My Nishino moment

Why now? This is what Japanese football fans asked themselves on the eve of the current edition of the FIFA World Cup. The Japanese Football Federation had just sacked coach Vahid Halilhodžić.

The Federation wanted to go back to what has made the Japanese team successful over decades – possession football. Halilhodžić and his foreign predecessors had pursued a more defensive style of football focused on counterattack.

Japanese-veteran Akira Nishino landed the job and the rest you might know already. Japan exceeded expectations in the tournament, played some great football and only narrowly missed a spot in the quarter-finals.

What does this have to do with investing? I recently had a ‘Nishino moment’ myself while attending an investment conference.

Return to simplicity

Most of the presenting companies at the conference had long histories of successfully competing in one or two clearly defined markets. Details of their industries, business models and strategies were scribbled on a few pages of my notepad. This stood in stark contrast to the 40 pages I wrote recently while researching Italian telco Telecom Italia (BIT:TIT).

This made me realise that, thanks to surging stock markets, I have been progressively moving towards riskier and more complicated investment ideas.

I don’t think I am the only one that needs refocusing. Investors in general have been venturing into areas which they would have quickly dismissed only a few years ago. Foreigners piling into Chinese disruptors like Alibaba (NYSE:BABA) and Tencent (SEHK:700) is emblematic.

All the talk at the moment focuses on the rate of growth of these new giants and the enormous size of their addressable markets. Little attention is paid to profitability, capital allocation and governance, usually key tenets of successful investments.

Xiaomi not for me

This passage from an article in the Economist about smartphone manufacturer Xiaomi, which starts trading today in Hong Kong with an estimated market capitalisation of US$54bn, makes the point that this growth comes with complications.

“Xiaomi is probably China’s most successful consumer brand, but ever since it started selling smartphones in 2010 it has also been difficult to categorise. […] Almost three-quarters of its $18bn of sales last year came from selling smartphones, where it has a global market share of 7%, but there is lots of sprawl, which is by design. As well as smartphones, Xiaomi has hundreds of other products, from vacuum cleaners to electric bicycles, and even owns 30% of a small bank. It incubates new hardware suppliers by buying small equity stakes in them. The cost of this ate up a fifth of its free cashflow in 2016-17 and could spiral further. Ferocious competition at home, meanwhile, has meant erratic performance. In 2015 it made an underlying loss and in 2016 sales stagnated after its handset market share in China dropped.”[…] But Xiaomi takes tight control to a new level. Founder Lei has majority voting control. Like the BAT firms—Baidu, Alibaba and Tencent—Xiaomi has a “variable-interest-entity” structure to get around rules on having foreign shareholders. The firm’s holding company, in the Cayman Islands, has contracts with operating entities in China. The contracts give it control and profits but not ownership, which in several cases remains in the hands of Mr Lei.”

Xiaomi and most of these innovative Chinese conglomerates will continue to grow. But will this growth translate into higher profitability? And, if it does, will minority shareholders be able to benefit from it?

I wouldn’t bet against any of these things happening. But ferocious competition, government intervention and opaque governance makes answering these questions nigh on impossible. And even if you could answer them, the rapid sprawling of operations would require constant reassessment.

Patience needed

The stock prices of the companies that presented at the conference I mentioned earlier are far from cheap. That’s why I found myself looking at more complex investments in the first place.

But what’s clearer to me now is that having patience is key. Getting to know such companies well is likely to be more important to the Fund’s future returns than venturing up the risk curve at this point of the cycle. I don’t know when the next downturn will be but this knowledge should prove valuable when it happens.

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