General

From a health perspective, we are happy with the progress of widely distributed testing, enforced social distancing, mass mask wearing and the latest, strong vaccine pipeline with some major ones currently being used to inoculate front line workers and people who are in the key risked category. For those who are interested in a more in-depth review of the 2020 COVID-19 pandemic, we would direct you to Mr. Bill Gates:

Bill Gates – Year in review 2020

From a stock-market perspective, we have seen two things. One is the rapid rise in the valuation of tech stocks, and the other is the extraordinarily low interest rate around the world. As a relatively inexperienced investor the former surprised us. The tech stocks trade at a very high revenue multiple, and they mainly come from the software-as-a-service (“SaaS”) space. We think a lot of them will disappoint, but a few will be winners. A lot of them will probably not be able to generate the expected fat profit margin they promise to investors, a few however will be able to. Overall we can see a big red warning sign ahead, we will let Mr. Scott McNealy remind us :

“But two years ago we were selling at ten times revenues when we were at U$64. At ten times revenues, to give you a ten-year payback, I have to pay you 10% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of good sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that, with zero R&D for the next ten years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at U$64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?” – Scott McNealy – CEO of Sun Microsystems, Business Week interview – 2002

Regarding the low interest rate environment, it is really confusing:

“Does negative interest rate scare you, Warren?”

“It puzzles me, but it doesn’t scare me” – Warren Buffett, Yahoo Interview – March 2020.

If interest rate is at 0.5%, the P/E ratio of a risk-free bond is in effect 200x (1 divided by 0.5%). One could then justify investments at 200x P/E, equivalent to roughly 20-40x revenue multiple assuming an earning margin of 10% – 20%. We suspect that this is the line of logic when large sovereign wealth funds deploy a small % of their asset under management into start-ups and the new SaaS companies. A small % of their AUM could well be in the billions, and which can contribute to the rapid rise in valuation of these companies.

Does that give us a free pass to buy things at 200x P/E? The answer is no. The rationale is that 1/ we cannot predict where the interest rate would go from here. If it goes back to 3% or higher it will cause tremendous stress and pressure on these companies to realise their fat profit margin expectation – a not-so-easy feat to do, and 2/ there are still sensible things to do in the market at a more reasonable multiple. 

Portfolio

Alphabet (20% of the portfolio)

Alphabet is the holding company of Google, Youtube, Google workspace, Google Cloud Platform (“GCP”), and other companies such as Waymo.

The stock has been in our portfolio since 2017. Our reason to purchase the stock then, and to hold the stock now is that it is a great company with a deep engineering culture, it is ran by a superb manager – Mr. Sundar Pichai, it is conservatively managed from a financial perspective, and because of the many underearning assets it owns, its stock price has remained cheap to reasonable. Looking forward, the cloud market remains large with GCP growing at around c.50% and we are also optimistic about the large runways for the old existing Search business and Alphabet’s other initiatives such as that in Shopping:

“The way I would think about it or the point that I hear the most often, let me put it this way, is what is called the above the line advertising market, that’s $0.5 trillion market roughly across the world, slightly different estimates on it. That’s usually what’s defined as our addressable market. There’s obviously, I feel, the below the line advertising market that includes budgets for promotional pricing, product placement, sponsorships and so on. So that’s a very, very significant market as well. And then there’s completely different ways of looking at it, you can take a very different vector, for example, and look at commerce penetration in the US. And as you all know, over — or somewhere in the 80% range of commerce in the US, it’s still being conducted offline. So with this shifting overtime, obviously there’s a significant opportunity, I would say. And an interesting number again, 80% of our searches, we actually show no ads. And so most of the ads that you’re actually seeing are on searches with some form of commercial intent, whatever, it could be anything, T-shirts, shoes, baby Yoda, dolls, whatever you take here, right? So the question we have to ask ourselves is, are we actually optimized on this, or is there more room and can we do better in this area.” – Philipp Schindler, SVP and Chief Business Office, UBS TMT Virtual conference – Dec 2020

Facebook (13% of the portfolio)

Facebook is a social media company, with an ecosystem that is made up of Facebook, WhatsApp, Instagram and Oculus.

The stock has been in our portfolio since 2018. We bought the stock then thinking highly about its hackathon culture as shown by the constant addition of new features to its platform, about its owner-operator – Mr. Mark Zuckerberg, and also about the relatively reasonable price it was at, also owing to its underearning asset in WhatsApp. During March 2020, we took advantage of the low price to add significantly more to our Facebook position.

Similar to Alphabet, Facebook has come under intense scrutiny of regulators. It was sued by the Federal Trade Commission who accused it of multi-year anti-competitive practices. Naturally we would expect the company to fight any claims they deem unfounded, but at the same time we also think they deserve scrutiny, given how large and important they are. That said, our biggest concern when it comes to regulation is that managerial time and talent is now devoted significantly more to answering the regulators, instead of to innovate. As the FT puts it for Alphabet:

“For Sundar Pichai, Google’s chief executive officer since 2015, defending the company against the multiplying legal and legislative threats has become almost a full-time job.” – FT, ‘Regulation can get it wrong’: Google’s Sundar Pichai on AI and antitrust – Dec 2020.

We think Mr Mark Zuckerberg is on the same boat as Mr Sundar Pichai.

Berkshire Hathaway (8% of the portfolio)

Berkshire Hathaway is a conglomerate company in its corporate form but a partnership in its economic reality.

The company has been in our portfolio since 2017. Our reason to purchase the stock is that it has an extraordinary corporate culture guided by rationality, it houses some of the most wonderful businesses in the world such as the BNSF and GEICO, it has a great reputation as the “museum” for businesses that have been “lovingly put together” by their founders, and it was and still is priced reasonably.

In contrast to the quiet period between Q1 and Q2 2020 when Mr Buffett still saw an “extraordinary wide” range of economic possibilities as a result of the pandemic, Q3 2020 saw the positive developments of vaccine and countries exiting hard lockdowns, and in a presumably high-correlation manner, Berkshire repurchased more shares, bought a group of 5 Japanese general trading companies, the Dominion Energy natural gas assets and a few other smaller things.

From a personal perspective, while we admire greatly Mr. Buffett and Berkshire Hathaway it is likely that we will have to part with the business because of regulatory reasons (my employer audits an affiliate company of Berkshire – though arguably is quite immaterial to Berkshire’s size, and my grade with the company has changed, which demands stricter employee ownership guidelines). Having said that we will continue to watch Berkshire’s economic progress through the management of its many CEOs, and of course the capital allocation decisions of Mr Buffett and Mr Munger along with their two investment managers.

Amazon (4% of the portfolio)

Amazon is an e-commerce and cloud company founded by Mr. Jeff Bezos.

We bought the stock around mid 2019 because in the ex-China e-commerce and global infrastructure-as-a-service (“IaaS”) cloud markets Amazon is the most dominant company. It has a terrific runway for growth with a tiny c.2% market share in global retail and similarly a single digit share in total IT spending despite its dominant position in both area: c.40% of US ecommerce market, c.25% of non-US/China, and 50% of global IaaS market. It is run by an owner-operator who takes an annual salary of just c.$80k and during 2019 it was priced quite reasonably.

Despite our enthusiasm with the company, going back to 2017 when we first finished reading all of Mr Bezos’s letters, we have kept our position to a mere c.4.0%. Looking back, that was a huge mistake of omission. Having said that, our conviction for the company has solidified and despite the run up in its share price of c.70% during 2020, we actually found it to still offer quite good value.

Without dwelling into a highly subjective estimate of Amazon’s earning power, we would highlight couple things:

1/ If Amazon share price in 2019 represented a reasonable capitalisation of the business relative to its intrinsic earning power, and that if Amazon’s intrinsic value has gone up by c.40% this year (measured simplistically by its revenue growth), then the stock has become roughly c.30% more expensive relative to its intrinsic value. If this 30% get unwind over the next 5 years, it would only present a valuation headwind of roughly c.5% per annum, which we think is a fair headwind to pay to get more exposure to a marvellous company that has the potential to continue growing its intrinsic value at c.20% p.a. in the next 5 years. This would still leave us with a 15% compounding growth on the stock.

2/ The potential to grow 20% in the next 5 years for Amazon is underpinned by:

a/ continued top line growth, driven by continued share-taking in a fast-growing ecommerce market, continued displacement of on-premise IT spending from the cloud and finally the more attractiveness of Amazon.com real estate where ads can be sold, and;

b/ improving operating margin, driven by lower shipping costs per each $1 of gross merchandise value (“GMV”). For this we note that despite the significant increase in Amazon prime memberships, at roughly around c.25% per annum in the last 5 years, shipping cost per 1 prime member grew at a remarkably steady rate of 3.0%. Effectively this means at some point in the future shipping cost per GMV will start seeing great operating leverage. Based on our modelling and also looking at other people’ forecasts, a 15% ebit margin in 2025 is within reach. That said it will be a give and take between opportunities to grow quickly (e.g. more content spending on Prime video to attract even more prime members) and operating leverage (e.g. shipping costs, R&D costs, G&A). We will refrain from commenting further on precise forecasting even though we still engage in rough forecasting. As the saying goes “Predictions are useless but predicting is important”.

Unilever (4.5%)

Unilever is a consumer-group company with a portfolio of 13 EUR 1-billion brands.

We have owned shares in Unilever since 2016. We bought the stocks because it has the largest emerging-market exposure out of all the major consumer-good companies, on a daily basis c.2 billion people use their products, the culture of the companies can be boiled down to 1/local management, 2/always in emerging market (the first time Unilever operated in EM was back in the 20s, under the management of William Lever) and 3/ constant reshuffling of its portfolio of brands to position itself favourably with secular trends – we like all of these points. Last but not least, the share price looks cheap to reasonable. We would point out that the Indian subsidiary of Unilever commands c.30% of the group’s market cap yet only 10% of the group’s EBIT. That leaves the remaining of Unilever to be quite cheap, at around 10x pre-tax earnings (though we are not counting on a spinoff or anything like that at any point).

Brookfield Asset Management (4.5%)

Brookfield Asset Management is a hands-on asset manager, managing $570b in AUM with $290b currently earning fees.

We own the stocks since 2019. We bought it because it has one of the best, if not the best private equity business specialising in infrastructure, property and renewable. The huge moats of Brookfield are 1/ a long established track record in managing money, 2/ a lot of sticky relationships with large institutional funds (such as sovereign wealth funds) and 3/ scale. The last one stood out, as Mr Bruce Flatt puts it:

“There is one thing we’ve found in businesses that we are in: scale matters. And when you buy things, there aren’t that many people that have the amount of capital that we have to be able to compete…The industry has been consolidating into larger amounts with less people, luckily we are one of the those”– Bruce Flatt, CEO of Brookfield Asset Management, Bloomberg interview – October 2020

Brookfield is positioned to take advantage of the long-term shift to alternative investments, especially under a low interest rate environment. The stock is currently priced at around 13x earnings including target performance fees, or carried interests, but around 16x if conservatively excluding target performance fees on uncalled capital commitments. We deem the stock price to be reasonable.

Others and cash (c.50%)

The other companies in our portfolio are high-quality companies which we have commented on in the past and would comment on in the future. The cash amount as at Dec 20 represented 18% of the portfolio, largely due to savings accumulated over time that wasn’t allocated (not complaining, it is a nice problem to have, especially during a pandemic!). Having said that going into 2021 we have grown in conviction for the 5 companies mentioned above and would look to deploy all this cash into those. We will eventually build up a reasonable cash amount again as savings for 2021 come in.

Recommended reading

One reading that stood out in the quarter is the investment partnership letters, written by Mr. Nicholas Sleep. Mr. Sleep has a wonderful track record managing money.

I found his thinking and writing to be very clear, helpful, with many case studies and insights. In a way it reinforces many lessons, one stood out in particular: when faced with a great opportunity, do it in a big scale! Mr. Sleep’s concentrated investment in Amazon drove most of his performance. Mr Sleep gave an example when someone judged a manager’s performance and said that without buying x, y and z his performance would look terrible…well the point is he did!