Pembridgecap

A Wealth Creation Journal

Author: XC (page 2 of 3)

Baoye Group – a mistake & a lesson

I recently sold my ownership in Baoye and ended the 4-year partnership with the business. I registered a 5% loss, but the real economic loss is much higher after accounting for the opportunity cost of having the capital tied up in an unproductive venue.

This experience changed my view on what constitutes a truly conservative investment. I used to consider securities, such as Baoye, trading below its net asset value as a conservative investment. However, for such an investment to be profitable, the discount to intrinsic value needs to narrow over a reasonable time period. Unless there are clear paths such as activist involvement to value realisation, time may not be your friend in these situations. On the other hand, time is the friend of a great business that can grow its intrinsic value. Mr Market may at any point misprice a great business, but the market value will generally grow alongside intrinsic value. Hence a truly conservative investment is a great business selling at cheap to fair valuation. The lesson is not about avoiding average businesses with dirt-cheap valuations; instead, it is about a better calibration of the relative attractiveness of investment opportunities.

Phil Fisher believed that there are only three reasons to sell the ownership of businesses: 1) “a mistake has been made with the original purchase”, 2) the company’s business quality starts to deteriorate with the passage of time, and 3) a more attractive investment opportunity that is more deserving of the capital. In this case, Baoye was sold because of the first reason as I committed a mistake in my original investment analysis. The most unfortunate part is that it took me four years to recognise and correct this mistake. I promise to learn faster next time!

As a reminder, Baoye Group is a Chinese company that is vertically integrated with construction, residential real estate development and building materials. We became a partner in the business because Baoye offered 1) very attractive valuation, 2) good and well-aligned management team, and 3) potential growth prospect from prefabricated buildings. My biggest analytical mistake was with Baoye‘s growth prospects. I believed that prefabricated buildings would drive growth at Baoye’s building material business. While Baoye did build numerous prefabrication factories, they only contributed 2% to operating profit. Most of the business’s profit is still in residential development.

This is evidenced in the capital allocation decision as well. Over the last four years, management allocated capital in the following manner:

  1. ~RMB 5.7bn in land purchases for residential property development
  2. ~RMB 1bn in capex (mostly for building housing industrialisation related factories)
  3. ~RMB 0.2bn in share buybacks

The vast majority of capital was recycled in residential development. On its balance sheet, Baoye has a book value of RMB 8.7bn as of June 2019. It carries a cost value of ~RMB 9bn land and properties for residential development. While the founder of Baoye, Mr Peng, has been talking about the revolution in construction through prefabrication for many years now, he has not allocated capital according to his vision. Without growth from the prefabricated construction business, Baoye is just a regional residential property developer in China with undifferentiated product offering in an increasingly consolidated sector. I do believe that housing industrialisation will one day revolutionise the construction sector, but I am not sure Baoye will be the main beneficiary of it.

I have misjudged the management team’s desire to profit from the cheap market valuation as it is trading at 0.3x P/B with 50% of its market capitalisation in net cash. Given Hong Kong Stock Exchange’s listing rules, the company is only allowed to buy back 1-2% of total share base each year. So, sizable share buyback is impossible. There is a lot of social status attached with owning a listed company in China that I suspect Baoye management enjoys. I believe they are fully capable of taking advantage of the cheap valuation. But they chose not to because they have other capital allocation priorities.

TC comments

I haven’t sold and have learned at least a few things.

As your partner blogger, I reject the “great biz at fair” vs “fair biz at cheap” argument. This seems only correct in hindsight. As you say, the lesson is not to never do fair biz at cheap, it’s the calibration of correctly trading off these two that needs to be good.

I still believe this is a very “fair” (neither great nor bad, but high conviction of being “average”) business at a *very*  cheap valuation (high conviction of cheapness). So in terms of this calibration it seems fine to me. Rather, if this was a stock listed on US (it isn’t & not saying this is somehow “unfair”), this might have worked in the same ’16-’19 time-frame.

Maybe the already large management ownership together with the steady share buyback is working against minority shareholders, as the stock becomes more illiquid and the market starts discounting a future where a squeeze-out becomes a possibility. A calibration takeaway here might be to prefer management owning 20-40% versus more than 50% from the thesis outset.

Another calibration for me is to lighten up on a similar company when management *that already has high ownership percentage* stops the dividend. If I recall correctly, we could have trimmed our positions at roughly the same price when this happened years ago. In hindsight, the reasoning management gave “housing industrialisation capex” was only a half-truth, as the company still has plenty of cash. The company has only done buybacks since.

Another interesting thing is that we learned (or indeed both have the illusion of having learned) different things.

Maybe it is not as important to the thesis, but the following is an insight for which I have the highest conviction that it is actually a correct insight from this situation:

A few years ago, I became a dogmatic believer in tax-efficient buybacks, always preferring buybacks to dividends because of taxes. Indeed, from a theoretical point of view, when keeping future stock “% discount to NAV” valuations *constant* to the current % NAV discount, buybacks are exactly as accretive as dividends (only difference is taxes).

However, as I outlined above, in situations were minorities might get nervous because liquidity decreases disproportionally (buying 1% of outstanding if float is 30% outstanding is 3% of float, vs buying 1% of 99% of outstanding only 1%) and a squeeze out is getting discounted, this is where practice starts disagreeing with my theory. In other words, % discount to NAV does not remain constant (i.e. “value + return of capital in bb/divi is its own catalyst” argument) but widens. I believe the devil’s advocate argument here is to say that 1 pp buybacks of a very small float should also have a very big boosting effect to the share price when they are carried out.

That is a long-winded way of the hindsight gut feeling “bird in the hand is worth two in the bush” that really teached me the virtue of a dividend. Tax efficiency is NOT the only difference with buybacks in practice.

My last take-away is that I am reinforcing my belief that countries with stock markets that are going sideways or down do *not* tend to become more efficient in the cross-section. In other words, in a rising Chinese stock market, this stock might have gotten discovered by more sophisticated international stock pickers. Instead we got increasing international scepticism vs China / HK, even from the “low base” when we invested in 2016.

A thought I wrestle with: is this truly a safe stock because of its large cash position? Or does it tank when the global economy sinks, as geopolitics typically becomes more muddy (or at least the perception) and international investors lose faith in (1) enforcing property rights in the future (2) values denominated in a currency that has capital controls etc. This is what I will call “cyclicality thru geopolitics”. Is Baoye similar to owning a cash-rich “safe” net net in Georgia or Taiwan (with invasion of neighboring country becoming more probable to please populace when the economy sinks)? That would make its fundamental *conditional* beta higher in black swan situations higher than we might think (i.e. low beta until things really go awry). But yes, I am probably overthinking this, and maybe this is already under-owned by the international investor community.

Dart Group Memo – Dec 2019

One of my major contributor my profit this year is Dart Group. Since my initial purchase of Dart Group’s business ownership in Oct 2016, it has both doubled its revenue and net profit while the share price has increased by 4.3x from GBP 3.7 per share to GBP 17 per share due to the most wonderful combination of earnings growth and multiple rerating. I am proud to report that with more than 14m of annual passenger traffic, Dart has overtaken Tui to become the largest package holiday operator in the UK. Better yet, it is also more profitable than its main competitors. Dart enjoys 10-11% operating profit margin while Tui’s margins are half of that.

The initial investment thesis in Dart Group was anchored on 1) demand for package holiday will remain resilient after Brexit, and 2) Dart Group is a good quality business that is misunderstood. I underestimated both factors. UK’s demand for package holiday was more than resilient; it grew at an annualised rate of 5% for the last three years. Dart’s management team did a first-rate job successfully launching a new base in London Stansted, launching new products and constantly improving customer value propositions. I did not foresee the exit of two large competitors in a relatively short period of time. Hence, the timing of purchasing more Dart shares in the first half of 2019 was incredibly lucky. The third-largest package holiday operator, Thomas Cook, declared bankruptcy in September 2019 and since then Dart Group share price soared more than 100%. Thomas Cook roughly represented 20% of total market volume and have ~30% volume overlap with Dart Group. I fully expect Dart Group to capture 20-25% of Thomas Cook’s customer base and enjoy some temporary price increase. Net profit margin in FY2020 could rise above the usual 4-5% range and reach 6-7%. However, the profit boost will be short term in nature. Just like the bankruptcy of Monarch in 2017, the market will respond to supply shortage swiftly which will lead to normalisation of prices and compressing Dart’s profit margin.

In Nov 2017 (link to the 2017 memo), I wrote that “Jet2 will run at around 11-12m pax capacity with 91% load factor” and have “GBP 2.4bn revenue in 2019”. Oh, boy, was I wrong! In 2019, Jet2 actually have 14m passengers and a GBP 3.5bn revenue. Again I credit this excellent growth to Jet2 management team and more specifically Steve Heapy.

Dart Group grew its package holiday business at an annualised rate of 22.8% for the last 11 years. Dart is now ~20% of the total European holiday market in the UK in terms of holiday visits. Narrowing down to the European package holiday segment, Dart’s market share is even higher at 30%. The European holiday market is growing at 5% and the European package holiday market is growing at 8%. I believe Dart can continue to gain market share but at a much slower pace. Or said in another way, there are no more new airports in the UK that Dart could enter to change its growth trajectory materially. For the next 10 years, Dart is extremely likely to grow at a much slower pace versus the previous 10 years. My best guess is that 10% would be very respectable. Again I could be wrong here again….

On the profit margin side, I expect the profit margin to slowly deteriorate due to general cost inflation and limited pricing power. Dart’s value proposition is to provide good value for money holidays to its customers. There is also limited operating leverage in the business without pricing power. One potential source of operating leverage comes from higher Winter revenue. Typically, Dart makes all its money in Summer and must endure losses in the Winter because the Winter volume is not high enough to cover the fixed cost. If Dart could grow its Winter business materially, then there could be some operating leverage. However, the overall UK winter holiday is roughly 2-2.5m visits per year. This pales when compared to the Summer market of 20-30m. The size of Dart’s fixed cost is determined by the peak capacity of 2m passenger per month during the Summer months. Considering the overall Winter holiday market size, it is very unlikely for Dart’s Winter revenue to ever become large enough relative to the fixed cost base that is determined is peak volume during Summer months.

Another possibility for the profit margin to expand is to increase penetration of package holiday relative to the flight-only seats. The cost to serve a flight-only customer and a package holiday customer is roughly the same. Hence if Dart can convert more flight-only customer into a package holiday customer, its profit margin should improve. Currently, 52.8% of total customer choose the package holiday product. I believe that for mature airports such as Leeds, it is not possible to increase the package holiday penetration materially in the future. For newer airports such as Stansted and Birmingham, the package holiday penetration is still quite low. Over the next 5 years, one could see package holiday penetration increasing further to 55% at best.

Combining the slowing revenue growth outlook and compressing profit margin together, earnings likely to grow at less than 10% over the next 5 years. For a company with no pricing power and confined long term grow runway, I am comfortable underwriting a 10-12x terminal multiple on net profit. Correspondingly, the position size has been trimmed back from a 13% position to a 5% position.

Investment Decision Log – User Manual

I have recently created a spreadsheet to record all of my investment decisions. The goal is to track decision quality and try to learn from mistakes and reinforce things that I am doing well. This is a long term project to improve my decision-making skills.

Decision-making is inherently statistical in nature. Hence the nature of this assessment should be statistical in nature too. With a sufficiently large sample size, the assessment of the decisions should start to become meaningful as the quality of my decisions will converge with share price performance.

I also included ideas that I have done some work on but not acted on….

Each decision will be given a rating based on two dimensions – 1) share price performance since decision; 2) facts that evolved since the decision to measure the soundness of decision logic e.g. I sold DTG because I think the risk of long term price competition is not sufficiently captured in the valuation.

The second dimension is still subject to my own judgement and hence the risk that it is not sufficiently well captured. The good thing is that I still have share price performance as an objective measure to capture things that clearly look out of place. For example, if the share price is down 90% while I claim the original decision is good then I need to have a very convincing explanation backed by strong evidence. I trust that I can be brutally honest to myself.

To assess the second dimension of decision making:

      1. Did what I predict to happen actually materialise?
      2. Based on the outcome of the events, was the original probabilistic assessment correct?
      3. Was luck involved in the magnitude of the outcome? (added to comments)

If the answer to all three is positive, then it is a good decision. If 1 and 2 are conflicting, need to explain why they are conflicting. Will still need to make a collective judgement. Also need to comment on the role of luck. For example, I expect a positive event to yield a 10% increase in share price but it went up 50% because of extraneous factors. Then luck was responsible to push up the magnitude of the return

There are five possible ratings for each decision:

      • G – Good Decision and Good Outcome
      • U – Good Decision and Bad Outcome
      • L – Bad Decision and Good Outcome
      • E – Bad Decision and Bad Outcome
      • X – Unable to evaluate decision quality regardless of the outcome

The goal is to prevent U decisions to discourage me from making the same decision in the future. Nor should I let L decisions to trick me into over-confidence. And allow for reinforcement by G decisions and learn from E decisions. Rating X is given to decisions where there is insufficient facts and time to evaluate the quality of the decision.

The assessment period for each decision depends on the nature of the underlying decision. For example a special situation investment decision depends on the outcome of a specific event. So even if I sold the position before the event crystallises and make profit on it, I must still wait for the outcome of the decision to determine the quality of my decision. On the other extreme, an investment in Games Workshop requires a longer time to evaluate because the fundamental investment thesis is a long term one. For example, Warhammer IP is a very good one requires continuous assessment. Hence each investment decision should be assigned to different assessment periods.

Ways to analyse my own decision:

      • Based on position size – big vs small – am I good at making big position decision vs small position decisions
      • Value of add and reduces
      • Decision by investment categories – General / Compounder / Workouts
      • The magnitude of mistake of omission
      • The decision over the lifetime of each investment
      • The decision that yield the best returns vs worst returns

Shortcomings of this decision log – it doesn’t capture a lot of passively made decisions such as to do nothing to an existing position when stock prices go up. This is something I need to think about how to capture better.

Information Flow – A Force of Nature

I have been going through old interviews by Meituan founder, Wang Xing. He is obsessed with the mechanism of information transmission in our society and technological advances that improves information transmission brings about drastic changes to how people interact and conduct their daily lives. And when people change their ways of conducting daily lives, it usually means formation of new businesses that take advantage of these changes. Incumbent businesses that rely on the older way of information transmission will be left in shatters.

Wang Xing likes to define information technology (IT) as technology that enables the flow of information. So in this sense, just like Internet and smartphones, older technologies such as printing press & books are also IT. In fact, three out of the four ancient Chinese inventions (papermaking, printing, gunpowder and compass) are about IT. Papermaking is about storage of information. Printing is about mass replication of information. Finally compass is about production of geospatial information.

Internet brought about a revolution in terms of information transmission. Not only does it lower the cost of information transmission, it also unlocks new ways to transmit information. For example, social networks built on top of Internet allows information to pass through the network of humans. We share news, products, services, personal experiences with our friends on social network. Direct to consumer businesses have taken advantage of this change. This is challenging the long-held belief that FMCG companies have impregnable moats.

Technology does not just reduce cost of information transmission. They also allow new types of information to be transmitted. For example smartphone allows the individual location information to be transmitted instantly and hence new businesses such as ride-hailing and food delivery platforms to emerge. Smartphones also allow companies like Meituan which is a marketplace for local services such as hairdressers, beauty salons and restaurants to market to potential audiences more efficiently than before. Meituan will show consumers nearby local services based on location information which are most relevant to the user.

The impact of information flow is even more nuanced than just allowing new business models to emerge. I believe that because the digital revolution has brought about reduced communication and management costs which has reduced the transaction costs within a firm. This partly explains why we are seeing companies becoming larger than ever. I don’t think this trend will reverse.

As investors, the appreciation of the magnitude of changes and the path of change can be very lucrative. For example Uber drivers have driven demand for vehicle hires and this demand for rental vehicle has driven fleet sales in Brazil. Since fleet sale is done at wholesale price, this meant that auto OEMs has to accept lower unit price and margin compression.

The increased digitalisation will transform the food industry in the next 10 years. The first step has been the arrival of the food delivery platform which brings food from the restaurants to the consumers. This can happen because the consumer side has been “digitalised” with smartphone. The next step is to digitalise the restaurant. Currently the bottleneck in terms of food delivery efficiency lies with waiting time at the restaurants. Digitalisation of the kitchen will allow the food delivery platform to predict cooking time much more accurately. Then it is about the logistics. Instead of delivering with clumsy human beings, the next step is to deliver with autonomous robots. Eventually, I believe that food production will be centralised and cost of food comes down dramatically. People will continue to go to restaurants for social experiences. But new flats might not have kitchens anymore.

After studying Wang Xing carefully, I am 100% with him that digitalisation will continue to change the society. And the next stage of change is mostly focused on the enterprise side. While Warren Buffett has derided “change” as detrimental to the investors, I think “change” can be quite lucrative if it is misunderstood by most.

The HLP Lessons

In the past couple of months, I spent a lot of time and effort researching Hang Lung Properties (HLP). It is a Hong-Kong listed commercial property developer and owner. HLP has a portfolio of prime retail properties in HK and mainland China. My initial interest in the company originated from my belief that despite the threat from eCommerce, well-positioned shopping malls in demographically strong areas should continue to do well.

There is a lot to like about the company at first glance. It was trading at close to 4% dividend yield, a strong development pipeline and have at least 2-3% rent growth from its existing shopping mall portfolio. The shopping malls are relatively high-end and located in some of the biggest cities in China. Most importantly, it seems to have a well-aligned management (HLP is family controlled) and a “legendary” capital allocator at its helm. I recommend you read the Hang Lung’s Chairman Letters where the CEO’s impeccable ability to time the real estate cycle and reluctance to overpay are both well documented.

It was almost too good to be true. You have 1) very competent capital allocator, 2) a high-quality retail properties portfolio, 3) a highly visible development pipeline, and 4) a cheap valuation for this business quality. I allowed myself to become very excited about the company as I devoured the Chairman Letter religiously. I am actively looking for evidence to further support my investment thesis. Sure there are a few problems but as a long-term investor, I can look past these “short-term” issues.

However, as I learnt more about these “short-term” issues, inconvenient evidence began to accumulate. The consumption power of Chinese Tier-2 cities does not grow nearly as fast those implied in Hung Lung’s Chairman Letters. The oversupply of retail space in Tier-2 cities would take so many years to digest that the return on incremental retail properties in these Tier-2 cities is just too low for the level of risk involved. However, the company seems focused on its Tier 2 city strategy in China. Not to mention the first mover advantage of the luxury mall in Tier-2 cities is so entrenched that it is a winner-take-most economics. Most luxury brands will not open two stores in a Tier 2 city in China and luxury brands need to co-tenant together. This means that once the first high-quality mall captures most of the large luxury brands in its mall. It is extremely difficult for the second and third mall to compete. You can build mid-end malls but then you would have so many similar malls that the low rent almost guarantees an unsatisfactory return. Chinese Tier-2 cities retail space is over-supplied from high-end to low-end malls.

At this point, I am just confused. Why would such a smart and rationale capital allocator commit to such an obviously sub-par strategy? As I spoke to people who are close to the Chairman, it became clear that this is an individual who has a huge ego. It would be extremely difficult for him to openly admit the mistake and change course. It is unclear to me if he is just too proud to admit the mistake or that admitting the mistake to something that is so central to his personal identity (he sees himself as the smart guy that never overpays) is just too difficult for him.

In any case, I learn quite a few lessons which I can take along with as I continue my adventure in the investing jungle.

  1. Don’t give too much credit to CEO / Chairman just because they can write fantastic annual letters
  2. When the business’s core operation is transformed in volume or in nature (in Hang Lung’s case from property management to property development), one cannot assume that the company will naturally be able to adapt
  3. Even when the manager is heavily invested in the company, the ego can still get in the way such that mistakes are not corrected
  4. Human irrationality is more powerful than you might think
  5. Past track record does not guarantee future success

Of course, I could just be wrong in thinking that building malls in Chinese Tier 2 cities is a sub-par investment strategy. I hope I am wrong.

MC

Dart Group Memo – 25th Nov 2017

Dart Group (DTG) released its latest 1H FY18 results on 16th Nov 2017. Operating results were very satisfactory. The total number of passenger sector flown for the period between Mar-Sep 2017 increased by 41% while the ticket yield decreased by 17% from GBP 92 to GBP 76. With the competitive pricing, load factor remained at an impressive 93.2%. Consequently, leisure travel revenue grew 36%. Operating profit grew 22% which led to a continued margin compression of 12.3% as compared to 13.5% in 1H FY17.

Advanced sales grew by 38% from GBP 519m to GBP 713m which is indicating a strong growth for the Winter of 2017/2018. The growth in Winter programme corresponds to Jet2’s capacity expansion as the company grows its aircraft fleet. Strong free cash flow generation with impact from working capital is largely neutral. Capex spend is expected to be much higher in 2H 17 with aircraft delivery.

All things considered, this is a very impressive operation performance by the Dart Group management. The share price rallied strongly upon the release of the set of performance. The market seemed to value DTG very differently over a 5-month period. However, the intrinsic value of DTG most definitely did not change as much as that implied by the share price. I added to my position after Mr Market taking a dim view of the company’s prospect after results release in July 2017. I am glad that Mr Market has changed his view since then.

Post the recent share price rally, DTG is the biggest position in my portfolio by far (~30%). Naturally, I am re-evaluating the appropriate sizing for DTG. To arrive at what is the optimal position size, one would need to understand 1) the expected upside and 2) the downside risks.

DTG can generate further upside by 1) growing its free cash flow; 2) pay down of debt 3) expansion of valuation of multiple. While I do believe that the current multiple on DTG is on the conservative side, I typically do not count on multiple expansion for value creation. As such I would focus on future earnings growth and value creation to equity holder through debt repayment. DTG can generate further earnings growth by:

  1. Volume growth – this can be achieved either through 1) expanding to new airport and 2) adding new routes to existing airports

  1. Pricing growth – this can be achieved either through 1) increasing prices and 2) improving revenue mix by getting customers to purchase higher valued products

  1. Cost efficiency – given that the mix of aircraft is skewing towards new planes, one would expect some degree of operational efficiencies

  1. Operating leverage – as DTG continue to grow in its bases, it should be able to spread fixed cost over larger revenue and achieve some margin expansion. This is especially true at newer bases

DTG might be able to expand to new bases to generate further growth, but it would not be prudent to anchor an investment on such an aggressive assumption. I am happy to be wrong here. So in this analysis, I assume that future volume growth is only coming from adding new routes to existing bases. In the short term, DTG is likely to enjoy high single-digit volume growth due to the collapse of Monarch. In the longer term, DTG is unlikely to grow its volume above the market as competition in the airline/holiday industry is intense. Similarly, on the pricing side, I suspect pricing growth is very limited due to competition. But DTG does get some insulation from pure price competition because they are focused on holiday destinations and are currently very profitable while being very price competitive. Putting the two together, DTG’s organic revenue growth over the next five years is unlikely to exceed 10% while the risk of a cyclical downturn is more severe at current valuation.

By replacing older aircrafts with modern aircrafts, DTG should be able to realise cost savings through fuel efficiency and lower maintenance cost. But the impact of this should be fully incorporated by 2019. It is difficult to estimate this precisely, but I am not expecting a more than 1% of EBIT margin improvement. On the other hand, the risk of a higher fuel price weighs down on the cost savings from the new planes. Operational leverage might kick in with further growth, but this is difficult to quantify.

Putting the above together, I estimate that Jet2 will run at around 11-12m pax capacity with 91% load factor. Assuming a conservative pricing environment, I get GBP 2.4bn revenue in 2019. With an 11.5% EBITDA margin and no working capital benefit, I get ~ GBP 200m operating cash flow. The question of what is the right maintenance capex is a difficult one. I assume that with newer aircrafts in the fleet, the run-rate maintenance capex is close to GBP 60m. Deducting the maintenance capex, the FCF would be ~GBP 150m; implying a close to 15% free cash flow yield on GBP 1bn market cap. Assume that all FCF is used for debt repayment, equity value should increase while the FCF yield would decrease assuming that FCF doesn’t increase too much over time. In today’s world, 15% FCF is still a very attractive rate. Nonetheless, the upside on DTG is probably around 30-50% without any multiple expansion. Given that, I have investment opportunities with similar downside risk but 100% upside. It no longer makes sense to allocate such a large size to DTG.

However, Jet2 is still the best-valued package holiday business where it strikes a great balance between customer service, experience and price. The company is managed by an excellent management team and a well-aligned owner operator. Jet2’s position as value for money package holiday operator should prove to be most robust in a recessionary environment.

At this point, I believe 15% position size is probably the right one for DTG. I am retaining a large position size because I am very keen to partner alongside a competent and well-align management at a reasonable if not cheap valuation. However, I will be selling down more DTG shares.

MC

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