2019 Performance Review

Published on 01/07/20 | Saurav Sen | 3,867 Words

The BuyGist:

We had some wins. And we took some punches. But overall, we came out of 2019 with a good showing, more confidence, and more conviction. Our process works. The proof is in the pudding.

The proof is in the pudding.

I’ll jump right into it. We outperformed the S&P 500 by a considerable margin. Here are the facts again, just to be clear:

Should we pat ourselves on the back? No, not yet. I think an investor’s track record is an on-going barometer. Only when we hang up our boots (hopefully not for another couple of decades, at least) will we have the right to say, “look, we did well, we outperformed any so-called “passive” strategy by miles…”. For now, any track record number is an imperfect and incomplete barometer of our skills.

But we will say this: The number is gratifying to us because it suggests that our hard work is worth it. The hours we spend combing through 10Ks, 10Qs, Earnings Calls, Presentations, Interviews and other lateral sources of data – to distinguish between a comfortable company and an uncomfortable one – have been worth it.  I wish we could scream that we’re so smart but that would be disingenuous, to put it mildly. To us, our strong outperformance is proof that our method works more often than not. That’s a good start.

“The most successful investors get things “about right” most of the time, and that’s much better than the rest.”Howard Marks

Why compare to a benchmark?

To put it crudely: to silence the naysayers. No matter what our performance number reads, there will always be somebody who’ll slice and dice our portfolio in a way to say, “Aha, you didn’t outperform based on this factor…”. Yes, we know that, thank you very much. But all we’re after is this: greater than 10% annualized return over the long-term. We don’t care what’s in the S&P 500 or the Dow or the Nasdaq or XYZ ETF. We just find a few comfortable companies at comfortable prices playing the right sports – ones that we think will shape the next few decades. That’s it. And we think our process – of deliberate rumination and deep research in the way that the giants have taught us – will generate those double-digit returns that we want. The process matters. The outcome will take care of itself.

But we still compare ourselves to the S&P 500. Why? Because we consider it to be the most easily executable “Passive Investing” strategy out there. And if we can beat that, the The Buylyst is worth our time. This is a criticism we hear, ad nauseum, from naysayers: “Dude, why don’t you just index?” And, in response, we usually make a self-derogatory joke, just to avoid talking finance at a cocktail party; something like, “We like to work hard for our Index Returns!” And yes, usually the joke falls flat. But the real answer to their question contains the following:

  1. We don’t like to spray and pray. We like to know exactly where we’re invested and why.
  2. If we do take the naysayers’ recommendation seriously and “index”, then it gives rise to more questions: 
    1. Which index?
    2. A mix of indices, you say? Which ones? And how do I mix it?
    3. A kick-ass asset allocation model, you say? What’s so kick-ass about it? Who built it? Do they have their own money in it?
    4. Can this kick-ass mix beat the simplest strategy of all – putting all my money in the S&P 500?
  3. We don’t want index-like returns. The S&P 500, for example, is widely expected to return 8% annualized over the “long-term” (whatever that is). Well, that’s not good enough for us. We want double digits: 10%, at least. Why? We want financial freedom in 20 years or sooner. Simple calculation.
  4. We like finding pockets of progress in our world and taking a stake in them. We think that’s how we’ll achieve our audacious return target. Simple.

To be clear, we’re not against indexing. We think it’s the way to go for most people. And there are several outstanding Financial Advisors who can help you with a “passive” strategy. But it’s not for us. And if you’re like us – if you like finding pockets of progress in the world and investing in them – then we are here to help. We can lead by example. We don’t recommend or advise or pontificate or theorize. To borrow a popular slogan, we “just DO it”. We observe. We think. We read. We analyze. We do our research. We invest our own money. And we publish all our work – how and why we did what we did. That’s our product. That’s how we help – by example.

If we put ourselves in your shoes, we think our outperformance should suggest that we know what we’re doing. Maybe we’ve learned from our experience on Wall Street. Maybe we’ve learned well from the giants of investing. Maybe both. But, above all, maybe we have the emotional fortitude to practice long-term investing in a short-term world. Emotional fortitude is an on-going characteristic that we must hone. Our hope is that we keep getting better. If nothing else, our performance so far gives us confidence to keep improving.

It’s been all about the Trade War.

2019 looks great on year-end tables and charts but it’s been topsy-turvy for those of us glued to the markets. The biggest driver has been the Trade War. Will there be a deal or no deal? Will Trump yield? Will Xi yield? Who tweeted what? It was a made-for-TV drama that played out all year. And now, as I write this, Phase 1 of the deal is stuck in translation. Really, translation? You can’t make this stuff up. But Mr. Market lapped up every little nuance in this ridiculous developing story in 2019.

Then there were other excuses. I’ve read many articles and blogs on how The Federal Reserve has been flooding the market with too much liquidity. Most of these articles insinuate that the Fed is rigging the game. We disagree. The Fed looks at Inflation more than any other barometer, and that’s been indisputably low. And Chairman Powell has repeatedly stated that the Trade War has put a wrench in the US economic machine, which calls for a more accommodative monetary policy. The idea that the Fed is driving the markets is misplaced. Most people complaining about the Fed, I suspect, were (are) short the market. They’re just grumbling over their losses with ludicrous conspiracy theories. Did the Fed’s policies drive a lot of the 2009-2018 returns? Yes, considerably. But that was off the epic crash of 2008. Swings in 2019 have been more about the Trade War.

May was gut-wrenching.

We had a horrible May 2019. When the Trump Administration put a ban on Huawei, our portfolio was in free-fall. Now, The Buylyst Portfolio is heavily weighted towards themes that scream Progress: AI, 5G, Renewable Energy, etc. Any opposition to technological progress will create havoc in our portfolio. We knew this. But the extent of our beat-down in May was unprecedented. You can run all the fancy Risk Management simulations you want, but when sh** hits the fan, there is no way to model it.

Semiconductors took a beating. Software stocks took a beating. Anything exposed to China took a beating. Above all, there was one high-flying Buylyst holding that took a massive hit: Lumentum.

We had built up a sizeable position in Lumentum. Huawei, it turned out, was (and is) a major customer of Lumentum. We knew this, but we ignored it when we wrote the thesis. Our interest was myopic. We were excited about Lumentum’s face-recognition technology finally permeating the massive Android phone base. And we were excited about Lumentum’s Optical Transceiver products riding the inevitable 5G wave. Both were long-term plays. We expected it would take at least a year since we posted our thesis for these drivers to manifest as sizeable stock returns. Things were going well for a while. Lumentum had gained more than 20% since we had bought it. And then news of the Huawei ban broke out. Bang! Lumentum stock drops 10%. And 10% more after that. This went on for nearly a week. We had to go back to the drawing board and re-evaluate our thesis. This was tough to do while we were seeing -5% to -10% drops in Lumentum’s stock price. But we decided to stick to our guns. And in a few months, our resilience paid off handsomely.

May was a passage through hell. But it toughened us up.

Some early wins helped.

One reason we could get through May 2019 with some semblance of sanity was the fact that we had booked some early wins: namely Xilinx and Microsoft.

In both cases, our thesis played out perfectly. It played out a lot faster than we had anticipated. We didn’t complain. Our Xilinx thesis was hinged on its dominance in FPGA chips, which we surmised would be in demand as various companies test out their AI progress. We had made this call in the summer of 2018. And we booked more than 50% returns by February 2019. As for Microsoft, our thesis was simple: we surmised that CEO Nadella’s strategy of “Productivity Software for Enterprises delivered via Cloud” had almost no competition. Reality mimicked our thesis, and much sooner than we anticipated.

Through the summer, these gains partially offset the pain caused by Lumentum and Semiconductors – both numerically and emotionally. 

More wins in the fourth quarter.

We had ups and downs. The rest of the summer was tolerable. September was another rough patch. There were earnings expectation misses, more Trade War salvos…the usual. We kept our heads down and kept grinding to makes sense of the world and come up with investment ideas. By the time November rolled around, we suddenly started seeing more of our holdings reach their target prices. Our performance numbers started looking good. Some stocks rocketed through their target price in a matter of weeks. Some were more measured. By the end of the year, here’s the list of holdings whose prices were at or beyond or near their Buylyst Valuations (our rough target price):

  1. Xilinx
  2. Microsoft
  3. Apple
  4. Sensata
  5. Vestas
  6. Nvidia
  7. Lumentum
  8. NXPI
  9. TSMC
  10. Palo Alto
  11. Ciena

For a portfolio that hovered between 15-25 “Buy” rated names, this was not bad. I can hear many naysayers grumbling about “Beta” – the idea that our picks did well because the market did well. Sure. We agree. But that wasn’t the whole story. We like Beta. But that’s why we compare to the S&P 500 as well. Our outperformance was considerably large, which suggests it wasn’t all luck and Beta.

Of those names, luck played a bigger role in some, and almost no role in others. How do we measure it? By looking back at our thesis, we can tell if it played out or it didn’t. If a stock rallied because of no discernable connection to our thesis, then it was luck. If we could see a clear replay of our script, luck didn’t have much to do with it. We’ll give an example of both.

Lumentum was mostly luck. After the gruesome indigestion it gave us in May, things have looked overtly optimistic. Our Lumentum thesis was hinged on it’s largely untapped Android base, where it’s iPhone-style face recognition technology was yet to be deployed. And we thought its core business of backhaul fiber-optic components would ride the 5G wave. Well, neither of our two thesis-pillars have substantially materialized. Yet, the stock keeps soaring. We’re still hanging on to a smaller portion of it because we’re still waiting for our thesis to be played out.

TSMC – our largest holding – was a game of slow-burn and patience. For more than a year, we just couldn’t understand why investors weren’t seeing this company for what it is – a true global dominator with an extremely high barrier to entry and almost no competition. We still believe this company is one of the best ways to play AI & Big Data, 5G & IoT, and Autonomous Vehicles. Over the last 3 months, since the last earnings call, it appears that investors are waking up to our prognosis that every non-Intel semiconductor company that will be at the heart of the AI revolution will be manufactured at TSMC. And that’s playing out. We may have missed out on AMD, but hey, they get their chips made at TSMC. This remains our top holding.

Apple is an example of both luck and hard work. Our thesis was hinged on its non-iPhone revenue growing – Wearables and Entertainment – and on our assessment that Apple would finally see a tipping point in India. The first part of our thesis played out. The India part didn’t. Now we know that Apple has begun manufacturing cheaper iPhones in India. Revenues from that initiative have yet to trickle in. But due to the market’s sudden optimism on Apple’s Wearables and Entertainment businesses, the stock has now crossed $300 as we write this. Not so long ago, Apple was nearly at $150. We felt a bit foolish then. But upon painful reflection, we stuck to our guns. And it paid off handsomely. A bit of luck and a bit of fortitude – we’ll take returns any which way, thank you.

But some picks are still languishing.

We’ve taken some punches too over the past 12 months. Some of our early picks are still languishing. We watch these investments with a confusing mix of frustration and patience.

Interdigital was one of our early 5G picks. The company sells cutting-edge research to cellphone manufacturers and telecom equipment companies. They sold research through all the wireless cycles – 2G, 3G, 4G. In return, they get royalties – either as flat-fees paid regularly or on a per-unit-sold basis. Over the last 18 months they’ve been receiving more flat-fee payments for their work on 4G and less per-unit fees. The result has been a more predictable but less bountiful revenue-stream. We knew this would happen. But our thesis was hinged on payments they’d receive for their 5G research – we knew that Interdigital was heavily involved in 5G standards-setting. But the 5G royalties haven’t even begun. Our mistake was the assumption that the market would factor in substantial 5G revenues from 2020 and beyond into the stock price. Instead the market has just pummeled the stock for declining 4G revenues. Interdigital is in a limbo phase now, and we’re holding on to it until 5G revenues start trickling in.

And then there are 2 turnaround stories that don’t seem to turnaround: IBM and Ford. IBM seems to be stuck at its $10bn-ish Free Cash Flow range, with no progress on carving its own AI niche. Our thesis was hinged on the fact that the combination of Watson + Cloud + Consulting would be a significant competitive advantage. We had wagered that Data is just as important as Code in the new world of AI, which would allow IBM to compete even if Google and Amazon lured away the best coding brains. All our thesis points have yet to materialize. But IBM’s numbers have been resilient. The market behaves like it’s dead, but it generates a significant amount of Free Cash Flow. We’re going to give it another year and, at worst, sell it for no loss if we see no progress.

Ford is saying and doing the right things. But this company is in transition – from a seller of gas-guzzlers to a seller of sleek electric workhorses. This is going to take a while to generate returns. But we like the decisiveness of Ford’s strategy. They have a few money-makers (like F-150, Mustang, Transit Van), and they’re going to spruce them up with electric motors. We’ll wait.

Last but not least, Micron. This has been the bane of our existence. But lately, the market has been waking up to the fact that Micron is one of 3 major Memory companies that make both DRAM and NAND. In a world that’s going to demand significantly more memory in the next 2 years, Micron looks like a good conduit to harness the AI & Big Data and 5G & IoT themes. Now, it seems, the market agrees. As we write this, Micron is up more than 8% today! We were right about our thesis, but we overestimated one thing: that the inevitable increase in volume of memory demanded would offset any price decline (due to oversupply). It turned out that price declines still overshadowed increases in volume. But the declines weren’t nearly as severe as what Micron experienced in 2016. That’s what the market was pricing in when Micron stock reached $28 at the beginning of 2019. We like our Micron thesis and we think it will play out.

Mistakes of Omission were also made.

We’re normally more worried about mistakes of Commission rather than mistakes of Omission. With omission, what’s the worst that can happen? We don’t make money; but we don’t lose money either. However, in 2019, there were 3 companies in which we – regrettably – did not invest. We’re talking about Disney, ASML and HDFC Bank.

In January 2019, we did a deep dive on Disney and came out thinking, “meh, it’s fairly valued…”. When we looked back at the analysis, we realized that it was fairly valued IF we assume NO GROWTH. For a company like Disney that has a distinct competitive advantage and a wide Moat, “no growth” is a silly assumption. We didn’t pull the trigger then. And it still hurts.

ASML is a rare company that has no competition. That’s not an exaggeration. They have none. Nobody else makes EUV machines – the machines that semiconductor manufacturers need to extend the limits of Moore’s Law. Every time we look under the hood, we come away thinking it’s fairly valued. Well, maybe we’ve been too conservative with our growth assumptions.

HDFC Bank in India has been a big miss. Our thesis played out almost perfectly: their tilt toward Retail Banking being both a growth driver and a risk mitigator. We had concluded that HDFC Bank was fairly valued at the time. But they’ve emerged as the unblemished leader in a severely damaged Indian Banking industry.

One recently high-flying stock we don’t regret omitting is Tesla. Yes, the market loves them now. But we did a deep-dive on them in the summer and we stick by that. We thought it was fairly valued at the time. And we think it’s ridiculously overvalued now. But yes, we see the reason for the excitement. It has no credible competition now. None.

We’re still positioned for PROGRESS.

The Buylyst is still positioned to harness tailwinds from our 9 progress themes. We think of these themes as near-inevitabilities and we try to find the best investment ideas within these broadlines. If anyone asks us, “what is your portfolio exposed to?”, we reply by listing our 9 themes. That’s our exposure. That’s our bet.

If we zoom out, we can say that our bet is on Progress. Our bet is on a better world – more connected, more intelligent, more sustainable, and more livable. If we zoom out even further, we can say that we’re betting on rationality. That’s a strange thing to say but if 2019 has taught us anything, it’s that if political moves get in the way of progress, our portfolio will suffer. Wars will be fought, policy mistakes will be made, and humans will be humans – egoistic and unpredictable. But through it all, our bet is that rationality will prevail, more or less. If we thought otherwise, we wouldn’t invest at all. We’d be out there digging our own nuclear bunker.

Think of The Buylyst Portfolio as a bet on Progress, despite the inevitable hiccups that will come in the way. Nothing in life moves in a straight line, least of all investment returns. Stick with us. We’ll get through it with deep analysis and a calm mind. We’ll stick to our process. The returns will take care of themselves. So far so good.

Here’s to a more bountiful 2020! Many Happy Returns.

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