Far fetched reasons for holding your growth stocks

A key question in every investors’ minds is when to sell. You might own a few stocks in your portfolio that are going very well, perhaps some new-age businesses that are growing fast. And you’re still trying to work out whether you should be selling at today’s prices or whether you want to ride these businesses for a very long time to come.

In this video, I sit down with Steve Johnson to discuss a stock we own in our International Portfolio called Farfetched (NYSE: FTCH), where we’re grappling with this very issue.

Main points discussed:

• A quick summary of the business and why we like it
• Why the company is not just an online retailer
• Making sense of the valuation
• How the business is riding COVID tailwinds
• Some key questions yet to be answered
• The opportunity ahead for the business
• Managing the position in the International Portfolio

Watch the video or read the full transcript below.

Transcript:

Steve

Hi, everyone, and welcome. It’s Steve Johnson here, Chief Investment Officer at Forager Funds joining you for our weekly video. And today we’re going to do something a little bit different. The marketing people tell me to keep these videos short, but I’ve got a topic that’s going to take a bit longer to explore. And I really want to get stuck into it. Because I think it’s a topic that a lot of people are dealing with at the moment, you might own a few stocks in your portfolio that are going very well, some new-age businesses, perhaps that are growing fast, and you’re trying to work out whether you should be selling at today’s prices, or whether you want to ride these businesses for a very long time to come. And we’re going to talk about a stock in our international portfolio called Farfetch where we are grappling with exactly that issue. And hopefully give you some insights not just into Farfetch, but into how to think about some of these businesses that are performing very well. I’m joined to talk about that by the person responsible for Farfetch being in our portfolio. Chloe Stokes. Hi, Chloe.

Steve

Look this stock listed back in September 2018. Maybe you can just start with a quick summary of what this business does, and particularly why you were interested in it.

Chloe

So Farfetch is a digital platform for the luxury industry. They operate on a global scale, including here in Australia. So, I’ve been interested in the business from a consumers perspective for a couple of years. Now I’ve ordered from the platform, and so have a lot of people that I know, the stock has been loosely on my radar for a year or two. And the price has been super volatile.

Steve

What type of stuff do you buy on Farfetch? So when you say luxury, what are you talking about?

Chloe

So it’s quite a broad definition for luxury on Farfetch. It’s got your typical Gucci, Balenciaga, Bottega handbags, which can set you back thousands of dollars a pop. But it goes right down to a pair of shoes or a T-shirt that could be $100 to $200, which makes it accessible for a much wider range of consumers.

Steve

But, this premium retail product is a good way of describing it. So, you can buy shoes, handbags, shirts, clothes, anything retail related, but it’s generally expensive. And it’s generally boutique brands be those very well-known ones or new up and coming ones as well. So, you like the product, you think people using it, you’re seeing lots of bags around? What made you interested in the stock.

Chloe

So, as you said it listed in late 2018 in September at $27 a share by December that year, it was trading below $18. And that price volatility has continued until very recently. I’ve been interested in the business for a year or two. Whenever I’ve been looking at it, I couldn’t quite work out how to value it, whether it looked cheap, whether it looked expensive, because it’s not making any money. So, it took me quite a while to get comfortable around the stock, it got down as low as $7 in March this year. Of course, we wish we bought it back then, but we were looking at other things. In June, when it was trading at around $20, we started to do some pretty deep research on the stock. And we started to get comfortable around the value that was in the business.

Steve

Now when you first came to me with this idea, you said the word digital platform earlier, rather than an online retailer. And I think as a customer, you’d go there and think well, this is an online retailer like any other. But the most interesting thing when you brought the idea to me was an insight into this business, that it’s not your typical online retailer that they’re doing something different here. Can you explain how the backend works quickly?

Chloe

Yes, so as a customer, as you said, it looks like an online retailer. But the reason it’s a platform is because it doesn’t actually take inventory risk for most of the goods on the website. So, they have more than 1300 suppliers on the Farfetch platform, who provide the inventory for the consumers that are shopping on there. And they have an algorithm running in the background so that when I go onto the website and decide to order a pair of shoes, in the background the algorithm will go through all of the different suppliers and choose the one that best fits me. And they’ll consider things like the rating of the supplier distance to me and obviously the availability of stock

Steve

Down to even if you change, say the size of Jimmy Choos that you wanted to buy on the website, it’s going to change the supply or potentially even the price may be that those shoes are served up to you on the site.

Chloe

Absolutely. And I’ve seen the price of a pair of shoes doubled when going from a size 35 to a size 39 and women’s shoes so the difference can be very stark.

Steve

Yeah, and you probably don’t notice that normally because you’re only looking for one size. But it is an insight into how the back end of this is working in. For me from a finance perspective, that is very interesting because they don’t hold the inventory, right? I think most retailers, you take all this risk around buying, identifying trends holding stuff that you might not be able to sell, that’s not happening here. They’re literally running a digital platform for a whole bunch of other businesses that need to hold inventory. Absolutely. Okay, so maybe some metrics back in May in June here. Why did we think it was attractive? You’ve already said it wasn’t making money at the time? How did we get comfortable with the value on offer?

Chloe

So, it was trading at around $20, as I said, which is five times sales. It’s hard to get comfortable around in business when they’re not making a profit. But we had kind of two key questions that we were thinking about, at a market cap of around $6 billion. The questions weren’t too difficult, it was, do we think Farfetch is going to be the dominant platform in the global luxury industry? And then the second question, which I think was a key question for Gareth, when we were discussing the stock, is in the future if Farfetch is the dominant platform? Why would those big luxury brands allow that to happen? And at what level of profitability would they be happy to be handing away some of their sales?

Steve

Yeah, and I think we’ve modelled on that the company has said they can make more of the margins. What percentage of the revenue of the retail price of the goods do they take on average as the platform?

Chloe

So, they take around 30%, but it varies depending on the size of the brand, or the boutique that is offering to them, they don’t actually tell us what that take rate is. And we have to kind of come up with assumptions.

Steve

So, the question from Gareth, therefore was you’ve got these massive big global brands like LVMH, that are very protective of what they’re doing, why would they let a platform like Farfetch become dominant? And they take margin? That was a question, I was really confident that, just as an overall picture here, $6 billion for something that was the dominant online platform for global luxury goods didn’t seem like a massive number to me. So I think those initial conversations were around is it going to win. And if it did win, whether the margin was a bit lower, or I felt like that the business was going to be very, very big, and you were very confident that it was going to win. So that was almost, you know, that the thesis at 6 billion of market cap was pretty simple. What’s happened since?

Chloe

So since then, the price has run up pretty significantly, as you said, it’s up more than 100% on our purchase price. And it’s been for a couple of reasons. Obviously, COVID has been great for them, consumers are forced to shop online. And for somewhere like China, where they did a lot of their luxury spending internationally, they have been forced to find new ways to purchase those luxury goods. Farfetch has been a huge beneficiary of that. The reason that the Chinese consumer used to travel to shop is because they could not actually access the design of goods that they wanted in Shanghai or Beijing, they got what was called the China edit of the designer stores. So, they will travel to Europe or the US to get the European or the American handbags. Whereas Farfetch which with its 1300 suppliers can provide those goods to Chinese consumers from the comfort of their homes. So you’ve got the COVID benefit benefits. And obviously, that’s in customers and sales increase. But we also had some pretty big news a couple of weeks ago, around investments from Alibaba, and Richemont into both Farfetch the company and also into a joint venture in China with Farfetch. So that gives us a lot of comfort around the fact that these big players think that Farfetch is doing something pretty impressive here. They also got an investment from Artemis, which is the controlling shareholder of caring who owns Gucci and a plethora of other luxury brands.

Steve

Yeah, well, so I guess one of their main concern here that the brands were potentially in conflict with this platform because they wanted to own that distribution themselves. You got a really, really strong signal here that they like it and be they want to invest in it and see, they’re probably going to back this platform over all of the others. You said COVID has helped. But Farfetch has been dramatically outperforming other players that you might line up and say similar businesses.

Chloe

Absolutely. And I think the platform model has a lot of benefits in here because they’re not left holding inventory that might not have sold throughout COVID. They’re getting changing inventory up to date inventory from those suppliers that they have, which will help them out the other side as well.

Steve

Okay, so on the back of that pretty positive news and people changing their perceptions of the risks here, good growth as well, the share price is up more than 100% since our first purchase and you’ve now got a market cap of 15 billion. And I think as value investors, the easy thing is to say we’ve made our money and it’s now trading at fair value and we want to sell the stock and move on. But I think we’ve got something really, really interesting here in this business. And we are, we need to grapple with some different questions at this valuation, it’s no longer as simple as, if they win we’re going to make lots of money because I think the current price assumes they’re going to win. What are some of the issues that we’re trying to deal with now if you’re going to make money from here out of this stock?

Chloe

So, we still have the other question we were talking about at the beginning, which is, the suppliers, the designer brands, how comfortable are they with Farfetch having a significant portion of the online share of luxury? And at what level of profitability are they happy for that to occur? That question is a hard one to answer. And it’s one that we have been discussing in the office since we initially invested, I think the biggest thing that I’m thinking about here is, when you look from the outside in, you might think Farfetch is taking sales from those designer brands. And they’re paying them a say 30% take rate for the pleasure. But if you look at it from another angle, Farfetch and this is true for a lot of platforms, it’s actually broadening the market for luxury goods, and especially for luxury goods online, because it’s getting rid of a lot of constraints that those retailers would have had in their bricks and mortar stores. And even on their online platforms were on their retail website, sorry, not platforms, where they could be taking weeks to deliver a product to a consumer based on where they are in the world.

Steve

Yep. So yeah, I guess you’re starting to talk about how much is this business going to grow into the future. And I think when you look back over the past 10 years, we’ve had a huge amount of change to the way the economy works. And looking back, we and I think a lot of other investors made some big mistakes with businesses like Google and Facebook to say, here’s the advertising market, right, everyone’s spending all this money on TV, and they’re spending money on radio, and 50% of that is going to go online over the next 10 years. And these two businesses are going to dominate that space. That was a pretty consensus view back in 2010. And yet, people’s models got the revenue wrong by multiples, not just by a little bit, that search advertising, for example, has grown from 30 billion to 200 billion over that 10 year period. And it’s because it made advertising accessible to a huge number of businesses that couldn’t advertise before you couldn’t afford to put an ad on TV. But I can afford to do all this micro-advertising on Facebook and Google and it’s actually expanded that market dramatically. And I think that’s what we’re thinking about here is okay, we know what the luxury goods market looks like, at the moment, we know what size that is. But is that actually the right constraint for Farfetch long term?

Chloe

I think Amazon is another good example of that when people initially were looking at Amazon, they’re thinking about it as a regular retailer. But a bricks and mortar retailer has a number of constraints that Amazon doesn’t have. First of all, they need to find the appropriate land to have a store on in a population-dense area. And then within those stores, they’ve got the shelf space, you can only have so many products on the number of shelves that you have. And consumers are limited one by physical constraints, how much can they carry out of the store? And also, how far are they willing to travel to pick up the goods that they’re after? I think Amazon and also Farfetch in this situation, they don’t have the same constraints that a bricks and mortar retailer had and still has.

Steve

yeah, it’s potentially opening up the option to buy to a whole range of people that might have done at once a year when they travelled or might not have been able to do it at all if they live in a regional centre or something and even think that the definition of luxury will expand because of a platform like this. And it is expanding through younger generations that want to less I think, an overt show of wealth, but still want to own trendy and cool things. And there’s a lot of new brands on Farfetch as well that are very expensive and very exclusive still. But I can see it expanding that market a lot.

Chloe

Absolutely. And Farfetch has two-thirds of its sales coming from millennials and Gen Z consumers. So they are at the forefront of luxury fashion. And as you said, it’s not just the fancy designer bags on there. There’s expensive streetwear, you’ll see pairs of Nikes on there. So, they are expanding the definition of luxury.

Steve

Okay, so we’ve got a really interesting business here, a market that we think can grow for a long period of time, but a share price that’s up 100%. How are you thinking about the investment and the waiting in the portfolio now?

Chloe

So I’ve been thinking about it a lot, and we’ve had a lot of discussions and there have been a lot of sleepless nights, but we have been managing that position. So we’ve sold more than half of what we initially bought in Farfetch. I think it’s down at a manageable position. Now, it is a brilliant business and one I want to own in the portfolio for a long time. I still think there’s a lot of upside from here, although it’s not as obvious as it once was.

Steve

I think that’s a really good insight into portfolio waiting there, Chloe because a lot of people think I need to either need to hold this investment forever or I need to sell the lot and you have choices that are in between, and people that have owned Cochlear and ResMed and some of these great growth businesses here in Australia. You could have owned those stocks for 20 years without letting them become 50% or 60% of your portfolio participating in that performance, but also keeping the weighting at a sensible level. And I think that’s what we’re trying to do here. We want to own this business. There are some other great opportunities out there in the space at the moment. And we want the ability to add to it again if the price falls over time. So it’s a stock that we do want to own but we’re trying to keep the waiting sensible. This videos going on for long enough I’ll be in trouble from the marketing team. I hope you found something interesting in it though. If you’ve made it this far, leave us some comments and let us know what you think. It’s a wonderful business Farfetch. Well done Chloe. It’s made a really positive contribution to the funds returns this year in May and get out there and find some more thanks to thanks for watching.

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