How/When/Should A Tiger Change Its Stripes?

It is fair to ask of your portfolio manager: if growth has resoundingly beaten value over so many years, why persist against the grain? Why the insistence on a strategy that appears handicapped? Why not adapt to a new normal?

Fact is, it’s not that simple. Publicly traded growth stocks attract primarily speculators. And if there’s one thing I will never endeavor to be, it is that of a speculator. A speculator cares not about the underlying fundamentals of a company, only how/when its stock price will rise. These “investors” are behind every bubble’s dramatic formation and destruction, and over the long run, their odds are no better than a run-of-the-mill casino game.

And yet, there have been spectacular growth stocks that deserved every penny of their erstwhile inflated valuation and more. I am referring to, of course, Google (Alphabet), Apple, Facebook¹, Amazon, and Microsoft, et. al. They are truly wealth creators of epic proportions. Over the past 12 months alone, they accounted for over $250 billion in bottom-line profits. They actually earned it and their share prices reflect their profitability, fair and square².

Their success has caused a ripple effect of investors looking for the next companies that can generate seemingly endless growth. This guessing game of who will be the next trillion dollar market cap behemoth is a rising tide that has buoyed the entire technology sector, which in turn, as it inflates, come to constitute and contribute to an ever bigger portion of the S&P 500. 

It is a difficult game to play because it’s not at all obvious. Assuredly, there will be, in the long run, a whole chunk of losers that get outcompeted, just as assuredly there will be a smattering of ridiculous winners, all of whom trade at nosebleed valuations. I have nothing inherently against investing in growth, but right now, there is no margin of safety and I have no edge. Case in point is our saga with BlackBerry. My thesis, pinned on their turnaround growth, has thus far failed to pan out, but we still enjoyed outsized profits thanks to internet message board speculators driving up their stock. We got lucky. But any investment program dependent on luck is by definition irregular and unsustainable.

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¹ To be clear, however, I am not a fan of Facebook’s destabilizing societal impact. It’s improbable I will ever invest in them (in their current form), as it would feel icky to root for such a company and share in their profits.

² https://www.axios.com/earnings-largest-companies-tech-giants-77de0e35-e3b3-42d6-9dd4-b56bb4064ea1.html

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On the flip side, the more that non-tech names continue to contract, the more their opportunity grows. As capital chases the ephemeral, it ignores the businesses that build and make “real” things. Without affordable capital to build and make, they won’t. Which leads to shortages, which leads to higher prices, which leads to bigger margins and profits… which should eventually lead to, once again, more capital. 

The canary in this coal mine are semiconductors. Once a boom-or-bust cyclical, the redheaded stepchild of sexy tech that could never attract consistently affordable capital, persistent shortages are now endemic. Building new semiconductor plants are expensive and years-long, and supply fell far behind the demand curve. As capital gushes back towards the industry, semiconductors and companies that comprise its value chain have been some of the best performing stocks in recent years. 

To wit, the Philadelphia Semiconductor Index (SOX) went pretty much nowhere from 2002 to 2016, dramatically underperforming the broader Nasdaq 100 for 14 years:

But from then on, it has more than held its own, especially over the past year and a half:

Until humans can simply upload our consciousness and live solely in The Matrix metaverse, we will need mundane, earthly things. We’ll need to get around in cars and trucks. We’ll need electricity and the power plants that generate them. We’ll need buildings to live and work in, and we’ll need banks to finance them all. These necessities ensure the long-term durability of our portfolio companies, while capital’s cold-shoulder has made their equities cheap. If the story of semiconductors is instructive, this won’t last forever. 

A Little Bit of “2020” Hindsight

Rudyard Kipling once wrote, “If you can meet with Triumph and Disaster / And treat those two impostors just the same,” which pretty poetically summarizes my feelings about our past five quarters. From the early days of 2020 to the very depths of our worst drawdown that troughed on March 23rd, we saw our portfolio’s marks decline by nearly -50%. But then from thereon out to the end of Q1 2021, a period that spans only one short year, it rallied over 175%.

Practitioners of Modern Portfolio Theory, of which most sophisticated institutional investors are at least part-time, would downright faint at that level of volatility. For they make one key assumption: volatility = risk. Bluntly put, that is an analytical shortcut. It actually works serviceably most of the time. Risky security issues are typically volatile! But not all volatile securities are risky. And as a corollary, not all volatile situations are risky.

That was what we were facing in March of 2020: a volatile situation erupting from the first global pandemic in a hundred years. The key to decoding whether it was truly risky or not was our collective response. Do our governments hem and haw and wring their hands and ostrich their heads in the sand? Or do we unleash the full forces of monetary and fiscal stimulus while pouring in whatever resources it takes to develop vaccines in record shattering time? Very early on, it became clear it would be the latter¹. America would respond. And with that insight, volatility became less risk and more reward².

Through it all, the composition of our portfolio was little changed³. We earned our returns not through frantic trading nor furtively chasing “what worked”, but simply by staying steadfast and assertively increasing the ownership in our favorite, most familiar businesses at increasing discounts. Buy more of the same when prices are low sounds simple and unsexy. But I submit that it is not at all easy. It requires having a depth of confidence that can only come from the accumulation of knowledge and scars after following or owning a stock for years, which is needed to buffet against the psychological forces that threaten to overwhelm rational thought during periods of great tumult. It actually has nothing to do with any pompous notion of courage –– sometimes the right course of action is to sell in a proper panic if the situation warrants it –– and everything to do with, again, to quote Kipling, keeping your head.

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¹ However, if one mired oneself in political Twitterverse, one might very well have missed the forest for the trees given the rancid partisan rancor. Social media does not equal reality – a patently obvious statement but totally worth slapping on a sticky note on your desk.

² (Getting on my footnote soapbox here.) The development of four (and counting) effective vaccines against SARS-CoV-2 in less than a year is nothing short of a scientific miracle and a shining example of human ingenuity when facing a global crisis. Had COVID-19 emerged in, say, 1819, it would probably have slowly burned through the world population, mutating and spreading and exacting a multi-year death toll rivaling any of the great plagues in human history. We in America are indescribably fortunate to be first-in-line to be inoculated against this disease. But as of this writing, it is still raging in countries such as Brazil and India where access to vaccines remain extraordinarily scarce, so I cannot help but feel despondent toward those of us who reject vaccination because of, I dunno, political or conspiratorial or devil-may-care reasons while literally billions of people elsewhere would give anything to get vaccinated to escape humanitarian crises. It’s the epidemiological equivalent of the old admonishment, “don’t you know there are starving children in Africa?” when you waste food, except way more serious and way more sad.

³ Although you may recall my chagrin in my annual letter for not being sufficiently aggressive in investing in new names that I have long admired but never found the right valuation to enter into. It’s unclear whether or not our current returns would have been boosted if I did, but it’s more probable we missed out on steadier, longer term gains that those stocks would have provided in the coming years.

2020 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.