A Special Report: Your Portfolio Manger’s First-Hand Experiences in China

I had spent the majority of October traveling in China. It is a complex country, and anyone who reduces it to a sound-bite like “all Chinese companies are frauds” or “China’s empty skyscrapers proves it is a massive bubble waiting to pop” is doing a grave injustice to the truth¹.

This past trip was the second time in two years that I’ve been to the fastest growing major country in the world. In aggregate, I’ve spent approximately a month’s worth of time in the mainland, mostly in the Sichuan province, but have also spent ~25% of the time in Beijing. I've tried to not just glide through as a simple tourist but to try to feel what it'd be like to live there day to day, to, to my utmost extent, imagine what my hope dreams and fears would be if I were amongst the citizenry.

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The first impression anyone will have of China is the sheer amount of people in the country. I've lived in American metropolises most of my life, Los Angeles during formative years, then New York for seven years, and perhaps the only apt comparison is that of Grand Central at around 6 PM on a weekday. That would be the median feel. Peak traffic hour feels like when the President is in town and half of the city is gridlocked due to blockades. Or when Penn Station is suffering from technical problems on the Wednesday before Thanksgiving.

The effect is you quickly adopt a very visceral fear of congestion. There is no time or space to be polite. If you try to be a gentleman and you will be consumed by the crowd, stuck in stasis as people nonchalantly push you aside. Any hope of getting anywhere or completing any errand within a decent timeframe will require you to "do as the Romans" and ratchet up your inner aggression. Push forward. Cut into any lane with an open space. Speak loudly in quick clips for any request. Brandish hyperbole liberally. And you will find that, in contrast to the stares and reprimands you may get in western nations for being rude, people generally acquiesce as if it's common protocol, which in a weirdly unwritten way, it is. For example, drivers being suddenly cutoff in traffic strangely generates no road rage. There is copious honking but more of the hi-I'm-in-your-blind-spot-don't-hit-me variety rather than the long, loud, F-you variety. My father-in-law more than once drove on the wrong side of a (small) road, very casually telling me after I startlingly pointed it out that it's because it's less congested on this side.

Beijing subway circa 1800 hours on a Friday

China’s single minded goal of economic advancement has been made into a rallying cry: 趕英超美 — “Chase down England, Surpass the United States”. It is capitalism by edict. The outcome has been wealth creation on a magnificent level, but at the same time, jaggedly uneven. Shooting into the skies in Beijing are modern towers of marvel, but walk a few blocks in any direction and you’re bound to pass ancient dilapidated structures or holes in the wall hawking their wares. The energy required to power this capital of 11 million produce choking pollution that, on bad days, feel like a perpetual sandstorm and such frequent traffic gridlock that it saps the will of its populace to commute beyond the part of town where they live/work. China’s smartphone apps are the most sophisticated in the world, in which you can conduct or receive almost any service you can imagine. However, the delivery mechanism for those services are often grunt laborers biking through smog and congestion, dropping off the food you ordered or delivering the package you sent out or giving you their patented 5 minute haircut or whatnot.

The pursuit of prosperity and the displays thereof has permeated into the culture. Consumerism is the holy text. My wife walked into an old bookstore that she used to love, but left ten minutes later, confused and irritated that the bookshelves are now dominated by how-to’s on getting rich instead of holding volumes representing the diverse tapestry of culture that is China. And while manners are still very much intact in between friends and family, I got the impression it has eroded between businesses and their customers. More than once I’ve witnessed unhappy exchanges in restaurants, drink stands, and stores, the patron certain he or she has been bilked and the waiter/waitress or customer service rep either being forced to take a berating or arguing back aggressively. Such quickly triggered naked displays of dissatisfaction are, it seems to me, symptoms of no longer viewing the other party as a human being but instead as merely the opposite side of a transaction.

This extreme imbalance of population versus available resources and the barely disguised worship of wealth explains a lot, in my opinion. Why do Chinese companies have the reputation of being shady? Because there's less incentive to trust and more incentive to take what they can upfront. In financial parlance, it's the prioritization of Present Value versus Future Value. The discount rate placed on Future Value is extremely high because you never know what tomorrow will bring. Competition amongst 1.4 billion people is maniacal and rule of law is less established than in the west. Also remember: it's not even been one generation since the country exited the Cultural Revolution and advanced out of an agrarian-centric society. The collective memory of the Chinese citizenry have no basis to extrapolate how the future might look. If you have the chance of grabbing a bird in the hand right now versus the mere possibility of two in the bush tomorrow, it's a no brainer. Close your fist and run. Tomorrow is not guaranteed because there's nothing in history that implies it would be. Most importantly, if you don’t take “what’s yours”, someone else will.

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On the upside, the work ethic of the populace is undeniable. The desire for a good life, a better life, is intense. The primary and secondary education system is light-years ahead of the U.S.  Kids attend long after-school tutoring sessions beginning at a young age and teachers are respected—the best of whom are as popular as rock stars and get paid like it, resulting in a virtuous cycle of attracting the best talent to the teaching profession. Young adults right out of college in Beijing bust their butts like Wall Street investment bankers regardless if they are in finance or not. Leaving the office before midnight is an early night.

It’s no coincidence that Chinese multinational conglomerates like Huawei and Dalian Wanda are eating the cake of its competitors in the global marketplace. The lazy explanation is they have the tailwind of unfair trade agreements, but don’t discount the fact that they just work a lot harder and are not wasteful corporations. In this kind of environment, progress seems inevitable. Mistakes will be made, sure, but as Charlie Munger has said, mistakes are a part of life. The important thing is how fast you scramble out of them. China will plow forward interminably because its citizens are tireless and there are literally billions of them. Those empty skyscrapers will be filled sooner rather than later².

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¹Adding further to this complexity is a personal wrinkle: I was born in Taiwan, a country that is ancestrally Chinese, colonized and modernized by the Japanese, and became the refuge of the Nationalist Party after their defeat by the Communist Party during the civil war, stayed from its certain demise only because they savvily secured the United States’ obligation to defend them during the height of the anti-communist wave in the ‘50s. In other words, although I look and speak the same language as those in China, I was brainwashed as a child to believe we are not one; to, indeed, believe China is a country to be suspicious of and feared.

The truth, of course, is much more multifaceted, and given its antiquity, perhaps never to be unraveled in its entirety. Over the course of decades, good or bad fades away and gives way to tragedy for we all inherit the sins of our fathers. Long story short, I feel fortunate to have developed an independent mind and to have met my wife and her family who is from the mainland. I continue to be fascinated by my own history – learning about China will be a life-long interest.

²“An Update On China's Largest Ghost City” – http://www.forbes.com/sites/wadeshepard/2016/04/19/an-update-on-chinas-largest-ghost-city-what-ordos-kangbashi-is-like-today/#6005ae331e08

Case Study: DreamWorks Animation

My previous case study on Virgin America was received with some enthusiasm. I suppose with all this highfalutin discourse on long-term thinking and intrinsic value one naturally craves something a little more practical. I will endeavor to supply this going forward.

DreamWorks Animation (DWA) is a movie studio controlled by Hollywood luminaries Steven Spielberg, Jeffrey Katzenberg, and David Geffen. Their crown jewels are the blockbuster franchises of Shrek, Madagascar, and Kung Fu Panda.

When we talk about great businesses, we tend to banter about pricing power and high margins and asset-lite models. In layman’s terms, it’s getting people to pay for something that costs you nothing. So what’s great about beloved fictional cartoon characters? They never demand a salary. They don’t get embroiled in real-life scandals. They don’t grow old.

Disney understood this almost 100 years ago. This is also why they acquired Pixar, then Marvel, then LucasArts. They all have intangible, indestructible franchises that live forever. Not only can you keep making movies about them, you can sell tons of merchandise and erect entire theme parks around them. All of this, if managed well, can be a perpetual geyser of profit.

It is, however, difficult and expensive to establish these franchises. It costs a lot of money up front to make movies. Accounting principles then dictate film production costs are to be amortized once revenue beings accruing. As such, most of the expenses are front-loaded. This is a quirk but it is not unreasonable – most filmmaking endeavors are boom or bust; they do not have a long tail. Only by thinking a little harder about the nature of animated films, and more specifically, successful animated films, can one come to the realization of the hidden intrinsic value in companies like DreamWorks.

Here are how their movies have fared for the past five years:

You will note: a string of profitable releases, with a number of blockbusters raking in over half a billion in gross receipts. Although it may not be in the league of the Pixars or Marvels or LucasArts, it certainly should be considered as a reliable hit-maker at this point. More importantly, they are strengthening their franchises, franchises headed by immortal and incorruptible animated characters that represent cost-free revenues in the long run.

The stock market, ever schizophrenic, does not seem very impressed. Over that same period, DWA has been as low as $16 and as high as $35 – a 100% swing from trough to peak:

Meanwhile, the world has been changing. Distribution of entertainment, once comfortably ensconced within the movie theater -> VHS/DVD -> network TV paradigm, is being disrupted by Netflix, Hulu, Amazon and their ilk. Content has become more valued in a world where distribution is being commoditized by the internet. You want people to watch your channel or subscribe to your service? Offer exclusive content.
 
You know how this story ends. In late April, Comcast made a bid for DreamWorks for $41 per share, a 50% premium above DWA’s 52-week high. Intrinsic value wins again.

Unlike the Virgin America case study, it was not guaranteed you would bank a great return if you bought DWA anytime within the past five years. If you bought at the peak at the end of 2013, you only made 6.5% annualized return. One would imagine, though, if you had the conviction then, you would have made additional, larger purchases as the stock sold off over the next two years. As such, a cost basis of anything under $25 within the past five years would have yielded a double-digit compounded return. Within the past three years, it would be in the high teens.

DWA was a stock I had watched for a long time. I never pulled the trigger because I never got comfortable enough with the valuation. Intellectually I understood the thesis, but I kept hoping for it to get cheaper. Patience can be difficult – a dual-edged sword, especially in the stock market. Patience in waiting for a security to become fully valued is a virtue, but excess patience in waiting for a security to reach an acceptable price could result in lost opportunities. Neither is preferable: Not taking enough risks is as big an impediment to wealth creation as taking too many dumb risks. Finding the balance is a never-ending quest, a life-long learning experience.

Case Study: Virgin America

If you’ve flown Virgin America before, you know they are legitimately differentiated from the soul-sucking national leviathans. New planes that pulse like a night club, high tech seatback concierge systems, flight attendants who don’t totally hate their jobs, surprisingly competitive prices, etc. They’ve been gobbling up market share ever since their inception in 2007 and went public in November of 2014.

The airline industry has been consolidating aggressively for several years now. Historically an industry that is in the hall of fame of value destruction, M&A (and collapsing crude oil prices) have helped the players settle into an uneasy but profitable oligopoly. Meanwhile, Virgin America’s success has not gone unnoticed, although you’d never be able to tell if you just looked at the stock price. Here’s a chart of VA’s performance since their IPO until late March:

For a year and four months, the stock went exactly nowhere. Chart technicians call this “range bound”, with “resistance” above $40 and “a floor” around $30. But underneath, business was booming. Gross profits grew 24% year over year while operating profits nearly doubled thanks to cheap jet fuel. Their presence at LAX and SFO grew stronger. And two of their competitors began salivating.

On March 23rd, word leaked out that VA was “in play” – Street Lingo for “for sale”. Shares popped 13%. And then, several weeks ago, on April 4th, Alaska Air announced they were acquiring Virgin America for $2.6 billion, or $57 per share after a frenzied bidding war against JetBlue. VA shares shot up another 47% that day:

If you’re following along with your calculator, that’s a cool 83% return in about two weeks. That kind of return is impossible to the proponents of efficient markets. Of course, no one could have (legally) timed it perfectly, but consider:

• If you bought VA at its closing price of $30 on the day it IPO’d, you earned a 54% CAGR.
• If you bought VA at its peak prior to the buyout (~$42.50), you earned a 21% CAGR.

(The calculated CAGR is assuming you didn’t “trim profits” or “cut your losses” at any point in between, an endeavor that, by my estimation, adds no more long-term alpha than a coin flip, but is an endeavor heavily practiced by the vast majority of market participants.)

So any way you slice or dice it, VA shareholders got paid, ranging from handsomely to a flat-out bonanza¹. And while the stock price may not reflect it, value always matters, especially private value, i.e. how much the business is worth to someone as a whole, someone who can control operations or allocate its cash flows. The timing is unpredictable, but eventually, over the long run (count ‘em in years, not months), the market is a fine arbiter of value – a right proper weighing machine.

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¹And here, buried in a footnote, I humbly beseech you to not ask the question begging to be asked, which is “why didn’t we own any VA?” to which the answer will be an averted gaze and some mumbled variant of, well, hrm, I looked at it last April but, ah, it fell off my radar… A costly error of omission resulting in beaucoup regret.

2015 Annual Letter To Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.