The start of the year has not been kind to equity investors and especially so to our portfolio. Many of the same trends that persisted through the second half of 2021 continue in force today. The challenge of navigating around unusually high inflation has been exacerbated by Russia’s war of aggression against Ukraine. We have been watching events unfold with immense sadness and helplessness. While there is much we could say about the tragic war, the subject matter of this letter relates directly to our portfolio and how we think about markets today. The war Russia started against Ukraine has had a very real impact on the global economy and an especially acute impact on European markets in which we own several equities. There is a prevailing narrative that no-earnings tech stocks are the only pocket of the market truly experiencing a correction, though in reality the chastisement in markets is far broader. In this letter, we will shed light on how our portfolio as a whole is built for resiliency in the face of various economics risks, offer a framework to think about the valuation of the portfolio as a whole, rather than piece by piece, and shares our perspective on how although our portfolio has not been acting in diverse ways, it is in fact incredibly diverse, with a multitude of revenue and margin drivers, valuation ranges, geographies, growth and most importantly, risk factors. We will also offer our perspective on what has been hurting our portfolio company stocks and how we see things playing out from here.
We focus on deep fundamental work on every single one of our investments. We approach this process from the lens that we want to own companies with demonstrable quality, reasonable valuations, proven and deliverable growth, change on the industry or corporate level, in companies that are strategically significant assets in and of themselves, and with some degree of optionality (strategic or otherwise, not necessarily baked in the price). Not every single security in our book can perfectly embody all six of these traits but we are uncompromising to the fullest on the first three: quality, valuation and growth. There is a prevailing narrative today that “growth at all cost” companies are what have been beaten up and otherwise the market has been fine, though we categorically disagree. The market pains have largely been confined to consumer and technology-oriented companies, irrespective of the degree of growth.
On a weighted average basis, our portfolio features a mid-single digit free cash flow yield, a mid-teens growth rate for 2022 and a mid-teen revenue compound annual growth rate (CAGR) through 2025. The numbers we are using here are reflective of consensus estimates and some necessary adjustments where critical deficiencies in harmonized data neglect to reflect business realities. Note that on each company we have our own estimation built up from the key revenue and margin drivers, though we are not dogmatic in treating either our estimation or analysts’ estimations as gospel. We are using these numbers to shape the counters of a broader conversation. Further, we would emphasize that reality is guaranteed to end up different from both our expectations and analyst expectations. Some companies are likely to disappoint, and some companies are likely to pleasantly surprise.
We think it’s helpful to discuss both the free cash flow yield on the market cap, as well as the free cash flow yield on enterprise value. One reality of the kinds of companies we seek out is they often feature incredibly resilient, well capitalized balance sheets to weather economic volatility and position strategically for opportunistic M&A. This is where enterprise value to market cap comes in. Another way to think about this is a mid-teens percentage of our companies in aggregate is purely cash and to a much lesser extent liquid equity investments. For every $1 of stock we buy in the market in our portfolio, we are buying over 13 cents of cash with the remaining 87 cents representing the business itself. The average company in the S&P deploys net debt in order to maximize returns, meanwhile our companies are loaded with cash. One day, as our companies mature, cash will be deployed strategically and enhance returns, and debt will eventually be layered on, though we think that is well down the line. In times like these, the opportunity to deploy cash is as great as ever—companies can repurchase their own stock or be on the prowl for M&A at far better prices than has been witness in the recent past. One added benefit; this makes our own companies easier targets for M&A as we saw with Twitter.
The weighted average free cash flow yield of our businesses in the mid-single digits is less than the S&P’s free cash flow yield of approximately 7.5%; however, our aggregate portfolio is far less capital intensive than is the S&P 500 since the assets employed by our businesses are largely intangible. Our companies get to invest through margin in driving growth today and for the future, whereas the average S&P company must invest in considerable physical capital to maintain earnings. To that end, our weighted average growth rate of our holdings is 2.75x the expected growth of the S&P 500. Although the growth rate of our companies is expected to fade from 2022’s strong number over the next three years, the CAGR from ’22-25 is expected to be at least 2.5x that of the S&Ps.
Some might contend it is inappropriate to look at free cash flow yields in growth companies which feature some portion of stock-based compensation. This is a fair critique, though we caveat that over half the companies in our portfolio will use aggressive share repurchases to shrink their share counts with a combination of balance sheet cash and cash flow from operations this year. In some cases, these repurchases will be especially aggressive, and in several of them the companies will shrink by upwards of 5%, with Dropbox at the high end. Notably, Dropbox is expected to repurchase approximately 12% of its shares outstanding at today’s stock price. This is a powerful driver of future returns as it supplements growth and indicates a degree of confidence in future performance from our management teams. Stock-based comp is a real consideration; however, in presenting these numbers, we are not adding in top line growth enhancements for the economic reality that we will own a greater proportionate share of these businesses at the end of the year than we do today without buying additional shares.
Nearly every single portfolio company we own invests in growth, and thus their margins down the line will be higher than their margins today. We have a few companies who are as of today unprofitable on a GAAP basis though by and large, our companies do generate positive free cash flow with two small exceptions. On the opposite end of the spectrum, we own four positions that yield right around 10% on a free cash flow to enterprise value basis. These are large positions (relatively speaking) in our portfolio (Dropbox, Nintendo, Bristol-Myers and Facebook). All are repurchasing shares in an effort to return cash to shareholders and shrink the stock’s float at a time where low prices meaningfully enhance per share intrinsic value. We do not believe that all companies must invest cash today, nor do we believe that all companies must maximize today’s free cash flow. In fact, the ideal investment is a company with an incredibly long runway to invest free cash flow and drive growth. The problem is that every now and then the market insists companies in this state demonstrate the ability to generate cash before affording the stock a more reasonable multiple.
The range of industries in our portfolio is vast, with little concentration to any one end-market. Although we are more exposed to the consumer than the S&P on average, the exposure is diverse in range from services like matchmaking to products like high quality drink mixers. Our industrial companies include the world’s dominant supplier of narrow-body jet engines to the world’s best developer of machine vision equipment for manufacturing and logistics. We also own substantial positions in healthcare, from biotechnology to pharmaceuticals to mission-critical services and solutions for research, all of which are durable franchises with results that have little correlation to the macro environment. In aggregate, our portfolio companies deploy very little capital, generate returns well in excess of their cost of capital and boast considerable pricing power should inflationary pressures persist longer than we think likely. In our last commentary, we spoke in depth about inflation and we continue to believe the primary inflationary forces exist today due to the turbulence of shutting down and reopening our economy rather than structural forces. That said, it will take time for the situation to ease and the Fed will do whatever it takes to ensure it does.
As for valuing the portfolio as one single, diverse unit,, one simple valuation framework holds that the expected return for an investor is equal to the cash flow yield multiplied by the rate of growth and the change in multiple. A 5% free cash flow yield and a 12% growth rate multiply out to 18% expected annualized returns. While the 12% growth rate would be on the low end of the revenue expectation in our portfolio, we expect our companies to deliver considerable incremental margins which enhances returns. We do expect multiples to contract over time as growth rates fade from mid-teens downward. Assuming margin expansion and multiple contraction cancel each other out, we are looking at high teens returns from here. We provide this framework with no absolute guarantee, but as a way to think about how our portfolio companies, in aggregate, work together and how we feel these results will drive forward returns.
Why have things gotten this bad?
We spent much of our last letter talking about inflation and the forces behind it. As a result, inflation has induced an inflection in Federal Reserve Bank policy from accommodative to support the emergence from the pandemic to hawkish in order to squash inflation. Deflation has been the enemy over the past decade and the Fed had to build a new toolkit to prevent deflationary risks from impairing the economy. Considering this reality, we have argued during this period that the Fed toolkit right now is asymmetrically geared for fighting inflation. One consequence of the risk pendulum flipping from deflation to inflation has been a pronounced change in the bond market. The below chart from @NewRiverInvest is incredibly helpful in visualizing how the risk pricing paradigm has changed.
What this chart shows is the level of drawdown at each respective key maturity in the Treasury curve. These mark-to-market losses are worse than any point in the observable history of the Treasury curve. Most important for us is how as you walk further out on the curve (i.e. go from two years to ten years to thirty years) the pain increases significantly. As far as our portfolio is concerned, we invest in companies that feature more growth than the average company and less free cash flow today. Growth companies in contrast to the average, or even pure value companies, are more analogous to the longer-dated Treasuries in a pure risk pricing environment. In the short-term, this manifests in painful drawdowns; however, in the long-run the true economic reality of the companies will prevail. In other words, so long as we are correct in our fundamental understanding of the businesses and that the businesses earn more money each passing year while defending their competitive positions, performance will not be influenced by the variances in long-dated Treasuries. To be more specific, we have consistently underwritten our investments with a cost of capital that reflected a more “normalized” environment and not the low prevailing rates while the Fed Funds Rate was at 0%. Throughout the past decade we have used a cost of capital of 10% or more, depending on the specific situation. Further, when we test the sensitivities of our model, over the long run, the value in our typical investment is far more dependent on growth and margin assumptions than it is on cost of capital. To put it bluntly: if we are wrong about an investment, it will not be because we used the wrong cost of capital; rather, it will be because we are wrong about the company’s ability to compete, grow and drive profitability.
This alone does not entirely explain the problems in growth companies. We think a second, perhaps more powerful force is at work. To explain this, we offer our own illustration:
Think of the solid blue line as the log-scaled growth of an average growth company (this message applies similarly to revenue or EPS, the distinction need not matter here). During COVID, these growth companies saw their growth rates accelerate. In other words, the second derivative (the rate of change in the growth rate) stepped upward. From this acceleration, there were five possible paths though we will focus on four. The fifth excluded path is the ephemeral beneficiary who received sales that would never have happened were it not for COVID. The first basket of companies is the “revert to trend” whereby the growth rate slowly atrophies back to trend, at which point trend growth resumes. Smoothed out over many years it would look as if COVID never happened. We think PayPal is a company that ends up in this bucket. The purest of the beneficiaries are what we call a “higher plateau trend growth.” This basket of companies grew quicker during COVID and from there, have gone on to grow at a similar rate to before COVID. This basket features the fewest companies, and we would put Roku in that bunch. The third group are those who will undershoot trend on the way down but then have a catch-up period and get back onto their trend growth. Similar to the reversion to trend though different insofar as growth will be negative or much lower for a while before a step back upward to the trend. Over the long run, these companies similarly will look as if COVID never happened and core inertia won out. The last bucket of companies is those who accelerated maturity and coming out of COVID will grow at a state more consistent with the economy at large. Some may argue the recent move in Netflix (which we do not own-yet) reflects this kind of reality.
Now that we can explained the various paths and possibilities we can speak about the consequences. The problem for the market is that it cannot grasp major changes in the second derivative—the rate of change in the growth rate. When the growth rate stepped up, the market sent these stocks to the high side of fair value. The reality is that on the way down, even the purest beneficiaries, whose growth rate is reverting to a new trend, the second derivative is always negative, even if growth remains robust. To put numbers to it: Roku will fall from the 55% growth rate experienced during COVID to a more modest 30% growth rate. “Falling” growth rates is the manifestation of negative second derivative. In this environment, amidst rising interest rates, the market is treating every single company with negative second derivative, from the truest beneficiaries to those who have accelerated maturity, as if maturity is here now.
Markets generally are efficient pricing mechanisms; however, they often do not grasp nuance in dramatic moments and ownership contagion further exacerbates these problems. Many growth funds, especially those who operate with leverage, ended up way over their skis in overvalued positions and thus must sell even as prices become increasingly attractive. Although we are experiencing this pain ourselves, we have a more diverse portfolio than merely “growth” and do not operate with any leverage. This puts us in position to take advantage of what we think is the greatest opportunity set we have seen in our careers, especially now that one of our largest positions—Twitter—agreed to an acquisition at a fair, although disappointing value. We sold our shares of Twitter, because nearly the full deal price had been priced in and we are enthusiastic about deploying the proceeds into today’s environment.
What happens next?
We do not know when the pain in stocks will end and fully expect things to get worse before they get better in the near-term. Over our investing time horizon of five years, we expect to see the actual fundamental performance of businesses themselves drive value and we think the environment could not possibly be better for many of our companies. In the heady growth market days during the COVID environment, capital became way too cheap for some business models that will never prove out. Stated another way, companies that never should have been funded were able to raise considerable capital and burn it along the way to trying to build a viable business. These companies never rounded the corner to profitability and thus must continue to raise capital in order to stay afloat. Now that the environment has changed and investors will not give unprofitable companies with terrible unit economics any capital, these companies will cease to exist.
We saw this happen in the payment space already where Fast, a PayPal competitor closed down not long after raising considerable sums of money at over $1 billion. We mention fast in particular, because as PayPal shares have slid, many have blamed the slide on “competition” and the proliferation of alternatives. Few spaces had as much hot money as digital checkout and the reality is that as fundraising rationalizes, scaled players in leading positions will benefit considerably from waning competitive intensity. PayPal is growing revenues in the double digits at a time when the average gross merchandise volume (GMV) at the scaled ecommerce companies is stagnating. Ecommerce growth rates year-over-year are negative, while PayPal remains on pace for double digit growth. Were competition truly the culprit, PayPal would be growing slower than ecommerce, not faster.
When many of the COVID-winning tech stocks turned lower, the narrative was about slowing growth rates and rising competitive intensity. We covered growth rates above, but competitive intensity for many of the tech companies furthest along the scale curve came from other large tech cos pursuing adjacencies and from unprofitable upstarts plowing generous venture capital dollars into industries and sub-industries that had proven very profitable during the pandemic.
With the sudden, dramatic change in environment both dimensions of competition will quickly abate. First, larger companies investing gross profit dollars in adjacent areas pinches their ability to generate free cash flow in the near-term. Without obvious incremental free cash flow, these companies will have to narrow their focus to core capabilities. Second, venture capital dollars will become increasingly scarce, especially for those companies who invested mightily over the past two years only to see the unit economics they were chasing collapse. This environment will thus favor scaled technology incumbents who have proven unit economics and already generate free cash flow.
While looking at the markets broadly, although large caps do not look downright cheap, small and midcaps (where our portfolio tends to concentrate) are trading at amongst their cheapest valuations in recent decades. Yes, you read that right: small and midcaps are at valuations that were only seen in the Great Financial Crisis and the COVID crash in recent times.
This is the setup from which long stretches of opportunity are born.
Words of encouragement:
Although the stock prices within our portfolio are down, and in some cases considerably, over the past year the value of each of the businesses we own has increased substantially over the same time period. A company’s value and the price of its stock do not necessarily move in tandem. Market sentiment weighs heavily on a stock’s price, while value itself is determined by the level of cash flow, growth and rate of return a company can deliver on its assets. All of our companies grew in the past year, will grow this year, and earned cash flow that either adds onto the balance sheet, gets invested for future growth or share repurchases. These are companies that individually can and will weather any kind of economic storm. This has been evidenced between the Great Financial Crisis and the COVID crash and stresses during lockdowns. Inflation is a new challenge, but as we have been emphasizing–for our companies who deploy little physical capital and rely heavily on intellectual property, with pricing power or tollroad-like economics–it will be manageable and, in some cases, an outright opportunity. Although stock prices are down in the short-run, business value will grow each and every day and one day the market will hold these shares dear again.
We have always been humble and we have further been humbled by this past year. We are working as hard as ever to take advantage of what we think is the single greatest opportunity set in our careers. This market environment is equal parts frustrating and inspiring. Frustrating for the obvious reasons, but inspiring because we know that lower prices translate to less risk, and more future return. In times like these it is critical to maintain both perspective and discipline.
Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-1945. Alternatively, we’ve included our direct dial numbers with our names, below.
Warm personal regards,
Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Partner, President
O: (516) 665-1940
M: (917) 536-3066
Elliot Turner, CFA
Managing Partner, Chief Investment Officer
O: (516) 665-1942
M: (516) 729-5174
Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of: (i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.