Insights

Shares are not mere pieces of paper. They represent part ownership of a business.-Warren Buffett

Over the past 150 years[1], the U.S. stock market has generated a healthy inflation-adjusted return of 6.9%. However, the stock market’s performance isn’t equivalent to the average stock’s performance that makes that market. Indeed, individual stock returns, on an average basis, have fared much differently.

While the stock market generated solid returns, the average stock failed to beat the return of the U.S. 1-month T-bills. In a 2018 study[2], Hendrik Bessembinder reported that since 1926, the majority of common stocks generated lifetime buy-and-hold returns that were less than one-month T-bill returns.

High probabilities of permanent losses

In what comes as a surprise to most stock investors, what Bessembinder found is that the single most frequent outcome over the entire lifetime of a typical stock is a loss of 100% (Figure 1).

Nearly 12% of all firms suffered complete losses as measured by their lifetime returns, including reinvested dividends. Another critical data point reported by Bessembinder was the median lifetime buy-and-hold return of a typical stock: -2.29%.

Interestingly, the study found that individual common stocks tend to have relatively short lives with a median lifetime of 7.5 years as a publicly listed company.

 Figure 1: Lifetime buy-and-hold returns of stocks – most frequent outcome is a 100% loss [3]

A very few winners – a positively skewed distribution

What accounts for this stark difference between the performance of the “average stock” and that of the stock market’s performance on an average? It turns out that the distribution of lifetime returns of stocks isn’t a gaussian distribution. Instead, it is a distribution that is positively skewed. What that means is that in a winner takes all like outcome, a small fraction of all companies account for all of the net wealth generation. This can be seen in the fact that just about 1/4 of stocks, 26.1% of all stocks in Mr. Bessembinder’s study, generated lifetime returns that were greater than the equal weighted portfolio of all common stocks over matched time intervals.

A sensible way to play the game – saying “no” most of the times

To rehash, the average stock generates poor lifetime investment outcomes, the most common outcome for individual stocks is a 100% loss, and a small proportion of companies generate superior investment outcomes over their lifetimes.

With these points in mind, what is a high probability way of playing this game? When posed with this question, investors are quick to conclude that to generate superior investment outcomes, one must identify companies that can generate extreme positive returns. Indeed, Mr. Bessembinder himself reached that same conclusion. He concluded that active strategies that have a concentrated portfolio of such winners, can generate substantial stock selection returns. Not surprisingly, it is the same idea that Wall Street and fund salespeople regularly extol as they bring up the best performing funds of the recent past as evidence of the fund manager’s stock selection abilities.

However, we think that such a conclusion is misplaced. The German mathematician, Carl Gustav Jacob Jacobi, offered the best process for solving complex problems using a simple strategy: “man muss immer umkehren” (translated as “invert, always invert.“).

Creating a different investment universe by following a process of removal

In keeping with Jacobi’s solution, we propose that the first steps to solving this problem involves removing businesses that are likely to generate poor investment outcomes. The set of companies that have been so filtered can serve as one’s investable set of businesses. However, as against choosing an overall market segment defined by heuristics such as geography and/or market capitalization, it is a problem of rejections/removals. For each one of the businesses we evaluate, we filter them for the following criteria:

• • questionable quality of earnings (understand the language of business – accounting)
  • questionable corporate governance,
  • poorly structured balance sheets
  • poor capital allocation actions (understand the returns on incremental investments as well as M&A actions), and
  • businesses that deliver products or services that lead to dissatisfied customers (business has to create a net positive value for its customers).

This process of rejections leads to the removal of a vast majority of businesses. Note that we are not saying that each one of the businesses so removed will necessarily generate poor investment outcomes. Clearly, in pulling out the weed, we will end up removing some flowering plants as well. What we are shooting for is a basket of rejects with a much higher mix of value destructors than the broader investment universe.

By filtering out a significantly larger portion of losers than winners, we believe that we end up with an investment universe that will generate superior lifetime returns. This outcome is driven by the curtailment of the distribution’s left tail while retaining much of the right tail.

China-based businesses

As discussed in our December 2021 monthly letter, our investment universe currently does not include any China-based business. The reason for this lack of “direct”[4] exposure to China is rooted in the process of eliminations discussed above. For each one of the China-based businesses that we have evaluated over the years, one or several of these rules triggered.

In the discussion that follows, we offer our analysis of a few of these businesses that we have researched in the past and decided to classify in the basket of rejects.

Alibaba

Alibaba, on all our counts, comes across as a fantastic business. It’s presence across China’s small and medium-sized businesses as an enabler, be it the tech stack or marketing and distribution platform and services, is unparalleled. At the same time, their reach across Chinese consumers helps it build a network effect like business.

However, we decided not to invest in Alibaba as we found ourselves with corporate governance and quality of earnings red flags that we couldn’t resolve. One of these questionable corporate governance practices was Alibaba’s transfer of its online e-commerce payment business (Alipay) to a related party. In 2011, the company transferred the ownership of Alipay to a new company (Ant Financial) that Mr. Jack Ma controlled. The approvals of key shareholders, Yahoo and SoftBank, were not obtained, and the terms of the transaction were not disclosed.

Another issue was related to disclosures. In 2019, Alibaba stopped breaking out the loss incurred by Cainiao, their logistics arm. In the previous year, the losses from the business amounted to ~RMB 5 billion. Interestingly, our analysis suggested that the losses at Cainiao may have more than doubled in 2019 compared to 2018. Efforts to contact their investor relations to get clarifications went unanswered.

The ownership issue is also present with Alibaba’s ADR listing. The ADR confers ownership of a VIE domiciled in the Cayman Islands, which has contractual agreements with operating entities. The validity of these agreements, as far as Chinese regulators are concerned, is unclear. Additionally, we also had concerns regarding Alibaba’s complex organizational structure and notably, Alibaba Partnership. The Alibaba Partnership, which comprises Mr. Jack Ma and members of the management team, has the exclusive right to nominate or appoint up to a simple majority of the board members. The Partnership thus essentially controls the board and limits the influence of outside shareholders.

China Mobile

When we looked at it back in 2009, China Mobile had an extremely dominant position within the Chinese telecommunications business with a 70% plus market share. The other two competitors, China Unicom and China Telecom had much smaller market positions with market shares of 20% and 8%, respectively. The backdrop was that China Unicom was losing market share to China Mobile. At the same time, China Unicom’s accounting practices were rather aggressive.

The corporate governance and capital allocation issues for China Mobile were driven by the fact that the PRC Government owned a 70% plus stake in the company and was also the controlling shareholder in the two competing businesses. As the Government wanted to build out a homegrown technological network, it mandated China Mobile to adopt the homegrown TD-SCDMA technology, which proved to be inferior to international standards. The competitors (China Telecom and China Unicom) who offered 3G services based on international standards (W-CDMA) quickly gained market share.

This impact was that the company lost significant market share. It’s market share declined from 72% in 2009 to 63% in 2013 while incurring considerable capital expenditure on the TD-SCDMA network buildout. The market share impact was much more pronounced within the 3G market, i.e., the smartphone market. Within this market, China Mobile’s dominance was lost entirely, with the market roughly equally split amongst the three competitors at the end of 2012.

To gain incremental 3G/4G customers, the company started to subsidize the cost of handsets sold heavily. As a result, by the end of 2016, the company’s operating profitability was cut in half, with operating profit margins declining from 30%+ to 16%. And so were the returns on capital. Returns on Equity (RoE) declined from 20%+ levels to just about 10%.

Another questionable capital allocation policy was an investment of ~RMB 40 billion (~US$ 6 billion) for a 20% stake in SPD bank in 2010. In our assessment, the company’s decision to invest in a banking business did not seem like a reasonable use of our capital.

China Merchant Port

China Merchant Port is another example of a company under the State’s influence with questionable capital allocation policies. Since 2012, the company has been acquiring overseas ports where transactions did not seem to have been driven by a desire to deploy its capital rationally. One such example was Hambantota, a Sri Lankan Port where the company acquired the port operations in 2017. The transaction’s economics were questionable at best as the company already had port operations at Colombo which themselves were losing money.

As part owners of businesses, we expect to be treated transparently and provided with disclosures necessary for our evaluation of the business. To assess a port operator’s business value, one key factor is to have details about the remaining life of port concessions. As the company did not provide these details, we couldn’t assess the company’s business value. Further, disclosures and reporting in the case of associate entities were also inadequate.

Petrochina

Similar to China Merchant Port, we observed that the State’s policies impacted Petrochina’s operations. In 2017, the Government set a target of increasing natural gas’s share in its overall energy consumption to 10% by 2020 and 15% by 2030. The policy of encouraging natural gas consumption for environmental reasons has increased import dependency. The company is required to import LNG for meeting domestic demand at unfavorable rates compared to regulated domestic gas prices. The resultant impact was rising losses from imports from Central Asia. Unless domestic gas prices de-regulate or there is a rapid decline in import prices, there is a slim chance of reducing losses or turning profits on this part of the business.

Baidu

Like many other Chinese Internet companies listed in overseas markets, Baidu operates under a variable interest entity (VIE) structure. Thus the ownership issue is also present with Baidu’s ADR listing.

We view Baidu’s search business, much like Alphabet’s and Yandex’s search businesses, as a relatively robust network effect business. However, in the case of Baidu, the company engaged in a few questionable capital allocation transactions. As a result of these transactions, the search business’s relevance within its overall business mix has reduced. The company expanded its online-to-offline (O2O) services (such as online food delivery, group buying, and OTA services) with significant investments in these businesses. These businesses have thus far been associated with poor financial economics. Further, as they operate in intensely competitive markets and as the competitors are all engaged in substantial price discounts, it isn’t clear who the winners will be.

Tencent

Much like Alibaba and Baidu, the ownership issue is present with Tencent’s ADR listing as well.

While Tencent is like the East’s Facebook with a solid user base for its platforms, we are unsure about the sustainability of competitive advantage for its gaming business. Gaming business contributes significantly to its operations with ~30% of revenues and a much more significant portion of its total profits. Games require frequent new launches. Missing one cycle can impact the business negatively. Regulations delaying license approvals for some games can lower the monetization window as the cycle of games can be short. Concerns regarding the adverse impact of gaming on the users could also result in the enforcement of new regulations that negatively impact the business’s revenue.

Summary

While we continue to spend our research efforts on evaluating China-based businesses, we haven’t yet identified any company that can be added to our investment universe. With China accounting for 16% of the global GDP, both China and its businesses will be relevant to our investments. However, we will refrain from investing in such companies until they pass our elimination criteria.

As one thinks of equity investing, its necessary to keep in mind the lifetime returns for individual stocks. Such a perspective is crucial when you invest in portfolios like ours. This is so because we do not invest in the broader markets; we invest in specific businesses.

Critically, it is essential to understand the dynamics of the game one is playing. Remember that efficient market idea of picking stocks with a monkey throwing the darts. Well, if one acts like that monkey and then holds the stocks so selected for their lifetimes, it will amount to playing a game with rather poor payoffs as the average company is associated lifetime investment return.

While we are at it, we will also remind you of that oft-quoted idea of buy-and-hold and/or low trading turnover. The critical point here is that if you are going to have monkies throwing darts, you shouldn’t look to buy-and-hold. If, on the other hand, you want to construct portfolios with long holding periods, you mustn’t be playing in the pool of average stocks. This is why we fish in a carefully selected pool of businesses and why we devote nearly all of our research efforts to keep that pool clean of questionable businesses.

 *In reference to the companies mentioned in this report, Alibaba, China Mobile, Tencent, and Baidu were researched for the Global Moats Fund, whereas China Merchant Port and Petro China were researched for the Global Select Value Fund.

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[1] https://www.advisorperspectives.com/articles/2020/07/27/the-biased-history-that-drives-excess-allocations-to-equities

[2] Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447

[3] Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447

[4] Our businesses do provide us with significant indirect exposure to China and Chinese consumers as many of them derive a meaningful portion of their revenues from China and/or Chinese consumers.