Volatility: Not a Risk but an Opportunity

"In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not a risk, but it is an opportunity."?- Li Lu

Dear Readers,

As most of you are aware, the markets have been extremely volatile over the past few?months. Investing in this current environment is not for the faint of heart. Inflation, the rise of interest rates, waves of apprehension of new Coronavirus variants?(Omnicron and now BA.2), and the recent Russian invasion of the Ukraine have all contributed?to the uncertainty of the markets. However, when looking out a few years, our investment perspective becomes different. And if history has taught us anything, it is that humans absolutely hate uncertainty...especially if it concerns the immediate future. So while we normally start this newsletter with a quote from Buffett or Munger, we felt the quote of Li Lu, a famous?investor and business partner?of Charlie Munger, best captured how we are thinking about the current environment.?

Currently, we are down?5.37%?this year, but we feel relatively good about managing our risk considering that the Dow Jones Industrial Average (DJIA) is down?6.27%, the S&P500?is down?8.00%?and the tech-heavy NASDAQ is down?12.47%?(especially important considering that most of our holdings are technology companies).??

When stock displays are awash in a sea of red, it is easy to feel helpless or throw in the towel. But long-term investors know that strong businesses tend to make it through tough times, which is why we've been slowly buying on the way down (our cash position is now about 3%).

Moving forward, we believe that stocks will remain sensitive not just to the vagaries of the news on Russia-Ukraine, but also other factors such as competing remarks by central bankers and data releases that are significantly different from forecasts. The current environment requires investors to anticipate more unsettling volatility and have a strong stomach for dealing with it (remember, many of the major investment mistakes occur at such times). It also warrants favouring individual name selection over indices, and subjecting holdings to granular quality reviews on a much higher frequency basis than has been warranted in recent years.

If current uncertainties alter the economic fundamentals of a company, we will reassess. Otherwise, we plan to take this market as an opportunity to find?discounted,?high quality businesses with strong underlying economics that should compound over the next 5-10 years. As Warren Buffett said, "The stock market is a device to transfer money from the impatient to the patient.” We plan on being the latter.?

Our returns over the last few years show the success of this philosophy. Specifically,?our last year's average client return was 25.89%?compared to 21.39% of the NASDAQ, 18.92% of the DJIA and 26.89% of the S&P 500. Yes, we marginally underperformed the S&P 500 for the year, but it's important to note that we had outperformed the index until the very last day (and had outperformed it in 2020). Again, our approach of owning concentrated positions in a small 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 time.

And now onto the portfolio...

Biggest Gainers:

CVS Health Corp (Ticker: CVS)?- Management has made a concerted effort to pay down its debt, while it continues growing its online pharmacy presence, employing stores with Minute Clinics, and offering services via Aetna (3rd largest healthcare provider in the U.S.), which has allowed the company to generate approximately $13 billion in free cash flow every year. CVS distinguishes itself as it becomes a one-stop-shop for healthcare. And while retail pharmacies have struggled with reimbursement and competitive pressure. CVS’ management recognized these challenges relatively early and reinforced the company’s competitive position through vertical integration, including the acquisitions of pharmacy benefit manager Caremark and managed-care organization Aetna. We don’t expect much net income growth from CVS, but we believe a double-digit free cash flow yield can still provide an acceptable total return.

Schlumberger NV (Ticker: SLB)?- As the world increasingly returns to pre-pandemic life, society will need the energy to fuel the planes, trains, and automobiles that move people and goods from place to place. With oil trading at the highest level since 2014, there are incentives for oil producers to bring more barrels of crude to the market. Although, getting that oil above ground isn't as simple as turning a spigot. Oil producers rely on oil services companies like Schlumberger to drill new wells or increase the flow from existing wells. And with oil trading at multi-year highs, oil producers can afford to invest in the costly capital expenditures that will increase their output. Additionally, it will likely take a long time for oil producers to ramp up production. And because of that, Schlumberger could benefit for years to come.?

Discovery Communications Inc. (Ticker: DISCA)?- The risk-reward for this stock has become extremely favorable and the pending merger with WarnerMedia (NYSE:T) could make the combined company a global media powerhouse. We believe that both companies have highly complementary assets, with WarnerMedia having best in class film and TV studios, while Discovery has strength in lifestyle, reality-TV and unscripted brands. Additionally, it's likely that the $3 billion in cost synergies that Discovery mentioned is achievable, if not conservative in our opinion. The merger should also provide the company with enough financial capacity to invest in content globally making it a great long-term investment.?

Alphabet Inc. Class A (Ticker: GOOG)?- Alphabet has a mixed record of execution, in our opinion, with a few brilliant moves counterbalanced by wasteful spending and half-hearted new product launches. However, growth and margin expansion have accelerated in recent quarters, renewing our faith in management. Opening Google Shopping to unpaid listings seems to be making the search engine a top destination for e-commerce again, and the company’s best-in-class first-party data should help it navigate privacy changes on Apple’s iOS.

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 and diversifying across the different asset classes (e.g. stocks, bonds, commodities) is so important. I am no exception to this rule. However, as my winners outpaced my underperformers, I'm still happy with the performance of the portfolio as a whole.??

DraftKings Inc. (Ticker: DKNG)?- The stock is off from $71.98 on March 19 to $22.20 as of Friday's close. However, for the 12 months ended Dec. 31, DraftKings reported $1.296 billion in revenue,?which was more than double the $614 million it generated in the 12 months of 2020. That's the company's third consecutive year of accelerating revenue growth. DraftKings grew overall revenue by 17.9% in 2018, 42.9% in 2019, 90% in 2020, and 111% in 2021. The growth is driven by an increasing appetite from state legislatures to legalize mobile gaming and increasing popularity in existing states of operation, which now includes the lucrative state of New York with an estimated potential of $1 billion in gross gaming revenue annually. In all, the states where DraftKings offers sports betting encompass roughly 36% of the U.S. population -- demonstrating the progress it has made, but also plenty of runway to continue. In addition to expanding into new states, DraftKings increases customer engagement in existing markets. Based on states that were live for the entire Q4 in 2021 and 2020, the online sportsbook handle, which measures the total value of wagers made, increased by 65%. Similarly, iGaming's gross gaming revenue increased 61% under the same assumptions.

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 a 9.9% dividend (which we believe is not in question given the company's strong cash flow).?

StoneCo LTD (Ticker: STNE)?-?Shares of StoneCo are down considerably since the company announced fourth-quarter results that missed analysts' earnings estimates. We believe investors were concerned about increased funding costs, the cost of investment initiatives, increased competition, and the integration software provider Linx. Stone 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. Investing in emerging markets is not for everyone. A stock price pullback can be a blessing in disguise, though investors will obviously have to decide for themselves if that's the case, with StoneCo. The extra layer of risk isn't just from the emerging market itself -- there is bound to be more uncertainty on the part of international investors, making them susceptible to getting spooked more easily, adding further to the volatility, versus a North American stock. StoneCo's credit product issues and reduced margins have provided just the fodder for investor anxieties. But underlying some of StoneCo's short-term operational weakness has been management's deliberate intent to pursue long-term growth and bigger scale. For U.S.-based companies, this would often be met with investor enthusiasm. It could take some fortitude to navigate the volatility, but it looks like StoneCo still presents an opportunity for the long-term oriented investor.

Alibaba Group Holding Ltd - ADR (Ticker: BABA)?- The bottom line on Alibaba's Q3 earnings is that they highlighted what we always knew about the company. Namely, that it is a fundamentally strong entity with solid profitability and revenue growth, that has the ability to grow more from this point onward. Yes, higher taxes and increased competitive pressure will eat into the growth somewhat. But none of these factors are fatal to Alibaba's core business, which will start to thrive as it laps the weak 2021 quarters later this year.

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

Best regards,

Portfolio Management

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