August 8, 2017
Dear Partners,
The table below summarizes the Partnership’s historical performance since our inception:
Rowan Street Capital Gross return for the first half of 2017 was 11.3% compared to the S&P 500 total return of 9.3%. Since inception in March of 2015, the fund has gained 23.6% (Gross) compared to the S&P gain of 21.1%. In our 2016 year end letter, we had explained what the fund expenses are and the effect they had on the fund performance (Net) as we first started out and were relatively small in size. We had also explained that as our fund grows, these expenses will be immaterial and will not have much effect on our investment performance. Well, we are very happy to report that our fund grew significantly in 2017, and from this point on our fund expenses will be multiples cheaper (in relation to overall partner’s capital) than they were in 2016 and in first half of 2017 - great news for everybody!
As the number of partners continues to grow, we feel it is necessary to reiterate the important distinction between the short-term and the long-term in the context of performance assessment.
While the initial impulse may be to focus on the First Half figure, a six-month number deserves only scant attention in the course of performance evaluation. Such figure – good or bad – generally reflects random price fluctuations, rather than skill of assessing the fundamentals of the underlying businesses. This emphasis on the accidental, rather than on the tangible, renders a six-month figure virtually meaningless when it comes to forming expectations regarding future long-term performance.
In contrast, the Since Inception number is a much more meaningful metric, and will become even more meaningful as time goes on and RSC becomes more mature. Keep in mind that we have only been around for 28 months, and the investment horizon for our investments is at least 3-5 years. This long-term Since Inception figure reveals whether our appraisals of business fundamentals have been accurate and whether we have had the discipline to purchase these businesses at sensible prices. Identifying the securities selection ability (or lack thereof) makes the long-term performance a useful guide for assessing the future performance outlook.
We are pleased to report that our fund has outperformed the market by 2.5% (Gross) since we started. What’s even more notable is that we have been able to do that despite holding on average 70% cash in a rapidly rising market and despite not owning any of the high-flying FAAMG (acronym used for Facebook, Apple, Amazon, Microsoft and Google) stocks that currently represent 13% of the S&P 500 Index and have been responsible for 40% of the S&P performance this year. Although we have done well relative to the market since our fund started, we are not about chasing returns and will not attempt to keep up with raging bull markets for the sake of impressing you with short term results – we will let others on Wall Street to play that game. However, we expect to protect your capital much more in the down markets, thus seeking to achieve solid long term compounding over a full market cycle. If there is a correction in the FAAMG stocks over the next 12-18 months, we expect to fair very well considering the attractive valuations for the stocks in our portfolio.
PORTFOLIO COMMENTARY:
Our portfolio currently holds 10 high-quality businesses with unlevered balance-sheets acquired at what we believe are attractive valuations with expected double-digit returns over the next 5 years. So far in 2017, we added 3 new ideas to our portfolio that we believe ought to compound value for us at very attractive rates of return over the long-term horizon.
Revisiting our Rolls Royce (RYCEY) thesis
In the third quarter of 2015, we outlined our investment thesis for Rolls Royce in our quarterly letter. Our average cost basis on this position was $8.95 and we have owned it for about 22 months as of this letter. Our position has gained 37% so far as we are writing this letter, which is a very respectable return compared to the 26% gain for S&P 500 over the same time period. However, this gain has not come smoothly and required a lot of patience and conviction in our original investment thesis. Initially, the stock dropped 20% after its first earnings report following our purchase. Our deep research and the long term view that we take on companies that we invest in, gave us the confidence to add to our position at the time when the inherently impatient and short-term focused market was fleeing the stock in fear. Our position was still at a slight loss at the end of 2016, after 15 months of holding and occasionally adding to our position. This can be psychologically painful for most market participants as one might be inclined to conclude that their investment thesis is not working and tempted to buy what is currently working. It was Blaise Pascal who said:
“All of humanity’s problems come from man’s inability to sit in a room quietly along.”
This cannot be more true and applicable to investing. After a long stretch of underperformance and negative news, RYCEY is one of the best performers in our investment universe in 2017, gaining 49% since the beginning of the year, significantly outstripping the S&P gain of 11.8% over the same time period.
We find that our ideas require at least an 18-20 months holding period to start “showing fruits of our labor.” Think about it as planting a crop at the opportune time, cultivating it by deep research, allowing time to build our conviction, and then gathering the crops after about 20 months. By gathering, we do not mean selling and realizing gains, but seeing the real returns come in (we aim to hold our positions for at least 3-5 years). In the end, it is not how your stock has done this month or this quarter or even this year that matters, but how it has done over long stretches of time covering the entire market cycle (amazingly, the fast-money crowd prevailing in the marketplace today does not look at it this way).
The Podium of Errors
“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” —Charlie Munger
One of our founding principles is to always communicate with investors as candidly as possible. It is with constructive attitude, in order to always improve as investors, that we provide analysis of some “painful” errors that we had made and learned from. In this case, both errors that we are about to present are not in the purchasing, but in not holding on to our investments longer, exercising more patience.
Priceline Group (PCLN)
Priceline is a textbook example of a company benefiting from the network effect, meaning the business grows stronger as it gains size. Hotel operators and other service providers want to go with an online travel platform offering access to a big amount of potential customers, and more travel options are also a major advantage for travelers. This means travelers and industry operators attract each other to the platform, and the service becomes more valuable to both parties over time. The company makes most of its business via the agency business model, meaning the company earns a commission on every transaction, as opposed to buying inventory from operators and then reselling it to travelers. This business model is enormously profitable and has low capital requirement needs, allowing Priceline to produce an operating margin of more than 35% of sales on an annual basis.
We began accumulating shares of Priceline back in the summer of 2015. At the time, PCLN stock had been languishing over the past year because of investors' concerns over a depreciating euro and its impact on Priceline's big European business. However, external conditions come and go, and our view was that Priceline is still a remarkably attractive business trading at an attractive valuation, so chances were, temporary weakness would turn out to be a buying opportunity for investors with a long term view. We opportunistically added to our position when the market tanked in the beginning of 2016 and then again following BREXIT in June 2016 when PCLN stock fell 11% in one day. In the two months following that, PCLN stock had quickly recovered gaining 20% over our cost basis, and we ended up selling our position after a 16 months holding period. Since our sale, the stock went on to gain another 30%. Our mistake was in letting the macro worries about the end of the economic cycle influence our investment decision. In this case, a longer-term holding period of 27 months would have produced a total gain of 53% (not bad). Huge lesson learned!
Bank of America (BAC)
Pretty much the same story happened with our BAC holding. We had owned the stock since mid-2015. It was stuck in the trading range of $14-17 for about two years prior with historically low interest rates impacting its earnings. The maximum point of pessimism happened early in 2016 when financial stocks were at the forefront of a heavy sell-off as persistent concerns about the health of the global economy, coupled with worries about the impact of negative interest rates, triggered a broad-based flight from risky assets. BAC stock hit a low of $11 in February of 2016, as we were adding to our position at the time when nobody wanted touch the stock. Next scare came in June of 2016, when global banks plummeted following the U.K. voters’ decision to leave the European Union. We used this as another opportunity to add to our position at 0.6x book value. A few months following that, BAC stock had recovered to $17 and we ended up selling our position just prior to the election with a gain of 20% after a 19 months holding period. This was probably our most painful mistake thus far, as the stock went on to gain close to 40% following the election (we could not let this one go for at least 3 months following that). Obviously, nobody could have predicted the meteoric rise in bank stocks immediately following the election, but had we exercised more patience, our buy and hold gain would have been 65% over a period of 27 months (nobody would complain about that). In this case again, the biggest payoff came following a 20 months holding period. Another huge lesson to learn from!
CLOSING
We would like to close this quarterly letter with a quote from a legendary investor Benjamin Graham:
“All the real money in investment will have to be made—as most of it has been in the past—not out of buying and selling but out of owning and holding securities, receiving interests and dividends therein, and benefiting from their long-term increases in value. Hence stockholder's major energies and wisdom as investors should be directed toward assuring themselves of the best operating results from their corporations. This in turn means assuring themselves of fully honest and competent managements.”
That is, in fact, what all of our energy is focused on at Rowan Street Capital.
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
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