Fund Performance Review
For the month of May, the Hennessy Japan Fund (HJPIX) returned 0.71%, outperforming the Russell Nomura Total Market™ Index which returned 0.37%. The Tokyo Stock Price Index (TOPIX) returned 1.21% for the same period.
Among the best performers were our investments in Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads as well as providing human resource services, ASICS Corp., the high performance running shoe maker, and Misumi Group Inc., the maker and distributor of metal mold components and precision machinery parts.
SoftBank Group Corp., the telecom and Internet conglomerate, Mercari, Inc., the operator of the “Mercari” flea market application, which has accumulated one hundred million downloads, and Murata Manufacturing Co., Ltd., a manufacturer of electronic modules and components, detracted from the Fund’s performance.
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A Deeper Look at Softbank Group
Since 2015 when the Fund started investing in SoftBank Group (SBG), the stock has provided strong returns contributing to the Fund’s performance. However, it has been far from smooth sailing as the company was often misunderstood by the market.
For example, there are divergent views about founder/chairman/president/CEO Masayoshi Son’s leadership quality. Some opine their negative views, citing the recent WeWork debacle and his overly ambitious, and at times, seemingly reckless business decisions. We, on the other hand, take a more charitable stance. Given his entrepreneurial track record over the last 40 years as head of the company, it is difficult to understate the numerous positive impacts he has made on the Japanese society (from which he deservingly built a huge fortune as Japan’s richest person).
For instance, in the early 2000s, Son made a foray into the asymmetric digital subscriber line (ADSL) broadband infrastructure business, which led the company to incur cumulative losses of roughly $3.5 billion between fiscal year (FY) 2001 and 2004 before it became a powerful growth driver for the company. Thanks to Son’s bold commitment, Japan’s internet quality advanced significantly, giving high-speed connection to households at affordable prices.
The 2006 Vodafone Japan acquisition was widely regarded as a risky endeavor as the company had no prior experience in the mobile carrier space. Nevertheless, Son defied the skeptics by swiftly turning around what was then the weakest industry player by putting Apple’s iPhone in the hands of Japanese consumers thanks to an exclusive distribution agreement between Son and Apple’s founder Steve Jobs.
These are no small achievements and are also a testament to the company’s mission statement: “Information Revolution – Happiness for everyone.”
More recently, there were misunderstandings around the interpretation of its financial performance. When management reported a full year operating loss of over $10 billion in FY2019 due to difficult investment performance of its holdings (increase in unrealized losses), news media slammed it as the largest ever recorded by a Japanese company. However, for the telecom operator-turned investment holding company, their true economic worth could no longer be measured by reported profits on the income statement. Rather, we believe its real value lies in the balance sheet consisting of key investment holdings such as Alibaba, SoftBank Corp (domestic telco subsidiary), T-Mobile (formerly Sprint), ARM, and the Vision Fund. When marking-to-market these assets where applicable, its total net asset value (NAV) had remained largely flat in FY2019 while the share price remained undervalued by a wide margin relative to it.
What’s more, the media and rating agencies often viewed the company as heavily indebted. However, the truth of the matter was that the majority of these debts were attributable to the investees such as SoftBank Corp and Sprint to support their respective business operations, and as such were effectively non-recourse to SBG. For these reasons, our view has been that SBG was actually one of the most asset-rich companies in Japan. Since the company started to make the transition to the present structure and more publicly tout its effort, the market seems to have caught on to this notion.
Based on its NAV, SBG was worth $260 billion according to its investor presentation as at the end of March 2021, far greater than its own market cap of $150 billion. Even if you take into account the broader declines in the tech shares since then and the theoretical capital gain taxes SBG would eventually have to pay on Alibaba shares upon exiting, we estimate that the aggregate NAV would still be around $200 billion.
Interestingly, SBG’s market cap was roughly trading in line with our conservative NAV estimate until the end of April. However, there is once again a wide discount after the company made an announcement to retire all of its treasury stock amounting to 16% of total outstanding shares.1 This event resulted in a reduction of the market cap even in the absence of a major share price movement around that time. Though there is no way to determine whether the market had priced in the share cancellation prior to the announcement, we are delighted to have this discount so we could buy more shares of SBG with a better margin of value if we wanted to.
More good news is that not only has the NAV increased over last several years but also SBG’s composition has become more diversified, mitigating an over-reliance on its Alibaba stake. Until recently, Alibaba dominated SBG’s investment portfolio, making up around 70% of total NAV. Today, Alibaba represents just 40%, and roughly a quarter of NAV is contributed by the Vision Fund (which was less than 10% before). This is due to a series of partial sales of the Alibaba stake and a sharp improvement of investment performance at the Vision Fund in FY2020.
Outlook for the Vision Fund
The gigantic Vision Fund was launched with fanfare in 2017, with nearly $100 billion in AUM, but it was met with a severe drawdown in performance in 2019/2020. Unfazed, Son and the Vision Fund team continued to forge ahead. Today, the Vision Fund’s total fair value before distributions has grown to $143 billion, a significant increase in assets purely attributable to investment performance since inception. For all the criticisms, we think it is safe to say the business has been a success. One score for Son.
The Vision Fund segment now has three vehicles up and running: SVF1, SVF2, and LatAm Fund that are collectively invested in more than 200 startups around the world. According to the tech startup and venture capital data tracker CB Insights, there are over 600 privately held startups “unicorns” globally with an aggregate valuation of over $2 trillion today. Of course, not all of the Vision Fund investees are at the unicorn stage, but a big chunk of them are considered so. Based on our estimate, there are at least 70 unicorn-size start-ups in the Vision Fund stable. This is equivalent to one of every 10 unicorns.
The analogy often applied to describe the venture capital business is that it is comparable to buying a lottery ticket. Most are losing tickets with only a tiny percent eventually morphing into huge wins, which can outstrip the cost of failures by far (hence the lure of the business). Judging by the current state of the Vision Fund business, we believe there is the potential for a favorable outcome.
As we discussed in our July 2018 letter, some critics initially said that the Vision Fund’s extraordinary size is a major disadvantage and expect it to have a hard time making enough investments to use up available capital. However, when looked at from a different angle, the Vision Fund’s formidable firepower can be a decisive advantage.
Here is what we wrote over two years ago:
"It is often said that finding a successful startup company is like finding a needle in a haystack. But, using a lottery ticket analogy, what if you can buy up most tickets issued to make your chance of winning much higher? This is exactly the approach the Vision Fund is taking in our view. The $100 billion fund is far bigger than all the other venture capital funds.2 We feel that this is a smart way to raise the probability of investment success. We also think that the Vision Fund’s strategy of mainly targeting late-stage start-ups is a sensible approach. The critical element in platform companies, the kind of business the Vision Fund aims to take stakes in, is that you need to ramp up scale quickly at all costs to a point where other potential competitors are no longer able to match up. Across different verticals, the overarching economics is that a successful platform can create ‘winner-takes-all’ dynamics. As such, by focusing on late-stage start-ups who are on the cusp of coming out of the initial heavy loss-making platform building phase and providing them with abundant capital, SoftBank aims to cement the investees’ leadership positions even further. At Fortune Magazine’s Brainstorm Tech Conference last month, this point was emphasized by SoftBank managing partner Jeffrey Housenbold, who said, ‘There are certain industries where writing a bigger check helps increase the likelihood of success.’
"Moreover, Softbank’s playbook is to take meaningful minority stakes which gives them the top shareholders’ seats after the founders. Its objective is to build an ecosystem consisting of dozens of investees and encourage them to collaborate where it makes sense to maximize each other’s growth prospects. This should also contribute to extending the lead of its investees in their respective arenas, effectively raising the odds of eventual investment success for SoftBank.”
SBG’s Management Culture
Lastly, at SBG, the company’s leadership culture is often thrown into doubt whenever adverse outcomes from business decisions hit the company. Critics point to Son’s dictatorship and potential lack of checks and balances. Yuko Kawamoto, an independent director of SBG who recently announced her resignation, has left an interesting departing note to provide an unbiased insight into the company’s boardroom culture. As a former McKinsey consultant as well as a member of various government committees, Kawamoto is well-respected and widely regarded as an expert on corporate governance. This message could help capture SGB’s management culture: Please follow this link if you have an interest in reading her note.
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