#131481
Re: Cobas AM: Nueva Gestora de Francisco García Paramés
It is hard to believe that it was over eight months ago that I wrote about our new investment which we had initiated late last year, Alibaba. As I mentioned at the time, I had long admired access Alibaba provides Western investors across a host of consumer products companies to Chinese commerce and economy. Alibaba has long provided exposure to China’s foremost commerce hubs, especially through the form of Taobao and Tmall (especially its Luxury Pavilion collections). With roughly one billion Chinese average annual consumers and roughly 260 million additional consumers outside of China, it is hard to imagine shopping in China without involvement in one manner or another with Alibaba. Alibaba’s focus on serving the needs of both merchants and consumers alike has allowed it to deliver its e-commerce at amongst the lowest take rate of any leading retailers. Alibaba also provides investors access to China’s leading cloud business. Alibaba, in efforts to be transparent, has reported its cloud segment separately since 2017. By reporting cloud results separately, Alibaba allows investors to measure the substantial extent to which Alibaba has exercised both the “capacity to reinvest” as well as Alibaba’s management’s “capacity to suffer.” Alibaba’s management team enjoys the “capacity to suffer” as the result of protection from Wall Street’s disruptive censures as a result of protection provided them by Alibaba’s founding shareholder, Jack Ma. 7 During decades of Alibaba’s greatest growth, Mr. Ma evidenced a preference for taking on projects which, more often than not, eroded reported profits as investments he selected for greatest long-term growth in intrinsic value on a per share basis burdened reported profits in the near term. In addition to attractive businesses which possessed the ability to reinvest internally, Alibaba was well capitalized. In late 2020, as we sized up our potential investment interest in Alibaba, we realized that Alibaba had a rock-solid balance sheet and financials in general. Not only did Alibaba have nearly $71 billion in cash and short-term securities within the company, but they also had investments in a portfolio of over 100 independent, digitally disruptive start-up companies. While most start-up investments are in Chinese companies, there are portfolio companies that also include non-Chinese start-up businesses. Finally, Alibaba currently has over a 30 percent interest in Ant Financial, which at the time of our initial investment research had been recently valued at over $300 billion of estimated value. Ant Financial’s valuation declined sharply over ensuing months as efforts to embrace “safer” financial capital requirements weighed heavily on near-term reported results. Alibaba was valued at a modest multiple of EV/EBITA of just over 10 times, quite modest considering the ability the company possessed to reinvest its current, mature segment free cash flow into new regions and into new product and service extensions. We also agreed internally that we would keep the position weighting relatively modest (between 2.5 percent and 3.0 percent). We recognized back in late November that the autocratic moves available to China’s Communist Party head and head of the People’s Liberation Army were vast, required no public authorizations to exercise, and could prove to be terminally crippling of one or many of those wonderful companies with substantial competitive moats that exist at such attractively low valuations within Alibaba. I described to investors late last year my thought process of investing in a company’s shares which possessed multiple business gems, that serve in many instances as the only way that consumers could obtain such goods or services, even though such businesses confronted political, economic, and regulatory headwinds. Alibaba had businesses that provided brands and products that consumers believe they cannot do without and could only obtain through Alibaba’s entities. We had witnessed three or four such major pushes for reforms autocratically announced in China as we prepared for our initial investment in late 2020. Indeed, it was the existence of such unbridled autocracy which we felt was responsible for driving down the share price to the level which we felt, for the first time, could justify a modest investment in Alibaba shares. We recognized risks of confiscation, closure, etc., by executive fiat existed, but reasoned that China would eventually recognize how much they needed the Western-style, modern retail, and a robust innovation pipeline such as that which Alibaba had long provided China. I have proved to be flat-footed in light of near-term performance thus far on our Alibaba investment. The shares have declined over 25 percent since our first investment. However, few 8 could have imagined the pace and appetite of regulatory declarations and investigations since late last year. Since November 2020, there have been over 40 major decrees threatening to strip companies of products, power, etc. The same 40, in some instances, commenced initiating investigations for antitrust breaches, data breaches, and threats to financial stability (like the entirely unanticipated dismembering of Ant Financial, which started so much of the use of recent, heavy-handed autocratic measures). Alibaba has even been fined over $2 billion for past behavior that regulators deemed to have had an antitrust impact. Fortunately, Alibaba had ample resources to meet the fine and to begin to espouse the need for future protections to prevent others (largely Alibaba’s competitors) from having the ongoing ability to price future products at their “stores” at prices below their own costs. “Disinfectants” Many of the demands President Xi Jinping and his associates have levied have served as disinfectants designed to combat toxic risks that have risen over decades of business misconduct. The government has set in motion steps which, if complied with, will in many instances make Alibaba’s long-term business run more smoothly once the dust settles. Below are some ideas as to how the disinfectant, even though autocratically delivered, may ultimately lead to more healthy business practices: 1. Ant Financial. Ant Financial has had an illustrious run as it was for decades treated as a subsidiary of Alibaba. Indeed, Alibaba relied so heavily on Ant Financial to provide its shoppers with unsecured credit that it potentially contributed in the Chinese markets to systemic risk. Ant Financial was using traditional Chinese capital to fund their consumer purchase loans and was able to underwrite with limited financial reserves. More importantly, there were no credit checks available at the time to even begin to measure risks which Ant Financial presented by the time it reached its peak just prior to its collapsed IPO. Ant Financial had a credit scoring system untested in a recession. Regulators did not know if Ant Financial’s security would work in a downturn and feared the rapid growth of such loans. Today, Alibaba actually benefits from the financial system protection against Ant Financial’s prior risks of lending with little idea of credit risks. Ant Financial today shares the credit check business with the Chinese government, an outcome that should eventually stabilize Chinese capital markets. 2. Data Security. Given growth in sophistication for internal use of data which Alibaba retained from its consumer transactions, Alibaba quickly became the largest data source in China. The government resented having inferior data. One area of Mr. Xi’s current pressures is applied to allowing the government to secure better and more competitive data. Given the Chinese government’s paranoia of Alibaba’s data reaching improper users, Mr. Xi has led for reforms that tighten up the potential for random, unsupervised use of data. As standards for data use increase, Alibaba will most likely enjoy their historic ability to deliver more targeted marketing and in so doing yield better long-term business success. The government fears loss of data to non-Chinese. This fear surfaced with DiDi, whose recent IPO the Chinese government attempted to forestall so that essential data would not leak in 9 the open process of going public. The government’s efforts to limit data collection, at present, should enhance Alibaba’s effectiveness moving forward as the illicit use of consumer data diminishes with measures intended to comply with tighter government standards. 3. Below Cost Pricing. As Alibaba reported its recent quarterly results, Alibaba announced that it would be spending all its incremental income this year on new technology and new services. One area in which this will likely help clean up business will involve reduced pressure from the very low cost competitors who offer products for sale below their own costs. Pinduoduo is the biggest such competitor, at present, with high subsidies and pricing well below cost. Alibaba believed that over the recent period of industry scrutiny regarding below cost pricing, its competitive position should improve as the government’s tightened demand should help drive better business practices. 4. Future Investment. Alibaba’s Vice Chairman announced at their recent quarterly results meeting that they would direct all their incremental income this year to investments both direct as well as alongside of industry colleagues. They focused on investing in new technology to satisfy government pressure designed to insist that firms deepen and broaden technology investments. 5. No More “Choose One from Two.” One practice which is being cleaned up via the disinfectant of new practices involved the removal of delivery of food/meals by the elimination of the “Choose One from Two” campaign. In this campaign, two potential competitive delivery firms agreed amongst themselves which firm would get which delivery orders. Once established, that firm would thereafter rely on just one supplier. Historically, this practice was designed to make logistics less complicated. Consumers “Choose One from Two” and will stick with the same delivery provider, unlikely to switch providers over time. The fact is, however, that over time the delivery system that comes with such shipments should be more available for Alibaba as previously unbreakable choices were set permanently at the outset. 6. Increase War on Counterfeit. The war on counterfeit involves ongoing battles that should allow Alibaba to compete more effectively, once there are fewer available, low price counterfeits in the marketplace. Alibaba’s business is based on the merchant taking on enormous responsibilities for the authenticity of products, etc. Ultimately, there will be ongoing steps from government reform that will lead to more economic logistics and more robust inspection to assure that the consumer receives authentic goods and services. 7. Academic Expectations. Academics really matter in China as controversy over two extraordinary efforts requested from some recently proposed reforms will highlight. First and foremost was the assault upon the gaming industry leader, Tencent. The episode commenced with a recognition that the amount of time youth spend before video games (aka “opium of the young”) was not healthy nor likely to land one’s child a spot at Harvard. At the same time, however, there was investor fear that Chinese companies involved with providing learning-based tutorials were making children unnecessarily neurotic about education testing. On the one hand, administrators attempted to outlaw excessive video gaming as it diminishes chances of acceptance at Harvard. At the same time, other college applicants are today being denied access to tutorials which allegedly overly stress students applying to the next level of education. Both 10 the video game leading company, Tencent, plus a large number of tutorial companies, whose shares publicly trade, have gained sharp erosion in their market values as a result of these recent attempts to enhance academic outcome by removing distractions and reducing stress. Mr. Xi and his administrative officers have directed reform aimed at improper financing practices (cf. Ant Financial), data security, below cost pricing, “Choose One from Two” anti-competitive distribution practices, and disruption to academic preparations (eliminate/reduce video conferencing and severe restrictions on high pressure college admission prep courses.) The above-mentioned steps are just a handful of those (over 40 to date) that have been promulgated since November alone. Alibaba has exposure both through directly owned divisions and through their 100-plus portfolio of venture funded start-up businesses. As the leader in so many of its businesses, it is our belief that the disinfectant that presently is being administered to China’s businesses, social networks, and political networks will eventually result in a world wherein the clear market leaders (like Alibaba) will eventually go from strength to strength as business practices become more fair and less cut throat competitive. Sanguine about the pace at which reforms and improvements will show up in benefits for Alibaba shareholders, we are not the least bit sanguine about the extent to which Alibaba’s shareholders should financially benefit from such reforms. We are going through a period when headline risk drives share price. For example, The Wall Street Journal and the Financial Times recently reported that SoftBank, a global leader in Chinese FinTech investing, has recently decided to cut additional investments into the China Tech market until the Chinese technology sector “calms.” There is, nonetheless, undoubtedly systemic selling by global shareholders to eliminate evidence from their portfolio reports of Alibaba’s recent underperformance. I show just a few examples above of the fiat decrees and investigations which have disrupted the near-term investment prospects for Alibaba shares. We believe, however, that Alibaba will financially recover from near-term disruptions and once again evidence the extremely crucial role Alibaba has long played in Chinese commerce. I believe that this is to be the case given the following advantages it possesses – i.e., the financial strength of Alibaba; its dominance in commerce platforms that continue to be indispensable for its manufacturers and merchants; its commitment to invest heavily in new ventures even when such investments cause near-term results to “suffer;” its robust and fast-growing cloud business; and its prospects for enhanced business practices that I believe will arise from many of the very same reforms that are being poorly received by equity investors today. Given my many reasons expressed above for continued holdings in Alibaba’s shares due to its strong future prospects, our investors, I hope, have an idea why we believe the investment continues to make sense at the measured amount of Semper Vic Partner’s capital allocated to Alibaba shares. We recognize the potential disruptions that had commenced in the first three or four reforms when we first invested eight months ago. We surely did not anticipate the full throttle of an additional 36 imposed reforms placed over the past eight months and surely do not expect a similar round of regulatory breach over the ensuing eight months. 11 Finally, I have been pleased to see just how much less the pressure has seemed to be driven by a political attack against Mr. Ma or other persons historically involved with Alibaba shares. Indeed, the measures have increasingly addressed issues across dozens of firms and increasingly do not seem to reflect a vendetta based on the culture or conduct of the once more flamboyant profile maintained by Alibaba might suggest. With improvement in both business practices and with the breadth by which censure was being “democratised” broadly across companies beyond Alibaba, both financial benefits rising from such reforms and improved political collaboration leaves me comfortable with the positive reform beginning to take hold. I was comfortable to see that, against fiat selling by Western institutions, Alibaba was willing to engage its share repurchase program. It had already raised the share repurchase program size from $10 billion to $15 billion. Thus far, Alibaba has deployed nearly $4 billion in share repurchases (from its cash holdings of $72 billion) and does so at valuations that value its shares at roughly 8.5 times its commerce EV/EBITA. The above comments reveal our balancing process that supports our belief that we should be able to properly balance risk and future return over the long term through our holdings. That was our reasoning, at least up until last week, when Alibaba sadly found itself the center of controversy relating to poor conduct within the company. You Cannot Make This Stuff Up Just before this letter was to go to press, we learned that an executive at Alibaba had been accused of sexual predatory conduct. The event allegedly took place at a company-sponsored, mandatory gathering. There was allegedly severe pressures brought upon all who attended to drink in social manner, including shots of one of the world’s most challenging beverages, Baijiu. After what was an alleged to be a far too long, liquid, and drawn out affair, one female colleague alleged that she was sexually assaulted. Since publication of the lawsuit alleging sexual misconduct, Alibaba has taken on a full course of review of all conduct. Alibaba has assembled a team of its five most senior women to serve in an ongoing capacity going forward inside Alibaba to whom whistle blowers can direct complaints. Alibaba has installed electronic stations where complaints can also be processed. China’s #MeToo movement is already up and running to combat such deplorable conduct. Tragically, such misconduct took place at Alibaba, which speaks poorly of its corporate culture. The immediacy of their official response, coupled with efforts to change corporate conduct may end up helping to rid Alibaba of all-too-long, mistakenly permitted practices. There is, with this tragic episode, an interesting look across to several of our other portfolio companies. Over the past decade, Chinese companies have attempted to reign back excessive, allegedly coerced social drinking with work colleagues. The allegations show that as prominent a new world fashioned company as Alibaba might be, Chinese businesses, nonetheless, broadly still suffer from some of the worst practices from past Chinese corporate culture. Alibaba’s Board Member, Wan Ling Martello, its Chief Financial Officer, Maggie Wei Wu, and a team of similarly powerful women present within Alibaba, I believe, will surely help craft internal Alibaba policy that will be designed to head off such future behavior. Alibaba is taking their #MeToo allegations very seriously, indeed. 12 A read across to the changes that are mandatory at Alibaba, as expressed by the allegations, informs our view on our own investments in international spirits company shares. I have held shares in leading European spirits companies for years, believing that Asian taste for Western-revered trademarks would drive successful adoption of their cherished brands (e.g., Chivas Regal, Martell Cognac). However, success has proved to be extremely elusive. It appears that an enormously high percentage of spirits consumption at meal occasions (especially business-mandated meal occasions) involve Chinese heritage spirits brands. Despite reverence expressed for Western spirits brands, such as Pernod Ricard’s Martell and Chivas, and despite four decades of my patient investment hopes in Chinese adoption of Western brands, Chinese Baijiu retains primacy. Western spirits welcome the opportunities for consumers to prefer their own brands at events that are open and non-coercive of company participation. The likely outcome is that business dinners over time will be forced to alter conduct in a way that will offer the ability of Western market celebrated trademarks to begin to reflect consumer tastes. In the more open choice of modern, social gatherings that do not require uniformity in what is required of one to drink, consumers will hopefully have, for the first time in decades, an explosion of choice that has long been stifled due to required conformity of business-related entertaining. We will see how the second order outcome will evolve as we watch future consumption growth for Western premium brands as they grow in use as adherence to tradition is lessened. We will surely press Alibaba in all forums that they disclose to investors descriptions of added steps taken to drive away the risks that have arisen from such forced occasions as that in which today’s recently alleged abuse occurred. We will continue, as well, to stay vigilant in our research into the ongoing strength which Alibaba offers investors. We believe growth will remain at Alibaba Cloud as the largest participant in this important growth corridor. We believe that Alibaba core commerce business will continue to grow sharply through adoption of joint ventures and business partnerships with many of our fastest growing consumer goods companies in China. Finally, we do believe that Alibaba will atone for its #MeToo event which they confront head on today. Current Alibaba management must be resolute to oversee driving out such impermissible conduct everywhere within its entire ranks of 250,000 associates. In addition to the above questions relating first to our long-standing practices in support of DEI, ESG, sustainability, etc., and our discussions about our most recent portfolio holding, Alibaba, I also wanted to address one limited partner’s questions in general over our portfolio’s top two holdings, Berkshire Hathaway and Nestlé. The amazing thing about both companies is that you could have asked questions about both of them at any time from their first appearance in my investor portfolios in 1982 for Berkshire Hathaway and in 1986 for Nestlé. Both have been remarkably productive investments, Berkshire Hathaway for over 40 years and Nestlé for roughly 36 years. I believe both remain very attractive, supporting their continued presence amongst our top three holdings (alongside of Mastercard).
