Competitive advantage period (CAP) --- Part 1

In 1991, Barrie Wigmore, a Goldman Sachs limited partner, released a study that attempted to determine what factors drove the stock market’s above-average returns in the decade of the 1980s. After carefully accounting for earnings growth, interest rate declines, M&A activity and analysts’ rosy forecasts, it appeared a full 38% of the shareholder value created in the 1980s remained unexplained. Dubbed the “X” factor, this mysterious driver of value left Wigmore and the Wall Street Journal, which published a feature article on the study, at a loss. Given overwhelming evidence of well-functioning capital markets, it appears completely unsatisfactory to attribute such a large component of share price performance to some unidentifiable and seemingly inexplicable force.

Fortunately, there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. The focus must be on the economic drivers of a business, which can be defined as cash flow (cash-in versus cash-out), risk (and appropriate demanded return) and what is dubbed “competitive advantage period”— CAP— or how long returns above the cost of capital will be earned. CAP is also known as “value growth duration”.

In this context, Mr Wigmore’s “X” factor can be explained by the market’s extension of expectations for above-cost-of-capital returns. As Mr Wigmore’s analysis suggests, the length and relative change of CAP can have a substantial impact on the value of a business and the market overall. For example, the revision in expectations of Corporate America’s ability to generate returns above its cost of capital is a powerful indicator that investors believed that America was more competitive at the end of the 1980s than it was entering the decade. This conclusion was later supported by economic analysis. It should be noted that in a well-functioning capital market all assets, including bonds and real estate, are valued using similar economic parameters. In the case of bonds, for example, the coupon rate (or cash flow) is contractually set, as is the maturity. The bond price is set so that the expected return of the security is commensurate with its perceived risk. Likewise for most commercial real estate transactions. At the end of the day, the process of investing returns to the analysis of cash flow, risk and time horizon. Since these drivers are not contractually set for equity securities, they are by definition expectational and, in most cases, dynamic.

Remarkably, in spite of CAP’s importance in the analytical process it remains one of the most neglected components of valuation. This lack of focus appears attributable to two main factors. First, the vast majority of market participants attempt to understand valuation and subsequent stock price changes using an accounting-based formula, which generally defines value as a price/earnings multiple times earnings. Thus CAP is rarely explicitly addressed, even though most empirical evidence suggests that the stock market deems cash flow to be more important than earnings, holds true to the risk/reward relationship over time, and recognizes cash flows many years into the future.

Second, most companies use a forecast period for strategic planning purposes (usually three to five years) that is substantially different from their CAP. As a result, investor communication is geared more toward internal company-based expectations rather than external market-based expectations. If the determination of stock prices is approached with an economically sound model, the concept of CAP becomes immediately relevant.

Appraising San Teh

San Teh’s cement business continues to be its main revenue driver. Riding on to its excellent FY06 results, FY07 has also proven to be a successful year. Since FY04, the cement business has returned to the black after many years of losses. Turnover of the Group rose 26% to $162.7 million and profit after taxation improved 14% to $11.9 million. Sales in cement operation went up by 31% to $128.3 million and the operating profit increased 39% to $21.0 million. The average cement selling price was higher at RMB256 per ton as compared to RMB240 per ton in FY06. In FY08, the average cement selling prices are expected to hover at around RMB250 to 260 per ton on the back of strong fixed-asset investment and GDP growth in China. Profits have continued to be depressed in the plastic division due to the rising PVC resin prices. The low occupancy rate in the newly opened hotel in Suzhou has resulted in a loss for the hotel division in FY07.

Since 2006, the government of China, through The National Development and Reform Commission (NDRC) has started closing down the smaller size cement companies with outdated capacity. Such a drastic step from the government is a very important factor for the China cement industry in the next few years. Although new capacity supply should stay at high levels, the volume of outdated capacity being shuttered should keep net capacity increases low compared with the increase in new demand. Oversupply should gradually ease in the next few years due to the above reason. The main objective for closure of outdated capacity is to reduce discharge and save energy as the remaining players have a more efficient manufacturing process and at the same time weed out all rouge companies operating without permit from the government.

Due to the fact that the existing plant in Fujian Longyan is running at full capacity, the management has decided to build a new cement plant in Dali with an output per year of 1 million tones. It is expected to contribute positively to the bottom line starting from the second half of FY08 onwards and also around 33% of the cement revenue from FY09.

San Teh is in the process of preparing their cement operation for a listing on the Shanghai Stock Exchange by end of this year. Recently, one of the three largest cement groups in China, the Southern Cement Group, together with the other three institutional investors, have invested RMB72.0 million for a 6.67% interest in San Teh’s cement operation. Based on this, the whole cement operation is estimated to be worth a whopping RMB1079 million (S$210 million). Assuming the plastic and hotel business is worthless as they are making losses, San Teh's share price should be at the S$0.72 level.

The current share price is significantly below San Teh’s NTA of S$0.93 as at 31st December 2007. Given the potential events described above taking place in the near future, this huge price discrepancy is unjustifiable. The group’s financial position is healthy and the expansion strategy is right on track to become a mid sized cement manufacturer. This discount gap should narrow considerably once the cement operation has been listed successfully.