Coho Capital Partners annual letter for the year ended December 31, 2016.
Coho Capital increased 6.3% in 2016 compared to a rise of 12% in the S&P 500. Our portfolio did not participate in the post-election rally, which was led by heavily leveraged, commodity and industrial companies. It is always nice to beat the markets, but we consider annual results short-term in nature and focus our efforts on compounding capital over the long-term. Over the last five years, Coho Capital has increased at 20.2% per year compared to 14.7% for the S&P 500. We utilize the S&P 500 Index as a comparison because it is the most difficult index to beat over time. We realize our investors have alternatives for their money and want them to compare the performance of Coho against their best option, an S&P 500 Index fund.
Coho Capital Partners
Given our global mandate to seek value, we could utilize the MSCI ACWI Index as another way to assess performance. Relative to the MSCI, Coho Capital has returned an extra 10.6% per year, resulting in aggregate outperformance of 92.5% over the past five years.
In our note about Amazon, we wrote about investing in businesses that are inevitable. Part of what makes a business inevitable is a self-reinforcing business model. Google is a great example. The company processes three billion searches per day. Every individual search refines future search results, further optimizing the accuracy of Google’s search algorithm. This feedback loop continually strengthens the efficacy of Google’s search product while simultaneously widening its competitive moat. Compare the virtuous circle of Google’s business with the vicious cycle of a mining business: A mining company mines surface level ore first, but upon depletion must drill further into the earth incurring greater costs the longer it is in business. Thus, the business becomes structurally weaker over time.
There are not many self-reinforcing business models in the world, but of those available we feel there is a greater representation within the technology sector than any other segment of the economy. Value investors are often quick to dismiss investments in technology companies for fear that competitive moats are ephemeral. The evidence is strong in this regard, with technology’s inexorable march vaporizing former sure things. But what if we have entered a new paradigm? The phrase “new paradigm” may set off alarm bells, but it is our contention that software focused business models possess more durable moats than when hardware ruled the roost. Venture Capitalist Marc Andreessen advanced this notion in his seminal essay “Software is Eating the World.”
Many value investors view technology through a hardware-centric lens, a view premised upon the manufacturing of non-essential gadgets with ever shrinking margins. After a brief window to make money, bankruptcy is all but assured once someone invents a better mousetrap – essentially, grist for the creative destruction at the heart of capitalism. The shift from a hardware-centric to a software-centric world, however, has turned this notion on its head. Software-centric business models are some of the most compelling in all of business; light capital expenditures, infinitely scalable, high switching costs, and naturally conducive toward network effects. In short, many of the qualities one sees in a self-reinforcing business. We want to own these types of business and the Market is offering them to us at attractive prices because too many market participants remain focused on a hardware-centric notion of technology.
We scooped up several self-reinforcing business models at attractive prices during the second half of the year. They are profiled below:
We have studied Alibaba for a long time beginning with our investment in Yahoo, which represented a backdoor way to acquire Alibaba, not publicly traded at the time. In our year-end 2013 letter, we wrote the following on Alibaba: “Founded by former English teacher Jack Ma, Alibaba is a phenomenon. The company dominates the world’s largest e-commerce market with a 49% share, compared to Amazon’s 20% share of the US online retail market. Approximately 73% of all online retail transactions in China utilize Alibaba’s online payment platform, Alipay. Alibaba possesses profit margins of 44% compared to 0.5% for Amazon. It would not surprise us if in a few years’ time, Alibaba is amongst the world’s most highly valued companies. “
We visited the company again in our 2014 mid-year letter, as we outlined our rationale for purchasing Softbank:
“In short, we continue to believe that Alibaba represents one of the most compelling growth stories in global markets. With a nearly unassailable position within its business segments, enviable economics, and a long runway for growth, we believe Alibaba has a shot at becoming one of the most valuable companies in the world.”
It is fair to say our thesis on Alibaba has not changed. The company has a lot of things we desire in a business: network effects, switching costs, scalability, and latent pricing power.
Alibaba is a collection of business units, but is most well-known for its e-commerce segment consisting of Alibaba (business-to-business), Taobao (consumer-to-consumer and business-to-consumer) and Tmall (online shopping mall for branded goods). The group grew sales 54% year-over-year during the most recent quarter and counts 493 million monthly active users across its three platforms.
Like Amazon, Alibaba’s multiple business units reinforce each other, creating a business ecosystem that grows more valuable with each additional user and transaction – a self-reinforcing business model. With one out of every three Chinese using Alibaba’s ecommerce options, the company possesses tremendous network effects. This provides Alibaba a platform for onboarding new services, such as Alipay (online payment), YunOS (second largest mobile operating system in China), Autonavi (China’s leading map service supplier), Tmall Supermarket (online grocer), Juhuasuan (group shopping) AliCloud (cloud computing) Youku Tudou (online video hosting and streaming) and others.
Alicloud and Ant Financial in particular are poised to emerge as lucrative growth drivers over ensuing years.
Alicloud is the leading cloud company in China with a 70% share. Like Amazon, Alicloud has aggressively lowered prices to rapidly scale, having dropped prices sixteen times last year. Increased economies of scale create a virtuous cycle with reduced prices attracting new customers, enabling greater scale and widening Alicloud’s competitive moat. In addition, Alibaba’s significant in-house demand for cloud computing services provides a natural platform to scale offerings and incubate new technologies, providing the company a substantial advantage over competitors.
AliCloud already has a $1 billion run rate and is expected to grow by a 100% compound annual growth rate over the next two years. However, because Alicloud is still in investment mode and sustaining operating losses, the market ascribes it minimal value. Amazon’s cloud business achieved operating margins of 22% once it reached $3B in sales, suggesting Alicloud could demonstrate profitability as early as next year. Once Alicloud demonstrates a profitability inflection we think the market will confer a rich multiple on its earnings stream. Ultimately, we believe Alicloud can be the Amazon AWS of China, but at its nascent stage of growth, the market does not yet recognize the potential. We saw a similar scenario play out with our holdings in Amazon and expect a favorable outcome with Alibaba as well.
While the market may not rerate Alibaba’s cloud