Dear Partners,
2016 was definitely an interesting year to say the least. So much unexpected change took place at an unprecedented pace. Who could have predicted Brexit, Italy’s constitutional reform, and Trump’s nomination and presidential victory? Financial markets, as always, discount such geopolitical news with ferocious speed. 2016 was the year that interest rates bottomed as the 10-year U.S. Treasury fell to just 1.36%, corporate earnings bottomed after a five-month recession, and oil bottomed after OPEC reversed its two-year strategy of flooding an already oversupplied oil market, breathing life back into a heavily depressed non-OPEC E&P industry and heavily depressed OPEC fiscal budgets.
Despite maintaining a heavy cash position (over 60%) throughout most of the year, we were able to generate a 10.7% gross return in 2016. Please refer to the table below for our performance since inception:
Due to a number of new investors in the fund, we would like to share a paragraph from our Q3 2015 letter, which gives you an understanding of our fund expenses:
“Let me explain what the fund expenses are. These include our start-up costs, amortized over 5 years for accounting purposes, a fund administration fee, an audit fee, as well as tax and financial statement preparation fees. We should emphasize that our start-up costs and our operational costs are incredibly low by industry standards. By our estimates they are probably, at most, 1/3 of the general operating costs of a comparable fund. We were able to achieve these low costs thanks to Joe Mass and his other company, Synergy Financial Management (SFM), which is a Registered Investment Advisor (RIA) based in Seattle, WA that is overseeing Rowan Street Capital, LLC for compliance purposes and provides us with various financial subscriptions necessary for our research. Although there are many synergies between our fund and Synergetic Finance, there are fund expenses that we must still pay for and even though they are relatively small, they do have an effect on our fund performance (net), since our fund is very new and still relatively small in size. As our fund grows, these expenses will be very immaterial and will not have much effect on our investment performance.”
We are happy to report that since then we have made significant progress in raising our fund’s capital by 360%, therefore, making our fund expenses significantly cheaper in relation to the overall partners’ capital. We are very grateful to our partners for referring new investors to us, and are in the process of signing new partners (we expect to grow our capital by about 50% in Q1 2017). This is great news for everybody, as our overhead (fund expenses) is expected to remain roughly the same going forward, but as the fund grows, they become smaller and smaller in percentage terms for all our partners.
Cash Position
The chart below depicts our average cash position as a percentage of overall portfolio since we started in March of 2015.
Our goal is to compound partners’ capital at double-digit annual returns over a long term investment horizon. In doing so, we place a very strong emphasis on preservation of capital. The rationale behind maintaining such a heavy position was simple - we were not finding many attractive opportunities that met our investment criteria while providing the margin of safety we require. We did find a few, and have done very well on those investments so far, but the overwhelming cash position was a big drag on our performance in 2016. If you look at the chart above, you will notice a dramatic decrease in our cash position in December (we are currently fully invested). This came about purely from bottom up, as we found an overwhelming amount of attractive investment ideas in November (after a big “draught”, it all came at once as it usually does). In fact, we were so busy researching our newly found ideas and putting your capital to work the last two months of the year, that we almost missed Thanksgiving and Christmas (our families were beginning for forget what we look like).
The Next Five Years for Rowan Street Capital
Our current portfolio boasts substantial upside potential over the next 3-5 years. Given the opportunities that Mr. Market had presented us with late in 2016, we were able to put together a portfolio of 10 solid companies with favorable long-term prospects selling at very low valuations in relation to their intrinsic values. In fact, we estimate that our portfolio of companies should be able to compound capital at double digit annual returns over the next 5 years.
This is our threshold whenever we consider an investment opportunity. No matter how good the company is and how “sexy” its future prospects may sound, unless we can purchase at an attractive enough price that offers us an opportunity to compound at double-digit returns over a 5 year holding period, it does not make it to our portfolio. Such a high threshold sometimes makes it a challenge to deploy capital, as was the case in 2015, when we were not finding many opportunities that offered us a high probability of such returns. However, we believe that it’s extremely important to not relax our investment principles during times like these and exercise a lot of patience. The beauty of the public markets is if we are patient, there is a good chance that the volatility of the marketplace will give us a chance to own companies on our watch-list at prices that offer us a high probability of reaching our goal of double-digit returns over a long term holding period.
The Next Five Years for the US Stock Market
We are much less optimistic about the performance prospects of the US stock market over the next 5 years. Despite the prevailing consensus, we think it’s highly improbable that the S&P 500 will see its string of double-digit annual gains continue over next five years.
As you know, your investment return comprises of 3 components (1) future earnings growth (2) earnings multiple expansion/contraction (3) dividend yield. Current market P/E multiple based on expected 2016 earnings is 21x (long term historic average has been 16x). In order for the S&P 500 Index to produce double-digit investment returns over the next 5 years, either its underlying earnings have to grow at double-digit rates or the multiple has to expand.
Let’s take a look at a few possible scenarios:
(1) Market as usual scenario
Historically S&P 500 earnings have grown at 6.7% over the long run. We believe its unlikely that they will grow at a rate substantially above that, especially following an 8-year economic expansion is unlikely. So let’s assume that earnings will grow at historical rate of 6.7% (4% GDP growth + 2.7% inflation rate), and that the multiple will stay the same at 21x. In this case, your investment return will be 6.7% + 2% dividend yield, which equals to 8.7% per annum. Not bad as it pretty much equates to returns that have been produced by the market over the long run.
(2) The highest probability scenario
Market multiples are a function of expected future earnings growth. If the expectations are high and the market participants are full of optimism, they will place a high earnings multiple on a future earnings; conversely, pessimistic expectations produce low earnings multiples. Over the past 20 years, S&P 500 trailing earnings multiples have ranged from a high of 31x (during the 1999-2000 dot-com bubble – you know what happened after that), and as low as 10.5x (at the height of the financial crisis in 2008-2009 – you know the returns that the market had produced following that). Let’s assume that the market multiple contracts to the historical average of 16x from current 21x. If this happens, it will result in a negative 5.3% ‘hit’ per annum to the S&P investment returns. Let’s do the math: 6.7% earnings growth minus (-) 5.3% multiple contraction plus (+) 2% dividend yield (assuming this stays the same) = 3.4% annual return. Not exactly a number to uncork your favorite bottle of Champaign about.
(3) Low probability scenario
This would be an overly optimistic case where earnings would have an above average growth of 8% based on very strong GDP growth and decent inflation, and a market multiple expansion to 25x, which would move the valuations into a historical bubble territory. In this case, market return over the next 5 years would be 8% earnings growth + 3.5% multiple expansion + 2% dividend yield = 13.5% per annum. This would approximate the returns that S&P 500 has produced over the last 5 years (14% to be exact), but we would not “place our chips” on this scenario. Back then, companies were coming off of trough recessionary earnings and the expectations were very pessimistic as the market multiple at the time was 12-13x. We are in a very different place today.
PRA Group
One of the most significant contributors to Rowan Street performance during 2016 was PRA Group (PRAA). We started researching this business back in 2015, but only started accumulating shares in the first quarter of 2016 as we thought that Mr. Market finally offered us a very attractive price substantially below the intrinsic value of this company. In fact, the sentiment on the business was so negative that their stock dropped 40% in 2015 and another 25% early in 2016. At the time, PRAA traded at such low valuations that it offered us a 25-30% annual compounded returns over the following 5 years (nobody was interested), and it quickly became our largest position in the fund. Only 10 months later, the stock has recovered substantially and currently trades at $38.40, 46% above our average cost basis of $26. This increase in stock price, of course, was not linear and incurred a significant amount of short-term volatility, which required a lot of patience and conviction to stick with our position. In fact, this investment is a great example of our investment approach – we buy significantly undervalued solid businesses at a time of maximum point of pessimism, and hold on to them throughout all the pessimism and volatility, sticking to our convictions, which can be a difficult psychological endeavor because that involves ignoring the consensus view and “conventional wisdom” and going against the grain.
A little background on the company. PRA Group was formed as Portfolio Recovery Associates, LLC on March 20, 1996 in Virginia Beach, Va. Co-founders Fredrickson and Stevenson created the company to address the lack of professional businesses in the debt recovery market. Their goal was to build an ethical company focused on treating customers with respect and fairness, interacting with clients and banks with the highest degree of operating expertise, compliance and reliability, and creating meaningful and rewarding careers for employees. The company went public on November 8, 2002 as Portfolio Recovery Associates, Inc. and changed its name to PRA Group in October 2014. Over the past 20 years PRA has grown to become one of the largest debt buyers in the world, with 3,800 employees in 10 countries throughout the Americas and Europe. In 2015, the company recorded cash collections of $1.54 billion, total revenues of $942 million and net income of $168 million, with $5.1 billion in future estimated remaining collections.
We believe PRA Group has favorable long term prospects to grow their earnings at approximately 15% per year and, although not as attractive valuation-wise as in early 2016, still offers us an opportunity to produce double-digit returns over the next 5 years.
Quarterly Reporting
Going forward we are shifting reporting (account statements) that you receive from our fund administrator (HC Global) from monthly to a quarterly basis. This is an industry standard employed by most comparable funds, and we are implementing this in order to reduce expenses incurred by having to report 12 times per year. We believe quarterly reporting will also have an added benefit of focusing our investors’ attention on the longer term results.
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We are honored to be partners with such a great group and appreciate your continued trust and capital commitments. As always, we encourage you to refer new investors to join our expanding band of like-minded partners in our quest to compound capital at double-digit annual returns over a long term investment horizon. We look forward to reporting to you again in the coming year.
Sincerely,
Alex and Joe