Regime change

We’ve had a lot of important news over the last couple of weeks. Biden has been declared victorious in the US elections, though Trump is yet to concede defeat. On Monday we also had the groundbreaking news that Pfizer’s Covid vaccine is claimed to be 90% effective. These changes have resulted in a lot of stock market volatility. This hasn’t been great for my portfolio so it seems important to take stock of the situation.

The reaction to Biden’s election victory had been overwhelmingly positive, with the stock market rapidly reclaiming the losses of the previous weeks and tech stocks doing particularly well. This wasn’t particularly surprising. The market probably saw greater prospect of more expansionary stimulus and Republicans have maintained control of Senate, reducing the chance of some of the more aggressively anti-corporate Democrat policies. While the result was controversial, it may have been less controversial than feared. It seems unlikely that Trump’s legal cases will get very far as they appear to be lacking in any concrete evidence. There have been no riots in the street so far. More prosaically, it’s likely that investor fears were multiple and not clearly defined, in keeping with the classic adage, ‘the market hates uncertainty’. Since the world didn’t end, the more panicky investors that had reduced their exposure to the uncertainty decided it was now time to creep back out from behind the sofa.

The vaccine announcement had a much more dramatic impact on the stock market. Overall the stock market rose following the announcement. More significantly, there was a savage rotation towards the cheaper, cyclical businesses that have been more severely affected by the Covid restrictions, away from the mostly technology-oriented businesses that had benefited or been relatively unaffected.

The direction of this move makes sense. The news that the vaccine has 90% effectiveness is much more positive than some had speculated. The likely duration of lockdown restrictions and accompanying expansionary policies may now be shorter. However, while the impact on my portfolio has not been too severe, the extent of the reaction has surprised me. While some uncertainty has been resolved positively, a lot remains. There is still some way to go in gathering evidence on the Pfizer vaccine’s safety. There is also still considerable uncertainty about timeline for implementation and the extent to which this will contribute to the recovery of the businesses that have been affected by Covid restrictions.

The question now is whether this is the start of the long-awaited regime change from growth to value. I’ve read that in factor terms there was a rotation towards value of an unprecedented magnitude in a single day on Monday. However, this seems like a potentially misleading way of describing the shift that happened. If I look across my watchlist of 100 high quality shares there are quite a few highly rated shares that have been positively affected. The pattern seems to be of a shift from lock-down immune to lock-down sensitive rather than from value to growth, which would of course makes sense given it is the reaction to news of a vaccine. As I’ve said several times before, I think the big picture for growth vs value is driven primarily by prospects for interest rates. It’s plausible that this vaccine announcement could be the advance signal of an imminent economic recovery and less accommodating monetary policy but this seems unlikely to me. I think it’s more likely that it will soon become clear again that the macroeconomic situation is little changed and the inexorable advance of high quality tech stocks will resume. However, in the short term we may be due a bit of turbulence.

I don’t think there is much reason to change my strategy. However, given the uncertainty, I might look to increase my weighting towards cheaper recovery plays in the interest of diversification. Volatility creates opportunities as the knee jerk reactions of many investors can often be to throw the baby out with the bathwater. To this end I took advantage of some of the turbulence this week to increase my weighting in Games Workshop, which fell quite a bit despite its cracking trading update last Friday. I also decided to trade in my LSE holding for a small profit and took the opportunity to buy some shares in Tracsis. Tracsis has been negatively affected by Covid restrictions, but was exceptional in its share price not reacting much to the vaccine announcement. I’ve had my eye on it for a little while as the share price has declined to a level where the valuation has started to look very attractive.

The last few weeks have also seen a lot of corporate results for the shares on my watchlist, especially those listed in the US. Overall, they have been remarkably positive with the vast majority significantly beating expectations. One exception was Mastercard, whose results suggested the impact of Covid restrictions on its profits from cross-border transactions was worse than previously anticipated, causing me to sell. This was a difficult decision. As I’ve said several times I have a lot of conviction in Mastercard’s business long term. However, a profit warning is a profit warning and I thought my money was better off elsewhere. The fact that selling Mastercard allowed me to raise the remaining funds for my house purchase all in one go also helped tip the balance. The vaccine news has obviously changed things and in the benefit of hindsight it’s already clear that this trade was mistimed, though I don’t think I could have reasonably predicted this in advance.

I used some of the proceeds of my MasterCard sale to buy a small position in Facebook.

Facebook

Facebook is of course an ad-funded social network and also the owner of Instagram and Whatsapp. It has rapidly grown to join the ranks of the other tech giants, though is a bit smaller than some of the others (Google, Microsoft, Amazon and Apple). There’s a lot I could say about Facebook but I’m going to keep my assessment very high level. The investment case is pretty straightforward.

Quality

  • Business economics: the economics are excellent. Facebook is highly profitable with very high margins and returns on capital. There are huge scale economies in Facebook’s business model. The incremental costs of getting advertisers to spend more in its advertising auctions are negligible. There is a need to invest vast sums of money in continually innovating to stay relevant to its users but these are dwarfed by the the scale of its existing ad business and the opportunities it has to expand into new markets.
  • Track record: the track record is pretty astounding. Similar to other ad-funded platforms, Facebook spent a long time developing the quality of its platform and expanding its number of users across the globe before it developed the advertising side of its business. In recent years the advertising side has grown extremely rapidly with compound growth rates consistently around 40%, despite already being fairly large. It has very rapidly taken a huge share of the online advertising market, accounting for more than half of display advertising revenues.
  • Competitive advantage: there are two sides of the platform to think about when assessing Facebook’s competitive advantage. On the advertising side, Facebook’s competitive advantage seems fairly impenetrable, as the quality of its user data puts it far ahead of rivals. This has been demonstrated by its rapidly expanding market share. There is clearly scope for competition to increase in the future from the likes of Google (and YouTube) and various other display advertising platforms, though I wouldn’t bet on the unique advantage of Facebook’s data being eroded any time soon. On the consumer side, the emergence of various other social platforms such as Snapchat and TikTok, as well as the success of Instagram, does raise questions about long term sustainability of the competitive advantage from Facebook’s ‘network effects’. I’m also conscious that certain cohorts of users (including me) have drifted away from spending much time on Facebook. There is clearly some risk. However, I’m not overly concerned. Instagram still seems to be going strong among the younger generation and no other competitors replicate Facebook and Instagram’s ‘pure’ social networks. Over the longer term, there will always be a competitive threat from rival innovations, but Facebook has a significant advantage in already have established the widest possible existing user base to whom it can quickly roll out its own innovations.
  • Growth prospects: while growth in consumer time spent on the platform has definitely started to slow down, the advertising side of the business continues to grow strongly. However, the most exciting prospects come from the opportunities Facebook has to enter other markets using its existing platform as a base. Facebook Marketplace is probably the most exciting of these currently but I expect there will be many other opportunities for Facebook to grow and reinvent itself. It has a lot of ‘optionality’ as some would say.

Pricing

One of the reasons I chose to buy Facebook was that it had just issued from very strong results, handily beating expectations. It warned that it might face more of a challenge next year in beating this strong performance, partly driven by a Covid induced boom in ecommerce (and associated advertising), but it has a track record of issuing cautious outlooks so I’m not too concerned. Momentum is excellent with the share price near its highs. The valuation looks anomalously cheap to me given the obvious business quality.

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