No. 20: Vertical Integration, From the Archive: Li Lu Discussion on Modernization, Tencent: One of the World's Greatest VCs with a Super-App Attached, Chinese Investments - Five-Year Plan
This is the 20th week of me writing Capital Buddha. Thanks to those who have tuned in regularly - the response has been fantastic, and a very good incentive to keep sharing what I am thinking about each week :)
As I mentioned in earlier posts, I hope to expand the range of content, and am working with friends and connections in different industries to see if we can bring some interesting stuff to the table.
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Vertical Integration
I was talking with a few people last week about the merits of owning the whole value chain, versus owning only parts of it. Both models can be successful – but I guess it’s really matter of preference or circumstance which route a business takes. The smartphone industry provides an interesting case study of the pros and cons of each approach.
Android is an operating system owned by Google which gets deployed onto a variety of handsets, each with different hardware specifications. The plus side is that Android (and therefore Google apps) gets onto many devices without Google having to undertake capex to make smartphones. Instead, they shift this capex to handset manufacturers and license Android to them.
Apple, on the other hand, controls the entire value chain for the iPhone. It requires a much higher capital outlay to manage design, production, supply chains, software distribution, customer service etc. Though expensive, if this approach works (and it does), they can detect weak links in the supply chain, make improvements to product, and control user experience.
Android and Apple smartphone businesses are very different – though both produce very high returns on capital. However, in my view, Apple produces something that is very hard to compete against. Though Android scales rapidly through its license business, hardware across different manufacturers is inconsistent. The overall performance of a phone relies not only on the individual quality of components or software, but how they integrate on the device. Splitting software and hardware across several different parties opens Android up to performance inconsistencies - which has meant that the vertically integrated iPhone model has leapt ahead in terms of overall performance – despite some Android smartphone manufacturers having very good hardware specs. Android cannot control the value chain end-to-end due to the variety of hardware manufacturers, customer service, design and product spec – and therefore cannot guarantee quality of device performance. This performance gap between Apple and Android has grown over time.
I had another similar conversation about the Chinese e-commerce space. JD has a business model much like Apple – high capex, strict control of the user experience, but ultimately gains users that love using the platform and spend almost twice the amount versus alternative platforms like Alibaba or Pinduoduo. Alibaba on the other hand is famous for investing very little capital into its new businesses and leveraging minority stakes in logistics partners, for example, to grow sales and users rapidly - despite a poorer overall user experience. JD tends to grow more slowly, however users on JD tend to be more loyal and bigger spenders than those using Alibaba platforms.
There is space for both business models in most circumstances – but what I have noticed is that if a vertically integrated model works, it really works well. If the smartphone business analogy is anything to go by, e-commerce in China looks like a very interesting space to observe.
From the Archive: Li Lu Discussion on Modernization
I found it interesting to go back and look at what Li Lu summarized from his study of human history. I try to go back to this at least once a year to understand some of the challenges we have faced, and obstacles overcome. For instance, human populations declined below 20,000 at some point around 150,000 years ago due to the harsh climate – and the only inhabitable place was in Africa near the equator. To go from the brink of extinction to thriving as we do today has been no small feat. Human kind seems to be quite resilient.
Tencent: One of the World's Greatest Tech Investors with a Super-App Attached
While I was aware that Tencent had made some great investments, I only really understood what was in their portfolio when I saw this amazing table on Twitter.
Though the Tesla stake was sold at the end of 2019, Tencent owns major chunks of many great businesses. They’ve also added a stake in companies such as Afterpay, an Australian buy-now-pay-later company whose stock quadrupled in 2020 alone.
Even if we haircut the portfolio by around 40% (it can be argued that we’re in a very hot stock market), we still end up with around $150bn of asset value. Given that the total market cap of Tencent is around $600bn, today’s price would give you We Chat and other great assets like the gaming business for a total of $450bn.
WeChat is also much more entrenched than many of the other assets in the US or Europe which boast higher relative valuations and lower relative growth prospects. A smartphone in China is useless without WeChat – whereas a smartphone in the US is still useful without FB, Instagram, What’s App, Amazon, or Google respectively.
While the company looks to be selling cheap at first glance – I’m sure critics have valid points. I’m not close enough to understand the level of competition in Chinese tech. Fierce competition may lead to WeChat’s incumbent advantages being destroyed much faster than they would in the US or Europe – therefore justifying a steeper discount than a Facebook or Google. Is Tencent still able to attract the best engineers? Or would the best talent prefer ByteDance as their first choice? To all these points, I have no answer. And while it may not be the next 1000 bagger, it still looks like a decent bet.
Chinese Investments - Five-Year Plan
For additional perspective on how Chinese politics shapes the investing landscape, I greatly enjoyed Lillian Li’s post about the Five-Year Plan. For people venturing into Chinese investments, it’s good to pay attention to this. For example, the real estate and private education sectors will be reigned in during the next Five-Year-Plan, making these sectors practically un-investible for investors not close enough to the ground to understand nuances of the market - or who the likely survivors will be.