Alibaba Stock: Unjustifiably Cheap According To Buffett's 10x Pretax Rule

Nov. 30, 2021 1:36 PM ETAlibaba Group Holding Limited (BABA)171 Comments

Summary

  • For Munger and Buffett, the best thing is when a great company gets into temporary trouble so they can buy it on the operation table.
  • Munger recently bought doubled down on his Alibaba bet despite the prevailing market’s concerns over its uncertainties in China.
  • This just provides yet another example of the grandmaster’s investment wisdom and the so-called Buffett’s 10x Pretax Rule.
  • Priced at only 8.4x pretax earnings, an investment here provides dominant odds for double-digit return even growth completely stagnates.

China-Based Internet Company Alibaba Debuts On New York Stock Exchange

Andrew Burton/Getty Images News

Investment Thesis

Alibaba Group (NYSE:BABA) has been facing quite a few uncertainties: Fines, and antitrust regulations, and a potential slowdown of the overall China economy. This month's earnings release showed a "slowed" revenue growth (among other concerns such as higher tax rates) and another wave of the selloff of BABA shares followed - even though BABA's revenue growth is still 29% YoY.

Under the above background, you will see that the thesis here's really simple - the stock has now become unjustifiable cheap according to the so-call Buffett's 10x pretax rule. As to be detailed later, if you pay 10x pretax and bought a business that stagnates forever, you would have bought a 10% yielding bond and enjoys a 10% annualized return. And if you get a business that offers ANY growth, you will have a large chance of a double-digit return compounding for a long time. BABA is currently for sale around 8.4x pretax earnings when adjusted for its cash positions, and it will not stagnate forever. On the opposite, BABA stands best poised to benefit from our world's e-commerce movement, particularly in the Asian-Pacific region, the center of the movement.

Buffett's 10x Pretax Rule

If you're a devout Buffett cultist like this author, you must have noticed or heard that the grandmaster paid ~10x pretax earnings for many of his largest and best deals. The list is a really long one, ranging from Coca-Cola, American Express, Wells Fargo, Walmart, Burlington Northern, and of course the more recent AAPL purchase.

As detailed in my other writings before, it is not a coincidence that most of his best and largest investment success is from buying businesses at 10x pretax earnings, because:

  • Buying an average business that stagnates forever at 10x pretax would already provide a 10% pretax earnings yield, directly comparable to a 10% yield bond.
  • In case you get to buy an above-average business (like BABA here) at 10x pretax, then any growth would be a bonus on top of the 10% yield above, leading to a double-digit return.

As seen from the chart below, the market now presents BABA as such an opportunity. The following chart shows the price history of BABA and its 10x pretax earnings plus its cash position (since it has a sizable cash position). Pretax earnings are also referred to as "EBT", Earnings Before Taxes, in this article. As seen, for a business like BABA, the price should be high above 10x EBT, as it has been in the past. But during the recent market overaction, the price now is actually close to the 8.4x EBT as seen (again correctly for cash)!

BABA chart

Source: author based on Seeking Alpha data

So, in this case, even if BABA stagnates forever, by paying 8.4x pretax, the investment would already provide a 12% pretax earnings yield, directly comparable to a 12% yield bond. And to be seen next, BABA has an excellent prospect to grow also.

Warning!

Here a strong warning is in order. I'm not suggesting you go out and start buying every/any stock that is below 10x EBT. As investors, we face many risks. Two of the major risks are A) quality risk or value trap, i.e., paying a bargain price for something of horrible quality, and B) valuation risk, i.e., paying too much for something of superb quality. The 10x pretax rule is mainly to avoid the type B risk AFTER the type A risk has been eliminated already.

Then how do we eliminate type A risks? I look for three things primarily:

  1. The business should have not an existential issue in the long run. However, in the end, this is largely a subjective judgment.
  2. The business should have no existential issue in the short run either. This can be quite reliably and objectively evaluated based on the cash flow and debt coverage.
  3. The business should have a decent chance to grow its earnings in the long term (and estimate the so-call perpetual growth rate). This will be a plus. Because remember, even if the business stagnates forever, I'm already perfectly happy to be making a 10% return pretax - it's like holding a bond with a 10% yield. Any growth is a bonus.

So with this framework, let's examine BABA more closely.

BABA: Does It Have Any Existential Issue?

I really do not see any existential issue for BABA either in the short run or the long run. I will just be brief and go through my thought process here and then move on to focus on the growth perspective.

As aforementioned, existential issues, in the long run, is largely a subjective judgment. If some of us even entertain the possibility that BABA would have trouble surviving, the root of our concertina is probably the Chinese government. My judgment is that the Chinese government will not only not let BABA fall, but also will work with BABA to make sure it continues to prosper. I have traveled extensively in China and read extensively about its recent history. The current regulatory shock waves are nothing new historically. They've happened before (even at a larger scale and with strong intensity) and will happen again most likely. As for BABA, it's reached a status too big to fall, and also at the same time, too good to fall. It's in the Chinese government's best interest to keep it alive and thrive - which leads me to the next point.

The recent announcement that BABA will invest RMB100 billion (about $15.5B) to the Chinese Common Prosperity fund actually supports my above view. To me, this announcement shows convincingly that a path forward is being worked out for BABA - and it's a peaceful path that's nothing like what the market has feared.

Charlie Munger's recent movement also seems to support my above view. The long-term Buffett's partner recently doubled down on his Alibaba bet despite the prevailing market's concerns over its uncertainties in China. With Munger's long track record as a disciplined and long-term investor, he must have no doubt at all about the long-term staying power of BABA.

Short-term existential issues are a lot easier. This can be quite reliably and objectively evaluated based on the cash flow and debt coverage. And BABA certainly does not have any of these issues at all. Just take a look at the following snapshot of its capital allocations in the recent year. The picture is really simple here: BABA earns a load of cash organically from its operations - even considering its fines, commitment to the common prosperity fund, and potential tax rate raises. And it does not need to spend much. Just take a look at its finances in recent years. It generates more than $30B of operating income per year in recent years. BABA is effectively debt free (its debt interest expenses are merely $0.5B). BABA does not pay a dividend. And its capex is only about $6.4B, about 20% of its operating income. When we expand our horizon a bit wider and examine its capital allocation over the past decade, the picture does not change that much, as shown in the next table.

BABA use of cash as percent of OPC

Source: author and Seeking Alpha.

BABA: What Is Its Growth Potential?

It's an unstopped trend that our world is moving toward e-commerce. Even though many of us are already impressed by the success of e-commerce giants like BABA and Amazon, the movement toward e-commerce has just actually gotten started and the bulk of the growth is yet to come. The global e-commerce market size was valued at USD 9.09 trillion in 2019 and is expected to grow at a compound annual growth rate of 14.7% from 2020 to 2027. The secular support is even stronger for BABA as the Asia Pacific region already is dominating the market for e-commerce with a share of 55.3% in 2019. Furthermore, this region is expected to witness the fastest growth from 2020 to 2027 as seen below. Even by as early as 2023 - in about two years that is, retail e-commerce sales in Asia-Pacific are projected to be greater than the rest of the world combined.

Asia Pacific B2B e-commerce market size

Source: Grand View Research

And BABA stands best poised to benefit from the world's movement toward e-commerce and especially the Asian-Pacific momentum. Capitalizing on the continued e-commerce growth requires a combination of scale and reach, government support, and technology. And also, finally, geographical proximity and cultural compatibility certainly help. And BABA has all these stars aligned for its further expansion - especially in the Asian-Pacific region. The China government might be tightening its regulations on its domestic market, but it certainly encourages the overseas expansion of its tech giants like BABA. And BABA already has accomplished a substantial lead in capturing overseas markets, with its close neighbors such as Indonesia and Vietnam posting revenue growth of over 100% YoY recently.

Finally, A Reality Check

Finally, what I always like to do is a reality check as shown in the chart below. It's essentially a back of envelop calculation to estimate what's the growth rate and valuation required to deliver a target ROI in the next a few years, say 5 or 10 years. And see if such growth rate and valuation can pass a common-sense test.

As an example to provide a tutorial to read this chart, if we require a 10% annual ROI, represented by the black horizontal line (10% annual return translates to 160% total return in 10 years because 1.1^10=260%), the growth rate will have to be about exactly 10% if the valuation ratio does not change from its current level (i.e., 8.4x EBT) - something we all know already. And if the valuation contracts to 7x EBT as shown by the green line, the growth rate would have to be about 12% to deliver the required 10% ROI.

With the above background, we can see that the current valuation easily passes the reality check. In particular, investment here enjoys a large margin of safety from several factors:

1. A large gap between market perception and fundamentals. As seen, under the current valuation, we're very likely to enjoy double-digit returns even if growth is not double digit. To put things into perspective, BABA recent "slowed" growth rate is about 29%. And the secular trend can easily support a double-digit e-commerce growth in the next decade (say around 15% CAGR).

2. A very compressed valuation. If you pay 10x pretax and bought a business that stagnates forever, you would have bought a 10% yielding bond already. At BABA's current 8.4x pretax valuation, even when growth slows all the way to 6% AND valuation further contracts (say to 7x EBT), the investment would still make a profit of about 4% per annum.

BABA growth rate and PE required to delivery target ROI in 10 years

Source: author.

Risks

First, there's always the risk that the Chinese government could confiscate foreign investments in BABA if they decide foreign investments made in BABA under the VEI structure are illegal. This is very unlikely to me for so many reasons. Readers who want a detailed discussion of the unlikelihood of this scenario should read the Asian Investor's excellent analysis of the VIE structure here.

Second, as a milder version of the above confiscation risk, there's a chance that BABA could be delisted from the US stock market. Delisting Chinese stocks has just happened recently, and both the Chinese and the US regulators each have their own reasons for delisting BABA. But do not forget that they also have their own reasons not to delist BABA. The US and China governments can dislike each other without destroying each other. And even if BABA stock indeed ended up delisted sometime in the future, that would not necessarily lead to a total loss of capital.

Third, the unfolding Evergrande situation and the overall bad debt problems in the Chinese real estate sector could be a risk for BABA. Even though BABA has no exposure to real estate, the uncertainties in real estate could cause many ripple effects and impact BABA. As an extreme example, given the scale of China's real estate sector and its debt, it could substantially slow down China's entire economy and even the world's economy.

Conclusion & Final Thought

The recent market overreaction presents an opportunity to buy a great company that's having temporary trouble, and while it's still on the operating table - as Buffett and Munger have done so masterfully in the past. The thesis of this article is therefore really simple - companies like BABA should never be priced below 10x EBT but it is now. The current pricing is such that BABA is valued significantly below 10x pretax earnings. And as a result,

  • Even buying an average business that stagnates forever at such a valuation would already provide a doubt-digit return.
  • Yet, BABA is nothing but an average business that will stagnate forever. BABA stands best poised to benefit from the world's movement toward e-commerce and especially the Asian-Pacific momentum. To put things into perspective, BABA recent "slowed" growth rate is about 29% YoY. And the global secular trend, especially in the Asian Pacific region, can easily support a double-digit e-commerce growth in the next decade of more than 15% CAGR.
  • The margin of safety is so thick here that even when growth slows all the way to 6% AND valuation further contracts to 7x EBT, the investment would still make a profit of about 4% per annum.

This article was written by

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** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have a beneficial long position in the shares of BABA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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