To be diversifed or not, that is the question
After a series of visits to tech OEM manufacturers across Asia, I came away with several impressions. Several years of oversupply has resulted in continuing consolidation in this sector. Acquire aggressively or be acquired is the general theme, especially in the smaller mid size players. There seemed to be two major types of players in this sector.
1) The highly concentrated specialist - whose top 3 clients probably makes up the majority, or over 60% of the company's revenue, or
2) The diversified player - who has clients which are no more than 10-15% of the revenue at any one time.
The growth rates are generally faster at the former, especially if its clients hits the jackpot (for e.g. Motorola RAZR phones, IPOD parts etc), however, interestingly, these companies are also the most vulnerable to a takeover (easier to understand their expertise, acquired for their client base etc, more uncertainty of future business). Anecdotal evidence seem to also suggest that this group also has the highest failure rates, as a client shifts its manufacturing to a lower cost producer or is closed down, it loses an irrecoverable amount of business, resulting in bankruptcy.
The interesting question, therefore is, is it better to be a diversified player or not? This question is a highly relevant question, and one that is close to my heart. As manager for the NTAsian Discovery Fund, we tend to run a highly concentrated portfolio, focusing on (hopefully) not more than 20-30 names across the region of some of our best ideas. Undoubtedly, for larger returns, a more focused approach is better. However, portfolio theory hardly recommends this approach for fund management, on the other hand, Warren Buffett is not exactly known for his diversified investments and he doesn't seem to have done too badly for himself.
Interestingly, surveys of top 50 richest people in the world often shows that there were more single equity investors in the top 50 than any other category (Microsoft, Walmart etc). Another interesting point to note though is that if you looked at this list perhaps 5 or 10 years ago, the biggest changes in wealth also came from this category, including the biggest category of individuals who drop out of the top 50 richest list. Easy come easy go (easy for some at any rate...). Point being, if your wealth is tied to one thing, it's a faster path to richness, on the other hand, it will also drag you down just as quick!
I digress, the quickest way to rapid returns is undoubtedly through focusing your investments in your best ideas. On the other hand, if you want to keep those returns, you better have the ability to switch to your investments to your next best ideas, or you could be liable to go back down with your investment (large shareholders tend to have difficulties selling out at top!). Hence one of the prime reasons for our fund's philosophy to run a concentrated portfolio (focus the approach but not too much that we are stuck with our investments all the way up and all the way back down).
Going back to the IT sector. Most of the smaller players try to land the big fast growing account, to ride the coattails of a hot product, generate the cash to expand and finally to try and diversify and catch the next big customer. A faster way to do this is to buy an existing player to diversify your own portfolio (to reduce reliance on one customer). This latter is often more feasible, largely due to the short lifespan of consumer electronics products, it just doesn't give a manufacturer time to diversify its customer base through organic growth to reduce reliance on a single customer/product. Diversify (before your product cycle runs out) or die. Fact of life for an OEM manufacturer in Asia.
Although this does it make it somewhat difficult for our fund, which focuses on long term investments of at least 2-3 years, to invest in non diversified OEM manufacturers (will it still be around in 2-3 years time?), it nevertheless throws up the interesting idea of arbitrage by buying any manufacturer that are trading at below their book value, especially if they have modern manufacturing facilities and have a heavy reliance on large customers. Having made this argument, would it be hypocritical then for our fund to invest in a diversified OEM manufacturer given our fund focuses on running a concentrated portfolio? By investing in a company with diversified customer base, does this mean that we are in fact indirectly diversifying our investments? Should we put our money behind the fast growing player to ride the high returns?
In my view, if a diversified OEM manufacturer is trading at deep valuations especially as the market is focusing on the fast growing IC packagers, for e.g., we should be looking at the former, not the latter. Our focus is to generate high returns by investing in companies trading at deep valuations from underresearched or out of favour companies. In essence, buying something that is worth $1.3-1.50 for $1 rather than buying something that is worth $1.3 for $1.4 and hoping that it would grow enough to be worth $2 next year. Or even better buying something that is worth $1.3 for $1 but that will growth to be worth $1.5 in a year's time. After all, a bird in hand is better than two in the bush. Happy hunting!
1) The highly concentrated specialist - whose top 3 clients probably makes up the majority, or over 60% of the company's revenue, or
2) The diversified player - who has clients which are no more than 10-15% of the revenue at any one time.
The growth rates are generally faster at the former, especially if its clients hits the jackpot (for e.g. Motorola RAZR phones, IPOD parts etc), however, interestingly, these companies are also the most vulnerable to a takeover (easier to understand their expertise, acquired for their client base etc, more uncertainty of future business). Anecdotal evidence seem to also suggest that this group also has the highest failure rates, as a client shifts its manufacturing to a lower cost producer or is closed down, it loses an irrecoverable amount of business, resulting in bankruptcy.
The interesting question, therefore is, is it better to be a diversified player or not? This question is a highly relevant question, and one that is close to my heart. As manager for the NTAsian Discovery Fund, we tend to run a highly concentrated portfolio, focusing on (hopefully) not more than 20-30 names across the region of some of our best ideas. Undoubtedly, for larger returns, a more focused approach is better. However, portfolio theory hardly recommends this approach for fund management, on the other hand, Warren Buffett is not exactly known for his diversified investments and he doesn't seem to have done too badly for himself.
Interestingly, surveys of top 50 richest people in the world often shows that there were more single equity investors in the top 50 than any other category (Microsoft, Walmart etc). Another interesting point to note though is that if you looked at this list perhaps 5 or 10 years ago, the biggest changes in wealth also came from this category, including the biggest category of individuals who drop out of the top 50 richest list. Easy come easy go (easy for some at any rate...). Point being, if your wealth is tied to one thing, it's a faster path to richness, on the other hand, it will also drag you down just as quick!
I digress, the quickest way to rapid returns is undoubtedly through focusing your investments in your best ideas. On the other hand, if you want to keep those returns, you better have the ability to switch to your investments to your next best ideas, or you could be liable to go back down with your investment (large shareholders tend to have difficulties selling out at top!). Hence one of the prime reasons for our fund's philosophy to run a concentrated portfolio (focus the approach but not too much that we are stuck with our investments all the way up and all the way back down).
Going back to the IT sector. Most of the smaller players try to land the big fast growing account, to ride the coattails of a hot product, generate the cash to expand and finally to try and diversify and catch the next big customer. A faster way to do this is to buy an existing player to diversify your own portfolio (to reduce reliance on one customer). This latter is often more feasible, largely due to the short lifespan of consumer electronics products, it just doesn't give a manufacturer time to diversify its customer base through organic growth to reduce reliance on a single customer/product. Diversify (before your product cycle runs out) or die. Fact of life for an OEM manufacturer in Asia.
Although this does it make it somewhat difficult for our fund, which focuses on long term investments of at least 2-3 years, to invest in non diversified OEM manufacturers (will it still be around in 2-3 years time?), it nevertheless throws up the interesting idea of arbitrage by buying any manufacturer that are trading at below their book value, especially if they have modern manufacturing facilities and have a heavy reliance on large customers. Having made this argument, would it be hypocritical then for our fund to invest in a diversified OEM manufacturer given our fund focuses on running a concentrated portfolio? By investing in a company with diversified customer base, does this mean that we are in fact indirectly diversifying our investments? Should we put our money behind the fast growing player to ride the high returns?
In my view, if a diversified OEM manufacturer is trading at deep valuations especially as the market is focusing on the fast growing IC packagers, for e.g., we should be looking at the former, not the latter. Our focus is to generate high returns by investing in companies trading at deep valuations from underresearched or out of favour companies. In essence, buying something that is worth $1.3-1.50 for $1 rather than buying something that is worth $1.3 for $1.4 and hoping that it would grow enough to be worth $2 next year. Or even better buying something that is worth $1.3 for $1 but that will growth to be worth $1.5 in a year's time. After all, a bird in hand is better than two in the bush. Happy hunting!
posted by Kenneth | 3:36 PM
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