Paper Portfolio – January 2023 Update

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.

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Due to a challenging travel schedule towards the end of November, I did not update the Paper Portfolio last month. The current post aggregates performance and thoughts for the last two months.

As 2022 comes to a close, the Paper Portfolio wrapped up a challenging year. Over the last two months, the Paper Portfolio returned -4.0% vs -0.5% for the SPY. This brings full year returns to -55.2% vs -18.1%.

With hindsight, it’s clear the market peaked sometime in November 2021. Although we were quick to recognize the potential challenges on the horizon and reduced weights including meaningfully cutting our top position, Cloudflare, in December 2021, we simply didn’t do enough.

This was even more true following the surprise invasion of Ukraine in early 2022, which dramatically altered the path for inflation, interest rates, and economic growth. Even though the Paper Portfolio brought cash up from low-single digits before the sell-off to ~10% by April 2022, 10% cash was much too thin of a cushion to brace against the impact of holdings falling -50%+.

However, that is now all water under the bridge.

The question is how to navigate going forward.

Given the dramatic sell-off over the last 12 months, there are likely many attractive opportunities given the appropriate investment horizon. Capital Flywheels’ has strongly advocated this view since late May and reiterated this view when stocks revisited the bottom in October. And this is a view I am reiterating again as we close out 2022.

By April, the Paper Portfolio had already declined ~50%, which Capital Flywheels believed likely limited the amount of possible further downside. The upside, however, could be immense once the market turns. Since then, the Paper Portfolio has only declined marginally more, ending the year at -55%. The market is not ready to recover, but Capital Flywheels continues to believe it will eventually.

Looking forward into 2023, the first half will likely remain choppy. The Fed will likely continue to raise interest rates, which will further tighten liquidity available to capital markets and slow economic growth. These developments will likely continue to put a ceiling on stocks and equity multiples. However, the dynamics should be different by second half of 2023. We do not need the Fed to reduce interest rates or for economic growth to accelerate to do well. We simply need these two factors to stop applying negative pressure at the margin. At the end of the day, most of the businesses in the Paper Portfolio are still growing quite well (though not all…names like Snap have decelerated far more dramatically than I had anticipated) but not enough to offset equity multiple compression. If the external pressure abates and multiples bottom, then we can at least start to rebuild and grow off of that lower base.

What’s important is to distinguish mirages that could never have been real against business plans that simply haven’t been realized, yet. This sell-off is an important moment of reflection. Some mirages were never going to become real. But other dreams may remain very viable.

Much like the challenge that parents face, we now have the hard job of objectively deciding which one of our children is likely to one day run a business or run from the cops.

Let’s see what 2023 brings.

Onward.

Disclosures: Of the stocks mentioned, I own shares in NET, PINS, SE, KIND, MRNA, UBER, SNAP, U, SDGR, OKTA, AYX. I may transact in shares mentioned in the next 48 hours.