Quarterly Letter, VIP IC

Quarterly Letter from CIO, VIP International Chapter, Q1 2023

Dear Sponsors, Board of Advisors and Members,

I hope this letter finds you well. As we reflect on the past quarter, I wanted to take this opportunity to provide an overview of our investment activities and share some insights on the market trends that have influenced our investment thinking and the resulting strategy. It has also been roughly a year since the combined fund structure was established, hence I will also take this opportunity to share more about what we’ve learned about investing under such a mandate over the past year.

As the first quarter of the new year kicked off, we see that most of the markets under our purview have continued their recovery from the disruptions caused by the pandemic, albeit with some variations across regions. Business sentiment and consumer spending have noticeably improved, but stock prices are currently still factoring in expectations of limited future rate hikes from the Fed. The FANG+ (which includes Facebook/Meta, Apple, Amazon, Netflix, Google/Alphabet, Microsoft, Nvidia and Tesla) rally reflected this as early as January, and prices continued to rise post-SVB collapse.

In China, stocks experienced significant growth following the relaxation of Covid-19 restrictions by the Beijing government at the beginning of the quarter. Investor sentiment received additional support from favorable measures in the property market and a reduction in regulatory scrutiny on Chinese technology firms by the government. These tailwinds resulted in overall market optimism despite the re-emergence of tensions between the US and China after a Chinese high altitude balloon was shot down in US airspace. The Fed remains a decisive factor in when the PBOC is going to pivot into any quantitative easing, hence uncertainties in the US continue to spill over into China.

Over the past year, geopolitical tensions, inflationary pressures, and the risk of interest rate hikes have added an element of uncertainty to the investment landscape. We have remained focused on our core principles of rigorous research, requiring a margin of safety, and a long-term perspective. Since the inception of the combined portfolio in April 2022, we’ve tried to take advantage of bargain valuations while staying out of an investment with valuations soared too far above a level that would give us a comfortable margin. However, the heightened volatility of the market has made it difficult for us to ascertain which price movements contain important signals for us and which we should treat as white noise. We still think it is paramount that we prioritise figuring out the long-term stories that companies and industries are most likely to tell, but it has admittedly been a difficult year of deciding when to enter and exit positions to protect limit our downside risk.

Nonetheless, we have had a very active quarter, having been able to build on our previous research in China’s EV sector as well as our analysis of Alibaba. The endowment’s current investments are accounted for in the table below:

During the past quarter, we have acquired 375 shares of BYD Co. Ltd. to constitute 40% of our portfolio based on Javier Chan’s (Team Spring Portfolio Manager) initial pitch for the company.

BYD

Founded in 1995 and headquartered in Shenzhen, China, BYD Co. Ltd. is a leading global manufacturer of electric vehicles and rechargeable batteries. The company's name stands for "Build Your Dreams," reflecting its commitment to sustainable transportation and clean energy solutions.

The company started off as a rechargeable-battery factory and grew rapidly by supplying batteries to various mobile phone manufacturers. Since then, BYD has established itself as a major player in the EV industry, offering a wide range of electric vehicles, including cars, buses, trucks, and forklifts. It has gained recognition for its advanced battery technology and integration of renewable energy solutions. Additionally, BYD has continued the manufacturing and assembly of electronic components and products, including cell phone components and handsets, and has also expanded into related sectors such as energy storage systems and solar power generation.

In 2022, BYD surpassed Tesla to become the world’s largest EV producer by volume. As of Mar 2023, BYD holds a 45% market share in China’s overall EV market (accounting for 70% of its sales), and has expanded into foreign markets like Japan, Germany, Singapore, Australia, and India. China continues to be one of the best EV markets in the world, constituting 65% of public EV charging stations out of the world total of 1.15 million stations. Of which, Guangdong Province has the highest number of charging stations of 343,595 stations. China’s EV market has undergone a substantial shift in the policy-driven growth to more organic EV adoption driven by lower costs, improved charging infrastructure, upgraded eco-friendliness, safety and driving experiences as well as greater consumer awareness.

The biggest challenges facing EV makers now is the sensitivity of their margins to changes in raw material prices amidst rising costs and a fiercely competitive landscape. However, we believe that BYD has numerous measures in place to safeguard their profitability, namely their vertically integrated supply chain, cheaper proprietary battery technology, and product price hikes.

Firstly, unlike nearly all its peers, BYD produces its own EV batteries. Furthermore, it makes about 70% of the chips used in its EVs in-house and relies on outside vendors only for the higher-end chips (e.g. for autonomous driving). This allows them to bypass the average third-party sales markup of 82% (derived from the industry gross margin of 45%).

Secondly, BYD’s proprietary Blade Battery technology also allows them to produce cheaper yet high-capacity EV batteries at scale, achieving a 42% cost saving compared to traditional LFP batteries. Blade batteries are currently not fully implemented across the entire product line, but as BYD continues to roll out its use, company gross margins stand to widen from lower vehicle manufacturing costs, as well as additional leverage from the sales of Blade Batteries to Tesla.

Lastly, BYD can secure higher top-line growth through their strong pricing power and successful price-hiking, as evidenced by resilient scales despite raising prices on their cars by 3,000-6,000 yuan (US$471-942) in March of 2022 only a month after a first hike of 1,000-7,000 yuan. Looking at BYD’s track record of price hikes, we can observe that their price hikes have been accretive to gross margins. This ability to raise prices will serve as a strong safety net for them to preserve margins even as raw material costs rise, in addition to getting BYD ahead of the competition due to the difficulty in replicating such measures.

Overall, we believe in BYD’s ability to emerge as a winner in the Chinese EV space due to its wide moat and superior technologies. We are optimistic about its ability to generate stable cash flows given its leading market position and sustainable competitive advantage, and propose a 3-Y target price of 430HKD (106% upside).

Alibaba

Alibaba announced 2022Q4 earnings in February, reporting a 2% year-on-year increase in revenue in Q4 2022, rising to 247,756 million yuan ($35,921 million) compared to 242,580 million yuan ($35,167 million) in 2021.The company delivered a solid quarter despite softer demand, supply chain and logistics disruptions due to impact of changes in Covid-19 measures. The company also continues to maintain a strong net cash position of 379 billion RMB or 55 billion USD. cash from operating activities was RMB87 billion and free cash flow were RMB82 billion, respectively, which were up by RMB7 billion and RMB10 billion versus a year ago. Majority of the difference between operating cash flow and free cash flow is operating CAPEX at RMB5.8 billion, down by RMB3.5billion versus a year ago.

Revenue from the Cloud segment, after inter-segment elimination, was RMB20.2 billion, an increase of 3% mainly driven by healthy double-digit public cloud growth. Adjusted EBITA of Cloud segment, which comprised of Alibaba Cloud and DingTalk, was a profit of RMB356 million in December quarter, increased by RMB222 million year-over-year. During the earnings call, CEO Daniel Zhang reiterated that cloud computing is one of Alibaba’s core strategies for the future. The company believes that technologies such as generative AI and virtual reality are going to require massive computing power, hence Alibaba expects to see exponential growth in demand for computing power.

With the announcement of Alibaba’s split into six independent business units, Alibaba remains committed to maintaining its leading market position in the Cloud sector, with Zhang leading Alibaba Cloud being a clear indicator of the business’s strategic importance to the Group. The plan ahead for Alibaba Cloud is to go back to the fundamentals of providing digital infrastructure and computing power in a way that ensures consistently high availability, high security, and high stability, achieving performance standards that satisfy and even exceed customer expectations.

Alibaba will also be looking to place greater emphasis on developing public cloud offerings and striving to set a standard for China and the world. The company will need to constantly pursue technological breakthroughs in core capabilities around IaaS and PaaS, to ensure that they sustain their leadership in China and globally, in terms of both performance and cost.

Alibaba will be announcing 2023Q1 results very soon and we will continue to review the business to test the strength of our assumptions and make adjustments to our view of the company before making an updated investment decision.

This brings us to the end of the team’s updates for this quarter. We appreciate your ongoing support to the Club, to each and every member that you dedicate your time and attention to. As we begin a new recruitment cycle for the next batch of young, eager investors, we hope you are just as excited as we are about what lies in store for Z Club, and we look forward to updating you on our progress in the upcoming quarter and the new names we’ve welcomed into the team.

Warm regards,

Rebecca Yang

on behalf of the Value Investing Program’s International Chapter Team