National School of Development at Peking University
November 14, 2009
Paul B. Kazarian, Founder, Chairman, and CEO
of Japonica Partners (荣泰资本公司)
Successful Global Investing: Entrepreneurship, Innovation, and
Building Leading Global Companies
-- Significantly Raising the Bar for the Best Investments Globally --
- To significantly raise the bar for the best investments globally requires entrepreneurship, innovation, and building leading global companies. The most important investment wisdom is that building “perfectly aligned” relationships both cultivates entrepreneurial returns and is the foundation of low risk.
- Please allow me to express my sincere appreciation to the National School of Development at Peking University and the China Center for Economic Research for inviting me to address you today on the topics of “Successful Global Investing: Entrepreneurship, Innovation, and Building Leading Global Companies” and “Significantly Raising the Bar for the Best Investments Globally”.
- A special note of appreciation to our host, Ho-Mou Wu, Executive Associate Dean of National School of Development and Deputy Director of CCER. And, Yang Yao, the Deputy Director of the China Center for Economic Research and Deputy Dean of the National School of Development at Peking University.
- It is a great honor to speak at a university with such an extraordinary tradition of educating China's leadership, and providing the intellectual capital for China's extraordinary growth and prosperity. The National School of Development at Peking University's success in following the principle of “Small Organization, Big Network” is recognized around the world. Peking University is also highly regarded as one of the world's top universities in the new era.
- I'm also honored to be following distinguished recent speakers at the N.S.D., including U.S. Secretary of Treasury Timothy Geithner, and Nobel Prize for Economics winner Joseph Stiglitz.
- As Founder, Chairman, and CEO of 荣泰, I've been fortunate to oversee our growth since our founding in 1988. You may be interested to know that the western name of our firm has its origin in a small manufacturing community in the northeast United States. My grandparents immigrated to this community in the United States in 1915. The community is named after the flourishing mountain trees, similar to those growing in the small farming community in historic Armenia where my grandparents were born. Armenia is located at the crossroads between Asia and Europe. And, our Chinese translated name – 荣泰 – remains true to our heritage, as often represented by obsidian stones of the Armenian mountains, signifying clarity of mind, strength, and discipline.
- Our firm's involvement with Asia dates back to 1990 when we acquired a diversified global large cap that had its regional headquarters in Hong Kong. This acquisition occurred even before the rapid ascension of the special economic zone, Shenzhen.
- As for the topic of today, “Successful Global Investing: Entrepreneurship, Innovation, and Building Leading Global Companies; Significantly Raising the Bar for the Best Investments Globally”, I will first provide a brief background on how we define successful global investing and then discuss in more detail three important components: (1) Entrepreneurship, (2) Innovation, and (3) Building Leading Global Companies.
- Let me provide a few statistics to put today's topic in perspective. Our research indicates that global market indices as a percent of the total market indices have increased 300% over the past 10 years. The universe of leading global companies has seen their non-home market sales increase from 20% to nearly 50%. And, for the same universe of companies, almost two-thirds of their organic growth has come from outside their home market. Hence, it is clear that investing has become, and continues to be, more global by the day.
- As for the importance of entrepreneurs in global investing, our research indicates that almost 30% of annual global stock market growth comes from companies with an entrepreneurial culture, even though these companies account for only approximately 10% of the market capitalization of the total group.
- As for the importance of innovation in global investing, let me share several additional statistics. It is estimated that one-third of developed economy market capitalization is based on the value of intellectual property innovation. And, 40% of the economic growth is attributable to intellectual property innovation. One-half of the same groups' exports are from these products.
- As for building leading global companies, one observation is worth noting. Investing in companies that build this growth through high profile acquisitions is a very risky strategy. Both our internal research and other external research indicate that the success rate of such acquisitions could be as low as 30%. And, that the rate for global expansion acquisitions may be less than half of this already very small percentage. To become a successful and leading global company through acquisition is difficult and risky.
Successful Global Investing – Significantly Raising the Bar for the Best Investments Globally
- We define successful global investing as that which significantly raises the bar for the best investments globally and provides benefits to all stakeholders, including investors, employees, customers, suppliers, and the communities in which we operate. I contrast that with the much more narrow definition that focuses on investor returns only.
- As global investors, we have maintained this basic and important principle since our founding and have seen the power of its benefits to all our stakeholders. I understand that this principle is quite at odds with prevailing contemporary investment practice. However, it is one that we believe is the correct definition of successful global investing.
- This definition is important in that it has direct and significant impact on virtually all decision making. For example, it means that successful global investments are made based on business plans that build businesses through creating strong competitive barriers to entry that justify significant investment. It means, investing heavily in education and training of our people, as they are your most important asset. It means prudently using the global capital markets and financing for profitable growth without dangerous and excessive amounts of leverage; not for short-term returns to investors who have little regard to building leading global companies,.
- Recently, I read yet another study that attempts to claim that LBOS have no higher risk of damaging stakeholders from their excessive leverage than do non-LBOs. Such claims are both fatally flawed and dangerously reckless. These authors should be publicly censured.
- At the core of successful global investing and significantly raising the bar for the best investments globally is the single most important investment wisdom that we have learned since our founding in 1988. And, there is no question in our mind that this is the single most important wisdom in successful global investing. This investment wisdom may be only fifteen words, but its importance cannot be underestimated. This wisdom is as follows: “Building perfectly aligned relationships both cultivates entrepreneurial returns and is the foundation of low risk.”
- And to be clear, “perfectly aligned” relationships are applicable to all sectors of investing, including investment banking, brokers, financial advisors, mutual funds, private equity, hedge funds, and portfolio company management, etc.
- Before moving on, let me provide a little detail as to what a “perfectly aligned” relationship is and how it both cultivates entrepreneurial returns and provides the foundation for low risk.
- Building perfectly aligned relationships is a goal that must be continuously pursued and worked towards rather than achieved once and then forgotten. There must be an ongoing effort to protect the integrity of the relationship. All significant relationships must be assessed on a comprehensive basis to include the economics, structure, and governance of the relationship. For us, we use the term “perfectly aligned” to mean that a manager's performance must significantly exceed a top quartile performance standard in order to receive superior economic compensation.
- Such a “perfectly aligned” relationship cultivates entrepreneurial returns primarily because its structure is most appealing to entrepreneurs who have the entrepreneurial passion for extraordinary performance well beyond the top quartile. A handful of simple and currently relevant key performance indicators (KPIs) are essential to strengthen the relationship. And, with such KPIs in place, there is a clear economic path as to what is required in order to significantly raise the bar for the best investments globally.
- You will find the basic principle of “perfectly aligned” relationships, as we define it, highlighted in the first of the three slides we've distributed. The nine points in oval boxes provide you the framework to assess and build “perfectly aligned” relationships.
- The nine principles are: (1.) Passion for entrepreneurial performance with low risk; (2.) Real Top Quartile performance hurdles; (3.) Bilateral information sharing and productive transparency; (4.) Consistency, Predictability & Growth; (5.) None better communication & education; (6.) Continuously raise performance bar more tomorrow than today; (7.) Beauty in simplicity; (8.) Protect integrity of the relationship; and, (9.) Work, work,… work.
- Importantly, building “perfectly aligned” relationships provides the foundation of low risk. This is a topic that must be focused upon intently. Before making an investment, you must assess the downside risk thoroughly. And, then only after satisfied, proceed to assess upside opportunity. This foundation of low risk is also true for the economics, structure, and governance of compensation relationships. You must have very long-term performance compensation provisions to ensure that managers' incentives are not misaligned. We have found five to seven years to be best, and three years to be way too short. It was only recently that the general market has finally come to recognize how misaligned terms create reckless and risky behavior.
- This may seem either very straightforward or exceedingly complex. It is neither. However, a strong word of caution is appropriate here. It is all too common for those with conflicting, vested interests to either directly or indirectly attempt to obfuscate misaligned relationships. In fact, we repeatedly continue to see conflicted, high profile individuals and highly marketed firms trying to sell highly misaligned, and indeed, reckless relationships, under the rubric of so-called “fully aligned”. In fact, the truth could not be more the opposite. This is especially found in the financial sector and with inevitably reckless consequences to investors.
- There are numerous regulatory entities and quasi-regulatory entities that are currently assessing issues related to misalignment in the financial sectors. However, little of substance has been accomplished to date. Too often, the wolf is inside the house.
- Substantive change will require leadership by the most responsible thought leaders of our time. Who will be the real leaders of the next generation is yet to be seen.
- We have suggested a global roundtable of the most significant and responsible leaders in the investment sector as a necessary step to send the right message that misaligned relationships expose the investment sector to massive trauma, and such relationships should not be sugar-coated.
- For example, investment related incentive earnings and fees should only be earned for risk adjusted performance exceeding real benchmarks and such earnings should only be taken after investors have had substantial opportunity to get back 100% of their investment as well as returns up to the benchmarks. Allowing compensation and fees to be taken prior to this is a recipe for financial recklessness and the resulting ruin.
- For those interested in learning more, we suggest the insights of those time-tested sages who have spoken honestly without the taint of financial paybacks.
- Before moving on to discuss our three main components today (Entrepreneurship, Innovation, and Building Leading Global Companies), let me briefly mention a checklist of five investment principles that you should include in your quest for significantly raising the bar for the best investments on the global landscape.
- (1.) Risk lovers and ethic-less salesmen are to be avoided. Taking more risk to earn higher returns is often a major fallacy marketed to sell investment products with higher intermediary fees. In many western capital markets, risk has been cultivated by distancing the originating investor from the final investment manager. For example, a manufacturing worker contributes his savings to his pension. His pension fund managers then typically allocate these hard earned savings to a fund-of-funds of hedge or private equity funds. These fund-of-fund managers then invest the funds in hedge or private funds. By this point, it is not a surprise that a risk lover, with very misaligned economic incentives, is making investment decisions on the asset-owner's behalf.
- (2.) The principle of “long-term investing” can be very misused. You should invest as a long-term investor only so long as the managers of a company deserve your continued support. Management should always be very wary that you will sell and should never take your continued support for granted. Rather than short-term or long-term, we use the phrase “merit-based-term” as we believe this is much more appropriate. Our most important and high value creation relationships are merit-based.
- (3.) IRRs and rate of return calculations are too easily manipulated to hide real performance. For example, as shocking as this may seem, a 90% loss of capital can almost disappear if held for the life of a typical private equity fund using industry standard IRR math calculations. And, it is equally surprising to many, that a heavily marketed and often repeated in the media 40% IRR can quickly disappear to less than a 10% IRR when a fair and objective measurement standard is utilized. What matters most to the investor are cash-on-cash returns.
- Do not be misled by the all-too-common inflated investment returns touted by endowments. As surprising as it may seem, there is little to no regulatory body with responsibility to oversee the claims of endowment investment performance. As you know, endowment investment returns are aggressively marketed to raise funds in plans that often provide the option to split returns with donors. As has become apparent more recently, assets have not been properly marked-to-market on the endowment books.
- The reporting of endowment investments in alternative asset managers is often over-valued by using techniques such as side pockets in hedge funds and non-public marks for PE funds under the guise of long-term investing. When in fact, these funds would flip their positions as soon as a profit made it attractive to do so. Equally misleading is that we have yet to find an endowment that has put an offsetting liability on its books for the potential liability of defaulting on very long-term commitments. Such defaults can cost the endowment up to 50% of their investments and take away most of their rights. And with the flood gates having been opened on IPOs of alternative asset managers, it becomes much more apparent that the endowment's book value of such assets is much higher than the public market pricing. This is a very recent trend, and it brings to the forefront the overvaluation of such assets.
- Pension funds and endowments have been broadly convinced that keeping mission-related decision-making and investment decision-making separate is both a best practice and a fiduciary requirement. A more fair-minded and open-eyed view is that such a belief is actually a worst practice and a contra-fiduciary action. What is so ironic about the current systemic view is that pensions, which are there to benefit the workers, and endowments, which are mandated to improve society through education, are directly stoking the flames of reckless, risk loving investments that are actually damaging society.
- If there were to be one culprit of the latest financial meltdown and economic trauma, quite possibly it would be those that have betrayed their mission to protect pensioners and advance university stakeholders. They economically incentivized investment advisors and managers to stoke the flames of financial recklessness. Establishing a necessary fixed return on assets at unrealistic levels has effectively forced reckless risk chasing. This mirage-like fixed return rate is often nothing more than a financial marketing tool to sell high margin products. Their actions remind me of an Armenian fable of the trees, the woodsman, and the ax. A woodsman, carrying a wood-handled axe is walking into the forest to chop down and kill the trees. One tree says to another, “it's so ironic that the real culprit is one of us.”
- For those looking to read more on this topic I strongly recommend a book published by our affiliated non-profit foundation, entitled New Philanthropy Benchmarking: Wisdom for the Passionate. Several sections of the 400+ page textbook focus on such topics.
- From our experience, an investor needs to beware that well over half the AUM growth of successful money managers is from salesmanship, not performance. To think otherwise is just plain wrong.
- I need not comment on the suspect quality of performance returns of mutual funds, as this has been amply covered in the mainstream media.
- (4.) The current gold standard for measuring investment performance is called GIPS, which stands for Global Investment Performance Standards. While not perfect, it seeks to provide apples-to-apples comparisons of investment returns across all asset classes. It is more the rule than the exception that investment professionals and associations oppose the adoption of GIPS as it restricts their ability to use smoke and mirrors to inflate marketable return metrics and provide an unfair picture of a lower risk profile. We strongly recommend that you carefully analyze GIPS and its benefits to the capital markets and take a world leading position advocating for its adoption universally.
- We have also recommended that dollar-weighted returns be shown for hedge funds to avoid highly-marketed claims of long-time span returns. Earning 30% on $10 million AUM for one year and 2% on $1 billion AUM does not mean an annual an average return of 16%.
- (5.) Avoid flavor-of-the-moment investing. Searching for a lost car-key at night in the light of a nearby street lamp--regardless of where the key was lost, but because that is where the light shines--will not likely start the engine.
- As for non-company, flavor-of-the-moment macro bets, such bets are all too often made by those professionals who want to invest other people's money under an investment theme that cannot be proved or disproved analytically. This is the classic wealth transfer model, not to be confused with a wealth creation model. In these situations, it is typically all about fees, salesmanship, and misalignment.
- With this as background, I will now address in more detail: entrepreneurship, innovation, and building global companies. And, I will also discuss how to significantly raise the bar for the best investments globally.
- I had previously mentioned the economic significance of entrepreneurial cultures and market valuations to companies. From our experience, the term entrepreneur can have and does have very different meanings depending on geographic location and other culturally unique histories. First, I will define how we use the term, and then describe what it is, and what it is not. Then, I will briefly discuss how to cultivate an entrepreneurial culture where it has yet to flourish to its optimal level.
- Entrepreneurial culture is a common passion based on building a company that all employees and other stakeholders are proud to be associated with. It is a passion and a relentless pursuit to significantly raise the bar for the best globally. This becomes embedded in the DNA of the company and its employees. It occurs when innovation is second nature and where an individual's perception of success is tied inextricably with the company's. It's where meritocracy transcends all other criteria. We also find it very common that entrepreneurs have, at a minimum, one-third if not virtually all, of their liquid net worth invested in the company. The entrepreneurial passion can be both latent as well as manifest.
- Such merit-based relationships, especially those that seek to be “perfectly aligned” both cultivate entrepreneurial returns and are the foundation of low risk. All our most important and high value creation relationships are merit-based.
- Entrepreneurship is not based on short-term profit or maintaining the status quo. Equally clear, entrepreneurship is not based on misaligned compensation. It's not based on a sense of entitled satisfaction or a belief that challenges facing a company are issues for others to deal with. It is not based on compensation from fees before an entrepreneur's investors have achieved their own entrepreneurial returns. This is often an area of considerable confusion. Most of this confusion is intended by those seeking to profit from misalignment.
- One of the most telling signals of what is not entrepreneurial is finding senior executives that are inflicted with what we call the “curse of the mogul”. This is where ego replaces good business judgment.
- While it may be difficult for many to distinguish, PR spin is no substitute for real entrepreneurial passion. Nor is hiring several PR firms on multi-million dollar annual retainers an effective long-term strategy.
- As for how best to create an entrepreneurial culture where one does not exist, it starts with all members of management wholeheartedly supporting and participating in internal university-type education and training programs. And, it is up to the C-level managers to make smart decisions that demonstrate the best practices of leadership.
- As an aside, the first HBS case on 荣泰 documents the importance of entrepreneurial management to our success in building leading global companies and significantly raising the bar for the best investments globaly.
55. Top-quartile, if not top-decile, innovation is absolutely critical when assessing which companies are the best investments. We have found that innovation is the second largest value creation opportunity, very close to our number one high-value creation component, 100% globalizing of all operations
56. I mentioned earlier the importance of innovation on a company's stock market capitalization. Let's take a moment to set forth what we believe innovation is and what it is not.
57. Innovation starts with superior intelligence as to a company's competitive landscape, and projecting out one to two product cycles. And, in parallel, the same superior intelligence into customer desires, both latent and manifest, is essential.
58. Innovation must be based around a competitive core competency and building strong barriers to entry.
59. One of the sheets handed out, entitled Global Leadership R&D: 3 KPIs, highlights a very useful framework for assessing a company's competitive position. As you see, the vertical axis is the innovation productivity KPI. The left axis is the performance of quality and speed KPI, and the right is the resource allocation KPI. We view these KPIs as invaluable in assessing and managing a company's innovation value.
60. These three KPIs work so well that we have used and continue to use these same three KPIs to assess alternative locations for our R&D centers, which (as you may suspect) can involve thousands of R&D engineers. In fact, our teams are currently conducting top quartile benchmark and high value creation best practice research on eight countries as part of our continuously raising the performance bar more tomorrow than today with our leadership R&D innovation. The winning locations for our largest R&D centers will have the highest scores on these KPIs.
61. What innovation is not can very simply be identified by a lack of quality KPIs utilized by management. We have seen all too often that those responsible for managing R&D waste massive amounts of money year after year and at the same time allow a company's barriers to entry to decline to the point of destructiveness.
62. There are tremendous gaps between the best and the worst. And, there are almost as wide gaps between the average and the top quartile.
63. Unfortunately, in our experience, there is no easy way to measure innovation other than the KPIs. Simple metrics such as R&D spending as a percentage of revenue (often called R&D intensity), or R&D as a percentage of operating profit (often called R&D productivity), are not very useful. Indeed, our experience is that mismanaged R&D is curvilinear, in that the worst-managed companies are at the opposite ends of these percentage spectrums (the highest and lowest R&D spenders).
64. Similar metrics are used to compare country R&D innovation efforts. Here we have found that these macro metrics are actually more useful in our selection process. R&D as a percentage of GDP is a very telling metric. We use a 13-point spider ranking scale as part of our process to evaluate locating our R&D centers. Currently, we have eight countries in our scope of evaluation.
65. All the major consulting firms offer their proprietary processes for assessing R&D productivity as do many niche firms. You have probably analyzed most of the work available by these firms on R&D. Depending on your level of knowledge, these are good starting points along the education path. The major consulting firms have annual rankings and updated publications that can be useful as an entry-level primer.
Building Leading Global Companies
66. As for the third component of significantly raising the bar for the best investments globally, building leading global companies, let me very briefly describe how we determine what is such a company and what is not such a company.
67. In assessing what is, and in building, a leading global company, we use a frame work of five components, which we collectively call “High Value Creation D-C-C”. Or, as we say in Chinese, .
68. As with building “perfectly aligned” relationships, we capture this image on one side of our pocket card. This image is the second of the two images in the packet we have distributed. From left to right, they are 100% globalization of all business operations, leadership R&D (which relates directly to innovation), barrier breaking branding, trending setting technology (which also relates directly to innovation), and collaborative leaps in supply chain management.
69. Each of these has its own key performance indicators (KPIs). The most successful leading companies are those that not only strive to be the benchmark and utilize the associated best practices, but are those that continuously raise the KPIs more tomorrow than they do today.
70. As may be obvious, this level of assessment can require significant effort and expense. There is, however, one indicator that often serves as a proxy for an initial estimate. That proxy is what we call the value-add of the shareholder base. As we at 荣泰 have found, the business logic for this is that such shareholders will work to add value to the companies in which they invest, and such high value creation propels leading global companies to achieve higher levels of KPIs.
71. For example, our firm has dedicated itself to strengthening its core competencies of cultivating high value creation from our partners through internally developed processes. In fact, all of our most important relationships are merit-based.
72. Equally important, let me very briefly describe what is not building a leading global company. By way of illustration, let me broadly classify these into two groups: underperforming global large gaps (or UGLCs), and companies that are owned and managed by the worst of those using what is often referred to pejoratively as the “private equity (or hedge fund) playbook”.
73. UGLCs are companies that suffer from a loss of passion for innovation and performance. These may be companies that have undiscovered transformational opportunities to create value. Or, they can be the contemporary business world's version of an extinct species. They are often diversified conglomerates.
74. As for those controlled by funds using the most egregious of the PE/hedge fund playbook, the level of abuse is both systemic and very damaging to society. This is not true of every PE and hedge fund, but the use of such playbook tactics is systemic. These include massively excessive leverage; reckless cuts to R&D and employees; using company resources for personal gain (especially through high-risk trading); uneconomical deals with suppliers to inflate short-term gains; binge-like acquisitions; use of non-GAAP financial reporting to camouflage declining performance; short-term customer alienation; reckless extortion-type pricing; and the list goes on and on. To be clear, this does not build a leading global company, it only destroys a valuable contributor to society.
75. And, do not expect the media, or sell-side analyst reports, to distinguish between those companies that are truly leading global companies building stronger barriers to entry every day, and those that are either UGLCs or being run by the PE/Hedge fund playbook.
76. If you have an interest in learning more on this topic, there is a well-written Harvard Business School case study on the successful building of a global leading company, which happens to focus on one of our investments.
77. Successful global investing requires clarity of mind, strength, and discipline. You should fully appreciate the competition you face in significantly raising the bar for the best investments globally. Be honest with yourselves in investing. There are tens of thousands of professional investors competing for superior returns. Ask yourself: what is my competitive advantage and where do I rank? Ask yourself: how often would I want to make a decision when the party I am buying from, or selling to, has superior information or intelligence compared to me? Invest for all the right reasons, never because you are pressured. What you don't invest in is more important than what you do invest in.
78. Entrepreneurship and innovation are essential in building leading global companies. And, as is our strongest recommendation, never forget the number one investment wisdom: building “perfectly aligned” relationships both cultivates entrepreneurial returns and is the foundation of low risk.
79. We will be hosting a roundtable on the topic of the global consequences of misaligned relationships in the capital markets and the benefits of building “perfectly aligned” relationships. We are considering several locations for the roundtable, whose attendees will be among the most respected global investors and business-focused individuals in the world.
80. I'm more than happy to answer any questions.