The end of July marks the 2 year anniversary of the Paper Portfolio. During the last two years, the Paper Portfolio has returned 150.42% vs the S&P500’s 52.60%.
While the Paper Portfolio has performed well over the last two years, it has occasionally been defined by periods of excess volatility. This includes the first six months after launch in which many of the high quality stocks in the Paper Portfolio were impacted by fear around WeWork collapse. This was followed by extreme volatility in early 2020 as the world reacted sharply to COVID-19 and global shutdowns before rebounding strongly throughout the rest of 2020.
And so far 2021 has been another period of elevated volatility.
But, the magic of owning high quality companies that are firmly in control of their own destinies is that external challenges generally do not alter the long-term trajectories of these businesses. Many times, external challenges create the conditions for these high quality businesses to accelerate as they rapidly capitalize on the misfortune of competitors. Though not all companies are identical, most of the companies in the Paper Portfolio have created powerful flywheels in their own unique ways. They grow not only because they are good. They grow because their competitors are bad. And they grow because they are well positioned to take advantage of every misstep and every opening that competitors (and the macro environment) give them.
Still, good things can become overvalued in the near-term. Many of the stocks in the Paper Portfolio trade at very high valuations. And when (not if) bad news comes, many of these stocks will very likely react poorly.
2021 has unfortunately been filled with bad news landmines scattered about. Sometimes the bad news is company specific. Sometimes it is not. But bad news is bad news all the same.
Capital Flywheels has no power to change the pace of bad news or the existence of bad news. All Capital Flywheels can do is to, hopefully, correctly analyze the long-term potential of these businesses. And if we do that part right, the returns will very likely take care of themselves. Even in the most highly valued stocks held in the portfolio, most of the companies get much closer to the market average multiple with 2-3 years of compounding assuming the businesses remain intact and indeed are able to compound as we expect. Is 2-3 years a lot? It absolutely is if we suddenly discover that the business is not as strong as we expect, but 2-3 years is an acceptable premium to pay for a business that can remain above average for far, far longer than that. As a thought experiment, if you transport yourself to 2005 and consider what the right premium is for businesses like Apple, Google, Netflix, etc (businesses that, with hindsight, have proven to be above average for more than 15 years post-2005), paying 2-3 years premium seems more than acceptable.
But it all hinges on being right.
And sometimes Capital Flywheels can be very wrong as this month’s results will show below.
Hopefully, over the long run, the mistakes are contained. The beautiful thing about investing in businesses that can create immense value is that a single winner can offset many mistakes. Nonetheless, the goal is still to have many winners and few losers, and not many winners and many losers.
Let’s see what Year 3 brings.
Turning now to the monthly results, July was a bumpy month. The Paper Portfolio returned -1.76% vs the S&P500’s 2.36%. This brings YTD performance to 9.93% vs 17.96%, respectively.
The underperformance was particularly unfortunate because Capital Flywheels completely misjudged the near- and long-term outlook for TAL. After having completely sold it from the Paper Portfolio back in February, Capital Flywheels decided to add it back last month since the stock had fallen ~2/3 since February. Capital Flywheels thought there was still a bright long-term future ahead for this business but was blind-sided by regulatory action that now severely limits the operations of the company.
It is now quite clear that investing in TAL was a mistake (and the Paper Portfolio will be selling the remaining stake as part of the rebalancing).
The silver lining in all this is that TAL was a 2% position. Even though the stock fell 76% over the past month, this has dragged overall performance by <2%.
On the winning side, there were 3 key contributors:
1/ Cloudflare – Cloudflare returned 12.08% during the month as investors increasingly recognize Cloudflare’s long-term potential in the cloud as well as the role it can play in cybersecurity. Cybersecurity is a growing concern around the world.
2/ Moderna – Moderna returned 50.48% as investors increasingly realize that COVID-19 is not going away quickly, especially as the Delta variant spreads. This is forcing many investors to readjust their expectations. As a reminder, when Capital Flywheels added Moderna to the Paper Portfolio at the beginning of this year, investors were expecting Moderna’s revenues to fall rapidly after 2021 because COVID-19 would effectively be “over”. In addition, S&P added Moderna to the S&P500 index, which has likely created meaningful buying.
3/ Adyen – Adyen returned 10.95% likely as a result of growing optimism around the company’s potential to beat estimates near-term. Adyen’s partner, Ebay, recently disclosed that they are shifting volumes away from PayPal towards Adyen at a faster-than-expected pace.
The losing side is long.
1/ TAL – TAL was, by far, the biggest loser, declining 75.94%. As discussed above, the Chinese government revealed highly negative regulatory actions that significantly curtail TAL’s ability to do business. Tutoring companies are no longer allowed to provide tutoring services that touch on compulsory education for K-9 students. In addition, tutoring companies are required to become “non-profits”. The regulators also currently appear to ban foreign investors in investing in this space, though implementation details are still unknown.
2/ Pinterest – The other key loser was Pinterest, declining 25.40%. Pinterest released 2Q results that showed weaker-than-expected user trends. Users in the US have started to decline as user traffic normalizes post-pandemic. While revenue growth came in very strong, the company is currently trying to push (short and live) video aggressively, and hence will be dialing back monetization in the near-term in order to prioritize long-term strategic initiatives instead. As a result, investors are likely concerned that both user trends and monetization trends will be weaker than expected in the coming months. While these are unfortunate headwinds, Capital Flywheels currently still believes the thesis remains intact. Capital Flywheels believes Pinterest has a natural wedge into e-commerce, which the company continues to expect to launch before the end of this year.
3/ Uber – Uber declined 13.29% likely as a result of fear around the rise of delta variant and its impact on Uber’s business. In addition, Softbank (a major shareholder in Uber) decided to sell a portion of their stake recently, which likely contributed to pressure on the stock.
4/ Zillow – Zillow declined 13.06%. Zillow is likely being impacted by high frequency data that suggests house transactions have weakened recently.
Beyond these stocks, a number of other stocks performed poorly including SDGR, AFTPY, AYX, and FLSY. Most of these stocks are down mostly because of the overall market sentiment.
As part of the rebalancing, Capital Flywheels is going to completely sell out of TAL (just 0.49% left since TAL fell ~76% in July). In addition, Capital Flywheels will also completely sell out of MTCH. While MTCH remains a highly attractive business, the Delta variant may pressure the business near-term with uncertain outcome. Capital Flywheels would like to use the opportunity to swap into other businesses that likely have more attractive long-term potential.
The Paper Portfolio will add 3% positions in both ASML and AMD.
The Paper Portfolio used to own ASML before we swapped from ASML into NVDA during the depths of the COVID-19 sell-off. So far, Nvidia has outperformed ASML since the swap, but not by much (and by less than I would have expected). This is because ASML’s business is turning out to be much stronger than expected. Near-term, the demand for semiconductor equipment is incredibly strong as the world tries to cope with semiconductor shortages. In addition, Intel has finally decided to adopt EUV aggressively under a new CEO. This is likely raising medium / long-term demand for ASML in a way that was previously unanticipated.
While AMD has been mostly a turnaround stock over the last few years, it is now firmly challenging Intel for CPU leadership. This is largely the result of AMD shifting manufacturing to TSMC. TSMC has overtaken Intel in terms of manufacturing leadership recently because Intel has been unable to get their leading edge manufacturing right. Intel has repeatedly delayed their roadmap over the last several years, which has allowed TSMC to not only catch up, but also to surpass them. Despite Intel’s aggressive shift towards EUV now and desire to catch up, Intel is unlikely to match TSMC before 2025. As a result, Intel’s challenges almost guarantee that AMD will have a competitive edge for at least the next few years (and potentially more). AMD is likely to gain share across the board. Although AMD shares have done well over the last 5 years, there is likely more to come if AMD (and TSMC) are able to maintain their edge against Intel in the coming years.
Let’s see what August brings.
Disclosures: I own shares in NET, PINS, SE, MRNA, SDGR, U, SQ, UBER, AYX, PLAN. I have no intention to transact in any shares mentioned in the next 48 hours.