- Investment is all about taking calculated risks and only placing bets when odds are in our favor.
- The recent developments of Alibaba represent a textbook example of an investment opportunity with horrendous uncertainties and attractive returns at the same time.
- After carefully reviewing business fundamentals, this article examines three possible scenarios for the uncertainties to play out.
- A rational assessment of the risk/reward profile is then performed using a Kelly bet size analysis, and the results will help decision-making and risk control.
Background and Investment thesis
The recent developments of Alibaba represent a textbook example of an investment opportunity of high risk and high potential return at the same time. As detailed in my last article, it reminds me of and shares several similarities with American Express during the salad oil scandal in the 1960s. On one hand, there is still a high degree of uncertainty. But at the same time, the valuation and reward/risk profile is too attractive to ignore. The reward could be about 100% in the near term, but the loss could be large also.
Usually, the discussion involving such a highly uncertain situation would turn into a subjective debate. The bulls will emphasize the good scenario and potential gains, and the bears would emphasize the risks. As such, this article first reviews the business fundamentals and recent developments surrounding BABA. Then based on the review, this article lays out three possible scenarios for the uncertainties to play out. So that potential investors can gauge the range of uncertainty and variance in the outcomes anchored with fundamental analysis. And finally, a rational assessment of the risk/reward profile is performed using a Kelly bet size analysis, and the results will help investment decision-making and risk control.
This section provides an overview of BABA’s business segments to facilitate the rest of the discussions. It is the largest e-commerce company in the world in terms of gross merchandise volume. Its major business includes commerce retail and wholesale in China, commerce retail and wholesale in the rest of the world, cloud computing, digital media and entertainment, and innovation initiatives, et al.
Out of all these sectors, the Commerce retail and wholesale in China is currently the bread and butter of the business, contributing about 2/3 of total sales. This is where the ongoing government crackdown on cyber technology giants is supposed to impact the most as to be elaborated later.
The cloud computing and innovation initiatives currently contribute less than 10% of the total revenues and many initiatives are not profitable yet. But BABA has a leading position in all these areas, and these areas are seeing high growth rates (overall above 30% YoY). Furthermore, these areas should be little impacted from the regulations (at least the regulations announced so far).
With these backgrounds, now we go into details of the current developments surrounding the business and possible future scenarios.
The conservatively normal scenario
First, let’s consider a conservative normal scenario. Let’s face reality first – BABA’s good old days are probably not coming back (at least not anytime soon) and the Chinese government crackdown will definitely hurt the business bottom line. However, I do believe it is in the Chinese government’s best interests to make sure BABA returns to a “new norm” – it is business too big and too good to let it fall.
And the recent announcement that BABA will invest RMB100 billion (about $15.5B) to the Chinese Common Prosperity fund actually supports my above view. To me, this announcement actually adds substantial clarity to the situation. It shows that a path forward is being worked out and hints at what a “new norm” could be for BABA.
And the following chart shows what BABA’s profitability will be under this new norm. This new norm essentially projects BABA’s future profitability assuming that its commitment to the Common Prosperity fund becomes a permanently recurring cost or tax (at $3.1B per year) of doing business. And my following projection is on the conservative side because of the following reasons:
1. It assumes no growth in BABA’s earning from current businesses at all (mainly its retail commerce, the one assumed to suffer the largest impact from the new regulations), i.e., BABA operation cash flow (“OCF”) will stagnate at its current level of ($33.3B).
2. It assumes the only income growth will come from its investment in new strategic areas such as Cloud computing, digital media and entertainment, community marketplaces, Taobao Deals, Local Consumer Services and Lazada. As you can see from the following chart, these areas are all showing a rapid growth in operating metrics. The YoY growth rate has been in the 30+%. These areas generate about RMB100 billion of revenue currently per year. Some of them are not profitable yet. But assuming a modest growth rate of 15% and an EBIT margin of 20% (BABA’s average EBIT margin is about 33%), these areas will be able to contribute about $2.9B of OCF per year in about 3 years.
3. It assumes the $3.1B per year contribution will be permanently recurring and furthermore it assumes that these contributions are truly a cost or tax. But in reality, from the language of the announcements, such contribution may actually generate some return for BABA. The language reads like it’s a venture capital fund.
4. It assumes a valuation of 20x CFO. To put things under perspective, BABA’s historical valuation has been on average 28x CFO, and Amazon’s valuation is about 35x CFO.
Under the above conservative assumptions, BABA’s CFO will be about $12.5 per ADR and price is projected to be $250 at a valuation of 20x CFO. And if this scenario plays out, the return will be about 67%.
Source: author and Seeking Alpha data.
Source: BABA earnings release
The bad scenario
This bad scenario assumes that BABA’s retail commerce business, its bread and butter segment, loses ½ of its earnings permanently in the future due to the new government regulations, and the details of this scenario are listed in the chart below.
Source: author and Seeking Alpha data.
Note that these new regulations are being released and interpreted as we speak, and I do not think anyone knows how they will impact BABA’s business (or China’s tech business in general). My interpretation is that these regulations are meant to encourage competition, as a key component of the regulation urges tech giants like BABA to unblock web links from competitors in their services.
It is not clear to me if such regulation would necessarily hurt BABA or how much if it does. As a simple example, consider Alibaba and Tencent. BABA and Tencent used to block users from sharing product links from each other due to their long-term rivalry. Under the new regulation, they must stop such blocks. And see, the key here is that they BOTH have to stop such blocking – BABA will lose some business due to the encroachment of Tencent’s links, but at the same time will also gain some business because BABA gets to encroach Tencent with its links too. And therefore it is not clear to me whether this will hurt BABA (or Tencent) and by how much if it does.
But as a bad scenario, let’s assume the following: it only hurts BABA unilaterally and it hurts so bad that BABA’s retail commerce business loses ½ of its earnings in the future. Note that these regulations should not impact BABA’s other business segments (such as their enterprise cloud services, digital media, and many of the new strategic investments mentioned above). BABA’s retail commerce brings in about 80% of the EBIT earnings currently as seen from the chart below. Losing ½ of this will cause the existing earnings to decrease by about 40%, as shown by item C1 in the table above. And the CFO will be $7.5 per ADR under this bad scenario.
Finally, under this scenario, let’s also assume the valuation stays at a terminally cheap 15x CFO. And if this scenario plays out, the return will be about negative 25% as seen.
Source: BABA earnings release
End of the world scenario
Finally, this is the end of the world scenario, where investors (or foreign investors) lose 100%. I personally do not think this would happen, but let’s entertain the idea.
BABA could just go under. But to me, this is totally implausible given its scale, competition moat, and the fact that it is actually in the Chinese government’s best interest to keep BABA thriving. The Chinese government could require BABA to be delisted from foreign stock exchanges. This has happened in the recent past to a bunch of Chinese stocks (although it is the US government who required the delisting in that case). And foreign investors did not lose everything in that episode.
They were required to sell by a given deadline – at fire-sale prices for many of the stocks, but they did not lose everything. Lastly, the Chinese government could confiscate foreign investments in BABA if they decide foreign investments made in BABA under the VEI structure are illegal according to Chinese law. This is very unlikely to me for so many reasons. For starters, China certainly understands that playing by internationally recognized rules is a big part for her to be recognized as a major global power, and has learned the lesson the hard way that it is much better to have access to foreign investments.
Kelly bet analysis
So, it is indeed a high uncertainty investment. Both large potential gain and loss are possible.
Usually, the discussion from here would turn into a subjective debate. The bulls would emphasize the good scenario and potential gains. And the bears would emphasize the risks. I have been in such debates plenty of times. The method I’ve learned to turn such debate into more action-oriented decision-making is to apply a Kelly bet analysis. The Kelly bet analysis is a way to determine bet sizing as a percentage of bankroll that leads to optimal growth in the long run (i.e. if you place a large number of the same bet over and again).
The reasons I use it are twofold. First, it not only considers expected return, but also the variance among the outcomes, which is equally important, or more important in my view, than the expected return. Imagine two bets, A and B. You have a 50% chance of winning (and also a 50% chance of losing) in both bets. The difference is that in bet A, you get back 2.2x of your wager (i.e., 120% return) if you win, and you lose your wager completely (i.e., 100% loss) if you lose.
In bet B, you get back 1.4x of your wager (i.e., a 40% return) if you win, and lose 0.2x of it (i.e., 20% loss) if you lose. As you can easily confirm, both bets provide the same expected return of 10%. But I bet you intuitively see that you should not bet the same way – because of the variance. You have a good chance of total loss in bet A, but not in bet B. So you can (and should) bet more heavily in B than A.
More precisely, the Kelly bet analysis would tell us we should limit the bet size in A to only 8.3% of our bankroll and we can bet 100% of our bankroll in B every time – a difference of day and night. Second, the analysis optimizes growth in the LONG RUN. As investors, we have no control at all for each and every one of our bets – whether we like to admit it or not. The result on each bet is more about luck than anything else. All we hope for is that if we find the correct process and keep making bets based on the same process so that statistics would take over and push the role of luck to the side in the long run.
A Kelly bet analysis is shown below for the BABA investment for the scenarios analyzed above. As seen, the Kelly analysis shows that even with a probability of 45% for the conservative normal scenario, 50% for the bad scenario (i.e., the bad scenario is more likely to happen than the normal conservative scenario), and 5% for the end of world scenario (which is hugely exaggerated in my mind), the expected return is still positive and bet size is 45% of the bankroll.
Even when the odds further shift out of our favor, as shown in the next column, so that the probability for the conservative normal scenario is now 35% and 65% for the bad scenario (i.e., the bad scenario is about 2x more likely to happen than the normal conservative scenario now), the expected return is still positive and bet size is still about 9% of the bankroll.
Do not get me wrong here. The Kelly bet analysis cannot – nothing can – turn investment decisions into a completely scientific and objective process. If uncertainties/risks can be quantified, then they are not uncertainties/risks to start with. In the end, some degree of subjective judgment is always required based on each person’s risk tolerance. For me, the Kelly analysis provides insights to help me form that judgment. And in this case, based on the results shown above, my judgment is that the odds are in my favor and I should take on this bet.
Conclusion and final thought
The recent developments of Alibaba represent a textbook example of an investment opportunity of high risk and high potential return at the same time. This article first reviews the business fundamentals and recent developments surrounding BABA. Then based on the review, this article lays out three possible scenarios for the uncertainties to play out.
And finally, a rational assessment of the risk/reward profile is performed using a Kelly bet size analysis, and the results will help investment decision-making and risk control. The results show that, even under very conservative and pessimistic assumptions, the expected return under current conditions is still positive and the bet size is sizable.
Lastly, as seen from this discussion, the Kelly bet analysis helps to turn a subjective debate into a more action-oriented discussion. Instead of debating the rewards and risks, it helps us to focus more on HOW MUCH to bet given your risk tolerance. For me, if the amount I am willing to bet is too small to have any impact on my portfolio, I will just skip it. Otherwise, the bet size controls my risks.
Author: Envision Research, Seeking Alpha