Opportunities in Asia: September 2018 Update

Dear investors,

The Fund returned 1.63% net in August, vs the ASX200 at 0.63%.

Afterpay launched in the United States in May, and data from independent web traffic analyzers indicates their number one source of traffic globally is now US-based Urban Outfitters. After a ~3x advance this is now our largest position, with a commensurate impact on volatility, though we have reduced our position steadily along the way.

Given the firm is executing well, and remains substantially below our valuation target, we decided not to dilute any further, and await further data on their progress in the USA, the UK and in new markets in Australia and New Zealand.

Rising US Dollar and opportunities in Asia

The most striking feature of markets this year has been the outperformance of US stocks vs the rest of the world.

We have certainly not been immune from this, with most of our exposure ex-US.

Much of this is due to the rising US dollar. There are many reasons for this – rising interest rates, tax cuts, and the fact the US is simply further ahead in its cycle than the rest of the world.

Needless to say, this is causing enormous pressure on emerging markets. Companies who took out ‘cheap’ US dollar loans are now watching their leverage ratios explode, just as their economies come under pressure. The aggregated amount of this lending is quite significant, with $2.7 trillion of US dollar debt due before 2025.

For a sense of scale, US dollar loans to Turkish non-bank lenders exceeded 22% of the nation’s GDP.

These crises appear political, but we believe are at heart driven by the US dollar, compounding the effects of borrowing decisions made by corporate treasurers over the past five years.

This is a vintage macro story – US rates driving currency and causing all kinds of trouble.

Asia has been hit particularly hard, and is now as cheap as it has been in a long time. Valuations in Hong Kong and China are at levels not seen in years.

Hong Kong’s main index bottomed at 7.3x EBITDA in the depths of the financial crisis. It is now at 8.1x. We have two stocks listed in the country, AAC Technologies, the leading provider of haptics, speakers, and other components to the global smartphone industry, and Country Garden, one of Asia’s largest real estate developers, trading at 27% 2019 free cash flow yield. The rising US dollar and a trade war have pushed down valuations of both companies substantially.

Invariably, there have been babies thrown out with the bathwater. In the past, our best investments have been made at times like these, not because we have the foresight to anticipate such moves, but because we invest long-term in the best opportunities these indiscriminate sell-offs produce.

This is how things should work – global investors with broad mandates should be investing after significant sell-offs, and earn consistent premia for doing so.

Fortunately we can be highly selective in what we buy, and have limited our investments to the leading companies in each sector. For example, in the past two months we have invested in:

  1. Alibaba, China’s number one retailer (we originally purchased at $76, roughly 50% below the market)
  2. Weibo, China’s number one social network
  3. iQiyi, China’s leading video streamer.

We’ve discussed Alibaba and Weibo before, but iQiyi makes interesting case.

Without wanting to push the analogies too far, the company resembles a Chinese mix of Youtube, and Netflix, with revenue split roughly 40/40. The remainder comes from ancillary revenue streams like on-selling their own content to other firms. iQiyi has 489 million monthly active users, who generate revenue through advertising, and ~60 million subscribers who pay a monthly fee of ~US$3, roughly one quarter of the cost of Netflix.Most interestingly, subscriber growth is growing at 75% year-on-year.

Valuing these companies is hard, as both Netflix and iQiyi spend everything they can on content, and underprice their subscription costs to drive membership numbers up. While not without risk, this is a rational long-term strategy, as their expanding libraries of content offer more and more value to subscribers.

On a forward Sales to EV ratio, iQiyi is about 40% cheaper than Netflix.

As with Netflix, there is plenty of competition, with Tencent and Alibaba’s Youkou in hot pursuit. Our view is that people will be willing to subscribe to multiple streamers if each has can’t-miss programs, but be assured we are watching the competitive landscape closely.

iQiyi was only spun out of Baidu this year, and promptly tripled, then dropped 40%. We are looking through this volatility to where the company is likely to trade after multiple years of user and membership growth.

Portfolio Changes

In light of the above, we made a few important changes to our portfolio.

1. We sold out of Xero and the UK land developers. We originally bought Xero at a sales multiple of 12x. This has now expanded to 17x, and sales themselves have grown at nearly 40% per annum. This has allowed us to catch a significant movement.

Xero creates considerable value each year by signing up new customers that stay for many years, as few have the inclination to change their accounting software once it’s integrated. Xero has plenty of room to grow, and has considerable pricing power – which was why we bought it – but having reached such a nosebleed valuation, it makes sense to sell and buy cheaper companies that are growing faster. Australian tech stocks are one of the most richly valued sectors in global markets, and it was with some relief that we reduced our portfolio exposure here.

We don’t have a position, but the story of ASX-listed Jumbo is telling. In 2015 the firm had an A$14 million enterprise valuation on A$29 million of revenue. Now revenue has increased 26% to A$40 million… but the enterprise value is up 26 times. I’m sure management is bemused.

2. We allocated to iQiyi, Weibo and Alibaba, for reasons given above. We also added slightly to our Hong Kong stocks, Country Garden and AAC Technologies.

3. We added a biotechnology company growing at over 150% per annum. The firm sells genetic tests for US$1500, that cost ~$280 to run, and has barely scratched the surface of its market.

In effect, we sold Xero trading at 17x sales at 30-40% growth, and bought two companies growing faster, at nearly around a third of the sales multiple.

4. We added portfolio hedges in emerging markets.

We have conducted most of our hedging in the United States, where markets are most liquid. This was a period of outperformance of the United States, and bear markets in many places elsewhere, which squeezed us on both sides of the trade.

Going forward, we will better match our hedging with our exposure, while still maintaining our usual VIX and index protection.

Please contact me directly if you want more detailed information on our portfolio, and a sincere thank you for your support.

Best wishes Michael

Geographic Exposure

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