Housekeeping
Like always, it goes without saying that nothing that I write in these posts is intended to be or shall be constituted as financial advice. Also, the opinions here are solely my own and they don’t reflect the opinion of any company I might be affiliated with.
Stocks
The Alibaba Bear Case
Alibaba is the largest position in my portfolio at ~11%.
There’s more than enough content online on the long-term potential of Alibaba, even as China’s tech sector and economy go through some rough patches. High top-line growth, high free cash flow generation, dominant position, solid management, rock-solid balance sheet, China’s market opportunity, etc., etc.
However, something that is essential before making an investment is running through the potential pitfalls of the thesis. I recently came across this post by a British investment manager in which they outlined, back in December 2020, why they didn’t and wouldn’t own Alibaba. I missed one of the reasons they gave while I was doing the research, so I had to look at it for myself in order to reevaluate. The reasons are:
Bad stewardship & governance - the legal structure of Alibaba is…iffy, got to give them that. And I agree that Jack Ma is a volatile character with some dubious personal usage of Alibaba’s balance sheet and abuse of his control of the company. My thinking: in this particular point, I curiously believe that China’s crackdown on the tech sector, and on Alibaba/Ant specifically, will result in these issues being reduced. At the time of Ant’s IPO suspension, Jack Ma’s position in Alibaba was already not as prominent as before. In any case, he has already been put in his place, and the government has asserted the role they want these companies to play, leaving less room for misbehavior from management.
Loss of monopoly power - Alibaba rose to prominence partially due to the government favoring the company, which allowed it to achieve the position it did. Now with loss of government support and the government’s efforts to make the tech sector work for the country, the argument is that this will result in lackluster performance due to lost monopoly power. My thinking: my thesis was never built on monopoly power. Other tech companies are also on the government’s sights, and BABA has plenty of resources to outcompete others on a level playing field, especially smaller players. Plus, China is a growing pie in terms of wealth. There’s no reason why the company can’t do very well even with lower market share.
Accounting irregularities affecting earnings - this has been a loud cry from Chinese bears, and I considered it initially. But I missed one specific irregularity:
The Interest & Investment Income line includes gains/losses from revaluations of the company’s investments in other companies. It caught my eye just how large this was as a % of Net Income.
Originally, I saw this and I checked the investments they were revaluing, and it made sense. They own stakes in some good companies, and in a bull market there was nothing strange with these stakes rising in value. However, I missed a method they used to boost gains from recent acquisitions.
In summary, they first acquire a stake in a company that represents less than 50%, say 49% at a valuation of $100, so they pay $49. They then buy a further 2% stake, for say $6. This second transaction implies a valuation of $300, and the fact that they now own 51% of the company means they have to consolidate it as a subsidiary on their books, so the investment is re-marked up to $153. Just like that, they have a $104 gain for making the $6 transaction. The article I linked above details how the company did this for their investment in the Cainiao Network, for example, while other acquisitions don’t have such a detailed explanation, leaving room for speculation that they have done this in other occasions.
I’ve been thinking long and hard about this, and I decided to keep my position in Alibaba. For starters, I base my valuations on operating income, not on earnings, since I know the latter can be more easily manipulated. The company has still grown their operating income tremendously and remains cheap on that basis, even though margins have fallen. That said, I will keep a closer eye on capital allocation moving forward. While I judge the situation today to still be manageable, there’s a chance that the CCP’s crackdown completely destroys effective capital allocation within the company. I know there are plenty of risks present with Alibaba, but I think the potential long-term gains eclipse these risks today. We’ll see if that remains true.
Avoidable Investment Mistakes
The Bearish Thesis
One easily avoidable investment mistake is to fail to consider the bearish thesis of an investment. I’m not saying considering every single pitfall is easy, it takes work and deep thought, particularly in trying to leave aside the positive bias we all have with a company that we have already spent valuable hours researching. It’s also possible to miss details, as it happened to me with Alibaba. But it’s a necessary step in analyzing any investment. Do not forgo doing it.
Catching a Falling Knife
Finally, another mistake I made with Alibaba. When a stock is immersed in deep negative sentiment, there’s 1 rule that always pays to remember:
“No matter how shitty things are, they can always get worse”. - Some wise guy (or girl), probably.
Catching bottoms is a fool’s game, but it’s also not good to start positions that are too large from the get-go in these cases. In my case for example, I would love to have bought more Alibaba at $143, but because I was too fast in building a large position I hit my limit in terms of % of the portfolio already. I’m confident that my current cost will see gains, but patience would have paid off even more. Opportunity cost is real. Lesson learned. In the end, I did still get a company that is undervalued based on its business fundamentals, so don’t obsess over it either. It’s a less of a worrying concern if your portfolio is more diversified than mine.
On that note, hope you enjoyed this edition and looking forward to the next! All the best!