COVID-19 and Portfolio Thoughts

Well, that was a fun! *sarcasm alert*

Our Man isn’t a doctor and, unlike far too many in finance and politics, he doesn’t even want to play one on TV! It says far too much about today’s world that the most sensible thing about COVID-19 from a non-expert came from the manager of Liverpool FC!

Thus OM isn’t going to opine on the spread of COVID-19, how you should deal with it, and what the various estimates of the virus’s potential R0, incubation period and case fatality rate are or what they might mean.  If, like OM, you work at a smaller company he will point you in the direction of Elad Gil’s primer and if you want to start thinking about the broader economic effects of a pandemic then Professor Wren-Lewis has you covered.   The three things OM will note is that so far we’ve learned:

1. Strict containment works in limiting COVID-19’s spread (see Singapore)
2. Aggressive and broad testing helps identify early who to isolate in order to prevent the virus' spread (see South Korea).
3. Western countries have, so far, been slow to do both of these things.

Instead OM is going to talk about is the market and some forward looking thoughts, as well as what it might mean for the portfolio. 

While COVID-19 originated in China, it was largely ignored by Western markets until the end of February, which coincided with (was caused by?) a sharp rise in cases in the West. The subsequent correction has been swift, sharp and brutal.   The largest factor in COVID-19’s market impact is the uncertainty – how far will it spread, how bad or deadly is it, and how much impact will it have on the economy and life. In the absence of high quality data, and limited trust in leadership and institutions (WHO, Chinese Government, CDC, etc.), the range of outcomes is wide and it’s often the loudest, not the best placed, voice that holds court. After not affecting the markets for ~6 weeks, this uncertainty quickly became doubt and fear.  In such times, investors go where they feel safest and to what has worked previously – especially government bonds. In the US equity markets, that has been Software and especially Software-as-a-Service, which ended February +7% for the year.

Since COVID-19 started in China, OM will be watching to see the resumption of normality there first.  Like all systems, China’s is incentives based - watch what the government does not what it says. OM is doing that by stealing Bill Bishop of Sinocism’s playbook for signs of China declaring victory.   OM doesn’t expect to be a buyer of much until we at least start to see:

• Xi visit Wuhan
• The Two Sessions is re-arranged
• Kids are sent back to school

OM’s operating assumption is that the uncertainty is the West will linger until there is greater clarity on COVID-19’s spread and impact, and the stock market will reflect this.  The longer it lingers then the worse the economic impacts of COVID-19 will be.  Even at this stage, OM suspects we’re starting to approach the point where we need both fiscal and monetary stimulus and the much like in 2008, it’s not going to come (in enough size) immediately.  Finally, the UK with an emboldened Prime Minister, a new Chancellor and a new Governor of the Bank of England might even be the first country to go full MMT on us!

So what is OM doing with the portfolio?

Unfortunately, nothing so far. 

Here are the things on his docket for the coming days/weeks:

- Technical Book: It saw its sell signal near the end of February.  Real-life issues meant OM failed to exit it during last week’s bounce, he won’t be so remiss next time.

- Uranium:  Though it has largely held up pretty well, OM is looking to exit the Uranium ETF (URA) position that is about 50% of the uranium exposure.  This reflects the reconstitution of the ETF to provider broader uranium exposure, and not just to the miners.  OM’s thesis is focused on the miners and a new more appropriate ETF (URNM) launched at the tail-end 2019.  Expect the capital to end up there eventually.

- Emerging Markets exposure:  OM has a LOT of it – Greece, Vietnam, Brazil and India are ~40% of the portfolio.  Irrespective of the long-term outlook, in times of financial stress emerging markets are never the place to be and OM will be trimming this exposure back.  This was not an unknown risk, and he should have been more proactive much earlier in the year!

- Software-as-a-Service: is largely flat on the year, despite everything.  OM suspects that it goes one of two ways from here: 

(i) COVID-19 fears are quickly dispelled and Software becomes that mythical investment; it protected when there was huge uncertainty and is also growing rapidly.  If so, OM expects to hear justifications that surely such a business, which was valued at 10x Sales before the model proved itself in times of economic stress deserves a higher multiple still?  And so, a real bubble shall have its narrative (and crypto as the logical extreme of this concept will go crazy).

(ii)  Or perhaps SAAS stocks are just 2020’s version of commodity stocks in 2008 – bullet proof and up healthily in mid-2008, until they collapsed to end the year down ~80%.  If so, they’re probably an attractive buy with far far better valuations at that point!  

Either way, OM will be exiting his position in the broad Software ETF (IGV); originally, it was the best of the bad proxies for SaaS.  OM would rather add capital to the existing position in the WisdomTree Cloud Computing ETF (WCLD), a recently launched SaaS-specific ETF, when it becomes clearer which path software will take.

- Shipping:  Oh shipping, that beautiful delightful hot mess.  See the most recent post!

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take it that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc. 

4th Ind. Revolution Theme: Enterprise SaaS (Part II)

As this theme is a little complex, and more speculative than most of OM’s positions, I thought I would invert this post by starting with the conclusion and then walk through some of the underlying valuation parameters and rationale.   There’s a small bonus for readers who make it to the end…

Conclusion

Our Man has taken a small(ish) position in the iShares Expanded Tech-Software Index (IGV), a broad US software index.  In time it will be replaced with the recently launched Global X Cloud Computing Index (CLOU), which better represents the Enterprise SaaS market.  OM took this position, despite the high valuations in the Enterprise SaaS market, as it reflects:

• OM’s flaws as an investor; he is better at following and adding to positions when already invested as opposed to just tracking it.  In this case, OM believes it’s a multi-year secular theme and so is comfortable with a small position that he will add to at lower prices.
• It is a more speculative position.  In short, despite the moves of recent days, OM believes that there’s a significantly underappreciated chance of a melt-up market (think S&P 4,000 within 18 mos), and in such a scenario software is likely at the epicenter of it*.  This would see valuations go from the current expensive to ridiculous!

However, as noted this is on the speculative end of OM’s positions and at these valuations…caveat emptor!  Our Man has expressed his queasiness at stocks, let alone an entire industry, trading at over 10x revenue; it’s rarified air, for only those stocks that have (or will have) BOTH good revenue growth and great margins.   The margin for error in these stocks is small, as this 2002 quote from Scott McNealy, the former CEO of Sun Microsystems (which traded at 10x revenue in 2000) reminds us. 

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

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SaaS Valuation
Rather than inundate you with excerpts from my crappy badly formatted spreadsheets, I will let the below chart from the HighPeak Financial blog succinctly tells the story of SaaS valuations (~51 cos) over the last half-decade.

Source: High Peak Financial - Cloud/SaaS Public Company Valuation - Q2 2019

The chart shows a very visible step-change in valuations since the start of 2018; before this date, the group had rarely traded over 8x sales and since it, they’ve rarely traded below 8x.  This is not something that’s gone unnoticed with numerous newspapers (e.g. WSJ) and finance sites commenting on the high valuations.

The justification from public investors has largely been as follows;
- The Q4-18 swoon had no major impact on the businesses of market leading/best in class SaaS companies, providing further evidence of the resilience of the SaaS model.  This is a further sign that the business model is proving out.

- The largest SaaS companies - especially Salesforce (CRM) and ServiceNow (NOW) – continue to show strong growth and meet the ‘Rule of 40%’.  The Rule of 40%, is an industry rule of thumb for a healthy software company that states your Growth Rate + Profit (typically EBITDA is used, but that’s a whole separate debate!) should add up to 40%.  As a rule of thumb it is of course imperfect (the trade-off between growth/profit is not linear, unit economics are vital but not included, etc.) but nonetheless the spirit is a good one.  The strength of the growth/profitability of ServiceNow and Salesforce, which are $50bn+ enterprise companies that are 15+ years old,  is viewed as particularly given data shows the difficulty of meeting the Rule of 40% as companies age and grow.
However, this less impressive than it seems.   Visa is the poster child of a company that has traded at more than 10x Sales, it has done so for the last half dozen years and is currently at 17.7x Sales.  It’s Revenue Growth (12%) and EBITDA Margins (67.4%) come in at over 79%, rather higher than the Rule of 40%!

- Recent M&A is used to justify current multiples, such as the recent deal where Salesforce acquired Tableau Software at 11.2x TTM Sales.

- Low interest rates and limited growth, means companies with real organic growth deserve a premium valuation.

- Finally, the number of recent IPOs means that only a small portion of the shares are available to be traded (as some investors remain locked up, and unable to sell).  As such, demand to own these stocks is outstripping supply (available shares) leading to higher valuations and in the medium-run this will likely moderate as locked-up shares become available for sale.
However, in the short-run there is the possibility that SaaS stocks might act like Giffen goods.  That is that the high stock prices from the current excess demand will lead to an increase in the float (shares available for sale, as investors sell them and crystallize these valuations after the post-IPO lock-up ends) AND increased demand from programmatic or rules-based buyers (e.g. ETFs) that automatically increase demand as the float increases and the stocks became eligible for inclusion (or larger position sizes) within indices.

How to Express the Enterprise SaaS Theme?
There are approximately 100 Enterprise SaaS companies in the US, of which just over 50 are publicly listed.  This makes gaining exposure to the theme via public markets relatively easy.

a). The optimal way is a concentrated portfolio of 5-8 well-researched positions, utilizing the liquidity of the public markets to adjust position sizes, and buy/sell positions with a long-term (i.e. multi-year) horizon.  Professional friends will recognize this as a fairly typical hedge fund co-investment strategy, where a skilled manager can take advantage of a secular trend, in-depth research, concentration and a longer-term horizon to outperform an index.  The difficulty of such co-investments is that the best managers for it are ‘true believers’ and so the decision to exit lies entirely with the allocator.  Typically, this is the most difficult decision professional allocators face as there's no perfect answer and most decisions lead to job risk as they entail:
(i) The allocator admitting they got the theme wrong (i.e. should never have been in Enterprise SaaS), which is embarrassing and job threatening (especially when there are committees and boards involved, which were likely initially skeptical).
(ii) The allocator getting the theme right, but picking the wrong manager (i.e. would have been better going with a passive option).  This is frustrating but not typically job threatening; making good money is better than no money!
(iii) Dealing with the consequences of being right and choosing the right time to redeem a successful investment is, ironically the hardest and most risky proposition for the allocator.  This is as it is emotionally difficult and likely heretical since most people find it hard to sell things that have made them a LOT of money.  To get it right requires both a clarity of thought and a certain ruthlessness.  It also will almost certainly lead to the professional investor getting marginalized or fired.  Why?  Nobody remembers that the allocator was right to exit the investment unless the theme performs just averagely post-redemption, and things that do exceptionally well rarely then perform just averagely!  If the theme collapses after the exit then it was just “lucky timing”, and if it continues to rise rapidly then the investor was overly conservative/foolish/scared and cost the firm $X by redeeming when nobody else wanted to.  Generally, Our Man hopes to be lucky often, but will settle for being called conservative/foolish/scared.

b). There is an index just for SaaS companies, the Bessemer Venture Partners Nasdaq Emerging Cloud Index which tracks the performance of ~51 SaaS companies.  Sadly, there’s no ETF based on this index though that’s not for OM’s want of trying (he was politely told ‘interesting idea, now go away’ by more than one ETF provider when he suggested it)

c). Sadly this only leaves imperfect solutions of which two standout.  The  iShares Expanded Tech-Software Index (IGV) is a $2.8bn broad software ETF where SaaS companies make up around 1/3 of the exposure.   Secondly, Global X launched a Cloud Computing ETF in mid-April 2019, in which SaaS companies make up around 2/3 of the exposure.

* Well done for reading all the way down here!  If it does come to pass that software is the epicenter of a melt-up in the markets, then the savvy investors amongst you will recognize that cryptocurrency (i.e. software-as-a-currency?  Software as money?) will likely be at the whip end of that move.  Who knows, in that environment we might even see Tim Draper prices for bitcoin in the next year or two! 

Disclaimer: OM holds crypto assets outside of this portfolio, and IGV in this portfolio (obviously!).

Portfolio Update: New Position - 4th Ind. Revolution Theme: Enterprise SaaS (Part I)

Our Man has talked a lot about software over the last 12mos+, yet the theme is not in the portfolio.  This was due to professional considerations; he was researching and allocating to a Software-as-a-Service (“SaaS”) focused fund for a client portfolio as well as writing an insight piece into Unicorns and software.  With both complete, Software can be added to the portfolio and the rationale is below.   Much of OM’s early drafts of this piece were subsumed into the second half of the aforementioned Unicorn paper (let OM know if you want a copy!), so what follows is a shortened version. 

The rise of software is not new, it was foreshadowed in Marc Andreesen’s seminal Wall Street Journal article - “Software is Eating the World " - in August 2011.  Software, and its key role in the 4th Technological Revolution, is also one of the drivers of Our Man’s bullish long-term view (more on that another time!).

The Rise of Software

Over the last dozen years, the world has transitioned online driven by increased computing power, cloud storage and mobile usage. This has increased accessibility and vastly reduced delivery costs (i.e. an internet download, or app).  This transition provides a secular tailwind for software companies, allowing them to scale and quickly generate substantial revenues, and to become entrenched in consumer’s lives and companies’ business.  These same technological transitions have also enabled many software-driven companies to change their business models from a traditional product sales/licensing (i.e. remember those floppy disks/CDs) to a cloud-based subscription model that generates recurring revenues.  Though the subscription model sees a smaller monthly fee, it leads to both higher recurring revenues and higher retention rates for the company.  Finally, the smaller regular subscription cost increases the size of the potential market and helps margins, as the marginal cost of providing a new cloud-based software product approaches 0% as the customer base grows (e.g. imagine the marginal cost of the 10,000th stream of TV show, or the millionth download of a song, etc.). 

Enterprise or Consumer?

Our Man has a strong preference for enterprise (i.e. business) focused companies rather than those that focus on the consumer.  It is only natural that the consumer market developed first, given the speed of the different decision-making process - you making a decision vs. your firm making one – and that in consumer-world the limiting factor was marketing and distribution.   Before the Internet almost all consumer business was either (i) local or (ii) space-constrained (shelf-space, channels on your TV, etc.).  The Internet resolved this - websites are accessible across the country/world, Amazon has unlimited shelf-space and cloud-based product is infinitely divisible (Netflix can let you watch everything and anything on its menu at any time, irrespective of how many others are watching it). 

The approaches to data in the consumer and enterprise environments are necessarily different, which impacts the business models.   For a company, its internal client data is a key part of its business (and often covered by regulations) which means it cannot have its software partners collect and share that information.  This contrasts with the consumer-side, where collating personal data is often key to the business model whether the data is used to help target advertising or to try and create network effects.   This difference in approach to data has further driven enterprise software towards a paid subscription model, whereas the consumer side remains a mixture of different models, including advertising driven (Google, Facebook, Pinterest, etc.), subscription (Spotify, Netflix, etc.) or models focused on the delivery of a physical good/service (Uber, Lyft, Amazon, etc.).

The value proposition to the client of the subscription model is centered on the greater flexibility that it provides. This flexibility comes in many forms;

• Easier Administration: The client can better control and match the number of licenses that are used. Since the subscription model is a pay-as-you-go system, subscriptions can be increased/decreased as required.
• Greater Compatibility & Security: As the software is hosted in the cloud, all users are using the same version of the software, ensuring compatibility across a firm. Furthermore, the software provider is responsible for updating, patching, and security, and these are done automatically rather than on a user-by-user basis.
• Cost affordability: The steady price and recurrent nature of subscriptions means that they can be budgeted for more easily.
• Global Accessibility: Users can access their software from any device as it is hosted in the cloud. This has increased in importance as the prevalence of mobile has expanded.
• Integration & Scalability: Most SaaS applications are designed to support some level of customization, and vendors allow connections to both internal applications, but also other external SaaS applications. This means that information is available in a more accurate and timelier fashion than before, which has notable impacts on productivity. For example, sales people in the field can immediately check real-time data (via an application on a mobile device) on inventories before committing to a sale, rather than going through a longer and more manual process of speaking to head office directly to get the information.

The biggest benefit of this increased flexibility for clients is that using a cloud based SaaS solution leads to increased productivity, as the clients can focus on their core businesses.

Companies’ transition to subscription models has also led to significant benefits for investors;

• Higher Recurring Revenues: The subscription model means that the firm’s revenue stream is more predictable due to the steady income from subscriptions, which helps management in planning and investors to value the business.
• Higher Retention Rate: The model changes the nature of the sales process from one where the firm is looking to complete a solitary transaction (e.g. sell X number of licenses) to one where it’s selling a long-term relationship with the client. The model also changes the nature of the client’s behavior; clients must make the decision to leave a provider rather than make a new purchase. The behavioral nature of this change has been important for software providers as it has led to increased client retention.
• Increases Total Addressable Market: As the recurring subscription cost is small (relative to the prior cost of purchase under the licensing model), the SaaS model helps increase the market size through greater accessibility for small businesses and non-core usage within large firms.
• Uniformity of Updates: As the implementation of updates is driven by the provider, not the client, and is done in the cloud, this helps ensure that updates tend to be done more frequently and that all users are utilizing the same version of the software.

For investors, the first three of these benefits - higher recurring revenues, higher client retention, and a larger market - has changed the long-term profitability of software companies, making them a more attractive long-term business. In addition to improving profitability, it has also meant that SaaS companies are less prone to changes in the economic cycle. This is a function of the productivity benefits that the SaaS model offers customers, which results in higher client retention. Given these productivity benefits and the substantial switching costs of changing software providers – including retraining employees and linking the new software into existing systems – SaaS companies often enjoy a “sticky” customer base. Typical retention rates for successful SaaS companies have been around 90% of annual revenues. This strong retention rate reflects the benefits of the SaaS business model; software subscriptions are now targeted (rather than company-wide) and at an affordable recurring cost (rather than substantial one-off license fees), which means that customers are more willing to retain subscriptions during any softening in the market.

While software is indeed eating the world, OM thinks we’re still in the earlier innings on the enterprise side.  In part II, we’ll talk a little about valuation and how to invest….

Things from my Newsblur; 2019 Part I

Let’s begin this year as we mean to go on, with an early edition of “Things from my Newsblur”.  As usual, the most investment-related stuff is at the end.

Dwarf planet 'The Goblin' discovery redefining solar system
Approaching Halloween last year, one of Our Man’s son’s was very into space and especially the hypothetical Planet 9 and the  Dwarf planets.  Imagine the joy, at (i) the discovery of a new dwarf planet, (ii) that it’s called ‘The Goblin’, and (iii) that its existence and orbit further suggest Planet 9 is out there.  Happy days, though the song needs updating!
(Hannah Devlin, The Guardian)

Women’s Pockets are Inferior
Mrs. OM hcompains about the frustration of women’s pockets, and especially the decorative faux pockets.  Well, here’s the data (and cool graphics) on the differences in pocket sizes and shapes in twenty of the most popular blue jeans for men and women.   Spoiler alert:  No shock but the data proves that women have a right to be upset!
(Jan Diehm & Amber Thomas, Pudding.cool)

Rodney Brooks: Tech Prediction Scorecard, January 2019
Predicting the future is fraught with the risk of looking foolish…and more so when you’re looking at to 2050 and thinking about technological change.  A year ago, Rodney Brooks made multiple predictions on self-driving cars, artificial intelligence and machine learning, and the space industry.  He will revisit them and highlight the progress, as well as where he is on track or off base.  If you only read one blog post on those subjects, each year, make it this one.
Why is it interesting?  Well, the future is interesting, and Dr. Brooks is more qualified than most to hazard these guesses.  Additionally, we can see how the data and his thinking evolve each year - process matters!  Dr. Brooks is the Panasonic Professor of Robotics at MIT, where he was also the Director of the MIT Artificial Intelligence Lab.  He’s also a Founder, former Board Member and former CTO of iRobot.
(Rodney Brooks, his blog).

Vietnam is Winning the US-China Trade War
With the current US-China trade war picking up, and the sense that it’s the start of a new dynamic between the two countries rather than a one-off spat, technology manufacturers are starting to set-up factories elsewhere.  This coupled with Vietnam opening up to free trade (e.g. the TPP and a trade deal with Europe) has meant that “Vietnam, once dependent on garments and other cheap exports, has begun to rival China’s tech sector.”  This is not something new, but merely Vietnam starting to tread down the path that Thailand took ~30yrs ago, and China ~20-25yrs ago.  Absent a major change, expect Vietnam to be Our Man’s portfolio for a looooooong time!
(Bennett Murray, Foreign Policy)

How Open-Source Software Took Over the World
Regular readers will know that OM has been reading about, linking to, and mentioning software (especially enterprise) a lot recently.  Five years ago, the idea that open-source software was viable let alone would be dominant was met with skepticism from investors.  The world has certainly changed, with IBM’s purchase of Redhat (for $32 billion!!) headlining a list of multi-billion dollar takeovers, IPOs and companies!  Mike Volpi goes through the evolution of open-source software from Linux and MySQL, through the second generation and how it evolved towards Software-as-a-Service business models enabled by the cloud.
(Mike Volpi, TechCrunch)

But…
AWS, MongoDB, and the Economic Realities of Open Source
What if enterprise open-source software is music; and the software cos are the record cos?  Music like open-source software is relatively worthless once it’s been produced, since it can be copied endlessly.  Record companies don’t sell music, but rather the tools that make music usable (i.e. CDs in the good ole days)…and it is the same with open-source software, especially in the cloud era.  Therein lies the rub, will the value accrue to software cos (or record companies) or to those companies (and products) like Amazon Web Services, Microsoft's Azure, etc. (or Spotify, Apple Music, etc in the case of music) that provide the convenience to the end customer.
(Ben Thomspon, Stratechery – if you like technology and read nobody else on a weekly basis, read Ben!).