Dear Partners,

The fund’s third quarter 2023 performance was -6.1% (net) compared with S&P 500 Total Return of -3.3%. Year-to-date in 2023, Rowan Street gained +67.6% (net) compared with S&P 500 Total Return at +13.1%. Performance for the trailing 12-month period ending in September 30, 2023 was +60.9% (net) compared with S&P 500 Total Return at +21.6%. Please see disclosures for the historical performance data.

Year-to-date in 2023, our top 5 positions (sorted below by size of the position) all contributed positively to the fund’s outperformance, with our top two outperforming strongly (Meta +149%, Spotify +96%):

A Narrative Shift

The second quarter was characterized by its bullishness on all things artificial intelligence (AI) and gave rise to a new group of market darlings, the Magnificent 7 (Apple, Microsoft, Amazon, NVIDIA, Alphabet, Tesla, Meta Platforms). These companies are now among the largest capitalization companies on earth. What’s interesting is the Magnificent 7 was largely responsible for the S&P 500’s total return year-to-date. Excluding these companies would drop the index’s return to just +3.2% year-to-date. Rowan Street only owns one of the Magnificent 7 names, Meta Platforms.

During the third quarter, the narrative turned negative again due to a growing consensus that interest rates will be “higher for longer” with commensurately higher risk of recession. Recession has been anticipated for the last 18 months and counting, starting with the Fed’s first rate hike in March of 2022. Below is a tweet that provides a perfect visualization of how the long term borrowing costs have increased since the beginning of summer of 2023:

We have never been in the business of predicting interest rates or recessions, and in our experience, trying to position an investment portfolio according to one’s prediction of a coming recession is futile and counter-productive. If anyone throughout history was truly able to predict recessions with any degree of certainty and consistency, we would surely see that economist/macroeconomic forecaster on the Forbes list. However, instead of profiting from their “unique macroeconomic insights” and warnings of a coming recession, they choose to sell you their recommendations of how to position your portfolio over the next 12 months. Isn’t that ironic?

Having said that, it is highly probable that the era of “free money” has come to an end. Our sense is that longer term borrowing costs will be at significantly higher levels than what investors have become accustomed to over the past 10 years, even if short term rates eventually come down from current levels. Our focus is on companies that can self-fund their future growth, without the reliance on capital markets. All of our portfolio companies have clean balance sheets (no debt), and generate plenty of cash flow in order to reinvest into their growth. More importantly, we look to invest in companies that are very disciplined in their reinvestment of capital. In the age of free money, reinvestment of capital had become an after-thought. However, your investment returns over the long run should approximate the difference between the return on invested capital that the company generates and their cost of capital, which is becoming increasingly expensive.

Meta Platforms (META): $550 billion rebound in market cap in less than a year.

A deep dive into what is driving the optimism for the stock.

It’s been exactly 11 months since we published an article: “Does a $750 billion decline in Meta’s market cap make sense?” META is up +240% since then compared to the S&P 500 advance of +13.5% over the same time period. We will examine what drove this abnormal return. But first, we can’t help but wonder: How is it possible for a trillion dollar company to first drop -75% to $268 billion in market cap and then skyrocket +250% to over $800 billion in market cap all in just less than 2 years. We are not talking about some micro-cap company here. META is the 7th largest company in the world. It is very well-known to everybody and is covered by 45+ analysts.

Are the markets really efficient when you witness this kind of a phenomenon?

Our belief is that the markets have actually become a lot less efficient over the short term with the proliferation of the internet, smart-phones, social media and effortless access to information. This is counterintuitive to what the academics teach us, but that is the way it has worked in reality. We will spare you further discussion on the efficiency of the markets as the purpose of this note was to discuss our investment in META. We wanted to share this observation and be clear that we are not exactly complaining here. Part of our job as fund managers is to exploit these market inefficiencies and drive value to the Rowan portfolio over the long run. And over the long run, the markets do a pretty good job in valuing companies.

What changed since last November that spurred such a drastic increase in the market value of META?

After 3 consecutive quarters of year-over-year revenue declines, which was a first in META’s history, their revenues are growing again, posting $32 billion in Q3 ‘23 (+11% growth) with management guiding to 20% growth in Q3 (see chart below):

Their total expense growth, which was a major pain-point for investors in 2022, is slowing down considerably as you can see below:

After growing at a crazy pace in comparison to negative revenue growth, expenses now look in check, growing only 10% yr/yr (the latest $22.6 billion in expenses includes $1.87 billion in accrued legal expenses and $780 million in restructuring charges). The year of efficiency so far is working out quite well as META’s operating profit growth is back in the black after more than 5 quarters of significant year-over-year declines (refer to chart above). Operating margin was 29% in the latest quarter, significantly above 20% all-time lows in Q3 and Q4 of 2022. Operating margin is estimated to be above 30% again for 2023. Please note that META is able to generate these incredible operating margins despite their heavy investment in Reality Labs that caused them to lose over $15 billion in that operating unit. That is how solid META’s core Family of Apps business really is! It generates north of 40% operating margins and brought home over $44 billion in operating profits. There aren’t very many businesses in the world that can consistently generate these kinds of operating margins.

On the earnings per share (EPS) front, they delivered 21% yr/yr growth after 6 consecutive quarters of yr/yr declines. In the table below, notice the astounding growth rates in EPS back during the COVID time (2020 and 1H 2021), which fueled investor excitement and pushed their market cap to over $1 trillion. If we look at the 2 years EPS CAGR, it is still in the negative territory as we are comparing to peak Q2 ‘21 EPS of $3.61.

All of this was music to investors' ears, and it's astounding how quickly they went from the maximum point of pessimism in November of 2022 to lots and lots of excitement about META’s future prospects.

Let’s take a look at how the valuations have changed

In our November note, we wrote: “Current valuations of Meta makes no sense to us”:

“Meta is estimated to make close to $120 billion in revenues this year. Gross profits are still around 80%. The core Family of Apps business generated $48 billion in operating profits over the past 12 months, and the entire market cap is currently $240 billion (5x core operating profits). Free cash flow over the past 12 months netted at $26 billion, even after the heavy capital expenditures we described above.

Since 2017, Meta had invested $210 billion into R&D and Capex — close to the current market cap. In 2022 alone, they are investing $65 billion into R&D and Capex (in comparison, Apple is doing about half of that). Is Zuck just burning through piles of cash? Given his incredible track record, his unique ability to see where the world and technology is headed over the next 10-15 years and to execute against his vision, we would not bet against him.”

Meta is now estimated to have close to $135 billion in revenues in 2023. Gross profits are estimated to top $100 billion. We estimate that operating profits in 2023 could come close to $45 billion, a significant improvement (>50% growth) from 2022 operating profits of $28.9 billion, but still shy of $46.8 billion in peak operating profits in 2021. The core Family of Apps business generated $44 billion in operating profits over the past 12 months. With the market cap currently at $810 billion, they are now trading at 18.4x core operating profits (a 3.7x jump from the November ‘22 multiple). If we adjust for $53 billion in cash they have on the balance sheet, Meta is now trading at 21.6x 2023 EPS and 17.4X 2024 estimated EPS. Although no longer “dirt-cheap” as it was a year ago, in our opinion, this seems like a very reasonable multiple to pay for a high quality franchise like META and the long term growth opportunities of this investment. If we take a look at its mega cap tech peers (Apple, Microsoft, Alphabet, Amazon), they are all trading above that multiple. We expect Meta to now generate over $32 billion in free cash flow in 2023, even after a massive $28 billion in Capex. This represents about 4.4% free cash flow yield, which we believe should grow at double-digit rates over the next decade. Compare that to the current 10-year treasury yield of 4.6%, which is guaranteed not to grow.

In our November note, we talked about the three pressing issues that Zuck & Co. have been dealing with:

1. Competitive threats from TikTok

2. Signal loss from Apple’s iOS changes

3. Economic downturn that is having a broad impact on digital advertising business

Let’s see how Zuck has addressed these issues thus far. First off, many don’t realize that despite all the competitive threats and numerous rumors that “no one uses Facebook anymore”, Facebook continues to grow globally and engagement remains strong. In 2023, for the first time, they crossed 3 billion monthly active users (MAU); daily active users (DAU) were 2.1 billion, up 5% year-over-year.

On the first two issues above, the investments that Meta made over the years in AI, including billions of dollars they’ve spent on AI infrastructure, are clearly paying off across their ranking and recommendation systems and improving engagement and monetization. Here is what Zuck said on the Q2 ‘23 call:

“AI-recommended content from accounts you don't follow is now the fastest growing category of content on Facebook's feed. Since introducing these recommendations, they have driven a 7% increase in overall time spent on the platform. This improves the experience because you can now discover things that you might not have otherwise followed or come across.

Reels is a key part of this Discovery Engine, and Reels plays exceed 200 billion per day across Facebook and Instagram. We're seeing good progress on Reels monetization as well, with the annual revenue run-rate across our apps now exceeding $10 billion, up from $3 billion last fall.

Beyond Reels, AI is driving results across our monetization tools through our automated ads products, which we call Meta Advantage. Almost all our advertisers are using at least one of our AI-driven products. We've also deployed Meta Lattice, a new model architecture that learns to predict an ad's performance across a variety of datasets and optimization goals. And we introduced AI Sandbox, a testing playground for generative AI-powered tools like automatic text variation, background generation, and image outcropping.

AI is quickly becoming another driver of growth for META

Barclays analyst has recently pointed out that “Meta Platforms may be poised for a new tipping point as it relates to artificial intelligence… Users may have a new ‘interaction layer’ to access information and transact via Meta’s four mega-apps: Whats App, Messenger, Instagram and Facebook.”

At the Meta Connect 2023 Event last month, the company announced new AI tools, including personal AI assistants with 28 AI personality characters, which can help users with tasks such as finding information, controlling devices, and translating languages. Meta is also developing AI-powered tools for creators, such as AI dubbing tools and AI background generators. These new products and services have the potential to revolutionize the way people interact with technology and with each other.

What’s even more exciting for us as investors is that after spending the past five years as a wartime CEO, Zuckerberg is finally getting back to exactly what he thrives at, which is innovation and creating amazing products. As he put it in one of his recent interviews: “For the next wave of my life and for the company — I define my life at this point more in terms of getting to work on awesome things with great people who I like working with.”

A few words on the Metaverse

A majority of investors have been very skeptical and critical of Zuck’s efforts on the Metaverse as the losses for Reality Labs have been substantial. However, our hat is off to Zuck for continuing to persevere on his vision on the next computing platform that he wholeheartedly believes in. That’s the benefit of being a founder/CEO that owns the majority of the voting shares. A “hired gun” CEO would never pursue such a vision and risk his career. Please take a look at the following presentation — it will blow your mind:

Looks like the Metaverse is no longer just a dream that is too far off into the future — it’s officially real!

Thank you for your confidence and trust in our investment discipline. Despite a meaningful rebound in our portfolio in 2023, we see a continued opportunity to intelligently deploy capital and to deliver long-term value to our investors.

As always, should you have any questions or comments, we would be very happy to hear from you. We look forward to reporting to you again at the end of the year.

Best regards,

Alex and Joe