Pembridgecap

A Wealth Creation Journal

Live Portfolio Update – 2020 #13

Bought 10% position in 51jobs @ 70USD per share.

This is a classic Chinese ADR privatisation deal with a PE sponsor. DCP Capital is currently offering to take 51jobs private. My guess is that mgmt team will join them in the privatisation deal at some point and hence they only have to buy 50% of the shares outstanding.

I should note that as compared to other Chinese ADR privatisation deal, the valuation sounds fair. So I believe there is very little chance of price improvement from here. Overall, I think the deal is very likely to pass within 3-6 months.

I see this deal as a way to earn a higher return on cash with a good risk-adjusted return.  I would not want to participate in merger arb if I can find high quality companies to own for the long term.

Live Portfolio Update – 2020 #12

Sold 4.2% of Avanza @ SEK185 per share.

It pains me to sell Avanza. But I cannot justify its valuation at this level. The trading intensity of Avanza customer base is so abnormally high (+50% versus an average of last 5 years) that it is only a matter of time before trading activity normalises. Hence current Avanza’s earning is materially overstated and putting a peak multiple (26x) on a materially overstated earning base is not good for prospective returns.

On the other hand, Avanza’s intrinsic value has benefitted from customer growth. I still have a 2% position in Avanza and I look forward to buying Avanza back at a lower valuation.

Generally, I do not try to trade around investments as I usually don’t make money out of it. Especially for a very high-quality franchise like Avanza. But when the valuation is so out of whack, I have to act.

Why I own Nintendo

After a lot of “backbreaking” research work, I am finally a proud shareholder of Nintendo!

Nintendo is a legendary Japanese video game company that has remained a mainstay in the industry for over 35 years, mostly because of its competence as a world-class game content creator. Nintendo owns the top 2 highest-grossing video game franchise of all time – Pokemon and Mario. Unlike most games that only last for less than 1 year, Nintendo’s most popular game franchises have exceptional longevity. For example, Nintendo’s current top 5 grossing games have been around for more than 10 years. I believe that Nintendo’s best days are ahead of it because its genius as a game maker will be amplified as Nintendo builds a direct and deep relationship with its gamer base. This new relationship with its gamer base will transform Nintendo’s cyclical revenue into a recurring one.

Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a cheap and effective medium to create all kind of problems for humans to solve. Nintendo’s genius lies in its ability to create problems (game contents) that are fun for the gamers to solve and to find the subtle balance between been too difficult and too easy. In short, Nintendo knows how to make games fun to play; or in Nintendo parlance, it “creates unique forms of play”.

Nintendo’s adopts the classic razor and razor blade business model. Gamers first purchase the Nintendo console, or more specifically Nintendo Switch which is the latest generation of Nintendo consoles, and separately buy the games to play on the console. Nintendo’s business model is to sell consoles at cost and make majority of the profit on the high gross margin game sales.

Traditionally, Nintendo is seen as a cyclical business because it is more reliant on the success of its console (hardware) rather than its true strength – games (software). Since new games released on the latest generation of console cannot be played on the previous generation of consoles (no backward compatibility), gamers might not upgrade to the latest generation of console which lead to limited incentives for game developers to develop new games for a console with small install base. This dynamic led to either huge successes or devastating failures. For Nintendo, Wii was a huge success but followed by Wii U which was a total commercial failure. But I believe this is changing as Nintendo’s relationship with its gamer is evolving to a more direct and continuous one which eventually lead to an almost recurring revenue stream.

Console games are evolving from distinct game worlds where gamers buy the game upfront with no further cost to persistent game worlds that gamers make ongoing payments. Many examples of very success persistent game worlds, such as World of Warcraft and League of Legends, have demonstrated incredible longevity and significantly higher revenue potential relative to distinct game worlds. As more gamers play more games with persistent game worlds, they are likely to play the console longer and more likely to upgrade to the new generation of console to enjoy better graphics.

Going forward, games’ backward compatibility is going to be a standard feature for the next-generation consoles. Without backward compatibility, each new generation of console resets the install base to zero, and the introduction of backward compatibility means that new console adds to the current generation console’s install base rather than a reset.

Nintendo builds a direct relationship with its gamer base through Nintendo Account which holds the entire library of games ever purchased by the gamers. This is a very powerful relationship as gamers could bring their games seamlessly onto the latest generation of console. Nintendo can also create new subscription products such as Online Membership which further improves revenue visibility.

Previously game developers found it very costly to develop for multiple gaming platforms (Nintendo, Sony, Xbox) as the underlying hardware architectures are different. Game engines such as Unreal and Unity provide a standard software development environment such that it is much easier for game developers to launch their games on multiple platforms. This dynamic amplifies Nintendo’s strength as a superior game developer relative to its competitors, who are primarily platform businesses with limited game development DNA, as gamers who previously buy Nintendo consoles just for the exclusive Nintendo games can now also get the games that are otherwise available on Sony and Xbox.

All of the four factors above – console games evolving from discreet to persistent game worlds, game’s backward compatibility, direct to gamer relationships and interoperability of gaming platforms – means that Nintendo’s strength as a world-class game maker is going to be the key driver for success going forward and the console’s cyclical risk is more muted.

Every time a big technology paradigm shift appears, there is always a risk that incumbents could somehow be disrupted. Cloud gaming is the latest technology paradigm shift. While it is still not clear to me how cloud gaming is going to change the industry, I am confident that Nintendo can thrive as long as they are able to apply their game development DNA to the cloud gaming environment. However, Nintendo might not be able to adapt to the cloud gaming world just as they still struggle to adapt to the mobile gaming environment.

Nintendo has failed to adapt to the mobile game environment because they do not have the operational capability to operate persistent game worlds that are live and requires a continuous content upgrade. Nintendo’s game production is more akin to making a movie rather than a talk show that requires new episodes every day.

I view Nintendo’s lack of game operation competence as the single biggest concern now. If I see evidence that Nintendo has developed a strong game operation competence, then I will increase our investment in Nintendo meaningfully.

I believe that Nintendo can easily have 100m of gamers who would consistently spend USD 100 per year on Nintendo games almost on a recurring basis within 1-2 years. This translates into a USD 10bn revenue base. Assume they breakeven on hardware, Nintendo could generate USD 4bn of net profit. This implies 15x P/E which is very reasonable valuation for such a high-quality company.

By the way, I have never had so fun researching a company!

Live Portfolio Update – 2020 #11

Sold out of Eslite Spectrum @ an average price of TWD 75 per share. Generally speaking a very disappointing investment because of my mistake in judgement.

In Jun 2020, Eslite announced the closure of Shenzhen mall due to an inability to reach a rental agreement with CR Land. COVID-19 probably accelerated the already sub-par performance of SZ Eslite.

The further deterioration of the HK business also compounded Eslite’s problems both due to social unrest and COVID-19.

TW business continues to have limited LfL growth.

I believe the key underlying issue is due to the core Eslite business model of bookstore + shopping is just not that strong. My mistake has been to overestimate the strength of this business model.

My original hypothesis depends on Eslite bookstore ability to continuously generate traffic which can be monetised through other merchants. However, traffic generated by the bookstore is neither high in volume nor valuable enough.

I hope Eslite would continue to do well as it plays an important role in spreading art and culture in Taiwan.

Live Portfolio – 1H 2020 Review

The portfolio delivered a net return of 7.9%[1] for first half of 2020 while FTSE Global All Cap index’s return is -6.7% during the same period. Our portfolio’s cumulative return since 2016 is 86.6% while the above-mentioned index’s cumulative return is 45.3%. Cash is 48% of the portfolio.

In the past six months, COVID-19 introduced unprecedented level of uncertainties and challenges for businesses. Most of the businesses in our portfolio performed exceptionally well given the tough circumstances. Below are some operational highlights:

Games Workshop reported revenue growth and profit growth of 4.6% and 8.3% for the 12 months ending 31 May 2020 despite having no revenue for 6 weeks. Fans are escaping to Warhammer to seek temporary respite from the stressful lockdown environment. On 25th July 2020, Games Workshop successfully launched the latest edition of Warhammer 40K with improved game play, new story lines and miniatures; and fans responded enthusiastically. The Warhammer IP continues to grow from strength to strength with a record pipeline of video games and an upcoming mass-market TV show. Warhammer is truly a global franchise which is still in the early innings of its growth trajectory. I am thrilled to be part of this journey. Games Workshop is our largest investment and constitutes ~15% of our portfolio.

As a travel company, Dart Group is disproportionately impacted as customers cancelled their holidays due to CVOID. They took this opportunity to build enormous customer goodwill by refunding its customers quickly. The management team also quickly sold assets and raised new capital to ensure they can survive under any conditions.

Avanza has benefitted from the global tailwind of increased participation from retail investors with the growth of new customers accelerating. 139,100 new customers joined Avanza during the 6 months ending June 2020 – an incredible 100% growth versus same period in 2019. Consistent many other retail brokerage platforms globally, the average trading volume per customer increased by 50%. With a largely fixed cost base, Avanza’s net profit grew 211%. Avanza’s short-term operational performance is driven by a myriad of market factors such as market volatility and prevailing interest rate level. However, in the longer term, the most important driver for Avanza’s intrinsic value is the growth of its customer base. Avanza’s current market value is probably ahead of its intrinsic value. I have resisted the temptation to sell Avanza shares as there is still an exceptionally long growth runway for Avanza. Avanza’s customer base is 10% of Sweden population but its share of savings capital is only 5%. Our long-term return should be slightly above Avanza’s long-term customer growth rate of 15% due to operational leverage.

Eslite Spectrum is a physical retailer from Taiwan. While its Taiwan operation is relatively well insulated from the impact of COVID-19, its mainland China operation took a big hit. Due to the pandemic, it closed the Shenzhen store. I believe the pandemic is simply a catalyst to reveal the inherent weakness of Eslite’s retail model of using Eslite bookstore as a traffic generator and monetised through carefully selected third-party vendors. My mistake is to over-estimate the brand reputation of the Eslite bookstore as a traffic generator and its merchandising capability. Hence, I will be exiting this investment.

When I consider my performance in this period, I give myself a B minus – reasonable but not stellar performance. It was not stellar because I was too conservative in deploying capital due to my hesitation to take advantage of investments opportunities that were offering attractive absolute long-term return. Overall, it is a reasonable performance as I have the conviction to hold onto existing investment and added two news investments – Nintendo and Ryman Healthcare.

I am increasingly convinced that partnering with great businesses is the most reliable strategy to grow wealth over a long period of time. Accordingly, the highest priority is to increase the weighting of great businesses within our portfolio. While I will always be open to the generally undervalued and special situation investments, the relative opportunity cost of owning them will increase as I find more great businesses to own.

I am glad to report that Compounders currently make up 36% of our portfolio up from 3% in 2017. As a reminder, I define Compounders as great businesses with durable business moats and an exceptionally long growth runway. I intend to hold our Compounders for as long as possible unless 1) there is a mistake in my judgement, 2) the valuation is so ridiculous that prospective long-term return is below risk-free rate, 3) there is better investment opportunities. In the last six months, we became business partners to two great businesses – Nintendo and Ryman Healthcare – which I will explain in detail later. I believe that our Compounders as a group can sustain ~10% return for a long period of time.

The high cash level is due to the successful closure of Yixin investment in June 2020. While no one can grow rich sitting on cash, I am willing to be patient and wait for great opportunities to present itself. After all, one must not lose money to make money.

[1] Assuming a fee structure of 1) no management fee, and 2) a 20% performance fee above 5% threshold i.e. 8.6% – (8.6%-5%)*(20%) = 7.9%

Live Portfolio Update – 2020 #10

Added 3% to Ryman Healthcare @ NZD 13.

Increased conviction in their Australia growth prospects where they literally don’t have any serious competition because a lot of the Australian retirement village operators are really property developers who are hesitant to take on age care operational risk in the scandal-prone Australia age care sector.

Ryman is hence very uniquely positioned to grow in a huge market for a long period of time. And Ryman charges 20% deferred management fee while competitors charge north of 30%.

How often do you find the lowest cost operator who is also the highest quality operator in a sector with VERY VERY long growth runways.

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