Churchouse Letter
November 2011         by Peter Churchouse

Finding Competitive Advantage in Asian “Hard Assets” Companies

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There can be few investors around the world – well the developed world at least – who have not heard of the great Warren Buffet and his mentor Benjamin Graham. Ben Graham was the undisputed pioneer of security analysis, and started his career on Wall Street in 1914. Prior to Graham, there was precious little in the way of analysis of stocks and companies in any disciplined way and the scene was dominated by statisticians who trotted out numbers for their traders. It took Ben Graham 20 years to publish his first edition of “Security Analysis” with co-author David Dodd, a Columbia professor, and “Graham and Dodd” is still regarded as the bible of security analysis.

Legendary Investor Warren BuffetGraham was not just an academic, having spent eighteen years teaching from time to time at Columbia University and also at UCLA, but also spent about 20 years investing in his own investment firm Graham – Newman. This made him a wealthy man and was considered in his day to be up there amongst the smartest investors on Wall Street.

Warren Buffet studied at the feet of Ben Graham, and came to be highly regarded by him. Buffet’s investment style was pretty much pure Graham and Dodds, certainly in his early days of investing. The compilation of reams of data and information, particularly financial data was and still is at the core of Buffets investment style and philosophy. His was not an investment style that embraced “concept” stocks, no “strike for the fences” companies, no conglomerates, no technology companies. His initial portfolio was focused on simple to understand businesses, adopting the Benjamin Graham philosophy and techniques of investment. Buffet’s first foray into investment began in 1956/57 with US$105,000 of initial capital in the partnership growing to US$105 million by 1969. The partnership did not suffer a single down year in that period despite some grizzly markets. In fact the partnership made money in some major down years such as 1966 and 1962.

While Buffet’s investment style was certainly shaped by Ben Graham’s disciplined approach to analyzing a company’s performance and financial condition, Buffet took the process a couple of steps further. Graham’s focus was simply to identify companies that could withstand economic downturns, while Buffet was concerned with identifying companies that would likely have long term consistent competitive advantage. Graham’s investment horizon was typically a two to three year horizon; Buffet was focused on companies that he could comfortably own for 10-20 years. It has to be said that some of Buffet’s more recent investments in financial companies in particular, do come across more as simply very good and profitable short-medium term opportunistic investments.

The Buffet philosophy is not necessarily to invest in stocks that are at “bargain basement” prices, but rather identify companies that are likely to be long term, consistent companies which enjoy competitive advantage. It is not just about identifying cheap, good companies that will survive economic hardship, but those that will likely remain ahead of their peers over the long term.

Buffet’s development of the Graham and Dodds old school value investment approach essentially focused on understanding the financial statements of companies to determine a company’s underlying business and its ability to enjoy competitive advantage over long periods of time. Early value investing was more a case of identifying companies whose shares are cheap in relation to intrinsic underlying value, or cheap relative to their own history. The essence was to identify cheap-ness and value rather than the longer term prospects of the business itself. If a stock was cheap, according to old school value investing (perhaps driven down by speculators, traders, short term events) then ultimately the market would recognize this and the stock would move back again closer to its intrinsic value or long term valuation metrics. Graham’s approach was to sell a stock if it had gone up 50%, and sell it if it had not gone up after 2 years or so. But as we have seen, many great companies may continue to provide good returns for a long time after they have risen 50%. At the very core of Buffet’s track record is a deep understanding and knowledge of a company’s financial statements.

Buffet took the view that understanding the long term financial statements and condition of good companies would help him to identify companies that enjoyed some competitive advantage which might allow them to enjoy some kind of monopoly position in their business, or have the ability to charge a premium price for their products over their competitors. A core part of the approach was not just to identify earnings growth potential but also to identify companies that had zero or very low risk of bankruptcy. So if the market speculators drive down the price of such stocks for whatever reason, then there was less risk of losing money in such stocks over the longer term. See Fig 1.

Figure 1: Share Price History of Berkshire Hathaway

Figure 1: Share Price History of Berkshire Hathaway from 1980 - November 2011. $10,000 investment in 1980 = $3.2 million now!

At the very core of Buffet’s track record is a deep understanding and knowledge of a company’s financial statements.

“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself.”
– Warren Buffet

The Buffet approach focuses on companies that produce a unique product or service, or are a low cost producer of a product that large numbers of people need on a consistent basis. The “product companies” that have been uppermost in the Buffet model are companies like Coca Cola, Pepsi, Coors, Kraft, Procter & Gamble, Philip Morris, Wrigley, Hershey, Budweiser. All of these companies have become imprinted in the consumer psyche.

Service companies that have caught the Buffet net have included American Express, Moody’s Corp, H&R Block, and Wells Fargo. Investments in companies like Solomon Brothers ultimately did not stand the test as such companies are often driven by the “rain-makers” of the investment world and these people can move around from company to company, making it difficult to institutionalize long term competitive advantage.

That still has not stopped Buffet from investing in Goldman Sachs and Bank of America, both of which most observers would argue are more in the nature of short-medium term trades than investments conforming with the long term Buffet “competitive advantage” dictums.

But what are the characteristics of a company’s financial statements that Buffet identifies to help establish that a company has long term, durable competitive advantage? Here we summarise the key criteria that help determine such competitive advantage with the aim of applying these to the “hard asset” space that we typically cover.

Property Companies Have Typically Not Been Part of Buffet’s Portfolios

Buffet’s Berkshire Hathaway has typically not held property companies in any large way in its portfolios over the years, perhaps reflecting a view that such companies rarely exhibit long term characteristics of competitive advantage. We wish to try to put this to a bit of a test and focus on some of the major companies in our Asian universe in the property space.

Would some of the Asian property giants pass the Buffet test of long term competitive advantage?

In considering the financial criteria that should make for long term competitive advantage, we can identify some quite subjective factors as well as hard financial criteria. In both cases we might be looking at how a company performs in absolute terms and in some instances how it performs against its peers in the industry, or even against a broader range of companies in very different sectors.

There are certain aspects of the property business that may be very different from other industries.

The Qualitative Criteria

Location, Location, Location!

Thus goes the familiar cry from just about anyone in the property industry. Success is largely about location. Some companies manage to consistently come up with very good locations for their developments, and have done so for many years. Sometimes this might be an accident of history, but more often it is a deliberate strategy, and often a high cost strategy. Mitsubishi Estates in Japan, for example, has built up a formidable portfolio of commercial properties in the heart of Tokyo’s central business district.

Hong Kong Land also had, for many years, almost a monopoly in high quality office and retail property in Hong Kong’s Central Business District (CBD). Sun Hung Kai Properties in Hong Kong has done a great job in securing top sites in the centres of new towns in Hong Kong and has more recently secured very high quality centrally located commercial sites in core CBD locations in Hong Kong and Shanghai. Capital Land in Singapore also has consistently secured extremely well located residential and commercial sites in that city and more recently in other cities around the region.

Australia’s Westfield has for very many years secured very prime sites for its large scale shopping malls, its recently completed mall in west London being a classic case in point.

Monopoly or Near Monopoly Conditions

Having a monopoly or near monopoly in any industry can be a huge part of a company’s competitive edge. Companies such as Microsoft spring to mind. In the real estate game, monopoly conditions are very difficult to attain, and a company that gets close to it stands out from the crowd.

For example, Hong Kong Land at one point had a near stranglehold on the commercial real estate market of Hong Kong’s CBD, some of the most expensive real estate on the planet. Recently, it has lost its edge to a considerable extent as others have crept into its core market. Mitsubishi Estates in Japan had such a large share of the central Tokyo commercial property market that it definitely had a competitive edge, and still does now that it can seek to redevelop older buildings in its portfolio and thereby strengthening its footprint in Tokyo’s financial heartland.

Ayala Land in the Philippines, after the Second World War, started to develop a very large tract of land it had acquired on the fringes of metro Manila. Its vision was to create a massive new heart of the city away from the existing crowded, obsolete and crumbling city centre. This development was a 50 year venture, and saw Ayala essentially control the growth of the capital city’s core business district. A very long term and definite competitive advantage.

In land starved Hong Kong, having access to land bestows a significant competitive advantage. There are four large companies that have amassed large quantities of agricultural land that may be converted in time to residential or commercial status – Sun Hung Kai Properties, Cheung Kong, Henderson Land, and New World Development. Some companies have secured significant competitive ad-vantage by getting their hands on land that affiliated companies or subsidiaries might have had under other uses in earlier times For example, Cheung Kong has converted large sites from power station use, port related facilities and oil tank farms to high value residential/commercial use. Swire Limited has also converted its old industrial sites to extensive residential districts and whole new commercial districts.

The Importance of Brand – It Can Lead to Premium Pricing

Certain companies in the real estate space have developed a brand or name for a particular type or style of real estate, and can often charge higher prices for product in that particular sector. In real estate the brand differentiation can usually come from developing properties to a consistently high standard and very often from managing the real estate to a high level of service and maintenance, something that is increasingly important to occupiers and owners.

Of the major companies we are focusing on in the region, Westfield out of Australia but now big in the US and increasingly in UK, has developed a clear brand in the retail mall sector, with high quality developments that are typically very well managed.

Hong Kong Land, in the office market again was very much a leader in development and management of commercial real estate in Hong Kong and more recently into Singapore and in China. It is losing some of its edge as other players enter its turf with high quality offerings.

Capital Land and its REIT offerings in Singapore are also known for good quality projects.

Sun Hung Kai Properties in Hong Kong – the world’s largest property company by market capitalisation – routinely is able to charge a premium for its residential properties and increasingly for its high quality commercial properties. Swire also has a reputation for quality developments and sound property management.

In China, Longfor is developing a name for quality development and quality execution. Soho has worked at developing a “hip” brand that so far has been able to secure premium pricing, but the market is increasingly questioning the poor construction quality of the company’s developments and inadequate attention to property management.

By contrast other heavyweights in the industry in the region notably have not developed a quality brand – and in fact have a neutral to negative perception of their product in the market. Cheung Kong in Hong Kong and its affiliate Hutchison Whampoa stands out in this regard, and to some extent Henderson Land in the Hong Kong market.

Soft Stuff is Good, But It Is In the Financials Where the Rubber Meet the Road

While it is hugely important for real estate companies that they appear to enjoy some competitive advantage through location, quality, branding and etc, if this does not translate into better financials than the peers, then the “soft, subjective” advantages don’t count for much when all is said and done.

While there are a great many financial criteria that impact on a company’s ability to secure long term competitive advantage, we here attempt to identify some of the most relevant that we see for companies in the real estate space.

But first a couple of observations about the nature of the real estate business that may differentiate the business from other many other businesses.

Cyclicality is a Given in Real Estate

While many businesses experience cycles of ups and downs of demand, the real estate industry is particularly vulnerable to cyclicality. This is driven from both the demand side and the supply side of the business. Drivers of cyclicality include the following core factors:

  • Economic growth drives top down demand.
  • Demographics, immigration and household incomes feature strongly in housing markets.
  • Availability of liquidity and cost of debt can be vital parts of the cyclicality potion.
  • Raw material costs have big impacts on the business.
  • Government policies in both banking and housing can have huge impacts on the real estate cycle, both positive and negative.

By comparison, sales of coke, for example, are unlikely to vary by 20% – 30% in an individual market. That is a frequent reality in real estate markets, particularly in Asia, and far from the case in “Buffet style” consumer product companies.

Development vs. Investment

There are generally two types of companies in the real estate space:

  1. Developers: Those that primarily buy land, build and sell completed floor space.
  2. Investors: Those that either buy or build property for purposes of longer term holding and deriving rental income. REITs generally fit into this category.

Developers are almost bound to suffer greater earnings growth and cyclicality of earnings and can be held hostage to the short term gyrations in the factors noted above. About two thirds of Asia’s listed property companies by market capitalization are focused primarily on the development business, but many have in the past and currently build large portfolios of rental properties. In markets such as the USA and Europe, the listed real estate space is more dominated by investment property companies and REITs – the opposite of Asian markets.

Investment property companies will likely suffer less cyclicality of earnings given that income is largely from rentals and these tend to be fixed for periods of several years.

Other characteristics of financial statements are likely to be different as between developers and investment property companies. Asset turnover is likely to be greater for developers than investment companies. Earnings are likely to be more volatile, and probably show faster growth than rental companies.

We have selected 22 major property companies in 4 core Asian markets – Japan, Hong Kong, Singapore and Australia. Within the mix we have included some REITs as well as property developers and property investment companies.

When we look at Competitive advantage, we might be looking at selecting best companies within a certain market, within a certain property type – REITs, developers, or investment companies – or in absolute terms across the entire region. Given the very different nature and activities of the different types of company, the financial characteristics are inevitably going to be very different according to individual company type and country.

Here we attempt to set out in very simple form the financial criteria that might indicate competitive advantage in hard asset companies, particularly real estate companies. In this we consider the characteristics through the Income Statements, Cash Flow Statements, and Balance Sheet.

Our study includes financials for the past 10 years.

We have undertaken our number-crunching on the basis of US$ to enable cross country comparisons on a like for like basis. This also recognizes that a considerable proportion of the investment community translates back to US$, and a great many investment funds are denominated in US$.
Translation of company income statements in US$ will produce different results from using local currency. Over the analysis period, three of the currencies – Yen, Singapore dollar and Australian dollar – have appreciated against the US dollar. This will tend to make income based numbers, retained earnings look better than if counted in local currency, but make debt and cost figures look worse. Hong Kong’s currency has been pegged to the US$ since the early 1980’s so any translation effect is insignificant.

Income Statement – Churn and Earn!

Here are the key characteristics we are looking for in income statements that might suggest competitive advantage. See Figure 2 for the income statement analysis.

Figure 2: Income Statement Analysis – % Gross Profit Margin, Averaged from 2001-2010

Figure 2: Income Statement Analysis - Percentage of Gross Profit Margin, averaged from 2001-2010. Hysan Development 83%. Hongkong Land 75%. Hang Lung Properties 67%. Wharf Holdings 65%. Cheung Kong 56%. Link REIT 52%. City Development 50%. Japan Real Estate 48%. Nippon Building Fund 46%. United Industrial Corp 45%. Japan Retail Fund 45%. Sun Hung Kai Properties 43%. Westfield 43%. Henderson Land Development 37%. Keppel Land Corp 35%. Kerry Properties 29%. Capitaland 29%. New World Development 27%. Sumitomo Realty 26%. Mitsubishi Estate 22%. Mitsui Fudosan 21%. Stockland 13%.

Criteria – Gross Margin

A high gross margin (gross profit as % of gross revenue) relative to peers. One might expect investment property companies to have higher gross margins than property developers.

Rankings of the 22 companies for gross margin is shown in Figure 2.

Gross margins across all markets tend to be significantly higher for REITs and property investment companies than for property developers.

Competitive Advantage in the Asian Real Estate Sector 2001-2010

Figure 3: Japan Companies – Income Statement Analysis

Company Mitsubishi Estate Co Ltd Mitsui Fudosan Ltd Sumitomo Realty & Dev Co Ltd Nippon Building Fund Inc Japan Real Estate Inv. Corp Japan Retail Fund Inv. Corp
Gross Profit: Up vs Down yrs 8↑, 1↓ 6↑, 3↓ 8↑, 1↓ 6↑, 3↓ 7↑, 2↓ 8↑, 0↓
Gross Margin – % – avg 22.2% 21.2% 25.6 45.9% 50.0% 42.2%
Hi/Low – % 18%-30% 19%-24% 24%-29% 42%-50% 46%-54% 39%-66%
Variation – Hi/Med/Low Med Low Low Low Low Med
SGA as % Gross Op Inc – Avg 33% 50% 29% 2% 4.2% 2%
Variation – Hi/Med/Low Med Med Low Low Med Low
Interest Exp – % of Gr Prof – Avg 15.4% 9.8% 15.7% 15.7% 12.1% 13.5%
Hi/Lo – % 8%-29% 7%-13% 11%-24% 9%-24% 7%-18% 2%-30%
Variation – Hi/Med/Low High Med Med High High High
Int in absolute terms Low Low Low Low Low Low
Net Op.Inc % growth – CAGR 16.2% 2.9% 8.6% 13.7% 21.8% 39.1%
Simple average growth – % 31.6% 3.2% 12.2% 24.2% 54.5% 163.0%
Variation – Hi/Med/Low High High High High High High
Net Op. Inc – up vs down yrs 8↑, 1↓ 7↑, 2↓ 8↑, 1↓ 6↑, 3↓ 7↑, 2↓ 5↑, 3↓
Rank on Income Statement *** * ** ** *** ***

Source: Reuters, Portwood Capital Ltd.; No. of Sample Companies 22.
Note: 3 *** is the best ranking.

In Japan, gross margins for the REITs we looked at are remarkably similar and consistent, and are about twice the level of the major property developers.

Figure 4: Hong Kong Companies Group 1 – Income Statement Analysis

Hong Kong 1
Company Cheung Kong Holdings Ltd Sun Hung Kai Properties Ltd Henderson Land Dev. Co. Ltd Hang Lung Properties Ltd New World Dev. Co. Ltd
Gross Profit-Up vs Down yrs 7↑, 2↓ 5↑, 4↓ 7↑, 2↓ 5↑, 4↓ 5↑, 4↓
Gross Margin – % – avg 56.3% 43.1% 36.6% 67.0% 27.1%
Hi/Low – % 37%-89% 25%-55% 23%-47% 50%-83% 20%-38%
Variation – Hi/Med/Low Med Med Med Med Med
SGA as % Gross Op Inc – avg 14% 19.7% 47% 6% 28%
Variation – Hi/Med/Low Low Low High Low Low
Interest Exp – % of Gr Prof – avg 17.4% 10.8% 39.1% 7.6% 26.6%
Hi/Lo – % 6%-37% 2%-25% 4%-80% 0%-23% 14%-44%
Variation – Hi/Med/Low High High High High Med
Int in absolute terms Med Low High Low Med
Net Op. Inc % growth – CAGR 20.6% 13.5% 0.0% 17.4% 0.0%
Simple average growth – % 48.8% 23.6% -68.8% 36.0% 28.7%
Variation – Hi/Med/Low High High High High High
Net Op. Inc – up vs down yrs 8↑, 1↓ 7↑, 2↓ 4↑, 5↓ 5↑, 4↓ 2↑, 7↓
Rank on Income Statement *** ** * ** *

Source: Reuters, Portwood Capital Ltd.; No. of Sample Companies 22.

Figure 5: Hong Kong Companies Group 2 – Income Statement Analysis

Hong Kong 2
Company Kerry Properties Ltd Hongkong Land Holdings Ltd Wharf (Holdings) Ltd Hysan Dev. Co. Ltd Link Real Estate Inv. Trust
Gross Profit – Up vs Down yrs 7↑, 2↓ 7↑, 2↓ 7↑, 2↓ 6↑, 3↓ 6↑, 3↓
Gross Margin – % – avg 28.8% 74.9% 65.2% 83.0% 51.8%
Hi/Low – % 37%-89% 25%-55% 23%-47% 50%-83% 20%-38%
Variation – Hi/Med/Low Med Med Med Med Med
SGA as % Gross Op Inc – avg 14% 19.7% 47% 6% 28%
Variation – Hi/Med/Low Low Low High Low Low
Interest Exp – % of Gr Prof – avg 17.4% 10.8% 39.1% 7.6% 26.6%
Hi/Lo – % 6%-37% 2%-25% 4%-80% 0%-23% 14%-44%
Variation – Hi/Med/Low High High High High Med
Int in absolute terms Med Low High Low Med
Net Op. Inc % growth – CAGR 20.6% 13.5% 0.0% 17.4% 0.0%
Simple average growth – % 48.8% 23.6% -68.8% 36.0% 28.7%
Variation – Hi/Med/Low High High High High High
Net Op. Inc – up vs down yrs 8↑, 1↓ 7↑, 2↓ 4↑, 5↓ 5↑, 4↓ 2↑, 7↓
Rank on Income Statement *** ** * ** *

Source: Reuters, Portwood Capital Ltd.; No. of Sample Companies 22.

For Hong Kong, the companies focused on property investment as well as those that are rather more in the conglomerate space (Cheung Kong and Wharf) enjoy higher gross margins than the companies that are more focused on development – Sun Hung Kai Properties, Henderson Land and New World Development. Cheung Kong and Wharf are multi-faceted companies that have property at their core but also are involved in areas such as transport, telecoms, infrastructure, electricity, ports, retail and other activities.

Gross margins for most companies over the 10 year period show generally quite wide variations reflecting the volatile nature of property markets over this time.

Generally gross margins have not been too consistent in this sector.

Figure 6: Singapore and Australia Companies Group – Income Statement Analysis

Singapore and Australia
Company CapitaLand Ltd City Dev Ltd Keppel Land Corp Ltd United Industrial Corp Ltd Westfield Group Stockland Corp Ltd
Gross Profit – Up vs Down yrs 5↑, 4↓ 7↑, 2↓ 5↑, 4↓ 4↑, 5↓ 7↑, 2↓ 8↑, 1↓
Gross Margin – % – avg 29.4% 50.4% 35.3% 44.8% 42.7% 13.0%
Hi/Low – % 14%-38% 43%-55% 25%-53% 42%-51% 27%-66% 6%-45%
Variation – Hi/Med/Low Low Low Low Low Med Med
SGA as % Gross Op Inc – avg 51% 34% 14% 17% 20% 0%
Variation – Hi/Med/Low High Low Med Low High N/A
Interest Exp – % of Gr Prof – avg 21.0% 5.9% 33.8% 7.9% 36.7% 67.0%
Hi/Low – % 0%-67% 0%-12% 12%-120% 2%-14% 10%-55% 19%-138%
Variation – Hi/Med/Low Low Low High Low High High
Int in absolute terms High Low Now Low Low High High
Net Op. Inc % growth – CAGR -1.1% 9.2% 9.5% 13.1% 5.5% 13.8%
Simple average growth – % -1.1% 12.1% 12.7% 22.6% 6.0% 24.5%
Variation – Hi/Med/Low High Med High High High High
Net Op. Inc – up vs down yrs 6↑, 3↓ 5↑, 4↓ 5↑, 4↓ 5↑, 4↓ 5↑, 4↓ 5↑, 4↓
Rank on Income Statement * *** ** * ** *

Source: Reuters, Portwood Capital Ltd.; No. of Sample Companies 22.

Within Singapore the distinction in gross margins by company type is less clear. But generally the variations of gross margins for each company are less pronounced. There may be an occasional “outlier” year, but generally gross margins have proved a bit more consistent than for Hong Kong companies.

For the two Australian companies included average gross margins are very different with Westfield, the shopping mall operator showing much higher gross margins that Stockland which has a more diverse portfolio of development and rental properties.

Criteria – SG & A Expenses

Important here is consistency of SG&A (Selling, General & Administrative) expenses, with no wild swings and a pattern of consistency of expenses with respect to sales or gross profits.

SG&A expenses, as a proportion of gross profit are typically very much lower for property investment companies and REITs than they are for development focused companies. This intuitively makes sense as property developers need to advertise and market their properties for sale, sometimes at considerable cost.

For Japan, the SG&A/gross profit ratio is very low for the REITs, at around 2% – 4%, and very consistent. For the three development/investment focused companies the ratios are very much higher and still consistent. They are spending 29% to 50% of gross profit on SG&A, very much higher than averages in the rest of the region. At 50% Mitsui Fudosan stands out as being the highest spender on SG&A in our study group, along with Singapore’s Capitaland.

In Hong Kong the pattern of lower ratios for the investment companies is clear with 6% to 14% being the range. For the developers the figure is more in the range of 20% to 47% in the case of Henderson Land – this company is a real stand out in this measure. Across the sector the variation of the SG&A ratio is quite consistent for each company with no huge variations from year to year. Kerry Properties and Henderson Land have the widest variations in the SG&A ratio, and it is noticeable that for Cheung Kong, the trend in this ratio is generally to the upside.

Figure 7: Ranking of SG & A

Company Reuters Stock Code Bloomberg Symbol SGA as % Gross Op Inc – Avg
Nippon Bldg Fund 8951.T 8951:JP 1.9%
Japan Retail Fund 8953.T 8953:JP 2.0%
Japan Real Estate 8952.T 8952:JP 4.2%
Link Real Estate 0823.HK 823:HK 5.7%
Hang Lung Properties 0101.HK 101:HK 6.4%
Hongkong Land HKLD.SI HKL:SP 9.1%
Hysan Dev 0014.HK 14:HK 10.0%
Keppel Land KLAN.SI KPLD:SP 14.0%
Wharf (Holdings) 0004.HK 4:HK 14.2%
Cheung Kong Holdings 0001.HK 1:HK 14.3%
United Industrial Corp UICS.SI UIC:SP 16.7%
Sun Hung Kai Properties 0016.HK 16:HK 19.7%
Westfield Group WDC.AX WDC:HK 20.0%
New World Dev 0017.HK 17:HK 28.4%
Kerry Properties 0683.HK 683:HK 29.0%
Sumitomo Realty 8830.T 8830:JP 29.2%
Stockland Corp SGP.AX SGP:AU 31.6%
Mitsubishi Estate 8802.T 8802:JP 32.7%
City Development CTDM.SI CIT:SP 34.3%
Henderson Land Dev 0012.HK 12:HK 47.4%
Mitsui Fudosan 8801.T 8801:JP 50.0%
Capitaland CATL.SI CAPL:SP 50.8%

Source: Reuters, Portwood Capital Ltd; No. of Sample Companies 22.

In Singapore, Capitaland stands out as having a very high SG&A ratio, averaging 51% over the past ten years, and it has been consistently high amongst its peers in the country and the region. That of City Developments at 34% is at the high end of the range of its regional peers and the ratio at Keppel Land shows a distinct rising trend.

For Westfield in Australia, the average number for the past 10 years at 20% is distorted by the earlier figures before the company’s restructuring earlier in the decade. Its more recent SG&A ratio, post restructuring is a consistent 2% or so, one of the lowest in the region.

Criteria – Interest Expense

Low interest expense as a percentage of gross profit is good. This indicates low debt (and possibly low interest rates in the country concerned), and probably low systemic risk, and we all know that high debt has killed more property companies than any other single financial factor.

Figure 8 plots the ratio of average interest payments to gross operating profit over the past 10 years for our study universe of 22 companies.

Some two thirds of the companies in our group have interest to gross profit ratios of less than 20%, a very comfortable debt position. We would hazard that interest ratios in this universe is generally a lot lower than in other major markets in North America and Europe. Australia, in general is showing higher interest ratios than other parts of the region.

Figure 8: Interest Expense as a Percentage of Gross Profit

Interest Expense as a Percentage of Gross Profit. Mitsubishi Estate 15.4%. Mitsui Fudosan 9.8%. Sumitomo Realty 15.7%. Nippon Building Fund 15.7%. Japan Real Estate 12.1%. Japan Retail Fund 13.5%. Cheung Kong Holdings 17.4%. Sun Hung Kai Properties 10.8%. Henderson Land Development 39.1%. Hang Lung Properties 7.6%. New World Development 26.6%. Kerry Properties 23.7%. Hongkong Land Holdings 27.3%. Wharf (Holdings) 9.5%. Hysan Development 9.0%. Link Real Estate Investment Trust (Link REIT) 11.8%. Capitaland 21.0%. City Development 5.9%. Keppel Land Corp 33.8%. United Industrial Corp 7.9%. Westfield Group 36.7%. Stockland Corp 67.0%.

The companies sporting interest ratios of less than 10% are a mix of both investment focused companies and developers to be found in 3 of the 4 countries. The Australian companies stand out as carrying the highest interest payment ratios, with Stockland’s average interest payment comprising 67% of average gross operating profit. Not comfortable!

Japan’s generally low interest rate environment over the past 15 years or so has definitely helped its property companies maintain relatively low interest payment ratios. In the group analyzed, all companies have average interest ratios over the past decade of 16% or less.

Henderson Land’s 37% interest ratio stands head and shoulders above its peers, and very much higher than its closest peer in the group, Sun Hung Kai Properties with its 11% interest ratio.

In Singapore, Keppel Land’s average ratio of 34% looks high but the pattern in recent years has seen a dramatic reduction to below 15%.

Companies with interest ratios of 15% or less probably have low systemic risk and some measure of competitive advantage in what is typically a capital intensive industry.

Criteria – Net Income

We like to see a consistent pattern of rising net income, but it is important to look beneath the hood here. Since the accounting mandarins have decreed in recent years that property revaluations must be taken in the P&L account, there is a high probability of wide swings in the REPORTED HEADLINE net profit that reflect revaluations of property portfolios rather than the underlying core income. Hence we want to identify earnings BEFORE property revaluations, or core earnings rather than the headline reported earnings.

There are occasions when property revaluations (up or down) can be more than the company’s core earnings – a huge distortion to reported earnings!

A property company that can deliver a consistent pattern of rising net income (excluding property revaluations) in such a cyclical industry, where the value of the underlying asset can have significant upward and downward movements in price, may have durable competitive advantage.

Along with this, a company that enjoys a higher net income from its core business in relation to gross revenues than its peers is likely to be at the forefront of competitiveness.

For our analysis here we take Gross Operating Profit less SG&A, less Interest expenses and other expenses to calculate a Net Operating Income – NOI.

Figure 9 Shows core earnings growth for the period 2001-2010 for our universe. Three companies in the group experienced zero and negative NOI growth over the period 2001-2010. Just over half of the group produced CAGR of more than 10%.

Figure 9: Core Earnings CAGR 2001-2010

Core Earnings Compound Annual Growth Rate (CAGR) from 2001-2010. Capitaland -1.1%. Henderson Land 0.0%. New World Development 0.0%. Mitsui Fudosan 2.9%. Hysan Development 5.0%. Link Real Estate Investment Trust (Link REIT) 5.4%. Westfield Group 5.5%. Wharf (Holdings) 6.8%. Sumitomo Realty 8.6%. City Development 9.2%. Keppel Land 9.5%. Hongkong Land 13.0%. United Industrial Corp 13.1%. Sun Hung Kai 13.5%. Nippon Building Fund 13.7%. Stockland Corp 13.8%. Mitsubishi Estate 16.2%. Hang Lung Properties 17.4%. Kerry Properties 19.3%. Cheung Kong Holdings 20.6%. Japan Real Estate 21.8%. Japan Retail Fund 39.1%.

Figure 10 looks at the number of down years companies had in the period from 2001 – 2010. No company in our group had an unblemished record over the period by scoring zero down years. However eight companies had two or fewer down years, with all three of the major Japanese developers suffering only one or two down years out of nine.

Figure 10: Down Years of Core Earnings Growth 2001-2010

Down Years of Core Earnings Growth 2001-2010. Companies with 1 Down year between 2001 and 2010: Mitsubishi Estate, Sumitomo Realty, Cheung Kong, Wharf. Companies with 2 down years between 2001 and 2010: Mitsui Fudosan, Japan Real Estate, Sun Hung Kai, Kerry Properties. Companies with 3 down years between 2001 and 2010: Nippon Building Fund, Japan Retail Fund, Hongkong Land, Hysan Development, Link REIT, Capitaland. Companies with 4 down years between 2001 and 2010: Hang Lung Properties, City Development, Keppel Land, United Industrial Corp, Westfield, Stockland. Companies with 5 down years between 2001 and 2010: Henderson Land Development. Companies with 7 down years between 2001 and 2010: New World Development.

Similarly Hong Kong companies featured in the low numbers of down years, with Cheung Kong and Wharf having only one down year (both companies have conglomerate characteristics and are not pure property companies) and Sun Hung Kai Properties and Kerry Properties having two down years.

Hong Kong companies however also dominated the poor end of the rankings with Henderson Land showing 5 down years out of nine and New World Development very much bringing up the rear at 7 down years.

Unexpectedly some REITs enjoy higher compound growth than developers.

Generally speaking we would expect core earnings from REITs and investment property focused companies where income comes mostly from rental income to have lower growth prospects and also have less variability/greater stability, predictability.

But that expectation is not borne out entirely at all.

For example, in Japan two of the three REITS in our universe have enjoyed higher compound annual growth or core earnings than two of the “big three” property companies in Japan

In Hong Kong, the Hongkong Land Company has secured higher average growth than the more development focused Sun Hung Kai Properties, and beaten developers such as Henderson Land and New World Development into a cocked hat – their average earnings growth has been negative!

Almost one quarter of the group recorded compound income growth less than 5%.

In our universe of 22 companies, four have shown CAGR less than 5% over the past decade. This includes Hong Kong’s Henderson Land, Hysan Development and New World Development, Singapore’s Capitaland and Japan’s Mitsui Fudosan. See Fig 11 for further reference.

The high volatility of property prices in the region over the study period which embraces the immediate after effects of the Asian financial crisis as well as the global financial crisis, have definitely played a part in volatile earnings in the property sector, particularly with respect to property sales, and the residential market in particular.

For example, average property prices in Hong Kong fell by around 65% from mid-1997 to 2003, and prices in Singapore were not far behind that.

Figure 11: Core Earnings CAGR 2001-2010

Core Earnings CAGR 2001-2010. Negative CAGR: Capitaland. 0-5% CAGR: New World Development, Henderson Land Development, Mitsui Fudosan, Hysan Development. 5-10% CAGR: Link REIT, Wharf, Westfield Group, Sumitomo Realty, Keppel Land, City Development. 10-15% CAGR: Hongkong Land, United Industrial Corp, Sun Hung Kai, Nippon Building Fund, Stockland Corp. 15-20% CAGR: Mitsubishi Estate, Hang Lung Properties, Kerry Properties. Over 20% CAGR: Cheung Kong, Japan Real Estate, Japan Retail.

To be fair, the starting or end point can have a big impact on the calculation of CAGR.

For example, if a company suffered a particularly poor year at our start date, and then “got back on track” with earnings, the CAGR can appear artificially high. For example Cheung Kong and Japan Retail Fund had inordinately low NOI in 2001, our start date, and this has tended to exaggerate the CAGR of NOI. By contrast Japan Real Estate’s relatively high NOI in 2001 has underplayed it CAGR.

Keppel Land suffered a loss in 2001, which significantly distorts the CAGR – its record since then has been quite positive with steady growth of NOI.

Summary of Income Statement Components of Competitive Advantage. Who Gets the Three Stars, Who Gets the Wooden Spoon?

Based on the analysis above we have awarded from one to three stars to each company (three stars being best) on the basis of our assessment of their income statement achievement of the criteria for longer term sustainable competitive advantage. There is always a degree of subjectivity in the assessment, but we have tried to identify the rankings in absolute terms as well as in relation to peers.

See Figure 3-6, Competitive Advantage – The Income Statement.

Figure 12: The Winners and losers in the Income Statement Analysis

*** Mitsubishi Estate Japan Retail Fund Japan Real Estate Cheung Kong Holdings City Development
** Sumitomo Realty Nippon Bldg Fund Sun Hung Kai Properties Hang Lung Properties Kerry Properties
Hongkong Land Wharf (Holdings) Hysan Development Link Real Estate Keppel Land
Westfield Group
Wooden Spoon Recipients
* Mitsui Fudosan Henderson Land Dev New World Dev Capitaland Stockland
United Industrial Corp

Some five out of our twenty two companies get the top rating, and six the wooden spoon, with the bulk somewhere in the middle of the road. Admittedly some of the two star rated companies are close to joining the top rankings. For example, Hang Lung has delivered good CAGR, and high operating margins, but earnings have not been too consistent.

The top rankings on income statement measures include three Japanese companies, one from Singapore and one from Hong Kong. What distinguishes the winners is either higher margins/lower costs than peers, or stronger, more consistent earnings growth (or both).

For example, Cheung Kong is pretty much top of the rankings amongst its peers in terms of margins, and consistent high earnings growth.

In Japan, Mitsubishi Estates enjoys similar margins as peers, but has delivered earnings growth head and shoulders above its peers.

City Development in Singapore has given consistently high margins and compound growth at the high end of the range.

Balance Sheet – Invest for the Best

Property companies are likely to have balance sheets that are quite different from those of most operating companies. Under current assets will be included land and properties that are under development, which for developers can be a rather large amount, and it may take a number of years for projects to be developed and then be sold or included as investment properties under noncurrent assets. Such projects under current assets are typically included at cost.

Inventory: For a property developer, a steady rise in inventory over time, usually properties for sale, suggests that it is growing its future revenue potential. A good sign.

Property investment companies on the other hand are likely to have low or even zero inventory as they are not building properties for sale.

See figures 13-15.

Criteria – Cash

It is always good to see a property company growing the cash on its balance sheet. Firstly it gives some comfort in terms of ability to withstand shocks to the system, which may come along more frequently than one might like. Secondly a cash stash indicates that the company is able to fund further growth of its business. In the property business that usually involves buying land or completed properties, which is normally a costly exercise.

It is important to determine if the cash is being built up through operations (rental income or sales of completed development properties) or from issuing bonds, other forms of debt or new equity.

The buildup of cash, if set against low levels of debt, can be a good indicator of sustainable competitive advantage.

Our universe of companies has to a very large extent grown their cash holdings over the period considered. But rates of growth of cash and short term investments in balance sheets have been in a wide range. Some like Hysan Development in Hong Kong has grown its cash at a compound clip of around 62%, but from a very low base in the early years of our analysis period.

Others, like Sun Hung Kai Properties and UIC have maintained cash at almost precisely the same level each year, with zero growth over the period. This appears to be a deliberate strategy on their part.

Westfield, for example, has seen cash expand and contract, with negative growth over the period.

REITs typically hold relatively low levels of cash as they are required to pay out most of earnings as dividends.

Figure 13: Japan Companies – Balance Sheet Analysis

Company Mitsubishi Estate Mitsui Fudosan Sumitomo Realty Nippon Bldg Fund Japan Real Estate Japan Retail Fund
NoI/Total Assets – % avg 2.7% 3.2% 3.6% 2.7% 2.8% 2.4%
Cash + S.T. Investments – CAGR 11.8% 0.3% 6.3% 33.7% 0.3% 39.9%
Simple avg growth 19.3% 0.3% 8.1% 140.6% 0.3% 171.0%
Characteristic/Trend Steady Falling Rising Rising Falling Flat
Net Assets – CAGR % 4.2% 5.9% 10.5% 11.0% 16.6% 35.6%
Characteristic/Trend Rising Rising Rising Rising Rising Rising
Total Debt/Equity – avg %131.2% 180.2% 405.2% 78.1% 75.0% 63.4%
Characteristic/Trend Flat Flat Flat Flat Rising Rising
Net Debt/Equity – avg % 119.3% 173.2% 392.4% 74.2% 75.0% 60.1%
Characteristic/Trend Flat Flat Flat Flat Flat Rising
Cash/Short Term Debt – avg % 112.6% 55.9% 33.8% 25.3% 62.0% 19.9%
Growth Retained Earnings – avg % 10.5% 10.3% 27.7% 5.2% 13.8% 67.0%
Rank for Balance Sheet *** * * ** ** ***

Source: Reuters, Portwood Capital Ltd; No. of Sample Companies 22.
Note: 3 *** is the best ranking.

Figure 14: Hong Kong Companies – Balance Sheet Analysis

Hong Kong
COMPANY Cheung Kong Holdings Sun Hung Kai Properties Henderson Land Dev Hang Lung Properties New World Dev
NOI/Total Assets – avg % 2.2% 3.6% 0.65% 4.8% -0.2%
Cash + S.T. Investments – CAGR 30.2% 0.0% 22.5% 13.4% 5.7%
Simple avg growth 108.2%% 0.0% 57.7% 23.3% 7.2%
Characteristic/Trend Rising Flat Rising Rising Rising
Net Assets – CAGR % 5.4% 7.4% 12.0% 14.3% 4.6%
Characteristic/Trend Rising Rising Rising Rising Rising
Total Debt/Equity – avg % 14.5% 18.6% 23.7% 24.5% 65.4%
Characteristic/Trend Flat Flat Flat Falling Flat
Net Debt/Equity – avg % 10.5% 13.2% 16.7% 13.6% 36.1%
Characteristic/Trend Falling Flat Flat Falling Flat
Cash/Short Term Debt – avg % 165.5% 472.5% 490.0% 493.0% 459.9%
Growth Retained Earnings – avg % 5.4% 63.7% 15.7% 15.6% 12.2%
Rank for Balance Sheet ** *** ** ** *
COMPANY Kerry Properties Hongkong Land Wharf (Holdings) Hysan Dev Link Real Estate
NOI/Total Assets – avg % 2.6% 3.1% 5.8% 2.8% 4.4%
Cash + S.T. Investments – CAGR 19.6% 10.2% 18.6% 61.6% N/A
Simple avg growth 44.7% 4.0% 40.3% N/A N/A
Characteristic/Trend Rising Rising Rising Rising Falling
Net Assets – CAGR % 12.7% 51.4% 12.9% 7.5% 11.3%
Characteristic/Trend Rising Rising Rising Rising Rising
Total Debt/Equity – avg % 36.1% 37.5% 27.0% 16.1% 19.8%
Characteristic/Trend Flat Falling Flat Flat Falling
Net Debt/Equity – avg % 25.6% 37.5% 27.0% 16.1% 19.8%
Characteristic/Trend Flat Falling Flat Falling Falling
Cash/Short Term Debt – avg % 347.9% 650.2% 122.4% 350.0% No ST Debt
Growth Retained Earnings – avg % 10.1% 53.7% 36.9% 24.1% 0.0%
Rank for Balance Sheet ** *** ** ** **

Source: Reuters, Portwood Capital Ltd; No. of Sample Companies 22.

Figure 15: Singapore and Australia Companies – Balance Sheet Analysis

Singapore and Australia
COMPANY Capitaland City Development Keppel Land United Industrial Westfield Group Stockland Corp
NOI/Total Assets – avg % 2.5% 3.8% 1.9% 3.7% 2.2% -9.8%
Cash + S.T. Investments 15.3% 8.8% 33.1% 0.0% Negative 18.3%
Simple Avg Growth 28.8% 12.6% 134.9% 0.0% 39.4%
Characteristic/Trend Rising Rising Rising Flat Falling Flat
Net Assets – CAGR % 10.0% 6.0% 11.8% 7.5% 0.0% 15.7%
Characteristic/Trend Rising Rising Rising Flat Falling Flat
Total Debt/Equity – avg 107.2% 90.1% 122.5% 36.0% 86.3% 34.8%
Characteristic/Trend Falling Falling Falling Falling Flat Flat
Net Debt/Equity – avg % 86.3% 85.2% 110.9% 33.3% 83.8% 34.2%
Characteristic/Trend Falling Falling Falling Flat Flat Falling
Cash/Short Term Debt – avg % 143.1% 34.8% 191.1% 28.7% 20.5% 16.4%
Growth Retained Earnings – avg % 11.9% 8.7% 68.2% 17.1% 3.8% 5.8%
Rank for Balance Sheet ** * ** ** * **

Source: Reuters, Portwood Capital Ltd; No. of Sample Companies 22.

Criteria – Return on Assets

This metric in our case measures net operating income (NOI) divided by total assets. As noted earlier, total net income for property companies is distorted by the accountants in our lives requiring net income to include revaluations of property in the net income calculation, something that hugely distorts reported net income figures. Hence here we consider NOI against assets to avoid the distortions of revaluations in the P&L account.

For property companies, we might examine trends of the ratio of total operating profit to total assets as a proxy for the conventional return on assets calculation. The thing about the property business is that barriers to entry are quite high given the large amounts of capital that are required to be a major player. Many service industries might have very high return on assets but have low barriers to entry and/or low capital intensity. Such businesses can therefore be very competitive, and the durability of any competitive advantage can be lower.

In the property space here we like to see consistent or rising return on assets, when compared against peers.

There is not a huge range in the return on assets figures but there are a couple of notable features.

1. Two companies, New World Development and Stockland have recorded negative returns on assets over the past 10 years.
2. In some instances, particularly in Hong Kong, there has been some-thing of a trend of rising return on assets, possibly reflecting the recovery in the local property markets following the Asian financial crisis of the late 1990’s.

Criteria – Debt – Short and Long Term

More property companies have gone to the wall around the world due to debt problems than for any other reason.

Property is a capital intensive business, and the temptation to grow through debt is enormous. Also, property investment is a long term business – it takes a long time to buy land, get building approvals, construct and sell buildings. But most bank lending to property companies is for relatively short periods of time – often 2-3 years only. This means that property companies are frequently faced with the need to roll over debt, or sell properties quickly to enable debt to be paid down. This can put even the most well-heeled property companies at risk.

Debt Is and Has Long Been the Achilles Heel of the Property Sector

In essence we like to see property companies have small amounts of debt in absolute terms and in particular in relation to their total asset base. Property companies that have total debt to equity ratios (Total short plus long term debt divided by total shareholders’ equity) less than 40% – 50% are likely to have lower and manageable risk. Companies that have net debt/equity ratios (total debt minus cash divided by shareholder funds) of less than 30% are probably going to be low risk players with long term sustainability in this sector.

A significant majority of property companies in Asia (and around the world) have total debt/equity, or even net debt/equity ratios well north of 50%, so ratios in the 30% range are the exception not the rule in the real estate industry generally.

Property companies with debt ratios north of 100% are common, and are not likely to fall into the category of companies with long term competitive advantage, and low systemic risk.

Because of the longer term nature of the property development and owning business, companies prefer to spread debt repayment over a longer period if they can. Low short term debt relative to total debt makes for lower risk.

Companies with High Levels of Cash Relative to Short Term Debt are Also Lower

Ideally in most companies outside the property sector we like to see companies with no long term debt at all, or at most, minimum amounts. It is extremely difficult for property companies to get into a position of carrying no long term debt. I am not aware of any larger listed property companies that have no long term debt at all.

Long term debt is pretty much always going to be part of the risk profile of listed property companies – it is the amount relative to assets and cash and the ability to manage that risk that distinguishes the long term survivors from the rest.

As a general rule, a property company that has net earnings of sufficient size to pay down long term debt over say 4 years is in a generally comfortable position. Moreover, unlike many other types of businesses, property owners may well be able to sell a building from its portfolio to pay down debt, something that operating business and industrial operations may not be able to do so readily.
The lower the amount of debt that a company has relative to its asset base, the closer it is to offering low systemic risk characteristics.

Even Low Debt Can Be a Problem in a Liquidity Crisis

But even property companies with low levels of debt in both absolute and relative terms came to grief in major economic crises over the past 30 years or so. If a major event occurs in credit markets, a company that might have been expecting to roll over even a small loan might find itself unable to do so. This certainly happened in the recent global financial crisis and also the Asian financial crisis of the late 1990’s. Typically it is smaller companies (not just property companies) that get sent to the wall in these circumstances, but also many larger property companies, for example in Australia, and even Japan, found it impossible to re-finance loans at the crucial moment, and were driven under as a result.

This can be a case of the larger the company, the larger the loans, the banks will be more likely to prove accommodating, but will put the squeeze on smaller companies. This can be how the big get bigger, and the small get crushed!

Off Balance Sheet Debt

A point to bear in mind also in the property space (as elsewhere) is the existence of off-balance sheet debt. Companies have often had a habit of not reporting in their financial statements their potential debt liabilities held in joint venture companies, affiliated companies and associates. That has been a particular problem in many Australian listed property companies.

Property companies that have been able to grow earnings and total assets while at the same time holding low debt /equity ratios are candidates to enjoy sustainable long term competitive advantage and low risk.

Debt in Our 22 Company Universe

A very simple set of findings emerges from the debt analysis of our universe:

1. Hong Kong property companies generally have very low debt, right at the low end of the global spectrum for listed property companies. This suggests there is low systemic risk from the debt angle for Hong Kong’s major property companies. Hong Kong companies here have all carried large amounts of cash and cash equivalents on their balance sheets, well in excess of short term debt. Hence there is strong ability to repay short term debt in the event of a liquidity crisis.
2. Singapore’s companies generally have somewhat higher debt than those in Hong Kong, but seems manageable. Our Singapore universe is a mixed bag in terms of ability to cover short term debt from cash – some can, some not. Therefore there is a greater element of risk in Singapore companies.
3. Japanese companies have typically carried high debt levels for many years, and it has always been a concern for investors. But surviving their debt has not been too difficult given very low interest rates in Japan over the past 15 years or so. The REITs have lower debt, but we saw how many companies struggled to roll over loans during the global financial crisis. Moreover, cash is generally kept at levels well below short term debt, making companies vulnerable to a liquidity squeeze.

All in all, Hong Kong property companies stand out from the crowd as having low systemic risk from debt, much lower than Japan and Australia, and some-what lower than in Singapore.

Criteria – Retained Earnings

A company can generally do three things with earnings – pay dividends, buy back shares, or retain earnings in the balance sheet and grow equity. A pattern of consistent growth of retained earnings can be one of the most important signs of long term competitive advantage in any company, property companies included. Regular and meaningful additions to retained earnings will likely grow net worth of the company. A company that does not make additions to retained earnings on a yearly basis is not likely to be a company with enduring competitive advantage.

REITs, due to their requirement to pay out at least 90% of net profits as dividends are not likely to therefore be able to grow shareholders equity via this route. The route to growth for them is limited to improvements in asset values (through property market growth or improvements they make to assets). Growth in total assets can really only be made through new equity issuance and/or new debt – both of which do not add to growth in equity per share as such.

In the property sector in Asia we see little growth in retained earnings through M&A activities – M&A is quite rare in Asia, less rare in markets such as Australia.

While investors love dividends, they do reduce retained earnings. If a company is able to use its retained earnings to make even more money, and more retained earnings over time, shareholder equity is likely to be raised substantially. There are few property companies in Asia that do not pay some dividends, though as a rule property developers pay a smaller percentage of earnings as dividends than property investment companies. Developers, therefore, should have better inherent chances of growing shareholder equity as a result. Some, however, may invest the retained earnings better than others!

Retained Assets Growth – Findings

Across the board there has been universal growth of retained assets in our study group, however the rates of growth have been markedly wide.

  1. Generally, Hong Kong companies seem to have racked up the consistently higher rates of growth of retained earnings more than companies.
  2. Growth rates in Japan have been surprisingly high both for major developers as well as the REITs.
  3. Rates of growth in our two Australian inclusions have been at the lower end of the study range.

It is important to bear in mind that retained earnings as defined in the accounts will likely include some measure of revaluation of investment property holdings, which will in turn reflect movements in local property markets.

Nevertheless, the findings are encouraging, and suggest that the companies are indeed growing equity on a reasonably consistent basis.

Summary of the Balance Sheet Components of Competitive Advantage. Who Deserves the Three Star Treatment?

The rankings we have accorded to companies on balance sheet issues are set out in Figure 16 – Competitive Advantage, the Balance Sheet. To a very large extent the property companies included here from the three Asian countries have very solid balance sheet characteristics, particularly in Hong Kong and Singapore. Debt features of some Japanese companies seem to present a barrier for inclusion in the ranks of long term competitiveness.

The Three Star Awards

In Japan, Mitsubishi Estates stands out amongst its brethren as most lowly geared, good cash coverage, and good growth of retained earnings. Japan Retail Fund also gets the three star nod for similar reasons.

In Hong Kong, as we noted above, property companies have low systemic risk and sport excellent balance sheet to a large extent. However, Sun Hung Kai Properties and Hongkong Land sneak slightly ahead of other companies in the sector with low debt, and high cash cover, strong growth of retained earnings.

As before, most companies fit into the two star category, but as noted above, some Hong Kong companies come very close to inclusion in the top table!

Figure 16: Competitive Advantage – Rankings on the Balance Sheet

Balance Sheet Rankings
*** Mitsubishi Estate Japan Retail Fund Sun Hung Kay Property Hongkong Land
** Nippon Bld Fund Japan Real Estate Cheung Kong Holdings Henderson Land Dev Hang Lung Properties
Kerry Properties Wharf (Holdings) Hysan Dev Link Real Estate Capitaland
Keppel Land United Industrial Corp Stockland Corp
* Mitsui Fudosan Sumitomo Realty New World Dev City Development Westfield Group

Source: Reuters, Portwood Capital Ltd; No. of Sample Companies 22.

Bottom End of the Table

At the bottom are the very high debt companies from Japan – Mitsui Fudosan and Sumitomo Realty, City Development Corp in Singapore has low levels of cash, low end assets growth and lower retained earnings growth than peers. While Westfield may produce and run fabulous shopping malls, it does appear to be struggling to get its house in order, with no cash growth, no net asset growth, high end of the debt spectrum, low cash cover, and low growth of retained earnings.

New World Development Hong Kong has similar characteristics, but does have decent cash cover.

The “Soft” Components of Competitive Advantage:

Here we identify the stand-out companies in terms of:

  1. Location of portfolios.
  2. Brand quality/recognition.
  3. Monopoly/near monopoly conditions/access to land.

The companies that appear to stand out to us in respect of these criteria are shown in Figure 17 – Competitive Advantage- the “Soft” factors.

While we call these “soft”, meaning subjective, they are nonetheless very important in a company’s ability to obtain and maintain an edge in what can be a very competitive business. A big edge in these factors can be a make or break factor for a company.

Figure 17: Competitive Advantage – The “Soft” Factors

Had a stranglehold on the core Tokyo CBD, and still controls a great deal of space in that area.
Criteria Company Description
Location, Location, Location Mitsubishi Estate Co Ltd *** Focus on prime down town core of Tokyo office market.
Sun Hung Kai Properties *** Focus on centers of HK new towns, recently high quality sites in downtown commercial areas in HK and Shanghai.
Hongkong Land *** “Owned” HK’s CBD, also prime core CBD sites in Singapore and Beijing
Capitaland *** Has long track record of securing prime sites in Singapore, both commercial and residential
Westfield Group ** Long history of malls in prime locations in Australia, more recently in USA and UK.
Brand, Quality = Premium Pricing Sun Hung Kai Properties A reputation for quality in its residential, office and retail properties.
Hongkong Land Has been a leader in development for high quality offices and retail, and more recently, residential properties.
Westfield Group Its malls are known for quality of design, and management.
Kerry Properties * Its residential properties (and sister company hotels) are regarded as high quality rental properties with very good management.
Capitaland Is probably regarded as the premier developer in Singapore in its own right and within other group companies.
Monopoly/Near Monopoly Conditions; Access to Land Mitsubishi Estates
Hongkong Land Once held the majority of office/retail space in core HK CBD, and still enjoys a major market share.
Cheung Kong ** Has been able to convert land that other group companies have occupied to higher value uses on numerous occasions.
Wharf (Holdings) Ltd Has converted land that other group companies have occupied to higher value uses.
Capitaland Has enjoyed its position in Singapore to secure sites that may have been very difficult for others to access.
Link REIT * Has a retail and car park monopoly in HK’s public housing estates which accomodate approximately 40% of HK’s 7 plus million people.
Sun Hung Kai Properties Hong Kong’s unique land system has resulted in these four companies acquiring large land banks of agricultural land that may be converted to urban uses over time. This gives them competitive advantage in HK’s very tight land market, particularly for residential development.
Cheung Kong
Henderson Land *
New World Development *

Source: Portwood Capital Ltd; No. of Sample Companies 22.

Figure 18: Competitive Advantage – The Income Statement. Summary Rankings and Comments

Thee Stars
*** Mitsubishi Estate Co Similar to peers in most things, but stronger growth.
Japan Retail Fund Inv Corp Similar to Peers, but more consistent, stronger growth.
Cheung Kong Holdings High margins, modest costs, high growth vs peers, consistent growth. Non-property business helps consistency.
City Developments High margins, low interest cost, solid, steady earnings growth.
Japan Real Estate Similar to peers in most things, solid consistent growth.
Two Stars
** Sumitomo Realty & Dev Corp Margins are similar to peers and consistency good. Interest cost slightly higher than peers, growth middling.
Nippon Building Interest costs are slightly higher than peers, growth a little slower, and slightly less consistent.
Sun Hung Kai Properties Margins good, interest costs low, growth lower than others in sector.
Hang Lung Properties Very high margins, low SG&A and interest costs. Good growth, but not totally consistent.
Kerry Properties Consistent earnings, margins at lower end, SG&A and interest at higher end, but growth also at higher end.
Hongkong Land Holdings Higher interest than peers, but higher growth than peers. Quite consistent growth.
Wharf Holdings SG&A slightly higher than peers, but low interest costs, very consistent margins and growth.
Hysan Development Consistent high margins, low SG&A and Interest Costs. Growth at lower end, and not as consistent as others.
Link Real Estate Inv Trust Margins a bit lower than others, but low costs. Growth at low end of peers.
Keppel Land Corp Margins middle of range, SG&A Low, but interest costs at the high end. Growth being sustained.
Westfield Group Margins good, but SG&A and interest costs at higher end of range. Growth since restructuring modest.
One Star
* Mitsui Fudosan Ltd Similar margins to peers, but SG&A at 50% and low growth. Low interest cost helps.
Henderson Land Margins lower than most peers, very high SG&A and interest costs. Poor earnings track record.
New World Development Lower end margins, higher end SG&A, higher end interest costs, very bad earnings record.
Capitaland Ltd Lower end margins, upper end SG&A, and interest costs, poor longer term earnings record.
United Industrial Corp Consistent high margins, low interest costs, relatively high growth, particularly recently.
Stockland Corp Low margins, very high interest costs, growth low/modest.

Source: Portwood Capital Ltd; No. of Sample Companies 22.

Figure 19: Mitsubishi Estate Co. Ltd. Share Price History since 1984

Mitsubishi Estate Company Limited's Share Price History since 1984.

Figure 20: Japan Retail Fund Share Price History since 2002

Japan Retail Fund's Share Price History since 2002. Japan Retail Fund is structured as a Real Estate Investment Trust.

Figure 21: Cheung Kong Holdings Share Price History since 1980

Cheung Kong Holdings Share Price History since 1980.

Figure 22: City Development Share Price History since 1982

City Development Limited's Share Price History since 1981

Figure 23: United Industrial Corp Share Price History since 1982

United Industrial Corporation Limited's Share Price History since 1981

Figure 24: Capitaland Corp Share Price History since 2000

Capitaland Limited's Share Price History since Q1 2001.

Figure 25: Competitive Advantage – The Balance Sheet. Summary Rankings and Comments

Three Stars
*** Mitsubighi Estate Co Lowest debt among peers, good cash growth, good cash cover for Short Term (ST) debt, decent retained earnings growth.
Japan Retail Fund Inv Corp Strong cash growth, lower end of debt spectrum, very strong growth retained earnings.
Sun Hung Kai Properties Very Low debt, very high cash cover of ST debt, high growth of retained earnings.
Hongkong Land Holdings Decent cash growth, high growth net assets, modest debt, quite low cash cover ratio for Short Term debt.
Two Stars
** Nippon Building Fund Very good cash growth, strong net asset growth, modest debt, quite low cash cover ratio for ST debt.
Cheung Kong Holdings Ltd Very good cash growth, modest net asset growth, very low debt, high cash cover ST debt, but low retained earnings growth.
Wharf Holdings High return on assets, good cash growth, slightly higher debt than peers, very good retained earnings growth.
Hang Lung Properties Ltd Solid net asset growth, low debt, high ST debt cover, solid growth retained earnings.
Henderson Land Dev Co Good cash growth, solid growth of net assets, debt modest, high cash cover of ST debt, and solid retained earnings growth.
Kerry Properties Strong cash growth, good asset growth, high end of debt range of peers, cash cover very high, retained earnings growth solid.
Link Real Estate Inv Trust Good asset growth, low debt, no cash cover for ST debt, and no retained earnings growth (REIT rules do not allow).
Capitaland Ltd Good cash and asset growth, high debt but falling, very good cash cover, decent retained earnings growth.
Keppel Land Corp Low return on assets, but solid cash growth, very solid net asset growth, low debt, low growth of retained earnings.
United Industrial Corp No growth of cash and low cash cover of Short Term Debt, but low debt, solid growth of retained earnings.
Stockland Corp Negative return on assets, but solid cash growth, very solid net asset growth, low debt, low growth of retained earnings.
Japan Real Estate Inv Corp Low cash growth vs peers, higher end of debt range, and rising, better cash cover than peers.
Hysan Development Co Ltd Low end return on assets, high cash growth, low end net asset growth, very low debt, very high cash cover, strong retained earnings
One Stars
* Mitsui Fudosan No growth of cash, modest net asset growth, high debt, low cash cover.
Sumitomo Realty & Dev Corp Some cash growth, decent net asset growth, but very high debt, low cash cover.
New World Development Zero return on assets, low cash growth, high debt vs peers, cash cover good, low end of retained earnings spectrum.
City Developments Low end cash growth, moderately high debt ratios, low end asset growth, low cash cover, low end retained earnings growth.
Westfield Group No cash growth, and falling, no net asset growth, high end of debt spectrum, low cash cover, low growth of retained earnings.


Figure 26: Hongkong Land Share Price History since 1990

Sun Hung Kai Properties Limited's Share Price History since 1980

Figure 27: Sun Hung Kai Properties Share Price History since 1980

Sun Hung Kai Properties Share Price History since 1980

Agricultural Land Banks Confer Competitive Advantage in Hong Kong

A particular comment needs to be made about some peculiarities of the Hong Kong market that might not be so relevant elsewhere. Hong Kong’s land supply system tightly controls access to land for development. There are four companies that have invested huge amounts of time and no small amount of capital in acquiring tracts of agricultural land in the northern parts of Hong Kong. This land may be converted over time to development land with potentially large increases in value to the owners. These four companies are Sun Hung Kai Properties, Cheung Kong, Henderson Land and New World Development. These land holdings give these companies an important measure of competitive advantage in an environment where access to development land is very tight.

A Small Group of Companies Have What it Takes…

The analysis above breaks down our assessment of sustainable competitive advantage characteristics of our universe into three components – Income statement, Balance Sheet, and “Qualitative” factors. We have accorded a star rating to each company for each set of criteria. Our assessment here inevitably involves some qualitative factors in making judgements on sustainable competitive advantage, and inevitably also in making judgements with respect to the numerical analysis – it is not all black and white by any means.

Figure 28 shows our combined rankings for these companies, embracing the three sets of criteria.

The analysis has produced a few surprising results, with companies that we might have thought would score at the top of the heap, but did not make the grade when all factors are considered. Moreover, some of the two star ranked companies are very close to top rankings – it is a close call.

Mitsubishi Estates in Japan makes the grade, and stands out notably from its peers, in both the “hard” analysis as well as the “Soft”, more subjective factors.

We rate three Hong Kong companies as fitting the bill for three star ratings in the long term sustainable competitive advantage stakes – Cheung Kong, Sun Hung Kai Properties, and Hongkong Land. All companies rank highly in terms of low systemic risk and the latter two have elements of competitive advantage in location, brand, and quality. Both Cheung Kong and Sun Hung Kai have good rankings on the “access to land” criteria also.

Figure 28: Property Companies with Sustainable Competitive Advantage

The Winners
Japan Mitsubishi Estate Co Ltd
Hong Kong Cheung Kong Holdings Ltd
Sun Hung Kai Properties
Hongkong Land Holdings Ltd
Close Contenders
Singapore Capitaland
Japan Japan Retail Fund Inv Corp
Hong Kong Hang Lung Development
Wharf Holdings

Figure 29: Summary of ALL Competitive Advantage Factors
Competitive Advantage
Summary Ranking Income Statement Balance Sheet “Qualitative Factors”
Standout Companies
Three Stars – *** Mitsubishi Estate Co Three Stars – *** Mitsubishi Estate Co Mitsubishi Estate Co
Japan Retail Fund Inv Corp Japan Retail Fund Inv Corp Sun Hung Kai Properties
Japan Real Estate Inv Corp Sun Hung Kai Properties Hongkong Land Holdings
Cheung Kong Holdings Hongkong Land Holdings Capitaland Ltd
City Developments Ltd
Strong Contenders
Two Stars – ** Sumitomo Realty & Dev Corp Two Stars – ** Nippon Building Fund Cheung Kong Holdings
Nippon Building Fund Cheung Kong Holdings Westfield Group
Sun Hung Kai Properties Wharf Holdings
Hang Lung Properties Hang Lung Properties
Kerry Properties Henderson Land Dev Co
Hongkong Land Holdings Kerry Properties
Wharf Holdings Link Real Estate Inv Trust
Hysan Development Co Ltd Capitaland Ltd
Link Real Estate Inv Trust Keppel Land Corp
Keppel Land Corp United Industrial Corp
Westfield Group Stockland Corp
Japan Real Estate Inv Corp
Hysan Development Co Ltd
One Star – * Mitsui Fudosan One Star – * Mitsui Fudosan
Henderson Land Dev Co Sumitomo Realty & Dev Corp
New World Development New World Development
Capitaland Ltd City Developments Ltd
Stockland Corp Westfield Group
United Industrial Corp

The inclusions on the “close contenders” list are indeed close contenders for inclusion on the top table. Hang Lung and Wharf in particular have many positive attributes in their financials that stand them out. Link REIT is clearly a low risk operation, with near monopoly conditions in its business. Its main risk is not financial but political.

Capitaland has done a great job of growing the various tentacles of its business in creating and spinning off a series of REITs around the region, but its financials have probably suffered a bit from all this activity.

The two Australian companies included have too many weak spots to justify inclusion in the top rankings.

I am sure some might take some issue with some of our judgements here, but we would welcome your views, and also bear in mind that some of our calls here we admit are close calls.

Happy investing!


“Warren Buffett and the Interpretation of Financial Statements:
The Search for the Company with a Durable Competitive Advantage”, Mary Buffett, David Clark, Simon and Schuster, 2008
“Classics II: Another investor’s Anthology”, Charles D. Ellis, James R. Vertin, Business One Irwin, 1991

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