Business

In Search of Mindful Compounders

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Note: It’s a republish of the General & Market Commentary section of 2020 Q3 Letter, for easier reference and access.

This pursuit started from studying my own largest omission mistakes (i.e. failed to buy the companies when I could have), namely Amazon, Microsoft (post Satya Nadella), Netflix. But before we dive in, I need to clarify what “mindful compounder” means. I see “compounder” as who persistently create value (not monetary value alone) for all stakeholders across the value chain, and “mindful” is a generalization of many traits I look for Tao & Commander factor, e.g. mission driven, purposeful, rationality, deep thinking & high awareness. (see more in my investment process post[1]). In all cases, I have identified the managers of these companies as mindful leaders yet didn’t buy for the fear of market being already efficient in pricing these mega cap stocks.

But how efficient has Mr. Market been in pricing the value of these companies really? Below I draw the time series of valuation (TTM P/S ratio), and annualized compounding return to date (i.e. if holding form that point of time to 9/30/2020). I excluded annualized return for recent 2 years since they are not representative for the short history.

One clear lesson to be learn here is that market has been far from efficient in evaluating the intrinsic value of these companies. Taking Amazon for example, the worst time to buy it was in January 2000 when it was priced at 17 P/S ratio, but you would still achieve 20+% annual compounding return if you hold till now. Buying it any other time later than 2004 and hold it till now would give well above 30% annual return! Obviously, valuation still matters, but the worst scenario of 20% is far cry from an efficient market return over 20 years. So, the market must have missed something! Luckily, all three companies have long history for me to study patterns that can help identify value earlier.

The “Stumbled-Upon” Quantum Leaps

The first important pattern is that none of them relied on a single product/service to achieve the substantial value compounding. As old businesses mature, all these companies in their lives experienced some pivotal “quantum leaps” expanding to new products/services, which ultimately contribute heavily to its long-term value but was not fully appreciated by the time. With few exceptions, the leaders later would admit that the leap was not by design, or at least that they didn’t foresee the full potential. For example, Netflix had two major pivots from DVD renting, to streaming & to original content. Microsoft also made a major pivot after Nadella took the helm to “cloud & open source first”. Amazon’s AWS was an internal tool built out of its own frustration of its ability to launch new projects/applications, later became a $40 billion annual run rate revenue monster!

Surrogation Bias & First Principle

All companies try to “leap” too, but more often they end with disappointment. I think what makes mentioned 3 compounders more successful in making such leaps is their mindfulness. Case studies of the failed attempts point to a pervasive, yet understudied bias – Surrogation, whereby the measure of a construct of interest evolve to replace the construct itself. Take Wells Fargo’s fake account scandal as example[2], the management initially use cross selling metrics to measure its relationship with clients. However overtime, subsequent executives started to believe the cross selling is the strategical goal (rather than client relationships), leading to the now-infamous mantra – “Eight is great” (to have 8 Wells Fargo products per customer). What made things worse is management started to tie incentives to this single metric for front line bankers, which ultimately led to faking accounts. Such misalignment is detrimental for company value.

On the other hand, all three mentioned companies deeply embed first principle in their operation to overcome surrogation. Amazon provides probably the best example, from Bezos’ first shareholder letter, Amazon has been obsessively following a “customer-centric” philosophy and repeatedly use this qualitative principle to guide quantitative measures & decision making. For example, Amazon started very early to not only use GMV & MAU to define their performance, but also added repeating customer orders because it was a better way to measure the stickiness, or value created for customers. Pinduoduo (one of our current holdings) is another example in putting a qualitative Polaris for Social E-Commerce (To focus on user engagement) around any measurements. Chairman Colin Huang in many occasions dismissed sell side analysts’ question regarding its ARPU trend & guidance saying:

… raising ARPU is not part of our management’s KPI, but I think it will be a natural result as the users’ engagement increases over time…

– Colin Huang, PDD 2020 Q1 Earnings Call

Also, regarding the measurement of users’ engagement, it uses a unique and well-thought-through metric – MAU/Annual Active Buyers. It is like Amazon’s idea of repeating customers orders, but more consistent in a normalized % form.

Radical & Prescient Decision Making

Another common theme I observed from mentioned companies is that on top of the first principle thinking, management tend to make seemingly radical decisions later proven prescient. Microsoft’s Satya Nadella made an impressive example[3], especially considering his soft-speaking personality (e.g. he’s never seen “upset, raising voices or firing off angry email” by colleagues). Yet he demonstrated assertion in many big decisions even early in his tenure as CEO. For example, Nadella decided to write off $7.6 billion from Nokia purchase first year in 2015 and to terminate its Windows division, which was split into Azure & Office divisions in 2016. Additionally, during the agonizing Windows to Azure reorganization (which one executive called “pulling fingernails”), Nadella showed his exceptional ability to make aggressive changes with little drama.

Netflix’s Reed Hastings, a half-mentor of Nadella (as board of Microsoft), is a hallmark of such decision-making ability[4]. Although the decision of pivoting to streaming & original content are both monumental, I think the most radical & prescient decision may be the one he made in earlier year to call off its streaming hardware right before its launch. I was December 2007 and Netflix has been exploring variety of new business models as its legacy DVD renting line matures. A team of about 20 had been working around the clock for years on a project coded “Griffin”. It was so close to the launch that marketing materials had been printed, advertisements were being shot, and Foxconn, the manufacturing partner, was ready to kick off production. Yet to the surprise of all the insiders, Hastings decided to kill it (subsequently it was spun off and became Roku). The magnitude of this decision is now much more clear, had Hastings chosen to pivot to the hardware business, they would compete with all other hardware players (TVs, Apple etc.) and wouldn’t be able to consolidate the demand side which is a conner stone of its later licensing streaming flying wheel. Roku, even at today’s steep valuation, would be worth 1/10 of the current Netflix. According to one inside source, Hastings explained this hard decision in a very simple but vivid way:

“I want to be able to call Steve Jobs and talk to him about putting Netflix on Apple TV, but if I’m making my own hardware, Steve’s not going to take my call.”

[1] Tao Value Investment Process: https://taovalue.net/2017/07/17/sun-tzus-five-factors-business-analysis-framework/

[2] Don’t Let Metrics Undermine Your Business, Harvard Business Review, https://hbr.org/2019/09/dont-let-metrics-undermine-your-business

[3] The Most Valuable Company (for Now) Is Having a Nadellaissance https://www.bloomberg.com/news/features/2019-05-02/satya-nadella-remade-microsoft-as-world-s-most-valuable-company

[4] Inside Netflix’s Project Griffin: The Forgotten History Of Roku Under Reed Hastings https://www.fastcompany.com/3004709/inside-netflixs-project-griffin-forgotten-history-roku-under-reed-hastings

China Internet Report 2019

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I want to share a great overview study of China tech industry landscape of 2019 by South China Morning Post & Abacus. I think the advanced AI usage by Chinese tech companies are highly under-appreciated by the outside world.

This study has many live evidences of what Kai-Fu Lee wrote/predicted in his latest book “AI Superpowers: China, Silicon Valley, and the New World Order” which I recently just finished. Highly recommended and will try to do a review later.

Another interesting trend particularly interests me is the integration of live streaming and shopping. I think this model (temporarily dubbed it as “QVC on steroid” for the sake of western world readers’ familiarity) has huge potential and I plan to study it more.

PDF can be downloaded:Download

Incentive System Evaluation – a Case Study of Coty

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Coty is a new position last quarter. As mentioned in my Q3 letter, I think the “system” factor of Coty is very impressive. As an effort to document my own learning as well as knowledge sharing, I here formalize my notes. It’s not intended as a support for my judgement, rather I think it would be beneficial in general for anyone who involves in a principal-agent situation (e.g. board of directors, entrepreneurs, etc.) for designing or assessing incentive systems.

Investing community generally agree that a management with owner mindset is preferred. But how exactly could one evaluate “owner mindset”? One way is to talk to the management in person and make assessment qualitatively, however that’s not possible for all shareholders. CEOs typically are also very good at marketing themselves, which adds another layer of uncertainty. These are the reasons why some investors prefer founder CEOs, who are inherently owners.

Coty’s incentive system has following uncommon designs based on a heavy ownership philosophy.

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All About Moats – Book Notes of Pat Dorsey’s Two Books

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If you haven’t heard of Pat Dorsey, here is a quick intro for you: He started his career at Morningstar as a sell side analyst, moved up to the head of the reach team in a few year and stayed there for about a decade. After leaving Morningstar, he started his own firm Dorsey Asset Management in 2014. Although his track record as a fund manager is yet to be tested, I found his books very insightful, especially for firm’s economic moat/competitiveness study.

 

Dorsey is the author of below two books:

Image result for The Five Rules for Successful Stock InvestingImage result for The Little Book that Builds Wealth

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Long Term Management Against Long Term Investing? – Thoughts on Activism and Short-termism

taovalue Business, Corporate Governance, Philosophy , , , , , , , , , , , , , ,

Corporate governance is complicated, and I usually don’t like to think too much about it because it’s just hard. However, I recently came across two very interesting and insightful articles, one from Harvard Business Review and the other from Atlantic with conclusion against each other on Activism. I hope this thinking process will be beneficial to me, and to my readers, in building up knowledge base and investment philosophy.

 

First, let’s go through a quick summary of the articles.

HBR, in their 2017 May-June magazine, published a package of articles titled “Managing for the long term” [link here], with a core article of “The Error at the Heart of Corporate Leadership” written by two well-regarded HBS professors Joseph Bower and Lynn Paine. The article started with the Valeant-Allergan acquisition drama involving Bill Ackman (by the way, I agree that Valeant was a questionable company which adopted questionable business practices and didn’t create social value. So I am with Allergan and this article on this point), and followed by challenges on the most widely used agency-based model in context of the corporate governance and proposed a new entity-based model which essentially proposes to gives company more discretion (i.e. power) by loosening them from the agent-principal handcuff. A quick summary chart exempted from the article below.

HBR_EntityModels

This article is thoroughly contemplated and aimed justifiably at the core issue of the capital market – Short-termism, however may have gone too far to directly link Short-termism to Activism. Thus, I have some reservation on some minor points, mainly due to this linkage (which could be a separate write-up, so I won’t elaborate here), but overall think it’s a great step to tackle such a socially important issue and think this new model may have profound impact on future corporate governance.

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Indirect Hard Lesson – Baker Street Capital

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The more hard lessons you can learn vicariously rather than through your own hard experience, the better.

– Charlie Munger

I recently came across this Forbes article [The 34-Year-Old Hedge Fund Manager Who Bet Everything On A Stock That Tanked] discussing about a doomed hedge fund due to heavy concentrated bets. In short, the fund invested over 85% of AUM in a single name, Walter Investment Management [WAC], and the stock suffered a 95% slump since its investment in 2015. Per this fund’s SEC 13F filing, WAC seems to be the only US long position it holds currently. Given the significant size and the drastic drop of stock price, regardless other non-US longs or other shorts, the WAC position will possibly wipe the whole fund out.

Out of curiosity, I further researched Baker Street and its founder Vadim Perelman. It appears that Perelman is a strict value investor, following legendary investors like Warren Buffett, Howard Marks & Seth Klarman’s doctrines closely. Before the WAC position, Baker Street had also played a concentrated bet on Sears Holdings (SHLD). More detailed info can be found on this Barron’s article.

Some resources and interesting reads:

Based on these writings, Perelman certainly appears as a talented and diligent investor (also with sense of humor for the sake of the Berkshire joke). However Buffett would hardly approve his approach as intelligent investing (remember the oracle of Omaha’s 2 rules: Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.) This drives me to think what went wrong to lead a talented value minded investor to such a flunk.

Trying to put myself in Perelman’s shoes, here are my further thoughts and some lessons I learned from this case study:

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What do you need to know about Internet Finance in China

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You’ve heard “Internet Finance” is booming in China, but what exactly is it? It all began from the inception of Alibaba’s Yu’E Bao (literally means balance treasure) in 2013. Metaphorically speaking, it’s like your Paypal account balance which is as liquid as your checking account, but EBay is paying you 5% interest yearly. Wait, what?! I know what you are thinking, no, I did NOT miss a decimal point. Since I was away from the country for years, I haven’t really paid close attention to this business model until recently.

It was about two months ago, one family friend from China asked me about investing in real estate in US. A REIT name – Inland Real Estate Corporation [NYSE: IRC] looked very attractive to me then and I recommended it to him (see my older post here). The company then hit the 52 week low at around $8 with yield of 6~% and FFO multiple of 8, and seems to be oversold compared to its still solid property portfolio and operation. As we are speaking now, it was announced to be bought private by DRA Advisor in a $2.3 million deal, paying $10.6 per share. However, my friend decided to pass on this would-be 20+% in two months opportunity because he wasn’t interested in investing in a non-principal-guaranteed asset for 6% yield. “I’d better off put my money in my XX Bao, which gives me up to 10%.” he said. Well, that is very impressive, especially they “guarantee” principal, so basically making it a “risk free” investment. I then asked two question: who are they, and what type of asset they have to invest in to give you that return? “I don’t know, why do I care when they guarantee my principal?” replied my friend.

After some research, I think I find some clue.

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How Far is Too Far: Tesla’s Valuation

taovalue Business, Investing

Since the first positive earning was posted in the most recent quarter, Tesla‘s stock price has been on a rocket, tripling from around $50 to a historical high level of $150. I’ve been following Tesla since 09, long before it even went public, because I did a valuation on it as a class project. I remember I got a 30ish price from a multi stages DCF model, which is not too far from its IPO price later. Did I buy any of it afterwards? Sadly no.

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Deadly Loans: Why China’s ‘Shadow’ Capital Market Persists

taovalue Business, China

[From TeaLeafNation]

Zeng Chengjie, a Chinese businessman from Hunan province sentenced to death for charges of illegal fundraising, was recently executed without authorities notifying his family, a lapse which sparked considerable backlash among Chinese Internet users. Zeng was not the first entrepreneur to receive a death sentence for financial crimes: Wu Ying, a businesswoman from Zhejiang province, was sentenced to death for defrauding investors of over 300 million RMB (about US$49 million) just several years ago. Unlike Zeng, her sentence was commuted to ‘death with a two-year reprieve,’ which in China’s judicial system is usually then commuted to a life sentence after two years. Yet both cases show that harsh sentences often await those convicted of economic crimes in China, without regard to the flaws in the system that have led to their actions in the first place.

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