Chinese net-nets

Finding quality net-nets overlooked by the market

Last year, a Financial Times article (https://www.ft.com/content/7d6c3c8a-97dc-4b98-8421-f881f185661e) stated that there are currently 252 Chinese groups trading in the US or Hong Kong that meet the definition of a “net-net.” Since then, the Chinese and Hong Kong stock markets have tanked even further, while, recently, more and more positive profit alerts have been issued.

In essence, Ben Graham's "net-net" investing approach was to purchase undervalued companies for approximately two-thirds of their net current asset value and diversify your portfolio with about 30 of these net-net companies. The idea was that if the company recovers or gets reevaluated, you make a profit. If it fails, you can still sell the assets and hopefully recover your initial investment.

The strategy of investing in "net-nets," as originally proposed by Benjamin Graham—purchasing a portfolio of 30 such stocks without additional analysis—hasn't been as effective in recent decades for several reasons. Although I remain convinced that blindly following Graham's method is unlikely to yield success in the current market, I believe there is an increasing number of net-nets that present intriguing opportunities.

I've noticed that recently it's possible to acquire companies that are decent, if not excellent and well-managed, for less than their current asset value. Naturally, these companies have their issues; otherwise, they wouldn't be trading below their net current asset value. However, with a closer examination, one can discover real gems. Often, these companies' fundamentals are improving even as their stock prices plummet. They also tend to have very strong balance sheets and may pay substantial dividends or aggressively buy back shares. Of course, no investment is without risk, but in these instances, I believe the potential rewards justify taking on the risks, as the downside is often very limited and the upside is significant. But make no mistake, I would still steer clear of investing in failing companies (a common scenario with net-nets), no matter how inexpensive they appear. I am searching for those gems that are misunderstood or overlooked by the market. I will provide some examples below, but in the coming weeks, I will cover more of these stocks in greater detail.

Everything I've mentioned applies universally, but why am I particularly drawn to Chinese stocks, especially those traded in Hong Kong and the US? The reason lies in a unique perspective: some view these stocks as uninvestable, which ironically makes them more intriguing to me.

A significant factor is the information gap. Due to capital controls, Chinese investors are largely restricted from buying these stocks unless they fall under the southbound trading channels. On the other hand, foreign investors, who have the freedom to invest, often lack a direct understanding of the products or services these companies offer, as their operations are primarily within mainland China. This creates a peculiar situation: those with firsthand knowledge of the companies are unable to invest, while potential investors from abroad hesitate due to a lack of familiarity. Honestly, if I were recommended a tech company from India or Brazil trading below net asset value without any knowledge of what they do, I'd be wary, too.

In essence, the information asymmetry surrounding Chinese companies might present an opportunity to purchase decent, or even outstanding, companies at below their net current asset value. This is what makes the net-net strategy especially appealing in this scenario.

Let me briefly discuss one example here: $HUYA and Douyu ($DOYU) operate in the game streaming space, akin to Twitch, but the comparison doesn't entirely hold. In both scenarios, Tencent ($TCEHY) holds a majority stake, underlining the strategic importance of these platforms to Tencent's broader ambitions. Notably, last year, Tencent invested further in Huya, acquiring an additional 16% stake from Joyy ($YY) at a 76% premium, amounting to $5.76 per share. Despite a recent uptick in $HUYA's stock price, it still trades at a 25% discount compared to the price Tencent paid just last year. This represents the perfect sidecar investment. The term sidecar investment was coined by Harvard Professor Richard Zeckhauser, a friend of Charlie Munger. It's about putting your money alongside an investment made by an experienced investor you trust. Essentially, you're riding along on their investment journey, betting on their expertise to lead to success. It's one of my favorite investment principles - here, you can find a link to the paper https://scholar.harvard.edu/files/rzeckhauser/files/investing_in_unknown_and_unknowable.pdf, but I might also write about it in the future.

That's all for now. I will discuss more companies in detail in the next few weeks. Let me know if you want to know more about the $HUYA background, which is interesting.

If you can't wait and want to see more Hong Kong stock ideas, you should have a look at

Jam_invest

. I always enjoy his articles, and you can find plenty of great ideas along the lines I have just discussed.