“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” — Warren Buffett, Fortune, 1999
Fortune wants to enhance its coverage of investing for executives who know a lot about business but not quite enough about the stock market to feel confident when making public-market decisions. It’s true that investing can be complex, but as a former journalist and current money manager I have long thought that like all professions, it can be demystified using a combination of experience, clear thinking and plain speech. Thus we've agreed to start a regular column in which I lay out my analysis and decision-making process about a single publicly traded company. The title— “Valuation”—is simple on purpose.
We chose Tencent Holdings as the inaugural stock because it’s a natural follow-up to a Fortune piece I wrote in November suggesting that the value investing community, of which I am proud to be part, needs to adjust its focus to encompass technology stocks. Defined as those who weigh the difference between price paid and value received, value investors have historically discounted stocks like Apple and Amazon as boom-and-bust miscreations of the millennium. But enough time has passed that it’s clear this scorn is misplaced. Seen from a “Value 3.0” perspective, these companies are the General Motors and Coca-Cola of our generation.
However, it’s important that when analyzing these businesses we use the same value-based framework handed down to us by Warren Buffett and his teacher, Ben Graham. If we don’t, we will be seduced by a business’ rapid growth or by its management’s charisma and succumb, as so many have done, to the buy-at-any-price syndrome. The value framework encompasses many variables, but it ultimately seeks to answer two questions: How good is the business I’m buying, and am I getting it at a price that will deliver a superior long-term return?
So how should a value investor assess Tencent? The company, No. 237 on this year’s Global 500, is a conglomerate with a $425 billion market capitalization. It’s a Chinese mashup of Facebook, PayPal, Spotify, and WhatsApp. As the comparisons suggest, the businesses it owns are excellent. Virtually everyone in China who owns a smartphone interacts with Tencent almost every day. Still, as much as I admire what Tencent has accomplished, I worry about it as a long-term investment—and my concerns center on the durability factor highlighted in the Buffett quote introducing this column.
WeChat's walled garden
It’s worth noting that some of the most widely publicized concerns about Tencent today are, from an investment perspective, red herrings. Video games, for example, represent Tencent’s largest current profit center and its biggest current headache. The company has spent the past couple of years dancing with the Chinese government over the addictive and violent nature of its most popular games, but the two sides are well on their way to a compromise that’s equal parts George Orwell and Monty Python. In May, Tencent changed its PlayerUnknown’s Battlegrounds game from a 100-player death match into something called Game for Peace. Now when players die, instead of spurting blood, they emanate rays of light. Then they wave goodbye and float off. Before the game starts, there’s a pre-roll ad for the Chinese air force.
Besides, over the next decade, Tencent’s other consumer franchises should surpass the gaming segment. The company’s music-streaming service, for example, has a 70% to 75% market share in China. Its payments platform enjoys a de facto duopoly with Alibaba. Tencent’s all-purpose app WeChat, however, is the most valuable franchise of all. WeChat functions as a messaging platform like WhatsApp for both business and personal use, but it also has a social media feed that is essentially the Facebook of China. More than half of all Chinese people have WeChat accounts, and they use them—a lot. In the West, we jump from app to app; in China, WeChat functions as a sort of walled garden, a single application in which people can gossip, share social media posts, collaborate at work, pay for restaurants and cabs, and even pay their income taxes. Time spent daily on WeChat is more than twice the time spent on Facebook, and a third of WeChat users spend more than four hours a day on the platform.
Investors can’t see the full financial power of WeChat yet because, like Amazon and other Western tech powerhouses, Tencent has been plowing profits back into its nascent businesses. As renowned hedge-fund investor Stanley Druckenmiller, who has owned Tencent stock in the past, recently put it, the company is “deliberately underearning.” It is also allowing users to get accustomed to WeChat’s services before turning on the monetization spigot. WeChat’s social media feed, for example, currently has less than half the daily ad load that Tencent says it could one day support.
Long-term investors love this kind of setup, wherein higher profits shimmer on the horizon. Tencent’s shares appear expensive at 27 to 28 times next year’s earnings estimates, and that valuation has scared off some investors. But if we adjust its earnings to account for the maturation of its emerging businesses, Tencent’s multiple drops to 14 to 15 times estimated earnings. Its stock seems even more reasonably priced if we give Tencent credit for the value of its many minority investments in companies like Tesla, Chinese ride-sharing company Didi Chuxing, and logistics provider JD.com.
A fickle business
So what’s not to like? To begin with, cracks have begun to appear in the wall around WeChat’s garden. ByteDance, founded seven years ago, now has roughly half as many regular Chinese users as WeChat, on the strength of its news-feed app and its short-format video service, TikTok. (For more on ByteDance and TikTok, see this recent Fortune story.) ByteDance now claims a 10% share of total time spent on the Chinese Internet—more than double what it was a year ago. Over the same period, WeChat’s share of China’s Internet screen time has slid from 54% to 48%, according to analysts who follow the stock.
WeChat’s share loss underscores the fickle nature of social media platforms. These are much less durable new-economy businesses, in my opinion, than search engines or e-commerce platforms. Facebook, the company, would certainly have a much lower market capitalization if it owned only Facebook, the app. Its Instagram and WhatsApp subsidiaries are healthy and growing, but legacy Facebook is showing signs of strain under both its heavy ad load and its implicit social contract to ensure fair and equitable discourse.
Discourse, in fact, is the larger problem I have with Tencent. The company’s key value driver is WeChat. Like Facebook in the rest of the world, it’s the social nexus where people in China meet to discuss everything from wedding plans to work plans to the price of tea. It’s fair to say that WeChat acts as the nation’s virtual Tiananmen Square—with all the baggage that image conveys. The Chinese government has allowed WeChat to flourish so far because Tencent complies with whatever the government asks it to do. Last year, Canadian think tank the Citizen Lab found that WeChat blocked 863 phrases, including combinations like “Overthrow Chinese Communist Party” and “Tiananmen tank.” Even those who own Tencent shares acknowledge that it can thrive only so long as it acts as the government’s agent in everything from video game content to the suppression of free speech.
One could argue this makes Tencent more valuable: too big and too cooperative to fail. That may be true—but valuable to whom? When you buy shares of Hong Kong–listed Tencent, you in fact own a Cayman Islands shell company that has no legal ownership of Tencent’s subsidiaries and tenuous claims to Tencent’s actual assets and profits. This opaque arrangement, called a variable interest entity, or VIE, is common in China (and played a role in the U.S. financial crisis a decade ago). And as corporate-governance groups have pointed out, VIEs leave shareholders with no influence over company management, not to mention no real ownership of the business as we understand it in the West.
This summer, millions have marched in Hong Kong to protect their civil liberties. If a similar movement were to rise inside fully Communist China, the government likely would curtail WeChat or shut it down entirely. If that occurs, Tencent’s income statement will not look pretty—if Western shareholders get to look at it at all. Do we as long-term investors really want to take these kinds of black-swan risks? To me, it makes more sense to buy Western tech platforms, which are just as powerful as Tencent—but much more durable and secure.
Adam Seessel is founder and CEO of Gravity Capital Management. His fund has no ownership stakes in any of the companies mentioned here. His column, “Valuation,” appears monthly on Fortune.com.
A version of this article appears in the August 2019 issue of Fortune with the headline "Soaring or Sinking With a Super-App."
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