Dear Partners,
2015 year end marked our first 10 months of operation. Rowan Street Capital, LLC was initially funded in March 1, 2015 and through December 31, 2015 the fund has posted a positive gain of 0.4%. During the same time period the S&P 500 had declined by -1.1% including dividends.
As you well know, Rowan Street Capital does not charge any management fees to our partners (qualified investors) and only takes performance fees after the 3% annual hurdle rate of return has been met. Since the hurdle rate has not been met in 2015 for most of our partners, there are NOT going to be any fees charged to any of the partner accounts. We only get paid when we make you money. When you win, we win. Our interests are completely aligned!
We would like to emphasize that our first and foremost goal is to achieve attractive long term compounded rate of return on the capital that our partners have entrusted us with. We believe that a huge part of achieving that is protecting our fund from permanent losses of capital. We will not take bets with significant downside risks in an attempt to put up an attractive performance number in any given year. Our investment horizon is focused on at least 3-5 years, and our investment performance should be evaluated on this basis as well. Having said that, we are delighted that we were able to protect our fund’s capital in a year when 90% of actively managed mutual funds and most well-known hedge funds lost money, some incurring very significant losses.
In our last letter we explained what our fund expenses are. In that regard, we have some very good news for all limited partners this year - your managing partners made a decision to ‘pick up’ all of the fund expenses for 2015, which means that not a dollar was charged to the fund for 2015. Starting 2016, the fund will incur normal fund expenses, but they are expected to be small in comparison to the current capital of our fund. As our fund grows, these expenses will be very immaterial and will not have much effect on our future investment performance.
To that point we have also made significant progress. In our last letter, we have stated that our goal was to at least double our assets under management (AUM) by the end of 2015 from where we were standing at the end of September, and we have done exactly that. We are also very happy to report that as we are writing this letter, our AUM have increased by 280% from the end of September 2015, with a couple of capital infusions that came in January 2016.
The general stock market
We typically don’t like to spend too much time on macro or market trends, but we have been observing something very interesting throughout 2015 and saw many signs of a market that maybe turning unhealthy. We track close to 500 high quality companies from various sectors and industries, and we have noticed that at the end of 2014 most of these companies were hitting their 52 week highs as S&P 500 Index closed at 2,058 on December 31, 2014. As we entered 2015 and as the year progressed, we noticed that fewer and fewer of the companies in our universe were making 52 week highs, and to the contrary, more and more of them started to enter a bear market (any equity down 20% from recent highs can be considered in its own bear market). As 2015 came to an end, we had observed that 60% of the companies we track entered bear market. Please take a look at the chart below, which depicts exactly what we have been observing throughout the year. Notice that the red bars represent percentage of companies entering bear market over time. However, one wouldn’t know this was going on just by observing the S&P 500 Index, which closed the year at 2045 (pretty much unchanged). What’s interesting about this is that we have noticed extreme selectivity -- fewer and fewer stocks were pulling the market upward in 2015. If you study history, we saw a classic example of this in the "Nifty Fifty" during the 1960s, and again in the dot-com bubble with a handful of leading stocks driving the Nasdaq. This is exactly what’s happening now! What we see is that only a handful of companies such as Google, Microsoft, Facebook and Amazon, which maintain a huge weight in the S&P 500, are holding the index up.
What does this all mean? There is a very good possibility that the current 7 year “bull run” has come to an end. Global markets have plunged in 2016 amid fear of oil prices and China slowdown. Shanghai index is already down 23% just in January alone, with a couple of 7% down days where they had to hault trading.
In our very first letter we wrote:
“Compared with other bull markets over the past 85 years, this bull market is already one of the longest on records. At (now 7) years in duration, it is over 2 years longer than the average bull market…there were only 2 times over the past 85 years when the bull market lasted longer: one that started in 1949 (7 years) and another one in the 90s that lasted more than 9 years and ended with the tech bubble.”
In order to understand how market cycles typically evolve let’s examine the chart on the following page by Goldman Sachs that presents four distinct phases of a typical equity cycle:
As you can see during the “Despair” period of the cycle, earnings typically fall around 7%, valuation multiples compress 19% and prices of stocks fall by 25% on average based on data collected going back to 1973. The most recent period this was experienced in was in 2008-2009, only things got significantly worse than average. This period is typically followed by “Hope”, when earnings stop falling and prices of stocks appreciate on average by 51%, pricing in future rebound in earnings (this is when the highest returns in the market cycle are usually being made). Next comes the “Growth” phase, when earnings increase by 23% on average, but the market increases by only about 11% as majority of the earnings growth has already been priced in the “Hope” stage. Then comes the last stage of the cycle “Optimism” when earnings do not grow very much, but the market pushes up valuation multiples and the prices of stocks to new highs usually overestimating the underlying fundamentals as well as the duration of the good times. It is my suspicion that we may have been in the “Optimism” stage in latter part of 2013 through the first part of 2015. Logically, if we were to believe that this bull run has ended, we may be ready to enter the next part of the typical market cycle again, which is “Despair” characterized by declining earnings and the bear market (decline of more than 20% in stock prices). Now, we would like to note that every market cycle is different, some are short and some are long, some experience severe declines and some are less pronounced, but almost all of them go through these 4 typical stages, and this time it will be no different.
On a positive note…
We have anticipated this for some time now as you may have read in our quarterly letters in 2015. When we started back in March of 2015, we couldn’t find much value in the market so we stayed patient and kept the majority of our portfolio in cash for times like we are witnessing today. At the risk of being redundant, our goal number one is always to protect our investor’s capital, and we did not feel that buying into companies at the levels we were seeing in 2015 would help us do that. The companies that did appear as being “cheap”, we did not want to own because of their highly leveraged balance sheets and poor track records of free cash flow generation. We remained committed to our distinctive governing principles that guide our investment decision making.
As of today, 85% of our portfolio is in cash waiting to be put to work. The good news is that S&P 500 is down 10.7% (not including dividends) from when we first started in March 2015 and values are starting to emerge. We expect 2016 to be a very volatile year as market participants are trying to make sense of what’s next for the global economy. As for us and our strategy, times like these are most exciting – this is when long term value is created. Time for us to go shopping! After patiently waiting, we are finally starting to see some “merchandise” on the sales racks, and we believe that “last call sale” is still ahead of us.
Thank you for your confidence and trust in our investment discipline. Should you have any questions or comments, we would be very happy to hear from you.
Sincerely,
Alex and Joe