#2 Investing Ideas – Elsoft Research Berhad (KLSE:ELSOFT)

Welcome to our Weekly Podcast Program, Investing Ideas

Audio Podcast

We chat with Gan MJ, an analyst at EquitiesTracker Holdings Bhd based out of Malaysia. MJ talked about one of his favourite investment ideas at the moment: Elsoft Research Berhad (KLSE:ELSOFT).

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You can download his presentation slide here:

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STANLEY: Hi, Stanley from Value Invest Asia.
This week we have a very special guest, his name is MJ. He is a research
analyst for EquitiesTracker Holding Berhad, which is a listed company on Bursa

EquitiesTracker Holdings they are mainly in
the investment education business and MJ has been researching for them for
quite a while, mainly focusing on stocks on the Bursa Malaysia market. I have
known MJ for quite a while and MJ has always talked about very interesting
companies and ideas within the Malaysian market. And this time around I am very
privileged to chat with him where he introduced one of a very unique company called
Elsoft Research Berhad which happens to manufacture machines to do testing for
LED lighting. So I have a great chat with him and I think that you’ll find his
idea and his thoughts on investing very unique and interesting as well. So here
we go

Hello MJ how are you?

MJ: Hi Stanley absolute pleasure to be on
the podcast.

STANLEY: Hey very good, thank you very much
for accepting our invitation. So maybe before we even begin, why don’t you share
a little bit about yourself? How long have you actually been with
EquitiesTracker and how long have you been investing?

MJ: Yeah, so I’ve been investing for about
four years now and I am currently a research analyst for EquitiesTracker for
almost two and a half years as of today and what does EquitiesTracker actually
do? So in a nutshell basically we help people invest better, and we help them
invest better in two ways. Early on, Stanley you mentioned that we are in
investor education. So education is one way and the other way we do it is
through technology. So we try to merge the two and basically make life easy when
it comes to investing in stocks.

STANLEY: Ok and about yourself, how would
you describe yourself as an investor, what was your investment style?

MJ: So if I can be totally honest, even
though I’ve been investing for four years, I think you know we always learned
that in investing we need to invest for a long long time right? 40, 50 even 60
years depending on how how all of you live on. So you look at it from that
perspective, four years really is very very small and because of that you know,
I can say that I do not really develop a very strong philosophy. I’m still in a
way open to a lot of different kind of strategies but only in relation to value
investing. I’ll just like to add that because most of my personal investments and
I manage funds for my family as well. I am mainly situated in Malaysia. And one
of the good or bad thing, depending how you look at it, is that because we only
have about 900 companies on Bursa Malaysia. So the opportunity set is a bit
small but then small can mean niche right? So why am I telling you this? The
reason it’s quite clear is that you cannot have a very specific strategy and
say I want to invest, you cannot say I only want to invest in two sectors or I only
want to do deep value investing or I only wanted to growth investing and so the
bad part is that there’s this limitation. But the good part is that you are
forced to actually entertain all different kind of investment strategy. So the
way I would say it is you know more opportunistic.  Because you know growth stocks, for example,
growth investing is definitely good but we have a few of that. But we cannot be
totally growth focused because you know valuations might get too high for it.
This isn’t to say that all good stocks have high valuations. It just means that
if you only do high growth stocks investing then you’re limiting yourself to a
tiny opportunity set. So then the same time you cannot do the old school sort
of statistical Graham-style investing because quite frankly there are not alot
of companies trading and the you know 2/3 of working capital right now. Anyway
even you find them you know you might wonder whether or not they’re actually
good companies and then you try and sift through everything. We are left with
one or two. I mean I can go on but I think the key things is that we are
opportunistic. If it’s time to invest in the boring type investment, we will do
that, if it’s time to go growth and if it’s deep value that’s the way I’ll do
that. Or just a mixture of all three.

STANLEY: OK, sounds reasonable but I think
you’re a bit too humble because every time you share your ideas with me I find
them very fascinating and certainly think that your investment at least your
strategy is doing very well for you.

MJ: Well, that’s only because I watch your

STANLEY: Thank you, I think the main gist of
our podcast of course “Investing Ideas:, is to look into some of the ideas
that you are currently looking at and you basically is pitching to me one very
interesting company which I do not know a lot about. Why don’t you introduce
that to our audience and why do you like it?

MJ: Alright, before I go on introducing I
just want to make it very clear to listeners that what I’m about to share represents
my personal view, not my company and just for the record I just wanna be clear.
 So the company that I’d like to introduce
to you is actually Elsoft Research Berhad, listed on Bursa Malaysia. Some basic
stats, you know as of the 13th of September (it has) RM610.7 million market
cap. It is a company that’s been growing in term of revenue, profit and even
the cash flows with operating or free. But what really is fascinating about
Elsoft to me is that they’ve grown a lot of this with close to no liabilities.
I mean there are no short term debt at all to speak of and the only some
long-term liabilities. And fun fact for your listeners, it is actually the
highest margin stock on Bursa Malaysia. I mean what it’s that the profit
margins are the highest in the whole of Bursa.

STANLEY: Really? You found the most
profitable business on Bursa Malaysia.

MJ: Yes, I like to clarify that this is data
based on financial year 2018. Now, because of the trade war and things like
that. It might look slightly different this year, but nevertheless you know
I’ll show you later what a bad year looks like.

STANLEY: But what do they do actually, for
this company?

MJ: Okay, so the technical answer to this
question is that they build what we call automated test equipment, automated
test equipment, auto test solutions, tester plus automation. That’s the boring
version, but you know to really simplify it, basically they develop tools or
machines or testers mostly to test LED products for their defects and functionality.
And to be more specific, the functionality means the voltage and the temperature.
so like LEDs lamps, like lightbulb? Yeah that’s that’s one part of it. Essentially
they have roughly four end product. Three then plus one.  So the first one would be your smart devices.
For example the iPhone, I’m not saying that they supply to iPhones, I’m just
saying that for example. Those flash, those LEDs, on your phone, that’s what
they test so again you can imagine that they in order for the flash to function
on the iPhone then it needs to go through a series of testing and so they build
the machine they use their intellectual property to manufacturing and then sell
it to whoever wants to test the equipment so that’s the first segment and it is
the largest segment at about 59% of revenue. Now next is smart devices followed
by automotive. So you know things like your day running lights, your front tail
lamps they also test those equipments. So roughly that’s about 49% in 2016, 41%
in 2017, 2018 drop to 27%. So that’s the second largest segment and followed by
what we call general LED lighting so that your lamp.

STANLEY: Does that include LED screens?

MJ: I’m not too sure but from my
understanding is that there is a possibility of this that’s what they do.
Because in fact it’s probably correct because they test LED lights in general. Last
but not least, they are embarking on a new sort of a new product, what they
called embedded controls which we will get into a little bit more later on.

STANLEY: You talk about their business
right, but what makes you interested in this company?

MJ: Ok so let’s say you are new to investing
and you really wanted to find out whether or not you know a quick-fire way to
figure out whether the company has some moats, rights? Stanley you talk alot
about moats in your videos, you know and the importance of moats. Now the truth
is to understand the moat requires quite a bit of homework but there’s a shortcut
way to find out whether or not, there’s a good chance to figure out and that is
actually figure out what their margins are. Margin’s basically what’s left over
after all the expenses have been paid off. Very simple. Now, just to use just
to compare Elsoft and the other competitors; MMSV, Teradyne & Chroma ATE. Their
pre-tax margins which is basically what is left over before they pay taxes, is
about Elsoft is (2014) 46%, (2015) 53%, (2016) 49%, (2017) 45%, and (2018) 52%.
So just to explain very simply right, every dollar of revenue they keep nearly
well on average 50%. Why I believe that they have a moat, even let’s say I
totally knew nothing about things like switching costs and no regulations and all
that stuff.

Their next closest competitor is MMSV, so from
2014 to 2018 is 26%, 26%, 28% and then down to about 21%. So the our closest
competitors have half the margin. Then you look at international companies like
Chroma from Taiwan 15%, 15%, 28%, 21%. Teradyne, based in the US, 6%, 15%, -3%
and then I think it’s 25% to 22%. So they are quite frankly head and shoulders
above the others. Why do you think that’s the case? So the truth is there’s
actually many reasons but the largest reason is actually simply intellectual

In fact, we spoke to the management of
Elsoft. Other members in my research team did, and obviously I wouldn’t share all
the technicalities but basically they are able to do lot faster and a lot more
proactive when it comes to the designs of their machines and the efficiency so
that gives them an edge because what you’re doing is you’re actually doing a cost
saving for your client. When you do things faster and only that you can do things
faster but your competitors cannot copy you, either they don’t know or you’re
protected by IP.

So that’s that’s the intellectual property
and I’m not an engineer so I’m definitely not qualified to explain exactly
what’s the intellectual property is but trust me. In fact we do study other
companies with single levels or margin. What’s pops up very clearly you know in
all findings is that intellectual property is by far the number one factor in
determining the margins of a company.

STANLEY: Right okay, and how are they actually
growing nowadays?

MJ: So as I mentioned early on, they are
actually in LED. It’s the fact is that well LEDs are simply

the most energy cost-saving things out
there. When you compare it to things like fluorescent lamps and all that, they
can actually reduce energy usage by 75% when it comes to lights. So it’s like
there’s virtually no comparison. Now, a little bit of history, basically in that
they started adoption from for all products was 0.3 percent. All the lights
that you see whether it’s automotive, general or smartphones used to be
non-LED. By 2020 next year, it will be 61%. So there’s more and more adaptation
into LEDs for future devices right? Yes absolutely and most interesting is that
this new technology, alright the person who discovered white LEDs actually won
a Nobel Prize way in 2014, it just cool facts right, Mr. Shuji Nakamura and
what happened was that or rather was startling to me is not so much the growth
but how fast it is for a new technology. Usually like the Internet or the car or
airplane usually takes a while, like a decade or two before it starts to gain
traction right? We see it now with blockchain especially. But this LED really
took up really really fast and and you know that’s where the growth is coming
from. So just some stats, so that’s the past right, so what can you look for in
future in terms of the entire market based on our research, it will be expected
to grow at about 14% over the next five years, four years until 2023. And the
entire addressable market we should say,  how big the market can be is roughly about USD105
billion dollars. So that’s how big you’re looking at.

STANLEY: Ok yeah, but having said that,
that’s the LED market and not the LED testing market right?

MJ: Yes correct. Well okay I get your point,
but of course you see if there are more LEDs then there’ll be demand for more testers
and internal capacity will have to increase.

STANLEY: Yeah fair enough okay.

MJ: So there is wear and tear and capacity
issues, these kind of things.

STANLEY: For this company, they do a few
sectors, which one are you actually more optimistic about?

MJ: Okay so I would say it would be the
automotive. Now why?  It’s because in
2012 the EU actually mandated that every single car in Europe will have to have
what we called a front running lights in terms of your front lights. Now long
story short, it just means that if you’re not using an LED, if your car does
not have LED lights for your front lights, it’s illegal. Oh okay. Yeah this is
actually illegal. And the reasons because Europe is in terms of global warming
the most the fastest right, they’re the most concerned about global warming. So
you know because LED reduces energy usage and therefore carbon emissions by 75%
so that’s why they are (supportive). And in the US as well the trucks are
already mandated to have day running lights so you know what happens there
eventually will also happen in Asia. That’s why I would think that is the
fastest growing of all.

STANLEY: Interesting interesting and if
they’re the case for you know a company that has so much potential, do you have
a stats like how much market share they really have because with a market cap
of only RM600 Million, it’s actually quite a small company.

MJ: I don’t have the stats for that because
it’s actually quite difficult as you can imagine for companies with alot of IP,
being private & confidential is very important. So we can reverse engineer
the numbers but really we can only guess like big is the market. But I don’t
think they’re that big. The second thing I will point out is that it’s not so
much about market share. To me is not the most important, the most important thing
is that is margins.

STANLEY: Okay okay and talking about
margins, you’re right, they could have something spectacular in terms of IP
that is giving them such a high margin but in terms of the risk side, what kind
of possible risk are you thinking about? Because from just looking at it right,
to me it could mean yes they’re very good company or maybe it could be a
fraudulent company. Do you see that as a risk?

MJ: I don’t think so, I think that because  they don’t play around with their accounting so
much based on their past ten years. So I wouldn’t say they’re fraudulent. Look,
at the end of the day we can never know but to me it’s more important that the
investors understand the business model because why would someone or a business
owner commit fraud? The reason he would commit fraud is because he believes he
can make more money being a fraud rather than actually running the business. This
gentleman has been around for a long time and you know, revenues actually fell
very very sharply during from nothing change and he was there through the hard
times and now he’s doing pretty well in the good times. Back to your original question
which is risk, it’s definitely true that there is risk. The first one is
actually LED saturation. Just to repeat right, so next year it will be 60%
saturation. So in 10 years, it went from zero to 60% Because it’s compounding,
so from 62% to 100%, Let’s say 99% 98%, it’s going to be a shorter time. So as
a result, the company is really relying on something that has a product life
cycle between three to five years. So that is definitely one reason of concern.
In the

IP risk, the knockoffs from our big
neighbors in Asia, that’s definitely a possibility. Because in certain
countries, intellectual properties don’t really matter, so for sure that is
really a risk. Now, I just want to say that let’s say even if adaptation does happened,
adaptation to 100%, it’s not possible but let’s say it’s 100% what happens
after that is the growth will not be there anymore. Or rather the growth will
not be as fast anymore. Because those existing LED products will need to be
replaced correct? So when they are replaced by newer more high-tech products
maybe, recently the iPhone has now three cameras, so as you can imagine the
camera lens makers would have to make more, to produce more. So it’s a boom for
them.  It is no different as LEDs get
into cars, get into houses, to keep replacing them it means that there’ll
always be a demand for testing for LEDs and therefore the demand for LED
testing. The key thing to understand is that it’s not going to  be as smooth. That’s one of the way to look at

STANLEY: You mentioned about the trade war
or the tariffs between US and Chinese have an impact on this company, why would
that be the case?

MJ: So the truth is that the trade war is
quite a complex thing right? Because it’s complex, because political leaders especially
across the Pacific from here can be quite erratic, So that is one element of
complexity but complexities actually in its supply chains. Now it’s very hard
to discern as to why the trade war is causing a bit of, you know like a confidence
crisis. Is it because it’s a truly economic reasons or is it because it’s a
confidence or psychological issue? Of course, once volatility returns back to normal
and clues become more stable. So I don’t know is it psychological or economical
I am not too sure. Okay so so in terms of maybe some of the customers are
holding on to all this and not ordering so much that could potentially impact
their business. Because they still need their customers to make LEDs in order for
them to have more successful for the Testing machine right?

STANLEY: Okay that’s interesting and I’ve
been just looking at the stock chart it has been quite hammered due to this.
Let’s start on valuation, do you find this attractive right now and you know
how do you look at the valuation?

MJ: Yes so you know one thing that I
actually learned from you is that  valuation
is like this very arcane, it’s like something out of a Harry Potter book but
really I think what you have told me also is that you’ve managed to really
simplify it into three boxes. The first one will be  basically a multiple base or P/E or price to
cash flow or price to book or multiple. Then there’s a second valuation where
you look at the balance sheet and the cash and the third cetera and then also
next would be the net present value or the discounted cash flow model. But what
I realized also is that you can actually co-mingle more than one of the
valuation techniques. Meaning you can use multiple and in this case you can
combine a multiple based and asset valuation base. So when you do that
basically, when you buy a company you’re also buying the cash and the debt of
the company,  you’re buying the property,
plant, equipment and all that. At least that should be the mentality going into
the stock market. It’s like buying the whole business, you are buying the
assets of the company, you’re also buying the cash flow of the company. So when
you combine that and you add the fact that it has a relatively high dividend
payout. And so the payout, just for your information, is roughly between 80%. Can
you imagine it has such high margin already and then they pay out so much
dividends right? That’s why it’s no surprise that the dividend is about 4.7% last
year. So when you take that into account, you’re looking at buying something at
eleven times earnings. Which give you roughly forward. So when you buying this
stock, you are expecting a 9.1% return. Now that might not be interesting to
your viewers.

STANLEY: Now, let’s run through that, how do
you come up with that expectation, that you can expect a this stock? What’s
your thinking behind?

MJ: Ok, so I’ve always follow the principle
that fundamentals will determine future stock prices. If  fundamentals don’t determine future stock
price, then value investing is dead. So the fundamentals in this case would be
the the operating cash flow that the company is generating. And in this case,
you’re looking at a multiple. And if you invert that, you will get a 9.1%. Because
it’s the yield you are getting. Ok, it’s not exactly the cash flow yield, it’s
the cash flow yield plus the asset valuation. So basically I take the market
cap and then I net off whatever cash and debt it has. I use that as the new market
cap and then I plug in the operating cash flow inside. It’s about 9.1%. The fancy
Wall Street term is cash adjusted price. It’s very similar to enterprise value
technically. Now, so 9.1% might satisfy some people because the Bursa Malaysia
price to earnings ratio right now is roughly 16-18 times, so you’re looking at
6% maybe 7% return going forward. So a nine percent will represent beating the
market so but that might excite some people, that might not excite some people.
Now if you looking for double-digit returns and you go and if you want but if
you want to get up double digit return on this, you have to take advantage of
the high dividend payout and dividend yield. When you receive those dividends,
if you reinvest those dividends into the same stock then you can actually boost
your returns from 9% to between 10-13% by my own calculation.

STANLEY: Okay if you reinvest it and
assuming that they continue to grow and produce that kind of return.

MJ: If you don’t use the dividends to buy iPhones,
yes then you can, there’s a good chance you can do that. Now this is more like
an absolute kind of valuation but when I compare it to peers and those four
same peers right so Elsoft is about about 14 times, Teradyne 15x and Chroma is
at good chance that you can beat the market with the stock but on a relative
basis, compared to its peers, it is quite attractive. Of course that’s all assumes
that the management, the same thing that they’ve always been doing. I have very
high respect for management but they might do the wrong thing or they might
have succession problems or whatever. So  that’s a risk.

STANLEY: That’s very fascinating looking at
its margin and the things that they do really reminds me of this company,

MJ: Well actually if you understand Vitrox you
understand how similar they are.

STANLEY: Thank you so much MJ for this
wonderful explanation on Elsoft Research Berhad. If you guys want to check out
more about MJ or Equitiestracker you can find them on Facebook and just search  Equitiestracker you should be able to follow
some of their own research and also what they have been up to. It has been a
pleasure talking to you MJ, thank you so much!

MJ: It’s my pleasure as well Stanley, see

****Disclaimer: The show is for entertainment purposes only, and should not be taken as investment advice. Please seek professional advice or do your own research when making any investment decision. 
Disclosure: Stanley owns Vitrox Corp, MJ owns Vitrox Corp and Elsoft Research at the point of recording.

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