Dear investors and well-wishers,
The fund declined 2.8% in February taking us to -26.7% for the calendar year-to-date and +13% per annum over the last three years.
Many of our companies are twice the size, half the price, and trade at less than a quarter of the multiple of 1 Jan 2021. Source: Sentieo
Two shocks rattled markets in recent months. The first was a surprise and persistent rise in inflation, led by commodities, food and autos, prompting the US Federal Reserve to shift one of the loosest monetary regimes in recent history to one of the tightest.
This caused a sharp rotation out of long duration assets where payoffs lie in the future – very much the kind of companies we like most. Capital rushed out of technology and growth and into commodities and energy assets, which after years of underinvestment are now scarce.
As the world was digesting this, one of the largest energy exporters invaded the largest grain exporter and was promptly isolated from most of the global economy. (The human tragedy dwarfs other concerns, but for context I’ll focus on the market impacts in this letter.)
The invasion set that original shock into hyperdrive, causing a second rip in commodities and a further sell-off in growth assets, specifically in tech and the life sciences. The XBI biotech ETF dropped 54% from its peak early last year.
The second shock had much in common with the first – rising prices – but also marked a regime shift, triggering a sharp reversal in European equities, travel and reopening plays, which were faring well before. Russian equities completely collapsed and Chinese stocks exhibited some of the sharpest index volatility in history as investors grappled with the implications of the Russia-China alliance. Tsarist Russia is often the counterexample to ‘stocks always go up’. Echo’s and rhymes.
RSX, the Russian stock ETF. Traded just long enough time for people to buy the dip, and is now suspended
Most of the time, when concerns around war, interest rates, macro and so on flare up, the moment is short lived, and those that panic sell good companies for non-business-related issues quickly regret it. The last twelve months has been one of the exceptions.
The story is not over of course. We are now at a compelling moment.
- Many companies are cheaper than they were at the lows of COVID.
- Our companies continue to grow and are well ahead of their KPIs. There is no recession in technology.
- Sentiment in small and mid cap tech companies is completely washed out. Some oversold measures in our sector exceeded those in the dotcom crash and 2008/2009.
- Falls of 60-80% were common across market-leading platforms and dominant software firms.
- The market priced in war with a nuclear power and an aggressive series of rate hikes and tightening.
We did make some mistakes over the last year and a half, which were largely ones of strategy, namely staying fully invested in tech and life sciences, which were two of the worst sectors to be in (we still think they will be the best performers long term), and within the sector, avoiding mega-caps.
We sold a significant part of our portfolio near the highs, closing some personal favourites that had rallied 10x or even 20x, like Afterpay, Square, Twist and Plug Power. We also closed obvious COVID beneficiaries like Teladoc and even a small position in Peloton. However, we committed to staying fully invested and reinvested that cash in other companies that still got hit hard.
It was not surprising to see SPACs drop over 90% (some have a further 90% to go), but I was surprised to see so many category-leading companies like Shopify drop over 70% (we bought back into Shopify over the last few weeks). Shopify traded below where it was two years ago pre-COVID, despite growing revenues ~4x and EPS ~12x from CY19 to CY22E.
This same approach ensures we are fully invested at the lows and we can rebound strongly. Given the last week’s price action this may have already begun.
The second issue, along with being fully invested throughout, was that we stayed away from the largest tech companies like Google and Microsoft that performed very well on a relative basis.
Over the last two years most of our own companies grew more, improved profitability more, and exceeded expectations by more. But their multiples collapsed 75-90%, whereas the few cash-rich mega-caps largely held their value.
During market sell-offs there is always a flight to cash, but within the tech space there’s an additional rotation from smaller companies to the handful of larger ones. We have been on the wrong side of this three times in the last few years: December 2018 right after we launched this fund, March 2020 barely a year after, and now November 2021 – March 2022.
Companies like Google and Microsoft are the new defensives, billing almost every company on the planet, sitting on piles of cash, generating piles more, and using much of it to buy back shares. Almost every company and every person pay tribute in one way or another to these companies.
In the future, we will use market rallies to build in more defensive companies into the portfolio. It’s likely this will improve our long-term returns, giving us more latitude to be aggressive in sell-offs, as well as reduce volatility.
Having said that, we have little doubt that many of the best opportunities in the market are in fast-growing companies that are so out of favour and marked down so severely.
In some ways, the case is clearer than in March 2020, when markets carried more serious existential risk, and the sell-off stabilised quickly.
There has been a fairly astonishing rally off the lows over the last couple of weeks.
While sentiment is so bleak, valuations so low, and fundamentals so clear, our existing strategy, which was one of the worst on the way down, is likely to be one of the best on the way up.
If you squint you can see silver linings in the new world order. The invasion of Ukraine is such a military and economic disaster for the aggressor that hot spots elsewhere in the world suddenly look more secure.
The age-old advantage of defenders over attackers clearly stands in the modern world. Like knights in shining armour in the age of guns, tank columns have proven surprisingly vulnerable to modern shoulder-held weapons and drones.
This will weigh heavily on larger countries contemplating invading their smaller neighbours, which is good news for the rest of us. Hopefully this view isn’t too optimistic.
There has also been a dramatic political turnaround in energy policies around the world, with even Elon Musk supporting renewed drilling for fossil fuels.
There is some low lying fruit. Norway’s sovereign wealth fund, for example, focuses on ESG while deriving all their own wealth from oil. Germany shuttered safe, non-emitting nuclear plants only to import fossil fuels from other countries. The US Government periodically constrains its own energy industry, while happily importing crude from some of the nastiest nations on the planet. The current administration cancelled a pipeline with Canada, about as friendly a country as they come (perhaps not to their truckers), only to be forced into rushed, failed diplomacy to secure supply from Venezuela and Iran.
The EU and the UK are moving decisively towards energy independence, nuclear energy is back on the table around the world, and both sides of politics in the US are re-examining energy policy, though the left around the world will always struggle to reconcile the labour and environmentalist sides of their party. Russia has changed the terms of the debate.
In the next year or two, all these measures will reduce the inflationary pressures causing so much trouble for consumers (and long duration assets). This is inevitable… and also some time away.
We were pretty active in the portfolio. We reduced some of our larger positions and added to Square under $100 (we sold in the mid $200s last year), Shopify in the $500s and $600s (we sold our last shares at more than twice the price) and added Elastic and leading software names in recent weeks. Shopify is down 66% and over 59% in this calendar year alone. We have been wanting to build a large allocation to software for some time, and were finally offered an opportunity.
The recent reporting period was tough year-on-year as a set of US stimulus checks were sent out around a year ago, with much of it going into online shopping (and directly into tech stocks). Nevertheless, it’s striking how well our portfolio companies continued to do, even while many suffered the worst drawdowns in their trading history.
This time next year we expect these effects to roll off, growth to be back on trend, and companies to be valued accordingly.
The last time multiples were this low these stocks bounced 3x-10x. This time, the sell-off has been more severe, the institutional sell-down of technology much greater, and the drawdown has happened over a longer period. The companies have progressed further, and multiples have compressed more. So, there’s certainly cause for optimism, though moves like that will certainly take longer this time.
If you have used search in an app, it’s likely you have used Elastic’s functionality.
We purchased Elastic at valuation lows of March 2020. Elastic has been a steady performer, though the multiple has been volatile.
The company itself has consistently delivered, with underlying performance substantially less volatile than the stock itself.
This was a challenging time for us as the strategies and tactics that are usually so richly rewarded fared the worst. This was one of the few times where it paid to panic sell, rather than to buy into the sell-off. Over the longer term, and perhaps even from now, we expect long term buyers and holders of good companies to be rewarded as usual.
Multi-year bear markets are rare. There have been three in the S&P500 over the last forty or so years, most recently 2008-2009 over a decade ago and 2000-2001 over twenty years ago. Before that, you have to go back to the early 1980s.
It’s important to take the right lessons from these periods. Many allocators who control vast sums of money today came of age during the dotcom rise and crash. Those that survived often did so due to cynicism about technology. That grinding bear scared an entire generation away from the space.
As it turned out, the two decades that followed saw perhaps the largest wealth creation in history in web, social, search, software, and cloud computing, not to mention cryptocurrency. You could practically rank the performance of funds by their exposure to the leading technology companies.
There was a similar bottleneck in 2008-2009. Short sellers were lionized, and the industry spent years looking for the next ‘big short’. As it turned out, the big opportunity was actually the bull market that ran almost continuously over the next ten years, only hitting turbulence in late 2018 shortly after we launched this fund. The past year may prove a similar watershed moment in the growth space, causing investors to abandon long-term investing in the space… and providing riches to those who stay the course.
The current period does have similarities to 2000-2001. The moves in mid-caps have been similar, with category leading companies like Shopify, PayPal and Square dropping 60-80% in a much shorter period of time. Revenue-less SPACs serve a similar role to revenue-less dotcoms, sucking in and destroying capital that would otherwise have been in more productive assets (technically, transferred to insiders).
The main difference is that tech companies today are doing exceptionally well, and many of those that have fallen the most are clocking serious and rapidly growing revenues and profits. This has certainly been a financial sell-off rather than one due to declining fundamentals.
Some software companies we track. Source: Sentieo
It’s important to note that those two sell-offs, 2008-9 and 2000-2001, also represented exceptional buying opportunities. It just took longer. And after the two-year bear market of the early 1980s, indices went up 8-fold by the end of the decade.
Over the last year or so, many of our companies have both doubled in size while their stock prices have been cut in half. Gross profits have risen more than revenues, though all our companies invest heavily in growth, largely through their income statement rather than balance sheet.
A historic sell-off is now in the rear-view mirror, and both valuations and sentiment have swung from record highs to all-time lows. Technology has gone from the ‘most crowded trade’ to the largest institutional underweight in over a decade, this institutional shift being both a major cause of the sell-off – and a reason to suspect long term performance on the other side of this.
Commodities are now the flavour of the month and for good reason, given the long years of underinvestment. Most energy and mining companies are run in a very investor friendly fashion, limiting capex and favouring dividends and buybacks.
But this sector is also not without risks. War could resolve and see significant supply returned to the market. New wells and mines will be drilled and dug, which over time practically guarantees a commodity bear market at some point in the next few years. And investor enthusiasm may over-reach.
For now, the rally seems to have legs, and the US and EU push for self-sufficiency ensures a serious boom for long-suffering suppliers, service providers and equipment manufacturers, regardless of short-term price movements in underlying commodities.
Moving back to our space, the feared US rate rise took place a week ago, and long duration assets actually rallied – including most of our portfolio. Given this was the driver of the first sell-off several months ago, this was encouraging. And there is plenty of cash on the sidelines.
Most importantly, our companies are continuing to deliver on their KPIs, are trading significantly lower, in some cases than they have ever been, are substantially larger and more profitable than they were a year ago, and are trading at a small fraction of the multiple.
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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