2022 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

A Little More on the Present Value of Future Cash Flows

In an earlier post I laid out why it mathematically makes sense all securities, equities and bonds alike, decline when interest rates rise. Essentially, the cumulative value of future cash flows become less valuable in the present because the risk-free alternative has become more attractive. Instead of earning 0% in completely safe bank accounts, you can now earn over 3%. That makes folks less interested in taking a particular risk for 5-6% returns, and would perhaps demand 9-10% returns for equivalent risk.  

At first blush, a 5% difference seems modest. But consider how it affects security prices. If we invest $100 in a security that will earn us $5, that’s a 5% return. But if we want to sell that security right now, when investors demand a 10% return, we’d only be able to sell it for $50. Obviously I’m simplifying a lot¹, but at the core, that’s how interest rates can nosedive the value of a security from $100 to $50.   

Nevertheless, it is largely irrelevant to us, the patient investor.  

Because if we ignore the price movements and don’t sell, and the security delivers its cash flows year in and year out, the value still accretes. The cash piles up irrespective of day-to-day interest rate movements and we continue to earn our return! If we put our $100 investment in a lockbox and don’t bother stressing about its present value on a regular basis, the only thing we care about is the cash it’s generating for us: the $5 annual return. And whether it can potentially grow to $6, $8, $12, and beyond in the years ahead.  

We cannot control interest rates, nor can we control the perception of market participants. What we can control is the accuracy of our analysis and the decision to buy or sell based on what the market is offering².

Our holy grail is an environment where interest rates are at or near a peak (thereby weighing on prices but without the prospect of further declines) and other investors are indiscriminately fearful (thereby demanding a higher rate of return, which further weighs on prices). When we invest in this environment, we get to own not just the intrinsic value of capable corporations growing their per-share values over time, but also the possibility of a lower interest rate future and improving investor sentiment that could pull forward even greater returns.

This idea, in essence, is why we value investors shouldn’t sweat the macro. Interest rates and elections and geopolitics and the animal spirits of markets will always be unpredictable. Good businesses purchased at reasonable prices will endure. Accordingly, I increasingly think of us as collectors: We collect enduring assets that benefit from time.

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¹ Don’t @ me, bond people.

² Simple, but not easy. I’m by no means saying this business is a walk in the park and everyone else is stupid.

One Equation To Rule Them All

For about, let’s say, 13 years now, since the economy emerged from the Great Financial Crisis, U.S. equities have been in a relentless bull market. 2020 provided a shocking reprieve, but the velocity with which it roared back essentially made it feel like a brief nightmare on a hot summer afternoon that you wake up from and realize, oh wait, I just fell asleep on my hammock in a tropical paradise. The bull was gored, but trillion dollar government handouts provided a turbocharged shot of morphine.

Well, now the drug has run its course, and there is no more on the horizon. Interest rates, particularly housing mortgage interest rates, have spiked seemingly overnight to levels not seen in 13 years as the central bank tries to contain inflation. This has been the missing ingredient in killing the bull market. Interest rates are intrinsically and inextricably tied to all security valuations. Like a see-saw, when rates goes up, prices must come down.

Slowing growth has also spooked erstwhile euphoric market participants, particularly those who piled into high-multiple tech names. For the first time in many, many years, Facebook, Apple, Amazon, and Netflix in particular are decelerating rapidly. This is primarily a function of their size, as they are now either so big they’ve run out of markets to grow into and/or they’ve accumulated too many enemies and/or they no longer attract the finest talent because they’re perceived to be soulless Goliaths more driven more by corporate interests than by the change-the-world ethos they were conceived from. And because of their sheer size, they have an outsized influence on the S&P 500 index.

Let’s quantify this double-whammy. A central tenant in fundamental equity valuation is the calculation of its so-called terminal value, whereby a stream of cash flow is divided by a percentage figure derived from subtracting its growth rate from its cost of capital (which is directly tied to interest rates). So now we have cost of capital rising and growth rate slowing, inflating the denominator of this formula which deflates the resulting terminal value. In other words, this all makes sense. The market is acting perfectly rationally by declining.

Terminal Value = Free Cash Flow / (Cost of Capital - Growth Rate)

I continue to believe the most comparable period to today’s market condition is the Nifty Fifty in the ‘60s rather than the 2000 dot-com boom and bust, although there are admixtures of both present. The tech giants of today mirror the Nifty Fifty: absolutely dominant companies who grew at such consistent paces that investors eventually (mistakenly) believed there is no bid too high. Similar to today, inflation then took hold, followed by rapidly rising interest rates, which pulled down security valuation across the board. The companies remained dominant, but their stock prices retreated and took years to recover. The dot-com era was in contrast riddled with mostly profitless companies with no path towards said profitability. This, though, describes large swaths of the crypto/Web 3.0 ventures. It does appear to me the vast majority of those will eventually fail as most do not actually generate any intrinsic value to society.

A fair sidebar question would be, if I am so steely convinced about this, why not go net short? And the answer is because the market is a forward discounting mechanism, i.e. every day, everyone is trying to figure out where rates will stabilize and by extension, where security prices should settle. As certain as I am that as rates go up, prices will go down, I’m just as uncertain how this is reflected day-to-day in the market. Predicting this movement is the purview of the short-term speculator, the trader who attempts to game the voting machine .

Also, I could be wrong! Macroeconomic stuff like interest rates are notoriously difficult to predict. Is it possible inflation quickly subsides later this year, leading to less rate hikes? It's certainly not impossible. There are always contra-indicators that inject just enough prognostic doubt in the short-to-medium term. And there's always the human element, prone to bouts of irrationality. The prospect of churning our portfolio and incurring capital gains taxes and trading fees in light of this much uncertainty seems like folly.

Contrary to many market participants, I’m feeling mostly sanguine (and edging towards enthusiasm) about this correction. It’s unhealthy for markets to become untethered to fundamental realities and pose as the world’s biggest casino. It distorts capital allocation which distorts incentives which distorts true, real growth in productivity and innovation. Companies that don’t produce sufficiently differentiated or necessary products or services to generate sustainable profits don’t deserve capital. Certainly, some speculation is necessary in cutting edge projects, e.g. biotech, but not in perpetuity. A return to a mostly rational market is good for humankind in the long run. 

2021 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

How/When/Should A Tiger Change Its Stripes?

It is fair to ask of your portfolio manager: if growth has resoundingly beaten value over so many years, why persist against the grain? Why the insistence on a strategy that appears handicapped? Why not adapt to a new normal?

Fact is, it’s not that simple. Publicly traded growth stocks attract primarily speculators. And if there’s one thing I will never endeavor to be, it is that of a speculator. A speculator cares not about the underlying fundamentals of a company, only how/when its stock price will rise. These “investors” are behind every bubble’s dramatic formation and destruction, and over the long run, their odds are no better than a run-of-the-mill casino game.

And yet, there have been spectacular growth stocks that deserved every penny of their erstwhile inflated valuation and more. I am referring to, of course, Google (Alphabet), Apple, Facebook¹, Amazon, and Microsoft, et. al. They are truly wealth creators of epic proportions. Over the past 12 months alone, they accounted for over $250 billion in bottom-line profits. They actually earned it and their share prices reflect their profitability, fair and square².

Their success has caused a ripple effect of investors looking for the next companies that can generate seemingly endless growth. This guessing game of who will be the next trillion dollar market cap behemoth is a rising tide that has buoyed the entire technology sector, which in turn, as it inflates, come to constitute and contribute to an ever bigger portion of the S&P 500. 

It is a difficult game to play because it’s not at all obvious. Assuredly, there will be, in the long run, a whole chunk of losers that get outcompeted, just as assuredly there will be a smattering of ridiculous winners, all of whom trade at nosebleed valuations. I have nothing inherently against investing in growth, but right now, there is no margin of safety and I have no edge. Case in point is our saga with BlackBerry. My thesis, pinned on their turnaround growth, has thus far failed to pan out, but we still enjoyed outsized profits thanks to internet message board speculators driving up their stock. We got lucky. But any investment program dependent on luck is by definition irregular and unsustainable.

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¹ To be clear, however, I am not a fan of Facebook’s destabilizing societal impact. It’s improbable I will ever invest in them (in their current form), as it would feel icky to root for such a company and share in their profits.

² https://www.axios.com/earnings-largest-companies-tech-giants-77de0e35-e3b3-42d6-9dd4-b56bb4064ea1.html

***

On the flip side, the more that non-tech names continue to contract, the more their opportunity grows. As capital chases the ephemeral, it ignores the businesses that build and make “real” things. Without affordable capital to build and make, they won’t. Which leads to shortages, which leads to higher prices, which leads to bigger margins and profits… which should eventually lead to, once again, more capital. 

The canary in this coal mine are semiconductors. Once a boom-or-bust cyclical, the redheaded stepchild of sexy tech that could never attract consistently affordable capital, persistent shortages are now endemic. Building new semiconductor plants are expensive and years-long, and supply fell far behind the demand curve. As capital gushes back towards the industry, semiconductors and companies that comprise its value chain have been some of the best performing stocks in recent years. 

To wit, the Philadelphia Semiconductor Index (SOX) went pretty much nowhere from 2002 to 2016, dramatically underperforming the broader Nasdaq 100 for 14 years:

But from then on, it has more than held its own, especially over the past year and a half:

Until humans can simply upload our consciousness and live solely in The Matrix metaverse, we will need mundane, earthly things. We’ll need to get around in cars and trucks. We’ll need electricity and the power plants that generate them. We’ll need buildings to live and work in, and we’ll need banks to finance them all. These necessities ensure the long-term durability of our portfolio companies, while capital’s cold-shoulder has made their equities cheap. If the story of semiconductors is instructive, this won’t last forever. 

A Little Bit of “2020” Hindsight

Rudyard Kipling once wrote, “If you can meet with Triumph and Disaster / And treat those two impostors just the same,” which pretty poetically summarizes my feelings about our past five quarters. From the early days of 2020 to the very depths of our worst drawdown that troughed on March 23rd, we saw our portfolio’s marks decline by nearly -50%. But then from thereon out to the end of Q1 2021, a period that spans only one short year, it rallied over 175%.

Practitioners of Modern Portfolio Theory, of which most sophisticated institutional investors are at least part-time, would downright faint at that level of volatility. For they make one key assumption: volatility = risk. Bluntly put, that is an analytical shortcut. It actually works serviceably most of the time. Risky security issues are typically volatile! But not all volatile securities are risky. And as a corollary, not all volatile situations are risky.

That was what we were facing in March of 2020: a volatile situation erupting from the first global pandemic in a hundred years. The key to decoding whether it was truly risky or not was our collective response. Do our governments hem and haw and wring their hands and ostrich their heads in the sand? Or do we unleash the full forces of monetary and fiscal stimulus while pouring in whatever resources it takes to develop vaccines in record shattering time? Very early on, it became clear it would be the latter¹. America would respond. And with that insight, volatility became less risk and more reward².

Through it all, the composition of our portfolio was little changed³. We earned our returns not through frantic trading nor furtively chasing “what worked”, but simply by staying steadfast and assertively increasing the ownership in our favorite, most familiar businesses at increasing discounts. Buy more of the same when prices are low sounds simple and unsexy. But I submit that it is not at all easy. It requires having a depth of confidence that can only come from the accumulation of knowledge and scars after following or owning a stock for years, which is needed to buffet against the psychological forces that threaten to overwhelm rational thought during periods of great tumult. It actually has nothing to do with any pompous notion of courage –– sometimes the right course of action is to sell in a proper panic if the situation warrants it –– and everything to do with, again, to quote Kipling, keeping your head.

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¹ However, if one mired oneself in political Twitterverse, one might very well have missed the forest for the trees given the rancid partisan rancor. Social media does not equal reality – a patently obvious statement but totally worth slapping on a sticky note on your desk.

² (Getting on my footnote soapbox here.) The development of four (and counting) effective vaccines against SARS-CoV-2 in less than a year is nothing short of a scientific miracle and a shining example of human ingenuity when facing a global crisis. Had COVID-19 emerged in, say, 1819, it would probably have slowly burned through the world population, mutating and spreading and exacting a multi-year death toll rivaling any of the great plagues in human history. We in America are indescribably fortunate to be first-in-line to be inoculated against this disease. But as of this writing, it is still raging in countries such as Brazil and India where access to vaccines remain extraordinarily scarce, so I cannot help but feel despondent toward those of us who reject vaccination because of, I dunno, political or conspiratorial or devil-may-care reasons while literally billions of people elsewhere would give anything to get vaccinated to escape humanitarian crises. It’s the epidemiological equivalent of the old admonishment, “don’t you know there are starving children in Africa?” when you waste food, except way more serious and way more sad.

³ Although you may recall my chagrin in my annual letter for not being sufficiently aggressive in investing in new names that I have long admired but never found the right valuation to enter into. It’s unclear whether or not our current returns would have been boosted if I did, but it’s more probable we missed out on steadier, longer term gains that those stocks would have provided in the coming years.

2020 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

CoVID-19

This is probably the most important quarterly memo I’ve written since our inception. Let’s cut to the chase – here are some of what I’ll be addressing:

1. Why the market is down
• COVID-19 has shut down the economy
2. Why we are down more than the market so far
• Liquidity has dried up, investors have fled financial stocks, but I am stepping up our purchases in anticipation of an inevitable recovery
3. Why we must stay the course
• We have been waiting for this moment!
4. Why this time is (not) different
• This is not the financial crisis
• We’re betting on humanity and betting on America

Why The Market Is Down

“The only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory.”

- Roosevelt, 1933

COVID-19 has forced most of the western world into lockdown. Business has essentially stopped, but bills continue to come in. A business’s expense is another business’s revenues. Once a business cannot generate revenues, it cannot pay expenses, which impacts the revenues of another business which cannot pay their expenses, and so on and so forth. What we are now experiencing is akin to an automobile crash pileup, where the lead car brakes suddenly and all the cars behind crash into the one ahead of it.

Financial markets have reacted with a panicky speed never before seen. It took less than 20 trading days to drop -20%, whereas the average and median time historically has been 255 and 156 days, respectively¹. The VIX index, which measures volatility and is colloquially known as the “fear index”, spiked to 82.69, a record high that surpassed even the 80.74 number that marked the scariest days of the 2008 crisis. I never thought I would see that record broken within a single generation.

Terror is feeding upon itself. The SARS-CoV-2 virus deserves every bit of gravity and seriousness it has generated, but we cannot lose sight of the fact that it is imminently beatable. We have swung from too laissez-faire to national panic virtually overnight. The rational response is in between. We must treat the virus seriously enough to enact policies that do not overwhelm our hospital systems. But we also must not burn down the house to kill the termites.

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¹ https://theirrelevantinvestor.com/2020/03/09/the-fastest-bear-market-ever/

Why We Are Down More Than The Market So Far

Firstly, we own mostly stocks that were under-appreciated by the market going in, and their under-appreciation only widens during times of broad panic. During times of terror, people rush to the safest, most liquid asset on the planet: U.S. dollars. As a result, there have been reports of liquidity problems throughout all kinds of financial markets. There have been days when all asset classes outside of cash — stocks, bonds, gold, even bitcoin – declined simultaneously, a truly rare phenomenon². The smaller, more obscure or more unpopular the security, the wider the bid/ask spreads, and the more intense the sell-off³. Most importantly, our declines are not the result of any of our companies deteriorating due to idiosyncratic factors.

Secondly, a significant portion of our portfolio are in financial stocks, and financials have sold off more than twice as furiously as the wider market as the fears of 2008 looms large in investors’ memories. Fears of laid-off people skipping mortgage payments, fears of businesses skipping loan payments, and fears of a frozen market that will force banks to mark down assets to a level where they become insolvent. However, as I will explain in greater detail below, this time really is different, especially for banks.

Banks have sold off more than twice as much as the broader S&P 500

And finally, I am increasing our stakes and adding new investments in consistent, methodical increments, which will inevitably make our short-term results look worse as long as stocks continue to decline. But on the flip side I also anticipate our recovery to outpace the market, perhaps significantly, once it takes hold. And it will take hold; we just don’t know when.

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² https://www.nytimes.com/2020/03/12/upshot/markets-weird-coronavirus.html

³ https://www.wsj.com/articles/low-liquidity-fueled-hidden-flash-crash-in-junk-bonds-11578661200?mod=hp_lista_pos2

Why We Must Stay The Course

“What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

- Buffett, October 2008⁴ 

To put it bluntly, this is what we have been waiting for. Nearly every quarter, I lament the endless bull market that has made outperformance so difficult for value investors like myself. Sure, we’ve experienced some harrowing dips along the way, but all have snapped right back within a few months, never once really threatening to derail a decade-long bull run. But now, in a violent fashion, the bull has definitively died and we will enter a deep recession. Finally.

I began my investing career in the wake of the 2008 financial crisis. I experienced first-hand how bear markets are where true wealth is created. Bear markets wash out the weak. The weaker companies, the weaker investors, they are forced to fold in an environment where consumers are more discerning, where bankers clutch their purses tighter, where capital is hyper averse to risk. The grittier ones survive, and when things inevitably bottom and start turning upwards, they are there to reap the spoils, the extra market share vacated, and emerge exponentially stronger.

Without a doubt, things look scary and terrible right now. When you open your statement, you will probably experience a jolt of cold sweat, an atavistic fight or flight response. This is perfectly normal, but let me assure you, individual stock prices right now do not accurately reflect any semblance of reasonable value. What they reflect is a fire-sale value. It reflects that fear you feel, of scared sellers overwhelming buyers.

There is no reliable method to pick market bottoms during recessions, but one saw is inviolably true: stocks always bottom well before the recession is over. If you don’t stay the course and pull out to wait for rosier economic indicators, you will miss out on massive gains. The graph on the right shows the return on stocks from the bottom of each bear market until the official end of each recession. Such returns average an astonishing 64% compared to long-term annual returns of 9.8%⁵.

Another way to look at it is what that long-term annual return would degrade to if you miss just a handful of the “best days” in the market. Missing just 10 of the biggest up days reduces your annualized returns by 2.7%. And missing the 50 best days… you might as well just leave your money in a checking account. Translated into dollars, if you invested $1 at the beginning of 1992 and held until the end of 2019, you would have $13.66. Missing the 10 best days nets you only $6.82, and missing the 50 best reduces that all the way down to $1.31.

Source: Goldman Sachs Portfolio Advisory Group “Rebalancing and Market Entry in Down Markets”; Bloomberg

According to data compiled by Charlie Bilello of Compound Advisors, -20% bear markets occur, on average, every 4.4 years, -30% every 9 years, and -50% every 20 years⁶. And yet, through thick and thin, stocks reliably outperform every asset class in the long run. To enjoy long-term returns that equity securities offer over fixed income, the price of admission is volatility—sometimes mind-numbing, cold-sweat inducing, vomit-reflex engaging volatility.

With that said, I will not put us in a position where we would risk margin calls. In other words, we will always be net cash positive. In this environment where prices gap up or down by double digit percentages with no fundamental reason, anyone on margin could get involuntarily liquidated by their broker. Enough money can be made with no leverage whatsoever, and besides, careful use of options, hedged or covered or in-the-money ones provide us with plenty of asymmetric return opportunities.

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⁴ https://www.nytimes.com/2008/10/17/opinion/17buffett.html

5 https://www.wsj.com/articles/how-i-learned-to-stop-worrying-and-love-the-bear-market-11585301582?mod=mhp

6 https://compoundadvisors.com/2020/the-price-of-admission

Why This Time is (Not) Different

What causes economic recessions? Traditionally, it is caused by an imbalance between allocated resources (capital and labor) and resulting productivity (profits). In other words, resources that do not produce profits. That results in losses in capital and layoffs in labor. For example, dot com bust happened because too many then-newfangled internet companies had no pathway to profitability and yet sucked up large amounts of capital and labor. The process of reallocating those resources into actual, productive endeavors is what eventually digs us out of a recession. 

In 2008, the financial crisis was precipitated by overinflated real estate prices. Capital and labor poured into the housing sector, building more homes and generating more mortgages than was needed by magnitudes. Eventually the mortgages could not be paid, which led to foreclosures, which drove down real estate prices, which halted new construction. The value of mortgage-backed securities collapsed, which decimated the banks which held large amounts of such securities, which led to a huge pullback in lending activity, which caused the intense recession. Digging out of it required a long and arduous process of reallocating the substantial amount of resources previously dedicated to housing and banking.

This time, it isn’t the popping of an asset bubble that is driving capital losses and mass unemployment.  It is, instead, an artificial halt to the economy. Instead of the invisible hand of free markets working to reallocate resources from unproductive sectors to productive sectors, it is a deliberate act of government policy to stop the spread of a pandemic. Once the pandemic is under control, labor and capital will mostly return to where they were needed prior to this recession. People will eat at restaurants again. People will travel again, probably even on cruises again. This is self-evident.

Compared to 2008, all the excess labor and capital left the housing and mortgage industries permanently. People were buying houses they could not afford by borrowing money that banks should not have been lending. Once that popped, all those people needed to go find real jobs or start other businesses that are actually sustainable. That created a prolonged period of pain.

Another significant difference is the government’s response. Typically in asset popping recessions, the government can be reluctant to step in and bail out those who had wasted all those resources to no end. The right thing to do is to let failure percolate, allowing painful memories to fester, which will discourage the same bubble from forming again. 

This time, since the government is directly “responsible” for the cause of the recession, they are 100% incentivized to bail out whomever is necessary. Already, over $2 trillion in stimulus have been approved to enter the economy to bridge us past this pandemic. The Federal Reserve immediately cut rates to zero and are committed to buying however much assets as necessary to keep liquidity and credit flowing. 

This difference cannot be emphasized enough: there is a bright green light to print money and hand it out. If the $2 trillion is spent and we are all still quarantined, they will print another $2 trillion, and it will again be overwhelmingly bipartisan. Of course, the mechanism by which this payment transfer is effected will inevitably run into snags as handouts of this size have never been attempted before. But the incentive is there and it is unwavering. That’s the key.

In this sense, we are experiencing a “crisis” more similar to World War II than any other typical recession/depression/panic, where the majority of citizenry and governments drop business-as-usual and participate in a joint effort to defeat a common enemy. WWII, of course, was also the definitive event that jolted the U.S. to slough off the Great Depression once and for all. 

***

How does this affect fundamental valuation of individual stocks? Without a doubt, earnings this year for most corporations will decline dramatically. But for most corporations, especially those that will survive this pandemic, one or even two years’ worth of earnings is merely a blip in the overall calculation of intrinsic value.

Intrinsic Value = Present Value + Future Value. PV roughly equates to tangible book value, e.g. cash on hand, owned assets, working capital, etc., minus liabilities plus current earnings. FV essentially equates to the accumulated future earnings stream from now until Judgment Day. What this recession will impact most skews much more towards PV than FV. It will certainly damage near-term earnings. It will surely damage the tangible book value of banks who will have to deal with troubled loans. But if you own shares in a company that will survive this crisis with no loss of reputation or human talent or brand value – in other words, no loss on their ability to generate profits in a normal functioning economy – it will continue to enjoy a long and growing tail of future earnings stream. The importance of FV in almost all typical going-concern operations far outweigh the importance of PV.

Another way to think about this is to invert: which kind of companies are unlikely to make it? It is companies that were already weak going into this crisis. Companies that were perched on a tipping point and needed some good luck to make it. Companies that are heavily indebted, whose intrinsic value are actually held by bond holders rather than equity holders. In cases like these, this recession will wash them out like every other recession. This time would not be different for them.

The major holdings in our portfolio, if my assessment about this being a maximum one to two year event with heavy and eager government support throughout, should all comfortably make it to the other side. Their intrinsic value may be nicked by temporary losses and mark downs, but that’s why I purchased our shares at discounts to intrinsic value. In other words, when I invested in our companies, I already baked in the certainty of future recessions and unknown catastrophes. I have not and never will invest in anything based on “blue sky” scenarios.

***

Some Extraordinary Commentary on a Specific Stock

The biggest contributor to our decline this past quarter was, by far, CIT Group. CIT, if you recall, is a mid-sized commercial bank with about $50 billion in assets, which entered the quarter as one of our top two positions. Shares went from $39.71 to $17.26 during March, but that doesn’t even account for the true magnitude because in late February it traded as high as $48 per share before hitting an intra-day low in March of $12.02 per share. That, if you’re morbidly curious, is a -75% drawdown. Ouch. The KBW Bank Index (BKX) over the same period of time (late Feb. to March lows) “only” drew down -49%.

The proximate reason for the shellacking of bank stocks is the fear of investors who believe we might be reliving the 2008 meltdown nightmare. However, banks are dramatically different today than they were twelve plus years ago. First and foremost, they hold much more “buffer” against losses now thanks to an rule called Basel III. Basel III forced banks to keep more capital on their balance sheet to defend against unexpected losses. How much more? Prior to 2008, banks routinely borrowed up to 30 times their capital base. These days, it’s down to around 10 to 12 times. This dented their earnings power post crisis, but it has them well protected coming into this pandemic.

Additionally, banks are now playing lead roles in recovery effort vs. being lead villains in 2008. Government guaranteed loans from the $2 trillion stimulus will be underwritten and distributed by banks to help businesses pay their bills and debt. Banks can then securitize these loans, plug into the Federal Reserve, and dump the credit risk onto the Fed’s balance sheet, which may be able to accommodate up to $4 trillion⁷ in such guaranteed low interest loans. This mechanism should theoretically act as a bridge for companies who otherwise would default on loan payments to get to the other side of this crisis intact.

With regards to CIT specifically, there were no fundamental reasons for it to decline with such a velocity outpacing the rest of the financial sector. The only probable explanation is their history, which saw them succumb to bankruptcy by the financial crisis – perhaps institutional memory had folks dumping CIT in fear of a redux. However, as I’ve explained in my annual letters, CIT is a completely different beast these days. Back then, they were encumbered by a mish-mash of random assets, including subprime lending, manufactured housing loans, aircraft leasing, etc. They weren’t even a bank holding company! Today, they are a legitimate, regulated, vanilla nation-wide commercial bank with an investment grade balance sheet, pure and simple.

Furthermore, as recent as 2017, CIT was required to undergo annual “stress tests” administered by the Department of Treasury⁸. The stress test scenario envisioned a prolonged, 9-quarter recession with double-digit unemployment and a nearly flat yield curve. In such an environment, CIT would suffer cumulative losses of -1.8% of assets, or just under a billion dollars⁹. It hurts, but it is a fraction of the $3.5 billion discount to book value CIT is currently trading at. In other words, shares are priced as if the losses will be over 3.5x the severity of the financial crisis. This is not to mention the fact that CIT is an even stronger bank today than it was three years ago.

Don’t just take my word for it. In light of these facts, insiders acted aggressively to buy stock on the open market. Twelve members of the board of directors and the management team spent over $1.6 million of their own money on CIT shares last month, with the two largest blocks coming from the CEO and the CFO. In a nutshell, the very people who are evaluating the company’s risk in real-time are the most bullish.

And so: I’ve been adding to our stake all the way down, which has temporarily made our results look rather dour but has me quite excited about the potential returns on the upside. I don’t typically disclose this much detail about individual stocks in quarterly letters, but during this extraordinary time, it is only fair to be transparent about my most aggressive moves so you understand I am making my decisions with rationale and logic rather than that four letter word h-o-p-e.

_____________________________________

⁷ https://www.nytimes.com/2020/03/26/business/economy/fed-coronavirus-stimulus.html

8 The requirements were changed in 2018 to only stress test banks with over $100 billion in assets.

9 https://s2.q4cdn.com/496078316/files/doc_downloads/regulatory_disclosures/7438aee2-cc0f-479d-6005-0a64fe25a385.pdf

To Sum Up

It is an extraordinary time to be living through right now, both as an investor and as a regular human being. I am in awe of the might of humanity aligning together against one objective: beat COVID-19. From the doctors and nurses on the front line, to the restaurants, grocers and essential workers working to feed us, from the scientists and researchers who have dropped everything else to focus on this virus, to the career government employees responsible for crafting policy and guidance that will help bridge us across these tough times – heroes one and all, but individually destined to be unsung.

Our companies have stepped up in kind, doing what they can. Our banks will be front-line distributors of loans and grants that shore up business cash flows and keep people on payroll. GM has retooled plants and leveraged their formidable supply chain to build ventilators and masks that will literally save lives. Dish is donating spectrum to T-Mobile and AT&T to ensure there will be enough bandwidth to communicate on and even giving free Sling TV access for 14 days to ease the burdens of quarantining. BlackBerry is providing 60 days free access to remote workplace tools that have become critical for white collar workers. Added together, the reputation of our companies will surely be strengthened on the other side of this crisis.

Soon the infections will peak, and soon we will have antibody tests to administer far and wide. Soon there will be targeted therapies that will save a majority of even the highest risk cohort. And then, there will be vaccines, and then it will be over. Although the timing is unpredictable, victory is inevitable. I will never understand the pessimists who bet against humanity and against America, those who may achieve a temporary thrill when their contrarian bets pay off once per decade but spend the rest of the time reliving past glories and hoping for future doom.

2019 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

Pocket Bubble

In my last post, I wrote about how tech IPOs have returned with a vengeance this year but highlighted the pitfalls of jumping into them on day one. The impetus was Uber’s IPO, which was priced at $45/share. Its stock as of this writing, on the back of a quarter that saw its largest quarterly loss ever ($5 billion, which included a whopping $3.9 billion of stock-based compensation costs, i.e. stock options given to insiders at the literal expense of common shareholders)  and a cash burn of over -$1 billion, has dropped -15% below its IPO price.
 
There is, however, one subset in recent IPOs that have performed spectacularly well which has lifted the overall valuation of its sector, and I’m not talking about plant-based meat substitutes¹: Enterprise SaaS companies.

First, here’s a chart of the Bessemer Venture Partners’ Emerging Cloud Index², which tracks the stock prices of emerging public companies involved in providing cloud software to customers:

And here’s a short list of some of the hottest enterprise SaaS names on the market, with their IPO year, current stock price, and enterprise value to sales (EV/S) multiple:

• 2015	Atlassian	TEAM	$144	29x
• 2016	Twilio	TWLO	$131	20x
• 2017	MongoDB	MDB	$144	25x
• 2018	Zscaler	ZS	$83	36x
• 2019	Zoom	ZM	$92	60x
• 2019	PagerDuty	PD	$37	20x
• 2019	CrowdStrike	CRWD	$93	45x

I use a multiple of sales rather than a multiple of earnings because most of these companies have either negative earnings or barely break even. Traditional P/E multiples are meaningless in this space. The strict GAAP accounting rules applied to subscription based software obfuscate the true economics of the business, so it’s somewhat acceptable to use EV/S as a crude substitute. But this only applies during the rapid growth phase, when recurring revenues do not match up with the upfront sales commission expenses and heavy R&D. There is an anticipation of eventually reaching profitable scale, and at scale, a la a Microsoft or Adobe, the EV/S multiple should settle somewhere in the mid-single digit, which translates into something like a more normal 20-ish x P/E multiple.

With that in mind, it’s pretty clear that the names above—taken as a whole—are overvalued. Obviously it would be unfair to label all of them as equally outrageous bubbles. Atlassian in particular has matured into a substantial positive cash flowing corporation while maintaining a 30-40% growth rate on a billion dollar annual run rate. Even so, valuation can act as a substantial headwind even for legitimately impressive SaaS companies. WorkDay (WDAY), a provider of HR and financial planning software, hit a $20 billion EV in early 2014 on sales of $500 million, an astronomical 40x EV/S multiple. And so despite revenues growing from $500 million to $1.5 billion from 2014 to 2018, shares basically went nowhere those four years.

But it appears the market is pricing in Atlassian/WorkDay-esque success for almost every company claiming to be 1.) SaaS, 2.) cloud-native, and 3.) enterprise-focused. For example: Zoom is a video conferencing app. A very slick and very well engineered video conferencing app, but still – a video conferencing app. PagerDuty is… well, basically a fancy pager. A very slick and very well engineered suite of software that facilitates integrated real-time incident response via multiple channels, but still – yeah, a pager that beeps when something has gone wrong.

They are real, legitimate products that are probably pretty awesome for end-users now in 2019. But they serve narrow functions, and so for Zoom and PagerDuty et. al. to be worth their current valuation not only requires them to dramatically grow their enterprise footprint, they must also aggressively grow horizontally within each enterprise year after year. It seems inevitable to me that they will eventually step on not just Microsoft and Amazon and Salesforce and Atlassian and WorkDay and Oracle and SAP and other established enterprise software competitors, but eventually also on each other. At which point, when (not if) their growth begins to slow even a few percentage points: watch out below.
 
And then, there’s CrowdStrike, a competitor of Cylance. You may recall Cylance was acquired by BlackBerry earlier this year. Both were founded by former Chief Technology Officers of legacy antivirus company McAfee. Both offer SaaS, cloud-native, next generation A.I. endpoint protection (read: Super Antivirus). And yet, CRWD is selling for a 45x EV/S multiple on the public market while BlackBerry purchased Cylance for a comparatively modest 7x EV/S. Meanwhile, BB is currently trading for 3x. All of BlackBerry, on track to generate over $1.1 billion in revenues this fiscal year, is valued at less than 20% of CrowdStrike, which will only book ~$440 million and be nowhere near profitability. Something’s not right.

This dichotomy implies total value destruction and transfer, i.e. not only has Cylance become completely worthless under BlackBerry, CrowdStrike will also scale into a multibillion revenue company in just a few short years³. It is almost certain that either BlackBerry’s valuation is too absurdly low, or CrowdStrike’s valuation is too absurdly high (or both). And it is almost certain that the enterprise SaaS darlings of today—as a whole—is likewise overvalued and many names will have collapsed over the next several years. Time will tell, so stay tuned. Caveat emptor.

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¹ Beyond Meat Inc. (BYND), IPO’d at $25/share and is now casually trading above $150/share, just a 700% rise over the past 3 months. They are now a $10 billion company with around $0.05 billion in annual gross profits and, of course, negative earnings and cash flows. ¯\_(ツ)_/¯

² https://www.bvp.com/bvp-nasdaq-emerging-cloud-index

³ And even if so, you still might not earn a return at today’s stock prices a la the WorkDay example above.

IPOs, Revisited

Given that Uber’s upcoming initial public offering is consuming much of the oxygen in the business press lately, not to mention the recent IPOs of Lyft and Pinterest (with Slack, WeWork, and AirBnB not far off on the horizon), it might be timely to revisit the topic of tech IPOs, which I first wrote to you about in a letter some five plus years ago¹.

In 2013, Twitter was the hottest IPO since Facebook. It debuted in November of that year at around $40/share. Revenue was $665 million and operating income was negative -$635 million. Today, revenues have grown to $3 billion and operating income has swung to a positive $453 million. But its share price as of this writing? Still ~$40/share. Even though the result has been nearly identical to that of stashing cash in your checking account, the journey has been far from it. After initially popping in exuberance to over $70/share, TWTR collapsed into the ‘teens. If we did this retrospective two years ago², the number I’d be quoting you would be $15/share.

As an added twist, TWTR shares outstanding were 588 million back in 2013. Shares outstanding as of Q1 2019 is a much heftier 768 million. For all the media attention about companies supposedly wasting money buying back record amounts of their stock, the other side of the equation is that companies, especially Silicon Valley based tech companies, are voracious issuers of stock options that often outpace buybacks. The buybacks exist mostly to prop up share prices which are then sold into the open market by insiders.

This is how it works: you’re upper management. You get stock options. When the options vest, you exercise and thereby create more inventory of stock. Then the company spends money to buy back shares, partially reducing the inventory of stock. The net effect is you have more money and the company has less. You essentially got paid by the company, just in a circuitous manner. In the meantime, the shareholder has been sneakily diluted all the while the company is trumpeting how generous its buybacks are and how shareholder friendly it is.
 
The point is, if you buy a hot IPO stock based on hype, you are probably getting suckered. Some IPOs turn out well, but most don’t. It’s simply not designed for the public to get rich off of. It’s designed for founders and early investors to cash out. It’s designed for investment banks to reap fees and dole out favors to their lucrative clientele. It’s designed to create a new type of currency (stock options) to “attract and retain” employees. As far as stakeholders go, Joe Investor is just about damn near the bottom rung of the ladder.

If you’re a long term investor, you can afford to watch and wait. Every world-beating common stock in the past decade or two, be it Apple or Amazon or Netflix at times experience dramatic declines. Twitter languished for years below 50% of its IPO valuation. Even Facebook’s IPO was widely considered a flop back in 2012³. Shares opened at $40 in May but by August it was below $20. Since then: 10-bagger. The moral of the story is, if you really like a public company, eventually you will have a chance to buy its shares. Just probably don’t do it on the first possible day (or week, or month).

_____________________________________

¹http://blog.incandescentcapital.com/2013/11/the-ipo-of-twitter-to-buy-or-not-to-buy.html

²And, perhaps, if it were not for a certain "Tweeter-in-Chief" ascending to the Oval Office in 2016…

³https://money.cnn.com/2012/05/23/technology/facebook-ipo-what-went-wrong/index.htm

2018 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

Measure What Matters

During the past quarter I read John Doerr’s Measure What Matters, an ode to a business management framework called OKRs. The acronym stands for Objectives & Key Results, a deceptively simple theory that the core cause of organizations’ underperformance is a lack of clear and measurable goals.

The TL;DR¹ abstract is that successful firms are fanatical about separating the signal from the noise, i.e. measuring only what matters. Select clear, rational Objectives for your organization, then identify measurable Key Results that, if diligently nurtured, inevitably drive said objectives to completion. Far from being just yet another Theoretical Business Guru, John Doerr has a formidable curriculum vitae, having steered his venture capital firm Kleiner Perkins into early investments in Sun, Intuit, Amazon, and Google, where he preached the OKR gospel to them all. The founding father of OKRs, however, was his mentor, Intel founding member Andy Grove, one of the great titans of modern business management.

***

Investing in public markets can feel dauntingly opaque at times. CEOs spout sanitized clichés on conference calls while Wall Street analysts confidently make up numbers and opinions and then change them with little rhyme or reason. The OKR framework has given me a useful methodology to evaluate businesses strategically on an ongoing basis. Do management set sensible objectives? Do they offer transparent key results with which to evaluate their progress and achievements?

For example, one of our banks has embarked on a strategy to reduce balance sheet size in this shrinking Net Interest Margin environment (← Objective) by halting origination of fixed rate apartment loans and focusing instead on variable rate commercial & industrial loans (← Key Result #1). Without pressure to grow assets, they can also re-mix their liabilities by focusing on growing core deposits to replace higher cost debt and preferred stock (← Key Result #2). Their goal is to achieve this within 12-18 months.

This strikes me as rational goals with clearly measurable metrics that, should they be achieved, will inevitably result in better margins and higher EPS. Quarter to quarter, there will be numbers that track these “OKRs”, which help me filter out the noise in each earnings release. If Mr. Market fixates on the macro and tosses this baby out with the bathwater, I can confidently buy more. Conversely, if management tries to spin bad numbers into an alternate narrative or appear to arbitrarily change objectives midway, I can see through the attempted deception and divest.

***

This framework, too, can be applied to Incandescent Capital. Our objective is to generate a double-digit rate of return over the long run. Importantly, what the stock price of our investments are on a month-to-month or even a year-to-year basis is not a key result. Key results are instead whether their underlying business fundamentals remain steady, whether their future prospects have improved, and whether we have purchased their shares at a discount to the estimated present value of its future cash flows. If the answer is yes to all of these, it is decidedly probable we will achieve our objective.

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¹Too Long; Didn’t Read. Cheeky millennial internet slang but hopefully evidence that I’m still with it.

2017 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

Case Study: Whole Foods Markets (WFM)

One material event to note this quarter is Amazon's pending acquisition of Whole Foods Market (WFM). Recall in my 2015 Annual Letter I mentioned purchasing WFM which, at that time, had declined from a high of over $65 per share in 2013 by more than half¹. Our cost basis was ~$30, which at the time reflected a fair-ish 13x multiple on cash flows ex-store expansion costs.

Shares were relatively range-bound for over a year, but things started heating up in 2017 Q2 after Jana Partners, an activist hedge fund, took a big stake and pressed aggressively for changes. On June 16th, Amazon announced a $42 per share bid for WFM, netting us a 40% gain. Annualized return over our roughly 18 month holding period was a satisfactory 25%.

WFM chart for the duration of our holding period. Things heated up in Q2 after Jana took a big stake.

The only pimple here was that WFM was never larger than a 2-3% position across our accounts. However, I harbor no regrets in not making it larger. It is always with hindsight that one laments not betting everything on black after the roulette wheel deposits the pinball on black. My analysis of WFM was that it traded at a fair price at around $30/share but possessed a platinum brand that would eventually be unlocked, whether through organic growth or M&A. Had shares traded down to sub-$25, we likely would have owned more, but alas, we settled for making not-as-much money. First world problems.

What’s more interesting is that very few people anticipated a strategic merger between these dance partners. Most of the chatter surrounded the possibility of Krogers or Albertsons or even Wal-Mart being the eventual acquirers of Whole Foods. The fact that Amazon, the online behemoth, is paying $13.7 billion, over ten times more than their next largest acquisition², for a footprint of brick & mortar stores across the nation is a hint that traditional retail is in fact not dead. Physical spaces that are well-designed and offer visceral pleasures are alive and well. It is the sloppier ones, the ones with poor product selections, with run-down facades, with demoralized underpaid staff that are doomed³. In the past, they were able to survive because despite being unpleasant to shop at, there were few other choices to buy what you wanted/needed without driving excessive distances. Now, there’s Amazon, and they’re taking their promise of customer delights to a physical store near you.

And so what’s going on is beyond the blasé “online shopping is killing retail” narrative. It is the very idea of capitalism encapsulated in a nutshell: increase productivity or make way for those who can, the ultimate winner being the consumer, who no longer have to suffer the indignities of poor parking layouts or sour-faced customer service reps or waste time driving between stores just to find a particular size in stock and can instead get it all with just 1-Click and then spend all that newfound free time going to places that are pleasant and stimulating and offer experiences that enrich the mind and soul. It’s not about online vs. offline. It’s about better vs. worse. It’s about progress.

“There are many advantages to a customer-centric approach, but here’s the big one: customers are always beautifully, wonderfully dissatisfied, even when they report being happy and business is great. Even when they don’t yet know it, customers want something better, and your desire to delight customers will drive you to invent on their behalf.”

-Jeffrey P. Bezos, 2016 Letter to Amazon Shareholders

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¹Yes, finally a case study in which we profited from!
²http://fortune.com/2017/06/16/amazon-buys-whole-foods-stock/
³I’m thinking of a chain that starts with an ‘S’ and ends with an ‘ears’

Case Study: Valeant Pharmaceuticals

Those that follow financial news on a regular basis can skip this post as I wager there has not been a name more covered than Valeant in the business press since 2015. Sorry to pile on.

Valeant is a pharma company that, until 2015, was thought to have struck gold in pioneering a new business model. It is the erstwhile brainchild of J. Michael Pearson, who took over as CEO in 2010 with the idea of acquiring rather than developing drugs. The thesis: R&D of new drugs is inefficient and unpredictable. Instead, build a platform to market and distribute and then buy up drugs that have already been developed and approved. And as icing on the cake, relocate to Canada to lower the effective tax rate from 25% to 5%.

This worked like a miracle in the early years. Revenues went from $1 billion to $8 billion by 2014, driven by dozens upon dozens of acquisitions in that span. VRX went from $15/share to over $200. At its peak, it was Canada’s most valuable company.

But the rule of thumb in finance is: there is never anything new under the sun. An acquisition oriented growth strategy relies on two prongs: 1.) affordable financing, and 2.) affordable targets. Thanks to the financial crisis, interest rates were at a generational low, so Valeant was able to issue debt with abandon. And as their stock rose, they were able to supplement their shopping spree with equity. The second prong proved to be a problem as they grew ever larger. To move the needle, they needed bigger acquisitions. By 2014, there were only a few targets large enough, and none of them were keen on selling out – at least not at a price anywhere near a bargain.

Mr. Pearson’s solution was novel: team up with a large hedge fund to hunt together. Enter William A. Ackman’s Pershing Square Capital, who in 2014 took a large stake in Botox-maker Allergan and pledged to vote his stake in favor of a hostile $50 billion Valeant takeover. To make a long story short, Allergan fought tooth and nail, and escaped Valeant by wooing a white knight in Actavis to acquire them instead for $66 billion.

Meanwhile, Mr. Ackman took home over $2 billion in profits from his Allergan trade. Pershing Square Capital finished 2014 up 40%. What happens next will form the moral of the story: he rolled his entire Allergan profit into VRX.

Valeant’s consolation prize in the wake of Allergan’s rejection was a $10 billion acquisition of Salix. By then, Valeant’s balance sheet had become bloated with debt. Less than $6 billion in equity was supporting almost $50 billion in total assets. And into this highly levered entity Mr. Ackman invested almost 20% of Pershing Square’s capital.

Almost everything went wrong subsequently. Valeant was discovered to be using extremely aggressive, borderline illegal tactics in pushing their drugs. They were also jacking up the prices on their drugs after acquiring them, sometimes as much as 10 times their original price, raising the ire of Congress and Presidential candidates. Charlie Munger accused them of being deeply immoral. As their stock began to collapse amidst intense public scrutiny, they lost their currency to do acquisitions; nobody wanted to be acquired by Valeant anymore anyway. Doctors began pulling back on prescribing their drugs.

VRX has since crumpled from $260/share down to $10. There is serious doubt whether they will survive their $1.8 billion of annual interest payments. Mike Pearson has been ousted as CEO, and Mr. Ackman, a man with an unquestionably high IQ and nearly unlimited resources, sold his shares last month at the bottom for a $3 billion loss. And it’s not just Mr. Ackman. Scores of brilliant fund managers had piled into VRX, even the venerable Buffett-endorsed Sequoia Fund.

***

As a fellow investor, it’s bad form (and possibly bad karma) to revel in too much schadenfreude. Things can and will go wrong all the time. Management can be dishonest, government can conspire against our interests, consumer tastes can change on a whim. If you’re in the business long enough, you’re not really doing your job unless you have a few deep scars. There are just too many factors out of our control. But what we can control is our buy/sell judgment. Not just whether to buy/sell but how much to buy/sell.

And so the lesson of leverage for us is: look-through. One may be adding implicit leverage to one’s portfolio by investing too much in companies aggressive with debt. If Valeant had been more modestly levered, their survivability would not be in doubt and their stock would still retain significant value (although it probably would not have gone stratospheric earlier either). There would have been more margin of safety, which, in the complex and uncertain world we live in, should be a virtue we strive for.

“I don't have any advice for young people who want to get rich. Basically, I think the desire to get rich fast is pretty dangerous. My own system was to get rich slow. It protracts a rather pleasant process. After all, if you get rich fast all you can do is be robbed by your own employees your yacht and so forth. Whereas if you get rich slow you amuse yourself over a lifetime.”

-Charles T. Munger, 2015 Daily Journal Annual Meeting 

2016 Annual Letter to Investors

 
_____________________________
The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

A Special Report: Your Portfolio Manger’s First-Hand Experiences in China

I had spent the majority of October traveling in China. It is a complex country, and anyone who reduces it to a sound-bite like “all Chinese companies are frauds” or “China’s empty skyscrapers proves it is a massive bubble waiting to pop” is doing a grave injustice to the truth¹.

This past trip was the second time in two years that I’ve been to the fastest growing major country in the world. In aggregate, I’ve spent approximately a month’s worth of time in the mainland, mostly in the Sichuan province, but have also spent ~25% of the time in Beijing. I've tried to not just glide through as a simple tourist but to try to feel what it'd be like to live there day to day, to, to my utmost extent, imagine what my hope dreams and fears would be if I were amongst the citizenry.

***

The first impression anyone will have of China is the sheer amount of people in the country. I've lived in American metropolises most of my life, Los Angeles during formative years, then New York for seven years, and perhaps the only apt comparison is that of Grand Central at around 6 PM on a weekday. That would be the median feel. Peak traffic hour feels like when the President is in town and half of the city is gridlocked due to blockades. Or when Penn Station is suffering from technical problems on the Wednesday before Thanksgiving.

The effect is you quickly adopt a very visceral fear of congestion. There is no time or space to be polite. If you try to be a gentleman and you will be consumed by the crowd, stuck in stasis as people nonchalantly push you aside. Any hope of getting anywhere or completing any errand within a decent timeframe will require you to "do as the Romans" and ratchet up your inner aggression. Push forward. Cut into any lane with an open space. Speak loudly in quick clips for any request. Brandish hyperbole liberally. And you will find that, in contrast to the stares and reprimands you may get in western nations for being rude, people generally acquiesce as if it's common protocol, which in a weirdly unwritten way, it is. For example, drivers being suddenly cutoff in traffic strangely generates no road rage. There is copious honking but more of the hi-I'm-in-your-blind-spot-don't-hit-me variety rather than the long, loud, F-you variety. My father-in-law more than once drove on the wrong side of a (small) road, very casually telling me after I startlingly pointed it out that it's because it's less congested on this side.

Beijing subway circa 1800 hours on a Friday

China’s single minded goal of economic advancement has been made into a rallying cry: 趕英超美 — “Chase down England, Surpass the United States”. It is capitalism by edict. The outcome has been wealth creation on a magnificent level, but at the same time, jaggedly uneven. Shooting into the skies in Beijing are modern towers of marvel, but walk a few blocks in any direction and you’re bound to pass ancient dilapidated structures or holes in the wall hawking their wares. The energy required to power this capital of 11 million produce choking pollution that, on bad days, feel like a perpetual sandstorm and such frequent traffic gridlock that it saps the will of its populace to commute beyond the part of town where they live/work. China’s smartphone apps are the most sophisticated in the world, in which you can conduct or receive almost any service you can imagine. However, the delivery mechanism for those services are often grunt laborers biking through smog and congestion, dropping off the food you ordered or delivering the package you sent out or giving you their patented 5 minute haircut or whatnot.

The pursuit of prosperity and the displays thereof has permeated into the culture. Consumerism is the holy text. My wife walked into an old bookstore that she used to love, but left ten minutes later, confused and irritated that the bookshelves are now dominated by how-to’s on getting rich instead of holding volumes representing the diverse tapestry of culture that is China. And while manners are still very much intact in between friends and family, I got the impression it has eroded between businesses and their customers. More than once I’ve witnessed unhappy exchanges in restaurants, drink stands, and stores, the patron certain he or she has been bilked and the waiter/waitress or customer service rep either being forced to take a berating or arguing back aggressively. Such quickly triggered naked displays of dissatisfaction are, it seems to me, symptoms of no longer viewing the other party as a human being but instead as merely the opposite side of a transaction.

This extreme imbalance of population versus available resources and the barely disguised worship of wealth explains a lot, in my opinion. Why do Chinese companies have the reputation of being shady? Because there's less incentive to trust and more incentive to take what they can upfront. In financial parlance, it's the prioritization of Present Value versus Future Value. The discount rate placed on Future Value is extremely high because you never know what tomorrow will bring. Competition amongst 1.4 billion people is maniacal and rule of law is less established than in the west. Also remember: it's not even been one generation since the country exited the Cultural Revolution and advanced out of an agrarian-centric society. The collective memory of the Chinese citizenry have no basis to extrapolate how the future might look. If you have the chance of grabbing a bird in the hand right now versus the mere possibility of two in the bush tomorrow, it's a no brainer. Close your fist and run. Tomorrow is not guaranteed because there's nothing in history that implies it would be. Most importantly, if you don’t take “what’s yours”, someone else will.

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On the upside, the work ethic of the populace is undeniable. The desire for a good life, a better life, is intense. The primary and secondary education system is light-years ahead of the U.S.  Kids attend long after-school tutoring sessions beginning at a young age and teachers are respected—the best of whom are as popular as rock stars and get paid like it, resulting in a virtuous cycle of attracting the best talent to the teaching profession. Young adults right out of college in Beijing bust their butts like Wall Street investment bankers regardless if they are in finance or not. Leaving the office before midnight is an early night.

It’s no coincidence that Chinese multinational conglomerates like Huawei and Dalian Wanda are eating the cake of its competitors in the global marketplace. The lazy explanation is they have the tailwind of unfair trade agreements, but don’t discount the fact that they just work a lot harder and are not wasteful corporations. In this kind of environment, progress seems inevitable. Mistakes will be made, sure, but as Charlie Munger has said, mistakes are a part of life. The important thing is how fast you scramble out of them. China will plow forward interminably because its citizens are tireless and there are literally billions of them. Those empty skyscrapers will be filled sooner rather than later².

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¹Adding further to this complexity is a personal wrinkle: I was born in Taiwan, a country that is ancestrally Chinese, colonized and modernized by the Japanese, and became the refuge of the Nationalist Party after their defeat by the Communist Party during the civil war, stayed from its certain demise only because they savvily secured the United States’ obligation to defend them during the height of the anti-communist wave in the ‘50s. In other words, although I look and speak the same language as those in China, I was brainwashed as a child to believe we are not one; to, indeed, believe China is a country to be suspicious of and feared.

The truth, of course, is much more multifaceted, and given its antiquity, perhaps never to be unraveled in its entirety. Over the course of decades, good or bad fades away and gives way to tragedy for we all inherit the sins of our fathers. Long story short, I feel fortunate to have developed an independent mind and to have met my wife and her family who is from the mainland. I continue to be fascinated by my own history – learning about China will be a life-long interest.

²“An Update On China's Largest Ghost City” – http://www.forbes.com/sites/wadeshepard/2016/04/19/an-update-on-chinas-largest-ghost-city-what-ordos-kangbashi-is-like-today/#6005ae331e08

Case Study: DreamWorks Animation

My previous case study on Virgin America was received with some enthusiasm. I suppose with all this highfalutin discourse on long-term thinking and intrinsic value one naturally craves something a little more practical. I will endeavor to supply this going forward.

DreamWorks Animation (DWA) is a movie studio controlled by Hollywood luminaries Steven Spielberg, Jeffrey Katzenberg, and David Geffen. Their crown jewels are the blockbuster franchises of Shrek, Madagascar, and Kung Fu Panda.

When we talk about great businesses, we tend to banter about pricing power and high margins and asset-lite models. In layman’s terms, it’s getting people to pay for something that costs you nothing. So what’s great about beloved fictional cartoon characters? They never demand a salary. They don’t get embroiled in real-life scandals. They don’t grow old.

Disney understood this almost 100 years ago. This is also why they acquired Pixar, then Marvel, then LucasArts. They all have intangible, indestructible franchises that live forever. Not only can you keep making movies about them, you can sell tons of merchandise and erect entire theme parks around them. All of this, if managed well, can be a perpetual geyser of profit.

It is, however, difficult and expensive to establish these franchises. It costs a lot of money up front to make movies. Accounting principles then dictate film production costs are to be amortized once revenue beings accruing. As such, most of the expenses are front-loaded. This is a quirk but it is not unreasonable – most filmmaking endeavors are boom or bust; they do not have a long tail. Only by thinking a little harder about the nature of animated films, and more specifically, successful animated films, can one come to the realization of the hidden intrinsic value in companies like DreamWorks.

Here are how their movies have fared for the past five years:

You will note: a string of profitable releases, with a number of blockbusters raking in over half a billion in gross receipts. Although it may not be in the league of the Pixars or Marvels or LucasArts, it certainly should be considered as a reliable hit-maker at this point. More importantly, they are strengthening their franchises, franchises headed by immortal and incorruptible animated characters that represent cost-free revenues in the long run.

The stock market, ever schizophrenic, does not seem very impressed. Over that same period, DWA has been as low as $16 and as high as $35 – a 100% swing from trough to peak:

Meanwhile, the world has been changing. Distribution of entertainment, once comfortably ensconced within the movie theater -> VHS/DVD -> network TV paradigm, is being disrupted by Netflix, Hulu, Amazon and their ilk. Content has become more valued in a world where distribution is being commoditized by the internet. You want people to watch your channel or subscribe to your service? Offer exclusive content.
 
You know how this story ends. In late April, Comcast made a bid for DreamWorks for $41 per share, a 50% premium above DWA’s 52-week high. Intrinsic value wins again.

Unlike the Virgin America case study, it was not guaranteed you would bank a great return if you bought DWA anytime within the past five years. If you bought at the peak at the end of 2013, you only made 6.5% annualized return. One would imagine, though, if you had the conviction then, you would have made additional, larger purchases as the stock sold off over the next two years. As such, a cost basis of anything under $25 within the past five years would have yielded a double-digit compounded return. Within the past three years, it would be in the high teens.

DWA was a stock I had watched for a long time. I never pulled the trigger because I never got comfortable enough with the valuation. Intellectually I understood the thesis, but I kept hoping for it to get cheaper. Patience can be difficult – a dual-edged sword, especially in the stock market. Patience in waiting for a security to become fully valued is a virtue, but excess patience in waiting for a security to reach an acceptable price could result in lost opportunities. Neither is preferable: Not taking enough risks is as big an impediment to wealth creation as taking too many dumb risks. Finding the balance is a never-ending quest, a life-long learning experience.

Case Study: Virgin America

If you’ve flown Virgin America before, you know they are legitimately differentiated from the soul-sucking national leviathans. New planes that pulse like a night club, high tech seatback concierge systems, flight attendants who don’t totally hate their jobs, surprisingly competitive prices, etc. They’ve been gobbling up market share ever since their inception in 2007 and went public in November of 2014.

The airline industry has been consolidating aggressively for several years now. Historically an industry that is in the hall of fame of value destruction, M&A (and collapsing crude oil prices) have helped the players settle into an uneasy but profitable oligopoly. Meanwhile, Virgin America’s success has not gone unnoticed, although you’d never be able to tell if you just looked at the stock price. Here’s a chart of VA’s performance since their IPO until late March:

For a year and four months, the stock went exactly nowhere. Chart technicians call this “range bound”, with “resistance” above $40 and “a floor” around $30. But underneath, business was booming. Gross profits grew 24% year over year while operating profits nearly doubled thanks to cheap jet fuel. Their presence at LAX and SFO grew stronger. And two of their competitors began salivating.

On March 23rd, word leaked out that VA was “in play” – Street Lingo for “for sale”. Shares popped 13%. And then, several weeks ago, on April 4th, Alaska Air announced they were acquiring Virgin America for $2.6 billion, or $57 per share after a frenzied bidding war against JetBlue. VA shares shot up another 47% that day:

If you’re following along with your calculator, that’s a cool 83% return in about two weeks. That kind of return is impossible to the proponents of efficient markets. Of course, no one could have (legally) timed it perfectly, but consider:

• If you bought VA at its closing price of $30 on the day it IPO’d, you earned a 54% CAGR.
• If you bought VA at its peak prior to the buyout (~$42.50), you earned a 21% CAGR.

(The calculated CAGR is assuming you didn’t “trim profits” or “cut your losses” at any point in between, an endeavor that, by my estimation, adds no more long-term alpha than a coin flip, but is an endeavor heavily practiced by the vast majority of market participants.)

So any way you slice or dice it, VA shareholders got paid, ranging from handsomely to a flat-out bonanza¹. And while the stock price may not reflect it, value always matters, especially private value, i.e. how much the business is worth to someone as a whole, someone who can control operations or allocate its cash flows. The timing is unpredictable, but eventually, over the long run (count ‘em in years, not months), the market is a fine arbiter of value – a right proper weighing machine.

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¹And here, buried in a footnote, I humbly beseech you to not ask the question begging to be asked, which is “why didn’t we own any VA?” to which the answer will be an averted gaze and some mumbled variant of, well, hrm, I looked at it last April but, ah, it fell off my radar… A costly error of omission resulting in beaucoup regret.