Global Valuation Comparison

Increasing Western Exposure as Dividend Aristocrats Rally in China

Before I start with this quarter’s letter, I’d like to share with you some elegant arts of root carving. All the statues that you see above are carved using either golden camphor wood or phoebe sheareri. In the last few days, I had the tremendous pleasure of visiting Huakang Pharmaceuticals, and with the gracious help of one of its largest shareholders (who also turns out to be one of our investors), we visited the root carving museum of Kaihua (开化) together. I was deeply in awe of Guqing Xu and his group of artists who devoted more than a decade to construct the excellent statues of the “Five Hundred Arahats”(五百罗汉). When Guqing started the root carving, he was already in his early 50’s, and the temple is now a 5A scenic areas. Great art, like our investment journey, simply takes time for compounding to take effect and create minor miracles, and we will press ahead with Guqing’s legendary art in heart.

Dear Readers:

For the second quarter, our net return turns out to be 7.33%. By comparison, the Standard & Poor’s 500 Total Return Index returned 4.28% for the quarter. Our net return is calculated as the time-weighted average return (TWR) adjusted for account size weighting, inclusive of reinvested dividends, net of any fees, carries, and expenses associated. Past performance doesn’t predict future results.

The primary contributors to our second-quarter return included First Tractor, Tencent, PDD, and Meituan. The primary detractors were CNH, Luk Fook Jewelries, and Samsonite. On the short side, we suffered heavy casualties as Carvana rallied 40% post-earnings, and we had to cover our position.  Digital Realty, another security we have discussed previously, also moved against us. For a post mortem on Carvana, please see page three of this letter.

In the second quarter, as the leadership in the US equity market substantially narrowed down to a group of momentum stocks and mega-caps purportedly benefited by artificial intelligence, many US securities started to sell off. The ones that have European operations and exposure were particularly hard hit due to the rise of the far right in France and Italy. On the other hand, several Chinese securities, especially the ones with high yield, were chased by the market as China’s domestic treasury yield hit a new low. As the risk-reward shifts between these two classes of assets, we started to sell some Chinese high yield stocks, and rotated into US SMID (small-and-mid-cap) stocks.

Trading Highlights, Second Quarter

We added to our Tencent position which was established last December during its sell-off due to the Gaming Draft for Comments (游戏意见征求稿). We sold Meituan as its valuation grew into our estimated fair value, and used the proceeds to add to PDD (Pinduoduo) as it was sold off by the market before its quarterly earnings. We substantially sold out First Tractor and used the proceeds to establish a position in Case New Holland (CNH), as First Tractor rallied and CNH was sold off. We bought Samsonite as it sold off after its quarterly earnings call, believing its dual-listing in the US in addition to Hongkong will serve as an interesting catalyst that can potentially unlock shareholder value.

Case New Holland Replaces First Tractor

We were probably one of the earlier investors who discovered the value in First Tractor. When we bought the stock, it was trading at 83% of the net cash position on its balance sheet and 6x trailing net earnings, yielding 8%+ in terms of dividend. It was also benefiting from explosive growth of exports. However, last Autumn Festival, it had zero, literally zero shares exchanging hands, indicating complete apathy from Western investors regarding this stock. As the share price tripled in two years and rallied at one point 100% this year, its appeal has substantially declined. When we started selling First Tractor, it was yielding about 4% in terms of its dividend, and trading at a 10x free cash flow multiple. The valuation was still not demanding, but we have found something more attractive.

Figure 1: Case tractor vs. John Deere — in the world of farming, farmers develop strong loyalty and affection towards Red/Blue (Case New Holland) and Green (John Deere).

We bought Case New Holland (CNH), a virtual duopoly with John Deere in the field of large agricultural combines, when it was yielding a 4.4% dividend and also a 10x free cash flow multiple. Large combines are mission critical to farming operations and CNH’s duopoly status is more attractive than First Tractor’s market position in China. For First Tractor,Weichai Power is a formidable opponent. CNH is attractively priced because 1). We are going through a downturn in the agricultural cycle clearly telegraphed from John Deere and CNH last year; 2). Scott Wine, the architect behind CNH’s recent operational improvements and recently its CEO, has left the firm somewhat unexpectedly.

Figure 2: Case New Holland’s dividend yield reaches close to 5%, and its attractiveness outweighs First Tractor, leading to our rational decision of replacing our stake in First Tractor with Case New Holland.

We believe neither of those problems should be of primary concern to a long-term investor. Like all commodities markets, agricultural goods have cycles, but we believe this cycle will be shallower than the 2015-2016 down cycle due to a more aged fleet and stronger replacement needs. In addition, despite the downturn, CNH has maintained its guidance of generating $1.2-1.4 billion free cash flow for 2024, and as it trades at $12.1 billion right now, it sports an attractive trough 10.7% free cash flow yield at the mid-point of management guidance. Scott Wine was obviously instrumental in improving the operations of CNH’s agricultural and more importantly construction segments’ margins. But we view the new CEO, Gerrit Marx, favorably due to his strong track record at Iveco and his focus on technological innovation.

One core thesis that leads to our investment in CNH is we believe CNH is the only player other than John Deere that has the capability of embracing the age of precision farming. CNH’s acquisition of Raven provides it with the technological knowhow to wade into the precision farming water, something First Tractor probably won’t ever have the capability of pulling off (given its state-owned-enterprise status and a completely different suite of required skillset for equipment digitization). As CNH increases its precision farming sales as a percentage of its total sales, the subscription based, recurrent and predictable cash flow enabled by its digital services should naturally enjoy a much higher multiple than cyclical equipment sales. Therefore, we should enjoy 1). A cyclical upturn leading to better free cash flow characteristics; 2). A larger percentage of precision farming revenue which enjoys a SaaS-like multiple. These two conditions should propel CNH’s shares upward through a classical Davis Double Play (a term coined by Shelby Davis that refers to the expansion of both profitability and multiple). Last but not least, we favor partnership with the Exor family over that of the Chinese government. Thus, the transition was a relatively straightforward call for us.

Carvana:

Carvana’s shares exploded upward after its May 1st earnings report. What I failed to follow closely enough was that Carvana and Hertz Global had a common large stakeholder. As Hertz was going through financial distress, it had to sell its disastrously acquired Tesla fleet only three years ago. Carvana was a key beneficiary. The fire sale from Hertz coupled with decent selling prices for used Tesla cars led to much improved profit margins for Carvana. The existence of the stakeholder made sure Carvana enjoyed the benefit of Hertz’s distress. In addition, Carvana owns warrants in Vroom, an automotive financing company. The Vroom warrant stake, with Vroom’s parabolic rise, harvested considerable unrealized gain and that was the key driver behind Carvana’s turning profitable in the first quarter.

Figure 3: We spent lots of time analyzing Carvana’s fundamentals, but failed to see the curved ball which hit us from Hertz — ironically, the transaction involved one of my all-time short nemesis, Tesla.

Recently, Hertz announced accelerated sale of its remaining 20,000 Tesla on Carvana’s platform and we had to close our short position at a loss.  We do still have several sold call contracts open at much higher strike prices remaining for accounts that allow us to play such a hand. 

All in, we painfully lost 1.5% of our net worth on our Carvana short. I am entirely responsible for our loss and I am sorry. One key reason that the late Charlie Munger did not want to short any stock was he hated seeing himself scrambling to meet margin calls while the crooks enjoyed his money.  We are experiencing precisely how Charlie feels right now. I believe Carvana will remain an unprofitable to marginally profitable operation and its current valuation is detached from reality. But on the other hand I find it difficult to argue with the fact that momentum stocks like Costco (which my colleagues own, despite my misgivings) and Wingstop (a chicken-wing restaurant franchise selling at north of 100x PE) can sometimes climb even though I believe they are severely overvalued. I believe the US equity market is going through a nifty-fifty moment similar to the early 70’s, and just like McDonald’s and Xerox back then, these momentum darlings will at some point come crashing down, burying a generation of momentum chasers.

Despite my belief that these momentum plays are silly, I have made the decision of reducing or eliminating some of our short positions. Apart from several contracts of index hedges and Carvana calls outstanding, we only have Digital Realty left as a short.

Another important development that transpired since I wrote the reflection was that noted short seller Prof. C might be in legal trouble. A former partner has sued him, alleging misappropriation of funds, a charge that Prof. C denies. As I have acknowledged in the past, I learned my skill of short-selling almost entirely from him.  The Wall Street Journal has reported that he closed his firm by the end of 2023.  If one of the finest and smartest business and securities analyst I have ever seen can’t make a go of short selling, perhaps short selling doesn’t deserve a big place in our operations.  We may compound capital faster and be much happier by not hating and hoping businesses we short to fail. At a certain stage of life, we all need to reconcile with ourselves, and we need to do subtraction to enjoy the fruits of simplicity.

We believe our portfolio, composed of a group of the best businesses we can identify in US and China, will produce satisfactory returns across cycles. Please don’t hesitate to contact me should you have any questions regarding any positions we hold in your portfolio. Thank you for entrusting your capital with us, and we shall safeguard it like ultimate bulldogs.