Flight To Danger
Q3 portfolio review
Broad commentary:
The portfolio is currently 100% long, which contrasts with Q1 and Q2 where it was at times net short. The vast majority is invested into small cap technology stocks, as this is where my bottom-up stock-picking approach leads me.
Sure, we might be entering a global recession, bonds are crashing, inflation is high, and currencies are trading like penny stocks. But how does this affect an IT outsourcing company that is:
50% cheaper than the competition
Growing 100% YoY
Generating Cash
Trading at 10-15x forward earnings
So small it doesn’t even represent a basis point of its TAM?
The answer is: it doesn’t. The business is outperforming its market so much that a decline in its market won’t be felt, growing so fast and cheap enough that rates can’t impact its valuation too much and doesn’t sell physical goods, so why would inflation be a concern?
For those of you that are not convinced by the analytical argument, there is a historical precedent in the .com bubble that supports buying the dip in small cap tech stocks, even if you expect indices to decline.
In many respects, the .com crash was very similar to the 2022 crash:
A tech IPO frenzy followed by a crash
Yields rising
The dollar hitting all-time highs
Geopolitical issues with 9/11
However, speculative small cap tech stocks, provided they had a real business model, bottomed months before the broader market.
Amazon bottomed in 09/2001, slightly lower than its 03/2001 low. The S&P 500 bottomed in October 2002. Between March 2001 and October 2002, Amazon was up 120% vs the S&P down over 20%.
Moreover, the NASDAQ started its bear market while the S&P was still making new highs, which is exactly what happened in 2021, many tech stocks started to crash as early as February, nearly a year before the S&P 500.
Actually, Soros describes this phenomenon in his book “Alchemy of Finance”, referring to the late stages of the 1986 bull market. I guess it’s a pretty common pattern.
So yes, the S&P 500 might crash another 30% from here as we enter a global recession, but that does not mean my small cap IT services company can’t double! Hope that explains the positioning.
Performance:
Starting this portfolio in January 2022 was unfortunate. Despite this, we have managed to protect capital pretty well, outperforming pretty much any passive benchmark.
The portfolio is down 4.35% YTD, but if you add back currency fluctuations & fees it was basically flat/up a little.
Though the performance sounds satisfactory, it really wasn’t. Our longs were basically down as much as the market and all of the portfolio’s performance comes from the short side (either through puts or selling).
I do not expect to have shorts all the time, as I don’t view them as hedges, just as ways to generate returns like longs. It is often much harder to justify the risk reward of shorting, and early 2022 was probably an exceptional situation with so many obvious shorts in US tech. Therefore, I can’t rely on them to protect capital structurally.
Moreover, most of the biggest losses could have been avoided. More on that below.
Biggest Losers
SFOR & TRUE B
SFOR & TRUE B were stocks that were suspiciously cheap. The reason was accounting problems for S4 and regulation/ethics for TRUE B. I was aware of these problems, and formed the opinion that they didn’t matter, and they may very well not matter in the long run.
However, I realize now that I didn’t have sufficient evidence to back my thesis on both of them. There were clear issues, that required extensive research to form an opinion on, not a few hours of web browsing. This is time that I don’t have.
So, from now on, I’ll avoid stocks with non-financial tail risks altogether, I leave the special situations/controversies to those that know how to deal with them and have the resources to go into the details. Lots of ways to generate alpha while ignoring these.
See short report on Truecaller.
B&M
B&M was also a mistake, but for reasons that I could have not learned any other way than by losing money.
B&M is still cheap right now, and I still think it’s an excellent buy. I don’t hold it anymore because more exciting companies got even cheaper, but if we get a tech re-rating there’s a fair chance I’ll buy it again.
However, it looked even more attractively priced relative to the market before it got cut in half, when I wrote this article.
My thesis, though based on sound principles such as free cashflow yield, growth opportunities, operational excellence and structural competitive advantage, ignored momentum.
I was buying a business at peak earnings, with lots of negative catalysts looming in the horizon (CEO retiring, UK economy imploding, rates rising), all of which realized. This put pressure on the multiple, to which we can attribute 80% of the stock’s decline.
Sure, it’s not really fair. If you do a long term DCF, the EV probably decreased by 10% maximum since those negative catalysts happened, and the stock is down 50%. However, investors don’t base their decisions on DCFs, they base their decisions on short term stories.
Think about it: UK retailer, CEO retiring, leveraged balance sheet, higher rates, inflation, cost of living crisis, inventory build up…
Even if that only translates into EBITDA down 10% for one year, people don’t want to hold through it. Short-sellers add to the pain, as a lot of them with short-term investing styles are attracted to these set-ups.
I thought it was a great long, because structural growth was 8-12%, P/E was around 15x and the business is a long term compounder. Well now, nothing has changed except one year of earnings and the P/E, which is now 8x.
Ignoring multiples, on the premise that stocks are the present value of future cashflows, is lazy. After all the point of all this is to make money. Next time, I’ll make sure I’m on the right side of this, and will pay attention to the direction of business momentum.
Exasol
Exasol hurts a lot right now. The CEO resigned 2 weeks ago. Q2 earnings weren’t bad, but there wasn’t much to be excited about. The stock hits new lows almost every single day.
However, my thesis was not based on the CEO, and the valuation already prices in that Exasol is going to miss guidance by a wide margin.
Though I am down close to 50% on the stock, I have yet to be proven wrong. Q3 earnings will be critical to the stock. I think that unless there is a significant negative surprise in store for investors, the stock will rally.
After all, mere mediocre execution of their plan would be enough to justify a stock price 4x higher.
Positions
Wise PLC - 18.81%
See here for long thesis
The multiple re-rating has been very generous on this stock, up 100% since I bought it and contributing to 11% to performance.
I already trimmed it a bit, as the valuation makes me a bit uncomfortable (8x NTM EV/Sales), but at the same time, I wonder if it is smart to sell a compounder like this because its a bit expensive.
Perhaps this is actually a fair multiple, and with 25% CAGR over the next 3-5 years, the math could still check out.
Spyrosoft SA - 16%
This is probably the most simple thesis I ever had:
On one hand, salaries are low in Poland relative to G7 nations.
On the other hand, polish people are really good at developing software
Therefore, it shouldn’t be a surprise that Spyrosoft grew its sales 100% in Q2, as it offers western companies the same, if not better quality work, for a fraction of the price of hiring a software development team.
Spyrosoft ambitions to grow at 35% CAGR in the next 5 years, and is currently trading at a NTM P/S of 1. In a few years, it plans to buy out all its minority interests and IPO in the US. Assuming the trajectory resembles EPAM’s, the upside is very significant.
Management owns 80% of the stock.
Opera - 15.79%
Recently, Opera announced it would buy back 20% of its market cap from a large shareholder. Though the price is significantly above the current market price, I think its ok due to liquidity and also due to the fact that it is at a price still below fair value.
That’s a >20% bump to normalized EPS right there.
Enquest PLC - 11.8%
TDCX - 10.66%
TDCX is another outsourcing play, based in Singapore. They work mostly with US/Asian tech on marketing projects and content moderation.
Similarly to Spyrosoft, the thesis is based on the salary arbitrage between Asian Tigers and the US.
Moreover, TDCX has opportunities to do accretive M&A in the SEA region.
Trading at 15x NTM earnings, with a structural earnings growth of 15-20%
Tune - 9.78%
See thesis here
I have a really long term view on this stock, so even if I expect a recession to hurt them quite a bit, I’ll just hold it.
EXL - 9.12%
See above and original thesis here
ZPUE - 6.49%
This one is a gamble.
ZPUE recently launched a personal charging station in the Polish market, which is currently in the HSD penetration for New EV Sales/New Car sales, a penetration rate at which EV sales in other countries reached tipping points.
It’s also a pretty big, long standing industrial/electrical infrastructure company.
The reason why it is a gamble is that EV charging isn’t reported separately, so I have no clue how much they actually sell right now. But the business is trading at a P/E of 5-6x, so the call option is extremely cheap.
Moreover, they rejected a tender offer for 276 per share, which is the same price I bought the company at (currently at 314 per share).
KSI -3,09%
KSI licences a validation software targeting pharmaceutical companies.
It currently has 8/10 large pharma companies on its client list.
This is very impressive considering its size.
Management sees a path to $50m ARR with current clients, which sound a bit low for the market cap, but:
its software is also entering new verticals
They can generate a high return on R&D, given their portfolio of deep pocketed clients.
They haven’t captured all their core market yet
Moreover, I think the main thesis is acquisition value, to someone like VEEVA. They will have to pay over 10x NTM sales, which would give a 50% return right now.