In my April update, I commented that it appeared that things were too complacent in the markets, with equity values rising too fast too soon, and that I was expecting there to be a noticeable dip, as much as 14% in Project $1M portfolio value by the end of 2019. While May didn't see this prediction come through, it did bring the start of what I expect to be a more sustained downturn over the next few months. Funnily enough, I didn't anticipate that the trigger for the downturn comes in the form of the on again, and now off again tariff deal. In any case, I view this latest pullback as very healthy, and while not enough to get me to increase my market exposure, something which I have been planning and preparing for.
My broader investment focus with Project $1M is the purchase and long-term hold of a clutch of high-growth, cash-generating businesses that are powered by secular tailwinds. The advantage of these secular tailwinds should be to allow the selected businesses to grow under any economic conditions that may be experienced over the life of the Project $1M portfolio (a decade or more).
Markets may move the prices of Project $1M businesses around, here and there, depending on sentiment. However, I am focused on the long-term returns on invested capital that my businesses can generate and the opportunity to deploy that invested capital at high rates of return over a long term horizon. For those that are new to the Project, here are Part 1, Part 2, and Part 3 of the initial investments in the portfolio.
The overall objective of the portfolio is to turn an initial capital base of $275,000 that was initially deployed in November 2015 into $1,000,000 by November 2025. This will be done primarily through buying businesses and holding high-quality businesses, helping returns compound and minimizing tax and trading costs.
Project $1M ended May with a balance of just under $470,000, a fall of almost $24,000 from the $494,000 that it finished April at. There were very few 'safe havens' in the portfolio in which to take refuge, but unsurprisingly, my collection of Chinese holdings were very aggressively dealt with, with Baidu (BIDU) and Alibaba (BABA) seeing falls greater than 20%. Baidu, in particular, was down almost 33% last month. On the positive side, Pro Medicus (OTCPK:PMCUF) and MercadoLibre (MELI) both had fairly strong months, with each business up more than 15%. Somewhat surprisingly, Project $1M was only down some 2.6%, compared to the S&P 500's fall of almost 5.65%.
In addition to generally heightened volatility against China-related names, the last month was impacted by particularly adverse results from Baidu. I also made the difficult decision to exit Booking Holdings (BKNG), and I have swapped it out with a new position in Salesforce.com (CRM).
Baidu Result and Share Price Decline
On its surface, the Baidu result wasn't particularly bad. The company still managed to eke out an increase of almost 20% in top-line revenue (excluding divestments). It was the aggressive bottom-line expense that the market didn't particularly like, with Baidu recording a loss as a result of aggressive investments in artificial intelligence enhancements, cloud computing, and autonomous driving technology. The magnitude of these investments sent Baidu's bottom line sharply negative, and Baidu stock was dramatically punished as a result. Baidu's stock price now sits at $110 per share and is at levels last seen almost 5 years ago, for a business that is producing dramatically better revenue. I look at Baidu as representing deep value here. The investments Baidu is making in artificial intelligence technologies should eventually enhance and simplify the core search experience and make this a better product for consumers. Investments in autonomous vehicle technology and cloud services are yet to demonstrate any material revenue traction for the business. However, these are large growth markets which Baidu's main competitors all are investing in, and which could be significant for Baidu in being able to diversify its business away from search in the future.
I ultimately refrained from increasing my exposure to Baidu for a couple of reasons. Primarily, I have a deliberate cap in my exposure toward China-oriented businesses, given a different regulatory environment than I am used to and transparency concerns around disclosure. That cap is around 10% of my portfolio value. Between existing investments in Alibaba, Tencent (OTCPK:TCEHY), Baidu, and Ctrip (CTRP), I have already hit this limit and, thus, cannot commit any new capital. Additionally, I have some concerns about the medium-term dominance of search in the China market, given the role that WeChat plays in the life of Chinese consumers and how successfully WeChat has been able to organize and curate vertical application niches that reduce the relevance of search. I still believe that there is a role and place for Baidu, but just how significant this will be is something that I am not easily able to tell.
Divesting Booking Holdings
After a fairly long association with Booking Holdings since the inception of Project $1M, I made the decision to divest the position in May. This wasn't an easy decision. In general, I'm opposed to selling anything, particularly such a long-standing position. There is much to admire about Booking Holdings. It has managed to aggregate a very disparate set of hotel inventory in the particularly fragmented EU market, where there are a significant number of small single proprietor hotels. While there a number of peripheral threats to the business, including the looming presence of Airbnb (AIRB) and the uncertainty of Brexit on European tourism, the biggest factor in my decision was the reality of Booking's slowing revenue growth and the outsized impact of search-based advertising on the business.
In recent quarters, Booking Holdings has given guidance which has been suggestive of a business that is very heavily dependent on search-based advertising for revenue. When advertising on search has been ramped up, that has been casually relevant to increases in expected revenue, while any pullback in search-based advertising has seen a ratcheting down in revenue expectations. It appears that Booking Holdings has now made a conscious decision to focus on margins and, with that, limit revenue growth to the high single-digit range going forward. While that is entirely respectable, I'm after businesses that have the potential to grow revenue at least double digits. This, coupled with the ever-stronger dependency on Google search, has created some long-term uncertainty for me on the outlook for Booking and how strong this growth picture would be.
Welcoming Salesforce to the Project $1M portfolio
With the disposal proceeds from Booking Holdings, I made the decision to initiate a new position in Salesforce. I was split between the addition of a new position in Salesforce, or Adobe (ADBE), both businesses that I admire and that I expect to grow strongly over the next decade. Ultimately, I decided that Salesforce likely had a stronger growth trajectory and represented better value today.
Salesforce is a beneficiary of enterprises moving on-premise applications to the cloud for resulting savings in IT infrastructure costs. Sales lead management, in which CRM specializes, is an area of considerable importance to most businesses and tends to be a very sticky service once implemented from which companies find it difficult to switch away. Over time, it's not just sales functions but also marketing and operations that start using and finding values in CRM tools.
A network effect gets created as existing users benefit from additional users being added to manage customer interactions. There are many adjacent markets and services that stem from CRM-based services, including marketing and financial reporting, that Salesforce is well positioned to grab share in. Marketing to CRM prospects and being able to monitor and view interactions with such companies is a natural extension of salesforce core capabilities.
Salesforce has been consistently growing revenue at over 20% annually over the last few years. Operating profit is relatively modest due to the upfront acquisition cost of new customers, and revenue deferral over contract life. Cash flow in the core business is very healthy, however, with free cash flow consistently north of 20% of revenue. Salesforce has performed strongly over the last five years, providing a rate of return on investment of 23% annualized. At just 8.5x sales, Salesforce appears fairly valued based on historical metrics and trades at a discount compared to other cloud players such as Workday (WDAY) and ServiceNow (NOW) which have multiples greater than 10x sales.
While the correction has started, it still has further to go, in my opinion. I fully expect Project $1M to have no greater than a 20% annual return in 2019. The portfolio currently sits on a YTD return of north of 27%, implying still significant falls. I do expect China-related stocks Alibaba and Tencent to rebound at some point later in the year. Both appear to be trading at very attractive levels to me at present. If we do get more significant share price declines in the order of what was seen in late December 2018, I will look very hard at deploying a more meaningful volume of cash, but we are still quite some way away from this still.
Disclosure: I am/we are long ALL POSITIONS IN THE TABLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.