Saturday, March 21, 2015

Keep It Simple, Buy Apple and Google

I tend to write about smallish and mediocre companies on this blog, but those are just a portion of my portfolio. In fact, about half of my portfolio are highly liquid large caps that I consider high quality and intend to hold over the long run.

The problem with this mixed approach of "cigar butt" versus quality at fair price is I end up spending most of my time on the former. Built to last companies just don't require as much attention as risky ones. When I buy a "quality" company my intention is to let it cruise along, check in once in a while to see if the thesis still holds, and perhaps add on the dips. This has all worked out very well so far. The problem is there's a strong temptation to equate "large" with "safe", and perhaps run the risk of complacency. I hope writing this blog will help prevent that.

I'm under no illusions that I have any unique advantage when investing in these names. The thing is you don't always need an edge. Investing is not a zero sum game. Nor do you get points for creativity. I think some people read Joel Greenblatt and obsessively ask themselves "whats my edge? is this obscure enough?" But sometimes the crowd is right, and the best opportunities are the obvious ones. (more that here.)

With the market being volatile the past few months, I took the chance to get into Google and Apple at the lows. At today's prices (GOOGL at $565 and AAPL at $126), I would still buy them if not for the fact that they're already full sized positions.


There's a decent chance this can double in 5 years. The way this works out, I think, is earnings double in 5 years (implying a a highly achievable 14% earnings CAGR). If earnings are still growing > 10% at the end of that period, then the market will put on a high P/E which doubles the share price.

For a company that grew its net revenue at 20% in 2014, Google is priced very reasonably, (I look at this in terms of GAAP earnings, and back out the value of net cash, which gets me to <20x 2016E earnings). This deal is available due to worries about what mobile means for Google. Google still makes most of its money from text searches, the fear is that with the world shifting toward mobile and "apps", Google's earnings growth will slow or even decline.

That seems exaggerated to me. Google owns Android and YouTube, so they do have a strong presence in mobile. Ok, they have not really monetize those two yet, but is it that hard to imagine they eventually will? Also, there are 2 trends that converges "mobile" together with traditional internet, where Google clearly dominates. One is that websites increasingly serve up the "mobile" versions, which are getting so sophisticated that there's no difference between normal internet site and an "app". Second, as phones get bigger and tablets more functional, there's less of a difference between the "mobile" world and the "desktop" world. In that sense cell phone, tablet, laptop...etc are all just screens where people interact with the internet.

In 2014, gross profit grew 20%+ while adjusted pretax profit was up only 11%. This is due to Google's high R&D and other investments. These are discretionary investments though. If they just keep expenses under control, they can easily "show" a much higher earning growth.

I'm no expert in tech, but Fred Wilson is. In this recent interview (around 37th minute), he was asked "Can YouTube be bigger than Google search?" to which he exclaimed "Yes! Easily!". Wilson also pointed out that Google's strength in data and the fact that it's still run by its founders.


For years I had a hard time getting comfortable with Apple. With technology changing so fast, I have no idea what products they will be selling in 10 years, so how can I put anything more than a 10x multiple on this? My thinking has changed into this: it doe not matter. Sure, eventually there is going to be tougher competition from Asia, but I just need to make sure 1) in the interim they will rake it in the next 2 years so that cash is worth something, 2) there are no close competitor in the upscale product /ecosystem / "fashion tech" segment.

Apple made an absurd $18bn in the quarter ending December 2014. In one quarter alone, they made more than the entire market value of some large cap companies! Surely this is peak earning, no? I think there could be more. Growth opportunity could come from 1) higher iPhone penetration in emerging market. Apple's market share in China was only 16% at Oct 2014. Could have doubled at this point, but certainly there's some room to run. Similar idea with France, Germany, Italy..etc. 2) the bigger iPhone 6+ has higher price points. 3) Apple Watch opens another revenue stream that could offset iPad weaknesses. 4) Upside options such as Apple Pay, partnership with IBM, healthcare initiatives could all work out. 5) Apple solidifies itself as a "fashion tech" brand and sells eye glasses, hats, or whatever to fanboys for $400 a pop.

What's the upside? Say earnings grow another 30% in a few years, put on a higher multiple and we could see 40-50% gain from the current price. There's a technical aspect that could accelerate the gains. With Apple being some 3.5% of the SP500, fund managers who are underweight Apple (and implicitly shorting it) could face a short squeeze, especially if iPhone 6 continues its spectacular run and Apple start doing some buybacks.

The downside is Apple Watch turns out to be a flop, which not only fails to replace iPad sales, but also disproves the "Apple as fashion/luxury tech" theory and demoralize Apple boosters. Also, if iPhone 6 sales stalls later this year, the market would reasserts that this is a cyclical business unworthy of a high multiple. This is not a stable buy and hold. The downside is real and I would have to risk manage this if prices fall below my cost basis.

Of the two, I like Google better and will allow it more time to play out.

Monday, March 16, 2015

Welling Holdings - Mediocre Business At A Great Price

Welling Holding Limited (“威靈控股”, 382.HK) is a manufacturer of motors used in air-conditioners and washing machines. It has 4 manufacturing plants in China, including 3 around the Yangtze River Delta area, and one in Guangdong. In terms of revenue mix, roughly 60%/30%/10% of revenue in 2014 came from air-conditioning (A/C) motors, washing machine motors, and other products, respectively. Although Welling gets almost 40% of its revenue from white goods giant Midea (“美的”, 000333.SZ), it also has a diversified international customer base including Panasonic, Haier, LG, Indesit…etc. As of December 2014, Midea owned 68.7% of Welling.

What Caught My Attention, and Key Questions

What caught my attention? The company trade at about at eye popping 6x LTM P/E, yet it has solid free cash flows, ROIC > 20%, and little debt (in fact, a net cash position). Some cursory research showed that Welling is a global leader in its motor business (albeit a fragmented and commodity one). This is a small/micro-cap with little analyst coverage.

Stock has been beaten down since mid-2014 and approaching its 52 week low. When something trades this cheap, the natural questions are 1) if I’m looking at some peak, non-recurring earning? 2) earnings/cash flows are about to fall off a cliff? 3) the business is facing some existential issues?

After digging through the numbers and filings, my answers to the above questions are “no”, “possible but temporary in any case”, and “no”. The company actually looks ok. Now, the industry is facing some competitive headwinds due to price competition, but I would say this is more cyclical then structural.

Attractiveness of Business and End Market Outlook

I can understand why Welling is cheap (although not THIS cheap). Making motors used in A/C and washing machine is just not a great business. The end market is commoditized, so you got the usual problems of price competition, excess channel inventory…etc. Being a parts supplier is probably even tougher – Welling is steps removed from seeing end user demands, and market signals get through the value chain with some delays. In Welling’s 2014 earnings release, it alluded to some of the industry problems and adopted a negative tone for its 2015 prospects.

Over time though, it comes down to end market demands and industry structure. And it’s not all bad for Welling. It helps that main customer Midea is one of the top players in white goods (along with Gree and Haier). Here I did a quick run through of Welling’s 3 markets: residential A/C commercial A/C, and washing machines.

  • Residential AC is the largest market segment here and has high penetration rate in urban areas, but low penetration in rural areas. Industry unit sales growth was 5% in 2014 (down from 7% in 2013). There’s currently a price war going on, with Gree doing some tough talk and signaling its resolve to retain market share. It seems to me the price war is due to excess inventory in the channels and slower housing market. Once that works though the next year or so, there should still be some runway for slower, but steady growth. The fact that Gree/Midea combines for 2/3 of the market makes it more likely to stabilize eventually. 
  • Commercial A/C market is a growth area. Industry volume grew 12% in 2014 and is expected to continue in the next few years. It has a high presence of foreign players, while the Chinese 3 (Haier, Midea, Gree) only a combined 35% market share. In the next few years I can see Midea, and by extension Welling taking more market shares in a larger market. This is an opportunity.
  • Washing machine competition is another weak spot, and possibly structural. This is under <30% of Welling’s revenue. Industry volume increased less than <1% in 2014. The sector already has a high penetration rate (98.0% in urban and 67.2% in rural in 2012, according to NBS) and suffers from fragmented competition. Amazingly, Welling’s revenues here actually increased 12% in 2014, mostly to higher prices. So perhaps they can mitigate some of the industry headwinds through higher value-added products. 

I would be more worried if this is a situation where the industry 1) is showing no growth and 2) suffers from highly fragmented competition. But that’s not the case for Welling’s sectors (with the exception of washing machines sector where Welling is actually doing fine). The current industry headwinds are real, but not insurmountable - China is still growing after all. Sure, 2015 could be an ugly, but longer term industry outlook and competitive structure is not awful. Looking out 2-5 yrs, Midea and Welling should be able to get through this and survive as one of the top players.

Other Reasons Why the Stock Is Cheap

  • Relationship with Midea. If Midea starts feeling some price pressure, it may be tempted to force some price cuts from Welling. Keep in mind Midea does account for 40% of Welling’s business. Even if transactions between the 2 are true arms-length transactions, Welling would have very weak bargaining power and likely get stuck with disproportionate share of margin pressure.
    • On the other hand, motors are a small part of the cost structure for A/C (average price for an A/C motors is 50-60 HKD, while an AC sells for as low as 2000RMB (~2500HKD)). Midea does not have strong incentive to cheat Welling above and beyond its normal share of pricing cuts.
    • The other potential is if that relationship with Midea prevents Welling from getting other customers. Apparently this has not happened – for example Haier is a customer.
  • Small size and lack of diversification
    • Some better technology for motors could develop that eliminates the need for Welling’s products (or worse, make its plant investment obsolete)
    • Threat of losing clients is a problem (perhaps due to their relationship with Midea)
  • Lower cash flows in near term. Due to rising labor cost, Welling has plans to speed up capital expenditure and install more automation. This would depress cash flows in the next couple years
  • Small market cap, no bulge bracket sell-side coverage. 


Despite all the issues listed above, at 6x P/E it’s not hard to see some upside. If this thing just plod along and survives, and earnings prove to be sustainable (say low single digit EPS growth next 5yrs), at some point this could get revalued to a modest 10x P/E. Johnson Electric (179.HK), another manufacturer of motors, trades at much higher valuations, but that is larger and more diversified so some discount is fair.

Give it a 2-3yr investment time frame, I can see 2017E EPS of 0.26 HKD per share * 10x P/E = 2.6/share. This would be a 70%+ return from today’s 1.47/share.

There’s a high probability this could work out. Survival should not be a problem given Welling’s low debt levels. Low single digit EPS growth is also realistic, as management’s target of 10bn RMB in sales by 2017 would imply 10% revenue CAGR.

Establishing a Position

There is no hurry to establish a full position. There are no near term catalyst and 1H15 could get ugly. Ideally you want the bad news to flush through first.

I got in with a starter position after the full year 2014 earnings came out and stock gapped downward. I want to see how the market reacts after 1H15 before making this a bigger position. The current trading price of 1.47 /share is not that far from the 52 week low of 1.3, a major support level for the past 2 years. If it breaks to say 1.28 (a 12% drop from current price), then I would stop out and wait for another entry point. For a 2% position that's a max loss of ~25bps to the portfolio.

Friday, March 13, 2015

Soros versus Buffett on Working

From Soros on Soros:
"Generally, we followed the principle of investing first and investigating later. I did the investing and he (Jim Rogers) did the investigating"
 "...But I don't like working. I do the absolute minimum that is necessary to reach a decision. There are many people who love working. They amass an inordinate amount of information, much more than is necessary to reach a conclusion, and they become attached to a certain investment because they know them intimately. I am different.  I concentrate on the essentials. When I have to, i work furiously because i'm furious that i have to work.  When I don't have to, I don't work."
I find these quotes interesting, and a bit surprising. Now contrast the above with Munger's description of Buffett's job as the chairman of Berkshire Hathaway. This is from Berkshire's 2014 report.
"His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became."
The Munger/Buffett idea of investing is what I imagine great investors do. It is what attracted me to investing in the first place, and what I aspire to do. Nonetheless, the 2 approaches are not mutually exclusive and Soros' does have some advantages:

  1. Invest first and investigate later. Actually, Buffett's value investing classmate Walter Schloss does this too. He would have a smallish starter position just to get the work going. 
  2. Not spending too much time on a specific name - at least in the initial cut - could help you avoid being "married to an idea".  But then again, Buffett's idea of investing IS to be married to the company forever. 
  3. Accumulating information. I believe Buffett's reading activities, while surely targeted to answer investment related questions, also have an element of learning for learning's sake. This is one of the reasons he's good friends with Bill Gates - the two just love to learn new things. I would actually find it hard to believe Soros does not accumulate knowledge this way. Soros said: "...I don't play the game by a particular set of rules; I look for changes in the  rule of the game.".  It would be a bit hard to recognize changes to rules of the game without accumulating some minimum amount of knowledge over time.

Tuesday, March 3, 2015

Notes on Some Chinese Industries

I watched a Chinese environmental documentary 雾霾调查:穹顶之下 recently and found it surprisingly relevant. I happen to be doing a quick scan through some of China's basic industries - just figuring out who does what, and get some very basic sense of growth prospects and valuation. As a first cut I tend to skip over the environmental issues. When I saw the video however, I realized that it tied together the various industrial /political dynamics I'm researching, but through the environmental lens.

It's one of those lectures that ties everything together. Chai Jing (柴静) traced China's air pollution issues to coal and diesel oil, then attributes those pollutants to various industries: steel, power generation, refining...etc. She then related that to industry over-capacity. Then she links all that to conflicts of interest in the governing bodies, and how that led to lack of law enforcement and the dynamics of "forced cheating" (if everyone else cheats and you don't, you'll be out of business the next month. So by not cracking down on cheaters the government is effectively forcing people to cheat).

When I think of China, I think of big brother blocking your Gmail and people chanting party slogans (well, one guy quoted Chairman Xi in the video). So I was pleasantly surprised to find a fairly unbiased, constructive criticism of the government. I mean, Chai Jing was standing there calling out various regulatory bodies, blaming government directed investments and trumpeting market based economies. It seems to me that the fact that this video went viral (instead of say censored), shows that she's got the back of some powerful politicians serious about taking on the issues above.

Miscellaneous Notes 

Anyways, going back to the investing. I've been looking across Chinese energy, power gen, ports, shipping, gas distribution...etc. These are really notes for my own references.

  • Gas Distribution
    • Looks like revenue growth will run in high single digits, yet many of these trade at low teens P/E.
    • China Resource Gas and China Gas are the big ones. My worry with these is they both get about half of gross profit from "connection revenue", which is basically an one-off revenue as a new building gets connected. Not only will that eventually tail off, it also means exposure to a weak residential construction market. The offset is residential gas penetration is still very low in China, and companies (China Gas for example) is starting to focus on connecting to existing buildings, as opposed to new buildings.
    • Beijing Enterprises Holdings (0392.HK) looks attractive to me.
      • Slower but more stable growth at cheap price. BEH has lower risk from residential construction slow down because Beijing is already highly penetrated and it seems they do not get much revenue (if any) from new connection fees. There's very little industrial exposure as gas sales are mostly for power generation and cooling/heating related. 
      • At the same time, the company still has many growth opportunities: continued policy push toward natural gas (for example conversion toward gas plants), more pipelines coming online, expansion into suburban areas, LNG/CNG...etc. 
      • Big into the environmental theme with stakes in BE Water, China Gas, and solid waste management business. The part that does not fit is Yanjing Beer (up for sale?), but that is a great asset in itself.
      • The stock trades about 12x LTM earnings after I back out some of these publicly traded subsidiaries. There are lots of non-recurring items so I have to take a deeper look, but my gut feeling is valuation would be solid even without those items.

  • Ports:  
    • Most likely GDP growth, which for China is a solid 5-7% the next few years. Valuation is reasonable. Stocks tend to trade low teens P/E, solid 2-3% dividend yield (some much higher). 
    • China Merchants (114.HK) looks most interesting 
      • I would prefer diversified ports over location specific ones such as Tianjin Port and Qinhuangdao Port. These specific ports have more sector exposures (very heavy on coal and iron ore), which I imagine is in turn tied to property exposure.
      • COSCO Pacific (1199.HK) is diversified but gets 1/3 of its profit from container leasing which is a bit much for my taste.
      • China Merchants looks like mostly containers, which I associate with higher valued added goods (compared to dry bulk), which is the direction China is going.
    • Port companies would seem likely beneficiaries for China's "One Belt, One Road" policy.

  • Oil & Gas
    • PetroChina /CNPC is more upstream; SinoPec traditionally more downstream; CNOOC is offshore & LNG
    • There's some rumor about CNPC merging with SinoPec to create a national champion that rivals ExxonMobil. That makes no sense considering PetroChina is a plenty big company already.. How does that encourage competition? Unless you say energy is a "strategic industry" and government wants even tighter control. The other theory is that CNPC has experienced some scandals and this would be part of the political shake out.  
    • I'm sure these guys will take advantage of the current situation and buy some international oil & gas companies...

  • Power Generation
    • Cheap for a reason: low growth, undesirable regulatory/pricing regime, outdated infrastructure.
    • China's power consumption growth was only about 4% - I would have thought that number is much higher -- maybe in certain areas?
    • Undesirable regulatory regime. Costs (coal) are priced by the market, but revenue are set by the government. When coal prices go down the government cuts power tariffs, which basically limits the margins of these companies.
    • Companies are still mostly using coal plants, except for China Power Investment (hydro) and Longyuan (wind)
      • Habits die hard - some have vertically integrated structure with a coal mining operations (China Resource Power and Datang)
      • Just my gut feeling - given the public's and government's desire to shift from away from coal, I can see major capex yet to be incurred (perhaps for natgas CCGT plants?) Any regulatory penalty for pollution/CO2 could mean higher cost of business or "maintenance capex". But some of these are so highly leveraged I'm not sure how they would move to natgas. 
    • Supposedly Huaneng and Huadian have higher mix of gas-fired plants. I would be more interested in those.

  • Shipping. I quickly skimmed this one over without getting to specific names.
    • I already have tanker exposure, not sure I want more of this ultra-cyclical industry with chronic over-capacity issues.
    • It's true that the container industry has shaped itself into global alliances like "2M", "Ocean Three", "G6"...etc, but it seems like these are more for market access as opposed to pricing rationalization. 
    • Is shipping a "strategic industry" for China?  Or is it shipbuilding? If it's shipbuilding, which would makes more sense for military/strategic reasons, then the over-capacity issue will always persist (especially given the excess steel China has).  

    I meant for this to be a quick scan but it was a lot more time consuming than I projected. It's only when you tried to invest in foreign companies that you realize how good U.S. analysts have it. Here are just a few problems I encountered in this process: 1) you really have to know your Chinese. The English presentations of companies are often vague or just don't make sense - until you read the Chinese version which says something different. 2) corporate pyramids obscure true source of profit. For example, you might get a revenue breakout in the footnotes that suggest this company makes most of it's money from "x" line of business, then you realize it actually gets even more profits from associates, which is in a totally different business. 3) Multiple sets of accounting: Some companies show financial statements in HK accounting, then the MD&A refers to Chinese accounting numbers. That's just massive confusion. 4) lots of companies don't do conference calls, much less transcripts..