2017 Performance Update

My portfolio gained 36.9% in 2017.

On an absolute basis, this is a good performance. But, we know with certainty that this is not a sustainable in the long term as there are bound to be years with low or negative returns which will bring down the long term compounded growth rate.

On a relative basis, this is less than desirable performance. The Hang Seng Index was one of the best performing stock index worldwide in 2017, returning 38.0% including dividends.

China property companies had a magnificent run in 2017, with companies like Country Garden (2007.HK) and China Evergrande (3333.HK) going up 5-6x. If I was running a short book, China Evergrande would be one of my prime candidates, even before its explosive growth in price. It is sometimes better to be lucky than good. This reinforces the notion that short selling is very difficult, and that you have to be really diversified. Jim Chanos’ long term performance of his short only fund is very impressive (a few percent compounded annual growth), given the difficulties in short selling and that the general stock market increases over time.

China Evergrande is one of the most leveraged property developers in China with a huge amount of inventory. In my opinion, any short term difficulty in the property or money market would easily cause it to go down under. However, 2017 was a very good year for property developers as the biggest players reported increases in sales of around 50% or more despite strong government controls in certain cities due to rapidly increasing housing prices. China Evergrande now trades at a price to book ratio of around 1.6, which I think is way too excessive.

Tencent Holdings (0700.HK) was responsible for a significant amount of the gains in the Hang Seng Index as it started the year at HKD 208, and ended at HKD 407 for a market capitalization of HKD 4 trillion. This is now equivalent to a 20% weighting in the market capitalization weighted Hang Seng index.

I did not have any position in Tencent at any point during the year, so this affected my relative performance negatively. Traditionally, value investors tend to avoid tech companies because it is difficult to predict their future given that the industry dynamics can change relatively quickly, drastically affecting their competitive positions. Blackberry is the most recent example that comes to mind. At its peak it was the best selling smartphone brand worldwide and worth over USD 70b. In a matter of less than 5 years, its market share was eaten away by Apple (AAPL) and Samsung. Today, there are hardly any consumers who use Blackberry phones.

I have been thinking the tech industry in the past few years, but never did any in-depth research so as to be able to initiate a position. My general observation and thoughts are that we have come to a point where an increasing amount of value in the economy in the future will be created by tech companies.

With such prospects, it may not be wise to avoid investing in tech companies just because of an old value investing paradigm. What works in investing are constantly being rewritten as the world evolves.

In 2018, I will look at tech companies more closely, and hopefully be able to get a level of understanding that allows me to initiate some positions in if the price is right.

Current significant positions:

Great Wall Motor (2333.HK)

Great Wall remains my biggest position, as I bought heavily in 2016 when it was trading at low, single digit P/E multiples. Rumours about a joint venture with BMW to produce electric MINI branded cars sent its price to a high of HKD 12, and it thereafter plummeted after the company confirmed that the two companies were still in talks. It ended 2017 at HKD 8.95 for a gain of about 31% for the year.

Since the automobile was invented in the 19th century, the returns of the US auto industry has not been good for investors. There were literally more than a hundred different auto manufacturers when the industry was in its early stage, as compared to the big three (Ford, GM, Chrysler) that we have in the US today, with GM and Chrysler emerging from bankruptcy reorganization in 2009.

Like airlines, auto manufacturing is a difficult industry. I think the reason for this is that there are little barriers to entry for mass market auto manufacturing. The industry as a whole does not earn good returns on capital because it is very competitive. For the mass market segment, only the lowest cost manufacturers can earn a good return on their capital. The Toyotas and Southwest Airlines of the world are the exceptions to the rule.

Despite the challenges, the reason I was comfortable with Great Wall was that it is a low cost, local vehicle manufacturer earning good returns on invested capital in an industry which still has a long runway for growth (Total vehicles per capita is only 0.2 in China compared to around 0.8 in the US). The fact that it was selling for a low multiple despite its impressive long term growth since 2003 also helped.

However, 2017 was a disappointing year for Great Wall. Total vehicle sales came in at 1.04m units (down 0.4% from 2016) vs the company’s 2017 target of 1.2m and around 4% increase for the industry. Profitability was also severely affected because of increased competition in the SUV segment, which comprised around 90% of the total vehicles sold by Great Wall.

Looking at competitors’ results, this is not what I had expected as other competitors like Geely Automobile (0175.HK) achieved higher profitability on the back of increased sales of around 60%.

Further, China is one of the world’s biggest markets for electric cars and is pushing to phase out fossil fuel cars by a few decades, so having an electric car model is essential for any auto manufacturer in China. Fortunately, Great Wall already has it in the works and the talks with BMW to help them produce electric MINI cars is a good sign.

The other major development in the auto industry is autonomous vehicles. This is still in its infancy, and it is difficult to predict how it will affect the industry.

Given the unexpected poor results and potential difficulties and uncertainties in the future, I will monitor future developments closely and sell down the position significantly if there is information to suggest that my assessment of the company was wrong.

 

Red Star Macalline (1528.HK)

Red Star Macalline is a owner of furniture malls in China, and by far the biggest player in the chain mall format. The furniture store industry in China is still relatively young and extremely fragmented, dominated by “mom-and-pop” individual stores.

Red Star Macalline’s business model is not what you’d expect in that it does not actually own any of the furniture inventory. Instead, it acts more like a property developer and landlord in that it purchases land to develop furniture malls, and leases out individual store units within the malls to furniture retailers.

Increasingly, in the past few years, Red Star Macalline has been moving towards an asset light business model, whereby it provides consultation and property management services to third parties for the construction and operation of Red Star Macalline branded furniture malls. This model allows the company to create a nationwide network at a much faster pace as little to no capital is required to provide such services to third parties. However, Red Star still retains ownership of malls in perceived good locations and tier 1 and 2 Chinese cities.

I think the industry is ripe for consolidation and there are significant advantages for the furniture chain mall format over individual stores. Being the biggest player in the industry and expanding quickly with an asset light approach, I believe that Red Star will be the market leader for years to come and may eventually be valued on a high P/E basis, in line with other asset light property companies such as Marriott.

Value Partners (0806.HK)

Value Partners is an asset manager, whose flagship equity fund had very good long term returns of around 15% after fees. They attribute this to their value investing and unique approach of conducting hundreds of company visits each year to conduct due diligence.

The results of asset managers can be very volatile, because the markets they invest in are volatile. Also, Their results may be affected greatly by client purchases and redemption, which are generally momentum driven by the results achieved by the manager in the recent few years.

That is to say, a lot of money piles in when the manager’s recent results are good, and the reverse is true when recent results are bad. For example, after the record year in 2007 when Value Partners achieved profits of HKD 1.4b with an AUM of USD 7.3b, the global financial crisis in 2008 made clients redeem USD 2.2b of funds.

Redemption of funds forces the manager to sell their holdings at the prevailing price, whether or not they think it is good for long term performance. Value Partners’ profit dropped to HKD 66m with an AUM of USD 3.2b at the end of 2008

Fortunately, Value Partners recovered subsequently and continued to deliver good results, ending 2017 with AUM of about USD 16.2b. I bought Value Partners in 2H 2017 because the market did not seem to be giving enough credit for the level of AUM and implied performance of Value Partners’ funds, given the good performance of the Hong Kong Stock and China stock market in 2017.

Zhou Hei Ya (1458.HK)

Zhou Hei Ya is a casual braised duck-parts seller. They offer products like braised duck neck, feet and clavicles. Judging from product photos, these are not things I will voluntarily put in my mouth. But, these snacks are well loved by the people in China.

In 2016, Zhou Hei Ya managed to sell 27,293 tonnes of braised duck parts through their self operated network of 778 retail outlets, generating revenues of RMB 2.8b and net profit of RMB 715m. All this from a standing start of a single outlet in Wuhan, Hubei in 2002, making founder Zhou Fuyu a billionaire in USD terms.

Zhou Hei Ya purchases duck parts from suppliers, and processes them in a factory in Hubei, before distributing them via their retail outlets, predominantly located in Central China. The economics of an individual retail store are highly compelling.  The average capex to setup each store of about 10 to 50 sqm is around RMB 120k and the payback period is less than a year. Stores in Zhou Hei Ya’s home province of Hubei are mainly in transport hubs and records annual sales of around RMB 4m per store, as compared to main competitor’s Juewei’s annual sales of around RMB 1m per store.

1H 2017 was good for Zhou Hei Ya. Revenues went up by 16.5% while net profits were up only 5.3%. Gross profit margins remained stable at around 60%, but selling and distribution expenses went up 37.3% due to increased marketing and promotion activities, for both online and offline. Marketing expenses are discretionary expenses which impact current earnings negatively, but are good for future earnings. This is because the image and consumer perception of the product is as important as the taste of the product itself.

The next phase of expansion will be centered outside of Hubei province. China is a big country, and there are different tastes and preferences of consumers in different parts of the country. It may be a challenge to adapt the product to local tastebuds. But anecdotally, Zhou Hei Ya and Juewei are the two most recognizable brand names in their category. I am optimistic about its growth prospects, although I expect annual sales of their stores outside Hubei to be lower.

Dali Foods (3799.HK)

Dali Foods is a snack food and beverage manufacturer from Fujian province. It sells snack food such as bread, cakes, pastries, chips, and biscuits, and beverages such as herbal tea, energy drinks and plant milk based drinks.

Its unique competitive advantage is the ability to launch and market new branded products quickly and effectively. For example, its energy drink brand, Hi-Tiger, was introduced in 2013 and brought in annual revenues of RMB 2b in 2016.

In 1H 2017, Dali Foods’ revenues went up 9.6% to RMB 9.9b and profits went up 6.9% to RMB 1.7b. A new soy bean milk drink was also introduced. The attractiveness of a branded food business is that once a brand is established in consumers’ minds through a combination of good taste and marketing, it will be a sticky and recurring source of revenue as consumers tend to form a habit in consumption and also tend to repurchase the same brand. Good processed food businesses like Kraft and Nestle can earn very attractive rates of return on their capital.

The interesting thing about Dali Foods is that it only placed the minimum allowable number of shares in their IPO in 2015, which is 15% of total outstanding shares. Looking at their financial statements, it seemed that they could have used internally generated capital to fund their near term expansion plans. This suggests that the owners IPOed due to other reasons. To date, their cash balance is around RMB 9-10b, which is just about the same amount raised during the IPO.

I started buying Dali Foods in mid 2016 when it was trading at around 15x P/E. I am optimistic about its long term growth as it introduces new products and widens its distribution network.

Link REIT (0823.HK)

In a typical REIT structure, there is a property developer parent who injects property assets into the REIT, sells it to outside investors but retains a majority shareholding. They are usually installed as the external REIT and property manager. The interests of the minority shareholders may not be aligned with the REIT manager’s due to their incentive structure and parent company backing. Hence, I am averse to investing in REITs in general.

To my knowledge, Link REIT is one of the very few REITs in Asia that is internally managed. It has the right incentive structure and a very good long term track record of creating value by good property management and through asset enhancement initiatives (AEIs) which boosts visitor numbers and rentals.

When I first bought Link REIT in 2015, it was trading at a considerable discount to its long term historical average. In 2017, Link REIT continued to deliver good results and increased dividends for the 11th year in a row, and the valuation gap has closed significantly.

 

Exited positions:

Anta Sports (2020.HK)

I bought a significant amount of Anta Sports starting in late 2016 at around 15x P/E. Anta is one of the most recognised sportswear brand (local) in China after Adidas and Nike, and recovered the quickest and strongest after an industry wide oversupply in 2013 led to significant declines in profit for all industry players. I thought that it was a high quality business with opportunities to reinvest capital at high rates of return, hallmarks of a long term compounder.  The stock experienced good earnings growth in 2017 and a big P/E multiple expansion, and I decided to trim the position significantly due to valuation. I am not sure if it is the right move to do anything but buy and sit tight when you find a good long term compounder, so I will make a mental note not to be averse to buy back shares at prices which are higher than what I sold them for.

AAC Technologies (2018.HK)

I bought some AAC Technologies in mid 2017 after it declined significantly on a short seller report asserting that it had inflated profits by offloading costs to previously undeclared related parties. AAC is a supplier of smartphone audio and haptic parts, its biggest customer being Apple. The main weakness of the short seller report was that the supposed related parties were actually profitable, albeit having much lower margins than AAC. You would expect these related parties to record a big net loss if AAC was shifting a significant amount of costs. Also given that AAC reported a sterling 1Q 2017, I bought some shares, which I later sold in 2H 2017 due to valuation after 1H 2017 results were not as good as 1Q 2017. The share price then proceeded to climb further.

Tier 2 & 3 (net net) basket

Sold Emperor E Hotel (0296.HK) +32.8%, China Ting (3398.HK) +69.1%, Chen Hsong (0057.HK) +24.5%, Hopefluent (0733.HK) +109.3%, Centron Telecom (1155.HK) +28.8%, Asia Cassava Resources (0841.HK) +97.9%.

Sold Sitoy Group (1023.HK) -13%, Jiangnan Group (1366.HK) -5.2% at a loss not long after I bought them after their fundamentals deteriorated which meant that the price had to fall further for it to be an attractive buy.

Outlook in 2018

I think that stocks are starting to become expensive in general, although the level of optimism in the markets is not indicative of a bubble. Also, there are no extremely mispriced bets in my portfolio, so I expect my returns in 2018 to be much lower than in 2017.