Dear investors and well-wishers
The fund contracted 6.3% last month (Nasdaq fell ~10%). We finished the quarter up 6%, while the Nasdaq 100 was down 4.4%, which is not much to be proud of right now, but so far we have held the May and June lows, even as major indices have pushed lower and yields around the world have pushed to significant new highs.
Goldman Sachs US Financial Conditions Index over the last thirty years
The current situation is often compared to the 1973/74. Nearly 50 years ago, equities made a low in October right before inflation peaked in official statistics. This proved to be a generational low and equities never retested this level.
Equity market (blue) bottomed shortly before a peak in inflation (white) in 1974
The nature of inflation has changed markedly over recent months. Cars, freight, supply chain issues and chip shortages have reversed sharply, and most commodities have been in a bear market for some time now (with notable exceptions like Australian coal and lithium).
Leading indicators are rolling over heavily – which is likely very relevant to Fed policy and equities
Retailers like Nike are reporting massive increases in inventory and will almost certainly have to discount prices to clear stock.
But as these initial triggers of inflation have subsided, new ones have risen, notably rents, as you can see below in green, which is one of the major contributors.
Core CPI Decomposition From January 2021 to September 2022, and forecasts. Source: Haver
The Fed focuses on year-on-year headline numbers, which are widely reported and carry the most political weight.
But leading indicators suggest even rents have rolled over hard, as measured by Zillow’s rental index which has a good record in leading official statistics.
Zillow’s rental index is a more timely indicator of rental pricing, leading on the way up by several months.
This is matched in other indicators, at the same time as Fed officials are pointing to rents as a reason to continue with aggressive tightening.
The 1974 analogue suggests there’s a good chance that the peak inflation will mark peak hawkishness, and perhaps peak pessimism/valuation lows.
We recently bought into Aveo Pharmaceuticals, who has the only third-line treatment for relapsed renal carcinoma. The firm traded below a $250 million market cap with $100m of high margin revenue, and was forecast to reach over $175 million in sales next year. The firm also committed to slashing costs and sharpening their R&D focus, a sign of frugality and shareholder focus that is slowly returning to the space.
Sadly the company received a take-over offer last week while we only had a small position, but it’s a good example of how cheap things are in the sector.
In high growth tech, the managment process is still taking some time.
Over the last decade, backing visionary founders made for brilliant investments. From a standing start, companies like Shopify, Spotify, Snapchat and Twilio added hundreds of millions of customers, and in some cases hundreds of billions of dollars of revenue, from a standing start barely ten years ago.
But now these founder-led companies are amongst the weakest parts in the market. With full or close to full control, strategic errors are not being corrected, and these companies are diluting shareholders to the tune of several hundred millions of dollars every single quarter, only unlike in their previous trading history, there is no natural buyer. Companies like Facebook (-61%) have had similar troubles, again with a visionary founder who has chosen to plow tens billions of dollars into a product with as yet, no market fit.
The dilution is quite incredible. On an annualized basis this represents ~10% of the current market cap. On the one hand, shareholders have worn an 83% drawdown. On the other hand, employees are $300 million richer in the last three months, and can expect to make over a billion over the next twelve months. It’s hard to imagine who is going to step up to buy this stock once it’s issued to employees.
The solution is simple – cut costs and lift prices. Apple Music just raised prices almost 10% last night – Spotify should do the same. Similarly, many users of Shopify pay very little, and those that do, often pay more to app developers than they do to Shopify. This is a company running almost ~$180 billion of sales through its platform annually, with an enterprise value of only $30 billion. In their Q3 report released yesterday they reported a $345m loss, -25% of revenue, vs a 0.4% loss last year, with over $400 million of stock-based compensation.
In the meantime there are growing companies trading on after tax profit multiples of under 5, and buying back 15-30% of their current market cap this year. We are orientating more and more of the portfolio to this part of the market.
As this year has progressed companies like Snapchat and Shopify have increased costs and stock-based compensation, right as revenue growth slows down to a crawl, effectively ensuring insiders are capturing all the value they’re creating. We’re reorientating to companies across healthcare and technology where these dynamics are pointing the right way, and if the bear market continues, at the very least these companies will be buying back stock at excellent prices and come out with a much reduced share count.
Google added 13,000 employees over the last quarter alone, right as growth collapses across their business.
And Facebook’s results last night were perhaps the most telling. Mark Zuckerberg is spending $4 billion a quarter on his Metaverse. Now, the metaverse may be quite large. I personally think that successful versions will be like Roblox – gaming and entertainment focused. But even if Zuckerberg is right, it’s highly unlikely that there will be a commercial return on $16 billion a year. You have to think the old Zuckerberg could do a lot more with less.
Over the last decade backing founders has been a winning formula, and many have been wildly successful. That has all changed this year, with founder-led companies posting some of the worst returns, many of which we owned. This has been tough for us, as my own instinct has always been to back successful, mission-driven entrepreneurs. As you go through the examples above, the scrappy fighters who built these companies now count amongst the most lavish corporate spenders. We’ll have to adapt our strategy to the new market too and find the next generation.
With time, 2022 will likely be remembered not for the bear market but the incredible progress made in artificial intelligence.
If you haven’t already, I highly encourage you to go to https://www.midjourney.com/home/, click ‘Join the Beta’ and spend a few minutes playing around. Midjourney has quite an interesting economic model, with payment and access provided entirely through the chat app Discord.
Until this year it was not clear if computers would ever master creative work in fields as diverse as art, music and literature. That has been decisively answered.
Originally it was thought that the first jobs to fall to artificial intelligence would be the least skilled, like driving. Then perhaps low level office jobs, then highly skilled professionals like computer scientists. Creative professionals like artists, musicians and authors would be the last bastion of humanity.
Surprisingly it looks like the order is happening in reverse.
Examples of art generated by Midjourney’s AI engine
In recent weeks artificial intelligence has made an important breakthrough in mathematics, discovering novel algorithms for multiplying matrices which have evaded human researchers for decades. So computers are now improving the very algorithms that they run on.
There are a number of startups now building on the technology. This is the new hot space with companies getting valuations of $1 billion+. Much of the best work is being done open-source and given away for free, so buyer beware. OpenAI launched a product with a pay wall and all kinds of ethical restrictions, only for comparatively free alternatives with fewer nagging restrictions to spring up shortly after. Regardless of whether the value lands, this is almost certainly going to lead to a substantial increase in overall computing power, which has its own set of investment consequences.
Chip shortages have been in the headlines all year, but this has shifted abruptly to over-supply, particularly in consumer devices like mobile phones and laptops. On the back of this, semiconductor stocks have sold off ~40-65%, right when future demand is crystallising to the upside in autos, industry and artificial intelligence. One day the consumer may return too.
Many companies in the space hold local monopolies over critical parts of the value chain. And unlike some of the examples above, these are profitable companies buying back stock. There is also a geopolitical dynamic, with both positive and negative investment implications.
The war in Ukraine and Chinese authoritarianism has alerted everyone to the risk of conflict in Taiwan, which has encouraged a global effort to invest in supply outside the region.
The US has effectively banned Chinese access to the leading technologies, and Taiwan Semiconductor has cancelled orders by Chinese firms for advanced chips.
Europe has announced plans to double its share of semiconductor production from ~10% to 20%.
ASML in the Netherlands is the only company on the planet capable of making the most advanced lithography machines, an immensely strategic and valuable asset. Their order book is full. And even consumer-orientated companies like NVDA and AMD are still reporting strong growth in non consumer verticals – and will be beneficiaries of Facebook’s capex largesse.
On the back of the US CHIPS act, Micron announced plans to invest $40 billion in new capacity and Qualcomm partnered with Global Foundries to build a >$4 billion fab in New York State.
Taiwan Semiconductor has themselves announced plans to build new factories in Japan and the United States.
As the world rushes to diversify semis exposure, the bulk of these investment dollars will land on a handful of companies, which will mitigate the slump in consumer demand for computers and mobiles (and announced capex cuts by the most affected manufacturers).
Near term a wave of higher rates and geopolitical tensions have made for an extremely challenging year. This bear market is now the worst on record in dollar terms for both equities and bonds. Needless to say we were over-optimistic earlier in the year. The silver lining is that prices have now come down to some of the most attractive levels in over a decade, and it’s becoming increasingly clear which firms will dilute excessively, and which are able to prosper even in times like this.
Timing is uncertain, but with so much cash on the sidelines there is certainly fuel for a rally
There has been a considerable level of retail capitulation over the last two months
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