2020 was a trying year for everyone, but I worked to make the best of what I could control and stay consistent.
I want to express my sincere gratitude to the people I connected with in the first year of Hindsight Capital and increased engagement on Twitter. I made new friends and learned a great deal. You’ve served as an inspiration and a motivator, and I’ve surely found some new ideas thanks to you.
I saw and felt euphoria that I have never experienced in the second half of 2020, and I would be lying if I said I didn’t feel the urge to swing the bat harder. The fast-money feeling is dangerous, especially when I feel like others are doing it faster.
In short, I am my own worst enemy, and I seek a process that best protects me from myself.
The third quarter got off to such a hot start that I began to fear conflating results with skill and letting hubris drive my decision-making. I took my foot off the gas for a short period and used the time to mentally reset and review my process.
I focused on returning to the core principles that drive my approach to investing. One that deserves emphasis:
Direction > Distance, Sustainability > Magnitude
Will Danoff is one of my favorite investment managers – he has managed the Fidelity Contrafund since fall 1990. Since taking over, Will compounded capital at 13.9% per annum, net of fees through August 2020 compared to 10.6% for the S&P 500 (source). A 3.3% difference over a one-year period does not sound like much, but that outperformance is mind-blowing when looked at over 30 years. $10,000 in the Contrafund in 1990 would be worth roughly $500,000 today versus $200,000 if placed in the S&P 500.
Just like small outperformance compounded over time can lead to miraculous results for a fund, a business moving in the right direction with sustainable competitive advantages can compound incredible economic value for shareholders that hang around.
Assessing the direction and sustainability of growth, profitability, and competitive advantages is a core part of my due diligence process. I make this a priority because it is easier to be correct on the strength and sustainability of a business model than on an estimate of the business’ value.
To make things easier on myself, I think step one in getting direction and sustainability right is making sure that I don’t get it wrong. I’m assessing the tide and finding ways to swim with it. I have no interest in trying to swim against the tide.
Some examples of what I avoid include:
The broad energy sector. I have not only little-to-no expertise here, but also no idea what the future of fossil fuels looks like versus increasing attention and application regarding cleaner energy. There are sensible, convincing arguments on both sides of the table, and that is my point. I’m not interested in making a bet on either side because I just don’t know. I’d like to avoid such two-sided arguments.
Sugary drinks and unhealthy food. If I’m betting on human nature, demand for these items will remain, but the “share of mouth” trend could change. While the Coca-Cola cash flow stream may last forever, I don’t have great confidence that it will be higher in 10-20 years. At the least, I’m not confident that sales growth will exceed GDP. “GDP growth plus a hair” is the floor that I typically look for, and that is ideally driven by volume, not price.
Physical businesses facing severe disruption by online offerings. Land-based casinos are a front-of-mind example here. Just about everything related to gaming and gambling is increasingly online, and the runway is very long for companies that are in the right position. Will there be demand for physical casinos 10 years from now? Absolutely. These businesses will probably experience a surge in activity once COVID is gone, but I do not have great confidence in the longer-term trend, let alone any estimate of when current pain will subside. This leads to my final example…
COVID re-opening and recovery plays. Judging by chatter on twitter, I was surprised by how many people appeared to be diving into recovery plays early on. Granted, many of these stocks were down a lot, but there was so much uncertainty involved. Still today, I get the impression that people expect a sort of “all clear” signal, and life will then quickly return to normal. I just cannot bet on that. I have no sense for how and when these businesses can return to 2019 performance, let alone growth. Now, many of these stocks have since recovered, and a handful of them are now valued above where they were pre-COVID! I don’t understand it, but I don’t really care. Assessing some of these businesses requires making predictions that I just can’t make. I will let someone else go after that alpha.
At the core of all avoid theses is a mantra: in a world of thousands of stocks, you only need a handful.
Now, some examples of how I look to swim with the tide:
Ecommerce (e.g. Amazon, Walmart). The internet has been life-changing and habit-forming for the consumer, whose spending accounts for roughly 70% of GDP. Successful ecommerce platforms have removed frictions to make online shopping simple, enjoyable, and frankly too easy. These platforms have become staple-like in some ways, and behemoths like Amazon and Walmart are reinvesting at very high levels, further strengthening their competitive positions.
Amazon and Walmart’s antifragile characteristics were on display through 2020 as COVID-19 accelerated the trend toward ecommerce, taking the online share of addressable retail from mid-high teens to over 20% in the U.S. I believe it is more likely than not that this share will increase over time in the U.S. and abroad. Large, customer-centric companies with a frictionless shopping experience should be beneficiaries.
Home improvement and home-related skilled labor (e.g. HVAC, electricity, plumbing). Stocks I own that fit in this broad category include Watsco, SiteOne, Home Depot, Sherwin Williams, Carrier, and Otis.
I like to think of home improvement like highway construction. It’s always happening. We’re either building new roads or fixing old ones, and as the web grows larger, the number of roads that need to be fixed only increases. The installed base of homes is always growing, or at the least, it won’t shrink.
The majority of home improvement products are not suitable for ecommerce and shipping, and they often require technical knowledge and/or consultation.
Keying-on Watsco…HVAC systems are a key part of the home and account for roughly half of all energy consumed. These are things we use all the time. When they break, the average person has no idea what to do, but they want it fixed ASAP. This is something I am comfortable betting on not changing long-term.
People that service these areas are price makers, not price takers, and demand is consistent. Per management, HVAC units are “indifferent to the economy. They don’t care what currency is. They don’t care who is president. The machines are going to break.” A company of Watsco’s size (2-3x the next largest competitor) is able to reinvest its earnings in technology and related to pull away from the pack. Add a world-class management team, and Watsco has the makings of a superior long-term investment in my eyes.
Fertility benefits (e.g. Progyny). Infertility is a growing problem that, in my opinion, is not being discussed enough. Worldwide fertility rates are dropping, and people are waiting longer to reproduce. The United States is behind in addressing this issue. Fertility needs, for which Progyny is a leading provider, are on the path to becoming more recognized, requested, and required by employees and candidates. While awareness continues to increase, I am betting that there is a gap between the perceived importance of fertility needs and the ultimately realized importance. With near 100% client retention rates, Progyny enjoys fantastic leverage in sales and marketing and is able to reinvest on a low-risk runway as the business is relatively predictable.
Online dating (e.g. Match Group). The mating dance is relatively insensitive to the ebbs and flows of the economy, and the taboo surrounding online dating is withering away as apps like Tinder, Hinge, and Bumble grow in popularity. In its recent S-1 filing, Bumble estimated that the global online dating subscriber pool would grow at an 11% CAGR from approximately 190 million people today to 391 million in 2025.
I am most interested in Match Group as it owns the world’s most popular dating app, Tinder. Tinder benefits from a fantastic network effect. Let’s say there are 100 people on Tinder Dallas. Your odds of meeting someone are not great, but with each incremental user, your odds improve. That is great for the user and great for Match. At scale, it presents the most attractive option.
Further, consider the early adopters and who the apps have been marketed to -> young folks. As teenagers and 20-somethings age, you will see usage increase among the 30-40 year-old cohort. There is a naturally growing subscriber pool, and it will grow with users to whom online dating feels more normal. Propensity to pay is a tougher sell versus subscriber growth (currently 16% of online dating users in North America are paying per Bumble S-1), but the cost is small compared to the potential reward. I am betting that more people will pay over time.
The biggest risk to me is that someone builds a better mousetrap, but you can also make the argument that Match only gets stronger as it grows. Incremental investment required is small, so Match can reinvest further in product development and in sales and marketing.
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If I swim with the tide and find exceptional businesses with shrewd management, I think I can reliably hit singles, which can very-well turn into doubles and triples. If I can get in at a “singles” price, which may not look optically cheap, I can still win a lot. I’m putting myself in a position to be pleasantly surprised.
Valuation is, of course, an important factor, but I try and save it for the end of my diligence process. It is moreso a sanity check than it is a driver of an investment decision. After developing a view on the business model, I evaluate whether the prevailing market price over or under-appreciates the business. Underappreciation of a solid business with good management = green light.
This has been a key shift in my approach over time. When I first started investing, I looked for attractive stocks (i.e. optically cheap) instead of attractive businesses. Over time, my approach to valuation has shifted from thinking of companies as “under-valued” to “under-appreciated”. I think that mindset shift has helped and gives me an edge over the average investor who is too short-term oriented and/or prefers to focus on merits other than sustainability.
Portfolio Commentary
Additions
Roku (ROKU): This was my first buy of the second half, and it could not have been earlier…pre-market July 1. ROKU is the leading provider of smart TV operating systems in the US, reaching over 50 million households as of the end of 2020. They’ve won big share by giving away their operating system to TV manufacturers while everyone else was focused on streaming boxes and sticks. ROKU generates revenue primarily through advertisements on its platform. More simply put, they monetize their massive user base. Because ROKU owns the most eyeballs in streaming (and their associated data), the value proposition is strong for companies to shift advertising away from linear TV and toward ROKU. I got the sense that ROKU was a bit misunderstood, and a sanity check on enterprise value (~$15b at the time) told me there was not nearly enough optimism baked into the price.
Walmart (WMT): Walmart is a proven staple in retail, serving over 265 million customers each week in its ~11,500 stores and online. The company grew stronger through the pandemic as stores remained open, and the recent launch of Walmart+ underscores a long e-commerce runway that is a fantastic opportunity for the reinvestment of cash flow and growth of the Walmart brand.
At the time of purchase, WMT was trading at 4.5% trailing FCF/EV. That is not expensive for a company with ridiculous staying power. I feel comfortable underwriting pedestrian returns with potential for more at such a price. This can also be thought of as an AMZN hedge, although that was not a driver of the investment decision.
Inmode (INMD): Inmode is a medical aesthetics company that has been growing like a weed with impressive returns on capital. The company is led by the founders, who own almost 1/3 of shares outstanding. I noticed little-to-no institutional ownership at the time of purchase, which was also interesting – stock was at ~$1B enterprise value, so rather small for most funds. INMD stock was hit hard in the first half of 2020 as discretionary procedures came to a halt, but the company still generated cash flow on 2Q sales that were down -21%. The valuation looked too good to be true at low 20s P/E on normalized sales growth of ~50%. I was particularly drawn in by the fact that Inmode reminds me of Ubiquiti Networks, which had similar criticisms and valuation years ago. The main concerns for me are uncertainty regarding the sustainability of low R&D spend, reinvestment opportunities, and what revenue growth could look like in 5-10 years. At the time of purchase (~$30/share), these concerns appeared to be well-baked into the price.
Microsoft (MSFT): Like Walmart, nothing special here. Microsoft is a juggernaut that I have watched run for far too long, and I found an opportunity to buy the stock in 4Q. At the time of purchase, Microsoft was trading at > 3% FCF/EV while growing FCF at a double-digit rate. The company is investing almost $20B/year in R&D, a size few can match, and it generates impressive incremental returns on capital. I expect Microsoft can continue this successful reinvestment for many years as it is a core player in the growth of the internet age. CEO Satya Nadella is a fantastic leader that I trust to put my money behind.
Fulgent Genetics (FLGT): Fulgent Genetics is an owner-operated genetic testing and diagnostics company. Fulgent leverages technology and automation to efficiently perform tests on top of one of the lowest cost bases in the industry, which is important in a space that, to me, will ultimately be commoditized. That said, I did not buy the stock for the core testing business. I bought because Fulgent rolled out COVID testing in March 2020 and has been firing on all cylinders since.
Fulgent entered 2020 operating close to break-even and is now generating significant cash flow from rapid COVID testing. They are winning new core business and building long-term relationships due to best-in-class execution – more than half of 3Q20’s largest core customers were new in 2020. At the time of purchase (cost basis ~$40), FLGT stock was implying only 1-3x FCF for the COVID business after backing out the core business at a peer multiple valuation. To me, this valuation implied an abrupt end to COVID testing in 2021 (something I am willing to bet against) and likely underappreciated the long-term benefits accrued to the core business from recent success. This is a rapidly changing story that neither analysts nor markets have been able to put a finger on, and I expect the 4Q20 earnings report to be very strong.
Fathom Holdings (FTHM): Fathom Holdings is a cloud-based real estate brokerage that is unique in its commission structure and strong culture fostered by founder and CEO Josh Harley. This recent IPO has a very low fixed cost base relative to office-based peers which enables the company to offer agents the most attractive compensation and incentives in the industry. Focus on culture has played a part in driving industry-low attrition along with an exceptional 4.8-star glassdoor rating.
While the narrative is focused on agent growth, Fathom is progressing toward something interesting in title insurance and mortgage services. Fathom acquired a title company (Verus Title) in November 2020. Should Fathom acquire a mortgage services company, they’d be the only brokerage with fully owned title and mortgage.
Franchise real estate models can’t legally compensate agents for attaching other services. EXPI and others have chosen to JV mortgage services as they focus on building their brokerage. These agents are not as incentivized to attach title and mortgage services because they can’t be compensated as well as they could under a fully owned model. Fathom has an opportunity to develop a great retention tool here.
Closing Thoughts
I think I have developed comfort in my portfolio by focusing on long-term direction and sustainability. The qualitative nature of these characteristics makes them difficult to measure, which puts their merits at risk of underappreciation. I am increasingly interested in what cannot be measured as more investors use computers, data, and focus on measurable factors.
I’m not sure what’s to come after a decade-long bull run, but I want to be ready. 2020 turned out very well from an investment perspective. I’m in trouble the moment I take that for granted.
Going forward, I will continue to structure my investments and mindset so that I can play offense when the average investor is fighting fires. Let’s continue looking for companies that will deliver pleasant surprises.
PS, if you are considering an investment journal of any kind, I highly recommend it. Putting my thoughts into written words made me look at my process and portfolio in a new light. The short-term results of this year are not enough to draw any conclusions, but I do feel that my process has improved. That is the desired outcome from which good, sustainable results will come.