(MENAFN - ValueWalk) I started investing when I was not even allowed to drive yet, but my investing activities became more serious in 2012, after I had relocated to Hong Kong, started to work and had some money to actually invest. It didn't take much time for the inexperienced me to make his first important mistake. At the time, I was already a big fan of value investing and knew the main concepts quite well. However, I was lacking in experience and investing is an industry where a few grey hair can help (which is now starting to happen…). In the next few paragraphs, we will look at why I made that mistake and more importantly, how we can learn from it.
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At the time, I was only looking at companies listed on the Hong Kong Stock Exchange, which made sense as I wanted to learn about that specific market. Not long after, based on a simple stock filter, I identified a company named Huabao International Holdings (336.HK), which as you can guess, became my worst mistake (so far)!
In summary, Huabao is principally engaged in flavours and tobacco-related businesses and it operates through four main segments: 1) flavours and fragrances, which mainly includes the sale of flavours to the tobacco industry (59% of FY2017 revenue); 2) tobacco raw materials, such as reconstituted tobacco leaves (20%); 3) aroma raw materials, for soaps and others (13%); and 4) innovative tobacco products, such as e-cigarettes (8%). Except for the innovative tobacco products segment which sells mainly in the US, the company's clients are mostly based in mainland China. In terms of market cap, Huabao is currently valued at approximately US$2 billion.
After having identified the company, I looked at several items such as the usual financial ratios (Price-to-Equity ratio, Enterprise Value-to-EBITDA ratio, Price-to-Book ratio, Debt ratios, and others.), historical financials and growth, sales segmentation, etc. To give you a quick idea, the net income margin of the firm for the FY2012 stood strong at over 52%(!), its P/E ratio was at about 7x, together with a cash rich balance sheet, no debt and a year-over-year revenue growth rate of over 16%. Based on my initial analysis, all of the aspects considered pointed to a financially healthy yet very cheaply valued company. Previous to my initial analysis, in April 2012, a 44-page issued by Anonymous Analytics led to the suspension of the stock. The report accused the company of being a 'pump and dump scheme with the primary objective of enriching its Chairwoman'. As I was considering buying the stock towards the end of 2012, I quickly dismissed the report thinking that it had been some time already, nothing significant had happened, and that these accusations were probably just a way for the short sellers to make a quick buck. So after a few weeks, I decided to buy some shares and took an initial position from the end of 2012 to the beginning of 2013 with a blended price of HK$3.73 per share. I mentioned this company to a good friend of mine, who I consider a savvy investor, and he also got interested in the stock and ultimately decided to invest in it as well. I thought I was pretty smart, but this was only the beginning…
The stock price didn't do much in 2013 but started going up in the middle of 2014 and went up to almost HK$7.00 per share. It then started to go down and as I had started managing some more money by then, I decided to increase my position at the beginning of April 2015 at a price per share of about HK$5.80. Right after I increased my position, the stock rocketed to almost HK$9.00 per share in less than one month and I thought that I had just hit the jackpot. As I was in it for the long run, I didn't sell any of my shares and from that point on, the stock price started going down the drain (see chart below). The financials of the company started worsening and without any clear sign of reversal, I got fed up and sold all of my shares in July 2016 at about HK$2.81 per share – yes, that was a painful loss! Luckily, I made it all back since then, with other investments.
That being said, the question is: could I have avoided that mistake? In short, yes. And most importantly, what can be done to avoid similar situations in the future? Let's have a look at the factors which led me to take a wrong decision.
Historical financials: As mentioned previously, the historical financials of the company at the time (FY2012 and previous) were extremely impressive and right from the start it gave me the wrong impression that the company and its management had to know what they were doing to be able to deliver such impressive results. I ignored some very important factors (see following factors) on the back of these extraordinary results. An important lesson here is to avoid putting too much importance on the historical financials of the firm. The past is not a good base to predict the future. Predictions, if any, should be prepared with a lot of care and based on applicable factors as of today or even tomorrow, not based on what has already happened.
Questionable integrity: The Anonymous Analytics short-seller report directly questions the integrity of the firm. Higher-than-average profit margins, several and important related-party transactions, major sell-offs of shares by the company's Chairwoman, and a severe reduction in dividends are all factors brought up by the report. The fact that the Chairwoman, Chu Lam Yiu, is never seen in public (and has had the same picture in the annual report for the last 10 years) is also quite worrying. I initially thought that these facts would ultimately be clarified and justified. However, it's never really happened and it seems like the investment community has always kept doubting the integrity of the firm, hurting its stock price.
Industry trends: The firm operates mainly in the tobacco industry in China and although it's a sticky kind of industry/product, it's not a growing industry. In addition, for Huabao, there are industry factors such as the overall level of inventory of tobacco leaves which are important and which can easily be missed. As a rule, I now favour industries where most stakeholders can benefit from the product or service offered and it's not the case with tobacco products. Tobacco firms now face important challenges with most governments and tobacco is obviously not a product which benefit the consumer in the long run. This adds a lot more resistance and challenges for the producer. At first, I believed that the company would be able to grow its other non-tobacco product lines, such as food flavouring. However, there are several important players in these other sectors and