July 16th, 2024
Dear Clients,
We hope you and your families are doing well.
Market Summary:
The stock market continued where it left off in the first quarter with a strong performance in the 2nd quarter of 2024 (see chart above). The rally in stocks during the 2nd quarter continued as the Federal Reserve held interest rates steady and investors began to speculate on future rate cuts. In our past letters, we talked about historically low valuations and an overly pessimistic sentiment which tends to be a contrary indicator. More recently, confidence has returned to the market due to the rise of AI and an aggressive interest rate cut outlook. Economists view the chances of a soft landing (no recession) as more probable now that inflation has cooled and sits ~100 basis points above the Fed’s long-term inflation target of 2% (see chart below).
We believe a major reason for the rally has been increased expectations for an interest rate cut in September due to softer employment data and lower than expected inflation data (see chart below).
While the stock market has had a strong start to the year, we continue to monitor the position sizes of each company in your portfolios. This includes trimming when we believe their weightings get too big or selling them completely when internal price targets are achieved or their fundamentals have changed. Exiting the second quarter, we held a larger cash balance and are positioned well to redeploy that cash in new ideas. Additionally, we have continued to hold oil stocks as hedges against the persistent inflationary environment that we find ourselves in. While oil stocks are not the typical growth stocks we tend to look for, we feel that their defensive and contrarian characteristics make them well suited for this uncertain macro environment. Many of them also pay dividends, providing a source of income in addition to capital appreciation.
The top performing sectors in the first half of 2024 include Technology, Communications, and Energy. Technology rallied as the market increased exposure to companies benefiting from artificial intelligence. The outperformance in technology was also due to the heightened investment made in the “Magnificent 7” (Apple, Amazon, Google, Microsoft, Nvidia, Meta, Tesla). Investors flocked to safety in the “Magnificent 7” companies as they were looking for high quality balance sheets and earnings to hide in amidst an uncertain economic environment in 2023. While this strategy has proven effective, we don't believe that those stocks offer good value relative to their growth rates going forward (see chart below).
While small and mid-cap stocks have participated in the overall market rally, we feel that relative to large, there is still room for them to outperform given the valuation differences. We continue to look for new ideas with superior products and services, providing long runways for growth.
Portfolio Review
Contributors
Zeta Global Holdings Corp. (ZETA) which we identified in early 2022, was a top performer during the first and second quarters, up over 125% year to date. Zeta is a marketing technology software company which benefits from multiple market tailwinds in the advertising industry. Zeta’s software platform combined with artificial intelligence helps companies' market more efficiently by targeting ads based on specific demographics. The Zeta marketing platform helps customers deliver advertisements through all channels such as email, social media, web, chat, connected TV and video. Zeta is unique in that their platform doesn’t use cookies. This reduces risk from a regulatory and customer standpoint as they are not impacted by these issues. Consequently, they can take market share from competitors like Adobe, Salesforce, and Oracle who have all made legacy acquisitions to enter the space. In May, the company announced their first quarter earnings where they beat and raised their previous guidance and claimed their sales pipeline was the largest in the company’s history reflecting their continued momentum in the business. They are bullish on the remainder of 2024 and remain ahead of their 2025 financial targets of $1 billion in revenue and 20% EBITDA margins. The company was founded by former Apple CEO, John Scully, and the management team has a strong track record of performance (the company has beat their revenue guidance for 10 consecutive quarters since their IPO in 2021). As marketing budgets tighten, Zeta is well positioned to take share and potentially benefit from the weakening macro environment.
As a result, we believe the company can accelerate revenue growth in 2024 (analyst consensus expects 23% growth for a second consecutive year) due to 3 factors: 1) insurance and automotive industries are expected to flip from headwinds to tailwinds 2) political spending tailwinds into 2024 election cycle 3) the introduction of a mobile messaging marketing channel. We went into detail on these factors in our previous two quarterly letters, and since then the thesis has begun to play out. Similarly, the valuation gap between Zeta and their competitors is beginning to close. Zeta competes with Braze Inc. (5.4x EV/Revenues) and Klaviyo Inc. (5.1x EV/Revenues) who both have similar revenue growth rates yet are far less profitable than Zeta (4.1x EV/Revenues). We are hesitant to sell or trim Zeta shares as we believe they can ultimately trade at a premium valuation to these peers. We continue to hold Zeta as a large weighting in client portfolios.
Mama’s Creations (MAMA) was a strong performer for the portfolio during the first and second quarters of 2024. MAMA markets, manufactures, and distributes ready-to-eat deli style packaged food products. Their products include beef meatballs, turkey meatballs, beef meat loaf, sausage and peppers, chicken parmesan, and other similar meats and sauces. Shoppers are increasingly looking for ready-to-eat food options at grocery and convenience stores with a focus on cleaner, protein items with simple ingredients. The company has distribution established with retailers across the eastern U.S. and plans to expand nationwide over the coming years.
The company has a new CEO, Adam Michaels, who has previously worked at Mondelez International, one of the largest food companies in the world. Since Adam joined the company in September of 2022, the management has improved multiple operational processes within the business. Mama’s Creations has over 45,000 product placements in Whole Foods, Costco, Sam’s Club, Albertsons, and Safeway. Mama’s Creations is mostly focused on the Eastern U.S. grocers for their products. Mama’s has a total of 8,650 stores they are in currently, excluding some of the largest retailers including Walmart, Target and Kroger. Management believes that winning any one of these new retailers could represent a $100+ million annual opportunity. The company believes they can win one per year over the next several years. The company's management thinks they can achieve their $1 billion revenue goal in 2030, up from the $120 million in revenue expected in 2024.
We originally purchased Mama shares at $2.50 and $3.50 upon previous employees selling their stakes in the company. Those employees decided to retire after working for the company for many years, which presented an opportunity for us to buy. Since then, the stock has more than doubled and Mama’s new CEO, Adam Michaels, has filled the vacant positions with strong talent from his prior career at Mondelez. The stock continues to trade at a reasonable valuation of 17x 2025 EV/EBITDA compared to other food peers in the range of 16x 2025 EV/EBITDA while growing faster and taking shelf space at the grocery stores.
Detractor
TELA Bio Inc. (TELA) was a detractor to performance during the quarter. TELA is a commercial stage medical device company focused on providing soft-tissue reconstructive solutions for hernia repair, abdominal wall reconstruction, and facial and reconstructive plastic surgery. TELA’s primary product is a surgical mesh product called OviTex. OviTex is produced using biological material with polymer fibers, resulting in a lower infection rate (biologic material) and lower hernia reoccurrence rate (strength of polymer) than traditional synthetic meshes (plastic). OviTex also costs about 20-40% less than comparable products on the market. TELA competes with companies like Medtronic, Allergan, and C.R. Bard. C.R. Bard currently faces over 33 thousand lawsuits for their synthetic hernia mesh which has been known to cause severe side effects and chronic pain. TELA has recently had success in hiring C.R. Bard sales representatives due to what they believe is having the best hernia repair product in the industry. We forecast that TELA will continue to take share in the $2 billion annual U.S. hernia repair market. TELA recently won their 3rd hospital group purchasing organization (GPO) contract allowing them to sell their products directly to additional hospitals. Currently, they can sell to roughly 6,000 hospitals with their first two GPOs. We believe TELA will continue to gain market share and is an attractive buyout candidate for one of the larger medical technology companies who can plug TELAs products into their large existing salesforces.
Despite the negative stock performance over the last few quarters, TELA remains one of the highest conviction companies we own. Their stock is highly correlated with the Dow Jones US Medical Equipment index which experienced a selloff throughout August, September, and October of 2023 as the markets digested the release of many of the GLP-1 drugs expected to improve the obesity rates and the comorbidities associated with them. Other issues came in Q4 (March 21st, 2024) when TELA’s revenue guidance was set too aggressively and missed expectations. Since then, we believe the company has corrected those issues beginning in the first quarter. TELA reported revenue growth of 39% in their Q1 earnings report (May 9th) beating their guidance and raising expectations for the remainder of the year. Management stated that this year’s guidance is a “commitment to investors” displaying their confidence in hitting their revenue targets. Additionally, management reiterated they believe they continue to have enough cash on their balance sheet to reach profitability, a point that investors have challenged them on in the past. TELA’s peers with similar growth rates trade at 5-10x EV/Revenues while TELA trades at 1.2x EV/Revenues. We believe that TELA will begin to close this gap as investors realize TELA has a superior product and value proposition in the $2 billion annual hernia/reconstructive market their products address.
Outlook
We continue to see tremendous investment opportunities in the market. In addition, we believe that the current environment provides an opportunity for stock selection and active management versus passively investing in indexes that are heavily weighted towards the “Magnificent 7.” By continuously screening for companies with new products and services, large market opportunities and high revenue growth with strong margins, we believe your portfolios are well positioned. While we are cautiously monitoring macroeconomic events, our time is best spent looking for new ideas and re-evaluating your portfolios despite the noise. While the companies in our portfolios started the year well, we believe they continue to have upside potential throughout the remainder of 2024.
In conclusion, we thank you for your continued trust and support. We encourage any questions or comments you may have. As always, we are available for portfolio reviews anytime. Please contact us if you are interested in learning more about the stocks you own.
Sincerely,
GROW Team
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