Event/Catalyst- driven Value Investing in China

In times like now when global macro uncertainty is high and valuation is nearly depressed for most stocks, it’s not hard to find “cheap” stocks. The really hard part is how to construct an investment case in which downside risk can be quantified as objectively as possible and thus limited, while upside reward can be quite significant with great certainty and could be further enhanced if some extraordinary things happen. 

Investing is essentially about getting two things right: magnitude of upside vs. downside and probability of upside and downside.  In our experience, thoughtful analysis of events/situations (that have occurred) and identification of appropriate catalysts (that will likely occur) can come to help in big way.

We look for positive corporate events that are very specific to the firm itself and quite independent of macro or policy changes. These events/situations, if our analysis proves correct, tend to create 1) rising market interest and above average trading liquidity that effectively put a “floor” under the stock and provide immediate trading upside; and more importantly, 2) an opportunity to structure cheaply priced or even free “calls” to participate in potential “home runs”, thus eliminating risk of permanent loss of capital. Such events typically include legal outcome, regulatory changes, new market entry, new product development, R&D breakthrough, spinoff/splitoff and other recapitalizations, M&A, etc.

On the other hand, to improve the odds of “home run” scenario to occur, we focus on discerning significant mis-pricing opportunities and potential catalysts to narrow valuation gap. Mis-pricing typically occurs on two occasions: 1) when the market is short-sighted and ignores compounding power of a great business; 2) when the market is stuck with stale view about a business but completely misses inflection points reached in that business’ transformation underway. By digging deeper to understand the underlying business and detect what the market likely misses, we turn our investment hypothesis into conviction and gain better insight into both magnitude and probability of upside scenario.

Our recent investment in Guangzhou Pharm is one of such examples using event/catalyst to help frame our invest thinking and create a synthetic call on potential “home run” upside at a very attractive price.

The core business of Guangzhou Pharm for the moment is traditional Chinese medicine (TCM) manufacturing. It is also a major regional healthcare distributor inSouth China. With key raw material prices retreating from cyclically high, earnings growth for the core business is just starting to rebound from the depressed level. It recently announced the merger with a sister company Baiyunshan Pharm, further streamlining its core operation. Despite regulatory headwinds still not letting up in the immediate future forChina’s healthcare industry, TCM is favored by the government policy and healthcare remains a secular growth industry given aging population and rising income standards inChina. On conservative basis, Guangzhou Pharm’s healthcare business should be valued anywhere between HK$8-10 per share, or 15x 12M forward-looking earnings.

Between April and early May, the stock had surged from HK$6 to just under HK$10. Excellent 1Q12 earnings and announcement of merger with Baiyunshan Pharm were two drivers. However, the market had been also speculating on a positive legal outcome for Guangzhou Pharm to take back the brand ownership of Wang Lao Ji (WLJ).

 

Originating from 175 years ago in the Dau Guang period of the Ching Dynasty, Wang Lao Ji tea was used as herbal medicine drink to prevent inflammation inSouthern China. With honeysuckle flower, licorice roots, chrysanthemum and other herbals, the red can Wang Lao Ji has a discernable herbal taste. It has become the best selling herbal tea brand inChina, boasting annual revenue of Rmb 16bn in 2011, exceeding even Coca-Cola’sChinasales.

On May-11th of 2012, the verdict finally came and Guangzhou Pharm won the case. Without surprise, the stock jumped higher on the day of announcement and rose above HK$12 but then quickly retreated to below HK$10. The market got confused with details of the verdict and started to question Guangzhou Pharm’s capability to roll out its own WLJ products in time and ability to maintain significant enough market share.

To us, this was simply a rare opportunity to buy into the most valuable consumer brand inChina, which by some estimate could be worth over Rmb 100bn, at a very cheap price. As frequent travelers toChina, your manager has his first-hand observation how high WLJ’s brand awareness insideChinais. Our proprietary research also verified that during the previous negotiation, Guangzhou Pharm once demanded royalty fee of over half a billion yuan a year as alternative settlement. Using that as a reference point, we figured out WLJ’s brand to Guangzhou Pharm should be worth at minimum Rmb 8bn or 15x royalty stream. On per share basis, that would add HK$7 to the current stock price. Later on, Guangzhou Pharm announced its ambitious plan of achieving Rmb 30bn annual sales of WLJ branded products in five years and Rmb 60bn sales by 2020. While it’s hard to tell how much value the WLJ brand can be ultimately realized by Guangzhou Pharm, it’s become quite clear that, even under mediocre management which Guangzhou Pharm managers might very well be, WLJ brand should be worth more than Rmb 8bn that a fair licensing deal would indicate.

Our average price paid to acquire Guangzhou Pharm stocks was between HK$11-12. We might have missed the stock when it was trading well below HK$10, but at that time, without access to insider information, which is illegal anyway, and without litigation analysis, of which we’re not experts, it’d be just a speculation as its core business can only offer limited upside. However, the legal event puts a “floor” under the stock around HK$10. Therefore, it’s now a very cheap “call” on something quite big. We think the stock is more interesting at HK$ 11-12 compared to several months ago when it was below HK$10, as it has largely eliminated risk of losing permanent capital and raised the odds of upside occurring. In other words, the legal event improved reward/risk profile and converted a perhaps so-so speculation into a superior investment opportunity.

Why does such opportunity exist in the first place? It happens because the business is at an early stage of a major transformation. The market is unwilling to give much credit to the management at the moment. However, by securing the ownership of WLJ brand, Guangzhou Pharm has now reached an inflection point where it now has a great brand platform to transform from an average TCM manufacturer to a full-range wellness-oriented food & beverage company under the nation’s #1 brand of Wang Lao Ji. Over the next several years, each time when WLJ sales reach a major milestone, such as hitting first Rmb 10 bn sales target, first time breakeven for the red-can WLJ tea, first new product developed outside herbal tea, etc., these events will form positive and significant catalysts to keep moving the stock up towards fair value of WLJ’s brand equity. 

 

 

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