ZagInvestor September 2020 Newsletter

ZagInvestor Newsletter September 2020

September has been challenging. A minor meltdown in the market seem to have fazed many investors (especially retail) who religiously follows the “Stocks only go up” mantra. Our portfolio remained resilient and delivered a +4.1% over the month of September, outperforming our benchmark when global stock markets are down ~2.4%.

Having said that, we expect heightened volatility going into the 2020 US Presidential Election in November, especially with the set of three debates between Trump and Biden kicking off.

As usual, we provide an update to our portfolio holdings and update our view on what could play out going forward.

In case you’ve missed, here’s a list of articles we’ve published in September.

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Table of Contents
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    Our investment philosphy

    We aim to own around 10 names and adopt a buy-and-hold bottom-up investing strategy, with a 3-5 years’ time-horizon (or earlier if fair value is achieved). Our current exposure to both US and UK stocks means our goal is to outperform the average total return of S&P 500 and FTSE 100.

    Our investment philosophy reflects our view of the global economy. We adopt a style-agnostic approach, which means we are solely focused in investing in the best companies, whatever the “style” of investing. We employ a bottom-up fundamental investing complemented with a macro overlay.

    We continue to avoid sectors with high dependence on interest rates, such as banks, especially those with a significant exposure to retail and commercial lending.

    Our view on the airline industry has not to change. As discussed in our article written in early June, we expect further furlough and capital infusion in to the industry given the balance sheet weakness. We continue to think that the current valuation for airlines is unsustainable and consolidation would be inevitable.

    In the semiconductor world, we are paying close attention post the Intel meltdown, which also led to the “melt-up” of AMD and TSM. Globally, we still see value in niche chip producers.

    We have been looking into cloud services, web-infrastructure and website-security companies, as they suffer a drawdown despite its better than expected results. Perhaps, this is unsurprising given its massive rally since the March lows. Companies such as Keysight Technologies (KEYS), Cloudflare (NET), Fastly (FSLY), Alteryx (AYX) etc look overdone from a price technical perspective. We continue to seek opportunities in this space. Our recent article on Snowflake highlights the ample opportunity the space offers.

    Portfolio updates

    ZagInvestor Portfolio performance since inception
    ZagInvestor Portfolio performance since inception.

    The portfolio delivered +4.1% in September, relative to S&P’s -3.9% and FTSE 100’s -1.6%. In alpha terms, we delivered +7.0% this month, with an above average annualized vol of ~25% and a portfolio beta of ~1.07.

    The key driver in September was Peloton, ~30% driven by results the launch of new products (see below). Direct Line and Disney both suffered from FCA’s ban of loyalty pricing and the resurgence of coronavirus in the US, respectively. TSM remained defensive for the month despite aggravated geopolitical US-China trade tension, while S4 Capital continues deliver, +7% over the month of September.

    This is our 5th consecutive month of beating our benchmark. A clean record so far and we aim to keep that. Since inception, we delivered a total return of +46.8%. This compares with our benchmark of +7.4%, equivalent to an alpha generation of ~39%.

    ZagInvestor Portfolio Stats for September 2020
    ZagInvestor Portfolio Stats for September 2020.
    Global equity markets performance in September 2020
    Global equity markets performance in September 2020.

    Direct Line

    On September 22, 2020, UK’s insurance regulatory, the Financial Conduct Authority (FCA) announced the banning of insurance companies charging existing customers more than new ones for motor and home insurance covers.

    Traditionally, partly driven by its competitive nature, renewal prices tend increase gradually, in part to subsidize new customers. Essentially, this means that for similar risk profiles, new policyholders could pay less relative to someone who has been a long-term consumer.

    This is a well-known phenomenon that happened in the UK for a long time. In fact, according to Which, there are still ~5m drivers in the UK that allows its insurance to automatically renew, and therefore accepting any price increases proposed by its existing provider, instead of shopping for better deals.

    In the new setting, effective in the second half of 2021, insurance companies would be prevented gradually increasing the renewal price over time, a practice also known as “price walking”.

    Clearly, Direct Line, being active in the home and motor insurance space, will be affected. However, we argue that the impact may be less than expected as the company has already gradually moved away (not totally) from this practice. From its most recent report, Direct Line reported that it has already introduced some caps on renewal price increases.

    There is no denying that this is an unfavorable news for the Group, but we think the fundamentals of its business remain intact.

    Disney

    Disney has had a challenging month, with its stock price dropping ~5% for the month. There is no surprise that the drop in its share price coincides with the resurgence in coronavirus cases globally (US, in particular).

    Despite our investment case, Disney is still being treated as a “reopening play” by the market, alluding that parks and cruises business will ultimately drive the re-rating of the business. We disagree. Nevertheless, with Disney+ picking up steam, ultimately, Disney will be driven by its growth and scalability potential of the platform.

    In other news, the coronavirus resulted in Disney cutting 28,000 jobs at its US theme parks. Around 67% of the 28,000 were part-time employees, nevertheless, this is significant. Last year, the revenue from its parks, experiences and consumer product segments accounted for 37% of the Group’s total revenue.

    S4 Capital

    For the first time since Sir Martin Sorrell took charge of S4 Capital, the Group reported its first profit since launch. Specifically, the company reported a pre-tax profit of £100k in the first half of 2020 vs prior year of a loss of £8.5m. Likewise, like-for-like sales in the six months to June 2020 was £141m, +7% year-on-year. This was boosted driven by new clients which includes PayPal, Shopify and the Los Angeles 2028 Olympics. Interestingly, Sir Martin also commented that S4 had in the past few months been helping brands convert cancelled events into virtual shows and had worked with the NBA on streaming live games.

    Another month, another merger. Earlier in September, the highly acquisitive S4 announced its acquisition of Dare.Win, an award-winning Paris-based digital creative agency with MediaMonks, S4’s Content division. With over 80 people, Dare.Win’s clients include Netflix, Nike, Google, Francaise des Jeux, PlayStation and Warner.

    Separately, S4 also held its inaugural Capital Markets Day. We highly recommend for readers who are new to the stock to visit its virtual event here. They also included a “breaking news” where they officially announced their partnership/mandate with BMW and MINI brands. We think this will be a precursor for many projects that may come with leading brands in the world for S4.

    Peloton

    What a month for Peloton, delivering more than +30% in the month! We’re not complaining for sure. We’ll cover two key events.

    First, its best results yet. Global membership base hit 3.1 million end of June, more than double a year ago. Consequently, this led to record revenue of $607m, +172% year-on-year. A minor setback is its supply chain. Peloton continue to have a sizeable backlogs, prompting length waits for its equipment.

    Secondly, new products. Concurrent to its results announcement, Peloton also announced the launch of new (and pricier) versions of its bike and treadmill, specifically Bike+ and Tread+.

    Bike+ and Tread+ will retail at $2,495 and $4,295, respectively. Additionally, the original Peloton bike’s price will drop to $1,895 from $2,245 (slight over 15% cut).

    In our view, this changes is actually more critical than it appears. By lowering entry cost the Peloton ecosystem, the company is gradually making this more accessible to the wider market. While still pricey, we argue that on a longer term basis, Peloton is actually more economical relative to traditional spin classes.

    While we intend to hold Peloton for long term, we postulate that the recent run up in its stock prices, makes the risk-reward less attractive. Nevertheless, go Peloton!

    Taiwan Semiconductor

    With the broader US-China trade war intensifying, the market is being increasingly cautious about TSMC’s position as the world’s biggest contract chip manufacturer. The increasing protectionism pivot by both countries will only drive costs higher for both parties, in our view.

    In fact, Mark Liu, the company’s chairman, has recently warned of higher production costs, stiffer industry competition amid geopolitical tensions. TSMC’s plan to build a $12b factory in Arizona is a signal of the company’s intention to at least alleviate the policies implemented by the Trump administration.

    While we acknowledge the macro risk in this stock, we continue to believe that the demand of chips especially with TSMC’s high tech infrastructure creates stickiness for its products.

    Macro

    Winter is coming: The resurgence of coronavirus

    With coronavirus cases slowly creeping back up combined with the colder weather, the market is beginning to show early signs of such risk being priced in. It goes without saying that this also coincides with the US Presidential Election.

    It seems to us that the market is now convinced that any commercially available coronavirus vaccine will likely to happen in 2021 and beyond. With record bankruptcies being filed and Fed essentially conceding that this is as far as they can go, the US government will have to sooner or later take a stance on its fiscal policy. Despite aggravated tension in the US political spectrum, we expect a stimulus package of ~$2 trillion to be approved before the election.

    2020 US Presidential Election scenario analysis

    During normal times, one might argue that a Biden administration may be bearish for the stock market. Fair enough. But then again, these are not normal times. The two game changers are coronavirus and global trade.

    Rather than outline and analyze their pre-electoral “policies”, we’re going to look at the three different scenarios, specifically, Trump’s victory, Biden’s victory and a stalemate scenario.

    First, a Trump victory would very much mean status quo. We think the market will initially rally single to mid-single digits. However, given the reduced toolkit to boost the market (tax cuts etc), the catalyst to a bull market seems less clear.

    Second, a Biden presidency. Contrary to the market, we actually think a Biden presidency could be seen as a stabilization factor for the bull market. Many were worried about the healthcare and its tax policy, but, we do not think these will come to fruition given the coronavirus pandemic and worsening bilateral trade relationships. Broadly, we could continue to see a steady rally post-election, in our view.

    Lastly, a stalemate, we call it a doomsday scenario, for a reason. This is when no one wins or at least one candidate refused to acknowledge the results of the election. Looking back to the 2000 election, it took just over a month for the US Supreme Court’s highly controversial decision to rule in favor of George W Bush.

    Given the climate today, it’s an understatement to assume that this will be a peaceful process. As a result, we expect a sharp draw down in the stock market in the short term should this happen.

    Chart of the month

    This month’s CotM features none other than Nikola, a company that went from a market cap of $34b to just under $7b in 4 months!

    Nikola stock price
    Nikola (NKLA) stock price since May 2020.

    Founded by Trevor Milton, Nikola Motors (NKLA) aspire to bring commercially viable zero-emission vehicles, both electric and hydrogen, to the market. Brought into the market via SPAC, Nikola quickly bloomed into a $34 billion, despite never yet manufactured/delivered a single vehicle!

    The controversial ex-Executive Chairman, who once claimed “Very few people can “out-Elon” Musk in this world, I’m one of them”, resigned from the company approximately 10 days after being alleged by a short seller of being an intricate fraud built on dozens of lies. In fact, there were already red flags in the early days in June when all of these unfolded. Interested readers can read about the allegations here.

    Obviously, we find the Nikola story interesting in many ways. First, the markets’ obsession for the electrification theme. This year alone, we saw about a dozen of EV (electric vehicle) or EV related companies entering the market.

    Secondly, the change in fundamental valuation of pre-profit companies. Almost all EV companies are making a loss (except Tesla, and that’s also only on a GAAP basis), and are not expected to make any meaningful profit until 3-5 years (some argue longer!), so how did a company like Nikola, with no inherent technology can command a valuation of $34 billion? Are we sensing a change in the way the market value stocks? Time will tell.

    Lastly, regardless whether Nikola is proven to be a lemon or not, it serves as a good case study on investment red flags. In fact, no one called the company Theranos 2.0 without any reason. Here’s a quote of the two visionary founders from Nikola and Theranos, respectively.

    “First they think you’re crazy, then they fight you, and then all of a sudden you change the world.” - Elizabeth Holmes, Founder of Theranos

    “When you’re changing the world, doing good things, and you’re an entrepreneur, these people love to try and take you down.” – Trevor Milton, Founder of Nikola

    We’re not at all surprised if Nikola turns out to be just a glorified “drop-shipping” company after all.

    Till then, let’s ride the volatility this month and see you in October.

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    2 thoughts on “ZagInvestor September 2020 Newsletter”

    1. Appreciate you posting the old newsletters for newcomers like me!

      By the way, how did you make the charts and tables look like they were hand drawn?

      1. Hi Bob, happy you found it helpful!
        We try to write a monthly newsletter, so watch this space.

        Re the charts/tables, we use the Handschrift font type.

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