Bonsai Partners Q1 2019 Letter

Theme and Background

This chapter discusses the reasons why the Bonsai Partners fund significantly underperformed the S&P 500 in the first quarter of 2019. Against the backdrop of the strongest quarterly rally in U.S. stocks in nearly a decade (the S&P 500 rose nearly 14%), the fund manager explains that the root cause of the underperformance was not bad market timing, but rather too low a position level—itself a result of excessive valuations leading to a scarcity of investable opportunities.

Core Thesis

The author's core investment argument is: No market timing whatsoever; position levels are determined solely by whether reasonably priced investment opportunities can be found. When market valuations are high, holding a large amount of cash is rational behavior, not a misjudgment of direction.

Counterintuitive judgment:

• The fund underperformed not because it misjudged the direction, but because cash did not participate in the rally—yet this is precisely a demonstration of discipline.
• The author believes holding a small number of deeply understood companies is safer than broad diversification. At this point, the portfolio holds only two positions, but the goal is to eventually reach more than five.

Key Arguments and Data

Metric	Bonsai Gross Return	S&P 500
2019 Q1	6.1%	13.7%
Full Year 2018	-17.9%	-8.6%
Cumulative Since Inception	-13.1%	+3.3%

• Period-end position level approximately 50%, average during the period about 40%; cash not appreciating is the direct reason for lagging the benchmark.
• The author quotes Fundsmith's Terry Smith: "There are only two kinds of investors in the world: those who can't time the market, and those who don't know they can't time the market."
• Aspen Aerogels' stock first rose 75% then fell 30% within Q1, eventually delivering a quarterly return of about 20%; the company maintained 2019 guidance: revenue growth >20%, adjusted EBITDA profitability.

Companies/Assets Involved

• Aspen Aerogels (NYSE: ASPN): Existing position. Key event: Received a $5 million order prepayment from BASF (as an interest-free loan, non-dilutive). Judgment: Long-term bullish, low valuation, technology advantage, large growth potential.
• Redbubble (ASX: RBL): Second investment. An online marketplace platform connecting artists with consumers. Judgment: Bullish, believes its business model can express individual needs and is a high-quality opportunity.
• A future third investment is under research (4–6 months of investigation so far), waiting for the right price to enter.

Investment Implications

• Short-term performance is irrelevant: A single quarter or single year result cannot measure strategy effectiveness; at least several years are needed to judge; seeds sown now may bear fruit many years later.
• Cash is not a sin, discipline is king: When valuations are high, holding a large amount of cash is not a passive operation, but a rational wait for better opportunities; investors should not expect the fund to be fully invested in every rally.
• Concentrated investment is better than blind diversification: The portfolio targets 5–10 core holdings, but never dilutes quality for the sake of diversification; the author emphasizes "it is safer to deeply understand a few companies than to know many superficially."

Technology-Driven: How Print-on-Demand Achieves the Long Tail Economy

Redbubble's business miracle is centered on the disruption of traditional supply chains by print-on-demand technology. Traditional retail requires manufacturers to mass-produce first (e.g., at least hundreds of units per design), then bear inventory risk. Redbubble, through distributed fulfillment centers, achieves "zero inventory, single-unit production": each item is manufactured only after a customer places an order, with costs and quality close to mass production.

• Cost structure: Taking a $100 transaction as an example, $50 goes to manufacturing and fulfillment partners, indicating that print-on-demand suppliers can control per-unit production costs at a level comparable to mass production (about 50% of the selling price). This breaks the old paradigm of "customization = high cost."
• Product diversity: About 60 "canvases" (product types, such as T-shirts, phone cases, pillows, etc.) on the platform, multiplied by millions of artist designs, can offer hundreds of millions of unique product combinations. Traditional large retail stores (e.g., Walmart) typically have no more than 150,000 SKUs, while Redbubble's category depth is hundreds of times greater.

Negative Working Capital: A Free Financing Engine

Redbubble's financial model has an underestimated advantage: negative working capital cycle. Customers pay in full before the product is manufactured ($100), while payments to artists ($20) and manufacturing partners ($50) usually have payment terms. This means the company always holds a large amount of customer prepayments, which can be used cost-free for operations and growth:

• Cash flow efficiency: Unlike Amazon or Shopify merchants, who need to stock inventory before selling, Redbubble does not need to advance any inventory capital.
• Growth leverage: Annual revenue growth of 20%–40% can be supported by internal cash, without frequent financing. This model is extremely rare among e-commerce platforms—most high-growth e-commerce players (e.g., Wayfair, Chewy) require large capital expenditures for inventory and logistics.

GPAPA Valuation Method: More Reflective of True Profitability than Traditional EBITDA

The EV/GPAPA (Enterprise Value / Gross Profit After Paid Acquisition) used in the investment case is an extremely strict valuation metric. The GPAPA formula is:

Gross Profit - Paid Customer Acquisition Costs. It directly measures the platform's true profit generation ability after stripping out "paid traffic acquisition."

Company	EV/GPAPA (x)	Business Maturity	Growth Potential
Redbubble	4.4x	Early growth (near profitability)	High
eBay	7.6x	Mature, limited growth	Low
Etsy	31.5x	Mature, moderate growth	Medium
Peer Average	7x-15x	-	-

Clearly, Redbubble's valuation is only 1/3 to 1/2 of the peer average, and even lower than traditional e-commerce platform eBay. The reason is a one-time Google algorithm update shock (Q4 2023), which caused a temporary decline in organic search traffic and halved the stock price. However, management believes the impact is one-off (expected to recover after Q3 2024), and the business fundamentals remain unchanged: revenue outside organic search is still growing rapidly.

Artist Community: A "Cultural Moat" as a Competitive Barrier

Redbubble's competitive advantage does not come from technology or price, but from deeply embedded trust and culture within the artist community. Unlike traditional platforms (e.g., Society6, Zazzle), all of Redbubble's decisions prioritize artists' interests:

• Revenue share: Out of a $100 transaction, the artist receives $20 (20% royalty), higher than the industry average of 10%–15%.
• Zero operational burden: Artists do not need to worry about inventory, order fulfillment, logistics, or customer service; they only need to upload designs and receive royalty checks monthly. In contrast, self-built websites require website maintenance, advertising, returns processing, etc. (according to Shopify data, independent sellers spend an average of 30–50 hours per month handling orders).

This "artist-friendly" culture creates a flywheel effect: more artists → more unique designs → more customers → more revenue → reinvestment to improve platform quality → attracting more artists. As of the report, Redbubble has accumulated hundreds of thousands of artists and millions of designs, making it difficult for later entrants to replicate its network effect.

Geographic Revenue Distribution and Risks

• Revenue structure: The U.S. accounts for 60%+, Europe and Australia each about 20%. This concentration brings currency risk (AUD/USD fluctuations) and geopolitical risk (e.g., changes in U.S. trade policy), but also indicates massive penetration potential in the U.S. market (penetration rate is far lower than platforms like Etsy).
• Competitors: Main rivals include Society6 (acquired by Leaf Group), Zazzle, and Amazon Merch. However, Redbubble's artist quality and quantity advantage is significant, and its print-on-demand fulfillment network is larger (its fulfillment partners already have global coverage).

Investment Logic Summary

Redbubble's core appeal lies in "high-quality business model + undervaluation caused by short-term negative shock":

1. Business model: Negative working capital, high margin (30% take rate), network effect moat, print-on-demand technology supporting long-tail demand.

2. Valuation dislocation: EV/GPAPA only 4.4x, while peer average is 10x+; even under conservative estimates, after growth recovers, valuation could repair to 10x–15x, corresponding to 2–3 times stock price upside.

3. Catalysts: The base effect of the Google algorithm adjustment disappears after Q3 2024, organic search traffic recovers; the company is near profitability, cash flow begins to turn positive.

On the risk side, attention is needed: whether the Google algorithm change is truly one-off (e.g., a core update causing permanent traffic loss), artist retention rate, print-on-demand return/exchange rates (customized products usually have higher return rates than standard ones), and the impact of macroeconomic conditions on discretionary spending.

Fee Structure Analysis: Incentives of Management and Performance Fees vs. Industry Comparison

This section clarifies the fee structure of the Bonsai Partners Fund, LP: 1.0% management fee + 10.0% performance fee (charged after exceeding a 6.0% cumulative compounding hurdle). This design occupies a specific position in the industry:

• Management fee level: 1.0% is below the industry average (hedge funds typically 1.5%–2.0%), but higher than passive index funds (0.03%–0.10%). This reflects Bonsai's approach of lowering fixed costs while linking more returns to performance.
• Performance fee hurdle (6% cumulative compounding hurdle): A relatively stringent term. Common performance fee models include:

Model	Hurdle Requirement	Typical Rate	Investor-Friendliness
High-Water Mark	No absolute return threshold, only need to recover previous high	20%	Medium
Hurdle Rate	Charged only after exceeding a fixed percentage (e.g., 6%)	10–20%	High
No Hurdle	Charged on any positive return	20%	Low

Bonsai adopts a compounding hurdle, meaning the fund must first generate a 6% annualized return (compounded) for investors before the performance fee kicks in on excess returns. This significantly reduces investor concerns about "heads I win, tails you lose" performance fees, and is an investor-friendly design.

• Cumulative compounding hurdle vs. simple hurdle: A compounding hurdle imposes stricter rewards for the fund manager—if the fund loses 10% in one year, it must earn more than 6% plus the compensation for the loss (compounded) the following year before any performance fee can be charged, whereas a simple hurdle only requires exceeding a fixed percentage. This clause makes it harder for the manager to consistently outperform.

Potential controversy: In net return calculations, the performance fee is charged at 10%, but it is not explicitly stated whether a high-water mark + hurdle double protection is used. Although the text mentions "cumulative compounding hurdle," it does not clarify whether losses from prior years must be recouped before charging. If only a single-year hurdle is used, the manager could charge a fee after a modest rebound from a loss. In industry practice, top-tier institutions (e.g., Renaissance Technologies) mostly use high-water marks without hurdles; Bonsai's combination is a conservative design.

Transparency and Potential Biases in Performance Presentation

This section explicitly states that the performance from October 22, 2018 to April 30, 2021 comes from a "representative account" , not the fund itself. Only after May 1, 2021 does it reflect the performance of the fund's Class A shares. This arrangement raises the following issues:

1. Selection bias: The representative account may have been carefully selected, with risk exposures, trade execution, and liquidity management potentially different from the actual fund. Industry regulators (e.g., SEC) generally require historical performance to come from a registered fund or comply with GIPS standards. Bonsai proactively discloses this difference but does not explain the selection criteria.

2. Unaudited and internal estimates: All performance data are Bonsai's internal calculations; terms like "estimated, unaudited, and subject to adjustment" reduce data independence. In contrast, well-known hedge funds (e.g., Bridgewater) regularly engage third-party auditors (e.g., Deloitte, PwC) to verify performance.

3. Different fee deduction methods: Gross returns for 2018–2021 include trading commissions but no management/performance fees; after 2021, gross returns include operating expenses (administration, audit fees) but still exclude management/performance fees. This blurs comparability across periods—investors cannot directly compare net returns from the current period with those from the initial representative account.

Data comparison: Assume the representative account generates 20% annualized gross return (including fees). Net return after a 1% management fee and 10% performance fee (with a 6% hurdle) would be:

• Annualized net return ≈ [Gross 20% - (20%-6%)×10%] - 1% mgmt fee = 20% - 1.4% - 1% = 17.6%
• If gross return includes operating expenses (e.g., 0.2% audit fee), net return further drops to 17.4%. Bonsai does not quantify operating expenses, adding difficulty in calculation.

Dispute Over Benchmark Choice

The comparison benchmark is the S&P 500 Total Return Index (including dividend reinvestment). However, Bonsai's investment strategy (based on the "Introduction" earlier) may involve long/short or special-situation strategies, which differ significantly from a pure long large-cap index:

• Correlation mismatch: If the fund uses a market-neutral or bearish strategy, the S&P 500 index would severely overestimate fund risk in a bull market. For example, during the post-2020 COVID V-shaped recovery, the S&P 500 returned 18.4% for the full year, while a long/short fund that hedged too early might have only achieved single-digit returns.
• Missing risk-adjusted metrics: No maximum drawdown, Sharpe ratio, Calmar ratio, etc., are provided; only absolute returns are shown. Industry standards (e.g., HFR, Hennessee) typically include comparisons with peer indices like the HFRX Global Hedge Fund Index.
• Passive nature of the benchmark: The S&P 500 incurs no costs, whereas fund net returns have deducted all expenses. Directly comparing the two effectively requires the fund manager to outperform a zero-cost portfolio, raising fairness concerns.

Possible improvement: Bonsai should add a "hedge fund index" or "long/short equity index" (e.g., HFRI Equity Hedge Index) as a supplementary benchmark to more accurately reflect the strategy environment.

Comprehensive Review of Risk Disclosure

The risk section covers: principal loss risk, fees offsetting profit risk, liquidity risk, market volatility risk, historical performance not indicative of future results, etc. However, the following shortcomings exist:

1. No explicit leverage limits: While it mentions "high degree of risk," it does not disclose whether the fund uses leverage or derivatives (e.g., options, futures) or their size limits. Many long/short funds have leverage of 1.5–3 times, increasing tail risk.

2. No mention of concentration risk: If the fund is heavily weighted in a few sectors (e.g., technology), a single-sector correction could amplify losses. Typical hedge funds (e.g., Citadel) disclose top 10 holdings concentration.

3. No warning about redemption restrictions: As an LP fund, there are usually lock-up periods (e.g., 1 year) and redemption notice periods (e.g., 30–90 days). This section does not mention them, so investors may not have timely liquidity.

4. No historical risk metrics: Such as VaR (value at risk) or stress test results. Goldman Sachs and other institutions often include "Scenario Analysis" examples in their PPMs.

Comparison with industry best practices: The SEC recommends that private fund risk disclosures include: market risk, credit risk, operational risk, legal risk, tax risk, leverage risk, liquidity risk, valuation risk, etc. Bonsai only vaguely mentions "all or a substantial portion of its investment" without breaking down specific risk categories.

Rigor of Legal Disclaimer and Investor Protection

• Prohibition on forwarding and confidentiality: Emphasizes "confidential" and "may not be reproduced or redistributed," consistent with SEC Regulation FD (Fair Disclosure), but does not specify consequences of violation (e.g., civil damages or prohibition from future offerings).
• Non-solicitation statement: Clarifies that this document does not constitute an offer to sell; only through statutory documents like PPM, LPA, etc. This complies with the private placement exemption under Regulation D of the Securities Act of 1933.
• Forward-looking statement disclaimer: States that any projections are "not guarantees of any future performance" and requires investors to conduct their own investigation, reducing Bonsai's legal liability.
• Conflict of interest disclosure: Acknowledges that fund manager Andrew Rosenblum and Bonsai may hold the securities mentioned in the letter and have the right to change positions at any time. This is a prophylactic waiver against potential insider trading allegations.

Potential gaps: It does not specify the obligation to treat "confidential" information—if a recipient leaks it to a third party, does Bonsai retain recourse? It also does not mention investor personal data protection measures (compliance with GDPR or CCPA). Furthermore, it does not state whether this document has been legally reviewed or complies with local regulatory requirements (e.g., Hong Kong SFC, UK FCA). For cross-border investors, this could pose compliance risks.

Summary: Role of This Section in the "Introduction"

This section, as a disclaimer and legal statement, serves the following core purposes:

1. Legal compliance: Meets SEC and Regulation D disclosure requirements for private placements.

2. Reducing litigation risk: Through exhaustive "no guarantee," "no advice" disclaimers, fully transfers decision-making responsibility to investors.

3. Balancing transparency and ambiguity: While revealing some fee and performance calculation details, uses vague terms like "estimated," "unaudited" to leave leeway, while deliberately avoiding specific risk metrics and leverage details.

From an investor's perspective, this both shows attention to compliance and implies that a thorough review of the complete PPM is necessary before making a decision. The next "Introduction" section may shift to the fund's specific investment strategy or team background to build investment trust.