March 2021: Rising Rates, SPACs and Growth Stocks

Dear investors and well-wishers,

The fund returned 2.5% net in February, taking us to 15% net for calendar 2021.

For the financial year-to-date (since 1 July 2020) we are up 91% net, comfortably ahead of all major indices (the Nasdaq100 did ~30%, the ASX200 Total Return did ~15%). This brought our total net annualized return since inception to over 35%.

I joined Equity Mates on their podcast, available here. I will do another video update next week so please send through any questions.

Update

February saw a sharp rally into the middle of the month, followed by a steep sell-off in growth, which continued into March.

We were affected by this and gave back some of our gains since 1 January, though as I write are still comfortably positive for the year. We would prefer to be back at the highs, but it’s encouraging that we’ve generated strong returns over a period where the US 10 year interest rate increased >100 basis points.

This fund has now weathered two bear markets, a global epidemic, and our second rising rate environment. We could have picked a better time to launch a fund!

Higher rates have obvious consequences for growth assets, but if we had to guess, the recent retracement has as much to do with overextended valuations and sentiment as macro factors.

The table below is worth studying, showing the EV/Sales on 31 December 2020, and the EV/Sales for 30 December 2021, using current forecasts for revenues (which for our stocks generally prove conservative) and yesterday’s prices.

Disclaimer – we hold over 50 stocks, this is a selection of companies we’ve discussed in these letters before.

Despite large multiple contractions across our portfolio, the fund is actually up over this period. The ability to weather sharp multiple contractions is one of the reasons we focus on such fast growing companies.

You can also compare the change in multiple to the change in price:

Change in price and multiple. For 2021 numbers we used current market prices for prices and enterprise values, and analyst averages for CY2021 revenues.

As you can see, the sell-off has resulted in a large change in multiple since 1 January 2021, but only modest falls in price and indeed some gains. The change in price, ofcourse, is what we actually care about.

It turns out a fast-growing portfolio can weather quite extreme reductions in multiple, and still generate strong returns:

SPACs

I’d be remiss not to comment on SPACs which are a defining feature of today’s market.

Companies merging into SPAC cash shells skip the arduous process of listing, which can take well over six months, requires a certain number of years of audited financial accounts, and has all kinds of restrictions over, say, long term revenue forecasts.

The appeal to founders is clear: negotiating a simple merger agreement with full control over terms and timing, rather than dealing with investment banks and all the associated well-documented issues.

But there are real benefits to the traditional process, not least convincing a somewhat respectable institution to lend their support and passing their due diligence process.

There are now several listed battery companies with no batteries for sale. Multiple flying car companies with no flying cars. And many marketing 2025 revenues – but nothing until then.

And all these seem to be valued at billions of dollars, while no doubt requiring vast additional amounts of capital to have a small shot at winning what might be a large market.

Here is one example of how a flying car company is marketing 2025 estimates:

While we wish for flying cars as much as (and probably more) than most, there is likely a bumpy few years ahead for shareholders of such companies.

It’s easy to mock these companies (they may have the last laugh) but the sector demands attention, as the best companies of today are not doing IPOs, they are merging into SPACs.

This is a good thing: lower barriers means companies are coming to market sooner. There was an entire vintage of startups like Airbnb and Uber that stayed private until well into maturity, benefiting a very small group of ultra-wealthy investors, locking out access to those who loved their products but couldn’t invest in the companies during their most exciting growth years.

We are spending a lot of time sifting through these, and some of our most promising new investments have come to market via SPAC.

Changes

We used the recent sell-off to add to CuriosityStream, set up by the Discovery Channel founder John Hendricks, who grew his previous company to more than 2.5 billion cumulative subscribers across channels, generating $5.5 billion in annual revenue. CuriosityStream is growing at >80%, trades at ~10x CY21 EV/Sales and has built its subscriber base from 1mn in 2019 to over 13mn in 2020.

We were careful to be net buyers on the big down days, and bought two companies growing at well over 100%, with exceptionally high profit margins.

Over the past six months or so we had reduced renewables to ~3% of the portfolio, and software to even less. Renewables have been particularly hard hit over the last few weeks, perhaps as so much capital has been sucked up by all the shiny new green SPACs.

So we have started building that position back up. If the sell-off continues we will add to our favourite software names like Twilio and Shopify, but they still look a little rich for now.

What next?

My guess is as good as the next, but as rates continue to rise we expect multiples to continue to compress. Far more importantly, however, we expect our portfolio companies to continue to grow and create value.

The recent reporting season suggests our companies remain on track, though we did close a small number that didn’t prove up to scratch.

It’s helpful to remember that multiple contraction only happens once, while compound growth can go on indefinitely, at least over any relevant human timeframe.

Our main job now is to make sure every company we own continues to post rockstar fundamental performance.

It’s also worth noting that big growth selloffs tend to prove excellent buying opportunities. You could have done worse than to add at these kinds of extremes:

If you were waiting for a dip in tech, well, this is a dip in tech.

A sincere thank you for your support

Michael

Please note: We are now taking applications weekly, so if applications, funds and supporting documents are received by 2pm on a Friday, the investment will be priced for Friday COB / Monday morning start. We are also available on Netwealth and Hub24.

February Strategy Update

Dear investors and well-wishers,

We recorded a strategy update with topics and timestamps below, and are now accepting applications on a weekly basis.

Best regards,

Michael

Timestamps

1:27 – Overview of investment strategy

2:10 – Love, explosive growth, Apple and Tesla

4:32 – Customer love: how we measure it

6:03 – Our long-term goals

6:50 – How can a company lose money and create value?

8:31 – Xero: A case study

10:30 – Square’s return on $32m of marketing

11:28 – The Amazon example

12:02 – What happened if you overpaid for Shopify or Afterpay a few years ago?

13:14 – Why you have to be on the right side of these shifts to perform

15:17 – Question: Do we still own Alteryx?

15:54 – Question: Thoughts on Fiverr and Upwork?

16:17 – Question: Our view on cryptocurrency?

18:20 – Question: How do you stay on top of 50 companies in your portfolio?

19:33 – Question: What are our thoughts on big tech?

21:38 – Question: What do we think of rising interest rates and inflation?

23:20 – Question: What scenario causes you to lose faith in a stock?
24:42 – Question: Do you have a view on the Australian dollar?

26:13 – Question: What is your view on using leverage in equity investing?

26:57 – Question: How much cash do you hold?

28:05 – Question: Are you still looking at daily liquidity for the fund? (We are now accepting weekly applications)

28:23 – Question: Views on Redbubble?

29:13 – Question: How do we model companies?

30:53 – Question: Will the fund look to make a distribution?

31:27 – Question: What is the outlook from here?

December Investment Update

Our fund advanced 24.8% net in November, taking us to +92% net for the calendar year-to-date. Since inception we have compounded at 28% net pa, over a period which included two fierce bear markets and several sharp shifts in policy and economic conditions.

This compares favourably with market indices. For every $1 the ASX 200 Total Return has generated, for example, we have made well over $4 net.

For another touchpoint, we have now outperformed the ASX200 Total Return by >20% on an annualized basis.

These returns have been broad based: we currently hold ~40 investments and all of our current positions are under 7%. It is one thing to generate returns like this with four positions, quite another with forty.

Concentration

It’s fashionable in some tech investing circles to run highly concentrated portfolios. We’ve been sympathetic to that approach in the past, but think a broader portfolio is better, as it ensures we capture the explosive organic growth of our companies without overexposure to any one name.

We know that for many of our investors, we are their only exposure to these companies, and there’s something inherently unpredictable about which of our companies will perform best at any one time.

Perhaps the best risk/reward in finance is found in a 3-4% position in a fast-growing company. The downside is 1-2%, but a high performer can easily add >25% across an entire portfolio.

With 2%-4% positions it’s also straightforward to add to companies that have temporarily sold off, and to sell a company that no longer displays the explosive growth and customer love we find so useful as a guide.

Given the rapid explosion in technological adoption this year, we don’t think we’re going to run out of opportunities any time soon.

The 21st century started in 2020

This is attributed to Peter Thiel and we couldn’t agree more.

For all the trials and tragedies of 2020, this was a year when all kinds of technology accelerated.

In 2020 the use of hydrogen in transportation reached critical levels, much to the benefit of Plug Power (6x), whose fuel cells now transport ~30% of US retail food and groceries.

It was also a good year for space, with Virgin Galactic (which we own) and SpaceX (which sadly we can’t) both laying down serious milestones in what will be one of the future’s largest industries.

Biology has always had data at its core, but in 2020 this data science reached new heights. Chinese scientists posted the genetic code of the coronavirus online, and within days the Moderna developed the first of what will likely be many mRNA vaccines without any access to the virus itself. Truly science fiction stuff.

Fortunes were invested in biological research this year, and it has never been cooler to be a biological scientist. Talent and capital is a thrilling combination. The next decade should be a good one for the life sciences.

Risk

We’ll always position our fund at the forefront of technological shifts. It’s often uncomfortable on the front lines. Balance sheets and income statements are messy, and the extraordinarily talented people that build new businesses are often odd.

But it’s far riskier, in our opinion, to be on the other side of these shifts. Simply look at the performance of Tesla and Carvana versus the auto industry, Afterpay and Square versus global banks, and Shopify, MercadoLibre and Sea versus traditional retailers.

Our mid and large cap companies are growing at over 75% pa. In a world of flat to weak GDP growth, this revenue must be coming from somewhere else.

And that somewhere else is where the vast majority of capital is invested – and quite likely most of your own.

This was a year where those taking extraordinary risks to advance the human race were richly rewarded, and for that we can all be thankful.

Rotations and double winners

Readers will know we laid the groundwork for November by reducing our exposure to richly valued software companies (for example) and investing in companies well placed for a recovery.

The best companies right now are double winners with these two characteristics:

1) They’re already growing exceptionally fast, and

2) will also accelerate in a recovery.

This is a tough ask for any one company, but there are indeed some.

Disney is an example we have given before, with an explosively fast-growing consumer business (Disney+) combined with broadly loved theme parks, which used to contribute almost half of Disney’s profit, and will soon do so once more.

Another example is Square, which is already amongst the fastest growers among companies with market capitalization over $100 billion, while also standing to benefit from a return of foot traffic to retail malls.

Square is interesting for another reason.

The holy grail in payments is creating a closed loop, where transactions between customers and merchants all happen within a single ecosystem, effectively on a company database rather than through the archaic payments network.

This would bypass traditional banks, the likes of Mastercard & Visa, and all the other payment layers that plague us (we seem to discover new ones all the time).

A closed loop payment system would allow instant, highly efficient transactions, which is precisely how financial data should flow in the 21st century.

We think Square could be the first to achieve this.

Square began with those familiar smartphone card readers for merchants. But Square also has a rapidly growing cash app in the United States. This now has over 30 million users, up from 15 million last year, and as you know we love growth rates >100%! These users are transacting about 15x per month on average.

So they have two sides of the prized closed loop:

We think the graphic below is interesting not only for what it says about Square, but also how it illustrates what’s going on in financial markets today.

A $32 million investment in Sales and Marketing in Q1 2015 is now generating $172 million of gross profit a quarter.

Imagine a value investor looking at the financial statements in Q1 2015… they will just see that expense as a cash flow drag, a cost with no corresponding balance sheet item. Yet this kind of return is one and perhaps two orders of magnitude greater than what’s achievable from traditional capital expenditures in factories, equipment and the like.

The optimal strategy here is to spend all those subsequent gross profit dollars on even more sales and marketing.

Winners Only

The best guide to 2020 was to focus entirely on companies that were thriving in the prevailing market. E-commerce, digital health, payments, the right life sciences companies – these served us extraordinarily well.

We plan to use the same process to guide us over the next 12 months: we will only invest in companies thriving in the current market conditions. The good news is the kinds of companies that we invest in can thrive for decades, and perhaps generations, like the evolution of hydrogen energy, solar, electric vehicles, advances in genomic sequencing and space.

Outlook

It’s good to know that even in a year including an astonishingly brutal bear market (which hit us quite hard) we can still net over 90%. The juice has been worth the squeeze.

It wasn’t easy in March… there were more than a few McDonalds-eating Buffett-quoting managers who turned out to be sellers, rather than buyers. And to be fair, a nastier virus could have lead to a more prolonged shock – though this may have led to a stronger policy response, a sharper rally after, and perhaps even greater returns to our holdings in ecommerce, digital health etc.

Finally, a comment on timing.

I had multiple discussions around June/July about timing. Many thought things had run hot, and they had. But as we approach the new year, quite a number of our portfolio companies are already 30-40% larger. And June wasn’t so long ago.

There are people reading this who invested on 1 October 2018, right before the trade war and Jerome Powell’s short lived attempt to raise rates. There are others reading this whose funds were invested on 1 March 2020, moments before one of the sharpest sell-offs in market history.

Both sell-offs hit us hard, and friends of mine will attest I wasn’t exactly the best of company during those months. But when markets really started moving, we proved one of the steadier hands, and were able to take advantage of the opportunities on offer.

Our net IRR includes those sell-offs, as well as the rallies. And even for those who invested at the two worst possible times over the last decade, the fund has performed.

The smart play now is to stay invested in the fastest growing highest quality companies we can find. That was our approach in March, and remains our approach today.

It’s a sad fact that at some point in the future a new turn of events will shake markets to their core. And when that happens, you can rely on us to act in exactly the same way.

A sincere thank you for all your support

Michael

Disclaimer

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.

The information provided is for general information purposes only, and does not take into account the personal circumstances or needs of investors. The Company and its directors or employees or associates will use their endeavours to ensure that the information is accurate as at the time of its publication. Notwithstanding this, the Company excludes any representation or warranty as to the accuracy, reliability, or completeness of the information contained on the company website and published documents.

The past results of the Company’s investment strategy do not necessarily guarantee the future performance or profitability of any investment strategies devised or suggested by the Company.

The Company, and its directors or employees or associates, do not guarantee the performance of any financial product or investment decision made in reliance of any material in this document. The Company does not accept any loss or liability which may be suffered by a reader of this document.

October Strategy Update

Timestamps

1:00 – Our investment framework

2:30 – Why you can’t afford to ignore these companies

4:18 – Question 1: How high can Redbubble go? (ASX: RBL)

6:26 – Third party data

8:38 – Question 2: When do we sell?

11:21 – Question 3: Is it too late to invest?

11:55 – What would have happened if you paid the highest price of the year for Sea  in 2018 or 2019 (NYSE: SE)

13:05 – Question 4: How does customer love work in the life sciences?

15:27 – Ultragenyx (NASDAQ: RARE) and biotech competition

16:33 – Question 5: What’s the impact of the US election?

18:15 – Question 6: Will traditional investors continue to miss the boat? 

24:10 – Summary

Disney and Recovery Plays

Hi everyone,

We recorded our recent strategy update.

As the virus recedes, it’s increasingly clear that the worst case scenarios feared in March are unlikely to come to pass. Attention has turned to recovery plays. Here are a few that keep coming up in conversation.

Six Flags is a pure play on theme parks – though the firm was under pressure before the coronacrisis:

Six Flags Entertainment Corporation

Vail, which runs ski resorts, is another commonly discussed candidate, though as you can see you had to move quickly to take advantage:

Vail Resorts Inc

We found ,,Christine Jurzenski convincing on ,,Live Nation, which runs a surprisingly integrated model providing premier live entertainment and associated ticket and product sales. It’s hard to say if concerts will be back in 3, 6 or 12 months, but it’s probably safe to say that within two years business will be booming again. Premium, live, and memorable experiences are likely to continue to do well in the digital age.

Live Nation

Buying airline stocks seems to us a poor way to play the recovery, as losses are still accumulating, gnawing away at balance sheets. Future value is path dependent, and paths are unpredictable.

It is almost certainly an excellent time to start an airline. Tightly held airport slots around the world are up for grabs, new-build and second hand planes are on the cheap, and there are plenty of qualified staff looking for work.

Enduring demand for cruise ships continues to surprise those of us who never quite understood the appeal. These are capital intensive, competitive and cyclical businesses at the best of times. Perhaps some people will do well with their timing here, but it is not for us.

We thought the equity outlook at the end of March was positive, but instead of recovery plays, we intensified our focus on leading technology companies that accelerated through the crisis, such as e-commerce leaders like Pinduoduo, Shopify and Sea.

Buying high quality, fast growing technology companies may be the single best way to take advantage of the indiscriminate liquidations. This proved true in March 2020, as well as December 2018, early 2016, 2008-2009, and certainly the aftermath of the tech wreck of the early 2000s.

For some reason people look at those episodes and take the lesson that markets can sell-off more than one might expect, and hence equities are dangerous. But perhaps a better lesson, and one that we’ve taken to heart, is that buying fast-growing technology leaders during those crises would have done extraordinarily well.

This time proved no different:

Sea Ltd

Pinduoduo, which we wrote about last year ,,here

Shopify

Nevertheless, there are some recovery plays we are looking at closely. Airline software firms like Amadeus and Sabre, for example, have fallen steeply and are within our technology remit:

Sabre Corporation

These are not the sort of software companies we would usually look at. You could argue Sabre and Amadeus have market leadership, but they are low growth and, as they were once considered low risk, carry debt.

Booking systems are critical to airline operations so their bills tend to be paid even as airlines themselves flip in and out of bankruptcy. These features attracted a certain sort of private equity investor, so they’ve traded in and out of public hands, and suffered the lack of investment and innovation that sometimes comes with cash-flow focused investors.

At least part of the reason why booking airline tickets is such a pain in the neck is due to chronic under-investment and cash-flow harvesting by companies like Sabre.

Our portfolio consists almost entirely of the opposite: companies with insatiable demand, investing every dollar they can to put their brilliant products in front of more people. These invariably look terrible on cash flow measures, but often create the most equity value. (As a side effect some are heavily shorted. This overlap is coincidental, if somewhat predictable).

Compare the pain of rebooking an airline ticket, to the joy of a company like Shopify, and you can see why we stick almost entirely to the later.

Nevertheless, there is a price for everything, and the factors that caused such a rapid fall going in to the crisis may also make firms like Sabre leaders coming out.

If ever there was a time for a modern competitor to break the Sabre/Amadeus oligopoly… it would be now. Airlines may never again have a better chance to renegotiate long-standing contracts, nor have a greater need for incremental efficiency. Something to watch for.

Disney

Which brings us to a better recovery play, and one that fits our focus on joy and customer love.

Disney is a fascinating company. The list of creative brands is inspiring, including Pixar, Marvel, Star Wars, 21st Century Fox, a license deal for the Simpsons, as well as ESPN, Hulu and National Geographic.

Disney’s portfolio of parks, resorts and cruises is no less impressive:

Customer love and market leadership – Disney certainly has that in spades.

With Disney+, the firm now has the third pillar of our strategy: explosive growth. Disney+ added 55 million users in five months, which is a spectacular feat given the competition in the sector and the time it took Netflix to accumulate 190 million.

As always, we don’t form opinions on what we think people will like, we simply look at the data.

This achievement was not without cost. Disney pulled their content from other platforms, costing billions of revenue. They have priced the product to sell, at A$8.99/month. The business is going to burn cash for quite some time.

But it is a masterful move. The low price point ensures Disney has direct access to the credit cards and viewing habits of what (we believe) will eventually measure in the hundreds of millions of customers.

This opens up a range of strategic options, and any future price increases will drop straight to Disney’s bottom line, though the focus for the foreseeable future will be driving viewer numbers.

There are many trying to replicate Netflix’s success in building a direct-to-consumer streaming platform, but none with the library and catalogue of the calibre that Disney brings to the table. Pixar, Marvel, and Star Wars are brands that can generate blockbuster after blockbuster. Disney had 5 of the top 6 grossing films in 2019.

Disney derives more of its profit from theme parks than content, but this is the wrong way to look at it. In effect, it is all content. Disney+ offers another route to monetization.

An interesting aspect of modern media is that it has materially improved the quality of the shows we watch.

It is not just the advance of technology that enables full scale battle scenes in popular TV shows – it’s the ability to sell these directly to hundreds of millions of viewers over longer and longer periods of time. This justifies a magnitude of spending unthinkable ten years ago. Given all the capital available, there is likely no better time to act, write, or direct for the screen, nor indeed, to watch.

This crisis offered a rare opportunity: to buy Disney at a dramatic discount. The stock traded over $150 only a few months ago, only to lose nearly half of its value, as though their entire suite of theme parks was written down to zero.

Which is, of course, nonsense. The parks are still there, and as the fear of coronavirus recedes into a sad memory, people will return. And Disney+ will be there with all its monthly-paying viewers, increasing both the demand and the consumption of Disney content, all while showing Disney precisely what is working and what is not. Their entire offering, from screen to park, will be constantly and systematically improved.

Disney is on the larger end of companies we’d look at. The median market cap of our portfolio is typically less than a tenth of Disney’s. But the risk reward here looks solid. A rally from $100 to pre-crisis levels implied a ~50% return in the short to mid term. And it’s entirely reasonable to expect the stock to trade above $300 within 5 years, which meets our 3x-in-5-years return target. Of course, the stock has rallied since our first purchases, but the path to recovery is also now clearer.

Given the unique nature of Disney’s content, the extraordinary integrated model, the joy the firm brings to people around the world, and the early success of Disney+, we expect Disney to be a core position for quite some time… and one of the highest quality ways to play a rebound.

Michael

ps I think you will find ,,this, interesting.