Everything has beauty, but not everyone sees it – Confucius
During the months of August and September, the proverbial wall of worry suddenly looked too steep for many investors’ comfort level thereby prompting an en masse retreat across the market. From our perspective though, we find a less crowded wall much easier to climb. Each nook, cranny, and toehold is easier to see, and the entire path upward towards the summit moves into sharper focus.
In many ways, today’s market represents the latest chapter in an ongoing trilogy of macro obsessions. First, it was U.S. credit and the consumer, then it was southern Europe’s credit with the fate of the EU hanging in the balance, and now it is near-term growth in the emerging markets and its credit implications (being further complicated by U.S. Fed policy). To be fair, each scenario has been complex and warranted some concern. This time is no different.
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We believe what makes the current investment environment nerve rattling to so many investors is the coupled decline in Chinese economic growth and global commodity prices. During the past fifteen years the two phenomena of steady Chinese economic growth and rising commodity demand (and prices) walked hand-in-hand. Now that commodity prices have drastically reversed course, investors interpret collapsing commodity prices as having deeply pessimistic implications for the Chinese economy, and perhaps other economies and their aggregate demand. We accept the premise that China’s turn away from investment led growth is a negative for industrial commodity prices. However, we find the corollary that lower commodity prices carry such a negative read-through for the Chinese economy in the years to come as an over-simplifying and shakier heuristic. We see the Chinese economy as ships passing in the night, with technology and knowledge-based firms racing ahead, while the old State Owned Enterprises (SOEs) face slow growth or decline. We believe share price volatility created an opportunity to spot bargains in the former, but less so in the latter. Still the fact remains that the coinciding presence of slowing overall Chinese growth—which is a necessary byproduct of its government’s changing policies—and declining commodity prices have augmented uncertainty and confusion in the market regarding near-term prospects. Given this fear, the idea that the Federal Reserve might increase interest rates in this environment only serves to fan these flames of uncertainty towards five alarm status.
We believe when facing such near-term uncertainty, employing a long-term perspective is not a tagline, it is a necessity. On this matter, history provides some evidence. In depth research (Super-cycles of commodity prices since the mid-nineteenth century, Bilge Erten, Jose Antonio Ocampo) into commodity super-cycles suggests that there have been four commodity price super-cycles dating from 1865-2009. If we look at the two super cycles prior to the current one dating from 1932-1971 and 1971-1999, and then take the respective peaks of those markets in 1951 and 1973 as signals to sell equities, investors would have missed out on compounded returns in the S&P 500 of 11.38% from 1951-1971 and 13.94% from 1973-2000. We consider these annualized equity returns to be attractive, and note that they coincided with commodity price collapses of -43.3% from 1951-1971 and -52.5% from 1971-1999. In sum, we believe that the presence of falling commodity prices possesses little predictive value for equity investors. Importantly, this same study suggests that falling commodity prices reflect weakening aggregate demand with a six year lag. With that said, we do not believe the observation that global economic growth stalled six years ago in 2008-2009 is a revelation.
What may be something of a revelation though, or perhaps just something often forgotten, is how infrequent corrections (such as this most recent one) and bear markets tend to appear in an investor’s lifetime. Also worth noting is the relatively small historical decline these events represent in comparison to the market gains that have followed. In the illustration below produced by Morningstar, we can see a tidy summary of these events over the past forty-years in the S&P 500.
Bearing all of this in mind, we viewed the past few months of unsettling volatility and declining share prices as an opportunity. In our view, it was a better opportunity than the magnitude of the declines suggested with losses of only -12.4% on the S&P 500 and -14.9% on the MSCI ACWI, respectively. The reason we believe the correction represented a better opportunity than usual is owed to the unmitigated correlation between share prices across the various spectrums of the market, whether that be size, quality, or industry. These are the same correlations that have plagued stock pickers and active managers over the past several years, but as share prices fell, we believe this phenomenon became a bargain hunter’s best friend. Normally, we would expect quality companies to fall less in price during a correction, as this has been the case in historical market environments, and so the ability to purchase new positions in quality, growth oriented businesses was a pleasant surprise.
Spotting specific bottom-up opportunities always requires some work, but during the most recent correction it became clear that China was the primary source of market uncertainty and therefore, nearly any business with ties to the country or the emerging market consumer found it shares being unusually punished. With that said, we adhered to Sir John Templeton’s timeless advice of searching for bargains where “the outlook is most miserable” and based on the news headlines, and rapid share price declines that place appeared to be China, in our opinion.
In the case of a panic, correction, or even a bear market, we focus our initial research process on enterprises in a strong competitive position and possessing attractive long-term secular growth opportunities. The benefit to this strategy is that a competitively positioned, growing firm’s near-to-medium term returns on capital have a better probability of being maintained at attractive levels. This in turn may lead to higher compounded returns for shareholders over time, as capital continues to be invested, and returns are realized, all things equal. In most cases this means temporarily eschewing the stereotypical low multiple valuation businesses that are often associated with value investors. These latter businesses are more often tied to a mean reverting investment thesis. We also favor these bargains very much, but find that these businesses are often already on sale prior to a market correction, and are just as likely to remain so following the market’s recovery. Put differently, the window of opportunity is less likely to slam shut as market sentiment rebounds. With that said, we also found opportunities during the sell-off in energy and agribusiness firms, but we will be discussing those ideas in a follow-up commentary. Returning to China, we found that the sell-off and ongoing discontent surrounding the country’s near-term economic growth rate drove share prices in both the internet search firm Baidu, and the e-commerce firm Alibaba down to attractive levels.
At first blush, these firms and their valuation multiples may not be the most obvious choices for a bargain hunter. The key here though is how the multiples compare to future potential growth, and as we alluded to earlier some probing beyond the superficial P/E multiples is often necessary. This was the case here as well. Beginning with Baidu, the firm’s P/E on estimated earnings dipped to 18.9x during the heat of the sell-off in late September, and although that compares favorably with the firm’s earnings growth rate of 25-35%, its P/E after removing its large cash balance dropped to 13.9x against the same EPS. The firm’s ex-cash P/E in September 2015 proved to be materially discounted versus its January 2009 crisis low of 16.0x. Even so, we believe some additional context and analysis brings the scope of the bargain into even better focus. Baidu in many ways can be thought of as China’s version of Google, insofar as the two firms dominate internet search in their respective markets. Baidu, also like Google is investing heavily into its future, including the secular aspect of “singularity” that we described in our investment thesis for Google earlier this year. With that said, Baidu’s consolidated operating margins tend to mask the underlying strength of its core search business, as corporate investments and particularly Baidu’s push into O2O (online to offline) businesses with their necessary marketing expenses weigh on current levels of profitability. Bearing this in mind, if we peel back the effect of these corporate investments we believe we can get a clearer picture of what investors were paying for the firm’s core search business during the September sell-off. Moreover, we believe core search will continue to drive Baidu’s earnings and cash flow in the near-to-medium term. To begin, we start with the firm’s market cap of $46.5 billion in late September, and then subtract the approximate value of holdings in Qunar and iQiyi of $4.5 billion, to arrive at a standalone market cap for Baidu search at $42.0 billion, which then divided by search net after tax profits of $5.3 billion gives us a P/E of 7.9x for the firm’s core search business. The bottom line is that the dominant search engine business in China was available at less than an 8x P/E where internet penetration remains only 49% versus 87% in the U.S., based on World Bank figures. From our perspective, those dynamics represent a bargain.
Turning to Alibaba, we see many of the same valuation and growth dynamics at work. Although the firm’s P/E on estimated earnings fell to 17.1x in late September, its P/E with its heavy cash balance backed out of the valuation was even less demanding at 15.2x EPS. Again, the P/E multiple needs to be placed in the context of long-term sales and earnings growth, and despite the slowing economic growth in China, Alibaba released this week quarterly sales and earnings growth of 32% and 38%, respectively, that beat expectations. In our opinion, the China-centric share price correction conspired very well with Alibaba’s own share price flop (shares have declined 51.8% since its 2014 IPO high) to drive Alibaba’s valuation down to an attractive level. Irrespective of the near-term share price movements, we see a long-term opportunity in owning the firm’s shares. Given our longstanding attraction to the development of the emerging market consumer, we view Alibaba as an attractive potential long-term holding given the still nascent development of e-commerce in China. So while overall internet penetration in China remains low by developed market standards, e-commerce penetration is even lower. For example, consider that based on Morgan Stanley’s estimates there is an addressable female e-commerce market of 410 million women in China, and only 30% are currently shopping online. This translates into 290 million women that are not shopping online, a figure that is approaching the entire population of the U.S. at approximately 319 million (based on U.S. Census figures). Applying the same data set from Morgan Stanley, the percentage of women shopping online in Tier 3 cities is considerably less at 13%. By comparison, the penetration rate in Tier 1 and Tier 2 cities is higher at 37% and 47%, respectively. We believe that these underlying fundamentals may support continued growth and adoption of e-commerce in the context of a secular growth trend that may be able to resist cyclical factors including the recent slowdown.
Moving beyond the simple goal of integrating the Chinese consumer into its e-commerce fold, Alibaba possesses the more ambitious target of serving 2 billion consumers within the next decade. A significant component to this goal is the construction of a vibrant cross-border marketplace where international brands gain access to the Chinese consumer, and undiscovered high-quality Chinese firms gain access to developed market consumers also. Alibaba’s edge here lies within its big data resources, and a strong understanding of the Chinese consumers and its preferences. Although one might think that Western brands could market directly to the Chinese consumer, history has shown multinational efforts there to be frustrating, tricky, or all altogether failing. Through its big data and distribution resources Alibaba is shifting its Tmall platform into a business to consumer (B2C) branding platform that optimizes the intersection of high quality Western goods (for which there is strong demand) with the specific tastes and nuances of the Chinese consumer. The clearest example of success here can be seen through the surging sales for infant formula manufactured by European firms such as Danone that are now finding their way to the Chinese consumer via Alibaba. Given China’s 2008 milk formula scandal (50,000 babies were hospitalized), demand for high quality European formula is significant and the most readily available distribution channels are e-commerce platforms such as Alibaba’s. Conversely, European consumers are also top of mind for Alibaba, where the firm believes these markets suffer from narrow product breadth. In this case, Alibaba believes it can identify Chinese firms within the marketplace that meet Western standards. Given the value proposition on both ends of the market, it appears that Alibaba has the potential to both create and control the sales channel in a scaled way that is reminiscent of Wal-mart (and its bargaining power), as it expanded rapidly decades ago. The potential for this advantage seems more apparent on the domestic vendor side as the overall Chinese retail space is relatively fragmented, and undeveloped which means the opportunity to leapfrog a brick and mortar channel is not only more obvious, but perhaps essential to a Chinese firm aspiring to increase its retail sales channel.
In sum, it is too difficult to know the near-term path of China’s overall economic growth as it steers its economy towards services and consumption, and away from materials, construction, and investment. On the other hand, internet usage, and e-commerce strike us as global secular growth trends that will continue expanding regardless, and given the long-term size of the opportunity in these markets, we were thankful for the recent pessimism and share price volatility that followed. Without this turbulence, we suspect that we would not have been presented with these opportunities, given our valuation discipline. In our opinion, these were still only a few of the recent opportunities created. Rather than stretch our commentary into a much longer missive though, we are segmenting our quarterly commentary into more than one letter. Long investment letters run the risk of boredom, or to adopt a quote from the late professional baseball legend Yogi Berra who passed away in September, “It gets late early out here.”
Thank you for your support, and please stay tuned for additional commentary.
Lauren C. Templeton
Principal & Portfolio Manager
Past performance may not be indicative of future results. Please see attached disclosures.