Included in Li Lu's book, "Civilization, Modernization, Value Investment and China," are two detailed case studies of his early investments, which he shared during his 2006 lecture at Bruce Greenwald's Value Investing Course at Columbia University. I've read the notes posted by someone who attended the lecture, but found them too short and lacking in details. Li's book included the edited version of the full discussion of these two case studies. I personally think these case studies are very helpful.
Idea generation
Li loves reading Value Line and used to read it page by page. He paid special attention to the new low list. In the fall of 1998, he came across an interesting idea – Timberland Co., which is now part of VF Corp. (VFC, Financial). The first thing he does when he comes across a potential investment is look at the company's valuation. If it's not cheap, then he passes on the stock.
Is it cheap enough?
Timberland was trading at $28 to $30 per share and the earnings per share for 1998 was estimated to be about $5 per share. It was trading at 5.6 to 6 times earnings. The book value was about $23 per share, so on a price-book basis, the share was trading at 1.22 to 1.31 times book value.
What's in the book?
Li then analyzed the composition of the book value. At the end of the third quarter that year, Timberland's book value was about $300 million, of which about $275 million was operating asset. It had $100 million in cash and $100 million in fixed assets. If you dig a little deeper, you'll learn that most of the $100 million fixed assets was a commercial real estate building. And because the fourth quarter usually is the best quarter for retailers, he could confidently project that cash flow would be strong. So by the end of the fourth quarter, there would be more cash on the book.
Is it a good business?
The next thing Li analyzed was whether Timberland earned a high return on invested capital. Timberland's operating income margin was about 13%. At a revenue level of $800 million to $850 million, it earned about $100 million to 110 million in operating income. Invested capital was about $200 million, which included about $100 million in fixed assets. We can then calculate that the ROIC for Timberland was about 50%. It was a pretty good business.
Why is it cheap?
Li then asked the question: "If it's such a good business, why is it trading so cheaply?" It could be because of the Asian financial crisis, which has impacted Timberland's competitors such as Nike (NKE, Financial). He couldn't find any sell-side reports and thought that was interesting because it was a decent-sized and reputable company. Why weren't there any sell-side analysts covering it? Well, during the past 10 to 15 years, the company had never raised capital. It's also family-controlled, with the founding family controlling 40% of shares but 98% of the voting power. It also had a lot of litigations. Why were there so many lawsuits? Li downloaded all the court documents and read them. What he found was most lawsuits were about dissatisfied shareholders suing the management team for missing earnings guidance. The lawsuits also annoyed the family, so they decided not to deal with Wall Street anymore.
Is management honest?
The next question becomes whether the family is trustworthy. Li suggested to the students that they should act like an investigational journalist. Most entrepreneurs leave a trail for you to follow. You should spend some time and try to get contacts to their friends and family. You should find out what their neighbors say about them and what they have done for the community they live in. Li did just that. He found out that Timberland's founder was a simple and decent guy, and a high school graduate. He went to church regularly. He had a son who went to business school and was about the same age as Li. The son was slated to succeed his father as CEO of the company. Li then found out that the son was a board member of a non-profit organization called City Year, which was founded by Li's friend. So Li joined the board of City Year and became a good friend of the son. Through later interactions with the father and the son, Li concluded that they are honest and trustworthy people.
Is the brand still a good brand?
The next puzzle to solve was why Timberland's gross margin kept increasing. Li visited many of the company domestic retail stores. What he found out was that within Timberland's core consumer group, the brand had become a fad. Everybody wanted a pair of Timberland shoes and Timberland jeans. The stores managers often complained about not having enough inventory to sell.
International sales
Li was also concerned about the impact of international sales, especially in Asia. He discovered that international sales accounted for 27% of Timberland's total revenue and Asian sales were only 10% of international revenue. So even if Timberland's sales in Asia dropped to zero, it wouldn't have had much impact.
Putting it all together
It took Li a few weeks to conduct all the research, during which time he was wholeheartedly focused. He concluded that an investment in Timberland at that price almost had no risk because it was trading at less than 6 times earnings and earnings were very likely to grow 30% a year. So he bet big on Timberland and the stock went up 700% in the next two years.
Read more here:
- Hillhouse's Zhang Lei - Be a Friend of Time Part 5
- Hillhouse's Zhang Lei: Be a Friend of Time - Part 4
- Hillhouse's Zhang Lei: Be a Friend of Time - Part 3
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