Failures

2/8/2021

None of the following is investment advice.

As we move into another stimulus package, let me provide an update into my businesses' progresses during 2020. If you're expecting this to be good news, I'll nip it in the bud - it isn't good news. So I'll admit to the biggest failure I've ever had, which is something I think you can learn from. To preface the bad news, my Advisory produced a return of over 50% in 2020 and this year is now over 20% so far. This is going to be the epitome of a "humble brag", but I still think it's important to tell you what I've learned.

The month was July 2019. I attended an investor's meeting at the Monarch in Newport Beach and hit it off with one guy there named Anand whom is the investment advisor at the family office of an early Qualcomm investor; he asked to meet with me in August to compare notes. We met on August 21st, 2019.

At the time, I was about 2 years into owning (and operating) an RIA, but I knew he wasn't interested investing in something like that. He wanted a more defined strategy that could provide the highest risk-adjusted returns on behalf of his client. Since I would have no relationship with Anand's client directly, I would only be required to have a catch-all investment strategy only considering that the investor was wealthy enough to have a family office. There was no need to diversify for the investor, since Anand's job is to do that - Anand would only allocate to me if I could fill a niche better than someone else.

Keep in mind that I forced myself to make this presentation, as I had never done anything like it previously - I was going to pitch this guy a long/short hedge fund strategy. The first lesson for you is to always force yourself to make those presentations, because you'll learn by having pressure exerted upon you, even if self-imposed. So I scoured my portfolios, which are normally no more than 30 positions, for what I believed were the best chances for success. The 4 businesses I selected all turned out to be growth plays. The presentation was exact and plain, thinking that he would be more impressed by research than salesmanship (I was wrong, but that's another story).

I won't keep you in suspense. Here is my exact presentation, copied from the follow-up email I sent him, ordered by the conviction I had for each business:

APPS (price $7.47)

• First Mover advantage in direct application advertising. Historically, users are required to get apps through walled gardens of Apple and Play stores. This company helps developers nearly double conversion rate and will likely lower developer costs.
• CEO was VP of Qualcomm (local pride)
• Enables developers to connect directly with users, cut out the middle man.
• As application usage grows, Digital Turbine will also.
• No direct competition to be found for business models.
• Platform engages advertisers, OEMs, and developers simultaneously.
• Revenue and margins are improving consistently. Gross margin is relatively low to entice developers. 40% margin is okay with the large TAM volume.
• Checks in industry encouraging.
• Strategies employed are attached. Probably should be using Alteryx.
• Downside risks: advertising constituents copying model (FB, GOOG, TTD). Loss of Samsung, Verizon or AT&T as customers (subscription non-renewals).

STMP (price $64.20)

• Monopoly for eCommerce entry. eTailers on 10+ major platforms subscribe to batch ship in one place. All cloud based with no infrastructure owned by customers. Story hasn't changed in years.
• As eCommerce grows, Stamps will also.
• SGA have increased from M&A, can easily reduce costs if needed.
• Gross Margin over 70%, net margin over 20% normalized.
• Approach to M&A extremely accretive and shareholder friendly, not empire building. Ended USPS relations for same rationale.
• Talented, experienced, efficient leadership.
• Compare-shop and access to more shippers worldwide than any platform.
• Low CapEx requirement encourages ROIC for investors (significant buyback program currently).
• 750,000 paid subscribers, consistent level for almost 3 years and growing slightly. Churn is only 3% and eroding, meaning gaining market share. Averaging about $75 per paid subscriber.
• Subsidiary Shipping Easy has agency program paying customers for referrals.
• Provides 11B of packages a year, which is 4% of top 4 total revenues. Means TAM is very high if margins are profitable.
• Own Endicia, which has breathtaking patents within and without postage, including electronic stamps
• Q4 is historically best quarter.

BYND (short)

• Industry relationships will wane when customers understand product, although it tastes great and is better in theory for the environment.
• Obvious question: long term, why not eat a salad that is healthy than a plant burger that isn't? Who is the market for this? My research shows people bought the product once for its cachet, liked it, and went back to healthy food.
• Recent stock offering (at $160) saw many pre-IPO investors cashing out.
• More long term risks to investment thesis than long term benefits, most significantly the price point at restaurants. If product is long term successful, likely significant competitors (including Tyson and incumbents) will erode pricing power.
• If product is successful, the pea protein supply will be strained, and/or suppliers will raise prices. Currently only two pea protein suppliers. Difficult to scale without compromising current ingredient composition and taste.
• No significant chance of introducing new ingredients without losing credibility.
• Burger king reported same store sales 4% higher in total after adding the burger to menus, though such a performance is not sustainable.
• 40% Gross margin now, with the bottom line devoured by SGA costs. I expect the topline margin to erode and SGA to increase burn rate.
• Downside risks: May be taken over by large industry player.

TWST (price $30.69)

• No position until better margins develop and litigation ceases.
• First mover in synthetic DNA and digital data storage. Claims to be the answer to nextgen Moore's Law.
• Currently over 1,000 clients, including competitors like Gingko and Genscript.
• Significant gene library patents. Looks as though IP is clear of Agilent from 2016 Wells Notice.
• Highly regarded in industry as gold standard of gentech's future. LeProust well known.
• Shipped 152,000 synthesized genes in 2017, 273,500 in 2018 and 137,100 in first half 2019. Price per gene is currently under $0.09 and less than 15 day turnaround.
• Silicon base in genes provides for high scalability and extremely low error rate.
• Downside Risk: regulation (CLIA), loss of Gingko as a customer (currently about 1/3 of revenues), lawsuit with Agilent, a recession causing customer R&D budget cuts.
• Financial position: Working capital $160 Mil end 2Q and a $104 M est. burn rate/quarter.
• Issued significant convertible preferreds in 2018 before going public and stock at IPO. Likely appetite for a new offering, risk of dilution. 

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The failure may not be obvious. Key to this presentation is that these attributes were and are correct. Another lesson - the research you need to do to gain conviction should be big picture enough and focus on upside and downsides.

Anand and I met 359 trading days ago, or less than 1 and a half years ago. Here are the total returns these positions have returned in that time, measured against the S&P 500:

S&P 500: +32.47%

APPS: + 1,078.05%

STMP: + 301.87%

TWST: + 424.60%

BYND (short) : - 11.19%

Portfolio equal weight (150% long, 50% short): +896.66% total gain before deducting fees and interest expense.

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A 10X return in 1.43 years. A relatively small $10 million investment would be worth $100 Million. Here's how it played out:

At the time, I had large positions in APPS and STMP. They weren't as large as in the description above, since my Advisory has mandates, and I couldn't be short either. I had a very small position in TWST. I ended up holding APPS for months and averaging down from where I bought in. I sold it at about a 100% profit. I sold STMP just above $150 after it's 4th quarter earnings report. I sold everything I owned at that time, at the end of February. I bought TWST around $40 and sold around $80. I bought back STMP at $180 and still have a position. I haven't taken a position in APPS since I sold and after they reported 4Q earnings last week, the worst part of it all is that the company is still cheap. They are all relatively cheap, except BYND, which I still can't understand; Note that BYND has underperformed the S&P 500 since August 2019....

Importantly, all these small-cap companies dropped along the way by a big percentage and stayed down for weeks and months. APPS (capitalization of $500 Million at the time) dropped by 60%. STMP (capitalization of $1.1 Billion) dropped by almost 40%. TWST (capitalization of $1 Billion) by over 30%. While I saw the gains possible so clearly, I chickened out.

Because of all that, we only have seen a 2X gain in the portfolios instead of 10X (gross). Keep in mind that because of mandates for Advisory clients, the return could have never gotten to 10x.

What I have learned in 1.42 years from this?

As an investor, you must own and not operate. You cannot time the market successfully, and if you try, you might eliminate your biggest winners. It is very hard to just do the research up front and hold forever. With each piece of news, every quarterly report, you wonder if the business is still doing well, especially in 2020, when everything was ground to a halt. You wonder whether you should sell or hold. Warren Buffett only began primarily buying and holding in his late 30s, after he had made millions doing all sorts of mischief. He had a hard time finding things to do while he held, so he started his insurance empire at that very time, opening privately-held startups in almost every state virtually single-handedly.

The key to waiting is to have more conviction in your research, and learning from the failures when you lose conviction. In 2020, I lost conviction in the global market due to the pandemic, even though my long positions were, in fact, emboldened by it. Or you could be like Buffett and find a way to be an active investor in other things outside of the public stocks you own.

Truly, to grow wealth, you need to concentrate it in things you are certain will yield success. Whether that's a business someone else runs (stocks) or a business you run, you must concentrate where you have the highest risk-adjusted return. Recently someone said to me, "Grow wealth by concentrating it, protect it by diversifying."

This leads me to my next lesson - the role of an advisor is to provide the highest risk-adjusted return. There are myriad definitions of risk-adjusted returns, but I think it stems mostly from time horizon. Many times, a person with a net worth over $10 Million will say they need to protect their wealth by investing in things with very low risk-adjusted returns.

While it isn't fair to prescribe to someone a strategy without understanding their situations, objectively they need to learn how to properly invest. Many advisors simply take orders and refuse to convince an investor to abide by their time horizon.

By going to cash in 2020, I was guilty of this sin. I abided by the fear overtaking the market instead of the time horizon of my investors, which is very long in almost every case.

Selecting a lower risk-adjusted return purposely is active investing. Objective, proper investing would dictate always selecting the highest risk-adjusted return available.

When I told someone last week about my 2020 failure, all he said was, "There will be other chances." While I think that's the correct attitude, telling clients that they could have gotten a 10X return (probably with less risk) when they only got a 2X return really hurts. Some people are better motivated with pain - in this, I am motivated to not have to fail clients like this again.

Another lesson - a 10X return in just over a year is possible in public markets, not just in private markets. Equity is equity is equity. Private equity does have added benefits, but the business itself will dictate nearly all of the value of the ownership stake. Contrariwise, private equity can lose just like public equities.

The worst thing to happen didn't result in loss, luckily. Some decisions I have made have resulted in losses, but the losses can be made up. What can't be made up is buying great companies like these at amazing prices. Looking back through history, the most obvious and powerful lesson is that stock prices have generally always gone up after 1980. So each year you can look at the price and wish you bought then, but most of those years I wasn't managing portfolios. To be able to buy Apple at $0.10 split-adjusted or a property in La Jolla for $50,000 would be amazing today, but that's not possible.

The future is bright, and someday soon, people will wish they could have bought APPS at $88, STMP at $258 and TWST at $160. For this same reason, shorting is incredibly hard in new industries, and shorting is really only useful in situations that are incredibly obvious.

Consider this as the next stimulus package rolls out - what if the tech companies in the year 2000 kept running forever without Alan Greenspan intermediating? All those value investors that "Knew it all along" that were right thereafter would still be in pain, or out of business.

Until next time, stay safe and get vaccinated!