Dear Partners,
February 29, 2016 marked exactly one year of our operation. We are pleased to report that over the past year our fund has outperformed S&P 500 Index by 700 basis points (or 7%), gaining +1% in comparison to the S&P 500 decline of -6%. While +1% is not exactly a “sexy” return that you can brag to your friends about, we are delighted that we were able to protect your capital in a declining market. Our number one rule in investing is “don’t lose money”. Our number two rule is “don’t forget rule number one.” We strongly believe that keeping these two rules in mind goes a long way towards attractive long term investment returns.
Our activity
Over the past year, we invested in 12 solid companies with favorable long-term prospects and attractive expected long-term returns. One of our investments, Precision Castparts, was acquired by Warren Buffet’s company Berkshire Hathaway, producing a 13% gain on capital invested over a 6 months’ time period. Our target price for this investment was significantly higher than what Buffett paid, but he does not overpay for companies. We sold another holding of ours, MSC Industrial Direct (MSM) - a direct marketer and distributor of a range of metalworking and maintenance, repair and operations products. Our expected long term returns on MSM have become unattractive (single digits per annum) after a strong increase in the stock price this year of approximately 34%.
Recently, we added another company to our portfolio. We are excited about this opportunity as this company is a leader in its industry with many competitive strengths, has solid owner-oriented management team (CEO and CFO were the co-founders 20 years ago), and has very attractive valuations where we expect it to return 15-25% annualized for the next 5-10 years. Their stock has gotten battered last year due to some investor concerns about current headwinds that are short-term in nature. We are looking past the short-term noise and focusing on the long term value of this business. We believe Mr. Market is offering us $1 worth of value for 50 cents at today’s stock price, and we are happy to take advantage of it.
The Importance of Margin of Safety
“If you were to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” —Benjamin Graham
One of our guiding principles is: “always demand a margin of safety.” Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also, to minimize the downside risk of an investment. In simple terms, our goal is to buy a company worth $1 for 50 cents. Now, if things do not work out as planned, or we had made an error somewhere in our estimation of a company’s intrinsic value, and our company ends up only being worth 60 cents, we will be protected from permanent loss of capital, which we view as the main risk in investing, by paying only 50 cents. If our estimation of a company’s intrinsic value ends up being on the right side, we will get an extra bonus when the market eventually revalues the long term prospects of a company and its price is brought back closer to its fair value (as depicted in the chart above). The main part of our long term returns are, of course, expected to come from increases in intrinsic values of the companies that we own.
Now, let’s take a look at what can potentially happen to long term investment returns in the absence of margin of safety. Back in 1999, the top 30 U.S. based stocks ranked by market value were the engine of the entire market, whose earnings growth far exceeded that of the rest of the economy. The top 30 comprised of the world’s leading companies including Microsoft, General Electric, Intel, Wal-Mart, Cisco Systems, Merck, IBM, Pfizer and Coca-Cola. The average projected earnings growth rate of the Top 30 was 16.5% per year at the time (more than twice the estimated growth for the rest of the S&P 500 index). It has been our experience that the vast majority of market participants often “drive looking in the rear view mirror”, and future growth can often be overestimated, especially if the average earnings growth in the previous 5 years was 21% for the same Top 30 companies. When expectations for future growth are elevated, so are the prices that you would pay for these companies. The chart below summarizes what happened to the Top 10 (best sample of the Top 30) over the course of the next 16 years.
What’s truly shocking about the chart above is that the majority of the Top 10 companies had a negative cumulative 16 year return. Now, let’s see what happened to the actual earnings growth in comparison to what was estimated in 1999. As you can see above, none of the companies came close to meeting the growth projections. However, majority of these, with the exception of General Electric, Intel and Merck grew earnings at higher rates than the S&P 500, some substantially higher. So why did they experience such horrible returns over such a long stretch of time? The answer is the “foolish” valuations that investors were willing to pay for these companies back in 1999. The above chart shows you the price-to-earnings (P/E) multiples paid in 1999 in comparison to what multiples investors are willing to pay for the same companies today. Microsoft is a great example of the point we are trying to make. If you bought MSFT back in 1999 and held it until now, you would have realized a negative 18% return (market had produced a positive 41% return over same time period). Now, Microsoft as a company produced a very respectable 10.8% annualized earnings growth since 1999. But paying 80 times earnings for its stock in 1999 was imprudent and stacked the odds of success heavily against you (I know of some tech stocks that are the engines of today’s market that are trading at similar valuation multiples; they too have very high earnings growth expectations attached to them). The moral of the story is: we believe that having the discipline to always demand a margin of safety from investments, stacks the odds of success in our favor and protects us from the risk of permanently impairing our capital.
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We are grateful for our long-term partners who share our conviction. Our band of partners grew further in 2016, with our assets under management increasing 56% as of this writing. We look forward finding attractive investment opportunities for the cash that we have been entrusted with. Should you have any questions or comments, we would be very happy to hear from you.
Best regards,
Alex and Joe