October 2022

“We cannot predict when stock market declines occur. Yet no activity is more popular on Wall Street - whether from investors or their advisers - than trying to predict the market... all historical studies demonstrate unequivocally that it's a losing strategy"?- Francois Rochon

Dear Readers,

In an upcoming episode of our favorite investing podcast "Richer, Wiser, Happier" host and author William Green interviews investing great Francois Rochon, who's fund delivered a?15.3% annual compound return for nearly three decades (no small feat). His quote resonated with us for several reasons, but primarily because it reminds us of conversations we have with potential clients that almost always start with "so what do you think about the markets?"?

Our answer is always the same - we have no idea. We are not economists nor do we base our investment decisions on macroeconomic?factors. For someone to be successful using that approach, they would?need to absorb a great deal of information about many parts of the economy, synthesise that into a view about how particular sectors will react to what is happening and then extrapolate how individual companies will perform in their projected environment. This task is made even more difficult by the fact that geopolitical and social events can impact the global economy in unforeseen ways (e.g. Invasion of Ukraine worsening inflation).

Many times people are shocked at our answer. Shouldn't we know this as professional investors? If someone asks an orthopedic surgeon about a problem with their knee and they say that they have no idea, then it wouldn't inspire much confidence. It's unfortunate that Wall Street and the media have conditioned people to think this way. Sure, macroeconomic factors like interest rates, wars or inflation are important and will impact our portfolio, but we look at these things through the context of how they may impact individual companies over a long-time horizon - a significantly easier process than making a call on the overall market over the next 6-18 months.?

After finding securities that we understand and like long-term, we exercise?patience. After all, having a good process to pick stocks is an exercise?in futility?without patience. This has never been more true than this year. We find solace reading the philosophies of the great investors and their perspective during severe market downturns.?When interviewed after the 2008–09 financial crisis, Charlie Munger said, “This is the third time that Warren and I have seen our holdings in Berkshire go down, top tick to bottom tick, by 50%. I think it’s in the nature of long-term shareholding, of the normal vicissitudes in worldly outcomes and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

Years later, Charlie also said that?"Success means being very patient, but aggressive when it's time."?And that is where we find ourselves today. We don’t know how the markets will perform over the next year or if we’ve already hit a bottom. We do know that every time the market retracts 20% or more, there tends to be a strong recovery. Since 1950, there have been 13 of these market crashes (including this year). Here is a breakdown of the returns after every -20% drop. Please note that these returns were not calculated from the bottom, but only when the S&P 500?lost 20% from its peak (as it may have continued to drop afterwards).?

In almost every situation, if you were patient enough to hold on to stocks for 5 years, then you were rewarded with a great return. Much like after a forest fire, where the forest tends to?see the most growth. After all, the?fire removes low-growing underbrush, cleans the forest floor of debris, opens it up to sunlight, and nourishes the soil. Reducing this competition for nutrients allows established trees to grow stronger and healthier. The same can be said of high quality stocks that make it through economic contractions.??

Our current belief is that there are some great assets that are cheap. And that is our basic equation -?Great Assets + High Margin of Safety (Cheap) = strong long-term investment. It is in this context that we will discuss all of the holdings and decisions.?

However, before?we provide details on our individual positions, let's discuss our YTD returns.?As of yesterday's close,?our average client return this year is?-32.24% compared to -33.36% of the NASDAQ, and -24.70% 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 once it recovers.?

Moving onto our portfolio, here's a breakdown of some of our larger positions...

?Biggest Gainers:

Planet Labs PBC (Ticker: PL)?-?Founded in 2010 by former NASA scientists, the company operates the largest earth imaging satellite constellation, and can completely scan the entire world every day. On a daily basis, Planet labs captures over 30 terabytes of data and then transforms it within its platform for customers to easily use for a wide array of analytical purposes. The total addressable market for Planet is massive as its data can be used across multiple industries (e.g. finance and agricultural), which is why we see such robust customer growth. The company has paid off all debt and sits on a healthy cash balance and, in our view, will eventually gush cash flow once its satelite fleet matures and capital expeditures decrease.?

Snowflake Inc. (Ticker: SNOW)?-?Snowflake's growth story is just getting started with the rise of cloud computing set to continue over the coming decade. As per its management, Snowflake's revenues will still be growing at 30% per year in 2028 (with faster growth numbers expected in the next 3-5 years). Snowflake has strong fundamentals thanks to the secular demand. The risk of recession is partially priced at the forecast and stock price. With no long-term debt, over $1 billion cash on hand, and improving FCF generation ability, Snowflake will likely survive the economic downturn and prosper in the future. If the sell-off within growth stocks continues, it might further bring Snowflake's stock price lower, where we will have the opportunity to buy more.?

Costco (Ticker: COST) -?Costco is a consistently strong performer and has managed to grow earnings over the past year despite surging inflation and supply chain issues. The company has grown its revenues at 8-9% per year, while the increase in its margins, derived from the increase in profits from memberships, has pushed the company's profits above 10% per year. So while we do have some qualms about its high valuation, the company’s exceptional execution and results in the past make it worth holding for a long-time.?

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. We are 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.?

Alibaba Group Holding Ltd - ADR?(Ticker:?BABA)?-?At firs glance, the current situation for the stock seems like a textbook example of high-risk and high-return investment opportunities. There has been no lack of major events in the past 1- or 2-years surrounding BABA (Ant IPO, fine, VEI, delisting, etc.). In the near term, the China-U.S. trade tension and global geopolitical frictions will keep the stock prices in a highly volatile state. However, from a business perspective, there is little not to like about the Alibaba. It operates the world’s largest e-commerce platforms, generates massive free cash flow, earns solid returns on capital even at a time when earnings are depressed, and is effectively debt free. Unless something completely unforeseen happens (which is always possible), we plan on holding this for a long-time.?

Alphabet Inc Class C?(Ticker:?GOOG)?-?It's pretty crazy that a company with a $1.27 trillion market cap is continuing to see double digit revenue growth, but that's exactly what you have in google. It's?dominant search product is attributable to the fact that management continues to innovate and improve the product for users and advertisers by using artificial intelligence. The company has evolved into much more than search, as billions of people depend on Google Maps, YouTube, Gmail, Android, and Chrome. Ultimately, the company has more than enough resources to weather turbulent times, and at the same time, it has more than enough capabilities to continue to launch new products and services, which are able to create new monetization opportunities (e.g. Waymo) for the business and help it to further expand.

Advanced Micro Devices, Inc.?(Ticker: AMD)?-?The company has experienced an extreme change in sentiment from one that was positive to one that is becoming increasingly very negative. As a result, I think that investors can leverage on this negative sentiment and take on a contrarian investment approach with AMD as it looks set to be a winner in the space once the recession ends. I think that its market share gains story remains to be a multi-year development as it remains well positioned in the industry. Given that the company is priced at the 15x 2023 P/E currently, it looks rather reasonable as much of the recession fears and slowdown is priced into the stock.

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 IPO underscores a nascent software niche that is rapidly growing and demonstrates a winning solution. We believe the company has also 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.?

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 $13.68 (as of yesterady'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.?

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 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 2023, 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 well below its fair value make the company very attractive to the long-term oriented investor.

Positions sold:?

Bausch Health Companies Inc.?(Ticker: BHC)?- The company (formerly called Valeant Pharmaceuticals) has had a troubled past that had left it with a huge debt load (over $30 billion) and legal troubles. Management and the previous CEO, who recently resigned, cleaned up the company by settling the legal cases and reducing debt by ~$10 billion to $22 billion. Although, there was?substantial credit risk and default seemed like a real possibility in spite of the debt reduction achieved. As it turns out, it seems like we were correct as Fitch just downgraded its credit.?

Roblox Corp (Ticker: RBLX)?-?We originally viewed the company as a potentially very valuable platform for video games, social networking, and a virtual world all rolled into one. However, we became less comfortable with Roblox based on the wide range of potential outcomes and lofty valuation. Given that we sold at a loss. So while a return to a high price is certainly possible, given the wide range of possible outcomes for the company, it isn't one we view as most probable. Instead, we've added new positions to companies with more-established business models and more-predictable cash flows.

New Positions

NKE, AXOM, MKL

Companies we are monitoring:

DB, ABNB, CVS, XOM, ZS, BROS

Good Reads:

Our favorite podcast now has a newsletter! Please check out The Investors Podcast's new?newsletter?when you get the chance.?

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