Rowan Street commentary for the year ended December 31, 2021.
Michael Gelband’s Exodus Point launched in 2018 with $8.5 billion in assets. Expectations were high that the former Millennium Management executive would be able to take the skills he had learned at Izzy Englander’s hedge fund and replicate its performance, after a decade of running its fixed income business. The fund looks to be proving Read More
“Nobody buys a farm based on whether they think its going to rain next year. They buy because they think its a good investment over 10 or 15 years. It’s the same with stocks. Think of stocks as a part ownership of a business. It’s not that complicated.” - Warren Buffett
I think we can all agree that since the pandemic started in the beginning of 2020, it has been a very challenging operating environment for most businesses, and the stock market has had a very difficult time properly assessing risks and efficiently pricing stocks. After the initial and very rapid drop in the stock market in March of 2020, the digital economy and the so-called “stay-home-stocks” got launched into stratosphere as Mr. Market got overly enthusiastic about this part of the economy, possibly discounting a lot of potential future growth into just one year (2020). Below are some best performing digital economy stocks in 2020 as compared the overall S&P 500 performance of +18.4%:
- Tesla Inc (NASDAQ:TSLA) +743%
- Peloton Interactive Inc (NASDAQ:PTON) +434%
- Zoom Video Communications Inc (NASDAQ:ZM) +396%
- Etsy Inc (NASDAQ:ETSY) +301%
- Trade Desk Inc (NASDAQ:TTD) +208%
- Docusign Inc (NASDAQ:DOCU) +200%
- Shopify Inc (NYSE:SHOP) +185%
- Zillow Group Inc (NASDAQ:Z) +183%
- Roku Inc (NASDAQ:ROKU) +148%
- Teladoc Health Inc (NYSE:TDOC) +139%
- Chegg Inc (NYSE:CHGG) +138%
- Paypal Holdings Inc (NASDAQ:PYPL) +117%
- Spotify Technology SA (NYSE:SPOT) +110%
- Wix.Com Ltd (NASDAQ:WIX) +104%
- Atlassian Corporation PLC (NASDAQ:TEAM) +94%
- Apple Inc (NASDAQ:AAPL) +81%
- Amazon.com, Inc. (NASDAQ:AMZN) +76%
- Netflix Inc (NASDAQ:NFLX) +67%
As you know, we had started slowly transitioning the Rowan portfolio towards the digital platform companies back in 2017 as we described in our 2020 year-end letter (please see section “Evolving Our Value Investing Approach to the 21st Century”). So, the Rowan Street portfolio by design ended up being almost entirely composed of digital platform companies prior to the start of pandemic. Thus, we had a very good year in 2020 as measured by our market performance of +65.4% (gross) as compared to the S&P 500 +18.4%.
To the contrary, the physical economy such as retail, travel, transportation, restaurants, oil and gas, etc. got left behind and significantly underperformed in 2020, as Mr. Market became overly pessimistic about this part of the economy. Below are just some of the many stocks that struggled in 2020 for obvious reasons:
- Carnival Corp (NYSE: CCL) -56%
- United Airlines Holdings Inc (NASDAQ: UAL) -52%
- Wells Fargo & Co (NYSE: WFC) -41%
- Boeing Co (NYSE: BA) -34%
- Walgreens Boots Alliance Inc (NASDAQ: WBA) -32%
- Macy's Inc (NYSE: M) -31%
- Chevron Corporation (NYSE: CVX) -30%
- Under Armour Inc (NYSE: UAA) -22%
- Intel Corporation (NASDAQ: INTC) -17%
- JPMorgan Chase & Co. (NYSE: JPM) -7%
Thankfully, we did not own any of the physical economy stocks in 2020, and the only one that we did (Under Armour), we were fortunate to sell in January before the pandemic began. As you may remember, we sold UA stock due to fundamental reasons (please see our rationale) and not because we had some special insight into the future at that time.
2021, in a lot of ways, had been a complete flip-side of 2020 as the economy started reopening and a lot of beaten down stocks came back in a big way while the ‘digital economy darlings’ of 2020 experienced pretty significant declines (see below) all while the S&P 500 advanced +28.7%.
- Peloton Interactive Inc (NASDAQ:PTON) -76%
- Chegg Inc (NYSE:CHGG) -66%
- Zillow Group Inc (NASDAQ:Z) -54%
- Teladoc Health Inc (NYSE:TDOC) -54%
- Alibaba Group Holding Ltd (NYSE:BABA) -49%
- Zoom Video Communications Inc (NASDAQ:ZM) -45%
- Wix.Com Ltd (NASDAQ:WIX) -37%
- Docusign Inc (NASDAQ:DOCU) -31%
- Roku Inc (NASDAQ:ROKU) -31%
- Spotify Technology SA (NYSE:SPOT) -26%
- Paypal Holdings Inc (NASDAQ:PYPL) -19%
- Uber Technologies Inc (NYSE:UBER) -19%
Fourth quarter was particularly tough in terms of market performance for most digital economy stocks and for our focused strategy, where our portfolio declined -12.3%. This resulted in a -19.4% (gross) decline for the full year 2021.
Since 2017 (our fully invested period), our fund has returned +48.1% (net of fees) vs. +91.3% for the S&P 500 and +23.6% for the MSCI World Index ex-USA. This is quite a departure from the 2017–2020 result that we reported to you in our 2020 year-end letter, where our fund had returned +85.8% (net of fees) vs. +48.4% for the S&P 500 and +14.9% for the MSCI World Index ex-USA (please see details in the chart below).
Although this is a reminder of what only one year of negative returns could do to your long-term track record, we are not phased at all by this short term fluctuation. Why? Because the only stock price that really matters is the one you sell at, everything else is just there for entertainment. We are long term investors with at least a 5-7 years investment horizon, and since we have not sold any of our strong conviction positions in the fund and remain very optimistic about their long-term prospects, the 2021 result is just a temporary paper loss and not a permanent loss of capital (it's extremely important to distinguish between the two). As the father of value investing Benjamin Graham famously said:
“In the short run, the market is a voting machine influenced by popularity, but in the long run it’s a weighing machine.”
Holding stocks for a long time is hard. Holding stocks when prices are swinging wildly is even harder. But, holding stocks is the best way to create long-term wealth!
Despite these significant declines in the digital economy stocks in 2021, it’s pretty much a certainty that COVID has dramatically accelerated the shift to digital innovation platforms. The underlying economic forces that drive the incredible growth of these businesses are NOT temporary in nature. In our opinion, 2020 was just a preview of what’s to come. These are secular forces that are here to stay and redefine how we work, live, exercise, communicate, see a doctor, commute, learn and transact with each other. And Rowan Street is positioned to benefit from these secular forces over the next 5-10 years. Our motto is “only the best will do” and we spend all our time finding the best quality companies that are competitively entrenched, have solid growth opportunities and have extraordinary leadership teams that are responsible stewards of our shareholder capital. We want to own them for as long as they remain the best, which is hopefully measured in decades and not years. We will spend zero time trying to rotate a portfolio into what’s currently working just to keep up with the market in the short run — that is a sure prescription for mediocre long-term results. We think like business owners (not traders of stocks) and we will always approach all our investment decisions as though we were buying the whole business outright and retaining management. That is the overarching principle of our investment discipline!
As you can clearly tell from this huge divergence of the digital economy stock vs. physical economy stocks from 2020 to 2021, it would not be rational to judge the success of your investments just looking at one calendar year of market performance. In fact, it would be extremely misleading to do so! Let’s do a little exercise and pretend that Rowan Street is a private equity fund and that all the companies that we currently own in our portfolio are private and you cannot look up the most current stock price for any of them. What this exercise does is it allows us to put our business owner's hats on. Instead of focusing on the short-term stock price fluctuations (that are meaningless), our focus can now shift to the actual progress of the businesses that we own and their long-term prospects. Turning off the stock market, in good years and in bad, is an extremely useful (and very profitable) exercise for a long-term investor.
With that, let’s take a look at the actual business progress of some of our top holdings and how they have done since the pandemic started. Let’s look at a 3 year time period, since it incorporates one normal operating year (2019) and two non-normal pandemic years 2020-21.
Spotify (3 Year Business Performance)
- Monthly active users (MAU) grew by 95% since 2018 or 25% per annum.
- Revenues grew 82% or 22% per annum — a very respectable growth rate.
- Spotify has quickly become a number one podcasting platform with 3.2 million podcasts (growth rate of over 1500%) and, as data indicates, the top platform for podcast consumption in 60+ countries. They have also recently become the number one podcast platform the U.S. listeners use the most, and given that the U.S. represents the largest podcast market globally, we think this is quite significant.
“Audio is our right to win and while we've been relentless in our pursuit of being the world's largest audio platform, it is still early days and we're just getting started. The industry is only just starting to grasp the magnitude of this opportunity as we continue to remain focused on unleashing new experiences that demonstrate the future we envisioned for audio.” — Daniel Ek, Spotify CEO
- SPOT stock is up ~94%, which accurately reflects the business fundamentals.
- From the valuation risk perspective, the price-to-sales multiple remains very undemanding at 3.89x.
- Given the pace of growth and innovation at Spotify, we believe its not unrealistic to expect that they could surpass one billion in monthly active users by 2025, which implies a 25% annual compound growth rate. Their revenues could expand in a similar fashion and their gross margins could expand as well given the dramatic growth of their ad-supported business, driven by podcasts. Thus, we expect Spotify stock to double over the next 3-5 years as it reflects the fundamentals of the underlying business.
Meta Platforms (FB)
- Daily Active People (DAP) across the family of Facebook apps (including Instagram, What’s App and Messenger) grew from 2 billion (Dec 2018) to 2.8 billion in the latest quarter (38% growth).
- Monthly Active People (MAP) grew from 2.6 billion (Dec 2018) to 3.6 billion in the latest quarter. Please note that there are approximately 7.9 billion on this planet and it's estimated that 3 billion of them still don’t have access to the internet, which leaves us with 4.9 billion people. China has a population of about 1.4 billion and Facebook apps are banned there, so that leaves us with 3.5 billion people in the world that have access to the internet and have access to Facebook apps. So, Meta Platforms connects pretty much every single one of them, which is kind of mind-blowing to think about.
- Revenues grew 2.1x over the past 3 years or 28% per annum and are expected to be around $117 billion in 2021.
- Gross profits grew 27% per annum.
- Operating profits grew 23% per annum and are expected to be close to $47 billion in 2021.
- The valuation remains very reasonable at 8.2x price-to-sales (see below) and 23.7x 2021 estimated earnings, considering the quality of the business, very attractive growth opportunities and the incredible profitability of their business model.
Trade Desk (TTD)
- Revenues grew from $477 million in 2018 to estimated $1.1 billion for 2021, which represents a 2.4x growth over past 3 years or 33% per annum.
- Gross profits grew even faster at 35% per annum.
- TTD Stock has grown approximately 600% since the beginning of 2019.
- The stock advance has surpassed an already very rapid growth in the business itself as the price-to-sale multiple has grown from 7x to current 35x (see below). Trade Desk was a relatively unknown company back in 2017, operating in the space that was widely viewed with a lot of skepticism and now its has grown into a leader in the industry with solid growth and profitability (even though its still very early in its growth stage) and a massive total addressable market (TAM). Thus, Mr. Market has not only warmed up to TTD, but has grown very enthusiastic about the future potential of this business. We have been fortunate to acquire a position in TTD stock during pandemic lows in April of 2020 (our cost basis is $17.40) — the only time when its valuation seemed reasonable and presented some margin of safety.
- Finished 2018 with $701 million in revenues; in 2021 they are expected to make $2.1 billion (that's 3x in just 3 years)
- 477,000 paying customers at the end of 2018 grew to 1.1 million
- Customers spending more than $300k per year increased from 310 to 785 (2.5x growth).
- Docusign stock tumbled 42% after it reported in Q3 earnings in the beginning of December, in which it delivered a disappointing Billings outlook as CEO Dan Springer called out a “return to more normalized buying patterns following a stretch of “accelerated growth.” The company was viewed as a hot pandemic play, but recently the market sentiment has shifted to “the slowdown is as a sign a company might have grown too quickly as investors crowded into trades that worked.“
- As you can see from the graph below, Docusign stock was trading at ‘peak optimism’ price-to-sales ratio of 35x in the summer of 2020 and has now corrected to a much more reasonable 13x (or 10x expected 2022 sales). Thankfully, our position was insignificant before this correction, and we have been taking advantage of this significant decline in the stock price to build a much larger position, as we expect it to deliver double-digit returns from these price levels over the next 3-5+ years.
- Our rationale is simple: despite the recent decline in the valuation, it’s clear that Docusign is still in the early days of its $50 billion Agreement Cloud opportunity as digital transformation remains a high priority for organizations worldwide (our fund is a very happy user of their services). DocuSign is uniquely positioned to lead and capture eSignature and the broader Agreement Cloud market opportunity, given their strong brand leading market position (Docusign has now become a verb) and product differentiation. Even as the pandemic subsides and people begin to return to the office, they are not returning to paper. eSignature and the broader Agreement Cloud are clearly here to stay, and DocuSign’s value proposition will persist no matter how the future of work unfolds.
- The huge drop in company stock also triggered the company CEO, Dan Springer to purchase approximately $10 million worth of DOCU stock in the open market. This is the first insider purchase at the company since it went public in April 2018 at $29, and its the vote of confidence that we love to see!
It’s always good to remind ourselves of what we are trying to really do here in the first place?
As we constantly repeat this in almost all annual letters, our goal from day one was to compound our investor’s capital at double-digit returns over the long run.
Now, everyone loves outsized returns. We could compare a strong track record of long-term returns to a fit body. Both need a lot of patience, discipline and both require you to “pay the price.” The reality is that the majority of people lack patience, lack discipline and are just not willing to “pay the price.” We all know what paying the price in fitness really means, but let's take a look at what that means in investing.
Let’s look at an example of Netflix stock performance since 2010 and compare that to the S&P 500 index. As you can tell from the chart below, the difference over the past 12 years has been absolutely staggering and leaves anyone salivating over these kinds of returns (6,981% for NFLX vs. 312% for the S&P 500).
With that, now let’s take a look at the “Cost of Admission” in order to generate these kinds of returns. We want to show you the painful drawdowns over the same time period since 2010. Here, you had a couple of 80% drawdowns back in 2011-2013 time period, a bunch of 40% drawdowns, and countless 20%+ drawdowns.
So, the question is how many people do you think actually were able to withstand the volatility of Netflix stock over the last 12 years, pay the price and hold it all the way through? During the investment period shown above, Netflix was up almost seventy-fold, and this volatility is the price you had to pay to get it. A lot of market participants are striving for these outsized returns, but just don't want to pay that price. It seems too risky and they try to cling towards safety without realizing that this is the cost of admission for above average returns.
The good news is that at Rowan Street we do have the patience, the discipline and are very willing to ’pay the price’ in order to achieve the long-term results we have outlined. All that we ask of you, our Limited Partners, is to trust our process and to allow us to do what we do best — compound your hard-earned capital over time. If you can do that, our partnership will work like magic — we are confident in that! In addition, you should derive some comfort in that majority of our net worth is invested in Rowan Street alongside with you (we like to eat our own cooking). We want our partners’ financial fortunes to move in lockstep with ours.
“If everything you do needs to work on a three-year time horizon, you are competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you are now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow — and we’re very stubborn. We say we’re stubborn on vision and flexible on details.” — Jeff Bezos, 2011
We love this quote by Bezos because it works the exact same way with investing in stocks, only here, the majority of players are working on a timeline of less than one year, and often just a few quarters at best. This will never be our game because we don’t like to compete with the herd. At Rowan Street, we also invest with at least a 5-7 years timeline in mind, and compete with very few investors because few are willing and able to do that. If we like the business, the company’s management team, the culture they created and their vision for the future, we are willing to plant the seeds and let them grow while we patiently wait. Since we are not constantly buying and selling, the lack of action in the portfolio may look like we are snoozing. But what we are doing is actively waiting and allowing our carefully chosen management teams to execute. Actively waiting means verifying that the three parts to our ‘compounding machine’ are still intact (business, management, reinvestment opportunities).
Upgrading The Quality Of Our Portfolio
We have been working on upgrading the quality of the Rowan portfolio since day 1, taking advantage of the opportunities as Mr. Market presented them to us from time to time. This process takes time and we have been very patient. There are a few companies that we have been ‘salivating’ over as they are some of the very best and most high quality businesses around, in our view. Unfortunately, we have not been able to buy them for our portfolio in the past 3 years because of the stratospheric valuations that Mr. Market was willing to assign to them. As you know, we are very disciplined in terms of the price that we pay for our acquisitions as price plays a huge factor in our long-term returns. If you pay too much for even the best business, your long term returns can prove to be very disappointing even as the underlying business itself continues to do very well. For a rational and disciplined investor it has been a difficult market over the past 3 years as it has been anything but disciplined and rational. Mr. Market got especially frothy and speculative during the pandemic (2020-01) — we would call it “buy-at-any-price“ market. In fact, we were absolutely mind-boggled by the valuations that market participants were willing to pay out of FOMO (fear of missing out). As Warren Buffett once said:
“Nothing sedates rationality like large dozes of effortless money“
Well, a lot of froth is finally coming out of the market and many growth stocks are coming back down to earth. We view the current downturn as an exceptional opportunity to own these few extraordinary businesses that we have been studying and eyeing for years. We are very excited to ‘plant the seeds’ that will benefit the Rowan portfolio for many years to come.
A Unique Opportunity To Add To Your Investment In The Fund
We would encourage all limited partners in the fund to add to your current investment, if you have an opportunity to do so. This is one of those times when we have a lot more ideas than we have cash to take advantage of them. There is a very high probability that in 3-5 years we will look at current times as an incredible buying opportunity for our fund. All the companies we currently own in the portfolio are estimated to grow at 20+% over the next 3-5 years, which is 3x the expected growth rate of the overall market, and the valuations for our positions remain undemanding. As a reminder, the fund is open at the end of each month for new investments.
We hope that all of you stay healthy and safe. Better times are ahead, and we will come out of this much stronger and better positioned on the other end.
Please feel free to contact us with any questions.
Alex and Joe