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Does Alibaba Meet The 'Buffett-Would-Buy' Criteria?

Sep 22, 2015

In this issue:
» No growth for US companies?
» Indian IT sector's cost advantage put in perspective
» An update on markets
» ...and more!

00:00
Alibaba made waves when it came out with its IPO last year. At the time, the Chinese company was valued at US$223 billion (around 26 times sales) as reported in Forbes. Jack Ma, the chairman, had ambitious plans of venturing into the US and grabbing market share from the likes of Amazon, eBay, and Google (to name a few). The company's IPO generated a lot of interest at a time when ecommerce and tech companies were in general growing at a phenomenal pace.

And yet, despite all the hype and hoopla, the company didn't in the least bit interest Warren Buffett. Now why is that?

To answer this question, we must first understand the types of businesses that would interest Buffett. To this end, Charlie Munger, Buffett's partner at Berkshire Hathaway, offers an interesting analogy...

A hypothetical rich Atlanta businessman, Mr Glotz (Buffett's alter ego), is very keen to turn US$2 million into US$2 trillion by investing in businesses over the next 150 years. To decide which businesses he will invest in, Mr Glotz will have meetings with various CEOs not lasting more than 15 minutes. So those companies need to have compelling businesses before Mr Glotz even considers investing in them.

Now Mr Glotz will zero in on those companies based on how well he thought they had built an indomitable global moat based on a strong trademark and a 'universal appeal' that compels consumers to buy almost addictively.

In this 'analogy', Coca Cola fits the bill perfectly. Alibaba does not. Let us see why.

Coca Cola is not just some generic beverage. But a strong, legally protected trademark. It is a powerful brand with just the kind of unbreachable moat that Buffett/Glotz so admires. It is also a brand with longstanding universal appeal that consumers will continue to buy. Moreover, changes in technology aren't likely to impact the brand's moat.

The same cannot be said for Alibaba. Ecommerce is a very competitive space, and Alibaba does not boast of competitive advantages that set it apart from the rest. It also does not enjoy the same universal appeal of companies such as Amazon and eBay. Moreover, given the pace of technological changes, there is a big question mark whether Alibaba is equipped to respond to those changes.

But what if the price of Alibaba fell significantly to the point that valuations began to look compelling? Mind you, while the quality of a business is crucial for Buffett, he also emphasises the need to pay the right price.

Indeed, since listing last year, Alibaba has lost 30% of its value. Does that change Buffett's view on the company? No.

Even if the price fall brings Alibaba to more attractive levels, Buffett may have doubts over the long term sustainability of the company's moat, if any.

The lesson for the value investor is that it is crucial for these factors to come together: Not only must the business boast of a strong sustainable moat, but its stock has to be attractively priced as well. One cannot compromise for the other.

This is the approach that my team and I follow for ValuePro, our portfolio recommendation service. We focus on only those businesses that have strong competitive advantages in their fields. Furthermore, only if they are trading at attractive valuations do we consider buying them for our portfolios and recommending our subscribers to do the same.

Do you think that too much of financial and stock market information does more harm than good? Have you ever been a victim of 'information overload'? Let us know your comments or share your views in the Equitymaster Club.

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02:30
Stocks in the US have seen some volatile times in recent weeks. The S&P 500 index for instance is hovering around the 1,967 mark currently; down from its 52-week high number of 2,135 points. The index trades at about 20x its trailing twelve month earnings, which is way above its long term average figure. There have been debates whether the index is overvalued or not. On one side, the argument is that the earnings have not been rising. As pointed out by financial website zerohedge.com, the expected earnings for the S&P 500 index shows no growth for seven quarters and revenue declining. The index's estimated EPS (consensus) for 1QCY16 is that of levels of what it was in the third quarter of 2014. When it comes to revenues, the consensus figure for 1QCY16 would be less than what it was in the last quarter of 2014.

Other points in favour of this argument is that financial engineering and access to cheap funds has allowed companies to improve their balance sheets and thus their earnings profile; something which may not be sustainable once the ZIRP trend reverses.

On the other side, experts are arguing the high payouts and quality of earnings justify such valuation levels. Essentially, companies are paying out a big chunk of their profits. This would largely be a function of capex and growth levels being way lower than earlier. But again, this brings us back to the point of whether such a trend would be sustainable incase the US returns to its capex cycle and in the process invests more and pays out less.

All we can say is that at the current juncture, the times are very interesting. Investors would do well to stick to the basics and remember the basics - the odds of making good money reduce as and when one pays up more for stocks.

The fact of the matter is that FIIs have a big role to play in Indian stock markets and thus any volatility in the US would make EMs (including India) quite vulnerable to their whims and fancies. Investors would do well to be aware of such risks.

03:25
Chart of the day
India is an information technology powerhouse. This is very well known. The talent and cost advantage that the country provides gives it a very strong edge over its peers; something which the sector has extracted very well over time. We came across an interesting chart that helps put things in perspective. Today's chart of the day gives an indication of the difference in salaries of the average mid level IT professionals across the world. The article was published on Wall Street Journal's website. The survey was carried out by myhiringclub.com.

Indian IT: The outsourcing story remains intact

As you can see, the chart very much puts in perspective the cost advantage that India has when compared to its global and emerging market peers. And this is despite the rising incomes in India. In fact, India is believed to have swapped places with China this year, making it one of the lowest paying nations for mid-career IT professionals. Average annual salaries for mid level professional in India stood at the range of US$ 41,200 in 2015 as compared to that of about US$ 42,700 in China and US$ 132,900 in the US.

It must be noted that the figures do not take into consideration the purchasing power parity. So while the cost arbitrage remains intact, Indian IT firms cannot rest easy. That's because their clients are no longer only interested in cost savings. In an extremely challenging global economy, western corporations want Indian IT firms to deliver a more compelling value proposition in terms of growth prospects. Not all of the Indian IT firms will be up to the task we believe.

04:40
At the time of writing, the Indian markets were largely trading firm, with the BSE Sensex up by about 55 points or 0.2%. Gains were seen in stocks from the midcap and smallcap spaces as well with the representative indices up by 0.3% and 0.8% respectively. While stocks from the information technology and consumer durables spaces were the most preferred, those from the metal and power spaces were least favoured.

04:50
Today's investing mantra
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.." - Charlie Munger

Many Indians do not give much thought to retirement planning. While they focus on leading a rich and fulfilling life in their younger years providing for their kids and families, most are not able to maintain that lifestyle once they become senior citizens. Anisa Virji, the Managing Editor of Common Sense Living, has made a very strong case for retirement planning and why it is necessary if you want to continue leading a rich, independent life without having to depend on your children. Well, if you are serious about living well today and retiring well tomorrow, I recommend you read Anisa's thoughts on this and how you can get access to the Ultimate Retirement Bundle...

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Devanshu Sampat (Research Analyst).

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