2015 Annual Letter

A good marketing pitch book for an investment fund will have a clearly defined investment strategy.  Some sort of track record illustrating how this specific strategy has performed well in the past will also be front and center.  It might be growth, value, distressed, quantitative or some other variation.  However, the message is clear to current and prospective investors: this investment fund knows what it is doing and this strategy works.   

An oft-repeated line by Munger is “Tell me where I am going to die, so I won’t go there.”

Although this principle lacks the marketing glitz for a pitch book, it serves as a basic principle that supports an investment philosophy centered on not losing money.  In other words, I find it far easier to know what not to do.  A few examples from 2015 are in order.

Oil: The dramatic decline in the oil prices has lead a large number of investors into the field since the fall of 2014.  Oil is commodity.  Plain and simple.  99% of business dealing directly with oil (drilling, services, equipment providers, etc.) will do great when prices are high and poor when prices are low.  The timeline for investors in this space will go something like this: first wave of dip buyers will get smoked.  The second wave will calculate some detailed cost of production figure and get smoked.  The third wave will put forth elaborate supply and demand charts and get smoked; and the fourth wave will be just late enough to the party and buy as the price of oil heads north.  This fourth wave will garner accolades and most likely significant assets under management in the aftermath of their success.  Good luck repeating that process.  I am completely unclear in what wave we are currently, but I will avoid all four…

Cloning: The rise of cloning, copying another fund’s investment ideas, may or may not be a new thing.  I haven’t studied it, but it is pervasive now.  Ideas that have shaky valuations or suspicious growth stories are piled into based on the idea that X, Y, or Z investor has done their homework.  One fund with a roughly 25% position in a stock had a full-time employee specific to one company.  This fund was once endorsed by Buffett, how could this investment turn out badly?  I will save you the gruesome details, but it did.  2015 was a bad year for cloning.  2016 may be better, who knows, but it is certainly not an investment strategy.  Do your own work.

Value to Customer: Numerous businesses provide very little value to their customers.  Yet, these companies make a lot of money.  In the short run, their stock prices will reflect the profit they are currently making, but over the long run I am skeptical that this value will last.  For-profit schools, payday lenders, multi-level marketing, pharma companies selling branded generic-equivalent drugs at many multiples of the generic prices:  All of these companies will show short-term profits without providing the long-term value to their customers that is necessary to reward shareholders.  The behavior among investors supporting these stocks represents a sort of musical chairs, in which most know that the music will stop, but hope to exit the stock before the game is up.  

Melting Ice-Cube: A melting ice cube company is attractive to value investors due to the significant among of cash flow being “thrown” off.  The idea is that if the market estimates the rate of melting at X, but the ice cube melts at a rate slower than X, there will be value in the stock.  It’s a slight variation on Buffett’s cigar butt.  What the company does with this cash flow is crucial to an investment in a melting ice cube.  Few, if any, management teams want to see their company melt away so they frequently throw the cash flow against the wall of growth ideas, hoping something will stick.  Timing is also crucial to this investment theory.  Similar to commodity investors, there will be many waves and the last wave may make some money…be sure you are in the last wave.  

Story Stocks: If the investment thesis is: The Next Chipotle™ or The Next Amazon™, then you should Run™.  Often, investors look for heuristic shortcuts to make an investment idea more understandable. Additionally, the allure of past 10 baggers brings out the gold-diggers in all of us.  Restaurant stocks claiming to be The Next Chipotle™ over the past two years have performed poorly.  In fact, some of the best performing “food” stocks of 2015 were McDonald’s, Domino’s and Starbucks.  

Real Estate Value: If I had a dime for each investment pitch whose valuation was buttressed by a company’s real estate….

In this situation, an investor typically admits that the underlying business is poor, but a diligent effort at real estate valuations somehow persuades the investor that value can somehow be “unlocked.”  More often, the investor’s money is locked up in a situation where the realization of this “value” is years away and between now and then, the bad business on top of the real estate loses a large portion of this value through its subpar operations.  Retail operations are particularly susceptible to this trap, although healthcare sometimes joins the party.

This ends the things to “avoid” portion of the letter.  I should probably stop here.

Although I would do well in marketing if I consistently articulated a clear and decisive strategy for investment philosophy, I find myself frequently returning to the idea that, “It Depends.”  The Great A&P was once targeted by Roosevelt for antitrust concerns, but many of you have never been or even seen an A&P, myself included.  Just as in business, investment opportunities will change over time.  Buying high-quality businesses in 2009 was a slam-dunk.  Buying those same business in 2015 probably has you staring at 20-30% losses.  You could buy Costco, a truly great business, today at 30x earnings and about 18x cash flow.  These valuation numbers are some of the highest in Costco’s history.  It has worked out well for past investors, but I hesitate to run head long into a great business trading at such a hefty valuation.  Costco is only one example of great businesses selling at unattractive prices.

The alternative at this time is to hold cash and to pick your spots along the way.  Patience is one of the hardest and most structurally difficult aspects for an investment fund.  The more outside money an investor has on hand, the more “push” there is to justify his purpose.  After all, a mattress could at times replicate my job.

My biggest concern with holding significant amounts of cash is a longing for a time when valuations were extraordinarily cheap, which may prevent me from buying companies, even at fair prices.  This sort of fear may achieve the primary goal of “not losing money” at the expense of investment opportunities that are well within my wheelhouse.  Within the past two months we have picked up 4 investments that, although are not 2008/2009 cheap, are within my framework for great businesses at fair prices.  A lack of immediate growth in these companies future has led their valuations to look like a bond type investment.  Significant cash flows, no net debt*, strong competitive positions and potential for future opportunities provide me with comfort that even in a market downturn these companies will not only strengthen their competitive position but add shareholder value through smart capital allocation.

For regulatory reasons, I cannot post the full letter on a public website, however, I am happy to send to you upon request.  The only addition to the full letter is my performance results.  Just send me an email at matt@thesovagroup.com.

 

 

*One of the four has a small amount of debt secured by a portion of its real estate.

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