8. Capability Deals in Theory

During the 18th and 19th centuries, it was the United States that was the emerging market. Nineteenth-century British and European investors viewed the U.S. as a large rising market, but also as a somewhat distant and daunting business and investment environment. Even though they did not use the term “emerging market,” business trades of that time are full of references to the “New World” and the “American frontier.” Other common descriptions include “violent,” “crude,” and “constantly spitting brown tobacco juice” (from British novelist Frances Trollope).

For investors, America’s rise in the 19th century to an advanced nation can be viewed as a process of European and British capabilities migrating into a large new market. English law, manufacturing expertise, the printing press, foreign capital, and especially professional management were brought to the New World from the Old through tens of thousands of mostly small deals and investments. It was the investors and deal-makers who seeded the New World with the Old.

By the mid-20th century, this mostly unidirectional migration of capabilities evolved into a more dynamic exchange of American, European, and Japanese capabilities. New York hedge funds and Silicon Valley tech companies took their expertise to London and Cambridge. The budget airline model migrated from the American Southwest to London and Southeast Asia. Automotive capabilities traveled from Michigan to Tokyo. And in return, Japanese anime traveled from Tokyo to Hollywood (picking up Jackie Chan and Hong Kong wire work along the way).

Now, at the beginning of the 21st century, we are witnessing a repeat of this entire pattern. Investors and deal-makers by the thousands are moving Western and Japanese capabilities into China, Russia, Brazil, India, the Gulf Cooperation Council (GCC), and many other developing markets. Russian exploration companies are contracting with European engineering firms. Singapore’s Tamasek and Abu Dhabi Investment Authority (ADIA) are hiring British bankers. China is connecting its continental economy using high-speed trains from Germany, Sweden, France, and Japan. Analogous to the capability migration from the Old World to the New, we are now witnessing a capability migration from the Developed World to the Developing.

Although these capabilities can sometimes be accessed at a distance, investors and deal-makers usually build them into the local markets. Indian hospitals may ship in General Electric (GE) MRIs and Kimberly-Clark operating drapes, but the management is now local. The hospital itself is likely designed and constructed entirely by local companies, and the medical service payments are made by local insurance companies using locally hosted, and increasingly developed, software.

For value investors and deal-makers, a world seen through the prism of capabilities requires a shift in posture. It requires a departure from the standard strategy of evaluating relatively complete and stable companies and then investing from a distance. Global investors quickly discover that developing markets and local capabilities are in motion. Therefore, companies and competitive dynamics are similarly moving targets. If one hospital chain in India puts in a McKesson software platform or builds an open MRI center, that can change the competitive situation for every other hospital in the city. Much of global investing is about understanding competitive dynamics relative to migrating capabilities.

I have argued that global value investing gets easier with the broader philosophy of the “search for the opportunity to add value.” Adding value makes it easier to capture value in such uncertain and changing environments. Capabilities are the most powerful way to add value quickly.

Capabilities are the big guns of value point. Whether it’s a brand, a technology, a business model, a natural resource or other, capabilities are value keys that investors can use to open the door to investments and surgically add value. An energy investment group that has access to a deep bench of European or American technology (solar, turbines, wind, deep-ocean drilling, etc.) will be able to access even the most tightly held private assets in most places. Capabilities can also have an outsized impact on the other going-global problems—eliminating current and long-term uncertainties, strengthening claims to an enterprise and overcoming foreigner disadvantages.

Rethinking value investing and Graham’s Method for a changing global world, one of my early conclusions was that value investing today is as much about build-and-fix as it is about buy-and-sell. Investments follow as much from business strategy as from valuation and price. And because business strategy is industry-specific, the right combination of capability keys for a deal is also industry-specific. Investing between Las Vegas and Macau is overwhelmingly about gaming, entertainment, advertising, and human resources capability keys. For Carlos Slim, investing is about using his telecommunications and media capability keys to exploit opportunities in Mexico and the United States. Rupert Murdoch has chain-linked along his media capabilities (brands, publications, assets) from Australia to the UK to the U.S. (and now into emerging markets). Warren Buffett is exceptionally well positioned to extend insurance into India, the Middle East, and Africa (insurance scales nicely in lightly regulated, large-population, low-GDP-per-capita markets).

This chapter is a departure from the previous chapters’ strategies, which focused on primarily intangible advantages such as reputation and political access. Capability-based strategies are the meat and potatoes of most global deals. They are also the real crossing-over point from value investing into more hands-on value point deal-making.

From the New to the Newer World

Global value investing requires understanding the movement of capabilities and how this impacts competition and profits

It may be in part myth, but the story goes this way: During the 1920s, some Dutch businessmen went prospecting in the newly formed country of Saudi Arabia. At that time, Saudi Arabia was a large and mostly empty desert kingdom, populated mainly by small villages and desert-living Bedouins. The government was run from a mud palace in Riyadh, and the House of State often consisted of a traveling caravan of camels. It is said that the small country’s treasury was carried in the camels’ saddlebags.

To say doing business in Saudi Arabia in the 1920s was an adventure is a fairly big understatement. The country was poor and uneducated and had one of the world’s harshest climates—particularly the Empty Quarter, the large, unlivable stretch of desert that constitutes the eastern part of the country. It is rumored that at various points in the country’s history, people were killed simply by taking them out and leaving them in the Empty Quarter. Argentina’s Dirty War would later revive a variation on this tactic by flying people out and dropping them in the Atlantic Ocean.

What is known for sure is that the Dutch businessmen met with the young government of King Abdulaziz, the founder and first king of Saudi Arabia. And in 1926, Foreign Minister Prince Faisal (later King Faisal) traveled to the Netherlands on a diplomatic mission. Out of this, a joint-venture deal was struck that would create the first bank in what would shortly thereafter become the world’s oil capital.

The joint venture made simple business sense. The country’s residents kept their money in goats and camels (as assets) and in saddlebags (literally). The businessmen had banking expertise and the ability to create a relatively modern private bank. It was a deal based on capabilities. In 1926, they launched Saudi Arabia’s first bank, called the Netherlands Trading Society, which acted as both a private commercial bank and the central bank for the country. This bank would eventually evolve into Saudi-Hollandi bank, still one of the country’s top banks.

Twelve years after the launch of Saudi Arabia’s first bank, oil was discovered in the Kingdom, and similar Saudi-foreign bank joint ventures followed quickly (Saudi-British Bank, Saudi-American Bank, Saudi-Fransi Bank). Such capability-driven joint ventures still dominate the Middle East business and investment landscape. Not only banks but virtually every Middle East business is a similar combination of local assets and Western capabilities.

This original Dutch stake in the Saudi-Hollandi bank was later bought by ABN AMRO and eventually was caught up in the 2007 Royal Bank of Scotland Group (RBS)-Barclays bidding war for that bank. While Barclays and RBS were fighting to acquire ABN AMRO, Prince Waleed and other Saudi investors were vying to acquire ABN AMRO’s 40% stake of Saudi-Hollandi. Saudi banks are coveted assets, particularly when oil is more than $80 per barrel.

For investors and deal-makers on the ground around the world, very little discussion occurs about globalization, interconnected financial systems, and a “changing world order.” Most of the discussion is about capabilities and their impact on competition and economic value. Most deals happening today between the developed and developing world, or between the New and the Newer World, are still quite similar to this long-ago deal between Dutch traders and Saudi royals.

At a 2010 New York conference, ConocoPhillips’ CEO and Chairman James Mulva described its growth strategy as 50% organic and 50% inorganic, with most of the inorganic growth coming from these types of capability-driven deals. ConocoPhillips needs access to exploration, which often means building partnerships and other cooperative agreements with state-owned enterprises that control such resources. ConocoPhillips’ strength in such resource deals is that it has technology that many developing economies need. These types of “resource for tech” capability deals are as common today as they were 100 years ago. Direct investing in much of the world often gets boiled down to these sorts of simple capability-driven deals.

Viewing the investment world through a prism of capabilities, three significant trends are apparent:

• Capabilities are migrating.

• Capabilities are consolidating.

• Business models are being transformed.

Capabilities Are Migrating with Increasing Speed

Emerging markets are not quite the same thing as developing economies. In emerging markets, the middle class is, hopefully rapidly, rising. Newly ascendant middle-class consumers are abandoning buses and bicycles and buying their first cars. They start to consider products such as braces and veneers for their teeth and services like auto detailing for their cars. This can result in unusual experiences in places such as Kunming, China, where you might get invited to go to the new drive-in theater (a 1950s-type car culture is all the rage in some places), and 20% of the adults will be wearing braces.

Thus far, the emergence of these markets and the advancement of their economies have gone hand-in-hand with an inbound migration of mostly Western capabilities. This process can be fairly inspiring, such as seeing the first private tertiary hospitals get built in second-tier Indian cities. (A note to my old friends from medical school: Private pediatricians now make more in Mumbai than in California.) Sometimes the inbound migration of capabilities can be a bit ridiculous, such as the recent opening of a massive Louis Vuitton building next to Sukhbaatar Square in Mongolia. The store, offering Mongolians “chic nomadism,” is located approximately 300 feet from where General Sukhbaatar’s horse famously urinated during a 1921 rally.

In smaller, godfather-type economies such as Qatar and Indonesia, this capability migration occurs primarily through joint ventures, technical arrangements, management contracts, and franchise deals. For example, Saks Fifth Avenue has franchised its Middle East operations. You can find a 7-Eleven store on almost every block in Singapore and Hong Kong. And Citigroup, prior to its 2003–2004 much-too-public withdrawal from Saudi Arabia (and subsequent effective blacklisting from reentering), had a very successful management agreement with and a 20% ownership stake in local Samba Bank (previously Saudi American Bank). Given the fairly limited local management abilities and competition in these types of countries, such arrangements tend to be long-lasting. The Saudi-Hollandi bank deal has lasted over 80 years.

In the larger developing economies such as China and India, this migration of capabilities usually is accomplished by cross-border development deals happening in parallel with domestic development. In China, foreign joint ventures in automobile manufacturing such as Shanghai-GM have been launched in parallel with purely domestic automotive companies such as Geely Automobile. Sometimes this parallel approach can occur within the same company. This naturally leads to issues regarding technology transfer and complaints of legal and illegal copying. A reporter for the Wall Street Journal in China recounted to me the story of one foreign company that was so tired of its technologies being copied that it created internal designs for a bogus, nonworkable machine. Within a few months, a local competitor had the designs and began trying to manufacture the machine. The competitor was even bold enough to go to the company to ask for help when it couldn’t get the machine to work.

Sometimes capabilities migrate without any sort of cross-border deal or arrangement. Many of the leading companies in China, India, the GCC, and Brazil are copies of successful Western companies. Baidu is a copy of Google. Air Arabia is a copy of Southwest Airlines. Successful business models migrate as rapidly as capabilities. I know of one Macau group that flies to Las Vegas, looks at the various businesses around town, and then flies home to Macau and launches copies of them. Currently, Singapore is currently copying Macau’s casino businesses in similar fashion.

Across the board, this migration of capabilities into developing economies is driven by powerful business rationales. For Western companies, these rapidly developing markets often represent their best, and sometimes only, opportunities for revenue growth. Some, like Coca-Cola, succeed. Other Western companies go after developing economies as a type of “Hail Mary” strategy when they are in weak or declining positions at home. Sometimes this works, such as T.G.I. Friday’s and Hooters restaurants, which have conspicuously great locations in places like Beirut and Shanghai. However, more often this type of desperate emerging-market strategy fails, resulting in a phenomenon best summarized by Joe Studwell when he stated that China is the place “where American elephants go to die.”

For local governments, this capability migration has a similarly powerful rationale. In smaller cities, such as Wuhan, Bangalore, and Brasilia, importing foreign capabilities is the fastest mechanism for growing the local GDP and advancing the standard of living. As Henry Kravitz has said about the China market, “They need everything.”

For local companies, Western capabilities can create an important advantage in less advanced but often ruthlessly competitive local markets. Technologies, exclusive products, Western brands, and other capabilities can become competitive advantages if you have them and a competitive threat if your competitor does.

For example, in late 2010, Chinese car manufacturer Geely Holding purchased Swedish Volvo from its American owner, Ford Motors. The $1.5 billion cash and debt purchase (with Chinese PEs in the ’60s to ’80s, few foreign acquirees will accept Chinese stock) was widely described as part of the increasing Chinese outbound mergers and acquisitions (M&A) trend. And Geely Chairman Li Shufu has stated that the acquisition will “strengthen its presence in the U.S. and European markets.” But according to Peter Williamson of Cambridge Judge Business School, the Volvo acquisition appears to be a deal focused not on international expansion but on bringing foreign capabilities back into Volvo’s domestic market. It appears to be a capability deal, with Geely mostly focused on winning in the growing Chinese mainland market (Geely’s 2009 revenue had increased 228% year over year). Plus, with Volvo losing $2.6 billion over the previous two years and 13-year-old Geely’s revenues only at $14.1 billion, I would be surprised if Geely didn’t quickly shut down Volvo’s international operations and move everything to China. Geely has already announced a new factory in Beijing for Volvo models. Whether this will be a base for increasing international or domestic sales will be an interesting question to follow.

However, this migration of capabilities is not all positive for Western companies. Since 2006–2007, emerging economies such as Morocco and Mexico have increasingly started reaching out to China and India, instead of the U.S. and Europe, for new capabilities. Chinese products such as cars, cell phones, and white goods are in many ways more suitable to these low-GDP-per-capita environments than American and European products. Cheap Chinese point of sale (POS) machines are more suitable for small retailers in Latin America than National Cash Register Company (NCR) or IBM machines from the U.S. In addition to being cheaper, they are more suitable for environments where infrastructure, education, and distribution may be limited. Stand-alone solar panels that can heat an individual apartment’s water supply are common across many emerging markets and increasingly are coming from China. Compact, low-energy Haier washing machines are similarly becoming widely used in Africa and Latin America. These emerging-market-based companies have realized they possess advantages in reaching low- and moderate-income customers in other developing nations.

Within this trend, an increasing source of profits for developing-market companies is turning Western technologies into commodities and then exporting them internationally. Although GE turbines or Qualcomm CDMA (Code Division Multiple Access) chips are the core technologies in power generation and non-GSM (Global System for Mobile Communications) mobile service, a lot of the surrounding technology has already been commoditized by Chinese and Indian companies. Huawei, the Chinese telecommunications equipment manufacturer, produces most of the equipment for mobile service networks. Unsurprisingly, it uses its large scale and low labor costs to offer this surrounding equipment at a low price. Huawei already has opened centers and offices in Stockholm, Dallas, Jakarta, Bangalore, Moscow, and Ireland. As a result, mobile service providers in Kuwait might buy their core GSM or CDMA technology from the U.S. or Europe but virtually everything else from Huawei, now the world’s #2 telecommunications manufacturer. Of Huawei’s $21.5 billion in revenue in 2009, $3 billion came from the Middle East alone.

You can see a similar capability migration in the power-generation business. Companies might buy their turbines from GE but purchase all the ancillary equipment from Indian and Chinese companies. For those of us watching capabilities move across borders, the question of whether to draw from the U.S. and Europe or from China and India has changed in the last several years.

Capability Consolidation Follows Migration

Moscow supermarkets are mostly owned and operated by Moscow companies, and St. Petersburg supermarkets are mostly owned by St. Petersburg companies. This type of geographic fragmentation is common in certain types of industries, but also at certain stages of economic development. The economic integration of a country or region and the consolidation of its industries requires, among many other things, rising wealth, sufficient infrastructure (which requires lots of capital), and favorable government policies and management. China is particularly good at deploying infrastructure (total highways reached 40,389 miles in 2010, with about 3,106 miles added in 2009), and you can see a rapid consolidation across most industries in China today. In contrast, India is grappling with the realization that chaotic government and an inability to improve infrastructure is fundamentally limiting the country’s growth, particularly relative to China.

For investors and deal-makers, if capability migration is the first step, capability consolidation is the second. Not only do you have capabilities migrating in from developed economies, but you also have capabilities migrating within an economy. High-quality, technically proficient banks and hospitals unsurprisingly start to consolidate, and regional banks and hospital chains emerge. In industry after industry, you can see a process of initial development, followed by consolidation, leading to captured efficiencies, and then ultimately to competitive distance for the market leaders. Chinese M&A is currently transitioning from the inbound development deals of the last decade to a new wave of domestic M&A.

Consolidation, like migration, is driven by competitive considerations. The initial competitive drive to capture new capabilities is followed by a competitive drive to capture operational efficiencies and build scale.

However, for the investor, both fragmentation and consolidation can be your friend. We can do direct investments at both stages of the process with a value approach. I know of one investor who, while operating in a highly fragmented unmentioned country, effectively built a carry-trade around beer distribution. By setting different payment terms in different, largely disconnected regions, he was able to capture a carry city by city as he distributed the beer. The drawback of such fragmented economies is that you sometimes have to worry about things like bandits and highway robbers (true story).

Capabilities Enable Business Transformation

Moving a factory to Vietnam or a call center to Manila is something that the West pays attention to. Whether it’s because it has an actual impact on employment or because it’s a good way to scare people (and that’s a good way to sell newspapers and get votes) is debatable. But outsourcing and offshoring are two strategies that are surprisingly well known in the U.S. public, media, and government circles.

Offshoring and outsourcing are capability strategies. They are a subset of a much larger and more important strategy: drawing on worldwide capabilities to transform business models. As the worldwide mix of capabilities continues to evolve and migrate, you can leverage them into new types of business models and attack established competitors. How much of the success of Walmart’s low-cost retail business model is due to its use of low-cost Asian manufacturing capabilities?

Within the West, transformative business models are most commonly the result of a new technology or the falling cost of an old technology. The emergence of Internet commerce (a new technology) and the falling price of the DVD (an old technology) enabled Netflix to create a transformative business model that brought down market leader Blockbuster. Not surprisingly, shipping cheap DVDs from a central warehouse has a far higher return on invested capital (ROIC) than building, stocking, and operating stores across the country. But this sort of transformative business model is within a developed economy—American technology changing an American competitive dynamic. I am focused on leveraging the changing mix of worldwide capabilities into mostly local business models.

The most important characteristic of a multipolar world is that many of the rising systems are fundamentally different. They are new animals in terms of economics, demographics, and government—and also in terms of the business capabilities they add to the world mix. China and India, given their large scale, low labor costs, and low-income domestic consumers, have fundamentally new types of capabilities. Leveraging these resources into American retail enabled Walmart to decimate competitors across the country.

Using low-cost emerging-market capabilities to transform Western industry is just one approach. Drawing on global capabilities to transform industries in emerging markets is far more interesting. Remember, I am an investor looking to structure an investment, not a multinational thinking about strategy and operations. I am looking for tools to access closely held deals, to overcome foreigner disadvantages, to strengthen my claim to an enterprise, and to hopefully add rapid value to the asset value or earnings power value of a company.

We see such emerging-market business transformations frequently. To much fanfare, Western casino moguls such as Sheldon Adelson and Steve Wynn entered Macau following its 2002 reopening. But they did not just replicate Las Vegas in Macau. They reconsidered the gaming and entertainment business models. No longer limited by American labor costs, construction costs, or revenue models, they reimagined what a casino could be. Whether it is America’s reliance on technology to make expensive staff more productive or Saudi Arabia’s reliance on low-cost Asian labor and Western management to compensate for weak domestic human capital, it is important to be aware of how many of our business models are based on what was previously possible. If I can get government permission to master-plan an entire city and can access much cheaper construction, why can’t I build a profitable one-mile skyscraper? Why can’t I increase our casino staff by 300% in Macau? What impact would that have on a luxury service business?

For example, in 2007, the $2.4 billion Macau Venetian resort opened with 3,000 rooms and gambling and casino services on a scale never before seen (total gaming space exceeds almost 550,000 square feet. Not only does it have the world’s largest gaming space, it also claims to be the largest building in Asia and the second-largest in the world (after the Boeing Company plant in Washington state). Plus, by drawing on staff from Asia, Australia, and the West, they have increased both the scale and the service levels of the casino business. The Venetian is a reimaging of the casino business model based on assembling a best-of-breed combination of global capabilities. This has not gone unnoticed by nearby Singapore, which in 2010 opened its first casino, the Marina Bay Sands, in response. In its first 6 months of partial opening, the truly spectacular $5.5 billion facility logged more than 5 million visits.

With this same transformative approach, Middle Eastern developers pioneered a new field that caught the world’s attention: mega real estate. The developers took advantage of uniquely emerging-market capabilities: low labor costs, active government involvement, low construction costs, foreign customers, and an ability to master-plan very large areas. With this they transformed hotel, real estate, and convention center business models. Why can’t I make a skyscraper that rotates? Why can’t I build multiple harbors and waterways within my development and put the hotel under water? In fact, why can’t I build palm-shaped developments out into the water and double the city’s coastline?

Although Dubai’s recent debt crisis has resulted in some blanket criticism of its mega development projects, it would be wrong not to recognize how much the country has redefined what is now considered to be a premier real estate project—and how much success it has had. As a business environment, it is more dynamic and much nicer than most American or European cities. Plus the advantage of a bankruptcy after a real estate binge, particularly with excessive leverage, is that the fixed assets remain. The buildings and infrastructure are still there. We know what Dubai built with its excessive borrowing; where exactly did all that money go in Greece? If they had the choice, I suspect the European Union (EU) would likely abandon Greece and adopt Dubai.

The Madinat Jumeirah development, located on the Dubai coast between the well known Burj Al Arab sail tower and the first (only?) completed Palm Island is an example of mega real estate as a type of transformative business model. In addition to being a fairly spectacular development, the Madinat is also a particularly effective attack on the European corporate conference and retreat business market. Large and medium-sized European companies frequently host corporate conferences and retreats where they might send employees to hotels and conference centers for a weekend or even weeks. In European cities such as London and Paris, this can be particularly expensive, and going to cheaper locations outside the city centers is just not that exciting. However, sunny Dubai is a short flight away, and the large hotel and shopping complexes in the Madinat offer a facility, level of service, and price unmatched by European hotels and centers.

Designed by Mirage Mille, the Madinat’s facility is the type of mega real estate project that typically shocks Western visitors. Its design vision was to re-create life along the historic Dubai Creek, including waterways, wind towers, and a souk. It’s a compelling value proposition to foreigners: More than 600 hotel rooms are typically 30% occupied by large European companies holding conferences and retreats (the remaining rooms typically are occupied by Middle Eastern and Russian tourists). Similar to the Venetian, it’s a transformative business model that uses a best-of breed combination of capabilities: lower cost, larger scale, sunny location, higher service levels, and iconic architecture.

This view of the world as a sea of migrating, consolidating, and occasionally transforming capabilities is a bit strange for a value investor. But such capabilities play a central role in the rapidly evolving competitive dynamics of developing markets and cross-border situations. It is a crossing over from investing to more hands-on deal-making and using capabilities. Such deals can almost be thought of as corporate raiding in reverse. Instead of buying companies to break them up or sell off assets, we buy companies to add assets. But as detailed, the advantage of developing economies is that this can be done in a surgical fashion that meets all of Graham’s criteria.

Most Capabilities Are Local

The movement of capabilities is driving increasing localization

Sitting in a Kunming café one night, I chatted up a local businessman who had just joined a local auto service start-up. Being somewhat of a one-interest person, I began digging into his business. The company was being positioned as the first servicing and detailing business for luxury cars in the Yunnan Province. He cited the increasing numbers of Lexus and Mercedes being purchased by people in this quiet (relatively speaking) part of Western China. The strategy was to capture these luxury car owners by offering frequently used repair and detailing services at specially created centers in the major nearby cities, such as Lijiang, Dali, and Chengdu.

Although there are glamorous dreams of globalization, this Yunnan auto service company is a far more accurate symbol of the future. The company will repair and detail luxury cars made domestically and sold locally. The facilities will be of international quality and use highly trained local staff. It is run by local MBAs, many of whom are serial entrepreneurs in the region. It is symbolic of globalization in that it is a local service business of international quality run for local customers. Its strategy of building local economies of scale and a captive customer base with frequent visits (a sustainable competitive advantage) is the same approach you would see in the U.S. or Europe.

If you spend enough years on the ground looking at companies around the world, a fuzzy but consistent macro picture emerges. Going geography by geography, industry by industry, and company by company, the investment world looks mostly local, albeit with some interesting interactions (capital, trade, capabilities) among the different localities. There are certainly industries where the competition is truly worldwide (cars, cell phones, laptops), but these are the minority and often have the lowest profits. (For the value-crowd, the less competition the better, so we are especially wary of global indutries.) Looking at companies’ fundamentals around the world, it is overwhelmingly about competitive dynamics, and this results in a mostly local or multilocal worldview.

A mostly local worldview is a stark contrast to most globalization talk today, especially “the world is flat” idea. Thomas Friedman’s argument is that globalization has made the world a more level (that is, flat) playing field and that there is now increasing competition between companies in previously unconnected geographies. This is clearly true for a handful of industries, such as information technology and automakers—and it reflects the worldview of many multinationals.

But as a value person, I am interested in a worldview based not on competitive possibilities, but on competitive strengths. It’s not whether a company in India can compete with a company in the U.S.; it’s whether that company can win (and whether it can win consistently over the long term). The defining dynamic of the global age is not communication, it is competition, which is overwhelmingly about local strengths, such as captive customers and local economies of scale. Hospital CEOs, bankers, and lawyers in Shanghai simply don’t worry about what’s going on in New York. The largest distributors and retailers in Bangalore are not threatened by Walmart in the U.S., and vice versa. I ask the reader, in your particular business, be it healthcare, broadcasting, media, book publishing or whatever, how concerned are you about Brazilian, Chinese, or Indian competitors? Is your world flat? Or is it mostly the same as it’s always been? Much of the globalization talk falls into this type of situation—compelling in theory but not really seen in reality (or in the data). To practitioners, the business and investment world is overwhelmingly local. It is truly ironic that, after 500 years, “the world is flat” has been restored to its previous position as the most widely held false idea of its time. (On a side note: I am editing this section in a New York Starbucks in February 2011 and Thomas Friedman has just walked in. A little spooky.)

And for value-focused investors, the world looks even more intensely local, because we are always hunting for those rare companies that have a sustainable competitive advantage. In this sense, the more protected a company is from global competition—the more local it is—the more we like it. It is much easier for a company to achieve a dominant and stable market share in a smaller market, say, the Yunnan province, than it is in a global market. Ironically, the global migration of capabilities described, far from making the world flat, is driving, if anything, an increasing localization of competition.

Crossing the Governance Rubicon

Value-added deal-making can mean crossing into management issues

Ben Graham’s principles solidified value-based thinking in generations of investors: A company has a true value, and you don’t buy until you really know where it is relative to price. However, I think his career of reading financial statements and stock picking from an office also solidified in investors’ minds the idea that this is how value investing is done. Investments are surgical but also in many ways are hands-off and at a distance. Shareholders are at one level, and management is at another. Nonmanaging shareholders are sometimes involved in the significant capital allocation decisions (spin-offs, dividends, share buybacks) but usually not in ongoing business or operational decisions. Developed economies have a natural and structural separation between the capital structure and the company, between owners and management—and between the topics of finance, value, and capital and business, operations, and customers.

This is not the case in most of the world today. Global investing and deal-making often require crossing the divide, the “governance Rubicon,” between shareholders and management.

Many of the going global problems discussed reside at this governance divide. Accessing investments can be difficult. Minority shareholders can be powerless. Claims against the enterprise can be weak or impractical. Foreign owners can be at a disadvantage. Most of these issues sit at the intersection of management and ownership.

I have argued that the broadest approach for overcoming these problems is to both capture and add economic value. It is not the only solution and, certainly, traditional value investing approaches work quite well. (I actually use both traditional value investing and value point together.) But I find it can solve most of these problems in one surgical move and, therefore, open up a whole new class of assets for investment. But adding value means adding economic value (mostly), and economic value is built mostly at the business and operational level. So adding value means crossing the governance Rubicon and getting more involved in the operations of the business.

This is actually quite natural in most developing economies or cross-border situations. Owners and managers are often the same people. And when they are not, no real governance or agency theory formally separates them. The same underdeveloped regulatory and governance structures that make investing more difficult also make being operationally active easier.

Private equity firms typically are more comfortable with this situation. They are used to jumping into the operations of a business with a surgical mindset. Kohlberg Kravis & Roberts (KKR) has its 100-day plans. Cerberus has its turnaround strategies. There are well-known approaches for improving management, helping companies expand, and driving productivity increases. It is the traditional value community that seems less comfortable crossing the governance divide.

Global value investing starts to look a bit like private equity with the investors actively involved in operations. However, private equity in these same markets also starts to look more like value investing, because the standard leveraged buyout (LBO) and debt-financing tactics are usually unavailable or impractical. My experience is that most of the investment strategies converge to a mix of unlocking and adding value. And sooner or later you cross the governance Rubicon and discover that adding economic value to a business lets you comfortably invest in a way that meets Graham’s original principles.

Value Point’s Deep Well

Capability keys are the deep well of value-added deal-making

Value investors are obsessed with competition. It determines the company’s profits and most of your returns. But the competitive situation can change rapidly, particularly when few barriers to entry exist or when the company is in a rapidly evolving industry or environment (ie., many of today’s markets). A competition obsession turns out to be a fairly useful affliction in such situations, as well as in global investing in general. One could easily explain globalization, and this entire book, as an aggregate of local competitive dynamics. Competitive considerations and pressures are the key driver of virtually everyone’s behavior (companies, government, investors) in every market.

As discussed, competing successfully as a business in developing economies usually means building or acquiring the right mix of capabilities: a luxury brand, a regional sales force, professional management, local financing, a European technology, Asian manufacturing. If Hewlett-Packard (HP) has moved its service centers to India, Dell likely needs to do so as well. If an Indian coffee shop has franchised Starbucks, a competing local coffee shop probably needs a similar franchise. In some cases, such capabilities can create a real competitive advantage (exclusive brands, advanced technology, a unique resource). But in most cases local companies need to continually move up the development curve simply to stay in the game and make sure a competitor doesn’t pull ahead in scale or operating efficiencies.

Within a capability worldview, capability keys (such as brands and technologies) are very effective tools for value-added deal-making. They are effective because they speak directly to these competitive pressures and anxieties at the company level. Similar to the political access and reputable capital keys, they open the door to investments and add value.

However, unlike the previously mentioned more “intangible” keys, they can have a more direct impact on the balance sheet and income statement. Injecting a new capability, such as a factory or a product line, into a company (whether by franchise, joint venture, merger, or something else) can add a tangible or intangible asset to the balance sheet. And depending on the type of management, this can be translated to the income statement over time. Value-added investing is about impacting the AV, EPV, or DCF in the near term. We can also impact the relationship between EPV and AV by leveraging in management as a capability. This can be effective in targeting situations in which the earnings power value is less than the asset value. Recall from Chapter 3 “Value Point,” the discussion of the interrelationship among earnings, assets, management, competition, and capabilities.

Because the worldwide mix of capabilities is constantly changing and evolving, capability keys provide endless opportunities for investors. Capabilities are the deep well of value point and can be used to target capability gaps, as shown in Figure 8.1.

Figure 8.1. Capability keys and capability gaps

For example, a Four Seasons management contract is a capability key that can add significant value to a hotel, real estate, or service apartment project almost anywhere in the world. Luxury hotel properties in places such as Africa, India, and Russia are fairly attractive businesses as they benefit from a combination of low local labor and construction costs and luxury pricing. You can also sometimes create an additional upper pricing tier for foreign tourists, as local luxury and international luxury are not necessarily the same. The limitation is that they are “fixed asset-heavy,” so the return on equity is lower. And luxury hotels in emerging markets also tend to suffer operating losses quickly during economic downturns.

But from an investor’s point of view, the primary challenge with buying or building luxury hotels is acquiring the asset or location. A luxury hotel typically needs a prime location, which means acquiring either an existing hotel or vacant land in a valuable location. Such prime locations are almost always tightly held by families, companies, or governments. In places such as India and Egypt, such assets can be seen by their owners as not just assets but the family’s lifeline and inheritance. An offer to buy a majority stake of a well-located hotel or plot of land is unlikely to be accepted—at least not at the reasonable or low price you want.

However, a capability key can change this equation dramatically. Offering to buy a minority stake in such a hotel and to transform it into a Fairmont or Four Seasons is an attractive offer. The brand elevates the hotel to international luxury status and opens the business to a new class of Western luxury hotel customers. This capability often also improves marketing, management, and reservations and operating systems. Recall the cases discussed in Chapter 3, where EPV > AV, EPV = AV, or EPV < AV (refer to Figure 3.7). In this situation, we can likely increase the value in any of these three scenarios. In fact, the most attractive situation might be where EPV < AV, because we are confident that a management contract will correct that problem as well as likely increase the overall asset value. As will be discussed in Chapter 12, “A Global Investment Playbook,” “potentially great” companies (such as fixer-upper hotels) are often more attractive investments than currently great companies.

In addition to increasing access and increasing value, a capability key such as a luxury hotel management contract can give the investor stronger long-term control. He or she can acquire only a minority share and still have sufficient claim to the enterprise through control of the contract.

A luxury hotel management contract can actually add value to an entire real estate development. If a foreign investor with a Four Seasons contract and a local developer jointly bid on land in a prime location, the Four Seasons name would effectively brand the entire real estate development at a luxury level. Not only would this be perceived as a more attractive bid by the seller (often the government), but it would also drive value into the development’s residential units, service apartments, and shopping centers. This creates lots of possibilities, such as phasing the development with different pricing or selling the luxury residential units in the first year.

Recall that in Chapter 3 I expanded the definition of a market inefficiency by adding a third term for added value. Traditionally, a market inefficiency is the difference between true value and market price (a mispricing of an asset as it currently is). It is common for investors to try to expand the margin of safety by redefining the intrinsic value upward, say by digging into more intangible assets or incorporating more speculative future growth. Or they might attempt to expand the margin of safety by incorporating in what an industry expert might pay for the whole company.

However, I have argued that our real challenge is not to hunt for smaller and smaller inefficiencies as we go worldwide, but to address the increased current and long-term downside uncertainties. Measuring intrinsic value in these environments is difficult enough without further and further refining its definition. If we can deal with the uncertainties, the inefficiencies are quite large and don’t require ever finer definitions. The added value deal-making approach lets us both target the larger market inefficiencies and enables us to tackle the uncertainty problems. In the equation in Figure 8.2, you can see that we keep these factors separate from the estimation of the current intrinsic value as is. In this case, a gap in a company’s capabilities (a capability gap) that the investor can fill can be considered part of the market inefficiency in the second term.

Figure 8.2. The uses of capabilities

Unlike the previous two value keys, capability keys are mostly about crafting a compelling business strategy—not a financing or acquisition strategy. While previous keys show us how to access deals and capture existing inefficiencies, capability keys are more about adding value. They are also far more sustainable. Capability keys can help an investor in seven ways (see Figure 8.2):

1. Increased access to deals. Capability keys are particularly effective at opening the door to private investments in developing or cross-border situations.
2. Decreased entry price. Similar to a “reputation discount,” a capability key can often result in a discount. Additionally, if a key such as a Four Seasons contract will increase the value of an entire real estate development, one can argue for a deep discount on the hotel property itself.
3. Increased economic value of the asset or enterprise. Whether the capability increases value by earnings, tangible assets, or intangible assets, the impact on the value of the investment can be significant at the time of the investment (usually an increased asset value), in the near term (management increases EPV relative to AV), and in the long term (EPV).
4. Eliminated long-term downside uncertainty (a stabilized margin of safety). This is one of the most important differences between capability keys and political access or reputable capital keys. Many capabilities can add sustainable value, which can eliminate the future downside uncertainty. Note that this remains the primary objective when operating with a long-term value approach in uncertain and unstable environments.
5. Create advantages when competing for deals. When competing for a deal, a capability key beats no capability key almost every time. Even if two bidders have capability keys within the same industry, some capabilities are better than other (Four Seasons is more valuable than Hyatt).
6. Strengthened claim to the enterprise. A capability key can create a long-term operating partnership, which is more stable than just a financing relationship. It decreases your dependence on contracts and various shareholder rights. This is very important in some situations.
7. Increased defenses against nonmarket forces. This can be important in many state and godfather capitalist systems. Control of strategically important foreign expertise and technologies can be a good defense against political and other nonmarket threats.

Using value keys to craft business strategies is the core of value point and of expanding the value tool kit to more hands-on deal-making. The deal architect uses various keys to build a compelling business strategy that adds so much value to all parties and the company itself that the deal is a no-brainer for going forward. Because worldwide capabilities are always changing and creating new competitive pressures, this is the deep well for such deal-making. In the next chapter, I present various strategies for this in practice.