As always, this is not investment advice! Please do your own due diligence and take your own financial situation into account. Everyone has a different financial situation, which means different tolerances for risk and ability to take risk. What is appropriate for me may not be appropriate for you.
First off – Happy new year! May we all live in less interesting times in 2022.
The funny thing is I wrote the same thing a year ago, and it certainly did not come to pass…but a lot of the things I worried about (unfortunately) did come to pass:
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.
…
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.
Source: Paper Portfolio – January 2021 Update
I’m certainly feeling a sense of deja vu.
Markets are once again at all-time highs (!!)…though it might not feel like it depending on what you own. The mega caps (Apple, Microsoft, Google, Amazon, Nvidia, Tesla) had a banner year, and all handily outpaced the S&P500 despite the S&P500 delivering one of the strongest years on record.
Beyond the mega caps, you needed to own certain sectors like energy in order to have done well.
My fear last year that the most expensive parts of tech would need to eventually “digest” the strong up moves seen in 2020 did mostly come to pass. However, the dispersion has been high. Many high flying tech stocks are now significantly below where they were at the beginning of the year (e.g. Peloton, Zoom), while others are still meaningfully above, despite the recent selloff (e.g. Cloudflare).
Although there are company specific reasons why that may be the case, the general story seems to be either impact from Covid normalization (e.g. Covid beneficiaries that are now facing headwinds as the world learns to live with Covid) or crowding / leverage (e.g. too many people owning the same things, possibly with leverage…and when some holders are forced to sell, it creates a negative feedback loop causing others to sell as well).
That second part has been the story with major funds like ARK and Archegos, which together impacted a wide swath of (mostly tech) stocks. Despite Archegos’ liquidation and ARK’s dramatic shrinkage over the last 12 months, many stocks appear to continue to feel the after effects as it ripples across the capital markets, affecting both professional and retail investors alike.
Regulatory and monetary actions in major economies like China and the US also did not help.
However, in comparison to a year ago, many highly attractive businesses are now trading at much more reasonable multiples despite the index being at all-time highs.
2021 was not an easy year, but in a way, I’m feeling more cautiously optimistic about the coming 2-3 years than I did at the beginning of 2021, especially for businesses that are quietly (or loudly!) investing into areas that will benefit from the trends that have been accelerated by Covid. Areas like digitization, security, artificial intelligence, data / analytics, and biotechnology / genomics.
I’m not sure what 2022 will bring, but hopefully (finally?) a less interesting year. Hopefully a year with much less impact from Covid, much less impact on supply chains, and much less impact from risk-seeking investors / speculators.
Turning to the Paper Portfolio:
The Paper Portfolio sold off significantly in December, returning -10.67% vs +4.48% for the S&P500. This brings full-year returns down to 1.80% vs 28.66% for the S&P500.
The Paper Portfolio hugged the S&P500 for most of 2H21 before deviating significantly in the last few weeks of the year:
Many stocks experienced significant selloffs in December.
For example, Cloudflare declined 30.1%. Sea declined 22.3%. Moderna declined 27.9%.
While the gap in performance is certainly disappointing, what ultimately matters in the long run is whether we are invested in businesses that are creating value over time. For value-creating businesses, the challenge is to make sure we are not severely overpaying for that value-creation. Overpaying is likely unavoidable for good businesses (unless everyone else thinks it’s a bad business), but it is important to not overpay in a way that prevents us from riding through periods of rough performance. Overpaying for 6-12 months of execution is acceptable as long as we have the patience to accept 6-12 months of rough performance. Overpaying for 18 months is still acceptable though not preferred. But overpaying any more than that leaves us vulnerable to impatience (and likely loss of confidence) even if we are ultimately proven right.
Unfortunately, this is always an art and never a science…we cannot know for sure ahead of time.
Many of the stocks in the Paper Portfolio remain expensive, but much less expensive than a few weeks ago. And in almost all cases, my expectations are for higher value creation (especially over a longer time horizon) than what consensus is currently affording them. For example, consensus estimates for companies like Cloudflare, Sea, Pinterest, Nvidia, and many others are likely much too low, especially for 3+ years from now. For a company like Nvidia, estimates are likely too low even for the next 12 months!
Offsetting this, we have had some clear misses this year (please see Appendix for the full year attribution). With hindsight, it’s clearer that we likely not only overpaid for some businesses, but we also mis-assessed some businesses. For example, TAL. In these situations, we have permanently destroyed capital…no amount of waiting will likely help recover what we have lost. It’s important to minimize such mistakes. And it’s even more important to not further exacerbate the issue by not reallocating what we have left in these mistakes into better alternatives the moment we realize we have made a mistake.
For the rebalancing, I’m making only slight adjustments at the margin, but will sell Fastly and ETHE. Fastly is very likely a mistake that I should have never undertaken. I knew it was less attractive than Cloudflare for more than two years, but thought I could catch a falling knife by adding Fastly after it had sold off. While Fastly could bounce if the business regains momentum, it’s requiring more attention than I would like.
As for ETHE (and crypto in general), I continue to view cryptocurrencies as interesting technology, but a lot of details need to be worked out before it can be useful in a big way. 2021 was about people discovering some of the efforts that had already been underway for years (e.g. DeFi, NFTs, etc). Having now discovered most of the “new” stuff that had been cooking for the last few years, the crypto community needs to now either deliver on promises or execute quickly on new dreams to capture people’s attention. I’m not sure it makes sense to be too bullish on either near-term. As a result, the Paper Portfolio will sell down ETHE for now.
Alright, that’s all folks. Let’s see what 2022 brings.
Appendix:
Full-year attribution:
Average Weight During Period = Average weight of the holding during the year.
Total Return When Held = 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.
Contribution to Returns = approximately Average Weight * Total Return When Held.
Disclosures: I own shares in NET, SE, PINS, MRNA, U, SDGR, OKTA, KIND, UBER, AYX, and PLAN. I may transact in shares mentioned in the next 48 hours.
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