Paper Portfolio – August 2020 Update

Like June, July was a fairly volatile month with investors trying to decide which way to go. The Fed’s continued loose monetary policy supports value reflation trades, but economic growth remains weak with elevated unemployment. Weak economic growth tends to support secular growth stocks (more certainty) and companies with strong balance sheets (more defensive / survivability). Given the Paper Portfolio’s strong preference for the latter, the Paper Portfolio experienced a fairly volatile month with periods of significant outperformance punctuated with periods of significant underperformance.

Here’s what the relative performance looked like on a daily basis during July:

A few days ago, it looked like the Paper Portfolio was going to underperform for the first time this year, but the strong earnings of a number of stocks in the portfolio over the last 3 days helped push the Paper Portfolio back above the index.

For July, the Paper Portfolio returned 10.25% vs the S&P500’s 5.62%. Year-to-date, the Paper Portfolio has returned 59.00% vs the S&P500’s 2.33%.

What the world has gone through this year is nothing short of extraordinary. Not only is the world facing a once-in-a-century type pandemic, we are also in the midst of a decoupling of the world’s two largest economies. It is incredible that the S&P500 is already back in positive territory. It is even more incredible that the Paper Portfolio has performed this well…while we certainly have to profusely thank the Fed, the truth is the pandemic has accelerated years of tech and innovation adoption and therefore has pushed the earnings power of many of our holdings far higher and faster than we could have anticipated.

We will get past COVID-19 eventually. And when that happens, there will be some mean reversion. Some or many of our stocks will eventually lag. But the cumulative performance is likely to remain far above the index because COVID-19 has ensured that our future is a much more technological one than otherwise.

For example, e-commerce is likely to become much closer to the default channel of purchases for many more people than before. Shopify reported earnings earlier this week and saw an enormous 119% GMV growth for Q2 (and is now likely around half to 60% the size of Amazon’s GMV in the US). And on the digital payments side, PayPal has seen the largest growth in users the company has ever seen in its history.

These are likely not unique only to Shopify or PayPal. The upcoming results of e-commerce players like Sea and Mercadolibre and digital payment players like Square and Adyen are likely to tell the same story.

In terms of performance, the strongest performer was Pinterest at +55%. Expectations were low following COVID-19 since Pinterest’s foray into advertising and e-commerce are nascent. Investors were concerned about the defensibility of the business since Pinterest is unlikely to be the #1-3 advertising or e-commerce channel for partners and merchants. Pinterest reported results yesterday that completely blew away expectations. Not only was advertising more sustainable than expected (ad growth actually outperformed Google, surprisingly), the company is making very strong progress in e-commerce, and user engagement trends accelerated. Capital Flywheels continues to believe that Pinterest’s positioning is unique and under-appreciated.

Digital payment players, Square and Adyen were also standouts with 24% and 16% returns, respectively. While neither have reported, yet, peer results suggest both will deliver strong results as well.

Apple also came in very strong at +17% after reporting incredibly strong earnings. Apple has reclaimed the title of the world’s largest market cap from Saudi Aramco and is now ~10% away from $2 trillion market cap. Not only did Apple deliver growth across all of their geographies, Apple’s user base continues to expand far beyond what many investors likely thought possible (and think possible even now…). Despite an iOS user base that is now approaching 1.5 billion (maybe 1.2 billion for iPhone only), a double-digit portion of buyers are still new to the platform. Apple will likely, one day, reach 2 billion users with significant potential to increase wallet share. $1000 for an iPhone every 2 year sounds expensive, but it only comes out to ~$1.5 a day. $1.5 a day for an iPhone is an incredible value. And many buyers are actually holding on to their phone for 3-4 years now which means cost of iPhone access is <$1 a day. Apple is currently transforming its business into a subscription model…despite nearing $2 trillion market cap, the long-term potential of 2 billion users on a subscription model of $1 a day ($2 billion of daily revenues) means Apple can be worth much more.

On the losing side, ZoomInfo and Boeing were the two laggards. ZoomInfo is a new IPO. The weakness is likely a reflection of early IPO-holders that are now locking in gains. Boeing is one of the few value-reflation holdings in the portfolio. While Boeing performed very well last month, the continued uncertainty around economic reopening is dampening Boeing’s prospects. However, as stated when added to the Paper Portfolio, Boeing looks attractive on a multi-year basis given that travel remains a long-term growth industry, and Boeing is a meaningful supplier to the US military. While Capital Flywheels is not expecting US and China to engage in direct military confrontation, an investment in US military supplier makes sense as a hedge against such a potential. Despite the balance sheet pressure Boeing is facing from plane cancelations on the commercial side, the US government is unlikely to let Boeing go under due to its importance to military supplies.

Other than Boeing, the other major reopening trade in the portfolio is Uber. Capital Flywheels is far less optimistic about the pace of reopening than a couple of months ago mainly because it is still shocking to think about how poorly the US has handled the crisis, but Uber remains a fairly attractive long-term investment.

No names will be added or subtracted to the portfolio for the August rebalancing. There will be a minor reduction in weights in order to bring cash up a bit. Upcoming elections and the tapering off of stimulus despite weak economic backdrop may increase the potential for volatility.

In addition to the above, this month actually marks a huge milestone. While Capital Flywheels has been around for almost 4 years now, the Paper Portfolio was launched exactly 1 year ago. Early performance during the summer of 2019 was not particularly strong because WeWork collapsed and US / China uncertainty caused many high-multiple stocks to underperform. This is despite the Paper Portfolio’s specific preference for only secular growth stories (not just any growth story…) and only those with strong balance sheets (e.g. WeWork would never make it into this portfolio…). However, the weakness allowed us to continue to accumulate stocks in very attractive enterprises. The attractiveness of these enterprises eventually revealed itself in Q4 2019 and throughout 2020.

In addition, the temporary sell-off in March 2020 due to COVID-19 allowed us to increase exposure with confidence because the companies in the Paper Portfolio have incredible businesses that would accelerate, have incredible balance sheets that would allow them to survive, and have incredible cash positions that would allow them to acquire and strengthen their competitive positions in a downturn. Almost all of the companies in the Paper Portfolio are masters of their own destinies and are likely destined to be far larger in the next 5-10 years.

In terms of contribution to performance, the pool of winners was quite broad. Sea and Shopify were the two best performers with >200% returns over the past year. Both of these were also weighted within the top 5. The one clear mistake was underweighting Cloudflare. Cloudflare returned 120% despite being added only this year and with only average weight of 2.15% during the period.

On the losing side, not too many! Let’s hope it stays that way for the coming months and years.

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