Dear Partners,
2022 was a difficult year for the markets in general and for our fund. Rowan Street declined 61% in 2022 as our portfolio was dominated by growth companies, which were ‘out-of-favor’ with Mr. Market in 2022. Please see disclosures for the historical performance data. Repricing of growth stocks in our portfolio was particularly intense in the first half of 2022 (fund declined 57% in 1H), and had then stabilized in the second half of the year as valuations for our companies have gotten to unreasonable levels. The fund is off to a better start in 2023, +15% in the first two weeks of the year.
Just to give you some perspective, here is how some of the most well-known growth stocks have done in 2020/21 vs. 2022 (sorted by their initial advance in ‘20 &‘21 pandemic years in green column):
We think its worth reviewing what we wrote in our 2020 year-end letter after the fund posted +28.3% and +65.4% gross returns in 2019 and 2020 respectively:
What can we expect from the Rowan portfolio over the long run?
By no means should you be expecting the fund to generate anywhere near the kind of returns that we had enjoyed over the past two years. These kinds of returns are unsustainable, and without a doubt we will experience a market decline (perhaps a significant one) at some point in the future. Some of our portfolio holdings may experience drawdowns of 50% or more from peak to trough, just like they did in March of 2020. This is normal and part of the game of long-term compounding. Remember, we are not in the game of minimizing volatility. We are not traders, hedgers, market timers or “renters of stock.” We are strictly business owners and compounders of capital! And just like Sam Walton, Jeff Bezos, Reed Hastings, Larry Ellison, Mark Zuckerberg, or Elon Musk have never sold when the stock of Walmart, Amazon, Netflix, Oracle, Facebook or Tesla had declined by 25% or 50%+, and have always focused exclusively on the long term fundamentals of their respective businesses, you should expect us to do the same with our portfolio companies.
The biggest detractors from our fund’s performance were our top holdings Spotify (SPOT) and Meta (META). Spotify’s stock declined -66% in 2022, however its revenues were actually up +23% and its gross profits were up +14%. Meta Stock declined -64% in 2022, while their revenues fell just -2% and earnings per share (EPS) declined -37% due to a ramp-up in investment expenses, which we have covered to a great extent in our recent write-up on META). We expect both SPOT and META to be significant contributors to our performance over the next several years. Later in this letter, we spend some time describing why we expect this to be the case…
Below we listed some historical annual returns for our 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, the stock prices tend to accurately reflect the underlying business results. For example, Spotify’s stock returns appear very volatile from year to year, however if you look at their fundamentals, gross margins have been growing pretty nicely and steadily (see graph below). We will spend a lot more time on Spotify at the end of this letter…
So what was the drastic change that occurred between 2021 and 2022 that caused such a huge divergence in market results?
The narrative has changed…
As we wrote in our Q3 ‘22 letter:
“In our opinion, we are witnessing the results of a very poor monetary policy. We feel that the Fed has been driving while looking in the rear view mirror, and that they have been way behind the curve for a long time. They were way too easy in 2020-21 (and even much prior that) when everything was pointing towards inflation becoming a terrible problem, allowing all asset bubbles to inflate. And now, they are trying to be real “tough guys” that are focused on crushing inflation, again looking at the lagging indicators of the core inflation and employment, at the same time as the forward-looking market indicators all point to very different conclusions.”
Here is a visual that clearly depicts how rapidly the Fed raised rates in 2022 in comparison to previous tightening cycles. As you know, higher interest rates act as gravity on stocks. Especially, the growth stocks, which our fund is focused on, since high growth companies reinvest their growth profits back into the business and their eventual profits and cash flows are further into the future than that of mature companies that earn profits today, but are growing very slowly and do not have many reinvestment opportunities.
What was the consensus narrative in 2021?
It was something like this: “In the current economic environment where inflation is soaring at four-decade highs, interest rates remain near historic lows, cash will obviously be a losing investment because, with inflation raging at high single digit annual percentage rates, its purchasing power will be increasingly destroyed the longer you hold it. Even if you invest it in a short-term bond or savings account, you are unlikely to earn more than a few percentage points in interest, meaning that you will still be suffering from a ~600-700 basis point negative real return.”
Basically, everyone was in consensus that ‘Cash is Trash’ and you better get rid of it ASAP. It doesn't matter what you “invest” it into: crypto, NFTs, SPACs, ridiculously overvalued and hyped-up stocks, or bubble-like real estate. All of these options were perfectly sound investments, but that cash under your mattress was your worst enemy!
We pulled an interview from 2021 with a well-known billionaire investor, Ray Dalio, which was very characteristic of the narrative at the time:
Below are some headlines (in chronological order) that perfectly depict how the narrative changed over the past few years:
So what is the consensus narrative today?
Let’s see how the world has changed in just 12 months:
Bitcoin: -65%
NFTs: virtually worthless
SPACs: down ~90%
Growth stocks: (see chart above)
NASDAQ: -34%
S&P 500: -20%
Tesla (Wall Street darling that could do no wrong and was guaranteed to go to $10 trillion): -72% from its Nov. 2021 highs
Real Estate is much slower to be repriced, but we expect it will be…
In comparison, losing 8% of your purchasing power over the past 12 months doesn't seem so bad. In addition, most forgot the optionality value that cash can offer — having the dry powder around when asset prices get meaningfully corrected and panic selling kicks in. During these kind of times, as it happened it 2022, almost no one has cash and the ones that do have all the power.
Morgan Housel also talks about another positive benefit of cash in his book, The Psychology of Money. In the way it helps prevent you from ill-timed sales of your stocks during a bear market. We think investors who are willing to hold or accumulate cash when valuations are frothy are more likely to behave better during tough times when opportunities abound. By “behave better,” we mean sell less and/ or buy more.
So what is everyone doing today?
Selling and going to cash, treasuries and flocking to the “safe” securities — the Coca-Colas, Procter & Gambles, Johnson & Johnsons and Exxon Mobiles of the world. Investors are shriveled up in fear as they see no end to Fed's rate hikes and everyone is expecting a recession in 2023.
Is this a good idea for a long term investor looking to earn attractive returns over time?
The way we see it, the current consensus too will prove to be ill-fated and ill-timed. You cannot drive looking at the rearview mirror, you have to focus on what's ahead in your front windshield. So let's take a look at what's ahead:
Currently, 10-year treasuries pay about 4%. By buying these today, investors are essentially buying an equivalent of an almost “riskless” stock that is selling for 25x earnings and offers zero growth.
As you know, your future return from a stock = dividend yield + earnings growth + change in earnings multiple
Let’s take Coca-Cola (KO) for example. Its dividend yield is 2.8%, earnings are estimated to grow at only 3.6% rate per year over next 4 years, and its earnings multiple is currently at 24x (based on next years forecasted earnings). KO has an anemic growth, so we can argue that paying 24x earnings is not very attractive. Let’s assume that the multiple will stay constant over the next 3-5 years, thus our expected annual returns will be 2.8%+3.6% = 6.4% (that is below the current reported inflation rate and only slightly above the risk-free rate of 4%).
Let’s look at Costco (COST). Its dividend yield is 0.8%. Earnings over the next 3-5 years are forecasted to grow at ~10%. The current P/E multiple is a very pricey 34x for such growth rate. Now, Costco is an outstanding business with consistent profits and cash flows. However, the price that you pay is important (and you tend to pay a very high price for a “cheery consensus”) and if the earnings multiple comes down to say 30x, you internal rate of return (IRR) over the next 4-5 years will be around 6-7% from holding Costco’s stock. Its a decent market-like return, but nothing to be excited about (only a few percentage points over risk-free rate).
Let’s look at Procter & Gamble (PG). Dividend yield is 2.4%. Earnings are forecasted to grow at 5.9%, and its current earnings multiple is at 25x. Now, lets say over the next 3-5 years the market loses interest in the “safe”, mature companies that grow at anemic rates and gets an appetite for growth again. It’s very unlikely that Mr. Market will be paying 25x for 5.9% earnings growth. Lets assume that multiple declines to the market average of 18x — that would be ~6.9% drag per year on the total expected return over next 3-5 years. If we get 2.4% (dividend) + 5.9% (earnings growth) - 6.9% (decrease in earnings multiple) = 1.4% (annual return we can expect on average from this stock).
Basically, you get the point of what type of returns you can expect from the “safe” stocks that Mr. Market is in love with at the moment.
So what is the conclusion?
After a huge correction in the market, there are a number of great growth businesses with excellent management teams and solid reinvestment track records that are currently trading at the kind of valuations we have not seen in many many years — way below the 25x earnings multiple of Treasuries and with substantial future growth opprontiutes. Yes, these are not risk-free, but for these businesses the odds of compounding value at high rates of return over the next 3-5+ years are finally stacked in our favor. We believe this is the time to actually put that cash to work (selectively of course), not to sell and go to cash! Could these valuations become even more attractive? Absolutely! But we believe it is a huge mistake to not invest in a great company selling at attractive valuations because of stock market and macroeconomic worries. How many investors looked back at stock prices from the depth of the Global Financial Crisis of 2008/09 and asked themselves years later: why didn’t I buy at those levels?
We never have an opinion about where the market is going over the next 12 months because that opinion would not be any good and, on the contrary, it might interfere with the opinions we do have that are good. Our extensive investing experience has taught us that if we’re right about the businesses that we own, we’ll end up doing fine, as long as we don’t pay a foolish price for it.
With that, lets review two of our top stocks in the portfolio (SPOT & META) and see what we can expect from them over the next 3-5 years?
Spotify (SPOT) is currently selling for about $15 billion. Does this make any sense?
We have written a few times (Q2 ‘20 Letter, Q2 ‘21 Letter, Q2 ‘22 Letter) about Spotify and it still remains our favorite idea that is currently extremely mispriced by the market, in our view.
Spotify is estimated to end 2022 with 479 million monthly subscribers. Management thinks that their subscribers can get 1 billion over the next 4-5 years. The paid subscribers are estimated to end 2022 at 202 million. Therefore, based on today's price, we are paying only $74 per paid subscriber. Now, let's assume that Spotify can get to only 5 euros in ARPU (they are at 4.63 euros currently), then they would be collecting 60 euros per paid subscriber over a 12 months period, which makes our current payback period of only 1.2 years. This may not be an ideal comparison, but just for some context, Netflix is currently selling for $590 per user and traded as high as $1,400 per user in 2021. According to the “Netflixed: the epic battle for America’s eyeballs” book by Gina Keating, the founder/CEO of Netflix Reed Hastings offered $200 per subscriber to Blockbuster back in 2007. Blockbuster’s management was insulted by such a low-ball figure and rejected his acquisition offer — the rest was history.
This sounds like a once in a lifetime kind of deal for a very high quality brand and a unique audio platform that is still early in its growth stages. But that calculation does not even take into account their rapidly growing podcasting and advertising business, which had revenues of 1.4 billion euros over the past 12 months. When Spotify went public in 2018, their ad-supported revenues were only 542 million euros and podcasting was not even in the picture. We estimate that revenues from this business could double (we’re being very conservative) over the next 4-5 years and gross margins could grow significantly as they gain scale and pass through their very heavy investment cycle. In 4-5 years, this business alone could be worth the current market cap of $15 billion. We estimate that the premium revenues could top 20 billion euros over the next 4-5 years (assuming they can grow premium subs to 338 million and increase ARPU to 5.5 euros). If we placed just a 2x sales multiple on this business earning close to 30% gross margins, which we believe it deserves, then the entire company should be worth close to 60 billion euros in 4-5 years time, and we believe this number could prove to be very conservative. That is a 4X return from the current price over the next 4-5 years (30%+ IRR).
While virtually no one paid attention to profits and free cash flows over the past several years, in 2022 most investors have quickly reverted back to the ‘old school’ ways of evaluating the attractiveness of a business model and long term viability of a business. Overall, we think it's a very healthy transition from being focused purely on revenue growth while being completely ignorant of the economic realities of the business. However, just like with everything else in life, there is a healthy balance between making sure that a business you own generates healthy profits and cash flows, and whether a company reinvests sufficiently and profitably in order to grow and expand its competitive moat over time, making sure that their profits and cash flows are sustainable.
In the case of a digital platform business like Spotify, they reinvest into their future growth through Research & Development (R&D) and Sales & Marketing (S&M) expenses. R&D runs at about 10% of Sales and S&M expense runs at about 12% of Sales. When you have a business that earns about 26% gross margins (management’s long term goal is 30-40%), these expenses can make you appear as they do not have a profitable business model — which is exactly how Mr. Market currently views Spotify. Here is what Deniel Ek (CEO) said on their most recent earnings call:
“So if you recall, at our Investor Day in June, I said that I suspect many of you think Spotify is a great product, yet at the same time, you may also think that we're a bad business or at least a business with bad margins for the foreseeable future. And our Q3 results clearly show that our investments in the product and experience have resulted in strong user growth, retention and increased engagement, but they've also been a drag on near-term margins. Just to remind everyone, this is all consistent with the strategic decisions we communicated in early 2021 and again at Investor Day. So as we've said, we expect this drag on margins to start to reverse in 2023. As I also shared at Investor Day, LTV (the lifetime value of a user) is the primary tool we use to inform our business decisions and judge whether our strategy and investments are working and achieving better outcomes. And the beauty of LTV is that it factors in the longevity, quality and value of the relationship we have with the user. It is a critical metric to all teams at Spotify. And we're constantly experimenting with what leads our users to stay longer, engage more deeply and ultimately convert to our paid offerings. And what we've seen time and time again is how sticky our users are because of the product and experience that we've created.”
Consistent with these words from Spotify’s CEO, it's important to realize that the health and viability of a business model for digital platforms, especially ones still early in their growth stages, need to be evaluated by a different measuring stick than we typically use for mature physical businesses like Starbucks or Costcos of the world, which grow by opening new stores and investing into capital expenditures. The primary long term value driver of Spotify’s business is the lifetime value of a user (LTV) and how much they need to spend in order to acquire and keep that user engaged.
Simply put, this is how Spotify derives its long term value:
(Amount of users) X (LTV of a user — cost of user acquisition)
Thus, in order to grow its value, Spotify needs to heavily invest into (1) growing the amount of users through investments in Sales & Marketing; (2) making sure that the user experience is industry-leading and that users are engaged and stay with Sporify for a long time, which is done through investments in Research & Development. We believe that on these key metrics Spotify’s management has done a good job.
Below is a great example of how management approaches their investment decisions:
“We will make new investments with two criteria in mind. First, it must be accretive to margin over the investment period given this new hurdle rate. And second, over the long term, that investment must strengthen our value proposition to users and creators alike. This said, new opportunities will likely emerge in downturns. As an example, we may find that our customer acquisition cost goes down as the cost of advertising typically declines in a softer market. This would then offer us a clear opportunity to grow our market share even in a challenging economy because we can acquire users at lower cost relative to LTV. We saw this dynamic play out in the beginning of the pandemic, and we benefited from it. And we expect we would do so this time around should the opportunity present itself as well. And this philosophy is not new for those that have followed us for a while, but I realize that this may frustrate some of you who would prefer we manage to the quarter. Some companies do just that, and I get that's what some investors look for, especially now in this show-me market. But simply put, I don't think that's a winning strategy long term nor is it the right one for Spotify.”
Since Spotify went public in 2018, it has invested over 4 billion euros into R&D and over 5 billion euros into S&M. These investments helped Spotify become the number one audio platform in the world and grow their MAU from 207 million to 479 million. Spotify’s premium business gross margins are currently close to 30%, however they are willing to sacrifice these margins in the short run in order to invest into their podcasting business, which is pulling those margins towards mid-20s (another factor that Wall Street is not a fan of at the moment). We believe these investments will prove to be lucrative over time and Spotify could see a boost in its gross margins to 30-40% over the next 4-5 years (advertising business is much more profitable than the music business, where Spotify has to pay out 70 cents on the dollar to music labels). If that plays out and Spotify continues reinvesting at the same rate they have been in the past, they could be earning ~10% operating margins by 2025, which would translate to 1.3 billion euros in operating profits on our projected 24.5 billion euros in revenues (in comparison, their GAAP operating profit was just 94 million euros on 9.7 billion euros in revenues in 2021). If we were to adjust for their heavy R&D investments, which we project to be ~2.3 billion euros by 2025, their adjusted (steady-state) operating profits would amount to ~3.7 billion euros (or 15% adjusted operating margins). Let’s apply a very conservative multiple of 18x (for the quality of the business and its growth potential) — this would amount to ~67 billion euros valuation by 2025. This translates to ~45% annualized return or IRR. Even if they fall short on the future growth projections or on their gross margin expansion, we believe that this type of expected IRR compensates us more than sufficiently for the business and macroeconomic risks. In other words, we think that the risk/reward on this investment at today's price is incredible, especially if we were to compare it to the “safe” Proctor & Gambles and Coca-Colas of the world that barely get us to the mid-single digits IRRs.
Meta Platforms (META)
Meta is our second biggest holding in the fund and one that has been a significant detractor from performance in 2022. We published a write-up back in November: Does a $750 billion decline in Meta’s market cap make sense? We strongly encourage you to read it if you have not had a chance to do so. We expect our META holding to be a solid contributor to the fund’s performance over the next several years as well.
A unique opportunity to add to your investment in the fund
We cannot emphasize it enough that it is our behavior today that will determine the long-term results of our fund. Most people behave more or less rationally in markets where the underlying assets are not easily tradable, such as real estate, farms, privately held companies, etc. However, as soon as these assets are chopped into little pieces and can trade freely (such as stocks), market participants behave in the opposite way. They fail to recognize the fundamental value of a security other than its trading price. Again, its very important to remember that the stock market is there to serve us and not to instruct us.
Although the 2022 results are discouraging, we believe the sell-off in stocks in the Rowan Portfolio presents a generational buying opportunity at these levels. Frankly, we are as excited about the setup for the next few years as we have ever been since the launch of our fund in 2015. Based on our research, the companies that we own in our portfolio could be worth 2-3x of what they are trading for today in about 3 years time, based on their growth opportunities and assuming a reasonable repricing of their very depressed multiples. We would encourage all limited partners in the fund to add to your current investment, if you have an opportunity to do so. The last time we said this was after a sell-off in March of 2020.
It takes great courage to invest at the maximum point of pessimism, but it’s precisely these times that bring about the strongest long-term results. As a reminder, the fund is open at the end of each month for new investments.
Better times are ahead, and with a little bit of patience, we will come out of this stronger and well positioned on the other end. Please remember these wise words from a very successful long-term investor:
”Only those that succumb to the preasure to sell during stock market declines end up poorer. The winning strategy in 1962 — as in 1974, 1987 or 2008 — was to remain imperturbably invested… in order to eventually reap the fruits of corporate wealth creation.” — Francois Rochon
As always, we appreciate your trust. We hope you have enjoyed the holidays and we are always around if you would like to chat.
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 .