Saturday, September 28, 2019

2019 Market Review: The Phantom Menace

Eleven years ago this month, Lehman Brothers, one of the largest investment bank in the US, file for bankruptcy protection. It held over USD 600 billion in financial assets. The Fed and the other America banks had already engineered two other bailouts in the prior months: Bear Stearns and Merrill Lynch. Bear Stearns was sold to JPMorgan at $2 per share, along with all its assets and liabilities. This allowed the stronger JPMorgan to slowly clean up Bear Stearns' books which limited impact on the markets. Today, nobody remembers Bear Stearns. 

Phantom of Wall Street

Merrill Lynch got a good deal on the eve of Lehman's collapse, it was sold to Bank of America at a 70% premium to its last traded price. Unfortunately, it was not enough for Temasek, who bought it about a year ago and ended up losing a big chunk of its capital. But most importantly, the dirty laundry was kept out of limelight again and the buyer spent years cleaning things up. Alas, it was not so with Lehman Brothers.

When Lehman went down, its USD 600 billion of assets which was linked to trillions more was exposed. It pulled down the global financial system like a broken spider web and triggered the Global Financial Crisis. It was serious. Many believed that the worst case scenario was the end of our financial system as we knew it if the powers that be did not take the right steps. Fortunately they did.

In the aftermath, AIG, the insurer, was broken up as it insured those who bought sub-prime mortgages, including Merrill, and was on the hook to pay up the losses. The rating agencies were affected. They gave their stamps on approval to sub-prime and misled everyone. The US Treasury was also force to take over Fannie Mae and Freddie Mac, hitherto listed companies.

The GFC indirectly caused the banking crisis in Europe as banks in Greece, Iceland, Italy and UK all held financial assets related sub-prime and were in trouble. Asia was not spared. the Chinese government pumped the now notorious RMB4 trillion into its own economy to mitigate the effect of the global financial meltdown. It would continue to intervene and ultimately added close to USD 1 trillion in economic stimulus which ended up becoming bad debt as the money was inefficiently used, such as building entire cities with nobody living in them.

China's Phantom Cities

Back in the western world, the central banks launched quantitative easing (QE) to try to jumpstart the economies. They flooded the global financial system with money which ended up in the hands of a small segment of the population. These were people on Wall Street, people involved in prime real estate (including Singapore), the private equity folks, bitcoin promoters, people who dealt in art, wine, collectibles and needless to say, stocks and shares - yes all of us reading this. Not forgetting to mention, a few billions also went to Najib and the other corrupted governments around the world. Globally, QE did not benefit the masses. It causes a wider disparity between the haves and have-nots.

In retrospect, the issues today, Brexit, trade war, bitcoin, shadow banking all came about eleven years ago when Lehman collapsed. We are still suffering from the lingering effects of the global financial crisis. 

At the start of 2019, the risk that loomed large was Brexit. In 2016, the gap between the haves and the have-nots played out in the Brexit referendum and the have-nots won with 1.9% more votes (51.9% vs 48.1%). The then Prime Minister David Cameron resigned to take responsibility. But Brexit was a pyrrhic victory. The Brits wanted to leave Europe but did not know how. It was, and still is, a big mess. After two and half Prime Ministers and with one month to go, the probability of UK exiting without deal looked very high. If it happens, UK will go into a recession and millions of Europeans in the country become refugees overnight. It would be a disaster. 

Theresa May, UK's second female Prime Minister

Then, there's Donald Trump. Again he was elected because the have-nots thought he would help level the playing field. He decided that China was the root cause of all the world's issues and waged war against the Middle Kingdom. It started in July 2018 with the US imposing tariffs on USD 34bn worth of goods but soon expanded to more than USD 300bn and China hiked its own tariffs on over USD 100bn on US imports. This caused significant worry in the markets (even though it was actually smaller than Lehman's balance sheet) and global exporters and related stocks in China, Hong Kong, Japan, Germany and many parts of the world were negatively impacted. 

The trade war had also morphed into a strategic war on other fronts with Huawei being the prime example. Huawei is China's lead general in the technology war and must be killed. Cybersecurity warfare had already been fought and real world skirmishes likely occurred via proxies in countries like Syria and Afghanistan. The read should be this: the trade war will not go away, it's a strategic war. Hopefully it would not become another Cold War.

Having said all that, China has not really retaliated with a real damaging blow to the US. It could outright ban all US goods and services. It had already banned Google and Facebook, why not Apple, Hollywood, Microsoft and all other services? Well, China probably has a different thinking altogether. This trade war, while damaging now, is not a big deal in China's own big picture.

At a high level truce meeting held in late August, the delegates on both sides sat at the negotiating table behind a huge wall with a Chinese poem with an interesting allegory. China was a mountain that had been around for thousands of years, while a passing cloud (i.e. US) tried to wage a storm to intimate the mountain. It was a futile effort. In some sense, it's true. Huawei will emerge stronger after this saga. China will continue to gain technological and strategical advantage. Its brands, capabilities will grow stronger and it will have more allies in time. 

Phantom message for the US

So what does this means for the markets?

It just means turbulence will continue. The risk is on the downside rather than the upside. We have to use higher prices as sell opportunities. This situation has not change since our last market update. We are still at the late stages of the bull market. It's hard to spot when things would turn. It could continue to be like this for another 12 months. If the Fed cut rates more aggressively, the market could even rally further. Then we look real stupid selling now. But such is investing. We can never tell. So, we move in incremental steps prudently. 

There are also no signs of weak links could bring us to another financial crisis. Back in 2008, we could see the weak links although it wasn't clear that they would be so devastating. People talked about sub-prime for months before things imploded. Bear Stearns went down first. On hindsight, those were big warning signs before Lehman Brothers' bankruptcy. Today, there's no canary in the coal mine, yet. Or rather, it's still too difficult to spot. One could be Uber and Wework and the likes of startups with their diminishing valuations. The other could be the old shadow banking system in China finally blowing up or a big entity in Europe finally caving in, pulling down things as Lehman did. It's always hard to tell before it happens.

Meanwhile, Lehman's phantom menaces, so we need to stay vigilant and raise cash!

Huat Ah! 

Wednesday, September 18, 2019

Thoughts #17: How much can one spend?

As the 1MDB facts come to light, we caught a glimpse of the capacity of crazy rich people. Or rather, the max limit if you have unlimited amount of money to spend. It was reported that Najib, his wife and several others spent 700m ringgit or close to USD 200m on 12,000 pieces of jewellery, 284 designer handbags, 423 watches and 234 pair of sunglasses.

In my mind, I believe this marks the possible cap for a lifetime of spending for rational people. No rational person would spend more than USD 200m in his lifetime. Note that the key word here is rational. Conversely, we discussed in the first post on this blog what is the lower bound for spending. I believe the numbers had not changed much. But I also came across an interesting concept which is not tied to a fixed absolute number.

According to Mr Money Moustache, if you save 50% of your income when you started work at 21, you can retire by 38. Here's his blog below:

Monday, September 09, 2019

Activision Blizzard - Part 3: Risks

This is a continuation of a series on posts on Activision Blizzard.

In the last two posts, we established the investment thesis and laid out the positives for this stock. Today, we shall delve on the most important topic - the risks. Every investment has risks and it is important to lay out all the risk scenarios. I did not lay out the worst case scenario for Hyflux in 2011 and lost 80% of my capital. So, no matter how positive we are on a potential idea, learning the risks and debating these with other like minded friends would be paramount. Below's the key risks for ATVI.

Risk #1 - Old Franchises

Some of Activision's franchises are old, stale and overmilked. The two particularly at risk are Call of Duty and Candy Crush and together they contribute to c.20% of ATVI's annual revenue. If they do badly, we could expect a similar 20% hit to profits. This would be quite a bit of damage. Let's talk about Call of Duty.

This game came out in 2003 and had 16 titles since then. In the last ten years, ATVI launched a new Call of Duty title every year. It launched so many titles that some titles even have the same names, like Call of Duty: Modern Warfare. It came out in 2005 as Call of Duty 4: Modern Warfare and then relaunched again this year as Call of Duty: Modern Warfare. Spot the difference? 

The other peripheral risk is that Call of Duty is a console game. Together with other games, ATVI has concentration risk with 60% exposure to Sony Playstation and 30% to Xbox (and 10% Nintendo and others). If game console goes out of favour it would further exacerbate the decline of Call of Duty. 

Then, we have Candy Crush. This game came out in 2012 and took the world by storm much like Angry Birds and Plant vs Zombies. It's very simple and everyone can play. It also deployed tactics (discussed in the first post) to get people hooked. People also see through the tricks, it's not so much skill but the algorithm behind that determined whether you can clear the level. After seven years, there is only so many candies you want to match. The franchise is really getting tired and ATVI and King (the original company behind Candy Crush) had not been able to do come up with another game.

As such, ATVI needs to quickly grow other revenue (esports, advertisements, new games) to offset the decline in these two games. It's probably in the works. The management team knows these problem and it is not as if they were in denial. The risk is that these games decline much faster than expected. So, the mitigating factor here is good execution from the team.

This brings us to the next risk.

Bobby Kotick - CEO of Activision Blizzard

Risk #2 - Key Man Risk

Bobby Kotick is the CEO of Activision Blizzard, a position he held since 1991 after he bought 25% stake in the company (then Activision). He is an amazing entrepreneur, having the clear vision that gaming is big business back when gaming was just a geek niche. He engineered the merger between Activision and Blizzard. He was also big in giving back to society. With the success of Call of Duty, he created the Call of Duty Endowment to help war veterans. Then in 2016, he saw the potential of esports and jumped right into it, two feet deep by launching Overwatch League.

Over the last 28 years, he grew ATVI's revenue from USD 28m to USD 7.5bn (with mergers of course) with the best franchises in gaming. If Bob Kotick decided to retire tomorrow, ATVI share price would suffer a huge drop. Having said that, he does have a team in place with both the CFO and the COO having been in the company for close to ten years. 

Sadly, he is also often villianized by gamers for his many comments on how he could exploit games and get gamers to pay more. But that is what it's all about. Just like how we pay up for Disney soft toys and Avengers exhibition tickets. There is a tail risk if these gouging go to extremes like some pharmaceutical drugs, but we are not there yet. In short, this is a risk to watch out for but it's not a high probability event.

Worst case scenario

What is the worst that can happen?

Lastly, we need to discuss the worst case scenario - what can go wrong? Laying out a realistic worst case scenario requires experience and logic. It's not easy. The absolute worst case is bankruptcy, like Hyflux but that's not likely to happen with ATVI. This firm generated USD 2-2.5bn of free cashflow. It had so much cash pouring in it decided to spend USD 1.5bn buying back its own shares last year. It also increased its dividends by 9%.

ATVI also has no debt. It has USD 4.6bn of cash on its balance sheet at the end of 2018 but only USD 2.6bn in long term debt. But it does have USD 9.8bn of goodwill as a result of its past acquisitions. Goodwill arises when acquirers pay more than accountable for tangible assets. These are usually intangibles like brand, franchises, trademarks and synergies. In some cases, it's just bad acquisitions whereby the acquirers overpaid. But in ATVI's case, given how successful it had become, the goodwill is likely to be real and not get impaired. 

Putting things together, given its strong balance sheet, high free cashflow generation capability, the worst case scenario is not going to be bankruptcy. It would be business deterioration as discussed. We might expect ATVI to lose 20% of its profits as some of its franchises faltered. This would bring bring FCF to say USD 1.8bn (0.8 * USD 2.2bn). Over the past 10 years, ATVI's FCF yield ranged from 4% to 10% so assuming that the market then gives it 7% FCF yield (mid range) on this FCF USD 1.8bn, we would get to a market cap USD 25bn and adding back its cash, the worst case market cap could be USD 27bn. This would mean that ATVI's share price is c.USD 35.

As of last week, ATVI traded at USD 42, so that means that in the worst case, we could see another 17% downside for ATVI and if it ever falls close to USD 35, the risk reward would be really favourable. ATVI was trading above USD 80 just two years ago. So we are talking about 17% downside vs more than 100% upside.

Buy ATVI if it breaks $40! Huat Ah!