Chris Tell's  Instablog

By: Chris Tell at http://capitalistexploits.at/

The evolution of the Western shopper is well documented… Gone are the small local outlets from which our previous generation shopped. Modern adolescents now spend their waking hours roving shopping malls while glued to smart phones. I wrote an article on the topic of virtual crack a while back, it may be worth a quick review for those that missed it.

Traffic congestion, just like bureaucracy creates a lag on economic activity, but remains a valid barometer for identifying changing or accelerating trends.

In Economics classes, as boring as they are, we are taught about supply and demand. Where supply exceeds demand falling prices are the result. This is precisely why "rebooting" the world's economy by increasing the supply of useless scraps of paper (some call it "money") is asinine at best, and at worst will lead people and nations to conflict. But that's a topic for a later post. On the other side of the coin, demand exceeding supply typically results in rising prices.

Now, consider traffic jams with respect to supply and demand.

Last month in Phnom Penh, Cambodia it became painfully obvious that the increased supply of motor cars, trucks, buses and tuk-tuks has exceeded the capacity of the existing infrastructure. This is exciting for us, given that the infrastructure today is waaay better than it was 10 or even 5 years ago. A mere decade ago the roads, if one could accurately label them as such, were absolutely horrendous, yet were less, not more crowded. Back then the average Cambodian couldn't imagine to afford a tuk-tuk, let alone a car.

Today, not only are there plenty of vehicles on the roads, but they are now driving on roads which would be acceptable in any Western city, at least within the city limits. Those further out are shabby, but still remarkably good, and many times better than they were just a few short years ago. Things are vastly different in today's Cambodia, and they are changing rapidly and consistently.

An investment theme that we focus on quite a bit is that of changing consumer habits. This is where traffic jams come into my story, and in a most unlikely place… supermarkets. Yes, supermarkets.

Everyone knows that a rising middle-class enjoys higher levels of disposable income, the question is how they allocate their spending and who benefits and who doesn't. When your mode of transport is walking, a bicycle or maybe a scooter, you'll have two issues to confront when heading off to the store:

1. There is only so much you can carry as a pedestrian, or on a bicycle or scooter.
2. You'll naturally shop close to home to avoid carrying your goods a long distance.

Basically, consumers in markets which don't yet enjoy sufficient disposable income will shop accordingly, and you'll find little "Mom and Pop" stores are the most common. In economies and markets that are moving up the consumer spending ladder, there is a transition that occurs. Once disposable income increases, more motor cars hit the roads. Now it makes perfect sense to travel further to shop, since you can transport greater quantities of goods in a car.

While only anecdotal, I think there is a correlation between traffic caused by increasing disposable income and supermarkets. Mark and I saw this day in and day out while living in Thailand. The not-so-obvious beneficiaries of this are the smaller chain stores, not the large scale supermarkets such as Carrefour, Tesco, Makro, etc., but rather Alfamart (AMRT) in Indonesia, and 7-11′s (one on EVERY corner in Thailand). In Cambodia you have Lucky, owned by DFI, it's probably the best company to own in this space in our opinion. These (not so little) guys are simply everywhere, and their financials are pretty appealing.

Across SE Asia we're experiencing increasing urbanization and rising incomes. The impediment to "supply" is undoubtedly infrastructure. We can therefore glean a lot by watching the steady build up of traffic in frontier markets. Think of it as demand trying to (literally) get to supply. That's an investment opportunity that's easy to understand.

- Chris

"Ever consider what pets must think of us? I mean, here we come back from a grocery store with the most amazing haul - chicken, pork, half a cow. They must think we're the greatest hunters on earth!" - Anne Tyler, Pulitzer Prize-winning Novelist

Courtesy of http://capitalistexploits.at/

China circa 2008… six babies die from severe kidney damage while another 300,000 suffer kidney stones. As it turns out, melamine isn't meant to be in infant milk formula! The result was a few Chinese businessmen taken out back and shot, literally… and a nation that, for good reason, doesn't trust the dairy industry (for starters…).

Since then China has "enjoyed" multiple infant formula scandals, including formula containing aflatoxin, a known carcinogen, and a scandal involving milk powder containing mercury.

Outside of infant formula, but remaining on the topic of food found on Chinese supermarket shelves, it's also possible to buy "glow in the dark" meat. Turns out bacteria-laden pork does that. I figure there may be a market serving it in night clubs, instead of glow rods you could have "glow kebabs" - call it theme food.

Not to be outdone by the Europeans, who were recently caught passing off horse meat as beef, below I present a list of culinary delights to be found in the middle kingdom:

• Rice containing cadmium. A heavy metal which destroys your internal organs and causes cancer. Not a great ingredient in food methinks.
• Rat, Fox and Mink meat sold as Lamb. Come on…let's face it, most any meat deep fried and doused in sufficient amounts of soy sauce tastes pretty much the same anyway.
• Dead, diseased pigs sold as food. This was stylishly referred to as "swine gate". Turns out the pseudo-rabies virus in the pigs doesn't gel well with humans.

Deep fried with a bit hoisin sauce and it'll be alright, no?

In short, buying food off a supermarket shelf in China is a high risk adventure sport. What the average man may risk on his own behalf, he is far less likely to risk on his precious spawn. Those reading this article who have loved ones, especially children will likely agree with me when I say I would NEVER let my kid so much as look at any infant formula originating out of China. Even if there is a statistically small chance of poisoning, the ultimate penalty is death. Yeah, thanks, but no thanks.

It appears many Chinese parents feel the same way, which has led to mainland Chinese buying infant formula in bulk from Hong Kong, Europe, the US, and Australasia, thereby prompting a rationing in some countries by companies such as Danone and Mead Johnson Nutrition Co.

In a move reminiscent of US anti-drug trafficking efforts, the Chinese Government, exhibiting the intellectual capacity of a stuffed bear, have since restricted imports to just 2 cans per person. This has opened up a massive smuggling opportunity. You know the world is a screwed up place when transporting something so innocuous as infant formula is a punishable crime!

Hong Kong border officials last year arrested more people for smuggling baby infant formula than they did for heroin!

Markups now exceed 100% above retail prices in Europe, Hong Kong, Australia and New Zealand. When you consider I'm talking about the retail price and not the wholesale price, those of you who are not asleep, stoned, or dim, will quickly realise the obscene profits that smuggling generates. The average Chinese newborn consumes 22,630 grams of formula in their first 6 months of life, equating to a US$1,544 retail value. Demand is overwhelming supply right now.

When a market accepts and trusts people whom they don't know from Adam, selling infant formula out of their garage, then you know you have a market ripe with opportunity. Done properly the potential exists to create a powerful "trusted brand".

At present 70% of the imported infant formula market is controlled by foreign brands, with most of the independent brands run by small "Mom and Pop" companies from NZ and Holland, who as far as our analysis shows are successful mainly due to their product coming from "safe" jurisdictions. None we've found have strong marketing or endorsement programs, or are taking advantage of this opportunity in a well thought out manner.

Below is a graphic representation of the major players in this $12.5 billion sector:

Mark and I, along with our CPAN members have recently completed a "friends and family" seed financing round in a company seeking to change this.

Using a strong marketing platform they will seek to establish themselves as a niche, high-end supplier of infant formula to the China market. I'm here in NZ, and I just met with the CEO who is sourcing supply from a boutique New Zealand dairy company. He commented to me, "you know I wouldn't know what to do here in NZ, all the problems seem to be solved." This is exactly what excites us about emerging and frontier markets. There is NO shortage of problems, and the greatest profits always go to those who solve problems.

We believe this company is in the right market, has a solid strategy which they are systematically executing on, and most importantly they have a very well-established team of professionals with solid track records of operating in China. Those factors, combined with a compelling valuation, are some of the reasons we got involved.

As mentioned on our blog numerous times, we ALWAYS bet on talented, proven management first and foremost. By doing so we think the odds are stacked more in our favour than otherwise. Executed well, the rewards in this sector promise to be substantial. What is a sure bet is that someone in this space is going to make a fortune.

We have placed our bet, now let's see how it plays out. Time will tell, and nothing in private equity is ever a sure thing. However, I'm always cognizant of the deals which have vaulted my own portfolio, and most have had the ingredients of this one. We'll likely introduce readers again to the company in question once they hit cash flow, but prior to going public.

- Chris

"Even if there is only a 1% chance that Chinese formula is not safe, I don't want to be that 1%." - a "Mrs Li" (a Chinese mother)

Brokers, placement agents, middle men, promoters, consultants, financial intermediaries…call them whatever you wish. They have existed in the financial space since man invented a way to exchange one thing of value for another.

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Some do a fine job, provide a valuable service and deserve every penny they earn. In my experience however, and that of Mark and many of our friends who invest in private equity, these people, the deserved ones that is, are a very small fraction of those inhabiting this space. I've met hundreds of middle men and can count on one hand those I trust and value.

In the private equity space they are abundant. MAN are they abundant. In fact, I think we currently have a bubble in middle men. Doubt me? Hop onto LinkedIn and you'll find every Tom, Dick and Sheryl hard at work putting Nigerian scam artists to shame. To be fair, they may represent real deals which in-and-of-themselves are not shams, but beware the costs. Many "represent" millions in capital, yet like those "trusty" Nigerians, who also represent gobs of dough, somehow they just need that little itty-bit of additional capital from you and I to "pull it over the line."

I bring this up because of an amusing interaction I had recently with one such individual. I'd like to think that shining a light on some of these creatures lurking under slimy rocks may help other investors recognize these clowns when they see them. It may also serve as one of the red flags I previously spoke about for investors seeking an entrance into private equity deals.

Firstly, you'll likely have already come across some of them; they're quite possibly the guys "endorsing" you for your skills on LinkedIn. WTF..?

I'm confused, some guy I've never met and don't know from Adam, just endorsed me for "Strategic financial planning" skills. As confusing as this is, what really gets me is why I've not been endorsed for my great pancake making skills. My kids reckon I'm the best there is, and they actually know me and have witnessed said incredible pancake making abilities. The guy on LinkedIn…not so much!

Now these guys are nothing like brokers at all, but rather more akin to back alley abortionists peddling their wares, complete with the rusty, blood-stained "tools" from the last botched job. They litter the world of private equity like plastic bags on a Maputo high street, and frankly annoy the sh*t out of Mark and I.

A story to illustrate absurdity…

Onto my tale. I was recently put in touch with a gentleman of the type I described above, it turned into the stuff of high comedy.

Now, the underlying business was actually OK, which was why I gave the time of day to him to further explain the deal terms. However, the structure of the deal was such that the "promoter" got a fat chunk of the cash out of the gate, travel expenses (which were obscene), and sundry other expenses, which I showed to Mr. back alley boy, that amounted to fully 60% of the investors capital! I kid you not! Even more amazing to me is that this clown had in fact already found an investor of sufficiently low intellect to invest in the deal, taking out the majority of the offering. A 7-figure sum. I pity the sod. Something about "fools and their money" comes to mind.

This particular investor now requires a 150% return in order to simply break even. This, on an investment which is high risk to begin with, and where it's entirely possible to lose 100% of his money. Of course the promoter was doing his damndest to make the deal sound like a low risk, HUGE upside, fit for widows and orphans opportunity. He tried to weasel his way out of the facts when I presented them to him, but I was having none of it. In frustration he simply walked away saying I didn't understand the deal. Oh, I understood…and that of course was the problem.

This was one of the more extreme cases I've seen of friction costs, but I will say that it's pretty common for your investment dollar to be "attritioned" or "frictioned" to the tune of 15% or more on many deals I've reviewed. On a $100,000 placement you're looking at losing $15,000 right out of the gate if you don't pay attention.

You will almost NEVER be shown these details, but will need to closely examine the deal to find them out. Small print etc. folks. Look for font size 8 and read diligently.

As an investor it's crucial to understand the cost of capital for any business you are looking at getting involved in. Additionally, ferreting out the true cost of capital for a business, and whether you are getting hosed or not, is important in order to understand the true state of accounts in the company.

Some points:

• Find out how much capital hits the balance sheet. Unless its a "friends and family" round you'll likely have placement fees somewhere. No problem, but analyze them and make sure that they make sense.
• Always ask whether they have their own capital on the line, how much, and ask for proof and full disclosure of compensation to those involved in the transaction. Let me tell you there is a vast, Grand Canyon wide difference between having your own cash on the line and that of a client, friend, associate, or whatever you want to call "the other guy"… you know, the one who is actually putting up the capital.

Kyle Bass mentions the, "give a shit factor", and it is remarkably high when putting your own cash on the line. I should know, I've been "dumb enough" my entire adult life to be the guy putting his own capital to work and only getting paid when I'm right, and taking it on the chin when I've screwed up. It has frustrated me many times to have watched middle men walk away with larger sums than I…even after they never put a single dime on the line. No need to follow my path though, you can always become a mini-Bankster yourself.

Good luck out there, watch ceaselessly for this nonsense and make sure you ask the question first and foremost if any fees are being paid and to whom. Full disclosure should be given. So, next time some back alley abortionist lies to you, do us all a favour and punch them in the face.

- Chris

"Money talks and bullsh*t walks" - Sam Zell