Idea Brunch with Spencer Walsh of Kinesic Capital
A Masterclass in Tech Investing
Welcome to Sunday’s Idea Brunch, your weekly interview series with underfollowed investors and emerging managers. We are very excited to interview Spencer Walsh!
Spencer is currently the Managing Member of Kinesic Capital LLC, a concentrated long/short technology hedge fund he founded in 2020. Before launching Kinesic, Spencer was a research analyst at Matrix Capital Management and Dodge & Cox primarily investing in the technology, media, and telecom sectors. Spencer was born & raised in Louisville, Kentucky, graduated from Georgetown University, and currently resides in San Francisco, California with his wife, Allison.
Spencer, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and how you developed your passion for technology investing?
Thanks for having me on Edwin. Early in my life, I developed two passions: one for business & entrepreneurship and the other for technology. While nature might explain part of it, nurture certainly played a large role. My father at the time was an electrical engineering professor at the University of Louisville so we were always exploring new technologies together, whether that was building computers or playing around with equipment in the university’s nanotechnology cleanroom. My mother has run her own orthodontics practice since she completed her residency, and that opened my eyes to the world of entrepreneurship. She is one of twelve children and many of her siblings have gone on to have successful business careers. They also served as early role models for me.
Growing up I was always running small businesses to make money, whether that was stringing tennis rackets, arbitraging iPhone cases between Alibaba and eBay, or flipping high-end road bikes online. By the time I was in high school I knew I wanted to build or run a business long-term, and I just needed to figure out what that was going to be. Around the same time, I was introduced to the world of investing by one of my uncles. I was immediately hooked, and that’s when I started buying my first stocks.
I attended Georgetown University and continued to explore my interests in business and technology. I studied finance & computer science, interned at Hinge (the mobile dating app company) as one of their first employees, and then interned at a hedge fund in Hong Kong while studying abroad, where I spent my time identifying fraudulent Chinese companies that were taking advantage of US investors. The summer after my junior year I interned in the TMT group at Credit Suisse, and afterwards I knew I wanted to go straight into public technology investing.
After graduating from Georgetown, I moved to San Francisco to join Dodge & Cox, the ~$300B AUM mutual fund family. There I worked for Roger Kuo and Phil Barret, learning from some of the best long-term oriented value investors in the industry. It was a unique role, as our access and exposure to Fortune 500 management teams was unparalleled. After Dodge & Cox, I was looking for a more entrepreneurial investing experience and was presented with the opportunity to join Matrix Capital Management in Boston, a ~$10B long/short technology hedge fund founded by David Goel. At Matrix you were thrown right into the fire, expected to perform differentiated research and uncover the next disruptive business in tech. It was incredibly exciting to have that level of responsibility and impact so early on in my career.
When and why did you decide to launch Kinesic Capital?
I mentioned earlier that it was a dream of mine to build a business from the ground up ever since I was a kid. During my time at Matrix, I realized that the perfect way to combine my passions for entrepreneurship, investing, and technology would be to start my own investment firm.
Now, building an investment firm from the ground up is no easy task; in fact, I would say it is incredibly challenging. You have to have a differentiated investment strategy, an ability to execute and generate strong performance and earn the trust of individuals and institutions to let you invest their hard-earned money on their behalf. As someone who studies businesses for a living, I know that hedge funds face some significant challenges. While they are incredibly scalable and potentially profitable businesses, they are also very fragile businesses for a whole host of reasons. However, I felt that launching a technology-focused hedge fund was worth the risk if it allowed me to truly pursue my passions every day.
After two years at Dodge & Cox and three years at Matrix, I decided to finally take the leap in 2020 to launch my own firm focused on the technology sector, called Kinesic Capital. So far, the experience has been extraordinary; I’m able to practice the art of investing in its purest form, without the boundaries present within a larger firm with long-standing mandates, and I have total control over my time, able to focus on whatever opportunities I believe are most compelling.
Further, I’m able to structure the firm in ways that I believe are important. As an example, we charge lower fees than the average hedge fund, and following in the footsteps of Chris Hohn at The Children’s Investment Fund and some other managers, we have built a charitable component directly into our firm’s DNA. A portion of the fees I collect as General Partner every year is donated to charitable causes that I and our investors believe in. As we grow over time, I plan on increasing these contributions and solidifying this charitable structure.
Ultimately our job is to maximize risk-adjusted returns to our limited partners. Whether investing on behalf of an individual, an institution, or a teacher’s retirement plan, we have the ability to significantly better people’s lives if we do a good job, which serves as a daily reminder of just how important our work is.
We are still a young and growing firm today, and that comes with plenty of challenges, but if you truly love investing then I don’t believe there is a better job out there. Public market investing is simply one of the greatest games on earth: it is what connects every person and event around the globe. It is also one of the most competitive games on earth. But if we are able to continue to perform well for our partners then I plan on running Kinesic for a very long time.
It’s a crazy time to be a technology investor and we have seen many high-flying tech stocks get wiped out recently. In your view, what are the necessary ingredients for a successful long-term investment in the technology sector?
There are only two forces that drive the value of cash-flow producing assets up: number one is growth in those cash flows, and number two is a rise in the multiple that others are willing to pay for those cash flows. Those are the universal laws of investing, and they describe much of what we look for in our investments. On the long side, we look for high-quality assets that can durably grow cash flows and purchase them for attractive prices (aka. multiples that we believe will hold or expand over time). On the short side, we look for speculative or low-quality assets and sell them at unattractive prices (aka. multiples we believe will compress), with a catalyst on the horizon.
Regarding technology investing specifically, the additional variable you have to account for is that these are winner-take-most markets. Based on our research, the top 3 players in most digital industries (e.g. internet marketplaces and enterprise software) capture ~45% of the entire sector’s revenue and capture 55-70% of the entire sector’s profit pool. What is the consequence of that? It means that if you wish to generate outsized returns as a technology investor, you need to first identify the future winners.
Now that doesn’t mean you can own the winners at any price, and I think many technology investors have learned that painful lesson over the past year. If you wish to generate outsized returns you also need to buy the winners at attractive prices. Sometimes people discuss the returns generated by the mega-cap technology stocks as some kind of mystery, but the reality is that they have consistently traded for 15-30x earnings and compounded those earnings at 20%+ for nearly a decade. So the recipe for 20%+ IRRs is not all that complicated: 20%+ annual earnings growth + no multiple contraction. That is a very different recipe than buying an unprofitable business for 20x sales that will likely compound its topline at 30/40%.
The hard part is not screening for valuation multiples, it is identifying which businesses will be able to generate durable revenue & cash flow growth, and that is where I spend the majority of my time. There are a whole host of explanations for the recent sharp decline in tech stocks including COVID-induced supply chain challenges leading to rising inflation which is forcing the Fed to sharply raise interest rates. But those seem more like catalysts to me. The core issue is that many tech stocks simply reached far too high prices over the past couple of years, and that is correcting very sharply now as risk is repriced.
If you look at the data, tech stocks with true valuation support (say <20x earnings) have been hit recently but held up relatively well over the past year. The real carnage has been in highly valued tech stocks with unproven economics (aka. negative cash flow margins) where investors are starting to question if they will ever be durably profitable. We are learning (or re-learning) that there is no floor to EV/sales or EV/GP multiples if investors don’t believe in the long-term economics.
With all of that being said, the good news is that this is by far one of the most exciting times to be a tech investor over the past decade. Prices have declined significantly, meaning all else equal, future returns look much more attractive. For the first time in 5 years, you can buy high-quality tech franchises for <20x earnings, and you can also go bottom fishing for some unprofitable ones that are down 80-90% and now trade for 1-2x gross profit, that might have a durable business model after all.
In your most recent investor letter, you discuss a basket of short positions, the vast majority of which are companies that merged with SPACs. How do you determine which de-SPACed companies to short and how well has this strategy worked for you so far?
In sharp contrast to the high-quality tech stocks you can now buy for attractive prices, there remains plenty of trash that was dumped into the public markets over the past two years by venture investors and SPAC sponsors.
Since the tech and telecom bubble, the US has averaged less than 200 new IPOs per year. During 2020 & 2021 there were nearly 1,400. It’s no wonder that the Cambridge Associates venture capital index generated a mark-to-market return of nearly 80% last year. While some of the nearly 1,400 companies that entered the public markets over the past two years are very high-quality businesses, most went public at very high valuations, and many went public without even having a business model. The worst culprits of all were SPACs, representing 800+ of the nearly 1,400 IPOs.
I could talk for hours about the intricacies of the SPAC structure and why it is a case study on the misalignment of interests, but let’s start with an analogy. Most are familiar with the folklore character Robinhood, who supposedly stole from the rich and gave to the poor. While a criminal, his actions were viewed by many as morally sound as it was all for a good cause. Aka. the end justifies the means argument. SPAC sponsors are the opposite. Their actions are legal, but if you cut through all of the clutter and window-dressing, they in short steal from the poor (retail investors) and give to the rich (themselves).
Here is the rough math. In order to launch a SPAC, the sponsor needs to put up some at-risk capital to fund the operations of the investment vehicle while searching for a target. In exchange, the sponsor is given a handsome amount of equity or warrants. If the SPAC sponsor gets a fair deal done, creates no equity value for his/her investors in the SPAC, and the shares hold steady at ~$10, then the SPAC sponsor gets a ~10x return on their at-risk capital. If the SPAC sponsor gets a bad deal done and the shares trade down 80% to $2 per share, meaning his/her investors in the SPAC have lost 80% of their investment, then the SPAC sponsor makes a ~2x return on their at-risk capital.
You don’t have to be a philosopher to see the misalignment of interests there. Just for getting a deal done, and creating no equity value, the SPAC sponsor gets a 10x return. And if they do a very bad deal, they get a 2x return. As Charlie Munger said, “You show me the incentive, and I’ll show you the outcome.” The SPAC sponsor is highly incentivized to get a deal done above anything else, even if it means his/her investors will lose their shirt.
Given this misalignment of interests, it should be no surprise that the median SPAC underperforms comparable publicly traded peers by 46% during the first-year post-deal close, and by 75% during the first two years post-deal close! Those numbers are truly astounding.
I should disclose that I spend the vast majority of my time looking for great long ideas, not short ones, and that I ran Kinesic as a long-only strategy when we originally launched in 2020 as I felt prices were compelling enough to do so. However, as tech started to correct, I felt the opportunity to bet against some of these de-SPACs was just too attractive to pass up, and we have been steadily building a basket of short positions. I think of this basket less as a hedge and more as an attractive standalone investment opportunity because I believe the de-SPACs we are short are headed close to zero in the coming years regardless of the market environment, but they do certainly provide us some downside protection. De-SPAC is the phrase used to describe the post-deal SPAC equity which no longer has any redemption rights.
After sifting through 400+ SPACs, we identified 50+ de-SPACs that we believe are purely speculative and will trade to near-zero enterprise values in the coming years as they miss projections, mis-execute, continue to burn cash, and are forced to pursue dilutive financing or shut down. The basket of de-SPACs we are short has a combined enterprise value of nearly $100B despite generating only ~$500M in revenue in 2021 and burning $10B+ in FCF. On average, these companies have 2 years of cash runway left. These businesses run the gamut of speculation and include just about anything that a retail investor may find interesting: electric vehicle OEMs, new battery technologies, crypto mining, quantum computing, self-driving technologies, air mobility, material technology, indoor farming, and space travel.
In addition to these de-SPACs, there are another 30+ SPAC deals that are set to go through in the coming months that we are paying close attention to. I should mention that just because you find a speculative de-SPAC doesn’t necessarily mean it’s easy to make money on it. Liquidity can be tight, shares can be expensive to borrow, and if you wish to buy put options similar issues often apply. Our approach so far has been to short a broad basket to limit any potential risk of a short squeeze while still capturing their downside moves.
I believe the opportunity to short these de-SPACs will be present for the next year or two, and then will likely fade as the reputation of these investment vehicles will be tarnished once again. In the meantime, we plan to continue to capitalize on this opportunity, which has worked well for us so far.
What are some interesting ideas on your radar now?
One name that we are particularly excited about today is HelloFresh (Frankfurt: HFG — EUR6.78 billion). Shares trade on the Frankfurt stock exchange but the business is split ~50/50 between the US and international markets. Most investors completely dismiss the meal kit category after being burned by Blue Apron, which is why I think the opportunity exists today, but HelloFresh has clearly found a meal solution that works for 8+ million households across 15 different countries. The company is profitable, has grown its top-line at a 40%+ CAGR for the past 5 years to nearly $8 billion in sales, and today you can purchase shares for ~11x 2022e Adj. EBITDA. Going forward, I think the business is a 15-20% top-line grower with opportunity for multiple expansion from here, which gets you to a 20%+ IRR. The management team is also best in class and has been buying shares recently with their own cash, in addition to the company’s buyback.
Another name we find interesting is Poshmark (NASDAQ: POSH — $940 million).