Here is the pdf file of the investor letter for the second quarter of 2020.

CIO’s Market View

Volatility is the story of the year so far. As of the time of this writing, U.S. equity markets have rallied 40 to 45% from the lows, on March 23rd. The relentless upward trend in equity prices is puzzling for a number of reasons. First, from a positioning perspective, it appears retail investors are driving the rally, as many hedge funds and institutional money managers appear to have missed out on the rally. Second, from a flow perspective, the cross-border flows have been light, again indicating many non-U.S. money managers did not participate in the U.S. out-performance. Finally, we have experienced of deluge of dismal economic data on the real economy.

The Federal Reserve announced a number of emerging liquidity facilities in March and these, by and large, seem to be effective, as evidenced by: credit spreads have tightened, the U.S. dollar has weakened, and the yield curve has steepened. In addition, the corona-virus-induced equity market dislocation has been entirely recovered and now the market grapples with momentum and valuation concerns. The liquidity infusions have reflated asset prices to the extent that (i) price-to-earnings ratios are now near previous bubble territories and (ii) record-setting market breadth levels (e.g., developed market equities around the world are trading at their all-time highest levels, in terms of the percentage of companies trading above their 50-day moving average).

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Are we experiencing the calm between the storms or a turning point? Many believe that risk assets have become disconnected from the macroeconomic reality. Moreover, the euphoria associated with the re-opening of the economy is being buffered with concern over a possible second way of the coronavirus and/or the second-order effects from the first wave (e.g., a tidal wave of small business bankruptcies). The consequence, from an investment perspective, is that tail risks, both the left and right tail, are quite high right now and these increased possible extreme outcomes should be calibrated in portfolio construction.

Observations of Digital Economy

Before embarking on our investment journey in the global digital economy, we asked ourselves three questions: 1) Is the transition to a digital economy structural? 2) If so, what are the biggest drivers of digitalization going forward? And 3) Who are the companies benefiting the most in this process?

The answer to the first question is definite without much controversy. Think about how far we have come in terms of things that we could do on our smartphones. We are still in the early innings of a decade-long cycle of digitalizing every aspect of our daily life.

Our answer to the second question on the key driver of digitalization is the proliferation of 5G. When things are all connected at a faster speed, our everyday activities generate more data. With the help of artificial intelligence, data makes those activities smarter and more efficient. COVID-19 happened to massively accelerate the digitalization process, as Microsoft puts it, "We've seen two years' worth of digital transformation in two months."

To answer the third question, we studied the mobile internet transition in 4G, the last time digitalization accelerated. We concluded that economic value mostly resided with companies of either providing critical technology or building new applications on top of it. That led to our four-pillar investment strategy, focusing on the 5G ecosystem's building blocks: next-gen semiconductors, cloud computing, SaaS, and enabling technology.

Pillar 1: Semiconductors are in wartime

Semiconductors are at the heart of transitioning into the digital economy, of which we've been witnessing significant development this year. The semiconductor market hasn't been this dynamic for years, with multiple wars heating up at the same time. In the smartphone and PC market, OEMs like Apple, Huawei, and Google increasingly rely on their internally designed processors for differentiation. We see a similar trend in the server market, with Amazon and Alibaba aggressively investing in self-designed chips.

The traditional semiconductor companies are not standing idle either. The fight between Intel and AMD intensifies with AMD continuously taking share in the PC and server market; Nvidia raises the bar on machine learning with the introduction of Ampere architecture. Qualcomm's push into the RF space is also gaining traction for providing easy-to-adopt solutions for customers with less expertise in semiconductor design.

The biggest war of all is, of course, the ongoing battle between the U.S. and China. China has prioritized the self-sufficiency of semiconductors with generous state support and has made some early progress. The U.S. is now going in the same direction by pushing TSMC to build a leading-edge factory on U.S. soil while trying to leverage its strong position in semiconductor equipment to hinder China's progress. To complicate things further, Taiwan's dominating position in semiconductor manufacturing and sensitive relationship with both China and the U.S. adds another layer of complexity and uncertainty. This battle could last for years, if not decades, and we are likely just witnessing the beginning of it.

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Pillar 2: Cloud embraces multi-cloud & edge computing on a long runway

Cloud continues to be the crucial digital transformation infrastructure and shows no signs of slowing down. In the first quarter of 2020, Amazon's cloud business generated $10 billion+ in revenue for the first time, while still growing at 30%+ YoY and running 30%+ operating margin. In the grand scheme of things, cloud services only account for 15% of total IT spending despite rapid growth in recent years, suggesting a long runway ahead.

Companies are moving more and more workloads to the cloud; they also increasingly prefer multiple cloud approach for flexibility, avoiding lock-in, or data sovereignty. According to a recent survey by Flexera, 93% of the customers are planning to use multiple cloud vendors, and 60% believe cloud usage will exceed prior plans due to the pandemic. Public cloud incumbents, namely Amazon, Microsoft, and Google, are all actively pitching their versions of multi-cloud services.

Another new but inevitable trend is the convergence of cloud and 5G. In a recent interview, Navin Shenoy, general manager of Intel's Data Center Group, suggested that 5G is about computing as much as about communications. As a result, more core 5G networks will become datacenter like, and more computing power will move to edge locations closer to where use cases/data are. Since the beginning of the year, all public cloud vendors have actively struck partnerships with telecom companies to solidify their 5G ecosystem.

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In China, a new cloud strategy, "Middle Platform," virtually a comprehensive but integrated cloud-native data service, is getting more attention among Chinese enterprises. AliCloud first proposed the approach, "big middle platform, small front desk," for its cloud customers in 2015 by leveraging Alibaba's years of experience in integrating data across its vast business lines. Alibaba and Tencent package their own best practice of digital transformation and then sell it to their cloud customers. Who knows better than those two? Our channel check indicates that "Middle Platform" contracts are lucrative, and customers are usually governments or leading state-owned companies in financials, manufacturing, and energy sector.

Pillar 3: Is SaaS recession-proof yet? 

Although the first SaaS company dated back to 20 years ago, most of today's SaaS companies were not even around during the last recession. COVID-19 is the first real test these companies faced since they went public. There are negative impacts of some heavily hit industries such as hospitality and travel. Still, SaaS companies prove to be resilient so far, thanks to their recurring revenue model and easy-to-adopt products. Even the most technically conservative customers realized that legacy technology is not the place to be. Among them all, two groups have shown favorable results.

The first group is the collaboration software benefiting from remote working like Zoom and Slack, which hardly is a surprise. The hundreds of millions of people forced to work remotely due to COVID-19 is the most significant proof-of-concept project ever, and it is safe to say the concept is now proven. We are starting to see more companies adopting remote working permanently, which gives the collaboration software more staying power and likely benefits them in many years.

The second group is the cloud-native security software. The cybersecurity market has been expanding from the legacy architecture with security perimeters around corporate data centers to a new one, with the cloud being the center of gravity for security. When employees spend more time outside the corporate network, access Microsoft 365 and other SaaS applications directly and continuously, and companies are moving their workload to a public cloud, the legacy security infrastructure becomes irrelevant. COVID-19 was the catalyst for companies to see it clearer. You must secure people (identity management), devices (endpoint), network, and applications when they are no longer in your corporate datacenters but all in the cloud. The best of breed for these tasks include Okta, Crowdstrike, and Zscaler, respectively.

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We do not argue for SaaS to be recession-proof. MongoDB admitted the economic pain of COVID-19 worse than expected. The database vendor observed a modest but broad-based growth slowdown from the existing cloud customers, mirroring the macroeconomic contraction. SaaS companies who have exposure to hard-hit industries are likely to face a similar growth challenge in the near term.

Pillar 4: Enabling technology centers on streaming and eCommerce

The fourth pillar of our investment strategy mainly includes the technology or business model that digitalizes part of our daily life, such as what eCommerce does for shopping, search/social media for advertising, and streaming for entertainment. If we must pick one word to summarize the development over the past few months in the tech world, there is no better choice than "digitalization."

eCommerce continues to improve our overall shopping experience, from physical goods to grocery and local services during the pandemic. JP Morgan estimates that eCommerce penetration increased to 21.5% of retail sales in April, compared with 15.7% in 2019 in the U.S. Amazon, along with eCommerce companies such as Etsy, Shopify, and Wayfair, has all benefited significantly from surging online demand.

In the China eCommerce market, Pinduoduo and JD gained more market shares versus Alibaba, in the first quarter, since Alibaba's logistics partners were forced to shut down due to COVID-19. Alibaba hit back forcefully with a record high GMV of $98.5 billion in the 618-promotion event. The live-streaming eCommerce (Taobao Live) contributed the most to that success. Alibaba primarily pioneered this new concept by leveraging its robust cloud infrastructure and massive mobile user base, which has become a mainstream shopping phenomenon in China.

Media streaming is another area where digitalization separates winners from losers. Rupert Murdoch once said, "success in media business does not come easily or quickly." In addition to accumulating top content, successful streaming companies today have spent years building their technology backbone. For example, Netflix's "cloud-native" journey dated back in 2009 and only completed its migration to cloud eight years later in 2016. In the tech world, the company is also well praised for its early adoption of serverless architecture.

Company Highlights

Taiwan Semiconductor Manufacturing Company (2330 TT)

The key phrase for the semiconductor market over the past few months is "Silicon War." As the most advanced semiconductor foundry in the world, TSMC is at the epicenter of every single war we described earlier. For the conflict between different companies, almost everyone counts on TSMC for manufacturing, making TSMC the only arms dealer in town and well-positioned regardless of who wins. However, when the war escalates to the country level with geopolitical considerations involved, being the only arms dealer may be viewed as a threat to both sides. It is not a surprise that both China and the U.S. are pushing hard to bring advanced semiconductor manufacturing capability domestically. TSMC is still working on being "everyone's foundry" and remaining somewhat neutral so far, but the company may have to pick side down the road.

Microsoft Corporation (MSFT US) 

Microsoft's cloud solutions from IaaS (Azure), PaaS (Power Platform), to SaaS (Teams, Dynamic 365) were firing on all cylinders during the pandemic as customers accelerated the adoption of the cloud. With multi-cloud becoming customers' default strategy and the rollout of multi-cloud management tools (Azure Arc), Microsoft has been aggressively expanding partnerships with top SaaS companies to allure more customers. In the past year alone, Microsoft has formed or enhanced partnerships with Adobe, Oracle, ServiceNow, Salesforce, SAP, SAS, and Workday. Telco cloud is another area of focus. In the second quarter of 2020, Microsoft acquired Affirmed Networks and Metaswitch Networks to get closer to carriers. Microsoft also formed alliances with AT&T, SK Telecom, Telefónica to develop 5G cloud solutions jointly. We expect this trend to continue.

Meituan Dianping (3690 HK)

Meituan, who is often nicknamed by investors as the "Amazon for local services" in China, is the indisputable leader in both food delivery and in-store/hotel services. The food delivery business has demonstrated excellent unit economics and has consistently won market shares from Ele.me. The in-store/hotel business has a high-profit margin because of its advertising plus commission business model. 

While COVID-19 hurt Meituan's two principal businesses badly in the first quarter of 2020, it has emerged much stronger as China's economy reopened. The pandemic structurally shifted customer behavior to ordering food delivery more often, and many high-end restaurants also started adopting food delivery services, both of which are expanding Meituan's TAM. Recent reports suggest that Meituan has hired 1.07 million riders since the beginning of 2020 to meet the surging demand. The in-store/hotel business also witnessed a sharp rebound. 

To compete with Meituan, Alibaba leverages Alipay's user traffic to promote its local services. Our recent channel check suggests that T-Mall has been persuading many offline retailers (such as Heytea, KFC) to open online stores. However, Alibaba's efforts have seen limited success so far. On the other side, Meituan keeps pushing the boundary by rolling out credit payment and grocery delivery to counter-attack Alibaba's ecosystem.

Netflix Inc (NFLX US) & Bilibili Inc (BILI US) 

Both Netflix and Bilibili grew tremendously in the first half of 2020. Netflix's heavy investment in original content allowed it to launch many popular shows when other studios had to shut down due to the global pandemic. Netflix's streaming technology stood the test of surging viewership thanks to its state-of-art cloud architecture. Its pure subscription business model also sheltered the company from the decline of the advertising dollar.

Bilibili's growth was on fire even before COVID-19. The platform, combining anime, comic, gaming, and eCommerce, is the go-to destination for China's GenZ. It has been attracting top PUGC talents to allure more audiences in recent years. Sony made a $400 million strategic investment in Bilibili for a 4.98% stake in April. Bilibili is a rare asset in China as Tencent, Alibaba, and Sony all hold sizable stakes.