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NZS Capital Third Quarter 2022 Update
October 11th, 2022
Market Commentary
The third quarter was marked by the ongoing tug of war between investors, policy makers, dictators, and the painful landing of the pandemic-inflated economy. In the short term we expect uncertainty to persist; however, over the long term we know that the future, like always, will be determined by the optimists. Investing, like nearly everything in life, is a form of storytelling. When anyone buys or sells a stock, they are crafting a story about the future. But, of course, no one can predict the future with any precision, and relying on the past can be just as problematic. Therefore, the stories we tell must be based on what we can clearly discern in the present, no matter how foggy the environs might seem. We then live through these stories as they play out in real life, fact-checking our narrative with reality to identify plot holes, inconsistencies, and elements of truth that help us refine our story. There are some types of plots that tend to play out more often than others, there are always unexpected twists and, if you are lucky, a deus ex machina. At NZS Capital, we think stories of optimism – where the protagonist is adaptable and creating more value than they take (non-zero sumness) – occur much more often than stories of cynicism and pessimism, where the characters are rigid in their beliefs and extract too much value from society. The market, however, tends to be more cynical than optimistic, which creates cycles of fear.
Investing in the stock market is like buying a ticket to a movie about which we have little a priori knowledge. We can make educated guesses based on the title and trailer, but sometimes a seemingly feel-good rom-com has an unexpected horror subplot. The current market volatility implies a tension between two completely different plots for how our economic future will unfold. One story is a doomsday movie wherein government policy makers, in an attempt to rewrite their “certified-rotten” pandemic-policy script, send the economy careening off a cliff while geopolitical tensions send humanity into nuclear armageddon. Herein, there is no hero, and the only way out is time and patience. Like Major King riding the bomb in Dr. Strangelove, this movie ends with more uncertainty and questions than with which it began. The other script, however, has a happier ending. The underpinning of this second narrative is the self-healing ability of the economy, with innovation and hope driving a long cycle of post-WWII-like prosperity, investment in green energy, and a steady increase in global economic resilience. The first story implies that the last forty years of globalization, low interest rates, deflationary forces, and rising inequality will be met with a long and harsh punishment. In contrast, the second story plays to the evolutionarily ingrained resilience and ingenuity of humans. Of course, there are thousands of ways the future could play out, and we won’t know the ending until the lights come up and the curtains close.
Advantageously managing this uncertainty is what defines our investment process at NZS Capital, as we focus on adaptability, non-zero-sum outcomes, and matching investments to their potential range of outcomes rather than narrowly predicting the future. Like the complex world around us, the global economy is dominated by power laws and extremes. Humans, however, tend to be linear thinkers, so we can miss emergent, game-changing events unless we train ourselves to look outside our typical mental confines to routinely scan left field and beyond. Some of the best stories of the future may be written in surprising locations and combine different topics and technologies in novel ways. Importantly, in times of volatility, policy changes, and technological disruption, economic resources often shift and refocus on newly emerging areas. A series of events, such as the world has recently experienced, can create pivot points for society. We continue to see significant opportunities in the engines of the analog-to-digital transition of the global economy, such as software, semiconductors, and the Internet. But, we expect resources and attention to shift to new origins of asymmetry in areas like AI, automation, healthcare, and other parts of the economy.
While we cannot know the precise storyline for what lies ahead, we can appropriately prepare for all potential plot twists. The Optionality tail of our strategies is designed to seek out and take advantage of innovation wherever it is evolving, while the Resilient head of each portfolio is designed to provide enduring growth. We continue to see opportunities across the spectrum of companies that we believe will play key roles in scripting our economic future.
Performance Discussion
The NZS Capital Growth Equity strategy was down 4.58% net of fees in the third quarter of 2022; in comparison, its global market index benchmark declined by 6.75%. Year to date, the strategy was down 34.75% net while the index fell by 25.41%. Since inception, the strategy has cumulatively risen 31.52% net compared to a 2.44% return in the benchmark. The NZS Capital Select strategy was down 2.70% net in the third quarter of 2022, with a net year-to-date decline of 31.42% and a cumulative net gain of 41.89% since inception. Full Table in PDF.
Thank you for your continued trust, interest, and support.
About NZS Capital
The research process at NZS Capital is guided by complex adaptive systems and the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. We believe this combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy. Our investment framework can be found in Complexity Investing.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .1625% quarterly) from the gross return. Gross returns are inclusive of reinvestment of dividends or other earnings. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
NZS Capital, LLC claims compliance with the Global Investment Performance Standards (GIPS®)
GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
GIPS® Composite Reports are available upon request by emailing request to info@nzscapital.com.
NZS Growth Equity and NZS Select are reported in USD.
The benchmark for the NZS Growth Equity Composite and NZS Select Composite is the Morningstar Global Target Market Exposure NR USD. The index is designed to provide exposure to the top 85% market capitalization by free float in each of two economic segments, developed markets and emerging markets.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q2 2022 Letter
NZS Capital Second Quarter 2022 Update
July 11th, 2022
The NZS Capital Growth Equity strategy was down 23.44% net of fees in the second quarter of 2022; in comparison, its global market index benchmark declined by 15.64%. Year to date, the strategy was down 31.62% net while the index fell by 20.01%. Since inception, the strategy has cumulatively risen 35.33% net compared to a 9.86% return in the benchmark. The NZS Capital Select strategy was down 22.70% net in the second quarter of 2022, with a net year-to-date decline of 29.52% and a cumulative net gain of 45.84% since inception. For a full table of performance please download the PDF.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
Performance Discussion
The following second quarter 2022 performance discussion references the NZS Growth Equity strategy. Our investments and overweights in technology and communication services led the significant underperformance in the quarter, down 23.8% and 24.3% respectively. The top-owned positive contributors in the quarter were SailPoint, T-Mobile, and Danaher. Being underweight several large index positions contributed to performance as well – in times when most stocks in the market are declining, performance can be driven more by the stocks you don’t own than the ones you do. Among the largest active detractors in the quarter were several software and semiconductor investments, including Workday, Salesforce, Okta, Microchip, and Lam Research. We believe the stock valuations of these companies, and their sectors as a whole, reflect an overly pessimistic view of their long-term growth potential and an underestimation of the deflationary forces they bring to the economy, and we therefore added to many existing positions. Other negative detractors were in the media sector, such as Walt Disney, Paramount, and Snap, as slowing economic growth impacted advertising, and consumer media habits shifted toward short-form video. Lastly, aluminum can maker and aerospace company Ball detracted from performance over fears consumers would curtail their large, pandemic-era grocery store beverage purchases.
Market Commentary
Our primary focus at NZS Capital is finding companies driving the analog-to-digital transition in the global economy. These companies are largely powered by innovation and the creation of the most non-zero-sum (win-win) outcomes for all constituents, including employees, customers, society, the environment, and investors. In some cases, these companies are growing faster than the overall economy, are investing to improve their future prosperity, and are not overly focused on their short-term bottom lines. Rapidly rising interest rates in 2022 have had an outsized impact on the valuations of many of the types of companies in which we invest. Globally, growth stocks were down 20.15% while value stocks only fell 11.50% in the quarter, with year-to-date declines of 27.92% and 12.34% (respectively) according to Morningstar (1). Although we made several significant adjustments to the portfolio throughout 2021 to reflect the higher risk of interest-rate-driven valuation exposure, these changes were not enough to completely inoculate performance from the market’s reaction to the high inflationary environment and resulting aggressive central bank rate policies.
We build our portfolios with concentrated Resilient investments balanced by a long tail of Optionality investments. In times of extreme market volatility, such as we have seen for the last couple of years, we stay vigilant to assure that every position size matches the range of outcomes for each investment. In most cases when a stock value swings dramatically, it doesn’t indicate a fundamental change to the long-term range of outcomes for the underlying business. Accordingly, when stock devaluation is driven by the market using higher discount rates to value future cash flows, the stock can become more attractive.
One of the most important characteristics we look for in Resilient investments is adaptability. Periods of economic volatility offer an opportunity for such organizations to capitalize on their flexibility and creativity, and the best management teams will emerge stronger on the other side. Resilient companies tend to be extremely good at both investing for the future and maintaining economic sustainability, regardless of the ambient economic weather. Rather than reacting to uncertainty from a place of fear, the best management teams will play smart offense, preserving their own prosperity and continuing to look out for their customers’ best interests rather than dramatically cutting services or significantly raising prices. Such organizations understand that by always partnering with customers to economically and expediently solve problems, they have the best chance of preserving and growing their customer base and ensuring their own longevity. We therefore expect that, in aggregate, our Resilient investments will emerge from the downturn stronger than ever.
Optionality investments also tend to be adaptable, but they are generally more sensitive to economic weakness and other factors at play in times of uncertainty. Because these companies lean heavily on innovation and growth, they risk underinvesting if they don’t have the financial resources to weather a downturn. In combination with higher rates forcing a devaluation of future discounted cash flows, these less insulated businesses tend to suffer significant stock pull-back relative to the market. The market’s recent souring on growth stocks has created a once-in-a-decade opportunity to own Optionality companies with highly asymmetric outcomes in aggregate. Even though we don’t expect all of these investments to necessarily play out positively, taken in sum, the catalog provides an opportunity to compound positive growth for many years.
By considering the current characteristics of the stock market, the macroeconomic outlook, and the elements of Resilient and Optionality investments, we see a better setup for returns than we have seen in some time. We’re not in the business of calling market bottoms – we try to avoid all predictions that require a high degree of precision – however, we know it’s only a matter of time before the clouds clear and investors once again appreciate the value of the types of businesses in which we invest. It therefore becomes a question of how long it will take for the market to recover. We have prepared for this period by matching each position in the portfolio to its potential range of outcomes and incorporating a balanced set of businesses that we believe will both weather further uncertainty and be poised to see accelerating fundamentals regardless of what unknown storms the future brings.
While central banks are focused on trying to fix the inflation that resulted primarily from excessive fiscal spending and overly accommodative monetary policy during the latter stages of the pandemic, we are focused on how innovation remains the primary disinflationary force and productivity engine for the global economy. Taking our cues from biology, we know that adaptable companies providing the most value (non-zero sumness) to their ecosystems will take advantage of the ongoing volatility in the economy. By solving problems for their customers and providing more value for the same or less money over time, these companies will not only be combating inflation and contributing to economic recovery, they will be ensuring their best chances at prosperity.
Our expectation is that market-based economies in developed countries are generally self-healing. Thus, the fear of higher inflation is often enough to assure that inflation won’t come to pass. As the economy transitions to digital and information travels faster and faster, companies and consumers are able to adapt more quickly to changing conditions, including expectations of inflation. This should allow, in time, the self-correcting mechanisms of the economy to accelerate as well. For example, two companies that we invest in, Tesla and Amazon, both sell direct to consumers, allowing them to more quickly identify changes in demand and adjust their capital investments and headcounts accordingly. Such real-time knowledge and customer awareness are key contributors to adaptability and will become a more impactful motive force with the continued digitalization of the global economy.
While there are always reasons to be pessimistic, we see even more evidence to remain optimistic about the future of the companies we invest in on behalf of our clients.
Thank you for your continued trust, interest, and support.
(1) The Morningstar Global Growth Target Market Exposure NR USD and The Morningstar Global Value Target Market Exposure NR USD indices.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .1625% quarterly) from the gross return. Gross returns are inclusive of reinvestment of dividends or other earnings. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
NZS Capital, LLC claims compliance with the Global Investment Performance Standards (GIPS®)
GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
GIPS® Composite Reports are available upon request by emailing request to info@nzscapital.com.
NZS Growth Equity and NZS Select are reported in USD.
The benchmark for the NZS Growth Equity Composite and NZS Select Composite is the Morningstar Global Target Market Exposure NR USD. The index is designed to provide exposure to the top 85% market capitalization by free float in each of two economic segments, developed markets and emerging markets.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q1 2022 Letter
NZS Capital First Quarter 2022 Update
April 18th, 2022
The NZS Capital Growth Equity strategy had a gross decline of 10.54% (-10.68% net) in the first quarter of 2022 compared to its global market index benchmark, which was down 5.18%. Over the last twelve months, the strategy returned 2.65% (1.98% net) compared to the benchmark’s 7.29%. The NZS Capital Select strategy declined 8.68% gross (8.82% net) in the first quarter of 2022 and rose 2.89% (2.23% net) over the last twelve months. For a full table of performance please download the PDF.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
Performance Discussion
The following first quarter 2022 performance discussion references the NZS Growth Equity strategy. Overall performance lagged the broader market. For the quarter, our technology investments led the portfolio down, dropping 14.1% compared to the benchmark’s technology stocks, which were down only 10.4%. Both our weight in technology stocks and the stocks we were invested in relative to the benchmark detracted from performance. Other detractors were our relative underweights in energy and financials, which outperformed on rising interest rates and commodity prices. Positive contributions came from the communication services sector, where our positions were up 3.3% compared to a 9.9% drop in the benchmark. Both our overweight and performance of the communication services sector contributed positively. Our REIT investments detracted modestly as these stocks tend to underperform in rising rate environments. Among the top contributors in the quarter were Paramount Global, T-Mobile, Nexon, SailPoint, and Nintendo, as well as not owning Meta Platforms. Among the largest detractors in the quarter were Lam Research, Salesforce, Sun Communities, PayPal, and Okta.
Market Commentary
As expectations for interest rate increases rose in concurrence with global uncertainty, the first quarter of 2022 was a period of underperformance for our strategies. The market has a particularly hard time finding any sort of equilibrium in times of rising uncertainty, as we noted in last quarter’s letter. Focusing on companies that adapt, innovate, and grow over time inherently means that we assume their future free cash flow will be far in excess of today’s free cash flow. As investors discount cash flow back from the future to today, rising rates decrease the net present value of those theoretical profits. Around March of 2021, investing in the highest growth rate companies (i.e., companies with far more expected profits in the future, and, in many cases, losses today) became an explicit bet on interest rates. Meaning, with rare exception, the only way for that group of stocks to keep rising was for interest rates to keep falling, and thus making future cash flows more valuable. Our preference is to avoid having narrow predictions, such as “interests will fall”, steering our portfolios. Therefore, we reduced a portion of our exposure to the highest growth stocks between March and December of 2021.
One of the key advantages we have with our Resilience and Optionality portfolio construction framework (see Complexity Investing) is the ability to shift between durable growth companies (Resilience) and higher asymmetry companies (Optionality). Owing to this higher asymmetry, the outcomes of Optionality positions are more prone to rate-induced fluctuations because the majority of their value lies in the future. Shifting from Optionality to Resilience in 2021 helped, but did not completely immunize performance from the impact of rising rates in the first quarter of 2022. As long-term investors, we are comfortable with interest-rate-driven volatility in the portfolio, which we look to use as an opportunity. In most cases, rising rates do not significantly impact the fundamental range of outcomes for businesses in which we invest; therefore, stocks that go down due to higher short-term rates offer an opportunity, all else being equal. By not making an explicit prediction on interest rates, we can focus our energy on the fundamental range of outcomes for the companies we invest in and fitting those investments into our portfolio construction process.
Following the sharp correction in the highest growth stocks in the first quarter, we have quickly found ourselves in a different investment climate. In general, the market extrapolates the impact of short-term interest rate hikes to a degree that overly discounts future free cash flows. When that happens, it can create opportunities for long-term investors in companies with growing cash flows. As noted, predicting the future levels of rates has historically been a fool’s errand. However, taking advantage of the collective cognitive bias of the stock market can be a fruitful way to profit over time. In order for the long term value of a company to be reduced, you would have to predict long-term higher rates, which requires an inherent assumption of long-term higher inflation. However, that scenario is contradicted by the deflationary nature of technology and innovation.
We look for companies whose success in taking share of the global economy relies on as few predictions as possible and then match position size to the potential range of outcomes. For most investors, not making predictions can be an uncomfortable behavior, but in a world that is increasingly unpredictable due to the rising pace of change in the Information/AI Age, it’s of increasing necessity to build this skill. We believe thinking biologically helps identify the companies that will take share as the economy moves from analog to digital. As such, adaptability and maximizing non-zero-sum outcomes are the winning traits for long-term investments.
As the market continues to seek homeostasis, a key question remains: what part of inflation is structural and what part is due to the excess fiscal and monetary stimulus of the pandemic? The correct answer is: nobody knows with any level of certainty. It appears to us that the pandemic had little lasting impact on the global economy or people’s behavior, with the exception of the ongoing erosion of trust in governing institutions, and perhaps an acceleration of technology investment. Time will tell. As we emerge from the pandemic stimulus period, we can look at the long-term trajectory of rates, which tend to fall as leverage increases on an economy, along with the deflationary power of technology, which tends to accelerate in the face of higher costs. Further, with the rising specter of global conflict and supply chain snarls, one might assume inflation could rise due to deglobalization; however, the stagnant population growth and low immigration in developed worlds makes it inconceivable that we veer far from the path of continued globalization in the near future. This is a good thing for global peace, which ultimately depends on our rising interconnectedness.
As we survey the state of the global stock market today, there remains broad risk but also a growing set of opportunities as investors lump all growth stocks together and assume long-term inflation and structurally higher rates. It could be that rates will be much higher for much longer, but, as technology investment cycles speed up on the back of rising innovation, the deflationary power of technology will accelerate to solve the problems the world faces. The only thing we can say for certain is that we don’t know what the future will bring, but we continue to find companies that are creating and benefiting from that future.
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .1625% quarterly) from the gross return. Gross returns are inclusive of reinvestment of dividends or other earnings. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
NZS Capital, LLC claims compliance with the Global Investment Performance Standards (GIPS®)
GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
GIPS® Composite Reports are available upon request by emailing request to info@nzscapital.com.
NZS Growth Equity and NZS Select are reported in USD.
The benchmark for the NZS Growth Equity Composite and NZS Select Composite is the Morningstar Global Target Market Exposure NR USD. The index is designed to provide exposure to the top 85% market capitalization by free float in each of two economic segments, developed markets and emerging markets.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q4 2021 Letter
NZS Capital Fourth Quarter 2021 Update
January 10th, 2021
The NZS Capital Growth Equity strategy had a gross return of 5.91% (5.74% net) in the fourth quarter of 2021 compared to its global market index benchmark, which was up 6.62%. The year ending December 31st, 2021, the strategy returned 22.62% (21.83% net) compared to the benchmark’s 18.57%. The NZS Capital Select strategy rose 5.14% gross (4.97% net) in the fourth quarter of 2021 and rose 25.47% (24.66% net) for the year. The end of 2021 marked the two-year anniversary of the founding of the NZS Capital Growth Equity and Select strategies. Since inception, Growth Equity rose 41.60% (40.67% net) annualized and Select rose 44.79% (43.85% net) annualized compared to a 17.19% return for the index.
For a full table of performance please download the PDF.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
Performance Discussion
The following fourth quarter and full year 2021 performance discussion references the NZS Growth Equity strategy. For the year 2021, our top ten contributors were NVIDIA, ASML Holding, ViacomCBS, Alphabet, Lam Research, Crown Castle, Microchip, Sun Communities, Amphenol, and Microsoft. Information Technology was our top performing sector along with Industrials and our underweighting of Healthcare and Consumer Staples. Our largest sector detractors were our underweighting of Energy and Financials and our overweighting in Communications. The most significant ten detractors from performance were Peloton, Nexon, Redfin, Walt Disney, T-Mobile, Zillow, Zendesk, Take-Two, PayPal, and Snap.
For the quarter, our technology investments were up 11.83%, lagging the benchmark technology component by 1.09%. Among the top contributors in the quarter were Lam Research, Crown Castle, Amphenol, Microchip, KLA, Sun Communities, Cloudflare, Micron, Silicon Labs, and NVIDIA. Similar to the annual results, our relative overweight of technology aided performance while our overweight in Communication Services hampered performance. Further, our stock selection in Consumer Discretionary was a drag to performance. Bottom contributors included ViacomCBS, Peloton, Twitter, Snap, T-Mobile, Salesforce.com, Block, Redfin, PayPal, and MercadoLibre.
Market Commentary
All biological systems exist in an ongoing effort to achieve homeostasis – a perfect level of nourishment and comfort for the organism to optimally survive and procreate. The stock market, like the global economy, is analogous to a living organism in that it is constantly seeking homeostasis, i.e., some sort of balance between supply and demand that manifests as the price of a stock and of the overall valuation of the market. Living organisms and the stock market are also both complex adaptive systems, and that means that disequilibrium is generally the equilibrium state. In other words, we are always shuffling one way or another to try and achieve homeostasis, drifting through – but never maintaining – that ideal state.
In the body, we balance things like calories, sleep, temperature, mental wellbeing, satisfaction, etc. The financial markets are trying to balance interest rates, inflation, geopolitical forces, shocks to the system (oil supply, pandemics, wars, etc.), and the range of possible future states of the world along with the range of outcomes for each individual stock. In a complex system rife with chaos and emergent outcomes, maintaining equilibrium for any meaningful duration of time is of course an unachievable goal.
The human body is concerned with maintaining temperature, food, and water within a narrow band, because those parameters are so critical to survival and the minimization of physical disequilibrium. For the markets, the key element is probably a consensus around interest rates, because everyone in the markets has some sort of hurdle they need to meet in order to take on the risk of investing money rather than sitting on it or making other investment choices. For individual stocks, homeostasis revolves around valuations.
When the market has wide divergence in opinions on things like long-term interest rates, or when there are a lot of shocks to the system, its struggle to find homeostasis tends to become more dramatic. In other words, the typical disequilibrium operates in a wide band as price levels are more volatile than when the market can agree on a tighter range of future scenarios for variables like interest rates. This is an overly elaborate way of saying more unknowns create more volatility, but the key point I want to make is that thinking biologically can give you more context for how markets behave over time.
Humans need a full stomach, a warm fire, and a good night's sleep that isn't plagued by worries over the future. To feel equally sated, the markets need stable leadership, calm geopolitics, and a consensus view of future inflation and interest rates. But, predicting the future of any type of complex system is a fool’s game. So, we humans have learned to stock the pantry, have alternative heat sources on hand, and shelter funds for a rainy day. The markets, in contrast, have a more subsistent existence, digesting news minute-to-minute while never fully satisfied it can achieve any level of consensus. Whereas adult humans have a chance at understanding if they are hungry or tired, markets are more like a crying infant, unable to fully communicate what would calm them down.
When the future is unknowable, the best basic strategy is to own assets that require you to make as few predictions as possible for achieving a desired outcome. That means owning assets that imply a return rate above your hurdle rate without having to know with precision how the world will unfold. That's a challenge if you cannot pin down interest rates to a relatively narrow band, especially when the variables going into inflation are difficult to forecast. That conundrum seems to be what the markets are grappling with today, but it could be a million other things as well. It is complex, after all.
Fortunately, we can return to a few basic first principles that we believe hold true long term: 1) the future is always better than the past; 2) technology is an overarching deflationary force; 3) one person's debt is another person's asset, which impacts the direction of interest rates; 4) humans are innovative and rise to the challenge; and 5) given enough time, optimism always wins over pessimism and cynicism.
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .1625% quarterly) from the gross return. Gross returns are inclusive of reinvestment of dividends or other earnings. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
NZS Capital, LLC claims compliance with the Global Investment Performance Standards (GIPS®)
GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
GIPS® Composite Reports are available upon request by emailing request to info@nzscapital.com.
NZS Growth Equity and NZS Select are reported in USD.
The benchmark for the NZS Growth Equity Composite and NZS Select Composite is the Morningstar Global Target Market Exposure NR USD. The index is designed to provide exposure to the top 85% market capitalization by free float in each of two economic segments, developed markets and emerging markets.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q3 2021 Letter
NZS Capital Third Quarter 2021 Update
October 11th, 2021
The NZS Capital Growth Equity strategy had a gross return of 0.71% (0.54% net) in the third quarter of 2021 compared to its global market index benchmark, which was down 1.01%. Year to date, the strategy has returned 15.78% (15.22% net) compared to the benchmark’s 11.20%. The NZS Capital Select strategy declined 0.32% gross (-0.5% net) in the third quarter of 2021 and rose 19.34% (18.76% net) year to date.
For a full table of performance please download the PDF.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
Performance Discussion
The following third quarter 2021 performance discussion references the NZS Growth Equity strategy. Information technology remained our largest weighting at 56.45%. Our technology investments were up 1.97%, ahead of the benchmark technology component, up 0.58%. Among the top contributors in the period were Ball Corp, Salesforce.com, Cadence Design Systems, Microsoft, ASML, Adyen, Sun Communities, and Chipotle. Our relative underexposure to financials and energy weighed on overall performance during this period of rising rates and inflationary signals. Specific detractors from performance in the period included Lam Research, ViacomCBS, T-Mobile, Crown Castle, SailPoint, TSMC, Peloton, and Nexon.
The third quarter was emblematic of the global market’s recent roller coaster ride. Following a strong rally to the top of the hill, stocks soon descended the diving turn of worry. There might have even been a loop-de-loop in there somewhere. Sometimes, the weather does not cooperate. Late in the third quarter, there was a confluence of seemingly unrelated events that fueled inflation concerns. China’s factories were running strong in an effort to catch up with the post-pandemic surge in global demand for goods. Their energy usage was high, but a dry season across much of China resulted in lower-than-anticipated hydroelectric power supply, while the country’s price-controlled energy sector disincentivized electricity generation. And, looking west to Europe, a dampening of prevailing winds stalled wind turbines, and low rainfall reduced hydroelectric energy. As a result, natural gas prices spiked to multi-year highs, fueling inflation fears.
It’s not just the weather that is hard to predict. The world is a mind-bogglingly complex system, which is (though we may pretend otherwise) entirely unpredictable. Indeed, unpredictability is the only predictable thing. That’s why our primary focus at NZS Capital is on building portfolios that balance Resilient and Optional businesses with an emphasis on adaptability and non-zero sumness, i.e., businesses that create more value for the world than they take for themselves. Despite the inclement weather of late, the long-term forecast remains the same: the digital transformation of the economy will continue to accelerate, and we will continue to invest in the companies that stand to benefit from this decades long opportunity. We like it when the market weather is unpredictable – volatility is not risk, it’s opportunity.
The “AI” Age and the Ongoing Digital Transformation
The following has been adapted from SITALWeek #316: Back in the late 1990s, every business was either appending “.com” to their existing name or touting their dotcom strategy and how it was going to transform them or their industry. A lot of hyped-up ideas ended up being right, just twenty years too early. But, for the many legacy companies that put on dotcom lipstick at the turn of the century, the Internet was ultimately a negative disruption of their business. For some industries, such as media and retail, we’ve seen the near completion of the disruptive, Internet-enabled transformation. For more highly regulated businesses, such as the banking and healthcare sectors, which have successfully lobbied to keep disruption at bay, it’s unknown if/how they will ultimately be affected by the Internet Age. And, for a large bucket of companies that have harnessed the Internet to improve their products, supply chain, and/or customer interactions without significant disruption to their business model, dotcomization has been more subtle. For all industries, the Internet enabled an accelerated pace of change, and dotcom simply became shorthand for digital transformation. The biggest winners of the Information Age have been the new companies – those that were built in the late 1990s and early 2000s by the Internet and for the Internet. These are the familiar mega platforms of today, all of which are facing a global wave of regulatory pushback that is handicapping their ability to enter new markets or even innovate in some of their existing markets.
We find ourselves presently in another technological jargon bubble: AI. For most established companies today, AI of course is no more real than dotcom was twenty years ago for the 1900s Industrial Age companies. AI has become a metaphor for digital transformation in exactly the same way the dotcom label evolved. For most of today’s companies, AI will be a negative disruption – an acceleration of the digital transition that will bury the legacy incumbents and create new winners. And, AI, just like dotcom before it, will be enabled by software and semiconductors, the enduring engines of the analog-to-digital transformation of the global economy. It’s possible that the emergent dotcom winners of the last twenty years will power the new AI wave of innovation and transformation. Perhaps today’s mega platforms will maintain power, but that’s up in the air with regulation and the challenges any incumbent faces when a new market emerges. And, there will be new companies that will dwarf anything we’ve seen in the last two decades. AI also has a mega investment bubble associated with it. So far, this bubble has stayed more in private markets, while the dotcom bubble manifested a little faster in the public markets of the late 1990s.
There is one big difference with AI as the new marketing term for digital transformation compared to dotcom: the world seems to be willing to believe AI is real, but it’s not. At least not yet. We are seeing companies hand off decision making to AI as if it were something more elevated than a complicated search algorithm scanning pools of data. It’s this dangerous “invisible hand” mentality of AI that has me worried. It’s distorting how people are hired and fired, whether people can rent apartments and access government benefits, and how doctors and hospitals treat patients. It’s determining who people date, what music they listen to, what shows they watch, and who they interact with. Facebook was designed to collect, amplify, and reflect our own thoughts and emotions back to us in order to sell ads. In and of itself, social media is a dangerous echo chamber, but becomes even more so if we accord its half-baked algorithms any sort of divine power. All of these life changing algorithms have the transparency of mud, and to rage against them is to shout into an infinite abyss. AI is nothing more than a fallible human tool – it’s a reflection of human nature, and, lately, we all seem to be acting a little crazy. Along with the increased influence of social media algorithms, we’ve seen a rise in extremism, hate, misinformation, and violence. There will of course be legitimate artificial intelligence systems and uses that perform incredibly complex tasks and might be able to make short-term predictions and decisions that are useful. But, recently, when I see a company talking about AI, that is clearly not what they mean.
We will have incredible breakthroughs in artificial general intelligence when AI can gather enough context to make analogies, reason, and learn on its own. However, the computational burden of trying to make better decisions through deep learning systems might also hit a breaking point even with these breakthroughs. IEEE reports that halving the error rate in image recognition would require 500x the computational power! The world is complex and unpredictable by nature. And, that brings us back to the weather: the amount of energy required just to predict the weather an hour from now, on every square meter of the planet, might just not be worth it compared to looking out the window. Do the complex AI models gulping down massive amounts of energy-intensive compute power take into account their own insatiable appetite when they model global warming!?
The next wave of digital will bring major structural changes to the economy as well with deflationary pressures and job displacements. There will be periods where the short-term negatives seem to be worse than the long-term positives. Yet, I am optimistic about the ongoing, accelerated, digital transformation of the global economy. It will ultimately do a lot of good for people and the planet over the next few decades, but I am a little worried about the blind faith that’s being put into what amounts to nothing more than a marketing term. Just like twenty years ago, there is a lot of work to be done; but, decades from now, we will be looking at a completely digital, completely transformed economy, perhaps with a little bit of real AI.
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .1625% quarterly) from the gross return. Gross returns are inclusive of reinvestment of dividends or other earnings. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
NZS Capital, LLC claims compliance with the Global Investment Performance Standards (GIPS®)
GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
GIPS® Composite Reports are available upon request by emailing request to info@nzscapital.com.
NZS Growth Equity and NZS Select are reported in USD.
The benchmark for the NZS Growth Equity Composite and NZS Select Composite is the Morningstar Global Target Market Exposure NR USD. The index is designed to provide exposure to the top 85% market capitalization by free float in each of two economic segments, developed markets and emerging markets.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q2 2021 Letter
NZS Capital Second Quarter 2021 Update
July 9th, 2021
The NZS Capital Growth Equity strategy had a gross return of 7.58% (7.41% net) in the second quarter of 2021 compared to its global market index benchmark, which was up 7.21%. Year to date, the strategy has returned 14.97% (14.61% net) compared to the benchmark’s 12.34%. The NZS Capital Select strategy returned 7.50% gross (7.34% net) in the second quarter of 2021 and 19.73% (19.36% net) year to date.
For a full table of performance please download the PDF.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited for long-term investors as the global economy transitions from analog to digital. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
Performance Discussion
The following second quarter 2021 performance discussion references the NZS Growth Equity strategy. Information technology remained our largest weighting at 56.22%. Our technology investments were up 8.52%, ahead of the benchmark return of 7.21%; however, our technology holdings underperformed the technology component of the benchmark, which rose 10.59% in the quarter. This was in part due to underperformance in our software and semiconductor investments. Specific stocks that contributed strongly to second quarter performance include Nvidia, Cloudflare, Salesforce, T-Mobile, Microsoft, Shopify, and Constellium. Healthcare and energy, which are relatively underrepresented in our portfolio currently, outperformed the broader benchmark in the period. We believe the rotation into more value-oriented sectors so far in 2021 will be a short term phenomenon, and we therefore remain focused on the long-term transition of the economy to the Information Age where adaptable companies that are creating the most non-zero-sum outcomes will do well. Specific detractors from performance in the quarter included Nexon, Ball Corp, Walt Disney, Nexterra, Workday, Thor, and a handful of semiconductor companies such as Microchip, Micron, On Semi, and KLA Corp. We continue to see semiconductors as the long-term, global engine for the digital economic transition.
Time Travel to Make Better Decisions
The following is adapted from an essay titled “Time Travel to Make Better Decisions” published on July 4th, 2021. The complete essay can be found here.
Every time we contemplate a decision, whether big or small, we are attempting to see into the future. In other words, the act of scrutinizing options and possible outcomes is a form of mental time travel. Can we see how this decision will play out? What are the odds we make the right decision? And, the single most important (and emotional) question: will I regret this decision?!? If I could somehow communicate with my future (and ostensibly more knowledgeable) self, what would I want to know now to make the right decision today? The idea of mental time travel is especially relevant to investment decisions, a topic that I’ll return to later in this essay.
Despite wanting to make better decisions and predictions, we are constantly stymied by the fact that the future is largely unknowable and becomes more opaque the farther into it we attempt to peer. We know from complex adaptive systems that there are too many factors, agents, and relationships to know precise details of the future state of the Universe with any meaningful degree of accuracy – chaos ensures we’re always betting against the house. As such, we all have rather spotty decision-making track records. And yet, we tend to think that we’re pretty good decision makers, largely thanks to our brain’s serial overconfidence (perhaps our survival as a species is predicated on having a heightened sense of control, however false, over the unknown). In reality, luck factors into our successes far more prominently than our brain wants to admit.
One of the biggest inhibitors of good decision making is our brain’s inability to see things as nonlinear. We tend to think in an analog, incremental way, but the world itself is dominated by exponentials, power laws, and compounding – all of which we struggle to conceptualize. From an evolutionary perspective, linear thinking is likely a lot more energy efficient and less mentally overwhelming, which would be important for quick decision making to ensure day-by-day survival, as was required of our human ancestors for hundreds of thousands of years. Under such challenging circumstances, linear thinking apparently yielded a decent enough solution in a sufficient number of cases to let us wade through life (while the slower, more cerebrally-intensive thinkers were perhaps subject to a higher number of predation events). For those of us fortunate enough to exist in the modern world, however, we have the luxury (or perhaps the imperative) to become more cognizant of our path through time and the myriad possibilities/probabilities encompassed by our endlessly branching future.
The path we took through time to get to the present moment and which we will follow into the future is only one of an infinite number of possibilities. Existentially, our narrow slice of the multiverse is the only path we can travel simply because it is the path we travel.
One popular (and one of my favorite) movie/literary genres concerns time travel and the speed of time passing. These stories are a trove of insight into decision making, regret, and the folly of trying to change the past or predict the future. I think our cultural fascination with time travel boils down to our own regret over how little we confront the actual present, and, more specifically, how we often fail to be fully aware and present when we make decisions. What I’ve learned is that having a fascination with the present moment might be the only way to make better decisions about the future. As Russell Ackoff puts it: “I have no interest in forecasting the future, only in creating it by acting appropriately in the present.”
Better Decisions through Time Manipulation and Mental Time Travel
Poet David Whyte asks the following questions: “What would it be like to start a conversation with myself that my future self would thank me for? What would it be like to become the saintly ancestor of my future happiness?” Oftentimes it’s not the answers we are looking for, but the right questions to ask. How can we converse with ourselves today in a way that we ask better questions and arrive at better decisions? There are a few exercises that I find helpful, including a few specific conversations we have at NZS Capital when we are analyzing companies.
Slow down time: Try and spot the figurative gravity wells and light speed hacks that allow your clock’s gears to turn more slowly than others’, which will create a huge advantage in decision making. This entails figuring out how you should be spending your time so that you are asking the right questions, gleaning the most useful information, and giving yourself time to analyze, digest, and connect dots. If reading the news or scrolling social media is not causing you to ask better questions, or if it’s pulling you out of your awareness of the present, then stop – it’s needlessly spinning your gears and speeding up time. Remember to focus on intentions. Focus on your awareness of the present and being extremely intentional about what you want to accomplish, and you will find you can achieve more in less time.
Focus on what won’t change: We often reference this concept from Jeff Bezos who famously said his primary focus at Amazon was on what won’t change: people will always want more selection, lower prices, and faster delivery. Rather than focus on the competition, Amazon tried to continue to improve on these three dynamics of their ecommerce business. While we spend a lot of our time desiring to know what will change when we make decisions, often inverting the problem and seeing what is unlikely to change is more useful. So, fast forward through time or imagine an array of different multiverses. What remains invariant despite changing time/space and the unpredictable future paths?
Perform pre-mortems: This exercise helps you determine what could go wrong before it happens. A pre-mortem is a way to try and picture yourself in the future and work backward to decisions made today. It’s similar in concept to Jeff Bezos’ regret minimization framework: “I wanted to project myself forward to age 80 and say, ‘Okay, now I'm looking back on my life. I want to have minimized the number of regrets I have.’” We do pre-mortems for every stock we consider investing in by transporting ourselves into the future and trying to guess at the answers in these scenarios: 1) We didn’t buy enough. Why? What questions/data would have clarified our understanding of the potential? And, 2) We should not have bought it. Why did we? What did we miss about the range of outcomes, the degree of predictions forced by the valuation, etc.? Similarly, if we are contemplating selling a stock, we try to answer these questions as our future selves: 1) We regretted selling it and ended up buying it back at a higher price. Why? And, 2) We never regretted selling. What negatives were there that we were right about? Often, the question isn’t about buying or selling outright, but getting to the truth of what position size an investment should be. We use specific metrics from our Complexity Investing paper to answer these pre-mortem questions in the categories of Quality, Growth, and Context (chapter 3) and Resilient or Optionality position sizes (chapter 6).
This exercise may sound simplistic and obvious, but the key is to make time travel feel as real as possible to fully experience the thoughts and emotions of your future self. Making mistakes in investing (and life in general) is personal and painful – it’s a gut punch of regret. So, we try to literally vault ourselves into the future and see what it feels like to be selling a stock at a major loss – it’s a horrible feeling, how could we have avoided it? The answer can only be in the present. What information are we missing today, or, more likely, what questions are we failing to ask? What is it about the range of outcomes that we need to better grasp? Imagine you have an actual time machine to travel five years into the future. Imagine which path you took through time to get there and which ones you avoided.
The Importance of Awareness
One of the most freeing concepts that can improve decision making is: it’s worthless to dwell on regret because there’s no going back. Whatever happened, happened, and it’s now permanently out of your control. So, take a few moments to learn what you can about the factors that influenced your decision and then put it out of your mind. There are thousands of factors that can play into decisions over which you have no control. Neuroscientist Robert Sapolsky shares some devastatingly great insights on this concept in his book Behave. Here is a passage listing just a few of the unconscious influences on decision making: “blood glucose levels; the socioeconomic status of your family of birth; a concussive head injury; sleep quality and quantity; prenatal environment; stress and gluticocorticoid levels; whether you’re in pain; if you have Parkinson’s disease and which medication you’ve been prescribed; perinatal hypoxia; your Dopamine D4 receptor gene variant; if you have had a stroke in your frontal cortex; if you suffered childhood abuse; how much cognitive load you’ve borne in the last few minutes; your MAO-A gene variant; if you’re infected with a particular parasite; if you have the gene for Huntington’s disease; lead levels in your tap water when you were a kid; if you live in an individualist or collectivist culture; if you’re a heterosexual male and there’s an attractive woman around; if you’ve been smelling the sweat of someone who is frightened. On and on. Of all the stances of mitigated free will, the one that assigns aptitude to biology and effort to free will, or impulse to biology and resisting to free will, is the most pernicious and destructive.” (p. 597-598). So, focus on what you can control – your awareness of the present – to create a better backdrop for decision making, and then try not to regret decisions as soon as they are relegated to the immutable past.
Conclusion
Making decisions involves a paradox: we desire to see into a future that we can never truly know. It would be nice if reading (or, in my case, writing) this essay were sufficient to erase the longing to travel back in time to fix decisions and instantly transport forward to see the future. I'm afraid these paradoxes cannot be resolved. Instead, I hope that I’ve made the case for cultivating awareness in the present, which should ease the dual burdens of decision remorse and wanting to know the unknowable/predict the unpredictable. While we can harness deliberate and intentional mental time travel to our advantage, as with my example of the pre-mortem, our obsession with the impossible is just a mental trap that drains energy and shifts our attention away from the present. And, the actual present is our only window of opportunity to make decisions that positively shape the future. By cultivating awareness, trying to slow down time, and finding the right questions to ask (e.g., working backward, what won’t change, pre-mortem analysis) we can attempt to create a landscape for decision making that allows us to see good fortune when it comes knocking and take the next incremental step toward a better future. Since we can never know the future, perhaps it’s best to take Doc Brown’s advice: “Roads? Where We’re Going, We Don’t Need Roads.”
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .0542% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.
Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q1 2021 Letter
NZS Capital First Quarter 2021 Update
April 5th, 2021
The NZS Capital Growth Strategy had a gross return of 6.87% (6.7% net) in the first quarter of 2021 compared to its global market index benchmark, which was up 4.78%. Over the prior twelve months the strategy has returned 109.74% (108.42% net) compared to the benchmark’s 54.57%. The NZS Capital Select strategy returned 11.37% gross (11.2% net) in the first quarter of 2021 and 128.06% (126.63% net) over the last twelve months.
For a full table of performance please download the PDF.
Market Commentary
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited to the current state of the markets. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. These adaptable businesses will take share as the economy continues its decades long transition from analog to digital, sector by sector. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies (larger positions) with a long tail of Optionality companies (smaller positions). Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth and asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
A few months ago in our Q4 2020 letter, we discussed the high valuations present for many stocks across the market:
You cannot invoke the term bubble without concurrently discussing time horizons and hurdle rates. The idea of a bubble in the present time implies that valuations will correct down over the short term. High starting points for valuations also imply that long-term returns will be lower. However, if your expectation of equity returns over the next decade is lower than historical figures, then even valuations on some stocks today are not high when measured against a 3-5% hurdle rate. Most of us, however, strive to do much better than single digit returns on equities, and, therefore, many stocks today become uninvestable even on a five- to ten-year time horizon. Low interest rates are of course at play when any investor considers their hurdle rate for long-term returns. And, the lower rates drop, the more short-term valuations are sensitive to small changes in interest rates.
Almost like clockwork, amidst fear of rising inflation, the ten-year interest rate for US treasuries jumped on February 16th, 2021, coinciding with a near-term peak in expensive stocks. Some of these high-multiple stocks subsequently plunged 20% to 40% in short order. We tend to invest long term at NZS Capital, and do not overly worry about timing short-term moves in the market. Instead, we target a double-digit expected return averaged across the portfolio over the long term. To maintain our targeted expected returns, we tend to shift a modest percentage of the portfolio back and forth between our long-duration Resilient and higher asymmetry Optionality investment categories. After making a shift toward Resilience in Q4 2020, we began gradually adding back to some of our Optionality positions in the first quarter of this year.
As we have discussed in the past (most recently at the end of the SITALWeek newsletter #287), we believe the digital transition of the global economy will be more disinflationary than inflationary on a long time horizon. Sources of structural inflation are scarce; however, we are aware of potential pressure from labor costs, housing, and climate change. We have viewed periods of short-term inflation due to economic expansion as generally positive or neutral for long-term performance for the types of business we invest in, and we have therefore not made any material changes to the portfolio as interest rates have moved up to approximately where they were before the pandemic began.
We were pleased to welcome our third anchor institutional client in the first quarter. In addition to institutional investors, we started working with accredited US investors in Q1. In Q2, we will launch our growth strategy for investors outside of the US through our partnership with Jupiter Asset Management. For inquiries about NZS Capital investment strategies, please contact info@nzscapital.com.
Performance Discussion
The following first quarter 2021 performance discussion references the NZS Growth strategy, which represents our broadest approach in terms of number of names and sectors. Information technology remained our largest weighting at 58.18%. Our technology investments were up 6.4% compared to the technology component of the benchmark, which rose 2.13% in the quarter. Other significant contributors to performance in the quarter were our stock selection and overweighting of communication services. Performance was weighed down by our underweighting of energy, materials, and financials, all of which did well owing to rising rates and potential for inflation. In the first quarter, our top contributors were ViacomCBS and semiconductor companies Lam Research, ASML Holding, and Texas Instruments. We substantially reduced our position in ViacomCBS as the stock appreciated, and subsequently took advantage of volatility to increase our position throughout the quarter. Our bottom contributors in the first quarter included several companies that are perceived to be less advantaged by shifting behavior after the economy reopens. These included Ball Corp, Zendesk, Salesforce.com, and Take-Two Interactive Software. We added to Ball Corp in the quarter as we view their long-term prospects in aluminum cans and aerospace to be strengthening, and we are less focused on the short-term potential impact of people shifting back to consuming beverages at restaurants instead of in the home.
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (.65% annually, or .0542% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.
Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q4 2020 Letter
NZS Capital Fourth Quarter 2020 Update
January 11th, 2021
The NZS Capital Global Growth Strategy returned 23.41% (23.22% net) in the fourth quarter of 2020 and 63.51% (62.44% net) in the year ending December 31st, 2020 compared to the Morningstar Global Target Market Exposure Index returns of 14.75% and 15.83% for the same periods. The NZS Capital Global Select strategy returned 22.06% (21.88% net) in the fourth quarter of 2020 and 67.08% (65.98% net) in the year ending December 31st, 2020.
For A Table of Performance Please Download the Letter PDF
Market Commentary
The fourth quarter progressed through a backdrop of uncertainty and volatility toward potential light at the end of the tunnel with the approval of several promising vaccines. A small group of highly valued companies has been leading the market higher since the beginning of the global pandemic. The market dynamics are a striking echo to behavior during the dotcom bubble, with the important exception that today, companies with ballooning valuations, represent a much smaller part of the overall market.
You cannot invoke the term bubble without concurrently discussing time horizons and hurdle rates. The idea of a bubble in the present time implies that valuations will correct down over the short term. High starting points for valuations also imply that long-term returns will be lower. However, if your expectation of equity returns over the next decade is lower than historical figures, then even valuations on some stocks today are not high when measured against a 3-5% hurdle rate. Most of us, however, strive to do much better than single digit returns on equities, and, therefore, many stocks today become uninvestable even on a five- to ten-year time horizon. Low interest rates are of course at play when any investor considers their hurdle rate for long-term returns. And, the lower rates drop, the more short-term valuations are sensitive to small changes in interest rates.
When we think about valuation and position sizing in the portfolio, especially in the context of an equity bubble, we focus primarily on whether the range of outcomes is widening or narrowing (a concept we covered in more detail in our Third Quarter 2020 Letter: “If you let a winner run even though the range of outcomes is still very wide, then you are explicitly making a large bet on a narrow prediction about the future, which means all you have done is increase the risk in the portfolio. And, in turn, you are starving resources for new Optionality positions.”). To never sell or trim a stock simply due to a high valuation, no matter how large the opportunity might appear, would be a misunderstanding of risk at the portfolio level – at some point that strategy becomes gambling rather than investing. As always, we remain vigilant about the range of outcomes and implied returns across our strategies. With the world still in the early stages of the global economic transition from analog to digital, many sectors are still presenting good investment opportunities for long-term growth.
The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited to the current state of the markets. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
In the Year 2030...
When volatility is high in the short term, it’s best to imagine yourself far into the future: what will your day look like in 2030? Let’s assume the pandemic is over by then, and that, optimistically, the world is perhaps a little more stable. In 2030, it will have been about fifty years since interest rates began their steady decline, fifty years since inequality began rising as real wages began stagnating, and fifty years since the personal computer revolution began the Information Age in earnest – driving decades of deflationary pressures that enabled those declining rates while significantly expanding asset prices. What will be the same in 2030? What will be different? What will the path to the year 2030 look like?
These questions of course are not answerable with any level of precision, but at NZS Capital we are optimists, believing that conditions will improve no matter how bad they might seem in the present. That optimism is one of the few predictions we are comfortable holding on to when we think about the possible futures we might find ourselves in. Focusing too much on the present and the near future is what gets many investors into trouble. Loch Kelly quotes contemporary Tibetan Buddhist teacher Mingyur Rinpoche as saying: “If you examine even the present moment carefully, you find that it also is made up of earlier and later moments. In the end, if you keep examining the present moment, you find that there is no present moment that exists either”. The past seems to have slipped away, the present is elusive, and the future is unknown. What’s an investor to do?
Coming back to the questions of what will and won’t change in the next decade can be a useful starting point. So, let’s return to the speculation of what a day might look like in 2030. After a night of restful sleep – thanks to analysis and advice from smart health monitors (including wearable and radar-based sensors on your nightstand) – your smart assistant might wake you up at the opportune time for feeling rested. Your temperature-controlled mattress will contribute to better sleep and health. Overall, wearables will be generating an enormous amount of data in 2030, enabling a shift from a broken healthcare system focused on treating disease to one focused on preventing disease from taking root in the first place. Healthcare will be very different in 2030.
Will you work from home in ten years? Surely the ability for some to work remotely helped in 2020, and increased location flexibility going forward will be an equalizer that creates opportunities. However, the loss of ad hoc randomness from isolation may send humans back to group settings. Or, perhaps augmented reality glasses will bring lifelike interaction to the virtual world. Augmented reality will likely be a large part of daily life in 2030, with ambient audio, video, communication, and gaming woven into everything.
In many ways, technology will continue to remove friction from the economy as we transition from a world where less than 10% of transactions are digital to one where nearly every transaction and interaction is digital in some way. In the banking industry, for example, there remains an enormous amount of friction, but, if I am still writing paper checks and putting them in envelopes to mail in 2030, I may lose my optimism! Fintech is breaking down walls one at a time in the legacy banking system, and blockchain has a chance at creating a digital transactional currency and asset ownership system that could one day underpin much of the economy; however, 2030 might be just a little early for that revolution.
Will you have an autonomous vehicle? What percent of new and existing cars will be electric? Will we be far down the path to creating a green, distributed power system around the planet? These questions are difficult and complex, but the direction seems clear for energy and transportation – if not 2030, then 2040 or 2050.
What are the foundational platforms, both hardware and software, that will enable a better, more digital future in every sector of the economy? Will they be the same platforms we have today? If not, why? What would be a better foundation? The primary element that we believe will create the platforms of the future is non-zero sum, e.g., win-win, or generating more value for your constituents than you take for yourself. The higher the ratio of give to take, the more likely a technology will transform and take off with ever-increasing returns and network effects. Technology that creates value should disappear into the background to the point where you don’t even realize it’s there.
We can speculate endlessly about the enabling technologies of the future, but they can only be great if they are available to everyone on the planet, and if they make the planet better. The deflationary trends of technology are just beginning, and, as we enter the AI age, they will accelerate to a pace heretofore unseen (for more discussion of deflation see the ‘Can We Harness Technology’s Deflationary Pressure?’ at the end of newsletter SITALWeek #258). Technology’s growing impact on the economy can make humans feel less useful, a feeling which could grow even larger with the rise of AI. This disenfranchisement, combined with the decades of increasing inequality, has created a backdrop for fear, nationalism, and, in some cases, hate. If managed correctly, the balance of deflationary technology trends with fiscal and monetary programs around the world could ensure everyone has access to the sustainable, technology-driven improvements to life and wellbeing. It’s a Goldilocks meets Pollyanna scenario, but, like we said, we’re optimistic. Our job at NZS Capital is to create the landscape for luck to come knocking, and the best way to do that is to keep an open mind, always look for new ways to connect dots, and focus on the distant future.
Performance Discussion
The following fourth quarter performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors. Technology remained our largest weighting at 60.68%. Our technology investments were up 25.56% compared to the technology component of the benchmark, which rose 14.78% in the quarter. Other significant contributors to performance in the quarter were our stock selection in consumer discretionary and communication services in addition to owning fewer healthcare and consumer staples investments. In the fourth quarter, our top contributors were semiconductor companies Microchip, Lam Research, and Taiwan Semiconductor along with software companies Sailpoint and Zendesk. Financials, industrials, and energy stocks did well in the fourth quarter, and our lower weights in those sectors detracted from performance. Our bottom five contributors in the fourth quarter were Salesforce, Nvidia, Crown Castle, Moderna, and Air Products.
For the full year ending December 31st, 2020, our top performing sectors were a combination of weighting and stock selection in technology, followed by consumer discretionary, communication services, financials, and real estate. Owning fewer industrial and healthcare investments weighed on performance relative to the market. Our top five contributors to 2020 were Nvidia, Tesla, Sailpoint, Cadence, and Amazon. Performance across our top 20 was well-balanced between a mix of both Resilience and Optionality positions. Our bottom five contributors for the year were Comcast, ViacomCBS, Walt Disney, Lyft, and Heico.
Thank you for your continued trust, interest, and support.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (1.00% annually, or .0833% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.
Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q3 2020 Letter
NZS Capital Third Quarter 2020 Update
October 14th, 2020
The NZS Capital Global Growth Strategy returned 14.71% (14.52% net) in the third quarter of 2020 and 32.50% (31.83% net) year to date compared to the Morningstar Global Markets GR Index returns of 7.95% and .94% for the same periods. The NZS Capital Global Select strategy returned 19.10% (18.9% net) in the third quarter of 2020 and 36.88% (36.19% net) year to date.
For A Table of Performance Please Download the Letter PDF
The third quarter was marked by ongoing uncertainty and volatility due to the pandemic and geopolitical events. The research process at NZS Capital is guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited to the current state of the markets. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
The following year-to-date performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors. Technology remained our largest weighting year to date at 62.58%. Our technology investments were up 34.82% compared to the technology component of the benchmark which rose 29.03% year to date. Other significant contributors to performance in the period were our stock selection in consumer discretionary and real estate (REITs) along with our underweights in energy and financials. In the third quarter our top contributors were Nvidia, Sailpoint, Taiwan Semiconductor Manufacturing, Salesforce.com, and Tesla. Detractors from performance included Micron, Microchip, American Tower, Guidewire, and Thor Industries.
Commentary
The following is adapted from our weekly newsletter #259:
At NZS Capital, we are always reminding ourselves that no one can predict the future, even with perfect information. That notion can feel uncomfortable, and even a bit paralyzing. We do, however, know that there are certain elements of a company’s culture and products that afford better odds of future success. Chief among those are a company’s adaptability and the level of NZS, or non-zero sum, they provide – the more value they create for others, the more value they will ultimately create for themselves down the road. One way to frame a hypothesis regarding a future outcome, without having to rely too much on a crystal ball, is like this: “In five to ten years I think blank will happen, but I don’t know how it will happen, what it will look like, or who will win.” Example: In five to ten years, people will watch more video content, but I don’t know what types of devices it will be on (screens or AR/VR glasses?), what type of content it will be (scripted Hollywood, interactive life streaming, immersive metaverse gaming, casual games, etc.), or who will be making more of the content.
We can separate these statements into broad predictions, which are more likely to happen in various futures, and narrow predictions, which are difficult to know ahead of time. Some of the broad predictions would be: 1) semiconductors and connectivity will be in more demand; 2) creativity and storytelling will always be important; 3) data – and smart use of it – will be important; 4) if interactive content rises, gaming engines will be more important in creation of content; 5) cloud computing and AI will be important; 6) people’s tastes will always be fickle and personal, and thus hard to predict. These broad predictions create a landscape in which to plant various narrow predictions and monitor growth and outcomes. Many factors will determine which predictions grow stronger and which wither and die, including, first and foremost, adaptability and NZS, but also network effects, innovation, platform dynamics, etc. If we were to look today at, for example, what content is the most adaptable and highest NZS for consumers, it’s probably video games and life sharing/streaming via social networks or YouTube. These forms of content can change their storytelling easily, provide the largest amount of content per dollar spent, and generally create win-win for all constituents. Some views will be Resilient – fairly broad and safe predictions (e.g., semiconductors will do well), and some will be Optional – narrow predictions (e.g., specific content/video game will gain share). This process is at the heart of our investing strategy and is detailed in our paper, Complexity Investing, which provides a framework for identifying winning companies and constructing a portfolio that balances Resilience and Optionality.
As you objectively assess new information, you can water and prune this landscape of broad and narrow predictions. It’s important not to let the narrow predictions become giant weeds. Letting your narrow prediction winners run is a false narrative that feeds off a set of cognitive biases (bias traps are also addressed in our Complexity Investing paper). At NZS, we tend to let our Optionality (narrow prediction) positions grow in the portfolio only if the range of outcomes is becoming more narrow – meaning that the prediction itself is becoming more broad (see figure at the end of this letter). If the range of outcomes has remained the same, but a company’s market value is up, then letting the position grow in the portfolio is akin to doubling down at every spin of the roulette wheel without taking any chips off the table (an obvious and risky mistake given the very narrow chance of future payout). Further, when you prune an Optionality position, you use the excess to seed new Optionality positions and/or water the ones that are experiencing a narrowing range of outcomes. This strategy allows you to maintain the overall asymmetry of the portfolio while not concentrating risk. If you let a winner run even though the range of outcomes is still very wide, then you are explicitly making a large bet on a narrow prediction about the future, which means all you have done is increase the risk in the portfolio. And, in turn, you are starving resources for new Optionality positions. Complex adaptive systems teach us that very narrow predictions are overwhelmingly likely to be wrong. Some Optionality positions end up being giant, adaptable oaks that last decades; however, the majority – including most/all of your cherished favorites – end up as weeds.
Thank you for your continued trust, interest, and support.
Optionality positions, which have a wide range of outcomes, should only graduate to larger positions if that range is narrowing, and the predictions are becoming safer. For more see Redefining Margin of Safety.
There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Net returns are calculated by subtracting the highest applicable management fee (1.00% annually, or .0833% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.
Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.
Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.
Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.
Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services.
NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”). The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN
Q2 2020 Letter
NZS Capital Mid-Year Update
July 5th, 2020
Our disciplined, Resilience and Optionality portfolio construction process posted year-to-date returns of 15.51% (14.12% net) for the NZS Global Growth strategy and 14.93% (14.54% net) for the NZS Global Select concentrated strategy compared to the -6.69% decline of the Morningstar Global Target Market Exposure NR USD index. For the second quarter of 2020, the NZS Global Growth strategy was up 38.64% (38.43% net) and the NZS Global Select concentrated strategy was up 40.86% (40.65% net). The NZS Global Technology strategy, which launched in March 2020, was up 38.68% (38.48% net) in Q2 2020.
For A Table of Performance Please Download the Letter PDF
The research process at NZS Capital is guided by the unpredictability of the world around us. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.
The following year-to-date performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors.
The market experienced a significant decline in Q1 2020; however, technology led a rebound in Q2 2020. Our technology sector weight for the first half of 2020 was 62.44% of the strategy, which was up 18.54%. We outperformed the technology component of the index by 4.56 percentage points. At NZS Capital, we believe volatility is not risk; rather, it represents opportunity. As such, we took advantage of the market conditions in Q1 to shift a portion of the portfolio from Resilience to Optionality. Both components of the portfolio contributed to performance in the period; notably, in the Resilient portion, Nvidia, Amazon, Microsoft, and Zendesk outperformed as the pandemic raised interest in accelerated cloud migration for enterprise IT departments. Optionality was also well represented in top performers by Tesla, Shopify, Peloton, Redfin, and Adyen. From a sector perspective, the portfolio outperformed in technology (as previously mentioned), consumer discretionary, and real estate (REITs), and benefited from not owning stocks in the financial and energy sectors.
Among the detractors were media companies Viacom and Disney, which underperformed due to their advertising exposure, and, in the case of Disney, theme park shutdowns. We view these pressures as short term in nature and continue to own these investments. Several semiconductor companies weighed on performance due to slower economic demand including Amphenol, Soitec SA, and On Semiconductor. Semiconductors and related industries remain the largest portion of the portfolio given our long-term optimism for the sector. Constellium, a provider of rolled and extruded aluminum products for the automotive, aerospace, and beverage can market, detracted from performance as well. We added to the position based on the long-term outlook for the business. HEICO was negatively impacted by travel demand, and we exited the position given the risk of longer-term travel disruptions.
We brought on three new employees to NZS Capital in the first half of 2020. Jon Bathgate and Joe Furmanski joined co-founders Brinton Johns and Brad Slingerlend on the investment team. Jon and Joe spent 12 and 14 years, respectively, at Janus Henderson Investors in Denver, working with Brinton and Brad for much of that period. Adam Schor, former Director of Global Equity Strategies at Janus Henderson Investors, joined as President and Chief Risk Officer. Jim Goff, former Director of Research at Janus, became a Senior Advisor to NZS Capital. We were pleased that a large endowment and a noted sovereign wealth fund selected us to manage a portion of their portfolios in the first half of 2020. We will succeed as a firm only if we meet and exceed the objectives of these and future clients.
Market Commentary
The following is adapted in part from our weekly newsletters:
Well, that was an interesting 181 days. The COVID-19 pandemic and protests following George Floyd’s murder placed an even bigger spotlight on inequality. Capitalism worked for centuries to lift more people up from poverty than any other system over the same period. But, in its later days, the experiment has left far too many behind – vulnerable, and unjustly harmed. The last six months highlighted the hypocrisy of the tech platforms that have dominated our lives for the last two decades, as well as the ineptitude of our governments. And yet, in the West, freedom of expression and speech rose up to shine an even brighter light – hope for the future and a path forward. As we often say, cynicism sounds smart, but it’s never right in the long run. Optimism always wins over time, and at NZS Capital we are optimistic about the future for companies that create more value for society than for themselves. We strive to build our portfolios out of companies working toward a more positive future, and we see no shortage of opportunities today.
There is much speculation in the markets that the markets have too much speculation. However, the current positive impacts from fiscal and monetary stimulus, combined with the negative impact of the short- and long-term effects of COVID-19, make it hard to know if the market is underpricing or overpricing risk. Before the global meltdown, “risk-free” long-term US government bond rates had around 2%-3% yields, corporate bond yields were a bit higher, and the market multiple was ~20x forward earnings. Absent the drop in interest rates and the fiscal stimulus, which has so far guaranteed almost all assets are “risk free” (as the central banks continue to purchase nearly anything to provide liquidity and stabilization), the shallow correction in equities seems to underprice the risk of multiple years of rolling shut downs and the fat-tail fallout from the pandemic. However, the penalty of holding cash at zero (or in some countries negative) rates is strong motivation to bid up riskier assets with higher return potential. Therefore, with zero rates and fiscal stimulus, the market might be unexpectedly overpricing the risk of the pandemic, (particularly given the reasons for low rates discussed in more detail below), which brings us to valuations.
The starting point when you buy or own a stock matters. A high starting point forces you to try to peer further into the future, requiring very narrow predictions about how the far future will unfold in order to be correct in the present. Conversely, a low starting point allows for broader predictions, and does not require that crystal ball to be nearly as accurate. We know from complex systems that attempting to precisely and accurately predict the future is of little use. Therefore, there are two responses to a high starting point: 1) the more narrow your prediction(s), the smaller the position size should be (and vice versa); and 2) keep an eye on the totality of those small position sizes, such that you aren't making a portfolio level narrow prediction about valuations. It’s fairly easy when you simplify it: match the breadth of prediction to position size and monitor the total exposure of narrow predictions across the portfolio. None of this argues for selling a position entirely if the outcome asymmetry is still high; instead, it argues for thoughtful position sizing and portfolio construction – a good idea no matter what the starting point is.
Which Came First, Low Rates or Increased Debt?
Back in May, Warren Buffett sat by himself in an empty, 19,000-seat arena and wondered aloud: if rates can stay low forever, then why didn't civilization figure that out 2000 years ago? Over the last 20 years, there has been a persistent fear that ever-rising credit cycles will create ever-bigger crashes, as we saw in 2009. One might expect a major shock to the global economy to pop a credit bubble created by artificially low rates; this spring we got the biggest shock of them all, yet it appears the economy could eventually exit the pandemic reasonably intact. However, the unevenness of the recovery – with inequality rising even more as a result of the pandemic – remains to be addressed (a point we’ll return to shortly).
Do low rates and seemingly infinite government monetary and fiscal stimulus perversely mean that shocks make the economy stronger? But, what about inflation!? Surely the flood of money will drive up prices and cause rates to jump higher, thus popping the giant credit bubble. But this hasn’t been the case, despite being decades into the steadily declining rate trend and monetary stimulus. Related to this, NZS Capital’s President and resident finance Lecturer, Adam Schor, points to the collapse 49 years ago of Bretton Woods, the post-WWII global agreement to tie currencies to gold. Following the extreme inflation of the 1970s, rates began a steady, 40-year, downward march – which the termination of Bretton Woods likely facilitated. No longer tied to gold, central banks can increase monetary supply and interest rates with much more flexibility.
Did low rates increase debt, or did debt demand low rates? As an economy grows and debt increases, the borrowers – those people who need to make the interest payments and eventually return the principle – tend to be disproportionately less-wealthy, while the people who lend money out and make a return on it tend to be wealthier. As time goes on, the wealth of the wealthier is more and more tied to the interest payments from the less wealthy – one person’s indebtedness is another person’s asset. And, as inequality marches higher, the less wealthy have an ever-rising debt burden that can only be maintained by perpetually lowering interest rates. It’s in the best interest of the lenders to lend at lower and lower rates to preserve their assets. This explanation is somewhat at odds with the general narrative – that lower rates are the driving force behind rising debt. Certainly lower rates allow rising debt; however, the common view misses the crucial point that increasing debt necessitates lower rates – which actually has mathematical support.
As well as allowing rising financial inequality to go unaddressed and unchecked, decreasing rates have been one of the hidden deflationary forces in the economy, along with the shift from an asset-heavy Industrial Age to a data-heavy Information Age. Indeed, with a large number of people with rising indebtedness and stagnant incomes operating in an economy with technology-driven deflation, it’s hard to imagine what could create sustainable inflation.
Now, if this trend of falling rates and rising debt persists into perpetuity, the result would be infinitely negative rates and, in the end, one person would have 100% of the wealth while everyone else would be indebted to them. Thus, we find ourselves back in that empty, dark arena in Omaha, kindred spirits with Buffett in our puzzlement. Perhaps there is a solution to this quandary – one that almost seems demanded by the current, pandemic-exacerbated inequality in the world – redistribution. Economist and SFI External Professor Brian Arthur calls our economy today the “distributive era”. To paraphrase: we have created a lot of wealth in the global economy; now, it’s time to focus on increasing who has access to it. Distributing money to more people who are on less-certain financial footing is going to stabilize, or possibly reverse, the deflationary trend. However, it’s important to avoid excessive inflation and rising rates that would further burden the borrowers who are helped by redistribution.
It seems like a hard needle to thread, but it is not impossible. Why? The deflationary pressure from the technology sector is going to step up dramatically as we move into the “AI Age” over the next century, and every part of the economy becomes tech enabled, starting from less than 10% digital today. So, we probably have a wide berth to drive a little inflationary pressure and maintain low rates.
That’s a neat and tidy story, right? It’s one possible explanation, and, moreover, it suggests that redistribution could be a way out of our current socio-economic quandary. But, we live in a world dominated by complex adaptive systems, which means that predicting the future isn’t so neat and tidy. Or, as Jim Goff said in one of our recent team meetings, “Just when you think you have something figured out, that’s when the market kicks you in the teeth”. The theory relies on smart redistribution by governments, and, if we’ve learned anything from the last few years, then we probably shouldn’t bank on smart decisions by governments around the world. And, the economy remains extremely vulnerable to inflationary shocks, although they remain elusive for the time being.
While this mid-year update has focused on macroeconomic issues, we actually spend comparatively little time thinking about macro events from an investment perspective. As a whole, however, the recent turbulence serves to highlight the frequency of fat-tail events inherent to complex systems – and reinforces our philosophy of finding adaptable companies that are creating the new digital operating system for the economy. The pandemic of 2020 has accelerated the decades-long shift from the Industrial Age to the Information Age. Companies that are long-term focused, innovative, and maximizing non-zero-sum outcomes will disproportionately benefit. Our process is built to find these companies and craft a portfolio that balances Resilience and Optionality for our clients. Thank you for your continued trust, interest, and support.
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