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At Palm Capital, we look for businesses with a strong competitive advantage that are run by exceptional managers. We wait patiently to invest when their prices are lower than we think they are worth, aiming to profit as they accumulate economic value over time. We only sell if fundamentals deteriorate, or we see others offering potentially better after-tax returns.
Our performance
During the three months ending June 30, 2022, our portfolio declined 24.1% after management fees and trading costs.
Since we started, just over four years ago, our portfolio has returned 3.8% per year after management fees and expenses. We underperformed the MSCI World Index by 0.6% per year.
| End of time 30 June 2022 |
Our Returnλ |
MSCI World |
out-performance |
|
quarter |
-24.1% |
-17.8% |
-7.7% |
|
1 year |
-28.1% |
-15.6% |
-14.8% |
|
Since inception (annualised) |
+3.8% |
+4.3% |
-0.6% |
| λafter management fees and trading costs |
What we know about bear markets
The MSCI World Index officially entered a bear market last month. It has now fallen 21% from the start of the year to the end of June.
Bear markets are trying times for investors. Studies show that the pain of loss is psychologically twice as strong as the joy of gain. As a result, our sense of danger increases. We focus on negative news. We extrapolate. And we end up putting higher probabilities in the worst case scenario.
Hindsight bias lasts. It seemed obvious that the markets were going to crash – the warning signs were everywhere. The Fed is raising rates. Inflation prevailed. Markets are overpriced.
We went into panic mode. Mental shortcuts lead us to make quick, emotional decisions. The horizon of our time is shrinking. We ask questions like “how much more will I lose if I don’t sell?” and “When will the markets stop falling?” Our decision making is affected at the worst possible time.
But we ignore all the other times when there were warning signs and the markets didn’t crash. It’s not as obvious as it seems.
Our questions about market direction are pointless. The charts above the leaf show data on previous bear markets going back to 1929. There is no pattern in them. Markets may fall immediately or fall further for months. No one knows.
Source: Bloomberg, Palm Capital Analysis
Only two things about bear markets are certain; they are inevitable, and they will end eventually.
Focus on the basics
In these times, it’s more important than ever to follow a rigorous process that’s tried and tested. Ours focuses on the basics. Instead of trying to make short-term forecasts, we can look at the strength of the businesses we own and how well they are performing.
And for our portfolio of shares, prices may have fallen, but they are well positioned to withstand difficult conditions and they are all still thriving.
The median gross profit margin of the companies we own is 73%. This is comparable to typical companies in the MSCI World Index where the gross profit margin averages 45%. This means that our companies are less sensitive to inflation in the cost of sales. It also means they don’t have to raise prices too much to maintain profitability.
The median annual revenue growth for the first quarter of 2022 of the businesses we own is 23%. Furthermore, our portfolio has a high exposure to digital transformation that shows no signs of slowing down. IDC expects the global public cloud market to grow 23% by 2022. And as further evidence, all three cloud service businesses we own are growing strongly, with AWS, Azure, Google Cloud growing at annual rates of 53%, 46% and 37% respectively in the most recent quarter.
The slowest annual revenue growth over the past quarter among the businesses in our portfolio came from Meta Platforms (META, 7% growth). We do not see this as a cause for concern. After more than doubling its revenue over the past three years from $55b to $118b, we see it as more than a breather. And its growth for the full year is expected to be 15% – not exactly pedestrian. At a price of 13x earnings (excluding cash), this level of growth is nowhere near the price.
Here are some comments from recent management calls that further indicate the strength in the various businesses we own:
“(we see) based on broad advertiser spending power and strong online consumer activity” Alphabet Management, Q4 2021
“I don’t hear of businesses looking at their IT budgets or digital transformation projects as an area for cuts. i don’t have seen this level of need for automation technology to improve productivity, because in an inflationary environment, the only deflationary force is software.” Microsoft Management, Q1 22
“As a percentage of GDP, tech spending will, on a secular basis by the end of the decade, double.” Microsoft Management, Q1 22
“We continue to see that the demand for our systems is higher than our current production capacity…. In light of the need aAnd our plans to increase capacity, we hope to revisit our scenarios for 2025 and growth opportunities bthat’s it.” ASML CEO, April 2022
“We believe we will continue to grow above the rate of e-commerce and share. If we look at our track record over the last five years, we have consistently done that. And if we look at Q1 if it is in the totality of our portfolio, we believe we have done the same thing.” Paypal Management, Q1 2022
“We believe that digital and cloud projects are still a very high priority and are not being de-prioritized… we believe that the long-term the term trends in digital migration and cloud will still remain very strong throughout the cycle… so we feel like we’re in the very early innings in terms of deploying cloud workloads.” Datadog Management, Q1 22
Some companies, such as ServiceNow (NOW), even went so far as to raise their revenue target for 2024 from $10b to $11b.
So, while bear markets are never pleasant, in short-term prices often diverge from the basics. We can’t predict the price, but the the fundamentals of all the businesses we own are as strong as ever. This has created a once-in-a-decade investment opportunity that we look forward to taking advantage of.
Mahomed Ibrahim | July 2022
Original Post
Editor’s Note: The summary bullets for this article were selected by the Seeking Alpha editors.