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2021s Inflation-Based Rotation is Missing the Mark

Acts Chapter 4 verses 10 and 12 state, "then know this, you and all the people of Israel: it is by the name of Jesus Christ of Nazareth, whom you crucified but whom God raised from the dead, that this man stands before you healed. Salvation is found in no one else, for there is no other name under heaven given to mankind by which we must be saved."

Christianity is the only "religion" that claims God through Jesus Christ, was born a as a child, lived a perfect life without sin, was crucified on the cross and died, and was resurrected rising from the dead, ascending to Heaven. Jesus Christ also stated that all must come through Him to enter the kingdom of Heaven. This is the essence of Christianity, and the gospel message, or good news, that Jesus Christ commanded every Christian to take throughout the world. My job is to plant the seed of God's word, while it is God who continues to reach out to every single person on the planet to enter into a relationship with Him.

As I thought about this verse, I I felt it would be prudent to expand upon last week's blog on inflation. My goal here isn't to claim I know best, or anything like that, but to honestly express some thoughts about what is happening with the increase in volatility across equity markets thus far in 2021. I want to quote what mainstream media is saying in justifying the sell-off for growth stocks. This is from Barrons:


"Higher interest rates hurt growth stocks more than others for two reasons. First, high-growth companies typically need new capital to finance growth, and higher interest rates makes that more expensive. Second, higher growth companies generate most of their free cash flow far in the future, which is worth less - relatively speaking - than cash generated right now by more mature companies."


The article by Barrons titled, "Tesla is Down. GM and Ford Are Up. How Interest Rates Play With Stocks" goes on to also state that companies like General Motors (GM) and Ford Motor Company (F) benefit from higher interest rates as pension deficits are lowered, and/or eliminated altogether. Barrons admits at the end that this is an odd reason to push up stock prices for non-growth companies, and I think that this type of mainstream information in itself, is quite odd, and completely misses the mark on what is really going on in the growth versus value debates.


I believe that similar to March/April of 2020, today's volatility in Q1 2021 pushing growth stocks lower, while value stocks go higher, is not a reflection of the future, nor will it end well for investors. When the pandemic hit last year, growth stocks were crushed, more so than other categories initially, because many assumed that they would suffer the most. Pretty quickly in April though, the tables turned and as the year progressed, growth stocks, notably technology and other innovative companies, proved to be tremendously resilient.


Today, there are two things occurring misleading investors. First, the "rotation" isn't really a rotation at all. It's simply a return to what was lost for many companies last year. This is positive, but not transformative for their growth prospects over the mid-term. Second, the "rotation" is serving as a façade, as many growth-based companies will benefit tremendously from increasing interest rates, opposed to mainstream conjecture. I alluded to this in the previous blog, but with Barrons' statements on record, I think it is best to illustrate this more directly. Let's take a look.


Higher Interest Rates Makes Financing More Expensive

This claim makes perfect sense. If I raise capital by borrowing through debt instruments, inflation means that I will be paying a higher cost through interest expenses. This will reduce Net Income, and impact Cash Flow.


However, many growth-oriented companies raise capital via equity, and/or convertible debt, which tends to have much lower interest expense impacts, and is convertible to stock removing the need to pay continually and/or refinance over time.


I build detailed financial models of every holding in the portfolio, and one of the key metrics I measure a company's financial strength by is Net Cash. I rarely hold companies with Net Debt. Of the current 50 holdings, only Invitae Corp. (NVTA) and Teledoc Health (TDOC) have Net Debt. This means that credit risk is something that is not a concern in my portfolio. Sure, there may be some convertible debt exposure, but aside from this, debt instrument dependence is limited to non-existent. There are many growth-based companies out there with a profile based on Net Cash in addition to the ones in my portfolio.


So why are financing cost increases being equated to growth stocks? Because there are also growth stocks that do depend on debt instruments - ironically, the inclusion and focus on Tesla, Inc. (TSLA) in the article is misleading as Tesla has a Net Cash position as well. However, more capital intensive growth-oriented companies will likely continue to use debt instruments, even in the event of a Net Cash position.


Exposure to debt is something that has become ingrained for investors by mainstream media, as to how a business raises capital and operates. For next generation growth plays focusing on innovation, this is not the key focal point for how businesses will raise capital. The financial crisis has had a profound impact on younger generations who do not ascribe to relying upon debt as a consumer, let alone as a corporation. It has opened up one of the most amazing and transformational paradigm shift opportunities over the past 150 years, as consumer shifts will continue to gravitate away from debt laden practices. This is a clear reason why today's new and upcoming CEOs and companies they run do not rely on debt to grow the business. Credit risk is something that can be minimized, especially for those not in the financial sector.


This shift and actual distaste for debt is something that is illustrative of the generational pull that is occurring between Millennial and Gen Z generations, notably, versus Baby-Boomers. A changing of the guard, right of passage, whatever we call it, consumer preferences, expectations, and practices are not going to resemble the past, especially the past of many decades ago. By no means do I mean any disrespect for Baby-Boomers, in fact, many of their principles and creeds are very important and very relevant today. Respect of older generations is highly important for younger generations to gain wisdom from. As an investor, however, the future will change at a more rapid pace as technology continues to advance and scale, that will in turn, impact legacy versus newer businesses very differently.


Affirm Holdings (AFRM) is a great example of this as the company is bridging the gap for payments between consumers, merchants and financial institutions. Wait, don't we already have credit cards? Yes, but tomorrow's consumers don't trust them, let alone desire to use 6-10 of them. Affirm provides better transparency on all costs associated with transactions tailored to deferred payment - a credit card will make you pay extra for carrying a balance, Affirm won't. Coinbase Global (COIN) is coming public while cryptocurrencies garner more attention and demand, Bakkt (VIH) is pushing the digital assets opportunity, Insuretech is also growing. All of these newer companies have a similar theme, they recognize that tomorrow's consumers don't want legacy/incumbent/traditional products and services, and importantly, that these consumers are the future majority spenders and deciders of who will win and who will lose.


Higher Growth Companies Generate Most FCF in the Future

This second point illustrates naivety at best, and egregious misrepresentation at worst - the way Barrons writes, I'm not sure which one it is yet. The FCF comment is a very broad-based statement across the thousands of growth-based companies. But for me, it is extremely vital to investment success over time. I have multiple rules in place as to how a company is screened, considered, and selected for the portfolio. While Net Cash is a top priority, Cash Flow is the single most important metric to value a company on, and to consider a position in.


When I read the commentary from Barrons, it is disappointing to say the least - such broad-based generalization is detrimental to considering where strong opportunities exist. As I watch companies like Shopify, Inc. (SHOP), Crowdstrike Holdings (CRWD), Zoom Video (ZM), MercadoLibre, Inc. (MELI), DoorDash, Inc. (DASH), Roblox Corp. (RBLX), Roku, Inc. (ROKU), even Wayfair, Inc. (W), and many others witness substantial Cash Flow inflection, I find it odd that they are being lumped in with anything growth-oriented for the reasons stated above. Their performance is a severe contradiction of the statement, as they are some of the fastest FCF generators today.


Shopify's FCF is approaching $500 million from nothing a few years back, a nearly 16% FCF margin today. Crowdstrike has a 41% FCF margin, Zoom Video a 55% FCF margin, MercadoLibre has a 30% FCF margin, DoorDash has a 3% FCF margin (increased from -63% the past year), Roblox has a 46% FCF margin, Roku has a 5% FCF margin (increased from -4% the past year), and Wayfair has a 8% FCF margin (increased from -7% the past year).


While some may question lower FCF margins, not all are the same. For example, DoorDash's peers are currently incapable of generating FCF, let alone OCF, the same can be said of Roku, while Wayfair has displayed robust results versus peers. For many of these companies, inflation is not the problem. The real problem is that they were big winners during the pandemic, and they now have a target on their backs. It's the push-pull effect of change towards newer innovative winners taking market share away from legacy incumbents. Think Wallstreet, do they really want to push the new leaders to far from the legacy competitors? Of course not, any company that is not at risk of bankruptcy is tradable, as well a potential client. It's all part of the game.


Analysts and consumers alike continue to question the viability of growth-based potential. They questioned it during the pandemic, now they are questioning it post-pandemic (yet to occur), and in some cases are already looking out to 2022-2023 to question it further. This is a clear sign to me that the recent volatility and mini-correction (NASDAQ) that has occurred is not really about inflation at all, but more about the generational conflict that is afoot as Millennials and Gen Z will be overtaking buying power sooner than later, on a global scale.


It's also a deceptive tactic of Wallstreet to push growth stocks lower, so accumulation can occur for major institutions to attempt to get better prices to improve performance. Active management fund managers like Cathie Wood have been beating EVERYTHING, let alone simple benchmarks rigged to perform in-line, and it's weighing on Wallstreet.


Today's investor is very flippant focusing mostly on trading and quick gains. Valuation has been perceived to be a non-reality, when unfortunately, it remains the core driver for all stock performance. The stock market is riddled with investment mines, just waiting to go off. The majority of this stems from poor businesses built on legacy systems and models, or manipulation, and insatiable greed, as is being witnessed in Q1 2021. Wallstreet is picking losers for quick gains over long-term winners, for the simple fact that it can, and it knows it can still "rotate" back to growth winners.


Today's investor needs to be able to decipher these issues, in order to pick winners, and avoid making mistakes. I know everyone wants to get acclaim regardless of how they perform, I know everyone wants to think that the company they like as an investment is going to be a winner - but that's not how it works. I strive to determine who the winners are and keep my eye on the prize. I'm not perfect by any means, but I know one thing, focusing on who will drive the future for consumption in-line with the companies set up to reap the reward is paramount.


The next two-five years will be a true test, and will provide much more clarity of the transformative events that are occurring. There is a lot at stake for many legacy industries fighting against change, or at best, still trying to manipulate it to their advantage. This has been tried in the energy sector, and it has failed, it has also failed in the media/entertainment industries, we are seeing it occurring right now in the automotive industry, and sooner than later, it will intensify in the financial sector. All legacy sectors and industries are at risk, and legacy companies have just as much, or more in many cases to prove that they can survive, let alone sustain and/or see expansion of their operations.


Innovators and leaders for tomorrow's technologies for products and services are not going to be the legacy winners over the past decades - that's my opinion. And like last year when the early opportunities were misguided through mainstream media during the pandemic, the mid-term horizon opportunities today are similarly following suite as mainstream media continues to push the same misguided information in 2021. Chasing the next short-term hot topic is not going to work well for the long-term, or mid-term for that matter.


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