Q2 Zorik Capital Letter: 2024

Partners,

As the second quarter of 2024 comes to a close, we find ourselves looking at the economy with a positive lens, excited to further deploy capital.

Zorik has continued to pursue its strategy of identifying small cap stocks which are earning high growth adjusted returns on invested capital (GROICw), which allows for long term value creation.

Throughout the quarter, the fund saw strong performance from several newer positions such as Mama’s Creations, up 45% and Snap Inc, up 50%. Meanwhile, the fund saw weaker performance from names such as CVS Health, which declined 25%. Over the quarter, the fund outperformed the Russell 2000 by 18 basis points.

Zorik aims to invest in smaller-cap stocks that produce excess amounts of free cash flow which can be re-invested at high rates over a long period of time. We believe that this strategy best matches the Russell 2000 index. While we also look at the S&P 500, we believe the S&P 500 is less reflective of our strategy, given that nearly 30% of the S&P 500’s allocation is attributable to just eight tech stocks (such as Tesla, Netflix, and Nvidia).

Global Economic Overview

Looking forward, we continue our positive feel on the economy. 

Overall, inflation is hurting companies less and less; this is shown by the precipitous drop in companies citing “inflation” on earnings calls in the graph below. Nevertheless, it is interesting to note that the graph still shows close to double the number of mentions of inflation on earnings calls this past quarter than in 2019.

With inflation still clearly persisting–albeit far less than before–it is risky to assume very near term rate cuts by the Fed. Regardless, we believe that, in part, CPI has remained high due to the residual and stubborn lag associated with housing prices. Specifically, the housing category is still reported at 6% in CPI. Nonetheless, this should start to fall over the next several quarters.

While these categories, and others, remain elevated, we foresee the effects of past rate cuts continuing to hit the economy and continuing to slowly bring inflation down. Thus, we have no reason to disagree with the market, which prices a 70% chance of a rate cut in September, according to CME Group’s Fed Watch Tool. Overall, while the rate cuts may not be coming as fast as previously expected, we still foresee several rate cuts prior to 2025.

Thoughts on the Market

We continue to be excited about small cap stocks, which continue to trade at historically inexpensive valuation multiples. Adjusted for inflation, the S&P 500 still sits roughly 3% below its high in 2021, while the Russell 2000 is still down 15%.

Thus, we aim to continue deploying capital into small-cap stocks as we believe there will be a catch-up effect regarding returns on smaller cap versus large cap stocks.

Just eight tech stocks weigh in at 30% of the S&P 500; each of these stocks has earnings growth and valuation multiples far higher than the rest of the market. However, once some of these names are factored out of the equation, the S&P 500 is trading at a PE ratio of 18. This ‘rest of the index’ is projected to have strong earnings per share growth over the next couple of years (2024 quarterly S&P 500 projected earnings growth minus AMZN, GOOGL, META, MSFT, and NVDA pictured in the graph below). Regardless of how many times and how aggressively the Fed cuts rates over the next year or two, we believe that a couple of years from now, the economic picture will continue to look positive and that interest rates will be lower than they are today. Thus, as a whole, we continue to feel comfortable deploying capital into intriguing opportunities.

Discussion on a Few Key Positions

Mama’s:

• The one stop shop producer of deli-food for grocers such as Costco and Whole Foods had a very positive quarter with the stock up 45% percent. This was driven primarily by a very strong earnings beat by Mama’s due to new CEO, Adam Michaels’ continued focus on margins, doing an incredible job working to make the logistics and delivery routes more efficient and cutting out other unnecessary expenses. Additionally, Mama’s has continued to grow its product offering while maintaining the quality of food. Specifically, Mama’s is working on building up its brand-new, pre-packaged, long-shelf-life convenience store offering so as to start producing significant revenue within the next several quarters. We maintain our positive view on the stock, believing that the company will continue its revenue growth, while also continuing to expand margins.

Twilio:

• Down double digits within the past quarter, Twilio's stock experienced significant recent volatility. In mid-February, the company's stock price dropped notably following the fourth-quarter earnings report, which revealed revenues and earnings that surpassed estimates, but also included a decision not to provide a financial outlook for 2024. This uncertainty, combined with a change in CEO and a lower projection of future sales, contributed to the stock’s fall. Twilio, which provides the software to allow for mass text messages to be sent (such as text based advertisements) or, for example, for a consumer to be able to text a Doordash driver directly from their iMessages app, has a long runway of growth ahead. Regardless of how companies choose to spend their ad dollars in this quarter, or the next, we believe that Twilio dominates a fast growing ad market. We also still appreciate how Twilio intentionally maintains low gross margins, intended to dissuade other SAAS rivals from entering into Twilio’s SMS niche. Thus, we continue to remain positive on Twilio.

Snap Inc:

• Snap was up 50% this quarter. With over 400 million daily active users, Snap’s communications-focused social media platform, Snapchat, had previously struggled to monetize their young userbase (60% of which is under 24 years old). However, over the past year (similar to the path to value creation Zorik recommend in its 2022 letter to the Snapchat board), Snapchat has focused heavily on expanding their Snapchat+ membership. As Snapchat has added feature upon feature for Snapchat+ subscribers, the number of subscribers has grown from one million in 2022 to nine million today. This provides, several hundred million dollars of additional revenue which, overtime, should be close to completely convertible to EBITDA. We foresee continued growth in average revenue per user and daily active users, primarily internationally, to help propel future growth. We are glad that Snap has prioritized Snapchat+ (as we had described in our 2022 letter) and are excited by Snap’s growth and increased profitability, as a result. We also continue to view Snap as a ‘special’ social media platform given that, unlike other social media platforms, Snap is a necessity for genz-er’s daily communications with friends. While up 50% this quarter, Snap still has a price to sales ratio of 4.55 (this is compared to 7.3 for competitors such as Pinterest, and 7.4 for competitors such as Reddit). Thus, we still view Snap as undervalued and an attractive opportunity going forward.

Thoughts on Beta

Recently, I found myself considering the financial statistic ‘beta’. While found with a complex equation, simply put, a stock's beta measures how much the stock’s price moves compared to the broader market. A beta is higher than 1 means the stock is more volatile than the market, while a beta less than 1 means the stock is less volatile. For example, a stock with a beta of 1.5 tends to move 50% more than the market in either direction.

While individual stocks do not have to move up and down with the market, most of the time, a stock with a high beta will lead to the stock outperforming in a strong market and underperforming in a weak market. As the market will experience both strong and weak periods, the excess performance of a high beta stock in either direction should cancel out to achieve market average performance over time. Regardless of whether the volatile swings on either end cancel out over time, a volatile stock should be worth less than a non-volatile stock for most investors as they seek to minimize volatility and ensure more predictable, stable returns over time.

This rationale is what is built into the way many people value stocks. To find the net present value of a company’s future free cash flows, investors will often use formulas such as the capital asset pricing model (CAPM) as a discount rate. The beta of a stock is built into such formulas. Thus, a higher beta equates to a higher discount rate and thus a lower projection of net-present-value.

For a shorter-term investor this makes sense; however, for a long-term investor, volatility is not risk. If the investor knows they can hold the investment without needing to sell, the short term volatility of the stock is irrelevant (as long as the company survives until the end of th investment period); for a long-term investor, performance over the span of the investment is what matters. To put it simply, for a long term investor, the day to day volatility of a stock is irrelevant. What instead matters is where the company will be at the end of the investment.

Thus, long-term investors can selectively take advantage of stocks that are undervalued by short-term investors, who often use higher discount rates which undervalue volatile stocks that may be perfectly safe over a longer time horizon.

To test this, I plotted the returns of the past five years for the S&P 500 stocks against the stocks’ beta on the x-axis in the graph below. 

After cutting out some outliers (including all negative betas and betas over 2.5), my thoughts were confirmed: a higher beta produced a slightly higher return. 

While an R2 value of 0.16 would be deemed small for most regression models, for this it makes sense. The R2 value of 0.16 shows that beta is attributable for 16% of the variance in stock returns. In other words, 16% of a stock’s total return (over a five year period) is dependent on the stock’s beta value. It would not make sense for this value to be any higher because there are many other elements that drive a stock’s performance.

As a result, based on the past five years of performance of the S&P 500 stocks, the model above predicts a stock with a beta of 1 to return 9.2% a year, while a stock with a beta of 1.3 will return 12.4% a year. Though this was a small experiment and a confined year-range, the takeaway backs up my belief that opposed to short-term investors, long-term investors have the advantage of not caring about short term volatility. Instead, long term investors can select volatile names (that due to short-term investors incorporating beta into discount rates and causing volatile stocks to be valued less than less volatile stocks) will outperform over a longer term period of time.

Ultimately, by disregarding short-term volatility and embracing higher-beta stocks undervalued by a short-term focused market, long-term investors can leverage the purchase of volatile stocks as a strategy to achieve superior returns.

What We Plan To Do Moving Forwards

Moving forwards, we plan to continue deploying capital in intriguing investments. As discussed above, we believe the economic landscape to be positive, thus providing a strong landscape to continue deploying capital.

We remain positive on small caps given the historic undervaluation in comparison to large caps (as discussed in Q1 2024 letter). We are also excited on the premise of purchasing long term holdings that are undervalued due to short term volatility.

Conclusion

We are deeply grateful for your continued trust and partnership as we navigate the market. We are excited to continue deploying capital in businesses we aim to hold over the long term.

As always, we are truly appreciative of the opportunity to manage your investments.

Thanks,

Blake Zilberman