Below is the return summary for Q2 2025 (including dividends), as well as the breakdown of top holdings:

Key Portfolio Updates

During the six months from Q1 to the time of writing, I sold all holdings in Micron, Yihai International and PSBC, and initiated new positions in 2 small cap companies listed in Hong Kong (Alltronics HK: 833 and Pico Far East HK:752) as well as Globant, which is in the IT consulting space and a competitor of Nagarro - both of which were hammered heavily due to concerns from the impact AI on IT outsourcing spend.

Again, I want to share with you my thought processes on these actions I took, and hopefully through this process it will also clear up my mind and perhaps draw some insights as well into understanding the shortcomings of my decision-making.

On selling Micron, which I have held on for close to 5 years, the initial key impetus for my consideration to sell was that both Li Lu and Mohnish Pabrai sold their stakes in Micron in Q2 2023. I wrote about this back in my H1 2024 letter, but applauded myself for ‘independent’ thinking and not following the legends in selling Micron. However, as I read and analyze more into what’s happening in AI, it became clear that I do not have an edge over other investors in terms of understanding how crazy and how far the Big Techs will continue on spending on training AI models using brute force without justifying for ROI. In short, I feel that this is outside my circle of competence. The recent run-up in share price, investor frenzy over AI, and performances of memory players may not last long - how long it will last, I am not sure. But one thing I am sure is that Meta, Google and Amazon will not continue to spend billions upon billions of dollars on AI, without any considerations to the dollar returns on capex spend. To quote the kind of FOMO happening across Silicon Valley and Wall Street, Mark Zuckerberg said in a recent interview that “If we end up misspending a couple hundred billion dollars, that’s going to be very unfortunate obviously… but I think the risk, at least for a company like Meta, is probably in not being aggressive enough.” Particularly with the stunning rise of an alternative way of training AI models as evidenced by Deepseek, it became even more clear this won’t continue on forever. Coupled with the other uncertain factors (geopolitical risks and triopoly equilibrium breakdown with Samsung and SK Hynix), I do not feel comfortable holding onto Micron anymore and sold for a profit of ~1.8x or ~13% annualized return.

On selling Yihai International, I still do think the company is fantastic in terms of ROCE and the possibility of expanding beyond reliance on hotpot condiments. However, it became clear after a few quarters analysing the past margin trends that the founders are prioritising Haidilao’s margins, and rightly so, at the detriment of Yihai International. Yihai itself was born out of Haidilao as a side business and much of the brand value and marketing rode on the success of Haidilao. Hence, the GP margins that Yihai sells to Haidilao fluctuates wildly and it is too difficult to determine the value given the reliance on the related party transactions for the foreseeable future. With such uncertainties surrounding the core business of hotpot condiments (though I believe Haidilao globally will continue to grow at 5-10%), coupled with the uncertainties on the growth of ready-to-eat products (mainly self-heating packaged products), fierce competition and continued deflation in China, I became much less comfortable with how the business will look like in 10 years time. Even though the dividend yield is a good 6%, I decided to sell Yihai and invest in other companies with a superior margin of safety. If I want an exposure into the brilliant culture of Haidilao, I may at some point own Haidilao directly but F&B has always been a tough industry for me (I’m closely monitoring the ex-Haidilao brands’ growth).

On selling PSBC, which I have held on for 4 years, I initially bought the stock cloning Li Lu and was convinced about the structural advantage that PSBC has in terms of the cooperation with its parent company China Post. However, Li Lu started to trim its holdings back in Q4 2024, and that again prompted my re-examination of the company. Essentially, I still believe that the Company has decent return prospects coupled with stable cash dividend returns. It has high probability to continue growing at 5% for the next decade, and with dividend yield at 5-6%, coupled with operating efficiencies to be unlocked from non-interest income (investment banking, cards, wealth management businesses, etc.) should provide another 2-3% increase in margins - hence providing a good 10-15% IRR over the next 5 to 10 years (which can potentially be higher if there is multiples re-rating). However, the key uncertainty for me is that over the holding period in the past 4 years, I can’t see any improvements from the management team in terms of shifting more focus to unlock the non-interest income business (the high FD savings rate continue to become a drag on the overall ROE, though they are acquired at a huge cost advantage due to the extensive branch networks of China Post). It then became clear that unlike other profit-driven banks elsewhere, the Chinese government has many other political and social agendas in mind, and maximising profit is not the priority (though this implicit backing from the state also offers it stability that other private, profit-driven businesses will not have). Coupled with this heavy regulatory mindset, my lack of understanding of the management team and CEO (which can be changed in any case due to internal rotations) and the fact that China Post can impose different agency fees, it is almost impossible to determine if the bank will ever move closer to maximise its full potential. At the same time, I found another company with much better return prospects - Geely Auto, and hence decided to sell and move over to Geely. If there were not other stocks I have in mind at that time, I would have held on to PSBC since it will be better than cash or T-bills.

New Position Write-up: Wise Plc (“Wise”)

I first got introduced to TransferWise (as Wise was previously called) from social media (Richard Branson was advocating for it as he was an early investor back in 2014), and I later became a customer of Wise as I needed to transfer money at a low FX rate, and now I am proud to say Wise has become my go-to option whenever I travel overseas for vacation. It first caught my attention after I noticed how obsessive the company is towards building its products, and how hassle-free the whole customer service process is (you feel a bit like talking to your friendly aunt than a cold profit-seeking corporate).

Founded in 2011 by Kristo Kӓӓrmann and Taavet Hinrikus, Wise’s mission is to make money flow freely without borders, making international transfers cheap, fair and simple. Simple and clear Company mission statements are typical hallmarks of a great company. As with all great founding stories, it all began with the founders’ own frustrations with the incumbent cross-border transfers, and decided they can do it better.

Typically, the traditional chain of communication between banks is called correspondent banking. The banks are reliant upon a global organization called Society of Worldwide Interbank Financial Telecommunications (SWIFT) for communication. It is a member-owned cooperative connecting more than 11,000 banks, financial institutions and corporations in more than 200 countries. It is essentially an electronic communication network that tries to put in place a common language and some standards around how cross-border transfers work.

Under the SWIFT model, for a $1,000 transfer across borders, a multitude of banks may need to communicate and reconcile and verify and confirm that the transfer has actually taken place. As each transfer cycles through numerous correspondent banks, fees compound on top of each other and waiting time increases. The World Bank has estimated the average remittance cost globally at ~6.5%. Furthermore, incumbent financial institutions have exploited the lack of cross-border substitutes and opaque process to charge exorbitant ~2-4% markups on exchange rates, oftentimes as a façade for hidden fees.

What Wise does differently and wisely (no puns intended) is that they arbitrage the broken system and money never crosses borders in a Wise transfer. Essentially, it maintains an entire network of bank accounts that they own, and transfers happen between the customers and Wise’s bank accounts locally. For example, if Person A needs to transfer $1,000 USD equivalent to India from the USA, Person A sends money to Wise’s USD bank account in the US (after deducting fees), while Wise’s Indian bank account transfers IDR, at an agreed rate known to Person A when the transfer was made, to the recipient account in India. In order to scale this, Wise has established liquidity pools (local holdings to facilitate currency conversion) in various countries. The key value proposition and why the company managed to scale so quickly and loved by many customers are that Wise is 10x cheaper than the legacy alternatives and much faster, while also being incredibly transparent with the pricing.

It is amazing how laser focus Wise management team is on its mission - cheaper (any increases in fees they will work hard to pass onto their customers), faster (this beautiful chart below says it all). They believe strongly that advancing these core missions will benefit the owners of the Company (it’s interesting the Company called their IR page Owner Relations, not Investor Relations).

Wise’s Revenue Model and Operations

Wise’s primary revenue comes from transfer fees charged on foreign exchange transactions. Rather than a flat fee or high percentage fees, Wise uses a low, transparent fee plus the real mid-market exchange rate. The more volume of FX transfers that happened on Wise, the more revenue it gets. In terms of customer breakdown, as of Jun’25 quarter, c.95% of the 9.8 million users are personal customers contributing 79% of cross-border revenue, while c.5% is business customers contributing 21%. For the trailing twelve months to Jun’25, there was a total cross-border transfer of £153 billion, generating revenue of £844 million (c.60% of total revenue), implying a take-rate of 0.55%.

To give a sense of Wise’s transparency, they have created a comparison page that allows users to input the currency pairs, and the webpage will calculate and list the amount of fees they charge vs. what the competitors charge, and very often Wise is not the cheapest, but generally becomes the case when the transfer amount gets large (e.g., USD 10,000) - such transparency deserves applause, since when have you ever encountered such an honest and transparent salesperson.

Wise also offers a multi-currency account (“Wise Account”) for individuals and businesses, allowing users to hold balances in 40+ currencies, spend with a Wise debit card, and receive local bank details in various countries. Revenue streams under this segment include (i) card interchange fees (paid by merchants to Wise to payment settlement), (ii) currency conversion fees if the balance is not enough for payment, (iii) ATM withdrawal beyond certain monthly thresholds, (iv) one-time physical card issuance and replacement of cards, and (v) other miscellanoues services. The Wise Account and debit card offering set Wise apart from traditional banks by providing borderless banking functionality via a fully digital platform, which helps to drive customer retention through its added utility and ease of mind knowing that the FX rates are always fair. As of Jun’25, customers hold under their Wise Account a total of £18.1 billion, and generated revenue of £394.8 million for the trailing twelve months.

With such a huge amount of customer deposits, Wise has in recent years unlocked a new revenue stream - interest on customer balances. Wise typically invests the customer deposits into safe instruments such as money market funds or government bonds, and earns interest on these funds. As interest rates rose, Wise’s interest income surged, especially in an inflationary environment. To demonstrate another example of fairness and transparency, Wise has publicly shared with investors its ‘interest income framework’ - to retain all income under the 1% yield (and classified as “underlying interest”), and only 20% of interest income above the yield (“excess interest”), with the rest being paid to customers. For the trailing twelve months, this underlying interest income amounted to £160 million. To generate higher return for its users, Wise has in selected countries introduced a new product feature called “Wise Assets”, which allows customer to opt-in for higher return instruments - Stocks (by investing their deposits into low fee index tracking funds such as MSCI World Index), or Interest (by investing into interest earning funds).

Another important revenue stream is Wise Platform, the company’s white labelling offering, which allows banks (e.g., Stanchart, Morgan Stanley), neobanks (e.g., Monzo, Nubank), brokerages (e.g., Interactive Brokers, Moomoo), and other fintechs (e.g., Ramp, ProSpend) to integrate Wise’s international transfer infrastructure into their own services. Through API integration, partners can offer low-cost, fast cross-border payments to their customers, powered by Wise behind the scenes. For Wise, these partnerships expand its reach without heavy direct customer acquisition costs, and over 100+ partners have joined Wise Platform. Integrations with these customers range from simple cross-border transfers behind banks’ proprietary interfaces, to API connections, to full-fledged integration with Wise’s payment rails with the customer’s own KYC checks. Revenue is generated by sharing fees with partners or charging the partner institution. Platform volumes currently stand at 4% of the total, with management expecting this figure to rise to 10% in the medium term, and ultimately contribute up to 50% of overall volume.

Wise’s Moat and Investment Thesis

1. Solving a real pain point in a huge TAM - Anyone who has tried to optimise their dollars when doing FX conversions will feel the pain and opaqueness in the entire system. In my opinion, over the years Wise has successfully built the level of trust among consumers who feel confident that they will be getting a good deal from Wise, being one of the lowest cost FX providers in the market. Countries will continue to use their own currencies (the integration of Euro has been fraught with issues and debates are ongoing up to today on whether it is net positive or negative for Europe). Currently, the total volume of cross border transfer globally is estimated to be c.$40 trillion, and broken down into 10% (personal) and 40% (SMEs) and 50% (Enterprises). Several sources, including FXIntelligence and McKinsey, indicate that c.70% of such cross-border payments are still processed by traditional banks. That’s a whopping $28 trillion (70% of a $40 trillion market) handled by expensive, opaque, and slow incumbents! As a comparison, Wise handles an annual volume of £153 billion (or c.$205 billion), which by itself looks like an enormous number, but only represents <1% of the addressable market - that’s a massive opportunity. It seems only logical that a significant portion of these flows will gradually shift to more transparent and efficient providers. While this doesn’t seem like a winner-takes-all market, even a conservative 5-10% market share for Wise (bearing in mind the Wise Platform) would imply a potential 10-20x increase from its current level. The bottom line: as long as currency conversions and global trade remain, and Wise continues to offer the most cost effective and fast transfers, Wise is well positioned to grow volumes at double-digit rates for years to come.

2. Network effects and ecosystem advantage - After many years working with many banks and institutions globally, Wise has built up a network of ecosystem players - directly connecting to six countries’ domestic payment systems (and growing), with over 90 banking and payments partners across 160+ countries and 40+ currencies. More importantly, one of Wise’s moat lies in its ability to connect directly with nations’ government-supported domestic payment systems, obviating the need for bank partnerships. These instant and real-time settlement systems are the pinnacle of domestic payment rail integration, offering a near-instantaneous payment platform organized by the country’s government or central bank (e.g., FAST in Singapore, PromptPay in Thailand, DuitNow in Malaysia). Being integrated directly into such payment gateways allows a firm to circumvent the latticework of domestic payment rails while remaining connected to virtually all domestic bank accounts. However, such integration is an arduous process as global payment systems are heterogeneous, and local expertise is required throughout each market, which Wise has successfully integrated. In essence, Wise has created a typical moat of network effects, where consumers or banks prefer to get on a platform with more currencies that get transfer done cheap and fast (any incumbent will struggle to offer similar service level given the liquidity and infrastructure requirement). The more consumers come on board, the cheaper and faster the FX transfers will be, attracting even more consumers. As long as Wise continues to execute on this flywheel network effect, then it is very hard for competitors to dislodge its moat.

3. Obsession with Mission Statement - if you read Wise’s investor materials, you will be amazed by how much the ‘Company’s Mission’ is talked about. Wise, under the leadership of Kristo, has built a strong corporate culture that is long term oriented, customer obsessive and laser focus on its mission. Although Wise doesn’t break out marketing spend in its statements, we understand that the amount is minimal for a fintech and remittance company. Instead, Company relies on word of mouth with an estimated c.65-70% of new customers acquired through referrals instead of paid advertising, which means a super low customer acquisition costs (CAC). The remaining new users come via online marketing, partnerships, and organic search. In essense, management believes that the best marketing is offering the best product so that the existing customers can spread the word like an evangelist. In fact, sometimes the Company’s obssession with lowering cost have upset many institutional investors, who feel that the Company is giving up too much profit margins. This is music to the ears of the long term investor.

4. Founder led with strong alignment - The Founder Kristo is not only laser focus on its mission, he himself has a c.16% stake in the Company. Kristo has demonstrated to have long term thinking, customer oriented instead of profit driven, and created a strong corporate culture. With all these factors aligned, it will be likely that the Company continues its current growth trajectory, and I’m excited what Kristo and his team can achieve in the future.

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Below is the return summary for 2024 and Q1 2025 (including dividends), as well as the breakdown of top holdings:

Thoughts and Musings

Berkshire Hathaway Annual Meeting 2025 - around 1965, a then little known man from Omaha called Warren Buffett made one of his early mistakes in investing - instead of selling his shares in a dying textile business in New England, he reversed course, in an irrational move, to buy as many shares as he can because of a broken promise when the seller tried to low-ball the agreed transaction price by 1/8 of a dollar ($11.50 → $11.375). In 1965, as with so many great stories that began humbly and inconsequentially, Warren Buffett took over the company known as Berkshire Hathaway. Fast forward 60 years, Buffett (together with his partner Charlie Munger) compounded the share price by … hold your breath … 55,000 times. Every $100 invested then (worth about $1,000 in today’s terms) would be worth $5.5 million today! Caveat: only if you hold on to the stocks for 60 years.

This year Buffett announced his retirement as CEO, to a standing ovation lasting for more than 10 minutes. As I was watching the video from the comfort of my home (I wish I was there in person to feel the energy), I can’t help but felt an palpable sense of awe. What a life! I can’t imagine the sense of satisfaction that Warren must have felt at that moment. What’s more amazing is that the standing ovation wasn’t about his wealth or status at all, it is about his devotion to the craft of investing, the way he treats his shareholders and business associates, and most importantly, the unselfish sharing of his wisdoms demonstrated consistently throughout his entire life. People applaud because they admire and respect him, and truly want to thank him. I want to take a moment here to also thank Mr. Buffett and all his teachings not just on investing, but on how live a good life in general. I do feel a sense of pity that we can no longer see him again on stage during Berkshire’s annual meetings, but I am sure value investors in a century from now will be so envious of our generation, having lived in an era where the greatest investor of all time lives and breathes.

My Framework Towards Selling

In this letter, I want to share more about how I think about selling stocks. To many value investors (myself included), I found that the decision making process and psychological nuances are often more complicated in selling than buying. Many value investors including Buffett always preach about “I buy something to hold forever”, while Mohnish Pabrai has elucidated his painful examples in selling winners too early (think Ferrari, Frontline).

To me, the most fundamental (and often difficult) question to figure out is whether the moat of the company has been widening or has structurally deteriorated. Such an assessment needs to be objective (minimise the endowment bias), differentiate between endogenous vs. exogenous factors (company-specific issue vs. industry-wide issue), and has to be evaluated over a period of time (at least 1-2 years). There is often no easy answer to this question (if there is, there won’t be so many sell mistakes in investing), and it all boils down to some combination of intuition, pattern recognition and how much you truly understand the business. Unless there is a clear and major change in the economic prospects of the business (e.g., death of the founder, loss of a major customer, major acquisition gone wrong, etc.), the competitive position of a company usually doesn’t change over 1-2 quarters. After having studied the company and determined if the competitive position of the company has been improving, the usual thought process I’ll like to go through is to ask myself the following question:

“With all the information that I now know and assuming I haven’t owned the stock, would I still use the equivalent amount of cash to buy the stock at the prevailing price?”

Asking such a question helps to frame my mind against any biases and consider all the alternative choices available (the good old economics concept of opportunity cost). One note of caution that many value investors have spoke about is the mistake of selling too early. In general, in a situation where the company’s moat is widening, unless the company’s valuation goes ridiculously high (typically in a frenzy bull market), we should always err on the side of inaction rather than action, to avoid what Peter Lynch’s warning of “cutting the flowers and watering the weeds”. The last gateway in my selling framework is to consider the opportunity cost. As Charlie Munger so often alluded to, opportunity cost in investing means to always ask the hypothetical question in relation to the opportunity set available to you within your circle of competence. E.g., if I sell this stock now, do I have an obvious place to deploy the unlocked cash? If not, will cash or treasuries be a better place to park the cash?

Investors often fall into the anchor bias trap, whereby they have a mental anchor to the entry price they paid. The arbitrary anchoring of the entry price, which also manifest itself in loss aversion (the reluctance to sell before a depressed stock ‘recover’ back to the entry price), acts in a similar way for some investors with the urge to ‘cash-in’ the gains after the stock has doubled or tripled. To counter this, I found it useful to take a step back and mentally condition my mindset in two ways before even analyzing what is happening to the stock. The first is an internal reset to try and forget the entry price that you have paid for the stock. The second, which is an external factor, is to do what Howard Marks calls “taking the market’s temperature”. You can read the full memo here. Taking the temperature means to observe and collect various data points on where the market psychology stands in relation to the pendulum of optimism and pessimism. Although Buffett always talks about how little attention he pays to macro events, I feel that this second framing of mindset is crucially important, as it helps to set the overall tone between euphoria vs. depression, which will better inform the overall tendency between selling vs. buying

In summary, my framework for selling a stock can be condensed into the following easy-to-read flowchart diagram with a 5-step process:

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With the above framework in mind, I want to confess a couple of mistakes on selling - Beststudy, 3SBio and Tencent.

• Beststudy Education (HK: 3978) was a stock that I first started buying back in 2020, prior to starting Hillope Capital. The company mainly offers after school tutoring and talent program classes in China. During 2021, the entire sector got decimated during the infamous regulatory crackdown called “双减” - essentially a nationwide policy to reduce stress on families (psychologically and financially) due to excessive homework and after school tutoring. Over a 3-4 months time, the company’s share price (along with other similar listed companies such as TAL, New Oriental, Scholar Education) went down almost 95% as investors panicked and fled the entire sector. I was caught in the turmoil and didn’t act in the first instance when the news broke. As time dragged on, it became clear that the government is hell-bent on pushing through and enforcing this draconian regulation despite the criticism and public backlash. I decided to take the loss of c.80% and sold the stock because whatever residual value that was left was better than zero. Fast forward 3 years, the stock is now up c.30x from its bottom (c.15x from where I sold), as the government tacitly reverses its stance on the sector. Was I wrong on the sell decision? Looking back, I believed the decision was justified. If I were not to sell the position, it would have been a bet against the CCP, a conviction in the fact that parents will continue to send their kids for ‘illegal’ tuitions in its relentless pursue to get their kids ahead of others (hence rendering the Double Reduction’s original intent totally futile), and also believe in Beststudy management team’s turnaround capability to navigate such a once-in-a-lifetime crisis. Taken altogether and knowing what I knew at that time, it would still be a wiser decision to sell. Having said that, what was indeed a mistake for me was in not continuing to follow up with the industry and company’s progress after I have sold it. Had I continue to monitor the situation, feel the minor shifts in sentiments and from the ground, I may have been able to buy back the stock at a depressed price. As the saying goes, hindsight is always 20/20.

• 3SBio (HK: 1530) is a biotech company in China that does R&D, manufacturing and sale of various pharmaceutical products targeting a range of indications from oncology, hepatology and auto-immune diseases. Its key product (Tpiao) treats a condition called thrombocytopenia, which is a lack of platelets in the blood, and generates a sales of RMB 5bn (>50% of total sales). After holding the stock for almost 3 years, I decided to sell the stock in 2023 and I wrote about this in my Q3 2023 letters. In that letter I wrote, “ … if you have determined that the reason for selling is not that the price has reached above its intrinsic value, but is because the company is outside of my CoC in the first place, then it wouldn’t matter. Those profits, if it ever materialize in the future, are not made for you anyway.” As I am writing this letter (May 2025), the profits have indeed materialised, as the Company’s share price exploded from c.$7 in Feb 2025 to c.$20 today. This was due to a major announcement from Pfizer to license-out one of its R&D candidates - SSGJ-707, a bispecific antibody targeting PD-1 (a protein that regulates immune responses) and VEGF (a protein in stimulating the formation of new blood vessels), currently undergoing several clinical trials in China for non-small cell lung cancer, metastatic colorectal cancer, and gynecological tumors. Pfizer has agreed an upfront payment of US$1.25 billion and 3SBio is eligible to receive further milestone payments of up to US$4.8 billion. Such a blockbuster license-out deal is rare for a Chinese pharmaceutial company. Although this news was a surprise to me (and many industry observers), my decision to sell was justified because it would still be outside my circle of competence to be able to figure out the potential of this arcanely named candidate SSGJ-707.

• Tencent (HK:700) is a stock that I was familiar with and held for sometime. In Mar 2024, for no apparent reason other than out of fear (it was a gruelling 3 year bear market for China stocks) and wanting to buy Yihai International and Jiumaojiu but not with more cash (I was a bit worried about over-exposure to China), I trimmed and sold 1/3 of my holdings in Tencent at a price of HK$ 272. That proves to be a mistake given that the moat of Tencent was intact, and the valuation was low (would definitely buy the stock at such a depressed price). There is nobody to blame but myself, and to compound that mistake, some of the cash proceeds from selling Tencent was partially plouged into Jiumaojiu was eventually sold at a loss of another 40% (more about that below).

Key Portfolio Updates

During the past 9 months up to Q1 2025, I sold all my holdings in Jiumaojiu and China Education Group, and trimmed down my holdings Kangji Medical and PSBC, in order to add to Anta Sports and Yuexiu Service, while initiating new positions in Wise Plc and Pluxee NV. With the above selling framework in mind, I shall explain my actions here in more details:

• Jiumaojiu (HK:9922) - I wrote about this company in my last letter, I initiated a small position beginning in Q1 2024 as the valuation of the company came down a lot (from the peak of c.$35 in Q1 2021 to $5 in Q1 2024) due to what I thought were temporary headwinds as the management navigated a fiercely competitive environment coupled with weak consumer spending in China. However, after the 2024 results were released, it became clear that the challenges facing the company are immense and the new brands meant to provide new growth pillars didn’t materialise. As I always had an aversion to the F&B retail industry and seeing that Haidilao instead was doing much better, this was a signal that the thesis may be broken. Once it became clear that the industry headwinds were too severe and any remaining moat was illusionary, I decided to sell. A side note: with such an immense industry challenge, Haidilao was still able to deliver an industry-beating performance demonstrates how well the company is being run. Haidilao has again proven its magic (more on this and Yihai International in the next letter).

• China Education Group (HK:839) - After holding for almost 4 years, and having analyzed the sector and all its companies listed in HK, I have came to a conclusion that the regulatory headwinds are too severe with no hint of improvements in sight, and that the steadily increasing dividend growth story may not be a straightforward case. The longer the delay in any progress towards government granting approval to convert schools to ‘for-profit’, the less conviction I have in the belief that the government will eventually open up this industry. Moreover, the recent huge impairment loss in goodwill and intangible assets (wiping out almost 70% of FY2024’s net profits) relating to prior acquisitions, meant that the overall industry prospects are dim as student enrolments and the ability to increase fees are not as easy as previously thought. Though such impairment losses do not impact cashflows, it does destroy the value of the business since it meant that past acquisitions were overpaid. All these imply that the steady high dividend yield ‘fixed income’ thesis may be broken - indeed, the latest FY2024 dividend has dropped 24% to RMB10.28c per share, while no interim dividend was declared for FY2025 (vs. RMB18.77c in FY2024), all of which have hammered the share price tremendously. Having said that, I still believe that CEG is the most well run company among the higher education stocks in China, but until the government shows more tangible actions towards opening up the industry, it should remain ‘uninvestable’ in my view.

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That’s all for now. I shall write about the buy decisions on Wise Plc and Pluxee NV in my next letter on H1 2025 results, due around Sept 2025. Thank you for your attention. Lastly, as usual, I will end this post with the following quote:

Below is the return summary for H1 2024 (including dividends), as well as the breakdown of top holdings:

Key Portfolio Updates

During the first half of 2024, there is a more than usual level of activity on the portfolio. I sold all my holdings in Alibaba, AK Medical, Xtep International, trimmed my positions in Tencent, and added to Nagarro and Kangji Medical. Finally two new companies were initiated in the portfolio - Yihai International and Jiumaojiu.

As continued from my previous post, below are the updates on FY2023 for my the portfolio companies:

• Micron (NASDAQ:MU) - For the six months ending Feb 2024, Micron’s revenue grew by 36% while operating losses narrowed by 61% (from USD 2.4bn loss in H1 FY23 to USD 0.9bn loss in H1 FY24). In fact, operating profit has turned positive again in Q2 FY24 after 5 consecutive quarters in the red. As recent as Dec 2023, clear signs were emerging that the semicon memory sector has finally bottomed with NAND and DRAM prices both forecasted to grow by double digit in the next 3-6 months. Such a boom and bust cycle is well expected in the semicon memory sector which has been replayed a number of times over the past 20 years, but what surprised me this time round was the explosive growth in the high-bandwith memory (HBM) sub-segment driven by the ongoing AI craze (with Nvidia at the core of all the hype). SK Hynix was the first mover in terms of commercially launching the HBM3 but Micron quickly caught up with the competition for the latest HBM3e chip, which it claims to consume 30% less power than its competitors and is will be mass produced and shipped with Nvidia’s H200 AI GPU (critical in all Gen AI applications) in Q2 2024. Furthermore, Nvidia’s most advanced next gen Blackwell chips have seen orders soaring and will also be using Micron’s HBM3e chips. Both SK and Micron’s HBM3 orders have been sold out for 2024 and 2025 due to insatiable demand for AI chips. Samsung, meanwhile, has lagged its peers and latest reports suggest it has failed Nvidia's tests on its HBM3e memory stacks due to excessive heat and power consumption issues. If true and sustained, this may present a window for both SK and Micron to quickly capture market share in the surging AI segment. It is surprising to see how quickly market sentiments turn and narrative change from “it’s the worst memory chip slump in history” to “we are seeing a structural shift for AI chips”, which obviously investors are now rushing to cash in - Micron’s Q1 share price is up 43% and 1 year price has almost doubled.

  • I first encountered Micron after listening to investors like Mohnish Pabrai and Li Lu, both of which are titans in the industry that I admire a lot. In Mohnish’s own words, I have been a shameless ‘cloner’ in making this investment. However, both Li Lu and Mohnish sold their entire stakes in Micron in H1’2023, worth hundreds of millions. Since I started by cloning them, this presents a direct call for action to follow their decisions. I tried to figure out why they sold, which I believe to be a combination of geopolitical risks (like how Buffett sold its TSMC shortly after it invested) but more importantly, they probably felt that one of the original theses crumbled. The thesis was that after years of ferocious survival-of-the-fittest competition, the industry was essentially left with 3-4 major players, which confer an inherent equilibrium and price rationality among the oligopolistic players. However, that thesis broke when Samsung announced in Dec 2022 that it planned to weather the 2023 recessionary period by expanding memory production capacity and slashing DRAM chip prices significantly, in a bid to preserve and increase its memory market share and in direct contrast to Micron or SK Hynix, who were slashing its capex program and laying off workers. To me, that irrational behaviour was the core reasons for Li Lu and Mohnish to sell their Micron. I went through all the facts and decided it was too premature to tell how the equilibrium will be broken and not strong enough a reason since 2 out of 3 players (a majority) were playing by the book. I decided to diverge from the legends and not ‘clone’ them anymore. On hindsight, this seems to be an good case study of independent thinking (obviously too early to say), but I was lucky that the tide turned so quickly owing to the surging AI chip demand, which at that time wasn’t entirely clear. Will this AI craze fizzle out and be a passing fad like many other previous trends, or will this be a true ‘revolution’ comparable to the PC, Internet, Mobile revolutions?

• AK Medical (HK:1789) - AK Medical is one of the longest holding portfolio and it is regretful that I had to sell it (I have written about my thesis in previous post). I have followed the company since 2018 and watched the roller coaster price movements over the past 5 years. Essentially, most of my predictions about the outcome of the centralized procurement (Jicai; 集采) were largely spot-on, but what surprised me was that even though AK Medical emerged as a winner in this high-stake Jicai, the ‘benefit’ did not materialize. AK Medical had won the largest volume allocation from Jicai, but it won the bids with one of the lowest prices. This is in fact the whole premise of what the government wants to achieve - the higher the price cuts, the larger the volume (“量价挂钩”). It was touted as a way to force Company to keep improving its productivity and lower cost of production, to favour the leaders in the sector to consolidate further its market share, to squeeze out smaller players or prevent further unnecessary competitors from entering the market, and most importantly, for local leaders to replace MNCs (a.k.a. import susbtitutions or "国产替代”). However, the recent development obviously fell short of such expectations. The reality is more complicated. When the prices became too low after Jicai, although it is still at or above the ex-factory prices, there isn’t much juice left for the key stakeholders along the value chain - the distributors. The crux of the matter is that unlike drugs or other medical consumables/devices, orthopaedics are heavily dependent on these middle man service providers due to the number of variations and the complexity of the tools and instruments involved. That is why a player like Kangji Medical can choose whether they want to supply directly or still go through distributors after Jicai, whereas all orthopaedic companies have to still sell through distributors. They are the people who deals directly with the surgeons, nurses, hospital administrators, of which they have a huge influence on them. They are the customers that off-take AK Medical products and pay them. Hence, many of these distributors then resort to choosing and pushing those products that have won the bids at higher prices, to squeeze whatever margins that they can still get, or many of them gave up altogether (otherwise they will be doing the work without profits). There goes the most fatal collapse in the thesis, the lower the winning bids pricing are, it doesn’t automatically lead to higher market share, contrary to government’s intention and market’s belief. Once I realize this, however much I love the Company and the management team, I press the SELL button. This reminds me of Charlie Munger’s quote: “Show me the incentive, and I will show you the outcome”, an expensive reminder indeed.

  • The key follow-up question then is whether the other Medtech companies in the portfolio will be affected by this dynamics as well. This is something I am still monitoring closely and spend a lot of time thinking about.

• Peijia Medical (HK:9996) - Peijia Medical had a rather unusual series of events lately. Its trading was suspended from 2 Apr 2024 to 17 Jun 2024, and the reason cited was because of a disagreement on accounting treatment of an investment product with the value of HKD 80mn (vs. prevailing market cap of c.HKD 2,000mn), leading to a delay in releasing the FY2023 audited reports and therefore in breach of a HKEX mandated rule. It came as a shock because only recently one of its fiercest competitor in TAVR, Venus Medtech, just got suspended due to a series of fraudulent acts by the CEO and founder Zi Zhenjun. Would this be some kind of a similar situation masked within a seemingly innocuous disagreement with accountants? As one of the initial thesis for choosing Peijia was the strength and integrity of the founder Dr. Zhang Yi, any form of trading suspension raises eyebrows and should get your antenna up, and it was all the more unbelievable that they let a rather insignificant amount of accounting disagreements to cause any reputational damage or uncertainty among investors. Nevertheless, after a couple of months of speculation, the Company released a public announcement that there is no need for any amendments or rectifying actions to the FY2023 accounts published previously. So far, all the subsequent communications and IR events didn’t show any form of foul play or lack of transparency. As expected, market didn’t react well to such kind of mysterious and unexpected events and the stock sold off forcefully thereafter, dropping from HKD 3.6 to HKD 2.2 shortly after trading resumed. The Company reacted by aggressively buying back shares the equivalent of 1.6% of total shares outstanding in a mere 4 trading days, apparently in a bold move to show the confidence of the management in the Company’s future prospects. In almost all circumstances when the stock is undervalued, anyone would cheer such a move, but except for one circumstance - the Company is short of cash. Similar to all other TAVR companies, Peijia is loss-making by subsidizing the doctors and ‘educating’ the market in its bid to grab market share and is operating at a negative GP margin for each valve that it sells. With assumptions on the run-rate cash burn rate, the cash on its balance sheet may only last them until end of 2025 or mid 2026 (i.e., they have to quickly achieve cashflow breakeven or else will go under). It doesn’t help that there is such deep pessimism surrounding the Chinese markets, earlier than expected onslaught of Jicai on TAVR and that in such environment those company that are loss-making or cash burning will get dumped by investors in a blink of an eye. Therefore, instead of helping to provide buoyancy to the share price, the share buyback was seen negatively by the market as a way to accelerate the emptying of its coffer. In any case, the Company stopped buying back shares after 4 days (whether it’s an reaction to the circumstances or due to HKEX blackout period, I am not sure). Having said that, I still believe in the Company’s strong product pipelines, management team’s execution competency, founders' integrity and alignment of interests and the inevitable shift to TAVR vs. open-heart surgery. I hope the management team can be more prudent in managing the cash to tide through this period. Two recent events provide some comfort: 1) Microport Cardioflow announced a drop of 65% - 72% in net loss, suggesting that Companies have become more rational and cutting back heavy R&D and selling expenses (though Peijia’s announcement didn’t mention about reduction in net loss); 2) Venus Medtech’s troubles continue to manifest itself with even more dire cash situation, leaving Peijia and Cardioflow more window to capture market share; 3) Peijia’s investment in a TAVR product indicated for both aortic stenosis and aortic regurgitation (Jenavalve) was acquired by Edwards Lifesciences for a high price, demonstrating the clinical potential of the product as its launched in China (rebranded as TaurusTrio) and the management team’s R&D acumen. I will continue to monitor Peijia’s development closely.

• China Education Group (HK:839) - For the six months ending Feb 2024, CEG’s revenue grew 18%, while adjusted net profit per share grew 5% year-on-year. CEG continues to grow steadily in terms of revenue though margins have been impacted as the Company moves to hire more staff, renovate and install newer assets in preparation of the change to a ‘for-profit’ schools status. I expect school fees to continue increasing year on year, as they introduce various new degrees in line with the government’s push in certain industries. In addition, in a deflationary environment, I expect the staff remuneration expenses to increase less quickly. Going forward, I expect the margins to remain as the current level, while the tax expenses to increase once the colleges/universities got its ‘for-profit’ status. Nevertheless, at a current valuation of ~5x P/E and a dividend yield of 8-9% with a high level of certainty it will continue, I see this as more of a ‘fixed income’ high yield bond, with an optionality for an equity upside if regulatory uncertainty or macro sentiment improves. There are other more in-depth and nuanced discussions on the regulatory environment and whether the Chinese government can ever allow such a ‘high margin business’ to be ‘privately-owned’, but I shall save it for future posts.

• Yihai International (HK:1579) - For the year ended 2023, Yihai’s revenue remained flat against last year but operating profit (excluding FX gains) increased by 9%. Yihai is one of the latest additions to my consumption stocks portfolio (along Jiumaojiu and Anta). In summary, Yihai is an associate company started by the Haidilao co-founders who saw an opportunity to supply its centrally produced soup base for 3rd party hotpot restaurants (in addition to its own fast growing Haidilao restaurants). The Company then ventured into other food processing segments - compound condiments (e.g., 酸菜鱼，麻辣小龙虾, etc.) and ready-to-eat food products (self-heating rice and mini-hotpots). Company has grown tremendously from 2013-2023 at a 10-year CAGR of 35% for revenue and 44% for operating profit, riding on both the growth of Haidilao restaurants as well as the growth in new segments. ROCE has been extremely high at 50-100% with cash reinvesting back to the business as they continue to expand capacity both in China and overseas. Share prices have whipsawed as it skyrocketed from HKD 3.2 from end 2016 to HKD 115 by end 2020 (>35x in 4 years!), but subsequently plummeted to HKD 11 by end 2023 (90% drop in 3 years!). If you look at the 7-year operating metrics of the business and the share price chart on a no-name basis, you would not believed in the slightest imagination that both charts belong to the same Company - again, Mr. Market never fails to baffle me. How did the same Company go from a euphoric 100x EV/EBIT to the current 6x EV/EBIT? There are a few reasons which I hold a contrarian view.

  • Recent stagnant growth due to multiple factors (Haidilao’s over-expansion during Covid and subsequent growth concerns, China’s ongoing consumption weakness, reversal of Covid-19 eat-at-home trends, deflationary pressures, etc.). My contrarian thinking to the current pessimism are that: 1) Haidilao will likely still be the leading hotpot chain in China in 5 years’ time; 2) Haidilao overseas will provide the next leg of growth for Yihai; 3) consumer spending in China will likely recover in the next 2-3 years; 4) Yihai will continue to innovate and launch new products (both B2B and B2C); 5) ready-to-eat products and condiments will continue to grow due to Gen-Z and millenial’s consumption trend. Despite the ongoing challenges faced by the Company, it still manages to maintain a flat operating profit of around RMB 1.2bn over the past 4 years. I believe all the pessimism has been more than priced in at a 10x trailing free cashflow, and I hope the management continues its share buyback program soon.

  • Trading with Haidilao is not arms length and profits are easily transferred between the associated companies. My view is that this should be expected as a natural extension of both companies being started from the same founding team. But more importantly, even in 2021 and 2022 where Yihai was accused of selling at low prices to help prop up Haidilao’s margins (at the expense of its own margin), there are still profits to be made. Ultimately, as long as they management team understands the line and continues to improve their independence, I believe net-net there are more benefits than costs from being associated with Haidilao (a huge anchor customer that is assured to be recurring will lead to factory production efficiency and better capacity planning, brand equity from Haidilao in selling its other food products, no or low receivable risks, etc.).

  • Pessimism on Chinese stock market - this is a broader question of whether China is still ‘investable’. Yihai, being a market darling previously, has experienced an even more severe pullback compared to other Chinese stocks (hopefully the reversal stands true when the sentiment ultimately changes). As in all prior market cycles, I still believe that the pendulum will swing back at some point, but as Howard Marks has expounded numerous times, it will be impossible to predict when that will happen.

• Jiumaojiu (HK:9922) - Jiumaojiu is another consumer company that fits into my overall theme of domestic consumption with little regulatory risks as mentioned in my previous post. For the year ended 2023, Jiumaojiu grew sales by 49% to RMB 6.0bn, and store level operating profits grew 108% to RMB 1.1bn. 2023 saw an overall rebound in dining out as Covid restrictions were lifted in end 2022, leading to revenge spending surging across many consumer segments. While 2023 is a fantastic year, the focus should be on 2024 and beyond as the Company recently announced that Jiumaojiu’s PATMI H1’2024 declined sharply by 70%. Table turnover rates dropped across the brands and Song hotpot’s same store sales growth plunged by 37% year-on-year. This sharp deterioration in operating metrics have exceeded my expectations, and those of the other investors, which led to a decline in share prices in the past 6 months from HKD 5-6 to HKD 2.5. Consumer sentiments are weak in China, with many people cutting down on dining out, while F&B retail companies resort to a harsh discounts to lure companies, leading to margin erosion. Retail F&B has always been a fiercely competitive industry, and consumers always prefer the next upcoming brand or taste. However, one of my thesis for Jiumaojiu (I very much prefer Haidilao as a Company but the growth prospects are lower and I am already exposed to Haidilao’s economics via Yihai) is that the management team is innovative and constantly launching new brands/concepts to test the market, iterate and not afraid to close down if things didn’t pan out as they expect. They are a clear leader in 酸菜鱼, and I believe they will find the next leg of growth in other brands, as well as finding success in overseas market. Meanwhile, we will have to be patient to see when consumer spending will normalize in China, but with a net cash balance of RMB 1.8bn as of Dec 2023, and Company buying back shares and paying dividends, the risk of losing money in 5 years time is low (in my opinion).

Thank you for your attention. Lastly, I will end this post with the following quote:

Due to my slothfulness and your patience, I have only been able to write about the Q4 2023 letter until now. Another reason for such a delay is that I wanted to wait for the release of all the annual reports for my portfolio companies before writing the letter (reason which will become apparent below), though obviously I am not using that as an excuse. I will try to work on my Q1 2024 soon.

Below is the return summary for Q4 and the full year 2023, as well as the breakdown of top holdings:

My first full year of tracking PnL performance has been nothing short of a disappointment, considering the huge underperformance of almost 37% between Hillope Capital vs. MSCI World. Comparing to MSCI China index, it does not make me feel any better knowing that the gap between Hillope Capital (which has 2/3 of its AUM concentrated in Chinese companies listed in HK) and that of MSCI China is merely 2%. In fact, it hurts or embarrasses me even more since for some astute readers it may occur to you that I have somehow managed to track the worst performing country index to invest in while watching other investors raking it in betting on US, India or Japan. For me, the judgement of whether I am a good custodian of your money (and most of my money) should rest on an absolute yardstick vs. all easily accessible low cost index funds that track the developed markets (Dow, S&P500, FTSE100, HSI, Topix, etc.), since I could have well chosen to buy stocks in these markets but I chose instead to concentrate in China. Rest assure that this is not borne out of some warped inclination to be a ‘contrarian’ investor, but rather trying to be as rational as possible while acknowledging the risks involved.

Nevertheless, a single year of result mean nothing for me and hopefully for anyone serious about compounding wealth, though Chinese stocks have languished significantly against the peers for the most of past 3 years (ouch!).

The Basic Tenet of Value Investing

Any investor who has longed China stocks in the past 3 years will tell you how miserable it has been. Since the peak in Feb 2021 the HSI index has fallen more than 45% as of Dec 2023. Pessimism about the Chinese stock market and/or the Chinese ecnomy become almost unanimous and even some long term China bulls threw in the towel. Commentators can easily cite multiple factors that have led to the current state of affair (and isn’t it coincidence that such commentary largely emulates headlines across major publications) - real estate crisis, government crackdown, policy uncertainty, trade war or cold war, sluggish consumer demand, even hot war over Taiwan. However, when I look at some of the earnings from top companies in China, a much less pessimistic picture emerges. Consider this: of the largest ~240 listed Chinese companies by market cap, the aggregate revenue and net profit growth CAGR from 2019 to 2023 is c.8% and c.7% respectively, and that 90% and 80% of these companies demonstrated positive growth CAGR in revenue and net profit respectively since 2019. In fact, many of the household names across various industries show consistently high revenue CAGR growth over the past 4 years despite such ‘tough’ macro environment - Tencent (13%), Alibaba (17%), Moutai (15%), Anta (16%), BYD (47%), Nongfu Spring (15%), China Merchant Bank (9%), Haidilao (12%). Of course the past isn’t indicative of the future. Hence, there is some disconnect happening here - either the entire Chinese economy is heading towards a prolonged and deep recession or this is the set-up of an attractive value-price mismatch (think the likes of GFC in 2008). I don’t dispute that the Chinese economy is currently undergoing some tough challenges on many fronts as the government is working to re-engineer the economy away from the reliance of infrastructure and real estate growth towards consumption and tech self-reliance, but to think that the economy and companies are all headed towards disaster (as the valuation suggests) appears to me as fearmongering.

Here is my bold (and obviously biased) prediction: I believe that there are sectors and companies within the Chinese investable universe that currently present excellent risk-reward ratio, induced by the aforementioned disconnect and ‘broad-stroke’ fleeing of capital without regard to individual company fundamentals. If I were to guess on the reasons for such a disconnect, it would be due to the lack of understanding of the Chinese market environment by many investors (particularly the West) and the herd mentality at play.

This brings me back to the core tenet of value investing, as Ben Graham has famously said: “In the short run, the market is a voting machine but in the long run, it is a weighing machine”. If we can find companies in China that continue to widen their moats and execute on its growth strategy, sooner or later the market will feel the weight of its earnings and cash generated. Data speaks a thousand words, the table below shows the growth in intrinsic value (as determined approximately by the Buffett’s definition of owner earnings per share) vs. share price over the past 5 years, or since the stock’s IPO, whichever is later (Note: this table is prepared with Q1 2024 in mind, with some changes in the portfolio, and this is the reason to wait for the full 2023 result release).

Notes: (1) Intrinsic value is based on diluted owner earnings per share and approximated by (FCF - D&A or maintenance capex); (2) Based on closing share price of the last trading day between the two periods; (3) Based on the CAGR growth in owner earnings per share, for past 5 years or since year of IPO (whichever is later); (4) Weighted average based on portfolio weighting as at 31 Mar 2024; (5) Calculated as operating profit / total common equity (less excess cash only if the company is in net cash position); (6) Calculated as owner earnings / total capital employed (includes min. cash required to operate the business); (7) Micron’s ROCE and ROE are calculated on a rolling 5 year basis to smooth out the cyclicity of the industry, and its 5-year intrinsic value growth is approximated by the 5-year rolling ROCE; (8) China Education Group’s ROCE refers to levered capital employed (PP&E - debt) which is more applicable given the property nature of the business and high capex to build schools.

1.4 Billion Consumers

With such a backdrop in mind, over the past 12 months I have tried to find and study companies which display the following characteristics: (i) less susceptible to geopolitical risks (external shocks), (ii) less susceptible to CCP’s regulations (internal shocks), (iii) have high market share in China, (iv) demonstrate success in expanding beyond China, (v) have strong ROCE and reinvestment potential, and (vi) run by good management team. This led me to investing in companies operating in the consumer industry, whose business model is easily understood and hopefully within my circle of competence.

It is daunting to see how fiercely competitive China has become and whoever that survive and thrive in such a crucible will be a huge winner in China or even on a global scale. No matter what economic problems there are, there will always be 1.4 billion of consumers constantly looking to eat out, buy clothes, buy shoes, seek out entertainment, travel and play. On the whole, consumer confidence may have taken a hit due to the economic uncertainty and asset value depreciation. However, within the broad undercurrent, there is another countervailing trend of consumers opting to cut spending (“"消费降级”) and switch to more value-for-money local brands instead of foreign brands (“"国产替代”, think Anta instead of Nike, Xiaomi instead of Apple, BYD instead of BMW, Perfect Diary instead of Estee Lauder, on and on). Furthermore, because of the fall in property prices, people who otherwise would be saving up to afford the downpayment are now finding themselves with more disposable income to spend on non-property items such as food and travel. For the sharp eye readers, you would have noticed that I added two new consumer stocks to my portfolio - Anta Sports and Xtep International (and a couple more companies added in Q1 2024 which I will talk about in my next letter).

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Portfolio Updates

• Consumer: Anta Sports (HK:2020) - For the year ending FY2023, Anta grew sales and diluted EPS by 16% and 33%. However, share price drop 26% from $102 to $75 during the same period. I took advantage of the disconnect and bought Anta shares in Dec 2023 at an average price of HK$ 73.4 per share (which I added more in Q1 24). As I research more into Anta, I can’t help but am constantly amazed by the strong management team led by Ding Shizhong and how customer-centric the company’s culture is. From my limited experience I have always observe that companies who obsess with delivering the best product to customers tend to always win over the long term against other product-driven or sales-driven companies. It is fascinating how Anta managed to win the race among domestic sports brands (most of which originated from a single county called Jinjiang (晋江) in Fujian Province) and how it eventually overtook Li Ning as the leading China sports brand. It has recently also overtaken Nike and Adidas in terms of overall sales in China. Over the past decade, Anta’s sales and net profit have compounded at a 24% CAGR, with an average ROCE (on owner's earnings) of 55%. To give a sense of the prowess of the management strategy and execution, the turnaround success of Fila is phenomenal. First originated from Italy, Fila China was acquired by Belle International (backed by Hillhouse Capital) for USD 48m in 2007. After 2 years of unsuccessful operations and a net loss of RMB 33m in 2008, Belle decided to sell Fila China to Anta for RMB 330m in Oct 2009. With the brilliance of product marketing and pioneering the sports fashion trend, Anta managed to grow the Fila brand to a sales of RMB 25bn and operating profit of RMB 6.9bn in 2023 (>20x the purchase price in 2009!). With the huge success of Fila and Amer Sports, Anta has set its sights on overseas expansion and I believe the snowball will continue to roll on.

• Consumer: Xtep International (HK:1368) - after studying all the listed sports apparel makers and the industry evolution and competitive dynamics, I have decided on two companies to own - Anta and Xtep. Xtep was from the same county as Anta but started 10 years later in 2001. It has since managed to survive the fierce competition and the boom and bust industry cycle in 2012-2016. Since then, the company has carved out a strong niche and dominance in running shoes in China, with top marathon runners opting to endorse its brand and shoes. Although I very much prefer Anta than Xtep as a company, the valuation for Xtep was very attractive at the time of purchase (trading at 10x P/E with zero net debt). I was also attracted to the recent acquisition of Saucony China, K-Swiss and Palladium, which could provide a huge upside if they can grow well in China. This is one of those bets that Mohnish will term as ‘heads I win, tails I don’t lose much’ (P.S. I have sold this position to switch to Anta in Q1 2024, which I will talk about in my next letter).

• Property Management Companies

  • Yuexiu Services (HK:6626) - For the year ending FY2023, Yuexiu Services grew sales and diluted EPS by 30% and 17% respectively. Contracted GFA and GFA under management grew by 18% and 26% respectively. The contracted-to-managed ratio continues to trend down from previous years of ~150% to ~130% in 2023, which I would consider to still be healthy considering the current real estate crisis. Average property management fee for residential properties remained stable at RMB 2.7/sqm/month, while that for office buildings and shopping malls registered a slight decline of ~5%, which is well within expectations. GP and operating margins in 2023 have remained stable now after the drop in 2022. Trade receivables continue to remain stable despite the cashflow issues faced by many in the industry. Property managemment is one of those boring and labour intensive industry where nothing much seems to be worth highlighting for Yuexiu Services (and Binjiang Services) as the company continues to march along year after year. The financials, however, has been nothing short of an eye-popping performance. For the past 5 years, sales and net profit after tax have grown at 33% and 61% p.a. (that’s a 10x in 5 years!). Contracted GFA and GFA under management have grown at 23% and 27% p.a. respectively, notably about 60% came from independent third parties not related to the parentco Yuexiu Group. Although I expect growth to slow down amidst the current tough environment, I am still confident of the management achieving its target of mid teens CAGR growth in earnings in the next 3-5 years. With a dividend payout ratio of 50% and the market cap as of Q4 2023 being lower than net cash balance (yes, the market thinks the business operations are worthless or that the cash doesn’t belong to the company), I can definitely sleep well owning Yuexiu Services (albeit with occasional frustration with the capital allocation strategy of the management sitting on a pile of idle cash). Obviously, this cries out for an aggressive share buyback program but I also understand it would be limited in scope due to the float and daily traded volume.

  • Binjiang Services (HK:3316) - For the year ending FY2023, Binjiang Services grew sales and diluted EPS by 42% and 20% respectively. Contracted GFA and GFA under management grew by 19% and 31% respectively. The contracted-to-managed ratio continues to trend down from previous years of ~180% to ~150% in 2023. Average property management fee for residential properties continues to hold up well and remains top among all the large property management firms at RMB 4.21/sqm/month vs. RMB 4.26/sqm/month last year, owing to its premium segment focus (industry average is ~2.0 to 2.5/sqm/month). GP and operating margins in 2023 declined by 4-5 ppt from 2022 as the Company started to grow aggressively into home furnishing services as part of value-added services to home-owners, which is a low margin business. On a longer time scale, over the past 8 years the Company has grown sales at 43% CAGR and net profit at 60% CAGR (that’s >40x increase in 8 years!). The company continues to expand beyond Hangzhou with high growth in cities such as Jiaxing, Shaoxing and Jinghua. Parent company Binjiang Properties remain one of the most stable private property developer in China, rising up the ranks with growing sales while maintaining relatively strong balance sheet. Trade receivable days remain stable. What is amazing for both companies is just how little capital was required to gush out such an immense amount of cash year in and year out. Indeed, the ROCE is off the charts and makes little sense. I believe well run property management companies with strong parentco balance sheet, track record of 3rd party contract wins, focus on Tier 1 and 2 cities, remain misunderstood by the wider market, which I am not shy to take advantage of.

• Postal Savings Bank of China (HK:1658) - For the year ending FY2023, PSBC had a relatively flat year with revenue growing at 2.2% while net profit growing at 1.3%, owing to the overall macro environment, compressed net interest margins (decline from 2.2ppt to 2.0ppt in 2023) and less than expected growth in non-interest income. Net loans increase by 13% while total deposits increase by 10% (with a disproportionate amount being put into time deposts). ROE remained at ~10% in 2023. As usual, the bank continues to operate very conservatively and I believe its earning potentials and assets are not being fully utilized. Dividend yield is high at >7% as at end 2023.

• Nagarro SE (XETRA:NA.9) - I first invested in Nagarro in Oct 2023 after trying to look for ex-China companies to have some diversification (I have yet found any Japanese stocks that met my criteria). My average price paid was EUR 74, translating to ~11x owner earnings. What caught my attention about Nagarro was its unique heritage (being spun out of its parentco Allgeier in Dec 2020), its small cap nature (EUR 1bn) with little coverage in an European stock exchange. As I dig deeper into the company, I am fascinated by its unique culture and organization structure - it has no traditional CXO roles whatsoever, no headquarters, company is led by a ~50 senior management team members from ~15 different nationalities. Despite having 50 office locations in 36 countries with >18,000 employees, the company is organized around a virtual global organizational model that deprecates country organizations, with the primary dimension being that of the global business units or GBUs. A key role within the company, called Project Leaders, have freedom over everything from their clientele to their investment strategy without the interference of the management team. The end goal of such an innovative model is to achieve an organisation that is client-centric, entrepreneural, agile and non-hierarchical. In the IT outsourcing industry, the employee turnover ratio is usually pretty high, and the key differentiation is people and talent retention. Hence, the moat of any company competing in this industry will be the culture that enables the company to attract and retain the best IT talents. Even though I still have doubts on whether this can work well in the long run (smart humans are inherently difficult to organized in a big group), the audacity and will of the CEO Manas Human to even try out such an organizational design is laudable. On operating metrics, for the year ended 2023, Nagarro grew sales by 7% in 2023 but net profit declined by 33% as clients cut down IT spending across the industries. Over the past 5 years, revenue and net profit grew at 26% and 45% CAGR respectively, with average ROCE (owner earnings) of 21%. I believe that IT outsourcing and digital transformation are here to stay despite the threat of AI and democratization of software programming. The company should be able to weather this current temporary turbulence well, and continue to gain market share in this growing industry.

• Kangji Medical (HK:9997) - For the year ended 2023, Kangji Medical grew sales by 18% and net profit by 5%. Net profit would grown in line with sales, if not for the losses contributed by the surgical robotics subsidiary Weijing Medical (which will be de-consolidated from the accounts starting in FY2024 as the Company wants to give more autonomy to the management team of Weijing given that Kangji is only a 35% shareholder). Despite the fear of Jicai impacting its sales and Kangji’s product concentration on minimally invasive surgical instrument and accessories (MISIA) products, so far there is no nation-wide Jicai on its core products. Company has managed to navigate the provincial Jicai relatively well given the inherently high margins, flexibility to go direct without distributors or 跟台人员 and strong market share among domestic players. For the past 5 years, Kangji has grown sales by 21% and net profit by 18%, with an estimated average ROCE of >100%. Its GP margins consistently hover above 80% with net margins at 60%. After raising RMB 2.9bn in a IPO in Jul 2020, the Company struggles to deploy the capital as the operations continue to generate free cashflow in excess of RMB 1bn over last 3 years, which it has used to pay dividends and buyback shares in addition to capex and investments. Currently, the Company still sits on a cash pile of RMB 3.0bn at the end of FY2023. However, in another sign that the management team is shareholder friendly, the Company has declared a final dividend of RMB 0.41 per share, and a special dividend of RMB 0.99 per share. In totality, this represents a cash payout of RMB 1.7bn or ~22% of total market cap as of end Dec 2023, and Kangji would still have well over RMB 1.3bn in the coffer (with annual FCF generation of RMB 400mn). Though it all sounds bright and sunny, in my view Kangji’s problem lies in its future pipeline products and its ability to find the next growth drivers other than disposable trocars and ligation clips. I shall continue to monitor its progress on this front and update in due course.

• Lifetech Scientific (HK:1302) - I have owned Lifetech the longest time among my existing portfolio companies, and have tracked its progress for more than 5 years now. Fundamental clinical-driven R&D and global expansion are the dual strategies which the management team continues to execute and progress steadily. Over the past few years the company has been ‘cooking up’ some major product pipelines currently in late stage clinical trials - a few major ones will be IBS iron-based bioresorbable scaffold, G-branched Thoracoabdominal Artery Stent Graft System, Aortic Arch Stent Graft System, etc. In the next 2 years these products will be commercialized and start contributing to the earnings. For the year ended 2023, Lifetech’s sales grew by 15% while adjusted operating profit declined by 12% as the Company ramped up spending in R&D and higher expenses due to share-based payment expenses associated with the Biotyx Medical (excluding impact of Biotyx Medical will result in flat operating profit). Over the past 14 years, Lifetech’s sales and operating profit have compounded at 22-23% p.a., and ROCE (owner earnings) have averaged ~30%. Such performance for this extended period of time usually means some kind of a moat, which I believe is the continuous emphasis on truely innovative products from clinical-driven R&D programs. Although the competition has become more fierce in the MedTech space (e.g., many other LAA occlusion devices have sprung up) and the impact of centralized procurement on the industry, Lifetech has managed to hold up relatively well compared to other MedTech listed peers. Nevertheless, I believe the market has underappreciated the pipeline products and the overseas expansion potential.

I shall continue with FY2023 update on other portfolio companies (Micron, AK Medical, Peijia Medical, Yihai International, Jiumaojiu, China Education Group) in my next Q1 2024 letter. Please stay tuned…

As always, thank you for your attention and any comments are welcomed.

Below is the return summary for Q3 2023, as well as the breakdown of top holdings:

Key Portfolio Updates

During the quarter, I have completely sold my holding in 3SBio and continue to add to my position in Binjing Services.

On the Art of Selling

Among my portfolio companies, I would consider 3SBio to be a growth value stock - an oxymoron that I define as a company possessing a rare combination of high growth (>15% earnings CAGR for >10 years) and low valuation (<10x P/E). As Mr. Market remains sane most of the time, such a ‘gem’ in the stock market is indeed rare. Experience teaches us that if something is too good to be true, it usually is. I was very skeptical at first and more so because the company is in the pharma industry which I have to admit is definitely outside my circle of competence (and it still is today and likely be so for the rest of my life).

I am sure many investors have looked at companies before where the P/E (or any valuation metrics for that matter) optically looks enticingly low, but it later turns out that the Company is on the cusp of either an earnings cliff as the industry dynamics turn sour or a sudden loss of a large customer, or in some cases a huge one-off expenses due to a ligitation or patent infringement, etc. There are many reasons why the mass intellect prices a stock cheaply, and that’s why the intrinsic value of a business is all about how much cash can be extracted out for the remaining life of the business. In other words, stock price is about prospects, not what has transpired before. And off I went digging into the business, industry and prospects.

However, after much research, I was convinced that 3SBio has been unfairly discounted and the prospects look decent, even taking into some conservative assumptions about its pipeline drugs and reimbursement scenarios. Furthermore, as the Company derives most of its sales from just 2-3 drugs, and has found another leg of growth in consumer products (hair loss and acne treatment), I was getting more comfortable with the Company. Hence, I bought the shares and held it for more than 3 years (first bought since May 2020). To give you a sense of how absurd it is, the Company’s sales have grown 10x from 2012 to 2022 (compounded at 26%) and operating profits have compounded at an staggering rate of 31% for 10 years; all the while maintaining GP margins at close to 85% while operating margins at 27-30%, but yet it was trading at around 8-9x P/E!

The question you may ask is then - why do I sell it now? And the TLDR answer is the age old value investing tenet: Invest only in a business you understand.

• I do not understand the capital allocation of the management team - Company generates a lot of cash but doesn’t buyback shares aggressively, dividend them out or make M&As. I was patient at first but after 3 years of tracking it (and a couple of scratch-my-head type of capital market transactions), I start to wonder if the founder has any clue about capital allocation, or even bother about shareholders interests or both.

  • Lesson learnt: follow the Company as though you invested the stock 3 years ago at that prevailing price. This helps to eliminate some psychological biases. Read all the reports, transcripts, interviews, forums, glassdoor, etc. and assess the capital allocation skills and integrity of the management. Compare words to actions. If the share prices have been falling for 3 years since the ‘hypothetical’ entry price (usually the case for value investors), it is a good way to really test the contrarian convictions. On the other hand, if the prices have been rising, it is also a good way to see if the margin of safety is still good at the elevated price. In any case, try to feel the emotions as though you bought the stocks 3 years ago.

• I do not understand how poor their R&D progress is. Because of my lack of knowledge in pharma industry (again, outside my CoC), I didn’t realize that the progress of their pipeline drugs are really slow, having assume that drug R&D always take time. Although I have discounted most of their R&D pipelines, they would still look cheap given the existing drugs are gushing out cash for the foreseeable future and the consumer unit is growing well. However, for pharma companies, I have learnt that the prospects and R&D pipeline are where the market gives them value.

  • Lesson learnt: Always, always read the competitors to get a sense of the relative performance and whether the Company has true competitive advantage. If I had just look at BeiGene or Innovent or Jiangsu Hengrui, the difference in R&D spend or pipeline progress will be obvious.

• I do not understand why Hillhouse bought into 3SBio a sizable stake and then sold within 1.5 years. They were known to be heavily invested in pharma and has a strong healthcare team. Though I usually don’t read too much into what other funds are doing, this does seem to suggest a potential red flag?

With any buy or sell decisions, the key question I always ask myself is, with the information on hand, will I buy the stock if I have the extra cash in my portfolio, weighing against all the other potential stocks I can buy. If the answer is no, then I will sell it if I am holding the stock. This definitely doesn’t pass the test, and hence I sell it, and made a 15-20% overall profit off the stock.

Selling in a profitable situation is not too difficult, since the saying goes ‘You never go broke on taking a profit’. However, after reading and studying so many great value investors, it does seem to suggest that the biggest mistakes these investors have made in their career are those of omission rather than commission, i.e. selling winners too early. That’s the reason why I always err on the cautious side whenever I am selling. However, in this case if you have determined that the reason for selling is not that the price has reached above its intrinsic value, but is because the company is outside of my CoC in the first place, then it wouldn’t matter. Those profits, if it ever materialize in the future, are not made for you anyway.

On the other hand, if in this case the situation is the reverse, e.g., the stock is down 25-30% and I have come to the same conclusion, would I have been able to fight the psychological bias and keep the rational decision of selling at a loss? This hypothetical situation shall be a question for the future, and a true test of whether I can stay rational in my investment decisions.

That’s all for this quarter. Thank you once again for reading.

Share Hillope Capital Letters

Below is the return summary for Q2 2023, as well as the breakdown of top holdings:

Key Portfolio Updates

During the quarter, I have gradually added to four of my existing positions - Postal Savings Bank of China, Lifetech Scientific, Peijia Medical and Binjiang Services.

On PSBC, I continue to believe that the bank is uniquely placed among the various large state-owned banks in China to differentiate itself and continue to deliver better than expected growth. Banks have for a long time been undervalued in China due to various reasons, but the investment in PSBC is not a bet on the eventual multiple re-rating of the banking sector, but rather on the growth and steady earnings power of PSBC for the foreseeable future. Key theses remain as follows:

1. Unique business model with China Post Group allows it to reach places far and in between in the remotest area of China where no other banking players have a geographic reach that come close.

2. Strong and much cleaner balance sheet without the historical burden (and hence bad debts) of other state-owned banks (though some people believe that this exposes PSBC to do national service in the current times of economic turmoil, I doubt it will comparatively do more than other state banks, if at all).

3. As interest rate rises or normalizes, the bank’s agency fee model will benefit its earnings, while Post Group has the incentive to help the bank push more retail oriented and wealth management products, ultimately earning a higher ROE as the bank continues to execute on its strategy.

4. Structural moat in terms of large and low cost customer deposits in the form of personal time deposits which is still largely untapped, and should gradually be used to provide a higher interest margin spread going forward.

One of the key risk facing PSBC is definitely the property crisis currently unfolding in China, and it is hard to see how it will unfold. I believe the CCP government has both the willingness and policy tools to stablilise the crisis, but again over the past 3 years we have witnessed some quite unimaginable things that had happened in China. Nevertheless, with a >6% dividend yield and a long term consistent earnings growth of 8-12% p.a., I regard this as the safest investment in my portfolio.

On Lifetech Scientific, I haven’t written too much about this company but it is one that I have followed for the longest time. Suffice to say, the H1 2023 results are a little disappointing but the real gem in this company lies in the pipeline products that are expected to be commercialized in 2024/2025 (IBS, aortic arch stent graft, G-Branch TAAA stent graft, mitral valve clip X-Clip, etc.) and the progress it has made in going global - sales from overseas grew at 34% YoY and now constitutes 20% of overall sales. Sales from pacemaker segment was disappointing with a 25% drop YoY due to the VBP (集采) - this is something to monitor and see how they fare against the competitors from Microport and Lepu.

On Peijia Medical, I have added to my position sizing in Q2 2023 as I believe they have one of the best R&D and execution teams in MedTech companies in China. Key risks to watch out for will be the more than expected cash-burn in Q2 2023 (though some of it are due to BD milestone fees, of which the committed balance is now only ). There seems to be no signs of cost-cutting or slowing down given they are firing all engines on a range of clinical trials and R&D developments, which inevitably means spending more money. A key development is that the neurointerventional segment is close to breakeven as it continues to scale up, but the valve business looks to be spending a lot of sales and marketing dollars to gain market share (but the positive is that they have been gaining % market share). With the recent anti-corruption drive raging across the healthcare sector, this is a clear landmine risk that may have severe impact on the company. I hope they can pace themself and get to net positive cashflow before they run out of cash (which I am sure they can raise funds but at such depressed valuation it is value destroying).

Perhaps it is worth mentioning here about the recent devaluation of the entire industry as people now believe they have made a mistake in their assumption of the explosive growth in the surgical volume of TAVR, citing affordability as the main reason. I find it hard to fathom that cost is really a factor here at play, given that the benefits of TAVR over SAVR are huge (in terms of less trauma, less complication risks and better post surgical recovery) as well as psychologically more appealing (a small puncture at your femoral artery vs. an open heart surgery with a heart-lung (bypass) machine). The penetration rate of TAVR will increase steadily in the next 5-10 years as more clinical data supports the indications for “low-risk” patients. With a civilisation that is well-known in its culture to over-save for the rainy day in general but over-spends in proportion on education and healthcare, it is hard for the children to not opt for the best treatment for their parents when they are making a decision over SAVR vs. TAVR (even for low-to-mid income families in China). Even if the affordability issue is partly true, with the treatment now increasingly being considered for medical insurance reimbursement, this cost consideration should carry less weight going forward. I believe the key impediment now is more on lack of number of skilled surgeons being able to carry out a TAVR (and of course the 3 year Covid hiatus and all the regulatory chaos have definitely delayed this trend), which will also be improved given the incentives that drive both the doctors and the TAVR companies.

On Binjiang Services, I hope to write a separate post on it at some point but suffice to say, the key theses for me in investing in this real-estate related industry are that:

1. Industry wise, there should be gradual decoupling of valuation between property developers (the ParentCo) and their property management subsidaries. Market hopefully will realize that disparate business model, consistent and stable cash generating capabilities of property management companies, especially for those with strong growth in GFA under management from 3rd parties.

2. Binjiang is positioned at the premium market with many luxurious properties under its management and the Group has the largest market share by sales in residential property in Hangzhou by a large margin (~2x the next competitor in Hangzhou). Strong branding, good reputation, quality customer service and strong execution of management team provide the moat that allows the company to keep increasing the property management fee charged (raised fees 45 times since 2015) and the high per square feet property managment fees of RMB 4.3 psm per month (vs. National average of RMB 2.3 and Hangzhou average of RMB 2.7).

3. A key risk for property managemenet company is whether its ParentCo will siphon its cash away or the property crisis may drag down the entire group given a large proportion of the GFA growth still relies on properties built by its property development parent. I believe its parent company Binjiang Group is relatively safe among the private property developers and should be more shielded from the downturn than many of its peers. Furthermore, from the track record and actions of the management so far, it does seem to suggest that the boss 戚金兴 and 朱立東 are both long-term oriented and cares about its employees and shareholders.

4. Continued growth from expansion outside of Hangzhou into the neighbouring metropolitan cities in Zhejiang Province, and the Group’s growth strategy into project management business (代建) should continue to provide ample growth for Binjiang Services in the foreseeable future.

That’s it for this quarter! Thank you for reading. Please leave a message if you read until here, it will help provide some motivation for the next post.

Below is the return summary for Q1 2023, as well as the breakdown of top holdings:

I do not pay much attention, if any at all, to quarterly return performance. The benchmark for me, or indeed for any long term investor, should be a rolling 3 year performance target. I would urge everyone, especially myself, to start paying attention to the returns table only in Q4 2025.

During Q1 2023, not much has changed during the quarter, except for slight additions to the existing positions Yuexiu Services and Peijia Medical.

Yuexiu Services experienced a sharp drop in stock price of 20% after they reported their full year results. The results were mediocre but nothing disastrous, but the real killer was in the disappointing dividend payout despite good operating cashflow and a huge cash pile, which investors reacted violently. To me, the intrinsic value hasn’t changed much and hence I added to the position after the drop.

As for Peijia Medical, I am continuously amazed by the vision, strategy and execution capability of the management team. Although the company is still loss-making as they are running full speed on many fronts to commercialize their pipeline products and spend marketing dollars to gain market share, the cash on the balance sheet should still be sufficient for at least another 2.5 years, by which the company should start to breakeven or even generate free cashflow. Despite a relatively large holding position to begin with, I continue to see divergence between the share price and its intrinsic value, and hence I added to the position. Among the fiercely competitive TAVR segment, I believe they are most likely to emerge as the leader among the three listed TAVR players. I can’t wait to see their progress in the coming year.

Some Thoughts on Macro and China

As I am writing this post heading towards June 2023, Chinese equities have once again pull back sharply from its short-lived recovery since November 2022. Geopolitical tensions, macro-economic pressures, faltering domestic recovery (among other factors) have all led to investors, particularly foreign investors, to pull their money out of China once again. This sounds all too familiar as investors start to question again if China is ‘investable’ or not. Pessimism has once again permeated the psychic among investors, be it retail investor or professional fund managers. I have no crystal ball into the future and do not typically spend much time on trying to understand or predict any macro-economic or geopolitical events.

What is clear to me, though, is that we are sitting at the start of a prolonged clash between two superpowers, something which the world hasn’t seen in decades. I believe the ‘Cold War’ between Soviet Union and USA has a different parallel to the current situation - China’s share of the global economic pie is much larger, the world’s supply chain is much more integrated and trade volume much higher, conflict is centred more around technology in addition to military, and most importantly, China is not looking to impose its communist way of governance onto others, etc. If anything, the geopolitical tensions between the two countries will not get better, and the world has a lot at stake to make sure both of these two countries do not spiral into an outright conflict.

Having said that, I also believe much of how this conflict will turn out to be relies more on the Chinese side than the US side. And so far my belief is still that the Chinese government wants to behave rationally and economic stability should be a key part of their calculation. Although my innate ‘gut feeling’ being a long term value investor is to presume that '‘this too shall pass” and investors have overshot as the pendulum swings to the extreme pessimism end of things (to borrow Howard Marks’ analogy), it is still difficult to ignore the lingering doubt that maybe this time it’s different. What is the most worrying to me this time round is the loss of investor or enterprenural confidence in the country, which can take a long time to reverse. Words need to be backed up by actions and I hope more concrete actions can be taken.

With the macro backdrop, it can be a challenging environment for investors. What is assuring is that the companies in the portfolio are companies mainly serving the domestic Chinese market (except arguably Tencent and Alibaba), with little exposures to wider geopolitical events (though are definitely subject to the constantly changing internal regulatory environment). I believe the Chinese government still have quite some ammunitions in its bag to counter any financial or economic warning signs, but whether they choose to do it before it is too late, nobody can be sure. Only time will tell.

Ending Note

I would very much prefer to write a more formal letter with an in-depth analysis into one of the portfolio holdings, but due to my work and family commitments I have found it much more challenging to devote more time on Hillope Capital. I shall try to write more in my Q2 2023 letter. Thank you.

As we bid farewell to a tumultous and dramatic 2022 and welcome a brand new year, I have decided to start in the new year with a more formal semi-annual investor letter. This letter will be sent to all my investors (mostly my own wealth and my friends and families’ money) and be made open to all substack readers of Hillope Capital. There are a few reasons I am pursuing this.

Mohnish Pabrai has advised that the best way for any aspiring investor to start managing a fund like his Pabrai Funds is to first start investing with his own real money (regardless of the amount), practice the art of investing and formulate your own investing framework, learn and read ferociously about all companies to define your own circle of competence, then move on to managing your friends and families’ money. Then if the investor is any good at all, it won’t be long before the results speak for itself (at least a 3 to 5 year period and the timing of market cycle matters) and people will start noticing your track record as an investor and fund manager. This investor letter is my attempt to do exactly this - operate as though I am already a fund manager (short of regulatory compliance, audit and fund admin), document my portfolio holdings, investment buys and sells, and overall performance on a semi-annual basis (at the same time keep reminding myself that short term stock price gyrations shouldn’t matter), as well as a way to force myself to pen down my readings and thoughts on a regular basis.

The last point is particularly worth highlighting. While human brains are wired to remember the bad more than the good (loss aversion), we are also notoriously good at somehow forgetting the painful experiences and repeating the same old mistakes. As such, it is important to have a post mortem and a written record to thoroughly understand the investment mistakes made and make sure it sticks well in our memory. So far in the past 3 years of investing, I have made a few mistakes which have caused me a fair bit of pain and some fortune. I shall write more about my investment mistakes in future posts. In addition, what is more important for me to write this investor letter is to document down the investment thesis and thinking behind each company in my portfolio. This helps to keep track of the companies business performance and be less affected by the noise surrounding the macro environment or short term share price movements.

Reflections and Recap on 2022

Over the past few years, it is amazing to see how the Covid-19 pandemic has changed human behaviours on a global scale. From the initial stages of fear of the Covid-19 virus, avoiding crowded places, excessively hand-washing, routinely wearing masks and having virtual conferences online, many people have now reverted back to the old days of modus operanti for those countries that have opened up. If we read the headlines for most of 2020 and 2021, it is easy to conclude that ‘Covid-19 will upend many industries in the foreseeable future’, or ‘Covid-19 will change human behaviour forever’, etc. Although for now we still can’t say we are 100% back to pre-Covid days, but if we fast forward another 3 years to end of 2025, barring any new potent variants, I am pretty confident that as a general population most of our economic and social activities will be back to where we come from, i.e. before Covid-19 wrecks havoc in Jan 2020. Covid-19 will change all history textbooks, but it won’t change our fundamental human behaviours and our deep-seated need for social interactions.

Although this substack blog has been mostly quiet in 2022, I have been very active in terms of reading and thinking about my own portfolios, as well as researching about more companies across a broad spectrum of industries (hopefully I got time to write more about them in 2023). Over the past 3 years since I started to invest using the current value investing philosophy, there are a few major errors of judgment and lessons learnt. They came from the following companies: Perfect Medical (HK: 1830), Renrui Human Resources (HK: 6919), Graftech International (NYSE: EAF), Genetron Holdings (NASDAQ: GTH). I hope to share more about them in future investor letters.

Portfolio Holdings and Return Performance

Going forward, I will show my portfolio holdings and overall portfolio returns as at 30 Jun and 31 Dec of each year starting from 2023 onwards (do expect a 30 to 60 days delay in publishing the letter). To reiterate here again, my goal as an investor is to compound wealth at a 5% point higher than the benchmark index on an annualized basis over a holding period of at least 5 years. The two benchmark indexes I have chosen are MSCI World Index (USD) and MSCI China All Shares Index (USD). I seek to disclose all my holdings, buys and sells such that at any point in the future, anyone can easily audit my returns. My portfolio as at 31 December 2022 contains 12 companies, with maximum exposure of 13% per stock, and a cash holding of 20%.

Is China Still ‘Investable’?

Over the past 3 years, China has experienced so much change from both external macro events as well as domestic issues. Regulatory crackdown and scrutiny on various industries (K-12 education and after school tutoring, tech industry and platform companies, volume-based procurement in healthcare industry), prolonged debilitating Covid-19 measures, escalating US-China trade war, global supply chain disruptions, domestic political uncertainties, etc., have all pushed the narrative from both Wallstreet and Mainstreet to deem China as “uninvestable”. Readers of my blog or people who know me personally will know that I am generally bullish on the future trajectory of the overall Chinese economy (and by extension Chinese companies). That’s why I have devoted most of my time and attention so far to studying Chinese public companies.

If you asked me this headline question of whether China is investable in late October 2022 (right after the 20th China Congress), I would have wavered in my conviction and gave an uncertain answer of ‘maybe’, which is a stark change in my stance. This is because the events that have transpired leading up to that Congress, and the decisions that the Chinese government has chosen have all pointed to the inconceivable scenario that socialist idealogies and political power centered on one man trumps all other considerations. I was questioning myself whether there is still room for value investing in China, and that perhaps I am biased to keep believing something that I hold dearly when the facts have changed (indeed, a precedent-breaking 3rd term is a historic change in the course of modern China’s political history). It is little wonder that some eminent investors have avoided totally all Chinese stocks, citing political risks as too high and too unpredictable.

As soon as the dust has settled on the 20th Congress meeting, China has embarked on a drastic change in both regulatory tones and actions across many fronts - stabilising the economy being viewed as the top priority in 2023, acknowledging the importance of property sector, shifts in the ‘wolf warrior’ foreign policy and most notably opening up the country after 3 years of harsh Covid-19 policies. It is as though everybody, including the China experts both East and West, have all misread the signals coming out from the meeting. Did the top echelons of power in China really changed their minds in such a short time after the meeting? I highly doubt so. Nevertheless, political unpredictability is not a good environment for companies and economy to thrive. To my relief, the worst case scenario hasn’t transpired yet and there are numerous encouraging signs so far that ‘this too shall pass’ in China’s inevitable rise as a balancing superpower to the U.S. and her democratic system of governance. However, given the unpredictability and opaqueness of the inner workings of the CCP, I think it is still too premature to have a definitive answer to the above question. The key period to watch will be the next four to six months of 2023 and the actions taken by the government. The government needs to act decisively to shore up investor confidence, and not rhetorical pledges by some high-ranking officials. Actions speak louder than words, and so far the Covid-19 turnaround has proven their resolve. The speed at which the Covid virus has spread in China is astounding, which means they will emerge faster than what we expect (with the sad but inevitable deaths associated with all previous Covid waves around the world). With the Covid overhang hopefully subsided in the next 2 to 3 months, China’s consumption and economic activity should rebound strongly.

On Medical Device Industry in China

Medical device companies currently constitute one-third of my overall portfolio. This seemingly concentrated bet on a single industry is worth spending some time to lay out my thoughts. Though the companies themselves are in different sub-sectors of the medical device industry, they will all be subjected to the same macro-economic trends and regulatory forces. Amidst the recent regulatory headwinds impacting this industry, mostly from volume based procurement (VBP), I have spent much time reading and thinking about the potential risks on the companies in my portfolio.

Update on Joint Replacement VBP and AK Medical

Readers of my previous AK Medical write-up (link here) will understand the basics of VBP and my predictions about the probability of AK Medical winning the VBP tender and the magnitude of price cuts, and their corresponding impact on the sales and margin %. Now that the results of the joint replacement VBP was announced in Sep 2021, it is comforting to know that my prediction of the most likely scenario has indeed come true. This nationwide tender has a total volume of 540k units across all hip and knee products (total value of RMB 20bn), of which AK Medical’s expected procurement volume share is the highest among all brands at 14%. AK Medical won all tenders with a relatively acceptable price bids. Market participants were relieved and share prices of most orthopaedic companies rose sharply in reaction to the clear softening of this tender round, both in terms of lower price cuts and better policy guidelines (as compared to the coronary stent VBP). The key policy highlights are:

• Separated all companies into Group A and Group B to differentiate the major players who can supply to all provinces, and allow direct competition between local brands and foreign brands in Group A. This further reflects the “国产替代” trend while ensuring a fair game for everyone.

• Overall average price cut of 82% as compared to the >93% in the previous coronary stent, with hip product prices being cut from RMB 35k to RMB 7k and knee product prices cut from RMB 32k to RMB 5k. A 82% price cut for such a huge nationwide volume is indeed reasonable. Though it is only a 10 ppt difference between a 80% price cut vs. a 90% price cut, it can have a world of difference in terms of the GP margin impact. As shown in the table below, a 10% price cut can reduce GP margin by 30% (of course with some simplifying assumptions but the concept remains valid).

• A tender win rate of 92% (i.e. 44 out of 48 companies won the tenders). Such a high win rate ensures that companies won’t be forced into a “win or go bust” situation and bid for ‘crazy low’ prices.

• New regulatory rule to include a separate fee for “伴随服务”. This clearly shows the principle of “一品一策” and that the authorities listen to the industry voices, acknowledge and understand the nuances of each industry and doesn’t apply a one-size-fits-all solution.

While the outcome of the VBP has been decided, the impact on the company’s financials are yet to be seen. I am confident that my predictions for the sales and margin impact will hold, though in the initial 1-2 years of implementation we may see some slight margin compression as AK Medical adjusts its operating and sales model. FY2022 will be the first year of implementation of VBP and I am eager to see the full year results in March 2023. On the other hand, another major local listed competitor (Chunli Medical) priced its knee products too high in its bids and lost the tender - a major blow to the company which surprised many people. This loss from Chunli does show that nobody is ‘favoured’ in the rules-based VBP tenders, and that the VBP does force market participants to show their best hands and keep improving on its cost control and operational efficiency (of which local companies are much better than the foreign players). It will be interesting to see what impact it has on Chunli after losing such a key product group, and who will take over its market share. Another key metric to watch for will be how much more demand will come from the lowered prices, especially in this field where the surgeries can often be voluntary or optional. If the precedent of the coronary heart stent is any good guide (volume has increased by 1.8x of prior year after VBP slashed prices by 93%), the demand curve of joint replacement products may see similar trends (though other factors may dampen such uplift).

Other Evidences of Favourable Policy Directions

In addition to the above joint replacement VBP, there are other encouraging signs that the authorities are adjusting and tweaking the policy to be more reasonable. Some of the other key policy developments are:

• In Sep 2022, the healthcare authotities have given the most clear indication that innovative medical devices will not be subjected to VBP, and encourage companies to continue R&D and launch innovative products (link here).

• In Sep 2022, the latest nationwide spinal products VBP results showed an average price cut of 84%, slightly higher compared to the level for joint replacements but well within market’s expectation. Surprisingly, there was an additional qualifying rules that price bids which are <=40% of the “highest qualifying price” will automatically be qualified as winner. This further ensures there is a pricing floor and encourages more rational bids from competing companies. In addition, there is a new rule that stipulates a direct price-volume formula, which further helps to consolidate the industry and aids the largest firms to gain market share. Notably, due to the relatively large local brand market share, some of the reputable MNCs such as Stryker and Zimmer Biomet didn’t win the tenders while others like J&J DePuy have won only the limited volume, leaving a huge territory for local brands to gain market share (another example of “国产替代”).

• After the 2 years of the national VBP for coronary stents expire, in Nov 2022 the authorities have extended the effective period for the existing winning bidders for another 3 more years instead of calling for another auction-like bidding war. This improves business continuity and operational certainty for the winners and removes much uncertainty from guessing which companies will win the tenders again. Notably, the guaranteed volume has also increased by 40% vs. last year, reflecting the increased volume usage from hospitals post VBP.

• Importantly, the authorities have allowed prices of the coronary stents to be revised upwards, with an average increase of 20% across all products and largest increase of up to 70%, from RMB 469 to RMB 845 per stent. Furthermore, they have added the “伴随服务费” of RMB 50, similar to what was implemented for the joint replacement VBP. Though the absolute dollar increase is small (RMB 200-300 per stent), these policy developments further confirms that the authorities are not primarily driven by cost savings (i.e. price cuts), and wants the industry players to compete fairly and effectively while ultimately benefiting all stakeholders including the doctors and patients.

• There are still more evidences coming from various provincial tenders carried out across the country (which are too many to name), and all of them have shown increasingly softer approach both in terms of price cuts and bidding rules.

Framework in Picking Winners in the Medical Device Industry

With all the dramatic regulatory changes and market reactions that were happening over the past few years, the implications are clear, in my opinion, that the medical device industry in China is still very much worth investing. Gone are the days where any fortune seeking, risk taking entreprenerus can just copy the foreign technologies and start selling medical devices or consumables to reap huge profits. Gone are the days where medical device distributors can earn decent margins leveraging on their networks and ‘guanxi’ with the hospitals and doctors. Under the current paradigm shifts underpinning the healthcare reforms and the normalized implementation of VBP across the industry, I believed there are a few key criteria to look out for in trying to pick winners from this industry:

• The market sub-segment must be one that hasn’t fully gone through the import substitution phase (see point 2 from my post on AK Medical). I.e., foreign brands must still dominate at least 60-70% of the overall market, giving rise to the possibility for market share grab from local brands. The counter-example was the stent VBP which saw brutal price cuts and the corresponding painful drop in the sales and profitability of the companies, as the local brands already command 70-75% of the overall market for stents in China.

• Within the local brands, the target company must be the top player (if not a close 2nd) in their respectively sub-segment - both in terms of scale (revenue, distribution network, hospital touchpoints) and product capability (R&D capability, clinical superiority and product range). This is not the same argument from the tech sector where network effects or other factors congregate to result in “winner takes all” scenario. This is important because it again increases the probability of winning any VBP tender bids, ability to gain market share in import substitution trend, and allows the more innovative, non-VBP products to benefit from gaining access to the top tier (三甲) hospitals.

• The market sub-segment and target company should have a high GP margin (ideally >70%), and ideally should have the highest margin among the local brands (or same margin but lowest cost producer). This demonstrates the company’s economies of scale and operational efficiency (e.g., use of automation and robotics). This ensures a more competitive position in tender bids and a large enough room to buffer from unexpectedly high VBP price cuts.

• The target company needs to demonstrate some track record and ambition in going global, and not just in emerging markets but ideally have product already registered (or in the pipeline) from EU CE mark or US FDA. This may seem trivial but it does demonstrate whether the company is more of a product-driven or sales-driven company, and also reflects pretty well the company culture and strength of the management team. Across many strategic industries, Chinese companies going global will be a key theme in the next few decades as China continues to grow economically.

All of the companies in my portfolio fits most, if not all, of the above 4 criteria, perhaps except for Peijia Medical (in no ways do I feel less convicted in Peijia vs. other 3 companies), which I hope to write about in future post.

A Test of Courage in Holding Contrarian Views

I am a keen reader of Howard Marks’ writings and his book “The Most Important Thing”. In the book, he talked about how superior investing requires two primary elements:

1. Seeing some quality that others don’t see or appreciate

2. Having it turn out to be true

In today’s world, information edge has largely been arbitraged away due to the ease of access and transparency of disclosure. I believe in the case of medical device industry in China, it is one of those scenarios where analytical edge and time arbitrage edge provide the opportunity to earn superior returns. Market participants have previously priced in such pessimism that the risk-reward doesn’t make sense anymore. People argue that the Chinese government regulations are too volatile and unpredictable after seeing the entire after school tutoring industry being decimated almost overnight. However, drawing parallels between that and the medical device VBP misses the big picture and the true intention of the government. Over the past few years, many fund managers and investors have avoided the industry entirely citing unpredictable tender results and that no company will benefit whereby its industry just arbitrarily got shrunk by 80% or 90%. It is with such a pessimism that share prices have drop to mouth-watering levels in 2022, which I gladly responded with more purchases (similar to how when Häagen-Dazs goes on sale, I buy more, not less).

I have definitely done step 1 from the above, and step 2 is clearly yet to be decided. It does take a lot courage to hold contrarian views, especially when you see the share price tanking. To be fair, I might be right about the industry dynamics after the dust settles but still be wrong about the company itself (poor management, eroding moat, etc.), which I hope that diversification into four different medical device companies, each a leader in their respective sub-segments, will help to mitigate this risk.

Ending Note

Lastly, thank you for reading this letter and I look forward to sharing more in my next letter. Meanwhile, feel free to reach out to me at hillope.capital@gmail.com if you have any comments or questions. I wish everyone a healthy and joyous 2023 ahead!

I will end this letter with the following Howard Marks’ quote:

“You can’t do the same things others do and expect to outperform… Not only should the lonely and uncomfortable position be tolerated, it should be celebrated… The safest and most potentially profitable thing is to buy something when no one likes it. To beat the market you must hold an idiosyncratic, or nonconsensus, view.”

Kolberg Kravis Roberts (“KKR”) is often regarded as the pioneer of the modern private equity industry. Founded in 1976, KKR orchestrated some of the largest leveraged buyouts of their time and has since grown to be a diversified alternative asset manager with approximately USD 250billion of AUM. In private equity, a manager (in industry lingo “General Partners” or “GPs”) pool together money from its investors (“Limited Partners” or “LPs”) and invest in companies, hold them for several years and sell the companies in the hope to generate investment returns.

Both Berkshire and KKR have created immense wealth for itself over the past decades. Though their methods and corporate structures differ, on the fundamental level they involves buying and selling stakes in companies. On the surface, both involves some form of fundamental analysis looking at the soundness of the industry, competitive dynamics, business model and management team. But if we peel the onion, at its core the differences can be stark.

After working as an investment professional in a private equity fund for the past 5 years, while practicing Buffett-style value investing for my own stock portfolio for the past 3 years, it always bothers me how different both investment approaches are (and in a subtle and deep-seated way). This article is intended to pen down my thoughts as I am fortunate to have direct experiences on both sides and also find myself always trying to answer this question to people.

1. Let’s Get Married! (p.s. for only 5 years)

Warren Buffett has always said that his preferred holding period for an investment is forever. Though I suspect even Francis Gerety herself didn’t mean it literally when she created the slogan ‘A Diamond is forever’ for DeBeers, I doubt Buffett meant it literally as well (but 50 years of holding See’s Candies surely feels and looks like forever in Wall Street context). To me, the key word in that quote is ‘preferred’, not ‘forever’, as it speaks to the intention rather than the outcome (we will come to that later, as well as more exploration into the analogies between investment and marriage).

On the other hand, private equity funds have a fund life, which is typically 10 years (with up to 2-year extension). The first 5 years, called the investment period, is when the fund manager sources for deals and calls on capital from LPs once a deal is found. The next 5 years will be the period where the fund manager tries to sell its companies in the portfolio. This means that the theoretical maximum period a PE investor can hold an investment is 12 years. In reality, the average holding period ranges from 3 to 6 years. A key observation over the years is that performance of a portfolio company typically inversely correlates with the holding period after the first 3-4 years (i.e., fund managers prefer a quick flip and get a high IRR return, while poor performing companies get ‘stuck’ in the portfolio).

In today’s world of instant gratification and constant impulse to act, many investors would regard a 3 to 7 years holding period as a long enough period to be branded as ‘patient’ capital and true long-term investor. However, the fact of the matter is that the duration in investment holdings, like many things in life, is a relative concept. Take a look at the chart below and you will notice at every timescale, from milliseconds to decades, there are no shortage of people employing various strategies trying to beat the market. 1 minute will look like an eternity to the high-frequency traders, while 1 quarter is imcomprehensible to the business owner/value investor.

This then begs the question - what exactly is the difference between a 3 to 7 year holding period vs. a preferred forever holding period. As it turns out, I think the difference is immense (try asking the same question to your girlfriend or spouse and her reaction should give you a hint). At the core is the difference in incentive-driven mindset, which drives differences in decision-making and behavioural changes which trickles down the organisation from the top.

Since private equity managers already know they are going to exit or sell the company in the next 3-5 years even before they invest in the company, all they are thinking will be how to maximise the exit value. In a typical private equity deal, be it minority growth capital, MBOs or LBOs, the key drivers of exit valuation are profitability (typically EBITDA or NPAT), exit multiple (EV/EBITDA, P/E or P/B) and cash generation. This is why PE fund managers love to pile debt on a company from the get-go (in the fancy name of “balance sheet optimisation”), and then dividend the money out to offset some of the initial purchase considerations (doesn’t it sound similar to the popular saying “borrow your watch to tell you the time” in consulting).

If you know your are bidding farewell to the portfolio company and most likely won’t see each other for the rest of your life, and being in a position of control, what would most people do? Well, the fund manager will likely ‘dress up’ the company in preparation of an exit, paint a fancy growth story, cut costs where possible to increase earnings, stop investing in capex if that ROI only comes in much later and the spending benefits the next buyer instead (and at the detriment of the long term competitive advantage of the company, argh, this one really angers me). In short, fund managers will try all means to decorate the company to ‘juice up’ the returns. The only self-imposed governance mechanism will be the fund’s reputation since they need to keep finding the next ‘target’ and raise a new fund. When the operating timeframe and mindset is only 3 to 6 years, it is sometimes disheartening but not uncommon to see companies being tossed around between private equity funds.

On the other hand, you may observe that some value investor funds also sell their holdings within a few years and may well be less than a typical holding period of a PE fund. Before you accuse me of any hypocrisy, the key difference here is the intention. Businesses are incredibly fragile beings and they have to keep fending off the competition, innovate and adapt in order to survive the Darwinian selection. The fact is the hit rate for finding great companies well-deserving of the “forever-holding” bucket is extremely low (well, Nicholas Sleep found three and decided to close his fund and advised his LPs to put the money in the three themselves). True value investors sell for 3 reasons: i) underlying fundamentals and thesis for the business have changed; ii) we made a mistake; iii) we found something much better. All these are valid reasons to sell. Divorce rates are high, yet most loving couples hope to wed forever. This brings back to my earlier point - value investors prefer forever while seeking true love, PE investors want a bigger piece of the pie in a fling.

Given the above, you may wonder, what then does any company still want to invite such a “barbarians at the gate”? Well, I don’t think there is a simple answer and each company’s situation is different. Also, the above is not representative of all PE deals, a few do try to be a good partner, bring real value add and leave the management team to work their magic. Suffice to say, there are no short of companies looking for private equity money, and also no short of capital chasing too few deals (turn around to take a look at the VC space now and you will get shocked).

2. It’s All About the Fundamentals!

In my work as a private equity investor, the valuation metrics that we use and talk about almost universally are P/E and EV/EBITDA (and sometimes P/B especially for financial service firms). In PE’s fundamental analysis, we are trained to think that a low P/E or EV/EBITDA is cheap (and vice versa). So how low is considered cheap? An interesting observation is that most PE investors seem to have a mental scale in their heads about the kind of multiples that one industry should have vs. others. E.g., in the current environment contract manufacturers or automotive industry should be given 5-6x EV/EBITDA while healthcare or semicon industries will garner low-mid teens EV/EBITDA (it doesn’t help that PE investors often reference the comparables in the often mispriced public markets as the benchmark, as well as what others have paid in the past).

With such an anchor bias, then an analysis of how cheap a company is will be relative to a broad stroke and arbitrary valuation multiples (without much well-deserved considerations of the individual merits of a company). There is almost no mention (at most just an occasional whisper) of intrinsic value, return on equity (ROE), return on capital employed (ROCE), etc. I found this perplexing. How is it possible that a company with a wide moat and unique business model (e.g., Costco) be valued at roughly the same range of multiples as another more inferior company in their respective industry (e.g., Sainsbury’s). The fact is that PE’s fundamental analysis often do not go deep enough to truly understand the business model and drivers, moat and direction of moat, management team and culture, all of which are key determinants of long term value creation. Of course, if you are just holding the investment for 3-5 years, you may not be worse off ignoring these drivers (back to the above time horizon point again, duh!). At its core, a value investor and a PE investor views the fundamentals of a business with a different lens and a different focal point.

3. Swing, You Bum!

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.” - Warren Buffett

Buffett has often compared investing to baseball, and that the key is to wait patiently for the fat pitch. It is no wonder why Berkshire has in recent years been sitting on higher and higher cashpile, which is a clear indication of them not finding the opportunity to swing (though their size limits their investable universe and hence it’s harder for Berkshire to find the right opportunity than an average size fund). There is another subtlety to sitting on a cash pile, which highlights the key differences between Berkshire-style investing vs. KKR-style investing.

Unlike in Berkshire, which is structured in a way to not succumb to institutional imperatives (more about this at the end) and focuses on long-term compounding of a portfolio’s intrinsic value, in private equity once a fund closes the clock starts ticking as the investment period is only 5 years. In a typical PE fund there will be 10-15 portfolio companies, which means in an average year a PE fund has to do 2-3 deals. One of the reasons why LPs put their money with a PE fund is they want the fund manager to find good (and preferably proprietary) deals. If after a couple of years a PE fund can’t deploy the capital that the LPs have committed to them, then the LPs will question the deal-making capability of the GPs and whether fund size is right. It is hard to resist the temptation to swing when everybody else are having a good time swinging and laughing at your inaction. Unless you are deaf, it is almost impossible to ignore when the person yelling at you to swing is the person giving you the money to invest in the first place. Worse still, the KPIs of many PE investment professionals are often judged by how many deals he/she did for the year.

As with the entire alternative asset management industry, even though the PE industry is considered ‘long term’ capital, the temptation to deploy capital to the detriment of performance is pervasive and strong. This has all to do with the fee structure and incentive mechanism which we come to below.

4. Fee Structure Creates the Wrong Incentive

“Job one, two and three for your manager is investment performance, not asset gathering. Few practice this approach … Common sense and simple maths dictate that it will be opportune if growth can be channeled to coincide with depressed prices, and not market tops. We must aim for this standard, even though it is contrary to common practice in the industry. Had we adopted the industry standard open house approach the Partnership would be approximately three times its current size, but the results worse, and the quality of Partners meaningfully impaired.” - Nomal Investment Partnership Letters Jun 2004

Nicholas Sleep’s Nomad Investment Partnership closed in 2014 after a 12-year annualzied return of 20.8% (14.3% outperformance over MSCI World Index over the same period!). Throughout their time managing Nomad, they have mostly closed their fund to new subscriptions because they valued performance higher than asset accumulation. One of the key reasons why they shut their funds after 12 years and returned money to their LPs is because they find it increasingly hard to uncover great investment targets in a frothy external environment.

When is the last time we heard any PE funds closed because their results are excellent but just can’t find good deals. None that I know of. Instead, while the music is playing, most of them will rush to raise a new and bigger fund, touting the success of past returns and how they beat the competitor PE funds (even though quite a number of their after-fee returns struggled to keep up with a passively invested S&P 500 index fund).

The industry norm in the alternative asset management industry is 2/20 (two-twenty), i.e., 2% management fee on AUM and 20% performance fee (triggers only if a minimum 8% hurdle rate is met). The 2% management fee is a guaranteed annual payment regardless of performance, and it is justified by GPs to pay for all the salaries and bonuses, office rentals, fancy research tools, operating expenses (Business Class & 5-star Hotels anyone?), etc. When you have something so sweet in life that’s guaranteed, it is little wonder that PE fund managers will prioritize raising the next fund (and filling up the AUM on the brink of gluttony) over performance of the fund. The implications here are huge. If a fund did well for the first 50% of AUM committed and returned a good amount of money to LPs already, then the GPs is more likely to opt for sub-optimal but safer bets (note that safer is subjective) to ‘balance’ the portfolio, since they need to get to 75% of the committed capital deployed before they can go market and raise the next fund. Also, after the first 5-year investment period, the 2% management fee is paid on invested capital, and hence you can imagine during the last 3 months before the 5th anniversary, GPs will rush to deploy since they know they will earn a management fee on that capital as well. The list goes on.

In the actual operation of a PE fund, you will be surprised how much of the $100 of committed capital actually goes to investing in the companies that actually generate returns. For a typical $100m PE fund, only an estimated $70-75m goes into doing the real work, while $20-25m are expenses over the life time of the fund. Fund expenses (fund admin, audit, legal & compliance), deal-transaction expenses (DD costs, expert networks), and other one-time fees all combine to result in an average differential between the gross return (how much money got returned from money that went into the portfolio companies) and the net return (how much money got returned to LPs from committed capital) to be 7% in IRR and 1.0x in MoM. Next time you see any fund touting the alignment of interests with a 2/20 fee rule, think again….

5. Folly of the Institutional Imperatives

“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call 'the institutional imperative.' In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.” - 1989 Berkshire Hathaway Chairman’s Letter

It is one thing to have open mind and always learn the best from what others are doing, it is quite another to become irrational and blindly follow. Corporate world is not short of these follies as observed by Buffett, and which the fund management industry is not insulated from this unseen force. When you see other PE/VC funds pouncing on certain hot sectors, chasing a deal by paying up, and over-leveraging a business, the FOMO nature of the human psychology will kick in.

A certain sector is deemed more favourable with ‘good exit potential’ if there are many prior transactions involving PE funds. PE funds beefing up their portfolio management team and other esoteric specialists in a bid to differentiate themselves from the pack and add more conviction to the LPs that they can ‘value add’ to the companies. Sometimes when a portfolio company performs so well after 3-4 years and is in an ever stronger position to grow and compound capital for longer priod of time, the managers made the decision to sell. You may think most of these “forced-selling” is because the fund life is up, but in fact, from my observation, this is rarely the case. In the Peter Lynch lingo, fund managers often cut the flowers (and water the weeds as well) mainly because they want to show LPs a realized good return (along with a subtle message: please prepare money for our upcoming fund raise), or some buyer came along and offered a high price, or some belief that it’s better to exit now before the macro environment turns sour. Of course, the LPs will pat the back of the fund managers who got them a 5x return, totally oblivious to the true costs of forgoing a 10x or higher return.

And the list goes on.

P.S. Time is the most precious non renewable resource and I thank you for reading up to this point. If you like what I write, leave a comment, subscribe or share it.

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I read the Prospectus, annual reports and public releases. I thought it was a great company with a huge growth potential but then I did nothing. At that time, it was trading at ~ 20-25x for LTM EV/EBITDA and ~30x for P/E, which I thought was too expensive. I was ignorant about how to estimate a company’s true intrinsic value and thinking more deeply about a company’s moat and future cashflow. More importantly, I was stuck with the simple mindset of equating ‘cheapness’ to static valuation multiples both from reading about ‘deep value-investing’ and Ben Graham’s work, but perhaps more deadly from my years of professional work as a private equity investor (I shall write more about the differences being a PE investing vs. value investing in future posts when I have time).

I thought I will keep AK in my watchlist and buy only after it dips, thinking that I was being ‘discipline’ and applying the principle of ‘margin of safety’. Instead, I watched the price went stratospheric from HK$4-5 in mid-2019 to a peak of HK$27 in July 2020 – a 5x increase in about a year! I was cursing myself of not buying the stock with the all-so-common hindsight bias, and all the while trying to stay discipline and not FOMO into it (would you buy a property after its seller raises price by 30%?). At some point I gave it up and stop closely following the price to prevent further emotional stress. Then all out of the blue came the ‘Volume-based Procurement’ policy hammer which knocked the price all the way down from HK$27 to ~HK$9-10 in Mar 2021. After all the emotional roller-coaster, this is the buying opportunity I was waiting for. I did my research (more on it below) and bought the stock in a series of purchases at around HK$9-11.

As of Jun 2021, AK Medical became the largest holdings in my portfolio and I feel really good about it (though time will tell whether my wallet will end up reciprocating my feeling). In the Chinese language there is a term called “缘分”, which loosely translated means fate or destiny. I definitely felt this special connection, or fate, with AK Medical. Ok, enough sentimental talks, now back to the main analysis….

Business Introduction: Founded in 2003, AK Medical is a leading orthopaedic implants company in China focusing on R&D, manufacturing and sales of its own branded hip, knee and spine implants. It has the largest market share in joint replacement implants in terms of volume among all domestic and foreign brands. AK was the first medical device company in China to commercialise the application of 3D printing technology to orthopaedic implants, and has launched the first NMPA-approved 3D-printed acetabula cups in 2015. The company has grown at a 38% CAGR in sales and 35% CAGR in net income from 2014 to 2020, with average ROCE of ~70% and ROE of ~35% over past 6 years. It mainly sells its products to a network of distributors across the country who will then sell it to hospitals.

Summary of my investment thesis (TLDR version):

1. Large and predictably fast-growing market driven by macro-economic factors – aging population, rising prevalence and incidence rate of joint disorders, greater penetration rate of joint surgeries and rising expenditure on medical devices

2. Import substitution trend will steadily lead to dominance of domestic brands

3. Multi-disciplinary nature and manufacturing prowess of Chinese companies create an inherent moat for the medical device

4. Clear leader in 3D-printed orthopaedic implants demonstrates strength of R&D capability and barriers to entry

5. Best positioned to benefit from (or least affected by) the Volume-based Procurement policies to be implemented

6. Owner-operator with founder trained as an orthopaedic doctor

7. Demonstration of M&A capability and global ambition

Key Potential Risks and Concerns:

1. The single largest risk happening now is regulatory. This itself warrant a full 2-3 posts of discussion but I won’t go into detail here. In short, the implementation of Volume-based Procurement policy (Jicai or 集采) has far-reaching implications on a whole bunch of factors - pricing & margins, surgery volume and demand, changes to import substitution trend, sales channel and marketing, etc.

2. Product quality issue leading to recalls or medical adverse events

3. Channel stuffing leading to overestimated sales and profit

1. 骨科的风口，连大象也能飞起来

Lei Jun of Xiaomi coined the phrase ‘站在风口上，猪都能飞起来!’ to describe how an entrepreneur should choose industries with such strong macro-economic tailwinds that practically anyone can make it successful. To me, the orthopaedic market in China can lift up an elephant, and the ‘风口’ can be sustained for at least the next 5-10 years, due to the following key drivers:

• Rapidly aging population - China’s aging population issue has been widely publicised and considered the most staggering pace of aging any country has ever seen. The number of 65+ years old has increased from 100mn (7.7% of population) in 2005 to 175mn in 2020 (12.5% of population), and is projected to grow to 260mn by 2030 (17% of population), and 360mn in 2050 (26% of population). That’s more than the total population of U.S. today! Orthopaedic implants, especially hip and knee implants, are mainly used to treat osteoarthritis (OA) and rheumatoid arthritis (RA), both of which are common chronic illnesses that are strongly coorelated with old age.

• Many scientific articles have been published on the prevalence and incidence rate of osteoarthritis globally. In China, incidence rate of osteoarthritis in people aged 50 and above is almost 50%, and that for 60+ is ~62%. Key points to note here are that both prevalence and incidence rates are increasing over time, particularly in developing countries, as people generally live longer and getting richer with more sedentary lifestyle (too much sports or running can also lead to joint problems). Some studies have shown that the prevalence rate in Asian countries are even higher than in Europe or USA.

• Despite no less incidence rate in China vs. the rest of the world, the penetration rate of joint replacement surgeries are way lower in China compared to the rest of the developed countries. As an example, penetration rate of joint replacement surgeries per 60+ population are 0.4% in China, vs. ~2.5% in US and ~4% in Germany. This is not due to the surgery being difficult to perform or efficacy not proven. In fact, arthroplasty has one of the highest success rates of all surgeries. Two main reasons for the discrepancy are supply side issue with a lack of qualified orthopaedic surgeons in China and demand side issue where patients have less access to medical care, less willing to undergo surgery (especially for older people), and high cost. If we assume all else equal but just adjusting the penetration rate of China from 0.4% to 1.5% (half of the global average of 3%), that in itself implies a 4x growth in the 2020 surgery number, or over a 10-year period CAGR of 15%!

  

• Globally, the ratio of government healthcare spending on medical devices vs. pharmaceuticals is on average 35-40% in developed countries such as USA and Europe but only 15% in China. This was due to China’s unique healthcare developmental path which puts more focus into pharmaceuticals but this gap is expected to close as China focuses more resources on medical devices and high-value consumables. We can see in the chart below the staggering gap in per capita spending on medical devices between the countries, in which China is definitely being downplayed relative to its GDP per capita.

  • Another interesting fact: If we delve into the three sub-segments of orthopaedics, globally joint reconstruction is the largest with ~37% market share, followed by spine and trauma. However, in China joint replacement lags behind the other two segments.

    

I think any one of the above factors in itself will drive the growth of joint replacement implants, just like how a mature orthopaedic device market like the US have grown steadily over the recent years and supported the emergence of giant medtech companies like Stryker, Zimmer and DePuy Synthes (though a significant part of their growth story is also due to well-executed acquisitions). But it is the combination of all these three drivers acting in the same direction and reinforcing each other that will really drive the growth in China for a long time to come (such a share gain in a growing pie effect is why I think an elephant will fly!).

2. 进口替代，趋势无法挡

Import substitution is one of the ongoing megatrends being played out across various sectors in the Chinese market, be it in electric vehicle, semiconductors, aerospace engineering, telecom & 5G, etc. The core of the current import substitution megatrend is technology innovation and moving up the value chain, which China views as one of the core strategies to modernize and grow its economy in the future decades. China wants to transition from being the ‘factory of the world’ to being the ‘factory + brain of the world’ - a technology powerhouse to compete with the developed world.

Within each industry there are certain sub-sectors where import subsitution has been completed while others are still in early stages - e.g., in eletric vehicle sector, China has already caught up and became a real competitor in EVs, but still lacks in core technology such as semiconductor chips, AI, Lidar, etc. Having said that, China is catching up very fast, particularly with the US-Sino trade war heating up in the background and has propelled greater urgency within the Chinese government.

In my opinion, this megatrend has three fundamental supporting drivers which will help propel domestic companies to compete and dominate the imported brands in the medical device industry:

1. Favoritism policy by the government, which is something that the government is not shy of making it clear to market players. This manifests itself in various ways - e.g., in terms of % reimbursement from the public health system (see below), easier and quicker approval process for innovative drugs and devices (a.k.a. “green channels”), etc. There are numerous policy and clear signal from the highest echelon in the CCP that they view this as a priority, and I believe this type of favoritism policies will not change for the foreseeable future.

   

2. Over the past 10-15 years, Chinese companies have generally shifted their mindset and understood the importance of R&D, innovation and IPs. From the government’s top-down regulatory and financial support, to a highly educated population breeding many visionary enterpreneurs, to capital market’s influx of money, all these have led to an environment of rapid innovation and increasing quality of products and services at a much lower cost (and Chinese have started to gradually move from improvising copycats to true innovators in some sectors). This serves as a core foundation on which the value and quality of domestic products can match imported brands.

3. On the demand side, I think more Chinese consumers have become educated and well-travelled, and hence more discerning in terms of product selection rather than having blind faiths in ‘imported products are better’ kind of mindset. This is particularly true for the younger generations who increasingly want to embrace and support domestic brands, partly due to nationalistic sentiments and narrowing gap between product qualities between domestic and imported products.

All the above serve as strong driving forces for domestic brands to gradually take market share from imported brands, which are being played out across various sectors. In the medical device space, if we largely divide the sector into three levels of clinical or technological sophistication (see slide below), the low-value medical consumables and equipment have mostly achieved import substitution over the past 20-30 years, while the middle segment is currently undergoing a rapid trend of import substitution, and the high-value segment (largely consist of large medical devices such as CT and MRI scanners) is now just starting. A yearly time series animation of the slide below will see an original flat horizontal line at the bottom gradually rise to become a nice downward slope. I believe such an animated chart is being played out in various stages of development across multiple difference industries in China.

It’s worth talking about an example in the coronary heart stent market to illustrate the staggering pace of this trend. Prior to 2005, heart stents are 95% dominated by foreign brands such as J&J, Medtronic and Boston Scientific, but after domestic Medtech pioneers Microport and Lepu launched their own stent products back in 2004 and 2005, it took merely 4 years for domestic products to reach 70% market share! Today, it hovers around 80-85%. It’s a fascinating case study on why such a dramatic switching can occur on a Class III medical device, but I will leave it for another day.

3. 药品与器械的差异造就了护城河

To analyze the Medtech industry, it serves up great insights to analyze the parallels between Medtech and pharma industries. Two interesting observations:

• The global top Medtech companies have stayed more or less the same over the past 20-30 years (Stryker, Boston Scientific, Medtronics, etc.) while the global top pharma companies have changed names or merged - In 1990, the top pharma companies include Bristol-Myers Squibb, Glaxo, SmithKline, Ciba-Geigy while the likes of J&J, Pfizer, Roche were then only second tier (10-15 largest). In 2000, Pfizer and AstraZeneca jumped to top 5 (together with a merged GSK), and fast-forward to today, none of the top 5 names back in 1990 was still standing.

• The share price performance in the past 30 years of the largest Medtech companies outperformed by a large margin vs. the largest pharma companies and the S&P 500 index. (the top 4 lines are Stryker, Medtronic, Abbott and J&J). Interestingly, the big pharmas actually just about underperformed the S&P 500 index for the past 30 years or since they were listed!

  

The above two observations beg an explanation that I feel highlight one of the key structural difference between the two industries. In pharma, the process of drug discovery can be random, serendipitous and success is not guaranteed or directly correlated with amount of R&D spending. Furthermore, once a new drug has been discovered, the patent usually lasts for 20 years, during which the company needs to constantly pour large sums of R&D money, in the hope of stumbling upon the next big discovery.

If we look at the history of Abbvie, the success of a single blockbuster drug Humira can really drive the success of the entire company. Consider this: Abbott Lab (before Abbvie was spun out) bought Knoll Pharma in 2000 for $6.9bn and got the patent to Humira. Humira’s growth is staggering due to its ability to keep expanding indications to treat numerous different conditions (like a Swiss-Army knife). In the first full year of sales, Humira generated $280mn and it grew at a CAGR of 28% for 17 years(!), and in 2020 generated almost $20bn in sales, accounting for 50-60% of the total sales in Abbvie. A purchase price of $6.9bn for a lifetime revenue of $173bn and counting (What a deal for Abbvie!)

At Merck, the fascinating story of how the blockbuster oncology drug Keytruda rose like a pheonix from the ‘dumped’ pile of research pipelines to ultimately generating >$14bn in annual sales and accounting for 1/3 of Merck’s total pharma sales. What is more fascinating is that the drug was initially discovered in a Dutch company called Organon, and was totally not intended to treat cancer. In fact, the team set out to find drugs that would stimulate PD-1 protein to treat autoimmune diseases but ended up in the opposite direction of inhibiting PD-1. The research program went through two M&As before ended in Merck which designated it low priority and ready to sell away the program for close to nothing.

I will not be surprised that such stories abound in the drug discovery world, which ultimately means that drug discovery is not a linear process and hence it is entirely possible to see episodes of David defeating Goliath if a small biotech firm stumble upon a superdrug that drastically altered the competitive landscape. The long term success or failure of companies rest on the constant serendipitous discovery of the next novel blockbuster drug.

On the other hand, the medical device industry is a multi-disciplinary one that requires a combination of expertise from biochemistry, material science, precision engineering, fluid dynamics, etc. The R&D and improvement process is much more cumulative with new product launches relying on the foundations of earlier R&D work. As such, medical device discoveries generally progress linearly or in step-function. For example, many medical implants often started out as a 1st generation device and then subsequently launched a 2nd or 3rd generation products with better efficacy or clinical outcome. Furthermore, unlike drugs where it is either injected or swallowed, medical device companies have to consider ease of use and functionalities, and have inherent stickiness with the doctors once they get used to a certain brand and product features. As such, it is harder for competitors to ‘copy’ a medical device given the various moving parts and cumulative technical know-how in years of R&D and engineering (unlike in the pharma generics space where anyone can make the same drug once the patent protection is over). All these mean that each R&D dollar spent will ultimately translates to a stronger IP or sales for a medical device company vs. a pharma company, and such differences get compounded over time. In other words, medical device companies are able to constantly dug out a larger and deeper moat as they build up IPs and technical know-hows, which explains why the giants can remain giants for a long time in medical device industry.

4. 骨科3D打印逼近国际水平，突显研发能力

AK Medical has invested heavily in R&D over the years, and spends a larger % of sales on R&D relative to both domestic and global peers. This has resulted in higher number of patents across the orthopaedic portfolio, particularly so in the 3D printed field (note: Weigao and Double Medical have higher number of Class II devices due to their focus in trauma and spinal products)

AK Medical’s leading position in 3D printed orthopaedic implants is the key differentiator among the domestic peers, which I believe demonstrates its forward-looking vision and strong in-house R&D team. In 2015, AK became the first company in China to get approval on a commercial 3D-printed product, and in 2020 has in total 5 approved 3D-printed products - 3 standardized products in hip implants, artificial vertebral bodies and interbody cages, and 2 customized products in pelvis implants and cervical fusion. Though still behind the global powerhouses such as Stryker, I believe AK’s advances in 3D printed implants are catching up fast. From 2016-2019, 3D printed sales have grown at CAGR of 120%, and was flat in 2020 (123mn to 126mn) due to Covid-19. Margins for 3D printed products are higher and are outside the scope of the centralized procurement, given its niche and innovative nature. Government has in fact published clinical guidelines to encourage surgeons’ adoption of 3D printed products. This is a space to be closely watched once Covid and centralized procurement have settled down.

A key catalyst for adoption of 3D printed implants is a 3D surgical platform for surgeons to simulate and plan their surgeries, with inputs from a 3D clinical data. AK Medical, being the forerunner in 3D printed implants, has a proprietary platform called 3D ACT which helps lower the barrier of adoption for surgeons - from converting CT/MRI imaging to 3D models, to selecting customized or off-the-shelf implants and personalized instruments. I believe that as the cost of offering such personalized implants drop, more surgeons and patients (especially for revision or tumour cases where the surgery is more complicated to perform) will adopt it. It’s amazing to think that in dental braces we customized each brace to an individual’s teeth and mouth shape (and even colour preferences), while currently we shave off healthy bones and cartilages to fit standardized implant sizes.

Another key differentiation for AK Medical is its greater market share among domestic peers in both the knee replacement sub-specialty and the revision surgery market, both of which have higher technical barriers and currently still dominated by global firms. Knee replacement is currently severely under-penetrated in China and I expect it to outgrown the overall joint replacement market, hence placing AK at a much favourable position than the other domestic peers.

5. 骨科集采的未知与利弊，追根究底是概率问题

Volume-based centralized procurement (‘集采’ or ‘Jicai’) is one of the key pillars in CCP’s healthcare reform policy. Essentially, Jicai is a government-led (national, provincial or city-level) group-buy policy that guarantees the tender winners a specified minimum volume in exchange for price cuts. This procurement policy is not something new and have been experimented and tested in various ways, and applied nationally to generic drugs back in 2017/18, and lately to coronary heart stents in 2020.

Regarding the question of what medical devices/consumables could be subject to Jicai, various government officials have clarified their stance, and that there are a few key criteria before central or provincial governments will consider applying Jicai:

1. High clinical usage volume

2. High total reimbursement value

3. Relatively mature and clinical-proven medical implants/consumables

4. Medical implants/consumables with relatively strong competitive landscape

5. Relatively undifferentiated products with comparative clinical outcomes

With the above criteria in mind, it is understandable that orthopaedic products will fall into the ‘chopping board’ of the authorities. However, investors have to bear in mind what exactly is in scope for the Jicai, and how much does AK Medical’s sales fall under the blade. 3D-printed products (except for standardized metal 3D printed hip joint implants), revision surgery products, overseas sale, which collectively accounts for an estimated ~30% of total sales, will not be subjected to Jicai.

To fully appreciate why the CCP is taking such a drastic regulatory measures and understand their rationale, it will probably require a much deeper understanding of China’s healthcare system and the factors driving its development to date - political culture, economic history and societal norms. It is an fascinating discussion and I am still constantly learning about this, but will not elaborate it here (may require a full PhD thesis to lay out all the thoughts). Suffice to say, the core objective of the CCP is to lower costs for patients while reducing financial burden on the National Healthcare Security, and to achieve this by cutting middemen, reducing kick-backs and diluting purchasing powers from hospitals/doctors. To give two jaw-dropping examples,

1. A core hip implant component cost of production can be RMB900, ex-factory price increase to RMB3,000 (GP margin of 70%) and after a few layers of ‘distribution’, the final price that a patient pays can increase to RMB 25,000.

2. A drug-eluting stent (DES) costs about RMB 14,000 in China, while the same costs RMB 2,500 in Brazil, RMB 2,600 in India (capped), RMB 6,880 in France, RMB 8,000 in the UK, RMB 12,000 in US and Japan.

The above really begs the question of where did all the profit margins go, and also proves that manufacturers can probably earn a decent profit margin with a much lower end-user price.

The impact or uncertainty of Jicai on firms ultimately depends on two unknowns - % price cut and whether a company wins the tender (and how much volume vs. pre-Jicai). To understand the impact, it is useful to consider a 3x3 probability matrix and tackle each scenarios one by one, focusing on the downside cases. Investing, at the core, is trying to understand as accurately as possible the future probability cone and striking when the odds are in our favour.

The above are my best estimation of the likelihood of the various scenarios happening in Jicai, and what the impacts are on sales and margin. I think the impact of various scenarios on margins can be estimated with a fair degree of accuracy, but what the market is pricing in right now is the risk that price cuts are extreme (>90% as evident from the recent coronary stent national Jicai), and the uncertainty around whether a company (in my case AK Medical) will win the tender. Let’s tackle them one by one:

• On the likelihood of extreme price cut, it is worth noting that only in cases where price cuts are >90% will margins start to meaningfully deteriorate. This is not only because manufacturers have quite significant pricing room to absorb cuts but they can also shift their operation model to reduce distributors, opt for direct sales, outsource to contract service organisations, etc. such that there will be savings from SG&A which will partly mitigate GP margin decline due to ASP decline.

• Markets have generally priced in a >90% price cut due to the policy pressure from the highest level (and the fact that many local gov’t officials often try to implement a harsher interpretation of the state regulations to earn political ‘points’), and the precedent from the coronary stent Jicai was a slap in the face for many who still believe in a mild regulatory environment. However, there are three key differences between coronary stents (or even trauma) and hip/knee implants - 1) GP margins for stents or trauma products are higher to begin with (~80-90%) and the production process is less technically demanding, 2) domestic market share of stents is ~80% with import substitution largely taken place and pricing difference between imported and domestic stents are relatively small, and 3) coronary stents have less product differentiation. Hence, in such a relatively mature and competitive market, companies are forced to choose the lesser evil which is to go all out and bid for huge price cuts in order to capture market share. However, in the case of hip/knee implants, imported brands can costs 2-4x more than domestic brands and there are difference materials used in each implant system (metal, PE, ceramics, etc.) with higher technical know-how in terms of production, and I believe that such a competitive landscape will lead to a higher price floor and less fierce price-cutting battle.

• On the likelihood of AK Medical winning tenders, this is a risk that carries catastrophic consequences if it ever materializes (just take a look at Sinomed SH:688108 and its impact after falling out of the stent Jicai). This is also largely why the market participants (renowned for hating uncertainties) run for the emergency exit and watch how the ‘fire’ will play out first. To me, if we believe that the government ‘favours’ domestic firms, it is very unlikely that AK Medical, being the current leader in terms of volumes of implants sold, will not win most tenders. In fact, compared to coronary stents where there isn’t much market share to steal from imported brands, Jicai in hip/knee implants will be the real deal in driving the import substitution trend as mentioned above. Coupled with AK Medical’s strong R&D capability, quality products and KOLs/hospital networks, it is very unlikely that it won’t win a higher volume than before.

• On the question of whether domestic brands will suffer market share after price cuts. Consider this scenario - a RMB 60,000 imported implant vs. a RMB 25,000 domestic (a 35,000 difference) will become RMB 12,000 and RMB 5,000 (only 7,000 difference) after a 80% price cut. Will patients insist on getting the imported one since these things stay in their body for 10-15 years? It is a difficult question to answer but I believe the answer is not really. The arguments are: 1) Jicai dictates the volume for each brand that won the tender and hospitals have to fulfill the volume first, 2) based on historical usage, AK medical already has the largest implant share in terms of volume (~15% volume share but only ~7-8% in sales share) and won the trust of many doctors/patients, 3) reimbursement rate % still differs between domestic vs. imported brands, hence the above number becomes more like RMB 6,600 and RMB 1,500 out-of-pocket (difference is now optically more meaningful), 4) with a similar pricing dynamics, coronary heart stents and trauma implants are dominated by domestic products already, 5) quality of domestic products are shown to be close to, if not on par, with imported brands (quality difference doesn’t justify pricing difference).

Indeed, the recent rules announced on 21 June on hip/knee implant Jicai corroborated some of the above hypotheses. A few key points to note:

• Product groupings and the concept of ‘一品一策’: hip implants are divided into metal alloy-metal-alloy, PE-ceramic and ceramic-ceramic

• A/B Grouping to differentiate quality of manufacturers, which means less competition for those that managed to enter Group A (that will consists of the existing import brands), which AK Medical has a high chance of entering

• Larger than expected number can win the tenders (not like in many previous Jicai where many firms fight for a limited number of seats)

• Pricing includes the overall service delivery including instrumentation and accessories, transportation, ancillary services such as sanitization, etc. - this shows government’s thoughful policy-making and also illustrates the key challenges between a drug Jicai and medical implants Jicai

• Price is not the only determinant - this to me is the most critical shift in regulators’ mindset (possibly due to lessons learnt from the drastic price cuts in stents)

The above really demonstrates that the goverment is experimenting and tweaking their policies as they go, recognising the nuances involved in high-value medical implants, and the importance of supply and quality in addition to price alone.

In summary, one of my key insight into AK Medical is that the probability of AK Medical being hit significantly by Jicai is low while the market has priced in a much higher than expected probability. I am eagerly waiting for the Jicai results which is expected to be annouce in Sep 2021.

6. 带领管理团队的创始人是骨科外科医生起家

Founder of AK Medical is a man called Li Zhijiang (李志疆), who owns 46% of the company. LZJ appears to be a very low-key person with very little written or made public about him online. Before starting AK back in 2003, he worked as a Marketing Director for 2 years at another orthopaedic firm (北京天义福医疗器械有限公司) in Beijing, gaining experiences in sales and marketing. Prior to that, he worked at Stryker China from 1999-2001 as a Product Manager. Prior to that, he spent 11 years from 1988-1999 as a orthopaedic surgeon at 河北省唐山首钢矿山医院. LZJ once said in an interview that the best medical device product is always the result of the combination of clinical driven needs with superb product engineering. Indeed, if we look at the founders of leading global MedTech companies, they are mostly founded by physicians (Stryker, Abbott, Baxter, Intuitive Surgical). I believe that there is an edge in surgeon-founded MedTech companies due to better product development capability and clinically-driven R&D. The unique characteristic of medical devices is that though patients are ultimate end-users, in some sense doctors/surgeons actually are the key decision makers in terms of purchasing decisions and play a huge role in identifying clinical gaps and patient needs.

7. 国际视野与并购能力体现长远目光

Since listed in Jan 2018, AK Medical has stuck to its IPO plans of doing strategic M&A acquisitions. AK has acquired JRI in Apr 2018, a UK-based orthopaedic implants company founded >50 years ago, and Beijing Libeier in Apr 2020 from Medtronics China. I believe both acquisitions were the right strategic move by AK - JRI helping to acquire expertise in orthobiologics, shoulder implants and a platform for overseas expansion; while Libeier fills significant gaps in AK’s current orthopaedic portfolio (spine and trauma). Both acquisitions demonstrate management’s vision to be a diversified global player in orthopaedics, and I think both were done at reasonable prices (27x P/E for Libeier, JRI was loss-making and 1.5x P/B). Many companies fail at acquisitions or do it for the wrong reasons but I believe AK has proven its ability to deploy capital at value-accretive acquisitions (After consolidating JRI, sales grew from RMB 69m in 2018, to RMB 92m in 2019 while operating profits grew from RMB 230k to RMB 13.7m, though results fell in 2020 due to Covid.)

Some of the other key points highlighted in the announcement are:

• Reason for the termination is that Bytedance wants to bring all these info verification and client representative employees contractually in-house.

• Other services provided to Bytedance, including professional recruitment and BPO services will continue and be unaffected.

• From now until the end of 2021, the service premium paid by the customer will be reduced until the pending termination, and the impact on FY2021’s adjusted net profit from this termination will be a drop of 10% to 20%.

• Renrui plans to introduce a new product ‘HR SaaS’, a subscription-based service model which will allow its customers to subscribe to the Group’s proprietary HR management software (not much details are given)

• Despite the termination, business relationships with the other top 10 customers remain stable

As I wrote in my previous post, one of the biggest risks for Renrui is customer concentration. I didn’t expect it to happen so soon. I thought the probability of Bytedance to cancel its service will be very low, given that this part of the business is ripe for outsourcing and it makes much more sense for Bytedance to focus their resources on more value-adding areas. In the Investor’s call the next day, which happens to be a public holiday and markets are closed, Renrui’s management team kept reiterating that this is a one-off black swan event, and that the rest of customers are all fine. The call was somewhat reassuring and the tone of the management didn’t sound like they are defensive or trying to hide anything, but I can sense also that not many investors in the call are convinced, and there are doubts lingering around (maybe more a reflection of my own inner voice than what other investors really think).

After I gathered the data I need from the Investor’s call, I did a rough calculation to see what is the impact on sales and profit going forward. Adjusted NPAT was RMB 140mn in FY2020, and roughly RMB 90mn without Bytedance. Assuming a historical ex-Bytedance growth rate of 25% conservatively (the actual CAGR was closer to 30-40%), the adjusted NPAT will be RMB 110mn in FY2021, and RMB 140mn in FY2022. So if indeed this is a one-off black swan event, Renrui should see its profit back up to FY20 levels by FY22.

I was expecting perhaps a 30-35% drop in share prices when the market opens on Friday, but the cruel reality hit me right in my face. The stock opened down 45% and quickly moved to almost down 50%. As a result of Bytedance’s termination, half of the company’s value evaporated in a few hours.

As I settle into deep thoughts on what I should do next (honestly there are only three options – dump all, sell some or hold), I was reminded of the imaginary person Mr. Market and his all-too-often manic-depressive nature. I can see why people want to run as fast as possible to the emergency exit, and I can also see why that may not be the wise move and that the fire was a fake call. Here are my half-empty and half-full view of what the future may lie:

The Half-Empty View

• The loss of Bytedance is not merely a loss of revenue, it is a strong invalidation of the core fundamental business model for Renrui – one that provides tremendous value for clients in the fast-growing unicorn startups and the unique demands of the new economy. The loss can be interpreted that either there is no real value in its services, customers can easily switch providers, or that once its revenue scale to a meaningful size, the customer has incentive to cut costs and bring it back in-house.

  • ]This view will imply that all the flexible staffs deployed to other customers, particularly in the role of info verification and customer services, may be on a flimsy ground

  • A loss of such prominent player in the internet space will mean that Renrui’s credentials and reputation may be scarred – e.g., can they still get Kuaishou if they want to?

  • I suspect this is the main factor that cause share price to halve, as anything else is secondary once the core business model is fractured.

• The tremendous growth over past 3 years was driven in a large part by Bytedance. Given this loss and the shaky business foundation, the growth of the remaining businesses may slow down and the entire theses riding on fast-growing unicorns may not stand, and hence valuation multiple needs to be re-rated.

• Although the management team also recognized these shortcomings and has started to reap results in other areas such as BPO and ITO services, it may not take off as quickly as flexible staffing, and hence hard to fill up the ‘hole’ left by Bytedance.

The Half-Full View        

• This is indeed a one-off black swan event that could hardly have been prevented, and could happen to any other B2B businesses with large customer concentration. Few postulates that I have in mind on why Bytedance decided to do this:

  • Bytedance’s internal strategic review concluded that they want more control over its employees and create a better culture among employees (there are a lot of complaints online about whether an employee is a bona-fide Bytedance employee or not). However, this reasoning is least strong given that these info verification and customer rep employees are really administrative functions and may not even sit together with main employees (hence less culture issues).

  • Decision was driven from a pure cost cutting initiative, and because they have determined internally that these employees are more or less needed permanently, hence it’s better to do it in-house rather than give the 10% service premium to a third party like Renrui. This argument is also flimsy as they will need a much bigger and stronger HR team, which eats into the savings (not to say the amount of additional time and resources needed to recruit, onboard, train, exit, etc.). Assuming that they indeed can save all the premiums, would a company with FY2020 sales of USD 34bn and operating loss of USD 2bn want to go through the hassle to just save USD 15mn? Not impossible, and perhaps this is also a result driven by the recently joined CFO Chew Shou Zi from Xiaomi?

  • The most probable answer, in my opinion, is perhaps due to regulatory requirements and tighter scrutiny among internet giants by the Chinese government. As a result of recent uproar due to Meituan’s delivery personnel not having social security payments (五险一金), government has probably initiated a list of investigations into these ‘new economy’ employees to ensure proper adherence to social security payment. Bytedance, learning the lesson in Meituan (whose share price plunge due to this saga) and in its preparation of the highly anticipated IPO, wants to pre-empt this issue and decided to ensure they abide by the government’s regulations. Although Renrui claimed that they pay all these flexible staff 五险一金, it’s hard to enforce totally and the only way to ensure 100% compliance is to bring them in-house, given the reputational risks involved.

• If we buy into the argument that this is indeed a black-swan event, then this loss may only be a short-term pain which the company can recover and fill up the hole in 2 years. In fact, this may even turn out to be a positive event for the company long-term. Why is this so? Because it forces Renrui to focus on the higher value, higher margin business of professional recruitment, other higher salaried roles, BPO services, ITO services and HR SaaS.

  • This is especially true because delayed gratification is hard, both for humans and for businesses. It’s hard to reject and forgo easy revenue from Bytedance, even though it may not be beneficial in the long run.

• As confirmed by the management, there is no additional impact on the costs or any form of compensation needed, and no need to redeploy these manpower.

• The fact that Bytedance didn't switch suppliers and wants to bring those employees in-house meant that this decision is not due to poor service by Renrui, which are more detrimental to the business model.

• If we think of the intrinsic value of Renrui in 2 years’ time, where it no longer has a ticking bomb of customer concentration from Bytedance, a much mature and growing BPO and ITO business segments, overall moderate growth of 30% CAGR both topline and bottom line, would it deserve the current valuation of RMB 1.5bn, cash of RMB 1.1bn and implied ex-cash P/E and P/FCF of 3-4x?

• There could be an upside as they have hinted some M&As brewing and looking to close in H2 2021, though this is not something that any investor can count on until it’s announced. It could also go both ways depending on the target being acquired.

The key lesson for me here is to always think of second order effects of a big risk happening. To be completely honest with myself, I didn’t spend much time thinking through the possibility of Bytedance terminating their service, and what that will imply. The first order impact is loss of revenue and profit, but the second order impact is the crumpling of the business foundation in the minds of investors. Have I thought more deeply about this issue, I may have tried to find out more from people working in Bytedance or speak to people in the industry to understand the stickiness of the business model.

As it stands, given the facts now I am not able to have a firm decision on either the half empty or half full view. I plan to closely watch for more facts and data from the Interim Report to help me decide on the next course of action. I still do trust the management team and have confidence in them, but the brutal reality of capitalism spares no one.

• Do I understand the business well?

• Is the company likely to enjoy sustainably higher earnings in five to ten years’ time?

• Do the founders or management team display a long-term oriented mindset, sense of integrity and good capital allocation skills?

• Is the price attractive relative to the intrinsic value?

In this post I will document the thought processes behind my decision to buy Renrui HR (HK: 6919), which I initiated the purchase from Dec’20 to Jan’21 at around HKD 26.

Business Introduction: Founded in 2010, Renrui is a leading HR solutions provider in China focusing on providing flexible staffing solutions to many large corporates and fast-growing unicorns. From 2016 to 2020, Renrui has grown at a staggering 66% CAGR, reaching RMB 2.8bn sales in 2020, driven from rising demands from its fast-growing customer base and its ability to leverage technology to deliver better value to customers.

Summary of my investment thesis (TLDR version):

1. A leading player in a large, fast growing but underpenetrated market – 3-pronged growth engine driven by i) overall economic and employment growth in China, ii) increased penetration rate of flexible staffing and HR outsourcing, and iii) rising market share amidst industry consolidation

2. Carved a strong niche in the fast-growing unicorn startups sector, with attractive optionality in other related HR or BPO services

3. Focused on providing value to customers through its technological platforms and ecosystem, creating a network effect connecting employees and employers

4. Low margin is deceptive; Strong return on invested capital

5. Led by a visionary ex-Huawei HR veteran and core co-founding team from ChinaHR.com, management has so far proved to be strong, hungry, honest and incentive-aligned.

6. Aligned with government’s policy directions and generally supportive regulatory environment

7. My estimate of intrinsic value yields around HKD 50-70 per share

Key Potential risks and concerns:

• With AI and machine learning progressing leaps and bounds, there is a risk that increasing automation of mundane or manual jobs will drive away the need for those jobs (data verification, customer service, call centres, etc.) that rely on flexible staffing

• Customer concentration – largest customer Bytedance consistently contributes >30-35% of sales

• Large scale VC capital market crash with many startup customers laying off workers and changing attitude towards rapid hiring and expansion

  • Company experienced the Mobike debacle but impact was minimal

• Reputational risks from mistreating its contract staff, or understating costs (social insurance)

• Lack of evidence for strong M&A execution capability

• Ability to attract right talent and maintain strong corporate culture as the company grows

1. Leading player in a large, fast growing but underpenetrated market

According to CIC Report in the Prospectus, overall HR outsourcing services market has been growing historically at ~20% p.a. from 2014 to 2018 and reached c.RMB 200bn in 2019. This trend is expected to continue going forward, with the flexible staffing sub-segment leading the growth at ~25% p.a.

With little understanding of the HR sector, I was initially surprised by such a fast industry growth rate. I now believe there are two key factors that explains the growth rate and why I think this rate can be sustained.

• A key macro theme over the past decades in China has been the underlying structural shift in China’s economy from agriculture and manufacturing driven to one that is services and consumption driven. If we look at the data from OECD and World Bank, services-producing industries account for an overwhelming share (>80%) of the total employment added.

• Under the backdrop of this structural shift is the second largest economy in the world growing at a fast pace for a very long time. Such vibrancy in economic growth, coupled with continued urbanization, means large number of companies and jobs are being created in those sectors that demand the kind of talents and skills that require HR services and outsourcing.

  • Think tech companies like Alibaba, Bytedance, Meituan, or retail companies like Miniso, Haidilao, etc. and their supporting industries like logistics, customer support, call centres, data verification, etc.

The ratio of flexible staff to all employees in China is <1%, compared to developed countries at mid to high single digits. As China continues to move away from manufacturing-oriented economy to more service and consumption-driven economy, the penetration rate is expected to continue rising to the level similar to the more developed economies.

Renrui’s current market share in flexible staffing is c.2-3% in terms of number of staff and c.3-4% in revenue, and is the top player, with a close competitor Manpower Group China (HKSE:2180) slightly behind. Industry is highly fragmented in China with the top 5 players only accounting for <10% in terms of sales revenue. In contrast, top 5 players in developed countries with longer history and more mature staffing and HRO services usually command 20% or more market share. This bodes well for the ‘big gets bigger’ story for Renrui.

2. Carved a strong niche among the fast-growing unicorns, with upside optionality

Renrui first started out as a training school in collaboration with colleges to train prospective job seekers in customer service skills and then offered them jobs in Amazon. As Amazon expands in China, its demand for customer service roles exploded and Renrui landed its first large recruitment process outsourcing (RPO) contract with Amazon. With a global player such as Amazon providing a strong credential and seeing the opportunity in the fast-growing startup scene, Renrui has managed to speed up its growth and widen its customer base, mainly focusing in customer service.

The next breakthrough happened in 2016 when Renrui worked with Bytedance to help them with flexible staffing solutions on information verification roles due to their large volume of UGC. This quickly grew exponentially given Bytedance’s mind-boggling growth in recent years, and Bytedance is now the largest customer with almost 40% sales in FY2020.

Such a growth story reminds me of a core concept I recalled in the book “The Innovator’s Dilemma” by Clayton Christensen. The author describes how disruptive innovations often first take root in some niche areas of a market where the margins may be too low, returns not as attractive or inconsequential to the large incumbent players. This then allows a new player to come in and experiment with new ways of doing things, gradually innovating and improving on its products or services which eventually redefines the industry or grab the market share from the incumbents. In a similar fashion, among other HR services market, Renrui chose to first enter the low margin business of flexible staffing in the low-value staffing roles (customer service and information verification) but managed to build its reputation, established the platform and systems for growth and now become the leader within the fast growing flexible staffing sector. In the FY2020 reports and result briefing, management made it clear that the company will next focus its resources on growing both the BPO business and the IT Outsourcing business, which have higher margin and more sticky.

I believe with the core operations growing and a strong niche footing, Renrui has many options to grow. Just like how Amazon started out with selling books online (a niche vertical) and then selling everything under the sun, Renrui can gradually penetrate and compete in other industries (from ‘new economy’ to retail or finance sectors), or move towards higher margin placements (Company’s recent strategy towards IT Outsourcing or placement of engineers), or follow clients such as Bytedance in their overseas expansion (which they have started to do), or totally new HR service offerings (HR software, compensation & benefits, HR consulting and training, etc.). Management has also indicated their intention to acquire companies who can provide more tech-enabled capabilities which can help them source for more candidates, provide AI functions or improve existing operations. It will be interesting to see their first M&A announcement, which can provide a good flavour of how management allocates capital and thinks about future growth strategy.

I do acknowledge that I maybe a victim of representative heuristic bias here, and that the above association or extrapolation may only be my own hypotheses. I try to remind myself not to place too much weight into the positive association or be carried away by my own connections between the dots, I hope the damage from falling into such a bias will be minimized. I always try to focus on management’s ‘actions’ taken and I do hope that time will prove me right.

Side Note: More on ‘Information Verification’ jobs

Information verification, or what the West calls content moderation or human moderation, is a totally new type of role being created due to the internet economy and social media platforms. Basically, the job of a content moderator is to ensure that user generated content (UGC) being uploaded to a platform abides by the rules and regulations of the country. Typically, it means go through a vast amount of pictures or videos to ensure there is no violence or abusive content, pornography, cyberbully, and in China, political sensitive topics.

These roles have come into the spotlight recently due to various reports in the US of content moderators working for Facebook or Youtube developing depression and post-traumatic stress disorder symptoms due to their constant exposure to explicit, sadistic or violent content.

It is fascinating that despite all the money being poured into researching AI and facial recognition by the leading startups and internet giants, machines are still pretty poor at content moderation, often being over-zealous in its algorithms which leads to incorrect takedowns. Youtube has notoriously said it will bring back more human moderators in Sep 2020 after less than a year that they said will rely more on AI and machine learning to filter out content. This admission of failure by a leading internet giant looks like a huge slap in the face of the seemingly all-encompassing AI technology. I believe that it will really take time for AI technology to improve to a level where it can replace human totally. Meanwhile, machines and humans will have to work together to filter out the growing UGC content.

3. Focused on creating value to customers

In general, for any stock I research about, I always try to understand what exactly is the value that the company is providing to its customers and society in general. I always try to look out for companies or founders who are fanatical about creating value to its customers. In Renrui’s case, I believe the key value proposition lies in its ability to efficiently recruit, deploy and retain employees for its customers as the business needs of its customers grow or change. In today’s fast-pace and dynamic environment, companies face tremendous HR challenges as they grow organically, face greater regulatory oversight or shift strategic directions. Outsourcing part of the HR functions allows them to stay lean and agile, keep overall costs down, drive higher efficiency, transfer contractual risks and keep up with growth.

One of the key insights I derive from studying the company is that, on a macro-economic level, the core value proposition of a business model such as flexible staffing or RPO is to transfer repetitive but important HR tasks from a non-specialist entity (most companies do not see HR as a core activity) to a specialist entity whose bread and butter is HR. Economies of scale dictates that a specialized entity should always be more efficient in delivering the output. Like many other established corporate outsourcing industries (IT, payroll, accounting, marketing, etc.), the mental model I have for Renrui is one where it becomes the permanent extension arm of many corporates’ in-house HR department, aggregating and matching the supply and demand of various companies/employees.

Renrui has over the years leveraged on technology and built a series of proprietary software systems and platforms to have a fully integrated HR ecosystem, comprising of the following:

• Xiang Recruitment App (香聘) – O2O app portal for job seekers to search for openings, schedule interviews and for employers to post job listings, which acts to increase talent pool.

• Rui Recruitment System (瑞聘) – internal portal for Renrui’s employees to manage the entire recruitment process of each project and has built-in analytical tools and algorithms to tag individuals’ CVs and job preferences, and conduct smart matching in real-time.

• Rui Cloud Management System (瑞云管理) – a core web-based SaaS portal accessible by clients, Renrui’s employees and contract staff (via Rui Home Platform) to conduct all administrative tasks (e.g., leave application, overtime records, attendance checking, checking salary payments, etc.). As a value-add to clients, Renrui offers module customisations and allows docking of the portal to link the system to clients’ existing HR data to increase efficiency.

• Rui Home Platform (瑞家园) – one-stop interface built on WeChat Public Account for all contract employees of Renrui to perform admin functions (e.g., leave application, key personal data), network with other employees (via chat groups and internal short-video platform Xiami Video), and offer referrals to get rewarded.

• Integrated Contract Management System – underlying central database and backbone that standardize all contracts and data warehousing to enable the above applications

I believe the self-developed systems and platforms provide a certain level of “moat” in that Renrui is able to deliver its services (recruitment, onboarding, retention, etc.) faster or better than its competitors, and Renrui’s technology development centres around maximizing efficiency which is more practical. This reflects in the lower attrition rate (from 2016-6M19, an average ~10% of flexible staffing employees departed or were terminated before the end of their contract term vs. industry average of 15-20%) and client renewal rate of 100% for those clients with revenue of >$1m.

Side thoughts on Xiang Recruitment: On Xiang Recruitment app, I looked through the Zhihu comments and generally feedback is negative on the app and the company (with most comments along the line of not being transparent that they will be signing contract with Renrui rather than Bytedance, and interview process not being run properly, etc.). On one hand comments like this on forums/Zhihu are always selective biased, but it still provides some context into whether various stakeholders are being well served by Renrui. It would be much helpful to hear comments by customer’s HR personnel but I wasn’t able to find them.

On the statistics of the app, according to Qimai (七麦), Xiang Recruitment also ranks poorly as compared to other aggregator platforms such as Zhaopin or 51jobs, with monthly downloads and active users being small and growth slow. However, this doesn’t concern me as much because i) they are not directly competing against these other online job portals; ii) they didn’t spend the kind of marketing and lead generation expenses; iii) they are targeting a subset and rather niche segment for lower-skilled workers

4. Low margin is deceptive; Strong return on invested capital

Renrui’s GP margins are low at ~10-11% and operating profit margins at ~5-6%, which is lower than other competitors due to their higher mix of flexible staffing in lower-skilled workers. However, their flexible staffing margins is equal to, if not slightly higher, than industry average. Most people may have likely dismissed such a business arguing that a low GP margin business naturally means that the competition is fierce, switching costs are low and bargaining power is limited. This kind of System 1 thinking and jumping to conclusion can be costly (just ask those early investors who miss out on Costco).

My analysis suggests a rather different picture. Renrui’s flexible staffing business model operates in such a way that the Company only executes and mobilizes resources to hire staffs after a customer confirms the staffing requirements, pricing and contract terms. In the language of a manufacturing company, it is often called “make-to-order”, which means the company doesn’t need to stock up inventory to fulfil its customer orders, and only starts production after they receive purchase orders from their customers. Companies blessed with such a wonderful business dynamic are rare in the manufacturing world (usually reserved for big ticket items or ultra-luxury products – Boeing jets or Birkin bags?). Such a business usually means cashflows are good with low working capital requirements, which indeed is the case for Renrui.

There is a risk of clients terminating their entire contracts mid-way, which releases a large number of staff but historically the number has been kept at ~1% termination rate. In such scenarios, the client will have to provide prior written notice (which gives time for Renrui to plan its labour pool deployment), and pay them a liquidated damage and as well as compensate for losses. The other risk lies in the client terminating the contract staff due to performance issues (historically between 1-2% of all flexible staff are being terminated due to performance reasons). The bigger issue, which Renrui is well-aware, is the turnover rate of contract staff as Renrui typically offers free replacement services. This is a key operating metric that the management team monitors and has been trending downwards. In any case, Renrui retains the discretion to terminate its employment contract with the staff in accordance with the local employment laws and regulations.

In summary, Renrui’s flexible staffing model has a clear mark-up of 12.5% service fees on the total staff labour costs, with very minimal idle staff lying around under the payroll of Renrui. As Renrui gets bigger with numerous clients in various industries, geographies and seasonality, it should get easier for Renrui to manage its labour pool for redeployment. This then essentially boils down to one key performance metric – number of deployed flexible staff. In praise of management’s transparency, the company discloses this number every single month since Sep’20 and the rebound in numbers since Covid has been spectacular (>40% yoy growth every month since Nov’20).

It is no surprise that the ROIC is exceptionally high for such a business at ~100-110% for 2019 and 2020. In fact, this business requires little capital to generate returns, and the question is whether the company can continue to find new customers and grow with its existing customers, which I believe the industry tailwinds and consolidation as mentioned above bode well for Renrui.

I would be careful to draw parallels between Costco and Renrui, but I do believe that they share some similarities in that both have loyal or sticky customers (though Costco is much stronger with memberships), both have low margins (fixed mark-ups) but can grow like a clockwork through constantly delivering value to customers, large addressable market, and opportunity to improve margins through sales intensity (in Costco’s case it is sales per sqft whereas for Renrui it is number of flexible staffs per each internal employee). If we look at the efficiency ratio (defined as EBITDA divided by GP), you can clearly see the benefits from economies of scale.

I believe a really exciting aspect of Renrui is that in addition being able to continue growing its core RPO business for ‘new economy’ clients in the info verification and customer service sectors, as Renrui continues to explore other optionality, its margins will inevitably go up. Hence, I do see a double impact on future profits from both revenue growth and margin improvements.

5. Strong, Driven, Honest and Incentive-aligned Owner-Operator

Renrui first came into my radar from my general reading. I remembered being first intrigued by its superb growth and falling share price, but what really captivated me and made me delve deeper into the company was when I read about the company’s founder. I always love to read about the life experiences, career choices or past interviews of company founders. Short of being able to meet with them directly, I believe these anecdotal information does give a view of the competence and personality of the founder.

Renrui was founded in 2010 by Zhang Jianguo (张建国, or ZJG), who has >20 years of HR experiences and is one of the early pioneers in the internet HR industry in China. Among the numerous successful founders that China has bred over the years, ZJG’s experiences and credentials still stand out.

In 1990, like many young Chinese during that era who dreamt of striking it big post China’s economy opening up, ZJG left his comfortable job as a university teacher in Lanzhou and ventured to Shenzhen to find a job. He landed in a 3-year-old company called Huawei as the 25th employee (Huawei now has ~200,000 employees!). In his 10 years working in Huawei, he was put in various roles from Sales, Product Development but eventually settled on HR, and was instrumental in his contribution to the management philosophy of Huawei (“华为基本法”).

Like many other great companies, Huawei’s unique culture and HR strategy undoubtedly contributed to its success. Many of its ex-employees also went on to start their own business and became very successful. In ZJG’s own words, by participating in such a tremendous growth story of Huawei from 25 employee when he joined to 20,000 employees when he left, he has encountered and helped solve practically all management and HR problems one can imagine in a fast-growing organisation. I believed his formative years in Huawei has helped shaped him into a great leader and manager.

After Huawei, ZJG started to find his next challenge and went on to work in a few HR consulting firms as the General Manager, advising many corporates, large and small, in China. Around 2004, Cathy Xu (徐新), the investor of ChinaHR.com and later became one of the most successful VC investors in China, headhunted and persuaded ZJG to take on the CEO role of ChinaHR.com. ChinaHR.com, though was the first internet job search portal in China, was experiencing slowing growth and facing tremendous competition from Zhaopin and 51jobs. ZJG accepted the challenge. From 2004 to 2009, ZJG managed to turn around ChinaHR.com and grew both sales and profits, which eventually led to the full acquisition by Monster.com. This experience exposed him to the fast-pace internet-based HR economy and its competitiveness, while also learning from the best-in-class from a global powerhouse (Monster.com invested 40% in ChinaHR.com in 2005 before acquiring 100% in 2008).

Another key anecdotal evidence of ZJG being a great visionary leader is that two of his ex-colleagues in ChinaHR.com, Zhang Feng and Zhang Jianmei, are willing to quit their jobs to join him as co-founders of Renrui. Zhang Feng is now the COO of Renrui while Zhang Jianmei is the Sales VP. Both of them worked very closely with ZJG back in ChinaHR.com. According to the prospectus, ZJG gave each of the two co-founders 58 million shares, roughly ~4% stake.

ZJG is also well-regarded in the HR industry in China, seen as an industry veteran particularly in the new model of flexible staffing, and has published a couple of books on HR strategy and management (经营者思维—赢在战略人力资源管理) and Flexible Staffing (灵活用工——人才从为我所有到为我所用).

Though it still remains to be seen as company was only listed in Dec 2019 with limited track record, so far ZJG has came across as a visionary leader, curious and driven, embodies the highly successful Huawei culture, proven turnaround as a CEO, and has a close-knitted and strong founding team. All of these gave me comfort that Renrui has a strong management team and company culture.

6. Regulatory support and policy alignment

From my understanding of the Chinese government’s political culture, ensuring good employment growth and supporting job creation rank high on the political agenda and are key considerations in policy-making. As such, in recent years we have seen the government announcing new employment policies and regulations that support flexible staffing sector, particularly in response to keeping up demands of new economy sectors. There are numerous government releases or speeches touting the need to support the industry1. For example, in July 2020, Premier Li Keqiang said the following:

“要取消对灵活就业的不合理限制，引导劳动者合理有序经营。”

“过去很多人一讲就业就是‘固定工’，现在要转变这种观念”

One of the major risks when investing in China are regulatory risks, which can often be unpredictable (think Ant Financials or Alibaba recently). Although I am not an expert in employment law in China nor have I spoken to any experts on this topic, I believe this sector’s risk exposure should be low.

In this post, I want to share with you my thoughts on what makes a great investor. Given that in the investment management business there are indeed many different ways to skin a cat, what I want to focus on is what makes a great stock market investor. I believe a great deal has been written about this topic in one form or another, be it in books, annual letters, blogs or interviews, but somehow I find myself not able to distil into a few core ideas or a guiding framework. This post is the result of my attempt to answer this question, in the hope that it can be easily remembered and serve as a guiding framework for the never-ending quest to be a better investor.

First and foremost, I want to allude readers to the keyword in the title of this post – traits. By definition, a trait means some quality or characteristic that a person possesses, and it is behavioural in nature. In my opinion, what truly separates the great from the good in the investing game are not skills (as in mastering the perfect golf swing), not know-how (as in learning a secret Bolognese recipe that nobody else knows) and not even talent (as in having a photographic memory), it is a combination of traits that a person possesses which will ultimately, over a long period of time, determine how successful is the investor. Most investors know the strategies or principles that underlies value investing. I am sure most investors can regurgitate with precision many timeless quotes by the Sage of Omaha such as “be fearful when others are greedy, and greedy when others are fearful”, or “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, etc. We all know them but it’s damn bloody hard to do them. It is obvious to me that traits are precisely what will help an investor to do them well. This is because having some particular desirable traits determine what actions an investor takes during market euphoria or panic, whether he stays within his circle of competence while constantly widening its boundary, whether he holds on to the winners or sell too early, whether he consciously tries to avoid misjudgement and biases, etc.

“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments.” – Charlie Munger

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffett

Before I go into what I think are the most important traits of a great investor, I want to introduce the concept of ‘dualism’ in investing. By dualism I mean having two seemingly opposing but complementary qualities at the same time. It is akin to the Yin (阴) and Yang (阳) in the ancient Chinese philosophy. Having too much of one element without the other is not ideal and often leads to bad outcomes. The key is to find the right balance between the two elements and I believe this concept applies equally well in investing. While there are many counterintuitive behaviours that each investor has to grapple with on a regular basis, for me by far the most important ones that I strive to keep working on finding the right balance are the following three conflicting but yet complementary dual-traits:

1. Patience and Aggressiveness

2. Confidence and Humility

3. Daily Discipline and Long Term Mindset

I shall delve a little deeper into what I meant for each of the above and provide some thoughts.

Dual-Trait 1: Patience and Aggressiveness

Most investors understand the importance of patience in stock markets. In essence, patience requires inactivity. Patience means letting time be your best friend. I believe there are three key situations where patience demonstrates the utmost value:

• Prior to investing and waiting for the perfect pitch right in your strike zone;

• After investing and waiting for your thesis to be proven; and

• After investing and letting it compound for a very long time without interrupting.

I suspect most people may viscerally associate the idea of patience to the first situation, but I think the second and third situations are equally important, and require no lesser amount of patience to achieve them. This association may well be expected since the first situation is what most people experience easily (e.g., bought too early, chasing the momentum, demanded less margin of safety, etc.) and the feedback loop can be very fast and hits the investor hard. Patience in the first situation will often allow a good margin of safety which is an important first step in achieving great results. However, for an investor it is important to bear in mind that excelling in patience for the first situation alone is not enough to yield the great investment returns over a long period of time. If anything, one may argue that among the three situations, patience in the third situation, or the lack thereof, will have the most impact to your portfolio returns over a long period of time. Although I haven’t had the luxury of time to ‘prove’ the third situation with my own portfolio, numerous great investors have often said that one of their biggest mistakes is selling winners too early.

After talking about yin (patience), it is equally important to talk about yang (aggressiveness). To me, there are two key areas of aggressiveness in investing – strike big when the odds are in your favour, and sell without hesitation when the investment thesis changes or you find yourself committed a mistake. I think both are equally hard, and the key to achieving them are confidence (more about this later) in knowing whether your thesis is right or wrong, and removing emotions out of the markets.Indeed, how many times have you heard people saying that they have lost half of their investments in a stock but, for no good reasons, just want to hold on to ‘recoup’ the losses? People mistakenly judge that by not realizing a loss position it somehow does not become ‘real’. Loss aversion bias can really muddle a rational mind. The market doesn’t care what your entry price is and it doesn’t always have to mean revert. The question I always pose to them is: “If I give you the same amount of money as you would have by selling the stock, would you take the money to buy it again having known what you know about the stock and all the opportunity costs?”.

Dual-Trait 2: Confidence and Humility

By now it should be evident that the three ‘dual-traits’ I mentioned above are somewhat inter-connected. For example, you need confidence in order to be aggressive when market panic sells, and you need confidence to hold on and be patient while waiting for your thesis to be proven by the market. However, blind conviction can be lethal. You need to have confidence and be right. The being right part of the equation means fully understanding the business and industry dynamics, doing the detailed research and analysis, thinking deeply and widely about the company’s moat and future earning power, etc. One question I always ask myself: “How do I know whether my confidence is well-warranted or half-baked?” This is a tricky question and I don’t have a good answer. It is tricky because unlike in competitive sports or other skilful crafts, you know you are good when you beat your competitor or when most of your audiences love your performance. In investing, you can make the wrong decision or have false confidence but yet the market rewards you (or vice versa). The feedback loop is not direct and often can be misleading. On a short timescale, it is hard to attribute whether great investment performance is due to luck or skill. This is why a minimum of at least three to five years of track record is needed to judge an investors’ proficiency. The self-awareness needed to critically evaluate the question of whether your confidence is well-warranted is something that improves with time.

On the other side of yin-yang balance is humility. To me, humility means being open to many different views (especially an opposing view), always strive to be a learning machine, always seeking out the truth and admitting your own mistakes. I am a strong advocate of humility and believe being humble will lead to many good things. It helps you to keep emotions and ego in check, helps you to stay rational and focus on what is important, and helps you to stay within your circle of competence. If an investor wants to outperform the market, by definition you have to be contrarian and right at the same time. Humility is what helps you to increase the chances of being right.

When people describe the quality of others, it is seldom described as both confident and humble. This is because both qualities are at odds with each other. If I had to choose between the two, I would rather have humility than confidence. This is because the former reduces unforced errors, loss of capital and allows compounding to work its magic while the latter will contribute more to making you from good to great.

Dual-Trait 3: Daily Discipline and Long Term Mindset

On daily discipline, as with investment gains, it serves well to keep reminding myself the power of compounding. 1% better every day will lead to 37.8x better after a year. Although this may seem like a cliché quote from a self-help book, but no doubt it is a powerful illustration of compounding. To me, the keywords in that quote are not the numbers, but the three words “better every day”. It doesn’t matter how much better (for that matter it may not even be quantifiable), be it 1% or 0.1%, but the important thing is the direction and the discipline to keep doing it every single day. To me, being better every day means learning something new or being a little wiser every day.

“Spend each day trying to be a little wiser than you were when you woke up. Day by day, if you live long enough like most people, you will get out of life what you deserve.” – Charlie Munger

Daily discipline is tough in investing because when it comes down to the day-to-day activities, investing is just miles away from being an exciting sport. Warren Buffett has famously said that he spends an estimated 80% of his working day reading and thinking. It is this seemingly “sit there and do nothing” activity that information gets internalized, knowledge gets compounded and occasionally an investment insight can be found. Often times I find myself spending hundreds of hours researching and thinking about a business but in the end didn’t managed to pull the trigger. It is easy to fall into the trap of action bias, thinking that all the efforts and hours of research are ‘wasted’ if I do nothing. The truth is that all the knowledge and research, if well thought through and synthesized, gets compounded and eventually expands your circle of competence. Daily discipline means the ability to resist all the market noise, macroeconomic news, daily price fluctuations, and to focus on what is important – getting better every day.

In today’s investing world, I truly believe that having a long term investing mindset is a major competitive advantage. Looking at the decline in average holding period of stocks over the past decades and the 52-week highs and lows of the largest S&P companies in any given year, you will have no doubt that most market participants do not operate with a long term mindset. So why is long term mindset so important? Because it forces you to ask the most critical questions that underpins the long term intrinsic value of a business. A long term mindset helps you to make the right decisions easier. Will the company’s earning power be significantly better in 5 to 10 years? Are you comfortable buying the stock if the market closes tomorrow and re-opens 5 to 10 years later? Daily discipline with a long term mindset will help an investor zoom in on the most critical questions that matter.

Perhaps the best analogy of this dual-trait is that of a marathon runner who does not know the finishing line. If you tell anyone to keep running every single day but doesn’t tell him where the finishing line is, I wonder how many people will start running. That is why long term investing is so difficult. That is why you have to be more interested in the process of reading and thinking (running), and not only the pot of gold at the end (the finishing line).

Concluding Thoughts

You may wonder, for each of the dual-traits, what is the right balance for you as an investor? For that matter, what’s Warren Buffett’s right balance? Should you try to figure that out and just emulate his balance? The answer is obviously no. This is because each person’s right balance is different. Each person is born with a different set of DNA, different experiences and upbringings, influenced by different schools of thought and hence have varying disposition in each of the dual-traits. For example, for someone who is born to have patience and enjoy ‘watching the paint dry’, his right balance may well tilt heavily towards the aggressiveness scale.

This reminds me of an analogy from physics. In thermodynamics, the triple point is the temperature and pressure at which solid, liquid, and vapor phases of a substance can all coexist in equilibrium. Each substance has a different triple point, for example, for water it is ~273 Kelvin and ~612 Pascal while triple point of hydrogen is at ~13.8 Kelvin and ~7 Pascal. Similarly, to achieve the right balance of yin and yang in investing, there isn’t a fixed ideal balance for every investor. The ‘triple point’ ought to be different for each investor based on his or her DNA make-up and cumulative experiences.

So in conclusion, there they are, the traits that I feel are most important in the path of being a great investor. This is the framework that guides my thinking and actions, and one where I constantly strive to find my own ‘triple point’ among these three dual-traits as I continue rolling my snowball journey along the slope. Hope you guys enjoy this post, comments and thoughts are more than welcome!