2019: Second Quarter Update

Portfolio Update

- 4th Industrial Revolution:  OM added a small position in the iShares Technology-Software ETF (IGV) at the very end of the quarter, as a way to gain exposure to Enterprise SaaS companies.

Performance and Review

The second quarter saw the portfolio rise +6.80%, which outperformed both the S&P 500 Total Return (+4.30%) and the MSCI World (Total Return, Net Dividends) (+4.01%).   For the year, this leaves the portfolio at +17.93%, which is nestling in between the S&P 500 Total Return (+18.54%) and the MSCI World (Total Return, Net Dividends) (+16.98%).

As the table intimates, performance was driven by the Dislocation positions and in particular those in Greece (+398bps) and Shipping (+216bps). 

Greece rallied strongly in the final weeks of the month after New Democracy, the opposition party, comfortably won the European elections.  This led to Prime Minister Tsipras calling an early election, and investors began to think about Greece’s future under a pro-business New Democracy government.   Subsequent to quarter-end, New Democracy successfully won a majority in the snap Greek election.  New Democracy has been talking to investors for the last two years, and immediately presented a financial bill including tax cuts that it hopes will help spur growth.

Within the context of OM’s approach to dislocations, the election is the catalyst that OM believes will change the narrative around Greece and get other investors to look at it.  What does that mean for OM’s holding? Empirically, the most attractive risk/reward in dislocations is the 12-24months after the catalyst – the honeymoon period, where there’s low hanging fruit and investors want to believe the story.   Thus expect Greece to almost certainly remain in the portfolio for the next 12-24mos, with the caveat that price movement should justify this – seeing May’s lows ($7.80 for GREK) revisited would be concerning and the position would be exited if we returned to December 2018’s low ($6.75).  On the other hand, don’t expect OM to take profits for at least the first 12 months – setups like this are rare, and the compounding impact to performance is worth the residual volatility.

The Shipping (+216bps) dislocation was driven by its exposure to product tankers, which benefited from Clean Tanker rates holding up well.  The sub-sector continues to see favorable supply/demand characteristics and OM believes it is best placed to benefit from IMO 2020.  The Uranium dislocation (-60bps) fell back slightly during the quarter.

The Thematic positions were a wash during the quarter; gains in Argentina (+75bps) and Brazil (+38bps), offset by losses in Vietnam (-33bps), India (-21bps) and Blockchain (-41bps).  The 4th Industrial Revolution positions made no great contribution (+2bps) in the second quarter.

Elsewhere, the portfolio benefited from the positive trend in markets with the Technical positions (+61bps) buoyed by rising markets, which also helped the Funds (+43bps) in the idiosyncratic book.  Finally, Texas Pacific Land Trust (+8bps) was largely flat for the quarter, despite machinations between management and a group of activist shareholders.

Longer-term Chartology

With the portfolio having been run in this form for 3+ years, Our Man thought he’d throw in a rotating cast of “interesting” charts/statistics on the portfolio’s performance, drawdowns, losses, etc.   The chart below is a simple one, showing what would have happened if OM had put his money in a couple of other instruments.  As you can see, he’d have been better off (so far) putting it into US equities, Global Equities or even a simple 60% Equity/40% Bond.  Obviously, OM expects this to change …

Portfolio (as at 6/30/19 - all delta and leverage adjusted, as appropriate)

Dislocations: 42.1%

21.9% - Greece (GREK, ALBKY, and EGFEY)

11.4% - Shipping (STNG, NVGS, DSSI and EURN)

8.7% - Uranium (URA, CCJ and NXE)

Thematic: 30.4%

6.5% - Tech: 4th Industrial Revolution (JD & IGV)

6.3% - India (INDA and SCIF)

6.2% - Vietnam (VNM)

5.0% - Brazil (EWZ)

4.6% - Argentina (DESP, GLOB, GGAL and AGRO)

1.9% - Blockchain (OSTK)

Technical: 20.4%

20.4% - OEW Technical positions (DDM, SSO, and QLD)

Idiosyncratic: 13.2%

9.6% - Funds (CWS, GVAL, and CAPE)

3.6% - Equities (TPL)

Shorts/Hedges: 0.0%

Cash: 4.1%

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above 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. 

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….