Weekend Reading #44

Photo by freddie marriage on Unsplash

This is the forty-fourth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 23rd November. To receive a copy each week directly into your inbox, sign up here.

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What we're doing.

It’s been a busy week catching up with business after a frenetic and hugely rewarding trip to Jakarta. Thanks to everyone who took the time to sit down with us, hear our ideas and express interest in partnering with us!

We continue to work towards launching our deal platform for professional investors in the New Year. Pipeline is strong, with a strong focus on primary market equities. We knew this would be the case from preliminary conversations with VCs and others plugged into the primary markets ecosystem, but we’ve been surprised by the quality of transactions that have come across our desks.

The 3BC platform is developing nicely. We are still bug-fixing and optimising the user experience but we can see light at the end of the tunnel. To be frank, our aim isn't to reinvent the wheel technologically – our core differentiator and unfair advantage lies in the strength of our network in emerging markets and increasingly, developed markets too. We cannot afford to rest on our laurels, and as part of efforts to grow our reach we are putting together travel plans for early 2020. We’re particularly interested in attending conferences where we can get exposure to venture capital and private equity professionals, so please get in touch if you know of any events we should check out.

We also stopped by the Saatchi Gallery in London for the latest exhibition of artefacts from the tomb of King Tutankhamen, the last overseas tour before the artefacts return permanently to their home in Cairo. Despite it being a rainy Saturday afternoon, we were informed that 300 people were being admitted per half hour into the gallery, explaining the seemingly unending queue outside. The exhibits were fascinating, shedding light on how advanced the Egyptians were at that time in metalworking (including two interesting trumpets), artisanal craft, language and philosophy. And while we now look upon them as ancient history, their attempts to perceive the world beyond the present – into infinity, the afterlife and their legacies – are scarcely different from ours. Often mistakenly attributed to the Bristolian graffiti artist Banksy, the notion that “A man dies twice: once when he stops breathing, and then when his name is spoken for the last time”, finds its roots squarely in ancient Egyptian philosophy.

Ironic then that while the Pharaohs that superseded Tutankhamun attempted to wipe him out of history by destroying his monuments and removing his name from rituals and prayers, the discovery of his tomb by Howard Carter and Lord Carnarvon more than 3,000 years later has now made Tutankhamun the most spoken-of Pharaoh of ancient Egypt, granting him the immortality the ancient Egyptians so coveted.

What we're reading.

Not a lot of time for reading this week, but it happens to the best of us. We did manage to catch this fantastic piece from Eurasia Group on “The End Of The American Order”. Geopolitical maven Ian Bremmer starts the piece with the following salvo:

“China has made its decision. Beijing is building a separate system of Chinese technology—its own standards, infrastructure, and supply chains—to compete with the West. Make no mistake: this is the single most consequential geopolitical decision taken in the last three decades. It's also the greatest threat to globalization. It wasn't supposed to be like this.”

It’s safe to say the premise that China is no longer content with copying western culture (was it ever?!) and technology has now entered the mainstream – expect a deluge of cut and paste articles in the coming weeks and months.

This tweet from Garry Tan on the concept of “idea disease” also made us sit up and take notice. The idea that “execs and new founders frequently make a big mistake: overvaluing the big idea and undervaluing the execution” is so, so true. Ideas are precious, but only when combined with action. For those of you who want to explore this topic in more depth, it’s worth checking out Behance founder Scott Belsky’s manifesto “Making Ideas Happen”.

In the noise surrounding crypto and Bitcoin in particular, it can be hard to find commentary which takes a long view and considered the long term implications of decentralised finance. This thought piece on "Bitcoin And The ‘Great Wealth Transfer" from The Rhythm Of Bitcoin does precisely that. It argues that millennials (the wealthiest generation in history) have started making a major shift towards the use of unconventional banking, with Bitcoin posed to be the beneficiary of this structural change in the way people store and transfer wealth.

We're big fans of Jordan Schneider, Beijing-based host of the ChinaEconTalk Podcast. Every week he translates articles from Chinese media about tech, business and political economy, provided a much needed insider perspective on what's happening at the forefront of Chinese society. This week he shared his thoughts on China's co-working industry, with particular reference to Mao Daqing’s Ucommune. There is some really interesting colour on how the business is departing from the WeWork model and differentiating itself by focusing on operational profitability and incubating startups.

Later in the week we clocked this interview with a seasoned, seemingly inflammable Morgan Stanley banker Michael Grimes, who has played a role in the IPOs of Google, Salesforce, LinkedIn, Workday and hundreds of other companies. He openly admits that direct listings are more efficient than IPOs and the article contains some great insights into how banks seek to position companies (and themselves) for public listings and the rapidly changing landscape in equity primary markets.

What we're watching.

Friend of Three Body Capital Jawad Mian is one of the reasons we check Twitter everyday. He's a supremely talented content creator and curator. Here he shares a lecture from Peter Thiel, who he describes as "one of the most thoughtful prognosticators of society and the future." Thiel is a provocateur, but some of his statements (e.g. "China loves AI; it hates crypto") will get you thinking about where the world is headed.

This week we returned to The Crown, Netflix’s flagship period drama. Whether you are a royalist or a republican, you cannot fail to admire the craftsmanship that’s gone into this masterpiece – the cinematography in particularly is simply breathtaking. Watch it.

On the plane back from Jakarta, we began watching The Naked Director, also on Netflix. It’s a Japanese comedy-drama series telling the true story of Toru Muranishi, one of the fathers of the Japanese adult film industry. We thank one of our friends in Indonesia for the recommendation – although we must say that those readers who prefer a “cleaner” viewing experience should probably stay away, as the show is exactly what one would expect given the synopsis above!

What we're listening to.

By now most of us know that gaming has grown from a niche pastime into a mainstream phenomenon that dominates the entertainment industry. But have you considered how gaming actually reflects and shapes contemporary culture?

In this podcast episode, a16z general partner Andrew Chen, deal partner Jon Lai, and host Lauren Murrow do precisely that.

What we're writing.

Why structurally declining businesses can (sometimes) be interesting.

The past decade or so has truly been the decade of “growth”.

The rise of the FAANGs in the US and the “BAT” (Baidu, Alibaba and Tencent) in China has spurred an equal (if not greater) exuberance all around the world, driving capital squarely into companies that investors believe will be their local equivalents, like “The Amazon of Nigeria”, “The Netflix of Southeast Asia” or “The Alibaba of Latin America”. Add to this other themes like electrification of vehicles, cloud computing, renewable energy and financial disintermediation and the exodus from the “old economy” looks like it has only just begun.

The victims of these capital shifts are commonly the champions of yesteryear – from department store operators to TV stations to remittance services to brokerages. These businesses have seen their stocks’ earnings multiples collapse from mid teens to low single digit levels as their growth trajectories have been adjusted lower and lower.

A crushed multiple.

One well-known example is Macy’s, the US department store operator: from the stock’s high in 2015 when it traded at almost $70, Macy’s stock now trades at $15. Over the same period, its forward earnings multiple has been crushed, from just under 15x forward earnings to 5x forward earnings now.

While Macy’s, battered and beaten up by competition from the likes of Amazon, earns 28% less than it did in 2015, the market has decided that its stock is worth 78% less. Let’s be clear – we aren’t advocating the view that Macy’s stock is “cheap” and should be bought – certainly not when we tend to steer clear of businesses that lack growth prospects, at least as long positions.

But in the context of the shift from growth to value which we discussed several weeks back, it’s interesting to try and put ourselves in the shoes of a hypothetical “value” investor and work out where the appeal is. After all, it would seem that structurally declining businesses are everywhere looking for buyers, and it would be remiss to not at least entertain the idea of owning some of them.

Finding value.

Advocates of value investing typically seek out some basis for fundamental valuation, most commonly referencing the book value of a company, the value of hard assets which a company owns. The rationale is simple: buying companies that are worth less than the value of the stuff they’re made up of necessarily offers some margin of safety, since in the worst case (or so the argument goes) “even if the company goes bankrupt, we’d recover more than what we paid in the first place.”

More sophisticated deep value investors turn to metrics like “Replacement Cost” as a more accurate representation of how much the physical hard assets of a company are worth, but the underlying concept is the same, essentially attempting to spend $90 to buy a $100 note.

As a majority shareholder in these transactions, they make a lot of sense, since a majority shareholder is entitled to consolidate the newly acquired company into its accounts, permitting the buyer almost full use of the acquired company’s cash and other assets. As it happens, for a company that has a steady (but somewhat slowing) business like running a department store or collecting subscriptions for satellite TV, there is decent cashflow coming into the company’s coffers, with very little opportunity for deploying that cash barring a complete overhaul of the company’s business.

Of course, given some ingenuity, there is scope for financial engineering that could benefit the stock prices of an otherwise ex-growth company, as has been the case with Texas Instruments outlined by Ben Hunt in his blog here.

The cash just keeps coming.

But for most other structurally declining companies, scheming out a narrative change of growing earnings per share and executing that via a complex structure of buybacks and management incentives is one bridge too far. Most businesses just want to get on with it. As a result, cash starts to pile up, with nowhere to go. At the same time, future prospects for the business start to dwindle, further reducing the need to reinvest into the business. Dividends could be paid, but the cash just keeps coming.

The opportunity therefore is for a rapidly growing company, one of the many spawned in the liquidity fuelled exuberance of the past decade, to acquire some of these decently profitable, cash-generating (and sometimes cash-accumulating) businesses at a multiple that is absolutely reasonable by any standards. A company trading at 20x sales and no earnings using its still-abundant cash pile to acquire a target trading at 5x forward earnings and 3x enterprise value, laden with unused cash that keeps coming every year: one couldn’t imagine a better strategy to take.

In our own business, too, we’ve always believed in the mantra that “cash is king” – before going for the moonshot ideas that could (with a smaller percentage chance of success) make us a ridiculous amount of profit, it is more important to secure cash flow. As with our approach to managing money, once the base is secured, everything else is upside.

Ready, get set, dig.

Does this all mean that every cash-generating “deep value” company is going to get snapped up at a premium and value investors are going to have their day? We don’t know, but if you paid attention to the section above, there was one caveat that you might have spotted – all those “benefits” come primarily to the majority shareholder in those transactions.

We have in the past discussed the key difference between the company and its stock. A majority shareholder who owns the bulk of equity in a company invests in the company; a minority shareholder picking up shares in the stock market invests in the stock.

But it’s the same thing, just a matter of amount, isn’t it? Quite the contrary. As a majority shareholder, the benefits of profit, cash flow and cash reserves accrue directly to the entire group’s balance sheet.

As a minority shareholder, the only ways you enjoy those benefits are from selling the stock (hopefully at a higher price than what was paid initially) or from receiving dividends, at the discretion of management – not yours.

And when it comes to recovering more in a bankruptcy than what was paid in the first place just because you paid below book value, there’s a plethora of reasons why that won’t happen, starting with the fact that the road to bankruptcy is long, costly and a drag on the cash and valuations which we see today. Even worse would be staving off bankruptcy and management (against your protests) agreeing to a trade sale of the company at half the price you paid for it in order to keep their jobs.

Of course, as a minority shareholder, you also don’t need to worry about issues like debt coming back to haunt you (as Malaysian automaker Proton learnt the tough way with their acquisition of British carmaker Lotus, and their subsequent sale to Chinese carmaker Geely). Less control, less responsibility, at least that much is fair.

He who controls the cash is king.

Here’s the bottom line: cash is king, but only if you can control the cash. For a large corporate buying out a cash-generating business at a cheap multiple thanks to the spectre of “structurally declining” over its target, that’s good dealmaking. The same could be said of activist investors who take board seats and seek to influence the operations of a company.

Yet we, like many public market investors, aren’t dealmakers. We don’t pretend to be the gunslinging bankers and financiers in Barbarians at the Gate who walk in, find undervalued companies and flip them around like bartenders do with cocktail shakers. Like many public market investors, we invest in stocks, not companies.

Drawing the line between what makes “good business sense” and “good investment sense” is important. Given enough cash to buy a business that could provide us with strong cash flows and secure our base for the years to come at a reasonable price, we’d definitely want to take a look.

Investing is a completely different story. To do the same with a small portfolio position in the publicly traded stock of a company that “looks cheap on a 5 year trailing multiple basis” which offers “strong operating and free cash flow”, but which is also effectively seen to be out of growth opportunities by the broader market – for us that would be a trade, at best.