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.
- Don’t give too much credit to CEO / Chairman just because they can write fantastic annual letters
- 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
- Even when the manager is heavily invested in the company, the ego can still get in the way such that mistakes are not corrected
- Human irrationality is more powerful than you might think
- 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.