Alexander Sacerdote’s Whale Rock Capital had a strong start to the year gaining 13% net for investors during the first quarter, outpacing both the NASDAQ (9.8%) and S&P 500 (6.1%). Since inception (May 1, 2006) the TMT fund has produced a total return of 223% net, outperforming the MSCI World Infotech index by 78.2% and S&P 500 by 96.6%, according to a Q1 letter to investors reviewed by ValueWalk. During the quarter the hedge fund run by Alexander Sacerdote operated with a 60% net exposure.
Longs contributed 22.1% while shorts detracted 5.9% or 4.7% excluding currency hedges. At the end of the quarter, Whale Rock’s gross exposure was 202% gross and 57%. Hedging strategies accounted for 5.8% of the 73% short exposure at quarter end. Hedges comprise of various index and stock specific strategies.
Within Whale Rock’s letter, Alexander Sacerdote makes an interesting argument for a multi-year tech sector run, against the backdrop of sluggish growth in the rest of the world.
Whale Rock Capital Management, is a one $1 billion global L/S hedge fund. Prior to founding Whale Rock Capital, Sacerdote was an analyst and sector PM at Fidelity Investments
Alexander Sacerdote of Whale Rock Capital: The $1trn Tech Sector Opportunity
Sacerdote writes that many of the fast-growing tech sectors today, such as e-commerce, cloud computing, mobile advertising, mobile gaming and Internet video, are all still in the early phases with penetration of only 5% to 15%.
At the same time, technologies such as robotics and the Internet of things are only just starting to get off the ground. These “megatrends” are what will drive tech sector growth in the years ahead after several decades of stagnation:
“We are on the cusp of several new megatrends including driverless cars, artificial intelligence, robotics and the Internet of things, which are certain to play out over the coming decades. And in the midst of all these large megatrends, scores of sub- trends are emerging as well. This stands in stark contrast to periods over the past 20 years when the pace of innovation and growth has slowed.”
The tech sector’s largest players such as Google, Facebook, Microsoft, and Amazon are helping to accelerate these trends. The winner takes all dynamics are helping to jack-up returns for shareholders and are enabling market leaders to reinvest more capital. Sacerdote goes on to argue that the tech sector is also cheaper than the overall market with a forward P/E of 18x for the S&P Info Tech Index, equal to the S&P 500 “even though tech earnings growth is faster at 13% versus 9% for the S&P 500.”
The letter goes on “we also feel tech balance sheets are superior, with $641 billion of net cash whereas the S&P 500 has net debt. If you adjust the P/E for cash, tech trades at 16x, two turns lower than the S&P…And the ROE of tech is superior at 21% compared to the S&P 500 at 13%.”
There’s also a huge amount of capital sitting on the sidelines ready to buyout tech firms, or fund new startups. As Sacerdote explains:
“Masayoshi Son, Chairman, and Founder of Softbank, also sees this and raised a $100 billion fund to buy tech equities. In addition, in 2016 alone, according to Preqin $52 billion in fresh private equity capital was raised specifically for the space, and in 2017, Vista and Sliver Lake will each close $10 billion funds. If you assume this $170 billion of capital gets leveraged one time (likely conservative), this equates to $344 billion of buying power. On top of this, there is another $641 billion sitting on tech balance sheet likely to be used for buybacks and M&A.”
Against this backdrop, it’s easy to see why Whale Rock is so aggressively positioned (although the hedge fund has purchased some hedges as downside protection).
The average forward P/E ratio of longs in the portfolio is 28 times, but last quarter, the long portfolio reported revenue growth of 32.2% year-on-year. Main themes include 1) cloud computing and software as a service, 2) global e-commerce, 3) mobile advertising, 4) mobile gaming and 5) the 100 Gig optical upgrade cycle. On the short side, Whale Rock likes (or dislikes) 1) legacy IT, 2) S-Curve decliners, 3) e-Commerce losers and 4) wearables.
Alexander Sacerdote believes that Japan offers the best ground to find tech stocks. They note:
In search of the next big wealth creator, we benchmark business models, unit economics, growth and profitability of publicly traded e-Commerce players globally. We also carefully monitor e-Commerce adoption rates across countries and sub-categories, looking for tie next big inflecting S-Curves. Sometimes we find a market taking off, but cannot find investable winners (this was the case in India) and sometimes we find a strong winner that is already well-appreciated or for which growth has matured. In Japan, we think we have found one of the best e-Commerce S-Curves coupled with one of the strongest and most profitable business models we have seen.
The stock is Start Today which the fund likes in part based on the company’s retail ZOZOTOWN unit.
Whale Rock Capital states in its letter:
As the first mover, Zozotown’s brand became wildly popular and is synonymous with online fashion. This yields.powerful economic advantages, enabling some of the lowest customer acquisition costs in the world at —$20 per new customer. With the average customer (a 33 year-old woman) buying wet $350 of goods per year and Zozotown keeping 30%, it’s not hard to see why Start Today has the highest margins and return on equity of ALL public e-Commerce companies globally that we tract The few other start-ups, offline retailers (like Uniqlo) and major broadline e-Commerce players likeMVIZN and Rakuten have aggressively come after Start Today but have consistently failed for a variety of reasons that we think will persist. Last quarter, Start Today grew Zozotown 44%, while we that Amazon’s Japan apparel business may have declined and Rakuten grew less than 10%.
Alexander Sacerdote ends off the piece on the stock using the following valuation:
Start Today has a long runway and should generate a 25-30% EPS CAGR for several years to come. The company trades at —30x our 2017 EPS which is well below? peen such as Zalando, Asos and Yoox Net-A-Porter Group which trade at 40-60x earnings and grow.significantly slower. We think the multiple will hold and the stock should appreciate in line with earnings growth, with potential for greater upside if earnings grow faster and/or the multiple expands.
The hedge fund also had a long in Gigagom – that stock was recently pitched at Sohn Next Wave by Dave Thomas of Atalan Capital, only hours after Elliott Management took a giant stake in the firm. Whale Rock Capital exited the name after a 40% gain.
Another interesting long is AAOI which is a Lakewood Capital short, as we recently reported. Lakewood believes that the company is over-hyped and can drop around 60% to around $20 per share.
Whale Rock Capital disagrees and while not