Weekend Reading #40

This is the fortieth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 26th October 2019.

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What we're doing.

This week we got our hands on “v1” of 3BC, our online deal platform for professional investors.

We’ve said it before and we’ll say it again – private markets are too opaque and expensive to access. Our platform brings access and transparency to the process of investing in private assets, enabling professional investors to browse pre-filtered deals and connect with deal originators and qualified intermediaries.

It’s exciting to see the “alpha” version of the product, but we realise there is a way to go in refining the product. We’ll be spending the coming days road-testing the platform, spotting bugs and squashing them with the help of our talented product manager.

What we're reading.

“You like potato and I like potahto,
You like tomato and I like tomahto,
Potato, potahto, tomato, tomahto,
Let's call the whole thing off.”
– George and Ira Gershwin

This week brought news that Jeffrey Vinik, the billionaire investor who relaunched his hedge fund earlier this year, is calling the whole thing off.

In an interview, Mr. Vinik said he needed to manage significantly more money for the “economics to make sense” for himself and his business partners. He said he had been surprised to find how much the industry had changed since 2013, a period during which he had focused on the Lightning and a project to invest in Tampa’s downtown. Investors he had known had changed jobs and the decision-making process to invest was far more drawn out than in the past, he said. He said he made the decision to close recently as it became clear more money wouldn’t be pouring in at the start of 2020.

“I honestly believed, obviously foolishly, that I could raise $3 billion by March 1. What I learned after probably 75 meetings is, the hedge-fund industry of 2019 is very different than the hedge-fund industry when I started in 1996, and it’s even very different from the hedge-fund industry when I closed in 2013.”

High overheads covered by even higher management fees are simply not a sustainable way to run a business in a fiercely competitive marketplace defined by passive flows, tech-enabled investment strategies and fickle allocators. And if you can't build a sustainable business, how can you presume to judge the performance of others?

Here at Three Body Capital, we've structured our business model around investors, not ourselves. By aligning interests with the people we seek to serve, we can make active management relevant again and deliver on the original promise of the hedge fund as a vehicle for calculated risk taking and absolute returns.

Like potatoes and potahtos, not all fees are born equally. In contrast to the rent seeking behaviour inherent in excessive management fees, we believe the performance fee is the most elegant expression of risk sharing between investors and managers that’s available to us. If our investors win, we get paid. It's as simple as that.

In other news, this week we read O’Shaughnessy Asset Management's quarterly investor letter. It’s notable for its complexity and clarity, always a killer combo. What we love about OSAM is their generosity – on all fronts, be it with research, social media presence, or reading recommendations, they give freely and expect little in return.

Through some rigorous quantitative analysis (and hard-won experience), the newsletter posts out that value stocks – a category that’s done very poorly since the financial crisis – appear as attractive relative to the market as they have since 2000. This raises the question, is growth out and value in? Our blog post this week drills into this subject in more detail. If you haven’t read it yet, please scroll up!

What we're listening to.

This week we bit down hard on a seriously profound podcast episode with theoretical physicist Sean Carroll entitled, “Something Deeply Hidden: Quantum Worlds and the Emergence of Spacetime”. Caroll talks quantum physics and the validity of the many-worlds interpretation (MWI) of quantum mechanics.

Like many of the “Talks At Google” podcast episodes, this was educating, inspiring and a little bit terrifying! A welcome break from the machinations of capital markets and the political chaos that’s dominating the news here in the UK. Listen to this for some much needed perspective on life, the universe and our place in it.

What we're reading.

As the digital asset meltdown continues, we came across this deeply thought provoking piece on Ethereum by David Hoffman entitled “Ether is the Best Form of Money the World has Ever Seen”. It talks about his view of how Ethereum is creating an internet of value based entirely on permissionlessness (that is a new word). He provides an excellent breakdown of the pieces forming to create this ecosystem and what the implications may be.

What we're watching.

“The distance between insanity and genius is measured only by success.”
― Ian Fleming

By that measure, Todd Phillips’ latest movie Joker is a work of genius.

Set in 1981, it follows the story of Arthur Fleck (played by Joaquin Phoenix) and how he transformed into the character we have all come to know as The Joker. As origin stories go, this is an absolute masterpiece.

What’s really wonderful about this picture is that it doesn’t feel like just another Batman movie at all. The beauty was each scene was so captivating that there wasn’t even a chance to think about what comes next. This film challenges us to think about the boundaries that define success, sanity, freedom, love, even right and wrong. It’s also incredibly violent. You should go see it.

What we're writing.

At any time over the past 5 years, anyone brandishing a copy of The Intelligent Investor or Margin Of Safety and arguing that markets have lost their sense of intrinsic value would have been labelled a dinosaur.

We believe that's changing. Here's why.

Are we finally shifting from growth to value?

What a difference a year makes.

This time last year, private markets were all the rage – the heroes of Wall Street hailed from Silicon Valley. Founders and their ideas (occasional lack of profitability notwithstanding) were blessed by a seemingly endless supply of cash from investors, who were stoically committed to the “long term view” of eventual profits. The cult of the founder was in full swing, and these heroes could do no wrong.

Fast forward a year, and the change in mood is palpable. Perhaps WeWork’s dramatic collapse in valuation from US$47bn (some analysts estimated up to US$65bn) when it first filed for IPO to the measly US$8bn valuation implied by Softbank’s latest lifeline came as a result of the market starting to realise that in some situations the emperor had no clothes – and that ideas aside, positive profit margins were (lo and behold) a necessity for businesses to be viable. Many founders create great value for their shareholders, but many others don’t. Perhaps WeWork’s downfall was the first step in making that distinction.

At the same time, private market darlings Uber and Lyft, both emblematic of the liquidity-fuelled excesses and consumer subsidies from the past decade, have been terrible performers since their public market debuts. Uber is down more than 20% from its IPO price, and Lyft more than 50%.

Or perhaps the fatigue from private market investing was already taking its toll on investors, given the latest numbers from Pitchbook, demonstrating that with 2 months left in 2019, this year is very much not like any of the past five:

Either way, the tone of the market has shifted dramatically. In contrast to the liquidity fuelled mania of “growth at any cost” that characterised the past decade (especially the past 3-5 years), sentiment seems to be swinging towards the other end of the spectrum. “Hard financials”, as one journalist put it, matter once again.

The shift to value.

At any time over the past five years, anyone brandishing a copy of “The Intelligent Investor” or “Margin of Safety” and arguing that private markets (or markets in general) have lost their sense of intrinsic value would have been labelled a prude, an old-fashioned dinosaur (now there’s an implied tautology for you!) who has failed to recognise that in a world of abundant liquidity, all that matters is the relentless pursuit of scale. Seeking profits in the near term was short-sighted and asking questions about profitability detracted from the great visions of global domination (even if many largely indistinguishable competitors claimed the same lofty ambition). In the immortal words of Connor MacLeod of Highlander fame, “There can be only one.”

Value, it was said, was investing for grandpas. Moreover, any company that fell into the broad definition of “value” was probably “old economy”: steelmaking, car making, newspapers, telcos, cement, commercial banking, airlines etc. To some extent, that argument holds true: being less exciting with less attractive profit outlooks is a good reason for having a low trading multiple. Yet it’s also true that while companies in these “boring” sectors don’t enjoy growth forecasts, they at least make more than enough cash for their businesses to keep going.

In response to whomever sounded the bell on unsustainably unprofitable business models came the quip that just like economists who predicted 9 out of the last 5 recessions (a line made famous by Nobel laureate Paul Samuelson in 1966), these “value investors” predicting the shift to value were old codgers trying to market a strategy as antiquated as bell bottom jeans. They always predict a shift to value, and even if they did occasionally get it right, a broken clock can be relied upon to tell the right time twice a day.

Reality check.

It cannot be denied – the virtues of a profitable, cash-generating business independent of investor funding are real. Warnings about a shift to “value” have come true in the past, often unexpectedly, and most recently in the rally post Trump’s election.

Take for example Caterpillar, which doubled in the year following Trump’s election. Or mining giant BHP, which has also almost doubled since Trump’s election, and almost tripled since its lows in 2016. These aren’t exciting “growth” businesses, quite the opposite: mining was dubbed a sunset industry as the “end of the commodity supercycle” came along, while tractors and harvesters couldn’t be more different from free beer on tap and dog filters. But boring and unappealing as they are, their price performance told a different story.

A false dichotomy.

Our view is that investors have been offered a series of false dichotomies, oversimplifications largely orchestrated for the convenience of marketing teams.

“Developed” vs “Emerging” markets;
“Growth” vs “Value” vs “Momentum”;
“Tech” vs “Non-tech” (with the result being that every company claims to be a “tech” company);
“Active” vs “Passive”.

The list goes on.

In our view, the result of being offered false dichotomies is that investors start believing their outcomes are mutually exclusive with little middle ground: because of the ideologies and preconceived biases attached to these labels (e.g. “emerging markets are risky, developed markets are safe”, or “value is conservative, growth is aggressive”), investors are put in a position where asset allocation turns into an emotionally and ideologically charged exercise of “us” against “them”, “right” against “wrong”.

Whatever happened to common sense? There are good stocks, and there are bad stocks. “Growth”, “value”, “developed markets”, “emerging markets” and other labels have nothing to do with good or bad. Just as “growth” companies can offer excellent growth prospects reflected in their elevated multiples, they can also offer terrible growth prospects despite a high multiple.

Likewise “value” companies trading at depressed valuations could possibly offer a promising outlook, or they could perhaps be rightly shunned by the market. And then there’s Apple, trading near all-time highs, a reasonable 18x forward earnings, but for all intents and purposes as much “value” as you’d get for a “tech” stock.

The gap between the fundamental reality and the stock price is often the accompanying narrative, and narratives can drive huge movements. Yet one does not live on narratives alone – reality eventually bites back.

A means to an end.

At the end of the day, returns are made in the form of cash in the bank. Growth is a means to an end (profitability), not an end in itself. Our job is to evaluate the investment case for each instrument and work out the balance of risk/reward, and then deploy risk in either direction, long or short to capitalise on both winners and losers. As we’ve discussed in The Big Play and The Small Play, this entails objectively evaluating the fundamentals of the company, its industry and the market. Often they point in opposite directions, but when the stars align, opportunities arise for outsized profits to be made, in either direction.

Thanks to our personal and professional histories, we have a clear preference for investing in growth. “Emerging markets” (as much as we loathe the oversimplification implied by that label) was very much a growth story, and that interest continues into what we prefer to term “emerging opportunities” – not limited by geography or jurisdiction, but purely by the potential to generate returns.

Yet despite this preference, we aren’t ideological. If value makes money, we’ll be value investors. Same goes for growth, momentum or any other style label the industry comes up with. Just like Deng Xiaoping’s comment about black and white cats, any process that consistently generates solid returns is a good process, regardless of “style”.

Uncommon sense.

As we laid out when we first asked “where did all the money go?”, the paper trail leading to private markets made it clear that the majority of liquidity created landed up in the PE/VC world, which itself subverted the common sense notions of “reasonable” rates of return, at least at the institutional level. By lowering return hurdles on projects, investors were forced to start making forecasts that stretched ever-further out into the future, and which carried ever-more-bombastic expectations for eventual profit. Or world domination.

Into this bucket possibly falls the likes of Tesla (a million robo taxis), Uber (eventual (maybe) profitability that can only come from running a global monopoly), Beyond Meat (replacing all cows with plants), WeWork (elevating the world’s consciousness), to name a few. Perhaps we should’ve just asked “Where did common sense go?”

Abundant liquidity has to some extent created the perfect environment for a YOLO (you only live once!) mentality, under the illusion that apart from growth and given the surety of unending liquidity, nothing else matters.

Fortunately, it seems like common sense is prevailing, at least on the individual level, as investors reach inadvertently for higher returns. The flipside of this is the emergence of what we term “risk drift”, where investors unknowingly wander into risky territory in search of returns that only a decade ago were deemed somewhat pedestrian. And where the stock market has for many non-professional investors replaced their savings account, things could get properly messy.

What now?

Tucked at the back of our minds has been a constant reminder to watch out for signs of a shift in tone. And in the past few weeks, the signs have been ever more obvious. The bubbling exuberance of the past few months has died off, with tech stocks new and old(er) suffering sizeable drawdowns as questions are being asked about their profitability. Beyond Meat is down almost 55% from its July highs, after looking seemingly unstoppable, alongside media giant Netflix which is also down 30% from its July highs, despite solid profitability. So much so that the narrative around Netflix has morphed into one that paints it almost as a pariah.

Just as narratives drove the market up, it could also drive the market in any other direction, as we continue to roll through to another chapter of the neverending story of markets. Will we see a shift in style towards value over growth, as “fundamentals” take over? Or does the relentless reach for returns (and risk) continue in its current form? Who knows? The only way forward is to be prepared.

Which investment style? Or which market?

Take a cross-section of any sample of Chinese internet stocks and few exceptions to the selloff can be found, especially in the large cap space. Meituan Dianping and Pinduoduo are the two that are trading close to all time highs as we write this note, but for everything else from Alibaba to Huya to Tencent to Baidu, price action has been less than compelling, even if fundamentals look attractive. So is China internet a value play now?

For many Chinese stocks, the problems have been much more sentiment driven than fundamental. For sure, names like Baidu and Ctrip, with structurally challenged earnings profiles, are rightly under pressure, with their deteriorating outlook factored into their stock prices. But for companies like Alibaba, earnings continue to trend well: their only mistake is being listed in the US, and being weaponised as negotiating chips in the ongoing power struggle.

The flipside to the argument is that as far as the Chinese are concerned, they’re extremely happy with the direction their country is taking, based on the latest September 2019 update to the Ipsos “What Worries The World” survey we referenced last week, in which 94% of Chinese respondents believe their country is heading in the right direction. We’re not in a position to read the minds of 1.3 billion people in aggregate, but our guess is that in most cases, people who are happy and confident about the future are more likely to put their cash to work in the market.

The bigger question is: which market

Weekend ReadingEdward PlayfairOctober 28, 2019