Technology stocks have performed remarkably well in recent years and particularly amid the COVID-19 pandemic. John Christy and Stanley Lu, from our offshore partner, Orbis, compare and contrast the opportunity offered by the well-known US tech stocks with their peers elsewhere.
The largest US technology shares, known by the “FANGAM” moniker, are six rapidly growing and highly profitable businesses: Facebook, Amazon, Netflix, Google (Alphabet), Apple and Microsoft. As a group, they have outperformed the US market by 19 percentage points per annum over the past five years and now account for more than 20% of the S&P 500’s market capitalisation.
There is often very little room for nuance when it comes to the FANGAM stocks. You either look brilliant if you own them or foolish if you do not. One side will argue forcefully that the world has changed and they are “must-own” stocks, while the other will claim with equal fervour that they are overvalued and reminiscent of the dotcom bubble of the late 1990s.
As contrarians, we might be expected to fall into the latter camp. Instead, we would argue that being a contrarian does not mean mindlessly betting against the majority’s opinion, but rather following our own independent research and analysis. This often means we are going against the grain, but sometimes our analysis agrees with the market’s assessment. Similarly, we are quick to remind clients that we are “value-oriented” investors in the sense that we select stocks which trade well below our assessment of their intrinsic value. But we are not “value” investors in the naïve sense of limiting our search to companies trading at low multiples of earnings or book value. Indeed, we often invest in businesses that would traditionally be considered “growth” stocks, but only if we believe their growth potential is available at a compelling price.
We have, at times, found the FANGAM stocks attractive and we own Facebook and Alphabet today. Their valuations look undemanding given their growth prospects. While both have been positive contributors to the relative performance of the Orbis Global Equity Fund (the Fund), with hindsight, we would have been better off owning much larger positions. We have owned Apple, Amazon, and Microsoft in the past, and it is now clear that we sold them too early. As painful as it has been to watch them continue to outperform, it is far more important to stay disciplined and focus on identifying the stocks that offer the most compelling value at current prices.
Looking further afield
With a broad global research capability, we are able to compare and contrast the FANGAMs with their technology peers elsewhere. For example, China’s Alibaba has much in common with Amazon, yet it is growing faster and trades at around half Amazon’s valuation. Both are exceptional businesses, but at the valuations on offer today, we prefer Alibaba.
We are confident that the shares held in the portfolio represent compelling value
When we stack up the individual stocks in this way, a small number of companies exposed to the Chinese internet sector look like the more attractive investments and – most importantly of all – each trades at a significant discount to our assessment of intrinsic value. Collectively, these companies account for more than 15% of the Fund.
NetEase: Custom-made for a quarantined world
The largest position – at 10% of the portfolio – is NetEase. Long-standing clients need little introduction to the company, which we first bought in 2008. As a provider of online games, education and entertainment, NetEase is almost custom-made for a quarantined world and has been the largest contributor to the Fund’s relative performance since the start of the year. Its core online game business, which accounts for nearly 80% of revenues, is highly cash generative even after significant research and development spending to retain its competitive advantage. NetEase produces some of the highest quality mobile games in China, and the company is now expanding globally with some initial success, which should also extend its long-term growth potential.
Besides the core business, NetEase has some exciting new ventures that are currently loss-making, but which we believe offer substantial long-term upside potential. Perhaps the two best examples are Youdao and NetEase Cloud Music. Youdao operates a variety of popular learning apps, such as the most widely used dictionary and translation apps in China, and a leading K-12 online education business. The enormous after-school education market in China offers growth potential and should be a tailwind for the company. Youdao was listed separately in October 2019 and the Fund bought shares at the time. NetEase Cloud Music is one of the most popular music streaming apps in China, with its online music community creating particularly high engagement amongst younger listeners.
While the returns from NetEase’s investment in Kaola, the cross-border e-commerce business that it sold to Alibaba last year, ultimately fell short of our expectations, we were still encouraged that NetEase realised a US$1.2 billion gain from this investment. This indicates that NetEase’s management has a good eye for identifying investments which add value.
NetEase trades at about 24 times our estimate of 2020 earnings if we adjust for the value of its incubated businesses and Youdao. We believe this is a reasonable multiple in light of the growth it has delivered over the past 10 years. During this period, its revenue has compounded at 32% per annum and operating profits at a rate of 21%. It also has a pristine balance sheet with net cash equivalent to about 20% of its market value. To put the valuation in context, Activision Blizzard – a key partner for NetEase (and Tencent) in China – trades at close to 30 times earnings on a comparable basis, with less net cash, and we are more excited about NetEase’s long-term growth potential.
Tencent: Unparalleled user engagement
We are also enthusiastic about the Fund’s holding in Naspers, whose stake in Tencent is by some distance its largest underlying asset. Tencent arguably has the greatest competitive “moat” of any company in China. It owns a portfolio of internet businesses that surround its ubiquitous WeChat app, which encompasses a wide range of daily needs, including messaging, payments, entertainment, news, music and shopping.
Tencent’s user-engagement level is unmatched globally. China’s 900 million internet users collectively spend about 45% of their internet-usage time on Tencent’s many properties, which it monetises through various mega-scale services such as online games (largest in China, with global success), payments (highest market share in offline usage in China), and cloud computing (second largest in China behind Alibaba). Its market share in online ad spending in China, where “eyeballs” are most relevant, is still below 15%, suggesting ample room for future growth.
Tencent produces an enormous amount of annual free cash flow – US$16 billion over the past 12 months – and invests aggressively in future growth. As with NetEase, an investment in Tencent also comes with newer ventures that have exciting potential. These include its 40% stake in the maker of the wildly successful Fortnite game franchise and promising companies in areas such as e-commerce and food delivery in China.
owning an excellent business at a discount still strikes us as an attractive long-term proposition
In addition, Tencent has a portfolio of hundreds of additional investments in opportunities that would otherwise only be accessible in private markets. After assigning fair value to its investment portfolio, Tencent trades at around 33 times its free cash flow, which we consider reasonable given its growth potential. However, the Fund is able to have exposure to Tencent via Naspers, which is trading at around a 50% discount to its underlying assets. That discount has never been zero, so we aren’t counting on it narrowing swiftly or entirely, but owning an excellent business at a discount still strikes us as an attractive long-term proposition.
Alibaba: Innovative and agile
Our most recent technology purchase in China, Alibaba, is most similar to Amazon. Alibaba operates an unparalleled e-commerce marketplace, with a suite of infrastructure and features around online and offline retail to serve its online shopping customers. Its market share of retail e-commerce in China is over 50%, yet there is upside to its monetisation level when compared to Western peers.
Alibaba has also been ahead of its competitors in strategic new businesses such as cloud computing, fintech and omnichannel retail. We believe its history of innovation and agility, combined with financial resources from the core business and a deep bench of management talent, bode well for future growth over our investment horizon. At a valuation that is very similar to Tencent, we believe Alibaba is not only attractive in its own right but also compares favourably to Amazon, as described earlier.
What about China risk?
Corporate governance and the treatment of minority shareholders is often a concern in China as well as other emerging markets. We feel this risk is acceptably low for our holdings, some of which stand out as clear exceptions in this regard. Using NetEase as an illustration, the founder and chief executive, William Ding, owns 42% of the company. NetEase also has a history of being shareholder-friendly. In 2013, it became the first and only major, primarily US-listed Chinese company to pay a regular dividend. Including share repurchases, it has since returned over US$5 billion to shareholders – a return of over 70% of its 2012 average market value, to say nothing of its nearly 10-fold share price appreciation over the same period.
US-China tensions have also been a concern of late and US-listed Chinese firms are under intense scrutiny. We remain of the view that the business fundamentals of our technology holdings are generally less exposed because they provide domestically oriented services. Still, their extensive presence in daily life and access to customer data may expose them to geopolitical risks. While we recognise that the range of possible outcomes includes unknowable tail risks, we have found mitigating factors for some of them. For instance, the potential risk of a forced delisting from a US stock exchange can be alleviated by dual listings in Hong Kong, a process both NetEase and Alibaba have recently undertaken, and Tencent’s primary listing is already in Hong Kong.
we believe Alibaba is not only attractive in its own right but also compares favourably to Amazon
Excited about future prospects
When we step back and look at the shares that we own today – in the technology space and throughout the Global Equity portfolio – we are excited about their prospective relative returns. As noted earlier, we are neither “value” nor “growth” investors in the naïve sense, but our bottom-up stock selections currently provide more exposure to the broad performance of value rather than growth. This has been a headwind at a time when the value style has been deeply out of favour, but our willingness to look beyond headline valuation metrics has helped us avoid even more substantial underperformance during a time when growth shares – notably the FANGAM group – have been unusually strong. Indeed, the positive contribution to performance from our holdings in Asian technology shares has more than offset our relative lack of FANGAM exposure.
The lesson here is that we can still find value in shares that may appear expensive on traditional valuation metrics. But we are mindful that the bar is very high. The more we pay, the more certain we need to be about their ability to deliver outstanding results, particularly in an environment that is as uncertain as the one we are navigating today. We are confident that the shares held in the portfolio represent compelling value – without requiring heroic assumptions.