Category: Special Events

This morning, I gave a presentation for iFAST Global Markets’ Virtual Symposium – Strategies to Build Wealth During the Bear Market event. I would like to thank the iFAST Global Markets team, in particular Ko Yang Zhi, for their invitation. The title of my presentation is the same as the title of this article you’re reading. You can check out the slide deck for my presentation by hitting this orange button:

You can also find my speech, along with the accompanying slides, below!

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Presentation

[Slide 2] Hi everyone, I’m Ser Jing. I launched Compounder Fund, a global equities investment fund, July 2020 together with my friend Jeremy Chia. The both of us also run an investment blog called The Good Investors, with the URL (www.thegoodinvestors.sg). Prior to Compounder Fund and the blog, I was with The Motley Fool Singapore from Jan 2013 – Oct 2019. For those of you who may not know, The Motley Fool Singapore was an investment website and we specialised in selling investment research online.

[Slide 2] During this presentation, I’ll be sharing myths regarding the stock market that I commonly read or hear about. These myths are dangerous if they’re not debunked because they can harm your long-term investing returns by influencing your investing behaviour in negative ways. During the presentation, I’ll need your participation. There will be a few questions I’ll be asking, and I need your help to answer them. I’ll be covering nine myths in all, and there will be some time for a Q&A at the end. With each myth that I debunk – with factual data – I’ll also discuss a key lesson that we can learn from each of them. 

[Slide 3] Before I dive into the presentation, nothing I say should be taken to be investment advice or a recommendation to act on any security or investment product. I may also have a vested interest in the stocks mentioned during this presentation

[Slide 4] Let’s start with the first myth. Imagine that you’re now back in 1992 and you found a country that had a GDP (gross domestic product) of US$427 billion. You also have a perfect crystal ball that’s telling you that this country’s GDP would go on to compound by 13.7% per year till 2021, ending the year with US$17.7 trillion in GDP. Take a second to think if you would want to invest in the stock market of this country in 1992? Note that these are all real figures.

[Slide 5] The country I’m talking about here is China and if you said yes to my question, a dollar that you had invested in the MSCI China Index – a collection of large and mid-sized companies in the country – in late-1992 would have become roughly… a dollar by October this year. You heard that correctly: Chinese stocks have been flat for 30 years despite a 13.7% annualised growth in GDP over the same period. The reason is because stocks ultimately go up if their underlying businesses do well.

[Slide 6] And in the case of China, you can see that the earnings per share of the MSCI China Index was basically flat from 1995 to 2021.

[Slide 7] So the first myth I want to debunk is that a country’s stock market will definitely do well if its economy is growing robustly. And the lesson here is that the gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. 

[Slide 8] Now for the second myth. Let’s go back in time again, this time to September 2005 – in case you’re wondering, we’ll be doing quite a bit of time travelling in today’s presentation. You’re in September 2005 now and you can see that gold is worth A$620 per ounce. The perfect crystal ball you had in Myth 1 is now telling you that the price of gold would climb by 10% per year to A$1,550 in September 2015. The golden question facing you now in September 2005 is this: Do you want to invest in Australian gold mining stocks for the next 10 years?

[Slide 9] If you said yes, you would be sitting on a loss of more than 30%. The S&P / ASX All Ordinaries Gold index, an index of gold-mining stocks in Australia’s stock market, fell by 4% annually from 3,372 points in September 2005 to 2,245 in September 2015.

[Slide 10] So the second myth is this: You should definitely invest in a commodity-producer’s stock if you’re sure that the price of the commodity will rise. The lesson here is the same as the first myth’s: The gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. In that mile are things like the quality of the business, the capability of the management team, the balance sheet strength of the company, and so on.

[Slide 11] Moving on to the third myth, I need your help to choose between two groups of real-life US-listed companies that you would prefer to invest in if you could go back in time to 2010.

[Slide 12] The first group comprises Company A, Company B, and Company C. This chart shows their stock prices from the start of 2010 to the end of 2021 – Company A is the purple line, Company B is orange, and Company C is blue. More specifically, the chart shows the percentage declines from a recent high that each company’s stock price had experienced in that timeframe. The chart looks brutally rough for all three companies. Their stock prices declined by 20% or more on multiple occasions from 2010 to 2021. In fact, Company B’s stock price had fallen by 40% from a recent high on four separate occasions, and Company C even suffered an 80% drop in 2011. Moreover, their stock prices were much more volatile than the S&P 500; the S&P 500 is a major stock market index in the USA and it experienced a decline of 20% or more from a recent high just once in early 2020. 

[Slide 13] The second group of companies are Company D, Company, E, and Company F. This table illustrates their stock prices and revenue growth from the start of 2010 to the end of 2021, along with the S&P 500’s gain. The second group has generated tremendous wealth for their investors, far in excess of the S&P 500’s return, because of years of rapid business growth.

[Slide 14] This chart is a pictorial representation of the stock price gains that Company D, Company E, Company F, and the S&P 500 have produced.So take a second to think about which group you would like to invest in. As a quick recap: The first group had experienced severe volatility in their stock prices in the 2010-to-2021 time frame, often falling by huge percentages.

[Slide 15] I’m guessing that most of you would prefer to invest in the second group. But here’s what’s interesting: Both groups refer to the same companies! Company A and Company D are Amazon; B and E are MercadoLibre, and C and F are Netflix. Amazon and Netflix are likely to be familiar to all of you watching this, but MercadoLibre is not – it is an e-commerce and digital payments giant that focuses on Latin America.

[Slide 16] The third myth is that great long-term winners in the stock market will make you feel comfortable on their way up. But this myth couldn’t be further from the truth. Even the market’s best winners will make you feel like throwing up as they climb over time and there are two lessons here: (1) Volatility in the stock market is a feature and not an anomaly, and (2) The route to huge gains in the stock market will feel like a sickening roller-coaster.

[Slide 17] We’re now at the fourth myth, and it relates to something interesting about the stock price returns and business growth of Amazon, MercadoLibre, and Netflix. This table shows the revenue growth and stock price movement for all three companies in each year from 2010 to 2021. You will notice that the trio have each: (1) exhibited excellent revenue growth in each year for the period; (2) underperformed the S&P 500 in a few calendar years, sometimes significantly; and (3) seen their stock prices and business move in completely opposite directions in some years. But yet, all three of them have produced excellent business growth with matching stock price returns, as I discussed in Myth 3.

[Slide 18] The experience of Amazon, MercadoLibre, and Netflix are not isolated examples. In fact, Nobel-prize-winning economist Robert Shiller once published research in the 1980s that looked at how the US stock market performed from 1871 to 1979. Shiller compared the market’s performance to how it should have rationally performed if investors had perfect knowledge on the future changes in its dividends. The result is the chart you’re looking at now. The solid line is the stock market’s actual performance while the dashed line is the rational performance. Although there were violent fluctuations in US stock prices, the fundamentals of American businesses – using dividends as a proxy – was much less volatile. The legendary investor Ben Graham has a beautiful analogy for the stock market, that it is a voting machine in the short run but a weighing machine in the long run. Plenty of shorter-term voting had taken place in the US stock market over the course of history. But importantly, the weighing scale did function beautifully. From 1871 to 1979, historical data on US stocks maintained by Shiller show that the S&P 500’s dividend and price had increased by 2,073% and 2,328%, respectively. 

[Slide 19] So the fourth myth is this: If a stock’s underlying business does well every year, the stock’s price will also do well each year. In fact, and this is the lesson: A company’s stock price can exhibit stomach-churning short-term volatility even when its underlying business is performing well, but in the long run, business fundamentals and stock prices do match up nicely.

[Slide 20] We’re at the fifth myth now, and I need your help to quickly think about this question: We’re now at the start of the year 1990 – how do you think the US stock market will fare over the next five years and the next 30 years, if I tell you that all three of the following will happen during the year: In July, the USA will enter a recession and a month later, the country will fight in a war in the Middle East and the price of oil will spike?

[Slide 21] Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. 

[Slide 22] From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.

[Slide 23] What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table here illustrates. Yet, the S&P 500 had steadily marched higher in that period.

[Slide 24] The myth here is that stocks can only do well during peaceful times. But the truth – and the lesson – is that uncertainty is always around, and disasters are always happening, but that does not mean we should not invest as stocks can still do well even in the face of trouble.

[Slide 25] For Myth No. 6, let’s consider the importance that some of the best investors in the world place in trying to predict the short-term movement of stock prices. We can use Peter Lynch and Warren Buffett as examples. But first, I’ll quickly run through why the both of them are widely considered to be investing greats. Lynch was the manager of the US-focused Fidelity Magellan Fund from 1977 to 1990. During his 13-year tenure, he produced an annual return of 29%, nearly double that of the S&P 500. Meanwhile, Buffett has been in control of his investment conglomerate Berkshire Hathaway since 1965. From then to 2018, he grew the book value per share of Berkshire by 18.7% per year by using its capital to invest in stocks and acquire companies with outstanding businesses. Over the same period, the S&P 500 compounded at less than 10% annually. 

[Slide 26] So how do Lynch and Buffett incorporate short-term predictions on the stock market in their investing process? They don’t. In an old interview with PBS, Lynch said: “What the market’s going to do in one or two years, you don’t know. Time is on your side in the stock market. It’s on your side. And when stocks go down, if you’ve got the money, you don’t worry about it and you’re putting more in, you shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”

[Slide 27] Then there’s Buffett, who wrote a famous op-ed for The New York Times in October 2008, at the height of the Great Financial Crisis. In it, Buffett shared: “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

[Slide 28] Myth No.6 is something I hear often, and that is that great stock market investors know exactly what’s going to happen to stock prices in the next month or year ahead. But as I’ve discussed, even the best in the business have no clue what stocks would do in the short run, and yet that did not prevent them from clocking incredible long-term returns. So the lesson here is that we can still achieve great long-term investing results even if we have no idea what the market’s going to do over the short run. 

[Slide 29] The seventh myth involves stocks and recessions. What do you think will happen if you have perfect clairvoyance and are able to tell when the US economy will enter and exit a recession and thus sell stocks just before a recession hits and buy them back just before a recession ends?

[Slide 30] If you had this clairvoyance from 1980 to 2018, you would wish you did not have the special ability. According to research from Michael Batnick, a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. This is the black line in the chart. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. This is the red line.

[Slide 31] The seventh myth is that it is important for stock market investors to side-step recessions. But the data shows us an important lesson: Trying to side-step recessions can end up harming our returns, so it’s far better to stay invested and accept that recessions are par for the course when it comes to investing.

[Slide 32] Moving to Myth No. 8, when we’re in an economic downturn, I think it’s natural to assume that it’s safer to invest when the coast is clear. But the reality is that the stock market tends to recover before good news about the economy arrives. For example, if we go back to the most recent recession in the USA prior to COVID, that would be the recession that lasted from December 2007 to June 2009. In that episode, the S&P 500 reached a trough in March 2009 of around 680 points. Back then, the unemployment rate in the country was around 8%. But by the time the unemployment rate reached  a peak in late 2009 at 10%, the S&P 500 was already around 50% higher than where it was in March 2009 and it has never looked back.

[Slide 33] So the myth here is that we should only invest when the coast is clear. But as the data shows – and to borrow a Warren Buffett quote I mentioned earlier, “if you wait for the robins, spring will be over.”

[Slide 34] And last but not least, we’re at Myth No.9, where it’s about interest rates and stocks. There’s plenty of attention being paid to interest rates because of its theoretical link with stock prices. Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since bonds, being an alternative to stocks, are providing a good return. On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return. And falling valuations for stocks would then lead to falling stock prices. But the real relationship between interest rates and stocks is nowhere near as clean as what’s described in theory.

[Slide 35] Ben Carlson’s research has shown that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the USA’s central bank, the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.

[Slide 36] Meanwhile, data from Robert Shiller show that the US 10-year Treasury yield was 2.3% at the start of 1950. The yield reached a peak of 15.3% in September 1981. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to…  8. That’s right, the P/E ratio for the S&P 500 increased slightly despite the huge jump in interest rates.

[Slide 37] It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that were temporarily inflated, as can be seen by the trend for the index’s earnings per share in preceding and subsequent five-year periods.

[Slide 38] Then we have this chart, which illustrates the historical relationship that the S&P 500’s price-to-earnings (P/E) ratio has had with 10-year Treasury yields. It turns out that the S&P 500’s P/E ratio has historically and – noticeably – peaked when the 10-year bond yield was around 5%, and not when the 10-year bond yield was materially lower at say 3% or 2%.

[Slide 39] The ninth myth is this: Rising interest rates are definitely bad for stock valuations and thus stock prices. But what the evidence shows is that stock valuations and prices have risen over time even when interest rates have soared. So there are two important lessons here: (1) While interest rates have a role to play in the movement of stocks, it is far from the only thing that matters; (2) one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

[Slide 40] I’ve come to the end of my presentation today and I’m happy to take questions!

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Amazon, MercadoLibre, and Netflix shares mentioned. Holdings are subject to change at any time.

Acquisitions often pose an analytical challenge for investors.

Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.

The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.

Here is a short primer on the things to look out for in acquisitions.

Accounting for cash outlay

Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs. 

Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.

I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.

If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.

Let’s take Adobe’s acquisition of Figma as an example.

Adobe announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.

As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.

But given that it is a one-off expense, does this mean anything? A resounding, yes.

When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.

Consider dilution when looking at stock-based financing, instead of the current dollar amount

Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.

Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.

Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.

In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.

In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%. 

This is the real cost of stock-based financing.

Is the acquirer overstretching its finances?

Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.

Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.

Let’s take a look at the Adobe-Figma deal again.

Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion. 

Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.

Analysing the target company

Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?

As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc. 

Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.

Second, will the combined entity work well together?

In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.

Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.

Does the price match the value?

Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.

In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.

Final Thoughts

Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.

With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.

If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.

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The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Adobe. Holdings are subject to change at any time.

2021 will be remembered as a year of a bull market.

The widely-followed S&P 500 index, which comprises 505 of the largest US companies in the stock market, returned 28.7%, well ahead of its long-term annualised return of around 9%.

But that’s only half the story. While the major index witnessed a big upward, many smaller cap tech stocks did not do so well. In particular, “high-growth tech stocks” collectively had a terrible year.

The ARK Innovation ETF, an investment fund managed by Catherine Wood that invests in companies that deploy “disruptive technology,” fell by 24.1% in 2021. Although most of the high-growth companies in ARK’s portfolio continue to produce excellent revenue growth, valuation-compressions have driven their stock prices lower.

With high-growth stocks starting 2021 at relatively high multiples, decelerating growth from the highs of 2020 understandably caused some investors to ditch high growth stocks for value stocks whose valuation multiples have expanded.

Some of the biggest pandemic winners of 2020, such as Zoom Video Communications (-49%), Peloton (-75%), and Teladoc (-54%) sank the most in 2021.

Long-term secular trends

So is this the end of an era for high-growth tech companies?

Personally, I doubt so. Companies that are serving large and growing industries and are disrupting older technologies are likely going to experience durable revenue growth for many years. It is also not uncommon for high-growth stocks to experience valuation swings. One group of high-growth stocks that has seen frequent valuation contractions and expansions is the software-as-a-service (SaaS) stocks. 

My friend Eugene Ng, who is a seasoned investor shared this interesting table on Twitter recently:

Software valuation corrections are frequent (every 1-3 years), and not uncommon (over last 21 years, since 2001). pic.twitter.com/hohnhi3Ofm

— Eugene Ng (@EugeneNg_VCap) January 3, 2022

What it shows is that SaaS stocks have experienced numerous valuation-contractions in the past 20 years and yet eventually return to higher multiples. Although current SaaS valuation ratios are still higher than at most times in history, these high ratios could persist as long as superior revenue growth can continue.

In the past, investors had chronically underappreciated the durability of revenue growth of SaaS companies. Today investors have wisened up to this and are giving SaaS stocks deservedly higher valuation ratios compared to the past. So it is very possible for their valuation ratios to expand again.

Moreover, even with slowing revenue growth which I mentioned earlier, many high-growth stocks are still expected to grow their revenues in the mid-twenties percentage range for years. We could witness higher stock prices for high-growth SaaS stocks in the future even from strong revenue growth alone.

Don’t fret

If you’re one of the many high-growth tech investors who have underperformed the market in 2021, what should you do?

First off, don’t fret. Even though it’s not pleasant knowing that your investments have underperformed an “unmanaged” basket of stocks (the S&P 500), know that underperforming for a short time period is not uncommon, even for the best investors.

In the 1950s and 1960s, Warren Buffett was a running an investment fund. When he shut his fund in 1969, he recommended his investors to invest with Bill Ruane, a friend of his. Unfortunately, Ruane underperformed the S&P 500 for five years straight from 1970 to 1974. But he eventually had the last laugh. From 1970 to 1984, Ruane’s fund produced an excellent annual return of 17.2% for its investors, far in excess of the S&P 500’s 10.0% annual gain.

The beauty of investing is that it is not a short-term game. What matters is how you fare over your entire investing time frame. Most of us, investors, are playing a multi-year or even multi-decade game. Despite its relatively weak performance in 2021, the ARK Innovation ETF is still well ahead of the S&P 500 since its inception in 2015. 

As investors with a long time horizon, it is important to look at the bigger picture.

2022 and beyond…

With the start of the new year, I’ve read numerous articles about how investors should position their portfolios for 2022. Although the authors of these articles mean well, it is extremely difficult to make single-year predictions. As such, I believe the real question should be how do you position a portfolio for a multi-year time frame.

So instead of thinking about how a portfolio could do in just the next 12 months, I prefer to consider what a portfolio could do over a five-year time horizon at least. By thinking in multi-year time frames, I give time for long-term secular trends to play out. I also don’t have to worry about short-term mispricings in the stock market, knowing that eventually, stock prices trend towards their true value (all its future cash flow discounted to the present).

By looking at the multi-year growth potential of a company, I can focus on what really matters over the long term rather than just near-term estimates. This helps me crystalise my investing strategy to optimise for my entire investment life.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Zoom and Teladoc. Holdings are subject to change at any time.

I was invited by Autodesk’s Singapore office to give a presentation on investing on 30 June 2021. I would like to thank the Autodesk team for inviting me and for the event’s superb organisation. During my presentation, I talked about what stocks are; active versus passive investing; what asset allocation is; and useful resources for individuals to learn about investing. You can check out the slide deck for my presentation below!

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any shares mentioned. Holdings are subject to change at any time.

Note: This article is a collaboration between The Good Investors and The Woke Salaryman. It was written by me and edited by He Ruiming. An earlier version of this article was first published in The Woke Salaryman.

Investing in stocks is sometimes made unnecessarily complex.

But really, if you boil it down, it’s basically making an educated guess on whether you’ll see your money return to your hands (hopefully more than the initial amount). 

So, we decided to come up with an analogy that you might find all-too-relatable –  lending your friend money. 

Okay, but before the nitpickers start, we have a few caveats to make.

There are key differences between investing in companies and lending money that we will disclaim upfront. Namely:

• Lending and getting your money back (hopefully) involves a short time frame, but investments are often for the long term
  
• Lending can be an emotional decision; investing emotionally is often a bad idea
  
• You’d expect to get 100% of your money back when you lend people money, but you’d expect more from your investments 

Now that we’ve gotten that out of the way, let’s get straight to it.

These are the things that both investors and prospective lenders might wanna look out for when parting with their money. 

Factor 1: The industry they are in 

First things first. The industry they’re in matters, because that affects how much income they will be getting.

Are they exposed to a growth industry, or one that’s stagnated and going through rapid decline?

For example, you’d prefer to lend money to someone who’s working to develop productivity software as opposed to someone who works at a print newspaper. One has the potential for a lucrative career path. The other’s best days are over. It’s obvious who is more likely to return your money.

Similarly, when investing in stocks, the industry that the company is exposed to is important.

Being in a large and/or growing industry means that it’s easier for a company to grow.  But companies that are in a sunset industry have little room for expansion, and may meet their demise sooner than later.

Factor 2: The stability of their income

The next thing you think about is the stability of income.

Are they working at an established technology company as a software developer, or are they a freelance developer who relies on gigs?

Don’t get us wrong. Freelancing can be highly lucrative, but it may not be as stable as working at an established company – and having a stable income increases the chances that they can repay you.

When applied to the stock market, having stable income (in other words, having recurring revenues) is better than having income that comes from unpredictable sources (such as depending on big sporadic projects for revenue). 

Having recurring revenues means that a company’s management team is able to better budget for growth investments for the future, without worrying that the business may fall into a rut.

Remember – investors love predictability.

Factor 3: Their financial strength

Is your friend laden with a heavy mortgage, car loan, and/or credit card debt?

If so, it’s going to be really difficult for them to repay you, as compared to somebody who has minimal financial liabilities at the moment. After all, if they already owe so many people/organisations money, what is the likelihood you’ll get your money back?

In a similar way, companies can also be either heavily in debt, or be flushed with cash and assets.

I prefer a company with a strong balance sheet – (aka more cash than debt). This simple trait makes a company antifragile, in my opinion.

Antifragility is a term introduced by Nassim Taleb, a former options trader and author of numerous books including Black Swan and Antifragile. Taleb classifies things into three groups:

• The fragile, which breaks when exposed to stress (like a piece of glass, which shatters when dropped)
  
• The robust, which remain unchanged when stressed (like a football, which does not get affected much when kicked or dropped)
  
• The antifragile, which strengthens when exposed to stress (like our human body, which becomes stronger when we exercise)

Companies too, can be fragile, robust, or even antifragile. 

The easiest way for a company to be fragile is to load up on debt. If a company is heavily indebted, it can crumble when facing even a small level of economic stress.

On the other hand, a company can be robust or even antifragile if it has a strong balance sheet that has minimal or reasonable levels of debt. During tough times (for whatever reason), having a strong balance sheet gives a company a high chance of surviving. It can even allow the company to play offense, such as by hiring talent and winning customers away from weaker competitors, or having a headstart in developing new products and services. In such a scenario, companies with strong balance sheets have a higher chance of emerging from a crisis – a period of stress – stronger than before.

Factor 4: Their cash flow

Also linked to financial strength is cash flow – which refers to the cash they have left from their income after all expenses are deducted. 

Example: Let’s say your friend has a promising career, a high income, and little debt. However, they’re still living paycheck to paycheck because of an extravagant lifestyle.

This makes lending money to them riskier. In the event they lose their job, they might have to sell some of their stuff to get by. It also won’t be easy for them to change their lifestyle to make sure they have sufficient savings to repay you.

Similarly, when investing in stocks, I’m focused on the free cash flow that a company can generate.

All things equal, a company with higher free cash flow is more valuable than one with lower free cash flow.

Factor 5: Their income growth

Some people continuously upskill throughout life and improve their earning power – whether it’s through new skills, networking or starting a business. Others get stuck in jobs they dislike for years and take no action because of learned helplessness.  They suffer from little job and income progression. 

(To be clear, there’s nothing wrong with a person not wanting to improve their income over time. For instance, there could be cases where a higher income would mean a trade-off of lesser family time.)

But simply for our context, we’d prefer if the person we are lending money to has a history of growing their income.

In stock market investing, I too want to look for companies with a proven track record of growth. 

This is because I believe that businesses that are winning tend to have a certain momentum that allows them to carry on winning. Think about it. If you’re a talented employee working in a company that’s struggling, would you prefer to stay put, or join a competitor who’s flourishing?

What happens is that businesses that are winning stand a higher chance of attracting talented employees, which allows them to carry on winning, which allows them to continue to attract talent, and so on and so forth.

Factor 6: Integrity and history of personal growth

Is your friend a trustworthy and dependable person? Or one of those people who are infamous for owing people money, dodging calls, and going on radio silence? 

Make no mistake: Character and track record are incredibly important, and cannot be ignored.

Yet another important aspect about their character is attitude towards personal growth. We touched on this earlier, but it’s important to bring it up again. If your friend is someone who’s willing to constantly reinvent themselves, they’ll likely be able to enjoy a growing income stream in the years ahead. This makes it even more probable that they are willing and can afford to repay you. 

It’s the same with companies.

I am attracted to a company with a management team that has demonstrated integrity, capability, and innovativeness.  Each of these factors is important: 

• A management team without integrity can fatten themselves at the expense of shareholders. 

• A management team without capability is bad for self-explanatory reasons.
  
• Without innovation, a company will struggle to grow and can easily be overtaken by competitors.
  
  

The logic behind this investment framework

What we need to understand is that the fundamental nature of the stock market is a place to buy and sell pieces of a business.

What drives stock prices over the long run is the stock’s underlying business performance. If the business does well, the stock should do well, eventually. Conversely, if the business does poorly, the stock will fare poorly too, eventually. 

The word eventually is important, because a stock’s price can swing all over the place, in an unpredictable fashion, in the short run. 

But over the long run, the underlying business performance of a stock acts like gravity for the stock’s price, with the direction of pull (upwards, downwards, or sideways) determined by the state of the business.

Read more about my investing methodology here and here.

A final word

These last few paragraphs have nothing to do with investing in stocks, but it has something to do with lending money. We wrote this article with the intention to help make investing more easily understandable. 

That said, all of us need to realise that unlike stock market investing, lending money is often an emotional decision.

And if emotions now come into the picture, then all that logical decision-making-framework needs to be thrown out the window. The important question to answer becomes: “Am I willing to never see this money again if I lend it to my family/friend in need?”

If the answer’s yes, then you need to hope that you’re not encouraging reckless or wanton financial behaviour in your family/friend by lending them money. If the answer’s no, then you may be denying them of a second (or third, fourth, fifth) chance they might desperately need for a breakthrough in life. 

For that reason, the decision to lend money is incredibly difficult to make – it’s much harder than investing in stocks, and we hope you’ll always make the best decision for yourself and the person-in-need who’s knocking on your door.

The Woke Salaryman: But just to be on the safe side, when in doubt, don’t lend. 

Stay Woke, Salaryman

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Note: This article was first published in MOI Global’s website. MOI Global is a community of thoughtful investors that was created by its chairman, John Mihaljevic. I wrote this piece as part of my presentation for the currently on-going Best Ideas 2021 Conference organised by MOI Global.

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I’m thrilled to have the opportunity to present at Manual of Ideas’ upcoming Best Ideas 2021 online conference. The company I’ll be discussing is the Hong Kong-listed and China-based Haidilao (HK: 6862). This article you’re reading now is a short introduction to Zhang Yong, Hadilao’s co-founder and current leader.

What I want to do is to present translations of some of my favourite passages from a 2011 book on Zhang Yong and Haidilao. The book is in Mandarin and is titled “海底捞,你学不会.” Iin English, it means “You Can’t Copy Haidilao”.

First, some background

Hotpot is a popular meal among the Chinese. It involves people – often friends and family – sitting around a big pot of flavourful boiling broth to cook by dipping food items into the broth. Haidilao’s business lies in running its namesake chain of hotpot restaurants. At the end of 2019, the company had 716 restaurants in China and another 52 in other countries and territories around the world, including Australia, Hong Kong, Japan, Singapore, the United Kingdom, the United States, and more. 

I run Compounder Fund together with my co-founder Jeremy Chia and it has a position in Haidilao. Compounder Fund invests mainly in companies that we think can compound the value of their businesses at high rates over the long run (hence the name Compounder Fund!). To us, such companies tend to have the following traits: 

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
2. Strong balance sheets with minimal or reasonable levels of debt
3. Management teams with integrity, capability, and the ability to innovate.
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
5. A proven ability to grow
6. A high likelihood of generating a strong and growing stream of free cash flow in the future

We spend a lot of time looking at a company’s leadership. This is because of our belief that, in nearly all cases, a company’s leadership is the source of its competitive advantage (if any). A company’s current competitive advantage is the result of management’s past actions, while a company’s future competitive advantage is the result of management’s current actions. We study a company’s compensation structure, related-party transactions, and insider ownership to assess integrity. For capability and innovation, we think about how a company has grown its business over time and what really excites us are business leaders who have a unique way of looking at the world.

Zhang Yong is one such exciting business leader, in our view. “You Can’t Copy Haidilao” is written by Huang Tie Ying, a professor at Beijing University. The book is written from Huang’s point of view and it discusses the highly unusual way that Zhang runs Haidilao. It helped us to understand that while Zhang is not perfect, he has an immense kindness and love toward his fellow man, and an unwavering belief in the good of humankind. He had infused these qualities into Haidilao and it had helped him to develop employees who deliver extraordinary service to customers from the heart. And it is this genuine commitment to exemplary service from Haidilao’s frontline service staff that has propelled the company’s growth.

We invested in Haidilao before we came across Huang’s book. But we already saw strong signs that Zhang was unique. For instance, Haidilao’s 2018 IPO prospectus mentioned:

• The company has industry-leading compensation for employees among all Chinese cuisine restaurants in China.
• Restaurant managers are primarily evaluated based on customer satisfaction
• Nearly all of Haidilao’s restaurant managers started working for the company in non-managerial positions (such as waiters, bussers or janitors) and steadily rose through the ranks
• Restaurant managers share in the profits of the restaurants they manage, but that’s not at all – they enjoy an even larger share of the profits from restaurants that are managed by their first and second-generation mentees 

We cannot confirm if the Haidilao described in “You Can’t Copy Haidilao” is still the same today. But there are also no strong reasons for us to believe that the current Haidilao has completely warped. The hotpot business is not complicated. You do not require a chef in the shop, so nearly anyone can run a hotpot restaurant. It also means that competition is tough. But Zhang Yong has grown Haidilao’s revenue to RMB 26.6 billion (around US$3.98 billion) in 2019, up 56.5% from 2018. Profit was up 42.3% in the same year to RMB 2.3 billion. The company is today a truly massive and global business – when Huang wrote his book, Haidilao was only in China. 

We live in Singapore, so we’ve dined in Haidilao’s restaurants and those of its competitors on many occasions. As much as its competitors try to copy the form of Haidilao’s service, they can’t seem to get its substance. And we think there’s only a tiny sliver of a chance that Haidilao’s competitors can ever truly imitate the company. This is because Haidilao’s substance comes directly from Zhang Yong’s worldview, and it is something unreplicable, since no two humans are ever identical. 

We hope you’ll enjoy the translations I’ve made from “You Can’t Copy Haidilao”. I wanted to do this because I think there’s plenty that we, as investors, can learn from Zhang Yong. I am fortunate to be able to read Mandarin and understand the book’s content (just please do not ask me to speak or write about business in Mandarin!) so I want to pay it forward by introducing the book to the English-speaking world.

And three more things: (1) I want to stress that the translations are my own self-directed attempt, so all mistakes in them are my sole responsibility; (2) I hope I’ve managed to capture Huang and Zhang’s ideas well; and (3) I look forward to sharing more about Haidilao during the conference. Now onto the translations!

Translation: On providing legendary service

Even someone who has worked in Haidilao for only a day would know an aphorism of Zhang Yong’s: “Customers are won table by table.”

Why do we have to win customers table by table? Because every customer in a hotpot restaurant is there for a different reason. Some are couples on a date, some are there for a family gathering, while some are having business dinners. What every customer needs will be different, so how you move each customer’s heart will not be the same.

Zhang Yong has performed every single task that’s required in a hotpot restaurant… He knows that customers have a wide variety of requests. If you strictly follow standard operating procedures, the best result you can hope for is for your customers to not fault you. But you will never be able to exceed their expectations and delight them. For example, no restaurant’s operating procedure will include a free shoe-shining service.

In the early days after Zhang Yong opened his first hotpot restaurant, there was a familiar face who visited. Zhang Yong realised that the shoes of this old friend were very dirty, and so he arranged for an employee to clean the friend’s shoes. Zhang Yong’s little act moved his friend deeply. Ever since, Haidilao has provided free shoe-cleaning services at its restaurants. 

A lady who stayed above a Haidilao restaurant once ate there and praised its chili sauce. The next day, Zhang Yong brought a bottle of the sauce to her and told her that Haidilao would be happy to send her a bottle any time she wants to have it. 

These are the roots of Haidilao’s extreme service standards.

But these differentiated services can only come from the creativity of every employee’s minds.

Having processes and systems are critical when running chain restaurants… Processes and systems can ensure quality control, but human creativity is suppressed at the same time. This is because processes and systems overlook a human’s most valuable asset – the brain.

Requiring employees to strictly follow standard operating procedures means you’re hiring them only for their hands, and not their minds. You suffer the worst losses in such business deals. This is because humans are the worst “machines” – there’s no way a human can be better than a machine at repetitive actions. The most valuable part of a human is the brain. The brain can create and solve problems that processes and systems can’t!

The goal of providing world-class service is to satisfy customers. Since each customer has different preferences in the process of consuming a hotpot meal, it’s not possible to fully rely on SOPs to achieve 100% satisfaction….

… If some customers do not enjoy a free bowl of soya milk and sour plum soup, can we give them a bowl of chicken egg porridge instead? Even if we normally charge for this porridge, an elderly person with weak teeth who receives it for free may remember this considerate act for life!

A customer craves ice cream – can the restaurant’s waiters leave their station to purchase the ice cream from a neighbouring shop? A customer realises he has overordered – can he return a plate of vegetables? A customer wants to enjoy more variety – can she order half-portions? A customer really likes the dining aprons that the restaurant provides guests – can the customer bring one home for her child? 

When faced with these requests that are not included in SOP manuals, most restaurants will just say “No.” But at Haidilao, the waiters are required to exercise their creativity: “Why not?”

I grabbed a few stories from Haidilao’s internal employee magazine to highlight the company’s incredible service standards…

… Zhang Yao Lan from Haidilao’s third Shanghai restaurant says:

“Business was exceptional on a Saturday night. At 7:30pm, the Yu family visited the 3rd room… They ordered quail eggs and as I helped them cook the eggs in the hotpot, I noticed that Aunty Yu ate all the radish strips that came with the eggs. 

I figured that Aunty Yu loves radish strips. So I called the kitchen to prepare the plate of radish strips and I added my own special concoction of sauces. The Yu family were really surprised when I served the radish and asked if they had ordered the dish. I said that it’s a gift from me because I guessed that Aunty Yu likes eating radish strips and that I hope they like it… 

…They were really happy and praised me as they dug into the dish. They even asked how the dish was made… The following month, the Yu family came three times, and even brought their friends (with surnames of Cai and Yang) to Haidilao. See, how magical a plate of radish strips is – it’s helped me win so many customers!”

Translation: On winning over the hearts of employees (and more on providing legendary service)

Zhang Yong was once a waiter. So he understands that every employee is critical in ensuring the delivery of truly outstanding service. Haidilao’s employees are given the freedom to exercise their creativity and even make small mistakes – Haidiao can really touch the hearts of customers only if the company gets the short end of the stick at times.

But this is easier said than done. Haidilao’s employees have travelled far from home and come from villages that are mired in poverty. They have little education, have not seen much of the world, and are often looked down upon, resulting in an inferiority complex. How can Haidilao drive such employees to develop the initiative to provide excellent service for customers?

Zhang Yong said: “The hotpot business requires very little skill… Anyone can do it after some light training if they are willing. The key though, is the willingness. Waitressing is a physically demanding job with low social status and benefits. Most waiters don’t perform well because they had no other choice other than to take up the role. So to ensure that waiters can excel in their role, the focus should not be on the training methods. Instead, it should be on how to develop the willingness in people to take up waitressing jobs. If your employees are willing to work diligently, you win!”

I asked Zhang Yong: “Can you find me a boss who does not want hard working employees? This is the Himalayas for every boss in the world. But it’s rare for any leader to achieve this.”

Zhang Yong replied: “I think that humans have emotions. If you treat somebody well, he or she will treat you well in return. As long as I can find ways to let my employees think of Haidilao as their home and family, my employees will naturally care for our customers.”…

…How can Haidilao get its employees to think of the company as family?

To Zhang Yong, the answer is simple – treat your employees as family. If your employees are your siblings and they have travelled afar to Beijing to work for you, would you house them in underground basements that most people in Beijing are not willing to live in? Of course not. If you have the resources, you wouldn’t bear to let your family members stay in a place that’s humid and lacks proper ventilation. But for many restaurant owners in Beijing, they house their employees in underground basements while they themselves live above ground. 

Haidilao’s employees get to stay in proper housing, with similar living conditions to the locals in Beijing. There are heaters and air conditioning, and Haidilao ensures that there’s no overcrowding. In addition, each hostel has to be within a 20-minute walking distance to the restaurants that the employees work in.

Why? This is because Beijing’s traffic system is complex. Restaurant staff members work long hours, and as young adults, they require ample sleep. Because Haidilao is picky about where its employees stay, there are only a few suitable locations that also happen to be desirable among the locals in Beijing. This has caused some haughty locals in the city to be unhappy. 

There’s more. Haidilao also has specialised employees who take care of the hostels’ housekeeping needs. There’s free internet, TV, and phones too. Haidilao’s employees state that their hostels are akin to hotels with “stars”!

Getting employees to treat your company as family is not as simple as just repeating some words or educating them. Humans are intelligent – your actions will show what you truly mean. Haidilao’s employees come from poor villages. During Beijing’s cold weather season, Haidilao issues hot-water packets to keep these employees’ blankets warm. For some Haidilao restaurants, there are even employees in the hostels who come in the night to fill up the packets with hot water. Isn’t this something that only mothers will do?

If your siblings travel from your village to work in the city, you’ll naturally be worried that they won’t be familiar with traffic and that they will be looked down upon by city folks. Because of this, Haidilao’s training program also includes soft skills such as map reading, how to use flush toilets, how to navigate the transport system, how to use bank cards etc… 

…If your siblings have travelled somewhere far to work, what would happen to their children’s education? Haidilao set up a boarding school in Jianyang, Sichuan, for the children of the company’s employees.

Haidilao does not just take care of its employees’ children, it also cares for its employees’ parents. Haidilao provides a monthly stipend (a few hundred RMB) to the parents of employees who hold the rank of foreman and upwards. Every parent would want a capable child. Homecoming opportunities for Haidilao’s employees are rare. But Haidilao’s monthly stipend gives the parents of these employees a regular opportunity to feel pride for their children. Chinese people are stingy, the villagers even more so. Despite feeling pride, the villagers would only say: “My child is fortunate to have found a good company where the boss treats them as brothers!” No wonder Haidilao’s employees all affectionately call Zhang Yong, “Big Brother Zhang.”   

Translation: On extreme trust for employees

What does it mean to respect people? Does it mean you have to bow to your boss or cheer for your superiors? This is not respect for people – this is only respect for status and power. Respecting people means trusting them.

If I trust your ethics, I would never guard myself against you. If I trust your ability, I would entrust important tasks to you. This is what it means to respect someone! When a person is trusted, a sense of responsibility would arise within. When an employee is trusted, he can treat the company as family.

At Haidilao, employees are not only treated better than at other restaurant companies, but they are also trusted by the company. 

To treat employees as family is to trust them like you trust your family members. You have to show through actions that you trust someone – words are not enough. The only sign of trust is to confer authority. If your birth sister’s helping you to purchase your daily vegetables and meats at the market, would you send someone to supervise her? 

Of course not. So at Haidilao, any expenditure above RMB 1 million will require Zhang Yong’s approval. Anything lower than RMB 1 million is the responsibility of the vice president, finance director, and regional manager. Sectional managers and the heads of the Purchasing and Engineering departments have the authority to sign off on expenditures of up to RMB 300,000, while restaurant leaders can do so up to RMB 30,000. It’s rare to find private sector enterprises that have the confidence to delegate authority to such an extent.

What Haidilao’s peers find the most unbelievable about Zhang Yong is the trust he has in his frontline service staff. Even Haidilao’s ordinary frontline service staff have the power to give customers partial to full discounts without having to seek approval from their superiors. As long as the service staff think it’s appropriate to discount a dish or provide a free dish (or even an entirely free meal), they can do so. This authority means all of Haidilao’s employees – regardless of rank – are effectively managers, because such authority is usually reserved only for managers at restaurants.

In the spring of 2009, I invited Zhang Yong to give a lecture to MBA students in Beijing University. A student asked: “If all your staff can give full discounts for meals, will there be cases where rogue employees provide free meals to their own family and friends?”

Zhang Yong asked the student instead: “If I give you this authority, will you do it?”

The entire class of more than 200 students fell silent. Indeed, with our hands on our hearts: Will you bear to betray such trust in you?

The truth is, the vast majority of people know deep in their hearts that kindness needs to be repaid and they would not betray the trust that others have placed with them. 

Having been a frontline service staff, Zhang Yong understands this logic: If he wants to utilise the minds of his employees, he needs to give them authority. This is because the satisfaction of customers actually rests entirely in the hands of his frontline service staff. It is after all his frontline service staff who interact with customers from the moment they step into the restaurant till they leave. If a restaurant’s manager has to be consulted before a frontline service staff can solve any unhappiness a customer experiences at the outlet, the process itself will only vex the customer further.

Humans are often worried when they’re waiting for a problem to be resolved. So the only way to solve customer-unhappiness at scale is to give frontline service staff the power to deal with problems. More importantly, it is the frontline service staff who best know the whims and fancies of customers. They are the ones who can touch the hearts of customers table by table.

Translation: On treating employees the right way

Zhang Yong has an unwritten rule within Haidilao. And because he is the unquestioned leader of the company, the people within Haidilao believe his words.

He said: “Anyone who has been a restaurant leader at Haidilao for at least a year will receive a “dowry” of RMB 80,000 if they leave the company for any reason.”

I asked: “Even if they’re being poached by competitors?”

Zhang Yong responded: “Yes”

“Why?” His answer completely took me by surprise.

Zhang Yong explained: “The work in Haidilao is incredibly tough. Anyone who can rise to the rank of restaurant leader and above has already contributed significantly to the company.”

In fact, many of Haidilao’s leaders clock in overtime for extended periods and this takes a significant toll on their physical and mental health. Many of them are riddled with health issues even at a young age. Haidilao’s procurement head, Yang Bin, once set a record in 2004 by working for 365 days straight. 

Zhang Yong said: “Every Haidilao leader deserves credit for building Haidilao to what it is today. So we should give people what they deserve when they leave for any reason. If a sectional manager leaves, we provide a reward of RMB 200,000. If a leader with the title of regional manager or higher leaves, the gift will be a ‘hotpot restaurant’ – that’s around RMB 8 million in value.”

I asked, somewhat in disbelief: “If Yuan Hua Qiang [a leader in Haidilao with significant importance] is poached, you will reward him with RMB 8 million?”

“Yes, if Yuan Hua Qiang wants to leave today, Haidilao will reward him with RMB 8 million,” Zhang Yong said gently and plainly, while lowering his head as though deep in thought.

Even though I know Zhang Yong wants to win over every talented individual he encounters, this policy of his is highly unusual – not many will dare to implement it. It seems like if you’re not trying to be different and do what others won’t, you can’t ever win – but even if you do, it does not guarantee success! Zhang Yong walks the extreme path….

…When Haidilao first entered Beijing, the journey was rough. The company fell for a scam in its first real estate deal and lost RMB 3 million. At that time, it was all the cash that Haidilao had. 

“Did you manage to find the culprit?” I asked Zhang Yong.

“So what if we had found him? There was even a retired judge in the group of scammers. We simply were not aware that we had fallen into a trap.”

I continued to ask: “Did you scold anyone after you heard the news?”

Zhang Yong said: “How would I dare to scold anyone?! The Beijing manager was already so anxious that he could not eat for two days. In fact, I did not dare to call him in those few days. I only decided to contact him after I heard that they wanted to kidnap the culprit. I said, are we worth only RMB 3 million? Let’s start doing the real work.”

I followed up: “Did you really not blame him, or feel any pain?”

Zhang Yong replied: “Of course I felt the pain. The sum we lost was all our cash at that point in time. But I really did not blame him. Because if I was the one in Beijing, I would have fallen into the same trap!”

Dear bosses, after reading this, please ask yourself the following: If you had ran into the same situation, would you think this way?

No wonder Haidilao has only ever had to pay its “dowry” to three people in its 10-plus years of operating history, despite having more than a 100 people who qualified for the reward if they had left.

But as a company grows, there will be all kinds of people in it. Haidilao is no exception. Last year, there was a restaurant leader who quit Haidilao to join a competitor who set up shop just opposite her Haidilao outlet. She also brought along her Haidilao restaurant’s kitchen manager, area manager, and other service staff leaders. When she came back to Haidilao to ask for her “dowry,” Zhang Yong refused.

Translation: On priorities

In his 2006 New Year’s address to employees, Zhang Yong said: “If you’re talking to me and your phone rings because your staff is calling you, then you and I will stop our conversation. Your priority should be handling your staff’s issue. If you’re talking to your staff and a customer needs help, you and your staff should end the conversation and focus on the customer’s needs. This is what our list of priorities should look like when I talk about placing customer satisfaction at the centre of what we do. As I grow older, I’ve come to gradually understand the broader meaning of the term “customer” – it includes our employees.

Translation: On evaluating a restaurant business

Zhang Yong has an extremely strange way of evaluating the performance of every Haidilao restaurant. A restaurant’s profit is not part of the assessment criteria that Haidilao’s HQ uses. To add to the weirdness, Zhang Yong does not have any annual company-wide profit targets for Haidilao.

I asked him: “Why do you not assess profits?”

He responded: “Assessing profits is useless because profit is the result of the work we do. If our work is bad, it’s not possible to produce high profits. But if we do good work, it’s impossible for our profits to be low. Moreover, the company’s profit is the end result of all the work performed by various departments. Each department has a different function, so it’s tough to clearly define their contributions. There’s also an element of chance in the profit a restaurant earns. For example, no matter how hard a restaurant leader and his team works, a poorly-located restaurant can’t hope to outperform a restaurant with average-leadership but a superb location. But a restaurant leader and his team have no say in choosing a restaurant’s location. It’s not fair, nor scientific, to insist on assessing a restaurant’s performance based on its level of profit.”

I followed up: “The level of profit depends, at least to some extent, on costs. Each individual restaurant should at least be able to control its costs, right?”

Zhang Yong said:

“Yes that’s right. But in what areas can those below the rank of restaurant leader have the biggest effect? It’s in improving service standards and winning more customers! Lowering costs is not as important as creating more revenue.

As Haidilao started to introduce more SOPs, we also began to assess results more. Consequently, some sectional leaders started to include profit in their evaluation of individual restaurants. When this happened, incidents like the following happened: Brooms for toilets continued to be used even when there were no longer any whiskers for sweeping; the watermelons that we gave to customers for free were no longer sweet; and customers were given towels with holes to dry themselves after using the washroom. 

Why? Because each restaurant has very little control over its own costs. The important cost items in a restaurant – its location, renovation, dishes, prices, and manpower needs – are set in HQ. Rank and file employees can only focus on the little things if you insist on evaluating profit. We noticed this phenomenon before it was too late and promptly stopped using the level of profit as a criterion for performance-assessment. In actual fact, any employee with even a modicum of business sense does care about costs and profits. Even if you merely conduct a basic accounting of profit, everyone is already paying attention to it. So if you make the level of profit a key criterion for performance assessment, it will only magnify people’s focus on profit…

…I asked Zhang Yong: “You do not even look at a restaurant’s revenue when assessing its performance?”

Zhang Yong said: “Yes, our performance criteria does not include profit. But that’s not all. We also do not include revenue as well as other KPIs that are commonly used by restaurant companies, such as spending per customer. This is because these criteria are results. If a business manager insists on waiting for these results to know if the business is doing well or poorly, wouldn’t the food already be cold by the time? Imagine that there’s a polluted river and instead of trying to fix the source of the pollution, you’re only busily filtering, testing, and removing filth downstream. What’s the point?”…

…Zhang Yong said: “Now we only have three criteria for evaluating the performance of each hotpot restaurant. First is the level of customer satisfaction; second is the level of positiveness in the work attitude of employees, and the third is the nurturing of leaders.

I replied: “These are all qualitative criteria. How do you measure them?”

Zhang Yong answered: “Yes, they are all qualitative, so you can only measure them qualitatively. Teacher Huang, I don’t understand why these scientific management tools insist on scoring qualitative things. Let’s talk about customer satisfaction for instance. Do they expect every customer to fill up a survey form? Think about this. How many customers are willing to fill up your form after their meal? Wouldn’t customers’ unhappiness increase if they’re being made to fill up forms? Besides, how believable can a form be if you’re forcing it onto someone? 

I asked: “How then do you evaluate customer satisfaction?”

He said: “We get the direct superiors of restaurant leaders – sectional managers – to conduct frequent yet random visits to the restaurants. The sectional manager and his assistant will communicate at length with the restaurant leader. In what areas have the level of customer satisfaction increased or decreased? Have frequent diners appeared more regularly this month, or less? Our sectional managers were all once frontline service staff who rose to their current roles. They have intimate knowledge when it comes to customer satisfaction.

It’s the same when it comes to employee’s work attitudes. Teacher Huang, if you’re the one doing the assessment, it won’t work. All you’ll see are people running about, with smiles on their faces. But if it’s me, I will be able to tell you: Look at that young chap there with hair that’s too long. This young girl has applied her makeup too sloppily. Some employees’ shoes are dirty. This service staff is standing there in a daze. These are all signs on the level of positivity that employees bring to work, aren’t they?! It’s the same when a restaurant leader assesses his team leaders and when his team leaders assess their team.

I further probed: “So their rewards depend on these qualitative assessments?”

Zhang Yong replied: “It’s not just their rewards. Their promotions or demotions also depend on the three criteria. Think about this. How can most waiters have a positive work attitude if their restaurant leader is an unfair person? And how can customers be happy if they are served by waiters who are not positive at work? The revenue and profit numbers for such a restaurant will definitely be bad. There’s no need to wait for the numbers to be out to replace the restaurant leader or remind him that he needs to change his ways. And even if the numbers are good, it has nothing to do with the restaurant leader. We’ve had cases where we are unable to promote restaurant leaders who run very profitable restaurants. This is because they are unable to groom talent. The moment these restaurant leaders step away from their restaurants, problems occur. For these restaurant leaders, we may even demote them despite the high profits their restaurants are producing.”

Translation: What it means to truly care for employees

In 2006, Haidilao’s directors decided to establish a union. Unions are supposed to belong to employees, but Zhang Yong gave Haidiao’s union a unique mission. During the birth of the union, he said some important things:

“The 11 restaurants we have welcomed 3 million customers last year. The vast majority of these customers visited our restaurants because of the people working in Haidilao. This is proof of the excellent caliber of many of Haidilao’s employees. Since we have so many outstanding colleagues, shouldn’t we group them together, so that we can rely on them to influence even more people to remain at Haidilao and continue working hard (this is Zhang Yong’s purpose for setting up the union)? Because of this, I need the cream of the crop to join the union. The union should be an excellent organisation within Haidilao (Zhang Yong can really innovate!)…

…Every union member needs to understand this simple logic. We’re not caring for our employees to carry out the company’s orders. We’re doing so because we truly understand that we’re all human. And every human being needs to care and to be cared for. This care stems from a belief, and that is “all men are created equal.”

If our union members understand this point, then we’ll know that the union should not only be caring about the little things, such as taking care of employees when they have a small illness. What’s even more important is for the union to provide a platform for them to change their destiny. And to change their destiny is to win more diners for Haidilao with all their might. To open more restaurants so that there are more opportunities for career growth for the people of Haidilao to change their destiny. This is what it really means to care for employees.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Haidilao. Holdings are subject to change at any time.