Dear Partners,
Rowan Street gained +78.5% for the first half of 2023 compared to +16.8% gain for the S&P 500 Index. Please see disclosures for the historical performance data. The strongest contributors to our outperformance were: Spotify +103%, Meta +138%, Trade Desk +72% and Shopify +86%. Below we listed some historical annual returns for our top core holdings. As you can see, in any given calendar year stock returns can be very erratic, depending on the mood that Mr. Market is in (and the mood swings have been pretty intense over the past 3 years). However, the fundamentals of companies usually do not fluctuate even nearly as much from year to year, and over time, stock prices tend to accurately reflect the underlying business results.
Our portfolio remains dominated by digital platform businesses (a leading digital music streaming platform, a leading social media platform that connects billions of people worldwide, a digital advertising platform focused on making data-driven advertising as ubiquitous as electronic trading in equities, an e-commerce platform that empowers entrepreneurs and businesses of all sizes to grow their online presence and scale their operations, and a leading streaming platform for movies, TV shows and original content), which are all rapidly getting repriced by Mr. Market after their valuations were severely punished in 2022 on fears of persistent inflation and rising interest rates.
To give you an example, we included a table below that shows how the Price-to-Sales (P/S) multiple for the Rowan portfolio changed from year to year since 2019:
2019: 9.6x
2020: 17.4x (+81%)
2021: 13.4x (-23%)
2022: 4.8x (-64%)
2023: 8.2x (+69%)
Please note that we are using a P/S ratio in this example because companies like Spotify, Trade Desk and Shopify are currently operating at break-even and not showing the real earnings power that is inherent in their business models because they are heavily reinvesting for long-term growth. Netflix was actually in the same boat until about 2020 when they became cash flow positive after two decades of heavy investments. Despite not showing profitability, Netflix stock had advanced ~40,000% (400x) since their IPO in 2002 until 2020, when their business model started printing cash as Mr. Market had correctly assigned a lot of value to Netflix’s heavy investments over the years.
As you can tell from the table above, this has not been a normal operating environment. Over the past 3 years, Mr. Market had a very difficult time assessing the future prospects of our portfolio companies (and tech companies in general), swinging from one extreme to the other. Performance has been almost purely driven by changes in valuation multiples. In 2020, the multiple skyrocketed 81% from 9.6x to 17.4x as market participants were in a euphoric state of mind towards technology and digital platform businesses. However, the following 2 years saw a drastic decline in valuations. 2022 was a maximum point of pessimism for our portfolio companies, as the multiple declined to 4.8x — a 72% decline from the peak levels and almost half of where it was pre-Covid in 2019. In 2023, however, we are seeing a substantial rebound in confidence in our portfolio companies’ future prospects, where the valuation multiples are getting back to more normalized levels. We believe that from here, our portfolio performance over the next 3-5 years should be determined by the actual fundamentals of the underlying businesses rather than drastic swings in valuation multiples, barring major shocks. On that front, we are quite optimistic, as our companies are estimated to grow revenues by ~14% per annum over the next 5 years, and the weighted average earnings per share (EPS) for our portfolio is estimated to grow ~26% per annum. That compares quite favorably to the general market (S&P 500). Over the past 20 years, revenues for the S&P 500 grew by about 4.6% per annum and earnings per share (EPS) grew by ~9% per annum, which is also consistent with the growth rates over the past century. It’s no surprise that stocks as an asset class have earned on average 9% per annum over the past century as well.
Alignment of Interests
Please note that despite this sizable rebound in the fund’s performance in the first half of 2023, your fund managers will not earn a dime in fees until we make up all the lost ground from 2022. This is exactly why we set up our compensation structure this way from day one, which in our mind is the fairest structure that perfectly aligns our interests with that of our investors. It’s very simple — we only make money when you do. Additionally, be assured that we also eat our own cooking. The vast majority of our net worth is invested in Rowan Street as we want our investors' financial fortunes to move in lockstep with ours. Seth Klarman, a well-known billionaire investor, brilliantly described this simple philosophy in his book ‘Margin of Safety’:
“In the building practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer who built the arch stood beneath. If the arch came crashing down, he was the first to know! His concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived.”
Our Current Portfolio
Our current portfolio is made up of just 10 companies — we are very focused! We described our ‘10-Player All-Star Team’ philosophy in our Q1 2018 Letter (we encourage you to review it). We have been building this portfolio since our founding in 2015. In total, over the past 8 years, we bought stock in 47 different companies (that’s ~6 per year), and obviously, for anyone who is good at arithmetic, we sold 37 of them (~4.6 per year). We are constantly trying to learn from every decision (good or bad) that we make. We went through every position that we’ve sold since 2015 and analyzed how we would have done had we held on to those positions. The top 3 performing positions would have been: Chipotle (CMG) +630%, Tractor Supply (TSCO) +315% and Novo Nordisk (NVO) +387%. Your managers are at fault here because we sold all of these (in 2017-18) for non-fundamental reasons. All of these continued to be great businesses and management has executed at very high levels. In all three cases, we made a decision to sell because we thought the stock price got way ahead of itself.
If you ask us what is the biggest lesson that we have learned since we started the fund, including having gone through the drawdown in 2022?
Our main take-away lesson has to be Do NOT sell your winners and avoid adding more to your losers. Or as Peter Lynch once famously put it:
“Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”
It’s helpful to refer to our old letter back from 2018 where we explained our rationale for selling Chipotle (CMG) and Tractor Supply (TSCO). Both of these great companies were sold because the stock price got ahead of itself and, at the time, we thought we were reinvesting the proceeds into much more attractive opportunities. It turned out that the majority of these new opportunities did not work out even nearly as well as simply staying with these great companies would have (as you can tell by the returns shown above). Truly great businesses that are well-managed are very rare and to have an opportunity to purchase them at an attractive price is even rarer. We were fortunate to purchase CMG, TSCO and NVO at very attractive prices when these companies hit a temporary speed bump in their business. These were businesses that were simple to understand and we knew them very well as we had a chance to study them thoroughly for some time prior to our purchase. However, when you choose to sell you get the cash proceeds. First, you have to pay the capital gains tax and then you have to make another ‘buy decision’ or, in a lot of cases, a number of them. The more decisions you make, the higher probability that you will make mistakes. More often than not, you end up buying a business that you know less well and end up partnering with the management team, whose character, management and capital allocation abilities may still be somewhat moot to you. These things take time to get comfortable with! As we have learned many times over throughout our investing careers, it is usually significantly more profitable and also more enjoyable to stay with the great business that you know very well and have a high confidence level in their management team. And this is exactly what happened with CMG, TSCO and NVO. It was a costly mistake for our investors and it's an extremely valuable lesson that we have learned.
Now, the bottom 3 performers from all the companies that we’d sold were Docusign (DOCU) -76%, TripAdvisor (TRIP) -59% and Under Armour (UA) -57%. These represent the losses we would have incurred had we held on to these positions until now. We must note that all 3 of these were sold for purely fundamental reasons and we ended up being correct on all of them.
While buying 47 different stocks and selling 37 over the course of 8 years could makes us look “lazy” by industry standards (the average domestic fund tends to own 40-60 stocks and their average turnover is ~62% per year, which means they sell about 30 stocks on average in any given year), in our opinion we still made way too many decisions in the past. Our goal is to do less, much less! Since 2020, we have added just 3 new ideas per year and in 2023 we added zero. In our mind, this means we are getting better. If our goal is to own only the best, to NOT overpay for them and to hold these investments for at least 5-10 years, then we only need 1-2 new ideas per year. If we can only find one new idea per year, then we will have turned over our entire portfolio over the next 10 years — quite a contrast to most funds that manage to turn over their whole portfolio in less than 2 years.
The question that usually arises from this approach and mentality is what do you do with your time when you are only adding one new idea per year and sometimes none? There is a predisposition out there that good ideas are all you need for success (the more ideas the merrier), but in our mind it is actually the ability to say NO to almost everything that determines the long term result. As Warren Buffet once pointed out:
“I treasure my friendship with Charlie not just because he gives me good ideas, but because he destroys my bad ones.”
We believe that captures the essence of a good investing process and that is our North Star!
I have recently had a discussion with one of our fund investors on this topic. He shrewdly pointed out to me: “Alex, what you do is very difficult. You sit there and read annual reports, listen to earnings calls, interviews, podcasts and do all this in-depth research on a lot of different companies. You invest a lot of your time and energy and sometimes spend weeks and months studying companies and their management teams. The natural instinctive thing to do after you have done this much work is to act on it. It's very human to feel that if you are not acting, you are not making progress, which is true in every sphere of our lives (with the exception of investing). However, what you have to do is to discipline yourself to say NO to almost everything. And that is the most difficult thing to do!”
We expect that as time goes on, we will do even less in terms of activity in the fund (if we do more, that means we haven’t done a very good job in our company selection). We will keep doing more in terms of studying and learning about different companies and industries. Our job is to compound our knowledge every day, and to keep searching for the great businesses on behalf of Rowan Street and our investors. We don’t expect to find 10 or 20 or 30. Our hope is that all our hard work and dedication will lead us to one or two (three if we are lucky) that we can own for the next 10-20+ years. Yes, all we need is one or two to make all the difference, providing that we make a meaningful investment in them.
Over the years, we have gotten to know our portfolio companies quite well, and these companies and their management teams have become our hurdle, our high bar for investment. Any new idea that has a chance of entering our portfolio has to be better than what we currently own, and our confidence level in it has to be very high. Our motto is very simple: ‘Only the best will do.’
Thank you for your confidence and trust in our investment discipline. Despite a meaningful rebound in 2023, we see a continued opportunity to intelligently deploy capital and to deliver long-term value to our investors. We would encourage all limited partners in the fund to add to your current investment, if you have an opportunity to do so. As a reminder, the fund is open at the end of each month for new investments.
As always, should you have any questions or comments, we would be very happy to hear from you. We look forward to reporting to you again at the end of the third quarter.
Best regards,
Alex and Joe
DISCLOSURES
The information contained in this letter is provided for informational purposes only, is not complete, and does not contain certain material information about our Fund, including important disclosures relating to the risks, fees, expenses, liquidity restrictions and other terms of investing, and is subject to change without notice. The information contained herein does not take into account the particular investment objective or financial or other circumstances of any individual investor. An investment in our fund is suitable only for qualified investors that fully understand the risks of such an investment. An investor should review thoroughly with his or her adviser the funds definitive private placement memorandum before making an investment determination. Rowan Street is not acting as an investment adviser or otherwise making any recommendation as to an investor’s decision to invest in our funds. This document does not constitute an offer of investment advisory services by Rowan Street, nor an offering of limited partnership interests our fund; any such offering will be made solely pursuant to the fund’s private placement memorandum. An investment in our fund will be subject to a variety of risks (which are described in the fund’s definitive private placement memorandum), and there can be no assurance that the fund’s investment objective will be met or that the fund will achieve results comparable to those described in this letter, or that the fund will make any profit or will be able to avoid incurring losses. As with any investment vehicle, past performance cannot assure any level of future results. IF applicable, fund performance information gives effect to any investments made by the fund in certain public offerings, participation in which may be restricted with respect to certain investors. As a result, performance for the specified periods with respect to any such restricted investors may differ materially from the performance of the fund. All performance information for the fund is stated net of all fees and expenses, reinvestment of interest and dividends and include allocation for incentive interest and have not been audited (except for certain year end numbers). The methodology used to determine the Top 5 holdings is the largest portfolio positions by weight. The top 5 do not reflect all fund positions. The Top 5 can and will vary at any given point and there is no guarantee The top 5 will continue to perform and, more generally, there is no guarantee the fund will meet any specific level of performance.