Paper Portfolio – May 2020 Update

April was a very strong month.

April almost effectively reversed the pain felt during March.

While many investors likely have been surprised by the magnitude and pace of recovery (the S&P is now less than 15% below the peak in February whereas it was >30% below the peak just a little over a month ago!) given the still-uncertain COVID19 situation as well as a collapsing global economy, the situation does seem to be stabilizing. But the truth is investors are always forward looking – the prices you see today do not reflect the health of businesses today, but rather expectations on the health of the businesses in the future. And it’s becoming easier to believe that the future is not going to be worse than today.

Cases are still rising rapidly in certain areas / countries, but as China, Hong Kong, Korea, Singapore, Italy, and a growing list of places demonstrate, the situation is controllable as long as the right measures are taken.

Of course, the cost of these measures (social distancing and shelter-in-place / quarantine policies) are undoubtedly leading to the greatest economic shocks ever recorded in the past century.

It sounds bad. It is bad.

But, governments and central banks around the world are also unleashing unprecedented stimulus at the same time. Under normal circumstances, this type of stimulus would likely have driven stocks to astronomical levels.

It’s important to keep in mind that the stock market is not the same as the economy. This view is a very common one, but it is a mistake. This is a mistake that even the US President has made on multiple occasions whenever he references the stock market as a proxy for the health of the US economy. But the fact is, the stock market is just a market for a hodgepodge of businesses. While it represents a very large portion of the economy, it is not the economy because many, many businesses that you and I interact with are not publicly listed on any stock exchange. This includes your local restaurants, local barber, local cleaners, local auto shop. Economists estimate that 60% of jobs in the US are conducted through small-medium enterprises, and the vast majority of these companies are not listed on the stock market. And on the other hand, many publicly listed companies also conduct a material amount of business outside of the US. For example, the largest company in the US is Apple, but Apple generates >50% of revenues outside of the US. How then can Apple stock be a gauge for the US economy? Because of these factors, it is possible for the stock market to diverge from economic performance.

In most recessions, most companies are affected fairly evenly, which limits the amount of divergence that the stock market can have vs economic performance. This current economic shock is a very unusual one, however, because it disproportionately affects businesses that are not listed on the stock market. It disproportionately affects small businesses that tend to interact with customers face-to-face and have limited ability to do business digitally. For the businesses that are on the stock market, the ones that are feeling the most pain tend to be small. As a result, you end up with a stock market that is zigging and zagging in a way that is very different from what the economy is doing.

In Capital Flywheel’s view, the stock market is actually dominated by strong businesses that have very clean balance sheets, and these businesses are likely to benefit from this current environment. Companies like Apple, Microsoft, Google, Amazon, Facebook (the 5 largest companies in the US) are all going to benefit. Of course the stock market is recovering. And of course, it is performing very differently from the economy.

I don’t know if this is good for society 5 or 10 years from now. But that is the state of the world. Society will very likely be able to get past COVID19 mostly unscathed, but some will come out of this better than others.

So with that backdrop, one in which a weak economy is being flooded with unprecedented stimulus, the S&P500 rebounded sharply in April. The S&P500 increased 12.8% in April. The Paper Portfolio continued to eke out slightly better performance at +16.5%.

Most of the moves made sense – SE, SHOP, and MELI are clear beneficiaries since they are levered to games and ecommerce. Both of these are very likely to benefit from this environment.

Other businesses like SQ, UBER, Adyen, FB, and PINS face more uncertainty due to exposure to small-medium enterprises as well as local services, but even then it’s not hard to imagine how this environment would make their businesses stronger in the long run. While restaurants are suffering now, this situation likely has forced many more restaurants to join SQ’s and UBER’s platforms, for example.

The only two stocks that lagged a bit are HUYA and WORK. While WORK is benefiting from work-from-home policies, WORK is also facing a PR battle vs Microsoft. Microsoft Teams is a fairly different product but has gained significant traction due to Microsoft’s significant footprint in most enterprises.

Given the strong move in the market and the strong (out)performance of the Paper Portfolio, Capital Flywheels thinks it makes sense to take some money back. Since the mix of businesses in the Paper Portfolio is substantially better than the mix in S&P500, the Paper Portfolio will likely outperform the S&P500 over the long term even with a meaningful allocation to cash.

While COVID19 remains an uncertain situation, Capital Flywheels thinks it’s ultimately a manageable situation. What is concerning to Capital Flywheels is the drastically deteriorating relationship between the US and China. The relationship was already weak to begin with due to the ongoing trade war, but COVID19 has brought another dimension. Capital Flywheels thinks there is a meaningful chance that US (or the West as a whole) and China will return to more direct confrontation in the near future. As a result, half of the rebalancing / cash raise in the Paper Portfolio will be done through BABA, TCEHY, HUYA, and SE. The remainder will be done through SHOP given the extraordinary performance of the stock over the last few weeks.

Disclosures: I own shares in SE, SHOP, SQ, UBER, BABA, MTCH, FB, AYX, and TEAM. I may transact in shares mentioned above in the next 48 hours.