During February, the Paper Portfolio experienced volatile performance as global equity markets reacted to the pandemic potential of COVID-19. The portfolio ended the month down 1.32%, reversing the strong gains delivered in the first two weeks of February. While the reversal was disappointing, the Paper Portfolio continues to perform very well relatively and is well-positioned for the future. The Paper Portfolio continued to deliver significant outperformance relative to the S&P500’s decline of 8.22% in February.
Since inception, the Paper Portfolio has returned 10.73% vs 0.29% for the index. As a reminder, the Paper Portfolio held significant levels of cash until very recently. The high levels of cash was a significant drag, especially during the strong up market seen in Q4 of 2019. The stock-only portion of the portfolio (excluding cash drag) has returned 14.2% since inception vs 0.29% for the index.
COVID-19 has significantly impacted the market recently. Despite non-stop media coverage and global efforts to contain the spread of the virus, researchers still seem to have limited understanding of how infectious or deadly the virus is. As a result, people (and investors) are currently inclined to panic. Although fear is warranted and everyone should absolutely take precautions to guard against infection, the probability that this virus does permanent, lasting damage to the global economy is low. Equity markets have declined more than 10% from recent highs. While some industries will certainly see earnings decline by at least as much over the next 1-3 quarters, we are unlikely to see 10%+ permanent earnings impairment unless a significant portion of the world’s population dies. Unless this apocalyptic scenario plays out, the current decline in the markets is almost certainly to be temporary.
On to the stock review…
A number of stocks performed very poorly.
Uber declined 6.67% as COVID-19 led to fears of lower rides, especially airport rides (~15% of bookings according to the company).
Match was the worst performer, declining 16.9%. Match was not only impacted by the general decline in the market but also faced pressure from a short seller (Kerrisdale) claiming Match faces significant pending liabilities from a federal investigation into Match’s business practices.
MELI, FB, V, LVMH, NOW, PINS, PYPL, SBUX, ALGN, and ILMN all also performed poorly (approximate -5% to -15%) mostly as a function of market backdrop.
Partially offsetting this, SQ performed extremely well at +11.6%. SQ reported very strong results as the Seller ecosystem did not slow down as much as feared, while the Cash App is gaining more momentum than expected. SQ will be holding an investor conference in March. SQ is likely to detail future plans around their ecosystems, which could further drive excitement around the business.
Cloudflare also performed exceptionally well, increasing 19.3%. The company reported strong results. Now that we are a few months post IPO, the investor base is likely starting to mature/season. Investors also are likely to have a better understanding of the business including Cloudflare’s emerging edge computing platform called Workers. The potential for such a platform can be enormous in the long run.
The best performer in the portfolio was WORK, increasing 30.3% during February. Initially, WORK benefited from an incorrectly reported article claiming IBM has migrated employees to Slack (IBM employees were already one of the largest users of Slack, hence this was not new news). Although Slack corrected the report, it nonetheless helped bring renewed optimism around the company. This was further supported by Uber announcing that they are migrating their employees to Slack (real news).
Overall, the portfolio bucked the downward pressure largely by doing what this portfolio was designed to do: Compound/create value faster than the market. Most of the stocks in this portfolio will see very limited fundamental impact from the virus. Because these stocks will see limited impact on earnings, the decline in prices mean these stocks are now trading at much more attractive multiples than before. Capital Flywheels believes this drawdown is a good opportunity to play offense, especially since the large performance gap means we can afford to be aggressive.
In terms of rebalancing, most of the adjustments are minor except for the meaningful trims on BABA and Tencent. Both BABA and Tencent are likely to face significant near-term pressure due to the impact of the virus on the Chinese economy. Unlike the rest of the world, China chose to quarantine vast swaths of the population as well as introduce policies to limit economy activity. As a result, Chinese businesses will see significant earnings impact (BABA reported earnings in February…the company claimed revenues in the core commerce business will likely decline in Q1 vs growth that was previously trending at >20%).
ASML is the first complete sale from the portfolio. ASML actually has one of the best long term competitive positions of any business I have ever analyzed (monopoly position on a technology called EUV which is necessary to make leading edge chips, and this technology is likely to dominate at least through 2030). However, given the sell off, it makes sense to swap into another incredible semiconductor company: Nvidia. Nvidia is the leading GPU maker. Historically GPUs were only used for graphics/gaming. But in recent years, it has become clear that GPUs are especially useful for training AI algorithms. The world is likely still at the first inning when it comes to AI. The potential here is vast.
I am also taking the opportunity to add a 3.5% position to Apple. Apple is one of those businesses that should be impossible to make money in given the number of analysts and investors that constantly watch the company’s every move. However, over the years, it is clear that a large number of people/investors do not have a strong understanding of how Apple works and how Apple thinks. Apple is a hard company to forecast because it relies on surprise. This is why Apple, like Amazon, is hard to compete with. While I used to own shares in the company, I sold them in early 2015 at ~$120/share after riding it up from $30. Apple is a company that is dependent on product cycles, and those products (namely iPhone) was starting to mature in 2015. Now we are 5 years removed with the stock only a little more than 2x higher (and had the Paper Portfolio launched earlier in 2019, I think there is a good chance Apple would have been part of the inaugural list of holdings since it fell to as low as $150 in early 2019). While the iPhone is certainly more mature now than it was in 2015, it would be a mistake to assume that Apple is out of tricks. Apple has always been a company that looks like it can create magic when in reality Apple simply has a better grasp of technology curves and is able to better ride the waves between what is new and what is possible. Most companies operate either in the past or too far into the future. Apple (usually) has it just right. With that in mind, Apple looks like an interesting bet right when everyone thinks they are out of ideas.
Disclosures: I own shares in SE, SQ, UBER, ATVI, BABA, SHOP, MTCH, TCEHY, FB, and TEAM. I have no intention to trade shares mentioned in the next 48 hours.
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