Dear investors and well-wishers,
The fund declined 5.6% in March leaving us -31% for the calendar year-to-date and a rolling three-year return of 10% net per annum.
I recorded a video update last week and will post this once edited. Please send through any questions and I’ll address them in a podcast or video next week.
Twitter, one of our top holdings, was bid for by Elon Musk, which is an example of how companies with customer love seem to get lucky – something in short supply in the technology space right now.
There is an immense gap between the value Twitter provides to users and the value of the platform itself. The most interesting and prominent people on the planet invest their time heavily on the platform. It’s strange to think Elon Musk is served up a stream of ads in his feed.
Since listing Twitter has grown trailing twelve-month revenues ten-fold from $534m to $5.3 billion but the share price is almost flat, as multiples have compressed from 40x EV/Sales (80x at peak) to 6x today.
For reference, Google trades at less than 5x EV/Sales and approximately 20x free cash flow. This Twitter chart may be the future for high flying companies today that are still commanding such valuation heights, though after the last six months only a handful of market favourites are there today.
Twitter revenues (light blue) and EV/Sales multiple (dark blue)
Despite delivering on fundamentals, Twitter’s share price has gone nowhere since 2013.
Twitter has had decent traction with monthly active users over a time where online media consumption has been under pressure (Snapchat has also done surprisingly well).
Monthly active users indexed to 100 from Jan 2020
It’s interesting to see TikTok start to fade (these two charts sourced from Goldman Sachs/Tensor Tower)
Our solution (biased as a user) would be simple – offer a premium ad-free version, which would force the company to focus on improving the experience for users rather than advertisers. There is plenty of low-lying fruit with bots and spammers. Twitter seems to feel unable to delete these as it would cause a decline in users and activity, though it would improve the user experience.
Showing too many ads and the accompanying push for engagement has proven the beginning of the end for Facebook, which is facing declines in key demographics.
This is the usual lifecycle for internet platforms that monetize through advertising.
They start with a refreshing new feel, with no ads, and cool, young influencers posting content for free. Then as the site grows the algorithms start cranking in ads and driving more and more attention, invariably by highlighting enraging content, and of course stuffing more and more ads into the feed. It seems we are barely aware of this, but at some point a site just stops becoming fun, like Facebook today. Once people leave a platform they tend not to come back.
We sold most of our position after the bid. This was a modest profit, but we’ll take that in a period where so many internet platforms, including our own, have sold off so significantly.
Twitter is clearly worth a lot more than the bid, however there’s a good chance the whole thing turns into a circus, so we think best to sit largely on the sidelines and leave the merger arbitrage to those with the taste and for it.
There are finally private buyers swooping around technology firms after the steepest falls in over a decade.
One private equity fund, Silver Lake, has a board seat at Twitter, while another, Thoma Bravo, has over $90 billion of funds and is working with Elon Musk.
Thoma Bravo comes up a lot these days as it bid for Sailpoint and Anaplan, showing that the price that a cash flow focused long term financial buyer will pay for growth business is well above current market prices. We expect to see a lot more of this.
Selling down Twitter also released over 6% cash, which has been put to work in large, profitable, tech companies buying back shares, growing top line, EBITDA by more than that, and EPS more than that.
Tesla once again reported a strong beat for Q1 despite all the headline macro pressures. The quarter was especially strong from a profit perspective, with the firm beating operating income expectations and posting an industry leading 19% GAAP operating margin.
Revenues were up 81%, gross profits were up 147%, and net income up 648% year-on-year. The company delivered 305,000 cars and they’re increasingly obvious around Sydney.
Amusingly Tesla showed a bump after the super bowl, as viewers saw ads for other electric vehicles and turned to Tesla. We’ve always thought competition was no obstacle as Tesla is in a league of its own and does not compete on price and features, which has allowed it to avoid advertising almost entirely.
Source: Tesla Q121 report
Inflation shock and a new regime
This year has seen some of the sharpest rises in interest rates on record after an inflation shock reached new heights. It is a strange environment where some industries (defence, industrials, chemicals) have never had it better, while others are under extraordinary strain.
In the US there are 0.6 unemployed for every job opening. In other words, there is immense demand for labour.
Number of unemployed people per job opening. Source: BLS
Furthermore, savings are strikingly high and households are unusually unlevered.
As with companies, many people are thriving right now, while many others are suffering under much higher prices for energy and food, and soon interest rates.
The chart above has a parallel with the bear market of the early 1980s. This was one of the toughest times to an equity market investor, but also marked the beginning of a multi-decade bull market, something which we are keeping front of mind.
So we are being careful to balance the long-term opportunities of a time like this with the short term risks.
US CPI post World War 2. CPI has only been higher a handful of times.
Since the start of the year, 10 year Government yields have jumped over 100 basis points in the United States and 150 basis points in Australia, which seems a little unfair for us as we have seen lower price increases locally, lower wage inflation, and the Reserve Bank of Australia is less hawkish.
Of course, real estate has ripped more here than it has globally. If yields keep going the Aussie housing bear thesis so popular at various points over the last decade might finally come true.
US mortgage rates have almost doubled since this time last year
This has caused losses of rare magnitude for Government bonds, which is usually a very low risk investment. Australian 10 year notes are down ~20% since late 2020 (plus a small yield).
Capital return of Australian 10 year bonds showing a decline of rare magnitude
The best opportunities today
First, we are focusing on differentiated, category-leading internet platforms.
These are often profitable with net balance sheet cash. They were growing very strongly before COVID, and we expect will resume long term trends next year as the tough comparables from last year roll off.
To give one example, Farfetch has fallen from $70 to $11, effectively wiping out the vast bulk of value that was ascribed to it (by someone at least) not very long ago.
The second are the uncool software companies that have sold off hard and are now at both cycle and lifetime valuation lows, but have maintained >40% organic growth rates, have net cash, and are profitable.
The very best software companies still have several rounds of multiple compression ahead of them, so do not represent the best opportunities, in our view. We want to find the unfavoured companies that are robust and market leaders in their own little niches.
A third opportunity is in the world’s leading e-commerce platforms. the biggest detractors for us have been steep declines in e-commerce companies. Some of these are up several times from when we first purchased but have declined 70% or more over the last year or so. Some of these have increased 7-fold in size or more over this period, so it has been tough to have companies perform so poorly in the market when fundamentals are so far ahead of our initial forecasts.
Over the last year they have gone from cycle high multiples on COVID-helped fundamentals. This year growth has slowed (still positive for most) and they are on lifetime lows. We expect next year multidecade trends to resume, and these companies may once again find favour with investors. If multiples stay as low or lower than they are now, we can still generate strong returns, it will just take time. In almost every case, rolling two- and three-year growth numbers remain exceptional. The data supports our base case that most internet companies return to long term growth trends in the near future.
If anything, these are inflation beneficiaries, as the prices of all goods increase, and they benefit from heavy investments in automation. Looking forward 12 months (a scary prospect given the daily and weekly moves right now) we also expect a cyclical tailwind from a return to long term growth trends this time next year.
The fourth opportunity is in mid and large cap life sciences. These are benefitting from a rare cyclical upswing as hospitals and healthcare clinics open up around the world. Cancer franchises (for example) are usually as acyclical as multi-billion-dollar businesses come, but after years of hospital closures and widespread fear about visiting medical facilities, these are benefitting from a rare cyclical upswing right as the rest of the market turns South. It’s also helpful right now that these companies trade defensively.
Small cap biotechs remain under serious pressure, suffering one of their worst drawdowns on record. In a period where high quality companies 1-2 years away from profitability are selling off like bankrupt cyclicals, the appetite for investing in a drug that may or may not get approved in four years’ time is basically zero. We invested quite a bit in early-stage companies, often through IPOs and cap raisings. On one hand we are proud of this work as for every dollar invested with us at inception, multiples more have found their way onto the balance sheets of companies doing risky, scientifically complex work. But at the moment these companies have sold off hard with the sector. These account for around 4% of the portfolio today, and much of their current market value is cash.
How do these valuations in the life sciences resolve? There’s a chance big pharma becomes more acquisitive, markets rally, and this returns some level of risk appetite to the sector, though at the moment deals have actually dropped off. More likely, these companies will stay at deeply depressed levels close to cash until they succeed in trials or fail and become cash boxes.
Interestingly, those that succeed from these levels will go from trading at cash to worth hundreds of millions or billions of dollars. The return side of the risk/reward equation is staggering right now, but this is also one of the riskiest parts of the market.
We are running the ruler over our portfolio constantly and making sure every company can survive the worst-case scenario and thrive on the other side. We have reduced even our favourite positions, which along with a Twitter sell-down, has given us the flexibility to make new investments at a time when the opportunity set is greatest and there is indiscriminate selling, even amongst those who acknowledge these companies will be worth a lot more in the future.
Amidst all the negativity we know that the best opportunities come from buying assets at times like this. We know this has been a tough time for investors and the last year or so has marked one of the worst environments for a growth strategy on record. But the current state of affairs won’t last forever, and when the winds do shift, it may also mark the beginning of one of the best.
The information in this note has been prepared and issued by Frazis Capital Partners Pty Ltd ABN 16 625 521 986 as a corporate authorised representative (CAR No. 1263393) of Frazis Capital Management Pty Ltd ABN 91 638 965 910 AFSL 521445. The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.
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