Paper Portfolio – January 2021 Update

Happy New Year – May we live in less interesting times in 2021!

What a year.

Although 2020 could have been a lot better in many ways, especially when it comes to offline social interactions, capital markets were definitely much better than anticipated.

Not only did the deepest and sharpest recession in 100 years not lead to extended stock market weakness, we are now at all-time-highs significantly above where we started before the pandemic.

Not just for stocks, but also for bonds, real estate, venture capital, and cryptocurrencies.

While it makes no sense to complain about the positive outcome, we should view the situation realistically for what it is: Unusual and unlikely to sustain / repeat…mixed in with a lot of luck.

This isn’t to say that the market will fall. It may or may not. The market is very likely to be higher in the long run as it has proven to be the case for centuries (since what matters over the long run is value creation, and humanity has consistently figured out ways to create value over time).

But the extraordinary gains in certain parts of the market, especially in technology, have exceeded near-term value creation. Many tech stocks have seen their growth accelerate, for example, from 20-30% to 50%, but at the same time their stock prices have gone up 100-400%.

And if it continues to repeat over and over, asset prices will continue to disconnect from actual underlying value creation, even if value creation is accelerating.

There will need to be a period of digestion where stocks go up slower than the underlying value creation…this is necessary in order for value creation to catch up.

This could happen in 2021. Or in 2022. Or in 2023. But it will need to happen. If it doesn’t, the gap between valuations and value creation will continue to widen. And the wider the gap, the more painful it will eventually become.

Regardless, it’s never a good idea to time the market. So Capital Flywheels has no intention to do that or recommend that. But it also does not make sense to be blind to the reality of the situation. The best we can do is keep our eyes very wide open and react as necessary.

Turning to the portfolio, the Paper Portfolio returned 4.15% in December, slightly above the S&P500 at 3.95%. Given how much the Paper Portfolio has outperformed during the year along with the recent rotation from lockdown / tech stocks into reopening stocks, the Paper Portfolio is holding up decently well despite significant exposure to lockdown / tech stocks.

This brings 2020 full year returns to 111.51% vs 18.35% for the S&P500.

As a reminder, the Paper Portfolio started out the year with almost 28% allocation to cash. Since the Paper Portfolio only launched in July 2019, it was not fully invested until end of February 2020 (which was unfortunately bad timing since the Paper Portfolio became fully invested right as we headed into the full sell-off in March). Excluding the impact of cash, the Paper Portfolio returned 123.81% in 2020 vs 18.35% for the S&P500.

December saw meaningful divergence. We had a number of strong performers as well as a number of weak performers.

On the winning side:

1/ Zillow and Schrodinger – Both of these names were added just last month but were 2 of the 4 best performing stocks in the portfolio. Zillow returned 20.40%, and Schrodinger returned 13.80%.

Zillow’s vision for the real estate industry continues to gain momentum as they build towards an end-to-end platform covering all aspects of real estate transactions.

Schrodinger announced a transformative partnership in late November with Bristol Myers Squibb, one of the world’s largest pharmaceutical companies. Not only did this partnership validate the importance and value of Schrodinger’s software, it suggests material upside potential for long-term revenues and cash flows. The deal terms include almost $3 billion of revenue potential, which is very significant relative to Schrodinger’s ~$5-6 billion market cap. And this is only from 1 client out of a very long list of potential clients.

2/ Activision returned 16.82%. Activision benefited from strong recent game launches (Call of Duty, World of Warcraft) as well as growing interest in upcoming franchise updates (e.g. Diablo 4 and Diablo Immortal). Activision likely also benefited from CD Projeckt’s issues with Cyberpunk 2077. CD Projeckt is the game studio behind the extremely popular The Witcher game (which you may have seen as a TV series on Netflix). Cyberpunk 2077 is the latest franchise from the studio, but has been surprisingly poorly received due to the massive number of bugs / issues…it was supposed to be the hottest game this holiday season. Their issues are likely helping competitors like Activision a bit.

3/ Adyen returned 19.36%. As one of the new-age, digital-first merchant acquirers, Adyen is much more exposed to e-commerce than peers. Europe is currently in a renewed lockdown due to 2nd wave of infections (on top of the new strain discovered in the UK)…this likely helped push Adyen stock up as investors rushed to safety (in the form of anything e-commerce exposed).

4/ Outside of that, our usual strong horses delivered a good showing, including SE, MELI, AAPL, MTCH, and PYPL.

On the losing side:

1/ Pinterest declined 5.88%. This was a bit disappointing, but Pinterest has had a strong run.

2/ ZoomInfo declined 5.89%. Since ZI only went public a few months ago, it is hard to say how well investors understand this stock. It is also hard to say who holds it, and whether they are long-term investors or not. ZI is building a very unique sales / CRM relationship data platform. Capital Flywheels continues to believe there is significant long-term potential here.

3/ Alibaba declined 11.63%. BABA’s situation continues to get worse. After Ant Financial’s IPO was called off in early November, the government followed up with new antimonopoly regulations targeting the industry. Shortly after revealing these regulations, the government announced that it is investigating Alibaba for antimonopolistic practices. There isn’t much visibility here. It seems counterproductive for the government to push too hard given Alibaba’s importance to consumption and economic growth, but it is hard to know what trade-offs are being made. In any case, BABA is a fairly small position now (vs 4%+ in 2019) since Capital Flywheels was already concerned about regulatory pressures months ago.

As we begin 2021, Capital Flywheels thinks it is important to keep our eyes wide open. What we are going through is not normal. While I will not complain about how much we have benefited, the point of investing is not just to make money, but to keep it.

For the January rebalancing, there are no new names, but some of the weights will be adjusted. A few names that are benefiting from company-specific momentum (like Schrodinger and Apple) will have their weight increased slightly. Most other names will see a slight reduction. Overall, the portfolio will shift slightly more to cash. This seems prudent until Biden is confirmed in office (and Georgia Senate run-off elections are decided).

Appendix

If you are curious, here is the attribution / performance for full year 2020 at the individual stock level.

Avg % Wgt = Average weight of the holding during the holding period (which may be shorter than 12 months if the holding was sold during the year). Includes the impact and effect of weight increases and reductions.

CTR = Contribution to return (Avg % Wgt * Total Return during holding period).

Tot Rtn = Total return during the holding period. Only shows stock return for when it was in the portfolio. For example, for a stock held in the portfolio for March through July, it will only show total return for the stock between March and July.

It’s clear that certain holdings were not weighted correctly. For example, Cloudflare was the 2nd highest performing holding in 2020, returning 395%. Yet, its average weight was only 4.05% during the year, less than other lower performing names like Uber (average weight of 4.74%, total return of 71.5%) and Shopify (average weight of 4.56%, total return of 185%).

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Here is the attribution / performance since inception (July 31, 2019).

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