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Chinese Stocks Have Had a Rough Year

Here are two ways to take advantage of the dip. In addition, we talk: U.S. stocks, Bitcoin, Cannabis, and a podcast recommendation.

Quote of the Day

An analyst on Apple's earnings:

"Even though revenue and earnings numbers may be good, a lot of those eye-popping growth numbers were already known and expected this quarter."

-Darrell Cronk, CIO of Wells Fargo Investment Institute

Our view: The best companies don't always make the best investments. The price you pay matters.


Chinese Stocks

After a crushing year for Chinese stocks, investors are turning to options to bet on a comeback reports the WSJ (paywall).

What's going on?

  • Chinese stocks have suffered in 2018. Two reasons cited by investors are the trade war with U.S. and poor company fundamentals.

  • Bullish options on the most popular Chinese ETF, iShares Large-Cap China ETF (FXI), reached the highest level in 5 years as investors bet on a turnaround.

Follow the money

Fred Ruffy, an analyst at Trade Alert, said some institutional players are positioning themselves for an aggressive rebound over the next two months.

How to trade it

There are two China ETFs we will go over.

  1. iShares Large-Cap China ETF. Ticker FXI

  2. KraneShares CSI China Internet ETF. Ticker KWEB

iShares Large-Cap China ETF (FXI) | ETF Homepage

Quick facts about FXI:

  • Summary: The ETF's objective is to track the investment results of an index composed of large-cap Chinese equities that trade on the Hong Kong exchange.

  • AUM: $5.4 billion

  • Fees: 0.74% or 74 basis points. You pay 74 cents for every $100 dollars invested.

Top ten holdings

We think it's important to understand what the ETF is investing in. Some ETFs are better than others if you are trying to get a specific exposure. 

You can find the spreadsheet at this link.

FXI chart

Our view: It's trading in the middle of an extended range dating back to 2011. We would look to be buyers on a test and hold at the $28 level (blue arrow) or a break-out above $52 dollars (red arrow).


KraneShares CSI China Internet ETF (KWEB) | ETF Homepage

Quick facts about KWEB:

  • Summary: The ETF's objective is to invest in companies whose primary business is in the internet and internet-related sectors.

  • AUM: $1.6 billion

  • Fees: 0.70% or 70 basis points. You pay 70 cents for every $100 dollars invested.

A few highlights from their website:

  • They provide access to Chinese companies that are similar to Google, Facebook, and Twitter.

  • Exposure to Chinese companies listed in the U.S. and Hong Kong.

Why China?

  • Chinese retail web sales totaled $1.4 trillion in 2017, compared to $454 billion in the U.S.

  • China's internet population is ~721 million people, a 52% penetration rate. The U.S. internet population is 287 million with a penetration rate of 88%.

  • Total retail sales in China was $5.8 trillion in 2017, compared with $5.0 trillion in the U.S. over the same period.

Top ten holdings

You can find the spreadsheet at this link.

Conclusion

Chinese stocks have been unloved by investors in 2018. We believe investors will eventually rotate back into Chinese shares at some point. We don't know when; which is why use charts to help us with timing.

Whether or not investing in Chinese ETFs is right for you will depend on your investment strategy, risk tolerance, and time frame.


U.S. Stocks

The WSJ ran an article titled "Predicting the next bear market in six charts" (paywall).

Here are the six charts they used. We will look at bond spreads a little deeper.

  1. High-yield bond spreads-This spread measures what riskier companies pay to borrow money versus what the U.S. government pays.

  2. Yield curve-The yield curve measures the interest rates paid on government debt of different maturities.

  3. Deal Activity-The total dollar amount of mergers and acquisitions by month.

  4. Weekly jobless claims-How many people filed for unemployment insurance?

  5. Investor sentiment-There are many gauges of investor sentiment. A popular one is conducted by the American Association of Individual Investors (AAII). In my experience, sentiment measures area poor timing tools, unless they are at extremes.

  6. What the market thinks-Market based probability measured through options expiring in six months.

High-yield bond spreads

These spreads have historically sensed trouble before other assets. When spreads are tight, even companies with bad credit have easy access to cash. When spreads widen, it is more difficult for companies with shaky credit to access the debt markets. If they do, they often have to pay higher interest rates, denting earnings, and lowering future expectations.

The two peaks you see on the chart (One in October 2011, the second in February 2016), occurred when the stock market had already bottomed. Meaning, once you see the huge spikes in spreads, the worst is likely past.

I noted 5% on the chart. That seems to be the level, which if breached,  leads to a greater spike in yield spreads. That is the number we will be watching. Right now the spread sits at 3.60.


Bitcoin/Blockchain

Mentions of blockchain, bitcoin, and cryptocurrency are falling on earnings calls from S&P 500 companies.

Source: Axios

Our view: Two good rules of thumb I have learned over the years.

  1. Listen to investors smarter than me that take a long-term view.

  2. Watch where talent is going.

For the first one-Three investors/VCs I follow are Marc Andreessen, Chris Dixon, and Fred Wilson. Marc was the developer of the Netscape browser back in the early nineties. Raise your hand if you remember this? (I do, it was so slow...). Recently, he is a founding partner of Andreessen Horowitz (aka a16z). Chris is also a partner at a16z. Fred is a VC at Union Square Ventures in New York.

What they all have in common is their belief in blockchain technology, not crazy, dumb crypto tokens, but the potential of the underlying technology to solve real problems and create new business models. They were all early believers in the power of the internet when most people thought they were crazy. They are my go-to trio when I am trying to figure out what the future might look like and how we, as non-VC investors, can participate.

For the second one- Remember this: Follow the talent. Chris Dixon was on a recent podcast discussing the blockchain. What amazed him was all the engineering talent that had six and seven figure jobs at Google, Facebook, and other tech behemoths, leaving and going to work for, or starting blockchain projects.

A few years ago, on Tim Ferris's podcast, Marc was asked how they discover what the future might hold.

His quote:

"We look for what the nerds are building on the weekend"

Well, they and a bunch of other smart people are working on these projects. We should pay attention...


Cannabis

Cannabis prices continue to fall.

Source: WSJ daily shot, Cannabis Benchmarks

Our view: We don't believe the monopoly businesses in the cannabis space will come from farmers. We could be wrong, but we will be watching for other types of businesses in this space that have barriers to entry that are more difficult than farming.


Podcast 

A history of debt crisis

Barry Ritholz sat down with Ray Dalio, founder of Bridgewater Associates, one of the worlds largest hedge funds. In the episode, Ray walks us through the debt cycle, offers his insights into the common characteristics they all share, and tells us why he thinks now compares to 1937, just a few years before World War II.

To find this podcast, just search for "Masters in Business" on your favorite podcast player.


Thanks for reading,

Caleb

End of the Bull Market?

We also talk October IPOs, the future of retail, and Amazon's diverse revenue stream.

Question of the week 

The WSJ asks:

"Is this a healthy correction in a bull market with further to run, a reset lower in belated recognition of this year's geopolitical risk, or the start of a new bear market?"

Our view: Trying to figure out how deep a correction will be or how long it will last is a waste of time because it is out of our control. All we can control is our behavior. Let's focus our attention on deploying money into investments that we believe offer more upside than downside.


Public Offerings

Here are a few of the IPOs for October. We will take a deeper look at these in November.

StoneCo-Ticker: STNE. A Brazillian online payments processor. A good comparison would be Square's product that retailers use to swipe your card at checkout.

Quick facts:

  • Launched in 2014, they are already the 4th largest payment processor in Brazil.

  • Backers include Warren Buffett's Berkshire Hathaway, Jack Ma's Ant Financial.

  • This investment was made by Todd Combs, one of Berkshire's portfolio managers.


Yeti Holdings-They make branded coolers and other outdoor, recreational products. They will trade on the NYSE with the ticker symbol YETI.

Quick facts:

  • A couple brothers started the company in 2006. They were frustrated with cheaply built coolers whose handles kept breaking and their lids would cave in.

  • Net revenue-Grew from $89.9 million in 2013 to $639 million in 2017. That's a compound annual growth rate of 63%.

  • Operating income-Grew from $15.2 million in 2013 to $64 million over the same period. That's a compound annual growth rate of 43%.

  • Net Income-Grew from $7.3 million to $15.4 million over the same period. That's a compound annual growth rate of 21%.

Additional resources:


Upwork-An online marketplace for freelancers. They will trade on the NASDAQ under the ticker symbol UPWK.

Quick facts:

(When they use GSV, that stands for gross services volume. That number is the total amount paid by corporations and individuals to freelancers; not the amount going directly to Upwork.)

  • They operate the worlds largest online marketplace that enables businesses to find and work with highly-skilled freelancers.

  • As of June 30, 2018, their platform had $1.56 billion of gross services volume (GSV) across 2.0 million projects between ~375,000 freelancers and 475,000 clients across 180 countries.

  • They (Upwork) believe the opportunity set for their market, measured by GSV, was $560 billion in 2017. McKinsey Global estimates that, by 2025, online talent platforms could add $2.7 trillion annually or 2% to global GDP.

  • Revenue-Grew from $138.4 million in 2016 to $178 million in 2017.

  • Gross profit-Grew from $101.9 million in 2016 to $137.10 million in 2017.

  • Operating income-Loss lessened from -$14.4 million in 2016 to -$3.1 million in 2017.

  • Net income-Loss lessened from -$16.2 million in 2016 to -$10.6 million in 2017.

  • Top-tier VC fund Benchmark led the series B in oDesk in 2006. (oDesk and Elance merged in 2013 to create Upwork)

Additional resources: 


Recent IPOs are money losers

  • In the first three quarters, 83% of U.S.-listed public companies IPOs involve companies that lost money in the 12 months leading up to their debut according to the WSJ.

  • That is the highest proportion on record, breaking the previous watermark of 81% back in 2000.

Our view: People see these stats and say "we're in a bubble". If this is a bubble, the best thing we can do is to prepare. Prepare by doing sound analysis and sticking to what we know. Because if stocks do get crushed, some good companies will be thrown out with the bad and we want to be ready to put money to work.


The Future

What will the customer experience be like in 5-10 years?

Despite the emergence of Amazon, Shopify, and e-commerce in our culture, physical stores still account for 90% of retail spending in the U.S.

According to Axios, the big players in both worlds (e-commerce & physical) are betting the future of retail will be a hybrid of offline and online.

As they note, large Chinese retailers have been doing the hybrid model for years. Amazon just opened its third Go store in Seattle this month and plans on opening 3,000 by 2021.

In case you don't know, an Amazon Go store allows you to pick your items and walk out the door. It is a cashier-less store. You connect your Prime account to the app, and machine vision takes care of the checkout.

What companies do we want to own in this new environment?

Do we own the retailers who are adapting to the new normal or the companies who will provide the retailers with machine vision technology?

While Amazon's cashier-less stores are innovative now, will they be the only retailers who have this technology?

According to the article, Standard Cognition, a silicon valley startup, has developed an automated checkout system and is working with four retailers to outfit their 70,000 U.S. stores. (see above)

A secular shift, not disruption

In my view, this technology (automated checkout) will be table stakes for any retailer in 5-10 years. True disruption is when one company comes up with a new way to solve a problem and they capture all the new value they create.

It reminds me when stores, such as Kroger, added self-checkout machines. In the beginning, only a few stores had them. Now, it seems to be the new normal. No company gained a competitive advantage by installing them.

Final thoughts

More thinking and research will need to be done in this area. It's not clear which companies now or in the future will build a defensible position that others can't copy.

Amazon has a head start, has prime members, and owns Whole Foods, which are located in high-income areas. Can they create a shopping experience so good that people will stop going to other stores? Hmmm....


Charts

Amazon’s sources of revenue

Source: statista

Despite diverse sources of revenue, their core business, e-commerce, is slowing. (see below)

Source: L2

Our view: I have no insights into how Amazon's various businesses will perform and develop in the future. That makes it difficult to take a position based on fundamentals.

This is what we know:

  • Jeff Bezos is committed to the long-term. From his first shareholder letter in 1997.

We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position.

The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higherrevenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.

  • They are the market leader in e-commerce and cloud storage (AWS). These two categories have the wind at their back as both categories are set to grow in the coming decade.

What we don't know:

  • How much growth is priced into this stock? In investing, it's not how good their numbers are. It's how good their numbers are, relative to expectations. You won't find many Amazon bears on Wall Street...

For now, we will be watching the chart and taking a position only if the risk/reward is favorable.


Is 3M a leading indicator of the ISM?

Source: Deutsche Bank; @carquintanills

  • 3M (MMM) is a manufacturing conglomerate that sells everything from scotch tape, post-its, and other industrial and healthcare products such as surgical drapes and teethe whiteners.

  • ISM stands for the Institute for Supply Management. They conduct surveys. Their most followed survey is the ISM Manufacturing Index.

The survey measures 300 manufacturing firms. The point of the survey is to measure the manufacturing conditions of the country. A reading below 50 means manufacturing conditions are contracting; a reading above 50 means manufacturing conditions are expanding.

Since 3M is a supplier to a large number of company supply chains, Deutsche Bank thought it might be a good indicator to follow.


Will earnings suffer when the tax cuts expire?

Source: Axios

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