The Paper Portfolio’s continued defensive positioning during October turned out to be an appropriate move. The Paper Portfolio returned 1.36% vs -2.65% for the S&P500, despite being skewed towards well-owned names. This brings year-to-date returns to 74.38% vs 2.64% for the S&P500.
The initial shift into a defensive position at the end of August helped us avoid the volatile down-draft of September. Our decision to further shift defensively at the end of September helped us avoid another volatile month as investors try to make sense of a growing number of unpredictable risks. Initially, investors faced uncertainty as Trump contracted COVID-19. Later, investors faced uncertainty from COVID-19 trajectory, which is now back on a reaccelerating path across much of the world except for East Asia. And, of course, the US Presidential election is in three days…investors are now facing uncertainty around the election outcome as well as uncertainty in policy direction for the next 4 years.
While I thought our continued shift into cash / defensive position last month might cost us in terms of performance, that did not end up being the case. If risks did not rise, our defensive positioning would have been a drag, but it still would not have been a mistake. This is important to keep in mind. Risk management is an important aspect of investing. Investors that ignore this may learn the lesson in unkind ways. The trick is to be alert and intentional in assessing risk.
And it goes both ways. Taking a cautious stance when risk has been thoughtfully assessed to be minimal is also a mistake. For example, not taking a large enough position when a carefully analyzed, high-probability opportunity presents itself.
Ultimately, all of this is to say that risk management is not and does not exist in a vacuum. Risk management needs to be dynamic and considered with respect to one’s portfolio and the current state of the world. Too many investors employ risk management tools when it may not be necessary (e.g. being overly diversified all the time, and by virtue of being diversified, spend no time thinking about risk at all…) or employ no risk management at all (e.g. being too concentrated all the time). The world is ever changing and always dynamic…and risk management needs to be the same. The Paper Portfolio was positioned very aggressively in March, and now the external environment has changed in a way where a defensive position makes more sense, in Capital Flywheels’ humble opinion.
For that reason, the Paper Portfolio will remain in a defensive position for the November update. But this is simply to reflect the elevated uncertainty around the election next week as well as potential chaos immediately following the election. There is a chance, depending on how the markets and external environment evolves, that I will make an intra-month update to the Paper Portfolio.
Based on Capital Flywheels’ understanding, there is potential that the world may not know who wins on election night. The world might not know who wins for days or perhaps even weeks. And the reaction of the candidates as well as the candidates’ supporters are also unknown. This may lead to volatile markets. And the Paper Portfolio has been positioned to not only withstand but to also take advantage of such a risk if it materializes. If the risk does not materialized, we should still be okay since most of the stocks held in the Paper Portfolio should react favorably to a risk-on environment. The large cash position will be a drag, but that is a small price to pay, especially since returns have been strong year-to-date.
With respect to the performance of individual names, PINS and NET were standouts with 42.0% and 26.6% return, respectively. PINS reported very strong results with strong user growth as well as monetization acceleration. PINS’ advertising potential continues to strengthen, and the emerging opportunity in e-commerce provides a long-run runway for growth. Investors are starting to notice. NET recently announced new security-related products that significantly enhance NET’s long-term addressable market. Investors reacted favorably to that announcement.
Given the volatility experienced in the month, there were a large number of poor performers. However, almost all of the decliners fell simply as a function of market volatility rather than any underlying issues. The biggest decliners were PLAN (-11.6%), TAL (-12.6%), ZI (-11.6%), and BA (-12.6%). TAL is one of the few that require a callout. TAL reported mixed results with weak guidance. TAL’s online education business continues to drag on profitability, while the offline tutoring business is recovering slower than expected despite China’s rapid control of COVID-19. Investors are surprised and disappointed that TAL’s offline business is recovering slower than peer, New Oriental (EDU).
For the rebalancing, the Paper Portfolio will reduce some weights at the margin, while completely selling WIX and ILMN. Similar to our sale of TEAM last month, there is nothing wrong with these companies. But the added flexibility of cash may come in handy. With these sales, cash will come up to 14%.
Most of the reductions in weight are just mechanical in nature, but UBER specifically will be reduced to reflect elevated risk around Prop 22. As a reminder, Prop 22 will decide whether California drivers will be classified as employees or not. This could materially change the nature of the business in California and creates elevated near-term risk. Prop 22 was placed on the ballot in order to help settle the employment issue created by California Assembly Bill 5 (AB5). Supporters of AB5 want gig workers to be classified as employees in an effort to create more protections and fringe benefits for gig workers. Currently gig workers are considered contractors and hence have limited fringe benefits and protections. Capital Flywheels’ understanding is that the platforms are not against providing additional benefits for gig workers but do not agree that classifying them as employees would be the best way to do it since it will lead to reduced work flexibility that gig workers desire. Prop 22 puts the question to voters. And if successful, it explicitly states that gig workers are not employees but will aim to create a 3rd class of workers with their own set of rules and benefits. This should put them somewhere between employees that have the most benefits and contractors with limited benefits. If Prop 22 fails, then the platforms will be required to classify gig workers as employees, which will dramatically change how gig workers work in exchange for greater benefits. Ultimately, Uber (and Lyft) have the potential to navigate this risk, but it may take time for things to shake out.
Let’s see what November brings.
Disclosures: I own shares in SE, PINS, SQ, NET, UBER, SHOP, AYX, FB, MTCH, and PLAN.