Investing, Richard Lawrence-style
Investing, Richard Lawrence-style
On the book "The Model: 37 years investing in Asian equities"; reading time: 16 mins
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Richard Lawrence is one of the old-timers of the Asian investment scene. He came to Hong Kong in the mid-1980s and has now been running his firm Overlook Investments for over three decades. Over those years, the company’s Overlook Partners Fund averaged a yearly return of 14.3%.
A few weeks ago, Lawrence published a new book called “The Model”. It tells the story of how he built up his investment firm, recounting the many successes and failures he encountered along the way.
The book also provides a framework for investing in Asian stocks — the importance of paying attention to the quality of a business and studying management’s capital allocation.
Here are some of my takeaways after reading the book.
The origin story
Richard Lawrence was born into the industry. His father owned an investment management firm in New York engaged in traditional value investing.
After a degree in economics at Brown University, Lawrence moved to Venezuela in the late 1970s to work for conglomerate Organization Diego Cisneros. After this experience, he moved back to New York City, where he became a Vice President of equity research for J Bush, an investment management firm.
But he became restless in New York. So in 1984, he moved to Hong Kong and joined investment management start-up “F.P. Special Assets”, set up by Robert Meyer to invest in undervalued equities across the Asia-Pacific.
In the book, Lawrence is open about the many mistakes he made in the late 1980s. But despite initial challenges, F.P. Special Assets became a success, compounding its capital at a 32% rate from 1986 to 1994.
In 1991, most of the assets of F.P. Special Situations were sold. Lawrence then spent a year investing his own money before raising outside capital. The new fund was to be called Special Assets Overlook, to which FP Special Assets subscribed US$5 million and other investors another US$25 million. This new fund later changed its name to The Overlook Partners Fund.
Lawrence rented a small office from renowned investor and commentator Marc Faber, who also supported Overlook throughout its existence. In those early days, most of the capital came from wealthy individuals and trusts. In the mid-1990s, Lawrence formed a relationship with David Swensen of the Yale endowment fund, which later became a significant investor in the Overlook Partners Fund.
Claire Barne’s book “Asia’s Investment Prophets” describes Richard Lawrence as incredibly hard-working. He would do 150-200 company visits each year and perform serious financial modelling on each potential investment idea. Appendix C of her book has several extracts from Lawrence’s reports to limited partners, demonstrating his exceptional attention to detail.
From inception in the early 1990s until today, the Overlook Partners Fund compounded capital at a 14.3% rate - outperforming the benchmark by 6.5 percentage points per year. What’s more, the performance has been stable over the years, as can be seen from the following performance chart with the Y-axis on a logarithmic scale:
Overlook’s investment philosophy
Lawrence states that Overlook’s investment philosophy has four key pillars. These pillars are used to assess each new investment idea:
Superior business: High profit margins, predictable EPS growth, rational capital allocation, and strong pricing power.
A management team with integrity: Management’s track record in terms of 1) capital allocation, 2) operational excellence, 3) leadership/strategy and 4) alignment of interests.
A bargain valuation: New ideas are compared to their peers, apple to apples. And the valuation needs to be low in absolute terms.
Long-term investment horizon: Overlook prefers to invest in businesses with long-term track records, preferably a decade or longer.
The approach is then summarised through “The Overlook Pyramid”, with just a few stocks at the top exhibiting high return on equity, low debt levels and other markers of superior businesses. Lawrence now tells his team to concentrate on the stocks at the top of the pyramid, ensuring that by doing so, “you will outperform the benchmark”.
His team now meets with roughly 400 companies a year, digs deeper into 40 of them and invests in only four. A detailed one-page investment memorandum is written up on each new idea, highlighting the five primary drivers of its business. Overlook’s investment approach is research-intensive.
To help guide the valuation work, Lawrence and his team came up with a formula called “The Overlook Equation”, which ranks stocks based on how profitable and fast-growing they are, adjusted for their respective P/E ratios.
For example, Richard Lawrence’s then-partner David Devine said in a 2001 South China Morning Post interview that Overlook liked to buy stocks with earnings growth of 20% and return on equity of 20% at a PE of 10. Those numbers would have yielded a “Value Score” of 4. If the growth rate of a company is only 5% with a 10% return on equity and a P/E ratio of 15x, then the “Value Score” would fall to only 1.
Today, Overlook seems to use the return one capital employed instead of the return on equity in its Overlook Equation, but the result should be similar.
Overlook’s approach to portfolio construction is simple: invest in 20-24 companies in the portfolio, each with market caps equal to or larger than the assets under management (AUM). With a last-recorded AUM of US$7 billion, that means that Overlook now focuses exclusively on mid- and large-caps.
Further insights into Overlook’s investment philosophy can be learnt from Lawrence’s 2015 guest lecture at Ivey Business School and his 2021 Zoom guest lecture organised by the Chinese University of Hong Kong.
Other company policies
While Overlook is not precisely an activist investor, the fund has engaged with management teams throughout its existence. To avoid the negative connotations around shareholder activism, Lawrence now calls his approach “Modern Finance Technology”, which essentially stands for rational capital allocation from the point of view of minority shareholders.
In the early 1990s, Overlook decided to cap new subscriptions at 8-9% growth per year. This policy enabled the company to grow its assets under management steadily. An unintended effect of the subscription cap is that there is now a waiting list for new investments, which has enabled Overlook to put money to work close to market bottoms. Lawrence even goes as far as saying that:
“The cap on subscriptions has proven to be the single most significant business decision in our 30-year history.”
Another differentiating factor is that Overlook discloses the capital-weighted return to its investors. The capital-weighted return measures the return experienced by the average investor in the fund based on their respective investments and redemptions. Most asset management firms only report their time-weighted returns, which often exceed the returns experienced by the average investor in their funds.
While the fee structure has not been publicly disclosed, the management fee was about 1.3% in the mid-2000s, and from what I gather, the performance fee is currently around 13%.
War stories
The book starts with Overlook’s experience living through the Asian Financial Crisis. Imbalances had built up during the preceding boom in the early 1990s. There was a significant increase in unhedged US Dollar corporate debt. Currency pegs created a false sense of security among borrowers. After Asian current account deficits ballooned in the early 1990s, the pressure kept building on currencies to depreciate.
The crisis accelerated in 1997 when several currency pegs broke. The Indonesian Rupiah, for example, dropped from 2,500 to 10,000 to the US Dollar in just over six months. With falling exchange rates and panic selling, US Dollar-denominated portfolios dropped precipitously.
At the bottom of the Asian Financial Crisis in 1998, Overlook’s portfolio was down over 60% from the top. It was a near-death experience. But a surprise investment from David Swensen’s Yale endowment fund at the bottom of the crisis kept the fund running throughout those difficult years.
One of the horror stories experienced during the Asian Financial Crisis was investing in Indonesian auto financing company BBL Dharmala. The company had enjoyed a fat net interest spread of 6.9% and compounded its capital at a rate of 33% in the early 1990s. Lawrence took comfort in that BBL Dharmala’s US Dollar debt was fully hedged. However, at the depths of the crisis, he was astonished to find that BBL Dharmala had transferred the hedge to the controlling family’s holding company to shore up the family’s own balance sheet. The listed entity subsequently went bankrupt, and Overlook sold its shares in BBL Dharmala for pennies on the dollar. No one in BBL Dharmala ever went to jail.
Overlook had a much happier experience with Heineken’s Indonesian subsidiary Multi Bintang. I wrote a report on the stock here. Richard Lawrence first came across the company in 1985 on vacation to Bali, where a friendly salesman on a beach offered him a Bintang beer. Lawrence was attracted to Multi Bintang’s high return on equity, generous dividend pay-outs, strong balance sheet and the low per-capita consumption of beer in Indonesia at the time. While Multi Bintang’s office building was trashed in Indonesia’s 1998 riots, no one got hurt, and the company eventually recovered from the crisis. Overlook sold its shares in Multi Bintang after 19 years, generating a close to 20% IRR. Today, Multi Bintang trades at 14x pre-pandemic earnings, compared to a 10-year average of almost 30x.
In 1998, Overlook Partners Fund also expressed optimism about Hong Kong restaurant chain Café de Coral. Lawrence believed that wage deflation would improve margins for restaurant chains in Hong Kong, including for Café de Coral. Chairman Michael Chan was praised as a model executive who treated minority shareholders fairly. And Lawrence was convinced that Café de Coral had a superior business offering a solid value proposition to customers, high returns on capital, strong free cash flow and open-ended growth in the mainland market. The investment turned out well: in the following 14 years, Overlook’s investment in Café de Coral compounded at a 24% yearly rate. More recently, Café de Coral has suffered a double-whammy of weak tourism following Hong Kong’s anti-government protests and COVID-19. It now trades at 14x FY2019 earnings.
In those early years, another company that stood out to Overlook was tuna processing and packaging company Thai Union Frozen Food. Lawrence remembers visiting the company and being apprehensive when the founder’s son Khun Thirapong took over. But he soon realised what a brilliant Khun Thirapong was. Thai Union became one of the first Thai companies in the Overlook portfolio to commit to a high dividend payout. Today, Thai Union Food trades at 12x trailing EPS, though consensus numbers imply a drop in earnings back to pre-pandemic levels.
A horror story played out in 2004 with the Singaporean company Citiraya Industries. Citiraya engaged in recycling discarded electronics parts to extract precious metals for resale. The numbers looked good, and the technology was not complicated, so Lawrence felt comfortable with the investment. On a visit to the company in Singapore, the Overlook team found the factory floor completely empty. But for some reason, Overlook stayed with its investment. Not long after the visit, news broke from Singapore that the owner had run away. The computer chips had been diverted for sale overseas, and the precious metal extracted from the waste was falsely declared. Over 1,500 fake transactions had taken place, creating over US$160 million in fictitious revenues. Citiraya eventually went bust.
Another failure was the investment in Tien Teck Land. The idea was that the company’s 51%-owned subsidiary’s investment in Hyatt Hotel in Tsim Sha Tsui was worth significantly more than the company's market cap. But it soon became apparent that the family behind the company did not care about minority shareholders. After the investment, Tien Teck Land was found to engage in several related party transactions, including the renovation of its flagship Hyatt property. When Lawrence protested to the company, he came home to find his apartment on Victoria Peak completely ransacked by thugs - just one day before Tien Teck Land’s EGM. This was most likely a warning sign from the company that he better keep quiet. In the following 30 years since the investment, the stock has compounded at a meagre 3% per year. Corporate governance does matter at the end of the day.
Equally frustrating was Overlook’s experience in Korea, where there was tangible and quantifiable value but little commitment to delivering value to minority shareholders. In the mid-1990s, Overlook had a large proportion of its portfolio in Korean stocks, but the company has become more cautious with its Korean investments.
Lawrence recounts his experience with Taekwang Industrial, a producer of synthetic fibre. The first-generation leader had been a brilliant man regarding how he ran the business and how he treated minority shareholders. But after the founder’s son took over, minority shareholder abuses began happening with greater regularity. After the ListCo acquired a commercial building from the controlling shareholder, Lawrence became particularly concerned. He wrote a letter proposing a shareholder resolution to elect his lawyer as an outside auditor. His letter wasn’t well-received. Within a week, Lawrence received a phone call with a message from a Korean government official suggesting that Mr Lawrence was no longer welcome to come back to Korea. Since then, the stock has performed poorly, and it currently trades at a P/E ratio of 3.5x.
Overlook had a better experience with Taiwanese testing and measuring equipment company Chroma ATE. Overlook was impressed with CEO Ming Chang but frustrated with the company’s habit of investing in unprofitable, unrelated businesses. After several years of dialogue, Ming Chan finally listened to Overlook. It sold non-core assets, reduced its stock option program, started buying back shares, and paid dividends. Overlook sold Chroma ATE after 6 years with an IRR of 32%. Today, Chroma ATE trades at a P/E multiple of 20x.
Another example of constructive activism was with convenience store operator CP All, run by the well-regarded Chearavanont family in Thailand. According to Lawrence, convenience stores are fantastic businesses with consistent growth, stable margins, negative working capital, high returns on capital and strong free cash flow. In those years, the problem with CP All was the company’s reinvestment into loss-making Chinese supermarket chain Lotus Supercenter. But the management team finally saw the light. In the mid-2000s, CP All divested Lotus. Overlook enjoyed a 49% IRR on its investment in the company from 2004 to 2013. Today, CP All trades at 25x pre-pandemic earnings compared to a P/E ratio of 14x in the mid-2000s.
Lawrence has had a love-hate relationship with Chinese companies. His early investments in China-related Hong Kong stocks showed mixed results. He invested in several overseas companies with a significant presence on the mainland, including in companies such as Vtech, Wong’s International, IIH, QPLP, Tomei and Pantronics. He would buy them at 4x earnings and then sell them at 6x. But neither of them had any competitive advantage.
Lawrence first “true love” when it comes to Chinese stocks was printed circuit board (PCB) laminate company Kingboard Holdings (previously “Kingboard Chemical”). Around 2000, Kingboard Chemical had a 40% market share in Southern China and a 10% market share worldwide for PCB laminates. When Lawrence first met the company, it traded at 3.5x consensus estimates and offered positive guidance in the year ahead. At his first meeting with founder Paul Cheung, Lawrence was told that he was the first investment analyst to visit in over six months. That was music to his ears, confirming that the Hong Kong investor community had not yet discovered the stock. Overlook’s 14-year holding period generated an IRR of 41%. Today, Kingboard Holdings trades at a multiple of 4.5x pandemic-boosted earnings.
Another Chinese company Overlook fell in love with was video game producer NetEase. The social aspects of the company’s massively multiplayer online role-playing games (MMORPG) create significant network effects. And NetEase had demonstrated an ability to create new hit games outside its core gaming franchise Fantasy Westward Journey. Further, the company’s capital allocation was excellent, with opportunistic share repurchases and generous dividends - somewhat of a rarity in the Chinese Internet sector. NetEase now trades at a forward P/E ratio of 24x.
Another exception to the often poor corporate in mainland Chinese companies was A-share auto supplier Huayu Automotive, which Overlook met in 2013. The company impressed Lawrence having independent directors that sought his input in improving the company’s corporate governance. Huayu is connected with separately listed auto company Shanghai Auto, which might have the best reputation in the Chinese auto industry. Today, Huayu trades at a P/E multiple of 13x.
In 2014, Overlook came across A-share China Yangtze Power. At the time, the stock traded at only 10x earnings. China Yangtze is a state-owned enterprise owning the largest hydroelectric generator globally - the Three Gorges Dam. The dam has a 100-year lifespan yet has very little maintenance capital expenditure to speak of and few variable costs, causing free cash flows to be strong. Since Overlook’s investment, the P/E multiple has expanded to 20x.
In the book, Lawrence’s colleague James Squire described Malaysian rubber glove producer Top Glove as a “superior cyclical”. While the company is undoubtedly affected by rubber prices, Overlook believed it would grow across the cycle. Top Glove’s earnings rose significantly during COVID-19 and now trades at 19x 2022 consensus earnings.
According to Lawrence, the finest company across all of Asia is Taiwan Semiconductor Manufacturing Company (TSMC). He first visited the company in 2001. He quickly realised that the company had a competitive advantage: it doesn’t compete with its customers. The same does not hold for Samsung Electronics’ foundry business or TSMC’s mainland competitors such as SMIC. The problem with TSMC in 2001 was its measly return on equity of just 11%. Overlook sent letters to Chairman and CEO Morris Chang about paying greater attention to capital allocation. He took Overlook’s and other activist investors’ advice to heart. Today, TSMC enjoys a respectable return on equity of 30%, and the company’s capital intensity has fallen with its ever-rising market share. Since Overlook’s first investment in 2001, the investment has achieved an IRR of 18%, and the stock now trades at a P/E of 27x.
Other stocks mentioned favourably in the book include footwear maker Stella International, palm oil producer IOI Corporation, computer manufacturer Advantech, back-end semiconductor equipment maker ASM Pacific, Thai Reinsurance under the leadership of Khun Surachai Sirivallop, Indonesian pharma company Kalbe Farma, Chinese textile producer Texwinca, Chinese home appliance producer Midea and Shanghai International Airport.
Overlook’s current portfolio
Today, over half of the Overlook Partners Fund is in mainland Chinese companies. Lawrence feels that the quality of the listed universe of Chinese companies has improved significantly and therefore warrants a greater allocation than in the past.
While the early 1990s portfolio had an average P/E ratio in the mid-single digits, today, most of the stocks in the portfolio trade at multiples above 20x. The quality bias remains with most of the stocks dominating their respective industries.
The largest allocation in the portfolio is in China Yangtze Power, followed by large-caps TSMC, Alibaba and NetEase. Weichai Power is a high-quality company developing engines for heavy vehicles, though dependent on China’s construction sector and the excessive use of trucks to transport raw materials instead of trains. Samsung Electronics is another high-quality business trading at a modest multiple, with an improvement in corporate governance since JY Lee took over. It’s currently facing falling DRAM prices, but the outlook for Samsung’s foundry business remains excellent. Tingyi is China’s leading producer of instant noodles and a company that continues to trade at a surprisingly low multiple. Mengniu is one of two leading dairy companies in China, where milk consumption per capita remains at a fraction of the levels seen in developed markets such as Japan. LG Household & Health is a Korean cosmetics and beverage business run by shareholder-friendly CEO Suk Cha, and now trades at the low end of its historical P/E trading range. The preferred share trades at an even lower multiple. Lastly, game developer and social media company Tencent has one of the strongest management teams in China. However, it faces near-term headwinds due to China’s ongoing anti-corruption campaign.
Closing thoughts
“The Model” is a fantastic book. Not because of how it’s written but because Richard Lawrence is an intelligent investor with decades of experience. He knows how to analyse stocks, and he knows how to stick with them over the long run.
It’s fascinating to see the contrast between the value stocks he picked in the mid-1990s and the quality stocks Overlook has in the portfolio today. Many of the stocks in the current portfolio trade at multiples that I would consider to be “fair” rather than bargain-level. I wonder if the fund will perform as well as it has done in the past.
Nevertheless, I still think the book has much to teach us about paying attention to quality and paying attention to corporate governance. Earning a 49% IRR on an 8-year investment in CP All or a 41% IRR on a 14-year investment in Kingboard Chemical is just remarkable. A few such stocks in a portfolio can help create an enviable track record over the long run.
Thanks for reading!
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Tan Sri Dato’ Lee Shin Cheng was chairman of IOI, not Top Glove