May 2019: A good time to square up

Dear investors and well-wishers,

Portfolio Update

The Fund returned +3.6% in April 2019, ahead of the ASX 200 (+2.3%) but behind the S&P 500 (+4.6%).

This was largely due to our hedges and Aurelia Metals, which suffered a sudden change of CEO (we have since exited).

Carvana and Afterpay topped the contributors list for the second month in a row.

Carvana reported a Q1 organic growth rate above 110%, to $755m, while increasing gross profit per car from $1854 a year ago to $2429. This is the highest organic growth and some of the best operational leverage we have seen in a company this size. The company issued its first securitised bond of car loans, and the company now buys about nearly half as many cars from customers as it sells, all of which is increasing margins further.

The stock has rallied since we first bought it earlier this year, and so is likely to contribute to volatility in coming months (to put it mildly). However the opportunity here is immense, and well worth looking through the month-to-month movements.

Cars make up the largest part of retail, and have barely been touched by the internet revolution. Carvana is the leading company in the US and the only one so far to get the experience right, as judged by their rapid take-up.

Long term, Carvana’s model should be a more profitable than conventional dealerships too, as there’s no need for prime real estate or sales incentives to dealers. The firm has a head start against pure tech play start-up competitors, many of whom have already failed in a highly complex industry, and we believe the ‘innovator’s dilemma’ will keep competition from existing dealerships at bay, as their online strategies are hamstrung by the need to funnel customers into dealerships to generate commission for their stakeholders.

Short interest as a percentage of free float has come down from ~70% when we first purchased, but remains over 45%. So it’s fair to say we are out of consensus here.

To give an idea of the scale of the opportunity from here, Carvana generated over $2.35 billion in sales last year, and only has 0.35% of the US used car market.

Outlook and Positioning

As our portfolio rallied this year (+23% ytd) we have been steadily increasing our short positions in structurally flawed sectors. In the first week of May we increased these shorts further (the data below marks month end).

In January we thought the ingredients were in place for a sharp rally – now we think there are serious risks to the downside. US retail sales have fallen three out of the last five months, and industrial production has fallen three out of the last four months.

Trade has fallen off a cliff – and this was before the trade war escalated. Without wanting to spill too much ink on a well-worn topic, it was notable that:

1) the trade deal proposed by the US didn’t actually involve an initial removal of the 10% tariff, and 2) the US was insisting the Chinese rewrite domestic laws to fit their demands.

These outcomes seem unlikely, perhaps insulting.

And for all Trump’s tweets and friendship with Xi, the direction of tariffs has been in one direction:

It is almost as though Trump would prefer tariffs than a deal, and it was only the market downturn at the end of 2018 that brought him back to the table.

Note that the recent plunge occurred before the increase of tariffs from 10% to 25%.

The rally this year coincided with a) the US Fed dovish pivot, and b) moves towards a trade resolution.

We think equity prices need to fall much further for any more good news to come from either of these sources. In particular, the market is implying US rate cuts, but financial conditions will need to tighten significantly first (ie risk prices need to fall). And when it comes to trade, it may take a more serious sell-off to stop Trump poking the Chinese in the eye.

We have written about our short book before, but to recap, our structural shorts include:

1) A retail ETF, that is equal-weighted. In practice, this means it is steadily selling companies like Carvana and Amazon, which are gaining market share, and buying those that are losing it, such as traditional auto dealerships and over-leveraged physical retail operators;

2) A biotech index, as we’d like to isolate our secular thematics from intensifying political pressure on US drug pricing from all political tribes;

3) A coal ETF exposed to thermal, which is being hit by fund manager ESG selling and decisions to reduce the weight of thermal coal in national energy mixes; and

4) US industrials, which we believe are likely to underperform should data deteriorate. If the bull market extends, this sector lacks the momentum technology names that have been driving the bulk of index market movements. We also like the fact that Boeing is the largest member. The firm still trades rich relative to the extent of damage from two consecutive passenger jet destructions that are at least partly linked to reckless head office decision-making, not to mention belligerent US trade policy towards enemies and allies alike. US industrial multiples, at ~11x, certainly look exposed.

US Industrial Index and EV/EBITDA (Bloomberg estimates) 

In summary, we are long innovation and short incumbency across the portfolio, funding investments in the new with sales of the old.

We are in the midst of a US IPO boom, and there have been extraordinary performances by companies like Beyond Meat (26x forward sales) and Zoom (44x forward sales). Even for 2019, this is punchy.

We analysed a Zoom valuation that just about made sense of the valuation, but paying for a decade of execution in advance is no way to invest, in our opinion. We would prefer to sell on such assumptions rather than buy, as indeed insiders have done with their IPO.

We recorded a podcast discussing some of these ideas, as well as Disney’s new streaming service, with Anna Satouris, and a second podcast going deep into innovation and market positioning with Eti Amegor, director at Axius Partners. These are available on your desktop here or iTunes here.

Taking all this into account, we are positioned more conservatively than ever, and have increased our sector shorts since month end to cover our long term investments.

We have long had Uber’s IPO pencilled into our diaries as a likely mid-term top in the market, so it seems as good a time as any for two-way bets.

Best wishes Michael

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