Investing

Quick review of Chinese Tech Stock selloff – what does Mr. Market know that you don’t

taovalue China, Data Science, Investing, Uncategorized , , , , , , , ,

Chinese tech names are hit hard in the past few months. As holders of a handful of them, I’m curious to know what Mr. Market knows about them that I don’t.

Starting with Tencent, game monetization approval is indefinitely halted, corporate structure is shaking up. Maybe that’s why it lost 38% of its value in past 180 days. How about JD? Founder CEO Richard Liu got into this sexual assault scandal. That must be why it lost 48%% of its market value. YY? Oh, that must be because the new type of short video, e.g. Douyin/Tik Tok gaining traction leading to it’s 43%% market valuation evaporation. BABA? Jack Ma retiring must lead to 34% market value drop.

Well, if they are plausible, what about BIDU, WB, NTES, MOMO, SINA, CTRP & GDS who all happened to lose 30-50% from their recent high? Are there plausible fundamental reasons to explain each of them incurring so similar negative returns? I’m sure financial journalist could help find them if they want to. However, it looks to me such synchronized movements could hardly be explained well by idiosyncratic risks. I just want to see how much these movements are synchronized (correlated), thus can be attributed to market as a whole, rather than for each specific name.

I’m a R person, and below I try to do some simple statistic summary. I also attached my R scripts in markdown file for whomever is familiar with R and may want to play around with it.

Download R Markdown Notes: Link

  • Here is how daily close price looks in past 180 trading days:20181017_1_StockCharts
  • Here is the performance and max drawdown in same period

20181017_tbl_perf

  • here is the correlation matrix & its visualization

20181017_tbl_cormat20181017_2_CorMat

All these large blue dots indicate highly correlated daily price movement between these names, as well between single names and CQQQ (a Chinese tech ETF).

  • Let’s try to do a linear regression for YY to see how we can use CQQQ’s return to explain YY’s.

First, scatterplot the return of them, the best fit line already looks positive and close to 1.

20181017_3_ScatterPlot

Based on below linear model, slope of CQQQ is highly statistically significant (p value basically is 0). In other words, CQQQ’s return has high power to explain YY’s return. Note YY is less than 3% of CQQQ’s holdings.

20181017_tbl_formula

20181017_tbl_lm

 

In conclusion, my interpretation is that Mr. Market may not know more about each of these individual company than I do, rather it may be more driven by overall fear to macro events.

Book Notes – The Outsiders

taovalue Book Notes, Investing

I recently finished William Thorndike’s book “The Outsiders – Eight Unconventional CEOs and Their Radically Rational Blueprint for Success”, and think it is a great read. As usual, I jotted down the most important lessons & thoughts to me and document them below.

To get an initial understanding of the quality of this book, it is worth mentioning the origin of this book. Thorndike is a PE investor and a founding partner of Housatonic. When he was preparing a presentation to CEOs of their portfolio companies about “what makes an exceptional CEO” circa 2004, Thorndike wanted to do a case study of Henry Singleton, whom he regarded as one of the best CEOs, with the help of a HBS second year student. From there, Thorndike and subsequent then-HBS second year students continued studying 7 more CEOs who had pass his rigorous test (beat annualized returns of both peers & Jack Welch’s GE during their tenures by large margin), one CEO a year. Note that GE during Welch’s tenure has 20~% annualized return, which itself is a very high bar. Along the way, Thorndike found striking similarities between these CEOs and decide to make a book on these traits. Here is a Harvard Business Review short podcast in 2014 about the book & its origin [Link].

TheOutsiders

Below are important points & thoughts to me:

  • How to avoid Valeant: An inversed thought, but I think this is the most important lesson/thought I have from reading this book. It’s no coincidence that so many renowned value investors (Bill Ackman, Ruane Cunniff & Goldfarb, etc.) fell for Valeant – as J. Michael Pearson basically tried to model himself to these CEOs. Ackman had a pitch presentation for Valeant with the title of “The Outsider” with explicit reference of this book and nominating Pearson to be the ninth CEO fitting this book, you can see it here [Link]. William Thorndike, during a Motley Fool interview in 2014, also called out Valeant when asked about any younger generation CEOs he liked. Below is an excerpt where Throndike compared Pearson to Malone in their “roll up” strategy. [Link]

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YY – an Under-Followed Chinese TMT Play with Margin of Safety

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YY is a Chinese video live streaming + social networking business with two main operational segments, YY Live (the general entertainment content streaming, a loose equivalent of Periscope) and Huya (Gaming content streaming, an equivalent of Twitch). Its share has risen 135% YTD and valuation moved from a dirt cheap 11 trailing P/E by 2016 to a less cheap trailing 16 P/E (still cheap compared to other Chinese Tech peers), so why I am still interested in this name?

In short, a debt-free cash-gushing main business poised to take more market share as the general entertainment streaming market start to mature and consolidate, plus a fast growing gaming/e-sports streaming platform close to turn profitable and filing IPO in a favorable secular tailwind should warrant a market average valuation.  In addition, I noticed both platforms achieved market leading positions without promotion and successfully fended off competitors who tried to copy their business model. Add to it, YY has a deep-thinking founder-CEO with some track records of continuous innovation in fast changing market environment. All in all, this is something I think should be priced at a premium to market. My neutral assumption based valuation shows there still could be 29% upside, and a conservative assumption based valuation shows 0% downside. (optimistic assumption indicates 90% upside, but I don’t have to count on it)

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Book Notes – Big Money Thinks Small (by Joel Tillinghast)

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Joel Tillinghast is a tenured Fidelity portfolio manager for its Low-Priced fund, however his name was known by few, including me, until recently. Tillinghast recently published his first book – Big Money Thinks Small last month, and was featured in a Barron’s interview in 08/12/2017 (Link here). When I first saw his interview, I found this manager interesting for his ability to consistently beat his benchmark, Russell 2000, for years with 100+ holdings. This diversified approach is very different than the “traditional” school of value investing, who advocates concentrated bets. Another impressive trait of Tillinghast’s fund is the extreme low turnover – only 9% a year. This means he on average holds each position for over 10 years!

For the sake of these special traits, I decide to pick up his book and try to see if there is anything I could learn from him.

BigMoneyThinksSmall

Overall, I think it is a valuable book, especially for someone had some investing experiences and is eager for historical investing case studies. Here are my key thoughts/lessons:

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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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“Sun Tzu’s Five Factors” Business Analysis Framework

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[I recently finished my first quarterly letter to my investors, who are some close family members and friends. Below is an excerpt from the investment process section, where I spent most of the time explaining my unique (at least I think) business analysis framework, which is a combination of Sun Tzu‘s Five Factors (based on the Art of War) & checklist method.]

 

Investment Approach – The Process

I will start with where I spend my resources and our capital to. It’s mainly 3 investment themes: special situations, distressed assets and great operations at reasonable price. The core idea of all three is “buy low sell high”, however the way of analysis for each is somewhat different.

  • In special situations category, I look for entities undergoing some type of corporate event that might lead to a mismatch of value and price (e.g. depressed prices due to forced sells, or under-appreciated prospect that could increase the value). Examples of special situation investments include, but are not limited to, spinoffs, corporate restructurings, mergers, liquidations, and rights
  • In distressed assets category, I look for asset that is priced well below its value due to unfavorable developments. a.k.a. “There is always a price to make a crappy business an attractive investment.” Since the risky nature of distressed assets, heavy analysis is performed on balance sheet and solvency side. It also is the most time consuming from tracking perspective as any new development and disclosure could significantly change the value evaluation outcome. I typically size ideas in this category conservatively. Examples of distressed assets investment include, but are not limited to, cigar butts, scandals and high yield corporate debts.
  • In great operations at reasonable price category, I look for, as the name itself says, great operating businesses at reasonable price. This is what Buffett does for the late part of his career, and examples include well known Berkshire Hathaway’s holdings of Coca Cola, American Express and Wells Fargo, etc. The return of this category comes not from the price/value mismatch in current day per se, rather from the compounding growth of the value in future. Thus, my research spent on this category is mainly on the industry, business model and moat of the business, which drive the value compounding ability of an entity.

Next, I will talk about the process of how I approach analyzing an opportunity. I usually start with the business itself, trying to understand the business model, industry landscape & whether there is moat around the business. Then I will move on to balance sheet, to get an idea of what assets it has, last to its profitability (i.e. income statement). There are well documented metrics and valuation methods for analyzing the latter two, but the first (also the most important, in my opinion) item – business analysis – may worth more elaboration.

I use a self-developed “Sun Tzu’s 5 factors” method to analyze businesses. Sun Tzu’s classical military treatise, The Art of War, starts with the 5 most important factors affecting wars: Tao/Dao (道), Meteorology (天), Topography (地), Commander (将), System (法).

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Chinese ADR “Go-Private” Deals Overview-  A Changyou Buyout Inspired Study

taovalue China, Investing, Merger Arbitrage, Uncategorized , , , , , , , , , , , , , , , , , , , , , , , , , ,

On 5/22/2017, Changyou [CYOU] received a preliminary non-binding offer from its chairman Dr. Charles Zhang, who is also the CEO and Chairman of Changyou’s parent company Sohu, to take the company private with and offer of $42.10 per ADS. The offer letter can be seen here: http://ir.changyou.com/05_22_2017.shtml. It is interesting that it is Charles Zhang, the person, not the parent company Sohu, to make the acquisition.

As a current CYOU shareholder, I think it’s a OK deal despite I had higher expectation of the turnaround execution which just started to show some positive signs. As of 5/31/2017, there is still about 8% spread between the close price of $38.9 and offer price $42.1. If the deal could be closed timely, it would be a good risk arbitrage opportunity.

Inspired by this event, below I did a general study of all the Chinese ADR “go-private” deals in past few years. I’m keen to get answers to these 3 questions (which could help me evaluate upcoming similar deals’ risk/reward):

  1. How much percent of these deals fell through?
  2. What are the characteristics of the failed deals? (does CYOU have any of these traits?)
  3. How long do they usually take to close?

 

History of Chinese ADR Privatization Deals

Let’s begin with a rough understanding of a typical ADR privatization process. Credit to a Credit Suisse’s study [link here], here is a great chart showing the 6 milestones of such a process.

CPD_GoPrivateDealProcess

It is also important to understand the main incentive of such privatization deals, specifically for these US listed Chinese companies. Like most of the PE backed LBO deals, Chinese ADR privatization deals also target for a relist for higher valuation. However the difference is that, rather than streamlining and growing the businesses for a few year in private arms (in LBO cases), the Chinese ADR companies could seek a faster re-valuation by relisting the firm to its home market (which offered richer valuation, especially back in 2015 before the crash). This also explained why there were so many proposed deals announced in 2015.

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Shoulders of Giants – Bruce Greenwald Barron’s Interview

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Spend each day trying to be a little wiser than you were when you woke up.

— Charlie Munger

 

Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management in Columbia Business School, and also Director of Heilbrunn Center for Graham & Dodd Investing. He recently had an interview with Barron’s [link here], which I find very insightful.

 

Below are some wise quotes from the article & my thoughts for self-reminder purpose.

 

Opinion on Discounted Cash Flow

“There is a fundamental stupidity about discounted-cash-flow valuations.”

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Thoughts on Echelon Corp. [ELON]

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Company Overview and History

Echelon was founded in 1988 by Clifford “Mike” Markkula Jr., who also has served as CEO of Apple in its early days. For years, the company operated in two divisions: Internet of Thing (IoT) and Grid. Both sides suffered operational difficulties and wasn’t able to turn to profit. New CEO Ron Sege was brought in October 2010 to try to turn the ship. In August 2014, Echelon agreed to sell the whole grid business to a European company S&T AG. Around the same time, it also made an acquisition of Lumeware, a smart lighting startup. It was essentially an asset swap, so that the new company can get rid of non-core business and focus on smart lighting – the area management thinks has the most potential.

The troubled operation was reflected by the stock price as it lost almost 95% value since 2007. Also noted, that the firm had a 10 for 1 reverse split in December 2015, so you are basically looking at a penny stock to some extent ($0.6 if adjusted for the reverse split).

ELON_1

After the changes, the business operates in two segments: 1) embedded systems and 2) smart lighting. Embedded systems include the legacy IoT division’s products which are the networking products (chips, routers, gateways & software etc.) for Industrial IoT devices (smart meters, refrigerators, etc.), however this side of business kept deteriorating on a continued basis. Smart lighting, on the other hand, consist the acquired Lumeware products plus the existing lighting control IoT products (wired & wireless controllers, gateways, servers & software etc.) In the most recent investor presentation, management indicated the lighting business has seen 4 straight quarters increase (however, without further details). Clearly, the management has identified the lighting business as the future of company and allocated resources accordingly to pursue this opportunity (e.g. hiring lighting controlling sales veteran Rick Schuett on April 2016)

Basically, it is an unloved business by Wall Street as the legacy businesses are doomed and the turnaround seems to take much longer than expected, if not impossible. When a stock looks like a road kill, it may be a great opportunity for investor who can see through what appears at the surface. Next thing is to examine whether the price is attractive enough to make this crappy business (suppose it is for now) an attractive investment.

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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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