Signs of trouble?

The pace of my output has slowed considerably in recent months. This is partly just a case of losing a bit of momentum as work and life events get in the way and partly because the Covid-related disruption has changed my routine. I haven’t had my two hours of commuting each day to spend jotting down my investing thoughts and haven’t yet found the discipline to consistently set aside other time. That said I’ve got quite a few half-baked blog posts on the go and hope to be able to share them soon. Anyway, here’s a brief update on my latest thoughts on what’s happening in the markets and my latest trades…

The last few weeks have seen a rise in volatility, particularly for US technology stocks, with an almost parabolic move up followed by a sharp decline over the last week. This is naturally leading some to question whether we are about to witness the bursting of a huge stock market bubble. Many of the US traders I follow to get a sense of market direction have become bearish. Tesla, the poster-child for this possible bubble, has seen its share price rise almost 10 times over the past year before falling a bit over the past few weeks. And Tesla really does look like it’s in a bubble, with a valuation that seems mind-bogglingly excessive, especially given it’s really a car manufacturer.

From what I can gather from a bit of reading around, several people are pointing the finger at a huge surge in retail options trading as being the immediate cause of the recent volatility (see this article from the FT for example). Collective buying of short term call options by retail traders has a leveraged effect on demand for the underlying shares, as institutions are forced to hedge their positions. This seems to be consistent with the parabolic rises then sharp fall we’ve been seeing in certain stocks like Tesla and the fact that the phenomenon seems confined to the US, where I believe regulation on retail derivatives trading is a bit more lax.

This kind of narrative does set off alarm bells. It definitely sounds like the sort of thing that happens at the height of a bubble. However, I’m not convinced that is what we are seeing in general, as most valuations don’t actually seem that expensive (other than Tesla and a few others). For example, the big five tech giants, with the exception of the still rapidly-growing Amazon, are all on forward PE ratios of around 30. This actually seems pretty cheap to me, given the quality of these businesses. It’s also quite reassuring that other international markets haven’t been much affected. If you just invest in the UK you might well not even have noticed.

So I’m not overly concerned by this. My medium term concern is that we get inflation as the economy starts to recover and that this brings about tighter monetary policy. The challenge is that I don’t really have much idea of how long it will take and to what extent the market will anticipate it. However, I think this is still some way off.

I’ve made three trades since my last post a month ago. Four weeks ago I sold out of Somero for a small profit. This appears to have been a mistake as, after falling by 10%, Somero has rebounded over 20% on some better-than-expected results this week. Somero still looks cheap and is trading better than I feared it might, so I’d be happy to buy it back again in one of my next trades. It’s important not to be put off re-buying a share sold in error, yet many investors seem to find this difficult. Perhaps pride gets in the way? I don’t really find this a problem but I think it’s a question of mindset. I see investing as probabilistic and mistakes inevitable. All you can really do is try to systematically put the odds in your favour. On the other hand, if you too attached to the desire to be correct, I can see why it might be hard to revisit the scene of a prior mistake mistake and regain the conviction to re-buy something sold in error.

I replaced Somero with Broadridge Financial Services, a company I’ve held and written about previously. Broadridge is a relatively safe option, trading solidly and not especially highly valued. The share price is near its all time highs, having bounced around for the last couple of years after some minor set-backs.

Two weeks ago I swapped Adyen for Etsy. Both are highly related online platform businesses that are growing very rapidly, though recent Covid-affected results have favoured Etsy’s online marketplace over Adyen’s payment platform for large multinational retailers. This week I was forced to sell Microsoft again and swapped it for Pinterest.

[if you want more up-to-date information on my trades, please keep an eye on my watchlist spreadsheet where my current portfolio is highlighted in yellow]

Etsy

You’ve probably heard of Etsy. It is a US online marketplace for independent artists and designers to sell handmade artisan products. It’s monetised with both listing fees and commissions charges to sellers. I’ve used it a few times, mostly to find presents for my better half. It’s currently worth about £10bn and has very recently entered the S&P500.

Quality

  • Business economics: Etsy is the kind of business that should be very profitable once it reaches sufficient scale. It has only reached profitability fairly recently but margins and returns on capital are improving rapidly and already starting to look decent.
  • Track record: Etsy was founded in 2005. It has experienced solid growth in revenues over the last few years and reached profitability in 2017. Growth looked to be slowing since then but has exploded again in 2020, in part thanks to the Coronavirus.
  • Competitive advantage: Etsy looks to have a very strong competitive advantage. It is a two-sided transaction platform that should benefit from indirect network effects, as buyers care about being able to access sellers and vice versa. This creates scale advantages that make it difficult for smaller rivals to compete. There are also scale advantages from the cost structure and the iterative use of data to improve the user experience eg the search functionality. Longer term Etsy does face more dynamic competition to attract users from the likes of Amazon, eBay and Facebook. This does pose some risk and means there is some need to keep innovating to improve the user experience but overall Etsy looks sufficiently well-differentiated to resist this with a clear brand in a decent niche.
  • Growth prospects: Ecommerce as a whole obviously has great long term growth prospects, with the secular shift online being boosted this year by a tailwind from Coronavirus. Etsy’s growth this year has gone through the roof and I’m hoping the network effect dynamic should reinforce this in coming years as buyers trying platform for first time will use it more. There is also plenty of scope for Etsy to expand geographically beyond its core markets.

Price

Etsy’s last results were excellent with revenues up well over 100% as buyers have flocked to the platform during lockdowns. Share price momentum has been great – it has tripled from the lows this year following the March crash, but has fallen back a bit over the last few weeks. Given the pace of growth, the valuation still seems pretty reasonable to me. This pace will surely slow down from this year’s spurt but I reckon there is still a long way to go.

Pinterest

Pinterest is a US social media platform that describes itself as a ‘visual discovery engine’, where users can create and manage theme-based image collections. It allows users to search for and share images with similar theme and is integrated with image recognition technology that can bring up related images to photos taken by smartphone. This makes it a sort of hybrid between a social media platform and image-based search engine. It’s not a platform I’ve used myself, but my wife does occasionally, most recently in helping source decorations for our wedding last year. It’s monetised with digital advertising that can be targeted both in response to specific searches and targeting specific audiences. It’s currently worth around £16bn

Quality

  • Business economics: Pinterest should turn out to be a highly profitable business but a bit of faith is required as at the moment it is only just reaching the inflection point where it becomes profitable. At least it looks financially robust with plenty of cash on the balance sheet.
  • Track record: there’s not much of a track record. Pinterest was only founded 10 years ago and only floated about a year ago. It started monetising about 5 years ago and its revenues have grown rapidly since.
  • Competitive advantage: like Etsy this is another two-sided platform. However, rather than online marketplace, Pinterest is an ad-funded social network. The key competition happens on the user side of the market and the advertisers then pay to access the user attention that this generates. Pinterest seems well placed on the user side with a well-differentiated proposition that should benefit from network effects. Pinterest’s target market is young affluent women buying relatively high value products, which provides a high value audience for the advertising side. Given the nature of Pinterest’s service the opportunities for advertising are excellent – it’s the kind of platform where users want to be advertised to rather than find it annoying. Targeting can be both audience-based for brand awareness and search-based for generating sales, which means Pinterest could be a useful one-stop shop for marketing if you have the right kind of products. From what I’ve read these advantages seem to be borne out by Pinterest ads offering a higher return on investment for its advertising than rivals.
  • Growth prospects: the business is still in fairly early stages with plenty of scope to grow its user base further internationally and it seems likely to be only really scratching the surface in monetising effectively.

Price

Pinterest’s last results were excellent with strong growth in users on its platform. Momentum is good with the share price near new highs and holding up fairly well over the recent volatility. The valuation is a bit hard to gauge given it has only just become profitable but I think is warranted given the growth prospects.

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