it is mostly robust and extremely reliable

I will publish my findings in the coming days.  Maybe I will put some EU and US data so that readers familiar with those markets might feel more comfortable.

Zai Jian