Archimedes Finance

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Lesson in Course: Medes Newsletter (advanced, 14min )

I've been investing and trading for over 10 years. How do I personally make decisions and how was I able to achieve 267% returns for the past year.

Above is a screengrab from my Robinhood account, and similar to this year, it’s a bit peculiar. Let me start by saying that this screenshot is not intended to be boastful, nor would I ever post on r/wallstreetbets. Instead, I want to explain how, through a pandemic, I ended up with these returns and my general thoughts on the markets.

 

Who am I?

My career started in biotech, where I worked on the development of therapeutical drugs for rare diseases. After an exciting couple of years, I decided to switch careers entirely and pursue finance. With no experience, I went door-to-door in the financial district of San Francisco, knocking and asking for a job — I offered to work for free, buy coffee or run errands to get my foot in the door. Someone eventually took a bet on me, and I worked extra hours outside of work to be self-taught and more investment literate. A couple of years later, I reported directly to the managing director of a firm in Sausalito and invested millions of dollars a day.

In 2016, I left finance and headed into tech. I started the valuations team with a few others at Carta set out to develop the world’s first private company valuation platform.

I am currently the CEO and founder of Archimedes, and our goal is to give the emerging investor class the knowledge and strategies to succeed as long-term investors. Robinhood democratized access to the financial markets; Archimedes democratizes investing performance.

 

Setting expectations

A return of 267% YTD (year to date) is not standard and should not be an expected return for any investor. For context, the S&P500 index has returned 3% YTD and has an annualized return of 10% over 60 years, with great years returning as high as 30%. The S&P500 index is a benchmark that most investors use to measure the performance of their investments, and the return is often colloquially known as the market return.

For the majority of investors, aiming for a 10% annualized return is the gold standard — if we apply the rule of 72, we will double our money in just over seven years (72/10=7.2) with a 10% return! Exceptional investors like Warren Buffet’s Berkshire Hathaway have returned 20% annually since inception; every $1 handed to Warren Buffet turns into $2 in just 3.5 years. George Soros’s hedge fund also matched Warren Buffet in returning 20% annually to their investors every year for more than 40 years.

The longer the investment period, the harder it is to maintain the returns.

I was able to achieve a return that’s currently about 85x the market return by not following the market, taking on a large amount of concentrated risk, and applying leverage. Note: this year is certainly not over, and I have plenty of opportunities to make mistakes. Although, it would take a few significant catastrophes for me to lose my lead over the market.

 

Markets are not efficient

There’s a persistent theory out there that states markets are efficient at incorporating information, and it’s tough to beat the market over a long period. Passive investors buy and hold based on this theory, and even Warren Buffet once made a very famous $1M bet favoring a passive index against an active investor. Why would Warren Buffet bet on the side of passive investing when he follows in the footsteps of Benjamin Graham’s style of value investing? Buffet scrutinizes a company’s financial and operating history and purchases the shares of companies that he considers undervalued compared to the market to achieve an above-market return!

“Costs really matter in investments…If returns are going to be 7 or 8 percent and you’re paying 1 percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.” — Warren Buffet

The answer becomes clear if we take a closer look at what Warren Buffet is saying and why he placed his bet. He is not saying passive investing is superior to active investing, but rather the cost of active investing is too high. The work required to analyze and make investments that consistently beat the market is expensive and result in an average investor paying a high amount of fees. Compounded over time, the expenses significantly reduce long-term performance, and the average investor is better suited to buy an index fund with low fees.

I do not believe markets are efficient. Participants who believe the current market is wrong are vital for the health of our financial markets. Furthermore, if we follow the fees paid, the world’s most sophisticated investors are more than happy to pay hedge funds, private equity, or venture capitalists fees of 1.5/16 or 1.5% of their invested money per year and 16% of all future gains to have access to the brightest minds in active management. Since I do my own research and don’t have to pay any fees, I invest exclusively in individual stocks and options, and rarely rely on ETFs.

However, I do side with Warren Buffet on success in stock picking requires a degree of work and experience to do well. I would highly recommend that emerging investors start with passive investing first until they have gained sufficient knowledge before trying active management.

 

My decisions

Investing for the short-term

I decided to start an investment portfolio in December of 2019 as the primary way to finance the development costs for Archimedes. I had about $25k to seed the account, and it became apparent right away that a 10% yearly return on $25k wasn’t going to be enough. Even if I achieved Warren Buffet’s 20% returns, I still needed to lever my outcome to at least 10x that amount or at least 200% annual returns.

Robinhood: yes options, no margin

I decided the way I’d arrive at the amount of leverage needed was through a combination of investing in options and the underlying stock. Traditionally, options and margin can both offer leverage. Even though I had access to margin, I chose not to use it because the cost of borrowing money to trade stocks was too high, as well as maintaining my margin. The use of margin with options was not an option because it would have been way too risky and can blow up my portfolio — I needed to be aggressive but also very mindful that if I lost this money, Archimedes would not happen.

I chose Robinhood as my brokerage account because of the free trades, easy access to options, and the possibility of investing in alternative asset classes like cryptocurrency.

Pre-pandemic investing

Starting in January, the first thing I knew I needed to do was to come up with an investment thesis framework. Having a framework to work from would help me stay disciplined in identifying clusters of companies that out-perform the market. Fortunately, based on some work I had done for a previous Archimedes blog post about SaaS companies and net dollar retention(NDR), I had a head start.

  1. My first investment thesis was to invest in cloud SaaS companies that had net dollar retention of over 125%. I bought shares of DDOG, OKTA, TWLO, and ZM and decided to hold off on buying options until I had more support for my thesis. I didn’t want to risk substantial amounts of my principal if I was wrong.
  2. My second investment thesis was that the future of consumers would focus on more individual freedom. This included increased mobility, easier payments, and better personal health at home with in-home exercise and the availability of meat alternatives. I bought PTON, BYND, UBER, LYFT, and V.
  3. I also decided to purchase Boeing because, at the time, the timeline for the 737 Max to return to service seemed optimistic, and Boeing had a strong balance sheet supported by other revenue streams such as defense contracts.

My portfolio at the end of February

I was much more confident in my thesis behind the growth potential of SaaS companies than the other two, and we can see it in my portfolio allocation with more money invested in cloud SaaS in February.

Covid-19

During the last week of February, when the S&P500 dropped 13% in a week, I chose not to panic sell. At the time, the media had just started to report the first cases of Covid-19 in the States, and passengers aboard the Diamond Princess had just returned and were in quarantine.

Transaction history for February

I reasoned at the time that in the last 11 years, the S&P had more than tripled in value, and a 13% correction seemed overdue. Additionally, the industries that would be primarily affected would be those that have supply chain risk or market risk in Asia. I held no airline stock, nor did the companies in my portfolio generate a large amount of their revenue from Asia.

I also considered the worst-case scenario of a global recession. Compared to all of our trading partners, the US economy is still the strongest, and the US capital markets are the most regulated and provide the most liquidity. The risks of a prolonged pandemic would result in declines across entire global markets; however, after the dust settles, investors around the world would still need to generate returns. The US would be the best risk-adjusted place to do so, especially since the stock of great innovative companies would be on sale. Capital would flood back into the US markets, and the buying would lead to a steep recovery.

What I hadn’t anticipated was the country shutting down.

March and onwards

In the matter of a few short weeks, the S&P500 was down over 33%, and the world, including the US, was in lockdown. Could this moment be the Great Depression for my generation? I started feeling regret for not having sold earlier.

Be fearful when others are greedy, and greedy when others are fearful. — Warren Buffet

I decided to quickly cut my losses and dumped BA, LYFT, UBER, and V in the red. While I believe these stocks would recover over time, the narrative behind these companies had shifted dramatically. There was so much fear in the markets that the opportunity cost was too high to not have cash ready to buy. I made a straightforward checklist.

What Was New?

  1. Uncertainty of what the economy and country would look like after months of lockdown.
  2. No travel was happening.
  3. Employees and companies started working remotely.
  4. US companies were worth 33% less than they were a month ago.

What Was Unchanged?

  1. The US economy is still the largest, and it can withstand a global recession better than any other economy.
  2. With negative rates in Europe and Japan, global investors still need to find positive returns.
  3. Cloud SaaS companies have less operating leverage, meaning they need to spend less to generate $1 in revenue compared to non-SaaS businesses. A positive NDR means these companies generate more revenue from existing customers over time, in addition to any new customers acquired.
  4. SaaS companies can run and service their customers remotely without any problems.

Writing this list out helped me come up with my new pandemic investment thesis.

Time to bet big

A drop of over 15% across whole market indices caused a landslide of irrational panic selling leading to further losses closer to 33%. I knew eventually, selling fatigue would set in. Selling fatigue occurs after all the short-term investors have nothing left to sell, or the losses are large enough that the short-term investors are forced to become long-term investors. In the first week of March, I sensed we were getting close and decided to borrow $5K from my savings account to increase my purchasing power.

Call options bought

Out of my What Was New list, remote work requires communications and better security. I had already liked OKTA, best-in-class identity software for companies and their employees, and ZM, video conferencing, before the pandemic! If there was ever a time to invest with conviction, it was now, and I bought call options.

TWLO was already in my portfolio and also fit my new quarantine thesis. Being confined to staying home, people would have to order things online included groceries, household supplies, takeout, etc. Twilio’s revenue is tied directly to the number of individual text notifications sent by businesses, and texts for order and delivery status were sure to jump during the quarantine.

Lastly, I added AAPL options because AAPL has an incredibly strong balance sheet with tons of cash on hand. The 20% drop in AAPL stock price seemed disconnected from the fact that companies would have to order more computers in the short-term as everyone works from home. The 30% drop in the market also put AAPL squarely in the driver’s seat to acquire interesting companies at a steep discount.

When the markets started recovering in mid-March, my portfolio did exceptionally well.

What I got wrong

I’ve made my fair share of mistakes or wrong calls between January and now, and fortunately, most of these mistakes were small and relatively self-contained. There were, however, two notable ones.

Shorting TSLA

I lost $8K trying to short TSLA in multiple attempts of 2-month duration put options. I started buying these put options when TSLA hit $600 in April after the stock price recovered after the steep correction in March. My two main reasons to short were:

  1. Qualitatively, if we head into a Covid-19 recession, the luxury car market should see a steep drop in demand. It’s hard for many households to justify a $30k+ purchase on an electric car when financing options are more limited and expensive, and gas prices were rock bottom.
  2. TSLA has some unclear financial reporting regarding the regulatory credits and how they recognize the revenue for each vehicle sold. The issue at hand is that TSLA is reporting higher profitability based on the company deciding when to sell and book the regulatory credits awarded instead of acknowledging them upon the sale of each vehicle.

David Einhorn of Greenlight capital pointed out some of these discrepancies in his tweet. In the earnings call by Tesla, management disclosed that the sale of regulatory credits caused the differences.

 

What I learned after losing over $8k of my investments over a few weeks is that the markets didn’t care much about Tesla’s accounting and the current state of the business. Investors have completely fallen in love with the vision of the company, and shorting was getting way too expensive. Option premiums were skyrocketing with the stock prices, and I was losing too much money every day, hoping that the market would turn around and be more sensible to the growth prospects of the company. Looking back now, after TSLA hit over $2000 per share and split 5:1, I am glad I decided not to be stubborn and emotional. Cutting my losses and moving on allowed me to assess my opportunity cost and spend my time and focus on other investments that worked better for me.

Not taking gains

The second biggest mistake I made was violating my own rule — take any profits of a return over 150%. I was convinced that Slack, along with the majority of the cloud SaaS companies, was going to knock it out of the park for Q2 earnings. In mid-May, I decided to place 14% of my portfolio into essentially 1-month call options.

When ZM crushed earnings on June 2nd, WORK reached almost $40 a share, and I was deep in the money. Instead of following my rule and selling, I decided to hold through earnings. Slack ended up beating both revenue and on earnings estimates; however, Stewart Butterfield, CEO of Slack, wasn’t as confident as Eric Yuan of ZM and required a lot of help from Allen Shim, CFO of Slack, to answer some of the questions about the future growth of Slack. Shares were deep in the red the next day, and my position went from an $18K return to a $4K loss adding to a very costly mistake of $22K.

A better risk-managed strategy would have been to roll the maturity forward. I should have sold and exited all of the 6/12 call options when they reached a return of 150% and simultaneously bought call options further into the future (e.g., Jan 2021) to hold through earnings. The result would have reduced my volatility and exposure to Theta decay. I would have also traded some upside for more downside protection.

Looking forward

Increased political risk

2020 has been a challenging year, and we have what is probably one of the most contentious elections coming up in recent history. The unrest felt due to police brutality and racial tensions combined with a pandemic that mostly rewarded specific industries while crushed others has resulted in a deeply divided nation. The presidential and vice-presidential candidates feel tremendous pressure to present very different and opposing solutions to appeal to their voter base, and there is a lot at stake. This angst permeates the financial markets as trade policies, stimulus bills, and the US-lead efforts towards a vaccine greatly determine the future recovery of the economy.

Fortunately, we have seen some resiliency in our economy thus far. While I cannot predict the outcome in November, I can take active steps to protect my portfolio against future political or regulatory risks.

Consumer confidence through the pandemic is just barely lower than 2016

I remain optimistic about the US economy. I am doubtful a second lockdown will occur even if cases of re-infection are proven to occur. As we head into the fall and the winter months, I plan to invest more cautiously due to the recent exuberance in the stock market. At this point, alpha (higher than market performance) will be tougher to generate, and I think I’ll likely have some success looking for companies in more mature industries that can adjust quickly to the post-COVID world or in alternative asset classes such as cryptocurrency.

If there’s any interest in a periodical discussion around how I plan to continue to grow this portfolio, please email me at simon@getmedes.com.

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