To A Market That Did Not Have a 2% Correction in 6 Months
Dear Subscribers:
When I first started this Substack, I only invited my investors/clients and several close friends. Somehow I have been fortunate to attract a lot more subscribers than I ever hoped for, some of whom are very well established veterans in the investment field who I greatly respect and admire. I feel tremendously honored to have you on our investment journey together. In addition, special thanks to my pledgers — thank you for your pledges to support my Substack and to provide me with the right incentives to go the extra mileage, keep sharing my best knowledge and insights on investing. For every sum you have kindly contributed, I have elected to donate a portion of it to fight climate change, a cause of importance to my wife especially and myself.
“Though the stock market is massively larger than it was in our early years, today’s active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.”
Warren E. Buffett, 2023 Shareholder Letter
In Q1 2024, we have delivered an underwhelming 0.79% net return after all fees and expenses against a surging S&P 500 with a 10.7% return and this marks the worst quarterly underperformance since inception. The Hang Seng index, which continues its bearish run, declined a further 1.5% in 1Q 2024 after a 4-year losing stream certainly did not help, while our shorts of some of the silly bubbles in the US also worked against us due to insane liquidity conditions and undue optimism. Our net return is calculated as the time-weighted average return (TWR) adjusted for account size weighting. For our individual investors, please find your statements which will be mailed out by the 3rd week of April and if you have not received them by early May, please kindly let us know.
We are particularly grateful for our investors’ support and long-term focus. In January, the Hang Seng index collapsed and we experienced a large drawdown, yet neither you nor my other clients reached out to me regarding the large correction. Our investor base is our greatest advantage, allowing us to take a long-view rather than chasing momentum or focusing on the day-to-day. A big thank-you!
I continue to favor Chinese equities over U.S. ones for my clients. As you will see in the chart on the next page, the distribution of the price/earnings ratio of US equities is now to the right of what it was back in 2000. That was the year the Internet bubble burst and a bear market ensued that covered most of the period 2000-2002.
Based on FactSet, which in general overestimates EPS, the forward earnings per share on the Standard & Poor’s 500 Index is about $245/share. Based on the March 31, 2024 close, the S&P 500 is trading at 5,245, or 21.4x forward PE. In an economy with 4%+ yield and signs of reflation, apparently not much pessimism is baked in. Communications with peers who we respect seem to indicate that we are all in the same boat — excellent risk-reward is hard to come by in a market frothy with speculative fervor.
Speculation Reigns in the U.S.
I believe that today’s speculative mood dwarfs anything we saw back in 2000.
Here are two examples, which I dub as the “duo-micro”:
Micro strategy, a $30 billion market cap stock that is essentially a “closed-end” bitcoin fund, is selling at an implied bitcoin value of $170,000, while bitcoin itself is selling at $70,000. The company has not squandered a moment in taking advantage of cheap money, repetitively issuing convertible bonds to purchase additional bitcoins, while insiders such as CEO Michael Saylor sold hundreds of millions of equities to the speculators.
Super micro, a server vendor with a $60 billion market cap, is trading at 3x forward sales and 50x forward earnings while its historical and peer average multiples are in general less than 1x forward sales and 12-15x forward earnings. It is a company that was delisted by NASDAQ and fined tens of millions of dollars due to accounting fraud just several years ago, operating in a commoditized industry with little barrier of entry. For those who believe Super micro is “special” due to liquid cooling or block architecture, perhaps try to ask yourself why Jensen Huang (CEO of NVIDIA) “king-made” Michael Dell (CEO of Dell Technologies) during the NVIDIA GTC (GPU Technology Conference) Meeting (one of the most important events in the field of artificial intelligence) rather than Charles Liang (the CEO of Super micro). As mentioned during Dell’s 4Q 2023 conference call, apparently Dell is getting “thousands of orders” from Super micro’s largest customer CoreWeave, a specialty cloud service provider. Super micro, has, trashed its promise of “not to dilute shareholder value” made as recently as January 2024, issuing north of $1.5 billion convertible bonds in February and $2 billion of equities in March. Yet this company set a record of having a 12-week winning streak and a 14-week relative strength index of 95, the highest ever in the history of stock price movements — yeah, we’re witnessing some history here!
Apart from several legacy positions, which we believe are not a stretch in valuation, we find it incrementally more difficult to allocate capital to the US. market. This market is filled with inexperienced young professionals who have not seen a serious bear market — after all, the US equity market has been in a secular bull trend for 16 years, which is enough to eliminate most of the painful memories associated with compressing multiples and shattered upward momentum.
For us, the most active time periods in the market would be when there is a liquidity crisis, people are forced to sell, and valuations are dirt cheap. We find such a condition in the other side of the Pacific Ocean. In the remainder of the letter, we will review some of our core longs/shorts.
Year-to-date, the Hang Seng index has lost another 1.5%, continuing its 5-year streak of bearish run. As a friend of mine jokingly remarked, it seems that the Winnie the Pooh has beaten all of the other ferocious “bears”.
This is by far the longest, and third worst bear market ever for the index. I don’t know how long the pain will endure. But I am convinced that many Chinese equities offer good value at present prices.
To some degree, we have been fortunate that almost none of our holdings saw major structural issues in 2023. Many of them are, in our opinion, moving in the right strategic direction, executing well, and given their better competitive positioning, will most likely emerge stronger out of the current recession.
Meituan
Meituan is a diverse services company. If offers car hailing, bike sharing, food delivery, hotel and travel booking, catering and movie ticketing, among other services. Despite the stock’s incessant decline in equity price recently, we have been gradually adding to our exposure. Making it one of our largest holdings.
We have written about Meituan in an earlier post in Jan which we’d recommend you to read for some background:
Meituan is Our Next "Big Long"
Value Guinea 2024年1月10日
In Q4 2023, we are finally warming up to Meituan’s valuation. Despite its incessant decline in equity price recently, we have been gradually adding our exposure to make it one of our largest holdings. Back in 2022, Meituan was valued at a considerable premium vs. PDD, and we voted with our feet and bought PDD. The market believed Meituan should enjoy a …（Read full story）
Some updates on our original thesis:
1). The company literally started buying back stocks the very second trading day after our write-up.
2). We are favorable of the reorganization of the business that followed shortly. Chuan Zhang (张川) is, in our view, a good general to safeguard a citadel, but is not one to conquer and annex additional territory. We view Fuzhong Wang’s appointment positively — Fuzhong is someone that can take on the challenge of Tik Tok, who can with ease identify the optimal strategic path going forward, and who has clearly demonstrated his unparalleled executional excellence and strategic vision throughout his career thus far.
3). As we have discussed in the comments session in the previous post, the Eleme acquisition by Tik Tok, which we have always viewed as an argument made up by the bears to drive the stock lower, is now completely shattered.
4). As we have predicted, Xing Wang has been flexible in changing his mind, and the cost reduction in the New Initiative segment is unfolding right in front of our eyes.
5). If consumer sentiment and consumption ever swing back, we view Meituan as a prime beneficiary. With the right management and a potential cyclical upturn, Meituan has room to appreciate, in our view.
WH Group:
WH Group Ltd. is the world’s largest vertically integrated producer of pork and related packaged meat products. Although the company earnings declined more than 50% last year from 2022 levels, the stock has been one of the best performers in a collapsing Hang Seng index in 2023. I believe that WH Group’s fundamentals have bottomed. Long Wan has maintained the company’s dividend and based on our purchasing price that translates to a 7.5% dividend yield. Most of the disappointment last year occurred from their US operations (Smithfield) but the tide appears to be turning. Some of WH Group’s competitors here in the US are moving in the direction of shrinking their operations, reducing overcapacity, and focusing on profitability. For instance, earlier this month, Tyson Foods, a competitor of Smithfield, announced closure of its plant in Perry, Iowa, culling about 1,200 jobs in the process. Seaboard Corp., another competitor, is also reducing its capacity. I think the cycle will turn by mid-to-late 2024.
Two additional catalysts apart from improving fundamentals are: 1). WH Group has expressed its intention of spinning off Smithfield, following the example of JS Global which successfully spun off SharkNinja last year with stellar performance since then. Although the timetable is not set, we believe such an event, should it transpire, will significantly reward shareholders; 2). WH Group will likely start buying back their shares as they have substantially reduced their floating rate debt. There’s precedent for this — let’s not forget WH’s large tender offer for its own shares in 2021 at 7.8 HKD/share.
Conch Cement:
We like cyclical leaders experiencing a downturn. Historically, we have had success with this strategy by investing in Range Resources and Pioneer Natural Resources back in 2020.
As the entire cement industry is going through a purgatory in China, Conch Cement is one of the only profitable players, and its share of the industry’s profit has surged from 31% in 2022 to 44% in 2023. The company has also executed in an exemplary fashion. Receivables have declined while inventory roughly kept steady. Interest bearing debt has held roughly constant at 20 billion RMB as the company’s holdings in money market funds climbed 3% to 70 billion RMB. Long term equity investments increased from 6.8 billion RMB to 7.8 billion RMB.
Conch’s net cash plus long term equity investment stood at 57.8 billion RMB as of December 31, 2023. The market values the company at 80 billion RMB. Therefore the market values Conch’s operating business (net of cash and investments) at 22.2 billion RMB while annual profit for a year as difficult as 2023 has been about 10 billion RMB. We believe Conch Cement at the current price as being extremely undervalued.
The company has slashed its capital expenditure by 50% -- a step I view positively. , and operating cash flow has more than doubled, yielding a free cash flow per year of 6 billion RMB at a cyclical trough.
Some market participants view the dividend policy as being stingy. I disagree. I love what Pioneer said back in 2020 when the oil industry was on its knees — “don’t try to be a hero, just get to the other side”. In any case, the dividend yield is near 6%.
Conch is preserving its dry powder, protecting its fortress balance sheet, and waiting for opportunities to further consolidate this industry.
CSPC Pharmaceutical:
CSPC was a major contributor to our gains in 4Q 2023 but has been a detractor in 1Q 2024. It remains one of our largest holdings and we are happy shareholders as Chairman Tsai generously rewarded us with a 50% payout of its earnings in the form of ordinary and special dividends in one of the toughest years in its history.
The market seems to think CSPC has been transferring its assets to CSPC Innovation, depriving its shareholders of enjoying the upside. In addition, given the transaction price is uncertain, market participants believe CSPC may overpay for CSPC Innovation, hurting shareholders as a result.
First off, we believe transitioning innovative drugs development to CSPC Innovation is absolutely brilliant. CSPC Pharma’s HK valuation in no way reflects its true worth, and using CSPC Innovation as a cheap financing vehicle in a liquidity-rich mainland market lowers CSPC Pharma’s WACC (weighted average cost of capital) and in my judgment makes the company more, rather than less, valuable.
Secondly, CSPC Pharma will own more, not less CSPC Innovation after the recent transaction, and given CSPC Innovation is consolidated, the argument that CSPC Pharma will not enjoy the fruitful results of innovative drug developments is nonsense.
Thirdly, for those who worry about incentive alignment, we’d like to point out that CSPC
Innovation’s management team is incentivized by CSPC Pharma stock. As the late Charlie Munger commented, “tell me the incentives and I can tell you the results”. We like the incentive alignment.
Fourthly, some are concerned with the slowing growth. As we have pointed out in our 3Q letter, two of their major cancer drugs were undergoing centralized procurement (an effort made by the central government to curb healthcare costs through slashing drug prices from pharmaceutical companies and compensating them with volume), yet CSPC was still able to grow revenue by 2% unaided by the impending explosion of its drug pipeline. The 2% decline in profit could easily be engineered into growth territory if CSPC Pharma did not hike its R&D expense by 50%, but the fact the management has been willing to forgo financial statement engineering and focus on long-term growth prospects is precisely one of the most important reasons we want a slice of the company’s future growth.
Lastly, we have a substantial margin of safety with a 7x EBITDA, 12x PE (adjusted for cash it’s more like 10x PE and FCF multiple) double digit grower in an aging society with a shareholder friendly management team and a rich and valuable pipeline. We disagree with every bit of negative sentiment in the market place and believe CSPC Pharma has lots of room to run.
Our Shorts
On the short side, we are short some of the US equities that I believe are ridiculously overvalued.
1). We have discussed Digital Realty’s short thesis in 3Q 2023. Things have only changed for the worse since then. The company guided for 18% vacancy rate as demand for artificial intelligence destroys its legacy data-center model. Its financing cost is increasing from an average of less than 2.5% to about 5% or 5.5% and its refinancing needs will escalate starting from this year. Due to its massively negative free cash-flow profile, it kept issuing equity to pay a dividend creating an unsustainable facade of profitability — there is a name for this type of activity. Lastly, it is still sporting a close to 6x net debt/EBITDA ratio with a 24x EV/EBITDA trading at a premium to true AI beneficiaries such as Alphabet.
2). We initiated a short position in Carvana recently in the mid-eighties and we believe that bankruptcy is fairly likely. Carvana, fully diluted, is trading at a higher market cap than CarMax while its free-cash-flow profile has deteriorated. Its unit economics probably will never work, and the more cars it sells the more money it loses. The net present value of a bunch of negative free-cash-flow streams do not add up to a value greater than zero in the long term. We also use it to hedge the reflation risk, which we believe is increasing with data points coming out of Feb and Mar, supported by a Fed that seems to be more politically ambitious than truly salient and mindful of real economic conditions.
3). We continue to short WDFC (WD-40), a mid-single-digit grower with a still-bloated inventory that’s selling at 40x forward PE. There are many such names in the US and we use some of these names to hedge against our long US exposure.
As of March 31, 2023, I have on average less than 20% net exposure to the US market. I continue to hold substantial positions in the Hong Kong market not due to patriotism but due to meticulous assessment of numbers, facts, and morphing business fundamentals. I hope and believe that better times lie ahead.
*The performance record from April 2022 to August 2023 is the author’s performance at Atlas Capital of Boston, while the performance after August 2023 is the author’s performance at Dorfman Value Investments.
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