Paper Portfolio – April 2021 Update

March was a challenging month! The first truly challenging and divergent month for the Paper Portfolio in a while.

While I have been anticipating a period of underperformance since at least August of last year given the strength of the Paper Portfolio over the past 12-16 months (I just didn’t know when), the timing did end up being a little surprising. Having somewhat successfully navigated the choppiness of most of 2nd half 2020, I thought we would experience some calm until after the sugar-high of stimulus checks and the (just-revealed) infrastructure bill wears off.

But life is unpredictable.

And, instead, March turned out to be a very choppy and challenging month.

However, the markets were not uniformly challenging. The S&P500 index was actually up quite a bit on the month. Value and reopening plays all saw meaningful strength, whereas COVID-19 beneficiaries and high-tech names all saw significant pressure.

Unfortunately, the Paper Portfolio has relatively low exposure to the stuff that worked and may continue to work in the near-term.

What did that look like in numbers?

Quite badly: The S&P500 was up 4.54%, while the Paper Portfolio declined a very significant 8.65%. Year-to-date, the S&P500 is up 6.35% while the Paper Portfolio has declined 3.45%.

The delta is quite large…but that is simply the price we must pay sometimes for holding the assets we do. And in the grand scheme of things, Capital Flywheels thinks this trade-off remains a fine one given the significantly higher returns we have generated cumulatively from owning high-quality, secular growing assets even if they have become quite expensive overall. Since the inception of the Paper Portfolio, the Paper Portfolio has returned 119.9% (or 137.9% if we exclude the large cash drag early on due to the 6 month phase-in period of the portfolio) vs 37.5% for the S&P500 in just slightly under 2 years.

But a lot of that was luck.

While I believe strong, secular growing assets can and should outperform the overall market over long periods of time, the delta in performance is unlikely to be as large as what we have experienced in the last 2 years.

Because a lot of what happened in the last 2 years is unlikely to repeat. A lot of it was luck…the luck to live through COVID-19, a once-in-a-century period of forced change, from offline to online, while owning the primary beneficiaries of such change.

It is luck that gave us a lot of that outperformance, so I can’t complain if we have to give some back.

The good thing is that while a lot of things have gone up and become quite expensive and may be poised to give back some of the gains, Capital Flywheels has taken significant care in avoiding companies that have challenged balance sheets or non-secular drivers.

You may have heard investors and the media discuss the significant number of high-flying tech stocks that are losing significant sums of money. They exist. For example, Sea and Uber are losing money and have never generated profits ever in their history. While we own some of them, the Paper Portfolio mostly avoids money-losing companies. And in the few instances where we do own companies that are not profitable, the balance sheets are strong enough to support the losses and investments for years.

This is important because Reality is not always kind. And this is especially important to keep in mind when we walk amongst a lot of investors that are dreaming the dream. When investors dream, you have to eventually wake up. It’s nice to wake up because the dream you dream has become reality, but sometimes bankruptcies force you awake. Those are never fun. But with a strong enough balance sheet, the possibility of ever having to wake up to such a problem declines meaningfully.

In addition, many COVID-19 beneficiaries are currently seeing declining interest as investors rotate into reopening plays. In many ways, this makes sense. COVID-19 beneficiaries will see less benefit as COVID-19 disappears. But it is important to recognize that not all COVID-19 beneficiaries are the same. Some beneficiaries are not particularly strong secular growers (if at all), while some truly are. For example, Capital Flywheels does not own Clorox (which was up quite a remarkable ~55% in 1st half of 2020 during the depths of the pandemic, when the rest of the market was down 30-40%). While almost all names in the Paper Portfolio are COVID-19 beneficiaries, they are first-and-foremost secular beneficiaries of time and of technological progress, with or without COVID-19. COVID-19 accelerated these businesses, but to assume that a reopening economy will lead to a reversal of business fortune would be a mistake.

Still, the valuations for a lot of these names have risen quite a bit more than the businesses have improved. We will give some of those gains back. But if the market reverses too much, sooner or later, a lot of these names will start to look quite attractive.

As long as we are right about where the world is heading long-term, the longer our stocks are suppressed, the tighter the coiled spring.

Moving on to the Portfolio itself, there were very few bright spots.

Only 3 holdings were up on the month: Uber (+5.33%), Apple (+0.73%), and GBTC (+15.83%).

Uber likely benefited from optimism around reopening and vaccination progress. Both Uber and Lyft have spoken recently about strengthening trends in ride-hailing, while food delivery continues to hold up. Apple was approximately flat…not much to add here. Bitcoin had a volatile but overall strong month as investors reacted positively to various companies announcing acceptance of Bitcoin / cryptocurrencies for purchases, such as Tesla. Some of the NFT euphoria likely also rubbed off on Bitcoin even though NFTs are more relevant for Ethereum, instead.

There were a lot of losers. Basically everything else was a loser (and mostly in a big way). The good thing is that the vast majority of these moves were not due to deterioration in the underlying businesses. Most of them are down simply as a function of the market repricing what they think is an appropriate price for the same business.

The few names that did see some negative fundamental news flow were:

1/ Schrodinger – SDGR declined 25.6%, largely due to underwhelming guidance when they reported earnings at the beginning of the month. In addition, the company had to do an about-face and further lowered 1Q guidance by the end of the month due to contract timing issues. While this does not inspire much near-term confidence, I continue to believe SDGR’s long-term potential is significantly mis-priced. SDGR is a hybrid software + pharma company. The pharma investors are likely undervaluing the software business, while software analysts do not know how to value the emerging pharma pipeline.

2/ Okta – OKTA declined 15.7% after reporting solid results while simultaneously announcing an acquisition of Auth0. While Auth0 is likely a very good acquisition for the company, some investors have balked at the high price paid for the company. While the price is high, OKTA is acquiring it with it’s own high-priced stock. So net / net, the acquisition does not look particularly problematic to me (and looks quite good for the long-run).

Besides that, most of the other moves were largely just a function of market back-drop. Capital Flywheels is inclined to lean into the weakness a bit.

No new names, but some adjustments at the margin.

Let’s see what April brings.