Ask A Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, Frazis Capital Partners portfolio manager Michael Frazis tells us how he picks the shares for his fund and why he ignores EBITDA and balance sheets.
The Motley Fool: What’s your fund’s philosophy?
Michael Frazis: We’re looking for companies with two main characteristics. They are explosive growth and true customer love.
All the best investment stories over the last two decades – companies like Netflix Inc (NASDAQ: NFLX), Apple Inc (NASDAQ: AAPL), early days of Amazon.com, Inc (NASDAQ: AMZN), Tesla Inc (NASDAQ: TSLA) and in Australia, Afterpay Ltd (ASX: APT) – they always had these characteristics. This really intense customer base and explosive growth.
Those two things are really important. We’re not interested in a company that we think is going to be the next big thing. We want to see companies that are truly delivering that are twice the size year-on-year, that are adding users, adding revenue per new user and adding revenues every single day.
The interesting thing about these companies is they’re some of the most heavily shorted stocks in the market. There’s a huge amount of professional scepticism.
There’s a very good reason for that and that’s basically because these companies have that rare issue of having immense demand. Most companies, the issue is sales…. These companies have such compelling product offering and such loyal fan bases that they don’t need to do that. The challenge is actually investing to meet that growth.
The problem is, if you look at their income statement, you’d just see losses. If they’re clever, they’ll manage it to zero. You really cannot use those profit metrics to measure these companies.
Actually, EBITDA was one of the original innovations here. The thing with EBITDA was that you would separate the profit of the company from the amount that they’re spending on investment… If somebody invested a bunch of money in buying a new factory, there’s no point in marking that against them – it’s a positive. You’ll find the underlying profitability.
This is basically exactly the same thing. I mean, in this case, it’s not capex. Your capex is sales and marketing, which is above the EBITDA line.
Software companies are very much like this. They have very little tangible assets, very little book value. Think about something like Xero Limited (ASX: XRO). If they add a user, that user will be paying $30 a month of very high-minded revenue, that’s growing with the size of their business indefinitely into the future.
But what is the impact on the financial statements of that customer? All you would see is the sales and marketing spends put together.
So anybody that screens on profitability will miss not just Xero, but every other fast growing software company that can invest money to get that multiplied five to 10 times.
If you look at the balance sheet, there’s no line item for customer value. So anybody who screens on value metrics is systematically going to miss every single fast-growing software company. And it’s not just those. It’s any company that can invest heavily in sales and marketing and get an exceptional return on capital.
These companies… they didn’t exist six years ago and they went from zero to 25, 50, 100, 200, 400 million revenue. Now they’re trading on many billions of dollars of equity now, but how did they do that? They did it this way.
They had a product that was so good, they could invest in marketing and double their revenues year-on-year and they did so again and again and again.
So that’s how we look at things. We want true customer love. We want explosive growth. We don’t even use these traditional metrics that other people use. It’s been extraordinarily effective. I think we’ve got 18 things that have tripled or more from when we first bought them. Got a number of 4x or 5x opportunities.
We’ve been able to systematically find these things all using the same simple framework.
Motley: Is the strategy risky? Say interest rates go up?
Michael: Of course there’s risks. We are equity investors so we’re comfortable with equity market risk. We’re long only. We don’t hedge. We don’t short. We think this year was a case in point of why you don’t do that. You can lose so much money by being short at the wrong time, or even moving to cash at the wrong time and selling out on your stocks. It’s much better to stay invested.
One of the ways we mitigate the risk is by having such an exceptionally high growth rate in our portfolio. So you’ve been seeing interest rates rising and multiples dropping 30%, 40% – but that’d be a one-off drop. As I mentioned, our companies are 30%, 40% bigger every 6 months.
Look at us now. We’re probably up 60% current year to date, net. We can weather a 20% drop.
We’ve been able to achieve that because we were long in February. We’re long in February, it looked like the world was kind of ending. Both professionals and very smart people – Magellan, Buffett – rock stars of the financial world were selling.
But we took a view that we’re just going to stay long and ride it out, and that proved correct.
We certainly made some mistakes. But every time we sold something, we bought something.
Motley: Considering your fund’s strategy, would you say your clientele is reasonably young?
Michael: I’d say we’re probably younger than most. For some people we’re the only people that invested. But there’s a lot of much older people, with self-made super, who are looking at stocks and realising their portfolios have gone sideways for three years now.
They listen to all these smart people – these well-renowned investors came out and said Afterpay was a sell, Tesla was a short, sell Netflix. And they said it loudly. Then everybody’s seeing these stocks go up 5, 10 times.
So I think a lot of people, including some much older people approaching retirement or even are in retirement, are thinking, “Wow. The professional investment community in many cases got these stocks wrong and we want to be on the right side of change and the right side of technology.”
It’s not like they’re giving us their entire wealth. It might just be a small allocation, but it’s an extremely important allocation for them, because we’ll probably be the only growth stocks they own.
Buying and selling
Motley: What do you look at closely when considering buying a stock?
Michael: Revenue growth is really important to us. Something that’s really changing the world, if it’s truly special, twice as many people should be using it today as they were last year. And if something is that good and you can prove it, there’s a good chance many more people will be using it next year as well.
We talked about not looking at EBITDA and cash flows. We look very closely at things like web traffic, Google Trends, alternative data sources – there’s many ways of finding out how the revenue is tracking or estimating how revenue’s tracking using public information. We think that is the best guide because we really want to find these special companies that people truly love.
I think with these growth companies, it’s generally best if they don’t borrow. The perfect software company should have a bed of cash and then just invest every dollar that comes in and try not to invest more.
We’re looking for that special customer thing that people absolutely love and can’t get enough of. So the ability for Elon Musk, for example, to sell hundreds of thousands of pre-orders with one presentation – that is what we’re looking for.
Tesla went from a few thousand cars a year to… I think they did 367,000 in 2019 and they’ll be on track for half a million shortly. They increased production 50 times. All the short sellers who were looking at the balance sheet and cash flow were shorting a company that increased in size by 50 times.
One thing’s for sure – they always have their customers’ love. This girl was getting up and selling cars just with the presentation. There is no marketing, as a principle. No direct marketing anyway.
Now, look what happened. There’s been an absolute dead zone for autos around the world, but Tesla has created hundreds of billions of dollars of value.
You could argue, how is Tesla worth more than all these other cars? If you want a jeep or SUV, you can buy a Jeep, you can buy a Toyota. There’s probably 20 companies in Australia that will sell you a medium-sized SUV. They’re all competing on price, features, reliable. It’s horrible.
Tesla’s got that X factor. They’re expensive cars – they’ll charge a premium. There’s a good chance that they do to autos what Apple did to the smartphone industry, where everybody else has a huge market share, but a significant share of the gross profit dollars go to Tesla.
What we want Tesla to do is then spend that. We’d want them to invest that and go from 500,000 cars into the millions.
Motley: What triggers you to sell a share?
Michael: We want a portfolio of winners. We want a very high organic growth rate, so we will sell out of things once their growth rate drops to 20 to 30%, which most people consider high, but it’s actually quite low for the kind of companies that we invest in.
I’ll give you an example where we made some changes. In April, we basically decided that we’re only going to invest on companies that were visibly accelerating in that environment. So we weren’t buying cruise ships, we weren’t buying real estate. We weren’t bottom feeding.
We were buying companies like Sea Ltd (NYSE: SE) and Mercadolibre Inc (NASDAQ: MELI) – e-commerce providers around the world. Companies that were visibly accelerating. That proved more successful than we could have hoped. Many of those companies tripled from buying them only six months ago.
The interesting thing about that is, that was the right strategy before as well. The best returns in previous years came from companies that doubled, tripled, quadrupled in size, that were winning. So our strategy is, stick to winners.
It’s a really clear exit and sell signal. If it’s not the winner, we will exit and not look back.
What’s coming up?
Motley: Where do you think the world is heading at the moment?
Michael: Global GDP is flat and it will probably grow a little bit. The more developed the country generally, the flatter GDP will be, so there’s not that much overall growth. The population is only growing very slowly. There’s not that much underlying basis for growth.
However, there are very significant sectors in the economy – notably software, e-commerce, digital health, life sciences. There are some sectors that are absolutely exploding. These sectors themselves are growing incredibly fast, but that’s not happening in a vacuum.
So we think that’s actually going to continue. Old industries are going to stagnate – more dollars will go to new industries. It’s critically important now to be invested in fast growing, well-executing companies.
We’re as negative as everybody else. There’s been genuine wealth destruction here. The six months in Melbourne that it’s been locked down, we will not get those months back. Those earnings in tax dollars and profit that businesses would have made, that income that people would have made that have lost their jobs, that’s gone. It’s not coming back. There has been genuine wealth destruction.
We actually think the outlook for the average company is probably modest to bleak. It’s not pretty.
What could be interesting is if you could see the winners actually change. If you can imagine in 1 to 2 years’ time, travel will have their best year on record. I think many people would actually agree with that statement.
You think about where those stocks are trading, you think well, maybe there is some advantage in getting ahead of the curve. We haven’t done that, but it’s the sort of thing you think about.
Overrated and underrated shares
Motley: What’s your most underrated stock at the moment?
Michael: An interesting one is Redbubble Ltd (ASX: RBL).
It’s had a pretty big run. We’ve been buying. It’s growing over 100% and I think it was trading at 2 times sales. Two to 3 times sales. I think now it’d be on the higher end of that.
You’ve got a 100% e-commerce (company) with net cash, it’s profitable and trading on 2.5 times sales. An equivalent company in the US is Etsy Inc (NASDAQ: ETSY), trading at 12 times sales.
So there’s huge scope for this company to continue to execute and also to increase materially and multiple. So I wouldn’t say it’s totally underrated because there are people buying it, that’s for sure, but that is definitely one with potential. And it’s also quite topical. It’s quite interesting.
Motley: In your investors’ newsletter today you called it “a two-sided marketplace”. What did you mean by that?
Michael: They had to attract artists to the platform, but they also had to attract the users to buy the products. It’s very hard to do that because you need to get them both buying at once. That’s why I called it the Holy Grail. It’s very difficult to do, but once you’ve got it, they’re very valuable.
Motley: What do you think is the most overrated stock at the moment?
Michael: I don’t mean overrated, but I do say one of the things we are very careful is to make sure we stick to number ones.
I’ll give you two examples – buy now, pay later and the deregulation of US gambling. There’s two green-field opportunities. Everybody’s going bananas. Everybody’s growing extremely fast.
But the end state might not be very pretty. It’ll be a huge industry, but there’ll just be a few key players and everybody else will just have to buy market share by offering incentives or being extremely competitive.
Now, it’s great. Everybody’s growing fast, but the end state is not good. So we made really good money out of Pointsbet Holdings Ltd (ASX: PBH) but we did sell out.
Also we decided we don’t want to invest in gambling because everything else we do is so wholesome.
Buy now, pay later is also interesting because everybody’s still growing. But you do wonder with the fifth buy now, pay later [company] – what’s really their long-term role? It might not be pretty for those that aren’t number one, two or three.
Motley: Which stock are you most proud of from a past purchase?
Michael: There’s a couple. I would say one I was most proud of was Carvana Co (NYSE: CVNA). We bought that at 36 bucks.
It’s now over $200, but we bought it when it was trending down and short interest in the free float was 70%. There were short reports, many short reports, and global investment banks had sales on it. So we had to go against all of that.
Pinduoduo Inc – ADR (NASDAQ: PDD) is another one. We bought it not very well, I think it was $24, $25. Then it dropped down to $18, $19, and then we bought heavily. Now it’s above $80, a year-and-a-half later.
Again, you had extensive short reports and very negative coverage from some investment banks. So in those cases we had to go when the market was moving against us. We bought, we had to go against short sellers, investment researchers, and people who actually had far better access to the company in the region that we did.
They’re the ones that are the most enjoyable.
Motley: Has COVID-19 changed or altered your investment methods at all?
Michael: Maybe it would have been about six months before COVID-19, we decided to take out all of our shorts.
Six months later, you then had the worst selloff. In England, which has the record, the worst sell-off was the South Sea bubble 300 years earlier.
To think that having taken off shorts, gone long only right before one of the most epic market crashes in history, you’d think that would be a bad thing, but it ended up being our best year.
I think that really validated our shift in strategy. You can look really stupid in the short term, but in the long term, sticking to your guns, being really steady in those moments really pays off.
So I think it will guide how we invest the rest of our lives. Everybody who experienced that will probably guide how they invest the rest of their lives.
It really reiterates those very old lessons. The old lessons of being long term – don’t panic. Be the net buyer, not a net seller when things go down.