Lessons Learned in 2022

"The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of rational buyers.’’ - Warren Buffett

Dear Readers,

First and foremost, we hope all of you had a healthy and happy holiday season. As 2023 kicks off, we wanted to take this opportunity to touch on what we learned last year so that we can apply that to our investment selection process moving forward. In order to deliver market-beating returns, it's crucial that we constantly strive to improve. So without further ado, here are our key takeaways from 2022:

• Be optimistic during downturns - To Buffett's point above, one should not be irrationally optimistic regardless of circumstances, but consider seeking out opportunities during difficult times...something Buffett is well known for (he bought 16 different stocks last year). In our Q3 newsletter, we highlighted Akio Morita and Masaru Ibuka (who were the co-founders of the Sony Corporation in Japan during 1946), as an amazing example of optimism. The lesson that we took away from this is that even if things are at their bleakest, it's rational to be an optimist. Optimists are the ones who drive the world forward. And as an investor, it's the only way that you're actually going to make outsized returns through bear markets. It is genuinely the rational thing to do. So we will continue to believe that a drop in stock prices is not a risk, but an opportunity. When else would we be able to buy such an abundance of cheap stocks? These types of opportunities don't occur very often.
• Stay patient during market volatility - In the 1980s, Warren Buffett was asked how he differs from other investors and he provided a one word reply: “patience”. Without this characteristic there is no force preventing the drift toward short-term thinking. And we believe all the benefits from investing (and in life) arise from long-term thinking, so having the right temperament is (and will be) instrumental to our success. 
• Be mindful of over-concentration - As the year progressed and we took a hard look at our portfolio, we realized that we were overexposed to technology companies. And while we do believe in the long-term viability of the tech companies we invested in, we probably should have been less exposed to the sector (at one point we had over 80% in tech names). It's fair to say that we probably overlooked some hard assets that similarly make great investments and would've helped balance the portfolio (e.g. railroads, coffee chains, big-box retailers, etc.). We've already started to make this adjustment and look to have a more unbiased portfolio moving forward. 
• Stick to a checklist - There's no silver bullet to investing, but a checklist helps weed out certain companies that are innovative or have an exciting narrative. In no particular order, below are the characteristics we look at when analyzing a company. Please keep in mind that while some of these are timeliness, our list will continue to change along with the investing world. 

1. Insider ownership
2. Quality management
3. Long-term growth prospects
4. Free cash flow (less stock-based compensation)
5. High ROC (return on capital)
6. Low relative debt level
7. High relative cash reserves
8. Stable or emerging economic moat
9. High margin of safety (or low valuation) 

• Invert, always invert - A famous saying from investing great Charlie Munger who taught us that we should always argue the opposite of our opinions or investment ideas in order to truly understand the risks associated with each. This is a critical step in our process and is something we will always ask as the last step before buying anything. 
• Nobody can predict the market consistently - As famount businessman Peter Drucker says, "Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window." We now know not to pay any attention to macroeconomic forecasters. Looking at last year as an example, some of the brightest minds on Wall Street predicted the following prices for the S&P 500 at the start of 2022:
• Goldman Sachs - 5,100
• Wells Fargo - 5,200
• JP Morgan 5,050
• Ultimately, the market closed at 3,839. So nobody knows how the markets will perform over the next year or if we’ve already hit a bottom. We do know that every time the market retracts 20% or more, there tends to be a strong recovery. Since 1950, there have been 13 of these market crashes (including this year). Here is a breakdown of the returns after every -20% drop. Please note that these returns were not calculated from the bottom, but only when the S&P 500 lost 20% from its peak (as it may have continued to drop afterwards). The following graph was calculated by us and mentioned in our previous newsletter:

Moving on to our YTD returns, as of Friday's close, our average client return this year is -33.07% compared to -33.10% of the NASDAQ, and -19.44% of the S&P 500. Yes, we underperformed the S&P 500 for the year, but it's important to note that most of our positions were technology companies (as noted above), which makes the NASDAQ a better comparison. Again, our approach of owning a smaller number of high-quality businesses will result in higher volatility and periods of underperformance, but we are confident that we will outperform the market over a long-time horizon. 

Shifting focus to our portfolio, here's a breakdown of some of our biggest gainers/losers over the last year...

Biggest Gainers:

Nike Inc. (Ticker: NKE) - Many believe Nike stock to be expensive, but it should be looked at with the multiples of the luxury clothing industry. Nike is one of the most valuable brands in the world, and it is extremely popular across different geographies and ages, generating and benefiting from the casualization of fashion. Inventory and China-related problems will be solved and have created a buying opportunity as the stock traded down. We plan to hold this position for a while. 

Axon Enterprise Inc. (Ticker: AXON) - Axon Enterprise is a hidden gem for most retail investors as they are unaware of this stock and what the company truly can offer its customers. It is a steady growing company, with a moat in public safety devices and software, and has provided market-beating returns for its shareholders. This stock can help diversify any shareholder’s portfolio as it covers a unique space in public safety where there are not a lot of companies servicing these markets. In addition to the company’s unique original product offering of the taser gun, it has expanded since then by creating an entire ecosystem for law enforcement.

Biggest losers:

If you invest for long enough, you will always have both winners and losers in your portfolio, which is why having a margin of safety is so important. We are no exception to this rule. And while our portfolio has lost value this year, we are very excited for our potential returns over the next 5-10 years. 

Alphabet Inc Class C (Ticker: GOOG) - It's pretty crazy that a company with a $1.16 trillion market cap is continuing to see double digit revenue growth, but that's exactly what you have in google. Its dominant search product is attributable to the fact that management continues to innovate and improve the product for users and advertisers by using artificial intelligence. The company has evolved into much more than search, as billions of people depend on Google Maps, YouTube, Gmail, Android, and Chrome. Ultimately, the company has more than enough resources to weather turbulent times, and at the same time, it has more than enough capabilities to continue to launch new products and services, which are able to create new monetization opportunities (e.g. Waymo) for the business and help it to further expand. We also acknowledge ChatGPT's threat to Google Search, but believe the tech giant's robust balance sheet, unwavering commitment to innovation, and sprawling market share will continue to sustain its longer-term growth trajectory.

Crowdstrike Holdings Inc. (Ticker: CRWD) - Cyber breaches are the most significant threats businesses, governments, and infrastructure providers face daily. CrowdStrike's cloud-based platform is dedicated to defending against them. I've long been a fan of the company, but the market hasn't seen it my way lately, with the stock down 50% over the past year. It goes without saying that the company has a fantastic market opportunity, but the rest is murky. It is a 1-2 years away from returning cash to shareholders through buybacks or dividends, has no GAAP profits, and its free cash flow (which is getting impressive) is propped up by stock-based compensation. What CrowdStrike does have is ridiculous growth in customers and revenue (shown below), a 76% subscription gross margin, and fantastic customer retention rates. CrowdStrike's valuation has come down significantly to a more palatable 11 times sales. CrowdStrike is a bit risky; however, it has excellent long-term potential and could rebound swiftly and steeply once investors regain their appetite for growth stocks.

Tesla Inc. (Ticker: TSLA) - First and foremost, it is important to consider the challenges that Tesla faced in 2022, including rising interest rates, a global economic slowdown, and economic uncertainty. These factors likely contributed to the slowdown in demand and the increase in inventories in December 2022, as well as the decision to offer discounts in an effort to boost sales. Despite these challenges, however, Tesla still managed to achieve impressive year-over-year growth in both deliveries (40.34%) and production (47%) in 2022, totaling 1.314 million and 1.37 million, respectively. This is especially impressive considering the difficulties faced by the company in the year, as well as the fact that it fell short of its long-term delivery target of 50%. It is important to keep in mind that the long-term topline growth rate of any company will not be a constant number, and it is structurally impossible for it to be so. The topline growth rate in any industry fluctuates based on systemic and un-systemic risks, as well as the cyclical nature of the industry. Furthermore, in the case of Tesla, the company has set a long-term growth target of 50%, which it will likely achieve on average over time. Investors should not become overly focused on this number and assume that any deviation from it signals the end of the world for the company. 

StoneCo LTD (Ticker: STNE) - This company provides Brazilian micro, small and medium-sized merchants with payments and software solutions. Essentially, they are the Square of Brazil with a huge runway for growth and fantastic fundamentals. The company is growing incredibly quickly with a clear strategy, its financial position is strong, and its offering is well differentiated. Furthermore, the credit business, which historically is cash-flow generative and profitable, will come back online. Management has taken investor comments on board and are looking to prioritize margins alongside growth and have reorganized themselves to ensure each service offering is adequately nurtured. This should lead to a much stronger 2023, driven predominately by cross-selling. Overall, the robust revenue growth, the expansion of its product offering, and the fact that StoneCo has been oversold and currently trades well below its fair value make the company very attractive to the long-term oriented investor.

Shopify Inc. (Ticker: SHOP) - Despite a massive draw-down of approximately 75% in 2022, we like Shopify’s expansion into new businesses that are providing the merchant base with new products and services such as Shopify Pay Installments, fulfillment services, and the temporary provision of growth capital. Although the market currently does not hold Shopify in high regard, we believe Shopify’s broad ecosystem and scale give the company a unique advantage in the e-Commerce industry. While shares of Shopify are not cheap based on revenues, the growth opportunity in the e-Commerce market justifies its valuation.

New Positions

KMX, LAZY, CP, O, BROS, ABNB 

Companies we are monitoring:

DB, CVS, XOM, ZS 

I hope you found this publication useful, and that you’ll take some time in the coming weeks to review your current investments. If you have any other questions, then please review the attached document and or feel free to reach out directly. We’d love to hear from you and answer any of your questions in our next newsletter.

For more information on Sirmium Capital, visit our website at www.sirmiumcapital.com