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Notes From Peking University's Fall 2020 Value Investing Course - Kweichow Maotai Case Study

A case study of how to apply the margin of safety framework

October 29, 2020 | About:

In my previous two articles (linked at the bottom), I have shared my notes and thoughts from Himalaya Capital's Chang Jing's third lecture at Peking University's Fall 2020 Value Investing Course. During this lecture, Chang discussed margin of safety and risk events.

He also used Kweichow Maotai (SHSE:600519), an alcoholic beverages company, as a case study to illustrate the concepts of intrinsic value, margin of safety and risk. Below are the Kweichow Maotai screenshots used in Chang's lecture.

As of Oct. 22, with a share price of 1,732 Chinese Yuan ($257) and 12.56 billion shares outstanding, Kweichow Maotai's market cap is ¥2.2 trillion. Currently it has a trailing price-earnings ratio of 50 and a forward price-earnings ratio of 46 based on analyst estimates.

Below is a snapshot of Kweichow Maotai's stock returns since its IPO.

Needless to say, it's been one of the best compounders with total returns of a whopping 31,923%, which translates into a 35.12% annual compound rate. Over the same period of time, the Shanghai Composite Index's total return was merely 164.75%, or an annual compound rate of 5.21%.

Obviously, Kweichow Maotai has been a fantastic compounder. For such a great business, at what price will investors get a large enough margin of safety?

First of all, we have to know what Kweichow Maotai's intrinsic value is. Here, Chang applies Greenwald's framework, which breaks the intrinsic value down into three parts – assets value, earnings power and growth value.

Assets value

For the sake of discussion, I won't go into the details of Kweichow Maotai's balance sheet items. I will instead make some simple assumptions regarding the balance sheet. For instance, the inventory of alcoholic base is only counted at book value.

As of the end of 2019, Maotai had net non-operating assets of ¥121 billion, mostly cash and cash equivalents. It has net operating assets of ¥16 billion. Obviously there's a big gap between Kweichow Maotai's market value and asset value.

Earnings power

Last year Kweichow Maotai's revenue was ¥85.4 billion and the operating income was ¥55.7 billion. It paid about 25% in taxes, so after taxes, Kweichow Maotai earned roughly ¥42 billion in net profit. Obviously there's something special about Kweichow Maotai with its operating margin of 65% and net margin of 49%.

In the trailing 12 months, Kweichow Maotai's net profit was ¥45 billion. Now let's assume Kweichow Maotai's revenue, tax rates, operating margin and net margin don't change in the future. This means Kweichow Maotai will earn ¥45 billion cash profits every year in the future. If we use a 7% discount rate, which is the historical market return, we get ¥650 billion. This is Maotai's earnings power value.

Growth value

We have to make different growth assumptions. There's a wide range of possible growth rates for Kweichow Maotai. But a 20% growth rate gives you a much higher intrinsic value than a 10% growth rate. We could also use the two-stage method and assume that Kweichow Maotai can grow its profits at 20% a year for the next 10 years and that Kweichow Maotai could maintain its profitability after the 10 year period. We also use a 7% discount rate, with is the historical market return. With all these assumptions, we get ¥550 billion for Kweichow Maotai's growth value for the next 10 years' profits, with 1¥,600 billion for the terminal value.

However, if the net income can only grow 10% a year for the next 10 years, we get only ¥200 billion for Kweichow Maotai's growth value for the next 10 years' profits, with only ¥500 billion for the terminal value.

As we can see, growth is the biggest variable here. If Kweichow Maotai can grow 20% a year in the next 10 years, its intrinsic value, with all the above assumptions, is roughly ¥3 trillion yuan. But if it can only grow 10% a year in the next 10 years, its intrinsic value is only ¥1.5 trillion. This 10% difference in growth rates makes a huge difference.

So at today's price, Kweichow Maotai's margin of safety could be ¥800 billion or -¥700 billion based on these two situations. It depends on growth assumption. Whether the ¥800 billion can cover all the risk events that could happen during the next 10 years is also debatable. This also assumes the profit margin won't go down. There are a lot of assumptions behind our calculation, so we have to acknowledge the limitations.

Qualitative factors to consider

The above analysis is only based on Kweichow Maotai's financial reports and a basic understanding of the business. In order to assess Kweichow Maotai's intrinsic value and its margin of safety at the current price, we also have to ask many important questions regarding the business. For instance, can Kweichow Maotai maintain its pricing power? If so, how much can it increase its prices every year? What about capacity constraints? Are there any political risks? What other risks should we consider?

The point of the exercise is not to show how to calculate the intrinsic value of the business and margin of safety. I think Chang's point is precisely the opposite. While Greenwald has provided us with a great framework, it is only a framework. In fact, we probably shouldn't have too much faith in the calculation of intrinsic value and margin of safety because there are so many built-in assumptions. Each assumption can be debated and very likely falsified in the future.

However, if we combine Greenwald's framework with the qualitative factors Chang discussed in his lecture, we can get a rough sense of margin of safety after considering all the risks involved.

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About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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