Dear investors and well-wishers,
We had our toughest month since COVID -24.6%, leaving us -40% year-on-year, and +16% net per annum over the last three years.
Almost half the Nasdaq Composite has dropped over 50%:
We’ve just passed through one of the worst periods for tech stocks in thirty years. Source: Bloomberg
Biotech was hit even worse, with >130 companies now trading for less than cash.
Investor appetite for multi-year strategies in the life sciences is low right now, to put it mildly. Of course, that makes for something of an opportunity too, and fortunately the important work at the vast majority of these companies will go on.
The moves are being driven by the sharpest institutional shift away from technology since 2006 (last month, it was the sharpest move since 2008). Over the fifteen years that followed, technology performed exceptionally well, and you could largely rank managers’ performance by their allocation to the sector.
It seems strange to say it – but tech will have its time again, perhaps quite soon.
Many of our companies posted strong results and then traded down to multiples below those of March 2020.
The drawdown was driven by a steep correction with many of our leading names down over 30% in January – Sea, Carvana, MercadoLibre, Twilio, and Roblox.
On the positive side, investor positioning, valuations and sentiment are now extremely supportive going forward.
In 2020 we had a similar drawdown and it ended up being our best year. Unlike then, however, there is no systemic issue or question mark over the strength of our portfolio companies. The market has been quick to price in a rate rising environment and shift focus to the Russia/Ukraine escalation.
Strictly enforced lockdowns over the last two years glued the eyes of the professional class to their screens while food and goods were delivered to their doors – a boon for every internet company. This has made for a tough set of comparables for the entire sector. They were valued at cycle high multiples on cycle high revenues. Of course, unlike cyclicals, all our companies have managed to post significant growth over those COVID highs, yet the multiple compression has been severe.
It’s important to note we don’t need a recovery in sentiment from decade lows, or multiples to bounce from decade lows to perform well, even measured from the highs of 2021.
The question for everyone in the sector is – what is the normalized performance of these companies? COVID years were too high, but similarly, recent results are likely weaker than we can expect going forward, given that two years of growth was compressed into one (again, this is a major issue for the sector but our own companies are still posting strong year-on-year growth, despite difficult comparables).
With indiscriminate drawdowns across the highest quality companies, we are spoiled for choice and have re-entered some of the highest quality companies that have long been ruled out for us on exorbitant valuations.
Reducing exposure outright at times like this can offer short term relief, but causes serious long-term damage. Once we move out of the bottom percentile of sentiment and valuations, no matter how confident investors become, no one can go and buy back stock sold at the lows.
Recent purchases include Digital Turbine, which partners with smartphone manufacturers and marketing agencies to serve ads on Android phones, sharing the revenue stream with manufacturers.
Digital Turbine has grown EPS at >100% over the last three years with exceptional operating leverage. In their latest report, organic top line was +38% and EPS was +133% year-on-year, currently trading at a trailing PE of 28x. We actually first bought this at $4 and sold at $28, so it’s great to be back in. The company has a $4.5 billion market cap and is targeting a $1 billion EBITDA run-rate in the coming years.
As mentioned previously we bought Twitter, which was down ~50% (the stock continued to sell off since our purchase, now down nearly 60% from its highs). Twitter is trading on 17x EBITDA with >100% EBITDA growth forecast for calendar 2022.
The new CEO Parag Agrawal seems far more focused on monetizing the platform and less focused on political philosophy than Jack Dorsey, and has begun removing more incendiary accounts. This is arguably bad for free speech, but most definitely good for advertisers and creates a more wholesome, friendly product.
The first result with Parag was somewhat mixed, but he did announce a $4 billion accelerated buyback equal to ~14% of the company.
Promisingly, many of our other companies have done this as well, notably:
Upstart which was recently trading as low as $8b valuation and announced a $400 million buyback, with 9% of the free float held short.
Upstart recent quarterly result – stock still down 68% from highs and roughly at our effective average entry price. Source: company results
Upstart trades on 43x EBITDA and 56x 2022 PE, but is growing top line at >250% and bottom line by more.
There is a short thesis kicking around based on the relatively obscure relationship with their main funding partner, Cross River Bank, as Upstart itself is extremely capital lite. Cross River Bank is backed by KKR, Andreesen Horowitz and Ribbit Capital, a leading fintech venture capital firm. The bank focuses on supporting new fintechs, and we think it’s highly unlikely there is a conspiracy amongst all these firms.
Upstart focuses on personal loans but is moving into auto lending, with the end goal of mortgages, so they are right at the very beginning of their journey, which is exactly what you’d expect given their sector leading growth rates.
Most importantly, Upstart helps close an important blind spot in lending.
Credit scoring was an incredible innovation – consolidating the credit risk of a highly diverse population down to a single number that could then be (somewhat) relied upon by the financial industry to both lend and package risk.
However, this success and resulting ubiquity is also its failure, as it’s a blunt tool that leaves out vast swathes of the population who can’t get a decent score but will pay back a loan, from small business owners, to migrants, to those who have matured from youthful credit mishaps.
This leaves a highly profitable class of borrowers who are missed by the traditional system. and this is the core of the opportunity Upstart is targeting.
We were early holders of Shopify but sold out when the valuation went crazy. To be honest, this didn’t really help, as cheaper, more profitable companies in the space have sold off just as much.
Shopify is now down 63% and it’s back to 8x-12x EV/Sales range that it bottomed out at in the previous rate cycle low in Dec 2018, when there was both QT and interest rates 120bps ahead of where we are now. Important to note that they spend a lot on growth… and have been exceptionally successful at this, growing $1.5 billion revenue 4x to $6 billion over the last three years alone.
A year ago, internet companies were trading on high multiples off artificially high COVID numbers. Now (some of them) are trading on decade low multiples and reporting lower year-on-year growth – but still exceptional two year growth – as they lap tough comparables from last year. The true underlying growth number is probably somewhere in the middle, and we are only holding companies that were able to grow on those tough COVID comparables. This time next year the situation will be different, hopefully on both counts.
Shopify has joined the long list of tech companies trading below COVID low multiples, and one that we are very happy to get back into. If the sell-off continues we will make this a core position. The business is in a vastly stronger and more profitable position than it was in 2018-2019 and is about six times the size.
Multiples may have returned but the stock hasn’t. Shopify is up 30-fold to its current price in six years.
Shopify is still up six fold from the prior valuation low which was as recent as December 2018. On very tough comparables, Shopify reported revenue growth of 41% year-on-year last week. Over 51% of Shopify sales use Shopify Payments, which is both a challenge to fintechs and an example of how a platform can find new ways to serve a large, engaged, and rapidly growing userbase.
This is ~1% position and if we get the chance we will build it up to full size.
Fintech has been one of the hardest hit sectors, with leaders PayPal and Square both down 65%, with the carnage in smaller companies more severe.
There has been intense capital formation in the sector, with waves of new companies trying to get a share of payment revenue attached to every transaction. This has led to intense competition at both the checkout, and for investor attention in the stock market.
Secondly, Apple has created by far the best user experience for mobile payments. This is secure and runs across the internet. Apple will shortly allow users to take payments with a tap on an iphone as well as make them.
In Sydney restaurants you’re starting to be able to both order from a QR code then pay with Apple Pay, a direct challenge to every other POS company.
This is material for Square, Paypal and a host of others who have invested heavily in point-of-sale infrastructure which could quickly be made redundant. We are on the sidelines here, as we sold Square and Afterpay after their transaction was announced (a Pyrrhic victory as the e-commerce and life sciences companies we purchased posted similar falls.)
We think Apple is likely to win at the checkout, as will Shopify for their host of online DTC competitors. And there is only so much space on a screen for all the various BNPL, Paypal, and credit card options.
Sea had a particularly volatile time with their major shareholder Tencent selling down to a 10% voting stake. There was speculation this was done to appease Indian regulators uneasy with Chinese ownership of key apps – which played out as Sea’s other two apps promptly became the nation’s second and third most downloaded app.
A question mark remains over how Sea’s relationship with India evolves, though fortunately Sea’s GMV is highly geographically diversified.
Sea is playing a long game, building a highly engaged user-base and developing their burgeoning advertising model.
Sea, along with the rest of the growth space (and us, for the time being) is in the market sin bin. But we also expect Sea to be one of the highest returning large cap investments – certainly from these levels – and even after the washout it’s still up nearly 3x from our initial purchase.
Sea has increased revenues ten-fold over the last three years and is likely to move to profitability at the group level later this year on an enormous base – a decent return on their investment spend, we believe.
Sea is back to COVID lows on an EV/Sales basis. The stock is up 3.3x from the lows.
What we all would really want to do is go back in time and pay a much higher multiple for Sea a few years ago:
This would have returned ~8x over four years. The same dynamics – explosive growth, brilliant products and a hyper engaged user base are in place across our portfolio today.
Sea Ltd over the last three years. Even after a growth wash-out and savage multiple contraction, it was worth paying up.
MercadoLibre posted excellent results and remains at decade valuation lows.
Roblox sold off after results. We saw some weakness in the data going into the result so reduced and protected the position accordingly. Unlike Meta / FaceBook, who spent $10bn in 2021on investment in the Metaverse, Roblox has built a vibrant, cashflow-positive metaverse ecosystem that kids can’t get enough of.
The market is unforgiving around earnings these days. We generally don’t care if stocks miss vs expectations, instead our focus is on whether the long term thesis is intact. Roblox generated $570 million in revenue for the quarter, up 83% year-on-year and revenue for the full-year was $1.9 billion, up 108% year-on-year. Daily active users reached 56 million, and the Roblox developer community earned $540 million in 2021. Safe to say things are on track.
They continue to collaborate with the biggest brands, providing appeal for all users whether it’s StarWars fanatics or NFL fans allowing brands the ability to access a 56 million-strong daily active user-base. Over time, dynamic advertising and e-commerce which are untapped revenue streams will gradually be enabled on platform and with $2 billion in net cash on balance sheet, Roblox are investing in more engineers to roll this functionality out gently without impacting the quality of user engagement. We remain investors and supporters, and added back to the position after it fell, and will add more if the opportunity arises.
Where to from here
We’ve been asked a few times how long we think this sell-off will last.
Major companies, from Square to Paypal to Shopify have sold off over 60%-75% over the last three months.
This has been like a 2000-2002 tech crash compressed into a few months, kind of like how March 2020 compressed an entire economic cycle into a quarter. Old hands say this is the fastest market they remember in decades.
Seeing SPACs drop 80-95% was not a surprise, and we always expected drawdowns like this from time to time. It was somewhat surprising to see even the best companies in the space trade below COVID levels without any material slow down or fundamental issue. Instead it’s been a valuation and positioning reset characterised by a mass exit of the space by institutions.
As I write Ukraine is in the headlines. This has no real impact on our portfolio companies, but has a material impact on sentiment.
Sometimes international political crises mark significant lows as panic around something unrelated to company performance shakes people out of the market.
The last period of quantitative tightening (declining orange line above) and rising rates (light blue line) in 2016-2019 was actually characterised by rising equities, though there was volatility both at the beginning and the end.
The 2015-2016 scare around rate rises and quantitative tightening marked a major low in growth / tech, most notably software. Companies that executed well advanced several times from those lows in the years that followed.
We expect this time to be similar, though the level of panic and drawdowns are higher.
One thing that would mark an immediate reversal in the positive direction is a Fed Pivot. High yield spreads are creeping up towards the 500 bps level that caused Powell’s first dramatic pivot from aggressive tightening to easing after the Dec 2018 sell-off:
Put contract trading has reached extremes. Again, you would do very well to buy when these spike.
Sentiment is as bad as it has been in technology, with the drawdown in the Nasdaq 100 now ~20%:
Small cap valuations are at historic lows.
Small cap valuations have moved from record highs to record lows over the last few months
Companies like Carvana are at levels that preceded substantial advances in the past:
Carvana EV/Sales (dark blue) and revenue (light blue). Carvana still has ~1% of the market. After a substantial correction, Carvana is up over 3x from our initial purchase in only 2019
This was something of a perfect storm for us, landing on growth, life sciences and small caps.
My own history is one of finding the right companies but not making the most of it. Apple over ten years ago, Tesla 9 years ago, and a number more recently. The reason we didn’t make more money was being shaken out by some irrelevant factor at the time, while it was crystal clear that each company was kicking goal after goal.
Reviewing the underlying fundamentals – everything is on track and if you hadn’t been watching the market, you’d assume they were pushing to new highs rather than making new panic lows and trading at multiples below the COVID panic. And you have to go back to late 2008 to find similar extremes of some indicators – like the institutional rush to exit the tech space. Unlike then, there is no question mark over the financial system.
Crises in the past look quaint, manageable, and obviously resolvable, while current ones always feel endless. The good news is a significant valuation reset is now in the rear view mirror, valuations are at distressed levels, and most importantly our portfolio companies are performing as strongly as ever. Things can turn around fast.
In terms of the strategy, we will make some minor changes. Firstly, the biggest mistake was not selling more when valuations went vertical a year ago. We sold out of companies like Plug Power which went up 20x and a number of life sciences companies that went up 5-10x. However, we allocated to other companies, many of which still fell >50% from their highs. Next time, we will be sure to bank cash when valuations go vertical. In general, we would hold more cash to dampen the volatility, and likely even increase returns, by giving us more ability to buy aggressively at times like today. I excluded the large tech companies from the strategy in the past as I feel these are best purchased outright or through a high quality index like the Nasdaq 100.
However, in sell-offs there is a general rush to cash, but also within the tech sector, a rush into larger and safer tech companies like Google and Microsoft. This means their volatility is substantially subdued during corrections, though they also tend to underperform on the rallies.
Right now however, this is the time to be invested, not in cash. And the small and mid-cap tech sector we focus on is both the most beaten up, and the most likely to outperform from here in the future. So all these changes will happen on the other side of this sell-off.
I’ve been through a number of these over the last fifteen years. Each crisis was different and scary and new, and each the same, characterised by increasingly indiscriminate selling and a contraction in investor focus from the long term to the very, very short term.
In each case, companies that were growing, adding users, and kicking goals, vastly outperformed on the back end of the sell-off. I invested in Apple (prior to launching my first fund) over ten years ago and Tesla ~9 years ago. But was shaken out of that Apple position for the first time in 2011 when I was in Greece and ATMs literally stopped working for locals and it looked like the Eurozone was going to collapse. I had to buy back in at a much higher price, as so many had to do in the aftermath of March 2020. Similarly with Tesla, it advanced ~5x from a very early entry and I sold in one of the periodic half-remembered panics, only for it to add a full order of magnitude and it was only COVID that offered an opportunity to get back in.
The same way we used the drawdown of March 2020 to get back into positions that had run away from us, we are making similar moves today. It’s no accident that our best year also had a drawdown similar to the current one.
We have full confidence this is one of those times. Sentiment is in our sector is at decade lows, multiples have crashed below the levels of prior crises, and all this time, throughout last year and into this year, our companies have continued to execute and perform exceptionally well. So the path forward for us is crystal clear – hold the line.
Having said that, I do respect this is a tough time for investors who aren’t as close to the fundamentals as we are. We have had minimal redemptions and have actually been raising money throughout this period which has allowed us to be net buyers in heavy down days, so we’re very grateful for the support.
This sell-off has already turned into one of the ‘big ones’, and while the drawdown has happened fast, there is a good chance the recovery will be just as swift, particularly as we move into the latter half of the year and rate rises have been digested, inflation numbers roll-off abnormal year-on-year comparisons, and our portfolio companies put in another six months of growth and start to look towards 2023.
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