Q2 Zorik Capital Letter

Partners,

The fund’s second quarter in operation saw considerable market volatility. The general bullishness that lasted through December and January came to an end at the beginning of February.

The market, previously positive on the prospect of the Fed cutting rates, reversed course, realizing the Fed would only stop hiking rates when inflation hits their 2% target. Therefore, the Fed continued hiking (though at a slower pace), however, on top of that, the recent bank failures and decreased lending stemming from the crisis are assumed to have the effect of a 150 basis point rate hike according to Torsten Slok, chief economist at Apollo.

During this quarter we were pleased to be able to deploy capital in several exciting opportunities which we believe to be misunderstood by the market. We hold 70% of our capital invested in stocks that we believe can return 15-20% over the next 5-7 years. The remainder is invested in attractively yielding money market funds.

Our underperformance this past quarter can be attributed to the declines in one of our key positions, Digital Turbine (APPS). APPS led to 168 basis points of negative performance for the fund this past quarter, roughly 70% of our underperformance. All in all, we are not concerned. Holding a concentrated portfolio can result in risks associated with the volatility of specific stocks.

APPS, which was already one of our larger positions, suffered a share-price decline of roughly 30% on earnings after the company posted a revenue decline. After analyzing the situation, we concluded that the revenue decline was transitory and due to industry-wide issues with ad prices (down 10-20% across the board according to management) and phone sales (down 12% globally). This affects the company as it, in its most basic sense, makes money from selling advertisements on newly sold phones. Therefore, as the stock price—once valued for a high-growth company—corrected for negative revenue growth, we took the opportunity to purchase more shares of APPS at far cheaper valuations. All in all, we were happy to be able to lower our cost basis given that we believed revenue growth would resume after phone sales and ad prices recover.

For the period February 1 2023 to April 1, 2023, the fund’s returns were -2.77% compared to the S&P 500’s -0.34%. Since inception, the fund has returned 6.87% versus 6.47% for the S&P 500 in the same timeframe.

Market Forecast

A conjunction of the banking crisis and slowing inflation has led some investors to believe that the Fed may soon pivot. However, the one thing the bank has not altered is its refusal to stop hiking until the 2% inflation rate target is reached. Powell wants to avoid being remembered as the Fed chair who pivoted too early, thereby giving way to further inflation. Therefore, while inflation is slowing—predicted by JP Morgan to reach 4.5% YoY by year-end 2023 while then falling to 2.5% YoY by the end of 2024—we believe the Fed will not pivot prior to inflation hitting their target 2% rate.

Despite the economy's miraculous strength, such as strong spending and consumer balance sheets (as described in the previous letter), we remain cautious that the effects from the rate hikes will take time to completely reverberate throughout the economy.

I maintain the belief from last quarter’s letter that given these risks, the market remains overvalued in comparison to the returns one can earn in risk-free investments such as money market funds. The S&P 500, trading at nearly 20 times JP Morgan’s already contracted 2023 earnings projections, provides us with only a 5% earnings yield. This is while certain risk-free money market funds may provide up to a 4.3% yield. With the market trading above historical valuation multiples, with an earnings yield only slightly above that of risk-free investments, we believe that investors are not being compensated adequately for the risk of delayed pain stemming from prior and continued rate hikes that could take several months to impact and reverberate throughout the economy.

Therefore, as the market seems positive surrounding the picture of declining inflation leading to rate cuts, I remain cautious that the effect of hikes will be delayed and slow. I still believe that the US will enter a short and mild recession which may lead to a further earnings correction. Therefore, while always structurally long, I remain cautious about the market’s conditions, holding an excess cash level of 30% to allow us to take advantage of opportunities should the market correct further.

What We Are Doing

As we believe that the market may contract further, we are happy holding 30% of our portfolio in 4% yielding money market funds. This allows us to earn an attractive risk-free yield while also allowing us the opportunity to continue to deploy more capital should the market contract further. However, we aim to take a long-term point of view. Wherever we believe the market to be headed, if we stumble across a company in which we believe we can earn our target 15-20% IRR over our 5-7 year time horizon, we will disregard short-term volatility and invest.

An Interesting Stock Pick — A Special Situation Pick

Over the past few years, Alibaba Group’s New York listed ADR has gotten killed. Once a high-flying growth stock, the stock’s recent crash has meant that an investment in their 2014 IPO is up merely 4.8%. While many Chinese shares have performed similarly, the S&P 500 has appreciated 116% in the same time frame.

Clearly, something has been going wrong for China’s largest company. Alibaba is described as Asia’s Amazon for good reason. Alibaba’s two largest segments are its e-commerce platforms, Taobao and Tmall, and then like Amazon’s cloud arm, Amazon Web Services, Alibaba runs Alibaba Cloud. Additionally, there are several other units, such as their International Commerce arm which owns Aliexpress, the ultra-cheap Chinese-made wholesale store to the US as well as the logistics arm, Cainiao.

On a conventional basis, the business has been highly inexpensive. Even after the stock’s recent rise, the stock still trades at a mere 11 times our forward EPS projections and then at a free cash flow (FCF) yield of 10%. By comparison, Amazon, the American competitor that operates both in the cloud and e-commerce businesses, trades at 21 times Bank of America Securities’ 2024 EPS projection. This is roughly double the multiple that its Asian competitor trades at. Then one must realize that the e-commerce arm is BABA’s only profitable business. So, without even factoring in the rest of the businesses, such as logistics and cloud, the stock remains cheap. Despite BABA’s inexpensive valuations, we project the business to grow revenues at a low teen rate over the next several years.

The bulk of the inexpensive valuation stems from how American investors are scared to invest in China. Over the past few years, the CCP has seemed to clamp down on the country’s public companies. For example, a BABA-specific example would be how the CCP blocked Ant Financial’s IPO (a payments company in which BABA holds a 33% stake) a few years back. Additionally, several companies have been subject to heavy fines and penalties as part of China’s anti-monopolies crackdown.

With $47.8bn in net cash (17.7% of market cap) and a vastly inexpensive stock, one would expect management to employ the traditional methods of share buybacks or dividends to help encourage investors. However, it is abundantly clear that BABA does not operate as an average company would. Chinese restrictions have made it hard for the company to pay dividends or buyback shares. So, as BABA’s stock declined, management knew that buybacks and dividends were not an option that they could pursue. Instead, management knew that to grow and get cash off the balance sheet, they must instead expand through deploying capital towards building and acquiring businesses. However, BABA’s business-building activities have been too successful.

The company is now at a point where it is so large that they receive excess levels of scrutiny, regulation, and involvement from the CCP. Additionally, there are frequent concerns of monopolistic practices. This has been one of the key factors pushing the shares lower.

So, just several days ago, management decided to take action by separating the group into six smaller segments. The eventual goal will be to spin each of these segments out through methods such as IPOs. However, this may take some time.

The thesis in short is that the sum of the parts will be worth more than the sum of the whole.

BABA’s e-commerce arm which owns Taobao and Tmall should produce nearly $92.96bn in revenue next year. At a steady net income margin and a PE ratio of 12, in line with peers, this segment represents 82.8% of BABA’s current market cap.

However, this is disregarding the other five businesses.

We then believe, based on our conservative earnings and multiple assumptions, that Alibaba Cloud is worth $42 bn and then the remaining four, including the Ant Financial stake and net cash are collectively worth $127.9 bn. This, combined with Alibaba Cloud is worth an additional 62.8% of BABA’s current market cap.

Overall, we believe that the sum of the parts for Alibaba Group is worth more than the whole, as the intense government scrutiny increases risk, thus weighing down the stock’s valuation. Therefore, competitors that trade separately—not attached to large, scrutinized companies—each trade far higher than the multiple that BABA’s segments are assigned inside the group.

Therefore, as conservative estimates were used for the valuation of each new segment, we believe that as each business is separated and spun out, the stock will begin to re-rate with the potential to rise 45.6% within the length of time it takes to complete and execute these separation plans. Since the CCP would support the creation of these smaller, less powerful companies instead of one large, powerful Alibaba Group, we believe the Chinese government will help expedite the deal. Therefore, if we call the time until the plans are executed two years, to be conservative, the stock should return a 20.6% IRR over these two years, as a base case.

Closing

As a long-term investor, I am quite happy with this past quarter. While we underperformed, 70% of the underperformance was the result of an earnings disaster from one of our holdings, Digital Turbine (APPS). Ultimately, I would enjoy this same situation that happened with APPS to occur with each of our portfolio companies because after scrutinizing APPS’ earnings, we concluded that the situation was transitory, merely providing us with an opportunity to lower our cost basis.

So, as we look forward, we continue to be excited about the opportunity to purchase new securities so long as we believe we can return 15-20% a year on them over the next 5-7 years.

Thank you so much for all your support!

Thanks,

Blake Zilberman