BYD: Positioning Berkshire for the 'Chinese Century'

Warren Buffett is a margin of safety investor. That is, Buffet purchases equity stakes in companies only when he is more or less certain that he won’t permanently lose his capital and where the price is such that he believes he will earn an outstanding return on his investment over time. In order to practice this risk averse method of investing, Buffett has often had to pass on investment opportunities where it was not clear to him how the competitive dynamics of the relevant industry would change over time.

During the tech bubble of the 90s, for example, Buffett was derided as being a stodgy old man who simply did not understand the new era of business. However, while Buffett did pass on some outstanding opportunities, he did so because it was difficult for him to predict how these “tech” companies would reinvest capital into their businesses in a way that would maintain or grow their earnings such that the prices quoted for their shares provided a margin of safety. Buffett also knew that the “moats” of many of these companies could easily be crossed by new entrants selling the latest and greatest disruptive technologies and so he declined to participate across the board. This led to a general theory among the press that Buffett simply would not invest in tech companies because he did not understand how these companies worked.

So many Buffett followers were perplexed when he saw fit to buy close to 10% of BYD Company Limited (BYDDF.PK), a Chinese manufacturer of rechargeable batteries, mobile handset components, and cars, in October of last year. The purchase was largely viewed in the media as a bet on BYD’s batteries playing a large part in the future of personal transport, either through the sale of its batteries to car manufacturers or through the sale of its own cars. The purchase was also cast as an atypical investment for Buffett, since the company was trying to bring to market a new disruptive technology – namely, a low priced, all-electric vehicle. However, when one digs deeper into the investment, one begins to realize that the investment is vintage Buffett and will, in fact, probably turn out to be one of the best investments that Buffett ever makes in his lifetime. Berkshire’s (BRK.A) stake in BYD not only has the adequate margin of safety required by Buffett but also represents the future of Berkshire. Buffett and his partner in crime Charlie Munger are beginning to position Berkshire for what they believe will be the “Chinese Century.”

BYD deals with two businesses: IT manufacturing and auto manufacturing. It has production bases in several large Chinese manufacturing centers as well as in Japan, Korea, Taiwan and various emerging markets (such as Hungary and India). It is a public company and is listed on both the Chinese and Hong Kong stock exchanges. According to a Harvard Business School case study on BYD (required reading, in my opinion, if you really wish to understand Buffett’s interest in the company), the company opened up shop in 1995 and by 2002 became the world’s second largest manufacturer of rechargeable batteries. This was considered a remarkable feat because battery manufacturing was traditionally viewed as a capital intensive business that required large expenditures on things like robotic arms and dry rooms. Chinese companies’ comparative advantage was always thought to be their access to a large supply of cheap labor and so it was assumed that no Chinese company would be able to compete in the battery business. However, BYD was able to become a low cost producer of rechargeable batteries by changing the manufacturing process such that labor became a much larger input and capital equipment became a much smaller input.

BYD also had a one-up on most other Chinese manufacturing companies because it spent far more money on R&D focused on both product improvement and, more importantly, on manufacturing process improvement. This focus on both product and production process engineering is what enabled BYD to become the second largest rechargeable battery supplier in the world so quickly, as the company was able to manufacture batteries in a way that maintained quality control even while relying heavily on human resources for its manufacturing lines. It has also enabled the company to jump into other manufacturing businesses and become the low cost producer over time, as with its entry into mobile handset production. And while turnover on the assembly line side of the business is fairly high, turnover on the intellectual resources side of the business (R&D scientists) is quite low. BYD has been able to keep people on board by offering great benefits, including free housing, food, health insurance, access to free education for their children, and the opportunity to interact socially through athletic events, art programs, etc. In other words, BYD offers its employees Google-like benefits in order to keep them happy and working hard. This is just one of the reasons why BYD has been able to recruit from the “‘top of the top’” in China and why BYD will continue to innovate going forward.

Charlie Munger has called Wang Chuan-Fu a combination of Thomas Edison and Jack Welch, but I believe a more apt comparison for Wang Chuan-Fu is with the titan of American business Henry Ford. Like Ford, Wang started out as a skilled engineer and scientist who actually helped create and design new technological innovations (even working at the Edison Illuminating Company at one point). Like Ford, Wang eventually became a successful entrepreneur that excelled not only in creating innovative and value enhancing products, but also in coming up with new ways to optimize the manufacturing process in a way that made his company a low cost producer. Like Ford, Wang has vertically integrated his company so that it has become a one-stop shop for equipment manufacturing, thus capturing the entire value associated with the manufacturing supply chain. And like Ford, Wang has recognized that it is important for his workers – his human resources – to be taken care of both so that they will be more productive and stay at the company, but also because it is important that they themselves be able to buy the products they are manufacturing. Would you buy into a company run by the Chinese Henry Ford given the chance? I would.

By investing in BYD, Buffett has achieved several amazing feats at once. First, he has bought into a company that could potentially be the lowest cost manufacturer of a number of complex goods, not just batteries, handsets, and cars. BYD initially started out in batteries but then expanded into handsets, LCD screens, and automobiles, and it has always been able to generate profits in these growth enterprises by becoming a low cost manufacturer. BYD’s moat, it seems, comes from the company’s incredible ability to tailor the manufacturing process of complex goods in a way that takes advantage of China’s labor supply advantage. Additionally, BYD has done a good job of fending off competitors by vertically integrating the supply chain, thereby controlling the cost and quality of production and protecting its intellectual property and know-how. According to Wang Chuan-Fu, China is a ruthless place in terms of business competition, and its commercial law is relatively underdeveloped and under-enforced, so it is important that companies adapt their business models to deal with this reality. Learning how business works in China will be much easier with Wang Chuan-Fu at Buffett’s disposal.

Second, by investing in BYD Berkshire has gained access to the largest potential market for goods and services in the world. The growth of China in the coming years will be tremendous, and it is likely that the Chinese will be clamoring for products and service from home and abroad. Mobile phones, LCD TVs, and automobiles are all growth areas where the Chinese can supply themselves if they wish (through companies like BYD), but there are areas where the Chinese will want to purchase from foreigners or open up their markets to foreign investors. For example, the rapid industrialization of China will require huge amounts of electricity, and the Chinese would probably love to work with American utility companies who have expertise in supplying electricity using various types of generating technologies in a way that reduces pollutants and CO2 emissions. This presents a perfect opportunity for MidAmerican, the Berkshire utility subsidiary that made the strategic acquisition of shares in BYD. One can also imagine that the Chinese will increasingly see the social benefits of a robust and healthy private insurance market. By getting a toehold in the Chinese market, making business and political connections there, and learning more about the various risks of doing business in China, Berkshire may eventually be able to provide insurance capacity in China in the manner that it does in the U.S. This will give Chinese citizens access to insurance policies from a company that will always be able to make good on its promises due to its responsible underwriting and healthy investment practices.

Third, Buffet’s investment in BYD will better enable Berkshire to access one of the largest pools of talent in the world. China is continually churning out loads of intellectual talent, particularly in the fields of natural science, engineering, and business, and BYD is a top repository of such talent. Berkshire will be able to access China’s top talent both directly through BYD and through the networks of the individuals working for BYD, including Wang Chuan-Fu, thus allowing Berkshire to be more “linked in” to the Chinese business, scientific, and political communities. This in turn will enable Buffett and his successors to capitalize on new technologies that emerge from Chinese industry and to better understand the business climate in China as it changes. For example, if MidAmerican is deciding on investing in battery storage for its renewable energy portfolio, it can turn to BYD for advice on the appropriate technologies or even be directed by BYD to the companies BYD believes has the best technology for MidAmerican’s purposes. Or if Berkshire is interested in being involved in the development of traditional or renewable generation capacity in China, it can tap into BYD’s talent network to figure out what the regulatory outlook is like in China for allowing foreign investment in utilities.

Finally, given BYD’s growth potential, Berkshire has purchased its stake in BYD for what appears to be an outstanding price. Take a look at BYD’s annual report for 2008. Buffett infused about HK$ 1.8 billion worth of capital into BYD for a purchase price of HK$ 8 per share, resulting in a 10% stake in BYD. Last year, BYD earned RMB 0.50 per share, which is currently equivalent to about HK$ 0.57. Assuming that reported earnings are a good approximation of “owner earnings” and that BYD’s owner earnings will merely be maintained over the business’ lifetime, Buffet’s earnings yield for his stake is close to 7%. This is an excellent price for a company that in actuality has huge growth potential, especially when you consider that much of BYD’s income generating assets are intangible in nature (remember: its production process know-how is what helps it to be the low cost manufacturer).

BYD has a legitimate shot at becoming one of the largest suppliers of electric vehicle-related battery technology in the world given its low cost battery manufacturing capabilities. Furthermore, it is possible – though not necessarily probable – that BYD will become the largest automaker in the world. If BYD succeeds in this respect, it will probably be because its cars present a value proposition for emerging market customers rather than its cars being of the best quality. Regardless, BYD will almost certainly become a major auto manufacturer in China if the government subsidizes the purchase of all-electric vehicles. One must also remember that the Japanese were initially derided for manufacturing low quality electronics and vehicles, but now they are fierce competitors that are known for their manufacturing prowess across the globe. Just imagine if BYD is able to start generating valuable intellectual property related to its products in addition to its production processes. Could BYD become the new Sony (SNE) or the new Toyota (TM)? It’s possible, and Buffett has essentially gotten this option value on BYD’s success for free.

Buffett and Munger believe that while the twentieth century was the American Century, the twenty-first will be the Chinese Century. Thus, the BYD investment should be viewed as Berkshire’s stepping stone into China. Those who deride Buffett for having a subpar record over the last decade should take note: if Buffett continues to make investments in companies like BYD, Berkshire will easily outperform the U.S. stock market for years to come.

Disclosure: Please note that the author currently owns shares in Berkshire Hathaway (BRK.B).

Comments

[JC09058:]

It is true that Warren Buffett passed on Tech companies because of his lack of understanding their potential. Granted, he is correct on the their 'moats' and easy of entry as well.

However, that oversight seems to have been corrected by who he has sitting on his board now. It seems that he applied some of his same principles on choosing a company to invest in for this board member. That is the uber-geek Bill Gates. Now, there is a person that can see and understand Tech companies and the potential they have for the future.

So, I'm not surprised the he has entered into business with BYD Company Limited because he has a techie on the board to help him understand. Plus, his and Charlie Munger 's overall ability to understand Personal Dynamics of individuals allows him to know that Wang Chuan-Fu is the right kind of individual to lead that company into a future leadership position.

Personally, I am strongly considering a position in that company as well. But, it is not because Warren Buffet is there but because the company looks to be very strongly positioned for the future worldwide dominance as a Green Industry. Further research is required on my part before entry but it's looking pretty good so far.

May 01 08:30 AM

[Alan Young:]

Yes, Buffet is a careful investor, and we can trust that BYD will not go to zero, like some startups. However, he is also a very patient investor, and it may be years before the stock actually appreciates in value.

May 01 11:13 AM

[Road Runner:]

Excellent article. Thank you. You got at the essential nature of why Warren Buffet and gang bought into BYD, and why it is my most exciting investment.

Warren and gang saw the founder and CEO Wang Chuan-Fu as the complete entrepreneur package. He completely understands all aspects of this business from the technology, to the manufacturing, to the market.

Not only that, but the products he is creating have the potential to explode in sales.

One of BYD’s products is the revolutionary new battery technology of Lithium Iron Phosphate (I believe BYD calls it Lithium Ferrous Phosphate). This battery technology is far better an any other battery technology for electric vehicles (see my previous posts for an explanation why).

BYD is putting these new batteries in all-electric and hybrid-electric vehicles, and driving down the price of these vehicles for the car thirsty Chinese market. The government of China is promoting electric vehicles to help curb its air pollution problem. BYD can perfect its vehicles in China, then launch them in the first world countries undercutting prices because of BYD’s manufacturing cost advantage.

Note that China is the only proven reserve (though other unproven ones exist) of Lithium other than South America. Another competitive advantage for BYD?

May 01 02:39 PM

[Misha:]

I have my doubts about “Chinese century.” Essentially what we view as positive is the command element on the Chinese economy that allows them to “plan for a rainy day” by saving during good time, investing during the downturn, control the currency, etc. The same people who are concerned with the government involvement in the US are getting breathless when talking about China. Remember the Soviet Union and its march across the globe in 60s and 70s and into early 80’s? I do recognize that Chinese economy is a hybrid between market driven and command economy, which is better than what we saw in the Soviet Union. However, the command component, responsible for a “superior” stimulus plan and other components I just listed, gives me a pause. For now and for my money, the United States is still the place to invest and bet on despite all the current problems.

May 02 03:44 PM

[hondaicivic:]

Yea if you want to pay the high corporate tax rates and bullshit red tapes. Not to mention, ridiculuous high labor cost (e.g. unions). The corporate tax rate in the US is about 40% compared to China 25%. In hong kong, it's 16% and also no capital gains or VAT/Sales Tax. And you wonder why many of the MNC are relocating to Asia/China to do business. The infrastructure in the USA was given a rating D-. That gives you an indication of where good ol' Uncle Sam is heading in the 21st century.


On May 02 03:44 PM Misha wrote:

> I have my doubts about “Chinese century.” Essentially what we view
> as positive is the command element on the Chinese economy that allows
> them to “plan for a rainy day” by saving during good time, investing
> during the downturn, control the currency, etc. The same people who
> are concerned with the government involvement in the US are getting
> breathless when talking about China. Remember the Soviet Union and
> its march across the globe in 60s and 70s and into early 80’s? I
> do recognize that Chinese economy is a hybrid between market driven
> and command economy, which is better than what we saw in the Soviet
> Union. However, the command component, responsible for a “superior”
> stimulus plan and other components I just listed, gives me a pause.
> For now and for my money, the United States is still the place to
> invest and bet on despite all the current problems.

May 02 09:13 PM

[John Petersen:]

Thanks for the link to the BYD report. It gave me an opportunity to go back and calculate the core valuation metrics for Buffet's purchase of a 10% stake at a post-money valuation of $2.3 billion. The numbers are:

Price/Earnings – 12.3
Price/Book – 1.18
Price/Sales –0.6

May 03 02:44 AM

[John Petersen:]

Buffet's effective price per share was in the $1.12 range. Since BYD is now trading at about $2.85 (presumably from the Buffet halo effect) the market valuation metrics for investors are nowhere near as attractive as they were for Warren.

May 03 09:49 AM

[Road Runner:]

Misha, There is a huge difference between the new Chinese government and the old Soviet Union government. Communism is now recognized world-wide as a bad idea. There is no doubt now. The Chinese government, which is basically the old communist party, knows this well. And they know the only way it can stay in power is to create a continuously rising economy leading to a rising standard of living. Else, the masses (like over a billion people - gulp) will rise up against the government. This has created the best form of government, a benevolent dictatorship.

If you not convinced by my theory, you can see it in actions of the government. They funnel huge amounts of resources into infrastructure projects that will improve the economy and create a better life for their people in general. Look at the massive 3-gorges damn which will generate a massive amount of electricity and make much more of the river navigable. Look at how they managed the take-over of Hong Kong by building a major industrial city just outside Hong Kong to leverage the economic power of Hong Kong.

This new Chinese communist government is nothing like the deeply corrupt self-destructive communist government of the old Soviet Union. Don’t even try to compare the two.

May 03 10:24 PM

[Ravi Nagarajan:]

Very insightful - check out these videos:

www.rationalwalk.com/?...

May 12 09:29 PM

[topshelf:]

you've been consistently wrong re: BYDDF, which is now over $4. You should actually DD deeply BYD Company, my personal portfolio favorite. Buffet had nothing to do with my entry. I bought byddf before he entered on a search for a China battery maker.


On May 03 09:49 AM John Petersen wrote:

> Buffet's effective price per share was in the $1.12 range. Since
> BYD is now trading at about $2.85 (presumably from the Buffet halo
> effect) the market valuation metrics for investors are nowhere near
> as attractive as they were for Warren.

Jun 03 12:37 PM