Dear investors and well-wishers
We returned 16% for the month of July and are having a decent August so far. There’s plenty of work to do, as I write we are down ~50% for this calendar year-to-date.
Growth managers have had some tough decisions to make over the last few months with many heavily sold off companies dropping 50% or more in the 2nd quarter.
Many leading growth funds like D1, Coatue and Softbank slashed positions, closed funds and/or raised significant cash in Q2 2022. Tiger has dramatically cut its holdings. Arkk is holding the course and I suspect may end up outperforming the others through sheer consistency.
Tiger Global dramatically reduced its positions in the second quarter of 2022, likely exacerbating the steep falls. Many of the companies above have rallied strongly since. Carvana, for example, which we re-entered last month, has more than doubled from the lows. These filings are an incomplete picture as we don’t know if these sales are to satisfy redemptions, or the extent of leverage and derivatives.
Fund managers are historically underweight equities
Time will tell whether those who sold fast-growing leaders down 50-80% or healthcare companies trading for a fraction of balance sheet cash made the right call.
It seemed so in May and June, but I suspect it’s the buyers who will remember the period more fondly. The fund is currently ahead of where it was at any point in May, June or July, so selling out then would have been a painful move for us.
Even after the rally since 1 July, short interest remains exceptionally high and growth investors remain exceptionally underweight.
Life sciences bounced off what looks like a generational low. I doubt we will ever see companies win FDA approval and trade down in the same way again.
To give an update on the company that won a conditional FDA approval in June and rewarded us with a ~75% decline from $4 to $1… the stock has since rallied six-fold.
Another example is Bluebird bio, which is now one of our largest positions. Bluebird had almost all its equity value wiped out and traded for less than its cash balance, while during the quarter two of its treatments were unanimously recommended for approval by the FDA’s advisory committee. I owned Bluebird years ago (a story for another note) and re-entered after this clear validation and regulatory derisking.
There are still risks – gene therapies have all been delayed by manufacturing issues, and bluebird has limited resources to launch such complicated products, but this gives a clear path to regulatory approval. And in fact today Bluebird’s Zynteglo treatment was formally approved by the FDA.
One of our earlier successes in the life sciences was Avexis, which was bought by Novartis for US$8.7 billion. Bluebird trades at less than 5% of that value, with a broader pipeline, better treatments targeting larger target markets, and many more years of data.
M&A is heating up in the pharmaceutical market, as is the tech market.
A cookie today or two tomorrow?
A possible explanation of this dramatic market move is related to time preference.
Late last year investors were willing to assess the value of companies many years in the future, seen most vividly in Rivian’s >$100 billion market cap, a valuation which only makes sense if you assume many years of success.
At the lows a few weeks ago, even profits one year out were marked down almost entirely, with negative value ascribed to, for example, a probabilistic outcome in a biotech trial.
It’s as though when given the choice between a cookie today or more next year, the market chose one today, discounting those in the future.
Which is just as extreme as the situation last year.
My best guess is that from these levels, companies that execute will post phenomenal returns. But those that don’t deliver will not recover.
Selling stocks in inflationary periods is not as straightforward as this episode seems to show.
There have been multiple periods of rising rates and inflation that have coincided, or were shortly followed by, significant equity rallies. Rates were higher throughout the 1990s for example, one of the very best decades for growth stocks.
In 1980-1982 interest rates went substantially higher, the recession was significantly more severe and impoverishing, and ofcourse inflation was much higher. Small caps and no doubt the growth equivalents of the day sold off significantly more than the index.
This bear market proved a generational opportunity to buy equities, rather than sell. Ofcourse, during the bear market, anyone taking a long term view would have looked silly month after month for nearly two years.
What happened next? Equities recovered the whole drawdown in four months and went on to triple by the end of the decade, which includes the 1987 crash.
S&P500 index (white, LHS) and interest rates (blue, RHS) from late 1979 to 1990. The highest interest rate environment this century proved a good time to buy stocks.
There were multiple periods of rising interest rates in 1984 and 1988-1989 that coincided with equity rallies. You could be wrong 18 months in a row in the early 1980s, and make back all those losses many times over in the years that followed.
Coincidentally the drawdown in 1980-1982 is similar in size to the high-to-low movement of the S&P500 from November to June. And it has been about 18 months from the peak of life sciences / growth in early 2021.
My point is not to buy stocks when interest rates are rising (though I do think it makes sense to buy stocks when they are down), but rather to show how the relationship between equity prices, inflation and interest rates is not straightforward.
Selling stocks when rates rise is not always the obvious winner that it seems today, and in counter examples like the 1970s. Coincidentally, those bear markets were also followed by dramatic rallies.
The two decades that followed this period of exceptionally high inflation and interest rates saw dramatic advances in technology and included one of the greatest periods for technology investing in history.
Rising rates proved a bad time to sell in the mid 1990s too. There are examples of the opposite, this year most certainly being one.
Many highly profitable small caps sold off as much as fast-growing market leaders (which is saying something) and we focused our attention on those. Crocs is one example, selling off 75% down to a PE of 5 and forward free cash flow yield of 15%, with sustained top line growth of over 30%. There are a few examples like this.
Crocs was a recent purchase.
Crocs have become increasingly popular amongst artists, nurses, and those who simply find them comfortable. You may be surprised how many people you know who own a pair or two. The economics are excellent.
Crocs are made by injecting cheap plastic into a mould, giving gross margins of 52%, ahead of Nike at 46%. Crocs is expanding into sandals (organically) and casual shoes (acquisitively) through the purchase of a large but largely unknown brand HeyDude.
Shoes from Crocs acquisition HeyDude on the left, and Crocs sandals, a new focus, on the right
The firm made the wise decision to cut traditional advertising spending to focus on influencers and high profile collaborations with high end fashion brands like Balenciaga. This has paid off in spades.
Justin Bieber wears his Balenciaga Crocs and an ill-fitting suit to the Grammy’s in 2022. Vogue
The risks are that Crocs ‘over-earned’ last year when consumers were flush with cash. 102 million Crocs were sold in 2021, which equates to over 1.25% of the world’s population. Nike sells 8x as many, which perhaps offers something of a unit growth ceiling. Crocs is already a major brand.
And there are risks with all acquisitions. Sales of HeyDude may fall off if insiders sniffed out changing trends and sold at the right time.
So far this doesn’t seem to be the case. In the latest quarter – deep into the consumer recession and again belying the astonishing drawdown in Crocs stock – HeyDude grew 96% year-on-year on operating margins of 30%.
And unlike stock acquisitions that have been so ruinous for companies like Square, Teladoc and countless others, this was paid in debt, which has its own risks but is at least non-dilutive. Crocs generates plenty of cash flow and in the past has directed it towards buybacks.
Crocs paused its extensive buybacks program to divert all cash flow towards reducing gross leverage from 2.8x net debt/EBITDA to <2.0x by mid next year, when the company plans to resume buybacks.
Insiders have consistently bought back shares this year, often at prices well above what we paid.
We think that the heavy diluters in the tech space – which reached fairly extreme levels over the last year – will be amongst the last to recover, while those that can reduce share counts will be the first to reach new highs (which in some cases implies 3x-4x returns from here).
Magnus Court after winning a stage of the Tour de France on the podium in his Crocs
To contrast Crocs with a company we used to own, Twilio is losing over $300 million a quarter, and while this is largely non-cash, the share count has exploded.
Twilio is not going bankrupt any time soon as most of their losses are paid in stock and they sit on a vast cash balance. But the effect on the share price has been devastating, with the effect of dilution being magnified in a sell-off.
Much has been written on ‘Zombie companies’ over the last decade, referring to those companies with high debt loads that can only survive while interest rates are low.
There is perhaps an equivalent in the tech space with companies that post large losses, writing off economic value each quarter, but are nevertheless cash flow positive, covering cover those losses with stock issued at increasingly low prices.
Notably, Twilio and companies in a similar boat have largely missed the rally of recent weeks.
There has been a sharp divergence between heavily sold-off companies who have diluted too much. Twilio’s share count has doubled over the last five years, while Crocs has been steadily buying back shares – and will likely resume buybacks next year. Twilio has missed the recent bounce.
To give a quick update on the three companies we wrote about last month:
Disney offers an example of how rising prices can both create a sell-off, with interest rates triggering mass investor liquidations, and lead to strong returns after.
Disney sold off ~55%, despite developing a new business line in Disney+ and forming a direct monthly cash pipeline from over 150 million of their fans into Disney’s corporate accounts, a milestone that took Netflix several times longer to achieve.
The firm also posted bumper revenues and profits from its theme parks, with Disneyland Paris outperforming its pre-COVID benchmark with price increases across the board. At the lows Disney traded at a free cash flow yield of 5%, despite considerable resources diverted to building their direct-to-consumer business.
Last month Disney raised ESPN prices by 43%. This month Disney announced a price rise on Disney+ of 38%, and that their cheapest plans will now include paid advertising.
This is not a struggling company, merely one that is building new business lines, raising prices, and stashing away cookies today for many more tomorrow, causing many investors to sell to those with a more patience.
MercadoLibre remains our largest position. In June MercadoLibre was down ~70%. We added in the $600s.
MercadoLibre reported 58% organic revenue growth on tough comparables from 2021, in a difficult consumer environment. Profit growth was even higher, with gross profits growing over 70% year-on-year and operating margins reaching 9.6%.
Revenues are now up 2.5x from late 2020 to today, and MercadoLibre outpaced the South American e-commerce market by 20%.
This is a company executing phenomenally well at scale.
Instead of reflecting this progress, the market wrote off most of its equity value over this period.
MercadoLibre only traded this cheaply at the peak of the 2009 financial crisis.
We see similar stories across our portfolio – powerful execution, the development of new business lines, record low valuations, sadly steep falls from highs, but we suspect strong performance in the future.
MercadoLibre fell over 50% from March to the lows in June, and has never traded this cheaply on an EV/Sales basis in the last decade
This month MercadoLibre has recovered some of the drawdown, with some way to go.
We’re confident that once the dust settles, this value creation will be reflected in the traded value of these companies.
MercadoLibre continues to execute, even on top of >100% revenue growth last year, Source: Morgan Stanley
Cloudflare performed worse than MercadoLibre, dropping over 82%.
In recent weeks the firm reported sustained 53% organic growth, again proving strong execution on tough comparables in a difficult market.
Cloudflare dropped ~82%, including a 69% fall from the highs in March. A gnarly quarter for many, ourselves included. We are happy to be buyers and not sellers here.
Some of the same factors that make Cloudflare sell-off so much over the last few months, namely heavy investment in the next generation of internet infrastructure, are the same reasons that we expect it to perform so well in the future.
This has become a top three holding for us now.
The last year and a half will go down as one of the worst periods ever to invest in technology and the life sciences.
As of today, I don’t know a single investment professional who has a positive take on markets. I know multiple managers in Australia with decades of experience who sold growth stocks in June, having ridden them down from the top.
And we now have data showing that many of those overseas have done the same, including some of the leading names in the business with decades of experience spanning both the GFC and the tech crash twenty years ago.
I have my own mistakes to reflect on. I will never be one to liquidate holdings at the bottom of the market, or sell a performing holding down 50%, let alone 75%. And you can only look at MercadoLibre, or anything in healthcare, to see how fast things can change.
I expected more growth stocks to trade like Tesla, which dropped ~50% but quickly recovered the bulk of that, and is actually up from where it traded in early 2021.
Many of our companies grew more over this period, but had a more dramatic collapse in multiple.
Tesla has grown revenues ~2.6x from late 2020, and its EBITDA multiple has more than halved. Many of our companies grew more, but suffered a far more severe compression.
There is plenty to reflect on over the last two years, though the lessons will be most valuable at the end of the next cycle. This appears more a time for investment, not capitulation, and it’s the lessons from early 2020 and every crash of the modern era that are most relevant today.
I suspect as in the past when markets are rallying fast growing market leaders showing visible execution on long term business plans will once again be the best performers in the market. Especially now so many large, long term investment funds have sold out.
Many are taking the opposite view. The bear market in technology was the most severe in over a decade, there was no broader capitulation that marked prior generational lows.
But perhaps this is not so surprising. The world is still spinning. As of yet there is no financial crisis, or impoverishing rise in unemployment.
Energy prices are finally falling, and important measures of inflation are now flat or declining, such as the widely watched US producer price index.
PPI is now negative month-on-month.
Most companies in the US actually beat earnings estimates, in contrast to near unanimous bearishness amongst professionals – though not all of them. Soros was buying tech stocks in recent weeks.
Energy prices remain high, but are lower than any time after the Ukraine war. Perhaps it was this shock that gave an uncontrollable feel to inflation and interest rates, and ultimately caused so many long term investors to capitulate for the first time in their careers.
In our sectors however, that capitulation event most definitely did occur, with companies trading to lifetime lows and beyond, with market leaders falling 85% or more.
A higher percentage of stocks traded for less than cash than at the lows of 2002 and 2009.
Our portfolio companies and the bulk of our watchlists have bounced in recent weeks, but many remain at valuations well below than the peak of the COVID panic, even while the companies themselves continue to show strong underlying performance like those highlighted above from Disney, Crocs, Cloudflare and MercadoLibre. No doubt there will be more volatility in coming months, but over time this value creation will be reflected in performance.
And now that most of our companies have reported results to 30 June 2022, a period where for many, the bulk of their equity value was written down, their organic growth rate averaged well over 50%. These are not companies in fundamental decline, or in risk of near term bankruptcy. We are orientating more towards companies like Crocs that can demonstrate top and bottom line growth, and are committed to investor friendly buybacks rather than stock issuance. But we are also aware that the best returns are likely to come from those companies whose future prospects have been slashed almost entirely, but will nevertheless go on to achieve great things.
In short, we’re holding the line.
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