05 July 2019
Dear Shareholders and Friends,
One Transaction Capital (“OTC”) is six months old and what a start we’ve had! We launched the company in January 2019 to provide local investors with a scalable platform through which they can invest into market-leading global companies. We believe global equities offer tremendous opportunities to create long term wealth for investors but only a few people are tapping into it.
In the founding shareholder letter (you can read it here), I provided an overview of the opportunity set that OTC would be pursuing. We are interested in growth companies with a durable competitive advantage and operating in emerging sectors that have long reinvestment opportunity runway and a lot of white spaces. I’m writing this maiden half year shareholder letter to provide you with an overview of how the company performed over the last six months and share our thoughts on some exciting investment themes we see around the world.
The OTC portfolio grew 36.4% in the first six months vs. 17.4% for the S&P 500 on the back of a strong market rebound from the December lows. This was partly fuelled by the Fed’s decision in March to change course on interest rate hike cycle and given the sharp market sell off towards the end of last year, it provided a perfect storm for a market rally. Although global trade tensions continue to put brakes on investor enthusiasm, the market has generally held firm, buoyed by strong first and second quarter corporate earnings. It’s obviously too early to infer any meaningful conclusion about our investment philosophy but we couldn’t have asked for a better start.
Portfolio performance – H1 2019 (Returns in US$ basis)
|Period||One Transaction Capital||S&P 500||JSE Top 40|
Within the portfolio, there was robust performance across the board with our investments into Software-as-a-Service (SaaS), genomics and payment companies all doing well. At the end of H1, our portfolio was fully invested with the net cash position sitting below 2%. As you all know, OTC is still in the capital raising phase and continue to receive additional funds from new and existing shareholders which is progressively deploy into opportunities we have on our tracking list.
Are we heading towards a global recession?
Back in March, the U.S. Treasury yield curve inverted for the first time since the last financial crisis. Historically, an inverted yield curve served as an indicator of an impending economic recession and interest rate cutting cycle. However, a few months later, the market is still split on whether a recession is imminent or not. Paradoxically, everything about a recession is easy to predict except the timing, severity, duration and policy response. So yes, a recession is inevitable, but there is no way of reliably knowing when. So instead of obsessing over it, here at OTC, we spend our mental bandwidth thinking about how best to position the portfolio for the eventuality. Below we share some of our initial thoughts.
Market returns have primarily been dominated by growth stocks but good times don’t last forever. Away from flashy headlines, there is a group of companies with boring but cash rich business models that are taking advantage of far quieter systemic changes in the world. Two examples of such fundamental shifts include digitization of government services and the increased flow of private capital into infrastructure development (both public and private infrastructure like data centres and other global connectivity assets).
According to the Global Infrastructure Hub, the world needs to invest US$3.7 trillion per year between now and 2040 in order to meet the rising demand for quality infrastructure. The public sector alone cannot finance this bill and are increasingly reliant on private capital to drive the investments. Brookfield Asset Management, one of the world’s biggest alternative investment manager, estimates that 50% of all the new build infrastructure by 2050 will be private sector funded, owned and operated. The beauty about infrastructure assets is that they have recurring and predictable revenue streams which are anchored in extended contractual agreements with credible counterparties. Also, they have built-in inflation protection adjustments and bear limited technology and obsolescence risk. Such assets tend to do comparatively well during a recession.
On the other side of the spectrum, we have vertical software companies that assist governments in digitizing their services in order to meet the demands of the 21st century. Most provide mission-critical software solutions to public entities in categories like appraisal and tax services, courts and justice agencies, enterprise financial software systems, planning and regulatory software, public safety, records and document management and transportation. The advent of cloud-based Software-as-a-Service business model makes it easy and cost effective for these companies to deploy their solutions at very high operating profit margins (>35%). In addition, their ability to add complementary services makes governments increasingly reliant on them which in turn make their ecosystems very sticky even during recession periods. There are a couple of companies we are looking at in this space, and we will share with you our detailed thoughts in the future.
So, yes, a recession is coming and the market will definitely take a dip. When that happens, all I want is for us to emerge on the other end in a reasonably good shape.
Evaluating companies using unit economics framework
As I hinted earlier, we are growth investors with keen interest in early-stage businesses that have a structural right to win within their respective sectors. The term “growth investing” however, is often construed to mean companies with high revenue growth rates but this definition in isolation, is too narrow and doesn’t accurately capture our investment philosophy.
At OTC, our sweet spot is companies that are growing revenue while simultaneously creating shareholder value, meaning their ROIC is higher than WACC. This distinction is critical to keep in mind but as I will highlight below, things are a little bit more complicated in practice. How do you measure ROIC for a fast growing but loss-making company where traditional valuation metrics cannot be applied? Should we invest in a company with nose bleeding P/E ratio of 50x or 100x or one that is generating negative free cash flows? To complicate things further, if you overlay the fact that the future is highly unpredictable it implies these high growth companies in new/emerging sectors have a wide range of possible future possible outcomes. Let’s look at three very simplistic examples to illustrate this point further.
Company A makes bread at a cost of R10/loaf but sells it for R9/loaf, i.e. a loss of R1 for every loaf. Assuming the retail market price for bread is R11, Company A will grow its market share and revenue as customers flock to buy bread from it. However, the bigger the company grows its market share, the higher will its losses be and sooner or later, it will go bankrupt.
Company B develops and sells enterprise search software to ecommerce retailers. Assume it costs the company R10 to acquire a customer who contracts to pay R4 per year for the next five years to use the software. At the end of the year one, Company B will report a P&L loss of R6 but the present value of each five-year contract at a discount rate of 10% is a profit of R6.68. Given the attractive unit economics, management spends an additional R30 in year two to acquire three new customers, each who also contracts to pay R4/year to use the software. Therefore, at the end of the second year, Company B reports an even larger operating loss of R16 and so on.
Company C spends R10 million to set up a pet food e-commerce business. Their customer centric business model proves popular with its customers who in turn are spending more money on the platform. On average, each of company’s customer cohort spends 30% more money in each subsequent year, which implies a Dollar Retention Ratio of 130%. However, because it’s early days, Company C still doesn’t have a large enough customer base to generate sufficient sales to cover its distribution facility’s fixed costs. Therefore, by the end of year one, it reports an operating loss. Given the attractive DRR metric and large total addressable market, in year two, management decides to invest even more capital in marketing, promotions and subsidies to attract more customers and set up a second distribution facility. All these additional investments mean Company C will report an even bigger operating loss at the end of the second year.
The fascinating thing about Companies A, B and C, is that all are loss-making and the more customers they acquire the higher their reported P&L losses during this growth phase. However, at the unit economic level, Company B and C are actually very profitable and therefore are creating value for shareholders. When it comes to high growth companies, not all losses are created equal!
Although these examples are very simplistic in nature, they highlight one crucial aspect about growth investing, which is, investors must to go beyond the reported financial statements and look at the underlying unit economics (P&L per customer, cohort, client or project level) to understand how much value a business is creating. At OTC we use the following metrics to evaluate growth companies:
|Discounted Life Time Value / Customer Acquisition Costs (LTV/CAC). The average discount rate used is 10% which equates to the long-term return on S&P 500||The ratio measures the profitability of each customer on a present value basis. In other words, it’s the return earned on the investment made to acquire a customer||3x and higher|
|Dollar Retention Rate (DRR) on a cohort basis||This is a measure of dollar renewal from a cohort of customers. A renewal rate above 100% simply means customers are spending more money with a company this year than they did last year||110% and higher|
|Customer Retention Rate (CRR)||A measure of a company’s ability to keep its existing customers. Anecdotally, it is 7X less expensive to keep current customers than it is to find, nurture and convert new ones. In addition, existing customers tend to spend more with a company than new customers||90% and higher|
|Return On Invested Capital (ROIC) on unit economics level||A measure of how much cash a company produces on every invested dollar. ROIC is a much more robust metric compared to Return On Equity because that doesn’t get distorted by a company’s capital structure, tax planning technique and accounting standards||>15%|
|Reinvestment Rates||The ratio of a company’s earnings that is reinvested into the business. Growth companies with a long runaway have higher reinvestment rates||>80% as long as the incremental ROIC is higher than WACC|
|Efficiency of capital||Simply put, its Revenue/(Equity + Debt). It’s a measure of how much capital it has taken a company to generate one dollar in revenue for a particular year.||>0.6 based on historical successful growth companies|
Regardless how you look at it, valuation is both a science as much as it is an art and these quantitative metrics only serve as guardrails for assessing competitive moat and profitability at steady state. There are also several other qualitative factors we look at, for example, the value of optionality that a particular business model has. In other words, can this business model be replicated in an adjacent market verticals because that can potentially expand a company’s total addressable market.
Finding opportunities in a crowded market
“The rule of the game is simple: He who turns the most stone will win the game” – Peter Lynch
The global market is full of wonderful companies, but valuations are currently stretched to the limit. It is becoming increasingly difficult to find good but reasonably priced opportunities within the mainstream segment of the market. Given the level of liquidity in the market, any sharp pull back attracts a swamp of capital that is waiting on the sidelines.
Investors waiting to take advantage of a market pull back
As shareholders, you might now be wondering how we think about investing in such a competitive market. The strategy we have adopted is to move down the valuation stake and look at smaller emerging companies and also explore opportunities outside of the United States. Our sweet spot is companies with annual revenue run rate of less than $400 million and within industries that are still developing or changing rapidly. For example, we see considerable opportunities in Next Generation DNA sequencing, genomic testing, payments, enterprise search software and toll operators in platform ecosystems.
From a country perspective, the U.S. market has dominated the opportunity set over the last ten years but now we are beginning to see exciting opportunities coming from Canada, Scandinavian countries and South Korea. It’s still early days and we are currently busy turning the stones in those markets. I hope we will find some hidden gems.
Portfolio update: Invitae Inc. (NYSE: NVTA)
Lately, I have developed a great interest in the emerging medical field of DNA Sequencing and Genomic Testing (you can read my first post about it here). We all love our parents but unfortunately, they are a source of hereditary diseases like cancer, heart diseases, neurological and metabolic disorders. The nature of these diseases is such that there historically hasn’t been a way to identify them until it too late. For example, last year 18 million people were diagnosed with cancer and millions more with other forms of hereditary diseases and more than 80% of these cases were adults.
When a person is developing cancer, the tumour cells shed fragments of DNA into the blood. Early on during the cycle, these fragments are of such a low quantity that they can’t be detected using the existing technology. DNA Sequencing is the process of determining the organic molecule order of a given DNA fragment in the blood to assess if any of them are a result of developing cancer tumour cells and if so, what type of cancer it is. Genomic testing is the breakthrough technology that uses DNA Sequencing to allow people to proactively find out if they have a predisposition to any of these hereditary diseases. Not only can they use the technology to make the diagnosis, but can also use it to determine the stage and the most effective treatment option.
The argument in favor of genetic testing is obvious: Firstly, two-thirds of cancer cases are curable if they are diagnosed early enough, often with inexpensive surgery. However, in most cases cancer tumours are often detected late and hence fatal in 80% of the cases. Secondly, by identifying this risk early, the cost of treating the patient is far much lower as early stage surgeries are often inexpensive.
The use cases for genomic testing is also growing to adjacent areas like non-invasive prenatal testing which allow pregnant women to proactively check for and prevent any hereditary diseases on their unborn babies. Last year, approximately 1.2 million tests were conducted in the US, a number that is expected to growth at 30% p.a. for the next five years according to DeciBio Consulting. At the cost of $100 per test, this market alone is worth $450 million revenue pools in five years and I can see similar offtake profile in Canada, Western Europe and the developed parts of Asia.
A few years ago, these tests would cost tens of thousands of dollars and were beyond the reach of many people. However, increased investments into R&D have substantially driven down costs and as a consequence, we see an inflection point in the massification of genetic testing. Another catalyst for mass adoption will come from insurance and medical healthcare schemes which are starting to cover genomic tests and incentivising their customers to undergo the process, the same way they do for blood pressure, blood glucose, cholesterol, weight assessment and HIV tests.
Consider this; if 500 million people across North America, Europe and Asia seek some form of genetic testing at least once in the next five years at an average cost of $200, that will translate to a market revenue pool of US$100 billion. Even if you cut the estimate of the Total Addressable Market in half to US$50 billion, that is still a huge market opportunity.
Given these long-term secular tailwinds, in May we opened a position in Invitae Inc., a fast-growing genomic testing company based in the U.S. The company has an annual revenue run rate of +$160 million and growing at +45% year on year. Although the share price went by 24% since we bought it and helped boost our short-term performance metric, I am far more exited about the company’s long-term prospects. CEO Sean George articulated this better in the last earnings call:
“…our goal is to build a five to ten billion company over the next 3 to 5 years. I’d say that’s exactly where we are going. The faster we can do that, the better. It’s very clear to us. That’s the mindset”
I believe Sean’s views are conservative as you would expect from management. The adoption curve will be much more exponential as millennials spend more money on healthcare and institutions support the use of genetic testing for managing claims associated with hereditary diseases. Over the next few weeks I will send out our detailed analysis of Invitae in which I will provide a more detailed analysis into the company and its long term growth prospects.
Portfolio update: [Name withheld]
We are also looking at a fast growing company in Asia that is positioning itself at the centre of a large and growing ecosystem. The company operates as a “tax” or “toll collector” among the participants involved and has been reinvesting all the proceeds into making the system more efficient. In the last earnings call, the company reported growth in revenue of ~30% year-on-year but that number is less meaningful given that the company is also undergoing a structural shift towards an asset light business model. Based on our initial analysis, we believe the new business model will deliver revenue growth north of 45% year on year in the short to medium term and has higher gross profit margins. In addition, the new model will also open up a new frontier allowing the company to further grow its ecosystem.
We had an excellent start to the year but I wouldn’t for one second think such level of performance are repeatable over the long term. As long-term global investors, our interest is to find investment themes that we believe have long runways and many optionalities to create value for shareholders.
As most you of probably know, I also run an investment research blog, The Northerners (https://northerners.co.za/) where I research and share insights into some exciting companies and themes that I believe will deliver above market long term returns. You can sign up and receive these insights straight in your inbox.
To our founding shareholders, let me take this opportunity to thank you for entrusting us with the responsibility to manage your wealth. Even though we have a solid start to the year, I believe better times still lie ahead of us. As I noted in the founding shareholder letter, we are committed to building a long term multi-generational global investment company that will generate wealth and truly impact the lives of our shareholders and their families.
Going forward, I will be writing to you quarterly to keep you up to speed with how the business is performing. In the meantime, I am also available to discuss opportunities you see in the market.
Trevor Muchedzi, CFA | Founder and Chief Investment Officer
One Transaction Capital
 These are net returns for OTC. Individual returns may differ based on the date of funding
 Technically, this means the spread or premium between short- and long-term debt became negative. In essence, investors expect the economy and by extension, inflation to slump in future
 This is a high DRR compared to the industry standard standards of 110%. See definition of the DRR metric in the table below
 This is an image of the recent protest in Hong Kong but it’s a good analogy about how so many investors are waiting for a market pull back before jumping in y of each