Q1 Zorik Capital Letter

Partners,

Before kicking off the fund’s first quarterly letter, I just wanted to say a huge thank you to all of Zorik’s investors. I am super excited about the opportunity ahead and am excited to continue working with each of you.

The fund’s first quarter in operation saw considerable market volatility. From the date we began our investing activities, the market had already contracted about 20%. While in a volatile bear market, we decided to stick with our 5-7 year time horizon. Though I love studying economics, I acknowledge my job is to pick stocks, not to predict the economy.

As a one-person shop, my advantage doesn’t lie in predicting where CPI or interest rates will go. All I need to know is whether or not the economy will in a stable position by the end of our time horizon. Therefore, if I find an opportunity where I believe the stock can return 15-20% annually as a base case over the next 5-7 years, I will look past current volatility and buy.

In this market environment, we have invested 65% of our capital in panic-filled stocks which we believe are heavily discounted and should perform well over the long term, regardless of where the market travels in the next year or two. Therefore, we maintain the long-term view that we would like to be invested more, however, we believe we have the potential to see another slight contraction in the market which should spawn better prices. So, we keep 35% of our capital in cash (money markets yielding 4%), awaiting new opportunities.

For the period ended, February 1, 2023, the fund’s returns since inception (November 1st, 2022) are 9.91% compared to the S&P 500’s 6.82% over the same timeframe.

Economic Forecast

While we don’t attempt to predict short-term economic movements, we look at the economy through the lens of our 5-7 year time horizon.

In 2023, over half of US states are set to mildly raise their minimum wages, including New York, Florida, and California. This, however, has barely made headlines as most workers who work minimum wage jobs are already earning above the minimum wage. The general shortage of labor of the past few years has taught companies to be scared of laying off employees, even in a recessionary environment. Instead of seeing pressure in the workforce, 2022 has seen a 5.1% increase in US hourly wage growth and a fall in the unemployment rate from 3.9% in 2021 to 3.6% in 2022, according to the 2023 US Economic Outlook from Goldman Sachs.

What makes a recession severe is broad-scale layoffs — not just the Silicon Valley cost-saving layoffs, but layoffs on a broad scale, affecting the main street economy and workforce. However, given the still tight job market, companies have had to raise wages this year rather than instituting layoffs. The job market should begin to loosen, however, the loosening should be minor as companies are wary that the job market has remained tight.

Additionally, while many consumers are hurting and cutting back due to inflation, the broad consumer continues to have strong finances coming out of COVID. According to Federal Reserve data, assets as a percent of disposable personal income (income after taxes and all necessary expenses) are hovering close to an all-time high at 872.5%. This is compared to the 700-800% range the figure hovered around throughout the 2010s. Additionally, debt as a percent disposable personal income remains at 103%, the low end of the 120-100% range the figure has hovered in over the past ten years. This means that currently, the average American has more assets and less debt than they had on average throughout the 2010s. Thus, we believe that the consumer should be able to withstand this period’s inflation, without cutting spending too heavily. Some consumers have cut spending slightly, withdrawing from their 401k’s, however, this is not the majority according to the Bureau of Economic Analysis (BEA). Citing the BEA, inflation-adjusted consumer spending is up 1.4% YoY. This means that even if inflation is taken out of the picture, the overall amount people spent this year increased. Given that consumers, in general, continue to have strong finances, it is unlikely that this trend will reverse too strongly.

Goldman Sachs, along with most other investment banks, predicts that the supply chain’s recovery, paired with the fastest hiking of interest rates seen since the 1980s will lead to a decrease in core CPI inflation to fall to 3.2% YoY by year-end 2023 and then hit the Fed’s target 2.5% YoY by the end of 2025.

In the meantime, however, while the Fed is still hiking interest rates to help continue to lower inflation levels, the consumer, though strong, may start cutting back. This will then draw companies to follow suit in cutting spending, spawning a short, mild recession.

Nonetheless, there’s no question that the current rate hikes will harm the economy. Earnings this year will surely be affected, however, several years into the future, the economy will have adjusted. Therefore, we believe that this recession will be moderate and will not affect our 5-7 year, viewpoints on our positions.

Market Forecast

Since there will likely be a short-term recession, the one-year forward PE ratio, with a 9% forecasted EPS contraction (as predicted by JP Morgan), of 20 times earnings seems too high to us. A PE of 20, equating to a 5% earnings yield for the S&P 500, is far more expensive than the averages of normal environments. However, we are in a recessionary environment which should warrant even cheaper valuation multiples. Additionally, with many money market funds yielding around 4%, the 100 basis point premium for taking on the risk to invest in stocks is not enough for investors to be appropriately compensated for the additional risk of buying equities in a recessionary environment. Therefore, we believe that the market has the potential to contract slightly, after this recent rally, to achieve a fairer risk premium for equities when earnings start to contract.

Therefore, it makes sense for us to continue to keep 35% of our portfolio in these high-yielding money market funds to have extra available funds to purchase greater deals once the market likely contracts further.

What We Are Doing

Despite keeping funds available to find opportunities when the market contracts further, we take a longer time horizon. Yes, today’s market is uncertain, and yes any stock we purchase today may fall further. However, if we look 5-7 years out, in accordance to our time horizon, we are fairly positive on the economy (as we describe above). Therefore, we are excited to utilize our current cash pile to continue buying businesses that the market is taking an anxious, short-term point of view on. Overall, if this business is selling at a cheap enough price in today’s market to achieve 15-20% returns as a base case over the next 5-7 years, the short-term price action of today’s uncertain market should not matter. So, while this approach may result in some short-term unrealized losses, as it did this past quarter, we believe it is a necessary risk in order to maximize long-term returns for our investors. Therefore, we look to utilize more of our cash position to buy stocks that should meet our target returns over our longer-term time horizon, regardless of how they may perform in the short-term volatility.

An Interesting Endeavor

Snapchat, the social media platform with over 500 million monthly active users and 360 million daily active users has not been the primary focus of Snap Inc. Instead, Snap has been distracted by investing in augmented reality (AR) and virtual reality (VR). This has resulted in Snapchat monetizing at just 12% of Facebook’s average revenue per user (ARPU). Therefore, as a teenager, part of Snapchat’s target userbase, I decided to go activist and write a letter to Snap Inc’s management asking them to institute some of my suggested changes.

My plan focuses on two facets to help increase profitability. The first is to completely cut out the AR and VR projects. It makes no sense for a social media company to be devoting billions of dollars in research and development budgets to AR glasses. I used my perspective of being in Snapchat’s target market to help explain that none of these projects should make users spend more time on the Snapchat platform. But, after all, if Snap wants to develop AR and VR technologies, why shouldn’t they be a fast follower, following companies such as Meta which is devoting three times as much as Snap’s revenue to invest in these same technologies? I reasoned that by cutting these projects, $1.3 billion in EBITDA could be created.

I then argued that Snap should instill a higher focus on their subscription service, Snapchat+. This would add incremental revenue that would be highly accretive to EBITDA. I suggested ideas that I found from discussions with other high schoolers, all within Snapchat’s primary target base.

Combined, these measures should help generate $2.3 billion in EBITDA, pushing the EV / EBITDA down to less than seven times, over two times below the industry average of 15. Nonetheless, Snap should probably trade above industry multiples as on top of creating profitability through my plan, the firm should be able to continue its rapid growth into the future.

I hope Snap Inc seriously considers my suggestions, as I strongly believe they will drive material share price appreciation over time. If they do not take my suggestions to heart, I may look to take my campaign to the press.

Here is a link to the full letter.

An Interesting Stock Pick

This story only continues to get more and more interesting. The spin-off of AT&T’s Warner Media into Discovery could not have been timed worse. It was a classic example of how not to orchestrate a merger. When the income-focused AT&T shareholders were given shares of Warner Brothers Discovery, which would not be paying a dividend, they hastily unloaded their shares. Combine that with the impacts of a recession, a billion dollars of unexpected one-time merger expenses, and huge controversies related to cutting TV shows–which will always come with a $3bn synergy goal–you can understand why the stock is down over 50% since the merger 8 months ago.

Nonetheless, the long-term story is absolutely still intact. None of the short-term factors pushing the price down now seem to have the potential to continue hindering the stock five years from now. Five years into the future, Warner Brothers Discovery should have combined HBO Max and Discovery+ into the third-largest streaming service by number of subscribers. The streaming service should begin to leverage its subscriber base to achieve strong profitability. Additionally, the streaming service, now with a focus on profitability, will decide to release high-budget movies to movie theaters first as well as aiming to decrease overall content spend within the streaming service. Then, despite mild secular declines, the Discovery cable TV business which owns 33 different TV channels including CNN and TLC should continue producing strong free cash flow.

As the company continues to cut jobs and projects, we believe that the $3 billion synergy goal is achievable.

Additionally, the company, over the next few years will start to aggressively use its free cash flow to pay down its debt. Currently sitting at 4.4 times forward EBITDA, we believe that the company can bring its debt down to a respectable 3x EBITDA by 2025 based on its free cash flow generation.

Given to the profitability potential of the streaming business, the continued consistent free cash flow produced by the Warner Brothers and Discovery businesses, the cost synergies from the ability to produce less content for the combined streaming platforms, and the decreasing levels of debt, we believe that WBD should easily be able to achieve $7bn in FCF by 2028. This FCF generation would equate to a 25% FCF yield based on the current market cap. Based on competitors we believe a 13x P/FCF multiple is conservative. Nonetheless, in this case, at a 2026 market cap of $70bn, the stock would achieve a 19.5% IRR over the next five years.

To zoom out, this is the type of situation that I love. Due to the short-term issues of the AT&T shareholders selling, the cost synergy controversy, the recession, the one-time merger expenses, and the debt which should moderate, the long-term potential and profitability of the business are being ignored.

Closing

Over the fund’s first quarter, we leaned into buying many technology stocks which we deemed to be heavily discounted by the market. However, going into future quarters, we are seeing many more sectors that are undervalued. Therefore, we will look to purchase more positions in the coming quarters and continue to eat into our cash pile when the opportunity arises.

Overall, despite investing being a long-term game, we are happy with our results for the fund’s first quarter in operation. We would like to thank all of our investors for their support!

Thanks,

Blake Zilberman