Q3 Zorik Capital Letter

Partners,

The past several months have been a complicated period in the market, characterized by a strong yet narrow rally. Although a glance at the indices would suggest a robust rebound, there is more to this story than meets the eye. The impressive 7.99% rise in the S&P 500 during the quarter was primarily driven by "the magnificent seven," a term coined by several news providers to describe seven heavily weighted tech stocks within the index that rose massively on excitement related to the AI sector. However, upon excluding these seven stocks, the index's appreciation shrinks to only a couple of percent, while the majority of value stocks remained flat.

Due to the fund’s focus on value stocks, primarily outside of these seven, and due to the several holding specific events, the fund underperformed during this past quarter.

We continue to sit happily, holding our long-term picks as we know that despite market volatility and stock-specific under-performance, our thesis has not changed on any of our picks.

For the period April 1 2023 to July 1, 2023, the fund’s returns were -0.03% compared to the S&P 500’s 7.99%.

Market Forecast

The economy has seemingly remained strong in the face of the Fed’s continued hikes. However, Zorik believes we are slowly beginning to observe the lagging weakness that these hikes create.

As the Federal Reserve Bank paused its cycle of 15 consecutive months of rate hikes, real consumer spending (according to McKinsey’s Monthly update on the state of the US consumer: June 2023) declined YoY for the second month in a row. As rate hikes create lagging weakness, felt months after they take effect, we believe that there is further room for pain.

This is exacerbated by how inflation, though slowing, has stubbornly remained above the Fed’s 2% target. Goldman Sachs predicts that YoY CPI inflation will only reach "sub-3% sequential core inflation" by the end of 2023. While the Fed states that they will continue hiking after this current pause, there is certainly reason to believe that this cycle of high rates could last for longer than expected until inflation finally falls to the 2% target.

Zorik does not believe that these potential risks are fully priced into the markets.

This chart, derived from The Financial Times depicts this issue perfectly. The spread between the risk-free rate of three-month US Treasury bonds historically remained at a 400-700 basis point differential. However, this has condensed over the past year and a half to become equal. In other words, equities, as a whole, are the least attractive to own in comparison to bonds in the past decade. Therefore, while there are risks to the market and earnings which have the potential to play out over the next several quarters, the markets are priced very richly.

Regardless of what occurs with the economy, we find the current margin of safety for stocks to be non-existent to negative. Therefore, if earnings get hit beyond estimates or rates stay high for longer, the market may have considerable downside.

What We Are Doing

While the risk-reward spread for the broader market does not seem favorable, we have identified several, primarily value-specific opportunities that can generate outsized returns over the longer term.

As investors flock to overvalued AI names surrounded by hype, we look to purchase names that investors are tired of owning. Therefore, we believe that our concentrated portfolio of overlooked stocks should return 15-20% annually over the next five years. Comparably, we believe that the broader market will significantly underperform due to its current overvaluation, as described previously.

We intend to hold a 10-15% cash position invested in 5% yielding money market funds to take advantage of any potential downside in the market.

Thoughts on AI

I thought I’d do a section on AI as it may be interesting to help understand the next generation’s viewpoints and usage of the technology as well as Zorik’s unique strategy to take advantage of investment returns from the adoption of artificial intelligence.

Firstly, as you may imagine, my generation of high school classmates has been fast to adopt the recently available AI technologies—centering around Open AI’s ChatGPT. Already, students are accustomed to these technologies, using them to help with nearly every school project. Most students are using the technologies to help enhance their work, working in conjunction to produce more efficient, better thought-through work. While only a couple of months after the introduction of the technology, I would argue most students couldn’t imagine conducting a large school project without the use of the technology for help. Current students are, as a result, producing higher quality work more efficiently by outsourcing some of the steps to produce work to AI. Although many individuals in the existing workforce may not have embraced the mindset or gained the experience to effectively utilize ChatGPT for various tasks, the upcoming generation of workers will be far more proficient. In fact, for jobs that are not eventually replaced by newer iterations of this technology, a significant majority of white-collar workers from the next generation will likely employ this technology extensively, much like they currently do in educational settings.

The use of this technology will very likely have the benefit of increasing efficiency around the workforce, allowing companies to be able to hire fewer workers as AI-competent workers can work more efficiently and produce higher quality work than their prior counterparts.

Similar to the earlier days of the internet, it is challenging to invest in specific AI companies as it is not clear which ones will prevail. Instead, it is a better idea to invest in companies that may become beneficiaries of the technology.

Everyone knows that factories and trucking companies have margin upside as robots and AI will take over existing jobs in these fields. Therefore, some of this margin upside is priced into the stocks. What’s more interesting are opportunities in which a company’s greatest expense is its employees—and then on top of that, the employees can be replaced by AI. As an example, this may include news companies as much of the thought, planning, and writing process of developing articles can be executed by large language models and technologies similar to ChatGPT. All in all, it wouldn't be surprising if a news company such as the New York Times could cut the employee count by 25% in the future due to the employment of AI. This situation would bring in something in the range of 50% net income margin upside. We believe that this concept of margin expansion through a greater efficiency workforce has not yet been realized by the markets. As much of this is several years away, we have not yet identified any companies we would like to invest in that fit with this thesis. However, we will continue to work, identifying companies that fit, given that we think the thesis has true potential.

Our Largest Position — Digital Turbine

Digital Turbine (APPS) is a unique company. We believe that it is a strong, growing, advertising company that operates as a monopoly. Additionally, it has many ways to continue to monetize which are under-appreciated by the market.

Over the past year, transitory ad price and phone sale declines have caused the stock’s valuation to re-rate to levels of a far weaker company. Once the economy rebounds and growth returns, we believe that the valuation multiples should re-rate to that of a high-quality, growing company.

Android, being an open-ended operating system, downloaded onto 3.6 billion phones around the world, allows developers considerable freedom to develop as they please on the platform. This is because Google, which owns Android, primarily aims to ensure that its search engine is installed on all Android phones. Google aims to increase the reach of its search engine by increasing the use of Android. As a result, Google makes Android highly customizable and adaptable, allowing phone companies to easily add and tailor the software to their specific needs. This is where Digital Turbine comes into play…

Digital Turbine's On Device Media segment works with phone providers/carriers around the world, striking deals to pre-install its software (Mobile Delivery Platform) directly onto Android devices that are sold by these carriers/phone providers. This enables Digital Turbine to collaborate with companies wishing to pre-load their apps on the home screen of newly purchased Android phones. As an example, Uber may pay Digital Turbine to have their app installed onto any newly purchased Android phone. Therefore, users who may have previously relied on Lyft may find it more convenient to use the Uber app instead, as it will come pre-installed on their phone from the moment of purchase.

Thus, Digital Turbine has a strong moat within its niche in the advertising sector. Digital Turbine has formed long-term agreements with 25 phone carriers, giving it the power to attract and price advantageously to a much larger number of advertisers compared to what an individual carrier can attract alone. This is proven by the 150 million apps that Digital Turbine has delivered onto newly sold phones. Digital Turbine holds a dominant position in the market, functioning as a virtual monopoly, boasting three times the market share of its only other competitor.

Over the past several years, Digital Turbine’s revenue growth has benefited from adding new phone carriers as well as a strong ad market and strong phone sales. However over the past year, as a result of the current recessionary environment, Digital Turbine has been hit with a double-whammy of second-tier (outside of prime ad providers, ie. primetime TV, Google Ads, etc.) ad prices falling 10-20% and phone sales falling 14% globally. As a result, Digital Turbine took a 25% YoY revenue hit. Therefore, the stock proceeded to re-rate from trading as a high-growth company, to a low to negative grower. However, as the economy and spending recover over the next several years, phone sales and ad prices should also recover. As a result, the stock trades at a low 8.4 times EPS. This is compared to other advertising companies trading within the 10-12 times range. Nonetheless, due to the tailwinds of global mobile phone adoption, the shift to mobile advertising, and the continued acquisition of new phone carriers, Digital Turbine should be able to produce elevated growth, warranting it to trade at the top of this range. Reaching this multiple would produce 42.8% upside over the one to two years until their sales growth recovers.

Digital Turbine, however, doesn’t just place apps onto phones. The agreements that Digital Turbine signs with the phone carriers grant the company unique access to Android phones held by consumers. Because of this, Digital Turbine has a unique ability to build products that can monetize their access to peoples’ phones. Through its SingleTap technology, Digital Turbine allows consumers to download apps seen in in-app advertisements with one click. With this technology, users no longer need to leave the app or website they're using to download the advertised app. This is very valuable for the advertiser. The use of this SingleTap technology in an advertisement increases conversion rates by 200%.

While SingleTap is still in its infancy, having only just signed some of its first partners, which include Amazon and Epic Games, Digital Turbine estimates that this technology has the potential of bringing in up to $1bn in incremental revenue, or 143% of the entire company’s current revenue. While this is only a minor part of the thesis, it does emphasize the upside that the stock could have as Digital Turbine attempts to fully monetize its software’s presence on Android phones.

Until ad prices and phone sales recover, this stock will likely be rocky. However, looking past this period of difficulty, revenues should rebound, and valuation multiples should re-rate to that of a growing company---that quietly operates as a monopoly. This base case—which factors in very little of the potential upside from monetizing Digital Turbine’s on-phone software—gets us to a 17.5% IRR over the next five years. This can, however, be increased to 23% by assuming slightly more bullish growth, and ability to monetize their on-phone software. And, if one is slightly more bullish on the potential for products such as SingleTap, the IRR will soar.

Thus, we like the risk-reward with this name.

Closing

We want to stress that we feel very good about our portfolio this past quarter. In the process of buying unloved companies, we expect it to take time for the thesis to play out. That’s merely what we saw here.

As we look forward, we continue to be excited by our opportunity to find intriguing stocks that have been overlooked as a result of the excitement within the AI space of the markets. We, additionally, continue to be very excited by our portfolio’s holdings, believing they can return 15-20% annually over the next five years.

I want to thank everyone for their support!

Thanks,

Blake Zilberman