Q2 2022 Quarterly Update Partnership Investing Portfolio

Quarterly update on the Partnership Investing portfolio, the new Quality Score, upcoming posts and more.

A lot has changed since the last update. So much, in fact, that there have been a few changes to the Partnership Portfolio and I have been recalibrating my criteria for future investments. I will discuss each position individually, but before I do, I will explain what I've been thinking about for the past few months.

I am still early in my investing career. This allows me to make mistakes and improve on them without having my entire retirement funds at stake (yet). This blog was a project that started from a need to write my thoughts and investment theses down and share them with the public. This holds me accountable to you my readers, but more importantly to myself as an investor. There is no denying it, the last year has been full of mistakes as an investor. This year, the next, and the ones after that will probably also be. My goal is to make sure they are fewer and less costly.

So what will I improve to achieve this? I think it fair to say I have been more affected by the overall optimism of the market in the last few years than I would have liked to admit. With no experience of a bear market and years of a market where growth and high valuations have been rewarded, I have let myself believe in stories I probably should have been more skeptical of and let the prospect of potential future rewards outweigh current financial performance. This has led me to lack in discipline regarding valuation, considering the quality of management and overall rigor in my analysis.
I have slowly attempted to improve on this, starting with management after my experience with Pushpay and Intellicheck. You might have noticed in my posts I am less inclined to give management the benefit of the doubt when incentives are not aligned, if there has been some turnover or when there is no track record to back up the execution needed for the business to succeed.
To achieve greater discipline regarding valuation, I will be more transparent about the assumptions made in my valuation work. The Expectations Investing framework will still be featured, but you will also find more screenshots of the assumptions and outputs in my models that underpin a certain opinion on valuation.
Another way to reduce mistakes is to limit my future investments to companies with businesses that have proven they can grow profitably in a large end market. Paired with discipline on the valuation side, I see this as a decent rule of thumb and a common-sense way of limiting mistakes.

The portfolio

Naked Wines: The last set of results was disastrous, point blank. To cap of a year of basically no growth and deterioration in unit economics (especially in H2), my investment thesis and confidence in Naked Wines have been tested to the limits. Unfortunately, my thesis based on a business that gets better as it grows (economies of scale shared) has to be considered broken when you consider 1) Naked Wines’ growth is stalling, let alone meeting my expectations of >10% per annum 2) With the current metrics, Naked Wines is spending the vast majority of its marketing budget to replenish lost sales and 3) auditors have expressed concerns as to the viability of the business as a going concern. This is a bitter pill to swallow as I really liked the prospects for the business. Ecommerce is incredibly hard and despite its unique business model, Naked Wines has fallen short of many investor's expectations. The lesson I take from this is that it is dangerous to be enamored with the promises of a business model and that unit economics in D2C eCommerce can deteriorate quickly. Going forward, positive and growing cash flows will be a requirement for a business I invest in. Needless to say, I closed my position in Naked Wines at a painful loss in the weeks following the earnings call.

Vitec Software: Vitec Software experienced higher personnel costs in the last quarter, which had an impact on margins. This was the only noteworthy impact on financials for this otherwise predictabls business. Compared to the rest of the market, Vitec Software shares have held up well in the last months, especially considering the valuation it had to start with. I sold the remaining of my position in Vitec ahead of the recent results. The reason for it is not related to the performance of the business but due to the relative valuation of the company. When I underwrote Vitec shares in July of last year, it barely cleared my 12-15% hurdle at 350-370 SEK a share with some assumptions I would call realistic, but by no means conservative. With the share price reaching highs over 520 SEK a share at some point and the overall market going lower, the relative valuation of Vitec makes me want to raise some cash to reallocate to cheaper companies with the same quality or higher. For example, Topicus has come down more than Vitec, Constellation Software offers good returns at a lower valuation, and other serial acquirers, notably Lifco, look relatively more attractive. I am as of yet undecided on what to do with the funds from Naked Wines and Vitec, but it is likely I will look deeper into one of the few companies named. I hope to get an opportunity to become a shareholder of Vitec at the right price again sometime in the future as this decision was purely valuation-driven.

Surgical Science Sweden: Surgical Science Sweden has yet to report its Q2 numbers, but has published a press release indicating they have received a large order for Educational training software. This is a large chunk of the revenue I projected for this segment in 2022. Its first quarter results were more or less what I expected and I look forward to hear more about what happened during the quarter and the company's steps toward the 2025-26 plan. The company still has a lot of work to do on the Investor Relations side as it does not host conference calls and rarely publishes investor presentations. An improvement on that front would help me and other investors get a better grasp on the developments. Nonetheless, Surgical Science is an already profitable company that can compound earnings at >20% for the foreseeable future in a large end market. This checks many boxes and I am considering adding to the position.

Farfetch: Farfetch has had a difficult quarter. The first quarter was plagued with the stoppage of operations in Russia, which consisted of 6% of revenue and was a relatively fast-growing market, and COVID lockdowns in China. I explained how China was an important part of the Farfetch story and a large part of its revenue (~15-20%). The company issued guidance that reflected those difficulties. The market already seemed to expect this. As a shareholder, I am not all too worried about China as the COVID lockdown will end at some point. The Russian market was a notable part of revenue, but its loss shouldn't hamper Farfetch's growth ambition on a 5-year scale. The company seemed more inclined to reduce the growth in spending, which I see as a positive development, however, the stock price performance in the last year, lack of positive free cash flow, and potential dilution will probably have a larger impact than I initially would have expected. At the current price, I still think the business has enough legs to be at least a decent investment on a 5-year basis, but I am following the company's moves closely.
The company is slowly launching its Beauty offering, which I expect to be a positive catalyst for the business on a 3-5 year basis. What I hope to see in the next year or two from Farfetch is 1) increased discipline on capital allocation, and, 2) significant operational leverage and cost control. Beyond that timeframe, the Beauty segment, Farfetch China, Farfetch Platform Solutions, and a potential deal with Yoox-Net-a-Porter/Richemont should have positive impacts on the key value drivers of the business.

To address my decisions to sell Pushpay, Intellicheck, and now Naked Wines. Although I am a long-term-oriented shareholder, I think it is difficult to argue that the companies did not meet my expectations and that my initial analysis was either flawed or plainly wrong. I am all for staying a shareholder for the long term, but it is vital to realize that you were wrong. This has caused more turnover in my portfolio than in the past, but it will make me refocus on my investing philosophy and the quality of my analyses. Having this blog as a journal will continue to keep me accountable and re-evaluate my work.

Addition of the Quality Score

Finally, I will attempt to raise the quality threshold for companies added to the Partnership Investing Portfolio. To do this in a consistent and more transparent manner, I will introduce a Quality Score. This score is meant to rank the companies I am interested in against each other in a more quantitative and systematic way. This will help me quantify and compare companies against each other. The Quality Score asks questions about the financial performances, growth prospects, management, industry, competitive advantages, and capital allocation. The score is essentially a percentage of the total possible points. The scoring system rewards companies with higher margins, organic growth, positive and growing cash flows, high returns on invested capital, management tenure, a track record of sound capital allocation, and insider ownership as these are the base qualities I am looking for.

The Quality Score is far from perfect but gives me a baseline on which I can improve. It is very hard to create a good scoring system - What aspects do you weigh more? How much information is needed to be able to answer all the questions accurately? How much (subjective) judgement is needed to answer this question? How can the answers to these questions change over time? All these questions need to be thought through to find the balance between facts and nuance.
Biases and inefficiencies can make a Quality Score useless. For now, I will use it in my research and write-ups without weighing the results too much in any direction as it far from complete. Over time I hope to refine it and gather a large sample size of companies to compare against. What I will do is that extremely low scores will exclude companies from consideration. This probably will not happen often as I tend to pre-screen businesses myself before even computing the Quality Score.

I have computed the results for the last three posts (ArcticZymes, ChemoMetec, and Keywords Studios), Farfetch, Vitec Software, and Surgical Science to give readers an idea of the baseline.

Farfetch - 62

Keywords Studios - 77

Surgical Science - 68

Vitec Software - 66

ChemoMetec - 76

ArcticZymes Technologies - 72

All these businesses are strong in some aspects and weaker in others. I intend to refine this scoring system further and eventually plan to share its details with my readers. Consider this a Work-in-Progress on which I will keep you updated.

Future posts

The next post will follow in the next two weeks and will be about Avalara (AVLR).

To give an indication of the future posts you could expect, here are a few names I have the intention to write about at some point:

• Medistim

• Eurofins Scientific

• Topicus

• The Trade Desk

• Lifco

• CoStar Group

• Becle SAB de CV (Jose Cuervo tequila brand owner)

• IVU Traffic Technologies

• Oxford Biomedica

• Lonza

• Bonesupport

• Paradox Interactive

• Cogstate

• Veeva

• Camtek

• Nova

This list could get longer and I am open to suggestions. If you have any, feel free to DM me on Twitter @PartnershipInv or by e-mail at partnershipinvestingblog@gmail.com.

Disclaimer: Always do your own research. This is not investment advice and for informational purposes only. Partnership Investing is not a registered investment adviser and may or may not hold securities discussed on this blog.