Talk Your Book: Internet Stocks with Income

0:00Today's Animal Spirits Talk Your Book is brought to you by CraneShares. Go to Craneshares.com. slash clip. That's K-L-I-P to learn more about the Crane Shares China Internet and Covered Call Strategy, which we're going to be talking about today. That's craneshares.com slash clip. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:34Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:42Welcome to Animal Spirits with Michael and Ben. Michael, we've been talking a lot in the last year or so about covered call strategy. I think there was a Wall Street Journal story three or four months ago talking about the amount of money that poured into those types of strategies. I think we've heard from ones on the S &P 500, the NASDAQ 100, maybe some high quality individual stocks like consumer staples, those sorts of things. You think 2021 was the year of growth? Crazy momentum. 2022 was the year of covered call strategies. I don't know, that might be a stretch. And 2023 is the year of money market funds?

1:16Close, yeah. Could be. But this is marrying growth and covered calls, right? So we've talked to CraneShares in the past before. They have their China internet strategy, K-Web, that invests in China internet companies. And that's a very volatile strategy, right? Huge swings in price, big gains, huge losses all over the place. I think you mentioned this to me a couple weeks ago, and you said, check out this new covered call strategy on K-Web. Look at the distribution yield on it. And it was 50 % to 60%, right? Not a typo. It was something in that range, right? Mm-hmm. Which is crazy. And we looked into it.

1:58And it's basically because these stocks are so volatile and option prices are based on volatility that if you're writing options on these China internet companies right now, that's the kind of option income that you can earn. Yeah, pretty wild. It's not magic, not rocket science or voodoo. It's pretty linear, the relationship between, again, volatility and option prices. And when you're selling them, you're on the other side of buying them. Right? Duh. So that's where the income comes from. We get into all of that. How is it possible? What are the risks? Because of course, anything that distributes that sort of distribution is not risk-free.

2:36Probably the opposite. So Jonathan Schellen from Crane Shares explains to us how that is done. So without any further ado, here's our conversation with Jonathan Schellen. We're joined today by Jonathan Schellen. Jonathan is the chief operating officer at CraneShares. Welcome to the show. Hey, great. Thanks for having me. We're talking today about KLIP, which is the covered call strategy on the China internet sector, which I am very keen to talk to you about. But before we get there, I do have to ask you, I don't know if you know this, but the first investment that Ben made was not in a high flying Chinese internet company.

3:19It was of all things in a target date fund. He's the oldest, youngest investor of all time. I was very responsibly made in my IRA, I should mention. A little birdie told me that you have a history with target date funds. So I'd love to ask you briefly, what is your history with target date funds? Yeah, I was very fortunate that I joined the team way back when in 2001 at Fidelity that pioneered target date investing. And I was a portfolio manager on the target date strategies for 10 years until I left in 2011. I always thought it was Vanguard. That's interesting. Records set straight. Yeah, no.

4:07In fact, Fidelity started that business back in 1996. And now the entire target date industry is over a trillion dollars in AUM. Easily one of the biggest leaps forward, I think, for individual investors we've had over the last 20 years, right? To make it easy, one fund, diversified, low cost, rebalanced, all that stuff. Tax efficient. Yep. Yep. And, you know, it took a long time to figure out that we all have behavioral biases. And what I remember very clearly is until you have something like$50 ,000 in a savings vehicle, you're not going to really pay attention to it. So what we saw is a lot of young people starting their careers and doing nothing with their money for the better part of five or 10 years and just leaving it in cash.

4:56So target date helped address that kind of behavioral bias about not doing anything. Well, we're, we're huge advocates, anything that can accomplish all those sorts of things and let a person get on with their life and focus on things outside the market that are really more likely to move the needle with their personal health, wealth, success. We're all for it. So thank you for your contribution. My pleasure. So wait, how did you go from Fidelity to Craneshares? And what's the story of that next leap in your career? Well, so I was a PM for 10 years, and then I wanted to manage teams of investors.

5:33And so So at Fidelity, PMs can't be CIOs. So I left Fidelity and then joined JP Morgan's private bank, where I ran a number of different investment engines. So focusing on thematic multi-asset investing, concentrated equities, and custom fixed income. So, you know, had a decent-sized team in the private bank. So I've had the privilege, you know, I've been managing or been in the finance segment for almost 30 years, but 20 of those years have had the privilege of both managing money for institutions, individuals, and then also high net worth folks as well. And then just to close the loop, I met John when I was at JPMorgan.

6:17And when I was ready to do something more entrepreneurial again, I looked him up in 2015. And after spending a little bit a time with the CEO and the CIO here, I realized how little I knew about China. In fact, if you were to ask me in prior places, how much do you know about ETF investing in China on a scale of one to 10, I would have said a five. But after spending a couple of months with John and Brendan here, I downgraded myself to a two almost immediately. And since that time, I may be adding half a point to a point a year. So if I'm lucky, I'm probably a six right now. All right. Well, then if I'm just benchmarking, I'm a zero.

6:57I'm going to speak for Ben and say we're both zeros. So excited to get up to a 0.1 after this show, maybe even a one. All right. I want to start off with some statistics about China's internet. This comes from a wonderful presentation on K-Web that we will link to in the show notes. All right, here it is. Comparing the China, the China, that's not what it's called, China to the United States. The total internet population is 1.05 billion versus 311 million here. And they've only, I would say only, it's a big number. They have 74 % of the population has internet access compared with 93 % here. Obviously they have a much larger share of internet users at 22 % globally versus six and a half percent here.

7:40All right. E-commerce, their market is double the size of ours, 2 trillion versus 1 trillion. Total retail sales, interestingly, is playing this playing catch up there, 6.4 trillion versus 7.1 here. And their online footprint as a percentage of the total sales is significantly higher, 31 % over 14%. So there's not a question in there, so forgive me. What is the most startling thing to you or most interesting to you about the opportunity set with China internet companies versus what we're doing here in this great country? So a lot of the trends that you're describing have to do with massive urbanization that's taken place in China.

8:24If you think about it, China is moving from a society that was largely rural to a society that's now living in cities. And China's only about 60-some percent urbanized. So when you hear about a 70 % type internet penetration rate, that shouldn't surprise you. And if you look back 10 years, both of those numbers were probably in the 30s or 40s. So what I see is hundreds of millions of people in China that are still going to move from rural regions into cities. And with that comes a larger internet penetration rate. So that number in the 70s should reach something like in the 80s and 90s over time.

9:06And with that comes wealth creation, a growing middle class, and consumerism. Now, keep in mind, because of the rate at which this urbanization has taken place, China has leapfrogged in certain segments, right? Like many of the things that we're used to, credit cards, you know, brick and mortar shopping and so on, China had to fast track right into digital payment and online consumerism just to address this new demand from the growing cities. How has that translated into people investing in the stock market in China? Because I think the Gallup poll here a couple weeks ago said it's 60 % of people, of households in the US own stocks in some form.

9:53And I know I've heard that most of the trading in China is retail driven, but how much of the population that was actually invested in stocks in some manner? Yeah, it's a great question, Ben. And I would caution that the number in the U.S. probably belies the success of our 401k system, right? If you think about it, I don't know if 60 % of Americans own stocks outside of their 401k and IRA programs. I know a lot of those equities are held in those plans. And China's retirement system is still developing. They're just introducing a third pillar and the kind of safety net that we have here with our retirement plans.

10:38But right now, the equity ownership of the Chinese markets is still pretty low, definitely lower than ours here. But it's something that I would expect to develop just like ours did as their retirement system grows. What's more, very few foreigners own the Chinese mainland market. So if you think about the A-share market, which is those securities principally found on the Shanghai and Shenzhen exchanges, there aren't a ton of investments in those markets by non-Chinese investors. But it's growing and it's really being driven by institutions. So as global pension plans, endowments, and sovereign wealth funds get more interested in China as an asset class, China is an important part of their overall emerging market exposure, we can expect that to rise.

11:29Well, this seems like, I'm sure it's basics for you guys, maybe for the people who aren't as familiar with investing in China. Maybe you could just go over the different ways to invest in stocks. You talk about the A shares, what the differences are in the ways that you can access those stocks. Sure. So if you think about the ways to access Chinese stocks overall, and by the way, in total, the Chinese equity market and the Chinese bond market is the second largest in the world, second only to the US. So the three ways that you can access Chinese equities is through mainland Chinese stocks. These are referred to as A shares through Hong Kong listed Chinese stocks, which are called the H shares, H as in Henry, and then US ADRs.

12:14So if you look at, you know, Crane Shares ETFs, our ETFs hold some mixture of those different ways to access the market. So we have a fund called KBA, which invests only in A shares, the largest, if you will, 50 securities in the mainland market. K-Web, which is what we wrote clip on, built clip off of, invests primarily in ADRs and the H shares, those Hong Kong listed stocks. So those are really the three major pools of Chinese capital, if you will, from a stock market standpoint. And what we saw and what I think John and Brendan saw 10 years ago when Crane Shares was formed is that people weren't able to get these exposures, at least not distinctly.

13:05They had to rely on broader emerging market exposure to get exposure to China. But given that China's weighting within emerging markets is approaching 50 % of the overall opportunity, it doesn't make sense to get your exposure indirectly anymore. You should be getting direct China exposure. I want to double click on this. And I'm making fun of myself or the analysts. There was a chart floating on the internet this week. Ben, did you see this? of analysts, the number of times it's a double-click on an earnings call. For whatever reason, that just keeps going up and up and up. It's become very in vogue these days.

13:40Michael, is it like the new Unpack? It is. Yes. Yes. So before we unpack some of the differences between the different share classes, I wanted to just throw something out at you. And I'm an ideas guy. You can throw it right back if you're not into it. But KWeb is how we refer to it, right? We don't call it Queb. So why not? Why not? Instead of Clip, why not Caleb? Jonathan, over to you. I know. I know. And you know what? When we were thinking about tickers, we have a very, very stringent ticker committee here at Crane Shares. And I'm being facetious. We're not a bureaucratic firm. But we do have everybody opine on what we think the best tickers are.

14:22And Clip won. And part of the issue is because we started thinking about different options. We just never contemplated that somebody would call clip Caleb, but when you're clipping the coupons, you know, clipping the coupons, you know, it's, uh, you're getting a clip, but the challenge is since we've launched the fund, we've heard it used a bunch of times. Um, and, and it's all good. Like, we're like, okay, it doesn't matter what you call it as long as you buy it and you can call a what quen. All right. Well, now I get it. It went right over my bald head. So that's on me, my bad hand up. All right.

14:57So getting back to the matter at hand, what are the differences between the ADRs, which is I think what most people here would, you know, the, you know, BABA, obviously the big IPO and Baidu and all those tickers. What are some of the actual differences between the ADRs, the A shares and the H shares? Sure, sure. So it's just the exchanges that they're listed on. So the ADRs are US listed. so they're available on the New York Stock Exchange and the NASDAQ. And you won't be surprised to learn that the New York Stock Exchange and NASDAQ are going to have different listing rules than the Hong Kong Exchange, which is where the H shares are, or the Shanghai and Shenzhen exchanges, where the A shares are.

15:44So if you're a Chinese company thinking about how to access capital, you're going to first think about, well, where do I want my investor base to be? Where do I want to attract investors from? And so the U.S. markets are very attractive for doing that. The Hong Kong markets are also very attractive for certain of these companies. And in some cases, companies will list in both. So, for example, the version of Alibaba that we own in K-Web is the Hong Kong listed version. And increasingly, indexes that track Chinese stocks will actually say if the Hong Kong listed security is larger or even not larger but meets certain rules, that should be the primary listing because these are Chinese companies.

16:36So when given a choice, some of the indexes will actually default to Hong Kong as the primary listing. All right. Jonathan, we're going to get to the strategy in a minute, especially the yield, which is a showstopper. We have a lot of questions about that. But China in particular has been awful lately, specifically Chinese internet stocks. So K-Web had a huge run. And then in 2021 to the trough of the bottom, which was back in October, it fell 82%. And you guys have a great slide on some of the stuff, some of the main drivers of that sell-off and what you believe is already priced. And so I'm going to list the five main ones and you could go from there where you want.

17:21So we've got four sellers, which I think would, I would say, slash delisting concerns, which was a big one. You've got the Russia-Ukraine conflict, the China macro and regulatory picture, and then the US macro picture, which I guess would be, these are tech stocks and tech stocks got killed. But what do you think were the biggest ones that I've listed? And are the fears behind us? Is 82 % enough to discount whatever concerns people may have had? Did they overdo it? Yeah. A couple of different comments, right? So we track a lot of these macro and micro factors over time. And if you look at some of these a year ago, many of them were flashing red, Right.

18:05They were they were scary, at least on a geopolitical front. You had China in full lockdown with a zero covid policy. You had Internet regulation aggressively impacting many of the segments that K-Web invests in. And then you also had, you know, just questions on on China growth and whether or not how long it would take for China to recover once it does open up and how it's going to open up. And right after the National Party Congress, so in October, when President Xi secured another kind of unprecedented term, it became very clear to us that China was going to shift in a pro-growth manner. And that's not what a lot of market participants were observing, but we thought for sure that the way things were being positioned weren't in kind of terms of pro-growth.

18:57So we saw zero COVID policy, that Band-Aid was ripped off and China reopened. You saw internet regulation fade away, and that was already becoming clear by the October timeframe. And then you started to see a real commitment from the government in solving some of the real estate concerns that were taking place, which was also a big overhang, and just other support. Keep in mind that unlike the US, which has been in a very rapidly accelerating kind of interest rate cycle, we hope rates have paused, but it's not clear. China has not been raising rates. In fact, China has been in a more kind of stimulating mode with their economy, and the 10-year hasn't budged.

19:40It's been right around 3 % this whole time. In fact, for the first time in a very long time, the US 10-year had actually broken through China's 10-year. So to make a long story short, we saw very significant returns from October on fact, we're probably 35 % off the bottom in K-Web. And this is not unusual, by the way. K-Web is a volatile basket. It holds 30 to 40 securities typically, and it has volatility kind of in the 40 % range. And when you look at historical cycles with K-Web, they tend to be three to five year cycles. And peak to trough, you could have drawdowns that are 30%, 40%, 50%. 80 % is the largest that we've seen since the creation of K-Web 10 years ago.

20:32But here's what we do know from drawdown patterns historically. The recovery period for K-Web tends to be or has been six to seven months longer than the drawdown period. And why is that? That's because risk happens fast. So if you're going to have it take you six months to go peak the trough, it may take you 12 or 13 months just to get back to break even. This drawdown period was a 20-month period. This was the longest drawdown period that K-Web has ever experienced going back to February of 21 and we think bottoming sometime in October of last year. So we're just in the first or second inning of K-Web's recovery.

21:19And that makes sense, given that it took us 20 months to get to that bottom. And it may take longer than 20 months, based on history, to get back to some semblance of break-even. So it's going to be a longer cycle. And it's because we combine COVID and internet regulation and delisting risk and geopolitics all into one ball of wax. Yeah, there was a lot. There was certainly a lot of risk that showed itself in the form of an 82 % drawdown. The question of has all the bad news been discounted is, of course, unanswerable. But just looking at the top 10 holdings, which is Tencent, Alibaba, I don't want to try and pronounce the food delivery one.

22:02You want to help me out there? uh, Metuan. Oh, Metuan. Metuan. Okay. Um, the, the, the three-year average revenue growth rate for these companies is 21 % and 63 % for five-year average annual revenue growth rate, which is obviously, you know, insane, um, out of, on a forward PE basis, which is just, you know, it's, it's estimates. So it could be wrong, but we're looking at 20 times for, again, for the top 10, which is not that high at all for companies with that growth rate. Now you can make the argument that they should be trading at a discount given all of the various risks that we've described.

22:37But the point that I'm making is investors are, I hesitate to use the word underpricing the growth because who knows. But anyway, there is hair on these names and on the risk, which is why they're trading at the multiples that they are. Well, think about this, right? So those names are trading at a similar PE multiple to the S &P. the S &P could still experience earnings, downward earnings revisions. And then if you take the tech sector of the US equity market, it's 50 % more expensive on a PE basis. And that's not a PE to growth basis. That's just simple PE. But to push back, this is not apples to apples, right?

23:17Investing here is very different than investing in China. And we see this with EM as well, right? There's usually a 10%, 20 % discount to investing in the EM vis-a-vis US or developed markets. So some discount is appropriate, but we're pushing out far along the difference. And what I tend to look at very simply, as someone who spent a chunk of my career in active management is fundamental sentiment and valuation. And the fundamentals in valuation, at least on a relative basis, relative to what you see in developed and even EM markets is quite attractive. And sentiment is terrible. It's still terrible.

23:58And that's just because of the geopolitical overhang. So what we tend to forget, though, is, and I'll just make one comment on the strength of the economic relationship between China and the US has actually never been stronger as measured by dollars. There's 700 billion of bilateral trade that's taken place between the US and China last year. And that's despite all of these carryover sanctions from the prior administration. That$700 billion doesn't include the$320 billion that Chinese companies have made in revenue or that US, sorry, that US companies have made in revenue in China. So US companies are making a lot of money inside of China.

24:42And if you take those numbers together, that's a trillion dollar economic relationship. So we could sit here and think about the saber rattling that's taking place politically. But as long as it remains more bark than bite, and the dollars being, you know, economically created exchange between the countries continues to grow, I think that there's still considerable opportunity. We kind of need each other, right? We do. We know that there's things happening with supply chains and people are localizing those. But you can't just say, all right, we're just going to disintegrate this relationship between the US and China.

25:23It's actually very strong and I think will continue to grow in the coming decade. All right. So we've talked to Brendan in the past about K-Web and understand the general investing philosophy there. So CLIP is the new strategy that simply writes call options on K-Web. I'm curious how this works. Michael and I have talked to different call option providers in the past. Usually it's on more of an index basis or like a high quality name. So maybe you could explain to us the idea behind this, who this is for, and why this strategy was created, and then maybe some of the mechanics of how it works. Because I guess I've never thought about the call option on Chinese internet stocks like this.

26:01Sure, absolutely. So last year, at the beginning of last year, we took on the study to look at covered call strategies overall in the ETF industry. And they've grown a lot. I mean, I don't know if you've observed this, but there's over$40 billion, I think. Our inbox can confirm. We had a lot of emails about this. Tons of people, especially in 2022, it was a strategy that did very well in a bear market. People were clamoring for this type of strategy. And so we thought to ourselves, geez, K-Web has a 10-year history. It has a deep options market that we don't have anything to do with, right? We are supportive of the option ecosystem, but we crane shares don't trade in K-Web options, at least not until we created Clip.

26:47But we saw that it was a very large liquid market, billions of dollars of notional in K-Web options. And we also realized that when compared to the other principal strategies in the covered call writing space, which tend to focus on the S &P and NASDAQ, K-Web was two to four times more volatile. So if you think about the S &P, volatility of the S &P historically is in the 10 % to 15 % range. NASDAQ is in the, you know, call it 20 % to 25 % range. And KWEB is in the 40 % to 50 % range. So what that means is if you've got that much volatility and you're going to write call options, you're going to earn that much more income.

27:29It's not quite a linear relationship, but it's pretty close. So if I tell you that our volatility is 4x, another kind of benchmark or index, then our income will roughly be 4x as large. And so as we were studying the landscape, we said, how do we create, we want something very simple. This is our first foray into covered calls. How do we create a pure play income strategy? What are the things that we can do to make this an income maximizing strategy? Because keep in mind, we already have a growth maximizing strategy. That's K-Web. And so we wanted to have these bookends. K-Web on one side, Clip on the other.