2023 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.

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

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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.