Tail Risks as Margin of Safety

Why I’ve been buying Alibaba (BABA-NYSE; 9988-HK)

[My views are my own]

“The reason that I invested in China is they have much better companies at lower prices. So, I’m willing to take more risk.”

Charlie Munger

One of the investing lessons that I’m teaching my children is that you get paid for your ability to stomach uncertainty, volatility, and risk.

Over 30 years as an investor, hands-down, I’ve made my best investments when I’ve been terrified.

As I wrote here, my approach to investing is to “aggressively deploy capital during recessions,” to invest in “cycles of panic” which happen “like clockwork, every ~18 months,” and to “buy companies . . . that are emerging from nuclear winter.”

My discipline as an investor is to be a liquidity provider when others are panicking and heading for the exits.

During the March and May sell-offs, I started loading up the truck with shares of Alibaba (BABA-NYSE; 9988-HK).

Alibaba is the largest e-commerce company on the planet. It has been called the Amazon.com of China. It’s share of Chinese e-commerce is 55%, and it’s share of cloud computing is 45%. Other assets include $68B of cash and equivalents, $25B of investments in Chinese public companies, and a 33% stake in Ant Financial (which own’s Alipay, the world’s largest mobile payment platform).

With Chinese internet ETF KWEB down 70% since February 2021, the tail risk narrative appears to have become the conventional wisdom.

This doesn’t mean that I won’t be wrong.

The Chinese property crisis could push China into an economic depression. China could invade Taiwan, and I could be forced to sell my shares due to sanctions. Emerging mobile commerce competitor Pinduoduo could disrupt Alibaba. The ADS shares could be de-listed.

However, if I’m right, I think there is a good chance to make 5x or 10x my money over the next 5 to 10 years.

The bet I’m placing is that:

(1) Alibaba is one of the highest quality businesses on the planet today. The company will effectively monetize the emerging Chinese middle class over the next decade-plus given extremely strong network effects.

(2) Despite the political rhetoric, Chinese Communists understand that to stay in power, they require a strong economy, access to capital markets, and powerful global companies.

(3) The company will continue to aggressively repurchase deeply discounted shares with it’s strong free cash flows.

(4) If the U.S. shares are de-listed, I’ll transfer all of my ADS holdings to the Hong Kong-based shares (which I also own).

(5) The current valuation implies that Alibaba will have no growth in the future — which I think is unlikely.

On valuation, my preferred approach is to compare the company’s Enterprise Value to the perpetuity value of it’s trailing cash flows (more on this in a future post).

Enterprise Value / [(EBITA * (1 – tax rate) ) / weighted average cost of capital]

On this measure, companies of this quality normally trade at a ratio 2x to 3x (or more during boom market conditions). Today, Alibaba trades at approximately 1.0x net of cash and minority investments. At the March lows, it traded at a >30% discount (or <0.7x).

Alibaba is very good and cheap — a rare combination!

As a final thought, Alibaba stock could definitely go lower from here. I’m not a trader looking for a quick pop.

In fact, the one common characteristic of almost every single big win I’ve had as an investor is that I was early. Early . . . but right!

In addition, if the we get a deep recession, as I wrote here, all stocks are likely going lower.

“I hope I live long enough to see a couple of recessions in this country. It is the nature of capitalism to periodically have recessions. People overshoot. So, it isn’t the end of the world. I mean, as a matter of fact, for an investor, you know, it turns out to be the times when you make your best buys. I made by far the best buys I’ve ever made in my lifetime in 1974. And that was a time of great pessimism and the oil shock and stagflation and all those sorts of things. But stocks were cheap.”

Warren Buffett

How I prepare to navigate a potential recession scenario is with cash and equivalents. Enough cash to buy more shares at lower prices; and, enough cash/liquidity so that I don’t have to sell my shares if there is a personal adverse consequence in my life.

The name of the game is to buy excellent companies when they are covered in uncertainty (preferably during recessions and market panics), and to hold them through the cycle.

If you are interested in engaging further in this conversation, I’d love to go on the journey with you. Please subscribe to my free newsletter/blog. Also, please follow me on Twitter, connect with me on LinkedIn, and post a comment below. I’d love to know what you think.