A retro on 2022 for small cap tech investors 🤔
Oh the lessons we learned
2022 is a year that will stay in the books, hopefully for all my career as an investor. The lessons were many, and I’m penciling them down here in the hope not to forget them, and not to make the same mistakes again.
Whilst a whole book could be written on the last few years for investors (and I’m sure plenty will), I’ve forced myself to keep to five main lessons that I think were the most profound.
Reflecting on 2022 caused me to resurface a lot of 2021, hence you will see references to 2021 in this review. The contrast between these two years was long and deep, so will the scars I keep from experiences.
Pay attention to cycles, only a little 🔁
Peter Lynch will tell you that if you spend 13 minutes a year on economics, you’ve wasted 10 minutes. I agree with this. In 2022, all you needed was just about 2 minutes to be able to take a good guess on where we might have been in the cycle.
You didn’t even need to read Howard Marks’ excellent Mastering the Market Cycle. We all had this feeling in our stomachs that printing the most amount of money ever (arguably the right thing to do at the time with the information we had), would likely come at a cost. We also know very well as investors that the one big lever with the most impact on the markets are the infamous interest rates.
To bring Lynch back to the forefront, he’s right again that the head of the federal reserve can’t make an accurate prediction on where interest rates will be in 2 years. No one can say where we will be in 2025, but when you’re at 0, it feels like there’s only one direction in which you could go (no references to the band intended here). Would policy makers really walk the path of negative interest rates for years? Could we really expect the show to go on? If it seems like I’m being condescending here, I’ll be the first to admit that I fooled myself.
That interest rates are at 0 shouldn’t mean you liquidate all your positions and go to cash (although those that did in January 2022 might happily tell you a different story). In my humble opinion It means you want to have a good written strategy on what you do differently in different environments.
As an example, I chose to have a bigger cash weighting in 2021 than I would normally. I’m happy I did that because that protected my downside when small caps stocks were getting sold left, right, center. It also offered more dry powder to benefit from the bargain prices we saw in June 2022. I deployed much of the capital too early, but perfect bottom timing isn’t something I’ve been optimising for given I don’t think it’s consistently possible to execute on.
Still the wisdom of Buffet will always remain true: “I make no attempt to forecast the market—my efforts are devoted to finding undervalued securities.”
-Warren Buffett
Stick to your circle of competence ⭕
I’m not so sure how much the macro environment influenced this behaviour, but in 2021 I made one big mistake from taking a position in a company well outside my circle of competence.
I spent all my career in sales, and most of it in technology. What business do I have owning a waste water cleaning chemical business ?
The business in question, Scidev (ASX: SDV), ticked the majority of my checklist when I started researching it in 2021. Then in 2022, the hard times began. I’ll spare you the whole story here and instead focus on my mistake.
Instead of doubling down on my research to compensate for my gap in knowledge of the space, I did some high-level digging, read what other investors had to say about the difficult times, and satisfied myself with buying more, further enhancing my mistake in the process. (Note; Scidev seems to have turned a corner since and may well be onto the success I had originally imagined for the company. So perhaps I made two mistakes here, not only one).
That Scidev is now kicking goals again is perhaps another showcase of why one must stick to their circle of competence. Had I known more about the industry, it certainly would have been easier to get an accurate view of the current reality; are investors too pessimistic, or is this the new reality?
Write more things down ✍️
In the good times, we have a tendency (well, certainly I do) to get ahead of ourselves and think we’re above some of the most important parts of the process, Thinking we will be successful regardless. This happens because even companies announcing average results tend to go up. Not writing enough down is perhaps the biggest novice mistake I made in 2022.
Writing forces a level of clarity that puts a spotlight on bullshit. You can easily fool yourself if you keep your ideas in your head, but I find it much harder to fool myself when my ideas are on paper. Harder still is when the ideas are on paper and out into the world.
In 2021, with so many businesses experiencing so much momentum, some investors optimised for speed, fearing we would miss too much of the upside if we spent further time in our research. That’s a mistake.
Looking into this one further, I took 5 positions without a proper thesis written down. I’ve since amended the mistake by writing these down, and thankfully I hadn’t skipped every part of my process, but making the mistake was enough to cause the pain and learn the lesson.
Being more tangible here I found that spending more time reflecting over the bear case, studying the key risks, evaluating competitors, and listening/discussing with people who hate the businesses you love are amongst the best habits of a good investor. I force myself not to take a position without my top 3 risks written down clearly, and these can’t be generic ones (ie. CEO leaving, competitors eating their lunch.) Thank you to this bear market for emphasising this important lesson.
Patience my young padawan💆
I try to remind myself often of what game I’m playing.
Whilst it was painful to see my portfolio lose 15% in 2022, I’m confident my strategy can pay off in the long term. Winning in long term games means you will suffer losing short term battles. We inherently know this but until we experience the pain we can’t say with certainty how we will react.
I’m pleased with myself that I didn’t make stupid mistakes when things were looking the darkest (which I personally felt was June/July, although I wouldn’t say we’ve moved too far forward since).
“Waiting helps you as an investor and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”
Charlie Munger
Cash is king 👑
I’m leaving this one to last because it’s now too obvious and you’ve heard it too many times.
My perspective on this one (perhaps this will make me unpopular) hasn’t been to only invest in companies that are profitable. Instead, it’s to be comfortable with the dangerous outcomes that come with cash burners.
I chose to invest in cash burners if I can believe in their unit economics and see their pathway to positive cash flow. The mistake of 2021 was to not even go that far into your research. This meant you failed to dig into the unit economics, missing the operational leverage portrait that’s so central for software companies to get right, and missing how bad some cash margins were. When cash margins are too far into the negative, we saw how hard it was, even for good businesses with strong leadership teams to pivot at once when investors demanded it.
A good example of this is IntelliHR (ASX:IHR). I’ve followed this company for a few years and have been impressed with their execution on ARR growth. With their HR one-stop shop platform, they are playing in a competitive space and are winning impressive logos competing against the more established players. User reviews are positive. With some built-in flexibility, a nice-looking user interface, and ability to meet enterprise demands, they appear to be growing their community of happy users.
All signs pointing to what could be great product market fit. Unfortunately for investors, 2022 has been a horrible year to own the stock.
Why? Well, they are a good case of scary looking negative cash margins with a high cash burn rate compared to their market cap. The challenge with businesses at that stage is that it’s hard to forecast what will happen to margins as they grow. Workday is a good case study of this. Workday was known to have had unexciting margins as a young organisation as they focused on charging for services too to make sure their customers implemented well. Hopefully you didn’t overlook them completely for this, because we all know what unfolded in the decades afterwards.
I do not own shares in IHR, and do not plan to either until we start to see cash flow move in the right direction. I will however continue to follow them closely because they have shown great execution on their top line growth with their initial enterprise sales motion. Now that they are creating their partner channel, things could slowly start to look better every quarter.
Stepping out of the case study and zooming in to the larger lesson, I think we’ve all been reminded that discounted cashflows, even the simpler models, can be extremely useful. As an exercise, if it feels impossible to complete because the business is simply too far away from cash flows, maybe that’s an important signal not to miss.
Conclusion
We’re all hoping for a better year in what we experience in 2022. At the same time, I try to remind myself that hard times offer a better bang for your buck when it comes to important lessons. Also, hard times tend to offer the starting point of great returns to come in the future. More on this in a next post.
I’ve learned so many more lessons than the five above, and would welcome anyone keen to share their lessons too.
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