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.
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.
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.
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
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
The portfolio delivered a net return of 0.5% 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.
 Assuming a fee structure of 1) no management fee, and 2) a 20% performance fee above 5% threshold
Investment Action: buy 3% position in Beijing Capital Land @HKD2.5 per share
Offer price: HKD 2.8
Current share price: HKD 2.5
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.
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.
Bought a 3% position in Kuaishou at an average price of HKD 193 per share.
I believe that short video platform is a structurally good business with an excellent LTV / CAC ratio. Kuaishou is the second-largest short video platform in China behind Douyin (TikTok). Unlike long video platforms like Netflix, short video platforms have very little content cost due to a high degree of UGC and PUGC content. On the monetization side, short video platforms can make money by 1) ads, 2) live-streaming, and 3) eCommerce. In the future, I believe short video platforms can explore even more monetization opportunities through gaming and local services.
Short video platform’s favourable LTV / CAC ratio stems from 1) user behaviour, 2) product format and 3) AI-first product
Even though Kuaishou is behind Douyin in China, I believe Kuaishou’s China business is more like a community of KoL and users whereas Douyin treats KoL as commodity content suppliers. User experience on Kuaishou is more akin to going to a music festival where the music fans go there to see their favourite band whereas the Douyin user experience is similar to listening to a very smart radio programme that only plays music that you like.
I think both Kuaishou and Douyin would do well and continue to take time share in China.
That said, an investment in Kuaishou is very risky and many things can go wrong – competition, execution, new verticals didnt work out, international growth sizzle out. But the upside more than compensates for the downside at the current valuation.
I think Kuaishou could make a net profit of RMB 50-100bn in 2025 in base case and probably still have a respectable growth of 20+%. Hence the valuation feels reasonable to me.
I might write a full post on Kuaishou at some point in the future.
Nintendo reported, in my view, excellent results for the Fiscal Year (FY) 2021 and it is a real pleasure to be a business owner (and customer) in this fantastic business.
My core investment thesis for Nintendo remains the same: Nintendo Switch is a sustainable gaming platform because it is anchored by Nintendo’s world-class games and supported by a mix of long life-cycle games and new games by both Nintendo and third-party game developers. Nintendo Switch is in a positive feedback loop now where its large install base is attracting more third-party game developers which in turn attract more Switch buyers. If my assumption that the Switch gaming platform would defy the previous console lifecycle of peaking in year 5 and ending in year 7, then I assess Nintendo’s intrinsic value with the following factors: 1) Switch install base, 2) software revenue per install base, and 3) gamer engagement with Switch platform. Continue reading
Investment Action: Sold all Avanza shares @ SEK 304 which is roughly a 3% position now
Despite a set of very strong Q1 2021 results, I am going to sell Avanza shares and very unfortunately no longer be part of Avanza’s growth journey from here. I sold a large chunk of the Avanza investment in Oct 2020 at around SEK 185 and clearly my ability to time the market is terrible because Avanza shares trade around SEK 300.
The main reason for selling is the same as before: Avanza’s earning is cyclically high due to higher than usual trading activity from its customers (mostly retail customers). Continue reading