Truth be told – I did not realize January was about to end until the parking lot admin showed up yesterday with my February parking pass. I am usually quite good at keeping track of time…which made the situation all the more surprising.
But there is nothing like a continued firehose of news flow to make time compress.
In hindsight, a lot did happen…chaos in the U.S. Capitol, ensuing Congressional drama + inauguration, spread of new COVID-19 variants, and, of course, GameStop and WallStreetBets.
2021 so far seems no less unpredictable than 2020…
The good thing is that the Paper Portfolio held up decently well vs the index despite elevated market volatility. The Paper Portfolio returned 1.67% vs the S&P500’s -1.00%. This brings cumulative returns since inception in July 2019 to 131.6% vs the S&P500’s 28.1%.
The Paper Portfolio is certainly not doing anything as spectacular as GameStop (which has returned more than the Paper Portfolio ever has in just 5 days) or a number of recent high flyers. But that’s okay because the Paper Portfolio is not intended to be a high-velocity trading vehicle, and Capital Flywheels would much prefer to be able to deliver and retain returns over a long period of time. I am quite happy with the continued fairly consistent outperformance vs the index despite a rapidly changing environment.
There are and will continue to be a lot of takes about what is going on, especially as retail investors become the marginal investor in the market. The marginal investor always determines prevailing prices. It used to be large hedge funds that can deploy a lot of money. Now, it’s the WallStreetBets swarm.
The changing structure of the market has already been having a major impact on the investing landscape. Since mid-2019, passive funds and ETFs have already become a majority of the US stock market. And now, as retail investors increasingly become active (and have growing pools of capital to invest with), it further diminishes the power of professional active investors.
Many active professional investors are likely not happy with this. This is natural and should be expected since they have the most to lose. But what doesn’t make sense is ignoring it.
Investing well always begins with observing well.
For example, Capital Flywheels realized a few years ago that the shifting world we live in is going to make it increasingly rational to invest in the largest companies instead of the smallest ones, even while people were questioning whether any company is worth $1 trillion (now we have Apple that is worth more than $2 trillion and a few others that are worth $1-2 trillion):
While considering this problem more deeply, I’ve come to the conclusion that we are likely just at the beginning of a multi-decade transition in the global economy that will further concentrate commercial and financial power at the very top. There will undoubtedly be pockets of small cap outperformers, but many of the factors that helped smaller peers outperform larger peers over the long term seem to be eroding. In fact, large companies historically faced negative feedback loops that would act as mean-reversion forces, but many of those negative feedback loops are no longer as effective.
Source: Betting on Big
One of the themes that I should have emphasized more are the capital advantages stemming from the rise of passive investing. I argued back then that the largest companies now have an incredibly powerful capital advantage because the cost of capital is now lower than the cost of labor, and many of the largest companies are labor-lite. I should have further emphasized that the largest companies have preferential access to capital because passive investing by definition channels money into the largest companies since all of the indices are market-cap weighted.
(And for value investors, in particular, the longer they take to realize this, the more painful it will be…value investing works…but small cap investing and low quality investing increasingly does not. Unfortunately, what passes for value investing these days is actually mostly about buying small-ish, challenged companies. Objectively, FANG (Facebook, Apple, Netflix, Google) is value. And FANG also happens to be high quality, too).
For decades, small companies outperformed the largest ones, but the world has changed. And recognizing that is important.
Similarly, the market is changing, and to make money, we need to recognize it.
On social media, I have noticed that there is a lot of schadenfreude. Many “real” investors that historically focus on fundamentals cannot imagine how the current market is sustainable. While I agree fundamentals matter, investors should also be objective and recognize that fundamentals are not the only things that matter…and fundamental investing is not the only way to invest. Technicals also matter. I do not mean being a “chart shaman” necessarily makes sense, but money flows and psychology matters. And retail investors have a very different pattern when it comes to money flows and psychology.
And this needs to be recognized. Ignoring it is not an option. Unless retail investors get themselves into dicey situations where they lose their money (either through over-levered positions that go the wrong way or in companies with weak balance sheets), the current state of affairs can be highly persistent.
Have valuations gone up across the board? Yes. Is it a problem? Not necessarily…because valuations only have meaning when you take into account the opportunity cost of capital (e.g. What else can I do with this capital?). Retail investors are the marginal investors now…and they have much lower opportunity costs than professionals. They do not have access to venture capital, hedge funds, or other exotic alternatives. Is it so crazy for retail investors to pay up for (mostly high quality) stocks when they have limited investing alternatives in a world where capital is currently very loose? No matter how you feel about it, it makes sense to at least to try to understand it. And I think it’s not as crazy as it seems given the cards we are dealt.
Even GameStop is not that crazy. It’s not crazy because there are technical reasons why it is doing what it is doing. And the balance sheet isn’t bad, which is the only ultimate reality forcing function that exists in the market. Other than a weak balance sheet, what a company is worth is always an opinion determined by supply and demand for the stock. Always. If Capital Flywheels were running a short-term trading book, going long actually does make sense (assuming the regulators and financial system doesn’t do anything crazy to trap retail investors in the coming days).
Don’t take my words on GameStop as advice…do what you will, but, as always, it makes sense to be diversified and avoid excessive leverage.
My only point is that it’s not crazy…because the marginal investor is now retail, not professional. The opportunity cost for the market has changed.
Anyway…returning back to the Paper Portfolio.
Overall, the Paper Portfolio did fine.
On the winners’ side – SE, SDGR, MELI, FSLY, TAL, and BABA all did well, returning more than 5% in the month.
SE and MELI likely benefitted from the continued whiplash around COVID-19. SE likely also benefited from the positive news flow around fintech.
FSLY very likely benefitted from short-covering as WallStreetBets has scared the daylights out of short sellers. Since Fastly has pretty high short interest, short covering has helped push the stock up.
TAL rebounded as China quarantined a few cities. Theoretically this is bad for TAL’s offline tutoring business, but they do have an online tutoring segment that is likely benefiting as investors thematically shift their portfolios toward “digital winners”.
BABA also rebounded as investors gathered their wits about China’s crackdown on the company. Nothing much has actually changed, but investors are less fearful for the potential of a very draconian outcome.
On the losers’ side – PLAN, MTCH, ADYYF, FB, and BA all lost more than 5% each. Part of this is just due to market volatility, but there are also some company-specific items as well.
PLAN has decent hedge fund exposure. This likely meant that PLAN came under pressure as hedge funds dealt with the WallStreetBets assault on hedge funds. As discussed recently, if hedge funds are forced to reduce their short positions, they also likely need to sell some long positions since the short positions are often used to fund long positions.
MTCH likely also faced some extra pressure as a result of Bumble’s IPO filing. Currently, MTCH is the only investable vehicle in the dating theme. Bumble’s upcoming IPO would create more alternatives for investors in the dating industry.
ADYYF is likely facing a bit of pressure as Europe’s COVID-19 situation turns down.
FB reported fantastic results a few days ago, but, as discussed above, fundamentals don’t always drive the story…FB has a lot of noise around it right now including regulations and increasingly sharp rhetoric against Apple on the privacy arena.
BA continues to make progress on bringing their commercial planes back, but the travel industry is nowhere near an inflection point, yet. For now, it remains very much tied to COVID-19 progress.
Turning to the monthly rebalancing…
With a lot of the geopolitical overhangs out of the way, market volatility is opening a window to do some deeper surgery on the portfolio.
The Paper Portfolio will completely sell NOW, ATVI, BA, TAL, and BABA, and add AFTPY (Afterpay), MRNA (Moderna), TWLO (Twilio), and Bitcoin.
NOW has done very well since we purchased as part of the Feb 2020 Update (~+60%). It’s a fantastic business, but I think we can get an upgrade via the new names added to the portfolio. Before I discuss those, it is good to keep in mind that sometimes when I do swaps, it hasn’t always turned out to be the right decision. For example, we swapped from ASML into NVDA in March 2020. That looked like a great decision initially, but in recent months, it’s become a lot harder to tell.
NVDA outperformed ASML and S&P500 very quickly out of the gate, but in recent months, ASML has caught up and somewhat surpassed the total return we’ve achieved in NVDA since we did the swap. However, I continue to believe NVDA is a much better long-term bet than ASML since NVDA has the potential to grow and compound faster than ASML.
ATVI benefitted and continues to benefit from gaming interest, but there may be some headwinds coming up as COVID-19 situation normalizes in 2021. The stock has approximately doubled since we bought the position. Given the headwinds in the coming months, I think we can do better by rotating it into other attractive companies.
BA continues to be an interesting normalization play. I am sort of ambivalent about selling this one, but travel is going to take a while to recover. I think we may have another shot at this later this year.
The Paper Portfolio will be selling BABA and TAL. Both of them have recovered a bit. China has done an extremely good job in terms of handling COVID-19 overall. Even if the official numbers are under-reported by an order of magnitude, that would still put them among the best in terms of handling the pandemic. However, because they have done so well, the government has been quite conservative when it comes to stimulus and is already beginning to consider (responsibly) tightening monetary policy. When they do this, it will be a headwind for Chinese stocks. This is another example where “fundamentals” do not mean everything. Macroeconomic and policy factors often play roles that affect stocks as much as fundamentals. It’s all part of the game. As much as I would like to keep these two positions, I think it will be an upgrade if we make the swaps into the new positions.
The Paper Portfolio will buy:
1/ Afterpay – Afterpay is a leading fintech player focused on “buy now, pay later” (BNPL) products. It is primarily an Australian business but has since expanded in to other geographies including the US. From what I can tell, Afterpay is doing very well in the US. While I have some concerns about the long-term viability of standalone BNPL products, the good thing is the financial pie is very, very big and BNPL players are not standing still. They are all trying to evolve their model that will converge them with the rest of the fintech landscape. And if successful, a lot of the long-term concerns I have about the current models will become less important. And if successful, the new capabilities they gain by converging with the rest of fintech will also be very, very valuable and additive to the value of the business.
2/ Moderna – I’m certainly not early to this story (especially since it is up quite a bit in the past month), and everyone has heard of Moderna, at least from a vaccine perspective. Had I not been concerned about the transfer of power in January, I would have added Moderna to the Paper Portfolio at the end of December. However, it’s probably better to be late than never. What makes Moderna interesting is not the COVID-19 vaccine. What makes Moderna interesting is that they have created a novel way to combat diseases. Vaccines are highly effective ways of combating disease but despite 200 years of efforts, there are only just a handful of vaccines that are available because developing them is often very challenging. Moderna is effectively a platform that makes it quite easy to develop new vaccines. This will likely become very valuable in the future, beyond even COVID-19. We can pay just 20x earnings for the COVID-19 business, and essentially get free options on any other diseases they tackle in the future. The one tricky part is that Moderna is not the only company working on MRNA vaccines. There are valid questions on whether Moderna has the best platform. But if COVID-19 vaccine efficacy is an indicator, Moderna is head-and-shoulder above all.
3/ Twilio – Twilio is part of an emerging wave of API-focused companies. Instead of building a consumer-facing business or an enterprise service business, API-focused companies largely focus on creating digital infrastructure and plumbing that other companies can run on top of. Packy McCormick over at the Not Boring substack has written a wonderful essay on APIs and is well worth reading. Twilio is the leading player in communications APIs and powers most of the messages, phone calls, notifications, and emails that companies use to interact with consumers. As the world becomes more digitized, this capability will become ever more valuable.
4/ Bitcoin – Bitcoin is becoming more institutionalized and is finally getting traction in being folded into the existing financial system (for example, Square and PayPal now can act as conduits between Bitcoin and consumer day-to-day purchases at the counter). And more institutional investors are interested in holding Bitcoin as an alternative asset. I am no Bitcoin maximalist, though. I don’t think this is a forever asset, but I think it can be useful with the current confluence of institutionalization and as a hedge against what is going on with retail in the stock market. If retail investors are restricted from trading stocks, that pressure will likely flow back into cryptocurrencies. There’s a pretty tight correlation over the last few weeks between Bitcoin volatility and retail interest shifting into GameStop and other WallStreetBets favorites.
Let’s see what February brings.
Disclosures: I own shares in SE, PINS, SQ, NET, SDGR, UBER, PLAN, MTCH, SHOP, FB, and AYX. I have no intention to trade any names mentioned in the next 48 hours.
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