Light at the End of the Tunnel?
3Q 2024 Investor Letter
If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
… …
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
… …
Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son!
If, Rudyard Kypling
Portfolio Performance and Trading Highlights
The third quarter featured one okay month (July), one weak month (August) and one very strong month (September). Overall, you made good money in the quarter, we generated a time-weighted, account size-weighted average net return of 12.32%, outpacing S&P 500’s 5.89% return (inclusive of dividend) by 643 bps.
As consumption collapsed in China beginning in June, and as companies started reporting disappointing 2Q earnings, we stepped on multiple landmines and experienced major drawdowns until the last week of the quarter. Our US holdings behaved strongly, almost all marching up double digits in 3Q including Case New Holland (CNH), which we extensively discussed in our 2Q 2024 letter. The US market rally broadened out of the tech space, benefiting our US holdings. We reversed direction and substantially reduced our US exposure and added to some of the Chinese companies that dropped the most, before the strong rally in China that began in the last five trading days of the quarter. While there is a lot of volatility in equity prices, we kindly invite you to, together with us, think through the business reality of our investments, not to be easily swayed by sentiments and excessive expressions of emotion, and, just like Rudyard Kypling wrote, “meet with Triumph and Disaster, and treat those two impostors just the same”.
Our outlook for China’s stock market remains cautiously optimistic, as if treading on thin ice, with both diligence and care. The Golden God, David Tepper, may be right in his assertion that this is a “buy everything” moment (and trust me I hope he is right!), yet as a Chinese, in my view, I believe there are still structural issues we delineated in our Q4 2023 letters that cannot be easily resolved, including an aging population, poor local government balance sheets, expensive real estate prices, flagging consumer and entrepreneurial confidence, isolation from the West, tail risk of Taiwan, and ideological leftism from the very top – in other words, as Chinese assets are getting rerated higher, the margin of safety embedded in asset prices to account for these structural issues is also getting thinner over time, and we remain vigilant in monitoring the situation as dispassionately as we can. That being said, we are in general positive of the policy measures taken, and believe confidence can get a considerable boost from these governmental actions. The central bank is delivering the right message and as Tim Geithner rightfully wrote in Stress Test, “every crisis is a crisis of confidence”. We will follow the implementation and outcomes of these policies and adjust our Bayesian analysis of probabilities prior as time drones on.
The major disappointments of our performance are all Chinese names (or global companies that trade in Hongkong) including CSPC Pharmaceuticals, Samsonite, Pinduoduo, and NetEase. We sold out our stake in WH Group at a 50%+ gain, an investment we held for close to two years which we have discussed in previous letters. We sold our CSPC Pharmaceuticals position on Sept 30th at a small profit (!) after its recent surge as we believe the growth story remains to be played out and we have been wrong on the gravity of centralized procurement’s impact on its oncology drug portfolio. We added substantially to Samsonite, Pinduoduo, and NetEase, all near the very bottom. Their recent bounce contributed to our performance. We will discuss each of the three aforementioned names which we added to below.
Samsonite
Consumer brands have been sold off this year and Samsonite was especially hard-hit as the market dialed back its high-single-digit revenue growth expectation, so now the largest branded global luggage powerhouse is selling at only eight time earnings. It has much healthier balance sheet than it used to, after three years’ deleveraging. The market seems to have placed on a no-growth assumption on the business while completely disregarding a coming catalyst –the company seeking a dual listing in the US. Comparable publicly traded businesses in the US (e.g. Columbia Sports) are trading at 15-20x PE with similar growth prospects, and the market seems to be completely oblivious to this near-to-intermediate term catalyst. Further, the shares in Hongkong and US will be completely exchangeable, enabling arbitrage and close-to-identical valuation in both regions.
While some pointed to lower-class brand’s competition and blamed the slowing growth on the management team’s unwillingness to compromise on selling price and refuse to engage in extensive promotion, we believe such is actually the right strategy . It’s wise not to dilute corporate brands, and we view Samsonite’s competitive strength in global scale in marketing and advertisement, efficient procurement and supply chain, brand awareness, and economy of scale in manufacturing as getting no credit at all. Travel luggage is a fragmented industry with Samsonite owning ~16% of global share and it mostly competes with local brands other than another global competitor Rimowa (owned by LVMH). For instance, it competes with VIP Industries, one of the very few publicly traded competitors, in India. VIP Industries engaged in particularly aggressive promotional activities in 1H 2024, offering 50-60% discounts on many products in India. This caused Samsonite’s revenue to drop by 11% in 1H 2024, but note VIP Industries only grew 2% in revenue, while seeing EBITDA declining by close to 50% and operating income collapsing by 87%, reflecting the unsustainability of its suicidal strategy.
Pinduoduo
“We expect all vendors to consistently and voluntarily quote the lowest possible acquisition price available on all items. A vendor who does not consistently and voluntarily quote its lowest prices to our buyers will be permanently discontinued as a purchasing source for Costco.”
While we have discussed Pinduoduo in a separate note sent in the middle of the quarter due to its large drawdown and sizable position in our portfolio, we’d like to drive home Pinduoduo’s most crucial long-term competitive advantage
Throughout my 12 years of covering Chinese companies, I have not seen another company that comes close to Pinduoduo’s efficiency. E-commerce is intrinsically a highly profitable business protected by a double-sided network effect, and its moat is further enhanced if what Nick Sleep at Nomad’s Fund calls “scale efficiencies shared” is implemented. For anyone who’s familiar with Pinduoduo, the Costco quote above should sound strikingly familiar. As a matter of fact, the founder, Colin Huang, explicitly acknowledges Pinduoduo as having been modeled after “Costco + Disney”. Instead of cultivating thousands of high-stickiness merchants as Alibaba and JD.com do, Pinduoduo places a much greater focus on consumers through a “SKU-model” just like Costco. The benefit of this approach is that it is much less held hostage to a small selection of merchants. Recall earlier last year JD.com tried to push for another “10 billion subsidies” program but invariably failed as the narrowing set of merchants have an incrementally bigger sway in JD’s strategic direction as a recent vivid example of the drawback of an overly merchant-focused model. Nevertheless, it is also true that if driven to an extreme, ultimately merchants get fed up. Therefore, Pinduoduo told us during the last conference call it was planning to share some of its profit with the merchants, spooking shareholders the majority of whom are probably less long-term than we are.
As believers of Nick Sleep’s “scale efficiencies shared” model, we believe Pinduoduo’s approach is exactly what a long-term thinking corporation will adopt, and Pinduoduo has our full backing to go forward with such a strategy. Let’s try to shift our focus away from Pinduoduo from a moment, invert, and think from its competitors’ perspective – what do we see? We see a fearfully efficient corporate army with a profit margin that is higher than Tencent ready to share part of its profitability to attract and retain the best merchants for the long-haul, while embracing a war-chest amounting to $40 billion ready to strike. How would a competitor feel? If I were such a competitor, I’d be very, very scared.
It is interesting to observe how some of the most prominent investors like to preach the concept of “delayed gratification”, while so few are actually able to endorse a management team that truly adopts the long-view for incremental intrinsic value. We retain our healthy skepticism with respect to their shareholder friendliness and retain the right to alter our mind if we observe noticeable red flags.
Netease
It is funny that two of our top three holdings do not have chief financial officers. One is Pinduoduo, the other Netease. This should not come as a surprise as Colin Huang, the founder of Pinduoduo, and William Ding, the Chairman of Netease, are great friends and William recommended Colin when the latter was working for Google.
NetEase’s stock dropped after the 2Q earnings release as the market overly focused on sequentially deteriorating deferred revenue and worried excessively about large ARPU (average revenue per user) games. We started to accumulate positions right away and have been adding shares since, making it one of our largest positions.
We believe that even for high ARPU games, the expenditure per capita among higher income individuals in China is small and resilience is strong. While Fantasy Westward Journey saw declining cash flow in 1H 2024, we believe it was mainly contributed by cracking down of multiple-account arbitrage, a phenomenon that became widespread during the Covid times which negatively affected community cohesion. Like Pinduoduo, NetEast is sacrificing for the short-term, to benefit for the long-run. As a matter of fact, NetEase has repetitively emphasized that it prioritizes creativity, community culture, and corporate operations rather than short term financial targets, and it never gives out so-called financial guidance.
I’d like to quote a paragraph William wrote when NetEase was going public in Hong Kong several years ago:
In my view, "strategy" is a concept that has been mystified. When people talk about strategy, they often aim to showcase grand blueprints and intricate calculations. Yet, the charm of business lies in the fact that there are always unexpected factors that can render those meticulous plans on paper ineffective. For NetEase, our business strategy doesn’t stem from any grand vision. Before starting a new venture, we usually ask ourselves: Does this product solve a real need for users? Do we love this business, and are we capable of doing it better? At the core of this, user needs are fundamental, passion is the driving force, and capability is the capital. There is little room for scheming or pretense. I believe this embodies a unique philosophy of NetEase: persist like a fool, be passionate about an idea, and one day, we will find the answers we seek. Therefore, when you look back at NetEase's history through the lens of keywords like "users" and "passion," you will no longer find it incomprehensible. Trends will fade, and directions will shift. But the human heart remains constant, and user needs will always endure. NetEase believes in the power of people.
For anyone who followed NetEase for years, she will realize these are not just words – NetEase actually exercises these words on a consistent basis.
Conclusion
There is very little doubt that our greatest assets are our investor base. Again, as we experienced short-term performance setbacks for a certain period of time in Q3, not a single investor reached out inquiring what happened, and some of our investors doubled or even tripled their assets under management to take advantage of sell-off. We thank you genuinely for your trust, and we will spare no efforts to live up to your expectation and try to think long-term and deliver satisfactory absolute returns.
Yours sincerely,
Jingshu Zhang
09/30/2024
“scale economy shared ” I remembered？