Similar to July, August was another choppy month. Although the Paper Portfolio did close the month well, it did so with materially more volatility than the index.
The underlying reasons for the volatility remain the same as in the prior month. The Paper Portfolio is exposed largely to secular growth stories, many of which benefited from COVID-19 disruption to offline businesses. As the US / world evaluates the potential and pace of reopening, it will have an impact on the valuations of the companies in the Paper Portfolio.
This is a risk that we need to monitor because it will come sooner or later and will likely lead to near-term underperformance when it happens. August looked increasingly likely to be the month in which we would feel this impact only to suddenly reverse towards the back half of the month.
For August, the Paper Portfolio continued to deliver good returns at +8.57% vs the S&P500 at +6.98%. Year-to-date, the Paper Portfolio has returned 72.63% vs the S&P500 at +9.68%.
The Paper Portfolio’s top holdings continue to perform exceptionally well with SE, SQ, NVDA, and AAPL all delivering >20% gains in the month. While some of these gains are well deserve such as those for SE, SQ, and NVDA, Capital Flywheels is increasingly concerned by what appears to be excess building in the market. For example, while AAPL is certainly a fantastic business in Capital Flywheels’ opinion, a significant portion of the move was likely catalyzed by Apple’s announced stock split. Stock splits do not change the underlying fundamentals of the business and hence should not materially change the market’s valuation for the stock (though a small, few percent gain is possible due to improved stock liquidity). But it has. And very materially. Tesla has similarly seen >50% gains since announcing a stock split.
Elsewhere there are signs of excess building, too. Including many IPOs that pop more than 100% on initial trade. This would not ring alarm bells if we are in an environment of depressed valuations, but we are not.
However, it is impossible to know if there is too much excess…hence the Paper Portfolio will continue to remain invested but will continue to take a cautious stance by trimming and maintaining a cash cushion.
Increasingly, investor views are becoming bipolar. On one end, the cautious are starting to compare 2020 to 1999. While there are signs of excess, the market as a whole is nowhere near as egregious as it was in 1999 because the index is dominated by FANGMAN (Facebook, Apple, Netflix, Google, Microsoft, Amazon, Nvidia), and FANGMAN is gushing profits like no other cohort in the history of business. On the other end, the bulls are starting to forget that valuations eventually matter. Many SaaS businesses are incredible businesses, but likely at least a few of them will unlikely be able to justify their valuations for a very long time. Maybe some SaaS businesses are worth 30x+ revenues, but increasingly 30x appears more likely to be a starting point. And then we have Tesla, which is not SaaS at all yet has somehow achieved a multiple of 20x revenues. The excesses in the market are not related to perceptions of businesses but rather suspension of valuation anchors. While this happens every now and then, history has so far consistently recorded that such excess cannot go on forever.
Is it 1999? Who knows. Or is it 1997? Who knows.
The most sensible course of action continues to be invested in high quality businesses with business models and balance sheets that can not only survive any washout that may occur, but to be invested in high quality businesses with business models and balance sheet that can take advantage of any washout that may occur. I think that’s what we have in the Paper Portfolio. That, and a decent cash cushion.
Despite the good performance of the Paper Portfolio year-to-date, Twitter has managed to create some FOMO in Capital Flywheels. Many investors have trumpeted portfolios that have done 100%, 150%, 200%, and even one as much as 273% year-to-date! In some ways, Capital Flywheels wished he was good enough to have accomplished the same. But now having missed such comparatively high gains, it makes no sense to pursue risk in order to make up the difference. All large fortunes are built over time. As long as we remain consistent, we are compounding at rates far higher than necessary to create a very comfortable future.
Rounding out the discussion on performance – On the losing side, only two callouts are necessary. Cloudflare declined by 8.07% while Alteryx declined by 31%. Cloudflare reported strong results but were already largely anticipated by investors. In addition, there may be some fear that Cloudflare will see headwinds as the US / world reopens. As a reminder, Cloudflare is a serverless cloud platform. Capital Flywheels continues to believe that Cloudflare is building towards an incredible vision of serverless computing that will be worth multiples more if successful. Alteryx declined significantly after missing earnings. The company faced headwinds from COVID-19 as enterprise customers temporarily delayed product adoption. While Alteryx is levered to “digital transformation” by providing data analytic tools that anyone can use (not just data scientists), these tools are offered on-premise rather than as a cloud service. Many enterprises currently have workers working from home, which materially impacts product adoption. This seems temporary to Capital Flywheels and hence worth protecting.
Disclosures: I own shares in SE, PINS, SQ, UBER, SHOP, NET, AYX, FB, MTCH, PLAN, and TEAM. I have no intentions to transact in any shares mentioned in the next 48 hours.