Letter to Shareholders

Here is where we can get a summary of what the company accomplished in the past year. It usually starts with a summary of the financial performance of the year. It might be followed by a brief discussion of the company's operations. This part should also cover some of the achievements and mishaps that occurred during the year. Finally, this section normally wraps up with a discussion of the future plans of the company.

Companies with detailed and informative letters to shareholders are beneficial for shareholders. For example, Warren Buffett, chairman of conglomerate Berkshire Hathaway Inc., typically publishes detailed letters to shareholders. You could say that a letter of such detail is not the norm. On the other hand, there are also companies that go with a minimalistic approach.

In either case, we should be wary when:

• the tone of the letter is overly optimistic
• their plans seem too out-of-this-world
• the company's past actions contradict what they write.

A sign of an informative letter is when the company discusses what they did well and also their missteps in detail. However, it is important that the company learns from the mistakes rather than just repeating the same mistakes year after year. Also, if the company is a serial mistake maker, you might want to spend your time elsewhere.

When reading the letters to shareholders, do take note of:

• Tone: Language and expectations compared to previous years
• Strategy: Does it sound possible and how does it compare to previous years?
• Outlook: Do their future plans sound possible and is it consistent throughout the years?
• Shareholder action: Dividends and share buybacks?
• Execution: Has the company been able to do what it says?

Management Discussion and Analysis (“MD&A”)

If you are wondering where to look in order to have a better understanding of the company's operations, the MD&A (also known as Operational and Financial Review in Asia) would be your choice. If the Letter to Shareholders represents the big picture appetiser to how the company works, the MD&A is the main course when it comes to understanding the company's operations.

If we think of a company as a plane, the shareholders are the passengers, management are the staff ensuring that the plane is running properly and the board of directors are the ones plotting the course as well as keeping an eye on the pilots – in this case the top management. Hence when it comes to operational details, the MD&A (by the management) might be more helpful when it comes to understanding the business. Think of it as tapping directly into the minds of the management team, with a highlight on both their objective and priorities, at least to the extent that they want us to know.

Reading an insightful MD&A should give us the information to perform a SWOT analysis on the company.

SWOT stands for:

• Strengths: What is their economic moat?
• Weaknesses: What are they struggling with and how they can do better?
• Opportunities: What are their future plans?
• Threats: What are the key risks faced by the company?

Let's run through one example of what to look out for in the MD&A with Singapore-listed Super Group Limited (“Super Group”). The company's 2014 Annual Report's Operations and Financial Review provided quite a comprehensive discussion of its business.² Taking it from the top, Super Group came out with the painful truth that their operating environment in the past year was tough. However, they were clearly still profitable and still looked to be headed in the right direction in the near future. Next was a brief on their two core operations – what they sell, where they sell and who their customers are.

Subsequently, Super Group took it one step further with a breakdown of their core operating segments both geographically and by product. This was also presented during the review of their financial position. In our opinion, the part that gave us the greatest value-add were the in-depth discussions provided behind major significant events.

Next, when it came to their growth, Super Group gave a series of clear and actionable steps on how they were looking into the future. The keywords here are “clear” and “actionable”. We often hear management speak of expansion plans. But if it was left as vague as “the company is looking to expand overseas”, that's pretty much as useful as a toothpick in a gunfight.

All in all, even though we still had some unanswered questions (surprising if we didn't) after reading through the reports, we could see the effort taken by Super Group to communicate with their shareholders. Thus, we felt that Super Group's MD&A was definitely above average.

Here is also where our three-reads rule comes into play. It really is a pretty useful rule. As a rule of thumb, if you are unable to even have a basic grasp of how the company makes money after three reads, then the issue might not be you. Either the business is too complicated or someone is trying to confuse you. In any case, it might be better to move on.

Always keep in mind that, no matter how detailed the MD&A is, it is not audited. We should verify what was said in the MD&A with the financial statements and footnotes. If the management says one thing but the numbers show another, go with the numbers.

When reading the MD&A, do take note of:

• track record – does management walk the talk?
• how the company made money – the process and operations
• key products, operating segments and assets
• how the company did in the past year
• the company's economic moat over their peers
• how the industry is doing
• significant events during the year (acquisitions, divestments, reorganisation)
• feasibility of future plans.

Auditor Opinion

The role of an auditor is to form an opinion about whether the information presented in the financial statements is fair and whether the financial statements are prepared according to the country's accounting standards. At the end of an audit, the auditor issues the opinion about the financial statement for that year. Also, it is not an auditor's job to detect fraud.

An Enron tale comes to mind. We can use this example to illustrate to you just how ridiculous the Enron saga was. Imagine that your company has a dog as an asset but you need a duck to appear on your financial statements. Fortunately, there are specific accounting rules for what defines a duck. The rules state that a duck is something that is white, with yellow feet and an orange beak. So what you do is you take this dog and paint it white on the body, yellow on the feet and paste a bright orange beak on its nose. Next you say to your auditor: “This is a duck. Look at its yellow feet, white covering and orange beak! Don't you agree that it is a duck?” And the auditor says: “Yes, according to the rules, this is a duck.” Basically, everyone knows that it's a dog and not a duck. But it doesn't matter because it met the rules to be a duck.³

When the entire saga blew open, both Enron and its auditor, Arthur Andersen, went under.

Despite what we've just said, auditors in general do play a very important role by providing us with a basis to assess companies. And unless the auditor comes up with a qualified or adverse opinion, we tend to go with them.

Basically, an auditor can issue either three types of opinions or a disclaimer:

• unqualified: things are all good
• qualified: things are not so good
• adverse: things are not good at all
• disclaimer: unable to even give an opinion.

As a rule of thumb, we only look at companies with unqualified financial statements. Taking Singapore-listed companies for example, some companies that were given qualified opinions included Great Group Holdings Limited⁴ and Metech International Limited.⁵

If you think that this only affects smaller companies, think again. Hong Kong-listed Tianhe Chemicals Group Limited (“Tianhe Chemicals”), with its market capitalisation of over HK$40 billion during their IPO,^6,7 saw its auditor resign after the audit committee refused to accept the auditor's disclaimer opinion.⁸ As at January 2017, Tianhe Chemicals was suspended and has not traded since March 2015.⁹

When looking at the auditor opinion, do take note of:

• the reputation of the Auditor
• when the Auditor gives a qualified opinion – watch out!
• when the Auditor suddenly resigns – not a good sign.

Financial Statements

The financial statements are a treasure trove full of useful information and we should always investigate them. The financial statements alone can give us a decent idea of how the company is. Not only can the financial statements tell you how well the company is operating, but more importantly you can use the audited information to cross-check what the company mentioned in its Letters to Shareholders and MD&A.

Think of the company's financial statements as its yearly health screening. You might not know the character and lifestyle of the person from just the screening report, but you could be able to get a good idea on his present condition.

Typically, excluding the notes, financial statements consist of four main parts:

• income statement: how good the company is at making money
• balance sheet: what the company owns and owes
• cash flow statement: how much cash really went in and out of the company
• statements of changes in equity: showing the movement in reserves within the shareholders' equity. Note: Statement of Changes in Equity is an accounting necessity, but seldom used by investors.

So, in order for this story to come together, it is important for us to read at least the first three parts together. For instance, you do not have to be a sophisticated investor to notice higher revenue. Your first thought might be a good thought; how can more revenue be a bad thing?

However, there is always more to things than meets the eye. Apart from the revenue, we need to monitor other factors. Imagine that, apart from higher revenue, the company also experienced:

• ↓ Gross Profit Margin (Income Statement)
• ↓ Operating Margin (Income Statement)
• ↑ Trade Receivables (Balance Sheet)
• ↑ Inventory (Balance Sheet)
• ↑ Borrowings (Balance Sheet)
• ↓ Operating Cash Flow (Cash Flow Statement)
• ↑ New share issue (Cash Flow Statement).

What do all these mean? Historically, these points indicated that the company might be:

• ↓ Margins: selling more commoditised products, experiencing more challenging operating conditions
• ↑ Trade Receivables: having trouble collecting payment from customers or having laxer credit terms
• ↑ Inventory: having trouble selling their products
• ↑ Borrowings: having worsening cash flow or liquidity issues
• ↓ Operating Cash Flow: having trouble generating cash
• ↑ New share issue: having liquidity or funding issues.

In summary, the three main statements have to be read together. With that said, the financial statements by themselves are not enough for us to make an investment decision. No analysis is complete without reading the financial footnotes of the annual reports, which is next on our list.

When reading the Financial Statements, do take note of:

• How the company makes money
• How good are they at making money?
• Are they conservative or aggressive – industry-specific?
• Net profit is opinion, cash is fact
• Do the numbers tally with the Letter to Shareholders and MD&A?

Notes to the Financial Statement

Financial statements are based on accounting assumptions and they alone do not tell us what these assumptions are. Therefore, we need to investigate the financial footnotes to better understand the story from the company's financial statements. The phrase that best describes the notes is: “The devil is in the details.”

First of all, why are these called the notes to the financial statements? This is simply because there isn't enough space to expand on what each line item means in the financial statements itself. Hence, next to each significant line item there will be a number pegged to it. In order to make more sense of this line item, we can flip to the corresponding note in the notes section.

Looking at Want Want China Holding Limited's (“Want Want China”) annual report 2014, Revenue was reported as US$3.78 billion with a Note 5 at the side. So far, all we know is that the company had sales of US$3.78 billion for the year ended December 2014.¹⁰ However once we go to Note 5, a whole new world awaits us. Under Note 5, we find out:

• Want Want China's three core operations in detail
• the three core operations that made up over 99% of revenue
• that over 90% of revenue and business activity was done in the PRC
• the revenue, operating profit and operating margin of each of the core operations
• the assets, liabilities and equity of each of the core operations
• the same information for the previous year (FY2013) for comparison.

It is safe to say that we have learned more about Want Want China's operations from Note 5 compared to knowing that they had a revenue of US$3.78 billion. Not only do we know how much they made, we also know where they made it, how efficient they were at making it and how they did compared to a year ago.

So you see, the notes to the financial statements contain a large amount of useful information for investors. Here are some common information you can find within the notes:

• one-time gains
• the breakdown of expenses
• the remuneration of management
• shares outstanding of the company
• risks
• any other contingent liabilities not mentioned in the financial statements.

Sometimes you will come across very interesting information within the notes of the financial statement that will give you a better idea of how the company is really being managed. Once in a while, you might find golf club memberships, private jets, paintings or even mansions in exotic places disclosed in the notes. If you come across such items, that might give you an idea of how the company is being managed.

When reading the Notes to the Financial Statements, do take note of:

• consistency – any change in accounting practices
• how transparent the company is
• breakdown of each line item on the financial statement
• large hidden assets
• contingent liabilities
• operating leases
• cross-checking what was mentioned in letters to shareholders and the MD&A
• notes that do not make sense.

Directors and Key Management

Directors and key management are the head of the company, the ones leading the charge. As stewards of the company, you want your leaders to have good character and be held in high regard – or, at the very least, not to appear on the front page of the newspaper for the wrong stuff.

On a positive note, Asia-listed companies tend to have a rather comprehensive directors' profile section, with a good record of their professional experience and professional commitments in other companies. And although investment decisions are not made solely on the basis of the involvement of a particular person, they do matter. A recent example is Singapore-listed Wilmar International Limited's two recent additions in 2014 and 2016, George Yong-Boon Yeo and Pua Seck Guan respectively.¹¹ Both are distinguished businessmen in their own right.

On the other hand, you might think twice about investing in a company if:

• some of the directors are also directors of another company under investigation by the authorities
• directors and key management abruptly leave the company within a short period of time – if there is a mass exodus of key personnel, things within the company might not be that rosy.

When looking at the list of directors and key management, do take note of:

• reputation of the directors
• any significant changes in directors' composition within a short period of time
• any significant changes in key management team within a short period of time.

Shareholders

We do not find it unusual for a major shareholder to own a sizeable equity block in an Asia-listed company. As the decisions of an influential shareholder might be able to make or break a company, it definitely helps to take some time to appreciate the major shareholders. If they have a track record of value creation, that's definitely a positive for us. Take, for instance, REITs. If the REIT has the backing of a strong sponsor or majority shareholder, the company might have easier access to both liquidity and potential assets to grow its income stream.

However, if this particular shareholder is outrightly treating minority shareholders unfairly, we should reconsider investing in the company.

When looking at the shareholding list (Table 6.1), do take note of:

• the reputation of the major shareholders
• any sudden changes in the major shareholders
• the past actions of the major shareholders, both privately and within the company.

Company 1: Dairy Farm International Holdings Limited

Founded in 1886, Dairy Farm International Holdings Limited (“Dairy Farm International”) was literally a dairy farm (with 80 head of cattle) with an objective to supply clean and uncontaminated cow's milk. In 1972, Dairy Farm International was acquired by Hongkong Land Holdings Limited, also part of the Jardine Matheson Group.¹³ Today, with over 6,500 outlets and ranked one of the top retailers in Asia, it's not too far of a stretch to say that Dairy Farm International is the leader of Asia's modern retail business.¹⁴

1. Well-oiled rolled-up vehicle: Between 2008 and 2014, Dairy Farm International accumulated sizeable stakes in modern retail businesses throughout Asia, from Indonesia (PT Hero Supermarket), Singapore (MCP Supermarket), Cambodia (Lucky Supermarket), and the Philippines (Rose Pharmacy and Rustan Supermarket) to Malaysia (Bintang Retail Industries and Jutaria Gemilang Sdn Berhad). From 2008 to 2014, Dairy Farm International reported a 64% increase in revenue, 38% increase in operating profit, 53% increase in net profit and 30% increase in operating cash flow.¹⁵ This was achieved from both organic and acquisition growth. This indicates that not only is Dairy Farm International adept at integrating new businesses, they also appear to be good at organic growth.

   These investments (2015–2016) were less than half of Dairy Farm International's close to US$1.1 billion investment in Yonghui Superstores Co., Limited (“Yonghui Superstores”) in China.^16,17 This investment into Yonghui afforded the company less operational risk in terms of its China expansion. Many foreign retailers have failed in China and one way in which Dairy Farm International avoided that is by investing in a successful local player. Moreover, the investment gives Dairy Farm International other benefits as well. For example, Yonghui is very strong with its fresh produce business. The investment makes Dairy Farm International improve on its own fresh produce business as well. Second, Yonghui's network might be able to help the company with its own operations (Mannings expansion) in China. Lastly, Dairy Farm International is part of the Jardine Matheson Group – a group with a long track record.

2. Integration commitment: For many companies, integration is a tough challenge. And one key challenge is the integration of the back-office operations.

   Dairy Farm International has also been consistently integrating its international business. For example, it has pushing for SAP system implementation in:

   • 2010: Malaysia
   • 2011: Indonesia.

   Possibly totalling millions of processes to implement, this showed Dairy Farm's commitment for integration.

   A fully integrated and software-controlled system should greatly standardise the Group's operational controls. Implementing such a system may also lead to the company finding out more about where its weak controls are. For example, in Malaysia, the implementation led to Dairy Farm International uncovering an operation fiasco back in 2012. This also led to management changes in their Malaysian operations as well as a review of the Group's other principal operations. With these actions taken, it's unlikely that the same issue would resurface.

3. Operational discipline: Not everything a business touches becomes gold. But that is part and parcel of doing business. As Peter Lynch said, “In this business, if you're good, you're right 6 out of 10. You're never going to be right 9 out of 10”. Dairy Farm International was not always successful in every market it entered. However, it also decided to call it quits when things were not improving.

   Markets exited:

   • 2007: Thailand
   • 2007: South Korea
   • 2014: India.

   On the bright side, this implied that they were willing to take hits and not afraid of divesting those that do not fit into their playbook. Just two years into the business, Dairy Farm International closed their Thailand health and beauty operations as they did not meet the Group's expectations of being able to achieve rapid scale. Instead of throwing good money after bad, Dairy Farm International bit the bullet to concentrate on more promising markets.

   As the saying goes, it is okay to be wrong, but not okay to stay wrong.

Company 2: Heineken Malaysia Berhad

Heineken Malaysia Berhad (“Heineken Malaysia”) (previously Guinness Anchor Berhad) is the largest alcoholic beverage company in Malaysia. It was formed after Heineken N.V. acquired Diageo Plc's stake in GAPL Private Limited, the parent company of Heineken Malaysia, in 2015.¹⁸ The company has a long history in Malaysia, dating back to the pre-World War II period.¹⁹ How many companies can say that they have been in business since the 1930s?

Even so, Heineken Malaysia is still growing and has recorded amazing growth over the past decade, with revenue and net profit increasing by 6.3% and 7.1% annually respectively from 2005 to 2015.²⁰ The following three observations, not directly evident from a read of its financial statements alone, might give you a better appreciation of the strong economic moat of Heineken Malaysia's business.

1. Pricing power: The largest cost component of Heineken Malaysia by far was the excise duties and tax payable to the government. In 2015, excise, custom duties and sales tax made up 48% of revenue!²¹ Yet in times when the government raises the excise duties, Heineken Malaysia appears to be able to pass these increases down to consumers fairly easily.

   In fact, during the last excise duties hike, the company raised the price of its product on the very same day the new duties took effect.²² Moreover, during the next three months of operation, the company actually experienced a 15.6% jump in its revenue compared to last year.²³ This highlighted the strong pricing power of the company and how Heineken Malaysia can maintain margins without affecting sales volume.

2. Shareholder support: As a listed subsidiary to one of the largest breweries in the world, Heineken Malaysia, without a shadow of a doubt, has a world-class support infrastructure. Throughout the years, the company has been able to leverage the expertise of its parent company to grow its business. A clear example is the potential of its parent company, Heineken N.V., with a product arsenal of over 250 products.²⁴ The product portfolio of Heineken Malaysia is still less than 20 brands.²⁵ Think of the potential as the company decides to add more products into its range.

   Thus Heineken Malaysia can easily add more products to its sales channel without much research and development. That is certainly a huge advantage over a smaller brewery which lacks this strong support from a global parent.

3. Competitive landscape: Finally, when we look at the competitive landscape for the beer market in Malaysia, Heineken Malaysia, together with Carlsberg Brewery Malaysia Berhad, have the lion's share of the country's legal beer trade. With a less fragmented market, these two companies have enjoyed a certain degree of pricing power.

Company 3: Super Group Limited

Founded in 1987, Super Group Limited (“Super Group”) is an Asia-centric instant F&B player with Super, Owl and NutreMill as standout brands in their portfolio. What makes them stand out from their 3-in-1 instant beverage peers like Food Empire Holdings Limited, Nestlé (Malaysia) Berhad, OldTown Berhad and Power Root Berhad is their big push into the food ingredient business in 2010.

In 2015, Super Group's food component contributed 33% of its group revenue,²⁶ up from 16% back in 2010.²⁷ And this capital-intensive move inevitably involved the development of the corresponding infrastructure to support it, bringing us to our first point. . .

1. Execution track record: If you have been around construction management, things don't always go on schedule. So how was Super's track record when it came to delivering on their execution?

   From their track record (Table 6.2)²⁸ over the five-year period from 2010 to 2015, Super Group appeared to walk the talk. Most of what the management promised to deliver was achieved. What this does is to give us the confidence that they are able to deliver on their promises.

2. Succession planning: In recent years, the theme for Super Group has appeared to be moving into a new phase of growth, and the taglines for their Annual Reports in 2012 and 2015 of “A New Era” and “Building our Future” appear to correspond with that.

   Other than the business side of things, highlighted by their track record of timely delivery of projects, a key concern for businesses in Asia is the issue of succession planning. In many companies, it is even sort of a taboo to even talk about it sometimes. However, in the case of Super, it seems that succession planning is well in play.

   From 2010–2016:

   • Four executive directors stepped down, with two being direct family members
   • Three members of the younger generation came into the company, with one as a director
   • Prior to appointment, this individual was in a senior management position for four years
   • Four out of six new additions to senior management appeared to be non-family members.

   Interestingly, among Super Group's key management positions in 2015, there were certain individuals (non-family) that stood out. Two individuals previously started in Super then left for another company before rejoining the Super Group. It looks as if going into the “new era” is more than just words. Super Group appeared to be able to attract and retain younger talent to work for them.²⁹

3. Share buybacks and insider purchases: This brings to mind the words of Peter Lynch, “Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”

   Of course, there are exceptions. However, in most cases, when insiders with the company are repurchasing shares, it might indicate that those closely linked to the internal workings of the company do see value – a positive signal for us to dig deeper.

   Between August 2015 and August 2016, not only has the family increased their stake,³⁰ but both the company itself³¹ and a non-executive director (deemed a substantial shareholder)³² have all bought shares of the company in the open market.

   To conclude, we would like to emphasise that this is just the view of the insiders, and not yours. Although by itself this is a positive sign, you still have to do your own research to see whether the company fits with both your investment approach and objective.