Latest / The Dutch Investors / #61 | 3 Lessons from Prosus and Tencent | The art of capital allocation

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#61 | 3 Lessons from Prosus and Tencent | The art of capital allocation · The Dutch Investors

• 0:00
  SPEAKER_00: Before we begin today's episode, we would truly appreciate it if you could give our podcast a five-star review either on Spotify or Apple Podcasts.
• 0:11
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• 0:17
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• 0:18
  SPEAKER_00: Thank you so much.
• 0:43
  SPEAKER_00: At the core, both roles are about allocating capital in the most effective way possible.
• 0:50
  SPEAKER_00: It's a constant game of opportunity costs.
• 0:53
  SPEAKER_00: Every dollar spent in one place is a dollar not spent somewhere else.
• 0:58
  SPEAKER_00: And the best compounders are those that master this game, deciding exactly where each marginal dollar should go and ensuring every decision builds value over time.
• 1:11
  SPEAKER_00: Or, as Warren Buffett once said, the difference between a good business and a bad business is that a good business is the one where you invest a dollar and you get more than a dollar back over time, and a bad business is one where you invest a dollar and you get less than a dollar back over time.
• 1:29
  SPEAKER_00: Quite simple, huh?
• 1:30
  SPEAKER_00: After diving deep into Dutch holding company Process, we learned a thing or two about its business, but also holding companies in general.
• 1:39
  SPEAKER_00: Process is a company based right here in the Netherlands, but its fate hinges entirely on what happens in China.
• 1:47
  SPEAKER_00: It owns one of the most valuable tech assets in the world.
• 1:52
  SPEAKER_00: Process is a holding company spun out of NASPERS, the South African media group that made one of the very best, greatest investments of all time, buying 47% of Tencent in 2001 for just$34 million.
• 2:10
  SPEAKER_00: That stake alone is now worth over$150 billion.
• 2:17
  SPEAKER_00: However, while Tencent is pretty well known, barely anyone knows Process.
• 2:23
  SPEAKER_00: So let's dive into today's episode where we give you three lessons we learned from analyzing Process and Tencent.
• 2:32
  SPEAKER_00: Let's start with lesson one.
• 2:34
  SPEAKER_00: Great investments don't guarantee great companies.
• 2:39
  SPEAKER_00: Tencent is one of the most dominant businesses on Earth.
• 2:43
  SPEAKER_00: It owns WeChat, the super app that has over 1.4 billion users and combines messaging, payments, social media, and commerce all into one.
• 2:56
  SPEAKER_00: It's basically an indispensable part of life for nearly every Chinese consumer.
• 3:03
  SPEAKER_00: Tencent is also the largest gaming company in the world.
• 3:07
  SPEAKER_00: Some of the gaming studios they own are Riot Games, they own a percentage of Activision Blizzard, Paradox, Ubisoft, they own about 40% of Epic Games, they own almost 100% of Supercell, they own 100% of Funcom, Sharp Mob, and many others.
• 3:28
  SPEAKER_00: They're also the big player behind PUBG and Clash of Clans.
• 3:32
  SPEAKER_00: It's a real powerhouse in gaming.
• 3:36
  SPEAKER_00: Tencent is also building and investing heavily in cloud computing, fintech, and of course, AI.
• 3:45
  SPEAKER_00: And this is evidenced by their capital expenditures, which have increased massively from 3 billion in 2023 to over 13 billion in the last 12 months.
• 3:57
  SPEAKER_00: While this is a massive increase for Tencent, it still pales in comparison to the investments made by American big tech, as Tencent is known to be more conservative and patient.
• 4:09
  SPEAKER_00: Tencent also possesses what is arguably the strongest of all competitive advantages.
• 4:15
  SPEAKER_00: The ecosystem mode.
• 4:17
  SPEAKER_00: This is a very rare type of mode, held by only a handful of global companies like Microsoft, Google, and Amazon.
• 4:26
  SPEAKER_00: To earn this distinction, a company must have all other modes working together in a powerful synergy.
• 4:34
  SPEAKER_00: And Tencent fits this description perfectly.
• 4:38
  SPEAKER_00: It has a formidable combination of network effects, switching costs, intellectual property, regulatory protection, and economies of scale.
• 4:48
  SPEAKER_00: When you combine all these forces, the result is arguably the most powerful company in China.
• 4:56
  SPEAKER_00: It is also profitable, it's growing, and it's buying back stock.
• 5:02
  SPEAKER_00: Management is very good at capital allocation.
• 5:05
  SPEAKER_00: And yet, despite all of Tencent's strength, if we're being brutally honest, Process, the company that owns over 23% of Tencent, is not a great company in itself.
• 5:19
  SPEAKER_00: If we had to choose, we would pick Tencent over Process 99 times out of 100 based on the quality of the underlying business.
• 5:28
  SPEAKER_00: Yet, as our TDI members can see in our portfolios, we all own Process and not Tencent.
• 5:36
  SPEAKER_00: So why is that?
• 5:38
  SPEAKER_00: Process by itself is just a holding company with a pretty messy structure.
• 5:43
  SPEAKER_00: Some promising but still unprofitable ventures like iFoods or Payu or Emacs, and limited operational leverage.
• 5:52
  SPEAKER_00: Strip out Tencent?
• 5:54
  SPEAKER_00: And it's just a patchwork of loss-making internet assets.
• 5:59
  SPEAKER_00: So what's the lesson here?
• 6:01
  SPEAKER_00: Just because a company owns something great doesn't make itself great.
• 6:07
  SPEAKER_00: You can think of process as a wrapper, not as 10 cents itself.
• 6:13
  SPEAKER_00: If the wrapper allocates capital poorly or lacks investor trust, it can trade at a persistent discount, regardless of how great the asset inside is.
• 6:24
  SPEAKER_00: For a lower quality holding company to be worth investing in, it needs to be great at one thing, capital allocation.
• 6:33
  SPEAKER_00: And for now, Process appears to be proving just that.
• 6:37
  SPEAKER_00: We've unpacked Process and Tencent in great detail for TDI members.
• 6:42
  SPEAKER_00: From Tencent's reinvestment math to process buybacks mechanics, the risks, and the scenarios where the discount could close faster than expected.
• 6:52
  SPEAKER_00: If you want the full written analysis, plus podcasts including financials, competitive advantage, industries, charts, and valuation, consider joining TDI Premium.
• 7:04
  SPEAKER_00: You can find the link in the show notes.
• 7:07
  SPEAKER_00: And that brings me to lesson 2.
• 7:09
  SPEAKER_00: Capital allocation is what makes or breaks holding companies.
• 7:14
  SPEAKER_00: So let's get to the core of our thesis for owning Process and not 10 cent directly.
• 7:19
  SPEAKER_00: Process is trading at an approximately, and it varies of course, between 20 to 35% discount.
• 7:27
  SPEAKER_00: This can be lower as of today, and it can be higher when you're listening to this episode.
• 7:33
  SPEAKER_00: But that's the discount to its net asset value, or NAV.
• 7:37
  SPEAKER_00: At times it has been as high as 50 or 60% and as low as 18%.
• 7:43
  SPEAKER_00: That means investors can buy 10 cents for less than it's worth, and we get all the other assets for quotation marks free.
• 7:52
  SPEAKER_00: I mean, that sounds too good to be true, right?
• 7:56
  SPEAKER_00: Here's how you can think about the discount.
• 7:58
  SPEAKER_00: Imagine a store selling a gift box.
• 8:01
  SPEAKER_00: The gift inside is very valuable, let's say a gold coin, and that represents 10 cents.
• 8:08
  SPEAKER_00: But the store is selling the entire box at a steep discount, let's say 30% off.
• 8:16
  SPEAKER_00: So as an investor, you're getting the gold coin at a lower price and all the other goodies in the box for free.
• 8:24
  SPEAKER_00: But that discount only matters if the company can actually close it and realize that value.
• 8:31
  SPEAKER_00: If you can't sell the gold coin, it doesn't matter.
• 8:36
  SPEAKER_00: So how does Process get rid of the discount?
• 8:39
  SPEAKER_00: Well, through share buybacks.
• 8:42
  SPEAKER_00: Process has launched an open-ended buyback program, where it slowly sells parts of its 10 cent stake and uses the cash to repurchase process shares at a discount.
• 8:54
  SPEAKER_00: And this is extremely important for our investment thesis.
• 8:58
  SPEAKER_00: If this stops, we'll have to reconsider the investment in process.
• 9:03
  SPEAKER_00: The open-ended buyback program creates a powerful compounding effect.
• 9:08
  SPEAKER_00: The value from 10 cent sales is recycled into buying cheaper process shares.
• 9:14
  SPEAKER_00: Each buyback increases NAV per share for the remaining shareholders, and over time, this should shrink the discount and boost long-term returns.
• 9:24
  SPEAKER_00: A 10 cent share buyback increases process NAV and the value of its stake by reducing the total number of shares outstanding.
• 9:33
  SPEAKER_00: Since Process ownership percentage of 10 cent remains unchanged or is only minimally diluted by the buyback, its stake now represents a larger slice of a smaller pie.
• 9:46
  SPEAKER_00: In simple terms, for every share of 10 cent that the company buys back, the remaining shares, including the ones owned by Process, become a slightly bigger piece of the company.
• 9:58
  SPEAKER_00: This action therefore increases the value of Process NAV per share, hopefully returning in a slightly better return than owning just 10 cents.
• 10:08
  SPEAKER_00: So far this has played out with a 1.4% kagger for 10 cent and a 4.7% kagger for process.
• 10:17
  SPEAKER_00: Both are pretty bad, but there is an outperformance of about 2.5 times.
• 10:23
  SPEAKER_00: This is what we call a double discount thesis.
• 10:26
  SPEAKER_00: So what's the lesson here?
• 10:28
  SPEAKER_00: For a holding company to be a successful investment, it must be an expert at capital allocation, especially in a way that closes the gap between the value of its assets and its own stock price.
• 10:41
  SPEAKER_00: Let's go to the third and final lesson.
• 10:44
  SPEAKER_00: Discounts exist for a reason.
• 10:48
  SPEAKER_00: A discount on a holding company exists for several reasons.
• 10:53
  SPEAKER_00: The discount is a direct reflection of added risks and complexities.
• 10:58
  SPEAKER_00: It's the market's way of saying, hey, I don't know about hidden costs, uncertainties, and challenges that come with owning a company through an intermediary, which is the holding company.
• 11:12
  SPEAKER_00: For a company like Process, the discount reflects a few key issues.
• 11:17
  SPEAKER_00: First, structural complexity.
• 11:20
  SPEAKER_00: The nested ownership structure with NASPERS creates tax inefficiencies and a confusing setup that deters many investors.
• 11:29
  SPEAKER_00: Second, geopolitical and regulatory risks.
• 11:34
  SPEAKER_00: The primary asset is Tencent, a Chinese company that operates under the constant shadow of potential government intervention and regulatory changes.
• 11:45
  SPEAKER_00: Third, historical skepticism.
• 11:48
  SPEAKER_00: The company's past investments and capital allocation decisions have been a mixed bag, leading to a lack of trust from some investors.
• 11:57
  SPEAKER_00: This is why a holding discount is not a free lunch.
• 12:01
  SPEAKER_00: However, markets are not always rational and can often overreact to these risks, either to the upside or the downside.
• 12:10
  SPEAKER_00: So what's the third and final lesson?
• 12:13
  SPEAKER_00: The key to a successful investment in a holding company is finding a discount that is unjustified and being actively addressed by management.
• 12:25
  SPEAKER_00: In Process's case, a more focused management team and a large ongoing share buyback program are tangible actions that can narrow discount over time.
• 12:37
  SPEAKER_00: The real lesson is understanding why the discount exists in the first place and knowing whether you can profit from it or should stay away.
• 12:47
  SPEAKER_00: Just remember, buying a holder company is a bet on two things, the underlying asset and the capital allocator.
• 12:58
  SPEAKER_00: That's it for today.
• 13:00
  SPEAKER_00: Until next time, stay curious, keep learning, and happy investing.