Napoleon’s definition of military genius:
“The man who can do the average thing when all those around him are going crazy.”
With investing it is no different.
Dear Partners,
During the second quarter, the U.S. stock market continued its sideways movement, interrupted occasionally by sharp, temporary dips like the one after the Brexit vote. In fact, the Brexit scare was so short in duration (only two trading days) that by the time we had prepared a brief letter to partners describing the situation, it was no longer relevant as the market had already bounced back. Nevertheless, we would still like to share some of the content of that letter here in order to give you an idea of how we approach these type of situations.
BREXIT
As you may have read in newspapers or heard in the news, financial markets were rattled on Friday (6/24) and Monday (6/27) after the Brexit shock. On Friday, June 24th, following the news, Asian markets reacted with Nikkei closing down 7.9%, then European markets opened up with FTSE tanking over 8%, but quickly recovering and closing down only 3.15%. The U.S. markets followed, with Dow Jones closing down 610 point (3.4%) and S&P 500 closing down 3.6% at 2037. Immediately, we heard financial media pundits calling those two days a “bloodbath”, even though S&P 500 closed at the same level where it was only in May of 2016 (just one month back).
All of this action was positive news for us. If you refer back to Q2 2015 Letter to Partners, we had a section “Plenty of Ammunition for the hunting season” where we stated the following:
“We would like to remind our investors that fear, pessimism and falling stock prices could be perceived as a negative by most, but in fact, it’s our dear friend as we are trying to build a portfolio that will compound capital at attractive rates of return over the long run.”
“We are certain that as volatility picks up, more attractive opportunities will come our way and we will have plenty of cash to take advantage of them. As Warren Buffett pointed out in his 1987 shareholder letter "Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun." Well, ladies and gentlemen, our gun is loaded and as new partners come on board and add to our “ammunition levels”, we should be ready for the hunting season!”
We have been really patient, and before the market opened on Friday (6/24), our “loaded gun” had around 60% in cash. Fear and volatility was back in the marketplace, and we had short window of opportunity to deploy some of that cash we had been holding into our best ideas. Again, we were as excited (for those two days) as we have been since we started the fund in March of 2015, and you, as a long term investor in the fund, should welcome these lower prices as means of adding to our top ideas at prices that are likely to produce some very attractive long term compounded returns. We believe we may get a lot more of these opportunities over the next 6 months.
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We would like to re-emphasize our long term vision for our fund in this letter, especially given a few new partners that have entered the fund this year. In our very first letter last year we wrote:
“Our vision is to build something special at Rowan Street Capital, LLC where our partners can visualize themselves as part owners of a business they expect to stay with for a long time, just like they would if they owned a rental property or a farm in partnership with members of their family. The goal is to build a portfolio of great companies that will compound our partners’ family wealth at double digit rates of return over a long-term holding period.”
Even though investment possibilities are both many and varied, there are three basic choices available for investors:
Throw your lifetime savings under a “big old” mattress – this option has been strongly considered by many over the past couple of years. Although, this may help you sleep better in the short run, it will probably start burning a hole in your mattress over time. It takes no less than $2.20 today to buy what $1 bought you 30 years ago. Inflation rates maybe low today, but over time inflation “eats away” on average 2.5 - 3% of your savings.
You invest your money in bonds. 10 Year Treasury bonds currently yield 1.5%, and that is the return you can expect if you hold them to maturity. Subtract a long term inflation rate of 3%, and you will realize a negative return of 1.5% per year from this investment. You can take a bit more credit risk by buying 10 Year AA Corporate bonds, which currently yield around 2.4%, which doesn’t even cover the long term rate of inflation.
You can invest your savings in a general stock market. Characterized by the S&P 500 Index, the market closed at 2,168 as we are writing this letter. Although, this level is little changed from 2,107 when we wrote our first letter in April of 2015, by our estimation the market will likely return on average 5% over the next 10 years. After inflation, this should leave you with a miserly 2% annualized real return.
So there you have it, ladies and gentleman. The options we presented above may have you torn between a negative 3% and a positive 2% annualized real returns (please resist the urge to throw a lavish party).
So, the natural question to ask – what do we do from here? There seems to be a real disconnect between our long term goal of double digit-returns and what the investment options we have just presented to you.
Our answer and investment strategy is still very much the same as when we first started the fund. We will continue investing in a concentrated portfolio of carefully chosen, under-valued companies. We like buying a dollar of value for 50 cents where we can find it – but never at the expense of quality. We also prefer "operating assets", which generate cash and will do so in the future, rather than "dead assets" reliant on the price someone else may pay. Moreover, our bottom-up research process and multi-year time horizon provide the fortitude to stay with our convictions, even in periods of volatility. We believe this approach to investing should allow us to capitalize on opportunities and achieve significantly more attractive long term returns than the ones presented above.
Performance and The Present Portfolio
As we are writing this letter, the portfolio performance presented above (as of 6/30/16) is no longer relevant. The decline during the month of June was due to the Brexit situation that we described earlier in the letter. In particular, the two largest positions in our portfolio took a hit due to the market volatility at the end of June, but have recovered as soon as July started. In fact, we had taken advantage of the volatility and the decline in stock prices of our two best ideas and added to those positions at the end of June. Due to July’s rebound in stock prices, our portfolio performance is currently positive for the year as well as since inception.
Important note of evaluating performance: While we much prefer a five-year test, we feel three years is an absolute minimum for judging our performance. It’s a certainty that we will have some years when our fund’s performance is poorer than the S&P 500. The three years or longer period is the true test of our abilities and our long term investment strategy. The exception to the latter statement would be three years covering a speculative explosion in a bull market.
Our portfolio is currently invested in 8 companies and 2 work-out situations (described below), with 55% of portfolio still parked on the sidelines waiting for appropriate investment opportunities. At the end of 2015, we found 2 attractive ideas and have taken our time to study them thoroughly to understand their economics and evaluate their long term prospects. In 2016, Mr. Market has presented us with an opportunity to purchase their stocks at 50 cents on the dollar by our estimates. We had been gradually building our positions since the start of the year, and after recent volatility raised our position in these two companies to 20% of our portfolio.
Work-Out Situations (Merger Arbitrage)
A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.
Due to our current large cash position in the fund, we are looking to generate a yield on our cash to enhance the overall portfolio returns and at least partially insulate our investments from the behavior of the general stock market. Generally, we are looking to invest in an acquisition target with a cash offer price on the table, and a high probability of a deal going through over the next 12 months. We are also targeting those opportunities where the spread between the current market price and the cash offer is above 20% on an annualized basis.
So far in 2016, we have invested in three such merger arbitrage deals. One of those deals had already worked out – we invested in Cablevision CVC (acquisition target) at the beginning of the year and realized a 5.9% return with the deal closing only two months after our investment. We are currently invested in two other such deals, which are expected to close by the end of 2016. Our goal is to build a merger arbitrage portfolio of about 5-6 such deals that would make up about 20-25% of the overall fund. This policy should yield a superior return in the bear markets and average returns in bull markets.
Should you have any questions or we have not been clear in any respect, we would be happy to hear from you.
Best regards,
Alex and Joe