I am a very pessimistic investor. This lends itself to value investing, but it can also hold me back. I spend too much time concentrating on the negatives rather than focusing on the positives of potential investment opportunities.
As a naturally skeptical investor, I tend to stay away from investment propositions that appear too risky, even if the level of risk is relatively modest.
Still, I think my mindset helps me understand the risks of a potential investment much better than other market participants who may be too focused on the positives. One of these risks is not fully understanding the challenges a company faces; this is why I have put Alibaba (BABA, Financial) firmly in my "too hard" pile.
Inverting the thesis
Charlie Munger (Trades, Portfolio) has argued that the best way to analyze the potential risks of an investment is to invert the situation, and that's what I want to do in this article.
Indeed, the bull points for Alibaba are well-known. It is a dominant player in the Chinese e-commerce industry, a rapidly growing market. The Chinese economy has achieved outstanding growth over the past few decades, and it looks as if the region can maintain its growth trajectory as the middle-class continues to grow and the region's wealth expands.
Alibaba also looks cheap compared to its growth potential, and there is scope for it to expand its cloud computing business. Still, while Alibaba has a dominant position in the Chinese e-commerce market, it is not the only successful company in this space. It doesn't have the same monopoly as Amazon (AMZN, Financial). Its e-commerce market share has been steadily declining over the past couple of years as competitors have been edging in on its turf.
This trend is unlikely to go into reverse any time soon. Policymakers want to encourage competition, and venture capital companies are more than happy to throw billions of dollars at new start-ups. Maintaining the company's competitive edge is possible, but it is going to become more expensive.
That is without giving any regard to the regulatory environment in China. Regulators are cracking down on big tech in China in a manner that has not happened in the U.S.
This is where the comparison with a U.S. retailer like Amazon falls down. The operating environment in North America and China is not 100% comparable. Amazon has been able to maintain its competitive position by reinvesting all of its profits back into the business. Alibaba had the same luxury in the past, but that may be gone forever due to the regulatory environment.
I think we also need to ask, what happens if the Chinese economy does not grow? Amazon's stock has declined as fears about slowing U.S. economic growth set in. If you remove this tailwind, the outlook for Alibaba becomes a lot more uncertain. The company and its peers will be fighting for a share of the same pie. There is no guarantee it will come out on top in the hyper-competitive markets in which the company operates.
Put simply, Alibaba could become a tech and e-commerce company in a hyper-competitive, no-growth market, which is continually under threat from regulators. I don't think these qualities are particularly attractive, and again, I really don't understand the Chinese regulatory environment.
Considering the downside
I do not own a position in Alibaba, but I have done a lot of research trying to understand it, since it is a Munger holding and appears at first glance to be a good opportunity. No matter how brilliant an investment might look on paper, though, a company is always going to face threats which investors need to seriously consider.
Alibaba looks appealing as a value investment. The stock seems cheap compared to its growth potential, and there are some substantial tailwinds driving the firm forward.
Munger certainly seems to think the business offers value. But the firm is facing undeniable challenges. Whether or not these are short-term or long-term issues remains to be seen. That is why this stock goes in my "too hard" pile. There are just too many uncertainties.
