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Learn from your distinguished instructors

All We Want in Life Is No Competition

By Felix Narhi, instructor at Wide-Moat Investing Summit 2017. Access the session recording.

At Pender we sometimes joke that all we want in life is either no competition or an unfair advantage. This is only partly in jest. In truth, virtually all great businesses have unfair advantages – Warren Buffett calls such advantages economic “moats”. Moats are very valuable if they provide a business with the ability to generate sustainably high returns on capital, which creates wealth for its owners. The ideal business is one that uses very little capital, has a defensible business model and can continue to grow at a decent clip. The growth of such a capital-light business generates lots of extra free cash flow every year which is not required in the core business. As an investor, you get a double-barreled compounding effect from this earnings growth – first from the value of the growing business and second from the value of the excess cash which can be used to fund other promising opportunities, repurchase shares or pay out dividends. There are relatively few businesses like that, but this approach describes the business models of many of today’s tech giants including Apple, Google, Facebook, Amazon and Microsoft. As these enterprises illustrate, management teams that have the ability to look around the bend and make smart early bets on tomorrow’s promising trends and achieve critical mass have the potential to create large fortunes. Collectively, these companies have grown so rapidly that extra cash continues to pile up faster than many of these companies can deploy it . A high class problem!

We believe that Artificial Intelligence (AI) represents the next great technological leap for society and a once-in-a-generation opportunity to develop new commercial frontiers while transforming a wide range of industries such as automotive, health care, education, financial services and industrial automation. During the first quarter we bought stakes in Baidu (NASD: BIDU) in part to tap into the firm’s AI optionality. We believe it makes sense to value Baidu on two key pillars. First on a “what do we have now?” sum-of-the-parts basis, to assess if the valuation is sensible relative to the opportunity set today and second, on a “what are they going to do with it?”basis to assess future optionality.

What do we have now?

Led by its co-founder Robin Li, Baidu is often referred to as “China’s Google” because it is the dominant search engine in China. Similar to Google’s core business, Baidu’s search functionality continues to serve a very fundamental need for society as more and more information is digitized. The business model is very scalable and has historically generated consistently high margins. Baidu’s core search/advertising business fits in the ideal business profile noted above because it requires virtually no invested capital to continue to operate and grow.

Taking a page out of Google’s playbook, Baidu has used its core search engine’s cash cow to fund other start up business initiatives, albeit with mixed results. Successes include its fast growing on-line video service in China, iQiyi (comparable to Netflix) and investments that led to a 20% stake in China’s leading online travel agency, Ctrip (think Priceline and Expedia). But some missteps have overshadowed these successes. Last year the company faced headwinds following the death of a Chinese student who found a fraudulent cancer treatment searching on Baidu. The subsequent reputational damage and government crackdown on the advertising of its medical advertising partners caused Search Services revenues to decline for the first time since its 2005 IPO. In addition, some key investments have been disappointing, while losses in other major units continue to drag down company margins. Even iQiyi, which is considered a success, is not yet profitable. Not surprisingly, the stock has been pressured by these developments. However, we believe there are some early signs that a number of key business units could be nearing an inflection point, which could unlock hidden value in the shares.

Baidu is widely acknowledged as one of the pioneers of AI research and its early bets are already breathing new life into the search business with new products like “newsfeed” posting impressive adoption rate s over a short period of time. Moreover, the drivers of the losses in the non-core divisions are largely discretionary as management seeks scale to reach critical mass in large new markets. Management now anticipates the losses in these non-core businesses to moderate as those units reach scale over the next few years (iQiyi), are sold (Baidu Mobile Games), or as underlying business models change (Nuomi). In short, it appears operating prof its are set to rebound.

We believe a sum-of-the-parts (SOTP) valuation provides a good starting point for the fair value of Baidu today. Some assets like net cash and its 20% stake in publicly-traded Ctrip (NASD:CTRP) are straightforward to value, while others require conservative “guestimates” to derive sensible intrinsic value ranges. Excluding net cash and other non-core investments, we estimate BIDU is trading at less than 12x the normalized pre-tax profits of its core search business, a compelling discount to other well-known tech peers who operate other ideal businesses with deep moats. We believe a SOTP analysis provides foundational downside support for BIDU at current price levels, but Baidu’s value over the medium-to-longer terms will largely depend if it can parlay its early AI leadership in China into commercial success.

What are they going to do with it?

“The internet is just an appetizer, whereas AI is the real entrée. The latter is not a part of the internet, not the second stage of the internet; it is technological revolution comparable to the industrial revolution.” – Robin Li, Co-Founder & CEO of Baidu

Baidu recently made an all-in bet on Artificial Intelligence which we believe gives optionality to the stock that is not fully appreciated by investors focused on today’s opportunity set. There are three key ingredients for AI success: 1) ownership of massive hard-to-replicate data sets; 2) high performance computing to mine insights from the data and; 3) ability to harness a deep bench of AI talent. Given these gating factors, it’s not surprising that the early AI leaders are all familiar tech names that have collected massive amounts of user data over the normal course of their business operations for many years. As a result, a relatively small handful of high-profile tech giants own the most promising data sets which can be applied to some of the most interesting business opportunities. It has been said that data in 21st Century is like oil in the 18th Century – an immense, untapped valuable asset. However, unlike oil, the amount of data keeps on growing exponentially and is not depleted after use. Those who can tap into data’s fundamental value, learn to extract and monetize it should continue to see huge rewards. These include the “Super 7” hyper scale tech giants in the US and China: Facebook, Amazon, Google, Microsoft, Alibaba, Tencent and Baidu. It is virtually impossible to replicate the data treasure trove that has emerged from Facebook’s ubiquitous social media presence, Google’s global search data/mapping domination and Amazon’s online retail empire/ cloud computing expertise. However, these global giants are largely absent in China and as a result, the most valuable data sets are now owned by domestic tech equivalents.

Like the other tech giants, Baidu enjoys huge barriers to entry which would be very difficult for others to replicate anytime soon (if not impossible without a time machine!). As the leading search engine in China, Baidu has amassed vast amounts of diverse and proprietary data in a market with over 700 million internet users who speak the same language, have the same culture and abide by the same laws. Baidu also owns one of the leading map services in China, which is increasingly important as autonomous driving takes off and online/offline worlds continue to blur. These ever-growing data sets are becoming increasingly valuable as traditional learning
algorithms are supplanted by large artificial neural networks that are driven by advances in high performance computing. New business models are being created and many old models will be displaced as disruptors uncover new insights and possibilities from this data. Better to own the disruptor than the disrupted!

Beyond the moat created by the ownership of big proprietary data sets and advances in high performance computing, arguably the most unfair advantage in China is the support of the government. The government views AI as strategically important and as a once-in-many-decades chance for China to lead the charge in technology. Although Chinese peers Tencent and Alibaba are very strong players with huge accessible user databases of their own, earlier this year the government granted special permission to Baidu to lead the development of a national deep-learning AI research lab, further solidifying Baidu’s “moat” and status as the nation’s AI champion. Although details are still scarce and the benefits are hard to quantify, we believe this is a big deal because it will help nurture its homegrown leader and keep global competition at bay. Baidu can nowaccess the enormous amounts of data held by Chinese companies and universities, be aided by the large number of Chinese engineers being trained on both sides of the Pacific and obtain government backing(including funding and assistance with special permits required to test self-driving cars, for example). Baidu will work with leading AI researchers in Tsinghua and Beihang universities, as well as other Chinese research institutions and focus on computer vision, biometric identification, intellectual property rights and human-computer interaction. Interestingly, the Chinese government is accelerating its AI efforts just as the Trump-led White House appears increasingly distracted by internal issues and looking backwards to revive yesteryear industries like coal mining. In addition, Trump’s restrictive immigration policy is giving Chinese firms an unprecedented opportunity to attract top AI talent. Time will tell whether the leading Chinese AI firm or a leading US coal firm turns out to be the better investment opportunity.

Worth mentioning, many of existing Baidu business units have already been enhanced by AI. For example, search by voice or by image, instead of just touch/typing, is fundamentally changing the way people interact with technology. For Baidu, it extends the utility of its search capability to every device and in every scenario including in homes and cars, and moves society away from today’s ubiquitous head-down interactions with smartphones. Baidu has launched new AI-driven business units to maximise its world-class capabilities in autonomous driving (think Tesla’s Autopilot) and with its DuerOS Conversational Computing platform to harness voice-activated technologies (think Amazon Alexa/Echo). Both have the potential to be disruptive to their respective industries as consumers embrace new technologies to improve their lives, especially in China where Baidu enjoys essentially “no-competition or an unfair advantage” relative to their global peers. This is just the beginning, as we anticipate AI will open up many value creation opportunities which are hard-to-imagine today, but will no doubt be commonplace in the future.

Baidu – an emerging Chinese AI giant nearing an inflection point

We believe the stock was pricey five years ago, but the fundamentals have since back filled in nicely. Baidu’ s revenue is up four-fold over the last five years, but the stock has been range bound because operating profits have flat lined due to the drag from start-up losses in promising non-core business segments. As noted, the company could be near an inflection point as losses from non-core businesses start to fade and the core search business picks up momentum again following last year’s setback. Moreover, we believe the promise of AI is very real, with little to no optionality from potentially game changing opportunities yet baked into the stock price(autonomous driving and conversational computing being only the start). As Amazon founder Jeff Bezos might say, it is just “Day 1” in the AI sector which has finally reached a tipping point and stands at the cusp of its golden-age. The early promise of AI has not impacted the shares of all AI leaders (yet). Of note, Baidu’s hyper scale “Super 7” peers have market capitalizations that are 5-10 times larger than BIDU’s current market valuation. In our view, BIDU appears somewhat akin to a compressed spring, poised for significant upside as it starts to monetize its AI lead in China. Hence the opportunity. We are long BIDU.

How Do We Know We Are Right

By Gary Mishuris, instructor at Wide-Moat Investing Summit 2017. Access the session recording.

A first level answer that I heard early on in my career from some portfolio managers is something along the lines of “If the market price of the security that you bought goes up more than the index, then you were right, if it doesn’t, then you were wrong. Period.” This is a naïve and in my opinion flawed view of both the investment process, and what market prices tell us about a security. To elaborate, it is helpful to reduce the investment process to a simplified mental model.

The “urn and ticket” mental model for an investment

Suppose you are offered an opportunity to buy a ticket that gives you the right to draw one ball from an urn. That urn is filled with 8 green balls and 2 red balls, a fact that you have no reason to doubt. The process of choosing a ball from the urn is purely random. If you draw a green ball then you will be paid $100 with certainty, and if you draw a red ball you will get nothing.

It is your lucky day–the seller of the tickets has offered you a ticket for $50. You quickly calculate that the expected value of that ticket is $80, and make the purchase. The drawing is to happen three months from now, and so you eagerly await your opportunity to win the prize. At the end of the first month, you observe that John, who bought an identical ticket,sold it to Bob for $40. You weren’t the only one to observe that–Mike, your ticket value administrator, also happened to notice this transaction.Since it is the only one available, he helpfully sends you your statement with the month-end Net Asset Value (NAV) of your ticket “marked” at $40.

Unperturbed by the news from Mike that the market price of your ticket has declined, you finally reach the end of the three month period and have an opportunity to draw ball from the urn. One of two things can happen –you draw a green ball and get paid $100 or you draw a red ball and get nothing. Before you get the chance to draw your ball,however,you encounter another participant, Jim, who on the way to the drawing tells you that he paid $90 for his identical ticket. As you wait in line, Jim confides in you that the reason he made the purchase was that he “had too much cash, and his clients weren’t paying him to hold cash as they had already made the capital allocation decision for him.

Hopefully you would agree that you made a good decision by buying the ticket well below its expected value, even though20% of the time you will have an unfavorable outcome that will result in a realized loss on your investment of $50. Similarly, Jim made a decision to pay more than the expected value of the ticket, yet20% of the time he will have a realized gain on his investment of $10 even though his decision had negative expected value before the outcome was known. This illustrates why even with realized results after an investment has been exited, the outcome itself doesn’t necessarily tell you if the investment was a good one.

The “urn and ticket” mental model in the real world

There are two main differences between the simplified example above and the real world of estimating the value of a business. If we were to continue with the example of an urn with different colored balls as an analogy for a business with different potential financial outcomes, the two main differences would be:

  • In the real world, the number of the balls in the urn –the financial outcomes of a business –usually cannot be known with certainty ahead of time. That being said, there are various ways that we can go about estimating what is in the “urn”. In some cases this may lead to a reasonable range of what is inside, but in other cases,no matter how often we rattle the urn or try to peek inside, we cannot obtain a reasonable estimate of what is within. This is why a key tenet of my investment process is to only attempt to value businesses that possess characteristics that make their long-term economics sufficiently predictable so as to yield a reasonable range of values.
  • In the real world, the number and type of balls in the urn can change over time. Competitive dynamics and the results of management’s capital allocation decisions can both either increase or decrease the financial outcomes of the business in the future. So even if you knew with certainty the contents of the urn at the time you purchase the ticket, the contents would likely be different by the time the drawing is held. This highlights the importance of my focus on businesses whose value I believe is likely to increase over time as a result of a strong competitive position and management that is likely to undertake value creating capital allocation decisions.

How can we know whether an investment decision was a good one at the time that it was made?Unfortunately, there is no answer that is as clear cut as our urn and ticket example. Sometimes an undesired financial outcome will happen, and it will still be a matter of opinion as to whether the initial investment decision was a good one or not.We will not always know if we paid a good price for the ticket but happened to draw an unlikely unfavorable ball from the urn. Other times, the passage of time will make it clear whether we were correct or not in our initial decision to invest.

Here are some signs that my initial investment decision was wrong:

  • The Worst Case value estimate has declined materially over time. While we can’t know the future precisely, estimating the lower bound of the likely value range correctly is a key part of my investment process.Therefore, getting the range of values wrong is a much bigger mistake than being incorrect with respect to where the Base Case lies within the range.
  • The assessment of the quality of the business or management team needed to be materially revised downward. Since I rely on these quality assessments both for deciding whether to invest and for sizing the investment, getting one of these judgments wrong is a process error.
  • Making a mistake in analyzing the balance sheet in a way that causes a material unexpected impairment of the value of the business. There are situations where other factors can make a decision to invest in a security where the balance sheet has room for improvement correct as a function of other considerations such as the risk-reward ratio. However, taking on that risk without realizing it and without demanding commensurately higher expected return is a mistake.
  • Key economic variables that were identified as material to the value range are tracking worse than expected for a prolonged period of time.
  • My investment thesis used to justify the value range continues to evolve over time, and I find myself making statements such as “yes, my initial thesis did not pan out, BUT...,” with the end of that statement usually referring to how inexpensive the security is now.

Here are some signs that our initial investment decision was correct:

  • An acquirer purchases the business at a price consistent with my value appraisal.
  • A fixed-income security that I analyzed as likely to continue fully paying interest and return the principal matures, and we get the expected interest and principal.
  • My intrinsic value range goes up over time, at least in line with the 10% discount rate that I used in deriving it. Importantly, this is supported by visible fundamental improvements in the business, not vague or unsubstantiated estimates about the distant future.
  • Key economic variables that were identified as material to the value range are tracking as or better than expected for a prolonged period.

You might observe from the above that only in a few scenarios does one get near-certainty that the initial investment was a good one. In other cases, the odds begin to move in one direction or the other, with the judgment still far from certain. Ultimately, that is why as I recommended in the Owner’s Manual in the short-term the best thing to track is the investment process, but in the very long-term the majority of the weight should be placed on the outcome. Over a period of many years the outcome should converge with the process, and room for subjective judgment regarding the quality of one’s decisions should greatly diminish.

The above post has been excerpted from a recent letter of Silver Ring Value Partners.

Disclosures: The information contained herein is confidential and is intended solely for the person to whom it has been delivered. It is not to be reproduced, used, distributed or disclosed, in whole or in part, to third parties without the prior written consent of Silver Ring Value Partners Limited Partnership (“SRVP”). The information contained herein is provided solely for informational and discussion purposes only and is not, and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or vehicle managed or advised by SRVP or its affiliates. The views expressed herein are the opinions and projections of SRVP as of September 30, 2016, and are subject to change based on market and other conditions. SRVP does not represent that any opinion or projection will be realized. The information presented herein, including, but not limited to, SRVP’s investment views, returns or performance, investment strategies, market opportunity, portfolio construction, expectations and positions may involve SRVP’s views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date this information is presented—any of which may change without notice. SRVP has no obligation (express or implied) to update any or all of the information contained herein or to advise you of any changes; nor does SRVP make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. The information presented is for illustrative purposes only and does not constitute an exhaustive explanation of the investment process, investment strategies or risk management.The analyses and conclusions of SRVP contained in this information include certain statements, assumptions, estimates and projections that reflect various assumptions by SRVP and anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. As with any investment strategy, there is potential for profit as well as the possibility of loss. SRVP does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results. Investment returns and principal values of an investment will fluctuate so that an investor's investment may be worth more or less than its original value.

On Quality

By Gary Mishuris, instructor at Wide-Moat Investing Summit 2017. Access the session recording.

It can be tempting to leave the term “quality” without a precise definition. However, quality is too complex to rely on knowing it when you see it. Here are some attributes that I have heard referred to over the 15+ years of my professional investing career as implying “quality” when discussing companies:

  • Well-known brand
  • High return on invested capital (ROIC)
  • Good free cash flow generation
  • Strong competitive advantage
  • Rapid growth
  • High margins

Do some or all of these descriptions properly define what the term “quality” means in the context of considering a company as a potential investment? Maybe, but that is not the meaning that I have in mind when I use the term. Since it is an important component of Silver Ring Value Partners’ investment process I thought it would be helpful to elaborate on what I mean when I speak about a company’s quality.

For my investing purposes, I define a company’s quality as the degree to which its future economic characteristics are predictable. Since valuation is a lens on long-term expectations of company fundamentals and some companies are more predictable than others, it is only factors which increase predictability that affect my assessment of quality. Everything else can be taken into account in the valuation process itself.

The main factors that affect the predictability of a company’s future economic characteristics are:

  • Industry Structure – The slower the current and potential pace of change, the more predictable a business in a given industry is likely to be.
  • Competitive Advantage (a company’s ability to earn superior economic results that others cannot easily replicate) – Companies with stronger competitive advantages are better protected against unexpected adverse economic developments.
  • Management – The degree to which management can operate and allocate capital in the best long-term interests of the shareholders reduces the risk of competitive position erosion and destruction of value through the misallocation of capital.
  • Balance Sheet – The ability to withstand temporary financial adversity guards against unexpected circumstances that could force the company to take financial actions that could reduce its intrinsic value.

Here are two examples from my past investing experience of when quality was low and I failed to realize it sufficiently in advance:

1. About fifteen years ago, as a young equity analyst, I recommended that the large investment firm that I worked for invest in a company’s stock. It was a cyclical business, and I carefully analyzed the past financial statements and made what I thought was a well-reasoned estimate of the future mid-cycle earnings power of the company. Over a decade hence and with the full benefit of hindsight, I realized that I had been off… by a factor of 10x!-

  • How is it possible to be off by so much? Well, it turned out that the future was quite different from the past that I was relying on in my analysis. While this is always a risk, the magnitude of the deviation from past financial results was driven by the low quality of the business – its operations were in tough industries in which it had only very marginal, if any, competitive advantages. This made it unable to cope with the negative changes that the industry experienced after my investment recommendation, and caused the earnings of the business to permanently collapse.
  • The lesson learned? A business with no competitive advantage can have future economic characteristics that are drastically different from those it had in the past. What is worse, the direction of any unexpected changes in profitability is likely to be negative. This can make estimating the value of such unpredictable businesses an exercise in overconfidence and futility, and is thus better avoided barring extremely unusual circumstances.

2. Also at the beginning of my investing career, I was recommending the purchase of another stock. This company had a somewhat stretched balance sheet, but not so much so that I thought it was going to be a problem given that the then current credit metrics were OK. Right before Christmas, the company pre-announced a major earnings disappointment due to weakening demand trends, suspended its dividend, and announced that its expectations for next year’s results were now substantially below last year’s profit levels. With this revised view, the credit metrics were no longer OK at all.

  • That night, I woke up in the middle of the night very agitated, and I kept repeating just one word: “EBITDA! EBITDA!” (Earnings before Interest, Taxes, Depreciation and Amortization.) As I fully woke up, I remembered the dream that I was having – the bank group which had lent this company money was considering forcing it into bankruptcy due to non-compliance with the loan covenants, and I had been arguing with them for forbearance based on the company’s future levels of profitability.
  • The lesson learned? When the balance sheet of a business with no competitive advantage carries what seems like an appropriate amount of debt in a benign business environment, it leave no margin of safety for adversity which can quickly impair the company’s profitability and cause the balance sheet to become unhealthy quite rapidly.

Investing in quality companies quite literally allows me to sleep well at night, and us to reduce the probability of permanent capital loss.