Valuabl - Vol. 1, No. 6
Happy holidays, a look back at Valuabl in 2021, and my rating performance; On real risk-free rates and expected growth; A deep dive into my best investment idea of the fortnight
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Welcome to Valuabl - a fortnightly newsletter for value investors with investment research, stock valuations, and deep dives into my best ideas.
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In Today’s Issue:
Happy Holidays (1 minute)
A Look Back at Valuabl ‘21 and My Ratings (5 minutes)
Real Risk-Free Rates and Expected Growth (5 minutes)
Deep Dive Into My Best Idea (14 minutes)
1/ Happy Holidays
Happy holidays! We’re coming to the end of another wild year, and in the spirit of the season, I’ve decided to make today’s entire newsletter accessible to everyone.
If you want to access the best ideas I find every fortnight, then become a paying member. Anecdotally, members have reported that their Valuabl subscriptions have enormous ROIs (paying for themselves 20x over in some cases).
Moreover, when I talked about the inflation coming through the pipeline early in ‘21 and how Valuabl subscription prices would rise, this trend is set to continue into ‘22, and prices will be going up sometime next year. Get a subscription now, and lock in the current price forever.
This opportunity was like when Arthur Guinness leased the St. James’s Gate Brewery area in Dublin in 1759 for £45 per year on a 9,000-year agreement.
Even better, give your friends, families, and colleagues a subscription to Valuabl for Christmas. Or, at the very least, share it with them.
2/ A Look Back at Valuabl ‘21 and My Ratings
Since starting Valuabl, about 18 months ago, I’ve learned a lot about myself. Making some of my valuations and research public is humbling, frustrating, scary, and exciting.
It is humbling as when you make your research public, you cannot hide from your mistakes — and boy, do people love to rub them in.
And, it is frustrating because it is impossible to hit the ever-shifting goalposts of people’s expectations. For example, if I rate a stock a sell because my analysis suggests it is overvalued, a continued rise in the price in the days following are often taken as proof that I am wrong.
And, it can be scary because some people, if they disagree with my analysis like to take it upon themselves to send provocative messages, including talking about knowing where I live and others I won’t get into. These people get so mad, you would think I had kicked their dog or punched their baby.
But, most of all, it is exciting because it is a great pressure cooker that forces me to improve and embrace saying: “I don’t know” and “I was wrong”.
I think Mark Twain was right when he said:
“I am quite sure now that often, very often, in matters concerning religion and politics a man’s reasoning powers are not above the monkey’s.”
— Mark Twain
However, I wish he had added investing to the list.
As a general piece of advice, it is essential to periodically evaluate your investment performance and the methodology and techniques you use to analyze and select investments. Investing is a challenging game, and valuation is a complex craft. After all, there is no perfect methodology, nor is there any way of telling whether you were right or wrong.
In essence, you’re hitting a blind shot to a hidden green and trying to judge your swing based on the crowd’s reaction.
As part of my process, I keep a record of everything I’ve ever valued, including my model, my story at the time, and what I rated it based on my Monte Carlo simulation. I do this because it gives me a watchlist of everything I’ve analyzed. If something I’ve previously valued at ‘x’ has dropped to 1/2 ‘x’, it might be worth looking at again. This method reduces my workload and screening process over time, but it does not eliminate it. Moreover, I can periodically look back at how my ratings have performed to learn from my mistakes and identify biases.
Have no doubt, we are all biased, and we all make mistakes. My goal when investing is to reduce the number, size and impact of my errors and biases. If I can, on average, make fewer, more minor mistakes and be less biased than the market, then with appropriate portfolio construction, we will do well over time.
Some of the parts of my valuation, asset selection, and portfolio construction process that I have introduced over the years to reduce my own biases and errors are:
Never look at the final valuation number until I am satisfied with all of my inputs and estimates.
Never break the fundamental laws of valuation.
Set up my model to be granular and detailed, but drive it with big-picture inputs.
Never buy/sell based on feeling. Only buy/sell when the likelihood and payoffs are in our favour—which is where Monte Carlo simulation comes in.
Seek to construct a portfolio of 12-15 assets with low correlation and allocate weightings to maximize the long-term expected growth rate of the portfolio while minimizing volatility.
Since starting Valuabl, I have issued 142 public stock ratings based on my valuations. Since then, the price-performance (ignores dividends) for each rating class has been:
Buy: 25.2% (16x ratings)
Add: 5.3% (33x ratings)
Hold: -2.2% (54x ratings)
Reduce: -9.4% (28x ratings)
Sell: -13.4% (11x ratings)
I’m reluctant to read too much into these results as there are other potentially confounding factors (dividends, sample size, luck, etc.), but it seems as though over this time, there has, on average, been no bias in my method.
Now, let’s take a look at what my worst ratings have been:
By far, my two worst ratings have been GameStop (Feb ‘21 valuation) and Microsoft (Jan ‘21 valuation)—both of which I rated Reduce and both of which have increased dramatically in price since. Did I slice it out of bounds on those shots, or did a gust of wind carry the ball there? I will likely dissect these two in my next newsletter.
3/ Real Risk-Free Rates and Expected Growth
With inflation running amock across the world, Central Bankers remaining dovish, and Government bond yields staying stubbornly low, the question on everyone’s lips is: What does this mean for interest rates, and what does this signal about economic growth?
Let’s start by taking a look at yields on 10-year Government bonds—I have plotted these in the following chart.
On the one end, we have the European countries with negative yields. In fact, every country with a negative 10-year yield is in Europe. Moreover, out of the twenty countries with the lowest bond yields, only Japan is not in Europe. On the other end, with incredibly high yields, we have South American and African countries like Zambia, Venezuela, and Argentina.
There are, in total, 13 countries with double-digit bond yields and nine with negative ones. Taking the GDP weighted average of all 73 bond yields gives us a Global GDP Weighted Average 10-Year Government Bond Yield of 2.55%.
Next, we’ll take away the default spreads on these bonds and the core inflation rate for each country to get the real risk-free rate—again, I have plotted these in the following chart.
The first thing we notice is that broadly speaking, real risk-free rates are low—very low. At the one end, countries like Uganda, Namibia, Egypt, South Africa and Indonesia have positive rates, while countries like the US and UK have negative ones. I’ve left Venezuela off this chart because its real risk-free rate is an anomalous -1,546%(!?)
Only 16 (22%) of the 73 countries on this list have positive real risk free rates. And, if we take the GDP weighted average of these, the Global GDP Weighted Average 10-Year Real Risk-Free Rate is about -1.66%.
So, what does this mean? In a monetarist, cost of capital sense, it means two primary things:
Purchasing power is being transferred from savers of cash to borrowers of cash. If you have cash, the average risk-free rate of return you’ll be getting on it is -1.66% across the world. If you’re borrowing cash, you’re being paid 1.66% per year to borrow it.
Money now is, on average, worth less than money in the future. If given the choice between $100 now, and $100 in a years time, the $100 in years time is more attractive. The time value of money has been flipped. Consume, spend, and invest, rather than save.
This seems bizarre, doesn’t it? However, as I have argued previously, there is nothing intrinsically or fundamentally wrong with negative real rates. Moreover, negative rates are a fundamental part of a negative growth economy. There is an inexorable link between the real risk-free rate of return on capital and the real growth of the economy. This is why I tie terminal growth rates and risk-free rates to each other—letting your terminal growth rate be larger than the risk-free rate is, in my view, a grievous mistake that leads to impossible valuations.
A low growth economy brings about low risk-free rates of return, and low risk-free rates of return are a forecaster of low growth. As real growth in an economy begins to slow, real interest rates decline. This makes borrowing more attractive, which in turn, increases borrowing and the debt burden relative to the output of the economy. This reduces aggregate real spending because more money needs to be spent maintaining the debt, which reduces growth further. This is the capital cycle.
So, what does this mean for the world currently? It means that the market is forecasting real economic decline across the world (on a GDP weighted basis). Will this occur, and will it be sustained? Time will tell. But, real risk-free rates have been a solid forecaster of real economic growth in the past. And, because of their fundamental link to real growth, and the enormity of the debt burden out there, I wouldn’t be surprised.
4/ Deep Dive Into My Best Idea
China Shineway Pharmaceutical Group Limited (SEHK: 2877) - Valuation on December 13, 2021
The Business Model - Segments, Geographies, and Products
China Shineway Pharmaceutical Group Limited engages in the research and development, manufacture, and trade of Chinese medicines in the People’s Republic of China (“PRC”) and Hong Kong. The company started in 1984, went public in 2004, and its headquarters are in Shijiazhuang, China.
The company offers modern Chinese medicines in soft capsules, granules, and injections in various therapeutic areas, including cardio-cerebrovascular, antiviral, orthopaedics, paediatrics, gynaecology, neurology, gastroenterology, ophthalmology, oncology, and immunology. The company operates through five business segments:
Injections: Accounts for 42% of revenues.
Traditional Chinese Medicine (“TCM”) Formula Granules: Accounts for 21% of revenues.
Soft Capsules: Accounts for 17% of revenues.
Granules: Accounts for 15% of revenues.
Other Products: Accounts for 5% of revenues.
In terms of annual production capacity, China Shineway Pharmaceutical Group Ltd. is the largest manufacturer of Chinese medicine injections, soft capsules and granules in the PRC. Moreover, the company has the only automated production-line process for Traditional Chinese medicines in China and cultivates and extracts much of their herbs. As of 2020, the company had the capacity for:
Herbs: 20,000 tons extraction
Injections: 3.2 billion units
Soft Capsules: 3.5 billion capsules
Granules: 3.4 billion bags
TCM Formula: 3 billion bags
The company primarily targets the markets for middle-aged and elderly medications, paediatric medications, and antiviral medications, with a particular focus on the hierarchical diagnosis policies that the PRC has.
This hierarchy means that the company mainly targets institutions within the diagnosis hierarchy (from retail pharmacies and grass-root institutions to Class II and III hospitals). The company’s direct-sales network covers 31 provinces, cities and autonomous regions across the country and gives them sales coverage over:
Class II and III Hospitals: 6,400+
Grass-Root Medical Institutions: 330,100+
Retail Terminal Pharmacies: 170,000+
Finally, the company gets almost half (50%) of its revenue from grass-root medical institutions, 33% from hospitals, and 17% from retail pharmacies.
The Financials - The State Sponsored Resurgence of a 2,000 Year Old Industry
Since the company went public in December 2004, China Shineway Pharmaceutical Group Ltd. investors have received lacklustre returns. The total return to shareholders over these 17 years was 200%, or a 6.7% compound annual growth rate (“CAGR”) (below the average cost of equity for Chinese businesses over that time). Moreover, the stock price has grown at a meagre 2.2% CAGR, going from HK$4.70 to HK$6.75.
So, how has the business itself performed in that time?
When the company went public, it had an annual turnover of about HK$1 billion and an EBIT of HK$400 million. Now, 17 years late, the company is turning over about HK$3.6 billion and has an EBIT of HK$680 million. It has grown its revenue at a steady 7.7% CAGR and EBIT at a more modest 3.2% CAGR. Growth slowed through the 2010 decade, and the company even shrank modestly. However, since 2018, growth has been picking up again.
Since 2004, the company has reinvested about HK$5.1 billion in equity to fund this growth. This reinvestment sounds like a lot—the book value of equity has grown from almost HK$2 billion to over HK$7.1 billion—but the vast majority of this equity is just sitting in cash.
With most of the reinvestment into this business going into the cash account, the incremental returns on operating invested capital are much better than they first seem. The company had HK$1.7 billion in cash at IPO and now has over HK$5 billion, meaning that they’ve only had to invest about HK$1.8 billion into the operating business over that time while they’ve added about HK$214 million in after-tax operating earnings, giving them an incremental ROIC of 11.8%.
However, it hasn’t all been smooth-sailing for the company—the 2010s were a challenging decade. Not only did growth decline and even turn negative, but the company’s gross margins were also under pressure and declined from 72% in 2010 to 65% in 2018. And, because of the fixed costs involved in running a pharmaceutical manufacturing business, this 9% decline in gross margins had an outsized effect on the decrease in operating EBIT margins. These were above 40% in 2010 and declined to about 21% in 2018.
Moreover, the decline in EBIT margins over the last four years and the uptick in growth were caused by increased spending on sales and marketing. SG&A as a percentage of revenue increased from an average of 30-ish per cent in the decade to 2018 to over 52% in the LTM.
In 2018, with sales and profitability stagnating, the company began rolling out new sales and marketing channels and investing in expanding its direct sales network. This plan gave them more extensive coverage of terminals, pharmacy chains, and tier II and III hospitals.
Moreover, in 2019, the company invested in digital marketing initiatives such as creating a dedicated marketing department, rolling out healthcare partnerships, social media marketing and experimenting with eCommerce partnerships.
This new sales and marketing expenditure has helped the company return to growth, with the 3-year CAGR for revenue rising to 7.7%. Yet, the trade-off is that a permanently more extensive sales network leads to a larger cost-base and the potential for lower margins.
In the following chart, I plot China Shineway Pharmaceutical Group Ltd.’s EBIT margins back to pre-IPO alongside the margins of the company’s dozen largest competitors.
We can see that the company has enjoyed top-quartile margins for most of its life. However, over time, the effects of competition have eroded the company’s margin advantage, and margins have been slowly dragged down towards the mean for the industry (12.8% for 2016-2020).
Nevertheless, the company still enjoys a decisive cost advantage over its competition powered by having the only automated production line process for TCM in the PRC and its partial, backward vertical integration of the business (herb cultivation and extraction). As a result, the company still enjoys incredible gross profit margins of almost 75%.
Moreover, the company’s enormous gross profit margins help fund the increased spending on sales and marketing while still allowing the company’s operating profit margin to remain comparatively large. Consequently, since 2017, the company has been able to go from middle-of-the-pack on sales and marketing spending to top of the pack while keeping EBIT margins comparatively strong.
The Story - Sales Drives Growth but Increases Costs and Risk
China Shineway Pharmaceutical Group Ltd. is a Chinese pharmaceutical business focusing on Traditional Chinese Medicine. The Chinese pharma market is large (HK$1.4 trillion) and disjointed (3-6 thousand manufacturers), but national policies promoting the development of TCM, expanding the National Drug Reimbursement Negotiation list, and an ageing population will ensure it grows (10.4% CAGR). Shineway’s cost-advantage (backward integration and automation), R&D investments (HK$126 million p.a.), and sales and marketing (HK$1.6 billion) will help them maintain market share (0.28%); however, a more extensive sales network costs more and will permanently weigh on margins (19.1%) and increases the riskiness of cash-flows (operating leverage at 2.21x). The company faces some country risk (0.72% China country risk premium) and has a fair chance of distress (20.6%), but the biggest driver of value is the enormous cash pile they’re sitting on (HK$5 billion). However, this cash is subject to China’s Enterprise Income Tax (“EIT”)(20% flat-rate) and the additional risk that the CCP limits RMB remittance.
Total Market: Despite a budding innovative drug industry, the Chinese Government is equally focused on promoting and supporting the TCM market with ‘The Strategic Plan on the Development of Traditional Chinese Medicine’, which makes TCM development a national strategy of their Healthy China 2030 initiative. Moreover, the Government’s policy of promoting in-stock mandates for many pharmaceuticals in pharmacies and hospitals, and the expansion of the National Drug Reimbursement Negotiation list will help this market grow.
Economists forecast the Chinese pharma market to expand from HK$1.4 trillion in revenue (2021) to HK$2.4 trillion by 2026 at a 10.4% CAGR.
x Market Share: When combined with the cost-advantage, the ongoing R&D investments, expansion of the sales and marketing network, and investing in additional manufacturing capacity, the company will maintain its market share (0.28%).
= Revenues: The company has a fundamental growth rate of 6.95% (after capitalizing the sales and marketing reinvestment) which is lower than the market growth rate of 10.4% and much lower than analysts consensus of 16.2%. I have gone with the market growth rate and assumed the company will be able to roughly double its revenue to HK$7.5 billion by 2030/2031.
- Costs: The company will maintain its gross cost advantage; however, the more considerable expense from having a more expansive sales network will not disappear. I expect the gains from increased scale to offset the increased costs associated with having a much broader terminal sales coverage.
= Operating Income: As a result, the company will maintain margins of around 19.1%. If the benefits of scale outweigh the larger cost base, margins could expand. But, if the higher costs are here to stay, and the company’s gross cost advantage diminishes (most likely because of greater automation across the country), margins could shrink towards the industry average (12.8%).
- Taxes: The company operates exclusively within China and Hong Kong. As such, I have forecast for the company’s tax rate to trend from the current effective rate (26.2%) to the Chinese marginal corporate rate of 25%.
- Reinvestment: The company has produced an average of HK$1.30 in sales for every dollar of operationally invested capital. This efficiency is slightly better than the company’s competitors. I have assumed that this capital efficiency will continue as they plough money back into R&D, sales and marketing, and expand manufacturing capacity with new facilities.
= Free Cash Flows: Based on this, I forecast the company to remain free cash flow generative and that they do not need to raise capital.
Adjustcompany'se Value and Risk: China Shineway Pharmaceutical Group Ltd. is a Chinese Pharmaceutical Drug business (0.65 product beta) with substantial fixed costs (2.2x current operating leverage ratio), little financial leverage (0.7% Debt to Market Cap), Chinese country risk (+0.72% country risk premium), and a B1/B+ synthetic credit rating which I have based on the company’s Altman score. Based on this credit rating I have assigned a 20.6% chance of financial distress.
My estimate for the company’s WACC is 12.69%.
+ Non-Operating Assets: The company’s enormous cash pile (HK$5 billion) accounts for a considerable percentage of the company’s overall value. However, the practicality of extracting this cash is restricted—you cannot just buy the entire business and pay all the money out to yourself.
The company would have to pay a 20% EIT on the dividend (I have assumed that because the company is a Cayman holding corporation, it qualifies as an NRE).
Moreover, the cash bank balance is denominated in RMB, which is not a freely convertible currency in the international market. The Government of the PRC regulates the RMB exchange rate, and the remittance of these funds out of the PRC is subject to exchange restrictions imposed by the Government. As a result, I have assumed that:
There is a 1% chance that the Government forbids you from taking out the cash.
If they forbid you from taking out the cash, it is worthless.
These assumptions are extreme and not correct. The outcome of results is not binary like this. However, this is a practical way of modelling this risk. So, I have included both the likelihood of being banned from withdrawing the cash and the relevant extraction value in my Monte-Carlo simulation.
- Debts and Other Claims: The NPV of the company’s debts is roughly HK$37 million, and the company has about 4 million employee options outstanding that I have valued at almost HK$4 million. There are no unfunded liabilities.
The Valuation and Rating - A Free Option on the Underlying Business
I have valued the business in HKD.
Intrinsic value per share: HK$11.06
Price per share: HK$6.87
Price-to-value: 62%
Monte-Carlo percentile: 0%
Rating: Buy
China Shineway Pharmaceutical Group Ltd. shares are below all values in my Monte Carlo simulation. In fact, the shares are so cheap that the company has recently traded with a negative Enterprise Value—that is, the company has more cash than the entire cost of buying all the firm’s debt and equity, effectively making the business free.
One way to think about this investment is as a very low cost (borderline free) call option on the underlying business. If the business is worth more than nothing, then you make money.
Another way to think about this investment is based solely on the dividend. The company is currently paying out about HK$547 million a year in dividends, and they’ve committed to increasing this by 15% per year at least. If you bought all of the company’s equity, it would cost about HK$5.1 billion, and based on the dividends alone, you would receive all of your money back within five and a half years. Your capital is returned in its entirety, and you still own the company.
Finally, the shareholders’ yield (dividends + buybacks + debt payback) is 25.2%. If the company diverts the money it used to pay down its debt into dividends, you’ll get your money back in just four years.
I have added these shares to my portfolio because, by my analysis, they’re dramatically undervalued, and they are uncorrelated with what I already own.
Disclaimer: This newsletter is not financial or legal advice. It is independent research.
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