Pembridgecap

A Wealth Creation Journal

Live Portfolio Update – 2021 – #21 (Soho China)

Sold all Soho China @ HKD2.21. I sold all the shares because I was clearly wrong about the deal and that I would not have bought the shares at the current price even if I don’t have a position to start with.

I bought the position on two occasions – Live Portfolio Update – 2021 – #15 (Soho China) Live Portfolio Update – 2021 – #13 (Soho China)

The cost basis of this position is around HKD 4.3 which means a painful 50% loss!

A couple of lessons learnt:

  • This is my first unsuccessful special situation investment in the last 5 years. Despite the high probability of success, each failure carries a huge loss in the event of failure. As such, despite my four other merger arb successes this year, this one loss is enough to negate all those profits. This is a good reminder that merger arbs are fundamentally not the best investment opportunities since they have small upside and huge downside. So it is a game of not making mistakes and keeping the success rate high. It is another reminder that I should keep the average special situation position small to let diversification do its magic and achieve a reasonable average return
  • Clearly, I made a mistake by not paying as much attention to the “political” risk of the founder and instead focus too much on the business logic of the deal. In hindsight, if I had done more work on the founder, then I would have concluded that the situation was not analysable and hence belongs in the too-hard pile
  • Going forward, I will be much more careful when dealing with private enterprises in China

I will continue to invest in merger arbs if I am capable of assessing the odds and the return satisfactory.

Live Portfolio Update – 2021 – #20 (Kuaishou)

Added 0.5% to Kuaishou @ HKD 102.

This is a tough one. Kuaishou is the number two player in the short video sector and lags behind Douyin in almost any operating metrics. Usually, it is not a good idea to invest in the number two player in the Internet sector with strong winner-take-all or winner-take-most dynamics. In the case of Kuaishou, I think it is still a differentiated short video platform where it has ~30% of private traffic versus almost zero private traffic at Douyin. Douyin distributes the content from creators to maximise users’ video consumption while Kuaishou makes a conscious effort to allow creators to build stronger relationships with their fans. Kuaishou does this by placing more weight on followership-based traffic distribution as opposed to Douyin’s algorithm-driven content distribution which optimises user time spend, retention rate and active daily user size on the Douyin platform.

Kuaishou’s management team, while less aggressive than those at Bytedance, has proven their appetite to evolve with the industry. It took them a while to recognise the power of Douyin’s algorithm-based distribution model and adapt accordingly. They also aggressively expanded to compete with Bytedance in the international market. The founders at Kuaishou seem to get the balance between the pursuit of efficiency and user interests. But one could still argue they have been too slow to react and in such a competitive market, one cannot afford to be slow.

I think at this valuation, the upside to Kuaishou in the event that SV turns out to be a duopoly in China is at least 3x. But I could be wrong and the risks are numerous. If it turns out that content creators are indeed commodities, then Douyin might actually become a winner-take-all market.

Live Portfolio Update – 2021 – #19 (Netease)

Bought a 2% position in Netease @HKD 149 per share.

In my mind, Netease is almost the perfect game company – a DNA of game as a service, a healthy stream of cashflow from existing game portfolio and a proven game development track record. See previous post on game as a service vs game as a product.

To translate the above business characteristics into cashflow terms, it means that Netease’s existing games can generate stable and even slightly growing cashflow for a very long period of time. And Netease’s ability to develop new games only adds to this base of stable cashflow.

Unlike many successful game companies, Netease’s founder, Ding Lei, has proven to be a very capable capital allocator who owns 50% of the company. Few Chinese internet companies pay regular dividends and maintain a single share class structure like Netease. What’s even more impressive is that Ding Lei has successfully incubated new businesses beyond gaming with varying degrees of success. Netease cloud music is the best online music platform in China while Youdao (spun off to list in US) is the most popular dictionary app in China. Ding Lei’s forray into e-commerce has been less impressive but it managed to recoup investment cost by selling the business to Alibaba almost at cost in 2018.

Going forward, Netease’s next leg of growth could come from expanding its gaming business globally. It would take a long time but I think Netease can eventually crack it.

There are a lot of concerns about gaming regulation in China. My view is that 1) shorter term, minor gaming revenue is only low single percentage of Netease revenue 2) I am confident that minors will embrace gaming as they grow older because gaming as an entertainment format is superior. By regulating one of the major negative externalities of gaming – minor addiction to gaming, it is in fact more sustainable for the industry long term.

At roughly, Netease is roughly at fair value at 20x core gaming earnings and growing earnings at a rate of 10%. This is a business that I would love to buy more at lower valuation

Live Portfolio Update – 2021 – #18 (Nintendo)

Added 2% to Nintendo @ JPY 52950

Q1 2021 results show a YoY decline and the market seem to price in a steady decline in earnings from here. However, I believe that not only can Nintendo earn stable earnings from here, it can grow its earnings slowly but steadily from here. I have a fundamentally different perspective on the nature of Nintendo’s business franchise versus the market.

As discussed before Nintendo Investment Update – The End of the Beginning, I believe that the Switch ecosystem is very healthy and given the increasing proportion of online games, the game revenue base in increasingly recurring and a console upgrade cycle would NOT require Switch install base to start from zero again!

Drivers for earnings growth – more 3rd party games + more long lifecycle F2P games + more membership revenue + growing install base

Another Investment Mistake – AddCN

While it never feels good to write about investment mistakes, I have found that the process of revisiting the initial investment case and evaluating the decision-making process is critical for the advancement of my investing skillset. So let me share the mistakes that I have made with AddCN and why I have sold a big chunk of the position but still kept some. See Live Portfolio Update – 2021 – #17 (AddCN)

I first invested in AddCN (an online classified business in Taiwan) in Jun 2018 and my original investment thesis is based on my conviction in online classified businesses being high-quality businesses with ample pricing power. It was trading around 20x p/e and paying a 5% dividend yield. I believed that it could grow its earnings around 10% per year and hence the 20x P/E valuation is pretty cheap. 3 years on, AddCN is trading on 16x P/E and still paying 5% dividend yield. And its earnings only grew 5% between 2018 and 2020 and hence the multiple derating.

My average purchase price for AddCN is around TWD 261 and if I include all the dividends received, then the investment is flat over the 3 years. For a 10% position to be flat for 3 years, the opportunity cost is huge. Overall the investment performance has been very disappointing!

The biggest mistake that I made is to assume that online classified businesses are high-quality and overestimated the quality of growth derived from price increases. For a very long period of time, successful online classified platforms, such as REA Group in Australia, Rightmove in the UK and Seek in Australia, has been the holy grail of great businesses – high margin, strong pricing power, capital-light and hence very high free cash flow generation. However, price increases of the online classified platforms come at a cost of reduced RoI for the customer and hence the very act of increasing price in my view compromises the long term viability of the business since there is no incremental value created for the customers (typically customers are property agents, used car dealers and corporates posting job vacancies).

The rise of vertically integrated transactional platforms such as Carvana, Opendoor and Beike will slowly replace pure information-based online classified platforms such as AddCN. Though this transition could happen at very different paces in different geographies.

In short, my mistake has been to overpay for AddCN because I did not fully recognise the vulnerabilities of online classified platforms at the time of investment. This is a case of not properly weighing the risks.

In the case of AddCN, the transition from marketplace platforms to transaction platforms will take many years to unfold in Taiwan. At 16x P/E, AddCN is quite fairly valued given its 5-10% growth rate and defensible position as the leading property portal in Taiwan and hence I have not fully exited AddCN. If I found better ideas, I would not hesitate to sell AddCN completely.

Live Portfolio – 1H 2021 Review

The portfolio delivered a net return of 0.5%[1] for the first half of 2021 while FTSE Global All Cap index’s return is 12.7% during the same period. Our portfolio’s cumulative return since 2016 is 101% while the above-mentioned index’s cumulative return is 105%. Cash is 18% of the portfolio.

1H 2021 Portfolio Performance

In the past six months, I exited 51jobs and Avanza. The privatisation deal for 51jobs was finalised in June 2021 and we netted 12% profit over 9 months. We have 2 other workout situations within the portfolio comprising 9.5% weight. Works-out is a way to earn better-than-cash returns with a short duration and less affected by the general market price fluctuations. I will always prefer owning great businesses at a reasonable valuation over work-outs but in times where I cannot find sufficient such investment ideas, then work-out is often the next best option.

Unfortunately, we are no longer partners in Avanza’s growth journey because Avanza’s valuation was so expensive that the prospective return on a 5-year horizon is very likely to be negative. Operationally, Avanza is firing on all cylinders and I am very confident that they will continue to do well. If valuation becomes reasonable again, I would definitely like to own Avanza again.

We became a partner to a very high-quality business in China – Tencent. Tencent is a company that defies categorisation. It is so many things all at once – gaming, social network, fintech, media and cloud. Despite being one of the largest companies globally,  it still has a very long growth runway ahead and is likely to offer an excellent risk-adjusted return. Tencent owns WeChat which is in my mind a modern utility in the digital life of Chinese people. On one hand, the dominance of WeChat provides Tencent with predictable long term earnings growth but on the other hand, this same dominance also raises the spectre of anti-monopoly regulations. Tencent has leverage WeChat to weaken competitors by denying Bytedance and Alibaba access to China’s largest social network. In the not too distant future, Tencent is very likely to open up WeChat ecosystem to its competitors at the request of regulators and hopefully, this should be enough to satisfy the regulators. However, there is always a risk that Tencent would be forced to spin-off WeChat due to its position as a natural monopoly to truly ensure equal access to all stakeholders. At this moment, this risk seems small but significant. I take comfort in the fact that historically Tencent has been a responsible corporate citizen that cares deeply about its users and the wider society. For example, Tencent has been very restrained in terms of monetisation on WeChat while investing heavily into the digitalisation of industrial companies through cloud computing, enterprise software solutions and building customer relationship management systems on WeChat for corporates and SMEs. Going forward, Tencent is under increasing pressure to prove that it can create more value for society than it extracts from society. And Tencent’s track record suggests that they have a very good chance of creating value for society through constant innovations.

[1] Assuming a fee structure of 1) no management fee, and 2) a 20% performance fee above 5% threshold

Being Interesting or Making Money

This post’s title is a wink at the book “Being Right or Making Money” (never read the book, yet like the title).

 

It is important, yet hard to draw correct investment lessons from experience.

I think I recently found a personal bias in the last few years. I unduly focused on finding investments with *multiple* *interesting* thesis points.

Take GOOG as a counter point. For the vast majority of time, GOOG has been an analyst’s favorite, with “buys” outnumbering “sells” by a wide margin.

Yet GOOG holders are making money hand over fist time and time again.

I believe the main investment thesis on GOOG hasn’t changed much since IPO. The main thesis point is simply the “positive feedback loop”, i.e. better AI algorithms draw in more users. Users generate useful feedback to improve those same algorithms. Rinse, repeat. In my opinion, GOOG has always been the AI and large datasets company.

I have followed GOOG for a long time. It was the first company I wanted to buy as a young engineering student (my father stopped me) after reading “The Google Story”.

Once I gained control over my savings, I always felt I did not have an edge vs consensus. Everything I know about the company is public knowledge. Most insights are scattered around.

There is nothing interesting for me to write on GOOG, everything interesting has already been written by greater investors and greater writers!

Is it possible the edge here is to understand the “positive feedback loop” thesis point, given the AI dynamic, is not “very, very important”, but instead very, very, very, very, very, very, very* important?

Assigning outsized weights to thesis points does not make for very interesting blog posts.

The above lesson was largely learned by having worked for a great portfolio manager who fostered the ability, I believe, to spot super important thesis points.

Let me know what you think.

I believe FB is in the same boat (biggest network reinforced by AI = unprecedented). There might be a larger binary risk involved, but on a risk adjusted basis the low valuation seems compelling.

Disclosure: Long GOOG, FB.

TC

*aka high conviction on super durable long runway growth. Is this what John Huber means when he wrote on Facebook “the best business model ever created”.

As I’ve outlined before, there is no informational edge in most large-cap stocks, but there absolutely
is a time-horizon edge for those who are willing to thoughtfully analyze what most people want to
avoid out of fear of what the next year might look like.

I guess great investors who sometimes write 1 pager theses, like Mr. Huber, are telling us to focus on their thesis points as being “very, very, very, very, very, very, very important”.

Aug 2021 Games Workshop Investment Memo

Investment Action: Do Nothing

Games Workshop (GW) continues to be my largest investment at a 20% portfolio weight. For the 12 months ending May 2021, Games Workshop revenue and net profit reached GBP 353.2m and GBP 122m. This represented year-on-year growth of 31.6% and 71.1% respectively. When I first invested in Games Workshop in 2018, the net profit was GBP 59.6m. The company compounded earnings at a rate of 22% for the last 4 years. And I believe that the company can continue to grow earnings by around 15% per year for the next 5 years due to 1) continued geographic expansion 2) bringing Warhammer IP to a larger audience via animations, video games, novels, comics, and live actions series.

In 2019, I wrote in Games Workshop – An Investment Fantasy:

“Despite paying a hefty multiple of 24x 2020 earnings, I believe we are getting a fantastic bargain because this is a very high-quality franchise with strong growth prospects, under-appreciated IP monetisation potential and strong corporate culture that reinforces its moat with time.”

And GW continues to look like a fantastic bargain today especially as the prospect of Warhammer IP becoming a world-class media franchise is looking promising.

Consider the three categories of Warhammer fan base – Collectors, Gamers, and IP fans. Collectors and Gamers are monetized via miniature sales. The IP fans might purchase Warhammer novels published by Black Library (Games Workshop’s publishing arm) but the revenue generated is not material. Traditionally, the rich characters and narratives of Warhammer are more about creating long-term stickiness and loyalty of the existing fan base rather than recruiting new fans. I believe this is changing in a big way with Games Workshop’s two-pronged IP strategy. In a recent interview, Jon Gillard explained this two-pronged IP strategy:

“Firstly, there is already a lot of great fan content out there. Some of that is being brought in-house to sit alongside other internally generated animation projects. All this content will be aimed squarely at “Warhammer” fans and will provide levels of depth and nuance for this highly “Warhammer” savvy group. Secondly, in licensing, we will develop big content projects in partnership with companies worldwide that we expect to appeal to that broader audience that is less knowledgeable and will need more accessible offerings.”

GW’s recently announced subscription program called Warhammer Plus, which bundles the above-mentioned Warhammer animation, miniatures, and other ancillary contents, is clearly targeting the core Warhammer fans. Warhammer Plus is about increasing the core fan base’s average revenue per user and probably also helps with long-term retention.

GW is collaborating with Big Light Production to turn the Eisenhorn novel into a live-action series that is going to be released on Netflix. This is meant to be accessible and bring Warhammer IP to a large audience. In the same way that the recent adaptation of Witcher into a Netflix series helped to introduce many audiences to the video game of Witcher 3, some of the audience will be eventually converted into miniature-purchasing fans which is where the real money is made.

The two-pronged IP strategy will increase average revenue per existing fan while also introducing Warhammer to a larger audience which can help to lower acquisition cost per fan. GW still has a very long growth runway ahead and can grow earnings at 15% per year with a high degree of certainty. GW is my largest investment because it has the lowest probability of permanent impairment despite the rich headline valuation.

Secular growth of hobby games

It seems increasingly clear that Games Workshop is a beneficiary of the secular growth of the hobby games sector. Hobby Games, which includes board games, trading card games, role-playing games, and miniature games, typically require the players to meet in a physical space and involve physical objects such as cards, miniatures, and boards. This is clearly the opposite of video games where gamers interact in a virtual world. For a long time, many believed that video games are permanently taking time and money away from hobby games.  As such, the revival of hobby games in recent years has taken many industry insiders by surprise. The growth of hobby games remains robust despite the impact of COVID-19. Trading card games, such as Magic and Pokemon, are seeing very impressive revenue growth rates in excess of 20% in 2020. According to ICV2 (a hobby game trade magazine), the US hobby game sector generated USD 2bn of revenue in 2020 which was up 21% versus 2019 and up almost 100% versus 2015. In China, live-action role-playing games are becoming a huge hit with Chinese youth.

Operational Updates

The pandemic has revealed the extent of the fans’ emotional connection with Warhammer because Games Workshop sold more miniatures even as most fans cannot meet to play the tabletop game. It seems to suggest that the collecting and painting aspects of the hobby are much more dominant than I previously expected. The pandemic also revealed the bottlenecks in Games Workshop’s manufacturing and supply chain capabilities. For most of part of the first half of 2021, Games Workshop could not meet the customer demand due to manufacturing and supply chain limitations. However, the company is putting plans to steadily expand manufacturing capacity at the Nottingham site and building warehouses. I expect the manufacturing and supply chain bottleneck to be resolved by 2022.

Games Workshop has three sales channels – third-party trade channels, self-operated retail stores, and online sales. Sales from self-operated retail stores reduced significantly due to COVID-19 restrictions, and only accounted for 20% of total sales in FY 2021 which was down from 34% in FY 2019. The reduction in retail store sales was more than compensated by an increase in online sales as online sales accounted for 25% of total sales in FY 2021 compared with 18.4% in FY 2019. Physical stores are a very important recruitment channel and provide physical spaces for Warhammer fans to play tabletop games. Hence, I expect retail store sales to steadily recover as COVID-10 restrictions ease. While online sales might slightly decline as a percentage of total sales, it would remain important for fans who do not have easy access to offline stores.

Live Portfolio Update – 2021 – #16 (Beijing Capital Land)

Investment Action: buy 3% position in Beijing Capital Land @HKD2.5 per share

Offer price: HKD 2.8

Current share price: HKD 2.5

Upside: 12%

Probability of success: 90%

Beijing Capital Land is a SOE real estate developer that is majority owned by the Beijing Capital Group which is in turn fully owned by Beijing SASAC (SASAC is the department that manages state own assets). And it is currently being privatised by Beijing Capital Group through a cash offer of HKD 2.8 per H share. In short, Beijing city government is buying the minority shareholders of Beijing Capital Land.

Beijing Capital Land was first listed in 2003 in HK stock exchange and its total return since IPO reflects the quality of the business. In 2020, Chinese government started to cap the leverage employed by real estate developers through three measures – 1) liability to asset ratio, 2) debt to equity ratio and 3) Cash to short term debt ratio. If the real estate developer is determined to be too leveraged according to the three metrics stated above, then the developer cannot increase total leverage. In essence this is very similar to the prudential regulation faced by banks. This sparked off a wave of either equity issuance, asset sales and/or price discount on new home projects to recoup cash in the Chinese real estate sector.

Unfortunately for Beijing Capital Land, it does not meet the debt to equity ratio and cash to short term debt ratio. Within this context, the parent company is privatizing Beijing Capital Land such that it would be in a better position to inject equity into the developer and meet the regulatory standard.

Despite the offer price of HKD 2.8 carrying a whopping 62% premium over the last trading price before announcement, the offer price implies a price to book ratio of 38%. So valuation also make sense for Beijing Capital Group

And the deal would require ~HKD 5.3bn of cash which Beijing Capital Group can easily finance out of its own balance sheet.

Live Portfolio Update – 2021 – #15 (Soho China)

Investment Action: Added 0.5% to Soho China @ HKD4.2 as the spread to offer price has widened to almost 20% since my first purchase a few weeks back.

There seems to be some delay in the deal due to the need to get approval from SAMR which is the Chinese regulator for market competition. Buying a few office buildings should not trigger any concerns but nonetheless, it is critical to get their seal of approval. Seems like a good opportunity to add.

Live Portfolio Update – 2021 – #13 (Soho China)

Bought a 3% position in Soho China at HKD 4.45. This is a simple merger arb and I see it as a better-than-cash investment opportunity.

Blackstone is making an all-cash offer for Soho China at HKD 5 per share which translates into an 11% upside from current share price of HKD 4.5.

Time to closure: I expect the deal to complete within 8 months which gives a pretty decent 15+% IRR. There is some risk that this deal could take longer

Probability of Success: 90%.

  • Blackstone is a reputable real estate PE firm and the founders of Soho China are very well-known figures within the Chinese business community. I think it is very unlikely for the deal to fall apart.
  • The price seems to be fair for both parties. Blackstone can see some upside from this transaction as there should be quite some room to improve rental income by improving occupancy rate and general recovery from COVID-19. And maybe there is a little upside from rerating from cap rate. The current cost of debt is ~5% and Blackstone could probably lower it once they gain control. Finally there should be some 2-3% of the like-for-like rental price growth annually
  • For Mr and Mrs Pan, this is a reasonable valuation for them to exit the business. Building office space seems to be a very structurally challenging business in China due to intense competition and the rise of shared working space. Soho China’s premium office space positioning has helped to insulate them from the most intense price competition.
  • Given that it seems like a fair deal, then both sides should be motivated to close this transaction.
  • I don’t see material regulatory issues as Soho China’s market share is low and office space is not a sensitive sector
  • There is a general risk of unanticipated events happening and I am not too intimate with the parties involved

While the probability of failure is low at 10%, the downside from the deal not going through is very high at over 50% using the pre-announcement share price of HKD 2-3.

All things considered, I am only committing 3% capital as I would not consider Soho China a favorable long-term investment in the case of deal failure.

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