May 2022 Investment Update

Dear investors,

The fund returned -26.5% in April, bringing us to -49% for the calendar year-to-date.

In April the tech sell-off intensified, driving many companies to significant new lows. The Dow Jones Industrial Average just recorded its longest losing streak in 98 years.

The S&P biotech index is in the middle of the worst drawdown of its trading history (it fell considerably less in 2008-2009), wiping out over seven years of gains. Needless to say, there has been substantial progress made by these companies over this time. I came across this tweet thread this morning which captures the mood.

S&P Biotech ETF – last 12 years

There are early signs some companies are stabilizing around COVID lows. A swallow does not make a summer but it is something we are watching closely.

S&P Biotech ETF – last 3 years

The fact biotech index companies are trading for less than cash is well noted in both our own updates and elsewhere. This chart shows how largely unprecedented the current situation really is.

There continues to be a broad-based panic about the future amongst investors.

There was plenty of excess in the tech sector last year. But the pendulum has now swung just as hard in the opposite direction, and companies executing five-year growth plans are being discounted almost entirely.

Last week, we noticed a number of companies in our broader universe trade for 25% cash relative to their market cap, and above 50% in some instances.

The drawdown has been worse than we expected. I and the team are fully invested in the fund, we appreciate the difficulties of the moment, but we also know situations like this do not last forever and throw up opportunities as well.

Our focus now is making sure we sift through the universe and identify the right companies that will perform exceptionally well on the other side.

Most of our companies have reported over the last few weeks, and our weighted organic growth rate remains well above 60%. These companies are cashed up and are continuing to execute on their growth plans.

We will certainly incorporate lessons from this going forward.

My biggest regret is not shorting the >100x EV/Sales companies we were so sceptical and knew could not be sustained, along with the $50-100b companies with no revenues and little prospect of profits. These would have softened our duration risk and put us in a very different situation today. In future, if we see these opportunities we will take them, but the best opportunities today are likely to be long term investments in market leading companies when everyone else is rushing for the door.

We also underestimated the Fed’s willingness to destroy wealth to bring down inflation. Their actions in 2020 were very well justified. Continuing to ease throughout 2021 when the economy had largely recovered is clearly already a historic error. I suspect their actions in 2022 will be as well.

Much of the valuation excess is now gone.

Software multiples are at seven-year lows:

With the cloud index off almost 60% since November.

The last time these companies fell this much software returned 10x to the peak last year and 3x to today. We have been orientating the portfolio more to software in the sell-off and it currently represents 23% of the fund, focusing on best-in-class.

The S&P500 is now at its ten-year valuation average, which includes the period at the back end of the GFC.

Sea Ltd was a major detractor, despite reported 65% top line growth and guiding to profitability in its core markets this year.

A challenge for us has been that fundamental growth of our companies largely matched their shareholder returns. Sea for example, increased revenues by ~6x since we first bought, which is why we were comfortable holding through a similar move in the stock.

Companies like Spotify weren’t spared, falling over two thirds from the highs last year and are back below COVID lows:

Carvana

We are focused on pruning the portfolio and exiting anything that is not performing. One holding we exited was Carvana.

Six months ago Carvana had grown revenues from almost $2 billion when we purchased to a $14 billion run rate, had completed its first year of core profitability, and almost doubled their refurbishment capacity in anticipation of expanding market share from only 1%.

However, the consumer cycle turned hard, with spiralling energy prices and car financing costs dampening demand. While Carvana was able to post 15% year-on-year growth in a declining market, gaining market share, the firm’s near-term prospects deteriorated rapidly, as did the credit market. So when it came down to financing the acquisition, the terms were punitive.

Carvana raised $1.25 billion of equity at $80 (now <$30) and $3.275 billion of debt (now 85c on the dollar), corner-stoned by Apollo at 10.25%. In other words, over $300 million dollars of value a year will accrue to credit holders, not equity.

Carvana made substantial progress before an ill-timed acquisition at the top of the market, a turn in auto markets, and rapid deterioration in credit markets changed the picture dramatically.

Carvana’s 10.25% 2030 convertible notes have traded down to 85c

This is very much the opposite of most growth companies, which at the very least are capital-lite and sit on large piles of cash.

The change in cycle caught many off guard. Had they not made the acquisition, or raised equity when they announced the deal last year with the stock more than 10x the current price, the company might be in an entirely different position and far better situated to adapt and weather the storm.

The pain of exiting what was intended to be a long term investment is limited by the fact there are so many high quality tech companies down similar levels without the credit risk. Since selling, the price has deteriorated further.

The biggest detractor for us over the last year has been e-commerce. It has been tough watching core holdings sell down so substantially over a period where the businesses themselves have grown several times over.

A week ago many of these companies traded down to the point where a significant part of their market capitalization was represented by cash.

Interestingly, many tech companies used convertible notes to raise cash over the last few years. Some of these are trading at substantial discounts, offer high yields, credit protection and equity upside in the form of calls on the stock.

There is certainly an opportunity for someone to sift through these and play a recovery in a relatively capital-protected way.

Opportunities

At the moment, the market is ascribing almost no value to a company’s future prospects, as though interest rates were 50%, rather than the current ~3%. Growth performed so well over the last few years that it attracted fund after fund, and now these firms are rushing for the exit. Day-to-day price movements are dictated increasingly by who owns what.

There have been two events in the last twenty years that changed the funds management industry. The first was 2000-2002. The managers who made it through this period were almost all focused on value and cynical on technology. Over the following twenty years technology was one of the best performing asset classes with perhaps the exception of bitcoin (which might be included) as search, social, mobile, cloud, and all kinds of software businesses captured and drove the bulk of economic growth.

There was a second manager bottleneck was 2007-2009. This period saw market indices post negative ten year returns and long-short investors dramatically outperformed. Long term investing was dead and the industry focus turned to finding the next ‘big short’ (curiously, Australian banks often featured on the list and became an offshore obsession). Instead markets rallied for over a decade with only minor interruptions.

Unfortunately, the last two years have turned out to be one of the worst periods in forty years to take a long-term investment approach, with the exception of those two examples above.

We know many major funds have now liquidated their positions (for example Softbank’s has closed their growth fund and Melvin Capital announced their wind-down last week). These closures are likely behind the last two months of severe volatility in price action and why companies have sold down to such low levels. Someone selling a company for less than cash is generally a forced seller.

If the past is any guide, at the end of this when markets have put in a low, then the one strategy that is most toxic – which this time around is long term investment in growth and technology – will likely have its best years off an incredibly low valuation base and absence of institutional ownership.

The silver lining to all of this is that the baby has been thrown out with the bathwater and we are in an opportunity-rich environment, to put it mildly.

Market leaders have traded down as much as prospectless SPACs. Companies which compounded revenues at 50-60% for many years and hold plenty of cash have had the bulk of their listed equity value written off, while at the same time there are new companies with little prospect of making it through the required rounds of financing that are still valued at substantial amounts, even after 80-90% falls.

As discussed in our last letter, we think that internet platforms that have maintained >50% growth rates for several years and are trading at lifetime lows offer some of the most upside when conditions do change, with the caveat that this is currently one of the most volatile parts of the market.

We are orientating hard to best-in-class software opportunities, and there are multiple companies focused on the life sciences sector too.

Target just had the worst day since 1987 after posting a weak result. This is one of the consumer staples stocks that investors have rotated into in recent months. Even Nike has been under pressure.

We expect companies that improve cyber security or improve efficiency will remain in high demand and have taken positions in companies like Crowdstrike after substantial falls.

These were some of the most expensive companies in software for good reason, but in many cases have been cut in half since the beginning of April alone and are down 60-70% from all-time-highs. These companies have mostly reported well even as their consumer counterparts have faded.

In the past, cyber security firms hit a natural limit – if they got too big hackers would adapt to their codebase, limiting the size that a company could get without being so large that it was worthwhile for a bad agent to outmanoeuvre them. This also ensured there was always space for a new entrant with a new approach. Cloud security companies have escaped this inertia, installing agents on devices that can detect, monitor and block any threats. Most importantly these can be rapidly updated remotely, work well with external security service providers, and additional modules can be easily sold to each customer leading to high net retention rates and customer lifetime value.

MercadoLibre

Many of our companies are reporting well but have still suffered in the broader stock sell-off.

MercadoLibre is down 65% since November and 39% since the beginning of April alone (at the low last week it was down 50% since 1 April).

The firm reported a convincing beat and raise, posting revenues 13% ahead of estimates and EBITDA 38% ahead of consensus but this was to little avail. MercadoLibre has only ever traded cheaper at the peak of the financial crisis in 2008-2009.

This is a common theme across our portfolio. Most stocks are at lifetime valuation lows, and those that were around for several decades often only traded lower in the months following the Lehman collapse, and in 2002 at the back end of the dotcom bust.

The returns to growth and technology were spectacular in the years following both these periods, and we’re confident that as long as we stay continually invested in those winning customers and executing on their long term business plans, future returns will once again be as impressive.

Outlook

There are three things that could turn the situation around.

  • a peak in inflation,
  • a peak in interest rates, and
  • a peak in energy prices (some commodities, like copper and lumber, have already rolled over).

These are all linked, and were exacerbated by the war in Ukraine and stiff lockdowns in China.

Key components of inflation have begun to decline and the headline CPI result declined from 8.5% to 8.3%.

Quarterly Inflation Forecast, Goldman Sachs Research

One of the leading indicators of wage inflation was the hiring frenzy Amazon began last year, offering high wages, and enticing many teachers to switch careers. Now Amazon and Facebook have announced hiring freezes, and a number of companies like Netflix, Robinhood, and Peloton have announced layoffs.

Headline in Reuters/Daily Mail on Amazon’s hiring frenzy from October last year

A headline from May 2022 – too many workers!

US yields may have peaked but only time will tell whether this is more permanent. Energy has remained below the peak hit during the onset of the Ukrainian war. There is talk from Fed officials about pausing rate hikes in September – which is a very different change of tone from even a few weeks ago.

A peak in US yields? Feels like peak hawkishness right now, in any case. Lower yields will likely give relief to long duration assets, including growth stocks.

The Fed is continuing to withdraw liquidity as economic conditions are deteriorating rapidly, which remains the largest risk.

Inflation break-evens have been falling the last few weeks and Fed officials have made first mention of a rate pause in September this year

In future, we will be much more attune to that kind of shift. I was expecting a 2015-2016 or 2017-2018 situation, where interest rates and quantitative tightening triggered sharp but brief sell-offs and proved buying opportunities. This has morphed into something much worse – though it’s very possible we will all look back on this as a buying opportunity as well.

We also thought that by avoiding the highest priced sectors we would avoid the worst of the trouble and that growing companies would continue to perform well, or at least maintain their fundamental gains of the last few years.

But it turned out that many of our positions were crowded into by offshore growth funds which are under extreme stress. Some invested their funds in private deals which are dramatically underwater, triggering margin calls from banks that will no longer accept private stock as collateral, and private companies were priced even richer than public companies.

Snowflake has contracted from 200x EV/Sales to 29x historic, 13x forward. We don’t currently own but may if the multiple contracts further.

We made an early decision not to participate in the sell-off and stick to our long-term approach. This has been why we have suffered the worst of these falls, but also offers a path through this difficult environment.

An interesting case study is the oil and gas industry several years ago, which went from being one of the hottest investment sectors to under severe pressure, culminating in negative prices for WTI crude in 2020.

Energy-related funds were in severe trouble, and management teams spent huge amounts of capital on shale wells that were ultimately unproductive. There was too much money creating too much supply chasing too little demand.

The industry suffered worse than the technology sector today, but only two years later energy companies roared to the top of the performance tables with market leading returns, helped by the fact management teams became exceptionally disciplined and focused on shareholder returns.

Management teams in software have reacted hard, with even the largest companies like Facebook and Amazon announcing hiring freezes and lay-offs. Every earnings call is now focused on margins and discipline. Companies that have outperformed on these metrics are rallying whereas those that hit top line but miss on profit are collapsing. There may still be more market chastening required – the CEO of Shopify for example has chosen this moment to move to increase his personal voting share.

As happened with oil and gas, the message from market pricing and investor meetings is no doubt sinking in, and as companies refocus on operating margin and leverage, it’s likely the best years of the industry are ahead.

Personally we have had to reflect and adjust. Our process revolves around modelling and investing in companies over five years, but that left us exposed to the 90% multiple contractions we are seeing across the board and simultaneous bear markets in the two sectors we focus on.

If we see opportunities in this new environment we will take them, but we are going to be careful to make sure that we are consistently exposed to the technology themes that have been so painful over the last year and a half, but likely to be so productive over the coming years. It is also likely that, after such an indiscriminate sell-off, the best returning investment opportunities over the next five years lie squarely in our sector. So we are entirely focused on making sure we hold a portfolio of as many of those as possible.

Best regards
Michael

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