Dear investors and well wishers,
The fund returned -0.2% for the September quarter.
At the start of September we had small positions in leading US software and technology companies (Shopify, Exact Sciences, Twilio, Alteryx), which are now off about 20-35% from their recent highs.
These kinds of opportunities are welcome, as the sell-off pushed many companies below the valuations they were trading at December end of 2018, which you may recall was quite a Christmas panic.
Compressed multiples and >50% organic growth generally lead to strong returns, and most of these companies advanced over 100% in the months following the last time they hit these levels.
Even firms like Google are now below December 2018 levels, trading at 12.1x 2019 EV/EBITDA and 10.5x if you’re willing to look forward a year. The stock closed 2018 at 12.4x.
We’ve simplified our equity portfolio down to 16 stocks:
1. Software-as-a-service: Shopify, MongoDB, Twilio, Alteryx
5. Diagnostics: Exact Sciences, Invitae
6. Biotech: Amarin, Clinuvel, bluebird bio and Actinogen
Many of these companies reported rapidly rising short interest in September.
Short sellers have to buy back the stock they sell, so usually have no net long term impact on price. However, they do magnify extremes, pushing shares down further during sell-offs than they would go otherwise, and pushing stocks higher in rallies as they’re squeezed out of positions.
This volatility is unwelcome, but short interest is a good marker of sentiment, and our best performers generally had exceptionally high short interest at initiation. Some of these stocks (eg Twilio) seem to have moved full circle from consensus longs to consensus shorts over the past few months.
We have been wanting to make leading US software companies a core part of the portfolio for some time, as they’re simply some of the best businesses around. They’re capital-lite, loved by customers, have very high switching costs, post exceptional organic growth rates, and in most cases are only at the beginning of their journey.
This is not just opinion: it’s evident from their exceptional growth rates and the fact that, in our portfolio companies anyway, existing customers are spending 20-40% more each year. That might even underestimate the true pricing power of these firms, as they're currently optimizing for growth.
This table below summarizes:
1) how far these growth stocks have fallen 2) how high their organic growth rate is 3) an indication of how far their sales multiples have come from December 2018 levels. There may well have been exuberance two months ago. Now the opposite is the case.
We have no read on where markets go next, but do expect all these stocks to make significant new highs in the mid term.
After falling 20% in September, Carvana rallied strongly in October so far. This is the kind of volatility we aim to look through.
Carvana stock price (blue) and short interest (black).
As we discussed in our last letter, the firm reported outstanding results and web traffic suggests the company is on track during the current period. Nevertheless, the firm dropped to 1.9x consensus forward sales, and 1.6x on our own estimates.
This is a very interesting level, as Carvana has bottomed here in the past.
Far more importantly, Carvana may well be able to maintain this multiple at maturity, which would mean the shareholder return would equal the companies top-line growth, net of share issuance. Carvana’s current organic growth rate of over 100% per annum can come down quite a lot, and still offer a spectacular 5-10 year return.
To reiterate the thesis, Carvana has a vastly superior customer offering and better fundamental economics than traditional dealerships. The firm has 0.4% market share, and we expect the firm to achieve well over 4%, which is 10x from here, and would roughly triple the fund alone. Given the rarity of opportunities of this quality, we are happy to look through this kind of volatility. Short interest remains at about 38% of shares outstanding.
US software firms were one of the worst performers in September, though this was off the back of very strong returns.
Our portfolio company Twilio is now down well over 30% from its recent highs. We expect Twilio to be one of our strongest long-term performers, and we were able to add to this investment.
Twilio (blue line) and short interest (black line). As you can see, the firm rallied significantly the last time short interest rose this high.
Twilio negotiates and manages deals with telcos all around the world, then wraps this up into an API, so that any developer can easily incorporate SMS, messaging, email and other communication services into new applications.
Even the largest start-ups in the world (Airbnb, Whatsapp) use Twilio, as it’s more efficient to use the best-in-class provider and let them deal with all the problems associated with a constantly changing telecommunications landscape. The firm is expanding into new areas like call-centers.
Twilio has a net expansion rate of over 140%, so existing customers are paying 40% more each year, net after accounting for those that leave. This is a strong base line of growth. When you add in new customers, organic growth is running at 56% year-on-year.
As a sense-check, the firm is spending ~33% of sales to generate 56% organic growth in recurring revenue, so this is money well spent.
In December 2018, the firm closed at 13.3x sales. Twilio is now trading at 12.4x 2019 sales, and 9.3x 2020 sales. That’s quite a contraction, and again is approaching levels which Twilio could sustain as a mature company.
What’s particularly interesting here is the rising short interest, which is now equal to 17% of the firm’s shares, and will no doubt add as much spice on the way up as it has on the way down.
If organic growth slowed to the firm’s net retention rate (so no new customers) and Twilio stayed on its current sales multiple, this would equate to a 5x return over 5 years.
Current EV/Sales is 13.0x historic, organic growth rate at Twilio's latest results was 56%, so we assume a significant reduction in both.
MongoDB is a cloud-hosted database company taking on the likes of Oracle. If you learn to code online or at one of the many blossoming bootcamps, you will almost certainly learn on a stack that includes MongoDB as the database.
MongoDB launched their ‘Atlas’ product for enterprise, and this posted growth of over 240% last year, and now represents 37% of revenues. As momentum here continues, MongoDB could well maintain its 67% organic growth rate.
Again, we see high short interest and excellent fundamental performance. Could the stock fall another 20-30%? Absolutely. But that would push it down to levels where we could comfortably expect >5x returns over the next five years.
The firm spent $143 million in sales and marketing to increase recurring revenue by $161 million. This was only for one year, and MongoDB’s net expansion rate is running at over 120%, so the return from that sales and marketing expense is likely to be many multiples of this.
As MongoDB is a database, we can expect existing clients to pay more and more as their applications increase in size, and there are strong lock-in effects, as it’s non-trivial to switch this part of the stack. The real competition here are incumbent firms like Oracle, which rely on aggressive sales tactics and contracts to lock customers into old technology. MongoDB is cheaper, with a more flexible offering, and friendly SAAS land-and-expand sales model.
We’ve been tracking this company for some time, and after watching the stock drop over 30% from June 2019 highs, we initiated an investment at the end of September.
Shopify offers a cloud-based multi-channel e-commerce solution, allowing merchants to sell across physical and online channels, manage inventory, process and track orders and payments. We have been waiting for a sell-off like the one presented in September to build a core position in the firm, and should the sell-off continue, are ready to increase this substantially.
Products launched on platforms like Instagram invariably use Shopify to manage their website, take orders and handle payments. Merchants quickly become more and more integrated with Shopify with time, making switching harder – though Shopify is a clear market leader anyway.
Shopify offers a far friendlier solution than Amazon, who systematically tracks which products are selling well, and if anything proves particularly popular they launch and promote inhouse competitors. This is not the kind of backend you should build a business on.
The interesting part here is the customer base, to whom Shopify can sell more and more services. They launched payments provider and have started offering loans to the merchants on their platform. Shopify Capital has access to real-time sales data, so will have a real edge when it comes to lending. Shopify’s strategy of being a one-stop backend to e-commerce ensures that customers are willing to trust the firm in a way they would never trust a competitor like Amazon.
It’s quite likely Shopify becomes the leading contender to Amazon. The market has already begun to split into bulk, discounted offerings on Amazon, where merchants compete fiercely with each other and Amazon itself, while all new direct-to-consumer brands and start-ups build their businesses on Shopify.
Shopify is building out a fulfillment network, meaning they'll handle inventory management and distribution for merchants. This is the first viable competitor to Amazon Fulfillment, and for most merchants will be a superior option, due to the competitive conflicts mentioned above. This will generate more revenue per customer, and provide more incentives for merchants to stay with Shopify.
Shopify trades on a premium, but rightly so. The firm has sold off about 22% from August highs, and we have increased our investment. Should the firm sell off another 25% or so, we would increase our investment further still.
Exact Sciences offers Cologuard, a test for colon cancer, that is more accurate than previous stool tests, while being less invasive (and far cheaper) than a full-blown colonoscopy. The firm has recently expanded into blood tests, but the main game is expanding Cologuard. This test should be taken every three years from the age of about 45, so there’s an element of recurring revenue here.
The firm has 5.7% of the market, and is targeting >40% market share. As always, we look to operating performance to test these kinds of targets.
A few weeks ago Exact Sciences reported revenues nearly doubled organically, tracking at 94% year-on-year for Q219, at gross margins of 74%. The firm holds net cash of $1.2 billion (on a market cap of $12 billion).
The firm sold off sharply in September, from $122 to $90, and we took the opportunity to triple this position to a core >5% weighting. Using another barometer of sentiment, the last time the stock traded at this multiple, the stock doubled over the following four months. Irrespective, we expect to hold this for a long time.
Short interest is over 10%, so there’s certainly no exuberance here. The stock has retraced four times like this over the past three years, over a period where total gains were ~500%.
Exact Sciences EV/Sales multiple (blue) and revenue (black dotted lines). As you can see there has been steadily increasing revenue, but high variation in sales multiple.
In contrast to the volatile share price, operating performance has been metronomic. This is a common theme across our portfolio. The stocks themselves are highly volatile, but the fundamental performance is not. Gross margins are 74%, and the stock showed high operational leverage: in their last results the firm’s net loss margin improved by 17 percentage points over a year where sales almost doubled.
Over the next five years we expect growth to average considerably less than the current 94%, and the multiple to contract from 15x. But as you can see, when you model the company out and flex by those two variables, 5 year returns will still be excellent:
Latest reported organic growth rate was 94%, EV/Sales was 17x using last 12m sales, 10x using 2020 sales, so again we assume a dramatic slowdown in growth and significant reduction in multiple in the table above.
Even at this stage, Exact Sciences is posting 74% gross margins.
We have waxed lyrical about Afterpay before. The stock has now come off about 23%, but US search traffic stats are stronger than ever, and Afterpay has retaken top spot:
On the surface it’s disappointing to end the quarter down 0.2%, particularly after strong results in our core companies, but this offered a rare opportunity to invest in some extraordinary companies at multiples below those of December 2018, which was itself a rare buying opportunity. My own family increased their investment at the start of October.
All our portfolio companies have a realistic pathway to >3x returns over the next 5 years, and these calculations assume a dramatic slow-down in growth and contraction in valuation.
Our portfolio companies have high gross margins, improving profitability, exceptional organic growth rates and multi-year runways. With the exception of Afterpay and Carvana, they also have net balance sheet cash. In most cases we can track performance week-by-week using third party web traffic data, and these are all pointing in the right direction.
Our strategy from here is simple: we’ll continue testing our investment theses against quarterly updates and third party data, while slowly and incrementally increasing investments in the highest quality companies if and as they sell off any further. Feel free to get in touch if you would like to discuss the portfolio or arrange a time to chat in person.
Best regards Michael Frazis
Our fund is available to wholesale clients, and the online form can be accessed using the button above.