June 2022 Newsletter

"If farming were to be organised like the stock market, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.”?- John Maynard Keynes

Dear Readers,

From 1924 to 1946, John?Maynard Keynes outperformed the stock market by 8% a year, which places him among the elite investors in the past century. But how did he manage to generate such great returns during a timeframe that included the Great Depression??

Well, for starters, Keynes famously took a fairly dim view of how well markets allocate capital. He believed that the mania of the markets often drives prices away from their fundamental values. In his book, Keynes compared it to a newspaper beauty contest. Imagine a competition where you're supposed to pick out the six most beautiful faces from a group of 100. But remember, this is a contest. The winner is the person who picks out the six most popular faces. It's not a question of which faces you think are the most beautiful. It's a question of which faces you think other people think are the most beautiful. Of course, being a savvy individual, you realize this -- so you pick the faces you think other people will think other people will pick. And so on, and so on. The same thing can happen with stocks.?

If prices really can get so disconnected from the underlying fundamentals, investors are left with a few basic strategies. They can either ride the bubble, or they can bet against overvalued stocks. Now one might think that investors will choose the latter path. But, as usual, there's another Keynes quote for that?-- "The markets can remain irrational longer than you can remain solvent." And that's why investors don't always short highly valued stocks. Not only can a stock stay overvalued longer than an investor can afford to bet against it, but doing so may open them up to massive losses for only limited gains. Instead, it is easier to buy an overpriced asset in the hope that it will keep going up and up -- before unloading it on the greater fool. Unfortunately, that's?a fairly apt description of what the big banks belatedly did as the housing bubble collapsed.

Of course, there's a third option that we prefer: buying undervalued stocks. This is a simple method, but far from easy, and it is how Buffett managed to catapult himself up the ranks of the world's richest individuals. It's also how Keynes managed to generate outsized returns during such turbulent markets. This makes sense. If you think the social dynamics of markets push prices away from their fundamental values, you'd look for cases where that's happened -- and your risk of losing money is low. In other words, buy and hold stocks that the market underappreciates.

The reason this approach is so hard is because no one has privileged access to the future. Just take a look at the current environment. In the past week alone, Elon Musk said that he "has a super bad feeling" about the economy and Jamie Dimon warned of an "economic hurricane" while other banks, most notably Bank of America, implied the opposite. With rampant inflation, increasing interest rates, lockdowns in China and a war in Ukraine, the future is anybody's guess. And the markets have reacted accordingly -- with volatility. Could this be the end of days? Maybe, but probably not. We don’t honestly know and won't try to pretend that we do. We believe that the only way to make money is to buy great companies at a discount and hold them until either the fundamentals change or something else becomes more attractive. In a sense, that has been our competitive advantage.?We'll continue to remain dispassionate in these moments of tremendous turmoil, where many?companies are getting mispriced because investors are throwing the baby out with the bathwater.

Keynes also made this point back in 1937 when the market went down 50%. He said that if you can’t buy into the market when prices are falling?(and falling a lot)?then you can’t buy at all. Because if it’s the end of the world, well, then it really doesn’t matter. Lower prices are always more attractive than higher ones. And the most attractive prices are obviously at, or just close to the lows. Again, we don’t know if we’re there yet in the current environment, but we do know there’s a fair amount of pessimism in the market. The last five corrections we've had (2011, 2014, 2015, 2018, and 2020) were reached when we had about 40% of the S&P 500 making 52-week lows. Last we checked, we had about 25% of the S&P 500 on the new low list, but another 25% (actually slightly more than that) are within 3% of new lows, which would tell me that we’re probably close to a bottom. But again, we won't make a prediction on what the market will do. There's always a chance that it will get much worse before it gets better. However, if you're not withdrawing money from your account over the next few years, then you should not have anything to worry about.?

Moving on to our portfolio,?our average client return this year is?-19.19% (as of Friday's close) compared to -23.22% of the NASDAQ, and -13.80% of the S&P 500. Yes, we underperformed the S&P 500 for the year, but it's important to note that most of our positions are technology companies, which makes the NASDAQ a better comparison. Again, our approach of owning a smaller number of high-quality businesses will result in higher volatility and periods of underperformance...but we are confident that we will outperform the market over a long-time horizon.?

2021 Returns

2020 Returns

Here is a breakdown of our current portfolio...

?Biggest Gainers:

Salesforce (Ticker: CRM) -?We believe this company is one of the best long-term growth stories in software. While the company's best revenue growth is in the past, we believe margin expansion should continue to compound earnings growth of over 20% annually for at least the next few years. After introducing the software-as-a-service model to the world, the?company has assembled an empire that it can build on for years to come. Salesforce reported Q1 results that were good from almost any angle, beyond the high end of guidance for revenue and non-GAAP EPS, along with an improved revenue outlook for fiscal 2023. We are pleased to hear that the sales pipeline is robust, larger acquisitions are unlikely in the near term, and the company remains focused on profitable growth.

SoFi Technologies Inc. (Ticker: SOFI)?-?SoFi is an online financial technology company that started off?refinancing student loans. While this segment remains a big part of the company’s business, they also have?expanded their products to offer an?entire suite of financial services including personal banking, investing, and credit. Even though their collection of products is still evolving, the?company still managed to nearly double its member count over the past year and is growing 50%+ despite its loan refinancing business taking a hit due to the COVID-related loan moratorium. Furthermore, the company is close to obtaining a bank charter through its acquisition of Golden Pacific Bancorp, which would allow SoFi to take in its own customer deposits, lowering its cost of capital and expanding the company’s breadth of financial offerings. In our opinion, SoFi is best positioned to drive consumers away from the legacy banking model. Their one-stop-shop approach for financial services and their lack of a brick-and-mortar branch network to maintain may eventually propel them into becoming one of the larger players in the banking industry in the United States. Lastly, SoFi also owns Galileo, which provides an application programming interface (API) for payment platforms. Galileo's customers include Chime, RobinHood, and TransferWise among others. Galileo is growing just as fast as SoFi, totaling 89 million accounts as of Q3 2021 for USD 178 million in net revenue. Ultimately, Galileo could become something akin to the AWS of financial payments infrastructure, and its position within SoFi hedges against some of the risk that SoFi’s core business does not outperform its fintech and banking peers.

Lumen Technologies Inc. (Ticker: LUMN)?- There's no doubt that the sellers had their reasons for dumping this stock after the last earnings release. In hindsight, however, we believe they overreacted to Lumen’s financial results. Really, the big-picture scenario looks positive as Lumen has swung to profitability and has recently scored a lucrative government contract. So, let the skeptics have their moment. In due time, investors will come back to their senses. And while we wait for them to do so, we'll be rewarded with over an 8% dividend (which we believe is not in question given the company's strong cash flow).

Biggest losers:

If you invest for long enough, you will always have both winners and losers in your portfolio, which is why having a margin of safety is so important. I am no exception to this rule. And while our portfolio has lost value this year, we are?very excited for our potential returns over the next 5-10 years.?

Shopify Inc. (Ticker: SHOP)?-?This company strives to be a one-stop shop for small retail businesses, especially those focused on e-commerce. It offers a simple but robust e-commerce platform with a variety of add-on functionalities, including the Shopify Fulfillment Network, which converge into a turnkey solution for small and midsize businesses. Shopify’s rapid rise since its 2015 initial public offering underscores a nascent software niche that is rapidly growing and demonstrates a winning solution. We believe the company has established an economic moat, as switching critical e-commerce platforms has financial and operational costs for already resource-constrained small businesses. Investors have lowered their expectations after reports from some other notable e-commerce companies, but we remain bullish on e-commerce over the long-term. The company will have lower margins over the next year as it accelerates the investment phase for the buildout of its fulfillment centers, but that should drive profitability over the next 5-10 years and help it compete with Amazon.?

Warner Bros Discovery Inc. (Ticker:?WBD)?-?AT&T completed its spin-off of Warner Bros. Discovery, which merged it's WarnerMedia unit with Discovery on April 8. This new media company will bring together HBO Max and Discovery+, which together serve nearly 100 million paid subscribers. CEO David Zaslav believes that the combined ecosystem could eventually reach up to 400 million streaming subscribers over the long term. It also plans to expand both its ad-supported and ad-free versions to gain more viewers. As Netflix lost subscribers, HBO and HBO Max actually gained 3 million new subscribers sequentially in the first quarter of 2022. So while we also took a very small position in Netflix Inc. (Ticker: NFLX), we?WBD?more because it doesn't need to license expensive content from other media companies, it's a more broadly diversified media company (generates revenue from movies, TV shows, and its own licensing fees) and its cheaper (trades at just three times its adjusted EBITDA target for 2023 while Netflix still trades at 11).

Roblox Corp (Ticker: RBLX)?- Roblox can be thought of as a combination of a game engine (software used by developers to create video games), an app store, a virtual world, and a social network. Gamers want to use platforms with a wide variety of engaging games and where they can play with their friends. Developers want to be on platforms with a large player base, easy-to-use development tools, and a vibrant virtual economy. As Charlie Munger says, the best companies gush cash when they stop growing, which we believe to be the case with Roblox.?

DraftKings Inc. (Ticker: DKNG)?- At some point within the next three years, DraftKings will have followed other sector leaders by reining in marketing spend and begin to turn profitable. And when it does, it will produce dramatic earnings gains and huge gross margins common to some other tech names. In the interim, it will continue to burn cash at a high rate. Yet it has a nice cash position on its balance sheet now and its capacity to borrow, if need be, remains. Its current debt load is relatively modest, which tells us it can handle its cash burn in the intermediate-term without piling up huge amounts of new debt. While new state legalizations may tend to be fewer and in less densely populated areas, the company will be well-positioned to swoop in and get their share of the market among the leaders. Additionally, the stock is now selling at its lowest price-to-sales ratio since it became a public company and has a cash per share of $5.27, while its stock price only trades at $12.65 (as of Friday's close). So as we plan to hold this position for 5 years, there's a very small chance that we will lose money over the long-term.?

Mercadolibre Inc.?- ADR (Ticker: MELI)?-?Despite turning in a positive quarter, MELI’s share price has been driven lower amid the broader?tech selloff and inflation concerns in Brazil, the?company’s largest market. Brazil is currently?dealing with double digit inflation rates, although recent data shows those numbers abating slightly. This is not the first time that MELI has had to contend with high inflation in one of its major markets. Argentina has dealt with persistently high inflation over the past several years, but MELI continues to perform well despite this challenging macro environment. Macroeconomic headwinds certainly dampen 70%+ growth in?year-over-year net revenues but barring long-term hyperinflation and a broader economic collapse we still believe MELI has a bright future and is currently priced at a reasonable valuation given how quickly the company is growing.

StoneCo LTD (Ticker: STNE)?-?This company provides Brazilian micro, small and medium-sized merchants with payments and software solutions. Essentially, they are the Square of Brazil with a huge runway for growth and fantastic fundamentals. The company is growing incredibly quickly (138.6% Y/Y for Q1) with a clear strategy, its financial position is strong, and its offering is well differentiated. Furthermore, the credit business, which historically is cash-flow generative and profitable, will come back online. Management has taken investor comments on board and are looking to prioritize margins alongside growth and have reorganized themselves to ensure each service offering is adequately nurtured. This should lead to a much stronger 2022, driven predominately by cross-selling. Overall, the robust revenue growth, the expansion of its product offering, and the fact that StoneCo has been oversold and currently trades at below its fair value make the company very attractive to the long-term oriented investor.

Teladoc Health?Inc. (Ticker: TDOC)?- Although Teladoc continues to expect sustainable growth across its suite of products and services, it is experiencing challenges in the direct-to-consumer mental-health and chronic-condition markets. In the mental-health market, higher advertising costs in some channels are generating a lower-than-expected yield on marketing spending. In the chronic-condition market, Teladoc is seeing a longer sales cycle, as employers and health plans evaluate their long-term strategies to deliver the benefits and care that their populations need. Additionally, Teladoc took a $6.6 billion impairment to goodwill. So it wasn't a great report for those investors that live quarter to quarter. However, when we look out 5-10 years, the story is much bigger, particularly their business clients. Recently, they partnered with Northwell Health, New York’s largest healthcare provider, to deliver connected virtual care and expand care delivery to patients both inside and outside the four walls of the health system. The new enterprise strategy will leverage Teladoc Health’s collaboration with Microsoft, improving clinical teamwork and communication among Northwell clinicians. Their services will also be available to Amazon customers through its Echo line of intelligent speakers. So while the company has 16 million direct-to-consumer patients, we believe that the market is not factoring in the tremendous growth they can experience through their business customers.?

I hope you found this publication useful, and that you’ll take some time in the coming weeks to review your current investments. If you have any other questions, then please review the attached document and or feel free to reach out directly. We’d love to hear from you and answer any of your questions in our next newsletter.

For more information on?Sirmium?Capital, visit our website at?www.sirmiumcapital.com