Recent Investment Reflections

Performance and Valuation Levels of US Tech Companies

Recent quarterly reports have been frequently released, and we have been closely monitoring the fundamentals of the companies we are following. In terms of fundamentals, most companies have generally exceeded expectations (except for significant underperformance by INTC and SAP), and many outstanding companies have shown clear signs of emerging from the shadows of the pandemic in the past 1-2 quarters. Based on this, we have raised future earnings expectations for some companies and maintain confidence in the long-term competitiveness of technology leaders.

However, in terms of valuation and expectations, despite the recent market pullback leading to a decline in valuations, giant companies (mainly referring to AAPL/MSFT/GOOG/FB/AMZN/CRM) are at reasonable levels. These companies are expected to provide compound returns of around 5-15% in the future (with FB potentially around 20%). However, valuations for small and mid-cap or emerging hot tech companies (such as TSLA/NVDA/AMD/NFLX) remain at very high levels, and popular sectors like cloud computing are also at very expensive levels (some even reaching 30-40x PS).

Therefore, based solely on current valuation pricing and expected levels, we are not inclined to significantly increase the allocation to the technology sector.

Frequent IPOs of Giant Companies

Due to the exceptionally high market enthusiasm for tech companies, many long-term unlisted companies have chosen to go public for financing, and among them are numerous giant companies, including the recent listing of Ant Group, as well as the upcoming listings of Kuaishou and the rumored listing of TikTok.

The intensive queue of these giant companies for IPOs indicates at least two things: 1) They are satisfied with the valuations they can obtain from the market (otherwise, they have the capability to raise funds in the primary market). For example, Ant Group's valuation was over 32 times in 2021, and the first-day prices were generally expected to be over 40 times); 2) Due to the market's widespread expectation of high returns from IPO subscriptions, there has been a significant increase in subscription funds, which has heavily squeezed funds from other sectors. This has to some extent caused significant drainage and reduced trading activities in other sectors of the Hong Kong stock market in the near term.

However, in the long run, these short-term fluctuations cannot change the long-term fundamentals of growth and valuation systems. Outstanding companies will eventually return to their true value.

Concentration vs. Diversification

It is possible that some investors may express disappointment (and even anger) regarding our recent performance, and we can only express regret. As one of the main holders of our own product, we certainly do not want to see such significant drawdowns. As reflected in our previous monthly reports, our investment mindset and strategy have evolved over the past few months. We have been dissatisfied with the valuation systems of the sectors we focus on (primarily the Chinese and American tech sectors, especially small and medium-sized stocks, as well as most consumer stocks). Consequently, we have allocated more funds to sectors that we believe have solid long-term fundamentals and are undervalued (mainly the modern service industry in Hong Kong), which has led to an increase in our concentration in recent months.

Given the option, we do lean towards appropriate diversification. This helps to reduce the probability of simultaneous fluctuations in the fundamentals of our holdings. However, if there are no comparable opportunities available, we prefer not to deliberately diversify by investing in assets with lower value propositions or assets that we do not fully understand.

Certainly, an excessive concentration does bring vulnerability, both in terms of fundamental factors and short-term market fluctuations. Warren Buffett has been able to withstand this through his ultra-long-term and ultra-stable cash sources. However, most institutional investors may not be as fortunate. Concentration requires stronger confidence in the fundamentals and a lower margin of error.

Antifragile Systems

Recently, I've been extensively reading Nassim Nicholas Taleb's book series, and he is arguably one of the most renowned authors and amateur philosophers among investors. While his books can sometimes be verbose, they offer profound insights. One of his books discusses the concept of antifragile systems, which I find quite intriguing.

In terms of application to investments, some possible extensions include:

1. Benefiting from black swan events: Identifying investments that would thrive when unexpected and extreme events occur (e.g., the technology sector benefiting during the current pandemic).

2. Contrarian choices against mainstream thinking: When popular assets become excessively crowded or concentrated, it often indicates that expectations have been overpriced, increasing the potential for a reversal in the opposite direction.

3. Traditionally, financial risk analysis equates volatility with risk. However, when a company experiences a decline, reaches a bottom, and begins to rebound, it often implies increased volatility but decreased investment risk (as prices have declined significantly). Conversely, when a company experiences a continuous upward trend, it may appear stable without volatility, but it carries potential risks (similar to the perception of a turkey before Thanksgiving).

Therefore, analyzing the potential rewards/losses and probabilities, rather than simply analyzing historical price trends, is far more important when assessing risk.

Options Trading Model and Technology Stock Investments

Recently, I came across an interview with the renowned fund Baillie Gifford, where they discussed their approach to investing in technology stocks using an options trading model. This model takes advantage of the asymmetric nature of stock markets, where the worst-case scenario is a 100% loss, but successful technology companies have the potential to increase in value by several tens or even hundreds of times.

Baillie Gifford leverages the anti-fragility provided by a combination of high-growth companies and portfolio diversification. For example, their SMIT Fund portfolio covers 47 listed companies and 44 unlisted companies, with individual positions generally not exceeding 10% of the portfolio. They reduced their position in Tesla this year because its value had increased by over 400%, causing the position to become over-weighted. Baillie Gifford partner Tom Slater believes that if they can happen to invest in one or two outstanding companies that drive long-term market growth, it can compensate for the potential errors made in other investments.

While this investment approach is indeed worth considering, we acknowledge that there are certain limitations for us to fully adopt it. Firstly, we may not have the capacity to invest in dozens of companies that we haven't thoroughly researched just for the sake of diversification (as we are not a giant fund like Baillie Gifford). Secondly, in a market environment where optimism towards technology stocks is prevalent and future profit growth is being predicted for the next 5-10 years, it becomes challenging to find satisfactory options trading models.

Views on the Future of the Modern Service Industry

Overall, we maintain an optimistic outlook on the modern service industry in China for the next 10 years and beyond. Although this industry may not possess significant economies of scale or a massive market size like the technology sector, we believe the following factors contribute to its potential: 1) The market space is substantial and continuously growing. 2) There are evident competitive barriers, particularly at the local level, arising from brand recognition and regional scale effects. 3) Given its current size and valuation, there is sufficient runway and compounding potential.

Taking the United States as an example, an average American spends around $50,000 annually, with only $10,000 allocated to the purchase of goods, while the remaining $40,000 is spent on various services such as healthcare, education, finance, dining, and entertainment. Although the situation in China differs from the US due to its socialist nature, the fundamental reason behind the continued growth of the modern service industry lies in the constant increase in economic growth and productivity (with goods experiencing long-term deflation), coupled with a decline in available time for individuals. As the productivity of goods improves at a significantly faster rate than that of services, the value of people's time increases irreversibly. Therefore, based on the situation in developed countries globally, various modern service industries have shown long-term pricing power that significantly outperforms inflation, and even real estate prices.

Regarding investment opportunities in the Hong Kong stock market, we believe that the trend towards market-oriented and branded properties is still in its early stages. Property companies with a focus on branding are gradually expanding their management capabilities, offering substantial room for growth. Despite the recent correction, these companies still exhibit valuations of 20-25 times earnings, indicating the potential for compound growth of 30-40% for many years. However, it should be noted that the pricing power of properties may weaken, and the difficulty of raising prices could become apparent around 2025 as growth slows down, indirectly affecting the long-term valuation system.

In the education sector, recent concerns about policies, uncertainty related to mergers and acquisitions, and the conversion of schools have led to a significant decline in stock prices. Currently, the valuation stands at a low level of around 11-12 times earnings (EV/EBITDA below 10 times). We believe that this industry offers immense long-term growth potential (with the current gross enrollment rate at 50% and expected to increase to 70-80% in the long run), along with a pricing dynamic that tends to rise rather than fall over time. The current valuation reflects extreme concerns about policy, a discount on liquidity, and a lack of trust in corporate governance.