FY 2021
Kinsman Oak Investor Letter FY 2021
February 24, 2022
REVIEW OF 2021 & PREVIEW OF 2022
Last year was filled with drama as sentiment in many pockets of the market went from moon-bound to zero-bound in the span of months. Meme stocks, most notably GameStop (GME) and AMC Entertainment (AMC), saw their market caps increase 135x and 138x, respectively (Appendix A). Remarkably, these stocks have yet to fully collapse but sentiment around various other meme stocks, and overly promotional SPACs, are now zero-bound.
Gamma squeeze mechanics, a concept rarely discussed before this year, has permeated mainstream discussions to explain highly unusual price action. Abnormal parabolic moves are not confined to illiquid small market capitalization stocks either. Tesla (TSLA) benefitted from enormous call option buying throughout the year.
We believe ARK Innovation Fund (ARKK) serves as a barometer for the speculative appetite of market participants. It is abundantly clear reckless fervor waned as the year progressed, as the ETF declined by ~41% from its February peak to year-end and is down ~62% from its peak at the time of publication.
Asset prices have had a rocky and volatile start to the year. At a micro level, there has been plenty of multiple compression, earnings misses, and guide downs, with forward growth and margin compression coming into focus. At a macro level, investors are worried about soaring inflation, the number of rate hikes, and the magnitude and pace of monetary policy tightening.
There is a lot of uncertainty at this juncture and, with valuation multiples close to historic peaks, this doesn’t bode well for asset prices, broadly speaking. We envision a year with tremendous opportunity, but also a year where risk management will be especially important amid prolonged bouts of high volatility.
The Great Narrowing: Anatomy of a Bubble Burst
Jeremy Grantham, Co-Founder and Chief Investment Officer of GMO, describes the U.S. equity market as a three-sigma deviation “supper-bubble” similar to U.S. equities in 1929 and 1999, Japanese equities and real estate in 1989, and the U.S. housing market in 2006.1 He emphasized the following point: the higher these bubbles went on the way up, the more pain was eventually endured on the way back to trend.
For the purposes of this letter, we will use the term ‘bubble’ loosely because we do not want to prognosticate where broad indexes will peak or trough over the next few years. What we do know is today’s environment checks a lot of the boxes typically associated with textbook bubbles.
Market breadth becomes increasingly narrow as broad indexes continuously make new highs.
Parabolic price appreciation coupled with extreme valuations (and newly created valuation metrics).
Abandonment of traditional investing principles as “this time is different” (TINA justifies infinite multiples).
New class of investors are deemed to be the next Warren Buffet (Chamath Palihapitiya, Cathie Wood).
Proliferation of old financial vehicles re-branded as something new and excited (SPACs).
Volatility trending higher (rather than sporadic and intermittent bouts).
Rampant speculation and FOMO (especially amongst retail investors).
In our opinion, the most interesting bullet point is the first one. Bubble peaks cannot be predicted a priori but, with the benefit of hindsight, they often coincide with troughs in market breadth. Historically, bubble bursts begin with the riskiest and most vulnerable stocks and proceed to move through the market until the bulletproof blue-chip market leaders are the last pins to fall.
The S&P 500 has been increasingly propped up by only a handful of mega-cap stocks. The tide began to move out for highly speculative “innovation” stocks early last year, followed closely by meme stocks and overly promotional SPACs thereafter. Towards the end of the year, SaaS companies with nosebleed valuations were next in line along with pretty much any SMID-cap company that missed Q3 earnings. In fact, on January 6, 2022, Bloomberg reported 40% of all stocks within the Nasdaq Composite Index have declined by >50%2 (Appendix B).
FAANGM (and TSLA) did the heavy lifting for S&P 500 total returns last year. But, since recent highs, both FB and NFLX have been cut in half as market breadth continues to narrow. The remaining constituents have shown notable weakness year-to-date. We wonder if recent price action suggests a healthy correction within a bull market is underway or if this is simply the final stage of a bubble burst where the last pins are beginning to tumble.
Index Resiliency Masks Underlying Carnage
Although the S&P 500 has experienced only a modest pullback from all-time highs, significant swaths of the market are already in deep bear market territory. Many stocks have given back all gains over the past two years and find themselves within spitting distance of where they were pre-Covid. Our watch list is littered with companies that took long escalator rides into the stratosphere and then suddenly round tripped in an elevator (Appendix C).
High quality SaaS businesses were lapping unsustainable comps as they spent two years abnormally accelerating user adoption. Extrapolating hyper-charged growth rates on an inflated revenue base guarantees an abrupt expectations reset eventually. But many companies still have healthy three-year CAGRs despite recent deceleration. Further, while many are high quality businesses with deep moats and plenty of growth ahead, they were simply trading at valuations that were impossible to grow into, especially in a rising interest rate environment. The Nasdaq 100 is currently -18% year-to-date and -21% from its peak in November 2021.
The fourth quarter of last year was particularly devastating for SMID-caps reporting Q3 earnings. Many companies that posted slight misses, even if guidance was unchanged, declined precipitously. It was not unusual for stocks to react anywhere from down 20%-30% on the day. Despite what we would characterize as an overreaction, most big decliners did not bounce in the following trading days either.
We wonder how much of this dynamic (outsized declines followed by an absence of bidders) can be explained by inelastic theory. Passive investors, otherwise known as valuation-agnostic indiscriminate buyers and sellers, have become so prolific that active buyers’ ability to stabilize equity prices during negative news events is becoming more marginalized.
Passive vehicles will buy positive momentum when they receive incremental inflows. Negative news events create negative momentum, so selling often begets more selling. Fewer bids plus more offers equals lower prices. In our opinion, traditional valuation metrics no longer provide an implicit short-term floor for stock prices because a) of inelastic theory and b) the denominator in P/E multiples are the most unpredictable they have ever been.
Fed Walks a Tightrope with No Easy Choices
We find ourselves thinking about the pain of inflation versus the pain of recession, and how central banks can’t quell the former without causing the latter. Admittedly, we entered last year believing inflation would decelerate as base effects kicked in but changed our minds in the summer when it was clear that was not happening.
Investors overwhelmingly believe the Fed is prepared to raise interest rates until inflation is under control, or a recession is underway, both bad outcomes for the stock market. In our opinion, the Fed is walking a tightrope without a circus net. If the Fed couldn’t raise interest rates in 2018 without collapsing equity markets, they are probably incapable of doing so now. But higher sustained inflation will cause widespread multiple contraction, hurting equity prices too. Quite the conundrum. Even worse, we can envision a scenario where tightening monetary policy coincides with slowing growth, margin compression (PPI > CPI), and multiple contraction simultaneously.
A ‘soft landing’ would look like the following: Inflation decelerates to low-to-mid-single-digits, the Fed essentially accommodates it with negative real rates, economic growth slows modestly, and multiples stay elevated. We believe such an outcome is unlikely but certainly plausible. OER will put a floor under headline CPI for the foreseeable future, but supply chain problems are improving, and fiscal stimulus is done for now.
Investors may also have to re-conceptualize what they believe the term “Fed Put” means. Inflation is at the political forefront heading into midterm elections when approval ratings for the President are low. Should Powell have to choose between lower inflation or higher stock prices, it’s politically more convenient to choose the former. The Fed may be far less inclined to defend market corrections now, provided financial stability is not threatened.
Slowing Growth: Downside Revenue/Earnings Revisions is a Major Risk
We believe this year will be a year of lowered growth expectations for three reasons. First, as discussed earlier, analysts have extrapolated recent abnormal growth and their current assumptions will prove to be too high. Accelerated user adoption, pull-forward of demand, and the absence of stimulus checks will be big headwinds. One of the biggest risks to equity prices, in our view, is downward revisions to revenue/earnings estimates.
Second, higher inflation causes aggregate demand destruction as real wages are pressured. Middle-class families will be stretching dollars in their monthly budgets as CPI probably dwarfs annual wage increases. Consumers will be spending less money on hardgoods compared to the previous two years. Specifically, we believe estimates are generally too high for businesses that sell big-ticket items such as home furniture and expensive electronics.
Third, extreme over-indebtedness leads to weaker economic activity. Investors have used ultra-low interest rates as a justification for reducing their required prospective return rate but have maintained growth assumptions as they build out financial projections. This is the economic equivalent of having your cake and eating it too. Growth supercharged by debt issuance is not sustainable and, as leverage builds in the system, growth rates will decline (Appendix D). Central banks attempt to kick the can down the road by expanding their balance sheet but velocity is one offsetting variable they cannot directly control.
WHERE WE SEE OPPORTUNITY
Our watch list of attractive potential investment opportunities has exploded over the past few months. We are particularly interested in oversold SMID-cap stocks and a handful of high-quality SaaS businesses. Our base case is the broader market will experience more downside volatility short-term as the Fed attempts quantitative tightening and rate hikes, but plenty of stocks are becoming exceptionally cheap.
We spend a lot of time thinking about the dichotomy we discussed earlier. On the one hand, plenty of stocks are trading at compelling valuations yet, partly because of passive investing, cheapness does not provide an implicit floor for price the same way it might have in previous cycles. Our belief is that eventually underlying business fundamentals and earnings will drive stock prices over the long run. Investors with lengthy holding periods can benefit from interim volatility and compound capital at high IRRs, provided they select the right group of stocks.
Long duration technology and faux-innovation stocks have taken a walloping over the past six to twelve months. Many are down more than half, and plenty of perpetual cash incinerators are still very expensive. ARK Innovation Fund (ARKK) is down ~62% from highs and has given back all gains since Covid-19 began (Appendix E). Picking through the rubble, it appears quite a few babies may have been thrown out with the bathwater though.
For instance, Netflix (NFLX) is an interesting case study, which we have no position. Comparing FY19 to FY23 estimates: Revenues are expected to double, earnings are expected to triple, and the company has 33% more subscribers today than it did in 2019. Yet, the stock is -8% versus its pre-Covid peak. Either the stock was overpriced back then, growth expectations were wildly unrealistic, or it’s a bargain today.
High-quality SaaS businesses experienced hyper-charged growth and mass widescale adoption (as a result of lockdowns and work from home measures) followed by hyper-charged deceleration in the span of 24 months. Usually, that growth/deceleration cycle takes 5-10 years. But, with the sector round-tripping back to pre-COVID equity prices, you can buy businesses today for the same price as you could before that mass adoption took place.
Investors are overwhelmingly on the opposite side of the boat, buying energy, financials, cyclical value, etc. Evaluating opportunities in sectors which the consensus deems to be guaranteed money-losers can uncover some significantly undervalued securities. Right now, that sector is technology. Nothing will ever be the equivalent of negative oil, but from a sentiment standpoint, investors dislike tech stocks today almost as much as they deemed oil and gas un-investable back then.
We understand duration is a material risk to any asset which derives cash flows far into the future but (a) some technology companies are free cash flow machines today and (b) we believe there is an upper limit on how high nominal rates can rise without breaking something important within the financial system. Again, this does not mean the tech sector as a whole will outperform, and we recognize that more near-term downside is highly likely. But exceptional companies with secular growth, deep moats, low leverage, and strong margins may finally trade at reasonable valuations if the sell-off continues.
PORTFOLIO UPDATE
We ended last year approximately 85% net invested. The Fund owned 16 long positions at year end, two Canadian listed stocks and fourteen U.S. listed stocks. The top ten holdings are roughly two thirds of the Fund’s net asset value, excluding cash. The Fund does not have exposure to biotech, energy, or financials.
The Fund entered this year more net invested relative to last year, but individual holdings skewed slightly more defensive. We intentionally reduced our exposure to businesses where we felt pent-up demand yesterday would cause pent-down demand tomorrow. For instance, we sold half of our Tempur Sealy (TPX) position in the second quarter and the rest in the third quarter.
We also remain cognizant of many cyclical companies that appear cheap but have either over-earned in the previous two years and/or are hitting cycle highs. We have added to some of our long positions during the recent sell-off and continue to do so as valuations get more attractive. Our approach is to add gradually so as not to get whip-sawed in this highly volatile trading environment. We remain excited about the opportunity set that lies ahead.
LOOKING BEYOND 2022
Gains enjoyed over the past ten years were derived from stocks underearning their potential coupled with cheap starting valuations. Both of those factors are working in reverse today. There may come a point where broad markets go nowhere for ten years, but they will go nowhere in an interesting way. Investors can make money through flat markets, especially if volatility is elevated. We continue to believe the best way forward is to own undervalued securities with a long-term outlook and trust that stock prices will adequately reflect business fundamentals over time.
Sincerely,
