“If you’re going to invest in stocks for the long-term, or real estate, of course, there are going to be periods when there’s a lot of agony and other periods when there’s a boom. And I think you just have to learn to live through them.” — Charlie Munger
Dear Partners,
In Q3, the fund was down -4.4% vs. S&P 500 index being down -4.9%. You will be getting your statements from HC Global Fund Services early next week.
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 bubbles4 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.
How will this movie end? Are we going into a recession? Where will the market be over the next 6-12 months? We do not know the answers to any of these questions. All we can be sure about is that the market will continue to be volatile. No one has a crystal ball, but one thing that seems to be on everyone’s mind this year is that “there is no safe place to hide.” The general sentiment is very pessimistic and full of fear — complete opposite of the euphoria and extreme levels of greed that we had witnessed in 2021.
But the real question to ask yourself is: What is my investment horizon?
If you need cash in the next 6-12 months, the best place to be is obviously in cash. However, if your investment horizon is 5-10 years, and if your goal is to preserve and compound your family’s wealth over time, cash looks like a terrible choice, especially with the current rates of inflation.
Below is a great chart, which captures the essence of long-term investing. Staying invested in stocks over time pays off. Volatility is the price of admission that you must pay — as you can see investors over the past few decades did not get a smooth ride. There have been long stretches where investors lost ground, there have been stretches where stocks went nowhere, but there have been much longer stretches of time when stocks rallied very strongly and paid off very handsomely to those investors that have been patient.
“As a money manager, I have frequently looked at an investment decision that I felt had a high probability of success on a three-year horizon, but about which I had many doubts on a six-month time horizon.” — Robert Kirby
This is exactly how we currently feel about the Rowan Portfolio. As we have stated above, we have absolutely no clue what's going to happen over the next 6 months. But, if we extend our time horizon to at least 3-5 years, we feel very strongly that the companies that we own in our portfolio will be worth significantly more than what they are trading for today.
For example, let's look at our top holding, Spotify. It is estimated to generate almost 12 billion euros in revenues in 2022, with gross margins of over 3 billion euros. The whole company is currently selling for only $17 billion. Over the next 5 years, we estimate they could hit 1 billion users (currently at 450 million) and generate close to $25 billion in revenues. Their margins could also get a boost from advertising revenues in podcasting and other audio verticles they are investing in. We estimate that by 2025, Spotify could earn over $3.5 billion in adjusted operating profits. If we placed just a 20x multiple on that, which could prove quite conservative for a company growing 20+%, it would give us a $70 billion valuation (4x from the current market price). Now, the market may not reflect the value creation at Spotify over the next 6 months or even a year, but over the next 5 years the odds are the stock will jump significantly higher to reflect the underlying value creation at the company.
What makes investing hard is that things don’t unfold in an even or predictable manner. There are some great runs, there are nasty drawdowns (like in 2022) and there are extended periods where you seem to go nowhere. Each presents lots of pitfalls for investors to either make costly mistakes or to take advantage of incredible opportunities presented to them.
We do believe that this market, although psychologically painful at the moment, presents a lucrative opportunity for investors with a longer time horizon that choose to focus on owning great businesses instead of trading stocks. It’s that mindset of a business owner that makes all the difference!
After all, we did not start Rowan Street based on our special abilities to forecast interest rates, Fed moves, inflations or economic recessions. We started it because we wanted to compound our investor’s capital over time and we are convinced that the best way to do that is to own great businesses that are run by top entrepreneurs and owner-operators that reinvest capital wisely. Thus, we choose to focus all our time and energy on evaluating just these three components — we call it our “Three-Part Engine”. Our North Star remains the same whatever the weather is:
That’s it! Over the years, we have worked hard to identify 10 businesses that we like and that meet all three characteristics. At the current valuations, all 10 remain at very attractive levels. Or at the very least, we are definitely not overpaying for them. If we are patient and manage to prevent ourselves from making costly emotional mistakes (being our worst enemies), we believe we will do very well over time. It sounds very simple and it is, but not easy in practice.
Sold DocuSign (DOCU)
Our decision to buy or sell shares in a business is based on the same fundamental criteria. We begin ‘sell discussions’ when one or more of the three engine parts of our compounding machine (shown above) is cracked or broken.
In the case of DocuSign, the “Management” part no longer satisfies our requirements in order to remain in our investment portfolio. In the past 6-9 months, the company has had a huge turnover in both employees and upper management. In June of 2021, the board decided to get rid of Dan Springer, who had been a CEO of DocuSign since 2017 and took the company public in 2018. We found this decision strange as we thought that he actually did a great job growing the company over the past 5 years (revenues grew almost 5x from $519 million in 2017 to an estimated $2.4 billion this year).
Dan was faced with a very difficult, unprecedented operating environment just like all the CEOs of SaaS companies. From Q2 ‘20 until Q3 ‘21, during pandemic shutdowns, growth exploded from about 30% to 60%+, as there was a ton of pull-forward demand. The business doubled in about 6 or 7 quarters! As the world opened up after the pandemic, growth slowed quite a bit especially in comparison to these abnormal pandemic quarters. However, on a 3 year CAGR basis, growth was still very healthy (sales grew from $974 million in 2019 to $2.5 billion expected in 2022). They also had to dramatically increase their sales force (biggest expense) to keep up with all this unexpected growth. New employees did not have a chance to be trained properly, but it still worked well as they had demand easily coming to them. Now that there is a very different demand environment, a lot of this salesforce either needs to be retrained for normal sales cycles (land and expand) or be replaced. Employee turnover also compounded with a lot of people who were with a company when stock was going up and up, and now that the stock is down so much from the highs, their stock options are no longer valuable. Having said this, we are not sure any other CEO could have done a better job managing through such a difficult operating environment.
Dan Springer was also a sizable shareholder in the company — per latest proxy statement (March 2022), he owned 3.6 million shares or ~$350 million worth of stock at the time. As part of our investment philosophy, we only consider an investment in a company if it is run by the management team that owns a meaningful stake in the company — we call them ‘owner-operators’. We strongly prefer for the management to eat its own cooking. Currently, all insiders and executive officers at DocuSign own less than 1% of stock. Now that Dan Springer is gone, the company has NO owners — just a bunch of newly hired ‘agent-operators’, who will likely make decisions based on how they will be perceived by the public and the board and how it may impact their career prospects, which often runs at odds with the hard decisions that need to be made for the long term health of the business.
Therefore, we decided to sell this position and reallocate the proceeds towards better ideas in our portfolio that meet all 3 criterias that we described above.
We want to thank you for your partnership and trust. As you know, Joe and I have a significant part of our net worth invested alongside you, and we are very focused on compounding the fund’s capital over the long run. Remember that successful investing is about disciplining your mind to do the opposite of human nature: buying during panic, selling during euphoria, and holding on when you are bored and just craving a little action. Successful investing does not require a stratospheric IQ, but it does require the right temperament. Patience, controlling our emotions and behaving rationally is of utmost importance in the market like this. If we just stay invested in the excellent businesses that we own in our fund’s portfolio, we are certain that will see much better days and higher valuations ahead. We look forward to reporting to you again at the end of the year.
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). S&P 500 performance information is included as relative market performance for the periods indicated and not as a standard of comparison, as it depicts a basket of securities and is an unmanaged, broadly based index which differs in numerous respects from the portfolio composition of the fund. It is not a performance benchmark, but is being used to illustrate the concept of “absolute” performance during periods of weakness in the equity markets. Index performance numbers reflected in this letter reflect reinvestment of dividends and interest (as applicable). Index information was compiled from sources that we believe to be reliable; however, we make no representations or guarantees with respect to the accuracy or completeness of such data.