Q2 Letter to Partners
Results and Reflections
Audio Version:
To June 30th, 2023
The Results
During Q2 2023, the JB Global Capital Fund decreased by 2.60%. This compares to an increase of 5.30% in the VT Stock Index and an increase of 8.30% for the S&P 500. You can also see our YTD performance ending June 30th in the above chart. This short-term underperformance can be attributed to volatility stemming from China’s macroenvironment, political tensions between the U.S. and China, and the weakening of the Brazilian Real in relation to the U.S Dollar.
As previously mentioned in our Q1 Letter, we ask that you look at any short-term results with a sense of equanimity. Our goal as investors is to achieve outperformance over the long-term. We believe that the best way to achieve this goal is to focus on undervalued and sometimes controversial businesses.
Macro-Thoughts
China
China's economy grew at a frail pace in the second quarter as demand weakened at home and abroad, with the post-COVID momentum faltering rapidly and raising pressure on policymakers to deliver more stimulus to boost the economy. The youth jobless rate climbed to 21.3% in June from 20.8% in May, a new record high. China's property sector, which accounts for about a quarter of the economy, remains firmly in a downtrend, with new home prices for June stalling. Property investment slumped 20.6% in June year-on-year after a 21.5% drop in May, according to Reuters calculations.
As the macro environment continues to deteriorate in China, authorities are likely to roll out more stimulus, including fiscal spending to fund big-ticket infrastructure projects, more support for consumers and private firms, and some property policy easing.
If you are interested in reading about the current state of China on a more personal level, we recommend reading a recent note published by RV Capital, titled, A Postcard from China.
Brazil
The Brazilian economy has continued to show signs of improvement. Economic activity increased by 2% in the first quarter of 2023, supported by services and a large expansion of agricultural production. Consumer prices in Brazil decelerated more than expected in May and June, dropping to its lowest rate in nearly three years, clearing the way for the central bank to begin its rate-cutting cycle. Analysts expect Latin America's major central banks, which have led some of the most aggressive tightening over the last two years, to lead the world on interest rate cutting.
"It is a clear sign that the economy is being rebuilt. Everything is in place for our country to start lowering interest rates." - Alexandre Padilha, Institutional Relations Minister
The United States
In the United States, the economy has continued to remain strong with GDP growing 2.4%, unemployment at historic lows, and inflation finally coming down. Consumers led the way, as they have throughout the recovery from the severe but short-lived recession in 2020. Spending rose at a 1.6 percent rate, slower than in the first quarter but still solid. Much of that growth came from spending on services, as consumers shelled out for vacation travel, restaurant meals and Taylor Swift concert tickets. In speaking on the U.S. macroenvironment, Joseph Brusuelas, chief economist at RSM, said,
“If you’re looking for a working definition of ‘resilient,’ look no further than the American economy.”
While the current picture looks rosy, some economists are raising alarms for a potentially more difficult second half of the year. Many economists say consumers are likely to pull back their spending in the second half of the year, putting a drag on the recovery. Savings built up earlier in the pandemic are dwindling. Credit card balances are rising and student loan payments are set to restart after a three-year pause. The resumption of monthly payments in October increases the probability of a U.S. recession as borrowers cut back on spending, according to Oxford Economics. While difficult to forecast, we find it reasonable that the U.S. economy will have a material pullback due to the difficulties mentioned.
Portfolio Company Updates:
Alibaba Group (Top Holding)
In Q2, Alibaba reported financial results for the quarter and fiscal year ended March 31, 2023. Revenues for the quarter were $30.32B, a slight miss on analysts’ expectations and a mere +2% growth year-on-year. During the earnings call, management attributed this low revenue growth to weaker-than-expected consumption spending in China, and intense market competition from rivals.
Revenues from the cloud computing segment were especially disappointing, declining y/y by 2%. Management attributed the decrease in cloud revenue to a weak macro backdrop, and from a top customer phasing out Alibaba's cloud services due to data security regulations for their international business. While we are disappointed with the Cloud segment results to date, we are encouraged by three key data points, which we believe still hold true:
Alibaba Cloud is the largest player by market share in China and fourth largest in the world. We believe that Alibaba will remain as a market leader due to key competitive advantages stemming from capital intensity requirements and technological capabilities.
China’s Cloud market is expected to grow to $90B by 2025 as per McKinsey Research. As the market leader, we expect Alibaba to reap the benefits with the growth in Cloud adoption in both Mainland China and Southeast Asia.
Digital transformation trends are expected to grow over the long-term due to improved economics for businesses in every industry. Some of the digital transformation trends include wider adoption of low code platforms, increased migration to the cloud, greater leveraging of AI technologies, and increased automation. Cloud providers like Alibaba stand to benefit greatly from these trends, as they exponentially increase the demand for data storage and capabilities.
While revenue growth struggled to impress analysts and investors alike, bottom-line earnings for the quarter improved significantly to $3.64B, a 60% year-on-year growth rate. The material improvement in earnings was attributed to successful cost-cutting measures and improved profitability in their non-core segments, such as local consumer services and smart logistics. We are impressed by the company’s overall profitability as Alibaba continues to produce significant amounts of free cash flow. In the fiscal year ended March 31 2023, Alibaba generated $25B in free cash flow ($20B after deducting SBC).
For our Full Review of Alibaba’s Earnings, Click Here!
StoneCo (2nd Largest Holding)
StoneCo reported first quarter 2023 results on May 17th, surpassing analyst’s expectations for top and bottom line. Stone reported total revenue of $543M for the quarter, an increase of 31% compared to the same quarter last year. The growth in revenue is notable as it nearly tripled the overall industry growth at 10.7%, indicating strong market share gains for Stone. The company also saw a remarkable growth in its profitability, with adjusted earnings rising by 55.7% to $250.28M. There are not many businesses that can grow revenues above 30% a year while maintaining EBITDA margins above 40% (if you know of any, please let us know).
Stone’s Q1 results highlighted their success in taking market share from competitors, especially in the micro-merchant segment. Stone attributed the growth in the micro-merchant segment to a combination of their newly launched banking product, Super Contra Ton, and successful marketing campaigns through Brazil's most popular reality show, Big Brother Brazil.
The company, in another major development, resumed its credit business. As credit proved to be a major issue for Stone in 2021, the company has chosen to take a cautious approach, disbursing roughly $1.2M of the new credit product in the first quarter with a target of serving a maximum of only 200 clients. To improve the credit product, management has introduced several new features which include system automation, guarantees, tech-enabled decision models, and an improved credit lifecycle monitoring system. The results thus far have been positive, with key credit performance indicators in line with management expectations. During the call, management told analysts that they expect to continue expanding the credit business throughout the rest of this year.
For our Full Review of Stone’s Earnings, Click Here!
The Portfolio
Since inception, we have made 12 investments in 7 industries as classified by Morningstar. While the investments span throughout various sectors, there is material concentration in the sectors of internet retail, financial services, and cloud computing. There is also a geographical concentration in Brazil and China. We anticipate high volatility in the fund due to portfolio concentration, emerging market risk, and a contrarian investment strategy. While we do not aim to take undue risk, we are aware of the nature of funds such as ours. We would like to remind our partners on the need for patience and thank them graciously for their continued support.
Sincerely,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.