Olam case shows knowledge is vital

Just to highlight that this article is written too simplistically! Knowing a business is not simply understand the basic parts, but one must dig deep into the business model, numbers and other aspects. She makes it sound as if scuttlebutt is the only skill necessary to invest safely, but I think it's rather misleading!

For Olam's case, the lack of FCF over the years, high debt and tiny net margins would have sounded alarm bells for most prudent investors. Her idea of a good investment seems to be "double-digit growth rates". In, ahem, profits and not FCF I guess?

The Straits Times
www.straitstimes.com
Published on Dec 02, 2012
Small change
Olam case shows knowledge is vital
Detailed attacks have cast doubt on a seemingly sound stock

By Lee Su Shyan Money Editor

News of Olam International's troubles last week sent a shiver down my spine. If even such a respected, seemingly sound stock could be questioned, where is it safe to put my money?

Yet, Olam would have been a reasonable and sensible pick for share investors. It shows double-digit growth rates and is a leader in what it does. It is, for example, the world's second-biggest rice trader.

One of its largest shareholders is Temasek Holdings and it is a well-established company.

There is extensive coverage of the firm by research analysts and the media. The company has won a slew of corporate governance awards. It is helmed by long-time chief executive Sunny Verghese, who has taken home many best CEO accolades.

Yet the detailed attacks by Muddy Waters and founder Carson Block cannot help but sow doubt in investors' minds.

Muddy Waters and Mr Block allege that hundreds of millions of dollars have been spent on various acquisitions around the world that do not quite come up to scratch.

Muddy Waters also contends that much of Olam's profit comes from propping up asset values rather than good old-fashioned sales.

Its arguments are lent further weight when it reveals that it commissioned investigators on a three-month assignment to check out various Olam investments in Africa.

No retail investor would be able to do research on the same scale, which is why the risk is that some of the mud it throws at the company will stick.

I came across Olam not long after it listed in 2005 and was impressed with how it had developed a network among small coffee farmers in Africa, for example. Olam was able to collect their output and combine it to supply coffee beans to the likes of Nestle.

That supply chain ability was part of its early success. The business has grown to span operations in 65 countries, including many in Africa, with a much-expanded range of commodities.

Olam has also expanded the scope of its business and now operates in plantations and forestry concessions.

It has become a more complicated group. An investor would need to understand tomato processors, flour mills, fertiliser plants and cotton farms in overseas locations.

Is it any wonder that a retail investor, confronted with the ongoing arguments, throws his hands up in frustration and seeks refuge in buying property in Singapore?

That may be an extreme option, but buying property reflects what the investor feels - he understands what he's buying.

In other words, buying that condominium unit, be it in Bedok or Woodlands, makes sense to that investor simply because he's grown up nearby, he is familiar with the facilities and he knows where the schools are.

By contrast, understanding a stock such as Olam, even with everything being above board, seems less straightforward.

Many investors' eyes will just glaze over at the mention of negative goodwill and "biological assets" - that's plantations, crops and animals to you and me.

That is why it is so easy to lose confidence when a damning report is issued.

Olam's troubles are a reminder that retail investors should understand what they invest in.

For starters, some listed companies have mostly Singapore-based operations and have business models that are less complicated.

Take CapitaMall Trust, which has properties such as Junction 8, Raffles City and Tampines Mall in its portfolio. If it charges higher rents and more people come to the malls, profits will surely rise. Assessing whether their financials make sense can literally be done as part of a weekend shopping trip. Are most shops doing well? Are they packed on weekends but not on weekdays?

Or Mapletree Commercial Trust with its VivoCity. Any investor can rest easy seeing the crowds that throng the mall at the weekend.

Another listed company with Singapore operations is supermarket operator Sheng Siong. Simply visit its outlets to see if the cash tills are ringing.

An investor's familiarity with the properties could be one of the reasons why Far East Hospitality Trust has done better than Ascendas Hospitality Trust.

Ascendas is a well-established name, but perhaps retail investors are more confident because they can see and relate to Far East's Landmark Village Hotel and Orchard Parade Hotel better than Ascendas' Australian assets.

Investing solely in your own backyard is not feasible. Many Singapore-listed companies have grown such that they rely on contributions from overseas markets.

Still, a closer look will show that large-cap names like the banks - DBS, OCBC, United Overseas Bank - or property players such as City Developments still have a fair bit of Singapore exposure.

For property developers, there is a slew of data available - more than enough to gauge how the firms are doing. Another check will be to go and take a look at how their developments are progressing.

No investment in equity can be a sure thing. But understanding the business is an important step in making sure you can sleep easy at night.

sushyan@sph.com.sg

Just curious. Is there examples where a company undergoes many years of incubation period of -ve FCF from the start, and become big winner later due to this strategy ?

(02-12-2012, 07:59 AM)corydorus Wrote: Just curious. Is there examples where a company undergoes many years of incubation period of -ve FCF from the start, and become big winner later due to this strategy ?

yes, there is.

The United States of America, if you consider it as a company.

(02-12-2012, 08:19 AM)freedom Wrote: yes, there is.

The United States of America, if you consider it as a company.

That's a country, not a Company. USD is also the reserve currency so they can print their way out of problems.

With Singapore being run like a corporation, perhaps Singapore is as close as it gets to a country resembling a company!

Cory,

Biotech, junior mining explorations, tech start-ups, etc.

Cash burn, cash burn, until heart burn. Then if got lucky, 100 baggers!

But that's the realm of private equity and venture capitalists. 100 speculations, 99 fail, 1 succeed; happy like bird!

These are companies Warren Buffet won't invest in

Having said that, early "investors" of Facebook made a pile unloading during IPO.

Many ways to skin a cat I guess.

[Image: olama.jpg]

The dollars and sense of the Olam saga

When a company comes along and sells us a dream, it may turn out to be a nightmare if investors are not so savvy

WHAT'S the most lucrative business in this world that craves progress, growth and a better tomorrow?

It is that of selling a dream. The more grandiose the dream, the bigger your business can grow. World domination is always a good dream to sell.

Time and again, a company comes along and sells us that dream. It shows some initial success, and we are sold.

The business can "grow" for as long as people subscribe to the dream - that is, until a kid comes along and points out the emperor's new clothes, metaphorically speaking. It is at this point that the emperor must show that, indeed, he does have some threads on him.

But as in most things in life, once doubt is sown, once an aura is broken, it is difficult for people to get back to the prior "dreamy" state.

It feels just like that in the case of Olam - quite the darling of the Singapore stock market until the assertions made by Muddy Waters Research against it.

The weight of finance literature is on the side of Muddy Waters. Olam checks almost every box for why investors should avoid it, yet it continues to win over investors, fund managers and analysts. The few critics who were silenced clammed up either under pressure, in awe, or blinded by charm.

As an academic exercise, let's go through a list of things about Olam which could have raised the red flags for an investor:

First, let's look at its published accounting numbers. One of the basic things to look out for in analysing financial statements is to compare the net profit figure with cash flows generated from operations.

If net earnings are going up year after year, but the cash from operations is trending down, it is a cause for concern. This suggests that the earnings are not being backed up by real cash generated from operations, and that the profits may be inflated.


Chart 1 shows Olam's net profit, cash flow from operations and free cash flow since 2004. In that time, its reported net profit grew from $48 million to $371 million - an impressive compounded growth of nearly 30 per cent a year for eight years.

Olam's chief executive, Sunny Verghese, and his management team gave their board of directors and shareholders the commitment to double the company's earnings every three years. It seems they have delivered on that commitment.

But wait. The reported profit is but an accounting number. Is it backed up by real cash generated by the business? Of the past nine years, Olam generated positive cash flow from its operations in only three years. Between 2004 and its last financial year, its operations ate up $3.4 billion cash, versus its aggregate reported net profit of $1.89 billion.

Its free cash flow - cash generated from its business minus capital expenditures and new investments - in the past nine years amounted to a whopping negative $5.2 billion.

And it is funding all this with an ever-increasing debt. The group's total liabilities grew 10-fold in the past eight years - from $1.05 billion to $10.3 billion.

Yes, Olam is building for the future. But its business has to start paying back at some point - which doesn't look like anytime soon. And Muddy Waters' reports have shortened investors' and creditors' patience.

Second, capital discipline. James Montier, an astute analyst, put companies that have grown their total assets by more than a double-digit percentage on his potential shortlist. That, combined with a high price-to-sales ratio and deteriorating fundamentals (as measured by a low Piotroski F-score), make for a potent mix, he says.

In the past eight years, Olam's total assets grew by an average 38 per cent a year.

Creating value

I am always wary when a company goes on an acquisition spree. It usually means growth is slowing in its underlying business, and it is trying to pad it up with acquisitions.

If a company is valued at 15 times its earnings, and is able to acquire a business at eight times earnings, it can "create value" just by consolidating the earnings of the acquired business into the group earnings.

In late 2006 and early 2007, Raffles Education made a string of acquisitions. It bought Oriental Century, Easycall, Auston and Hartford. Raffles Education, if readers remember, was a high-growth stock which was valued at 50 times earnings then. News of its acquisitions increased the combined market value of these companies by some $1.3 billion in a few short months.

In this column in February 2007, I asked: "When so much 'wealth' is created in such a short time just by shuffling papers from one company to another, one has but to take a step back and ask how that is possible - even for a company with REC's impeccable record."

Third, a complex business few people totally understand. We keep being told by wise investors: Put your money in something you understand. Investors who put money in derivatives and structured products that they didn't understand - see where that got them? If one wants to bet on something uncertain, work in a higher-risk premium.

Fourth, a superstar chief executive. Empirical studies have shown that award-winning CEOs subsequently underperform, both relative to their prior performance and relative to a matched sample of non-winning CEOs. The underperformance is between 15 and 26 per cent.

At the same time, they found that these superstar CEOs extracted more compensation following the award, both in absolute amounts and relative to other top executives in their firms. They also spend more time on public and private activities outside their companies, such as by assuming board seats or writing books.

The incidence of earnings management increases after winning awards: the effects are strongest in firms with weak governance, even though obtaining superstar status is independent of corporate governance.

Anyone who has met Mr Verghese would know he has off-the-charts intellect. He is articulate and makes a lot of sense. He seems to know Olam's business inside out, outside in. He has all the numbers at the top of his head. Coming face to face with a person like that, it is hard not to defer to them.

This has reinforced my conviction that meeting company management is a dangerous thing.

Based on just the four points above, no true-value investors would be attracted to Olam. Some less-than-true-blue value investors could be persuaded. The commodity angle is sexy. The profit-and-revenue track records have been impressive. The CEO is smart. The company has the endorsement of Temasek.

As of now, the tussle is still in the domain of public opinion. Going forward, Olam will have to show real results. In the business world, real results means bringing in the profits, bringing in the cash. Following this, investors and creditors will get more critical.

Life has gotten tougher for Olam. "Success" has its price.


•The writer is a CFA charterholder

http://www.businesstimes.com.sg/premium/...a-20121201

(02-12-2012, 07:59 AM)corydorus Wrote: Just curious. Is there examples where a company undergoes many years of incubation period of -ve FCF from the start, and become big winner later due to this strategy ?

I have invested one probably

The company OCF is negative after invested in BOT projects 3 years ago. The cash is piling up as receivable. Much of the capital raised also invested into new BOT projects which have long ROI

The business model is not as complex as Olam, and the future gain is also much secured than the Olam's biological assets.

Next target of MW?

I dun wish to be long winded but knowing what you invest in is half a battle won - at least when you lose money you can't blame others for the risks that you assume.

Unfortunately, in this game of investment, most people want to make $ fast and wouldn't mind risks taking.

In this game of stock market, there is always darlings to be found in each cycle and these darlings are usually different from the previous cycle. Darlings are usually themes and this time round Myanmar concepts are the in-thing while Chinese stocks that were previously darlings were either in the dog-house or in the rubbish tip. Most darling chasers are driven by greed and usually disregard fears that accompanied it.

When the fear factor sets in, then darlings will one day become unwanted child. For value investments that this forum advocates, it is the hard work and patience that are being invested in the unloved and boring companies that will eventually reward the investor. It is painstaking and sometimes the rewards wouldn't show up until years later.

Ever wonder why companies are being taking private as oppose to delisted due to financial difficulties - cause their operational cashflow is simply too strong to keep it listed. Such privatisation usually entails rewarding substantial buyout premiums that even rewards investors that are taking them private (Cerebos and even Hersing are recent cases).

Hence knowledge is indeed vital when it comes to investments. However how much each investors choose to know will depend on each individual and what are their expectation of returns vs risks.

There must be enough meat for MW to target lol.

not to defend Olam.

Muddy Water's research report on Olam has more opinions than facts. Some of those little facts are also difficult to verify, and the sources are hardly reliable. Luckily, Muddy Water is not a newspaper company, otherwise, it is quite easy to be buried.

To call Olam not worth investing is easy to believe. To call Olam outright fraud, Muddy Water has a long way to go.

at right price, Olam could be a very good special situation play.