2022 Year-End Review
Results, top & bottom performers, reflection, plan for 2023, and themes to watch in 2023
Results
The fourth quarter of 2021 ended on December 31st, 2021.
The consolidated return for Torre Financial accounts was -2.57% for the fourth quarter and -42.29% for the full year.
The S&P 500 (SPY) returned +7.85% for the quarter and -18.18% for the year.
The Nasdaq (QQQ) returned -0.06% for the quarter and -32.58% for the year.
Returns for individual accounts will vary as each account is managed separately and tailored towards each client’s investment objectives and risk profiles.
Portfolio
Top performers
UNH is the single portfolio company with positive returns for 2022. Beyond that, it is no surprise to see other established, high quality companies as the top performers.
ADC, a triple net lease REIT, is the exception. Although a smaller company, and real estate had a difficult year, their high quality and conservative investment approach held up well.
MA and V held up well. We built these up as cornerstone positions starting around November 2021 as inflation concerns were mounting. Mastercard and Visa are entrenched, benefiting from significant network effects, and have a strong combination of growth, profitability, and efficiency.
Bottom performers
It is not surprising to see smaller, high growth companies rounding out the bottom five. These are large movements, mostly driven by multiple compression.
UPST is one exception, as the macro environment changes affected its fundamentals. I’ll dive deeper into this case below.
Regarding META, growth slowed and multiples compressed significantly. Such a large drop is rare for a large-cap company. However, META may be more in control of their future than many believe. They are applying machine learning to overcome attribution challenges, which will only distance them from the competitors on the monetization side. They’ve reacted quickly to fend off competitors, and their offerings have been gaining traction. Messaging applications are yet to be monetized. META is also very attractively priced. With an enterprise value of roughly $315 billion and FCF of $26.4 billion over the last 12 months, META has a FCF yield of roughly 8.3%.
Reflection
I’m not thrilled about our results and underperformance this last year.
This year has been challenging for investors across the board, across all asset classes.
Energy (+64%) and Utilities (+2) were the only sectors with positive results for 2022. We don’t have much exposure to these.
Some investment managers keep their portfolios close to indices, carrying similar compositions, weights, and exposure to their benchmark indices. Career risk is much too high. They would rather perform inline and keep their job, than risk having results that are too different. I don’t find that to be particularly valuable – in that case, investors would be better off investing directly in SPY or QQQ.
Notwithstanding the challenges of this year, my conviction is stronger than ever in our approach and in our portfolio companies.
Companies are the root of value creation. Companies create jobs, which spurs consumption. Real estate depends on the companies. If there are successful companies in the area, that attracts people, higher compensation, higher interest, and ultimately higher prices (i.e. San Francisco). Bonds depend on companies. Companies pay the interest rate in an attempt to create value beyond the cost of capital. The performance of equities over time have demonstrated that.
Our portfolio consists of quality companies that balance growth, profitability, and efficiency. Beyond the numbers, each company has a positive outlook with compelling future opportunities. To learn more about them, make sure to subscribe as I will be sharing updates on an ongoing basis.
That being said, there are some important learnings from 2022 that I want to share.
The value of cash flow streams ebbs and flows
Interest rates increased at the fastest pace in over 40 years. The result was multiple compression. Some may say multiples are an expression of confidence or sentiment. That may be true to an extent, but there is also a fundamental element to it.
The price or value of a stream of future cash flows will ebb and flow over time.
Capital markets are endlessly comparing yields and opportunities across the opportunity set. What is a good investment or yield is relative.
In 2021, there was no practical alternative to equities. Now, capital has value in and of itself. There is more competition. There are options.
Consider two equivalent, hypothetical options:
A safe company with a 20x P/E for 5 years (assume static revenue, expenses, earnings)
A safe bond with 5% yield for 5 years
Rising rates will have an impact on the safe company’s valuation. Consider the bond’s yield rising from 5% to 8%. With no change at all in the company’s performance, investors would only be willing to pay a P/E of 12.5 for its future cash flows. The 12x P/E is equivalent to an earnings yield of 8% – the going rate for the alternative option.
Yields coming down have the opposite effect.
This is the fundamental nature of capital markets. Rates will continue to move up and down over time. Asset prices will continue to fluctuate around those changes.
Fortunately, rates do not go up forever nor infinitely. Companies, on the other hand, have no cap to the growth or scale they can achieve.
My focus is not on optimizing for the macro (although I’ll be much more aware of it going forward).
Rather, I look for businesses that can grow their cash flow efficiently and consistently over time. If a business can continue to grow their cash flow, over time that will be reflected in the price. There will be less favorable times when they are lowly valued (like the present) – for the right businesses, these can be great buying opportunities. There will also be very opportune times when those cash flows are highly valued.
How valuable predictability is
An asset’s intrinsic value is the present value of their future cash flows. When modeling a discounted cash flow, it is common to model a fixed horizon (say 5 or 10 years), and then project a stable state for ongoing operations thereafter. This final element, the value beyond the explicit period, is known as the terminal value and it often makes up a significant portion of the valuation.
A business with stable operations (revenue, growth, margins) is more likely to be more accurately modeled, and understood, than one with significant fluctuations.
This favors companies with predictable, durable revenue. The more predictable a company is, the smoother the ride. This has, in fact, been an important element in my investment process.
Last year put the spotlight on exactly how valuable and critical that predictability is. Many high growth companies are down significantly: 50%, 60%, 70% or more. The fundamentals of more predictable, stable companies have not changed all that much. Other, more cyclical companies, such as Upstart, have seen significant deterioration.
Upstart is a lending platform. They make money every time a loan is issued. (They also service loans, which brings in recurring revenue, but is a much smaller segment).
Because their primary business is transactional, they only make money when loans are being issued. In good times, there tends to be more willingness to lend. In bad times, less so. Rising interest rates also significantly impacted the lending business. As rates are rising, there is no need to lock in today’s rates when an investor can wait a few months and lock in a higher rate.
In 2022, the lending market dried up. Capital pulled back. Loan issuance dropped significantly, especially the personal loans market where Upstart has been primarily operating.
Upstart’s revenue peaked in Q1 2022 at $310 million. For Q3 2022, Upstart reported revenue of $157 million. The trend is not great.
Looking at the broader context, Upstart’s annualized revenue is not all that bad. In 2021, Upstart generated $850 million. For 2022, Upstart expects to do $820 million.
Revenue growth shrinking dramatically in recent quarters has taken its toll on the share price. Upstart was down 91% for the year.
Upstart has been a casualty, and prior beneficiary, of the macroeconomic changes. Such drastic changes in macro policy are not the norm.
Notwithstanding the issues, I maintain a small allocation. Applying machine learning to underwriting loans makes sense. This is a better solution. Upstart has the right strategy. They are pushing for scale by partnering with financial institutions, as opposed to becoming an online bank wherein their technology would be limited to their own usage. When capital returns, Upstart will be able to scale back up just as fast. The team, their execution, and their outlook is compelling.
Cyclicality, however, has its cost; namely, uncertainty and volatility.
Predictability and forecastability, indicating a company has more control of its own destiny, is valuable.
Reading the story through the numbers
In 2022, I started doing more in-depth analysis of companies financial statements. I started manually tracking and monitoring company results, as opposed to only using prepared data sets such as from S&P Capital IQ or other providers.
Putting in the work myself has allowed me to approach it from a first principles perspective. I don’t want to just see the ratio, I want to calculate it and more deeply understand the relationships and implications. I have also started supplementing the financials with other data, and creating new ratios I find useful.
I have found this process to be very insightful. As a concrete example, consider working capital. Working capital can be a very revealing data point. A company that is able to pay their suppliers in the future, but they can sell and get paid today, is seen as being in a position of power. They have negotiated well, and are using their working capital to fund their own growth. They are likely to be bringing in more capital than their earnings might show. This story can be drawn out from the numbers, such as by having negative working capital.
The terms “net working capital” and “working capital” are often used interchangeably. The concept is also calculated in two very different ways.
Net working capital = current assets - current liabilities
Net working capital = current assets - cash and equivalents - current liabilities
Without knowing this difference, it is difficult to draw insights from prepared data such as from S&P Capital IQ. It is important to know the difference, to check how the metric is determined, to then be able to draw insights. Otherwise, one might end up with the wrong conclusions.
It is not just about specific ratios, but also better understanding broader accounting principles, how they are applied, and their impact.
GAAP accounting is very helpful in that it levels the playing field across all companies. Certain accounting policies, however, can have meaningful implications, benefitting or handicapping, particular industries or companies. As an example, most industries are able to capitalize their investments. In technology, most development is treated as an expense, hitting the income statement as it occurs, even though the output might have longstanding useful life.
Additional examples of considerations include looking through headline earnings numbers to free cash flow to assess a business’ viability, measuring the impact of SBC as dilution to the company, measuring efficiency across various metrics (ex. ROIC, but also FCF ROIC), better understanding the company’s total capital composition and the impact of goodwill on total capital for serial acquirers, and much more.
Diving deeper into accounting and financials can be very revealing. Understanding the nuances equips investors to better understand the story of growth, profitability, efficiency, and potential.
Plan for 2023 and Beyond
I am continually looking to iterate on and evolve my investment process. I will be sharing more about my process as we go. Below are some key elements I will be incorporating:
I will be tracking TF Focused Growth model allocation changes over time
I will be more diligent on any entry or exit decisions, explicitly writing down an explanation or thesis for each
I will continue to manually track financials for each portfolio and watchlist company after each earnings release
I will define a list of macro indicators and track them every quarter
Key Themes to Watch in 2023
The spotlight will remain on the Fed. Will they be able to thread the needle for soft landing? Or will they overshoot, causing more pain than necessary?
The following will be important metrics to monitor as we go through 2023.
Unemployment rate - Will the strong market persist, or will it ease up? A dramatic spike would likely imply a more significant recession.
Wage growth - If wage growth is sticky and persistent, it will make it more challenging for the Fed to bring inflation back down to the 2% target.
DXY - The USD index. As The Fed reaches the end of the rate hike cycle, the USA may be the first country to pause. Other economies are still ramping up. A weakening USD would become a tailwind.
Fed funds rate - How high we ultimately go, before flatlining, and perhaps cutting in the back half of the year.
Closing
Significant drawbacks, such as in 2022, can be uncomfortable. Investors should know it is the cost of admission. It is important to have a plan, and have conviction in that plan, to make it through these tough times.
As prices have come down, there are more and more opportunities. A few examples include:
GOOGL is trading at 9.3x EV/EBITDA, or a 10.7% yield
META is trading at a 6.9x EV/EBITDA, or a 14.5% yield
PYPL is trading at 11.9x EV/EBITDA, or a 8.4% yield
MSFT is trading at 15.6x EV/EBITDA, or a 6.4% yield
ADBE is trading at 16.2x EV/EBITDA, or a 6.2% yield
These are compelling yields alone – even more compelling when considering the probability of further growth.
Additionally, prior headwinds such as interest rates and the USD may become tailwinds going forward.
Over the long term, compounders will show their worth. They are sound companies with strong fundamentals. They are growing, generating cash efficiently, and investing in projects with attractive returns.
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Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
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