Volume 4 Issue 39: Intelligent Investing
I am going to just cut to the chase for this part with issue number four.
4. Perception
One of the most controversial issues at Capital Dynamics is the general perception towards the company. Well, I guess when we talk about the general perception, we have to first define the area in which we are talking about. There are several key perspectives when it comes to looking at Capital Dynamics. Capital Dynamics has two businesses, which are investment advisory and fund management. I will not delve into detailed information that is readily available on the company's website.
Instead, I will go through what I think the general opinion of the public is of their two businesses and of the group as a whole, and try to provide an interpretation from an insider's perspective of what is actually going on.
a) Views on the Fund Management Business
Let me first talk about the perception towards the fund management business. Capital Dynamics Asset Management (CDAM) is the fund management arm of the Capital Dynamics group in KL. At present, they manage personal investment accounts and also icapital.biz Bhd, which is a listed closed-end fund in Bursa Malaysia. Its two other offices in Singapore and Sydney also provide similar services.
In my opinion, the investment public typically perceives Capital Dynamics and icapital.biz Bhd (ICAP) to be synonymous. Some even use both names interchangably to refer to Capital Dynamics. One of the reasons for this is that, quite simply, ICAP is the more famous of the two names. The name of the fund typically precedes the name of the fund manager.
Moreover, ICAP has a history of relatively good performance when it comes to investment returns. At pixel time, its NAV reflects an annual compound return of about 16.0% (since its inception in October 2005). In comparison, the KLCI recorded an average annual gain of 8.3% over the same period.
In fact, ICAP's NAV managed to record annual compound returns of over 20% prior to 2011. But it has fallen to a much lower level since then. Nonetheless, because of this strong performance in the past, ICAP has developed a very strong fan-base. If one looked hard enough over the internet, one can still find blogs that are dedicated to the performances of Teng Boo. It suffices to say that, Teng Boo is more than well-known as a fund manager in Malaysia.
You may be surprised at my choice of the word "fan-base", but that is what it really is. This was evidenced by the strong support for Teng Boo's recommendations during ICAP's 2012 AGM. I will leave this AGM issue for later. What I would like to point out here is that the public opinion of Teng Boo and Capital Dynamics as a fund manager is generally positive, particularly among the investors of ICAP. This is usually supported by the investors' experience when it comes to the amount of effort that Capital Dynamics puts into its roadshows, seminars and presentations for the benefit of investors.
I have the benefit of being able to observe Capital Dynamics as an insider and an outsider. I believe that it is hard to argue against the fact that Teng Boo does take investors' interests to heart. This is evidenced not only by the amount of effort that Teng Boo himself puts in, but also the amount of effort that is expected from all the staff who work there.
From an outsider's perspective, the amount of work that is done on behalf of investors are usually not entirely apparent. But I think that more often than not, every one at Capital Dynamics has
performed significantly beyond their duties to benefit the interests of
investors. Because of its past performance and this investor-centric attitude, Capital Dynamics has developed a very strong supporter base. So much so that pretty much anyone among the fan base is willing to take every word that Teng Boo says as gospel.
Nonetheless, the events surrounding the 2012 AGM of ICAP has shed light into more cynical views about Capital Dynamics and Teng Boo. For example, you can see this if you visit
this particular post on Capital Dynamics' facebook page. I may not be paraphrasing at 100% accuracy here, but basically, Capital Dynamics was alleged to have "unfairly" charged management and advisory fees towards ICAP. I say "unfairly" because the company has done nothing against the law. However, certain parties were disatisfied with the fact that CDAM and CDSB have been collecting a total of 1.5% of the NAV as fees for its services despite having below average performances in the past year. Moreover, the company was also accused of not doing its job to narrow the discount (over 20%) of ICAP's price from its NAV. To some extent, it was even claimed that ICAP is worth more dead than alive.
One of the most commonly proposed methods to narrow the discount to NAV is a share buyback program. While this is not the time or place for me to go into the pros and cons of a share buyback, I think that such a suggestion warrants a closer look. While this issue has been addressed before at previous general meetings, I personally don't think that it has adequately appeased some disgruntled shareowners.
One of the reasons given by Capital Dynamics against a share buyback is that it will not work in a Malaysian context. They cited evidence that the discount did not narrow despite strong purchasing by two large institutional investors from London. Because of this, Capital Dynamics has proposed an alternative method that they are still not allowed to disclose. On top of that, Capital Dynamics has also claimed that a closed-end fund is greatly different from a company like Berkshire Hathaway and other businesses (that typically do share buybacks) because businesses generally have regular cash inflows while ICAP does not. As a consequence, using up ICAP's cash for a buyback will reduce its available cash for other investments.
Nonetheless, I feel that there are still obvious counterarguments against either reason provided by Capital Dynamics. For starters, by announcing a buyback program (as opposed to a one-off buyback), ICAP will generate a signalling effect to the investment public that ICAP will not allow its discount to go above a certain range. A signalling effect works via an expectations mechanism where buyers and sellers of ICAP in the market expect the discount to be no more than 10% (for example), and hence will trade accordingly, even without ICAP going into the market to purchase its own stock. As a consequence, ICAP may end up using up less cash than it would to fully narrow the discount.
In addition, ICAP has been holding on to its cashpile for more than a year. It is difficult to believe that there have been no suitable opportunities in Bursa Malaysia for the past year or so. While the investment decision is entirely up to the discretion of the fund manager, a claim that there are no suitable opportunities throughout an entire year is highly suspect.
Nonetheless, let us assume that the claim is true. Given that ICAP trumpets the fact that it expects its shares to trade at a premium in the future, it makes even more sense for ICAP to do share buybacks at a 20-30% discount and subsequently re-sell them when ICAP trades at a premium. This will restore its cash level to invest in other opportunities. In fact, this raises more cash than ICAP had previously used to do the buyback due to the premium. This can benefit shareowners who hold on to their ICAP shares throughout the buyback program all the way until the shares trade at a premium.
This is not the first time that Capital Dynamics has been accused of not taking its investors' interests to heart. Ah Yap, a prominent stock market blogger, also
highlighted an issue with the performance fee structure charged by Capital Dynamics before. It is a pretty long post, but I think it is worth your while if you want a more complete picture of what is going on. Essentially, Ah Yap argues that the
i Capital Global Fund and the
i Capital International Value Fund double-charges its investors for its performance as it does not have a high watermark in its performance fee structure.
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(Wonkish Warning: Read this part only if you already know about the performance fee structure of ICGF and ICIVF)
Teng Boo has time and again provided hypothetical evidence by claiming that a 6% compound return per annum is in fact a tough hurdle to beat. I find this a little hard to swallow when Teng Boo claims to be one of the best fund managers in Malaysia. With this proclaimation, and given his track record, generating 15% compound growth per annum should not be a problem for Teng Boo. What his explanation typically sidesteps is the fact that the difference between 15% and 6% compound rates of return after 30 years is huge. In fact, it would make the hurdle completely meaningless. Let us look at
figure 1.
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| Figure 1 |
I think the picture depicts very clearly how miniscule the 6% annual compound rate of return (ACROR) is compared to the 15% ACROR. At the end of Year 30, the NAV would be about RM58.
Now, assume that in Year 31, the NAV of the fund drops by 20% to RM48, but returns to RM58 in year 32. A performance fee of 20% is charged on the amount in excess of a 6% annual rate of return (AROR). This means that from RM48, a 6% gain would equal RM51.
Hence, the excess return would be RM7 (RM58-RM51). The performance fee will be 20% of RM7, which is RM1.40. This means that although at the end of Year 32, the NAV is exactly the same as that in Year 30, the investor would be required to pay a performance fee of RM1.40 (or 2.4% of NAV). This seems rather exorbitant considering the investor did not become richer from Year 30 to Year 32.
Why did I painstakingly go through the above calculation? To cement my point, let us now consider an extreme scenario where the NAV zigzags for the next 30 years - see
figure 2.
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| Figure 2 |
Now, you can see that the 6% ACROR hurdle rate is barely halfway to where the NAV is even after 30 years of absolutely no performance. The NAV in Year 60 is exactly where it was in Year 30. However, the fund would have charged a performance fee of RM1.40 on alternate years (when the NAV jumps from RM48 to RM58). So, while the investor does not get any richer from Year 30 to Year 60 (in fact, he/she would get poorer due to inflation), a grand total of RM21 (RM1.40 x 15 years) in performance fees would have been charged.
This would be a whopping 36% of the NAV in Year 60. I think the above example clearly illustrates that when we go out far enough after many years of strong performance, the performance fee structure no longer incentivizes the fund manager to continue performing in the best interests of the investors. In fact, the fund manager is incentivized to take exceptionally high risks by purchasing high volatility stocks as up and down movements will generate high performance fees for the fund manager, even though it does not create any wealth for the investors.
(End of wonkish portion)
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The above illustration would make it seem like Capital Dynamics is out to get you in 30 years time. Let me humanize the above picture and put things into a more realistic context. Do I honestly think that Capital Dynamics is out to get you? After working my butt off for three years in the company, I can confidently say that the answer is a resounding "NO".
Capital Dynamics has in more ways than one gone above and beyond its call of duty to serve its investors' interests. It is not the intention of Capital Dynamics to cheat its investors. I would probably attribute this to an oversight and perhaps lack of urgency in fixing the mistake.
In this regard, I strongly believe that Capital Dynamics has not done nearly enough to appease its investors. The performance fee structure is clearly not ideal. It is not because the company is unaware of such a problem. I am sure that they are aware. Honestly, I don't know why such a problem is allowed to fester. While this issue will not create huge problems in the near future, the scenario I highlighted above clearly demonstrates that it is a serious problem if allowed to continue. Since we are already aware of such a serious issue, it is imperative that it is tackled before the company moves on to other projects.
Otherwise, its reputation for maintaining its integrity would be in danger. As Warren Buffett says:
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.
I will continue with my discussion in
Part 12 on the outside views of the investment advisory business as well as about the group as a whole.
