Why I’m (still) bullish US Equities

I’m a big fan of Ark Invest and the work of Cathie Wood and Brett Winton. I regularly trawl through their research pieces to formulate my view on the markets and to guide my investment ideas.

This is a brief summary of my learnings and general conclusions from Ark’s most recent, ‘In the Know’ series. These views are my own and whilst I reference Ark’s research, I am not associated with Ark Invest in any way. If you found this helpful, please subscribe as I continue to build out this blog as a forum to share my learnings, thoughts and market ideas.

Headline Inflation numbers are skewed

There’s no doubt about it, money supply in the economy is rallying sharply and is on an upward trajectory. This is being fueled by Central Bank Easing (Fed purchases of securities) and Government Stimulus measures. Normally, this leads to higher inflation (increased supply of money means higher prices of goods and services). This is a popular narrative, especially as we start to see strong economic data feed into reports

US Money Supply is at record highs

Nonetheless, inflation reports this year are going to be skewed towards being more frightful, than accurate. This is because inflation is typically reported as a year/year comparison (to account for seasonality). Last year, we saw major deflationary effects in the economy (people couldn’t spend money, so prices fell and the economy sank into a severe recession). This leads to a ‘basing’ effect where now that we start to see this process reverse, the year/year reports start to look abnormally high (especially compared to the Fed’s 2% Target Inflation Rate).

Inflation data on a monthly basis avoids the same basing effects, and as of yet, we are not seeing any major inflationary pressures creep up in the economy (more on why that’s the case, below).

US CPI Inflation (Monthly)

Higher Corporate Income Taxes are not going to tip this market over

Government spending is beyond anything we’ve ever seen before. Federal Debt as a % of total GDP is ballooning. This should be a cause for concern because at some point, all this money needs to be paid back, through higher taxes and/or reduced spending.

Federal Debt is Approx. 130% of GDP

What is harder to know however is when it needs to be paid back. This is a function of political incentives, where we are in the economic cycle and how hard it starts to get for the Fed to start servicing this debt load. My view is that for the next 6 months at least, the market continues to ride the gravy train. This is because the new administration is still setting out their political agenda, forward GDP forecasts are being revised higher and debt service payments remain at historically low levels – so there is not an immediate need to balance the books.

With that being said, there is a lot of talk about Corporate Income Taxes (‘Corp Tax’) having to increase to fund this debt, eventually. The current administration has proposed increasing Corp Tax by 7% (from 21% to 28%, at a Federal Level). Firstly, I don’t think a tax hike of this scale ends up happening. Secondly, even if we did see some increase in Corp Tax (at a Federal Level), I think the effective change for most corporations would be muted because of relocation incentives between states. More on this below.

Corporate Taxes only make up for about 7% of total Government Revenues (Incomes Taxes are around 50% of revenues, on the other hand). Therefore, even if you assume a 33% hike in the tax rate (28% vs 21% and assuming zero elasticity in revenues, this only increases government revenues by around 2%, at most). So this is hardly making a dent on the overall fiscal balance.

Corporate Income Tax only accounts for 7% of Govt Revenues

More importantly, compared to other Advanced Economies (OECD), the US already has above average (Effective) Corp Income Taxes (26% vs 23%). A 7% increase would certainly put it in the running for the highest Corp Tax Rate out of the bunch, higher than France (32%), Germany (29%), Italy (29%). Optically, I struggle to see this happening as it’s not a position any major economy wants to have (let alone a broadly fiscally conservative, free market oriented, USA).

Even if we were to see some increases in Corp Tax at a Federal Level, there is a huge disparity in state level Corp Income Taxes which will mute the net impact on Corporations.

For example, a relocation from California to Florida, reduces the top rate of Corp Income Tax by 4.4%. Move from New York to Texas and you cut this by 6.50%. This explains why intra-US company relocation is at all-time highs (compounded by pandemic related shifts to working from home). Companies like Goldman, Telsa and HP are leading this charge and won’t be the last. Ark Invest are also considering the same.

Sizeable difference in State Level Corp Income Tax

*Texas does not have a Corp Income Tax. Instead, it has a Gross Receipts Tax (applied to revenues before cost deductions) which is not a direct comparison.

So long story short, Corporation Income Tax hikes are a red herring. The tax hike proposals are overly aggressive/ambitious and the reality is that this probably doesn’t mean much for what businesses end up paying. This likely mutes any resulting impact on stock prices (though it does make real estate investments in Texas/Florida look very compelling).

Significant (deflationary) economic tailwinds

The savings rate in the US remains at historically elevated levels (above 13%). This speaks to the amount of overall pent-up demand in the economy as people have been stuck at home for so long (and for many, receiving stimulus checks they haven’t been able to spend).

US Savings Rate at historical highs

Over the next couple months, we are likely to see the savings rate trend progressively lower; especially as more restrictions are lifted across the US and people have more places to spend their money. This will continue to drive GDP higher (70% of US GDP is made up of consumption).

However, to off-set the inflationary impact of this higher spending, we are seeing very encouraging signs in the labour market of deflationary forces playing out. Whilst we’ve seen employment rebound, we’ve also seen working hours increase at the same time, as firms extract more labour (productivity) from their existing workforce.

We are likely only at the cusp of these productivity gains in the workforce. Ark identifies five key platforms of technological innovation which are likely to drive further productivity gains and resultingly deflationary forces in the economy. These are: Robotics, Blockchain, Artificial Intelligence, DNA Gene Editing and Energy Storage. The breakthroughs in these areas are already at key inflection points and should spur a period of rapid economic growth with (positive) productivity led deflation in the economy.

US Treasury Yield Saga is likely over (for now)

One final thought is how quickly and efficiently the market has managed to shrug off fears of rising 10 Year US Treasury yields.

The 10-Year Treasury Yield nearly doubled in three months, which is a huge move in a relatively tame bond market. The narrative was that inflationary pressures seeping into the economy were being reflected by the bond market (as investors sold 10 Year Treasuries), and as a result, growth stocks in particular were being sold off (due to future cash flows now being discounted by a greater amount). FWIW, I don’t agree with this view and I explain why in my previous post.

Nonetheless, over the last couple weeks, we’ve seen a large reversal in equities with no news in the bond markets. Most growth stocks are up ~20% off their lows and the Nasdaq has rallied 7% from March lows, and is now at all-time highs. This is despite the 10 Year Treasury yield stabilizing around 1.6% (which is still 3x higher than the Aug 2020 low).

One interesting theory Ark posits here for this is that many investors overlooked the SLR requirements the Fed was planning to change for banks at the end of Q1 2021. From April 1st, the Fed removed the temporary relief on capital requirements for Banks, which had allowed them to exclude their holdings of US Treasuries, from their reserve requirements. (The theory is that by allowing banks to exclude Treasuries from their reserve requirements, they would have more cash to lend out and thereby kickstart the US economy). As this waiver was coming to an end, banks were forced to sell their Treasury holdings to meet the stricter reserve requirements. Since this has come into effect, we’ve seen a pull-back in bond market volatility (and a stabilization in yields). Given the Central Bank has a vested interest in keeping yields low/stable (which such a high debt load), I’d assume this stability is going to be enforced one way or another and therefore, I think we’ve likely seen the end of the yield saga for now.

Conclusion

In sum, I have a lot to be bullish about in this market. I expect to see some scary headline inflation numbers which surpass the Fed’s 2% Target but the reality is that the US economy is heading for a sharp rebound from a terrible 2020. So long as we continuee to see real productivity gains driving economic growth, I’ll ignore the noise and continue to be (levered) long equities.

Ecommerce Stock with explosive upside?

The global retail market is growing at 14% annually and it’s not close to slowing down. Even in 2020, an abysmal year for the US economy, total US retail sales grew by 7% (vs 2019), which in fact was the highest annual growth recorded since 1999.

Ecommerce leading the way

The key driver of this growth in retail sales is online ecommerce. In 2020, ecommerce sales accounted for 101% of the growth in total sales (it’s over 100% because it also off-set declines in catalog/call center sales). This was the first time in history that ecommerce sales growth accounted for all of the total retail sales growth (the last time it got close was in 2008, when ecommerce growth accounted for 63.8% of growth that year).

The pandemic clearly had a lot to do with this. When you’re under lockdown and need essential supplies, online retailers like Amazon prove to be extremely useful. This trend also incentivised traditional retailers to step up their online presence to keep up.

US Ecommerce penetration is still in its early stages

What’s surprising however, is that even after accounting for the pandemic led boost, ecommerce penetration in the US still isn’t very high. In China, 45% of all retail sales are made online today, and that’s expected to reach approx. 60% by 2024. Meanwhile, in the US, this is closer to 21% (pre-covid, this was 15.8%). The global average, which includes countries where infrastructure is lacking, is 18%.

For the US to only be 3% above the global average is pretty shocking, especially as the US economy is largely consumption driven (70% of GDP) and is still a global technology leader (fast internet speeds, high level of tech integration, mobile adoption etc.). This tells me the shift to online retail is still very much in its early stages in the US and whilst it is a global trend, the US is prone to a much faster rate of ecommerce adoption than most other countries.

US Ecommerce Penetration
Chinese Ecommerce Penetration
Global Ecommerce Penetration

There is sizeable room for new entrants

Amazon effectively has a monopoly on online retail in the US. It accounts for around a third of all online sales (around 7% of total retail sales). Nonetheless, as the ecommerce market continues to expand, Amazon is having to concede market share. Some of this market share is going to other established retailers that have geared up their online presence but it’s also going to local businesses that have only just started to transition online (made more convenient through channels such as Shopify, Etsy and Amazon marketplace). In 2020, the top 100 retailers had a 74% share of total ecommerce sales compared to only 49% in the previous year. On Amazon, now more than 60% of their sales are fulfilled by Third Party Sellers (hosting on Amazon’s marketplace). This speaks to how increasingly fragmented the market is becoming.

3rd Party Sellers on Amazon
Biggest online retailers in the US

Short term Tailwinds?

One frequent criticism I hear is that as the US comes out of the pandemic we will see a reversal in the trend towards ecommerce. The theory is that as people are allowed out, they will go back to buying things in person than online. Whilst I think this may be true for some purchases as people are no longer forced to buy almost everything online, I think there are two tailwinds that will keep us going.

The first is the sheer size of pent up demand, combined with rising personal incomes. No matter how you cut it, personal incomes, disposable incomes, personal debt/income ratios, all point to the US consumer coming out of the pandemic stronger than where they went in. This is mainly being supported by the size of stimulus but also because people spend less overall when they are under lock down (less Starbucks coffees, commuting, nights out etc). So whilst we may see some things being purchased in person as opposed to online, the sheer size of the amount of spending we are going to experience is likely to lift the entire sector (and therefore, in absolute terms ecommerce sales will continue going higher).

The second is a cultural shift. We can argue that you might order less takeout and eat out more, but the convenience of online shopping is evident. Many of these habits are likely to be sticky; if you’ve tried it once, you’re more comfortable with the idea of doing it again. This is creating a secular trend in the market towards online retail.

Mohawk: Ecommerce disrupter

Ok so enough big picture stuff. I know ecommerce is a sector with structural growth, low current penetration and short term tailwinds. But what I want to know is which companies will be potential multi-baggers because they are truly disrupting the industry.

This is when I came across Mohawk (Ticker: MWK). They are a pure play ecommerce business but they have focused on two particular aspects of the future of the ecommerce market; increased fragmentation and low technology integration for entrants. They have three key USP’s that are focused on these structural trends.

  • AIMee Proprietary Tech Platform

Mohawk hosts a tech platform called AIMee. This replaces some of the old fashioned, inefficient aspects of the retail business with a far superior tech based alternative. AIMee allows MWK to understand their customers better; it analyses customer feedback (through NLP) to quickly identify what customers like/don’t like (through text based reviews), it computes market trends by monitoring the features that the best-selling products have, and it optimizes pricing/logistics based on consumer feedback. These are not new ideas but their proprietary tech platform allows MWK to do these things more efficiently than others using a combination of Artificial Inteligence and programming.

This type of bottoms up analysis has become particularly important in markets with low brand loyalty (think iphone cases, essential oils, kitchen appliances). This is because by focusing so closely on the data from customers, MWK can get a bigger slice of the market share. I was surprised to find out that only 22% of searches on Amazon have a brand attached to them, and 51% of millennials have no preference between private label and national brands.  This nonchalance towards major brands is a key driver for MWK’s growth, because they can then use their technology to gain a competitive edge.

AIMee Technology
  • Reducing Go-To-Market Time

The second aspect of Mohawks business is one which I didn’t initially consider. A typical product takes around 18-24 months to go to market. The key hindrances that traditional retailers have is that they have to initially research/test the product and find distributors. Mohawk can use their AIMee platform to cut this down to 6-8 months, by replacing these two roles with a technology alternative.

Instead of having focus groups, AIMee can identify what’s trending and therefore, become an idea generator. This reverses the traditional role of product origination; instead of asking customers what they like, the AIMee platform tells you what customers are going to like. Similarly, the trading engine can figure out the optimal go to market strategy (inventory, pricing, product lifetime management).

For products which rely on a lot of hype (think fidget spinners, kids toys, smart gadgets), being the first is key to profitability. Most users will buy the item, use it for a short while and then move on. I see AIMee is helping to find this product.

Anecdotally, I know time how critical time to market can be. I launched a repair app (www.fixlee.co.uk) late last year and even whilst I’ve been busy making new iterations/testing the beta, I’ve seen multiple new players pop up trying to do the same thing that I am with my repair app.

  • M&A strategy

MWK traditionally relied on organic growth to fund their business but as more ‘mom and pop’ businesses have been set up, MWK has found it more cost effective to pursue an aggressive M&A strategy to integrate these businesses under their technology infrastructure (than to establish brand new businesses). The competitive edge for MWK remains their tech (by acquiring more businesses, they can spread a fixed cost over more products) but they have also proven to find very attractive M&A deals more broadly, buying companies at 3-4x EBITDA. Since 2020, they have already added 1000 different products and have 40 new product launches. The pool of potential acquisition targets is expected to increase with third party sellers expected to grow at 16% CAGR over the next five years.

Business financials

I had two concerns with the MWK business model that I wanted to see addressed in their financials. (1) Whether their tech had proof of concept in being able to generate incremental sales (2) their ability to scale their M&A strategy.

MWK have increased revenues every year since 2017 and expect to have 50% CAGR in revenues over the period 2017-2021. In the latest estimates, MWK forecast a 100% y/y increase in revenues 2020/21. They have also managed to turn this incremental revenue into growing EBITDA margins which turned positive for the first time last year. This shows the business is able to sell more and is now starting to return profits (using EBITDA as a proxy).

With regards to their M&A strategy, MWK have some attractive businesses they have managed to acquire which has helped to cement their ecommerce position. The good thing about this is that they’ve managed to add more businesses with generally no additional headcount and with a very quick turnaround time (~48hours to integrate), which speaks to their competitive advantage.

  • Healing solutions (31 Oct 2020) – 3.8x TTM EBITDA, 3300 products
  • Smash acquisition (30 Sep 2020) – 3.7x TTM EBITDA, 43 products
  • Truweo (8 April 2020) – 2.5x TTM EBITDA,

Valuation

Now I know what you’re thinking? Why do all of this analysis to buy an ecommerce tech business. Just buy Amazon, right? Strong, steady, growing….

This is where I think it gets interesting. I want to find the businesses with the best risk/reward and big upside. Call me skeptical but I struggle to see Amazon being 2-3x in the next 5 years (if Amazon doubled from where it is today, it would have a market cap the same size of German GDP)…This is where high growth, small cap stocks, become more interesting.

Here’s a quick and dirty optimised margin model on MWK.

Let’s start with Revenues. MWK experienced 62% growth 20/19 vs 100% forecast 21/20. Their 2021 Revenue guidance is between $350-$380m, and their long term optimized margin forecast is around 13-15%.

Basis achieving a long run operating margin of 13-15%, this implies earnings of $36-$45m. Assuming the business can grow in line with the rest of the market (i.e. 16%-24%), this implies 2025 Revenues of $735m-$1.14bn. Assuming the business is valued at a Price/Earnings multiple of between 10-20x, I am seeing 189% upside against 17% downside risk, with base case upside of 65%, at current prices (as of COB March 15).

Conclusion

Ecommerce is a secular trend that’s here to stay. As the market continues to grow, new entrants will emerge and MWK is providing fundamental value through its proprietary technology platform, AIMee. By being able to do things more efficiently, the company has strong growth prospects which it has shown through aggressive M&A expansion, consistent revenue growth and speedy product integration. I’m bullish the entire sector but I see this as a potential multi-bagger, that’s disruptive, consistent and trading at a good entry point.

Ticker: MWK
Stock Price (when post published): $30.38
Verdict: Bullish
Timeframe: 5 Years

Reflections on the stock market sell-off

Calling the markets turbulent over the last couple weeks is an understatement. Many new investors have not experienced drawdowns this large and based on the numerous emails/DM’s I have received, this seems to be leaving many bewildered, angry and scared. Instead of writing a specific stock recommendation, this week I’ve taken a step back to think about my high-level views of the market and the lessons I have learned as an investor.

Below are six guiding principles which I have found to be true and below each, how I intend to reflect these in my investment decisions.

Quick Recap: Current Market

The stock market is forward looking. We made new all-time highs during the peak of COVID-19 and now, as the economy shows signs of improvement, the stock market is showing signs of weakness.

The reason for this is because coming out of the pandemic is going to put upward pressure on prices (inflation). The bond markets are reflecting this through higher long-term yields on treasuries (as long-term bonds are sold in anticipation of more inflation). As cash flows and rates start to creep higher, this is resulting in (1) a rotation away from companies that don’t make money into companies that do and (2) is leading to a sell-off in equities, as markets expect an end to the accommodative policies of central banks.

Unfortunately for policy makers, you’re caught between a rock and a hard place. As markets price higher inflation in the future, it makes the cost of current (government) debt more expensive. But if policy makers increase interest rates now (to off-set fears of inflation in the future), it increases the chances that we end up risking the economic recovery we’ve only just started to see signs off.

#1 Productive assets yield the highest returns.

Stocks should form largest % of my invested asset base

Over the long run, productive assets yield the highest returns. Stocks are by their very nature, productive assets, as they are literally pieces of a business. Examples of non-productive assets would be Housing, Bonds and Gold. Over time, stocks have outperformed all these other asset classes. Arguably, some stocks are more productive than others (due to the underlying nature of their business), but short of having your own company, stocks are the easiest entry point to a highly productive asset base for the new investor. Resultingly, I believe stocks are the most efficient means of making long term returns.

Real Returns by Asset Class (ref. Puru Saxena)

#2 Revenue Growth is the biggest driver of Stock Performance

Invest in companies with pricing power

What the single most important driver of the price of a stock? You might think it’s metrics like P/E ratios, Profits or even Cash Flows. In fact, the biggest driver of long run stock performance (1990-2009) is Revenue Growth. Intuitively, if a business cannot sustainably sell its product, then everything else goes out the door.

The companies that have a natural advantage will have pricing power and large Total Addressable Markets (TAM). This is what is considered a “business moat”. Margins and Profits are not important in the short term, as if a business can sell its product (at scale), then there will undoubtedly be ways in which it will be able to monetize this in the future. Meanwhile, multiple compression is just the markets way of reflecting herd behaviors as we swing from optimism to pessimism and should not be a consideration for investment decisions (more on this below).

Sources of Stock Price Performance

#3 The long-term market P/E ratio is ~20x which implies a 5% yield

Assume 20x P/E in long term forecasts/price targets

Despite the media headlines around rising long term rates, the market has actually been positively correlated with rising rates over the last decade. This makes sense if you consider that long term yields rising generally reflect a more optimistic view of the future, and therefore, businesses should be doing better (all else being equal).

10 Year Treasury Yields vs Nasdaq since 2016

But there is something more interesting about this relationship. Even in periods where rates have been declining (such as in late 2019), we have not seen widespread multiple expansion. Or in other words, the market has consistently priced between a 10 to 25x earnings multiple on stocks (periods where it rallied above this such as in 2008 and 2020 were skewed as earnings were based on trailing 12 month averages). Another way to look at P/E ratios is as an earnings yield. A 20x P/E ratio reflects a 1/20 Earnings/Price Yield or in other words, a 5% return. So in other words, investors in the stock market already have an implied earnings yield/discount rate which is factored into investments despite what treasury yields are doing, and it’s around 5% (or a 20x multiple). This is the level I will use to model stock price targets in future blog posts.

S&P TTM P/E Ratio

#4 When inflation becomes a problem, you’ll have time to trade it

Don’t rush into inflation/deflation based trades

I was duped into the inflation trade during the on-set of the pandemic, as Central Banks everywhere, started printing massive amounts of money. My analysis was too simple (even though I was able to make a bit of money on my Gold hedges) and since then, Gold has underperformed the rest of the market.

Gold Spot Price

The reason for this is because a critical part of inflation is the Velocity of Money (that’s a measure of how quickly money is circulating in the economy). This is often neglected and hardest to predict. During the onset of the pandemic, we saw the opposite of inflation (deflation). Why? Because people were not able to spend the money they received from governments. Today, even though much of the US is open, we’re yet to see increasing inflation. Why? Because a large proportion of the money being printed doesn’t end up flowing through to ordinary people (it sits with banks who then recycle this money into treasuries). It is this velocity of money that guides inflation expectations and thats extremely difficult to predict.

M2 Velocity vs Inflation Expectations

The second aspect of inflation is its impact on the stock market. Again, this is a more nuanced relationship, as valuations have actually been pretty supported around a 0-4% inflation range. It’s when inflation starts to break outside of these bounds that valuations start to be negatively impacted. This leaves a wide range for inflation before it starts to creep into stock market performance and make a material impact to your portfolio.

US Inflation Rate vs P/E Ratios

My learning here is that inflation is a bit like the monster under the bed. It’s scary and dramatized but frequently misunderstood. When inflation truly becomes a problem, there will be time to trade it and it will be obvious. Until then, better to ignore the media frenzy around it.

#5 The traditional business has a debt problem

Technological disrupters will prevail in most industries. Old fashioned businesses are value traps

When looking at the inflationary/deflationary effects circulating in the economy, I came across an interesting video by Cathie Wood from Ark Invest. She makes some great points about the worrying levels of corporate debt in the economy. Debt to Equity values continue to remain elevated as many companies have taken the last decade to spend money wastefully (through share buy-backs and dividends). Ultimately, they are in for a hard reckoning here as traditional business models in many industries are due to be challenged by technological breakthroughs.

Some of these breakthroughs that I’m looking at are 3D Printing in Manufacturing, Robotics in Logistics, AI in Insurance and E-commerce. The only solution here is that these incumbants will need to re-structure their balance sheets and reduce prices to manage their debt loads but at the same time, will have their business models disrupted by new entrants who are smarter and more tech savvy.

S&P Large Cap Debt

#6 Don’t fight the Fed

Never take the other side of the Fed in any investment class

This is a common saying in the market. The Federal Reserve is the single biggest buyer of assets in the US economy and has an unlimited amount of resource to solve problems (literally, they can just print more money). If at any point in time in modern US economic history you had bet against the Fed, you would have lost.

Historically, the Fed has been able to respond to liquidity crises with ease. In the past, when yields have increased at a rate which has threatened the Government’s ability to maintain its debt load, the Fed has been able to artificially bring yields lower with remarkable efficiency.

Real Yields vs Federal Debt

The Fed is facing an issue right now with regards to long term treasury yields rising. In fact, the Budget Office estimates that a 1% point increase in yields would cost more than 10x the US annual Defense Budget in interest payments over the next 9 years. I don’t know ultimately how this plays out but with such high stakes and given the historical effectiveness of the Fed in getting what it wants, I expect this to be swiftly dealt with as soon as it becomes a meaningful problem. Indeed the Fed is already sitting on $1.5tn in 1-5 year Treasuries (which could be sold for 10yr + Treasuries to bring long term rates lower).

Federal Debt % GDP
Fed Balance Sheet March 2021

Conclusion

Markets can be extremely volatile and I have found it easy to get caught up in the minutae without taking the time to think about the overall objectives and view that I am trying to reflect. I hope by reading these principles you are encouraged to think through your own view of the markets and the lessons you have learnt so as to have a better game plan to handle swings during the trading day.

Disruptive technology that’s saving lives

Organ transplants save lives. As of today, there are 114,000 people in the US (0.03% of the total population) that are on the waiting list for a lifesaving organ transplant. Meanwhile, since 1988, the US has averaged approx. 21k transplants per year, which simply isn’t enough. This means that most people on the transplant waiting list will not receive a transplant in time and 17 of them die as a result, each day[1].

The demand for organ transplants continues to increase due to rapidly increasing populations and lifestyle choices, especially as more people move out from not having enough, to having too much (food, drink, drugs etc.). The global market for organ transplants is expected to reach $120bn by 2024 and is expected to grow at a CAGR of 8-10% over the next 4 years[2]. For context, this implies the organ transplantation market will be two thirds the size of the market for Cancer treatment ($180bn)[3], double the size of the Diabetes market ($60bn)[4], 10x the size of the Alzheimers market ($12bn)[5] and 20x the size of the Asthma market, globally.[6] This will rank organ transplantation as one of the largest healthcare segments in the world.

Demand for organs outpace available supply

Unsurprisingly, this market has a major supply issue as there are simply not enough organs available to meet demand.

This is because;

(1) there are not enough donors to start with (90% of us support transplants but only 60% of us sign up)

(2) the pool of suitable donors is small (80% of donor organs come from deceased patients)

(3) most donor organs are not suitable for transplant patients (only 30% of the available organs are fit for transplant use)[7].

Problems (1) and (2) are unsurprising to me; I think we are all sometimes guilty of believing in something but not having enough conviction to do anything about it. I’m not justifying it but I think signing up as an organ donor falls into that category. Second, I think it’s understandable that many potential donors are scared about the implications for being a living donor, so most organ donations end up coming from deceased patients.

I am however surprised (and disappointed) by Problem (3) – that only 30% of organs that are available (from an already limited pool of supply) end up being fit for transplant.

Why are organs unfit for transplant?

Organs begin to die as soon as they are disconnected from a living body due to a medical condition called Ischemia. This means that doctors have a limited amount of time (usually no more than a few hours) to transplant a donated organ before it becomes unusable. Unfortunately, this makes it effectively impossible to transport organs for long distances to get them to the patient most in need, and increases the chances that by the time the organ is ready for transplantation, that it is not in a useable state.

The solution? Transportation

Transmedics (‘TMDX’) is a company focused on revolutionizing the transportation of organs to increase their useability, so that more of the available organ supply reaches patients.

Traditionally, organs are transplanted in plastic bags, inside ice coolers, between sites. TMDX has created an Organ Care System (‘OCS’) which can transport organs in a condition which mimics the human body. The OCS system literally pumps in warm, oxygenated blood into these organs which means that they continue to perform their function as if they were in a human body (the heart pumps, the lungs breathe and the liver produces bile) and this ultimately means that there is no effective time limit for how long these organs can be transported outside of a human body. The company has over 200 patents worldwide for their technology and they remain the only viable alternative to cold storage organ transportation today.

TMDX OCS System

Lungs, Heart, Liver OCS Systems

TMDX has three OCS systems built individually for Lung, Heart and Liver transportation. These are also the three segments in the US with the biggest shortfalls in donor supplies, which makes it more critical that more of the available organs are utilized.

Does it work?

The results across all three segments have shown remarkable improvements in organ utilization. For the Heart and Lung OCS systems, the EXPAND Trial (which is a Phase III clinical trial) has shown organ utilization increase to over 80% when using an OCS system (and a 3x improvement in utilization versus Cold Storage Utilization).

The OCS system does more than just increase organ utilization as it also allows surgeons to perform real time tests on the organ and to change operating conditions during transport, which can improve post clinical outcomes. The OCS system reduces post clinical complications by 60% compared to traditional cold storage transport (12% of post clinical complications using OCS vs average of 32% using cold storage).

FDA Approvals

The FDA has already approved the Lung OCS system and it is being used across the US today .

The Heart and Liver OCS systems are currently under FDA review process and TMDX expects to have approvals for these later this year (Heart OCS system approvals are expected to come first).

It is worth noting that OCS system for Heart transplants is already being used outside of the US even though it’s not currently FDA approved. Check out this Youtube video to see the system being used for a transplant in the UK[8].

Market & Business Strategy

The market for organ transplantation in the US is highly concentrated; 55 transplant centers in the US account for approx. 70% of Lung, Heart and Liver transplants. This gives TMDX a highly concentrated customer base. TMDX is currently focused on the biggest transplant centers in the US, where they have already managed to build out a commercial presence.

TMDX makes money by selling these centers the OCS systems and then providing the solutions/medical equipment required to maintain the system (and obtain recurring revenues).

TMDX Commercial Presence

Over time, TMDX wants to have a bigger role in organ transplantation. Currently, the burden of transportation is placed strictly on the Transplant Center receiving the organs, as they have to arrange for transportation and surgical retrieval themselves. TMDX seeks to take that that burden away by eventually becoming a more comprehensive service provider; managing the OCS system, transport and retrieval of organs themselves. This ultimately means that transplant centers/donor centers can focus strictly on the surgical procedure/patient care and it gives TMDX the ability to build out a more efficient organ transportation network. These two things should eventually mean higher transplant numbers (and more lives saved).

TMDX to become an organ transportation service provider

Financials

In sum, I think alot rests on TMDX obtaining FDA approval for it’s Heart and Lung systems. If this is achieved in 2021, I am very optimistic about the companys future.

  • Rapid Revenue Growth

The average revenue estimate is calling for 90% top line growth between 2020 and 2021. (The one risk here is that we may see periods of rapid growth followed by stagnation, as TMDX sells it’s OCS systems for the first time to new customers).

  • Strong Balance Sheet

TMDX has a strong balance sheet with a Current Ratio of 6.25x. With the bulk of their Current Assets in Cash and Marketable Securities, this will allow TMDX significant headroom to continue to build out its network over the coming years.

  • Defendable Gross Margins

The company has 58% Gross Margins currently, and that’s with only one OCS system FDA approved. This is a very strong starting point, considering there are likely synergies as TMDX begins to scale their transportation network and have more OCS systems in the marketplace.

Valuation

TMDX is currently unprofitable but it is a high growth stock with huge potential so I will use an optimized margin model to generate a forecast for the stock over a 5 year time horizon.

To compile a Low/Mid/High valuation target for the stock, I will start with a range of analyst estimates for 2021 Revenues of between $36m – $62m (Yahoo Finance).

Based on investors valuing the business at (optimized) long-term Operating Margins of between 20-40% (in 2025) and a Revenue Growth rate of between 30-50% (2021-2024), this gives expected Earnings of between $15m-$94m in 2025.

Assuming that the stock trades at a PE ratio of between 20-30x, this gives a potential 189% upside to TMDX at it’s current valuation and a potential downside of 89% over the next four years.

The assumptions I used above are very conservative as I fully expect to see investors valuing the business at higher longer term optimized margins as this company has a strong moat around its patented technology. I also expect the stock to trade at a >30x Price/Earnings multiple in 2025 as TMDX cements its position as an organ transportation service provider (through it’s National Service Program).

Conclusion

I like the idea of investing in a company that is undoubtedly saving lives. TMDX has founded a technology which replaces a largely dated and inefficient way to transport organs and has proven that these technologies work. What’s even better is that the stock continues to trade at an attractive entry point for new investors with asymmetric upside over the next four years.

Ticker: TMDX
Stock Price (when post published): $35.89
Verdict: Cautiously Bullish (pending FDA approvals in 2021)
Timeframe: 1-4 Years

Property: The final frontier for the digital revolution

How often have you booked a hotel that looked great in the photos but when you get there, it’s cramped, dated and nothing like what you expected? That’s happened to me way too often. This has got me thinking about how the digital world can better handle physical experiences, like booking a hotel or viewing a house for sale. In this article, I look at a company that is taking that challenge head on.

Property is a BIG market

So lets take a step back and revisit the problem. Property is the largest asset class in entire world with a market cap of around $230trillion.

Global Nominal GDP

According to the World Bank, that’s about four years of annual global GDP or in other words, the total combined value of all properties in the world, is around the same value as every item we produce globally, over a four year period – so that’s a huge number![1]

Meanwhile, most of this global property stock remains large offline, as it’s not digitally accessible.

Offline = Undervalued

The problem is that being offline, means being undervalued.

Intuitively, if you’re in the market to buy a house, then your first port of call will generally be online agents. If a property is not listed, its likely to restrict a large amount of potential customers, some of whom, would have been willing to pay more than whomever ends up buying the place. The same goes with hotels and vacation homes.

3D Virtual Tours

Being online doesn’t mean just being accessible to rent or purchase, it also implies being able to truly experience seeing/being in the property, without physically being there. The most effective way to do this is through a 3D virtual tour.

Research has shown that potential customers spend 5-10x more time on websites with 3D virtual tour access and for the 18-34 age category, they are 130% more likely to book a hotel/buy a home, if they have a virtual tour of the place first. In the real estate market, you get 87% more views if you have a virtual tour function and 66% of users would prefer it.[2] This means that currently, there are still large numbers of people who would have been willing to pay for a hotel room or property, if only they had an enhanced digital experience viewing the property.

Market size

The total global property stock is roughly 4bn buildings with 20bn spaces in the world. Assuming you could take that online at $1/per space/month, this implies a total addressable market of ~$240bn.

Total Adressable Market

My ‘Aha!’ Moment

This is when I had my ‘aha’ moment . So far I’ve only discussed the classic rental/purchase of real estate, but 3D property visualization can have far reaching use cases; such as helping facilities manage properties, renovation work, insurance underwriting and online tourism. (Yes I do mean being able to take a tour of Buckingham Palace from your computer screen!).

Then there are the synergies from having that data, such as being able to see how users respond to visual tours i.e. do they want to look at the bathrooms in a hotel first, what features do success retail outlets have in common, are renovations missing safety features. So the market could still be a lot larger than the $240bn mentioned earlier!

Various use cases for 3D Virtual Tours

The Trade: Matterport (Ticker: GHVI)

Matterport is the leader in the market for enhanced 3D Visualisation for properties. In short, they own the software that creates 3D virtual tours and their mission is to digitize properties, globally. They are present in 150 countries, have 250k subscribers worldwide, recorded 18x growth in 2020 and have 100x more spaces under management than the rest of the market combined. So we could say we they are well on their way to that goal.[3]

Matterport Overview

Why is Matterport unique?

  • Software company

Although originally in the business for selling 3D cameras, Matterport pivoted to focusing on selling their software instead. Users take out a monthly subscription to use Matterport’s software which takes in 2D images to create 3D visualizations in return.

  • Cloud based

The second important features of Matterport’s business is that it is fully cloud based. This makes it accessible to anyone, from any device. This removes the need to download programs or have specific camera equipment. Users can upload photos from any camera device (including smartphones) and Matterport configures the 3D tour and hosts it on its own servers for anyone to access

  • Artificial Intelligence

Matterport uses Artificial Intelligence as it builds out its platform. Artificial intelligence makes Matterport’s platform gradually better, as over time, their software can correct for things like bad imaging or lighting, but it can also improve the user experience by performing functions like: calculating how many windows are in a room, suggesting placements for safety devices and how to maximize natural lighting in a specific room.

Artificial Intelligence Integration

Competitive Advantage

Ultimately, these three key features mean Matterport can (1) lock in users on a subscription based model, (2) maximize user accessibility and (3) have a product that evolves with user needs. This gives Matterport a competitive advantage amongst its peers and resultingly, they have been able to touch a number of different markets and customers.

Matterport’s Key Customers

Financials

Normally, I would start to discuss future financial projections now but what is apparent about Matterport is that they are already doing exceptionally well.

A quick overview on their financial metrics shows the business is very strong today.

Matterport Key Metrics – Overview

Revenue growth is a whopping 87% y/y, their subscription model has fantastic margins (82%), they have strong growth in users (18x last two years) and surprising for early-stage software companies, Matterport has profitable unit economics as they generate approximately 12x more from their customers than what they spend to acquire them.

Projections

The company anticipates that this momentum continues as they project strong revenue growth and gross margins into 2025 (leading to them turning EBITDA positive in 2024). They expect revenues to grow at 59% compounded between 2019-2025 and margins to be 25% higher in 2025 than they were in 2019. These are very optimistic forecasts (probably the most optimistic I have seen yet).

Matterport Financial Projections

Valuation

Like some of the other stocks I have covered, Matterport is being taken public by a SPAC (Special Purpose Acquisition Vehicle) trading under the ticker GHVI. The proforma shares outstanding after the transaction goes through will be roughly 291m.

As of close on 19th Feb, GHVI share price was $24.46. So the market cap of the business is approximately, $7.12bn.

This implies the following:

2020E: 83x P/S

2025E: 9.5x P/S, 90x Price/EBITDA

Matterport is still trading at relatively high multiples and clearly a lot of that future growth is priced in, particularly evident when you compare Matterpoint’s valuation against other high growth software stocks such as Docusign (67x P/Sales) and Zoom (42x P/Sales). If you assume Matterpoint can reach it’s optimistic 2025 financial projections and trade at a P/E multiple of 40x at the end of that period (to be closer in line with peers), there is still ~25% upside at the current share price over a five year period (workings below)*. This isn’t hugely compelling upside given that it leaves little room for management complacency.

Conclusion

The property market is huge and still remains offline. There is a strong need to digitize the way people view physical buildings online and Matterport is my pick. They have been the first mover/market leader in this segment for more than five years and continue to offer a unique product which has created a strong moat around their business. Future growth is clearly priced in to the stock at current levels and but understandably, given that this is a market with huge potential. I will look to add a position should the stock retrace below $20/share as this would provide a more attractive risk/reward for my investment.

Stock Price (when blog published): $24.46
Verdict: Cautiously Bullish (< $20/share)
Timeframe: 1-3 Years

*$747m in Revenues, optimised net profit margins of 30% = $224m net profit * 40x = $8.964bn over 293m shares outstanding = $30.60/share

Sofi: The ‘Amazon’ of digital banking

When I first moved to the US two years ago, it took me three visits and multiple hours to get set up with a local bank. It was a painful process. I haven’t set a foot into my local branch since and a few months ago, it was shut down permanently. This has got me thinking that there must be a better way to do banking; do you really need a physical branch? Why are banking apps so bad? Can I make do with just one bank account? In this article, I look at a publicly traded digital bank which I think has found an answer to those questions.

Retail Banking Today

I’m not the only one who has had the thought of taking all banks online. Digital banks, also commonly referred to as Neobanks, are taking the world by storm. The Neobanking industry is expected to reach a market size of $722bn by 2028, which is a CAGR (Compound Annual Growth Rate) of 47% from 2021[1]. This demand is being driven by people, like me, who value the convenience of digital banking.

Despite this growth projection, retail banking is still dominated by the large incumbents (e.g. Chase, Wells Fargo, BOA etc.). In fact, 50% of us bank with the 10 largest incumbent banks (in the US).

Incumbent banks still retain a large share of the market

Yet despite having such a large percentage of the market, incumbents are not doing everything right. Almost the same percentage (50%) hold more than one bank account and when asked why, 80% of these users cite inadequate one-stop shops as the reason for holding multiple bank accounts.

50% have more than one bank account

A One-stop Shop Bank

This resonates with me. I opened my first bank account in the US with the most popular retail bank (which was also a large incumbent). Over time, as I have wanted to trade stocks, take out a loan, set up a savings account, I have had to open more accounts with competing banks. I don’t think this is sustainable (and it’s a pain to manage logins, passwords and tax docs). The market and users would be much better off if there was a one stop shop for all banking needs.

My stock pick: Sofi

This is where Sofi comes in. Sofi is being taken public (via a merger with Special Purpose Acquisition Company, ‘IPOE’). The reason I like Sofi so much is because their entire business plan revolves around being a one-stop shop bank. In fact, they see the Fintech industry just like the market for food delivery, ride sharing, internet search or e-commerce. Just like Doordash, Uber, Google and Amazon, Sofi aims to be the ‘winner that take’s most’, in the Fintech market.

SoFi’s Business

Sofi’s business model has three different segments; Lending, Technology Platform and Financial Services.

Sofi Business Segments

Sofi’s business strategy is focused on what they refer to as “FSPL” which is just a fancy way of saying that they try to get customers on their platform, offer them superior products and then keep customers using their services for all their banking needs. In order to do this effectively as a start-up, Sofi has had to be extremely innovative. Over the last couple years, we can see they have added a significant number of new products to keep in pace with user demand.

Sofi has rapidly developed new product offerings

The virtuous cycle

I think this is very neat. Banks spend a lot of money trying to get new customers on their platforms (referred to as a “Cost of customer acquisition”). However, if Sofi can organically drive this growth by cross selling products to their existing members, Sofi can save these acquisition costs to then re-invest that into superior product offerings or cheaper products. Over time, this becomes a self-fulfilling cycle, as more users decide to stay on the platform in order to get better products, which means Sofi can invest in better products, which means more people stay on the platform…. you get the point.

We can see how effective this is by looking at one of Sofi’s case studies. If they were able to cross-sell a personal loan to an existing user with just a basic checkings account, this would result in an almost 80% improvement in the bottom line for Sofi, on that user (compared to selling both products to two different new customers). Not to mention that by cross selling products to members, Sofi can also focus on customers which it knows are credit worthy and have a built-up history with the bank.

Cross Selling drives an 80% improvement in bottom line (per user)

Is this strategy working?

This strategy seems to be working for SoFi. Over the last couple years, Sofi has grown members rapidly, and a large share of these members have gone on to purchase more than one product. In fact, Sofi is expecting 75% growth in total users but 95% growth in multi-product members (users who hold more than one product) over the next 12 months.

75% Member Growth
95% Multi Product Member Growth

What is truly remarkable to me is that 24% of Sofi’s product sales come from existing customers and for their more profitable segments, like Home Loans, this figure is even higher (69% of Home Loan sales come from cross sales).

% Product Sales from existing users

The Financials

This is having a real impact on Sofi’s bottom line. The company expects to post its first positive EBITDA in 2021. This is remarkable as most Neobanks struggle to make any money, particularly in their early years (and most remain loss making today)[2].

Sofi expecting positive EBITDA in 2021

Outside of cross selling, Sofi can also fall back on very strong margins for its core business.

(i) Lending: 58% Gross Margin

Sofi is 100% origination only for their lending business. This means that they do not buy outstanding debt obligations from other banks to turn a margin. Instead, they sell loans directly to end users, and then put these on their balance sheet before trying to sell these debt obligations to third parties (at a lower interest rate than they collect from their customer). This is the highest margin form of lending.

(ii) Technology Platform: 62% Gross Margin

Sofi also purchased Galileo, a leading fintech platform, for $1.2bn in 2020 and uses this to host not just its own tech infrastructure, but also outsources this to other Neobanks such as Robinhood, Chime, Moneylion and Revolut. This was a very smart move as this has effectively converted a traditional cost center for Sofi, into an income centre (the same way AWS has been for Amazon). Galileo de-risks Sofi as it captures the growth in the Neobanking industry. In 2020, Galileo was handling more than 90% of account creation amongst all Neobanks in the US.

(iii) Financial Services: Loss Making

The third and smallest part of Sofi’s current business (2% of total revenues) is their Financial Services Platform (which includes investing services for stocks, ETF’s and crypto). This is currently loss making but Sofi does expect this to start turning a profit and this is becoming increasingly likely as users transition away from apps such as Robinhood due to reputational issues.

Ultimately, this will allow Sofi to diversify its revenue base from primarily being a lender, to being diversified across these three segments which support high margins.

Is this a good time to BUY Sofi?

As mentioned above, Sofi is being taken public by SPAC. Investors in IPOE will get a 9.3% stake in the business.

Based on IPOE’s market capitalization as of the close on 5th Feb 2021, this implied the following valuation or Sofi:

40x Price/2025 Projected Earnings

6.8 Price/2025 Project Sales

Whilst this is by no means cheap, those ratios do not account for improvements to Sofi’s bottom line as a result a faster than expected transition to profitability in its Financial Services segment or Sofi obtaining a Banking Charter (which should add 25% to Sofi’s bottom line as it would allow it to borrow at cheaper rates).

Conclusion

Banking is an industry prone for disruption and I do fundamentally believe that this is a ‘winner takes most’ type of industry. The incumbents have failed to do this well and Sofi is pioneering the digitalization of one stop shop banking. They have a proven ability to cross sell, have a developed technology platform and have very defendable margins across two of their three key business segments. The stock is not cheap but with positive developments on the horizon, I will be looking to average in to my position at current prices.

Stock Price (when blog published): $23.10
Verdict: Bullish
Timeframe: 5-7 Years



Rare Earth Metals: Impending Supply Squeeze

So we’ve all heard a lot about short squeezes in the stock market recently. In this post, I want to look at a different type of squeeze. I want to look at the supply squeeze occurring in the market for Rare Earth Metals and which stock I think has most the gain from it.

The Basics

If you haven’t read my earlier post on Rare Earth Metals, here’s a refresher on what they are.

Rare Earth Metals (REM’s) are a series of metallic elements which have special properties; such as making great magnets or being heat resistant. They are not hard to mine (like Gold or Silver) but doing so profitably is very difficult because they are spread out along the earth’s crust.

Rare Earth Metals

The two most REM’s elements here are Nd and Pr. These are used to make magnets which power the batteries and motors used for Electric Vehicles (EV’s) and Climate Change Technologies (e.g. Wind Turbines). These also happen to be the two fastest growing end user markets.

Whats the big deal?

What makes Nd and Pr so important is that they are critical components of the products they produce.  The technologies they are used in are very settled, especially the motors which are used in EV’s.

EV Technologies by producer

Above is an overview of the different EV technologies used by car manufacturers. What is apparent is that regardless of producer, the motorization technology is the same, and to produce these components, Nd, Pr are essential.

There is no known alternative to these elements existing in the world today so these are clearly very important components of our lives.

The Problem

There are two fundamental problems here and in both cases investors have a chance to profit.

PROBLEM 1: THE SUPPLY SQUEEZE

The first problem is that demand is outpacing supply, at a considerable rate. You just need to look at EV policies across the globe to realise the scale of the problem. Nearly every major economy in the world has announced some form of EV push to combat climate change and EV vehicle penetration is going to continue to climb as we can see from the below.

EV Policies Overview
EV Growth

If we overlay the demand forecasts for Nd Pr for the EV market, REM supply will not even meet 50% of the forecasted demand for this in the next 10-15 years. This is before demand for Nd Pr from other sectors like wind turbines or smartphones.

This is the hallmark sign of an impending supply squeeze.

PROBLEM 2: EAST VERSUS WEST

The Second problem is that whilst their demand is global, the supply of REM’s is not.

85% of the World’s supply of REM is in China as the Chinese government has made a concerted effort to increase production and relax regulation (through various means).

This is not supposed to be a politically charged article but I think we can all agree that having so much supply concentrated in another country is problematic. What happens if there’s a trade dispute? Or a military conflict? China can and has banned exports to countries like Japan before, and this can severely disrupt supply chains. Just see the price chart of the last squeeze below.

The Trade

The solution is actually quite simple – we need more production and we need that to be in the western hemisphere. As of today, there is only one company operating in this space and that is MP Materials (ticker MP).

Why I like MP Materials Stock?

There are three things I like about MP Materials.

1) MP has a dedicated plan to shore up US manufacturing capabilities

MP has a three stage approach to shoring up US production.

Three Steps to increase US Production

The first stage of MP’s plan is to specialize in Rare Earth Concentrates production. This is the naturally produced concentrate of REM’s. MP has already completed this stage of their plan and they now produce around 15% of the world’s consumption of these REM’s. This is considerably more than what has been achieved at this mine in the past (particularly under previous management, Molycorp).

Stage 1 has been a remarkable success

The second part of MP’s plan is to process this concentrate into refined metals. They are on track to create an onsite refining of REMs in 2022. This will allow MP to be integrated further down the value chain (and ultimately less dependent on China). This is the most important stage for me and I’m optimistic this will be completed on time, as it has the backing of the Department of Defense and is fully funded.

The final stage is to further integrate downstream and to produce the magnets used to make EV Power Trains; also expected to be the fastest downstream market. This would allow MP to sell directly to companies such as Tesla and transition from mining into manufacturing.

2) MP operates in a sector with extremely high barriers to entry

The second thing about this business is that MP’s competitors are significantly behind as they have high barriers to entry. As we can see below, as MP meets Stage II of expansion, it will be at least one year ahead of competition and far cheaper than new Greenfield Sites opening in the US (with uncertain timing).

MP has a natural monopoly in the REM Market outside of China

3) Very strong Financial Position

Finally, I like this business because it has a very promising set of financials. MP forecasts strong growth in revenues as the company expands into refining/end user products. These products also come with higher gross margins of close to 60%. Meanwhile, the capex to fund this associated production will have already been put up by 2021, leaving sizeable Free Cash Flows for investors. Ultimately, this means more Revenues, Cash Flows and EBITDA (projections below).

Conclusion:

MP is doing everything right for me. The REM market is due a serious supply squeeze in the western hemisphere and is vastly under exploited. The only way to publically invest in this space is via MP which is already targeting production growth and will remain ahead of its competitors in a market with huge barriers to entry. Despite very exciting future prospects, the company is still only trading at 13x forecasted 2023 Sales which I think is a good entry point for new investors.

Verdict: Extremely Bullish
Timeframe: 5+ Years

Bitcoin: Stupidity Insurance

(1) Why does Bitcoin exist (2) How does it work and (3) Should you own it. Those are the three questions I aim to answer in this post.

Part 1: Why does Bitcoin Exist?

The Fiat Problem

The key feature of currencies around the globe (post-1971) is that they are not backed by any physical asset. Instead, they are worth what the institutions that create them, decree them to be. This is what is commonly referred to as Fiat Currency and as of today, all currencies across the globe operate in this way.

The fundamental problem with Fiat currency is that it centralizes power in the hands of banking institutions (that control currency supply and keep track of currency transactions). This is what Bitcoin tries to solve.

This is not a novel idea but it’s become more relevant as (1) Governments have printed more money (2) Money has moved online.

Money Printing

Governments print money for a variety of reasons. Some of these are often necessary to offset the harsh realities of recessions/economic crises but at other times, they can be heavily abused (to pay down unsustainable debts or to win political favors). The modern-day banking system compounds these changes through what is referred to as a Money Multiplier. Banks can give out more in loans than reserves they hold, so the actual money in circulation can increase by more than what the central banks inject. In the US, this multiplier is around 1.20x (so a $1 increase in the monetary base leads to a $1.20 increase in the amount of real money in circulation)[1].

The ultimate outcome of this process, all else being equal, is that the value of the money in your pocket, declines – which is what is referred to as inflation. The supply of money in the economy and inflation, have continued to increase at a compounded rate for the last century (and astonishingly 22% of all $ ever printed were printed in 2020!)[2]. You can see how this can easily get out of hand….

US Money Supply ($bn)
US Annual CPI Inflation Rate (%)

Digital Money

The second shift taking place is the trend towards digital money. In fact, only 8% of total currency is held in cash today[1]. Online payments are facilitated by a Central Payments Processors or ledgers, held by a bank or institution, to keep track of digital transactions (and to spot fraudulent activities). This has given more power to financial institutions to maintain, monitor and responsibly handle an increasing proportion of the monetary base.

The fundamental issue Bitcoin seeks to address is how to avoid a situation where the major institutions that we rely on today, abuse our trust or do something stupid. Whilst that sounds far-fetched, the two major trends of increased central bank ‘money printing’ and digitization of finance, have increased the power of these institutions to cause us serious harm. There are multiple examples of institutional mismanagement in the past, such as episodes of hyper-inflation (see table below) and financial scandals where banks have literally made-up fraudulent transactions (Well Fargo, 2016). There is no guarantee this will not happen again.

Historical cases of Hyper Inflation

Part 2: How does Bitcoin work?

Bitcoin as the solution

Bitcoin was proposed in 2008 as a means of solving the above issues. Principally, it does this by (1) inherently limiting the amount of currency (Bitcoins) in circulation (2) decentralizing the ledger that keeps track of digital payments.

The first of these concepts is pretty simple; Bitcoin supply is capped at 21 million Bitcoins. This means that there will only ever, be 21 million Bitcoins in circulation; protecting the holders of Bitcoin from supply led devaluation (aka inflation).

The second, relies on a decentralized ledger to record financial transactions. Instead of having a bank do it, the responsibility to record who is spending what, is shared between everyone who is on the Bitcoin network.

How does Bitcoin work in practice? (Disclaimer: Gets Technical)

The above explanation is usually sufficient. However, if you’re like me and want to understand how this really works, I have laid out the key features of Bitcoin below.

  • Decentralized Ledger

All Bitcoin transactions are stored on a decentralized ledger, which is called a blockchain. The blockchain is accessible to everyone and updated over 100x per day. The transactions on this blockchain are displayed pseudo anonymously in so far as they exclude personal details (such as name, address, items you purchased/sold) but they include account numbers, referred to as public keys.

  • Transaction Verification

To avoid fraudulent transactions being shared on the network (such as User A taking money from User B without User B knowing about it), all transactions need to be verified by digital signatures belonging to the users in the transaction before they can be sent to the network (and added to the blockchain). This is a bit like signing a bill at a restaurant but far more secure and involves computer functions.

The way this works is that the user in question, has two identifiers for their Bitcoin account (referred to as a wallet). The first is a private key, which only they can see. The second is a public key, which everyone on the network can see.

To verify a transaction, a user would need to approve a transaction with their digital signature. The signature is generated by taking the user’s private key and the transaction in question and putting it through a computer function.

When a digital key accompanies a transaction, Bitcoin software can check it’s authentic (and not just made up by someone) by taking the published digital signature and the public key associated with the user’s account, and checking if this was in fact generated by the user’s private key. The output of this test is a simple True/False to confirm if a transaction is valid or not.

  • Bitcoin Mining

The details of all verified Bitcoin transaction are posted publicly in the network in real time. Miner’s group these transactions together in what is referred to as a block (of normally 2,500 transactions). These blocks then get added to the ledger (following the previous block of transactions). This is why the ledger is referred to as a blockchain.

  • Hash Function

To avoid a situation where miner’s try to fraudulently enter data or make an error, Bitcoin uses a ‘Hash Function’, which is basically a mathematic puzzle that miners have the solve before their blocks can be added to the blockchain. The role of the Hash Function (SHA-256) is to make it practically infeasible for fraudulent transactions to enter the ledger and resultingly, to create a consensus as to which transactions form the blockchain.

A Hash Function takes a specific input to create a string of data as an output. The two interesting things about Hash Functions are that 1) it is impossible to figure out what went into the function to create the output, without using trial and error and 2) any small changes in the input, cause large, random changes in the output of the function.

So how is this relevant?  

After a block is verified, a miner needs to figure out what unique number needs to be added to the block of transactions, to solve the Hash Function (associated with that block). This requires a lot of computing power as it relies on trial and error to achieve. The first miner to solve this problem, gets a reward (more on that below). When they solve this, the unique number input (referred to as ‘Proof Of Work’) is added to the block of transactions, which then gets added to the blockchain.

If a miner tries to put in a fraudulent transaction in their block, they will have a different solution than the other miners for the Hash Function. If they were first to solve the Hash Function, they will have their block added to the blockchain. However, as more blocks need to be mined, it becomes statistically impossible for this miner to maintain their fraudulent version of the blockchain and ultimately their (fraudulent) version of the blockchain becomes discarded (in favor of other, correct, blockchains being solved by other miners).

The reason this works is because Bitcoin relies on the principle that the blocks with the most computational work (i.e. the most successful solutions to the Hash Function) be kept. As it is harder to keep solving the Hash Function when you have a fraudulent transaction, it restricts these from staying in the blockchain over time.

  • Inherent balances

Bitcoin maintains a system of self-regulation through ingenious supply/demand balancing mechanisms.

To encourage enough miners to be on the network to verify transactions, they receive a reward (paid in Bitcoins + transaction fees) for their work. This is paid out to the miner that successfully solves the Hash Problem associated with their block the fastest (which is one miner every 10minutes on average). This insures that there is an incentive to mine, which maintains integrity of the network.

The number of Bitcoins given to miners for their effort halves approximately every four years. This helps Bitcoin reach its supply cap over time (predicted to be around the year 2140). After this point, there will be no way to increase the supply of Bitcoin (thereby protecting the value of Bitcoin from supply shocks).

Finally, mining difficulty is correlated with the number of miners in the system (which is set by the difficulty of the Hash Function miners need to solve). If fewer miners are on the network, the problem gets easier to solve, which makes it cheaper to mine and therefore, creates an economic incentive for more miners to join the network. Conversely, if too many miners join the network, it gets harder to solve the Hash Problem, which then means you need more computing power which makes it less economical for some miners. This system ultimately maintains a steady number of miners in the network.

Part 3: Should you own Bitcoin?

As a currency, Bitcoin needs to meet two use cases to be productive: it needs to be a means of exchange and it needs to be a store holder of wealth.

Bitcoin as a means of exchange

Bitcoin is a long way from replacing fiat currency as a means of exchange (supposing that it was ever allowed to achieve this objective)[1].

  • Transaction Inefficiency

The Bitcoin blockchain method is an inherently inefficient way to process transactions at scale which will limit its widespread adoption. Visa, a central payments processor can process 1,700 transactions per second compared to Bitcoins meagre 4.6 transactions per second[2].

The reason for this is because of the way Bitcoin has been hard coded from inception. Recall that miners add a new block of roughly 1mb (2,500 transactions) every 10mins to the network. (That number does not change even if more people are using or mining bitcoin!). To get even close to competing with Visa’s transaction speeds, the way Bitcoin fundamentally works would need to be changed, to either allow more transactions in each block (going from 1mb to 377mb per block) or to reduce the complexity of the Hash problem to allow miners to add one block every 1.6seconds[3].

Making these changes will be undoubtedly problematic as it opens up a bunch of existential issues for Bitcoin; such as who is in charge of making these changes and whether or not this compromises the security of the overall network. As Bitcoin will always have to solve for how to maintain integrity on a shared network (something central payments processors do not have to worry about), I am skeptical that Bitcoin can overcome this shortfall.

  • Monetary policy

The second issue I have with Bitcoin is a textbook one. By capping the number of Bitcoins in circulation, you effectively remove one of the central pillars of modern-day capitalism i.e. the ability to give and receive credit. Without the ability to control monetary supply, economic recessions will arguably be more severe, wages will be sticky impacting unemployment and economic growth will likely be subdued. In fact, everything we know about economic theory would have to go out the window.

  • Mining/Power concentration

I see the merits of decentralizing financial power but Bitcoin is far from being a decentralized utopia. 70% of the total Bitcoin mining capacity exists in China and half of the Chinese mining network, is controlled by only 5 companies[4].

I don’t think this is a coincidence. As Bitcoin gains traction, it will require more and more resources to be mined, meaning that the distribution of said mines will shift to locations where power is cheapest or most accessible. To put this into perspective, Bitcoin mining today, already consumes the same energy as 5million US households, or the entire annual power consumption of New Zealand or Hungary. At the same time, as Bitcoin increases in adoption (and value), more miners will be incentivized to join the network and resultingly, more computing power will be required to mine Bitcoins (see Part II for why this is the case). This tends more power to mining pools, or groups of miners operating under one collective.

We are already seeing both of these trends play out in China where mining is located principally close to cheap coal or hydroelectric power stations, and mining power is principally pooled together by large Chinese mining companies [5].

The problem with this is both a political and a cryptographic one. Politically, such large concentrations of mining power in specific countries, will work to limit the adoption of Bitcoin as a truly transnational currency (or it being perceived as such). Second, when any single mining group controls more than 51% of mining power, something which was initially assumed to be impossible, it makes it possible for these miners to override the security protocols behind Bitcoin (and effectively opens up Bitcoin to the same problems as Central Payment Processors).

Bitcoin as a store holder of wealth

  • Volatility

It is tempting to buy Bitcoin when you look at the recent price action (or if you have ever used Twitter!). There is a lot of mistrust in financial institutions (66% Americans don’t trust the Fed[6]) and Bitcoin feeds off that.

Nonetheless, I struggle to justify owning Bitcoin to protect wealth, when its one of the most volatile assets on the board; more volatile than the S&P, Gold, USD, Oil, Copper… the list goes on. (The standard deviation of daily returns for Bitcoin over the last 30 days is a whopping 4.63%[7]).

Bitcoin Price as a % Off High
Bitcoin appreciation relative to other market ‘bubbles’

Then there’s the fact that over time, the best store holders of wealth have been the asset classes which have productive use cases; something Bitcoin lacks[1].

  • Stupidity Insurance

I am sympathetic to the argument that Bitcoin may act as some sort of stupidity insurance against a financial catastrophe or a black swan even, where the financial system as we know it, no longer exists. In this scenario, hopefully having a small (<2%) allocation of Bitcoin will more than offset the losses elsewhere in your portfolio (though if this happens, you will likely have plenty of other things to worry about). Bitcoin as an insurance policy is also easier to obtain and store (especially in non-fungible amounts) than alternatives such as precious metals (which have been taken out of private ownership multiple times by governments).  

Seeing that Bitcoin is still largely concentrated in few accounts (95% of total owned Bitcoins are held by only 2% of accounts[1]), even if the top 100 largest Asset Managers allocated 1% towards Bitcoin, we are likely to see a significant price appreciation in Bitcoin (potentially paving the way to +$500k).

Conclusion: Bitcoin as Stupiditity Insurance

This is the only convincing argument I see for Bitcoin. Principally, that it is a form of Stupidity Insurance. If enough people see it this way, you may even make money in the short term on your investment (but that should not be the objective). The questions this leaves me with are: (1) Do I want to own stupidity insurance now (2) How much do I want to pay for this.

Bitcoin is already up 350% in the last year and has yet to prove its productive use case. This price action is not being driven by people wanting to insure their portfolios but by speculation. Institutional ownership of Bitcoin remains low, and most Bitcoin holders don’t even hold their own Bitcoins (they leave them with exchanges or third party ‘hot wallets’). Meanwhile, the Fed is effectively back stopping financial securities and interest rates are basically at zero, making it far easier (and safer) to just be long equities as insurance against Central Bank stupidity.

Sure, if we see a sharp correction in Bitcoin (sub $20k), improving user adoption or I get to the point where I’m happy to write off some of my stock profits in Stupidity Insurance premium, then I’m happy to allocate 1% of my portfolio to Bitcoin. However, for now – I see better value keeping my money in the stock market and Bitcoin as nothing more than expensive stupidity insurance.

Verdict: Neutral (with max 1% allocation sub $20k)
Timeframe: 1-2 Years

[1] https://www.bloomberg.com/news/articles/2020-11-18/bitcoin-whales-ownership-concentration-is-rising-during-rally?sref=BXV5fZtz


[1] https://twitter.com/saxena_puru/status/1348079386638000129/photo/1


[1] https://finance.yahoo.com/news/iran-reportedly-seizes-45k-bitcoin-083734251.html

[2] https://towardsdatascience.com/the-blockchain-scalability-problem-the-race-for-visa-like-transaction-speed-5cce48f9d44

[3] https://towardsdatascience.com/the-blockchain-scalability-problem-the-race-for-visa-like-transaction-speed-5cce48f9d44

[4] https://cbeci.org/mining_map

[5] https://cbeci.org/mining_map

[6] https://www.crowdfundinsider.com/2020/12/170157-bitcoin-btc-investment-thesis-matured-in-2020-due-to-covid-19-which-led-to-unprecedented-macro-policy-report/

[7] https://www.buybitcoinworldwide.com/volatility-index/


[1] https://invstr.medium.com/only-8-of-the-worlds-currency-is-physical-cash-9cbf6787b62f


[1] https://tradingeconomics.com/united-states/m1-money-multiplier-ratio-bw-sa-fed-data.html

[2] https://www.somagnews.com/9-trillion-story-22-of-us-dollars-printed-in-2020/

Driving the bull case for Auto-Insurance

The US auto insurance market is nearly the same size as US car sales market ($309bn vs $545bn)[1]. In fact, auto insurance is the second largest auto related market in the US; 14x bigger than the Car Rental Market ($22bn), 17x bigger than Car Auto parts market ($18bn) and 5x bigger than Car repairs market ($66bn). Yet despite this huge size, the market is expected to continue to grow at a not-so-shabby rate of 3%pa over the next decade[2].

Is car ownership at risk?

On the contrary to what has been expected over the last decade, car ownership in the US is continuing to increase. 93% of households last year said they had access to at least one vehicle in the US and that number has been trending higher over the last decade[3]. Surprisingly, a large percentage of this growth has come in cities where ride sharing services such as Lyft and Uber operate, which studies put down to increasing ownership by drivers (more than offsetting decreasing ownership by riders)[4].

Whilst on paper, car ownership could see some headwinds as younger consumers delay buying a car in favor of public transport to work/ride sharing, for now this is being offset by cheaper financing costs for lease vehicles and the very large percentage of the US population which cannot functionally survive without a car[5]. For instance, millennials still account for 12% of all vehicles sold on the road today.

COVID-19[6]

We are seeing the trend away from car ownership being slowed down significantly by COVID19. The percentage of US consumers who think car ownership is necessary has shot up 14% in the last year (with 60% of those preferring to buy from a dealership).

This is despite ridesharing available to more than 20% of the US population (up from 7% in 2015)[7]. In 2020, ridesharing has experienced a massive hit to demand, with 65-70% of users between the ages of 18-24 having stopped their usage of these services due to COVID-19. Resultingly, Uber has had to lay-off 25% of its workforce (Lyft laid off circa 20%)[8].

Public transportation has experienced similar headwinds although it started from a much lower base. US public transportation has historically had very low rates of adoption (outside of a few major cities) with 45% of millennials (and 38% of general public) having reported to have never used public transportation.

US Public Transportation has a very low rate of adoption

But in the cities where public transportation started at higher levels of adoption (as a percentage of total transport) such as in New York, Jersey City and Philadelphia, we are seeing usage down significantly. In fact, across the US (according to Apple Mobility Data), public transportation remains the hardest hit mode of transport due to COVID-19 and is down 61% on average (compared to driving being down only 20%).

The outlook

What this shows is that car ownership is not experiencing a decline and if anything, the stickiness of consumer decisions to move away from public transport and ride sharing, should continue to provide a steady rate of growth for the auto insurance market over the coming years.

Case for disruption in the market

The insurance market has not changed much over the last 50 years. Put simply, the business operates on the law of large numbers – insurers collect smalls bit of data (like age and driving history), set you a premium and then hope for the majority, that they don’t get into an accident (and on the whole they do ok with 64% of premiums collected being handed out in claims)[1].

That being said, there are underlying problems in this market:

  • Inefficient pricing

The current auto insurance market experiences an inherent (economic) inefficiency arising from a lack of data distinguishing between good drivers and bad drivers. 35% of drivers put in more than more than half of total passenger miles and cause more than half of insurance losses[2]. However, a lack of data about which drivers are causing these losses means that premiums increase for all drivers, to offset these losses (and are not targeted at just the bad drivers). This effectively leads to 65% of drivers overpaying for auto insurance in order to subsidize the bad drivers.

  • Incentive Problem

There is an inherent incentive problem when trying to deal with pricing in the auto insurance market.

Firstly, the existing insurance market relies on a linear relationship between miles driven and insurance losses i.e., the less passengers drive, the less losses an insurance company is likely to experience as a result. In a market which has long been predicted (see above) to experience declining passenger car mile usage due to more public transportation and ride sharing, it becomes harder for companies to overcome the internal headaches/investments to change their pricing models.

Secondly, given that no US carrier currently has more than 20% market share, there is a reluctance on behalf of the larger carriers in particular, to fundamentally disrupt their business (via telematics-based pricing) at the detriment of conceding market share. This is a classic innovators dilemma as the larger companies have focused on sustaining technology/small scale disruptions to meet their customer needs today, instead of overhauling their business with large scale disruptive technologies for users in the future.

Both of these are evidenced by the relatively low penetration of finance technology and advanced data analytics in the US auto insurance today[3].

No carrier has more than 20% market share in US Auto-Insurance
Fintech Adoption has room to grow

The future of the market: Data Analytics

According to a comprehensive auto insurance study by Mckinsey, the auto insurance market in 2030 will belong to the insurers who have the best pricing capabilities[1]. In order to achieve this, insurance companies will need to adopt advanced data analytics and data collection methods (so things like: monitoring real time driving habits, integrating this with information about consumer behavior and then delineating risk to price policies). In fact, by 2030, they expect that over 90% of policies will be automatically priced and for the top tier of companies that can get this right, this will result in operational savings of over 30%.

From a compiled risk of disrupters in the insurance space, we can see this is getting some traction. Approximately 20% of new insurance technology companies are focusing on data analytics and Machine Learning models to improve pricing capabilities in the insurance market.

20% of Insure-Techs focused on Data/Machine Learning

Compiling a list of the major insurance technology disrupters, filtered by those with a market cap of minimum $1bn, there are only three companies dedicated to taking on this challenge in the auto insurance market; Lemonade, Root and Metromile. They are all currently publicly traded (Metromile is in the process of being taken public by SPAC).

How do they rank on key Metrics?

At surface level, Lemonade, Root and Metromile are similar. They all focus on data analytics, are rolling out across the US and intend to or have already expanded to insurance verticals (such as Renters and Pet Insurance). The things I like about each are that: Metromile boasts a pay per mile insurance policy, Root uses your smartphone (instead of a dongle) to track driving behaviors and Lemonade has a fully automated claims processing function (which I have personally used before).

At closer look however, Metromile comes out ahead of the competition on the metrics that will be most important. That is, Metromile is better than Lemonade or Root at (1) pricing insurance risk (i.e. lower Loss ratio), (2) retaining customers on its platform (especially important for insurance cross selling which decreases Loss Ratios by close to 15%!) and (3) has significantly higher life time value per customer in relation to the cost of acquiring these customers.

For me the most striking thing about this is that Metromile is the newest of the three businesses (originated in 2019), with the smallest customer base and in a sector where there are natural economies of scale (the more customers you have, the more data you collect, the better your pricing models).

Conclusion

The auto insurance market is a stable market and ironically, this is what will drive investor returns. The relatively sluggish pace of growth in the overall market (of 3%) has left room for tech disrupters to take a slice of the pie, which will likely come at the expense of the bigger and more inefficient providers of auto insurance. Whilst I don’t expect the industry to outperform some of the more exciting sectors that I have covered in other blog posts, I do expect the market share of tech rivals such as Lemonade, Root and Metromile to expand as they beat out these larger rivals. For now, Metromile is my pick.

Verdict: Moderately Bullish
Timeframe: 1-3 Years

[1] https://www.mckinsey.com/industries/financial-services/our-insights/insurance-productivity-2030-reimagining-the-insurer-for-the-future


[1] https://assets.metromile.com/wp-content/uploads/2020/11/24120556/Ext-Investor-Preso-vFinal.pdf

[2] https://assets.metromile.com/wp-content/uploads/2020/12/16214939/12.16.2020-Metromile-Financial-update-supplement.pdf

[3] https://www.mordorintelligence.com/industry-reports/united-sates-motor-insurance-market


[1] https://www.ibisworld.com/united-states/market-research-reports/automobile-insurance-industry/

[2] https://www.mordorintelligence.com/industry-reports/united-sates-motor-insurance-market

[3] https://www.thezebra.com/resources/research/car-ownership-statistics/

[4] https://www.newscientist.com/article/2264144-uber-and-lyft-operating-in-us-cities-linked-to-rises-in-car-ownership/

[5] https://investorplace.com/2019/04/4-charts-car-ownership-over/

[6] https://www.thezebra.com/resources/research/car-ownership-statistics/#own-lease

[7] https://investorplace.com/2019/04/4-charts-car-ownership-over/

[8] https://abc7news.com/ridesharing-apps-covid-19-rideshare-uber-lyft/6197137/

Riding the tailwinds of Chinese E-Commerce

China will overtake the US to become the world’s largest economy by 2028, five years earlier than previously forecast, according to the UK based CEBR (Centre for Economics and Business Research)[1]. This bodes well for the e-commerce sector which accounts for a whopping 36% of total Chinese GDP today, compared to only 15% in 2008 [2]. In this post, I will look at the particularities of Chinese e-commerce and how and why retail investors should want a slice of this pie.

Market Size

Growth Trajectory

The global e-commerce market is expected to grow at 16% compounded over the next four years (having already grown at 17% compounded over the last seven years). For context, that’s 1.5x the expected growth rate of the global smartphone market, 2.5x expected growth rate of home ownership and about the same as the forecasted growth rate for the Electric Vehicle market over the same period…so it’s a pretty big number[3],[4],[5].

Global E-Commerce Sales Growth

Shopping Experience

This is being driven by changing consumer preferences over how and where shopping takes place and improvements in mobile technology to facilitate this transition. 67% of millennials already prefer to shop online (and 56% of Gen X-ers), when compared to brick and mortar. Of these, about half make purchases whilst sitting in bed, 23% at work (and 20% from the bathroom or in the car!), representing how mobile technology has been able to make shopping more convenient and fulfill our endless desire to do things on our own terms.[6] These structural trends are not expected to go away any time soon particularly as a result of COVID-19 which has spurred increased online sales in most industries.

China led growth

Whilst the current global e-commerce market is around $4tn (roughly 5% of Global GDP), the bulk of this market share is in China, which boasts an e-commerce market almost twice the size of the US equivalent. E-commerce accounts for almost 35% of Chinese total retail sales, compared to only 10% in the US[7]. To put this into perspective, approx. 50% of global online transactions each day, happen inside of China and the largest online retailer in China, Ali Baba, has almost double the number of active users on its platform that Amazon has globally (600m vs 330m).[8]

As the first major economy to post GDP growth in 2020, the Chinese e-commerce market is facing two very strong tailwinds; a global structural trend away from brick and mortar to online, and high sensitivity to a booming Chinese economy, which is set to continue to grow 5-8% per annum over the coming decade.

Chinese e-commerce market

The Chinese e-commerce market is not identical to other markets.

  1. Mobile shopping

Mobile platforms generate 80% of retail ecommerce sales in the country (and 95% of total e-commerce activity) vs 64% globally. Put simply, this is because the average consumer in China spends more time on their smartphone (5 hours, compared with 3 hours globally)[9]. Given smartphone penetration is still far from reaching saturation (50% of the Chinese population), existing operators need to have a large-scale mobile retail presence to continue to expand[10].

2. Mobile Payments

This mobile technology has gone hand-in-hand with mobile payment platforms (such as Alipay, Wechat and Union Pay). In fact, 80% of smartphone users use mobile payments compared to only 27% in the US. The opportunities for newcomers in this space however are limited with Alipay (owned by Ali Baba) and Wechat (owned by Tencent) controlling 92% of the Chinese mobile payments market combined[11].

3. Omni-Channel Retail & Brand Awareness

The third distinction is that Chinese consumers are more discovery oriented than US consumers (i.e. they don’t always know what they want before they’re online), indicated by the former having more touchpoints with the brand before item purchase (8 touchpoints versus only 4 in the US).[12] This has made omnichannel retail (selling across multiple platforms), international brands and interconnectivity with social networks, particularly important to drive retail sales in China.

Current State of Play

All three main players in the Chinese e-commerce market (Ali Baba, JD and Pinduoduo), cover some form of mobile retail, mobile payments and omni-channel retail but Ali Baba is miles ahead. This is because, whereas, JD and Pinduoduo both have secured strategic investments from Tencent to add additional services to their primary retail presence (e.g. mobile payments and social networking) Ali Baba has been able to integrate these functions across its existing businesses (such as Ali Pay and Lazada).

Resultingly, Ali Baba has the biggest slice of the pie with 60% market share, led by its Business-to-Consumer marketplace, Tmall. To put that into perspective, Amazon accounts for 40% of online retail sales in the US and is widely considered an e-commerce behemoth in the US[14].  

List of Chinese e-commerce players

Tmall China (Ali Baba) – The third most visited site in the world and a brand driven B2C marketplace.

60% Market Share

JD.com (JD) – marketplace with in-house delivery and logistics.

20% Market Share

Pinduoduo – Group buying marketplace (like Groupon).

5% Market Share.

Others – (Wechat Store and Red/Xiahongshu)

~15% Market Share

Ali Baba as an E-Commerce Stock

Whilst Ali Baba is by no means a pure play Chinese e-commerce stock, 68% of FY 2019 revenues came from Ali Baba’s China based marketplaces (compared to 7% from international wholesale, 7% cloud computing, 6% entertainment and  4% logistics services). 85% of this in was via mobile sales. This illustrates that whilst Ali Baba touches many different industries, it is still very much a Chinese consumer focused, mobile e-commerce giant.

Ali baba strikes me as the most defendable business model within the Chinese e-commerce space. This is principally because it meets the threshold of having the strongest mobile retail penetration for the Chinese consumer (with higher gross margins), mobile payments integration and cross border retail presence to drive brand awareness.

Why Ali Baba is superior to competition

Overview of Ali Baba E-Commerce Businesses

Strong Mobile Customer Penetration (and a more profitable business model)

Based on Chinese internet users of over 855 million, Ali Baba boasts an 83% penetration rate for its B2C and C2C platforms (Tmall and Taobao), which are the two largest online marketplaces in China. About half of the Chinese population are users of Ali Baba and over 85% of total yearly sales on Ali Baba’s platform, come from mobile (with total GMV larger than Amazon and Ebay’s yearly sales, combined). This deep penetration has allowed Ali Baba to leverage network effects across its platforms (the platforms drive traffic to each other thereby lowering acquisition costs) and as a result, Ali Baba is usually the first shopping experience for Chinese customers. This deep penetration has allowed the company to maximize revenue per user relative to its competitors (GMV per active user was CNY 730 versus CNY 143 for Pinduoduo and CNY 362 for JD).

Direct Customer fulfillment

Ali Baba is often described as the Amazon of China whereas in fact, it operates more as an ‘Ebay’ of China. Tmall, it’s B2C platform, gives businesses direct customer fulfillment so they manage the warehousing and shipping of goods to the end customer. This allows Ali Baba to charge servicing fees for marketing on its platform but it does not have to take inventory on its own balance sheet. This vastly improves the overall net income margin for Ali Baba which is 22% (vs 5% for Amazon, 1% for JD) and Gross Margin OF 44% (vs 40% for Amazon, 15% for JD).

Mobile Payments Technology

Ali Baba also owns a 33% stake in Ant Financial, a mobile payments and microlending platform. Ant has the largest share of the Chinese mobile payments market (54%) in an industry which is set to double in size by 2025. Wechat is second in size at only 38% market share. This dominant position has allowed Ali Baba a virtual monopoly on mobile payments as it can integrate this with it’s online e-commerce platforms.

Omni-Channel Retail via cross border e-commerce

Outside of China, Ali Baba is the furthest ahead in integrating its business with global brands and cross border e-commerce. This is primarily facilitated by Ali Baba’s controlling stake in Lazada, a South East Asia focused e-commerce business (with 200million active internet users across these regions). In these regions, e-commerce accounts for a meagre 3-5% of total sales reflecting lack of existing providers and strong runway of growth ahead. In 2009, Ali Baba also purchased Koala from rival Netease (integrated into Tmall) to build out its import strategy; allowing global merchants direct access to the Chinese consumer. This will allow Ali Baba to accelerate import/export services, have (exclusive) access to international brands selling into China, and drive brand awareness.

Risks

The biggest risks to backing this tech behemoth is regulatory uncertainty in China. The two specific risks to the price of Ali Baba stock (though these developments still have a corollary impact on the broader sector) are:

  • Ant Financial

Ali Baba has a 33% stake in Ant Financial, whose long awaited IPO came to a grounding halt as Chinese regulators suspended the offering and proposed last minute changes to Ant’s business model. Whilst founded as an online payments platform, Ant has grown beyond this and this has become the sticking point for the regulators. 63% of Ant’s revenues come from matching consumers to lenders via its platform (this was 44% of revenues in 2017 speaking to the spectacular growth this division has experienced). Ant uses its own proprietary technology to provide customers with credit scores (Zhima credit scoring system), compiles lending risks and then securitize debt via third parties or to pass this on to conventional banks.

Chinese regulators want to treat these type of platforms as financial institutions and not tech companies, and resultingly want Ant to put up its own capital against these loans (30% of capital for joint loans with banks versus current 2%). This resultingly limits Ant’s leverage and growth rate, particularly if Ant also has to apply for new banking licenses.

Whilst Ant is not Ali Baba’s core business, the elephant in the room here is the Microlending/P2P scandal in 2008. During this period, China saw a rise in scandals and mismanaged debt which the government is keen to avoid the second time around[15].

My take on this is that unlike in 2008, the tech giants are providing a service which conventional banks have been unable to provide. Credit cards are not pervasive in China and financial records are largely inadequate in rural areas. This has limited access to credit in remote areas and to date, the biggest four conventional banks give out 75% of their total loans only in the form of mortgages (in 1H 2020). This has left a gaping hole for new microlending entrants who have the digital footprint and know-how to provide this service (and pick good borrowers from bad ones). Whilst Ant may be hamstrung by new regulations, this will likely come at the expense of short-term growth as this service cannot feasibly be performed by existing conventional banks or other private businesses without the same scale and expertise. In other words, the overall business opportunity remains intact but Ant will have to wait longer to achieve the same outcomes or at least, until regulators are more comfortable.

  • Anti-monopoly Laws

The second major risk to Ali Baba is an overhaul of the existing competitive framework in China for e-commerce. As we established above, Ali Baba relies on its massive network to be as effective within the e-commerce space. However, in 2020, the Chinese government first applied a monopoly law to fine Ali Baba (alongside others).

The newly contested issue is platform integration or exclusivity arrangements that Ali Baba may have for that prevent users from going on other platforms. This is a big blow to the company and so far, it is unclear how this will play out, particularly as there are so many avenues that they could pursue this with Ali Baba. For me, this is the single biggest risk to the stock as Ali Baba relies heavily on its expansive network to be effective.

Conclusion

I am bullish China and Chinese e-commerce. Ali Baba is the natural choice for investment, as it’s the biggest, most exposed and the most defendable business operating in the sector. Ironically, the biggest risk to this position is that regulators see these strengths and force Ali Baba to concede market share to allow new entrants in the market. Despite this, Ali Baba is sizably ahead of the competition and has cemented a strong position with the Chinese consumer. This should make policies short of actively breaking up Ali Baba, to be nothing but a slow burn; as what pieces of business Ali Baba may eventually lose to competitors will likely be more than offset by its levered position (and natural monopolies) in this fast growing industry.

Verdict: Cautiously Bullish (pending impact of regulatory investigation)
Timeframe: 3-5 Years

[1] https://www.bbc.com/news/world-asia-china-55454146

[2] https://tenbagroup.com/12-china-e-commerce-market-trends-2021/

[3] https://www.mordorintelligence.com/industry-reports/smartphones-market

[4] https://www.globenewswire.com/news-release/2020/04/14/2015310/0/en/The-Global-Electric-Vehicle-Market-is-expected-to-grow-from-USD-146-902-20-Million-in-2019-to-USD-359-854-56-Million-by-the-end-of-2025-at-a-Compound-Annual-Growth-Rate-CAGR-of-16-.html#:~:text=%2F%3Futm_source%3DGNW-,The%20Global%20Electric%20Vehicle%20Market%20is%20expected%20to%20grow%20from,(CAGR)%20of%2016.10%25.&text=The%20Battery%20Electric%20Vehicle%20commanded,Electric%20Vehicle%20Market%20in%202019

[5] https://www.mordorintelligence.com/industry-reports/us-homeowners-insurance-market

[6] https://kinsta.com/blog/ecommerce-statistics/

[7] https://kinsta.com/blog/ecommerce-statistics/

[8] https://business.cornell.edu/hub/2020/02/18/impact-e-commerce-china-united-states/

[9] https://tenbagroup.com/12-china-e-commerce-market-trends-2021/

[10] https://www.statista.com/statistics/321482/smartphone-user-penetration-in-china/

[11] https://www.paymentscardsandmobile.com/alipay-continues-mobile-payments-expansion-in-japan/

[12] https://digovation.com/2020/06/15/understanding-the-e-commerce-landscape-in-china/

[13] https://www.sellmasters.it/en/2020/01/28/e-commerce-usa-vs-china/

[14] https://www.emarketer.com/content/china-ecommerce-2020

[15] https://www.scmp.com/tech/innovation/article/3113410/how-chinas-online-microlenders-reached-tipping-point-worlds-biggest