Avory & Co.'s Quarterly Letter: Do Not Compare The Rise In Tech To 1999


Risk or Reality

It is now July of 2018. Time is flying. Rhetoric continues to build around numerous global affairs. Questions such as, what will happen with North Korea, will tariffs be a net negative and who will suffer, what should we make of global elections, will artificial intelligence kill jobs, is the market a bubble, what's going on with Russia, how to handle border security, and the stories go on...

All of these are real topics, but most of these play little role in businesses which possess the qualities we demand. With the S&P 500 fluctuating on a single tweet, my logic may seem naive. Some will say, "how does it not matter if the market is reacting?". My response to that remains pure and is deeply rooted in our investment process. Historically, businesses who have substantial competitive advantages will react accordingly.

We look for companies with tangible economic moats, a healthy balance sheet, a customer who is dependent on their product, a management team that can execute with scale, and a company with attractive unit economics. These are the characteristics which we require and provide barriers to headline risks.

A recent study by Statista suggested that the top three reasons why companies fail are product fit, cash shortage, and poor team chemistry. Typically the first two problems will lead to the later. The point of the stat is to surface the actual reasons behind investment failures. Blockbuster didn't fail because of Russia, Toys R Us didn’t go bankrupt last week because of trade tariffs, and Lehman didn't collapse because of global affairs.

All of these had company-specific missteps combined with poor financials, which led to their eventual liquidations. The quote on the prior page eloquently articulates the track record of the markets despite unfortunate hardships throughout time. International Business Machines IBM is 104 years old, Walt Disney Co DIS is 95 years old, Microsoft Corporation MSFT is 43 years old, and Apple Inc AAPL is 42 years old. They all survived the times, and our goal is to find the next company to last 50+ years. 

Views From the Frontline

After an eventful first couple months in 2018, the market is currently sitting in a broader trading range. The S&P 500 touched 2,872 back in January before crashing -10% to 2,581 in late January and again in March. A trading range is healthy in my view as it allows market participants to digest the topic of the month.

At the same time yields in the United States have risen to levels last seen in 2014. After bottoming at 1.35% in July of 2016, the 10-year yield now sits at 2.87%. This is a 112% rise over a 2-year stretch, the longest ever.

Let's dig into this a little bit as yields are critical to economic health. The second largest 2-year climb in rates was in 1981, which preceded the recession of 1981. At this time yields went from 9.0% to 15.8% on a month-end basis. The yield figure is essential as the flow through cost to businesses and consumers is less severe in today's environment. For instance, a $100,000 loan in 1981 would have added an incremental $6,800 to annual interest payments, compared to $1,520 using today's rate increase.

Also, the corporate profit margin in 1981 was 6% compared to near 12% today. This margin buffer is critical as companies may have the required cushion to withstand additional rate hikes. Eventually, margins and growth will be eroded away, however that day may be multiple years away, not months.

This leads me to technology. The technology sector now makes up 26% of the broader market index. Back in 1999, the sector shot up to 30% from 12% in 1996. Some are relating this heightened weighting as a sign of the times. I disagree and believe most investors misunderstand the economic moats which have emerged in the sector. I will start off with a reasonable way of thinking about technology today. Microsoft Office 365 is currently used by over 80% of Fortune 500 companies. The Microsoft product suite handles productivity tools, communication, security, etc.


These companies tend to have thousands of employees spread across multiple countries and exposed to various languages. As each new employee is trained using the current system, it makes it laborious to migrate to an alternative. 

Furthermore, enterprise software companies produce starting gross margins above 70%, leaving them sufficient capacity to market their products and build massive user bases from the start. As a comparison, Coca-Cola has 33% gross margins, leaving the industry with less margin of safety. This may sound counter-intuitive to historical economic theory, however, I believe some areas of technology are more of a staple today than what we have considered to be staple companies in the past.

Microsoft is simply just one example but there are numerous software companies rapidly building market share in other industries.

To wrap up, there has been a great deal of noise which has led to investor nervousness. I may add that I think it is prudent to be nervous, but let rationale thinking win out. While I do believe there are broader risks in the economy such as auto loans and the student loan burden, I do understand that every single company has their own unique story and it is our job to discern its merit.

Sean Emory is the founder and CIO of Avory & Co.

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