What to learn from a broken investment thesis

In April I wrote about the microcap HGL Limited (ASX:HNG). The investment case rested on three pillars:

1. HGL showed a long history of above-average profitability.
2. It was trading close to tangible book value (TBV). 
3. Consumer sentiment had improved. HGL's financial result should catch up very soon. 

This week, HGL released its half-year result. It was essentially breakeven.The new CEO conceded the company required further cost cutting and announced new restructuring initiatives that would burn $1m cash and require a $3-4m writedowns of its asset in the 2nd half of the year.

On the top of that, the management wanted to distribute $1m dividend.  Last year the company paid dividends from the proceeding of the sale of a business unit. This year, it is going to pay dividends from its capital base!

(This shows the obsession of dividend yields in Australia. Continuous dividends support the share price of a company even when the business is in life support. To US readers: Australia has a franking credit system that prevents double-taxing on dividends. Thus, dividends in Australia are treated in a more favourable light here than in US.)

Now, examine the investment case again: Pillar #3 is broken. While the rest of the retail sector in Australia has recovered from it dark hours, no turnaround is in sight for HGL. Pillar #2 will be further weakened by the writedowns.

When an investment thesis is broken, I exit my position.

What can be learned here?

1. Write down your investment theses

Without writing down why you buy a stock, when the fundamentals change, you won't notice.

Human mind is an interesting thing. It's not good at remember things when the past is in dissonance with the new reality. It's very plastic. It will reconstruct a new history, making up a story to fit the new reality.

It's so easy to fool yourself. In the case of HGL, I could've fooled myself restructuring were a sign of turnaround I originally anticipated. But, no, it wasn't. I was expecting a swift shift jump of profit. There is no way to hide the mistake when it is written down black and white.

2. When an investment thesis is broken, quit

There is no "but" or "if". Regardless how painful the lost is, exit your position when the investment thesis is broken. The investment thesis that you have written will help you here to judge the situation rationally without being clouded by your emotion.

HGL may eventually turnaround. There is always the possibility I'm missing the upside if I sell now. However, the key point is, I bought HGL because of the reasons I listed above. If they are broken, my downside is more risky than I originally anticipated. In other words, this is a matter of risk control. 

3. Process is more important than outcome

In investing, when you consider each individual action in isolation, good outcome doesn't necessarily mean good skills; likewise, good skills don't necessarily produce good outcome.

I first read about the significance of having a good process in Mausoussin's More Than You Know.

Source: Russo and Schoemaker, Winning Decisions.

At the time, I thought it was BS. Ask me to condone bad outcomes?! The endgame is always about returns, right? How the hell would the process be more important than outcome?! Yet, over the years, I gradually realised how fundamental and significant this wisdom is.

I think the best example to illustrate this is poker game. Poker and investing are very similar. Both skills and luck are important factors. Say you are watching a player playing a poker game. If you saw him losing a few hands in the last 15 minutes, can you conclude he has no skills? Or if he has just won a few hands, can you conclude he has skills? Apparently not. The only way to tell whether a poker player is a master or not is to follow him for a long time. Only long-term result can separate skills from luck. And how does a poker master achieve long-term result? He sticks to a good process consistently and painstakingly to allow the edge of his skills to play out. Each individual hand may produce bad outcome. But in long run, his edge will generate better than average result.

Look at the HGL case again. I lost 6% in this investment in real life. My original thesis estimated that the best case upside was 200%. So here we have a 30:1 reward-to-risk ratio. And I judged there was a fair chance the favourite case would play out. Asymmetric reward/risk plus favourable possibility. Even if it didn't play out this time, the decision to buy was the right one. So was the decision to sell.

(Disclosure: none)

Is HGL Limited a cigarbutt?

HGL Limited (HNG) is an Australian microcap listed on ASX with a market cap of $22m. Its current share price is $0.44. It has virtually no debt. Insiders own about 40% of the company. Its history traces back to First World War. It was originally founded in 1898 as Hancock & Gore, a timber mill operator.

Between 1985-2010, it was under Kevin Eley's leadership. Without a better word to describe it, I would call it a "micro-conglomerate". Eley copied Warren Buffett's Berkshire Hathaway model with 2 distinct operations: (1) investing in public listed companies and (2) buying and operating a group of private businesses. However, since 2009, HGL has shifted strategy and gradually exited its equity investments. In 2010, Eley stepped down and was replaced by then COO Michael Mahoney. HGL is now a pure operator of a bunch of unrelated businesses. (Eley remains to be a board member.)

While its businesses are largely unrelated with no syngery, they all follow a common theme: they are branded products and services operating in their very narrow niches. These niche markets are usually fragmented and allow HGL to exert some pricing power. HGL don't manufacture their products. Effectively, It is an importer/distributor.

HGL's wholly owned businesses (sale figures are FY2012's, in AUD):

• SPOS - point-of-purchase marketing services ($23m)
• JSB Lighting - high-end lighting ($15m)
• Leuteneggar & XLN Fabric- fabrics for home sewing and craft ($17m)

Businesses with 50% ownership:

• Anitech - large format printer products and services ($29m)
• Mountcastle -  school uniforms and headwears for police and defence forces. ($12m)
• BOC - ophthalmic equipments ($7m)
• BLC Cosmetics - skin care ($10m)
• Biante Model Cars - collector model cars ($5m)

Business was tough in 2012. Persisting high Australian dollar caused price deflation and consumer sentiment was the worst since GFC. Both SPOS and JSB suffered huge setback. Management at SPOS had misjudged demand. It suffered large writedowns and impairments. HGL's revenue fell 28% and its net profit was negative. Excluding the writedowns and impairments, EBIT margin was 0.3%, effectively breakeven, while historically it was in the range of 7-9% in the previous 5 years.

Our investment thesis is based on a simple idea: reverse to mean.

Between 2008 and 2011, HGL's average ROE was about 10%. However, HGL has goodwill from its past acquisitions on its book. Use HGL's own preferred measurement, EBIT / Capital Employed averages close to 20%. HGL has never lost money in the past 10 years. HGL is an above average business. If HGL manages to control its costs and achieve a typical 5% net margin, using the 2012 trough revenue of $118m, it can achieve a net profit of $5.9m. With a conservative P/E multiple of 8.5x, each share will be worth $0.68, 50% above the current price. If revenue returns back to historical average of $160m and net margin 6%, with a more "normal time" multiple of 10x, it will be worth $1.3 per share, 200% above the current price.

(HGL has non-controlling interests on its book who have a claim on HGL's profits and assets. All the above figures except EBIT and Capital Employed have been adjusted to reflect what equity holders get. All figures are in AUD.)

How likely can HGL turn around its business?

The catalyst that is helping us out is a swift improvement of consumer sentiment in the first 3 months in 2013.

(source: tradingeconomics.com, Westpac Bank, Melbourne Insititute)

The chart below shows HGL's share price against 2 Australian retailers, Harvey Norman and Myer. (Harvey Norman is comparable to Best Buy in US. I'm not too sure what the US equivalence of Myer is. Maybe JC Penney?) You can see the dramatic recovery of HVN and MYR in the last 3-6 months, coinciding with the improvement of consumer sentiment. You can see HGL is lagging behind because improvement of its profitability is not yet in sight.

(source: Google Finance)

After deducted the minority interests, HGL has a net tangible asset (NTA) value of $0.41 and a net current asset value (NACV) of $0.35 per share. While the current share price is very close to NTA, HGL is definitely not a net-net. We have some safety from the value of the assets, but it's not bullet proof.

The opportunity here is the possibility of a quick turnaround. We are relying on its operating leverage to propel its profit (and share price) quickly when sales volume picks up.

Make no mistake. Turnarounds are risky businesses. Besides, there are few things I don't like about HGL:

• Since each subsidiary operates independently with its own CEO, HGL has effectively 2 layers of management. It made sense when Eley was still around acting the capital allocator. But it's no longer the case. I think it's redundant and wasteful. (The corollary is: HGL will be worth more if it's broken up. The main it'll lose is the access of the capital market.)
• The non-controlling interests act like preference shares: always standing in the front of the queue to take a cut before the equity owners.
• Mahoney stepped down as the CEO because of "ill health" a few months ago. One got to wonder if HGL's poor result took a toll on his health.

On a balance, my view is the potential of a swift realisation of the upside is enough to compensate for the negatives. And I think HGL is qualified as a "cigarbutt". You quickly take your puff and then move on.

(Disclosure: Long HNG.AX)

Value of the century - the Aussie edition

I spent some time last month combing through the bottom end of the ASX market, looking at companies with market cap less than A$300m. I haven't found anything worth investing so far. Then, last night I saw Whopper's post ACGX: value of century? I just couldn't resist and decided to write this up for your amusement.

Details at a glance:

• Company: Richfield International Limited (ASX: RIS)
• Market Cap:A$1.6m
• NACV: A$6.3m, mostly cash!!
• Business: It operates shipping services in Singapore. It used to operate trucking services years ago.
• Profitability: Mildly profitable or break-even most of the years.
• Dividends: Never in the last 8 years.
• Insider ownership: 72% controlled by the directors

So, here you are. A crazy pile of cash. Buying a share of RIS is buying 25 cents dollar. Or, to flip it around, you are getting an instant 4 bagger. While the value isn't as extreme as Whopper's ACGX, RIS is a listed company with audited accounts and regular filings.  

What's the catch?  

I have serious doubt the company exists mainly for the purpose of running a business. It looks more like the directors' tax shelter. It's basically their family's piggy bank. The most likely end-game I can foresee is, when the business dries out, they will shut down the operations and gradually draws down the cash pile as salaries until it reaches zero. Well, there is no certainty. They may declare a surprise special dividend or announce someone tendering for the company. But I won't bet on it.


(Disclosure: No position)

A followup on GLG Corp

This is going to be a quick post.

I wrote about GLG Corp (GLE) last week. One thing that has kept me perplexed is: Why did they list in Australia? Australia ASX has arguably more strigent listing regulations than SGX in Singapore. (This was one of the contentions in the ASX-SGX merger talk back in late 2010.) Why the trouble? And what's the point of raising so little capital here? The CEO and founder still controls 75% of the company.  They were not in here for the money. But what?

Yesterday I met up with a Singaporean friend. He read my GLE post. He made this casual comment while he was cuddling his one-year-old daughter in his arm: "These people were here for the status in order to attract employees back in Singapore."

Wow, what a revelation! This makes a lot of sense. This fits the general mentality in Asian culture that status is important.

This taught me two things:

1. Local know-hows are all important.
2. Scuttlebutt is all important.

GLG Corp, a case study of (not) doing proper due diligence

GLE (ASX)

GLG Corp (GLE) is a Singapore-based company listed on ASX in Australia which provides apparel/knitwear supply chain management services. GLE's major customers are clothes retailers in the United States. It acts as a middleman between the retailers and the clothes manufacturers in China and other Asian countries. GLE is recognized in the industry locally as an established player. It's a micro-cap with a market cap of $18.50m.

GLE's share price has been hovering around $0.25 for quite some time. I originally looked at this company in mid-2011. Its value has improved substantially since then. NACV is now $0.34 per share and with the improvement in US economy its operation risks have subsided significantly. GLE has never lost any money since it was listed in late 2005. Both its margins and ROE before GFC look good. Average earning in the last 6 years comes to $0.085 per share. With a conservative 6.5x multiple, it will be worth $0.55. (GLE reported earnings in USD. But since exchange rate is close to 1, the difference isn't material in this discussion.)

So, we are looking at a 50%-100% upside. What did I do? I quickly bought a stake, of course. But the fun starts now.

Because the value looks so good, I actually wanted to buy more. But before committing more money, I decided to do more due diligence. There were 2 things in its financial statements that I initially grossed over. First is an "Amounts advanced to other parties" appeared in the financing activities section of the cash flow statements in 2012H1, 2011 and 2010. What the heck are they? I couldn't reconcile them to the balance sheets.

The other one is how GLE accounted for its trade receivables. It disclosed in the Notes that it did some kind of "offsetting" which seems to be related to how GLE accounted for its trust receipts. I re-read those few paragraphs a few times but was still not sure how the offsets worked. Besides, an entity called GLIT was mentioned here. GLIT was the spin-off from GLE when it was initially listed. It is a clothes manufacturer. In other words, it's GLE's supplier. It's actually GLE's main supplier. I'm not an expert in trade financing. So if I draw the wrong conclusion, someone please correct me. But why did a supplier have anything to do with receivables? On the top of that, GLE has also provided some $16m loan to GLIT since 2010.

With some google searches and through some Singaporean contacts, I tracked down 2 other public companies operating in the same industry in Singapore with comparable size: Ocean Sky and FJ Benjamin. Comparing their balance sheets to GLE's, I noticed a few things straight away. GLE holds far less cash, inventories and account payables than its competitors. GLE essentially has a very different capital structure than its fellow competitors. How so? Also, I didn't see the kind of trust receipt offsetting that GLE used.

If GLE is not a outright fraud, the only explanation I can think of is GLE doesn't do its own manufacturing while the other two competitors do. GLE outsources its manufacturing to GLIT. But, is it truly outsourcing?

By piecing together all these observations, I come up with a theory: Legally GLIT is an independent company. But it isn't, both commercially and financially. It's still part of GLE. As one can imagine, their operation is more capital intensive and they has probably lost money in the last few years. GLE has been shuffling money down the pipe to keep GLIT alive. Beyond the $16m loan shown up in the balance sheets, I guess GLE swept the transaction details all under those "trade receivables". Beyond that, nothing else about GLIT appears in GLE's book. The operation is basically off balance sheet. How profitability is the combined entity, GLE and GLIT together? What is the overall ROE? No one knows.

These are not facts. It's a guess.

But I was uncomfortable enough that I got rid of my stake at a small lost.

p.s. I was fully aware of Steve Johnson's post about a mistake in their financial statements. That alone didn't deter me from buying GLE. Stupidity? Greed? Maybe. But now with other supporting evidence, it fits the theory. It also fits the theory why GLE used a big name accounting firm in a small town.

(Disclosure: No Position... now)