2Q20

This is my first letter. I’m starting to write letters because I do not give nearly enough attention to portfolio management. This is my investing “journal” that will help me progress on that.

 

I am very pleased with 2Q20 as the 30%+ drop in equities during February and March presented some incredible opportunities to buy some new names, add to current holdings, and trade around a bit.

My objective with every move is to inch the portfolio closer to some ideal combination of sex appeal and safety, with individual positions falling on a barbell from “high growth, long runway, future cash-generator” to “better than cash, won’t get you killed”. I feel that I’ve made great progress on the objective YTD.

While I do benchmark to the S&P 500, my true mental benchmark is what I get from the bank/inflation. Any after-tax return above that is gravy. That may sound silly, but it helps me on the mental side.

I use the market to learn about the world and myself as much as I use it to build wealth. I am lucky to be able to invest to begin with. As long as I beat that bare minimum, I have little to complain about – and I am confident enough in my abilities that I believe I can do that and more over time. Benchmarking to the S&P 500 or All World indices will matter over time, but in the interim it’s noise.

Thinking About the Market and Opportunities

2020 has been a whirlwind. I think it takes panic to really separate quality stocks from their true values, and we saw that in March. I am fortunate in that I just turned 26 years old. My time horizon is very long, over 40 years. I likely would have felt different about the S&P dropping ~35% (many stocks > 50%) if I were 60 years old.

Pundits have been scratching their heads at the fall and subsequent recovery in equity markets, but in many ways, I think this time really is different. The only true constant has been human nature. I don’t fault the many seasoned asset managers who have been bearish – look at their context – many of them grew up pre-internet in an economy with much higher nominal interest rates. I know the foundation I am building today will likely anchor my train of thought when I am older.

Market-wide fundamentals will likely be poor over the next couple years, but there is one piece keeping hopes alive, especially for growing, high-quality companies – interest rates. Right now, discount rates for equities are very low, and I think you can argue they are still overestimated in world class businesses. Below is a chart of the 30-year treasury yield since 1977, currently sitting at 1.4%.

 

 

This framework on discount rates hit me upon reading a 2016 interview with Nick Train:

“I’m sure that if you’re optimistic about technology and innovation then you should be optimistic about equity markets. And in that sense markets are always cheap…To me it appears that “exceptional companies with durable competitive advantages” are in fact cheap almost all the time.”

Train compares the Diageo (one of the largest spirits companies in the world) earnings yield of ~5% to long-term government bonds at 1% and essentially says “look, this business is going to be around in 30 years. It’ll likely grow in real terms, and you’ll get inflation protection thru pricing. If you agree it’s going to be around and doing well in 30 years, you should be buying this all day over a government bond.”

I add some cushion to this and use ~3%, which roughly covers population growth and inflation. I apply this to free cash flow because cash is among the truest accounting metrics, and I generally think in a DCF-type framework. Recall the barbell I mentioned above…framed by the majority of stocks I own around the midpoint of the barbell, any fantastic growing business trading around an unlevered free cash flow yield of 3% warrants attention. Not a hard and fast rule in practice, but the idea remains.

I’m willing to make this sort of long-term 30 year bet on companies like Home Depot, Sherwin Williams, and Waste Connections. Something drastic would have to happen to keep these businesses from being larger in 30 years. I know I can beat the bank with these.

Broadband internet is the new consumer staple. I think we are really starting to figure that out. Many technology and internet-based companies proved in 1Q that their businesses are fairly resilient…even when the world shuts down for a pandemic.

To be sure, 2Q reports will be messier as many companies and their customers are having more trouble now than they were in March. The shutdown occurred very late in 1Q. We are now at 3-4 months of pain for some. Loan covenants are starting to kick in.

Ultimately, I’m glad that I am not in the business of making predictions because I have no idea what’s going on or what’s about to happen. I’m just trying to find individual businesses that stand out from the pack, pick a reasonable price, and hold on long enough that time (& the business) will bail me out if the price wasn’t right.

Portfolio Commentary

I own 25 individual stocks. After building my portfolio from an initial few, I spent a while holding 15-20 stocks but was often nagged by my interest in the n^th name + it was hard to let go of a position if I wanted to buy something new. My time horizon is too long to spend much energy wrestling over one great business vs another.

I have since expanded to 25 and believe this is a good size…offensive but diversified. I now cover most of what I want to industry/trend/theme-wise, and I have a few more opportunistic positions that I am not so married to. I think that wiggle room is helpful for when I want to pivot quickly.

Below my two big positions in AMZN and (formerly much bigger) VCEL, I have shuffled the deck considerably over the last few years in an attempt to find my niche. Thanks to a couple blowups, I have realized a slight loss in total since Jan 2018 (and net gains YTD 2020). Tax is very relevant if I want to build a sustainable strategy, especially trading as much as I have. I’m building a long-term portfolio while taking advantage of short-termism and volatility.

I now feel comfortable as ever with the basket that I own and foresee relatively lower turnover going forward.

My top 3 contributors for 2Q were AMZN, VCEL, and AYX. Bottom 3 were each SPY put positions.

Amazon Inc. (AMZN)

Amazon became my largest position in 2017, and I haven’t touched it since. The stock has had a heck of a run and feels pricey around $3,000/share now. Asking myself if I’d be a buyer at today’s price, the answer is almost certainly, “no”, but in weighing the risk of holding on vs the risk in selling shares, I must hold onto this incredible company with an incredible runway. I plan to direct all capital to positions smaller than AMZN until the portfolio is more leveled out.

 

 

Worldwide e-commerce still has a lengthy runway, and COVID-19 has accelerated the shift to online. From the most recent earnings call, Brie Carere, VP of Marketing and Communications for FedEx below:

“..what I certainly can tell you is I believe that the e-commerce change is structural. We have seen a huge uptick in the categories that people are willing to purchase online, certainly moved into a higher value. We saw this trend, obviously, pre-COVID, but it has accelerated when you think about things like furniture, large packages, high-value electronics. In addition, we saw a huge change in who was buying online. Over 65 finally moved to online from an e-commerce perspective. I do not anticipate that these buying behaviors will revert back post-COVID.”

Cloud is still in the early innings, and Amazon has a significant first-mover advantage with AWS (yes, MSFT is taking share), sporting 47% of public cloud market share in 2019. Global public cloud is projected to grow at ~15% annually for the foreseeable future.

The stock is pricing in a lot of credit for the future, but AMZN has been executing wonderfully under one of the world’s best CEOs in Jeff Bezos. All in all, I think my best bet with AMZN is to do nothing. Satya Nadella at Microsoft is a stud. I wouldn’t be surprised if he turns out to be the biggest “risk” in my AMZN investment.

Vericel Corp (VCEL)

I started buying Vericel Oct 2017 in anticipation for revenues of their hot new product MACI (approved Dec 2016) to ramp up. The 3Q17 report in November was good and kickstarted some great momentum.

2018 was a solid year as the company grew MACI sales to $68 million, displaying nice incremental margins and expanding the target addressable market, among other things. VCEL shares +219.3%.

2019, on the other hand, was tough. I believe VCEL became more of a “show me” story. Revenue guidance for the year was not spectacular (mgmt. tends to sandbag, but still), and costs were rising to expand the salesforce, which wouldn’t be productive for some time. At $15-20, the stock was pricing in a fair amount of optimism, much more than what I saw in 2017-2018.

VCEL stock returned 0.0% in 2019 and -20.6% YTD. I trimmed some in 2019 and more in 2Q to get down to a less aggressive, more normal-sized position of ~5-10%. I still like VCEL, but in hindsight I spent too long holding and adding to what had become a very large position while putting far less capital toward more attractive opportunities.

Pair this with a couple blow ups in early-stage healthcare, and I have taken away a lesson.

I think there are very distinct narratives and investor bases in clinical/early-stage healthcare:

Stage 1 – pre-approval and commercialization – is all about potential. Investors look though the lack of fundamentals (reasonable) and focus on all that the company or product could be. The stock prices in hopes and dreams and does not discount much of the execution risk in commercialization.

Stage 2 – approval occurs and commercialization begins – we got approval, which it great, but now the hard part begins. Commercialization is expensive, and it’ll take time to ramp sales. The narrative quickly shifts from being all about potential to the long road ahead.

Coupled with a lack of patience, I have found stage 2 much more difficult than stage 1. Any future investment in early-stage healthcare will make sure to emphasize the narrative and where the company sits on the timeline from pre-approval to developed commercialization.

SPY (put)

Puts are new to me. I started buying these “insurance policies” Friday Mar 13 and have had a position on maybe ~2/3 of the time since. I have only bought in-the-money as I feel they are priced better for the type of protection I am looking for. They feel like less of a gamble vs out-of-the-money.

While I have realized gains on options, performance has been nothing to write home about. Puts contributed 1% of the 37.22% return in the quarter – positive April and May, negative in June. My biggest takeaway has been that timing sentiment is much easier around “bottoms” where there is more volatility (March, April) vs “tops” (June). Fighting momentum is hard, and while I have been bullish from March, I tried to play uncertainty and buy puts after strong runs. The strategy has only sort of worked.

I think about return on stress and effort as much as I think about return on capital. Option return on stress and effort the last month and a half was very low. Actually, negative. In just the last few days of writing this, I have watched my SPY put position go from +50% to -30%.

I plan to continue using SPY put options but need to be less hard-headed with my application. This last week has reminded me that I need to recognize gains when they come as greed can lead to a quick turn of fortune. Regardless, gains are gains. I made money playing the short side of the SPY, which returned +20.2% in the strongest quarter since 1998. I’ve gained some experience and will be better next round.

Blunders and Regrets

Fastly (FSLY)

I started buying Fastly in January and February, added some in March, and sold in April. Whoops.

I first heard of FSLY on a Quantlayer podcast (episode 59). While not in my wheelhouse, Fastly sounded like a unique offering that could very well be part of the next wave in technology, and I didn’t sense that many people were aware of what Fastly is doing. I think of it like last mile delivery for content. Content providers must be fast and accurate if they want to attract and retain an audience, whose demands for “better, faster, now” will not subside.

I saw FSLY as a real beneficiary and envisioned a good 5-10 years of momentum for a trend like this. My blunder: almost every company that I buy either generates free cash flow or they are close to generating free cash flow. I need a line of sight to cash to feel comfortable making a purchase. FSLY is a ways from generating cash, and I didn’t do the work required to understand when that might happen. I understood enough to take a stab at the stock and left to focus on things closer to my wheelhouse. The lack of conviction also led me to part with shares very easily when my radar was full of opportunities in April.

The good news is that as I have grown, I am much better at letting things run by me that I don’t fully understand. Timing here was awful, but 2Q worked out just fine in aggregate.

Floor & Décor (FND)

Right in my wheelhouse. Got too cute on an entry price and didn’t buy. Whoops.

During summer 2017, I visited every flooring store that I could find in Dallas and came away thinking FND has the potential to be a hit. If you’re focused on hard flooring, Floor & Décor is the spot. FND carries the most SKUs, has by far the most in stock, and offers great customer service. Smaller shops like Lumber Liquidators and The Tile Shop just don’t compare, and Home Depot/Lowes are spread too thin to offer the product and service that you can get at FND.

Flooring is not e-commerce friendly and often requires consultation and/or visual engagement. You need a physical presence. The high fixed cost model thrives on same-store-sales growth and delivers significant benefits from scale. The company is led by Tom Taylor, who spent 23 years at Home Depot overseeing the United States and Mexico while the store base expanded from less than 15 to over 2,000 stores. Look at HD now.

FND plans to more than triple its store count to 400+ over the next 10-15 years. I think the ball is in their court. The only thing standing in their way is themselves.

I was eyeing FND through May in the low $40s, looking for $30s on market weakness. Didn’t happen. I am watching this one like a hawk.

New Position – Progyny (PGNY)

I’d like to highlight one company that only recently hit my radar and just as quickly joined the portfolio. I could see this position being much larger once I get my head wrapped around competition and valuation.

Progyny was an Oct 2019 IPO that provides fertility benefits management to large employers of more than 1,000 people – Alphabet, Amazon, and Microsoft are their largest clients as a percent of revenue. Partnering with Progyny has proven to not only improve clinical outcomes but also save employers 20-30% vs traditional health insurance carriers.

In addition, partnering with Progyny has led to better employee productivity, less absenteeism, and it helps diversity and inclusion programs. Fertility benefits have a strong social tailwind that should lead to them being more accepted, requested, and required.

Infertility (disease of the reproductive system) is a large, growing problem that I do not see slowing down, and it does not receive much attention, particularly in the United States. According to the World Health Organization, “the overall burden is significant, likely underestimated, and has not displayed any decrease over the last 20 years.”

These two resources do a good job laying out the state of the industry:

https://healthcareappraisers.com/birth-of-a-boon-the-rise-of-fertility-clinics/

https://www.fertilityiq.com/topics/fertilityiq-data-and-notes/fertilityiq-best-companies-to-work-for-family-builder-workplace-index-2017-2018

Progyny launched its fertility benefits solution with its first 5 employer clients in 2016 and now has 132 clients with 2.1 million members. Management notes an addressable market of 8,000 self-insured employers representing 69 million covered lives, and the space appears wide open for the taking.

Progyny has integrated with all the major national carriers and possesses a barrier to entry as a result. Carriers are not incentivized to partner with Progyny. Progyny’s pitch all along has been that the carriers’ fertility solutions are ineffective, so “some very influential clients” (likely among the big 3) ended up forcing the carriers to integrate. Further integration and deeper relationships will only strengthen Progyny’s position.

CEO David Schlager has said “when you look at the carriers as potential competitors, we’ve really seen no movement in the past 5 years..maybe it’s because the carriers are focused on the $3 trillion of health care expense that’s running through their companies and not the $12 billion fertility opportunity.”

Research suggests to me that carriers have essentially handed Progyny a runway that is superior to that of its competitors.

2 things that I particularly like about this business if we assume it can keep growing:

1. Operating leverage. Progyny has experienced near 100% client retention, which reflects well on the company, and it also means they benefit from leverage in sales and marketing after some time. Customer acquisition costs are incurred primarily in the first year of a relationship and to a lesser extent in year two. If Progyny remains a leader, you’re looking at relationships (and revenue) lasting well beyond 2 years. I envision very sticky relationships here.
2. Relatively predictable. Progyny revenue is a combination of enrolled members and utilization of benefits, both of which are fairly predictable based on current conversations and historical trends. Predictable revenue gives Progyny a low risk investment runway as it grows.

In sum, Progyny is growing like a weed in a space that isn’t getting enough attention. They are debt-free and generating cash under a business model that exhibits high quality characteristics. Progyny has a whole lot going for them, and a $2 billion market value may not price in enough optimism.

Wrap up + Call to Action

I’ve come to realize that stock picking and portfolio management are two very different skill sets, and I need to work more on the latter. Writing this letter is a step in that direction.

One might look at my returns since 2018 and say I’m doing just fine, but the going has been good! I had a great stroke of luck with Amazon and Vericel. In finding quality stocks, I believe the best homework is done at all time highs. I need to button up my portfolio management and do the same while the going is still good, because my strategy to date has largely been “winging it”. For all the time I spend researching companies, I spend very little thinking about the kind of bets I want to make.

In going through my filings, I found something I never would have admitted or even realized – I trade the bottom half of my portfolio a lot. I have a core of ~15 names that I am pretty set on unless the thesis changes. With everything else, I trade around “good enough” companies in which I don’t find enough optimism baked into the price, letting the cream rise to the top and adding as conviction increases. If something doesn’t work after enough time, I likely bail and swap into something new as there are always opportunities.

The bottom half of my portfolio really is on the chopping block with every trading day, but this is probably the highest quality portfolio I have had from head-to-toe. That may affect my activity. As long as I am cognizant of taxes, though, I have no problem trading around. Markets have had a strong recovery amid a ton of uncertainty. Having realized short-term taxable gains in 2020, I am more open to holding SPY puts knowing that if I am wrong and lose money, I’ll offset some of those gains, and my overall portfolio will likely be up with the index.

I plan to work on a couple things during 3Q:

• Place my positions into thematic buckets. Right now, it’s mostly in my head. Find some way to measure and rank conviction. I need to improve on position sizing, which leads to the next..
• Be more intentional and aggressive with position sizing. Naturally, as my portfolio has grown, my initial position size has increased, but some of my cost basis relative to conviction is terrible. I need to beef up the bottom so that AMZN doesn’t decide my fate.
  • HD is one of my oldest holdings with a great return, but the cost basis is at the bottom of the pack among my high conviction names. For as much as I talk about HD to friends, I’ve got to own more. I didn’t add much in March because it’s “cyclical”. I did the same with SHW. I am done with that nonsense.
  • SPGI is a high-quality company that I added in March but was careful as the business is highly correlated to GDP. I am now +65% and feel like it’s barely moved the needle. I would love to own more but watched it run from $200 to $300+ without doing a thing.

If you made it this far, I applaud your persistence. Thank you for your interest in letter #1. I am incredibly lucky and incredibly happy to be able to invest, write, and share ideas with others. Please do not take anything I say as investment advice because as I said above, I’ve been winging it to date.