A Watershed Moment




In Australia, the market was under significant pressure on Wednesday, with the ASX 200 dropping 1.6% to 5665. This was the biggest one day decline so far in 2017, and has wiped out the remainder of the market’s gains year to date. The selling was led by a soft performance on Wall Street, but clearly of a greater magnitude, with risk being taken off the table across the board. An earnings downgrade by QBE Insurance also clearly did not help the mood.

The resources and financials sectors were down 2-3%, while the REIT sector saw a similar loss. I have included a piece below on an arbitrage opportunity on the A-Reits versus the US sector, which has been written by Simon Wheatley, who is co-portfolio manager with me on the Fat Prophets Global Contrarian Fund. Simon has substantial experience in the market, having forged a career at Goldman Sachs as Head of Equity Research in New York, and Head of Real Estate Equity Research in Australia.

Days such as yesterday are a test of one’s conviction, but I still think that downside action in the ASX will be contained. The amount of cash on the side-lines is significant, and has regularly shown a willingness to be drawn back in towards the value, and given the relative unattractiveness of alternatives (cash and bonds). The Australian market boasts great yield (one of the highest globally) appeal, and as I have written, there is strong value in the key resource and financial sectors, even more so should the A$ weaken further.

The bolt from the blue yesterday though came from QBE, which were sold heavily, finishing 10% lower, after management lowered earnings guidance on the back of higher than expected claims in emerging markets. Increased claims experience year to date has been due to an increased frequency in medium-sized claims in Asia, weather-related claims in Latin America, and an adverse experience from legacy operations in Latin America.

The rise in claims is set to add around 1 percentage point to QBE’s interim and FY17 combined operating ratio (COR), and take it to between 94.5 and 96 percent – still a reasonably profitable level by industry standards. Previous expectations for the COR were between 93.5 and 95 percent. The emerging markets unit’s COR is set to blow out to 110 percent in the first half.

QBE is also a core holding in our managed account portfolios, being held in the Concentrated Australian, Share Income, and Global Opportunities Models. QBE Insurance is also a top 10 holding the Global Contrarian Fund, and occupies 8th spot currently. While confidence in the stock has clearly been knocked (and brought a sense of Deja-vu), I think that the fundamental drivers for being invested in the insurer remain in play. Our analyst team have also issued a mid-week alert, re-iterating the shares as a high conviction buy.

QBE has of course been no stranger to profit warnings in the past, and the question being asked now is whether there is anything else lurking beneath the surface? I sense though that management have learnt from the lessons of the past, and are being more upfront on this occasion.

The market clearly has some major doubts, hence the pace of yesterday’s selling. However, taking a more glass half fall approach, the downgrade was confined to emerging markets, and claims experience there. Encouragingly, premium income is in line with expectations, and the company’s Australasian, North American, and European businesses are performing well.

The group’s interim investment return is also currently above expectations, and the FY17 number is likely to be at the top end of previously advised guidance of 2.5 – 3 percent. This is also in keeping with our thesis that QBE is highly leveraged to an eventual steepening of the yield curve, which we continue to see playing out over the medium to longer term.

As a result of these positive offsets, the first half insurance profit margin is set to come in at between 8.5 and 9.5 percent. This compares to a margin of 9.7 percent at the full year results in February.

While the announced increase in claims experience in emerging markets was unexpected, I don’t think it derails the underlying investment case with respect to QBE. While the shares have had a setback on Wednesday, I am also optimistic that current levels of support will hold.

This is a stock chart for QBE

Tencent and Wanda team up to develop IP portfolio

Chinese social media and gaming titan Tencent Holding’s has invested heavily in building out its portfolio of content to offer consumers across a range of platforms in recent years. Some goals include deepening user ‘stickiness’ in its ecosystem to boost revenues from payment and advertising. The company also wants lock in consumers to subscription services for video, music and other forms of entertainment. These can range from the “freemium” model (the basic stuff for free) to premium, more expensive subscription tiers.

To do so, Tencent has partnered with some of the biggest names in media and entertainment, such as Sony, HBO, Warner Brothers and Universal to name a few. The company has also spent large on developing its own fresh content from internal business units.

This is a flow chart from Tencent

Source: Tencent

The latest partnership was unveiled this week at the Shanghai International Film Festival, with Tencent and real estate and entertainment conglomerate Dalian Wanda teaming up to form a joint venture that will be a IP (intellectual property) content powerhouse.

The film division of Dalian Wanda is also China’s largest cinema operator, while Tencent Holdings is the biggest video gaming company globally and has the largest social media platform in China. Tencent is a core holding in the Global Opportunities and Asian Managed Account Portfolios.

The venture deepens an earlier relationship between the two companies, when they said in April they would collaborate on producing and distributing films. The new venture will develop TV series, animation, films, games, e-books and attractions for theme parks (where Dalian Wanda is also a big player).

The first project to be developed is reportedly Battle Through the Heavens, which started as a popular online fantasy novel, then was adapted to an animated online series released on Tencent’s video platform.

Battle Through the Heavens:

This is Japanese Anitmation

Image credit: Battle Through the Heavens Wikia

IP content is becoming increasingly valuable and Tencent CEO Huateng Ma has often referred to its critical role for Tencent Holding’s future. The Internet giant still makes most of its money from gaming, with China’s mobile video gaming market now the world’s largest. Other content such as video, music and literature is yet to be monetized as effectively, but a huge opportunity exists to increase revenue from these areas over the next decade in China, with average user spending set to rise.

Tencent’s China Reading is the largest e-book and online publishing company in China and is reportedly mulling an initial public offering sometime this year. China Reading was formed from the merger of Tencent Literature and Shana Cloudary in 2015, with Tencent reportedly paying five billion yuan to snap up its competitor. The combined entity easily became the leader in China’s online reading industry, leading many to comparing it to Amazon’s Kindle Store.

According to the South China Morning Post, approximately a year ago China Reading reportedly had more than 10 million books available, across more than 200 categories. This has attracted some 600 million registered reader to its various e-reading platforms, which are more suited to Chinese text than native English e-book readers such Kindle.

Tencent Video is the company’s online video platform and one of the largest players in the local market, although it lags iQiyi by market share, with the latter a subsidiary of Baidu, a substantial holding in the Fat Prophets Global Contrarian Fund. Tencent Video is unlikely to displace iQiyi anytime soon in our view, especially as iQiyi recently signed a deal with Netflix that is set to bring appealing content to its subscribers soon. Like Tencent, Baidu has quietly diversified its business in recent years to complement its strong core search business.

Tencent Music on the other hand dominates the small, but fast growing Chinese online music market, with reportedly over 50% market share. Last July, Tencent acquired a controlling stake in competitor China Music Corporation and merged it with its own music unit to become Tencent Music Group. Tencent is reportedly considering an IPO listing that could be as high as $10 billion.

The bottom line is that Tencent generates enormous cash flows from its online gaming and social media businesses and is directing some of those proceeds to building out one of the biggest Internet empires globally. Like Alphabet (a core holding in the Global Opportunities and Asian Managed Account Portfolios), the company is not averse to taking some big swings. Not all will work out, but there is likely to be plenty more home runs in the innings ahead.

Disclosure: The Fat Prophets Contrarian Fund declares a holding in QBE Insurance, Sony & Baidu.

Carpe Diem!

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