Advantech: Investing for the Long-Term
Our investment approach focuses on generating healthy long-term returns while protecting downside. We invest alongside conservative stewards of capital who have built strong franchises that produce resilient earnings growth. Merely identifying such companies is only half the task, for the other important driver of returns is valuation and the price that we pay, which should always leave significant margin of safety. The twin disciplines of never compromising on quality, and never overpaying for it, helps us achieve the type of returns we deliver.
As long-term investors, we base our return expectations on 10-year valuations, which means taking a view on sales growth and cash flow return assumptions for the next 10 to 20 years. How do we gain conviction in our long-range forecasts in a business environment which is changing so fast?
Traditional investment analysis is focused on first-order questions and assumes a relatively stable and predictable world. Most strategy books talk about building an enduring (and an implicitly static) competitive advantage by establishing a strong market position (either through scale or an attractive niche), or they champion developing a core competency in an attractive market. However, as technology and globalisation constantly shift the boundaries of industries and start-ups backed by easily available venture capital try to disrupt incumbents, the picture becomes harder to visualise. It’s difficult to know what a company’s end markets might look like or indeed who its competitors might be 10 years from now. In this context, how can we assess the strength of a franchise in 10 to 20 years’ time, and make reasonable long-range forecasts for a business? We believe the limitations of traditional tools to analyse and value businesses are painfully evident in today’s rapidly changing world.
To take a genuinely long-term view, we believe second-order thinking is required. The source of sustainable competitive advantage for a company is perhaps not just its market position, scale, or first-order capabilities in delivering a product offering, but also its ability to read market signals and constantly evolve. We believe this is only possible if a business evidences multiple elements of strong stewardship, namely: i) a strong sense of purpose, driven by a desire to solve a problem for society at large; ii) long-term oriented leadership, which stems from the presence of a principal owner; iii) a progressive organisational culture which encourages debate and diversity; iv) an organisational design and incentive structure that embraces constant change, and is aligned with the purpose and strategy; and v) a culture of awareness for the risks/opportunities associated with sustainability issues. As this second-order thinking within investment analysis is hard, we believe that the quality of stewardship is seldom priced correctly by the market. Most investment analysts are obsessed with near-term financial results and focus on traditional methods of static business analysis. They fail to see the link between good stewardship and long-term franchise strength.
To engage in such second-order thinking about the sustainability of a business requires not just a long-term mindset but also a holistic approach to analysis, which goes beyond traditional investment analysis. At Aikya, we spend considerable time studying the history of a company, which means analysing the past actions of key decision makers. We also attempt to understand the culture of a company and test whether it is aligned with the stated purpose and strategy of the business. As a result, the type of questions we ask companies in our meetings are often very different to most of our peer group.
The successful implementation of our approach also requires an understanding of the unadulterated histories of the business families or entrepreneurs that we are investing alongside. Such information is rarely accessible easily and requires in-depth on the ground investigative work to uncover. We have developed an extensive network of relationships with trusted business families, independent board members, journalists, and other free-thinking voices over a long period operating in these countries. We have also engaged with non-profit organisations, leading academics, and environmental activists to access perspectives beyond mainstream media and financial analysts.
In this letter we will use the example of Advantech to illustrate how we gain conviction in our long-term fair value assessments. Based in Taiwan, Advantech is the leading player within industrial PCs and IoT (Internet of Things) platforms. In an industry where technologies are constantly evolving and end markets shifting, founder KC Liu has steadily grown Advantech into an industry leader.
Quality of Franchise and Financials
Advantech is a high-quality business. Returns on capital have been consistently strong (20%+) for a long period of time and the company has compounded both earnings and book value at a very healthy rate. It has never incurred a loss in its 30+ years history, and has always maintained a net cash balance sheet, which demonstrates the conservatism of management.
Advantech’s high-quality financials reflect the strength of its franchise, which is exposed to a large and growing addressable market. The company is an industry leader (30%+ share) within industrial computers. This is a very broad-based franchise, both in terms of geography and end markets, built with trust earned over multiple decades.
Industrial PCs or embedded computers form the backbone of IoT networks, and there are a few ways in which these PCs are different to consumer PCs. Firstly, they are usually custom made for specific applications, and therefore produced in small batch sizes, unlike consumer PCs which are standardised large volume products. For example, a computer controlling flow of chemicals in a chemical plant is very different to a computer that controls an automotive assembly line, which in turn is very different to a computer analysing information relating to which cars have paid congestion charge on London streets. Almost 50% of Advantech’s revenue is generated from such custom projects, and the rest comes from roughly 10,000 SKUs, where each SKU has a small batch size. The second key difference is that industrial PCs typically have a longer shelf life and need to perform in much harsher environments in terms of temperature, noise, and pressure. And finally, customer loyalty and trust are higher for industrial PCs as they are deployed in mission critical situations and require aftersales service for a long period. All these factors mean that industrial PCs carry much higher gross profit margins (40 to 50%) compared to traditional consumer PCs (10%).
As many of Advantech’s products get embedded into products/systems, which then get deployed by end customers, sales are mostly indirect. The company works with three different types of customers: machine & equipment manufacturers, distributors, and system integrators. This means that developing a third-party ecosystem of channel partners and system integrators is absolutely critical to the business and provides additional entry barriers. These relationships have been built over decades of mutual trust and cannot be replicated easily.
Embedded computers or IoT networks have widespread applications, ranging from manufacturing, utilities, transportation, healthcare and government, which translates into a market expected to be worth US$ 3 to 4 trillion in 10 to 20 years’ time. As a leading industrial PC/embedded systems developer, Advantech is extremely well positioned to benefit from the growth in IoT network deployment.
But how can we so sure about the future, just based on our analysis of how the franchise looks right now?
Quality of Stewardship
In a rapidly changing industry such as computing and IoT, traditional analysis does not answer the question as to whether Advantech can remain in such a strong position over the next 10 to 20 years? Or, out of the thousands of PC component makers which started in Taiwan during 1980s, why is Advantech the only company that emerged as a successful industrial PC maker, and could scale the business to such high levels? Our starting point on assessing the quality of stewardship is to study the history of the company and the key decision makers involved. We try to understand the thought process of the key stewards of the business, the management philosophy through which they run the company, and the work culture they instil throughout the organisation. We then speak to multiple actors involved with the company, including employees, ex-employees, suppliers, partners, customers, board members, and the management team themselves, to calibrate our understanding of the decision-making process of the key stewards.
In 1983, KC Liu worked as an ordinary systems integration engineer at Hewlett-Packard (HP), Taiwan. He realised that the market for industrial computers, while niche and small vs personal computers, was very profitable. Many mainstream computer companies ignored the market for industrial computers as it was deemed too small and too specialised to be scaled up. However, KC Liu foresaw that the application of computers in industrial automation would open vast markets in the future. In May 1983, he resigned from HP and founded Advantech alongside Chaney Ho and Yuh Min Hwang, two colleagues from HP.
In his famous essay “The Hedgehog and the Fox,”1 Isaiah Berlin divided the world into hedgehogs and foxes, based upon an ancient Greek parable: “The fox knows many things, but the hedgehog knows one big thing.” A famed author on management philosophy described this concept in his book, ‘Good to Great’, to articulate that truly great companies just focus on one thing and do it extremely well. A Hedgehog Concept is not a goal to be the best, a strategy to be the best, an intention to be the best, or a plan to be the best. Rather, it is an understanding of what you can be the best at. The distinction is absolutely crucial.
From the very beginning, KC Liu was influenced by the idea of being a Hedgehog. This was also driven by the highly specialised and niche nature of industrial PCs. For example, KC Liu’s first mission for Advantech was to build IEE488 professional, a specialised interface enabling the computer to control a piece of equipment. As Liu says, ‘When we were still a start-up, no one really paid much attention to us. IEE488 was a great move. When our clients saw the product, they immediately realised that we were experts in the business and contacted us’. He added: ‘while most people had no idea of IEE488, the clients did. It also demonstrated to them that Advantech was committed only to this extremely specialised business and nothing else.’
All this is great, but once you dominate your particular niche, how would you then grow, while not losing your hedgehog type focus? This is precisely how many small/medium sized businesses reach stagnation. Even in industrial PCs, many of Advantech’s peers never really grew beyond just a few niches they served well. The second pillar of KC Liu’s management philosophy neatly solves this problem.
KC Liu strongly believes in both nurturing entrepreneurship and decentralised decision making, and he implements these management beliefs through amoeba management2. ‘It’s like the continuous reproduction of amoebas’, KC Liu says. Amoebas are single-celled organisms that are constantly dividing themselves. The same principle can be applied to a company that reproduces many divisions. By pursuing the amoeba management philosophy, Advantech has spawned 50+ divisions, each committed to becoming the best in a certain niche market (or a hedgehog in its niche) and at least one-third of these divisions are No. 1 in the world in their area. Advantech is able to continually repeat its success because of its unique organisational design; ‘While our business divisions have different product lines, they operate under the same key performance indices and management logic’, KC Liu says. Given the customised nature of industrial PCs and IoT, the continuous ability to find niches and then grow into them through decentralised decision-making is key to success.
Long-term Thinking and Constant Evolution
We like companies with strong principal owners. These are the people with ‘soul in the game’ who are emotionally invested in their companies. The health of the company not only drives their net-worth, but also their entire sense of self-worth. A permanent owner-mindset enables them to make decisions that are likely to strengthen the business in the long-run, without falling for the typical short-termism which we see in many listed companies with no major shareholder. KC Liu, who along with his family, owns 32% of Advantech, has proven himself to be a principal owner with ‘soul in the game’.
Advantech began manufacturing components for Industrial PCs, like thousands of similar companies which started during 1980s. They evolved to produce a series of data acquisition cards, in the late 1980s, before producing their first industrial PC in 1990. As the 1990s progressed, Advantech produced a suite of industrial computer products for a range of end industries, before evolving further to manufacture highly customised built-to-order products.
It was one of the first Taiwanese companies to sell industrial PCs under its own brand, having invested heavily in its global sales force at an early stage. After opening offices in every major industrial country, including the United States, Germany, Italy, and Japan, Advantech set up a branch office in China in 1992. They were one of the first industrial computer players to take China seriously and commit significant resources to the country. In 2004, Advantech decided to focus on China as a key market, which led the company to open a factory in the city of Kunshan (Jiangsu province) and establish a China sales network with hubs in Beijing, Shanghai, and Shenzhen. They also set up R&D centres in multiple Chinese cities, and as the Chinese industrial economy developed, Advantech became a dominant provider of industrial computers in the country.
Choosing What to Avoid is Equally Important
By 2009 Advantech had established itself as a leader in global industrial computers, with a dominant market position in China, the US, and Europe. KC Liu then began to think about business opportunities that could further advance the development of the company, and the IoT concept captured his attention. While trying to evolve from an industrial PC maker to a serious player in IoT, Advantech had multiple strategic options, which we can explain in more detail.
For context, there are three types of companies involved in a typical IoT project: i) Companies that manufacture hardware-based embedded systems and interfaces that process data from various sensing devices. This is Advantech’s traditional domain, where they are the dominant player; ii) Companies with software development platforms, providing infrastructure (cloud based) to develop IoT software programs; and iii) Solutions providers which integrate various software and hardware systems for a specific end application, such as a congestion charging system for a city.
Many of KC Liu’s colleagues argued that Advantech should focus on manufacturing and become a vertically integrated provider for smart factories (Industrial IoT), which basically meant doing all of the activities outlined above. However, KC Liu decided to stay true to the company’s hedgehog mantra; Advantech kept its focus on its niche of providing high quality embedded systems and interfaces to a wide range of IoT applications. KC Liu explained the decision through a metaphor, ‘Suppose we are selling a variety of dishes made of beef. We are unable to cook the dish, mapo tofu3 for you right now, but we can prepare for you the required ingredients’.
Co-Creation Model: Developing Eco-Systems
An obvious risk in being a few steps removed from actually preparing dishes is that you could potentially lose touch with customers’ needs or be locked out of certain technology stacks/standards. Just because Advantech does not cook beef dishes does not mean that Advantech cannot partner with high-quality makers of various beef dishes. Following this logic, KC Liu wanted to extend the principle of decentralisation (amoeba management) beyond Advantech’s organisation through a ‘co-creation’ model.
Co-creation means that Advantech would seek partners for various IoT scenarios, launch co-creation projects to solve specific problems, and build teams to jointly incubate new ‘co-creation’ entities. While the partners bring their deep domain knowledge, local relationships and experience to the entity, Advantech is able to leverage their considerable technological expertise. Crucially, Advantech is willing to hold minority stakes in these co-creation entities, and over time create a strong ecosystem which is underpinned by its technology.
Even the highest quality stewards must eventually pass on the running of a business to the next generation. In this context, how can we assess what happens to Advantech after KC Liu? There are two key questions we ask when assessing inter-generational continuity: i) Is there both a strong culture and management team that can ensure the business is still properly managed once the founder retires? and ii) Are there still principal owners of the business, either in the founder’s family or elsewhere in the company, who are able to act as a long-term steward? If so, it means there is a presence on the board guiding the company in strategic and capital allocation matters.
In the case of Advantech, the answers to both these questions are positive. KC Liu’s management philosophy is followed across the organisation, and there is a very strong culture of entrepreneurism and client centricity throughout the organisation. The second and third line of leadership at Advantech have spent at least 10+ years and trained under KC Liu and the other founders. And lastly, there are strong indications that at least one of KC Liu’s sons will join the board and provide long-term stewardship as a principal shareholder. In any case, KC Liu is in his early 70s, very active, and, going by the precedent of other Taiwanese business leaders of his generation, he should remain healthy and involved for at least the next decade.
Growth and Valuation
Advantech is a high-quality company in our view. Its franchise is strong, well-diversified and has produced consistently high returns with good growth over the last 10, 15, and 20 years. There is a strong steward behind the business, who has continuously evolved the business to ensure it stays relevant in a fast-changing industry; he has put in place an excellent organisation structure and culture that adapts to changing market conditions in a highly responsive way. Such strong stewardship ensures Advantech’s business is getting better over time. And the company is one of the leaders in embedded computers and IoT, which is likely to remain a large market with high growth well into the future.
The next step for us is to assess what should be a fair valuation for Advantech in 10 years’ time. In this context, we apply the twin disciplines of never compromising on quality, and never overpaying. These factors are closely linked, as our conviction on quality often guides our view on valuation. We approach valuation from the perspective of absolute returns and try where possible to make ten-year assumptions in order to keep perspective of the long-term drivers for a business. In the case of Advantech, this means taking a view on the long-term demand for embedded computing, IOT, and assessing Advantech’s competitive positioning within the industry. With very reasonable assumptions, we envisage Advantech growing revenues slightly ahead of the industry, which translates to double digit growth in USD. At the same time their continued evolution can support margin improvement that means healthy double-digit earnings growth over the next decade. For all the reasons discussed, we remain convinced it can be a much bigger business in ten years’ time and that patient shareholders will be rewarded with handsome returns.
3 Mapo tofu is a popular Chinese dish from Sichuan province