Logic of JD Capital:No One-For-All Answer for Investment
2015-05-20
WU Gang, founding partner of JD Capital and Chairman of Tongchuangjiuding Management Co., Ltd. (JD Group). This is an excerpt of the speech WU delivered during his visit to Southwest University of Finance and Economics in May 2015..
Introduction
The pursuit of sustainable, stable yet high earnings has always been the theme of our investment practices. The past experience suggests that 80% of the failure came from the financial fraud. Hence, JD Capital has built a solid screening system to identify the frauds. Each time we invested in one project, we would scrutinize 10 first and get to know 100. The 241 projects JD Capital has so far invested meant 2,400 times of scrutiny and contacts with at least 2,400 companies. Moreover, the large amount of field trips also calls for quick and accurate judgment on the project quality. Unlike the secondary market, the primary market provides little room for bargaining and the valuation is normally at 8~12x P/E. However, investing in the secondary market is more about the price. Hence, JD Capital pays more attention to the company’s future development and only picks projects with potential EPS growth.
The dual-factor model for financial analysis
The model mainly focuses on ROIC (Return on Invested Capital) and growth opportunity. JD never invests in companies with high ROIC yet little growth potential.
The capital includes equity and long-term debts. With the focus on the ROIC, JD Capital has little concern for the capital structure, which could be adjusted without affecting the business model. ROIC, on the other hand, could better reflect the earnings indicators, such as EPS and ROE (Return on Equity). Companies investing the equal amount of funds in exchange of profit growth usually have low ROIC.
The growth opportunity normally refers to the companies with future potential after evaluating their ROIC. Some companies, despite high ROIC, fail to make efficient use of the incremental capital, which is usually left unused or distributed to shareholders. As a result, the EPS growth could not be sustained.
Three-tier model for corporate analysis
We usually conduct research and analysis from three perspectives. If we compare a company to a tree, the financial data would then be the branches and leaves at the top, business and products the trunk in the middle and the team and corporate governance the soil at the bottom. Therefore, the financial data is just a superficial result of business flow, while the corporate governance and team building is what really matters.
As the soil for a tree, the corporate governance plays a decisive role in the decision making. Generally, JD Capital classifies the corporate governance into several different types.
Stellar. In this type, the management team consists of one large shareholder and several small shareholders and those small ones would supervise the large one, which is a sound governance structure.
Team work. Just like JD Capital, companies adopting this type of governance have some large and capable shareholders working together.
Single superpower. Typical private companies only have one large shareholder holding the majority of the equity.
Equalitarianism. It is usually seen in those restructured SOEs, whose equity structure is highly dispersed.
When choosing the investment target, JD Capital would prefer the first two types and skip the others unless they are transformed into one of them.
As for the team building, JD Capital thinks highly of the entrepreneur’s ambition since only companies aiming high could grow strong. An ambitious entrepreneur is not all about making money, as his/her eager pursuit of success matters more. We have seen many proofs. The moral hazard may easily occur when those caring only about money suffered setbacks and some of them even chose to run off with the money. Also, these people would throw future opportunities away right after they made fortune profit. To steer clear of these entrepreneurs, we need to learn as much as we can from the conversation.
Surely, the ambition alone could not make it work. His/her capability, which usually means wisdom and diligence, is what JD Capital cherishes the most. Here, I want to say a few more here about diligence. From what I’ve learned, a diligent entrepreneur could always beat those who are not. Hence, diligence is just as important as wisdom. As a criterion for choosing the right entrepreneurs, rather than friends, it is often neglected by non-professionals.
The trunk – business operation. JD Capital normally conducts analysis from both the external and the internal perspective.
The external analysis focuses more on the macro things such as sector environment and cyclical fluctuation. JD Capital generally favors companies in fast-growing sectors. The cyclical fluctuation in demand could lead to changes in market size while that in supply would affect the company’s profit margin.
The internal analysis mainly looks from the competition side. To decide whether a company has core advantages, we need to conduct a thorough investigation on the overall competition pattern, i.e. to find out the company’s market share in sub-sectors and who its rivals are. By evaluating the company’s market positioning, target clients and regional positioning, we also need to determine its competitors and competitive advantages so as to explore its future potential. It is noteworthy that each company has its own major concerns in competition. For industrial companies, the cost always comes first. For consumer staple industry, however, their concerns would extend from cost to branding, distribution channels and management. JD Capital mainly focuses on the marketability, quality match with the target group, as well as the coordination among them.
Lastly, JD Capital would try our best to spot any financial fraud in our financial analysis.
The odds are that tier-1 investment institutions would find serious fraud in 20% of their projects. Our research shows that 80% of the failures in the PE sector were caused by financial fraud and only 20% by the occasional events like market environment change. Thereby, I believe the core competence required to invest in PE equity, especially SMEs, is identifying financial fraud. JD Capital has a well-established system to do so.
First, the pre-warning system trains our staff to be on alert for specific types of projects. The system has three levels, namely yellow, orange and red warning. According to the 33 conditions indicating potential fraud, companies found to meet a certain number of these conditions during our due diligence would receive more attention. For instance, any of the following circumstances is worth special attention: companies located in regions known for fraud; overly rapid response to due diligence; well-prepared documents in advance; delayed submission of required document; and entrepreneur always accompanied during interviews.
Next is our conventional weapon system, or financial index analysis. It includes the verification of original certificates and articulation. There is also the nuclear weapon system, which focuses more on the profit margin.
Last comes our organizational guarantee system. JD Capital takes a zero tolerance approach towards immoral behaviors by investment managers. Not only do we have professional ethical training, there are also strict punitive measures and supervision mechanism. Moreover, to build an incentive mechanism and performance evaluation system is of equal importance. All of these necessary measures could prevent our staff from turning a blind eye to the financial fraud.
It is important that the three systems be interdependent rather than separated during actual due diligence.
The verification and integration between finance and business
The estimates of financial statements. Before their visit to the company, people responsible for the due diligence would have no direct access to the financial statements. Instead, they are supposed to give their own estimates of the balance sheet, income statement and cash flow statement based on the company’s core business and revenue. It requires a thorough understanding of the business model and business operation. By doing so, we avoid any potential bias. The estimates would then be revised based on what we’ve learned from talks with employees in charge of recruitment, procurement, production and sales. Any major inconsistency between final estimates and the financial statements provided by the company calls for further analysis.
JD Capital sets a high bar for persons responsible for the due diligence. In addition to the mentioned work, they also need to conduct a reverse analysis on the business and sector at large based on the financial data. In this sense, they are masters of both business and finance.
Newton’s theory in investment
The very law of “investment excessive capital return rate = competitive advantage” might seem simple but could actually best reflect the equivalence between finance and business. It not only shows whether a company is worth investing in but also tells apart what’s true or not in the financial data.
For a specific industry, any company without core competitiveness yet with higher-than-peers excessive return rate might have something to do with financial fraud. We would also be on the alert when companies with no technical advantages have a higher-than-average profit margin.