Last year, I outlined some investment theses for 2019. With the year wrapped up, I'll quickly review how my predictions played out, and outline future investment areas I'm interested in. Writing these has helped me refine my own thoughts, and intentionally deploy capital aligned with macro views.
My theme for 2020 is an increased interest in mostly private, small (even, micro) cap companies. In alignment, we seem later in the economic cycle than before with such large multiple expansions, and so I'm skeptical about several assets that have performed well in the past few years.
If 2018 was a difficult year for many portfolios, 2019 was the opposite. Volatility contracted, US equities performed well, many unicorns IPOed, and interest rates remained low.
The US economy did avoid a recession, and equities outpaced my own expectations. Most tactical asset allocation strategies underperformed the broad market due to reduced exposure from 2018 volatility, but, as expected, did reduce their own variance. Risk is fully back on, largely fueled by multiple expansions.
Several active strategies performed well, including trend following recovering after a multi-year slump. Overall, I did well last year, but there hasn't quite been enough time to play out many of my theses (especially micro-PE). Several of the areas I deployed capital to do not have liquidity so it's too early to evaluate performance. Additionally, I left Google to co-found a startup1, taking advantage of my views of early stage valuations2. Notably, one litigation case fully settled during last year, which returned enough to cover all other litigation finance cases that I invested in.
I was most significantly wrong in two areas. Bitcoin recovered significantly more than I expected, though continues to have high volatility. Additionally, private equity massively outpaced my expectations, with one index returning 38% in 2019. Wow.
Overall, I'm lowering public market exposure, primarily to shift towards private assets. As expressed below, I have less conviction in large cap, growth exposure.
Small cap and value factor rebounds, particularly internationally
Position: See below, moving allocations around.
The Value factor has had a bad decade. Since value has many definitions, some expressions have performed well (such as high-profit “compounders”), but in general, classic factor returns using book-to-price and earnings yield have lagged.
In 2019, the cheapest (by price-to-book) quintile of US equities returned less than 1%, while the most expensive returned over 25%. This is an unusual spread, with market-cap weighting beating equal-weighting and growth significantly outpacing value. For context, when these sorts of imbalances have occurred previously, allocating to small value out-returns growth significantly.
This tilt continues when examining global markets. So, as a regression-to-the-mean position, I'd like to shift away from large-cap, and expect value, small cap, and international equities to equalize some of this imbalance. Right now, I have unrealized capital gains on my TAA exposure, and am glad a lot of my equities exposure was inside my 401k. I'm in the process of shifting a good portion of that to private investments, mentioned below.
As of now, I have no positions in direct value or small cap exposure. If I had more assets to deploy, I would invest in Verdad Capital’s Small Cap Leveraged International fund.
Likewise, I expect Growth and Large Cap to underperform, but certainly would not short this.
Commodity Trend Following continues to perform well
Position: 15% portfolio exposure to my futures trend following strategy3. No direct exposure to equities momentum.
2019 saw trend regain some of its losses. It remains not nearly as popular as equities momentum, which had an excellent year (GEM returned 23%). I expect CTA trend following funds continue with positive returns this year.
I see trend as a portfolio diversifier, and based on momentum's long term performance, expect it to continue to work well. This strategy isn't incredibly popular with retail investors due to execution difficulty and long periods of underperforming equities (due to non-correlation), yet in my experience can be captured most effectively with smaller accounts that have less transactional friction.
High-multiple, unprofitable startup IPOs struggle
This is more of a prediction than any specific position. Late-stage consumer startup valuations seem disconnected from reality, fueled by demand from large institutional funds. We watched the WeWork IPO implode last year, and I remain skeptical of other cash-burning companies like Casper, and perhaps even Away.
While writing Accreditation Laws are not Violating the American Dream, I highlighted how the median private investment dollar in Uber lost money, and their share price had not appreciated since late 2015. This is counter-narrative to many popular opinions, yet may be typical of other highly valued late-stage startups.
D2C has been a hot segment of venture during the past several years due to high profile acquisitions (Dollar Shave Club, Native, Harry's, etc). I suspect these purchases have been largely defensive, not based on classical value capture. Companies that shunned incumbent offers will have to justify their businesses to Wall St investors, which may be difficult.
Continued rise of Micro-PE
Position: Expanding exposure to 30% of portfolio, invested in Earnest, SaaS holding companies, and a few small niche web-based businesses. No liquidity.
If software is eating the world, we're entering the Deployment Age. Cost of creating new companies continues to decrease, and it's even easier to sell niche products to consumers and businesses. So, I believe entrepreneurship is undervalued. One way to solve this is with alternative funding vehicles. Tyler explains better than I can.
Additionally, founders of these profitable businesses want liquidity. Valuation multiples are still attractive, though I've seen increased interest from investors. Zooming away from internet businesses, Baby Boomers are retiring and selling their profitable businesses at increasing rates. Capital is cheap; the shortage is with operators.
I'm keeping most of my exposure centered around web-based businesses, but am also interested in wide breadth of cashflow generating companies. I have high conviction in this area, and have a lot to learn.
Private Equity's performance tapers
Private Equity vastly outpaced my expectations last year. My hunch is that, pressed for returns in a low-interest environment, institutional money has continued to chase PE, pushing multiples even higher.
This will contract, eventually. I've never directly invested in PE, but let's say if I ran CalPERS, I'd think a bit harder about this asset and stop treating delayed marks as diversification.
Position: Continued to invest in cases opportunistically, currently representing 8% of my portfolio
My thesis is unchanged from last year. I do not expect to increase exposure this year, but will re-invest in good cases if I have further liquidity events.
Position: Unchanged from last year, low conviction.
Early stage Startups
Position: I've invested in a number of very early stage startups, both directly and through syndicates, totaling <10% of my net worth.
Most significantly, in the past year, I've co-founded one, so have high exposure to this. With no liquidity and tepid median returns, I do not count these—in aggregate—as a part of my main investment portfolio. If one does very well, I'll treat it like my crypto exposure, which was almost entirely accidental.
Here's two themes with some of the companies I invested in this year. All are early stage, high-variance bets.
I continue holding a portfolio hedge built with far-OTM put back spreads, opportunistically put on, that targets a net portfolio drag of <1% per year4. I also run a couple short-term quantitative strategies on US futures markets as a diversifier.
As I'm taking a significantly lower salary this year, as a buffer, I'm holding more cash than usual.
One area I had no conviction in, Google, had a fantastic year, returning 32% in 2019 and 10% year to date in 2020. ↩︎
Hah, no, this is not why I left. ↩︎
Structured well, these are neat. If there's interest in a bit more quant finance deep-dives, I'm happy to show how they work. ↩︎