Investing Lessons to be gleamed from Eratat -- Avoiding a potential value trap

*This is a blog post written with hindsight, but I'm pretty sure it would have been dissed off and thrown aside had it been written earlier.*

Recently, just before Chinese New Year holidays, Eratat requested for a trading halt and subsequently suspension. It was a company I have been suspicious about since March 2011. Much of my analysis (with some calculations probably off) can be found here.
China Eratat

Note that this isn't an exercise or pure blog post done specially to ride on a S-chip suspension bandwagon, but to consolidate the lessons and what has been posted before since 2011.

The question is, is it possible to detect such fraud before it happens? Apparently, there were lots of clues to this, and this was posted in a few forums. Apart from that, from my recent read ups of marketing materials, I realise there are more things to investing in a business from a fundamental analysis viewpoint that is not often discussed about.

I might well be wrong, and everything turns out fine eventually. But I highly doubt so.

Let us first recap the pretty obvious red flags that were brought up over the course of time in different forums.

1) High percentage of receivables as part of assets.
2) The receivables would have been even higher had some of it not be written off as sales incentive and renovation subsidies.
3) Despite high cash levels, Eratat had "no choice" but to borrow at an effective interest rate of 32%.
4) As Greenrookie has pointed out in NextInsight forum, Eratat's subsidiary did not appear in the tax reports of top 100 corporate tax payers, which means it paid less than 3 mil RMB in taxes. The maths does not work out.
5) The director sold all his shares at a "deep discount" in Aug 2013 due to personal reasons that were never revealed. Now we know his "personal reasons".

I have also pointed out earlier that the NAV after netting off receivables looks constant after 2 years of being listed.


The suspension now points Eratat to being a value trap. The numbers does look well on the surface, but seriously, any of the above red flags should have sent investors fleeing it.

Is it possible to avoid the value trap? Probably so.

It is said by fundamental analysis proponents that investing in a stock is akin to investing in a business. I concur with that. The problem with some investors is, they are buying the feeling of being an investor, and not buying as an investor.

Seriously... Does buying a counter, looking at some ratios and numbers, and attending the AGMs, asking some "smart" questions, really mean that it is investing?

I say no.

If fundamental analysis was purely due to just numbers, then all accountants should have cracked the investing game and match the world's greatest investors!

I don't claim to be good, but my recent realisation is that fundamental analysis is much deeper than merely looking at numbers, at ratios, and attending AGMs.

Fundamental analysis includes looking at the business and marketing strategies of the business. In the business world, this includes looking at competition as well the branding and marketing efforts by the company.

A book I will recommend as a reading material is The 22 Immutable Laws of Marketing by Al Ries and Jack Trout.

With reference to the content in the book, Eratat would have committed "crimes" of marketing that would have doomed a small company like them to failure. While I am not an expert in marketing, the following are my observations:

1) Moving from shoes to clothes using the same brand. In marketing, this is called line extension. People probably known them as manufacturers of shoes, and extending the product lines when the company is still too small is an event that typically kills small companies. Reebok, Nike and Adidas were very famous in shoes before they extended their product lines further. The same went for other industries like GE.

Aztech was one company I invested in. Originally I thought extending their brands to other products was good, and I invested in it. On hindsight, it wasn't. Aztech extended their brand into LED lighting, related to electronics. This was ok. But they extended their brand further into Shipping, Materials and even Food. That pretty much killed most of their profits and the share price tanked.

In similar style, Breadtalk extended their product offerings via different brands, i.e. Food Republic, Ding Tai Fung, Toast Box. Imagine if they called it Breadtalk Food Court, Breadtalk Restaurant, Breadtalk Coffee House. Yucks.


2) Repositioning from casual wear to upmarket wear. Seriously... After a positioning attempt from shoes to casual wear, they tried to reposition into upmarket apparel. The repositioning efforts of Mountain Dew took 7 years (described in the recommended book). Many more examples in the books would have gone to show that Eratat's marketing efforts are probably in the wrong direction.

Eratat would probably have done better if they used a different brand for casual wear and another brand for upmarket wear. Not brand everything under Eratat.

I mean, imagine a cai png store telling you it is upmarket and selling you at $15 for a plate instead of $4 at a normal cai png food court store. Compare this to being served food in a 5 star hotel.


3) Customers Perception. Eratat is made in China, comes from China, but registered as a brand in UK. If anything, the recommended book mentioned that it is impossible to change human mind perceptions once it is there. Eratat Lifestyle was once known as China Eratat. The "China" tag is always on them. Who would know best? Of course their customers in China; they don't sell outside of China.

Do you think it will work if Ya Kun tries to reposition itself as European or American upmarket coffee? That perception holds for Starbucks or Coffee Bean, but trying to reposition Ya Kun into the same area is an almost impossible event once human perception is formed.

And Eratat claims it is positioning itself as upmarket apparel with Italian design (from previously a China Eratat).


Moral of the story: Fundamental analysis should never be just numbers or ratio. The market demand, the competitors, the business and marketing strategies, should all be taken into consideration as well. Which means for new investors, it would do well to study business and marketing books too! After all, the world's greatest investor is a businessman.