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This Insight is an extract adapted from the Panah Fund letter to investors for Q1 2016.1
TABLE OF CONTENTS
At the Panah Fund, as our time and energy are limited, we try to focus on finding and researching the most prospective investment opportunities. This usually means that we spend more time looking at those areas where we perceive there are more likely to be market inefficiencies. These may include small- and mid-cap companies, stocks with patchy or poor sell-side analyst coverage, and/or markets and sectors with (temporary) structural impediments to investment.
Investing outside the mainstream does bring its own risks, however, which we try to mitigate with a variety of tools, including quantitative analysis of financial statements (i.e., accounting quality); traditional and careful ‘qualitative’ analysis; getting to know management; and crosschecks with suppliers, customers and competitors. That said, we still don’t get it right every time, and inevitably do make some mistakes when deploying capital.
It is important to be able to recognise when we have erred and then act quickly to mitigate any damage to the portfolio. In order to protect capital, we typically aim to build positions steadily (in line with our degree of comfort with management and level of conviction with the investment case), especially for smaller companies with a shorter track record. We also regularly re-evaluate the investment case for our portfolio holdings in an attempt to identify problems early, before they can do too much damage.
One trigger for a rethink might be a large, sharp fall in the share price of a specific company we own. Another trigger to re-examine our investment thesis is the release of more information, including both regular corporate filings and ad hoc information.
Case Study: Hong Kong-China Financial PR Firm (Current Market Cap US $290mn)
An example from 2015 serves to demonstrate what happens when we get it wrong.
Early in the year, we met an interesting company with a unique position as the only listed financial PR company in Hong Kong, founded in the early 1990s and listed in 2012.
The firm enjoys a dominant (~80%) share of the IPO and financial PR markets in the territory. Most customers are mainland Chinese companies looking to list in Hong Kong. Ninety percent of IPO clients are converted to ‘recurring revenue’ customers, which require ongoing IR and company secretarial services. Growth potential for the firm, on the back of the new HK-Shanghai Connect, seemed promising. In the medium-term, there also seemed to be good potential to expand to Shanghai.
The company’s high return on invested capital (>20%) appeared to be sustainable even with strong growth (we estimated >25% per annum for the coming two years). The valuation also seemed low (a free-cash-flow yield in the mid-teens), with no debt and a reasonable amount of cash on the balance sheet (equivalent to 30% of market cap).
We also had a few initial concerns. The company had been listed fairly recently (2012), so had a short track record and still needed to prove itself. The chairman-CEO owned >60% of shares, and the free float and liquidity were limited. We were also wary of a concentration of power in the hands of this owner-founder-chairman-CEO (a strong character), as we thought it possible that his interests might not always be aligned with those of minority shareholders. We also would have liked to see a stronger board of directors, but thought that this was something that we might be able to encourage over time.
More generally, we were aware that the major risk factors for the company were the capital markets in China and Hong Kong (a bear market would adversely affect the IPO pipeline for the firm), as well as finding the right staff to grow the business (which was seemingly the major constraint on growth).
Despite our initial reservations, we decided that this was still an attractive opportunity to own a high-return company that dominated a growing business niche. Moreover, we judged that the ‘margin of error’ was acceptable as the company was still trading at low valuations. Panah thus initiated a small starting position in late March and early April 2015.
Shortly after buying shares in this company, the share price of the company skyrocketed upwards as the Q2 2015 HK-China buying frenzy took hold. However, it was not long before doubts began to emerge. In May, after the company’s stock price had doubled in just seven weeks, management decided to make an opportunistic share placement (leading to a ~15% share count increase), which prompted an immediate plunge in the share price.
We were disappointed that management had opted for a share placement rather than a rights issue, as liquidity was limited and existing shareholders were keen to maintain or even add to their stake. Instead, the placement went to six mainland Chinese asset management firms; the company justified this decision by stating that it would be important to have these institutions as shareholders to facilitate a future expansion to the Shanghai market. We were also slightly troubled that use-of-capital disclosures were vague; the company mentioned that it wanted to “build an ‘online platform’”, but further details were not forthcoming despite our enquiries.
Subsequent corporate filings (released just after the share placement) revealed that the company had decided to invest a reasonable proportion of its substantial cash balances in various corporate bonds. Moreover, the company had also decided to take on debt to add to these bond investments. Management was unwilling, however, to disclose exactly what these investments were.
Our initial concern about a weak and disengaged board of directors also seemed to be valid, as board meeting attendance for the financial year ending March 2015 had fallen to less than 50%.
Moreover, footnotes revealed the recent purchase of an expensive Hong Kong club membership for the chairman-CEO. Again, the company was unwilling to provide much in the way of justification or explanation.
We attempted to engage with management on these and other issues. Sadly, not much information was forthcoming, even when the IR director was replaced with a relative of the chairman-CEO. The final straw came in August, when the financial controller of the company was dismissed without explanation or announcement.
In our view, these lapses were unacceptable; we would expect a financial PR company to have especially high standards of corporate governance to set an example for its clients, but this was demonstrably not the case. After one last attempt to engage with management, we decided the most sensible course of action was to sell our shares, which we did in September 2015, at a slight loss.
While the company appears to have an enviable business model, it is operated primarily for the benefit for one man and his family, without taking into account the interests of minority shareholders. We have no reason to think this will change in the near future, and so decided to look elsewhere for better investment opportunities.
Thank you for reading.
Andrew Limond
Update: From the date of publication to end-June 2023, the stock profiled in this case study fell by -90%.
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
