Steven Ko’s memorandum to Starvine Clients on Brexit.
Memo to: Starvine Clients
From: Steven Ko
Worm Capital July 2020 Performance Update: Up 152% YTD
Worm Capital performance update for the month ended July 31, 2020. Q2 2020 hedge fund letters, conferences and more Long/Short Equity Growth Strategy Net Performance Long-Only Equity Growth Strategy Net Performance
Date: June 26, 2016
If paying a low or reasonable price is core to the success of any investment, then price volatility caused by geopolitical uncertainty should be seen as a welcome enabler. For long term value investors, I believe the history books will show Brexit to have been a temporary window to acquire stocks at a discount. That is not to say the sell-off is finished; there may be days, weeks, or months of strong price fluctuations remaining.
I have taken a name-by-name look through the Starvine portfolio and concluded that the underlying economic downside from U.K. exposure is limited. Seven out of the 16 companies in the portfolio generate a portion of their sales in the U.K. In aggregate, ~7% of the market value of the Starvine strategy can be attributed to the U.K., using sales as the measure. Furthermore, the businesses are in defensive industries for the most part. For example, it is doubtful consumption of frozen foods or medicine in the U.K. will waver much as a result of Brexit – people still need to eat and take their meds. Can you picture anyone having second thoughts the year after the referendum about buying a box of frozen fish fingers from the local Tesco? It is also unlikely that businesses will cancel 10+ year fixed contracts with IT service firms as a result of Brexit.
It is in a time like this that high quality companies have the potential to go on sale temporarily. Typically, market shocks like the one we saw on Friday trigger forced selling in the market via calls on margin loans. Add in fund redemptions by skittish investors and it is not difficult to see prices steeply falling within a few days as sellers outnumber buyers. Selling can beget more selling, in both the market at large and in individual stocks.
However painful the prospect of seeing one’s liquid net worth temporarily decline, there is nothing more a value investor should want than to see prices correct harshly on no incremental news specific to companies. I believe it is important to keep your eyes on the prized watch list: companies with distinct competitive advantages, whose management teams have stunning records of reinvesting cash flow intelligently. Most of the time, the market as a whole is not dumb about recognizing the value of a good business; a perceived defect or geopolitical event is required to shake up valuations briefly.
Most stocks in the Starvine equity strategy are already undervalued – some I would say are extremely cheap and high quality. The existing portfolio is hence a good and tough benchmark against any potential new names under consideration. I would like to see valuations drop further before making any changes, whether adding to existing positions or switching to new ones on the watch list.
So is Brexit a buying opportunity? In my opinion, yes. Based on Friday’s market purge alone, I would not say the market opportunity is too compelling yet, but that has the potential to change in short order. As discussed above, a cocktail of margin calls and investor redemptions can move prices swiftly and far beyond levels one would consider rational. In recent history, we saw this distinct “toilet flushing” of equity prices in 2008, 2009, 2011, and more recently at the beginning of 2016.