- “Sometimes you eat the bear, and sometimes the bear eats you.” – Preacher Roe (look it up)
On November 7, I posted a column about Alibaba that now looks like a really bad call.
I made the case that Alibaba – the Chinese internet and technology giant – was a screaming value play. In other words, I argued that it was significantly and artificially undervalued. The share price had fallen by about 50% in the previous 12 months – mainly, I thought, as a consequence of Beijing’s cancellation of the Ant Group’s Initial Public Offering (Ant was a spinoff from Alibaba), and the subsequent quasi-disappearance from public view of Alibaba’s visionary founder, Jack Ma – as well as a general campaign of regulatory pressure focused on the Chinese Tech Sector.
I called attention to the upwards-pointing twitchiness of the shares in response to several sightings of Ma – especially the Jan 20 video that provided proof that he was alive, and the reports in September and October that seemed to indicate he was at liberty, and could even leave China for a “vacation” in Spain. I interpreted this sensitivity in the Alibaba shares as an indication that as Jack Ma undergoes a step-by-step rehabilitation, the stock could see a strong recovery.
[Full disclosure: The case looked so good that I even convinced myself (always a mistake). I bought BABA (at about $160), which I still hold.]
In the month since I wrote that piece, the Alibaba share price has plummeted by more than 30%, crushed apparently by a “disappointing” earnings report (Nov 18), by Covid lockdown-impact concerns in China perhaps, and then by the announcement (Dec 2) that DiDi (another Chinese tech champion now under siege by the authorities in China) will delist its shares in New York (just a few months after its exuberant IPO there last summer) – a move which was seen as a decisive geopolitical shift –
- “…the clearest sign yet that two decades of Chinese technology companies securing huge valuations in U.S. markets is coming to a close, a sea change that threatens to ripple through $2 trillion of Chinese company shares traded in the United States.”
My “value” call on BABA now looks definitely non-smart.
Is It A Value Trap?
A cloud always hangs over a “value stock.” The company has suffered some sort of reverse, has fallen out of favor with investors, and has seen its shares sold off and the price driven down – perhaps too far? The “value” thesis is that the market often overreacts, and shares are mispriced – too low. There is also the hope that the company’s management will take steps to diagnose and correct the operational problems that may have been the underlying cause of the sell-off. For the value investor, then, the strategy is simple: Buy and hold, and wait for a correction as the market realizes that the situation turns out to be less bad than first thought, and as the company’s positive countermeasures take effect.
This cultivates a contrarian mindset. Value investors love to find unloved companies with beaten down shares – Warren Buffett has called them “discarded cigar butts” – and then to bet against the general consensus, buying when others are selling or avoiding the shares. For value players, bad news becomes good news – it can signal a buying opportunity. Instead of running away from distressed situations, value investors seek them out. Oddly enough, this works. Over the long run, and on average, “value stocks” have beaten the market.
Example: The pandemic shock last year created a market-full of value plays, as companies in all sectors sold off in a panic, far below their “true value.” In March 2020, you could have bought ExxonMobil for $35-40 a share (it had been $70 a share in January). The company had a 10% dividend yield at that point, a clear sign of either (1) disaster ahead, or (2) extreme undervaluation. It was an easy call. (More disclosure: I bought XOM at about $44, so I don’t feel completely inept at “value investing.”)
Sometimes, however, a low price is an accurate price – and does not signal a buying opportunity. Companies that suffer a strategic, structural change in their business prospects may never recover, and shares that look undervalued may in fact reflect a new reality that cannot be expected to return to the status quo ante. The value play becomes a “value trap.”
Example: Citigroup. Flying high (and perhaps blind) before the financial crisis of 2008 – the CEO famously declared that “as long as the music is playing, you’ve got to get up and dance” – Citi crashed hard when the crisis hit and the music stopped playing. The company barely survived (with government help). But its world had changed and the shares never recovered.
So, the question here is: Will the price of Alibaba’s shares look more like Exxon’s or Citigroup’s?
The Nature of “Value”
One way to technically describe a value play is as a bet on based on mean reversion – the tendency for fluctuations in the value of an individual stock to eventually return to the average value, or “mean,” of the whole population. High flyers come back to earth, and underpriced/undervalued companies may rise back up – in time.
The key is that as Value stocks recover, their valuation will be driven upwards not just by improved earnings (as the company fixes its problems and performs better), but by an expanding price-earnings multiple as market sentiment also brightens. Value stocks in recovery thus benefit from a tailwind as investors place a higher market value on each dollar of earnings per share. This is what drives above-market returns which value stocks have shown over the long run.
The Challenges of Value Investing
Having identified a potential value play – a stock that has declined significantly from its historical norm – the value investor confronts a twofold challenge:
- “Direction” – Is the company fundamentally positioned to recover? Which is to say – is it really underpriced?
- Timing – When will the correction occur? How long will the investor have to wait?
An optimal value investing strategy would have to be correct about both parameters.
The Timing Problem: How Long Do We Have to Wait?
Unfortunately, full optimality seems to be unachievable – because the timing of the correction, or mean reversion, is too difficult to predict. But we can predict that much patience is required. Benjamin Graham, the “founding father” of value investing, wrote that
- “The interval required for a substantial undervaluation to correct itself averages approximately 1.5 to 2.5 years.”
In a well-known academic paper, Werner De Bondt and Richard Thaler used a 3 year window to study mean reversion, and found that most of the reversion effect was seen in the 15-24 month window (essentially confirming Graham’s intuition). A later academic study found that it could take up to five years or longer to realize the full effect of the correction. That requires a lot of patience with market fluctuations.
Moreover, because the point at which the trend breaks – and the recovery begins – is not predictable, the investor’s position quite often continues to deteriorate after placing the bet. Markets show momentum – i.e., trends that persist. The prior trend for a value stock is always downward – so with momentum the price usually continues to move in the wrong direction (from the value investor’s perspective), often for quite a while. On October 16, 2008, the New York Times published a famous op-ed piece by Warren Buffett in which he announced that the time had come for investors to jump into the stock market with all they had. His succinct advice: “Buy American. I Am.” This was just one month after the collapse of Lehman Brothers. The market had experienced a 30% drop since the beginning of September. Though Buffett was sure about the direction, he made no attempt to forecast the timing of the correction.
- “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now.”
In fact, in the 5 months following Buffett’s pronouncement, the market fell another 30% before the turnaround took hold in March 2009. In the Exxon chart shown above – in which the reversion was relatively prompt (less than 1 year) – the stock also declined by almost 30% after my entry point, before it finally turned around in November 2020.
In short, a value play usually requires the investor to be prepared to wait for a lengthy and uncertain period before learning the outcome of the bet. This enforced inactivity – once the investment is made – is what makes value investing a difficult discipline for most people to maintain. The investment languishes “underwater” and may often decline further. This is why many investors shun the value strategy, which creates or reinforces the mispricing itself. “Value stocks” exist because of this self-perpetuating aversion to sitting still in a “losing position” for long enough to allow the market to recover.
So — at this point, all the can be said about the timing of the Alibaba value play is that the correction is not in sight. Uncertainty reigns.
Therefore, the case has to rest on the fundamentals.
The Direction Problem: Will Alibaba Recover?
What does BABA’s business look like? Does it justify a more optimistic outlook than the current share price would suggest?
My previous article focused on a very specific “fundamental” factor – the possible rehabilitation of Jack Ma, and its positive effect on the Alibaba share price (as suggested by the price-hops following the various sightings and reports of his whereabouts).
A full assessment of the broader business prospects of Alibaba would take up many pages of analysis, but here are a few points to support the view that the company’s fundamental performance remains very robust.
Alibaba’s portfolio of business models closely resembles that of Amazon. It includes of course the core e-commerce business in several forms (electronic markets serving consumer and commercial customers), technology initiatives such as artificial intelligence and integrated circuit development, cloud computing, media – including movies and music streaming, and even a leading newspaper (the South China Morning Post) – all of which parallel Amazon’s portfolio (if we may include the Washington Post, owned by Jeff Bezos).
Alibaba stacks up very well against Amazon in terms of key operational metrics. It is a younger, and smaller company in terms of revenue ($127 Bn for the trailing 12 months, compared to $457 Bn for Amazon). But it is much more profitable. BABA has a gross margin almost twice that of AMZN.
The difference in net profit margins of the two companies is even more striking.
As a result, BABA’s trailing 12 months net profit of $19.4 Bn is not far behind AMZN’s net of $26.2 Bn.
In terms of valuation, AMZN is worth almost 5 times more than BABA. AMZN carries a Price/Earnings ratio of 66, compare to just 17 for BABA. (I’ll accept that there is a China discount, but 75% seems extreme.)
The Big Picture
So, to summarize the Alibaba value case based on fundamentals, here is what I think is important:
- the Amazon/Alibaba model is certainly here to stay; e-commerce will keep growing; the cloud will keep growing; the media business will grow…
- Alibaba is much more profitable today than Amazon, with a very similar business model
- China represents a huge and still underdeveloped consumer market – the e-commerce model will have a long growth runway in China alone (quite apart from any international expansion opportunities)
- the rehabilitation of Jack Ma and his return as a creative force, even if only partially realized, will restore much confidence in the future of the enterprise
- Eventually, one way or another, Xi Jinping and his gang will pass from the scene; human nature and the patterns of history suggest that the next phase of Chinese regulatory policy will be less severe
How long will all of this take? We don’t know. That uncertainty is the price one must pay for taking a value investing position. But I will say that having looked at many such situations, I don’t recall another “value stock” where the underlying operational fundamentals were as strong. Even Exxon lost money ($22 Bn) last year, and still faces strategic concerns about its legacy oil-and-gas business (the “stranded assets” issue and all that).
So, there is a solid case for the direction call on BABA.
Still, my Nov 7 column looks pretty bad in light of the steep decline in BABA’s shares over the past month. What specifically did I get wrong?
I think the answer is that – aside from the Omicron Covid scare – I didn’t take into account fully the Xi Jinping factor. Beijing is in the mood to take rough measures with its tech champions (DiDi) and Alibaba is going to suffer collateral damage as long as the campaign continues. But let’s put a pin in the dip to $111 on Friday (Dec 3) and see if that doesn’t mark the bottom. (Hah — another foolish prediction, undoubtedly…)