HCF Newsletter – October 2020 Fund Updates: Volatility In Our Times

Dear Valued Clients and Partners,

What a bull run since the bottoming out of the stock markets in March 2020! Many major indices are up and flying, and it would be hard for one to find an investor who did not make any returns if he/she had invested in the major markets (US & China).

At the same time, I think the time has come for a certain level of caution. While I am personally not inclined to say that this is the peak, I believe valuations are stretched for many of the outstanding companies. While many that leveraged on technology will, if successful, sail through their high valuations and meet them in the mid to long run, there will be a number which, by the nature of competition in their respective business sectors, be sidetracked or even lose their edge and decline.

This is when more attention needs to be paid to the specifics of the respective industry dynamics and their niches. While the general direction of human economic activities is never in doubt, the specifics are always in the details.

I have never been too big of a fan of macroeconomics. While general economic trends are good to predict and help in determining the likelihood of success in any company, there are too many other factors that are more crucial for determining the success of a company. To see the big picture, I would keep a watch on the macro-trends that either relates directly or indirectly to a company than anything else in the field of economics.

Other important factors that have to be considered would be the industry and business model of a company. For example, while agriculture is crucial for the survival of humanity, many agricultural (related and supporting entities) companies are generally not ideal for investment. This is due to the fact that the agriculture model has been around for thousands of years and the economics around it has generally been determined. Furthermore, how a business scale in that industry is important to consider. In an agricultural context, it would be constrained by the land area and the quantity of living stock that is being grown for that purpose. In a modern manufacturer, the constraints will be tied to the efficiency of its manufacturing process and its capital equipment. However, the current Internet Age has provided another platform for businesses, where businesses can scale up by using computer code and virtual assets. The big difference is the current type of assets is much less constrained by land or space (limited resources where existing big players can afford to price smaller players out of competition). A software company with the “right strategy” can easily scale up its business on the backbone of various cloud services that are readily available, and the kind of skills needed from a “labour” force is more of brainpower, which can have exponential scalability by using Artificial Intelligence, rather than labour hours which has linear scalability. This contributes to the “self-made” tech-savvy (they would be called geeky previously) billionaires nowadays who are much younger than the billionaires of yesteryears.

This ability for businesses to build a platform via computer code has a profound impact not just on business scalability but will contribute to a social problem that many humans will face: wealth inequality. If one were to look at social media, read the non-fiction books or even just pay attention to the people around us, many voices have raised the issue of income inequality. However, I seriously think that many non-investors may have missed the point. Although income inequality is one of the factors, wealth inequality, a popular point for discontentment among most of the population, is generally misunderstood.

Majority of the wealth of the richest man (Jeff Bezos) or the richest people in the world were created by the equity (the ownership stake)  that they have in their respective businesses. Many financially illiterate people may think that being a billionaire equates to the person having a billion dollars sitting in his/her bank accounts, not knowing that the majority of their wealth are in Equity. With this information, my take is if someone wants to grow their wealth, one must either take a big risk and attempt to build a great business that can scale OR manage your risk by buying into great businesses that can grow and scale.

Prologue to next segment of Newsletter:
As usual, Richard will be sharing three interesting matters that the team has been taking note over the last 2 months, including views from a Giant in the investment circles! If you are wondering what this investing Giant has to say, please read on!

I hope you enjoy this issue of our Newsletter.

Warm regards,
Clive Tan | CEO
Hidden Champions Capital Management


3 of the Most Interesting Things That We Have Read

1. COVID-19

It is déjà vu all over again in Europe where COVID-19 cases rose beyond the 10 million mark, bringing them back as the pandemic epicentre. Throughout Europe, a sense of gloom hangs over them as stricter measures and full lockdowns are imposed to stem the relentless resurgence of COVID-19 infections.

For weeks, France has been reporting tens of thousands of new infections per day and is now recording more than 380 new cases per 100,000 people each week. The startling rate of increased infections are “overwhelming” France, and they will enter yet another month-long national lockdown to apply a what Singaporean’s know as “circuit breaker” on coronavirus infections.

The same is happening in Germany, where the number of new infections confirmed daily is currently at least double the levels seen during the first peak of the coronavirus pandemic in March and April. Although testing has ramped up significantly since then, the spike has also been blamed on social gatherings and nightlife. In view of a short term sacrifice for a longer-term benefit, they have also entered a one-month partial lockdown to curb the explosive spikes in coronavirus infections, in a hope that no far-reaching measures are necessary during the Christmas Season.

The long-feared surge in COVID-19 cases is currently on-going in the U.S, with the records of the highest number of daily and weekly cases being broken only recently, with no end in sight. New rounds of virus-related rules and restrictions as a result of the surging cases have quickly been met with resistance from citizens and governors alike. In El Paso County, Texas, County Judge Ricardo Samaniego ordered a two-week shutdown of nonessential services starting at midnight Friday, amid growing hospitalizations in the area. The decision was made based on hospitals being at capacity which will compromise patients’ treatments, but Texas’ attorney general has joined several restaurant owners in suing to block the order. This is despite them setting the record, having the greatest number of COVID-19 cases for any country in a single day, as infections and hospitalizations surged in the lead-up to the presidential election.

President Donald Trump’s Chief of Staff, Mark Meadows’ was quoted by the media that the U.S. is “not going to control” the pandemic, and likened the coronavirus to be similar to the flu, as he defended the White House response to the coronavirus after infections of close aides to Vice President Mike Pence. Instead, the U.S. response will be focused on vaccines and treatments, not containment, reflecting their priority of economy over the health of its citizens.

Instead of having summer on the horizon, we are headed for a long winter. Even with a vaccine, it will take time to manufacture and distribute it on a massive scale. Even with the virus controlled; economic stimulus is unlikely to reverse all the damage. There is less hope for a quick fix. The trauma runs deep, and the impact may not be easily shaken off. Large numbers of smaller businesses – such as restaurants, bars and shops will have to shut their business once again – and this time, likely not to re-open and those jobs are lost for good.

2. Malaysia Glove Sector: Boom or Burst?

Over the past four months, investment analysts have been raising the target prices of glove manufacturer stocks giving them premium valuations amid bullish views of their earnings prospects. It is of no surprise that the glove mania gathered steam, with bulls enjoying the rally.Subsequently in Mid-September, the euphoria has turned into dissent as investment analysts started downgrading the sector on the grounds that most good news was already factored into the share prices. This prompted the glove sector to experience a correction and share prices of the big four glove makers fell sharply. One foreign securities firm even downgraded Top Glove to “sell” and slashed its target price by nearly half, recommending clients to take advantage of the current lofty valuation to lock in a handsome profit.However, there may be still room for growth especially since the recent result announcement of Hartalega Holdings Bhd, which shows an exponential earnings growth. It recorded its best-ever quarterly net profit at RM544.96 million in the second quarter ended Sept 30, 2020 (2QFY2021), which is about five times the RM103.87 million posted last year. Quarterly revenue jumped 89.73% to RM1.35 billion from RM709.42 million in 2QFY2020. The stellar earnings growth was attributed to higher sales revenue, higher average selling price, lower material costs and better production efficiency.Moving forward, Hartalega is optimistic of their prospects in the long-term due to their growing demand for rubber gloves and their ongoing expansion plans.

3. To Be or Not To Be Investing?

One of the investors that the team looks up to with great respect is Howard Marks. He is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. In his latest memo on October 20 titled “Coming into Focus”, he shared his view that today’s low-interest rates environment had created the lowest prospective returns in history. He also shared the possible strategic alternatives for investors in the current environment:

  1. Invest as you always have and expect your historic returns.
    Actually, this one is a red herring. The things you used to own are now priced to provide much lower returns.
  2. Invest as you always have and settle for today’s low returns.
    This one’s realistic, although not that exciting a prospect.
  3. Reduce risk in deference to the high level of uncertainty and accept even-lower returns.
    That makes sense, but then your returns will be lower still.
  4. Go to cash at a near-zero return and wait for a better environment.
    I’d argue against this one. Going to cash is extreme and certainly not called for now. And you’d have a return of roughly zero while you wait for the correction. Most institutions can’t do that.
  5. Increase risk in pursuit of higher returns.
    This one is “supposed” to work, but it’s no sure thing, especially when so many investors are trying the same thing. The high level of uncertainty tells me this isn’t the time for aggressiveness, since the low absolute prospective returns don’t appear likely to compensate.
  6. Put more into special niches and special investment managers.
    In other words, move into alternative, private and “alpha” markets where there might be more potential for bargains. But doing so introduces illiquidity and manager risk. It’s certainly not a free lunch.

As managers of capital, we concur with Howard Marks’ pessimistic outlook of the market; none of these options is satisfactory to us as an investor. It is indeed discouraging to accept lower returns amidst this higher risk environment while knowing there are no other viable alternatives available.

An Ending Note

After a long day of work, I was just catching up with the daily news to relax when I was reminded of a very bleak outlook of the world presented by the events happening around us right now.

From the nearby Malaysia Political Crisis to the ongoing protest in Thailand, the world’s most powerful storm this year in Typhoon Goni happening in Philippines, Islamic terrorism stabbing incident in France, not to mention Covid-19 resurgence in Europe and US resulting in Spain, France, Germany and many other European countries going into another round of lockdown. Be it political instability, natural disasters or the resurgence of Covid-19 cases in countries, livelihoods of millions will be greatly devastated across the globe.

On the contrary, Singapore has been able to keep our community cases under control thanks to our strong health infrastructure, a proactive government that acted swiftly in response to the pandemic outbreak, coupled with the cooperation shown by fellow citizens that are willing to sacrifice for the greater good. It is through these collective efforts we can still be here to do what we love best, imparting knowledge and creating wealth for our students and investors.

However, let us not live in our own world and forget the turmoil happening outside of Singapore. We are indeed very blessed to be in a very safe and sheltered environment, but this has not come easy and we need to be grateful for what we have and not take things for granted.

Richard Sim Zhipeng | CFA, CA
Investment Manager
Hidden Champions Capital Management