Dear investors and well-wishers
The fund returned -14.5% in May. So far June has been positive. Equities continued to sell-off as CPI came in ahead of expectations. Core inflation was lower, but food and energy components accelerated. There has been some relief in recent weeks as both oil and corn prices have fallen quite substantially, though this will not come through until next month’s data point. Most growth stocks have rallied off their May lows.
We are now quite deep into this sell-off, which for our sectors has been going for nearly a year and a half. We made the decision to take a long-term view. Over most periods that’s the right approach, but this turned into quite an extended bear market, focused on small and mid-cap growth, healthcare and consumer tech, which has been our main focus.
Many internet platforms are now down over 70% calendar year-to-date, including Zoom, Roblox, Snapchat, Netflix, Pinterest, Spotify, Shopify, and Etsy. Both thriving and declining platforms have sold off in similar fashion.
The reasons these companies performed so well in the years prior are still in place, and most have ground out solid fundamental growth, even while their multiples have collapsed 80-90%. The returns to the correct companies on the back end of this will likely be spectacular.
Companies are responding aggressively to shifting investor demands, announcing extensive lay-offs and refocusing on profit margin, which will likely come through by the end of the year. To give one example, Sea Ltd is ending free shipping in some regions, cancelling promotions and increasing take rates across the board.
Source: Bloomberg, June 2022
Curiously, stock-based compensation policies have resulted in many of these companies having large amounts of cash, which combined with 70-80% falls represents an increasingly large part of their market capitalizations.
So if you’re wondering what happened to all the stock-based compensation that was paid in prior years that is now so deeply underwater… it’s often sitting there in unrestricted cash on the same companies’ balance sheets, while the losses have shifted to employees. In the first part of this year there was a concerted effort to compensate employees for these losses, but as the year has progressed companies have moved in the opposite direction and announced layoffs and hiring freezes.
It’s unclear what the end state is here… will growth stocks like this sell off until they are just cash shells and you can buy software businesses for effectively nothing? This seems unlikely, but we did just watch it happen across the life sciences. Australian small cap tech approached those levels in recent weeks, and companies have traded below cash at various points in the past, like when Benjamin Graham was writing his famous books. Some high-quality US software companies reached 40-50% cash at the lows a few weeks ago. If anything, this is a sign of how extended the move has now become and the long-term opportunity from here, painful though it has been for those of us focused on this part of the market.
For growth investing to work there needs to be operating leverage, and many companies that were displaying this 1-2 years ago are unable to demonstrate it now. Others, like CrowdStrike, Snowflake, GitLab, MongoDB and Elastic are showing it in spades.
We made a new investment in Cloudflare, which dropped from $220 to $120 and then $120 to ~$40 in the last few weeks. The moves in growth have been substantial indeed. It may take some time, but with consistent >50% organic growth and steady increase in margins, as well as a critical place in internet infrastructure and security, we expect this beaten up former darling to be at new highs in the mid-term, as will likely be the case for other smashed up tech companies who have had their multiples cut by a factor of 10 and are maintaining strong execution. There may even be a point in the future where these kinds of companies command a premium again, though that seems far away today.
About 10% of the internet runs through Cloudflare’s network. Cloudflare’s initial core offering was its Content Delivery Network, which effectively mirrors the internet in locations all around the world. If you’ve ever wondered why it is so blazingly fast to download content from a US website in Sydney, it’s because the data is likely sitting somewhere pretty close. Over 95% of the world’s population lives within 50ms of Cloudflare’s network.
Cloudflare bundles its Distributed Denial of Service defences, application firewall and Domain Name Services into a single product that makes websites fast and secure. This bundling was an early driver of growth – customers would come for Cloudflare’s DDOS, only to realize they could make substantial savings by moving all four essential services to a single provider.
Cloudflare is so core to the good functioning of the internet that activists often lobby the firm to remove their protection from particular sites, and they frequently protect the Government websites on both sides of a conflict.
A new part of the business is serverless applications which allow developers to bypass the need to provision and manage servers, in effect making life easier for developers, and by utilizing Cloudflare’s network, ensures applications are extremely fast. Cloudflare’s serverless offering is ~3x as fast as Amazon’s equivalent, showing the strength of their proprietary physical and software driven network.
This is in early stages, but with a significant speed advantage may take meaningful market share in cloud computing.
Cloudflare’s revenue and gross profit growth has been consistent. EBITDA margins have improved ~30% over the last four years. Source: Sentieo, June 2022
With its own unique role in network infrastructure and intrinsic advantages of its physical and software capabilities, we expect Cloudflare to become an increasingly relevant competitor to the cloud giants while also remaining fundamental to the good working of the internet.
Query speed in the last 30 days. Source DNSPerf
This is a new position we were buying in the mid-40s in recent weeks. This was one of the highest valued companies six months ago only to swiftly lose ~80% of its market value. From here we expect stock price performance to match the growth of the business, which has consistently averaged over 50% over recent years, all while displaying the operational leverage that makes growth investing so powerful over the long term.
We’ve been consolidating our positions and our top 20 now account for over 80% of the fund.
Events proved us too optimistic throughout this sell-off, but even so there is reason for cautious optimism today. A dramatic valuation reset is behind us, and it is becoming increasingly clear which companies are thriving in the current environment (there are many) and which are not. We’re consolidating the portfolio into those that are doing the best. As of last reporting season our companies grew over 60% year-on-year on average weighted basis.
Many of the worst case macro outcomes eventuated this year. Technology, growth stocks, life sciences and small caps were under the most pressure, which meant we were on the wrong side of each factor.
Valuations have swung substantially from high to low.
There has been a mad rush into commodities amongst institutional investors over the past few months, which has now become the most crowded trade (with our space becoming the new pariah).
The mass institutional underweight of growth and fund manager net cash balances forms a strong foundation for the next rally in growth and technology stocks. This has been a tough period for us, but the crash and opportunity set right now is far greater than usual too, and things can change fast in markets, particularly when so deeply oversold.
One challenging aspect of this period is that many of the highest quality growth businesses have sold off as much as lower quality firms that are increasingly unlikely to sustain prior growth or be able to raise capital.
This is likely due to a high degree of institutional consensus over measures of quality, leading to a common factor, but with time there will be increasing divergence between companies that are performing well and those that aren’t.
The strategy of investing in growth is a sound one – both for management teams and shareholders. Even now, many of these companies down 70-80% have created tens of billions of dollars of wealth and serve tens or hundreds of millions of customers, despite only being founded a few short years ago. These companies achieved this by hiring, building and investing in talent – all recorded as expenses – which is precisely what the market is marking down so severely right now, lumping all such companies into the basked of ‘unprofitable tech’.
The energy sector itself went through a moment like this over five years ago, when there was a complete collapse in values coinciding with overinvestment in shale. The resulting bust led to the laser-like focus on shareholder returns today, and those that stuck with the space ended up with an excellent outcome at a difficult time. We are part way through a similar shift in the tech space today, where refocusing management attention will pay off in spades later. There will certainly be a time when fast growing tech businesses are the highest performers in the market rather than the lowest, and this could be sustained for quite some time given the fact fundamentals themselves are growing (unlike fixed assets) and we are coming off such a low base.
Asset manager positioning as measured by futures open interest has hit extremes.
While we don’t expect valuations to hit the peaks of last year any time soon, at some point the factors are driving positioning, sentiment and valuations to such depressed lows (was, China lockdowns, supply chain issues, near record central bank tightening) will reverse, and valuations will normalize on companies that will in many cases be 2-4x the size they were going into this drawdown.
Of course, even if multiples never recover, the fundamental growth of our businesses, driven by the support of their customers, will be enough to drive a recovery with time and as always, we’re entirely focused on making sure we’re in the highest quality, fastest-growing businesses we can find.
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