Tarpon U.S. Equities – 2021 Annual Letter
Last year I wrote that results were unworthy of extended comments because they represented a short period for our strategy. This still holds true, as we have less than two years with this fund. Last year, however, it was easy for me to say, and for you to accept that, given we had beaten the index by a good margin. We are now in an opposite situation, and I owe you some words.
Let’s begin with our goal, how we plan to achieve it, and then look for where we failed in these last two years, as well as to what has worked fine and how we have adjusted where needed.
Our goal is to build a portfolio of great and future-oriented companies that should do better than the market over very long periods of time and enable us to participate in the upside from the constant reshuffling of the cards in the American/global economy, while sleeping well at night.
Translating that a little bit:
By “future-oriented” we mean companies aligned not only with macro-social trends, such as digital platforms and e-commerce, but also with modern management/business models, like network economics and stakeholder friendly management.
By “value creation from the reshuffling of the cards” we mean investing in the next big thing before it gets there. This is not a certainty game, rather this is a likelihood game, in which the best players will be defined by their sharper judgment of probabilities, rather than Excel-valuation work. (Note: the next big thing in this context isn’t necessarily the next trillion-dollar company; it could very well be a big winner in a niche market.)
By “sleeping well at night”, we mean a portfolio with which we can pass through the hardest of times without succumbing to pressures and selling out.
The way we see it, this portfolio has two main components:
The “resilient”, or better “tighter range of outcomes” part is where we have names like Amazon, Intuit, Autodesk, and telecommunications firms. Here both valuations and conviction in our assessments matter more, and some sizable positions are acceptable, but we should also have some diversification to be able to compound well over different macro scenarios over five-year periods or longer. Our intent with these companies is to compound capital with a high likelihood of success, through high moats and predictable businesses that already generate tons of cash and will do better and better for shareholders over time. We also need discipline on entry moments, using some “old school” investing wisdom and/or insights from deep analysis.
The “venture” or “wider range of outcomes” side is where we look for the next big thing. Here the approach must, with discipline, be like what top venture capital funds do: put an extremely high bar for quality and people, subscribe small (1-4%) individual positions, and let them ride widely up and down, but also avoid entering during obviously hype moments when odds get much worse. Eventually, over years, some of these companies will do great and crossover to the resilient side, while others will basically erase themselves out of the portfolio. Hopefully, on average, the IRR is great. There is a difference between this group and private venture capital worth noting though: it is unlikely that most “losers” in our portfolio will be “zeros”; these firms already generate hundreds of millions, or billions, of dollars in annual revenue, are usually cash flow positive, and have strategic value. The losers are likely to, as a group, give us a mediocre IRR over a five to ten-year period. Hence, we need less from big winners than VCs do - this is also very much expected given the higher prices we must pay to invest in public markets.
Today we have less than ¼ of the fund on the “venture” side, with positions appropriately sized (after adjustments that we did, more on that later). That exposure could go higher as the market gives us chances to pick individual companies at great odds.
Now, to our obvious mistakes from the past two years (obvious meaning we can already clearly set them apart from the huge noise in the market these days):
First, as we didn’t have the clarity of mind we now have for the sort of company we need for the “venture” side, we erred, especially early on in our history, in trying to do some “value fishing” there; for example, buying a good deal of WIX rather than the much more expensive and extremely better Shopify (from hindsight it is easy to set Shopify apart from WIX, but we could have at least split the investment). We have taken decisive steps to correct that in our routine and process – and the current “venture” portfolio already reflects this (hopefully) better strategy and mindset.
Second, in the resilient side, the world is so dynamic and full of money these days that some more diversification should help too, as should deeper thoughts on which companies own bottlenecks for the economy, stuff that tons of money cannot copy or replace, like Google’s search “monopoly” or some semiconductor technologies, whose value become crystal clear during red hot economic moments. Note: most of what we own in this part of the portfolio (telecommunications, “boring” software companies, and Amazon) should behave more or less the same regardless of whether we have dark clouds or blue sky out there, and we like it this way. Nonetheless, that doesn’t mean we should be so committed to these companies as to let pass the chance to buy some more macro exposed ones, like Google, when valuations reflect low expectations for them, as they obviously did eighteen months ago.
Just as we were launching this fund (March 27, 2020), the U.S. economy and stock market were embarking on their fastest and most furious up-cycle in decades, perhaps ever. From hindsight it is easy to draw the line from there to now, but we shall never forget there were other possible scenarios; for instance, the Fed and the federal government might not have kept pumping money into the economy as if there were no tomorrow. Part of our underperformance since inception was due to our goal mentioned above leading to a strategy that won’t be a good fit for all macroeconomic cycles - it seems to have been the worse this time. Over the long term, however, there is nothing new to suggest our strategy cannot work well. This is not to minimize our errors just described; they do account for a good part of the underperformance.
You can be sure we have been working extremely hard and humbly on our blind spots. As for the cycles, our goal is not to nail shifts in the economy or the market, such as rotations in or out of growth or value, or whatever. We are neither passionate about, nor good at that. Therefore, we need patience to live through not only hard moments (in absolute terms and relative to the broader market) without losing our minds, but also great times without letting it go up our heads.
Some words on four new investments, all on the “venture” side
There was a deluge of IPOs over the last 18 months. I have probably read a hundred or more prospectuses, discarding more than 90% of them as unworthy of our attention. But there is no denying that a few superb businesses that had been kept private for much longer than was usual in prior decades have finally come to the market. We are glad for that, even if we are still too small to get allocations on these IPOs (not that we didn’t try a handful of times).
Two of our newest investments were recent IPOs: Airbnb, which needs no introduction, and Unity, which is to game developers what Autodesk (we also own), the company behind AutoCAD and Revit, is for architects and engineers, in other words: an essential and extremely hard to replace tool, with scalable network effects. Unity has the further advantage of being in a fast-growing end-market, to which it can cross-sell additional services, like advertising and cloud tools. We tried to buy its IPO in 2020, got a tiny allocation, then watched as the stock more than doubled. We learned more about the business and waited for the opportunity, which came during May 2021, when growth stocks got hit indiscriminately.
Airbnb was a similar case, except that we got zero shares on the IPO and the waiting time for an entry point was shorter. Importantly, just as with Unity, and perhaps more pronouncedly, we like the company more and more as management communicates with investors. We are well impressed by how serious, decisive, and focused Brian Chesky, the founder-CEO, and the company have become after the near-death experience caused by Covid in 2020. Airbnb had already become the name in alternative accommodations and is now seizing the moment to vastly expand what that means, with people learning they can work remotely and going for longer trips, to unusual places. And that’s without mentioning that 2020 showed management they can be extremely less dependent on Google for new customers than they previously thought – few, perhaps less than a handful of companies, from all sectors, have a similar position, and this is valuable, hugely valuable.
Unity and Airbnb share a common trait that is of enormous value, especially during times of seemingly infinite supply of “good growth companies”: they are unique. There is no company like Airbnb out there, this is obvious for everyone at this point. Unity is almost the same, most mobile game studios simply have no choice – there is one competitor, Unreal, but Unity has a larger and expanding market share; it is the only tool many developers are familiar with. Being patient enough we will find more of those, hopefully with rare misses.
During the year we also built positions in Fiverr and Upwork, by far the two largest global freelancer marketplaces. Fiverr focuses on smaller jobs and quicker interactions, while Upwork is better for more demanding jobs. Both are growing north of 25%, and it seems that high growth can go on for many years, with expanding margins. We have all learned to appreciate the value of marketplaces once they become unquestionable destinations. If Fiverr and/or Upwork get to that point, we would, years from now, be calling them unique, like we just did with Airbnb, and our investments would have been great. But the road ahead is challenging as digitizing the whole freelancer hiring experience while operating at good economics is not easy. We will follow how these companies develop, always with an open mind, but it is important to note we like both management teams as they are showing constant innovations alongside financial discipline.
Coming back to our main investments
The enterprise IT sector had a terrific year in 2021 as economic recovery and the renewed need for “digital transformation” met full pockets at large companies to create growth levels that surprised many. Stock prices followed, but we did not benefit, even having ~13% of our fund exposed to the sector. Amazon’s cloud division, AWS, most of our exposure, accelerated from ~30% growth in 2020 to ~35% in 2021, which is hugely impressive, given its revenue approaching 60B USD, with almost 30% operating margins. If it were a public company, AWS’s stock would probably have boomed. The good part of this is that we could add to our Amazon position at relatively attractive prices and feel like this company has plenty of gas in the tank. Note: enterprise IT is a huge sector, with some great companies like Microsoft, Salesforce, and Workday. We have been dedicating a lot of time to it, learning to admire some businesses, but also to respect how competitive and ever evolving it is. In some parts of this market firms can go from darlings to “old-stuff” quickly. We have thus far played it safely, through AWS’s and Atlassian’s obviously high moats, which does not mean we will not try our hands differently when the right target shows up, especially now that we have more road time.
If AWS had a great year, Amazon’s retail operations went through a tough one, facing hard comparable quarters for revenue growth (versus 2020’s pandemic boom) and escalating costs on labor and logistics, all of which is transitory in our minds. Amazon is not losing share, but, frankly, it needs to keep innovating quickly to hold on to its position, not only delivering value to all stakeholders, but also putting it out intelligently to better nurture its image.
Below the surface, Amazon’s competitive position has grown tremendously over the last two years. There are now more than 200 million Prime members, giving Amazon an enormous advantage on customer acquisitions costs and repeat order behavior, the points that make or break an online retailer (retail is retail, always a tough business, whether online or brick-and-mortar). Moreover, Amazon probably delivers somewhere between 30% to 50% of all e-commerce packages in the U.S. It is now possible to place an order on Wal-Mart or Etsy and receive it on an Amazon box. Amazon’s retail operation alone carries about 100 billion dollars of property, plant, and equipment on its balance sheet, which is similar to what UPS, Fedex and Target have, combined. UPS and Fedex are raising prices, having the time (and profits) of their lives; Amazon, meanwhile is taking share, likely losing money on logistics… we have seen this film before – someday they will flip the switch. There is also advertising, a booming and high margin revenue line for Amazon, with huge growth prospects both in search and in connected TVs. I could go on and on, but this is enough, otherwise I wouldn’t have pages to write about our other investments.
Oh, and we get this “modestly advantaged” e-commerce company for a not modest discount to most other public traded online retailers, in terms of enterprise value to GMV. As we wrote in a paper early in 2021, we see Amazon as an infrastructure company, powering, through software, a huge part of the modern life. This should be quite a resilient investment.
WIX and GoDaddy
2020 was a record year for WIX. 2021 was a meager one; there is no denying that. WIX was the biggest individual contributor to our underperformance this year. As for GoDaddy, we sold most of our position earlier in the year, using the proceeds to enter more unique names mentioned above – we never saw GoDaddy as more than it was: a reliable cash machine with some growth still in the tank, but unlikely to yield us positive surprises given its corporate culture – its results have been about what we expected. We cannot say the same for WIX though, which has done great things for customers and shareholders since its IPO in 2016 and keeps aiming high. Aiming, however, is not enough. (Note: we have never bought or increased our exposure to WIX when the stock was priced too optimistically, giving us a good margin of safety and a good return on our investment, though we could have done much better if we had been more open-minded two years ago about how to invest in growth companies.)
Especially after May 2021, as travel and entertainment options reopened and small-business owners took time out, WIX and its peers saw a slowdown at the top of the funnel, leading to fewer net new customers than many expected. That number for 2021 is likely to come above 2019’s levels, but that was a bad year for that metric too, coming after a first-ever price increase. On the other hand, the customer mix is growing richer by the day, with more clients using online payments and other features, creating growth opportunities down the road as these customers grow their businesses. A customer running a business, be it an e-commerce or a yoga-studio, on WIX has multiples time the lifetime value of one with a basic subscription for a simple website. People from inside the company seem sincerely excited about these more valuable customers growing faster and faster; when WIX showed some data on that earlier in 2021, the market got excited too, perhaps too much so.
Further collaborating to a tough year were amazingly fast escalating prices for digital marketing, the result of a heated economy and tons of venture capital ending up on Google’s and Facebook’s pockets. The fact that WIX got hit by this is itself bad, signaling susceptibility to competition. The bear case for WIX is more of the same recent trends, with it becoming a 10-20% grower, unable to really expand margins and being relegated to tech’s graveyard, where names like Dropbox reside. This would be the outcome of relentless competition and subpar execution/vision, as we believe the addressable market is huge and there for the taking. If this is the case, we won’t be shareholders hoping for an activist or a white knight. Hope is not a strategy.
The bull case is WIX and one or two more peers, most likely Squarespace, a close second player with even better economics, getting so much ahead in terms of technology and recognition amid entrepreneurs and freelancers that not only competition eventually slows (VCs won’t throw money on Google and Facebook forever, especially after seeing public markets unwilling to buy WIX-like companies), but also more and more sites are created on these tools rather than on open-source software, where most of the market still is. WIX and Squarespace have good odds in my opinion, as they are much better, more secure, and more user-friendly than open-source tools.
We will continue to monitor the space with an open mind, but have already not only significantly reduced our position, rightsizing it to its risk/return profile, but also lowered our execution/valuation risk by also owning Squarespace, which came to the market through an overlooked direct listing in 2021 and has yet to find a committed shareholder base. The rightsizing point is extremely important: in this “venture” part of the portfolio, where we look for convexity, you should expect us to own more names, at smaller sizes, recognizing that some will sour, while others will, hopefully, reach escape velocity; if we pick our bets well, we should average nice returns over the years, participating in the active and relevant value creation derived from the constant reshuffling of the cards in the U.S. economy.
Liberty Broadband, Liberty Global and T-Mobile
Together, these three companies are roughly as relevant to our portfolio as Amazon (which we see as two companies, by the way). In my opinion we own a piece of, in order, the best fixed broadband company in the U.S., the best converged (fixed + mobile) one in the U.K., the Netherlands, Belgium and Switzerland, and the best mobile one in the U.S. All three will generate tons of cash in the near term; particularities apply, however. Liberty Broadband has been sailing smoothly through calm waters for years (shouldn’t last forever). T-Mobile has tough opponents, but the best hand going into 5G. Liberty Global has been battling challenging weather for years (shouldn’t last forever, too). All three did what we expected from them this year, but it being a boom year for the economy and them being amid the most linear businesses you can imagine, they significantly lagged the market (shouldn’t last forever, one more time).
Walk the talk
We are built to be long-term: 90% of my net worth is in this fund, Zeca is a substantial investor, we have an unwavering high watermark, and we are committed to lower management fees (hopefully significantly) as AUM grows.
Yet something still felt lacking. We are creating this fund from scratch and have no anchors – our goal is to optimize for long-term net returns to clients. This enabled me to question the industry’s one-year-period performance fee standard - our investment horizon is much longer than that. We are changing to a five-year measurement period for performance fees. No client asked us to do this, but it is a substantial benefit to clients, and it allows us to feel more aligned with our compounding mission.
In a fund-management business like ours, culture building must go beyond our internal team, because without aligned clients, everything succumbs during hard moments. Those moments will come - 2021 was just an appetizer. As you know, we believe in providing relatively frequent client withdrawal windows – we don’t want to trap your capital unnecessarily (we have no liquidity issues in our strategy). However, we also tell every client they should be sincerely willing to invest with us, through thick and thin, for at least five years. If that makes them uncomfortable, there are better suited funds (acknowledging things can change on the client side).
We are deploying capital today for perpetuity cash-flows, not for changes in sentiment about a stock or sector a few months from now. The longer our timeframe when we think internally about businesses and the portfolio, the more likely we are going to achieve our goal, as defined in the beginning of this letter. Understanding the drawbacks of changing our performance fee payment window from one to five years, such as the possibility of even longer windows without earning fees (the “new Covid” could come just as we end Year Five), the benefits for our culture, daily routine and long-term results make it an easy decision for me.
This change is meant to amplify our timeframe message. By leaving our variable compensation at risk for half a decade, we are walking the talk. This also provides you a financial benefit: your capital will compound over “deferred performance fees” just as Berkshire Hathaway’s and many other long-term thinkers’ do over deferred taxes on capital gains.
After reading this letter you may be thinking “2021 was a terrible year for Guilherme and Tarpon U.S. Equities”. Yes, the year was tough. But it is at these moments that we grow, and I am glad I have Tarpon’s team around and supporting me, especially Zeca, whose partnership I cannot be more thankful for, not to mention our whole board, with special notice to the “outsiders”, Chas Cocke and Pedro Machado, whose contributions have been invaluable.
After more than a decade managing investments professionally, I have never had a year in which I learned as much as I did in 2021. We learned a lot, not only about many businesses, but, most importantly, about how to allocate capital in the areas we are studying. Learning is just possible with an open mind and deep curiosity to challenge your old thoughts; we did a lot of that last year, taking steps to improve our model and portfolio.
To close, during 2021, we took a much larger step towards our vision of allocating capital wisely, using time-tested principles while incorporating newer aspects of an ever-changing economy, better detailed in our first letter from early 2020, than we had done in 2020 when our results were better. Zeca and I have a very long horizon for what we are doing together and Tarpon U.S. Equities, and we will work to age well, getting wiser and delivering better and better value to our clients.
I can promise you commitment, dedication, and skin in the game.
Thank you for your confidence,
I wish everyone a great 2022,
Guilherme Mattioli Partel
Tarpon U.S. Equities