While COVID-19 remains very much with us (unless you happen to live in the few lucky places that have decisive control over the virus such as China / Hong Kong / Taiwan, Singapore, Japan, Korea), May was a key turning point across the world.
Many countries / states / cities took steps to reopen even if the virus is only weakly controlled. This is largely a recognition that while lives are infinitely valuable in theory, economies can only be placed into comas for so long before people run into other problems. For example, millions of people across the emerging markets essentially were forced into starvation for more than a month. These are not issues that most people living in the 1st world consciously think about, but across many countries, people are discovering that death from COVID-19 and death from starvation is no different. In both cases, the victim experiences pain for an extended period of time. And in the end, death prevails.
So the world largely decided to start returning to a new normal in May.
This helped support equity markets in a more broad-based way. Many impacted stocks started to show some signs of recovery. This is materially different from April where market performance was narrowly driven by secular growth stories or companies that benefit from work-from-home / lockdown trends.
In addition to COVID-19, Capital Flywheels’ concerns around US-China relationship mentioned last month became front and center during May. The war of words between US and China continues with both sides pointing fingers, rightly or wrongly. Fingerpointing has also given way to legislative action that directly impacts the interests of the other side. Whether rightly or wrongly, the US continues to view Hong Kong autonomy as an important US interest. And at the same time, China continues to view Hong Kong sovereignty (and likely Taiwan sovereignty) as non-negotiable in a way that even the US-China relationship is not. This is a very scary thought if you think about it.
While I am always an optimist at heart and believe in the ability of humanity to find compromise and peaceful solutions to disagreements, I am also a realist and understand that all humans are also part animals. Humanity will eventually prevail as one, but in the near-term, Capital Flywheels is concerned that fear is going to lead many of us down a very painful path. Fear clouds the mind. And when animals are in fear, there are only two instincts – fight or flight. There is limited scope for reason for logic.
What does each side fear?
The US fears…whether rightly or wrongly, China’s seemingly inevitable path to eclipsing the US economy in the coming years. The US fears this because increasingly people believe that China’s economic rise has been a net negative for the US. If China’s economy rises further and exceeds the US, many fear it would worsen the negative impact on the US.
China fears…whether rightly or wrongly, the US’ historical desire to intervene in other country’s domestic affairs, which is not negotiable for the governing Chinese Communist Party. China fears this because the US has brought down regimes in order to push Democracy / end autocracy, as well as to protect human rights. These have already been ongoing areas of tension even if the US has never made any drastic moves on China unlike what the US has done in other parts of the world.
The US fears…whether rightly or wrongly, China’s growing military might in a way that rivals the US and China’s increasingly bold stance to challenge the US in the South China Sea. As you can imagine, when it comes to military leaders and military minds, animal instincts are the dominant instincts. Fear supersedes logic. What does a military mind think about a country like China with a known desire and the capabilities to potentially match US military hegemony?
China fears…whether rightly or wrongly, US control over most global institutions and systems that matter. The US controls much of the financial system, for example, with vast powers to sanction other countries in a way that could shut down economic activity overnight. While all countries have their own currencies, the currency of international trade is the USD. The US government has the sole power to deny USD transactions anywhere in the world even though a reasonable country may ask why that should be the case when the hard-earned USD belongs to them and not the US. The US also controls much of the technological standards that govern how the global internet and technological sphere work. China fears this because despite all they have accomplished, it can all end overnight at the whims of any US President, even one as unpredictable and often uninformed as President Trump. China’s economy is about to eclipse the US, but there’s no question it sits on sand called the USD. China’s technology is rivaling the US, but there’s no question it sits on sand called US semiconductors, equipment, software, and standards.
The US and China both fear…whether rightly or wrongly, that differences in regimes cannot coexist. This is an interesting modern concern. Prior to the 17th Century, all countries in the world had the exact same governance system – Monarchy. Conflicts between countries were solely over land and resources. Conflicts between countries were never about systems of governance. However, Europe and the US came along with something entirely new called Democracy*, which at times is at odds with the old monarchic systems. China does not have a monarchy, but single-party rule looks similar when you squint.
There are a lot of fears. Probably many more if we really sit down and think about. With all that fear, what’s the probability that logic prevails?
That’s the new normal that the world is entering in Capital Flywheel’s opinion. A new normal in a world where COVID-19 is with us. A new normal in a world where US and China have no capacity for trust with fear that is running wild.
With that context, let’s review the portfolio.
It’s remarkable that the market did well in May given the backdrop mentioned above. In May, the S&P500 returned 4.82%, bringing YTD performance to -5.00%. Not bad for a world that is falling apart from disease and conflict! Much to Capital Flywheels’ delight, the Paper Portfolio continued to outperform despite already outperforming in April. The Paper Portfolio returned 18.65% in May, bringing YTD performance to 29.40%.
Performance was strong across most of the portfolio, but the strongest performers are companies that clearly will see long term trends accelerate because of COVID-19. This included SE, Adyen, MELI, and WORK. All four delivered >30% returns in May.
Given that many countries and states / cities started to reopen in May, some of the secular but impacted names started to recover. This includes SQ, UBER, MTCH, and ALGN. As restaurants reopen and people start to move about, this should help SQ and UBER. Match should also benefit as people start to consider dating in real life, again. Similarly, as dental offices reopen, Align should benefit.
On the other end, the laggards were almost all exclusively Chinese names. HUYA declined 4.37%. Tencent and Alibaba gained only low-single digits %. Sentiment around Chinese stocks continue to be impacted by the ongoing tensions between US and China. On top of this, the US recently passed a number of legislative bills targeting China, including a bill (the Holding Foreign Companies Accountable Act) that could potentially force Chinese ADRs to delist from US exchanges.
The only non-China name to lag was Pinterest due to lackluster earnings and outlook. However, Capital Flywheels continues to believe that Pinterest is building out a very interesting e-commerce channel with high monetization potential in the future.
In terms of rebalancing, the Paper Portfolio is undergoing a few big changes. BABA weight will be further reduced. Tencent will be completely sold. While I think both are great companies, I am increasingly finding it challenging to see how either of those stocks perform in a really big way with the continued tensions. I also believe both are increasingly “doing their part” to help China through post-COVID-19 economic weakness as well as US tensions by devoting their strong cash flows to pursue national interests, which will detract from financial performance. The change in weights are not commentaries about whether this is right or wrong, but mostly a reflection that stocks ultimately follow financial performance and financial performance is being impacted negatively.
However, offsetting that China weight reduction, the Paper Portfolio is adding TAL Education Group, the leading after-school K-12 tutoring company in China. TAL provides a highly recognized and prized service in a country that has a very high focus on education. While most investors tend to be short-term focused, Capital Flywheels firmly believes that focusing on the long-term is what drives performance. And for anyone focusing on the long-term, it is clear that China is going to need to increasingly turn inward for economic growth due to weak economies abroad on top of the US’ desire to slow China’s international momentum. Inward growth cannot be driven by consumption alone, and increasingly China will need to create higher value-added jobs since the low-skill industrial and manufacturing jobs that China has relied on in the past will become increasingly hard to find. These higher value-added jobs can only be created with a highly educated populace. TAL’s services will likely see significant acceleration in the coming years.
With that change, our China-exposed weight is approximately maintained. Capital Flywheels considered removing HUYA as well, but Tencent just took full control of HUYA. There is some optionality depending on what Tencent wants to do. Given the small position, Capital Flywheels is willing to wait a while longer and see if Tencent can accelerate value creation there.
The Paper Portfolio is also removing Align and LVMH. While both remain attractive companies in their own right, there are other more interesting names to consider given the quickly changing environment.
The capital freed up from Align and LVMH allows us to add Anaplan (PLAN) and Boeing (BA) while still maintaining ample levels of cash (which is important given the uncertain backdrop).
Anaplan is the leading software provider for enterprise planning. The importance for enterprise planning is growing given the uncertain backdrop. Anaplan software is not only used for financial planning but also supply chain planning as well. Anaplan stock has underperformed recently because unlike other SaaS companies that primarily sell to rank-and-file employees, Anaplan primarily sells to executives. Many executives had their hands full with COVID-19 and thus were in no position to consider adopting new software. However, as companies increasingly get their arms around COVID-19 situation, they will likely start to see bandwidth free up for other considerations. Capital Flywheels thinks enterprise planning is probably very high on that list going forward.
Boeing needs no introduction. Boeing is a leading commercial aircraft maker. Boeing is currently undergoing a very hard time because of the fall in travel activity. Many airlines are stressed, which raises the risk that Boeing’s plane deliveries will be delayed as well. On top of this, Boeing has a meaningful amount of debt. While Capital Flywheels strongly prefers fortress balance sheets, Capital Flywheels is going to make a small exception for Boeing because 40% of Boeing’s revenues are actually from military / defense. Many people may not be aware that Boeing is a sizable player in the defense market. Capital Flywheels finds it hard to imagine that the US government would allow Boeing to go bankrupt given its importance in the defense market. Boeing’s stock has collapsed, which creates an interesting value opportunity if one can imagine the travel industry coming back in the next 5 years. Boeing is also a very interesting hedge because in a world with tense relationship between US and China, Capital Flywheels thinks a position in a defense company makes a lot of sense.
Let’s see what June brings us.
*Capital Flywheels is aware that the foundation of Democracy was formulated in ancient Greece, but Capital Flywheels intends to only make a narrative statement and not a historical one.
Disclosures: I own shares in SE, SQ, SHOP, UBER, MTCH, FB, BABA, AYX, TEAM, and PLAN. I have no intention to trade any shares mentioned in the next 48 hours.