May Update
I haven’t made many big changes since my last update, and am still holding a large portion of my portfolio in cash while I look for obvious opportunities.
The headline rise in the S&P 500 (+9.91% YTD) has masked some significant dispersion in performance between companies, with most of the gain driven by a handful of big tech stalwarts. At the extremes, euphoria has shifted from bankrupt meme stocks to any company that mentions “AI”; NVDA now trades at 29x sales, nearly as rich a valuation as CSCO’s right before the dotcom bubble burst and it subsequently plummeted 80%.
Before CSCO’s collapse, it was growing revenue at 55% YoY with operating margins of 24%. NVDA’s current growth rate is 0% with 21% margins. CSCO was a great company at the forefront of a technological revolution (the Internet). NVDA is a great company at the forefront of a technological revolution (generative AI), but with so much optimism already factored into the share price it’s hard to envision how this story ends differently.
NVDA is not an anomaly - by some measures, aggregate valuations are still higher than they were at the peak of the dotcom bubble, and, prior to the pandemic, exceeded only by a handful of inauspicious moments in history.
With that said, the continued strength of the economy has defied most expectations, and some companies have gotten cheap enough to be interesting. I recently opened up positions in LUV, MTCH, FHB, C and BrainPad Inc (3655.JP). The persistent speculative euphoria in the broader market makes me feel like I’m probably still too early, and these certainly aren’t the world’s greatest businesses, but valuations seem reasonable even when factoring in some fairly catastrophic scenarios, which should provide a decent margin of safety.
China
I’ve also closed out some Hong Kong stocks that I’ve held for a few years - Pico Far East (752.HK) and Analogue Holdings (1977.HK) - despite believing that they are still deeply undervalued. China’s increasingly autocratic tilt was worrisome enough when things were going well diplomatically, but the potential for direct conflict with the West appears to be escalating in many areas (Ukraine, semiconductors, Taiwan). Power is being exercised by the whims of one man, who seems increasingly desperate to build a cult of personality and ignore reality (a problem, admittedly, not exclusive to China). It is also somewhat telling that many rich Chinese are trying to get their money out.
Unfortunately, the risks of outright war are also likely higher than anticipated. Many pundits dismiss the possibility of war because China is too economically integrated with the West, and a conflict would be financial suicide for all parties, but this same argument was made by contemporaries in Europe about Germany before World War I, more than one-hundred years ago:
…during a series of lectures on The Great Illusion delivered at Cambridge and the Sorbonne, Lord Esher would declare that “new economic factors clearly prove the inanity of war,” and that the “commercial disaster, financial ruin and invidious suffering” of a European war would be so great as to make it unthinkable.
…trusting too much in the rationality of nations and seduced by the extraordinary economic achievements of the era…they totally misjudged the likelihood that a war involving all the major European powers would break out.
Lords of Finance: The Bankers Who Broke the World - Liaquat Ahamed
Known Risks
Many risks are unquantifiable because they are unknown. My goal is to try to reduce my exposure to “known” risks. In investing, I think the biggest known risk is the risk of overpaying for something. In general, this risk can be mitigated by valuing businesses using reasonable assumptions based on cash flows, and demanding a margin of safety on any purchase price. And although it seems uncomfortably close to the dirty phrase of “market timing,” I also think that you can improve your odds by being more aggressive on “offense” or “defense” depending on where you are in the market cycle.
Another “known” risk is the potential for permanent capital loss. This risk is harder to mitigate because it seems unquantifiable - What are the odds that a money incinerating startup in a completely new industry will survive? What is the probability of China invading Taiwan, how will the USA react, and what implications does that have for foreign shareholders? What are the limits to a mass psychological event, like a bank run? What is the price of Bitcoin? Probably the only way to mitigate these kinds of risks is to avoid them completely, or to have a venture-like portfolio of small, diversified positions with outsized returns for the potential winners.