Discussing Profit-Taking
Spotify: it's time. Hasbro: not yet.
Profit-taking is one of the hardest things in markets. On one hand, you never lose money taking a profit, and booking a win is a great feeling. On the other hand, sins of omission and selling too early are some of the greatest sins in the market. Imagine selling Apple in 2005 just to book a 100% profit, missing out on thousands of percentage points over the next 20 years.
These sins can be very costly.
Then comes the next questions: what do you do with that cash? Into what opportunities do you redeploy it? Are the opportunities you have to redeploy really better than the company you just sold? Those questions influence how I think about profit-taking.
I'll give two examples of decisions I'm making today:
Sell a portion of my Spotify stake.
Hold on to my Hasbro trade for longer.
Trimming Spotify
For those who have been following, Spotify has been my core position for the past three years. It's grown massively, both in the size it holds in my portfolio and in my conviction in the company. I believe that Spotify's long-term growth, along with the duration and stability of that growth and profitability, is immense. Yet, at what point do you trim a position in general and specifically when a position is 45% of a portfolio? I agonized over this question late last year, as I shared in my 2024 year recap (excuse the long excerpt):
The far harder part of holding Spotify occurred late in the year following the company’s Q3 report when it soared and reached a market cap of ~$96 billion. Now the question of whether to sell became a major decision for me - both in terms of portfolio management and in terms of the valuation of the company.
The first issue is strictly around portfolio management. Assuming I still believe in the upside of Spotify the company, the question for managing my portfolio going into 2025 is two fold: do I want to take the chance of 40% of my portfolio underperforming due to either a significant pullback in the stock or alternatively, not pulling back but simply not outperforming the market? Spotify has appreciated so much, its odds of beating the market are now shrinking almost by default. How can I afford to not trim and reduce this risk?
The second issue is simply the company’s valuation. At $100 billion, isn’t it fully valued? The second question naturally informs the first issue - if the company isn’t overvalued and I believe the upside is still there, it might be worth holding onto for the next few years. If the company is overvalued, it makes sense to trim or even exit the position.
I agonized over this issue for several weeks as I explored my analysis of the company once more. All of my analysis led me to the conclusion that despite it’s valuation, Spotify is still undervalued, still has significant upside and despite (or perhaps because of) its run up, the company’s future is once again misunderstood by many market talking heads.
Spotify is an incredibly durable business. Users stick around for decades and the willingness to pay increases over time. The questions around valuing the business are:
How many users can they acquire over time?
What will the ARPU be?
What will the margin and operating income or FCF look like?
Based on my answers for these questions, My base case is that if it optimized for operating income, Spotify could be making $7 billion in income within 5 years. Based on its moats and future growth prospects a 25 P/E wouldn’t be out of the ordinary, implying a $139B market cap. While this isn’t a conservative estimate per se, it’s also not overly aggressive, with the amount of levers Spotify has in their business.
While my brain is telling me to trim and reduce my risk on Spotify, one of the lessons I’ve tried to learn over the past few years is that once you find a successful company, with durable growth, moats, future optionality and the management to capitalize on it - just hold on.
As I mention in the review, in my research report on Spotify, I reached a variety of upside valuation scenarios, I believe the company still had upside of 50% - 75% to reach my 2030 target. After it’s YTD run of 58% that five year upside potential looks much much smaller.
This has led me to question a few things:
Could the market be right and I be wrong and what way: Could my estimates be too conservative? Is the market re-rating the multiple higher than my assumptive multiples?
Is there some other factor that means my assumptions for the upside in 2030 are too low?
Is the market wrong and if so, what action should I take?
Is the market right or wrong?
It’s a distinct possibility. In my research report, I used conservative estimates on various values and still concluded that at a 30 multiple of free cash flow, the company could be valued at a premium of around 30% to where it is today as of writing (valued at $145B). If those estimates were low, and if Spotify grows faster, either in monthly active users or their ad-supported tier, that could mean a significant bump in estimates, indicating my conservative estimates would be too low.
Another possibility is that the estimates are fine, but the market is simply re-rating the company and willing to give a higher multiple on my earnings. I provided various scenarios and multiples of free cash flow from 15 to 35. Personally I’m willing to pay a 30 multiple because Spotify has superior growth duration and stability. However, we have seen that the market is willing to re-rate companies with stability of growth and duration much higher than 30. Costco and Walmart both trade between 40 and 60 multiples due to their scale economies and the duration of their earnings power. Adyen also commands a premium multiple over Paypal due to many of the same considerations.
The market gives companies with higher certainty earnings power in the out years a much higher rating, and that re-rating could be happening with Spotify as The Street start understanding the power of this company.
Both of these are longer term shifts in the company’s value. The first from its earnings power and the second from a market re-rating.
The third option is shorter term. This run up could be a momentum driven one. The strength in Spotify has attracted momentum investors along with higher expectations for near term growth than is realistic. When the company inevitably grows at their expected rate, this may disappoint.
When I look at the three scenarios, based on the hours of work I’ve put into Spotify, I find myself leaning towards the third, but I also admit that it's very hard to judge. At Spotify’s scale, it’s simply getting harder and harder to grow MAUs at the same rate. If they beat my expectations it will be due to a mix of ad supported growth, premium ARPU or gross margin beating my expectations - all actually quite likely (ad supported growth picked up last quarter and management is focusing on it, there’s tons of demand for innovation in music streaming and with Apple giving way on IAP that can mean pure improvement in Spotify’s conversion metrics).
For myself, the way I look at Spotify now, and why I will be selling a part of my position, is this: Spotify is an outstanding company with long-duration growth and stability in earnings power, not only out to 2030 but all the way to 2040. That's 15 years of growth. The upside over those 15 years is unknown, but in my opinion, quite large.
However, in the near term, I believe the stock has run up massively and is pricing in a large degree of the upside for the nearer term (i.e next 2-3 years). The opportunity cost of holding Spotify at its current size in my portfolio, which is 45%, is becoming too large. After my trim, which will be ~15%, I will still hold a massive position in Spotify. Perhaps I should be trimming more, but I'm very cognizant that sins of omission are the largest sins. Spotify is a best-in-breed company in an outstanding market, and downsizing such a position is probably a worse mistake on a long term horizon. Therefore, holding it as a very large position in my portfolio seems like the right choice. However, raising 15% more cash in a very elevated market is something I feel comfortable doing.
Holding Hasbro for longer
The flip side to this is Hasbro, a company I traded in earlier this year, which is now reaching the target area of my trade, being up 22%.
Hasbro, however, has had changing fundamentals this year that lead me to believe there is further upside ahead. Hasbro reported a great Q1, and without the tariff noise, I believe they would have raised guidance. With a good slate of catalysts for the rest of the year, I believe Hasbro will be able to keep delivering, raise guidance in Q2 or Q3 and with a 5% yield at the price I bought, there’s still room for another 10-15% upside over the next 6-12 months. Further what I like about this trade is that it’s idiosyncratic to the tech focused market and portfolio I have.