Valuing Emerging Market Tech Stocks

By: Edward Lam

Based on conversations in the last month, there are two things top-most in investors’ minds: how high tech platform stocks can go, and why the Emerging Markets Dividend (“EMD”) strategy did not invest in Tencent.

The performance of tech platform stocks this year has been extremely strong. The average year-to-date return of a basket of Apple, Amazon, Alibaba, Google, and Tencent is around 30% in U.S. dollar terms. Tencent has been the strongest of these. Regarding Tencent, the first thing to say is that I don’t have any fundamental objection to owning it: it is possible for it to be in the EMD portfolio even at these levels of valuations (eMemory is just as expensive!). The issue of the legal status of variable interest entity contracts in China (partly documented in my previous monthly in May/June 2011) is not the same issue for Tencent as it is for Alibaba, and has now received some tentative support from a recent local court ruling on Ambow Education.

The difficult problem for anyone who owns Tencent is that it is a difficult speculation. Some religious fundamentalist value investors might have a problem with the fact that I characterise it as a speculation at all, but in reality all investment is speculation. The greater problem is really that to some extent or other, there is no objective universal truth contained in facts, but only in concluding unscientific postscripts to philosophical shrapnel.

As anyone who has done any valuation work knows, in most cases, most of the “value” in a stock is contained in its “terminal value”. Perhaps this points to a flaw in the framework, or perhaps only that this was precisely the philosophical objective of the author of discounted cash value investing, J.B. Williams. In the case of Tencent, it is not that we doubt the possibility that its terminal value could be so much greater than the company’s current valuation. The problem is that we do not have an easy way of assigning a probability or probabilities to various terminal outcomes. In our estimation, the probability of WeChat, the key platform for Tencent, being in existence and making money in 20 years’ time, is surprisingly low.

The history of Tencent should make one cautious about the future: in 1999, it launched QQ – an instant messaging platform. By 2010, QQ was “the most popular instant messenger globally with a user base of around 1 billion people”, and anyone valuing Tencent at that time would have placed a large emphasis on the terminal value of the QQ platform. In 2011, Tencent launched WeChat, a new and totally separate messaging platform. WeChat now has nearly 1 billion users, but in just seven years, the terminal value of QQ has gone from WoW to basically zero.

Tencent management are clearly geniuses, but there are rather a lot of geniuses in tech now, all doing the same thing. Uber, Tesla, Volvo, Google, LeEco, Baidu, Ford: how many companies in the world can you name that are going to have a Number One driverless car platform? There is a reason that not all internet platforms in the world can trade at 50x P/E. There is a reason that Uber China had to merge with Didi Chuxing. There is a reason why in most jurisdictions, Google will not be allowed to merge with Amazon.

The reason we have allowed ourselves to think differently about the valuation of eMemory, the Logic non-volatile memory design company based in Taiwan is essentially twofold:

  • Chip design is distinctly different from some of the activities of technology platforms, and in this case, it seems to be sustainable with low levels of capital expenditure; and
  • There is a certain amount of predictability in the product development cycle to eMemory, as it follows with a lag the decreasing geometries of chip manufacture. Once one is embedded in a foundry’s design consultation process, there is a tangible cost to switching.

None of this is to say that I know I am correct about these comparable valuations. Rather the opposite: I know I am speculating. But it is worth understanding that it is just as hard to predict the future as it was in the past, which is a fancy way of saying that the facts always need interpretation and that perspectives change as we move on. For some reason, we compare apples to oranges now and not to oysters or dimes.

 

 

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

 This commentary was provided by the portfolio manager responsible for the management of the Redwood Emerging Markets Dividend Fund. Any securities mentioned may or may not be held by the Fund. In addition the Fund may sell these securities at any time or purchase securities that have previously been sold. Nothing in any commentary should be considered a recommendation to buy or sell a particular security.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments [and the portfolio manager] believe to be reasonable assumptions, Purpose Investments [and the portfolio manager] cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

 

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