Hidden Champions Fund Newsletters: May 2019

24th May 2019

Dear Valued Clients and Partners,

Value investors tend to look forward to the one event that falls annually in the month of May: The AGM of Berkshire Hathaway. This year, our parent company, 8I Holdings, had the privilege of collaborating with our China business associates to interview Mr Warren Buffett himself during this period. Despite his age and diet, he still looks pretty sprightly and sharp intellectually.

If you would like to learn more about Berkshire Hathaway, Warren Buffett and his thoughts on the Chinese market, do click on the link to watch an exclusive interview that they did with him (most of it is in Chinese, but there are subtitles).

Watch it here

The recent market volatility due to the ongoing trade war has presented much more opportunities for us to take action on. We are focusing our team’s attention and efforts on that in particular.

The Trade War between US and China seems to be unabated. And while I have shared my general perspective on the clash of these two countries, in this issue, our investment manager, Richard Sim, will share with you his perspective on the Trade War. Despite us being a team, we each have our independent views which allows for plenty of robust discussions. At the time of writing, it was just announced that Huawei’s future phones will no longer be able to use Google’s Android Operating System (OS). This will impact Huawei’s mobile phone sales in the near term, particularly in their markets outside China, despite them having their own Plan B OS.

However, I believe that this move will open up possibilities for additional operating systems to be on the market that is not made in America, as companies will start to think of the possibility of Trump imposing similar restrictions on them. This may actually hurt Google’s Android OS dominance in the mid to long term as the phone manufacturers will be looking at possibilities of diversifying their mobile OS system away from Android, presenting opportunities for new competitors to gain market share in this once duopolistic industry. In fact, more news of other business ties of Huawei are being reported as time goes by, including UK chip manufacturer ARM, Germany’s Infineon and Japan’s conglomerate Panasonic.

In investing, the uncertainty of macro-events adds on much volatility on many fronts. This can come in the form of political, regulatory, environmental and other concerns. For most, if not all companies, the present Government will have their own political agendas to fulfil, and will often attempt to mold the legislation towards their desired outcomes. While it would be hard to determine the exact impact of any Government legislation, we must do our best to put ourselves in their shoes so that we can “anticipate” the legislation likely to pass through.

Governments (and regulators!) are often considered a hurdle for businesses to overcome, but it must be said that it is almost impossible to rely on businesses to “self-regulate”. Governments and regulators have the most unenviable job of coming out with sufficient yet enforceable rules to weed out the “sharks” in the commercial world, but at the same time allowing legitimate businesses to grow without too much restrictions. This balance is neigh impossible to achieve, as given too much of a free reign will result in poor corporate governance, despite the increase in enterprises. However, too much restrictions will result in companies with little enterprising spirit, despite the good corporate governance.

Companies themselves could also face possible disruption in their industry (Think Kodak and Creative). Hyflux forecasted their business on optimistic price forecasts and assumed minimal changes in prices of raw materials (not a wise decision on hindsight!). When a company is cyclical, the company can often be impacted by raw material costs that the company has no control over. Consumer goods and services are often subjected to supply and demand forces, and we may be wrong in our assessment and prediction. So, while it is definitely important for us to do our research, we must recognize that Lady Luck often plays a role in our stock returns.

Considering the many variable macro (and micro) factors, it is no wonder that the stock markets cannot help but fluctuate. We must focus on the probable long-term outcome and invest accordingly.

Prologue to next segment of Newsletter:

In this issue, Richard will share his perspective on the current Macro situation and also Huawei, while not listed, has many ecosystem and component suppliers in her value chain.

I hope you enjoy this issue of our Newsletter.

Warm regards,
Clive Tan | CEO
Hidden Champions Capital Management
www.hiddenchampionsfund.com


Introduction

In the recent weeks, the US-China trade war escalated to a whole new level. Apart from the usual tariffs imposed on goods by both parties, the US also banned business dealings with Chinese companies like Huawei, disrupting the entire value chain of products. The impact immediately hit key suppliers of Huawei such as Luxshare Precision Industry Co, O-Film Group Co., Shenzhen Goodix Technology Co, Sunny Optical Technology Group Co. and Q Technology Group Co.

The Huawei-Google Incident

On 19th May 19, Google abruptly rescinded Huawei’s Android license and halted its access to Google Play Services and the Play Store, effectively dumping it out of the Android smartphone market. This will tremendously hurt Huawei’s European business, its second-biggest market, as Huawei licenses these services from Google in Europe. On the other hand, impact is expected to be minimal in the Chinese market because most Google mobile apps are banned in China, where alternatives are offered by domestic competitors such as Tencent and Baidu.

Google’s actions come after the U.S. Commerce Department’s announcement on 15th May 19, which placed Huawei and some 68 affiliates on an Entity List, a trade blacklist, following an executive order signed by U.S. President Trump. The move is also reminiscent of the US ban on ZTE Corp in 2018, when the telecommunications equipment company was also placed on the same Entity List and became adversely impacted by it.

The efforts of Trump’s administration to cripple Huawei reverberated across the global supply chain, hitting some of the biggest component-makers. Since then, chipmakers including Intel Corp, Qualcomm Inc, Xilinx Inc and Broadcom Inc have told their employees they will not supply critical software and components to Huawei until further notice. At this rate, we feel that it will highly likely be a lose-lose situation for both Huawei and Google.

Huawei mentioned that they have foreseen such an event happening and spent the last few years preparing a contingency plan in case it was blocked from the Android operating system. Despite them reportedly having developed their own operating system, Hongmeng, which is already used in products sold in China, there are some key questions which immediately comes to mind: 1. How mature and stable this technology is, and 2. How important is the network effect of Google & Microsoft – users outside of China are heavily reliant on Google and Microsoft, and their impact is not something that can be easily replaced.

By cutting Huawei off, Google risks being deprived of the revenue-generating data of Huawei phone owners around the world. In addition, other Chinese smartphone makers, such as Xiaomi, Oppo and OnePlus, will be watching closely. Should Huawei build its own system which turns out to be viable, stable and effective, it is conceivable that those companies will join them in a bid to end their vulnerability from future actions taken by the US government or companies.

With the unfolding of Huawei’s event, it reminded us of a mini trade war that happened about thirty years ago.

Did History just repeat itself?

In 1987, Tokyo and Washington engaged in a small-scale trade war. Toshiba was guilty of selling military sensitive technology to the Soviet Union, despite US sanctions on the Soviet Union. This prompted the US to take massive actions against the company.

Firstly, the Japanese Police Department was ordered to arrest Erhe Lin, President of Toshiba Machinery Foundry, and Hiroshima Tanamura, President of Machine Tool Business, who were sentenced to 10 years’ imprisonment. Next, Toshiba’s factory in the United States was also forced to close and a 100% tariff was imposed on Toshiba products sold to the United States. Furthermore, a huge fine up to 1 trillion-yen, equivalent to $16 billion today, was imposed on Toshiba.

To provide some context, the White House was faced with a powerful Japan economic power that manipulated its currency, subsidized its companies, and erected stiff non-tariff barriers to imports. Toshiba, at that time, was the top of Japan’s science and technology industry, and also the hope and pillar of Japan’s manufacturing. After this incident, Toshiba went through a tough period, and its operating profit plummeted that year. However, they managed to recover 2-3 years down the road and subsequently performed better than before.

It is plausible that the U.S. attacked Toshiba not because it sold equipment to the Soviet Union, but because it affected U.S. interests. They may have believed that the Japanese semiconductor industry, represented by Toshiba Group, was seriously threatening the economic interests of the United States, and the Japanese high-end manufacturing plan threatened and challenged the technological hegemony of the United States.

With the benefit of this hindsight, we can draw some parallels between the Huawei of today the Toshiba of yesterday and it makes us wonder if the U.S. is banning Huawei purely for security purposes, or as a threat to their industrial sectors.

Putting Ourselves in Trump & Xi Shoes

We think that US and China may cut a trade deal a deal in the near future, but it will not be a true resolution. Despite a peaceful resolution being the best-case scenario for both parties, it is highly unlikely that either side will give in to the other’s demands.

Many observers are confident China will exercise rationale and restraint, and not do anything which will hurt investments or the growth of its economy, although one cannot rule out any response should the US push harder and act against other Chinese companies. Moreover, President Xi will likely remain at the helm to see through the plans of building China 2035, whereas the future of Trump’s administration is questionable.

From Trump’s perspective, he is simply unable to back down from the fight he campaigned on. Based on the Information Technology and Innovation Foundation report, a research institute focusing on technology and policy, American companies could lose between $14.1 billion and $56.3 billion in export sales over the next five years, with 18,000 to 74,000 jobs threatened. A second paper penned by Pinelopi Goldberg among others, the World Bank’s chief economist, noted that with the retaliation by the Chinese, the biggest victims of Trump’s trade wars are going to be the farmers and blue-collar workers in areas that supported Trump in the 2016 election. Hence, if this trade war prolongs and continues to weaken the US economy, Trump might not be re-elected in November 2020 Presidential re-election. This probably explains his burning desire to turn on the heat for a swift victory.

There is little doubt that the increased uncertainty and potential disruption of supply chains as a result of tariffs and technology restriction will only slow global economic growth. Arguing which side has more to lose is pointless; both will have much to lose.

What We Have Done at HCF?

At HCF, we have went through long discussions and intense research on how we should position the portfolio, to both defend against yet be able to take advantage of the market volatility created from this trade war.

For instance, upon discovering of the Huawei-Google news, the team immediately reviewed the companies that could potentially be adversely impacted by Huawei misfortune. We went through several sources, including researching news online, interviewing the suppliers and investor relations of affected parties, to validate certain facts reported. We found out that despite the drop in share price for one of our investments (supplier to Huawei) in response to the news, was actually misconstrued – Huawei only contributes to 20% of its revenue, and a much lesser profit. Furthermore, this gap would eventually be filled by other competitors, who are also their customers, should Huawei lose its market share in the mobile phone segment.

Rooted with these facts, the team will seek to exploit any further opportunities that will arise from this incident.

Regards,

Richard Sim Zhipeng | CFA, CA
Investment Manager
Hidden Champions Capital Management
www.hiddenchampionsfund.com