Mutoro Group Partners, LP
“It is true even though everyone says it is that you need to read and read a lot and read the best books. Not only do you need to read the best books, you need to read them well. I think it's true that generally speaking your writing can only be as good as the best books you've read. [...] It's true, too, that your writing can only be as good as the best readings you've given of the best books. I cringe when I hear someone say, 'I read a lot of books.' Better to read one good book well than a hundred poorly. Aspire to be a world class reader.” – Paul Harding
“Humans may crave absolute certainty; they may aspire to it; they may pretend, as partisans of certain religions do, to have attained it. But the history of science--by far the most successful claim to knowledge accessible to humans--teaches us that the most we can hope for is successive improvement in our understanding, learning from our mistakes, an asymptotic approach to the Universe, but with the proviso that absolute certainty will always elude us.” – Carl Sagan
“Tomorrow hides inside yesterday.” – Yusef Komunyakaa
Dear Partner,
Call it my seven-year itch if you will. In my 10 years as an investor, I have acquired positions in 15 different companies so far, and I have lost money on three of them. Two of those three were Chinese businesses, and I made those purchases seven years apart. The conclusion of the second Chinese investment, which occurred in the fourth quarter of 2017, I consider a positive moment in my growth as an investor. It showed I had actually learned a meaningful lesson from my previous folly and, more importantly, had the presence of mind to apply it. I want to share this story with you because of the effect this foray had on our returns last year and for the insight you might garner into how I assess investment opportunities.
This story begins in the spring of 2010 (so imagine me 15 pounds lighter), before I founded The Mutoro Group, and when the idea that someday I could have the pleasure and privilege of managing your money was a mere dream. In the spring of that year, while the U.S. bull market was still nascent, and feeling energized from my successes investing during the financial crisis, I searched overseas to acquire more geographic and currency diversity for my personal stock account. I was looking for obscure businesses, ones not covered by institutional research analysts, or ones misunderstood in some fundamental way because of currently circulating stories or long-accepted biases that analysts had against them. As the bankruptcies of the crash were still fresh in my mind, I applied conservative valuation metrics to screen for investment opportunities. In doing so, I came across a Chinese textile company listed on the Singapore Exchange but located in China’s Fujian province (which is on the southeast coast of mainland China). And there my troubles began.
While many textile companies are vertically integrated, with operations stretching from the production of synthetic fibers to the knitting of fabrics, this company was different. It focused on one job and one job only: dyeing and treating fabrics. It had performed that task well enough over the previous six years to average an impressive 51 per cent annual return on its net tangible assets (essentially free cash flow divided by book value, excluding goodwill and other intangible assets). After the collapse of the financial markets, sales in the Chinese textile industry slowed dramatically as exports dried up. This company wasn’t immune. But amid the understandable gloom in the sector, market participants seemed either to forget or ignore this particular company’s balance sheet when they glanced at its income statements. At a market price of $36 million, the business was trading for less than its net cash balance of $57 million. While I was initially concerned that operating losses might erode this surplus of cash, the company’s cash covered its historical selling and administrative expenses 14 times over. Lacking customer orders, the company’s production costs would be minimal because management could just stop running machines until trade picked up again. And then the kicker: The founder and CEO owned 54 per cent of the company, and so his interests would be aligned with mine—or so I naively thought. In the investment memo that I prepared on the company for myself, I wrote, “Absent executive corruption or self-indulgence, value will remain should salaries persist without customer orders. […] [The company is] selling at a price well below what its owners would fetch were it liquidated, were a large block of its shares repurchased, were a meaningful dividend declared, or were it sold to another firm.” My fellow partner, the road to hell is paved with shoulds and woulds.
My biggest hurdle to coming to a positive conclusion on the textile company was whether I trusted management, whether they had the cash they said they had, and whether they would do the things I thought they should do. So, I called them up. While the CEO and the company’s factories were in Fujian, the CFO was based in Singapore. The CEO did not speak English—and I do not speak Mandarin—so the CFO was my principle connection to the management of this small, thinly-traded company. He seemed good-natured, honest, and answered all of my direct questions just as directly, assuring me that whatever ailed the business was nonpermanent and would be repaired by the return of trade over time. And investors had time; a healthy balance sheet and frugal, capable management meant that as long as I remembered the difference between price and value and between volatility and risk, I had found buried treasure that I would unearth overtime. I decided to invest. I concluded my investment memo by writing, “This margin of safety should allow ample room for mistake or misfortune if in the long-run my appraisal of the true value of ownership is wrong.”
My work did not end there; I had to monitor the position. Aside from reading the company’s published, audited financials and tracking general Chinese manufacturing news, I spoke to the CFO monthly, sometimes staying up late into the night New York time so I could reach him daytime in Singapore. He would assure me that everything was fine and the cash on the balance sheet that was so key to my investment thesis was still in the bank. Nevertheless, the price fell. He would insist that local traders were ignorant of corporate finance and could not read balance sheets. Their loss, my gain, I thought. Moreover, he said, the CEO was actively pondering my advice to decrease the substantial difference between the market price of the company’s shares and its liquid assets by issuing a dividend or buying back shares. Good, I thought. A year went by and the market price was down to $19 million from $36 million, though net cash was slightly higher at $58 million. Whereas before I had purchased a dollar for 63 cents, now I could buy a dollar for 33 cents. I bought more, convinced the margin of safety had grown between the daily quoted price and the value inherent in the balance sheet.
After two years, the CFO, my one line to the company’s management, who, it is important to note, had never owned any shares in the business, left the company. Another year went by, the balance sheet value staying steady but the daily price of the business fluctuating well below it. It eventually became clear to me that whether or not the cash existed was now beside the point; all the basic shareholder-friendly actions I had hoped the CEO would take, such as buying back shares, declaring a dividend, or selling the firm, he was not doing and would never do, despite my and other shareholders’ appeals for it. I sold my position, having lost 70 per cent of my invested capital. I finally recognized the sunk cost fallacy I was making and the wise advice of Warren Buffett that “You do not have to make it back the way you lost it” and “Accounting numbers are the beginning not the end of business valuation.”
In hindsight, instead of speaking to the CFO of the company, I should have been speaking to their competitors and customers instead. Instead of valuing so highly what management said, I should have valued what they did. With the ethical character and decisions of the CEO being so much of the catalyst for the investment’s potential success or failure, I should have vetted him more thoroughly, language barrier or not. Or I should not have bought in the first place when I could not answer the crucial questions I needed answered. Following my sale in late 2013, the company’s shares were delisted in 2015, rendering them essentially worthless. Regulators from the Singapore Exchange began asking the same questions I had asked about the trustworthiness of the CEO. It turns out the CFO was honest, and the company did have all that cash in the bank. But stakeholders found out in the worst way; in late 2017, the Chinese government joined Singapore in investigating the CEO for transferring most of the company’s cash to three “customers” who may have been related to him. While the sum I had invested was meaningful to me at the time, happily I had not put so great a portion of my personal portfolio into the business that it significantly affected my overall net worth. And, thankfully, I was able to make it back in other ways.
Now the story returns to more recent times, to the summer of 2017. (I am heavier, but I wear it gracefully.) We are in what is likely the late stages of the U.S. bull market, and I am again searching overseas for geographic and currency diversity, though now for the Fund’s portfolio. I again use conservative valuation metrics to screen for opportunities. I come across a business based in mainland China but listed on the Hong Kong Stock Exchange. It is a 60-year-old company that was once a state-owned enterprise but today is publicly-traded, the largest domestic biscuit brand in the country, and one of China’s largest biscuit manufacturers. It had a market capitalization of $138 million, cash of $68 million, no debt, and average historical earning power of $14 million. If you stripped out its cash from its market capitalization, the company was trading at five times its cash flow. Its sales had been growing north of 14 per cent the last five years, its operating margins were above 10 per cent, its return on equity was greater than 20 per cent, and it was diversifying its revenue lines. This appeared very attractive, as did the sector; it was growing 11 per cent a year annually, and with Chinese consumers per capita eating one-seventh the amount of biscuits as Western Europeans and North Americans, it seemed to have room to grow. I looked at the competition: Whereas in the U.S. the biscuit market is consolidated, with the top five players accounting for 80 per cent of sales, in China the top five players account for only 10 per cent of sales volume. Being the biggest domestic manufacturer suggested that this company might have unseen advantages in growing; it might use its influence and cash hoard to acquire smaller peers, compete on pricing, increase distribution channels, or market to new demographic segments. I was interested.
As with my textile company investment seven years prior, the biggest hurdle to coming to a positive conclusion on the biscuit company was whether I trusted a management team that was squarely in control. The Chairman and CEO controlled 58 per cent of the company’s shares, with another 14 per cent controlled by a prominent private equity firm. Unlike with the textile company, management at the biscuit company seemed to see the value of traditional shareholder-friendly actions, as the company had a 6.7 per cent dividend yield. If I had to wait several years for price to rise toward value, this time at least I would get paid to do so. I had learned my lesson about hoping and prodding for good behavior. So, I made an investment. Within a month the shares plummeted steeply. The company though had not released any new financials or reports that would have led me to understand whether a change in fundamentals had precipitated this. My first inclination, the one I had displayed so strongly with the textile company, would have been to acquire more shares and reach out to management. I know the difference between volatility and risk, and if volatility had grown but not risk, I might as well take advantage of it. But I paused and reflected more deeply. I decided to step back and reassess the management, not on what they said, but on what they did. And one of the best ways to do that is through analyzing their regulatory filings to see what I could garner from their quantitative and qualitative information about what was really going on.
In a couple months, the company released its half-year financial report. In those reports, I noticed something troubling. The company’s inventory and accounts receivables were increasingly rising faster than its sales, suggesting they were having trouble moving their biscuits out the door and getting existing customers to pay them. Moreover, the company, which previously had $68 million in cash and no debt on their financial statements, suddenly had $47 million in debt and $26 million in cash. In the course of six months, the company had gone from a healthy net cash position to a significant net debt position. And it had no new buildings or product lines to show for it. What it had to show was new and large interest in outside joint ventures, which were sparsely and vaguely described. I did not have to call anyone to verify what I was seeing. I exited the position, realizing a 23 per cent loss. It was a significant contributor to our being down 4.70 per cent for 2017 net of fees and expenses. It was the shortest stock holding I had ever had, and I think time will show that was a good thing. A month after I exited our position, the biscuit company CFO stepped away from the business. A press release from the company depicted it as business as usual. Time will tell.
In both Chinese investments I made, I did something right in initially assessing the businesses from the perspective of what a patient, rational, and unemotional businessperson would pay for the company were she or he to buy the whole thing. But I eventually did something wrong. I weighed too heavily the quantitative conservatism of my screens, as many businesses that screen as “cheap” through valuation metrics are actually traps for value investors. This becomes especially clear if the management of the company is unable to grow cash flow and increase intrinsic value over time. The price of any asset (whether a condominium, a cryptocurrency, or a stock) has an investment component and a speculative component; sometimes those are equal but usually they are not, often incredibly so. The quantitative factors in both Chinese purchases that had investment merit were wildly supplanted by the qualitative factors in the character of management, which was highly speculative.
Thus concludes the latest chapter of my Chinese investment forays. None of the above is to say anything negative about Chinese business culture or investing in China. Whether it is randomness that two of my three investment losses were in Chinese companies or something intrinsic to founder-controlled businesses that I missed, I am unsure. Whatever the reason, if in 2024 I am speaking of an investment in the PRC, may I have the presence of mind to apply the lessons I learned this time before making it.
I want to now briefly review the rest of our portfolio. The chart below shows our portfolio composition at year end:
Portfolio Holdings
I make no predictions on how the markets will fluctuate this year. But as I have said in nearly every letter previous to this one, the surplus of cash on our books has us prepared to take advantage of whatever comes, especially if it is downward, which becomes increasingly likely with every new peak the market reaches. As I wrote in this letter last year, “Often the best short is cash.” But that is sort of beside the point. The only way I will find attractive investments for us is not by tracking or cheering on market volatility but by studying real businesses and their fundamentals. That will be my focus, not the gyrations of the S&P and Dow.
The quarter of our portfolio that is not in cash is in four businesses, just as it was at the beginning of 2016 and 2017; however, if you have read my recent letters you will notice that those four have changed. (To be clear, while my goal is to run relatively concentrated, I put no special stock in having four investments and am comfortable with two or three times as many.) While all of our holdings are headquartered in the U.S., they are in very different industries and have very different customers, providing us with some necessary diversification. I briefly summarize our current and former holdings here: Company A (a media company in captive markets; 1.1 per cent of the total portfolio), Company B (a software company with attractive network economics; 9.7 per cent), Company C (a niche industrial manufacturer; 2.9 per cent), Company D (a highly innovative technology business; sold in Q2 2017), Company E (a Chinese biscuit manufacturer; sold in Q4 2017), and Company F (a leader in a consolidated industry with high competitive barriers; 11.9 per cent). You will find longer descriptions in the appendix to this letter.
As always, thank you for your partnership in the Fund. Entering 2018 I still find as much joy thinking about how I can profitably manage our capital as the day we started, and I look forward to the opportunities this year brings us. Please do not hesitate to reach out to me via email or phone.
Sincerely,
Godfrey M. Bakuli
Managing Partner