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Business cycles — successful reinventions and those that fail

Tong Kooi Ong & Asia Analytica
Tong Kooi Ong & Asia Analytica • 17 min read
Business cycles — successful reinventions and those that fail
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We invest in equities on the expectation that companies will create value, leading to higher share prices and returns for shareholders (from the capital appreciation as well as dividends). And most companies generally do — create value for shareholders, that is — albeit to differing degrees.

Typically, shareholder wealth increases when the company’s profits are growing (for instance, through higher sales, cost savings, increased efficiency and productivity) and/ or valuations are rising (when investors become more confident in the stock because of proven management, good governance and improved earnings prospects).

Unfortunately, there are also companies that destroy shareholder wealth. This typically happens when companies suffer from falling profits or are making losses, demonstrate weak corporate governance resulting in loss of investor confidence in its growth outlook and integrity, and so on. The thing is, aside from cases of outright fraud, many of these value destroyers — whose share prices are in secular decline — did not start out as such. In fact, some were incredibly successful in the past, dominating the industry they are in domestically and even globally. How does a successful value creator turn into a company that destroys shareholder wealth?

We wrote about S-curves some weeks back. All businesses go through the S-curve life cycle, from infancy (low growth) to expansion (rapid growth) to maturity (low growth) (see Chart 1).

Obviously, some S-curves will be steeper than others, that is, their products have stronger rates of growth — for instance, owing to a major innovation that drives rapid adoption and demand across multiple market segments (market size). And some S-curves will have greater longevity, that is, sustained high growth (expansion phase) for a longer period of time because of, say, intellectual property protection or strong network effects. In other words, enduring competitive advantage. As we explained in a previous article (see “Can the superheroes, the Magnificent 7, hold up the bull market?”, The Edge, March 11), companies that have a steeper S-curve with longevity will also trade at higher valuations (share prices) (see Chart 2).

See also: The stocks in our Malaysian portfolio, and why they are there

Inevitably, though, no matter how successful the product is, growth must slow at some point (the maturity phase). This could be due to a number of reasons, such as increased competition, market saturation, technological disruption, regulatory changes and changing consumer preferences.

Ultimately, whether a company remains value creative or destructive depends on how well management understands this inevitability, its mindset and how successful it is in creating new S-curves — developing new engines of growth — ideally before the current cycle of growth reaches maturity (see Chart 3). New S-curves could include tapping into new selling channels and geographies for the existing product, or it could be expansion into a related business — for instance, starting a new product line and going upstream or downstream, or diversification into something entirely different (unrelated).

See also: Leave money on the table if you want investor participation

In short, the S-curve is dynamic over the company’s life, that is, the company should continuously reinvent, reinvest and create new S-curves to start new growth cycles. We see real-life examples of how this is done every day, and we will highlight just a few here. Chart 4 tracks the historical revenue for Press Metal Aluminium. The company started as a local aluminium extrusion producer in 1986. In the early years, sales were driven by gradual expansion of its market, including overseas. The first big S-curve jump came in 2006/07, when it moved upstream, initially by acquiring an aluminium smelter in Hubei, China, and then leveraging the experience gained, developing Malaysia’s first smelting plant in Mukah, Sarawak. The plant was commissioned in 2009, generating rapid sales growth for the next few years.

As growth started tapering off, Press Metal created the next S-curve with a second smelting plant in Samalaju, Sarawak, in 2012 — which hit full capacity in 2014 — and then, again, with a third plant (Samalaju 2) in 2015. Utilisation and ramp-up of Phase 3 at the Samalaju smelter reached full capacity in 2021. With each expansion, sales went through a rapid growth cycle — the company expanded into more markets, including listing its ownbrand aluminium ingots on the London Metal Exchange and securing new customers on long-term contracts.

Press Metal reinvented new S-curves through vertical integration and expanding into new markets through additional selling channels and geographies as well as widening its product range (customers in different sectors).

YTL Corp, on the other hand, has taken a different route — generating new cycles of growth via diversification into different sectors and businesses. The company started in the construction business, initially for defence and security installation, then property development and infrastructure. Its first major S-curve jump came in 1993, when it was awarded Malaysia’s first independent power producer (IPP) licence.

For more stories about where money flows, click here for Capital Section

The power plant generated significant cash flow annually, helping YTL Corp build a huge war chest of cash, which it subsequently invested into different businesses, and notably acquiring assets at bargain prices during periods of economic downturn. Case in point: the acquisition of Lot 10, Starhill and JW Marriott Hotel at the height of the Asian financial crisis. The next notable increase in sales came with the acquisition of UK-based water and sewerage operator Wessex Waters in 2002.

Another new S-curve was created when YTL expanded its power generation business into Singapore, acquiring one of the country’s largest power generators, PowerSeraya, in 2009. And when Singapore liberalised its power retail market, with the launch of the Open Electricity Market in 2018, the company expanded its power business downstream, selling electricity directly to customers (under the Geneco brand).

Over the past decades, YTL has also expanded its construction-infrastructure business upstream into cement manufacturing and acquired assets in the hospitality sector, including hotels and shopping malls in Malaysia, Singapore, Japan, China and Australia — creating new engines of growth with each venture. The newest S-curve is its data centre-accelerated cloud computing investments in Johor, powered by Nvidia’s high-end artificial intelligence (AI) chips and software.

As we said, the S-curve is dynamic over the company’s life. Each S-curve has a lifespan and, to continuously increase shareholder wealth, the company must keep reinventing and reinvesting in new S-curves. As we saw, both Press Metal and YTL have been successful in creating new engines of growth. But, obviously, previous success does not guarantee future success. And when companies fail to find the next successful S-curve to replace the existing mature product cycle, value creators can turn into value destroyers. Case in point: the Star Media Group.

Star had built a strong franchise in traditional print media and broadcasting (radio), and as the dominant news media company — the largest paid English newspaper in the country — it had, for a long time, garnered the lion’s share of ad revenue. The company was highly profitable for years, building a cash pile from its strong cash flow and also rewarding shareholders with steady dividends.

Then came digitalisation, which severely disrupted the print media industry worldwide. Vast amounts of news content were available on social media and online platforms such as Facebook and Google. Digital news is on-demand, conveniently accessible by anyone with a smartphone and mostly for free. News updates were near instantaneous, reported as they happened in real time and augmented with videos — and, in many cases, interactive, translating into significantly higher user engagement and improved experience. Newspapers, on the other hand, became literally and metaphorically yesterday’s news. Print media simply could not compete with the network effects and near-zero marginal costs of digital platforms.

Star hit the top of its print media S-curve — readership and circulation started falling and the newspaper increasingly lost ad revenue to digital platforms. For more than a decade thereafter, the company struggled to find a new S-curve. Between 2012 and 2018, it spent a lot of resources — time and money, including selling good assets to raise cash — investing mainly in other media platforms such as TV and video-on-demand, and putting their content online. Its scattered, piecemeal efforts — the lack of a macro game plan — failed to yield any return and were sold or written off as losses.

Sales and cash from operations spiralled into free fall (see Chart 6). Star then appeared to shift its focus back to its print media business, attempting to reverse its downward trajectory in an industry that has been irrevocably disrupted. To conserve cash, and pay a bumper dividend to shareholders in 2017, it sold profit-generating asset, Cityneon, offered multiple voluntary separation schemes and, finally, retrenchment in 2020. Not surprisingly, the print business did not turn around, and cash from operations shrank sharply in the following years. The company has basically generated near-zero return on assets since 2017.

Star’s latest attempt to create new growth engines is to diversify into property development and yet unknown new businesses. We have done the number crunching for its maiden development, Star Business Hub, and concluded that the project is value destructive — Star could make more profits simply by selling the vacant land (that it owns). Investors were not impressed.

Its share price tanked, along with sales, profits and dividends. The board of directors has a fiduciary duty to act in the best interests of the company and all its shareholders, not just the controlling shareholder. Surely that includes an obligation not to destroy shareholder value? And one must ask, what legal recourse does a minority shareholder have in such a case as Star’s? (see Box Article 1)

Box Article 1: What recourse is available to minority shareholders when  directors and management destroy the company’s value?

Directors and management of a company have a fiduciary duty to act in the best interests of the company. Case law has clearly stated that “company: means the shareholders as a whole, including minority shareholders. This is a legal obligation that is specifically addressed in sections 210 to 234 in the Companies Act 2016. A director must exercise reasonable care, skill and diligence when making a business judgement. The decision must be made in good faith, in the absence of conflict of interest and in the best interests of the company. There are similar provisions in the Securities Commission Malaysia’s Guidelines on Conduct of Directors of Listed Corporations and their Subsidiaries — intended to promote the proper discharge of directors’ (that includes the chief executives for operations-financial management of the company) fiduciary duties.

Here is our question, taking the Star Media Group as an example: Has its directors and chief executives breached their fiduciary duties by both their actions and inaction for more than a decade — for their unjustifiably poor decisions that have led to losses for the company and, by reducing the value of its shares, destroyed value for shareholders?

As we highlighted in the main article, Star has wasted precious resources (time and money) on various investments since 2012 — without a comprehensive game plan and a clear path to profitability. Almost all its investments were not profitable and eventually sold or written off as losses. It has also failed to articulate a reasonable plan of action to turn around the newspaper. The print and digital business was in the red in four of the past six years, and barely profitable in the other two years, simply burning cash in the process. Its latest “turnaround plans” were equally lacklustre, including introducing a Malay newspaper (a segment in which it has little competitive advantage) and developing property on land it owns, when simply selling the vacant land would bring more profits.

Its share price has collapsed from RM4.13 in 2010 to the current 42 sen — its market capitalisation has fallen from RM3.1 billion to just RM308 million today (less than even its net cash of RM351 million), meaning it has lost a whopping 90% of its value. Annual dividend was reduced from 18 sen per share in 2014 to 2016 to two sen per share in 2019 and none in 2020 and 2021, before recovering marginally to one sen per share in 2022 and 2023.

We would like to remind nominee directors that they must always act in the best interests of the company, that is, the shareholders as a whole and not just in the best interests of their nominator, the controlling shareholders.

If the Malaysian Chinese Association, as controlling shareholder, wants to do something in the public interest that benefits MCA, they cannot use Star to do so, unless there is a tangible benefit to Star from doing so.

An example of good corporate governance is the restructuring at Singapore Press Holdings (SPH) in 2021. Since the media unit was deemed strategically important in Singapore, it was taken private, into a non-profit company limited by guarantee. The rest of SPH’s assets (mainly real estate) were sold and all proceeds returned to shareholders, unlocking substantial value for minority shareholders.

Directors can be liable for breach of fiduciary duty if they consistently hurt the interests of the company — especially where there are conflicts of interest — and fail to adequately consider the interests of minority shareholders. In Malaysia, this legal provision has not yet been tested in court (and perhaps should be). The reason for this is that any breach of fiduciary duty by a director is owed to the company and not any shareholder. Therefore, the plaintiff is the company, not the shareholder. It is hard to imagine a director of a company initiating a suit by the said company against himself. This is why such actions happen only when there is a change of shareholders of a company with a reconstituted board, and then the new board sues the old board. A possible exception is if it can be proven that a majority of the directors are the wrongdoers and in control of the board — in which case, a shareholder can bring a derivative action in the name of the company as a nominal plaintiff.

The courts may also play a constructive role in improving corporate governance and enforcing shareholder rights if they start awarding costs on an indemnity basis to litigants who succeed, and these costs are borne by the directors, who were remiss, not the company itself. This helps create the right environment for responsible behaviour of corporate directors.

It is also to be noted that a minority shareholder with a stake of at least 5% can prevent the reappointment of an auditor of the company as well as the right to request and inspect the service contracts of the company’s directors, among others — as a means of check and balance on majority shareholders. Shareholders can act in their own interest; they are not obliged to act in the best interests of the company.

End of Box Article — 

In reality, all businesses face the risk of truncated growth cycles. Star’s business model in print media was effectively destroyed in the digital age, by technological disruption and shifting consumer preferences. For the majority, however, S-curve maturity typically happens in far less dramatic fashion, often when companies fail to innovate and/or adapt to operating environment changes to stay ahead of the competition. The risks are particularly acute for businesses operating in industries with minimal barriers to entry — and especially where minimal skills are required and cost is the primary competitive advantage.

We think local players in the paper milling and paper packaging (corrugated cartons) industry is one such example. Muda Holdings is one of the leading integrated paper manufacturers in the country. But sales have come under severe pressure from the entry of Chinese paper producers, whose presence in the global market, operations and market size are multiple times larger. When there is little to differentiate your product from those of your competitors — that is, near commodity-like — economies of scale (cost) become the biggest competitive advantage. And a price war will just eat away already wafer-thin margins. Muda fell into the red in 2022/23 (see Chart 7).

Malaysian glove makers may be in a similar situation. The Covid-19 pandemic was both a boon and a curse. The sudden sharp jump in demand and profitability attracted many new players into the market while existing producers also expanded capacity, notably in China and Thailand (see Chart 8).

Even after prevailing excess supply is taken up, we suspect that Malaysian glove makers will not regain their previous market dominance. In the best-case scenario, future growth will have to be shared among many more players, and we think the Chinese glove makers are particularly cost-competitive. In the worst-case scenario, our local companies will continue to lose market share, in the absence of any material competitive advantage.

Positively, the glove makers have amassed substantial cash piles from the massive profit surge during the pandemic. Whether they follow the route of Press Metal and YTL Corp or that of Star depends on what the companies do next — and how successful they will be in navigating the likely end to their existing S-curve cycle, and the creation of new growth drivers for the future. If we must take a position today, we think most are likely to follow the path of Star — that is, sell good assets, continue to invest in what the company knows but is already disrupted (often, those who are closest to a topic of interest fail to see the forest for the trees) and running down its cash pile, eventually trying to diversify and further wasting cash resources needlessly, instead of redistributing the cash to shareholders as it probably should, in the interests of all shareholders.

Box Article 2: ‘Imitation is the sincerest form of flattery’ — Oscar Wilde

Since last December, we have written three articles on the persistently low valuations of companies listed on the Singapore Exchange S68 -

(SGX) and Bursa Malaysia. We listed some of the fundamental and structural reasons for this. If left unresolved, it has the effect of not only marginalising our capital markets and denying their effective use as a financial intermediation for fund raising but also the cumulative effect of denying our overall economic growth and employment opportunities — hence the need for attention, focus and determination to find solutions for this low-valuation phenomenon. Obviously, some low valuations are appropriate for low-growth companies. The basis of our analyses of low valuations was justified on, primarily, the price-to-book ratio — that is, stocks are being valued at discounts to the breakup value of their assets. The fact we relied upon was that, of the more than 600 stocks listed on SGX, only one-third are trading above book value.

We have included the QR codes for all three articles here, as well as excerpts from each article.

We are glad Singapore Business Times (SBT) has also taken on this issue in a recent article (see QR code 4).

Perhaps SBT imitated us; perhaps it did not. Regardless, we are glad more voices are added to this crucial debate. Our interest in writing this column is to make positive contributions and we welcome anyone who agrees with our views and ideas to join our efforts to make the stock markets in Malaysia and Singapore perform better than they have.

— End of Box Article — 

The Malaysian Portfolio gained 0.6% for the week ended April 3, with all three stocks closing higher. Insas-WC was the biggest gainer, up 6.4%, while Insas gained 1%. Total portfolio returns now stand at 190.4% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 16%, by a long, long way.

Meanwhile, the Absolute Returns Portfolio is down 0.4% last week, on the back of selling pressure in the US market. The notable gainers were Itochu Corp (+3.2%), Tencent Holdings (+2.1%) and Berkshire Hathaway (0.8%) while Airbus (-2%), Swire Properties (-1.9%) and Sun Hung Kai Properties (-1.7%) were the big losers. We have adjusted our investment cost for Swire (72 Hong Kong cents) and Itochu (80 Yen) for dividends. Total value for the portfolio is down marginally, by 0.2%, since inception.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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