YE22 Investor Letter
Dear Investors,
Managed accounts declined ~32% over the course of 2022. As always, returns will vary based on the timing of onboarding and varying holdings so be sure to check your individual statements. For comparative purposes, the S&P 500 declined ~18% during the year. As you know, I consider absolute investment returns to be more important/relevant than relative returns which makes this past year all the more disappointing.
My results in 2022 were simply not good enough and I failed on a number of fronts, most notably, in protecting capital during a major drawdown. And as a competitive person, it has certainly “sucked to suck” at something that you care deeply for and have spent much time working on. While it’s also true that gyrations in markets and particular stock prices are out of my control in any given shorter period of time, it does seem to me 2022 represented a major opportunity to add value by not being like the rest of the market. Unfortunately, I was no different, and in fact, I was worse than the index averages. Along the lines of the 1H22 letter, this current letter will attempt to serve as a form of self-flagellation so as to identify and reflect on mistakes in my process so they can be avoided/reduced in the future.
For starters, the whole reason I sought to focus on absolute returns in the first place was to have the flexibility to side-step market extremes. The signs were clearly present that the period of 2020-2021 was quite abnormal and I recognized these excesses existed (even noted in prior letters). I thought I had taken steps to be more defensively positioned, believing an ability to invest in areas others cannot (small-caps, over-the-counter stocks, etc.) meant that the ideas I was finding would be more immune even though I know how volatile small-caps can be. In hindsight, that appears to have been an arrogant and/or complacent assumption. My picks have suffered alongside those of so many others.
It turns out that what you may not realize until it’s too late (read: until you’ve lived through a serious market decline – and this is my first real one as an active investor) is that in the leadup to the downturn, you’ve potentially and unknowingly ventured further out on the risk spectrum than you ever intended. Consequently, I was reminded just how critical patience and discipline are. They are what keep your actions rational and in-check against emotions that may be leading you astray as an investor.
So, how might have a deviation from my intended process introduced unintended and undetected risk? By initialing struggling to find compelling ideas when I started in 2021, I may have stretched too far looking for new ideas. Some underlying themes seem to have emerged in our stocks that our down the most which I continue to evaluate:
· Not keeping things simple enough
· Openness to companies with shorter operating histories, high growth, or lacking a consistent track record of profitability
· Convincing myself (a warning sign in itself) that I understood a company or its associated risks well enough
· Incorrectly handicapping respective probabilities of risks materializing
· Seeing things for how I want them to be vs. the underlying reality
· Being too influenced by other investors I respect
· Presuming a meaningful decline in share price was enough to equate to a cheap valuation
· Not paying a low enough price
A quick comment about investing in higher growth companies which I do deem desirable. After all, growth is a critical input in business valuation assuming it can be maintained. However, higher growth companies do pose potential for elevated mark-to-market losses, which I was harshly reminded of this past year. Sometimes their business model/competitive position is not quite established. And while an emerging business model with high growth and a developing competitive advantage is one place to invest for differentiated returns, this requires you are absolutely correct in your assessment. If market sentiment turns in the interim (as it did last year), or if you’re simply wrong in your conclusion, there is less to fall back on from a valuation/cash flow standpoint. As a result, the price swings in growth companies can be violent. I need to be willing to endure those with a grin and be right in the long-term. Both are difficult in real-time.
On the point regarding proven profitability and/or operating history, companies with a “pass” on making money are more likely to have bloated cost structures and inefficient processes. And since costs are the only thing a manager can truly control, they should be a focus given price/volumes received in the business will ebb and flow with time. When a cost base is lean, the margin of safety of a company increases while its profits enable future optionality. Our positions that are currently loss-making are being closely monitored to determine whether they can meet medium term profitability goals as announced by management. And for new incremental ideas, I have reoriented towards companies with longer histories and/or current outstanding value on the balance sheet.
Many investors rightfully advocate the merits of staying within your circle of competence. What’s always occurred to me is that many seem content to use this as a shield so that they don’t have to continue to learn and expand their knowledge base. Perhaps sticking purely to their knitting does work, but I believe there should also be an emphasis on challenging oneself in order to grow. One lesson I’ve learned however, is that you don’t have to invest just because you’re learning about a new product or industry. There is a difference between one’s circle of competence and current circle of learning. The latter should not necessarily impact the actions you take regarding the former. And while the call to action after spending a lot of time researching an investment can be strong, I must always be content to say, “I don’t know” and take a pass on an idea. It’s a work in progress. As I wrote a few weeks ago on Twitter…
Important things to say in both life and investing that I am still working on myself:
No
I don’t know
I call bullshit
I changed by mind
Markets and businesses are, and have always been, cyclical. Yet, I failed to recall this timeless lesson when thinking through certain business impacts. Covid-19 lockups and zero interest rates pulled forward a lot of consumer and business demand, fooling me when assessing the durability of those trends. To make matters worse, I have had the reality of the cyclical nature of investing driven into my head by my former firm, who practice an investing approach very cognizant of capital investment cycles, so making this error is even more egregious.
I would note that it’s easier to forget past lessons and lose your bearings in an environment when many around you do the same. This is why independent thought, patience, and discipline are so paramount.
A takeaway, particularly for anything cyclical is to wait for the crises to emerge, then take a look. I recently heard to read the news “with an eye to discover where the crazy is”. Whether it’s in regard to a specific country, industry, or business, “finding where the crazy is” in markets will help serve as a guidepost for investors. If valuations or sentiment within the space are extreme, then avoid it altogether. As one example, it steered me clear of crypto-currencies, NFTs, and stocks trading on a hope and a prayer. By contrast, if a disaster has already occurred somewhere, it’s probably a compelling space to spend some time researching, but not before. Before is where you get caught in the crunch.
On another topic, with higher inflation than markets have seen in several decades, a whole “cash-is-trash” narrative took hold in 2021/2022. Stupidly, I let this influence my thinking and decision-making too much. Ideally, you are not an investment manager getting paid fees to sit out and wait for more compelling investment opportunities, but sometimes that’s what it takes to succeed. And while it’s certainly accurate that inflation eats at the purchasing power of idle cash, coincidentally, the right call was probably to be holding more of it right at the time so few wanted to. After all, the whole point is to have the ability to invest at better prices to take advantage of the upside. Less financial/investment media consumption and more thinking for myself is the remedy I believe.
Portfolio Management
I also want to highlight my lessons with portfolio management as opposed to specific investment research and analysis. By portfolio management, I mean determining position sizes, initial allocation weightings, subsequent position building, idea re-allocation, cash levels, and employing comprehensive risk management. In this realm, I can also be better. With several risk controls in place from the beginning, the framework is there, but more fine-tuning and methodology will be helpful.
For starters, once an investment idea has been approved, there should be no immediate rush to build a position. Rereading old letters, it is clear to me I was in a bit of a hurry to deploy capital. But as the past year has reminded me, you will sometimes get opportunities to invest at prices and valuations that you wouldn’t have believed just a few years back if you are patient and disciplined. However, if portfolio cash has all but been deployed (or you’re already close to position size risk limits) there is less ability to capitalize on these favorable situations. So rather than targeting a standard ~5%+ position right off the bat, perhaps buying 2.5-3% right away and looking to fill the position in subsequent months/quarters as the price declines and/or the business executes and the story plays out will be a better way forward.
A down market also offers the chance to upgrade the overall quality and/or return prospects of the portfolio by replacing existing holdings with new ones. That is, assuming the new ideas are actually better than the current positions you intend to replace (a risk since you likely know the former idea better). This ability to re-allocate a fixed set of capital thoughtfully and effectively is another area I am seeking to improve. First, by requiring that new ideas represent a meaningful step up in the quality, safety, or return prospects versus current holdings. Marginal improvements from a theoretical and formulaic IRR perspective won’t be enough. Second, to do so more quickly as opportunities can come and go quickly. And third, I need to do a better job of recognizing and categorizing investment ideas on two competing frameworks – resiliency and upside optionality. Only the former should be made into more core, concentrated positions while the latter should remain smaller fringe positions, if allocated to at all.
Lastly, by knowing myself better now, I’ve also concluded that I will not want to build a position to the original position size limit of 15% of the portfolio (at cost) anytime soon. Consequently, I’ve lowered that internal ceiling to 10%. Many investors do remarkably well concentrating in fewer than ten names. For now, I won’t be one of them. However, I remain enthusiastic about holdings winning name above 10% as long as the future looks bright, even if the portfolio gets top-heavy as a result.
Closing Thoughts
I’d concede that most of what I’ve identified above should’ve been known and adhered to but knowing what to do and implementing it are not always the same. I am working to course-correct and jettison any positions that I believe no longer meet (or should have never met) my investment criteria. The challenge is doing so in a prudent manner so that what will turn out to be compelling investments aren’t given up on just because they tested my patience and conviction. Since I like to think of the future in terms of what may happen over the course of several years, my default is to typically allow said years to play out. Giving the thesis sufficient time and space to play out can work for or against you. As I’ve said from the beginning, price volatility is not risk, but sometimes there is signal in the noise. One does not want to hold a losing proposition any longer than necessary. As such, another skill I’ll be seeking to improve on is the ability to identify “portfolio duds” more rapidly. Summing up, in a rising market environment, it is not uncommon to for risk standards to be inadvertently lowered at a time when risk management is actually most important. I will strive to keep that in mind at all times.
So where to now? Well, the only thing I know is to keep showing up and putting one foot in front of the other in an effort to dig out of the hole that was 2022. While there is some degree of natural prerequisites required to invest well, the best part of the business is that one can always get better. Knowing what not to do by identifying and rubbing your nose in what hasn’t gone to plan is often a good step in avoiding future pitfalls. Hopefully this letter has given some indication of how I plan to improve myself.
Going forward, there will be increased emphasis on playing “small ball and getting base hits”. As a I’ve said before, investing is part art and part science and the game is largely played against oneself. With a renewed appreciation for simplicity, understanding lurking risks, and demanding compelling valuations with notable asymmetry, I believe things will get back on track long-term.
It appears the business performance of some of our portfolio companies may be turning in the near future so my expectation is for better days ahead. Of course, it can always get worse along the way.
I also want to note that going forward, I will be writing these letters only once a year. I think that pushed me towards even longer term thinking. As always, I continue to have the majority of my liquid assets invested in the strategy alongside you. Thank you for your support and please don’t hesitate to reach out if you have any questions.
Finally, I want to leave you with a writeup of another one of our current holdings. Evolus is a company who I believe is currently executing well and could return 2-3x from today’s prices. A brief overview of the company and investment thesis (written in 4Q22) is included in the appendix below.
Sincerely,
Brett Dorendorf
Managing Member
Shadowridge Value LLC
Evolus is an aesthetic neurotoxins ("NTs" – or injections to treat/prevent facial wrinkles) company headquartered in Newport Beach. At $9/share, the market cap is ~$500mn and the EV is only slightly higher with net debt of about $10mn (EV excludes several hundred million in NOLs). I discovered it as a result of talking with the significant other of a family member (who was a happy customer in her early 20s!) and believe in it for the following reasons:
· Evolus' sole product, Jeuveau, is rapidly taking share (approaching 10% by unit sales) in the $2.0bn aesthetics neurotoxin category, which itself is growing high single digits
· They are winning because they offer the only 900kj molecular formulation other than market leader Botox (60-70% share), but at a 20-25% price discount and in a cash pay format
o Based on numerous on-the-ground discussions I've had with practitioners (medspas, dermatologists etc.), they confirm this makes Jeuveau a more a more profitable product for their practices
o Critically, this dynamic creates a friendly middleman situation in the form of an economic incentive to recommend Jeuveau which aids in distribution and word of mouth (qualitatively, most end customers will go with the recommendation of their injector, especially if it saves them money and has similar characteristics to Botox, which Jeuveau does on both accounts)
o Importantly, Botox cannot match these lower prices to snuff out Evolus because ~60% of Botox is actually for therapeutic use and in order to be reimbursed for insurance purposes, you must offer the government best prices (lowering Botox's aesthetic prices would imply they aren't doing this with their therapeutics business)
o Additionally, Evolus can get more creative with their marketing (billboards, promos etc.) and get closer to cash-pay customers since they are an aesthetics-only company...they do everything they can to help their customers (practitioners) succeed
· With elevated royalties from an ITC settlement having rolled off in September, GPMs in the current quarter and beyond are going to jump from ~60% to ~70%, accelerating breakeven
· The industry is an oligopoly among 4 players/products - Botox, Jeuveau, Dysport, and Xeomin - and has barriers to entry in the form of FDA approval requirements
o The other players have product portfolios well beyond just neurotoxins (Botox is owned by giant Abbvie for example) so they don't have the same direct focus as Evolus
o Tailwinds include folks in the western world living longer and getting married/having kids later (or having fewer children) which means more discretionary income and a desire to look younger for longer
o Penetration is only 6% but NTs are gaining traction as it becomes more accepted and less stigmatized - young women are using it preventatively, elder women are more willing to try NTs for the first time, and some men are even using NTs now
· CEO David Moatazedi comes from Allergan (owned Botox prior to Abbvie buyout) as Sr. VP of medical aesthetics so he knows the business/competition and its strengths/weaknesses
I think Evolus is worth at least a double and likely more than that 4-5 years out. FY22 sales are on track for $150mn growing ~50%. I believe they will keep adding new accounts as word of their customer value proposition spreads and penetration within existing accounts deepens. At a 25% OPM on $400m of sales five years from now (22% CAGR) and applying 12x multiple to EBIT equates to about 3x from today's prices. I also believe there's little reason why steady-state margins couldn't potentially be even higher than 25%. We know the Allergan division with Botox did 90% GPMs and 65%+ OPMs, and Allergan as a whole did consolidated EBITA margins of 45%. InMode in Israel, who I'd argue benefits from some of the same aesthetic demand drivers as NTs does 35%+ OPMs as another example.
So why does this opportunity exist:
· It's a small/micro-cap company so it’s under the radar of many investors/analysts
· Evolus had a near death experience just over 1.5 years ago when the ITC ruled Korean manufacturer Daewoong (who licenses to Evolus) infringed upon Medytox's (who is partnered with Allergan) trade secrets and all sales were stopped. Evolus has had to essentially launch Jeuveau twice since 2019 - once after FDA approval and once after resolution of the ITC issue in 2021 (it is completely settled now)
o Interestingly, as part of the settlement Medytox took equity in Evolus and is one of its larger shareholders
· The market doesn't appreciate, or underestimates the qualitative factors I've outlined above, as well was how long the company can grow and how quickly the company will get to cash flow breakeven
Risks:
Economic downturn impacts consumer discretionary
· Counter: NTs are one of, if not the cheapest aesthetic treatments available so they should be more resilient. Many people view NT treatment as a regular requirement 3-4x per year so it has recurring revenue characteristics. And to the extent that consumer wallets do get pinched in a recession, Jeuveau at a 20-25% discount to Botox should be better positioned. In the GFC, Botox cosmetic sales grew 7% in 2008, declined 4% in 2009, and were back to double-digit growth in 2010 and beyond
Cash flow negative
· Counter: we know from Botox this is a high margin business with compelling unit economics. Evolus opex costs have stabilized around $35mn/quarter and less if you exclude a couple million in SBC. Combined with higher sales and the new 70% GPM baseline they will be closer to cash breakeven than many realize. EOLS currently has $65m cash on the balance sheet and can pull down another $50mn tranche by YE22 although the company doesn't think they'll need it. According to them, 1/3rd of their SG&A is variable today.
Competition – going against a heavyweight in Botox is no easy task and there is some hype for a new product coming from Revance that reportedly last ~6 months
· Counter: the customer value proposition is there against Botox and any duration gains by Revance's product are largely the result of being a double-dose which Evolus is also conducting a trial on. More importantly, from speaking with practitioners it is clear that they want to see their customers more regularly, not less frequently. This enables them to build better relationships and upsell products more often which is better for their business (a product like Revance would break the friendly middleman dynamic identified above). Also, mistakes are sometimes made by injectors and a 6 month treatment risks a droopy eyelid for that much longer.
Corporate governance – evidence the company spring loaded some equity grants early this year
· Counter: none really, I didn't like this, but I did call them on it with Investor Relations
