Qualivian Investment Partners commentary for the first quarter ended March 31, 2022.
In science you have to understand the world. In investing others have to misunderstand the world. – Nassim Taleb
Qualivian Investment Partners is an investment partnership focused on long-only public equities. We own a concentrated portfolio of 15–25 understandable companies with wide moats, long reinvestment runways, and outstanding capital allocation. Since we expect them to compound capital at a mid-teens rate, we hold them for an extended period. We are seeking investors who are aligned with our long-term investment time horizon. We do not short securities. We do not use leverage. We do not use derivatives. We are not macro investors. We believe that only a relatively small number of exceptional companies are worth investing in over the long term.
Long-Term Orientation + Long-Term Investors + Focused Portfolio + Quality Compounders = Maximizing Chance for Outperformance
Our investors should understand how we invest so they make the right decision. We encourage investors who agree with our long-term horizon and philosophy to contact Aamer Khan ([email protected]) at 617-970-9583 or Cyril Malak ([email protected]) at 917-742-2039.
Cumulative Performance Since Inception Through March 31, 2022
We have outperformed the S&P 500 Total Return1 index by 2.5% on a gross basis and underperformed it by 2.2% on a net basis respectively from inception (Dec. 14, 2017) through March 31, 2022. We have outperformed the iShares MSCI USA Quality Factor ETF (QUAL)2 by 24% and 19.3% on a gross and net basis. Similarly, we have outperformed the Invesco S&P 500 Quality ETF (SPHQ)3 by 22.6% and 17.9% on a gross and net basis respectively.
In Q1 our total return was –10.9%, which underperformed the S&P 500’s Total Return of –4.6% by 6.3%. Our performance was affected by the following factors:
- Rising inflation led to the Federal Reserve increasing interest rates and beginning a tightening cycle which will continue until inflation is reduced.
- The market responded by rotating out of growth stocks and into the Energy and Metals and Mining sectors, which are viewed as late-cycle sectors and as inflation hedges, as well as seeking safety in the Utilities and Consumer Staples sectors.
- Quality growth stocks overall underperformed. More specifically:
- Our over weighting in growth stocks negatively affected performance due to the growth stock selloff.
- Our lack of exposure to Energy, Materials, Utilities and Consumer Staples stocks hurt us due to their out performance.
Our Portfolio and Inflation:
- Despite the selloff in growth stocks, the intrinsic values of the high-quality growth stocks in our portfolio should be less affected because:
- A high proportion of them are oligopolies so they have higher than average pricing power, enabling them to pass higher input costs via price increases to their customers.
- They have higher gross margins than the average stock, so an increase in their cost of goods sold should have a more muted effect on their bottom line.
Portfolio Changes in Q1 2022
We made three new purchases in this quarter: Berkshire Hathaway (BRK-B), CSX (CSX), and Union Pacific (UNP). To fund these new positions, we trimmed Amazon (AMZN) and Alphabet (GOOGL), and we completely exited PayPal (PYPL) and Evolution (EVVTY).
Berkshire is a compounder whose intrinsic value had fallen behind its share price. It had:
- Leverage to higher property and casualty insurance rates, which are now in an upcycle.
- Exposure to railroads via Burlington Northern Sante Fe (see our previous quarterly letter for a discussion of the railroads).
- $140 billion in cash that can be used to take advantage of the recent market selloff to make purchases of public equities or entire businesses.
For a discussion of UNP and CSX please refer to our previous quarterly letter.
The fundamentals of Evolution (EVVTY) continued to perform but we sold it due to:
- News reports concerning irregularities regarding users accessing Evolution-supplied games with casino operators in unlicensed jurisdictions (which Evolution has denied; Evolution announced it is fully cooperating with regulators investigating these allegations).
- Increased concerns about the rising importance of ESG (Environmental, Social, and Governance) for institutional investors and the impact on casino-related stocks.
We sold PayPal due to our concerns regarding an apparent shift in its strategy to improve user engagement and revenue per user with the company walking back its target of reaching 750 million Net New Active (NNA) accounts over the medium term, having posted its slowest NNA additions in Q4 2021 and Q1 2022 and its slowing earnings growth. This was reflected directly in management lowering their financial guidance, and in PayPal making an unsuccessful bid for Pinterest. We presume this acquisition attempt reflected a desire to offset slowing organic growth with acquired growth in a different business, which we viewed as high risk for PayPal.
Fundamentals of Our Portfolio vs the S&P 500
As can be seen from the tables below, the Qualivian Focus Fund (QFF) continues to have superior gross, operating, and free cash flow (FCF) margins as compared to the S&P 500. Furthermore, QFF’s forward consensus revenue and EPS growth estimates continue to outpace that of the S&P 500. Our portfolio trades at a premium to the S&P 500 but considering the superior margin, growth and return characteristics, that makes sense.
We believe QFF’s superior fundamentals as compared to the overall market will generate S&P 500-beating returns over an investment cycle as the market appreciates the higher growth, margin and return on capital characteristics in the stocks we own. With the valuation reset in a lot of our high-quality and growth stocks behind us, we believe we should see the superior underlying earnings power of our companies come through as compared to the average company, which should stand us in good stead relative to the broader markets.
Sticking with Our Strategy and Avoiding Mistakes
Periods of market turmoil signal both opportunity and danger. They can lead to consequential decisions, both good and bad. The key is how portfolio managers react to a period of underperformance and market volatility.
Any investment strategy will have periods of underperformance. If there was a strategy that consistently outperformed, it would be widely replicated, so that its excess returns would be competed away. The periods of underperformance can interact with behavioral and institutional biases and lead to short-term actions by portfolio teams which are detrimental to long-term returns such as:
- Selling stocks below their intrinsic value.
- Changing investment strategies, e.g., moving from a growth to a value strategy.
- Increasing cash allocations due to market timing.
These actions are typically motivated by considerations such as:
- Trying to lock in gains for year-end performance,
- Not having genuine conviction in their estimate of intrinsic values, and
- Believing one can predict short-term market movements.
Harmful actions can also be due to portfolio managers having the wrong emotional characteristics:
- Not being able to withstand the “pain” of short-term underperformance. Peter Lynch feels “stomach” is more important than brains for investment success.
- Not having confidence in their own estimates of a stock’s intrinsic value.
Price and intrinsic value can diverge for a variety of reasons. Our investment strategy is premised on the belief that they tend to converge over a longer period, so it is a mistake to sell the stocks when they temporarily diverge (so long as we are confident in our assumptions regarding a stock’s intrinsic value).
The following table illustrates that even the best performing stocks can have fairly long periods of underperformance. Selling them while they were depressed would have been a mistake.
It is almost impossible to know when the market will change direction in the short term.
Relative earnings revisions drive relative performance over short time frames. However, the
duration of growth and incremental change in ROIC drive relative performance
over longer time periods, and we focus on these characteristics.
Don’t Let Volatility Scare You Out of the Market
Volatility can make being in the market dangerous over a short period. However, volatility can
make not being in the market over short periods even more dangerous.
The following graph4 illustrates how being out of the market for only a few days can severely
reduce long-term returns.
Munger on Market Volatility
In 2009, Charlie Munger was asked how concerned he was that Berkshire Hathaway (NYSE: BRK-B) shares — which made up most of his net worth — dropped more than 50%. He quickly interrupted the interviewer and responded:
“Zero. This is the third time that Warren [Buffett] and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it's in the nature of long-term shareholding that the normal vicissitudes in markets means that the long-term holder has the quoted value of his stocks go down by, say, 50%.
In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who can be more philosophical about these market fluctuations.”
Verisign: A Monopoly Franchise in the Internet Domain Space
We now discuss a business which is on our watchlist and illustrates our thinking.
Description: Verisign (NASDAQ:VRSN) is the internet registry service for several top-level domains including .com and .net. Verisign plays a vital role in supporting the Domain Name System (DNS) which is akin to a massive address book that matches human friendly domain names to the accompanying numbers-based Internet Protocol (IP) address. As of year-end 2021 VRSN had 173.4 million .com and .net domains, which represents about 51% of global domain registrations.
Our Investment Thesis: Verisign is effectively a monopoly, and barring an operational accident, likely to remain one for the foreseeable future. It has provided uninterrupted DNS services for the last 24 years and it continues to invest in infrastructure and cybersecurity measures to manage the risk of service disruptions. We forecast that it can sustainably grow its EPS in the low teens for the foreseeable future. We highlight the key elements of our investment thesis below:
- Verisign’s Durable Competitive Advantage: VRSN has an exclusive contract with the Internet Corporation for Assigned Names and Numbers (ICANN) for two of the world’s most popular Top-Level Domains (TLDs), .com and .net:
- Hard to Replace: Verisign is deeply embedded in the internet food chain and is unlikely to be replaced by another provider by ICANN due to (1) Verisign’s strong record of service and strong brand and (2) a change in registry operators would increase the threat of operational and security disruptions.
- Exclusive Franchise: The contracts with ICANN run for six years and have the presumptive right of renewal (i.e., cannot be put up for bid) provided Verisign meets contractual obligations of paying fees to ICANN, providing uninterrupted service, and operating key infrastructures.
- Pricing Power: Embedded in the most recent agreement with ICANN in 2018, Verisign has the right to increase its pricing on average 4.6% annually in perpetuity:
- As a result of its 2018 negotiations with ICANN and the Department of Commerce, VRSN was able to demonstrate that the market was competitive (given the growth in other domain names including country level domains). As a result, VRSN won an evergreen pricing provision5 which freezes pricing in the first two years of a new six-year contract cycle but provides for up to 7% price increases for its .com domains in the last four years of the contract6.
- Predictable and Visible Recession Resistant Demand: The demand for overall Top-Level Domains is predictable, historically growing in the 2%–4% range annually over the past decade, and likely to continue at similar rates for the next three to five years giving us substantial visibility into Verisign’s earnings. The .com registry grew from 112 million to 161 million over 2013–2021 (a compound annual growth rate of 4.6%). Domain numbers should hold up well in a recession since a website is among the last items a business or individual will drop if they need to reduce costs.
- Attractive Margins and Inflation-Resistant Returns: VRSN enjoys very high gross and operating margins in the mid-80 and mid-60 percent range, respectively:
- Free Cash Flow margins are in the mid-50 percent range. This in combination with its pricing power should allow VRSN to navigate the inflationary back drop (primarily wage inflation for VRSN) better than most.
- VRSN’s Return on Invested Capital is well north of 100% consistently, exemplifying the company’s ability to generate economic value from its capital expenditures for its shareholders.
- VRSN’s capital expenditures are low – around 5%–7% of operating cash flow.
- Excellent Capital Allocation: Verisign’s management has demonstrated excellent capital allocation. It continually returns excess capital via buybacks, retiring 3–3.5% of its diluted share count each year in the past four years, and well north of that in prior years. The company has reduced its diluted share count by approximately 40% in the past ten years via its share repurchase program which is enabled by its predictable and highly cash generative business model.
- Low- to Mid-Teens EPS Growth: We think the company can sustainably deliver low to mid-teens growth over the next three years, with:
- revenue growth of 6.5–8.5% consisting of:
- 2.0%–4% top level domain growth, and
- 4.6% pricing growth
- 30–40 bp annual EBIT margin improvement from operational leverage, and
- 3% reduction in share count from the company’s buyback program.
Valuation: The key issue for us is buying it at a reasonable valuation. The stock currently trades at 29.2X NTM earnings, which places it at roughly a little over two times its long-term earnings growth. As such, it remains on our watchlist and should market volatility further rerate this highly attractive and predictable business model, we will be at the ready to take advantage of that.
We look forward to continuing to share our thoughts on our investment approach, and to keep you abreast of our performance and changes to the portfolio. If you would like additional information about Qualivian, please refer to Appendix 2 for links to prior Investor Letters, our investor presentation, and an interview that Aamer did with Insider Monkey. In the meantime, if you have any questions, please feel free to reach out to us at the links below.
With best wishes,