Paper Portfolio – December 2020 Update

Entering the month, the Paper Portfolio maintained a defensive posture given election uncertainties.

We began to take this defensive posture starting late in the summer, which allowed us to escape the volatility of August, September, and October largely intact.

When we chose to further maintain our defensive positioning during the last update, Capital Flywheels argued that this could cost us in terms of performance but it would likely be the smart thing to do, especially since we have already outperformed significantly this year. In addition, given our skew towards high quality, secular growers, Capital Flywheels believed that our names would likely outperform the market overall, and as a result could allow our portfolio to at least keep up despite having 14% allocation to cash.

The Paper Portfolio performed better than expected.

During November, the Paper Portfolio returned 16.46% despite 14% allocation to cash. This is against the S&P500’s 10.88% return. This brings YTD returns to 103.08% vs the S&P500’s 14.14%.

The vast majority of our names either kept up or performed materially better than the S&P500.

While the election has been contested, the uncertainty is resolving itself rather quickly with Trump’s options quickly diminishing. This has dramatically improved visibility into policies (political, monetary, fiscal, and geopolitical) for the next four years. Trump and his team continue to drop surprises here and there on the China front, but markets are currently looking through it since Trump’s days in office are quickly coming to an end.

On top of this, recent positive news around COVID-19 vaccines have forced a massive rotation in the stock market towards “reopening” names and value stocks. This is despite the near-term reality of rising cases, hospitalizations, and deaths. But the stock markets are ever forward-looking…what matters is not what is happening now, but what will happen in the future. And our future will likely be saved by vaccines (sometime next year)…making reopening plays and value plays the hot stocks of the moment.

While the Paper Portfolio is short on both of these themes, the names in the Paper Portfolio continue to execute at an exceptional level. And this has helped us weather this rotation.

Square returned 36.2% as earnings showed continued momentum in the Cash App segment as well as surprising strength in the Seller ecosystem despite COVID-19 pressures. Square also continues to execute well on its strategy with recent acquisition of Credit Karma.

Cloudflare returned 44.5% as earnings showed significant acceleration in the business. Cloudflare’s differentiated products are already well recognized by customers, but investors started to realize this as well. Cloudflare’s recent launch of a suite of leading security products helped re-excite investors.

Mercadolibre returned 28.0%. Brazilian media is reporting very strong performance for Mercadolibre during Black Friday…historically, Mercadolibre has been a relative laggard during Black Friday. However, Mercadolibre has been revamping their operations since the beginning of the pandemic and appears to be gathering strength.

The two best performers were Uber and Boeing. Uber and Boeing returned 48.64% and 45.93%, respectively. Neither of these business are actually doing all that well since both have been materially affected by the pandemic…but both of these are reopening plays and hence have benefited from the recent rotation. What makes both of these stocks interesting, however, isn’t that they are reopening plays but that they are great secular growth stories. The pandemic has led to near-term weakness in their operations, but the underlying business remains strong and arguably has improved. So many new consumers experienced Uber Eats for the first time during the pandemic. And Boeing is now a few steps closer to relaunching their troubled 737 Max planes. It may be a while before people travel again, but Capital Flywheels believes the pandemic has made people that much more appreciative of travel. And many people will travel again with zest when it is safe to do so.

On the losing side, the largest decliner was Alibaba at -13.6%. Alibaba continues to be impacted by Chinese regulatory concerns. Alibaba’s long-term business is likely not impaired, but Alibaba is clearly in the penalty column at the moment. China is a place where being in the penalty column does have real business implications. It may be a few months before things clear up.

Alteryx declined 4.4% in the month due to weak earnings. Alteryx remains a fine investment, but the noise has definitely gone up. The business is not cloud subscription based like other software-as-a-service peers. As a result, Alteryx faces unique issues at the moment that many software investors are losing patience for. Capital Flywheels will see how the situation evolves for now.

Given that the election uncertainties are clearing up quickly, the Paper Portfolio will make several major adjustments including redeploying idle cash.

The Paper Portfolio will establish a 4% position in Schrodinger, a 3% position in Fastly, and a 3% position in Zillow. The Paper Portfolio will also completely sell Visa.

Schrodinger is a small but beautiful business with significant long-term potential. Capital Flywheels loves businesses where people cannot truly understand what it is, yet, but likely eventually will. Schrodinger is currently likely viewed as niche asset, but it is a unique software disruptor in the pharma space. Schrodinger provides a software tool that helps pharma companies discover drugs. This tool is a unique combination of physics simulation combined with localized AI modeling that help chemists rotate through potential drug candidates several orders of magnitude faster. Instead of looking at tens or hundreds of potential candidates, this software allows pharma chemists to consider tens of thousands or even millions of molecules. Not only is this tool incredibly useful, Schrodinger has been able to start negotiating royalties from pharma companies on drug candidates discovered using their tool. Not only does this business have the wonderful characteristics of a software company, they may one day have pharma-like upside without having to take on pharma-like risks…pharma companies take the risk in terms of drug development, while Schrodinger can happily skim royalties on top of the molecules that work. Win / Win.

Fastly is a CDN company that is trying to build an edge compute network just like Cloudflare. While Capital Flywheels vastly prefers Cloudflare’s starting point and positioning (Cloudflare is starting from security whereas Fastly is starting from the commoditized CDN space), the potential in edge compute is likely large enough for multiple players at least for now. Fastly sold off recently, which has created an interesting entry point.

Lastly, Zillow likely needs no introduction. Zillow is carrying out an ambitious strategy in the real estate space to completely transform the buying process. This is a high risk, high reward situation…like Uber when it was added to the portfolio a year, Zillow’s outlook is less certain than other names in the portfolio. But if successful, Zillow can create a significant amount of value. And for that, Capital Flywheels is willing to stake a small amount of capital. The pandemic has materially changed how people buy and sell homes…and some of these changes may stick.

Let’s see what December brings.

Disclosures: I own shares in PINS, SE, SQ, NET, MTCH, AYX, FB, PLAN, UBER, SHOP, and SDGR. I have no intention to transact in shares mentioned in the next 48 hours.