August Investment Update

Dear investors and well-wishers,

The fund returned 18.7% in July, taking us to 37% net for the calendar year-to-date. 

This put us to the #1 fund this calendar year-to-date in our Morningstar category and #2 over the last three years (29.5% pa / 117% total). At the end of July we had recovered 198% from the 2022 lows.

Aussie biotech and US growth have had diverging fortunes this year, and all of our returns (and more) have come from the later.

We’re planning to visit each of Australia’s major cities later this year to visit companies and investors, so please send me an email if you’d like to catch up. 

Risk models

I decided to share some internal work showing how our risk management works at the portfolio level. In the past I’ve only shared single stock examples.

To test how this would have performed in 2021-2022, we made a selection of stocks that long-time readers will be familiar with: MercadoLibre, Nubank, Sea Ltd, Carvana, and added some of the worst performers of the last few years, like Intellia, Camplify, Enphase and Chinese tech.

This would have grossed the following:

This is a backtest so the usual caveats apply, but you can see the strong run in 2020-2021, followed by limited losses in 2022. 

To see how the portfolio achieved this, we tracked individual holdings and trades. The blue line is the cash weighting and each stock is a different colour, darkened when in cash.

The portfolio was max invested around July 2020 (a great time to be long), then steadily reduced exposure, with cash weighting rising to 100% in January 2022, right before the sell-off accelerated. 

Instead of buying into the sell-off, this kind of approach sold ahead of it, completely flipped our trading pattern at the time.

While this is a backtest, we’ve outperformed these numbers since it was implemented live in late 2023, and it was particularly helpful during the large swings earlier this year and was largely responsible for our recent outperformance (stock selection also helped!).

A step further

How would a portfolio of only losers perform?

I somewhat arbitrarily included twenty companies that performed particularly poorly over the last few years: failed SPACs, Chinese tech, clean energy, busted software darlings, etc. If you’ve been following the space some or most of these will be familiar to you:

As the market rolled over, one by one the strategy closed these positions and moved to 100% cash around Jan 2022 - again before the sell-off accelerated - and it stayed above 75% ever since. 

Even a portfolio chosen to only include known losers - with our risk management system applied - still generated solid returns:

As far as I’m aware this approach is unique in the market. It’s not easy to make money buying stocks that go down.  

And it has worked well in practice, not just by monetising those big swings in the first half of this year, but also in the many cases where it kept us out of trouble.  

One example was RxSight, which sells light-adjustable lenses to ophthalmologists.

We invested on the back of high organic growth and glowing interviews with practitioners, only for the stock to completely collapse over the last year. We got out at a small loss long before the collapse. 

I built the initial version myself, but we’ve since engaged full-time engineers through aceventure.au to rebuild our systems from scratch and take them far further than I could alone.

I don’t want to give the impression this is designed to eliminate drawdowns. We’re still targeting top tier performance, and that requires taking risk and having a portfolio that moves. And part of our portfolio is in illiquid biotech companies where this approach isn’t practical, and this part has proven particularly volatile lately.

It was actually designed to work in long bull and bear markets, so it was a pleasant surprise it worked so well in the recent crash and recovery which seemed to happen over a matter of weeks.

Companies

It was a busy month for us, with a productive trip to Boston and New York (with thanks to Canaccord, who hosted us). 

We met Rhythm Pharmaceuticals, one of our largest holdings, which pushed to new highs.

Rhythm targets specific kinds of obesity caused by the same pathway in a number of genetic and injury-induced diseases.

The company is annualizing US$194 million from their approved drug setmelanotide, growing at 54% year-on-year, revenues which are helping fund its pipeline.

This has a similar risk profile to Neuren Pharmaceuticals, which we also own, and is using profits from its successful program in Rett Syndrome to fund multiple Phase 3 trials. Companies like this are in a different risk category to pre-revenue biotechs as they can self-fund, or partly self-fund, their clinical pipeline.

Without wanting to tempt fate, the trial risk for Rhythm looks low, as the pathway is well-proven and the drug well-characterised. 

We learned their peptide setmelanotide was once used recreationally for both weight loss, and skin darkening, which is a negative in the context of a drug, but I guess positive if you want a tan. Kind of like a sunbed combined with a bad GLP-1. The company didn’t mention the (presumably) less-welcome risk of priapism. 

We also heard the story of how they bought their next-generation small molecule, bivamelagon, which has so far shown the benefits of setmelanotide without the skin-darkening.

And it’s fortunate they made this acquisition: if bivamelagon was in someone else’s hands Rhythm would be facing near-term existential competition. 

We also had a win in Avadel, which is growing revenues at 134% year-on-year marketing a sleep medicine. Don’t ask what their drug is…

US growth

Reddit was a strong performer in US growth, with top-line growth coming in at ~78% on a GAAP net income margin of 18%. 

Reddit is well placed in a world where original, human-written content is at a premium. AI models need a constant diet of contemporary human input to stay useful. 

Reddit benefits from a snowball effect. More users add more content to the site, establish and populate more niche communities, which in turn improves the product and attracts new users. 

There’s still a risk that Google arbitrarily deranks them in search, but we’ve hit our first profit target and reduced the position substantially now regardless.

Syntara had a setback at the FDA, though this landed in August rather than July. The company hoped to move straight to a pivotal trial, but the FDA will now require them to do a Phase 2b, adding about two years to the timeline. 

There is a silver lining if you squint: a Phase 2b trial will be faster and cheaper than a pivotal, and at the end of a Phase 2b, if the data holds, it’s the perfect moment to attract a partner or sell the main asset. 

I suspect it will take a partnership announcement to move the stock back to its highs now. We’ve maintained it as a small position.

It highlights why biotech is so challenging, with all the risks of small cap investing plus an entire new set. This time the clinical data came in better than expected, but the FDA disappointed. C’est la guerre.

Outlook

The sell-off in April was large enough to reset investor sentiment and positioning.

I wrote that July was the month we expected momentum chasing CTAs and volatility targeting funds to pile back into the market, and so it turned out. We were lucky our risk models bought us back in well ahead of this move.

There are hundreds of billions of dollars in those strategies, so this feature of the market is here to stay for some time.

Reading the tea leaves, Powell has taken the hint from Trump, decided to keep his job, and turned slightly more dovish. Perhaps this should be less of a surprise - you don’t land one of the best Government jobs on the planet without an eye for career development.

All things equal this is positive for risk markets, but you have to be careful what you wish for with interest rates. The scenarios that bring about cuts are generally not good ones.

Fortunately we don’t need to make these kinds of predictions any more. I’ve shown above how our risk management process can protect a portfolio of even the worst possible stocks selected years later for their poor performance.

If there is an extended sell-off, that will sting in the short term, but it’s where we expect our risk management to add the most value.

I certainly don’t expect to string together 18%/24%/19% months like the last three any time soon, especially now the big quant buying is behind us. From here until the next big shakeout and recovery, performance will come from stock selection.

As mentioned, we’re planning a trip to see companies and investors around Australia, so if you’re in Melbourne, Brisbane, Adelaide, or Perth please let me know—we’d love to catch up!

Michael