As always, this in not financial advice. This is simply a public reflection of my thoughts on the year as it relates to my portfolio. Due your own due diligence and don’t trust the words of a random stranger on the internet.
This year I will likely end the year with a return -30% to -40%, currently down about 35%. As I have done (not on reddit) for several years now, I like to reflect on the quality of my decisions and the outcomes.
Entering 2022 I had the following holdings: GOOGL, AXP, BRKB, CHE, CHWY, CNSWF, DPZ, HIFS, LMND, MSFT, SPGI, SCI, TMX, TSLA, TOITF, U, YETI
During the year, I made the mistake of moving aggressively into beaten down low-quality tech. Names like U, LMND, PLTR, UPST, DDOG, OKTA, SHOP, TEAM, TOST. In terms of the quality of the decisions I would say that I was that I did not make complete well-rounded decisions. On one hand, I generally applaud myself for buying companies when they are out of favor. These names were down 40 to 60% at the time of purchase. Where I did not do well was look at more than factors other than torrid growth rate and a bright future fed to me on the beautiful pages embedded on their investor presentations (let’s look at that and avoid the skeletons in the 10-Q I said to myself). These companies were bought with too much sunshine and not enough rain.
I should have reviewed additional factors:
First, how are the financials trending other than growth. Sure, revenue was going up gangbusters, what about margins, or dilution or capital requirements, Revenue/EE, Revenue/Sh etc. As I dug under the hood later in the year most of these companies made no advancement on margins despite torrid revenue growth. I realized not digging this far was very very stupid.
Additionally, I realized throughout time the competitive landscape has changed and I need to update my assessment as well. Take DataDog. My belief about their competitive positioning was “due to the nature of their mission critical software companies are not likely to leave them due to the high switching costs.” One day I went over my portfolio holding by holding and I realized that I had virtually all software names that had an advantage in my view that stemmed from a switching cost. It kind of hit me this is ridiculous. How can every company have a switching cost advantage? The cloud changed everything. Without the need for servers, it is much easier to simply move from one company to another. Now of course there are still training costs and implementation costs to be sure, but the barriers to create software have never been lower and the number of options has never been higher.
The realization that switching costs in my opinion is not stringent enough of a definition led me to investigate competitive advantages further. As I do often when I feel I have lost my way in investing, I revisit some legendary texts. This time, I revisited Terry Smith’s Owner’s Manual (https://www.fundsmith.co.uk/media/mv3abv1h/owners-manual.pdf). In there, he has a section where he speaks about the types of companies they like. Here is what it said:
“We seek to invest in businesses whose assets are intangible and difficult to replicate
It may seem counter-intuitive to seek businesses which do not rely upon tangible assets, but bear with us. The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.
They can do this because their most important assets are not physical assets, which can be replicated by anyone with access to capital, but intangible assets, which can be very difficult to replicate, no matter how much capital a competitor is willing to spend. Moreover, it’s hard for companies to replicate these intangible assets using borrowed funds, as banks tend to favor the (often illusory) comfort of tangible collateral. This means that the business does not suffer from economically irrational (or at least innumerate) competitors when credit is freely available.”
This section gave me an epiphany! To sum it up, businesses with competitive advantages are built in a way that capital alone is unable to reproduce. In other words, there has to be an intangible factor that capital is unable to recreate. I combined this idea with the other questions I typically ask myself.
· Company Soundness
o Does the company have a good or services that is purchased frequently or a regular interval?
o Do they operate with significant leverage?
o Is their balance sheet will suited for a downturn and why?
· Can it be Replicated?
o Is their evidence that the company has defended its market position in the past?
o Is their evidence that market power is growing and that this will lead to strong financials?
o What is the competitive advantage?
o Would $10 billion of capital be enough to re-create the company?
o Are parts of the company not able to be recreated with capital? Which parts and why?
· Growth
o Is their a 90% chance that earnings will be up 5 years from now?
o Is there a 50% chance earnings will continue to grow in excess of 7% per year after the 5 year period?
· Decision
o Do you honestly know enough about the industry and company to make an investment decision?
o Bottom Line: Based on your answers is the company well insulated from economic and competitive shocks while able to grow for many years to come?
Answering these questions brought down a watchlist of ~75 names to 26.
This filter took names like Amazon off my list. In my opinion, Amazon derives most of its advantage from a long recurring investment in capital. Distribution centers for their retail business and data centers for AWS. Over time as firms have invested in DTC, this has marginalized much of Amazon’s advantage. Additionally, as more cloud players come into the space, the investment in data centers is becoming more common. Ironically, my opinion on Amazon is add odds with Terry Smith given his position in Amazon. As they say, that is what makes a market. Just pull up annual return on assets and you will see one of the reasons why Amazon is plummeting.
Below is my refined list of 26 companies and why I feel capital alone will be able to replicate them sorted alphabetically by name.
Company Ticker Are parts of the company not able to be recreated with capital? Which parts and why?
Airbnb, Inc. ABNB Network Effect for Airbnb's. Customers want to shop for Airbnb's where the hosts are. Host want to list where the customers are.
American Express Company AXP Network effect, to upset V you would need to sign up both consumers and vendors all while offering incentives from a significantly smaller scale.
Apple Inc. AAPL Network effects. App developer want to develop where the customers are, and customers want phones where they can access the services they customarily use. The Duopoly has been attacked by Microsoft and Amazon, yet we still only have two phone systems.
Berkshire Hathaway Inc. BRK.B Reputation. BRK's reputation has a financial powerhouse makes its insurance division one of the few insurers that can be trusted with large and complex risks. Additionally, management unique operating structure allows for very little conglomerate penalty due to the individual management of many businesses.
BlackRock, Inc. BLK Track Record. Launching new financial products is extremely difficult to draw assets without a track record. Given their entrenched history with Blackrock and iShares it will be difficult to upset these funds
Blackstone Inc. BX Track Record. Launching new financial products is extremely difficult to draw assets without a track record. Given their entrenched history across many alternatives it is difficult to select a smaller player.
Constellation Software Inc. CNSW.F Decentralized operating culture. Management acquires small niche vertically integrated software providers. Their capital allocation is uniquely pushed down to distant levels fromtop management which allows them to scale acquisitions on a decentralized basis. This extremely unique management approach is not something money can buy.
Costco Wholesale Corporation COST Low-Cost Provider. By selling items virtually at cost along with leveraging negotiating powers to drive lowest prices Costco has cemented a foothold in retail. All this value is captured in their annual membership fee.
CRA International, Inc. CRAI Reputation. Within Business consulting, CRAI has a reputation for solving large complex solutions across many industries. When a consultant work with 78 of the fortune 100, you know that paying high fees for results is worth it.
CrowdStrike Holdings, Inc. CRWD Network Effect. CRWD's cloud-based cybersecurity solutions and massive customer base allows for quick handling of threats. As one threat is dealt with, the solutions are synced through the rest of their cloud-based service. This means helping one client helps all and the more customers the strong the service.
Fair Isaac Corporation FICO Regulatory Entrenchment and track record. The FICO score is synonymous with personal lending. Often it is a key determinant for determining loan eligibility. Given its efficient track record at quantifying risk, newer options will be behind as they don't have the track record.
Hingham Institution for Savings HIFS Culture of Discipline. There are many banks in this world, virtually none of them are as efficient as HIFS. Their disciplined culture toward underwriting leads to lower than industry average charge offs annually while their focus on costs leads to above industry profitability. If you could re-create this with capital, banks with more scale would have similar returns.
IDEXX Laboratories, Inc. IDXX Trade Secrets. IDXX offers many proprietary tests for vets. This means that only IDXX labs can process them. Additionally, many vets are trained on their tests meaning switching would result in the need for new training.
Lemonade, Inc. LMND Potential to be low-Cost provider and culture of customer care. By offering insurance DTC, Lemonade can avoid many entrenched costs from agency model. Additionally, by getting Guinness World Records for fastest claim paid and removing the frustrating part of insurance which is using it, they have the potential to earn pricing power over time
Nu Holdings Ltd. NU Network Effect. In Latin America they are the leading provider of a P2P payment system (like Venmo). They have captured sizeable portions of the populations in Brazil, Mexico and Columbia.
RLI Corp. RLI Disciplined Underwriting culture and unique track record. Their underwriting culture had led to a 10 BPs lower combined ratio and lower ratio every year for the last decade. Money can't buy discipline. They insure a broad spectrum of odd risks. These are both not easily replicated but offer great diversification in their operations.
Rollins, Inc. ROL Low-Cost Provider. As the largest player in most of their markets, Rollin's benefits from major scale advantages. More contracts allow for pest control people to have greater route density during a day and therefore greater profits as well as negotiate better terms on inputs. This is something that a competitor is unable to solve by throwing money at it. Additionally with high brand awareness with Orkin man, they have a step up on smaller lesser-known players.
Roper Technologies, Inc. ROP Decentralized operating culture focused on end markets that benefit from efficient scale. Efficient scale is when an end market is logically only served by one player in a small area, like a freelance truck distributor. If you are looking for a delivery truck, it makes sense that one website would be best for that.
S&P Global Inc. SPGI Regulatory Entrenchment and Track Record. S&Ps credit rating are required by many contracts and regulations for many debt deals. If you need money and your bank requires it, you’re going to pay a hefty fee for their rating. Additionally, they own the IP for the S&P and Dow Jones indexes. These long track records will never be replaced due to their entrenchment and first mover advantage.
Salesforce, Inc. CRM Network effects. App developer want to develop where the customers are, and customers want to plug in their other products. Salesforce is truly the hub of so many integrated products.
ServiceNow, Inc. NOW Network effects. App developer want to develop where the customers are, and customers want to plug in their other products. ServiceNow is truly the hub of so many integrated products.
Shopify Inc. SHOP Network effect. For eCommerce players that are looking to compete independently from the likes of Amazon, Shopify is their lifeblood. This means that App developer want to develop where the customers are, and customers want to plug in their other products. Smaller player and late entries like BigCommerce have struggled to gain traction
Tesla, Inc. TSLA Network effect, Brand, Unique Operating Culture in a tough industry. Network effects stem from outsized number of cars on road all outfitted with self-driving equipment giving Tesla more data to develop self-driving cars giving them a data advantage for developing self-driving cars. Additionally, Tesla is the undisputed electric vehicle king given their first mover advantage. Finally, they operate differently than most of their competitors. They build the important and unique components in house whereas legacy auto tends to outsource all parts and simply assemble them. They sell DTC at retail prices whereas legacy auto sell wholesale to dealers. They have a standard labor force whereas most of legacy auto has unionized labor which is trained on legacy ICE engines. The auto industry is historically difficult to enter as it requires large amounts of capital, high fixed costs with a cyclical product.
Vail Resorts, Inc. MTN You can't re-create the limited supply of mountains in the world. There are so many mountains and locations with the proper weather conditions to enable skiing. This gives them pricing power, particularly when you account for how many mountains they own in many regions.
VeriSign, Inc. VRSN Government granted monopoly. All .com and .net domains must be registered with VRSN. Additionally, price increases are regulated. Fortunately, ROCs are not
Visa Inc. V Network effect, to upset V you would need to sign up both consumers and vendors all while offering incentives from a significantly smaller scale.
From there I reviewed the 26 companies by valuation and felt 15 of them are compelling investments at this time:
Company Ticker Target
Visa Inc. V 10.00%
Berkshire Hathaway Inc. BRK.B 10.00%
Blackstone Inc. BX 8.00%
American Express Company AXP 8.00%
Salesforce, Inc. CRM 8.00%
Constellation Software Inc. CNSW.F 8.00%
Hingham Institution for Savings HIFS 6.00%
Tesla, Inc. TSLA 6.00%
VeriSign, Inc. VRSN 6.00%
Lemonade, Inc. LMND 5.00%
Nu Holdings Ltd. NU 5.00%
Airbnb, Inc. ABNB 5.00%
Vail Resorts, Inc. MTN 5.00%
Shopify Inc. SHOP 5.00%
CrowdStrike Holdings, Inc. CRWD 5.00%
I feel much more confident in the portfolio after re-reviewing the soundness, ability to be replicated, future growth prospects. They key for future years is to avoid laziness when analyzing names. It is foolhardy and expensive to fall in love with an investor presentation and then go and buy it on hopes and dreams rather than seeing the larger picture.
The ironic thing is I have owned 14 of the 15 at some point in my life. For one reason or another I got shaken out of them and bought into the temptress that goes by the name of high growth. Like most temptresses, more research reveals not much substance.
For next steps, I will work on integrating the above process into my stock review routine and stick to it. I find that the hardest part with investing is simply sticking to a practical approach. Its too easy to waver to something new. Variety is the spice of life, but makes for the taste of cocoa powder in investments.
Obviously, these are just my opinions. I welcome your feedback.
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