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Investment Memo – Tencent (WeChat)

This investment memo is a detailed explanation of my investment in Tencent as documented in this post – Live Portfolio Update – 2021 – #3 (Tencent)

Tencent is a company that defies categorisation. It is so many things all at once – gaming, social network, fintech, media and cloud. At almost USD 700bn market capitalisation, it is the biggest company in China and one of the biggest companies globally. But I think it still has a very long growth runway ahead and likely to offer an excellent risk-adjusted return.

On a high level, my favourable outlook for Tencent is anchored on four parts:

1) WeChat is the equivalent of a modern-day digital utility in the sense that it is almost irreplaceable because it is both a utility app and a social networking app. The combination of utility-driven high switching cost and network effect creates an almost impregnable moat for the foreseeable future. It is currently under-monetised relative to the value created for its users. More importantly, WeChat continues to create new value for its users by expanding use cases on WeChat. For the next 5 years, WeChat’s advertising revenue growth rate will accelerate as its eCommerce ecosystems mature.

2) Tencent’s vertically created gaming business enjoys a very long growth runway as the video game is on a multi-decade march of gaining share of the entertainment budget.

3) Tencent’s corporate DNA, user-centric and bottom-up culture, is robust enough to deal with ever-changing technology changes and shifting consumer tastes.

4) Tencent has laid the seeds of future growth in Cloud, Fintech and enterprise software

For this blog, I just want to focus on the WeChat part of my investment thesis and I will write about other parts of the Tencent investment thesis separately.

WeChat

With 1bn of users, WeChat has transcended its inception as a messaging app and become a modern-day utility in digital life. People use WeChat to message, socialise, pay, read blogs, buy grocery and play games. In very practical terms, one cannot live life in China without WeChat just like one cannot live life without electricity in the modern era. No other social network, even Facebook, comes close to being as much a utility in people’s daily lives as WeChat does.

This means that WeChat’s risk of disruption by another social network is actually even lower than the like of Facebook and Instagram. In fact, WeChat will become more relevant to people’s lives by providing even more valuable services such as discovering restaurants, local services and financial services (payments, wealth management, personal loans).

Given WeChat’s importance in Chinese people’s lives, it is incredibly under-monetised. Tencent’s ~ RMB 80bn of advertising revenue is actually smaller than Bytedance’s advertising revenue. I think I am safe grounds if I say that advertising dollars follow user time spend. Below is a chart that maps ad spend to time spend. This data is from 3Q 2019 but it is still valid.

Tencent under index on its share of total ad revenue in China

Interestingly, Alibaba has the largest share of the advertising dollar with ~1/3 of the total China online ad spend. Bytedance’s ad revenue also saw a meteoric rise. Both Ali and Bytedance have the most mature and sophisticated monetisation infrastructure. Bytedance’s well-tuned algorithm can deliver unparalleled precision while Ali has the most comprehensive eCommerce marketplace.

Tencent is lacking behind in ad revenue because:

  1. the creator of WeChat, Allen Zhang, is resistant to introducing commercial activities on WeChat in fear of dealing permanent damage to the ecosystem
  2. for a very long time, Tencent lacks a coherent advertisement infrastructure (but that has been largely fixed now)
  3. there was no proper medium to carry ads on WeChat
  4. for a long time, games is in itself a strong enough growth driver

But all of the above are changing. And I believe that Tencent’s ad revenue will reaccelerate in the next 5 years and could reach RMB 200-300bn in the next 5 years.

On a high level, I believe the growth of WeChat’s e-commerce ecosystem will drive Tencent’s ad revenue. But why is Tencent able to crack eCommerce this time around? Tencent made a go at eCommerce in 2014 which did not go well. They end up selling their eCommerce business to JD.com. So what has changed?

Since 2014, China’s eCommerce infrastructure has grown significantly where the payment and logistics are becoming APIs that anyone can plug-in and start an online business. A vast ecosystem of service providers such as Youzan and Baozun has surfaced to provide software and operational competences to run an online eCommerce business. Most importantly, Chinese merchants have accepted eCommerce as the default way to do business and the majority have decent know-how when it comes to running an eCommerce business.

So it is in this context that Tencent decides to have another go at eCommerce and this time through WeChat and more specifically WeChat mini program (MP).

Merchants will be able to set up shop using WeChat MP to market and sell their products. WeChat MP has a built-in payment API (WeChat pay), a logistics API link and other useful modules such as live streaming and eCommerce software. This means that WeChat is a closed-loop transaction platform just like Taobao!

And this is VERY important. For a very long time, merchants have advertised on Tencent properties but the transaction is typically completed either on Ali or JD or PDD. As merchants now have the option of directing transaction to WeChat MP, merchants will be able to acquire customers, complete transaction and provide aftersales service within WeChat. This ability to close the transaction within Tencent’s walled garden has two huge implications for its advertising business.

1) Tencent can finally provide a true performance advertising product which means merchants can measure their RoI with incredible precision. We have seen many times that the ability to demonstrate a clear marketing RoI is an excellent way to persuade merchants to shift their advertising budget. Facebook is a good example here.

2) Tencent will be able to collect better data and, with its improved advertising infrastructure, it can finally be able to match its peers in terms of precision and accuracy. Here there is a very fine line to draw between protecting user privacy and advertising efficiency. I trust that Tencent will approach this balance with an abundance of prudence. I think it would be naïve to believe that there is no loss of user privacy but I think it will be moderate.

One of the biggest challenge in terms of growing ad revenue on WeChat has been this: how to show users more ads while not completely destroying their user experience. Just imagine how annoying it would be if you keep seeing ads while messaging your friends. So WeChat has to create a completely independent public domain for commercial activities while keeping the core messaging user experience simple and pleasant within the private domain.

The introduction of WeChat MP and WeChat Video Account solves this problem quite well. But the deliberate separation created by WeChat MP means that discoverability is a big issue for merchants. How can merchants reach users on WeChat if they are only given a very limited opportunity to market themselves? WeChat has come up with two partial solutions. 1) they are trying to make the search within WeChat much more powerful. At the moment WeChat search capability is very limited as it cannot search for content within MPs very well. 2) the creation of a short video product within WeChat, known as WeChat Video Account, where users can watch short videos in a feed style. I suspect this would be an important portal for merchants to acquire users in the future.

In the long term, there is a question about how much activity can WeChat carry within a single app without breaking the user experience? Is WeChat trying to do too much? I think at some point in the future, it will be a big problem for WeChat. But at this point, I think the early evidence suggests that WeChat can support a vibrant commercial community on its app.

Tencent reported that WeChat generated RMB 1.6trn of GMV in 2020 with over 100% YoY growth. It also reported a 400m DAU for WeChat MP. WeChat has 1bn users and let’s assume 50% of them end up buying things on WeChat and assume an ARPU of RMB 10k which is in line with major eCommerce platforms in China. It is not inconceivable that WeChat can do RMB 5trn of GMV by 2025. If we assume a 5% take rate on RMB 5trn GMV, it translates into RMB 250bn of revenue for Tencent which is incremental to its current base of RMB 80bn revenue.

Live Portfolio Update – 2021 – #5 (Sogou)

Bought Sogou shares @ USD 8.25 per ADR. 6% position.

This is a merger arb with 8% spread over 5 months. While I focus on finding long term investments in high-quality businesses, I just cannot resist myself when short-term investment opportunity with good risk-reward arise.

Tencent is privatising Sogou with an offer price of USD 9 per ADR. This deal has reached a definitive merger agreement in Sep 2020 and hence the spread completely disappeared.

In Dec 2020, Sogou announced that they amended the merger termination date from 29/03/2021 to 29/07/2021 due to the need for antiregulatory filing and subsequent clearance from Chinese regulators.

“In late November 2020, THL and Parent made an antitrust filing with relevant PRC regulatory authorities in connection with the Sohu Share Purchase and the Merger. Considering the time needed for the clearance of such filing, the parties decided to extend the termination date under the Sohu Share Purchase Agreement and the Merger Agreement. On December 1, 2020, (i) Sohu.com, Sohu Search, and Parent executed an Amendment No. 1 to Share Purchase Agreement, to extend the termination date under the Sohu Share Purchase Agreement from March 29, 2021 to July 31, 2021, and (ii) the Company, THL, Parent and TML executed an Amendment No. 1 to Agreement and Plan of Merger, to extend the termination date under the Merger Agreement from March 29, 2021 to July 31, 2021.”

I am confident that Sogou deal will get approved by Chinese regulators because:

1. Tencent is not dominant in search

2. Sogou is very important to WeChat commerce ecosystem that Tencent will go out of its way to make Sogou deal happen

I expect them to get approval before 29/07/2021 and hence the expected time to completion of 5 months.

Live Portfolio – 2020 Review

What a year! Despite being stuck at home for most of 2020, it has been a very eventful year.

The portfolio delivered a net return of 15.6%[1] in 2020 while FTSE Global All Cap index’s return is 16.8% during the same period. Our portfolio’s cumulative return since 2016 is 100% while the above-mentioned index’s cumulative return is 81.9%. Cash is 32% of the portfolio.

I prefer to show the investment return net of imaginary fees because any aspiring investment manager should be able to generate excess return net of fees.

[1] Assuming a fee structure of 1) no management fee, and 2) a 20% performance fee above 5% threshold i.e. 18.3% – (18.3%-5%)*(20%) = 15.6%

Live Portfolio’s 2020 Investment Return

Live Portfolio Investment Positions as of 31 Dec 2020

The 5-year milestone

During Warren Buffett’s early years operating his investment partnerships, he encouraged his partners to evaluate his investment performance on a 5-year basis and “preferably with tests of relative results in both strong and weak markets”. And so at this 5-year mark, it is time to take stock and reflect.

I am very pleased to generate an annualised return 15.6% over the last five years which has a respectable 2.2% advantage relative to our performance yardstick, FTSE Global All Cap Index, with an annualised return of 12.7%.

Our high cash level, fluctuating around 20-40%, has been a significant drag on investment performance for the last 5 years. Due to a combination of high market valuation and the relatively limited scope of my circle of competence, I have not being able to find enough attractively priced new ideas. While there is nothing I can do about the high market valuation, I am steadily expanding my circle of competence which should ultimately translate into more investment ideas and lower cash level.

This investment return is generated against the backdrop of a generally rising stock market over the last five years. The portfolio did experience a violent but short bear market in March 2020 where we fared better against the general market’s 30% decline with 15+% decline. By and large, I do not believe that I have experienced a full market cycle of bull and bear market to pass Warren Buffett’s test of “relative results in both strong and weak markets”.

Our investment journey has, so far, been very pleasant as we have not suffered a loss in any year so far. But I would like to make a prediction – this investment operation is almost guaranteed to suffer a loss in at least one of out the next 10 years but I just don’t know when the losses would occur. As Charlies Munger said:

“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get.”

While I would rather avoid any losses, especially the 50% decline ones, it is better to be mentally prepared for it. Unfortunately, I am confident that my prediction would come true. Better to accept it as a fact of life.

While we are on the topic of making predictions, I believe you are entitled to know my expectations for future investment return even if it is largely based on my simple estimates. You should note that my expectations are in fact more like aspirational goals and risk of disappointment is quite high.

Over the last 100 years, the annual return for US equities averages around ~7.5% while the Chinese equity market generated ~9% average annualised return for the last 20 years. So in the long run, we should expect equity returns to be in the range of 6-9%. For our chosen benchmark of FTSE Global All Cap, it generated 7.5% annualised return since its inception in 2002 which falls exactly in the range of 6-9%. Since the goal of this investment operation is to generate above average return, it is reasonable to expect 6-9% return as the lower end of our future return expectation.

While beating 6-9% might not seem like a very ambitious goal, vast majority (90+%) of fund managers are not able to beat the market consistently after accounting for management fees. This is true globally including US and China. Said in another way, only truly exceptional investors can generate better than average return in the long run. If you do not find an exceptional investor, you are better off with index investing.

But there are a few exceptional investors who has been able to outperform the market very consistently for a very long period of time. So it would be illuminating to evaluate their investment track record and use their track record to form the upper limit of our future investment returns.

Below are my best estimates of some of the world’s greatest investors returns based on publicly available information and I tried to use after-fees net return as much as possible.

World-class investors’ track record

These world-class investors generate long-term annualised return in the range of 15-30% and averaging around 20%. These are truly impressive performance as every one percentage point of outperformance when compounded over long period of time can lead to massive difference in cumulative return. For example, the difference in cumulative return between 10% and 9% annualised return over 10 years is 22.6%. Only world-class investors can sustain the advantage of 10-20 points above the long run equity returns of 6-9% for a long period of time.

In general, I believe it is fair to conclude that any investor who can compound at a rate of 20% net of fee for more than 10 years should be considered a highly competent one. Said in another way, any investor’s achievement of 80% return in any single year is clearly not representative of that investor’s long term performance. While 20% return may not sound like a lot, the power of compounding guarantees a very wonderful result over the long term. Just look at Warren Buffett, 99% of his wealth came only after his 50th birthday!

While I have every ambition to become the best investor that I can be, it is hubris to compare myself against the greatest of investors of all time. So I would consider myself doing a great job if I can achieve 15% annualised return net of all fees for the next 10 years. This is going to be no mean feat considering the current valuation is at alarmingly high levels.

Investment Memo – CD Projekt

I bought some CD Projekt shares in my previous portfolio update here. I am very excited to finally become a partner in this wonderful business after following it for 3 years.

I will first discuss CD Projekt’s business at a high level and then go into the recent debacle with Cyberpunk 2077.

As I wrote in my previous blog post – Thoughts on video games:

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

CD Projekt has one strong game franchise – Witcher and in the process of building out a second franchise – Cyberpunk. Despite the launch drama, I think CD Projekt has a reasonable track record as a game developer. So CD Projekt does not fulfil those two criteria – owning strong game franchises and proven game development capabilities – very convincingly.

But I think there is sufficient evidence that CD Projekt can continue to develop its capabilities and strategically build out future game franchise. So there is not really a lot of margin of safety here and hence this is a 2% position.

I always prefer game companies that own and operate persistent game worlds which provide game-as-a-service revenue model rather than game-as-a-product revenue model. Unfortunately, CD Projekt adopts the game-as-a-product revenue model which means its cashflow is very tied to game releases and very dependent on the success of each game release. This has historically lead to a hit-driven business model which many investors hate because it is impossible to predict the sustainability of the company’s earnings.

This has been my biggest reservation about CD Projekt. But a few things changed my mind – 1) the launch Witcher mobile game; 2) the launch of Witcher Gwent card game, 3) the planned launch of Cyberpunk multiplayer online game and the 4) the release of Witcher series on Netflix

In some sense, CD Projekt has a very similar business model to Disney. Disney use movies to anchor its IP franchise which can then be further monetised through theme parks, merchandises and video games. For CD Projekt, it anchors its game franchise with flagship AAA games such as Witcher 3 and Cyberpunk 2077 and then develops spin-off games based on these core game franchises. It also produces TV series to further expand the influence of its game franchise.

CD Projekt’s real upside comes from 2 sources – 1) it builds out new game franchises and 2) transition one or more of its game franchise into persistent game worlds which can build strong customer loyalty and generate stable cash flow. With Witcher mobile game and the planned release of Cyberpunk multiplayer game, we are already seeing some signs that it is happening.

On valuation – it is very hard to value CD Projekt. As part of the company’s incentive program, it announced a goal of generating an average net profit of PLN 1.5-2bn for the period between 2020 – 2025. Assuming that they hit this goal, then I paid 15x multiple based on earning base of PLN 1.5-2bn net profit. Not too ridiculous but also not very cheap.


CD Projekt share price plunged after the disastrous launch of one of the most anticipated game in 2020 – Cyberpunk 2077. Here is a good Bloomberg article that documented the events that lead up to the game’s launch. In short, Cyberpunk 2077 built up an incredible hype but ultimately disappointed gamers as the game was full of bugs and glitches. It was so bad that Sony had to take the game off the shelves because it was almost unplayable on consoles.

Marcin, the co-founder of CD Projekt, posted a video to apologise for disappointing gamers and explain what happened.

He cited the technical challenges of making the game work with the next-gen and current-gen console & COVID-19 restrictions leading collaboration challenges as reasons for the failed launch.

From the outside, it is absolutely clear that the management team had huge pressure to get the game released before Christmas 2020 and that pressure led to the bad decision of launching before the game is ready. I am sympathetic to the challenge of COVID-19 situation which would have really complicated the entire development process.

The legendary game developer, Shigeru Miyamoto, once quipped that “a delayed game is eventually good, but a rushed game is forever bad”. This comment was made when games are primarily sold on physical copies and played with consoles that had no Internet connection. So there was no way to update the game after launch.

Fortunately, CD Projekt (CP) lives in the Internet era where it is possible to continuously update and improve the game once launched. In fact, Witcher 3’s launch was very problematic too. See this Eurogamer article written in 2015 to recount the disaster! And it feels eerily similar to Cyberpunk 2077 – last-minute crunch, graphic downgrade issues and the 2000 game bugs. Post-launch, CD Projekt continued to support Witcher 3, patched the bugs, launched DLC and won universal praise for the game. I believed something similar is going to happen here and that Cyberpunk has the potential to become another great franchise.

Ever since CP transitioned from a regional game distributor to a game developer in the mid-2000s, CP has been pushing its technical and game-making competence with every game. With Witcher 3, CP had to make a game engine that worked in an open-world while developing the game at the same time. CP has insane ambitions to grow as a world-class game developer.

I think with Cyberpunk, CP was trying to push the limits of what they can accomplish again. For example, they had to upgrade the game engine for FPS and driving. The Cyberpunk world was bigger and more complex. Except for this time, they had the complication of COVID, higher expectations, bigger gamer base and co-existence of two generations of consoles.

CD Projekt clearly screwed up this time. But from an investment perspective, I focus on three things – 1) what does this incident show about the company’s game development capabilities, 2) what does it reflect about the company culture and 3) the long-term potential of Cyberpunk 2077 franchise.

For me, it seems like CD Projekt’s ambitions might be ahead of its game development capabilities this time. But it is also clear that CD Projekt is improving as a game developer and based on the company’s historical track record of learning from mistakes, this could be another learning opportunity for CD Projekt albeit an expensive one. I am more concerned about how this incident could crash their ambition and kill the operational momentum that they have been on.

Few game companies have developed such a strong brand within the gamer community. CD Projekt always believed in treating gamer well which is exemplified by their ethos of providing good value for money – free DLCs and DRM-free games. I personally don’t believe there is anything sinister going on here except for the fact that there is immense pressure to release before Christmas 2020. During game development, there are constant trade-offs to be made and we could argue whether CD Projekt has made all the right trade-offs. But I don’t think there are any bad intentions here. I guess we will see how CD Projekt make up to the gamers in the months ahead.

After reading through many reviews and playing it myself, I think it is a good game and has the potential to become another long-running franchise for CD Projekt in the same way as the Witcher franchise.

Ultimately, I think there is a pretty good chance that CD Projekt can bounce back from this fiasco and become a better game company in the process.

Live Portfolio Update – 2021 – #3 (Tencent)

Buy Tencent as a 8% position @ HKD 645 per share.

Tencent is a company that I have actually spent the most time researching for the past 3 years because of work. While I cannot invest it in personally due to compliance reasons, I want to include it in the portfolio here.

Expect a full blog on Tencent soon!

Games Workshop – 1H 2021 Results Update

What a joy it is to be a business owner of Games Workshop!

Despite the closure of retail stores, GW reported excellent 1H 2021 results with revenue up 26% and gross margin expanding to 75% on the back of the higher volume. Net income reached an all-time high of GBP 73.9m and net margin improved from 39.5% to 49%.

The margin expansion has driven by operating leverage.

GW CEO, Kevin, reported that “operating profit – pre-royalties receivable – both value (up £35 million to £83 million) and profit to sales ratio (up 12% to 45%) have improved in the period. Our high margins are delivering incremental profit compared to last year at 91% (2019: 55%).

91% incremental margin!

In the long run, the margin should shrink a little as they reinvest into their business given the many avenues of reinvestment opportunities to drive future growth. It is not reasonable to expect GW’s margin to expand at its current rate, and I would rather them aggressively reinvest back into its core businesses.

China got a special mention from Kevin:

“An extended range of core products have now been certified for China Compulsory Certification (CCC) and have been available in the country. With Space Marines proving to be more popular than ever, we have enjoyed success in stocking and selling selected complementary licensed products within our own sales channels, key amongst which have been some action figures. These are also stocked in mass-market locations, helping us with brand awareness. We are expanding our translation team to ensure our customers in China and other overseas countries can enjoy the official Warhammer experience.”

I have been in close contact with the Chinese Warhammer community and translation quality is atrociously bad! I have no doubt that when they finally fix their China operations, it will provide the next leg of revenue growth. China is a huge market and I know Warhammer IP appeals to Chinese fans as much as it does in the UK and US.

A slight disappointment is to see the royalty income decline from GBP 10.7m to GBP 8.7m. But royalty income is going to be chunky. With the Warhammer IP going from strength to strength (TV series, animation and comic), it would ultimately be reflected in the royalty income at some point. Not to mention a strong pipeline of Warhammer game in 2021 and going forward.

In the long run, GW’s intrinsic value is driven by 1) the number of fans and 2) revenue per fan.

GW is a vertically integrated entertainment franchise that has historically monetised through miniatures. In the last few years, it expanded its fan base through better marketing on social media and better product campaign. Going forward, it is also exploring new ways to grow fan base through TV series, animation and comic. Not only is the fan base growing, it is also increasingly able to sell its fans more products such as mobile games.

So we are seeing both the fan base and revenue per fan growing for GW. In the next few years, this will prove to be a very potent combination!

Investment action: Adding 1% @ current market price

Jet2 (previously Dart Group) – a mistake of inaction!

After evaluating the financial resulting ending Sep 2020, it seems clear that I was probably being too conservative for not adding to Jet2 during the period of time where they raised new equity and sold logistics business. At that point, the risk of ruin is extremely remote and I have always believed in the normalised earnings of GBP 150m which means I could easily justify a market cap of GBP 1.5bn.

So I could have made a purchase around GBP 1bn market knowing full well that the risk of ruin is minimal. But I didn’t. And I don’t really have any good justification. So this is a mistake of inaction.

However, we are where we are now at a market cap of GBP 2bn. What to do next?

Jet2’s lack of a long growth runway concerns me quite a bit as it already commands a 40-50% market share within the UK’s package holiday sector. Hence Jet2 is unlikely to be a multi-bagger from here. But it could grow its market share to 60-70% as it comes out of this pandemic. I estimate its package holiday business could grow to 5 million customers within the next 3-5 years up from its current 3.2 million customers (pre-pandemic).

On the pricing side, I continue to be worried about ticket pricing due to a glut of plane capacity. But Jet2’s route network overlap with the major airlines is minimal and expect to shrink coming out this pandemic as Ryanair and easyJet retreat from the regional airports.

Finally, Jet2 gained incredible customer goodwill which could improve the sustainability of its franchise.

So on balance, it is a better business now versus 9 months ago. It is set to recover in 2021 and beyond.

I think I am in a better position to take advantage of any price correction now!

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