Dear investors and well-wishers,
The fund advanced 16.7% net in May. This took us to +10% net for the calendar year-to-date, and +22% net for the financial year-to-date (over this period the ASX200 total return was down -10%).
The past few months proved an excellent example of the strength and defensiveness of the technology sector. We believe those rare companies at the forefront of innovation should form a core part of investor portfolios, rather than their usual peripheral allocation.
The outperformance of technology is not unusual. The same pattern occurred in Q418 and the sell-offs in late 2015 and early 2016 (which seem cute relative to the last couple of years). This strength and defensiveness was also on display in 2011 and the various Eurocrisis sell-offs, and indeed the 2008-2009 financial crisis itself.
There are a number of structural reasons for this outperformance.
Firstly, many technology companies are able to add users and grow throughout recessions. Indeed, many of ours visibly accelerated. Our performance in May was largely due to the decision to focus the fund almost entirely in these companies, as we wrote about in our last letter.
Secondly, companies that are able to grow irrespective of the market cycle are a natural home for the waves of stimulus and liquidity that invariably floods the markets after economic shocks.
Government and central bank support is a feature, not a bug, and can generally be expected in the aftermath of crises. One thing that would change our optimistic market outlook would be a shift from policy makers from loosening to tightening, or any talk of austerity, which has so far been mercifully absent.
A third element - which was far more pronounced in this crisis than usual - is that tough market conditions foster new business models and behaviours. This time, the companies that benefited most were precisely those common sense would predict: e-commerce and digital health.
Finally, most tech firms hold net balance sheet cash, so are less leveraged to surprise falls in demand. In the software investing circles, the key debate is how much spending on high value licenses will slow. This is a far cry from the existential decisions facing leveraged industrial companies during an extended period of weak demand.
These characteristics ensure that portfolios of leading technology firms are surprisingly defensive. It's just our good luck that the very same companies can perform best in bull markets too.
We recorded a podcast with Alexander Portz, from UK VC firm Redline Capital, discussing novel technology companies and technology investing in public vs private markets. Available on iTunes and Spotify.
State of the Market
We wrote a couple of months ago that the perfect storm for equities was brewing, and indeed this was the case.
Short term momentum signals have recently flashed red, but sentiment (in the professional investor community anyway) remains negative, and professional investors are still holding large cash holdings. Tens of billions of dollars of central bank liquidity is still entering markets daily. We expect dips to be bought.
We remain optimistic about timelines around vaccine development, largely due to calls we've had with leading specialists in the institutions developing these vaccines. Some of our calls are transcribed, so get in touch if you'd like a copy to form your own view.
As I write, the market has erased its performance for June. For all the talk of market exuberance, the equal-weighted S&P500 is still down about 16%. This would usually count as a significant sell-off. The fact we have moved off strongly form the low is more a reflection of the severity of the sell-off, rather than where we are now.
There are parts of the market that are red hot, and demand caution.
Certain software firms, for example, have pushed to new valuation highs above pre-crisis levels. This is not entirely irrational, given that interest rates are lower and these firms have been largely unaffected (or even positively affected) by the crisis. Nevertheless, this directly reduces future returns from here. More than ever, this is a time to be intensely focused on valuation and price.
With this in mind we have continued reducing our holdings in software firms that have doubled or tripled from the lows, and are reinvesting the proceeds in areas where we think are next most likely to benefit, like renewables. We are also holding far more cash than usual, at over 15%. Long term readers of these letters know we won't be shy about deploying this at the right time.
Renewables are in a double sweet spot: the companies are seeing rapidly increasing demand, while the stocks themselves are attracting a similar intensity of interest from investors.
Governments around the world are announcing new solar projects, as the long-heralded cost advantages have finally become reality. Storage solutions are also coming of age, as seen in the highly publicised 150MW Tesla battery farm in Adelaide.
One market leader we invested in on your behalf is Enphase, which makes microinverters that turn DC current into the AC required for modern power systems.
These inverters are software enabled, so can easily manage, monitor output, and diagnose any issues panel by panel. Enphase, along with Solaredge, has clear market leadership. The firm has powerful support from solar installers, which is visible in the data: Enphase roughly doubled revenues in 2019. Based in California, over 500,000 solar systems on homes in Australia include Enphase inverters.
This clearly ticks all the boxes we look for: customer support, exponential growth and market leadership.
A key dynamic here is that decision-making often lies with those installing the panels, as installations generally come with long warranty and maintenance obligations. The solar industry has been plagued with cycles of over and under supply. There have been so many boom and bust cycles that installers only want to deal with the largest and best companies that can be relied upon to answer a phone call and supply new parts in 10 years. The demands on rooftop solar systems, namely decades of exposure to the elements, are intense.
As always, it pays to focus on the decision making process to understand the dynamics of these companies.
This is a core part of our investment process. We are intensely interested in understanding that moment when a decision maker picks one product over another.
Over the past two years the stock has grown EBITDA from $5m to $162m, and the stock is up significantly. We picked up quite a few shares during the coronavirus sell-off.
Multiples have compressed significantly from recent highs, largely due to the extraordinary growth in earnings:
SolarEdge, based in Israel, is at a similar intersection of intense demand for their products, and amongst the investment community, intense demand for their shares. Like Enphase, SolarEdge also benefits from a strong reputation within the installer community, and as with Enphase, we used the volatility of the past few months to build our position.
The bear case for these stocks rests on competition fears and a return to the old boom and bust cycle. But we think it unlikely that Huawei will be flooding the US with product any time soon. Relying on a Chinese partner is a risky proposition for installers, irrespective of who is in the White House.
Plug Power is another recent investment. Plug is a clear market leader in hydrogen fuel cells, with over 90% of hydrogen refuelings going into a Plug product.
Plug's fuel cells can be plugged into existing battery sockets for electric forklifts.
Hydrogen fuel cells have several advantages over typical battery systems:
- lead acid batteries lose their power with time, Plug's do not
- fuel cells involve lower overall cost and less labour
- fuel cells are non-toxic, with the primary waste product being water
- compact hydrogen refueling stations can release factory floor space reserved for battery storage.
Typically forklifts need three batteries: one in the vehicle, one charging, and one cooling down. This can all be replaced by a single station and a 90 second refuel when required.
The next step is delivery vans and automobiles. As always, we love a staged approach to value creation.
The key advantage for cars and trucks, of course, is that refueling can be done in a fraction of the time it takes to recharge a lithium battery.
Tesla was another investment in which we added to around $470 on March 16, near the crisis lows. Tesla needs no introduction, and we have written about it before. The Model 3 has now been the best-selling car in the United Kingdom for two months in a row.
Once again, investing in a category creator with true customer love, exponential growth, and genuine market leadership had paid off, even in a deep auto recession.
It's striking how well our two auto picks, Carvana and Tesla, have performed in a market where, in multiple geographies, auto sales have dropped over 50%.
Our base case remains that economic activity is depressed around the world on average, but significant pockets of the world are experiencing a true boom, specifically parts of the technology sectors.
E-commerce trends have remained extraordinarily strong, and promisingly, this strength has continued in areas which have removed lock-downs.
We have remained invested in over 35 stocks across our core thematics of: 1. Software 2. E-commerce 3. Digital health 4. Life sciences 5. Renewable energy 6. Companies changing the way we live A sincere thank you for all of your support,
ps we'll be hosting a webinarwhere we'll go through the current investing landscape and our portfolio in more detail next Wednesday, 17 June 2020, at 10.30am. You can register here.