RV Capital Co-Investor Letter for the first half ended June 2022.
Dear Co-Investors,
The NAV of the Business Owner Fund was €600.80 as of 30 June 2022. The NAV decreased 40.2% since the start of the year and increased 505.5% since inception on 30 September 2008. The compound annual growth rate since inception is 14.0%.
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Part I: The Big Picture
In my half-year letter, I traditionally discuss the operational development of our companies. Given the decline in the price of the fund in the first six months, I can imagine this top-of-mind today. Accordingly, most of this letter will address the development of our companies as well as the major themes that have driven share prices in the first half year including: the increase in interest rates and their impact on long-duration cash flows, the resurgence in inflation, the war in Ukraine, the possible bursting of a tech bubble, and the situation in Taiwan.
There have, however, been some important organisational changes at RV Capital, which I would like to start this off with as I do not want them to be missed if they are at the back of a long letter.
For those of you who would like the punchline now, so you can get back to doing what you love and leaving the job of worrying about investing to me, here is the big picture:
It is important to realise the market as a whole or individual sectors occasionally go through periods of extreme pessimism. It is also important to realise that no investment manager, certainly not this one, is immune to making mistakes. Finally, there is no guarantee that the two do not happen at the same time. In this letter, I endeavour to unpick where prices have declined due to changes in sentiment and where they declined due to poor investment decisions on my behalf. Needless to say, it is some combination of the two.
Ultimately though, I am convinced the fund will do fine. In aggregate, we own a collection of advantaged businesses, run by passionate and honest managers who are all taking actions today to adapt to the new set of circumstances and will exit any crisis in a stronger position than they entered it. Over time, the increase in the value of the winners will far outweigh the declines in any losers. To the extent I have made mistakes, it may weigh on performance in the short run, but I will learn from them and ensure that they drive superior performance in the longer run.
Part 2: Organisational Changes
I am delighted to announce two new additions to RV Capital. Andreas Lechner will join full-time as co-managing director of RV Capital. Reinhard Zimmermann will join as an independent director.
Andreas is one of my oldest friends and somebody I have exchanged ideas with on investing on a weekly if not daily basis over most of the last two decades. He is also the finest investor I know. In terms of background, Andreas is entirely self-made. He left university at a young age to manage his own modest savings and has achieved financial independence entirely through his own investing acumen. For those of you who do not know him, I had the pleasure of doing a fireside chat with him in Engelberg in 2020 which is available on my YouTube channel . Andreas’ intelligence and our chemistry come across loud and clear.
Reinhard is now retired but was formerly Senior Risk Manager at Suva Luzern, the Swiss National Accident Insurance Fund. As a non-executive director of RV Capital, he will be responsible for overseeing the compliance function. The Swiss regulator will no doubt be delighted to see someone of his experience and stature join RV Capital. Investors can be too. Reinhard has a substantial investment in the Business Owner Fund and will be keen to see the continued healthy balance between investment research and compliance activities.
These organisational changes will not change how Andreas or I allocate capital. We have regularly exchanged investing ideas for most of the past two decades, so Andreas joining RV Capital effectively formalises what up until now has been an informal collaboration. We will continue to make our own investment decisions. Historically, there has been some overlap between our portfolios, but they have been mostly different. I expect this to continue to be the case.
A reasonable question is perhaps “Why these changes now?”. The immediate reason is a new law in Switzerland which requires RV Capital to obtain a licence as an investment manager by 1 January 2023. A backup for me as managing director as well as an independent compliance function are part of our application.
Although these changes have been driven by regulation, I could not be happier about them. They are a win-win for everyone. Andreas joining RV Capital provides me with a backup should I ever be incapacitated whilst allowing Andreas, as part of a regulated entity, to take on external clients should he ever choose to do so. Reinhard gives me peace of mind that we are complying with both the spirit and the letter of the law, whilst allowing Reinhard to continue to participate post his retirement in an industry he is passionate about.
Our application with FINMA, the Swiss regulator, is ongoing and further organisational changes are possible, but I hope to be able to report in my 2022 letter that the process has been brought to a successful conclusion.
Part 3: Your High-Level Questions
How Am I Dealing with the Drawdown?
I have had the opportunity to speak with many of you during the first half-year. Nearly every conversation started with the question of how I am doing given the steep drawdown in the fund’s price. I greatly appreciate the kindness behind the question and feel lucky to have so many wonderful relationships through investing. Yes, there have also been some critical questions and observations, but that is ok too.
I am happy to report that I am doing fine. When I started managing the fund, I knew there would be periods of poor performance – no manager is immune to them. The trick is to manage through them with sufficient equanimity to be able to continue to function rationally, but not so much equanimity to be oblivious to the feedback that the market is giving you. Overall, I think I have been able to strike the right balance. I have invested through three crises in the past – 9/11, the Great Financial Crisis, and Corona – so this is not a new exercise for me.
One question that has preoccupied me is whether I am enjoying the downturn – what probably seems like an odd question to ask. It stems from Warren Buffett’s observation that a true value investor enjoys share price declines as they present the opportunity to buy high-quality merchandise at a discount.
I will discuss this question for each of our companies in this letter, however, the short answer is “not as much as I would like to”. Buffett’s observation presupposes that the price of a company falls in a vacuum. In practice, this is seldom the case. A sharp decline in share price typically goes hand-in-hand with a setback at the company level or the broader economy. Frankly, I do not enjoy being confronted with the news of these setbacks. It is stressful, especially in the period before an opinion can be formed on their likely impact (if any) on the long-term cash-generating ability of the business and hence intrinsic value. Furthermore, the sharp decline in a share price tends to make bad news appear more plausible, at least at first blush.
What I do enjoy are share price decreases at companies that are buying back their own stock in size. It is an enormous source of immediate value creation for remaining shareholders such as us. I am happy to report, that we own several companies doing this. If such share buybacks were to go on long enough at these or lower share prices, we would end up billionaires. Hold off perusing listings on eBay of Russian oligarchs’ superyachts for now though as the more likely outcome is that either share prices bounce back or, less favourably, the companies have to scale back repurchases.
Are we over-exposed to long-duration cash flows?
The next most frequent question I get is whether we are overexposed to companies who are losing money today and whose cash flow lies in the distant future. In other words, is there too much “jam tomorrow” and not enough “jam today”. With interest rates rising, the question is particularly pertinent today as the market is attaching lower value to further away cash flows.
I disagree with the premise of this question somewhat. Each of the top five companies in our portfolio is solidly profitable today, in fact obscenely so. In the case of at least two (Credit Acceptance and Meta), they are also on low multiples of near-term earnings. Nevertheless, I do accept that most of the more recent investments (Carvana, Slack, Salesforce) have been of the “jam tomorrow” variety, whereby Salesforce is profitable, and Slack is no longer in the portfolio.
What helped me think through the “jam today/jam tomorrow” conundrum was Jacob McDonough’s excellent book on Berkshire Hathaway, called: “ Capital Allocation : The Financials of a New England Textile Mill 1955 – 1985”. In it, McDonough describes some of Warren Buffett’s earliest investments at Berkshire Hathaway.
What struck me was how laser-focused the early Buffett was on purchasing cash - either directly by buying companies with excess cash or easily sellable assets on its balance sheet (e.g., Berkshire Hathaway or Blue Chip Stamps) or indirectly through buying companies which were highly cash-generative (e.g., Pinkerton’s). A recurring pattern was that if a company’s share price fell, he would keep buying until he controlled its cash and could then buy other undervalued stocks with it. If the share price rose or the company was taken over, he would recycle the cash into other undervalued securities. Whether the share price rose or fell, he came ahead – “Heads I win, tails you lose.” With this approach, it is easy to imagine Buffett enjoying declining share prices.
What does this mean for RV Capital? On the one hand, I can see the attraction of strongly cash-producing assets in an environment such as today. It is much easier to pass Buffett’s test of “enjoying the downturn” with companies such as Credit Acceptance or Prosus that are buying back huge quantities of their own stock. On the other hand, companies with assets that can be readily liquidated, or high upfront cash flows tend not to have a whole lot of reinvestment opportunities. I know from experience that the truly great investments are in companies that can grow by reinvesting their cash flow as companies like Ryman Healthcare, AddLife or Wix are doing, for example.
It strikes me that a portfolio needs to strike the right balance between the two. I acknowledge that I likely over-indexed towards “jam tomorrow” in recent years when the market viewed this type of opportunity favourably. I do not want to repeat the error now by over-indexing towards “jam today” opportunities now they are in favour.
What is the Impact of Inflation?
The dramatic increase in inflation, how high it will go and whether it is here to stay are concerns for many of you. Like most value investors, I am reluctant to forecast where inflation shakes out at, though it seems certain to remain elevated in the short term. My reluctance is not because I think the rate of inflation is unimportant. It is because I think neither I, nor anyone else, can predict it.
I must confess that this scepticism did not prevent me from opining about inflation in the past. In my 2010 letter , I voiced the concern that the huge amount of money created during and after the financial crisis would lead to runaway inflation. What ensued was a decade where the world teetered on the edge of deflation. Perhaps now, you believe me when I say, “I simply do not know”.
What fascinates me as an observer of the global economy is that the current spurt of inflation had little to do with money printing and everything to do with the shortages of all kinds of goods and services resulting from the Covid-19 lockdowns. Once supply chains normalise, this gives me some optimism that the balance between supply and demand will be restored, and inflation will subside. On the other hand, by then we could be stuck in an endless cycle of one supplier raising prices in response to another’s price increases. Like I say, I do not know.
Despite my ignorance, inflation is not a topic I lose a lot of sleep over. My approach to investing in an inflationary environment is derived from Buffett. He argues that the best companies to own in an inflationary environment are ones that have plenty of pricing power and are capital-light. The attractions of pricing power are self-explanatory. The capital-light bit requires perhaps a quick explanation. The idea is that an asset-heavy company’s depreciation charge will understate the cost of replacing an asset as it is recorded at its historical build cost. As a result, the company is taxed on profits that are artificially high, leaving equity holders empty-handed.
On both of Buffett’s criteria, I see our portfolio as well-positioned. Take Wix. It is difficult to imagine a company that is better positioned to navigate an inflationary environment. A website costs as little as $10 per month to run but is essential for nearly any business. No entrepreneur will shut down their website or go through the hassle of switching providers just to save a few dollars per month. In fact, Wix recently announced that it raised prices by 20% (after foregoing price increases during Covid) and has seen little impact on churn.
The tech sector is very much out of favour today, but it strikes me as one of the best places to park your cash if inflation is your biggest concern.
Are We Over-Exposed to “Tech”?
Many of you have questioned our large exposure to the tech sector given the steep decline in the share prices of tech stocks this year.
Here too, I disagree somewhat with the premise of the question. Whilst we for sure have a large exposure to the tech sector, approximately half of the portfolio is in non-tech stocks including Credit Acceptance, Ryman Healthcare, AddLife, TFF Group, and Grenke. Furthermore, I see companies like Meta and Salesforce as a different kettle of fish to the classic hyper-growth, hyper-loss-making midcap tech stock.
I am also somewhat sceptical whether the term “tech” today means the same as it did a decade ago. Companies like Amazon and Netflix are retailers and media companies first and tech companies second. If “tech” is defined as the modern incarnation of old industries, then frankly, I would insist on 100% exposure.
Today, the tech sector is very much out-of-favour - how times change! Many sceptics draw parallels to the bursting of the tech bubble in the early 2000s. As a telecoms analyst in the late 1990s, I had a front-row seat when the bubble burst and am sceptical of the analogy. Most of the first generation of internet companies did not have functioning business models (eBay was the main exception) and quickly fell by the wayside when funding dried up. Most of the businesses I see today, by contrast, have perfectly legitimate business models.
So, what is happening? In my view, the pandemic caused many tech companies to throw cost discipline out the window as Covid-19 drove a tectonic shift in consumers’ and businesses’ behaviour, and the opportunities seemed unlimited. This has left many companies with bloated cost structures. I see this in some of our investments, in particular Wix and Carvana, but no company seems immune. Even Amazon announced that it had overinvested in its logistics network.
What has made matters worse was what turned out to be a pull-forward in demand during the pandemic. As a result, most tech companies are seeing a marked slowdown in growth just when costs are spiralling, leading to high losses in many cases. Understandably, sceptics question who on earth would want to own companies that are ex-growth and haemorrhaging cash.
What the sceptics miss is that the passage of time will fix both these problems. Companies as a group, not just tech companies, are nothing if not adaptable and will adjust their cost bases to the new reality. I see this in every company I follow. Furthermore, at some point, the pull-forward in demand will work its way through the system and growth will revert to trend. The market’s perception of these companies – when they can show growing revenues and improving margins – will likely be very different to how it is today.
The important thing is to have sufficient balance sheet strength and profitability to weather the current storm and come out on the other side stronger. I am happy to report all our investments have this with the possible exception of Carvana, which I will discuss later in this letter.
What About the War in Ukraine?
The war in Ukraine is first and foremost a human tragedy. In the days after the Russian invasion of Ukraine, I found myself in a state of shock, glued to the live news broadcasts, watching events unfold in disbelief. Images of tanks rolling across borders in Europe were something that I thought were only to be found in history books. The war felt and feels like an anachronistic way for nation states to resolve their differences.
The range of outcomes of the war is wide. In a best-case scenario, the war peters out as each side fights the other into exhaustion. In a worst-case scenario, NATO states are drawn into direct conflict with Russia, and it escalates into a nuclear war. The latter would make any investment considerations moot.
From a geopolitical perspective, what I find fascinating is the way the conflict confirms the new global balance of power. For most of the last hundred years, the course of history has been determined by two and a half superpowers – the US, Russia/USSR, and China (the half). Each bloc played one off against the other to improve its own relative position. China, as a fellow communist State, was closely aligned to Russia until the early 70s when it realised its relationship with Russia had reached a dead-end. It was only then that it sought a closer relationship with the West, which culminated in it re-joining the global economy after the Nixon Mao summit in 1972.
What has changed is that today, there are only two superpowers – the US and China. Such a tectonic shift happens perhaps just once a century. Barring radical regime change in Moscow, Russia is likely to be closed off from the Western economy for at least a generation. This leaves China as the only game left in town for Russia and relegates Russia to little more than a vassal state. The clear winner is China. It will gain privileged access to Russia’s raw materials and will be the sole source for essential manufactures such as high-end electronics – almost becoming a monopolist and a monopsonist vis-à-vis Russia. From a geopolitical standpoint, it is a disaster for Russia and a boon for China.
Some of you have voiced concern that China will enter the Ukraine conflict by providing military support to Russia. I doubt this will happen. China already has Russia where it wants it and has little to gain by deepening the relationship further. Moreover, China will be keen not to unnecessarily antagonise the West given the importance of Western export markets to its economy.
At a high level, I doubt very much that China was informed of Putin’s intention to invade Ukraine or that it would have approved the invasion had it been. Sovereignty is a core value in China given that its borders were constantly encroached upon over the centuries, the motivating factor behind the country’s most famous landmark: The Great Wall of China.
Is China Investable?
The war in Ukraine led many Western investors to pose the question afresh whether China is investable. This question was top-of-mind last summer in the context of the regulatory crackdown on tech companies in China. I discussed this at length in my H1 2021 letter and argued that, with the exception of the education companies, the purpose of new regulations was to reinforce the market economy, not dismantle it, as many feared at the time. By and large, I think this letter has aged well, and investors’ focus has moved on to other topics.
Today, the primary concern seems to be that China, deriving inspiration from Russia’s invasion of Ukraine, will attack Taiwan. I find this highly unlikely but not impossible.
Highly unlikely because it is difficult to imagine a worse point in time for China to invade Taiwan. The CCP derives its legitimacy from and hence is focused on the economic development of China. With China still dependent on Western semiconductors and know-how, global supply chains in disarray, the West likely heading into recession, and China suffering from the economic impact of zero Covid, it is difficult to imagine less propitious timing.
Not impossible as whilst China likely has no appetite to revisit the question of Taiwan’s status today, the West apparently does. The most recent manifestation of this trend is Nancy Pelosi’s visit to Taiwan. Why this was so provocative requires some historical context.
Peace has been maintained for half a century across the Taiwan Strait through the formula agreed upon between Mao and Nixon and captured in the so-called “three communiques”. In them, China affirmed its conviction in the ultimate unification with Taiwan, and the US affirmed its view of the importance of a peaceful settlement. Given the obvious ambiguities, this is an imperfect compromise but vastly superior to all the alternatives. It paved the way for over a billion Chinese to exit poverty and has maintained peace across the strait. By visiting Taiwan, Pelosi seems intent on unpicking this compromise. This strikes me as an act of diplomatic vandalism.
Henry Kissinger explains why in his book “On China“:
Quiescence on Taiwan could be maintained only so long as none of the parties challenged the three communiques. For they contained so many ambiguities that an effort by any party to alter the structure or to impose its interpretation of the clauses would upend the entire framework.
Issues of sovereignty are a hot button for any country – my birth country went to war over a strategically unimportant rock in the Pacific in the 1980s – so Pelosi’s visit will no doubt illicit a strong response from China, which may trigger a still stronger response from the US. It is easy to see how this tit-for-tat could spiral into a full-blown confrontation.
My hope and expectation is that cool heads prevail. Neither side can afford the type of confrontation with each other that the West currently has with Russia. The costs would be unfathomable, not just to companies with direct exposure to China but to all companies.
Part 4: How Are Our Companies Faring?
At the start of the year, the five largest companies in the fund were Credit Acceptance, Prosus, Meta Platforms, Salesforce, and AddLife. In addition, Carvana became a larger position in the earlier part of the year though is smaller today, regrettably, due to the sharp fall in its share price. I will restrict my discussion to these companies to permit a more detailed discussion of each investment. In aggregate, they accounted for 73% of the fund’s assets on 30 December 2021, so they account for most of the price development.
Credit Acceptance
Our largest position both at the start of the year and today is Credit Acceptance, a lender to subprime borrowers to purchase a used car. I explained our reasons for investing in Credit Acceptance in my 2014 letter . I was very optimistic about the investment then – naturally, otherwise why else invest – but the investment has surpassed my high expectations. From 2014 through 2021, adjusted earnings per share grew by 21.4%, 19.6%, 15.7%, 38.9%, 22.2%, 10.3%, and 34.2% respectively. This is the stuff that investing dreams are made of – each year varied from good to fantastic.
Great though the company’s operational performance was, what supercharged growth in earnings per share was the company's willingness to repurchase its own shares. At the time we invested, the company had 20.6 m shares outstanding. As of 25 July this year, that number stands at 12.9 m. This means that not only has the company greatly increased its earnings power, but our share of those earnings has increased by 60% over the holding period.
If you think the investment has been plain sailing though, you would be mistaken. I have lost count of the number of times, the share price fell by 10%, 20%, or more in a single day based on some piece of news or other that supposedly impaired the company’s value. It is a wonderful illustration of Ben Graham’s dictum that in the short run the market is a voting machine and in the long run, it is a weighing machine.
With the used car market in disarray and a recession potentially on the horizon (when is a recession ever not potentially on a horizon?), the share price development this year reflects the market’s concerns about what the immediate future holds. I am not concerned on either count.
The recent surge in used car prices has been great for loan performance at Credit Acceptance but priced its core sub-prime customer out of the market. As a result, Credit Acceptance has seen declining unit volumes (though the trend shifted in the most recent quarter). A normalisation in the used car market would be a tailwind in this regard. No doubt, it would be accompanied by headlines about how terrible the decline in used car prices would be for loan performance, but, in reality, the proceeds from repossessed cars are a relatively minor source of cash flow for the company. All the company’s energy goes into “keeping the customer in the car” – a refrain I repeatedly heard whenever I visited the company’s collections centre.
A recession would be a short-term negative for loan performance as employment levels closely correlate with collections. However, historically Credit Acceptance has made the greatest strides in earnings performance when other lenders are forced to scale back lending. Credit Acceptance is the company with the strongest balance sheet and the highest margins. As a result, should other lenders be forced to scale back lending in a more hostile economic environment, it should be able to lean in. The headlines may be ugly, but if history is anything to go by, Credit Acceptance will do fine. Moreover, you can be sure the company will use any share price declines to lower the share count further.
Credit Acceptance is, for sure, a company that passes the Buffett test - you can enjoy it when the share price falls.
Prosus
Prosus was our second largest position at the start of the year and still is today. I initiated the position in 2020 and described the investment hypothesis in my H1 2020 letter . Prosus is a Dutch internet holding company, whose main investment is a 29% stake in Tencent, China’s largest consumer internet company.
The Prosus investment rested on two legs. First and foremost, I viewed it as a proxy for Tencent, a company I admire enormously. Second, I viewed the size of the discount of Prosus’ sum-of-the-parts value (the main component of which is its stake in Tencent) to its market value as irrational. This was the reason for investing in Prosus rather than in Tencent directly.
As of today, the performance of the Tencent leg of the investment has been mixed. On the one hand, the operational development has been less positive than I expected at the onset. At the time of the investment, I expected the company to grow at 19% p.a. through 2025. Whilst in 2020, it grew by 28%, the rate slowed to 16% in 2021. In 2022, it looks like revenue growth will disappear altogether whereby the situation is somewhat extraordinary given the loss of key advertising verticals such as education, the suspension of gaming approvals, and the economic consequences of China’s zero Covid policy. Assuming some normalisation in 2023, I expect a strong rebound in growth. It will be interesting to see then where growth shakes out at.
On the other hand, Tencent’s investment portfolio, which is a vital part of its overall value, has done well. Including the value of its stake in JD that it recently spun off to investors, the value of the portfolio increased over our holding period despite a prolonged bear market in China (which predates the one in the West). Moreover, I have gained a greater appreciation of both the extent of this portfolio – Tencent has 100s of private holdings in addition to the listed ones – and just how advantaged a capital allocator Tencent is. Much is made of the “franchise value” of the most storied VC brands on Sand Hill Road given their ability to influence the outcome of their investments by giving their seal of approval. By this measure, Tencent has outsized franchise value. It can help its investees in numerous ways, not least by providing privileged access to Weixin, China’s “remote control” for the Internet.
A further additional positive surprise is that Tencent has started to realise the value in this portfolio and share the proceeds with investors – it recently spun off its stake in JD. I am convinced that over time value in Tencent’s investment portfolio will exceed its entire market capitalisation today. This de-risks the overall investment significantly. It is not every day that you get one of the world’s most valuable internet franchises potentially “for free”.
The discount part of the investment hypothesis has developed better than I expected. This may seem like an odd thing to write as the discount is likely wider today than when the investment was initiated. My reasoning is that Prosus recently announced that it plans to indefinitely repurchase up to 25% of the daily volume of its shares traded (the maximum allowed), financing the repurchases with the concurrent sale of Tencent shares (equal to roughly 4% of Tencent’s daily volumes). At today’s share prices (which imply a discount of roughly 40%), Prosus will be able to repurchase 13% of its shares p.a. In addition to the 10% of shares it bought back last year, the company will have repurchased almost one-quarter of its shares outstanding by the end of this year by which time we will have owned the company for two and a half years.
This too is a company where you can smile when the share price declines.
Meta Platforms
Meta Platforms, until recently known as Facebook, is the single most frustrating investment I have ever made. Since the initial investment in 2016 , the company has been dogged by a near-constant drumbeat of negative news flow. Despite the doomsday prophecies though, the financial development has been excellent. At the time of our investment, I expected the company to earn an EPS of $4.20. In the most recent year, it earned $13.77, whereby earnings will likely dip temporarily in 2022. Taking a contrarian position in a company that subsequently has a great financial development is normally a recipe for investment success. In the case of Meta, however, the share price has only modestly gained versus our initial investment. Plenty of pain, no gain.
This begs the question as to whether I missed something. For much of the holding period, I would answer “no”. Facebook’s critics see it as being at least in some part responsible for most of what is wrong with the world. Brexit, the election of Trump, and mass shootings were generally accompanied by accusations of the nefarious role played by Facebook.
I strongly disagree – obviously, otherwise, I would for sure not have invested in the company. As an aside, even if you violently disagree with me on this point, I recommend keeping an open mind that something other than Facebook may be responsible for these aberrations, as if – just if – they are not Facebook’s fault, the terrifying implication is that the actual culprits are getting off scot-free.
In my view, what the critics miss is that allowing the free flow of information has both upsides and downsides. Like everything in life, there are trade-offs, but in the case of the internet in general and Facebook in particular, the upsides far outweigh the downsides. The overwhelming majority of exchanges on Facebook are hugely value-creative for all parties. Families and friends connect; small businesses find customers.
Of course, we would all like more of the “good stuff” and less of the “bad stuff”, but apart from the instances of the clearly illegal, it is far from trivial to draw the line between the “good” and the “bad”. For example, two thoughtful people might reasonably disagree over whether the democratically elected President of the USA should be de-platformed. Moreover, who should determine what is “good” and “bad” given the enormous potential unintended consequences? With some justification, Mark Zuckerberg does not think it should be him. Most people would agree. Politicians though are reluctant to take on the responsibility themselves as inevitably the losers of these judgement calls are more vociferous than the winners. It is a no-win proposition, and politicians calculate that it is better to be on the sidelines hurling brickbats than in the direct line of fire.
These are not easy questions to answer. Multiply them by billions of users interacting with each other multiple times per day and the magnitude of the challenge becomes clear. Under the circumstances, I think Mark Zuckerberg has done a great job. I admire him. If you disagree, remember there is an alternative universe in which Myspace became the dominant social network, a part of the same media empire as Fox News. The status quo should be judged against the likely alternatives, not some theoretical utopia.
Meta’s share price development in the first half reflects the market’s concern on three new challenges Meta faces: the spiralling costs from its development of virtual reality headsets, Apple’s unilateral decision to kneecap digital advertising (otherwise known as “ATT” which stands for “App Tracking Transparency”), and the inexorable rise of the short video app TikTok.
Of the three, I am least concerned about Meta’s spending on or - depending on your viewpoint - investment in headsets. It may yet turn out to be value creative. If it does not, I have no doubt that Mark Zuckerberg, as a rational owner, will pull the plug.
I am more concerned about the changes Apple has made to the digital advertising ecosystem. For the uninitiated, the principal change has been to prevent companies like Meta from collecting data on whether ads convert to a sale or other desirable outcome when the conversion takes place on a 3rd party app or website. This negatively impacts companies like Meta as it deprecates their ability to calculate the ROI on existing ad campaigns and improve targeting on future ad campaigns. It is a clear negative – Meta calculates the annual loss of revenue resulting from the changes to be around $10bn. However, it is far from a mortal blow. Meta remains hugely profitable.
Moreover, I am optimistic that the implementation of ATT will improve over time. ATT is unfair - it disproportionately affects smaller businesses that are dependent on targeted ads to find customers. It is misguided – whilst many people are concerned about privacy online, conversion data is likely not what they have in mind. And it is arbitrary. Google, which perhaps not uncoincidentally pays Apple billions of dollars every year, continues to receive conversion data on its search ads. The optimist in me believes that betting against something that makes no sense pays off over an investing lifetime if not in every instance.
My largest concern is TikTok, ByteDance’s Western version of its similarly successful Chinese app, Douyin. Short video is an insanely addictive format. As a close follower of the Chinese Internet, I saw how it took engagement away from Tencent’s Weixin and was under no illusions what the impact would be in the West.
Despite this, I did not sell Meta. There was already a lot of bad news priced into Meta’s stock. A year ago, the market’s biggest concern was the risk that Meta would be broken up due to a monopoly in social networking, a risk TikTok presumably renders moot. It seems unfair that Meta first got hammered for being a monopolist, then got hammered for having a competitor. Furthermore, TikTok already seems to be ubiquitous in its target demographic. This would imply the risk has largely already played out and seems manageable. Finally, I expected a more robust response from Meta than from Tencent. Tencent’s focus has always been on the super app element of Weixin vs. the social elements per se. This too has largely played out as I expected with growing evidence that Facebook’s and Instagram’s reels products are a source of incremental revenue growth.
Have I enjoyed the decline in Meta’s share price? “Frankly, no.” The loss in earnings power through ATT is real and the full impact of TikTok is not yet clear. However, I am optimistic that it can work its way through these challenges, and they seem more than priced into its share price. Meta also has the firepower to buy back its stock in huge quantities should it choose to do so. Perhaps in a year’s time, the answer will be “yes”.
Salesforce
Salesforce is a recent investment which I wrote about in my H1 2021 letter . As of today, the investment, if not the share price, has worked out as hoped. Given the utility-like nature of its business, it is the kind of investment I thought would do well in a market panic, but alas it was not to be.
The investment thesis rested on three legs: an enormous moat based on the ubiquity of its software in most of the world’s largest companies, robust growth driven by the growing need for digitisation as well as the huge potential of Slack, and steady progress towards a mature operating margin of 40%.
The company has performed well against all three measures. I do not see any obvious threat to its moat. Judged by the growing number of “multi-cloud” deals it has announced, it seems to be deepening its relationships with its customers rather than vice versa. Growth has tracked higher than the 18% p.a. I assumed at the time of our investment. Moreover, I continue to be optimistic about Slack. Revenue growth has accelerated since its acquisition by Salesforce, and it is yet to see the full benefit of becoming the main way that customers access Salesforce’s suite of applications. Finally, the company has made steady, if not spectacular, progress in improving its margins.
There is one aspect of my investment hypothesis that I feel less comfortable about today: the long-run operating margin. I wrote then that at maturity, the company would have a 40% operating margin. It was an assumption I made too lightly, likely influenced by the optimistic Zeitgeist of the time. To be clear, I still think the company has the potential to achieve this margin, and on an underlying basis, it may already do so. However, my thinking was that when growth at some point inevitably tapered off, so too would growth costs, and the margin would drift higher. I do not expect growth to decelerate in the short term unless there is a deep recession, but were it to happen, my best guess today is that initially, costs would continue to go up. In other words, a slowdown in growth would more likely lead to a falling rather than a rising margin. I could of course be wrong, and, as I have written elsewhere in this letter, companies are nothing if not adaptable. If Salesforce can earn that type of margin and wants to be valued as such, then at some point it would have to show it. I have no doubt it would, but it would likely require a period of painful adjustment to get there. Whether Marc Benioff would be the best person to lead the company through such an adjustment is also an open question.
Have I enjoyed the share price decline? “No.” However, I remain optimistic about the business and at the current share price, things should work out well even at a far lower end-state margin.
AddLife
The investment in AddLife has worked out far better than I could have ever imagined. We invested in 2017 , one year after it began its existence as an independently listed company. Despite its apparent youth, AddLife heralds from a long tradition of wonderful Swedish companies. AddLife was a spin-off from Addtech which was a spin-off from Bergman & Beving, a company that traced its roots back to 1906. As a group, the companies have been successful for over a century by efficiently running value-added distribution businesses and using the proceeds to grow by acquiring other businesses. I got to know Addtech particularly well and admired it enormously. I decided to invest in AddLife though as it was at an earlier stage of its lifecycle. I saw an opportunity to buy an Addtech before it became the Addtech.
As already indicated, this played out better than I could have hoped. At the time of our investment, the company earned an EBITA of SEK 234 m. On the most recent 12-month rolling basis, this has risen to SEK 1’290 m. After a slowish start as a listed company, it really hit its stride with acquisitions in late 2018 when it purchased Biomedica, a large company that took it outside Scandinavia for the first time. Many acquisitions have followed since.
What supercharged growth was Covid-19 as AddLife has a large business selling diagnostic equipment and the tests that run on it. This provided the company with windfall profits. I would like to emphasise this element of the story, lest you were starting to worry that I am lacking in that most vital quality in an investment manager – good fortune. The company has largely redeployed this windfall into acquisitions which should help it to maintain its earnings power after the windfall profits from Covid-19 dissipate – as we all hope!
Have I enjoyed the decline in the share price? “Not really.” The company can reinvest all its excess cash flow in acquisitions, so it is unlikely to benefit from a falling share price by buying back stock. In fact, to the extent it loses its own shares as a viable currency to purchase other companies, the price decline is a modest negative. Despite this, I remain an enthusiastic owner of the business. It is one of the few companies I can think of that did not increase costs in response to the Covid windfall. All the excess revenue went straight through to the bottom line. As Covid-related revenue falls off, there may be a hiatus before the earnings from its newer businesses kick in. However, the company looks perfectly positioned to continue to follow a playbook that has been proven out for over a century.
Carvana
I wrote about Carvana as recently as my 2021 letter . In the short period of time since, the stock has lost much of its value. It has been a traumatic experience, so to skip straight to the punchline, no I have not enjoyed the decline in the share price.
Oddly enough given all that has happened, there is not much I would change in my 2021 letter. There was, however, one enormous mistake on my part which I would like to be completely clear about. I underestimated the financial leverage of the company. I hate debt and seek to avoid it at the companies I invest in. At companies, where debt is an unavoidable part of the business, I try to make sure that it is low both in absolute terms and relative to peers. And yet, an impartial observer looking at the financial situation of Carvana today might reasonably conclude that it will run out of money. This is not the way that I seek to invest – period.
In my defence, the company was not overly indebted at the time we invested. The debt came about through a series of coincidences – some under the company’s control, others not. The company over-hired towards the end of 2021, like many companies, in anticipation of strong growth in 2022. This growth did not materialise due to a combination of the re-emergence of Covid-19, winter storms, and unprecedented inflation in the price of used cars. The upshot was spiralling losses and growing debt. In addition, a long-planned acquisition came to fruition at the worst possible time from a financing perspective. It bought Adesa’s physical used car auction business. Whilst the acquisition makes a lot of sense in my view given Adessa’s valuable real estate footprint, and Carvana likely had little choice but to complete the deal then or lose it forever, it greatly increased the indebtedness from already elevated levels given the spiralling operating losses.
So much for dealing with the past, what is the situation going forward? The financial situation aside, I remain as optimistic as ever about the size of Carvana’s market opportunity. The way used cars are traditionally sold is flawed and Carvana’s approach is better from a customer perspective from every conceivable standpoint. Furthermore, the chances of another company replicating Carvana’s business model seem more remote today than ever given the pessimism about the business model. I also remain convinced by both the talent and the good intentions of Carvana’s CEO and founder, Ernie Garcia. As Carvana’s woes deepened, I read much negative commentary about Ernie. I firmly disagree with it and would do even if the company were to announce its bankruptcy tomorrow. He strikes me as a decent person who is completely dedicated to the company he founded. If Carvana fails, it will not be due to duplicity or want of trying on his part.
The elephant in the room is, of course, the current financial situation. I am confident that the company will make it through its current travails. It has $4.7bn of cash potentially available, which should comfortably see it through to cash flow breakeven – hopefully sometime next year. Most importantly, it has talented and engaged leaders as well as employees that continue to root for the company from everything I hear. If you extrapolate Carvana’s current losses indefinitely into the future, of course it will run out of money, but companies, to repeat myself, are adaptive, and all the evidence is that Carvana is adapting. I cannot be certain of a good outcome – Carvana is dependent on capital markets and in a Lehman Brothers scenario, it would not be first in line for financing and may well be last. However, at the current share price, it strikes me that there is an enormous asymmetry between the best and worst-case scenarios. I should not have dealt myself this hand, but now I have it, I quite like it.
RV Capital’s 2023 Annual Gathering
RV Capital’s 2023 annual gathering will take place on the weekend of the 14th and 15th January 2023. I am delighted to announce that we will be joined by Ryman Healthcare. Ryman is the most purpose-driven company I have ever come across and is the embodiment of the type of company I love to associate myself with. I am sure you will enjoy meeting some of the key people in person.
I will open registration much nearer to the event, most likely November or even December. Nobody knows what the Covid situation will be in the autumn, and I am keen to avoid the on/off situation we had this year. As a reminder, investors in the fund have a guaranteed spot so there is no need to wait to register if you would like to plan your travel. For non-investors, I would ask you to hold off for now as typically there is more demand for spaces than supply, so I cannot guarantee a spot.
I very much look forward to seeing everyone then. In the meantime, happy investing and stay healthy!
