Due to popular demand (yes, we did have requests!) we include below the annual letter to clients for 2009. As always, please let us know if you have any questions or require further details.
1 Summary
Our gain in net worth during 2009 was 33.27% in USD terms. The S&P 500 gained 16.43% during the same period.
Our main performers were Chaoda Modern Agriculture and Burlington Northern Santa Fe. In the case of the latter, we had the pleasure of receiving a buy out bid from Mr. Warren Buffett, which was almost twice our purchasing price. This is as satisfying as life can get for any value investor who has the pleasure of kicking money around. Our worst performer by far was Kraft Foods, whose price has been effectively flat since purchase earlier in the year (we have received zero capital gains so far, but have received a dividend yield close to 4.3%). We believe this is primarily due to its headline hitting bid for Cadbury’s (we feel their is a higher probability it will proceed than not). Meanwhile, we remain happy shareholders of the stock and are not at the slightest concerned with its volatilty and relative poor performance in the short term. Indeed, we have been buyers of the stock on several occasions as the stock has suffered, and would continue to be should even better pricing become available.
During 2009 we processed twenty one security transactions: eighteen purchases and three sells. At year end, we were owners of 11 separate securities (all common stock). We averaged less than 2 security transactions per month (many transactions involved buying more of a stock already owned): that’s the way we like it. We want to focus more time on researching many ideas to distil our best ideas, rather than trade our 45th best idea.
We would like to highlight that the above mentioned performance is likely be viewed as ridiculously good when placed into a historical context. Please note that since World War II, the S&P 500 has averaged a compounded per annum growth of a little over 7.5%. We cannot continuously out perform this index in such spectacular fashion, but you can bet your bottom dollar we will be trying year in, year out. Though we cannot guarantee performance, we can guarantee your experience will be the same as ours. Your author has a substantial amount of his net wealth involved in this investment strategy - we believe in eating our own cooking.
We believe our outperformance originated from aggressive buying of stock throughout the year, but more so in the first six months whilst most people were deeply worried about taking on risk. We felt that risk was actually considerably smaller during this period for the specific range of companies that have attributes that we specifically look for (please see section 3), than it has been over the last five years. This is because when placed in a historical context, risk premiums were very small over the last few years. This was most certainly not the case for most of 2009, hence we were net buyers (unlike 2006-2008 when we where 100% in cash, satisfying, but it didn’t win us many friends back then!).
2 How well did the strategy really do?
It was pleasing to see the fund almost double the performance of the S&P 500, which is not likely to happen many times in an investor’s career. However, let’s ask ourselves what the performance was relative to the following strategies:-
1. Buying the worst performers of 2008
2. Buying the best performers of 2008
The worst performing stocks of 2008 were not surprisingly financials. If you had bought the stocks of those companies that did not go bankrupt/disappear in 2008 (which were 5/15, please note PNC Financial Services purchased National City for about $5.2 billion in stock with funds from the U.S. Treasury in October 2008. The acquisition was described as a "take-under", meaning the purchase price was below National City's market value) you would have gained approximately 107% during 2009 (2 of the remaining 10 disappeared during 2009).
With this basic information you may ask yourself, why bother with paying people to look after your monies? Simply buy the companies that did badly last year, and this year they seem likely to do better! There seems to be a mean reversion character to the markets that any astute person should be able to take advantage of. May I take this opportunity to include a word of caution, and compare our personal investment style to this rather crude, but what seems to be, non trivial method.
Note that many of the stocks included in this list had fallen more than 90% at one point in 2009. One questions whether many investors of this strategy would have had the "stomach" to hold on. Furthermore, such volatility is to be expected from highly leveraged companies, which financial institutions often are. We view companies as leveraged when they have a debt load that is greater than 70% of shareholder equity. Many of the companies/financial institutions in the worst performing stocks of 2008 had outstanding debt greater than thirty times their shareholder equity! We must note that this debt is senior to stock, which means the shareholders would be the last investor to get paid should the company not be able to fund its debt through cash flow generation, and be forced to meet payments via a forced liquidation. Many of these companies, in our opinion, had a liquidation value less than there financial debt outstanding. This means there isn’t enough money to pay back in entirety the senior debt holders, so you can be sure the shareholders will get nothing in such a scenario! We, as investors, don’t like to be last in the queue when it’s close to closing time. There is a real risk of suffering a permanent loss of capital, which we find totally unacceptable. When something goes to zero, it does not matter how "cheap" you bought it – you lose all your money! Of the list included only one stock caught our attention: E W Scripps, a diversified media company with interests in newspaper publishing and television. This company had virtually no net debt and was trading at a fraction of its book value. It was an interesting balance sheet play and not surprisingly, it was the second best performer on the list.
With regards to the best performing stocks of 2008, as you can see below, the majority were acquired. If we look at the companies still trading in the public markets at 2009 year end (eight), than holding that portfolio of stocks would have performed approx. 4.81%.
On this occasion, we can see the performance of the 2008 worst performing stocks was considerably better than our own performance. Whilst our performance was considerably better than last years winners. We are happy with this scenario. Should one or two more of the worst performing stocks have gone bankrupt (which was very possible without state support), the performance of that basket would have been awful. This element of good/bad results changing drastically dependent on factors we cannot estimate to any great degree of confidence, and resulting in a permanent loss of capital (you can hold the stock to infinity, but you will still receive zero return!) we do not want to be involved with. As a result, we primarily invest in companies with low debt, which meet our quality conditions and are available at prices below our estimate of their objective value. We therefore aim to get a return that is consistently higher than yesterday’s leaders, and on average greater than yesterday’s worst performers. We feel we can achieve this by reducing considerably our possibility of suffering a permanent loss of capital.
As a final note with regards to our performance this year, we feel much of the gains are illusionary - stolen from the future to look good today. The market, in our opinion, seems to be currently distorted by the impact of governments and central banks. There is no doubt this distortion can create a new reality, which will mean current pricing may become "accurate". However, we don’t feel this is probable. In our opinion the major market index is not fairly valued anymore due to this influence, and as a result we are now finding it more difficult to add equity and bond positions. We are therefore likely to accumulate a greater cash position during 2010 unless market prices fall. Indeed, we would not be surprised if many of the companies we currently own will be priced lower at the end of 2010 than they were at the end of 2009. Here’s to dividends!
3 The Objective of the Investment Strategy
The primary objective of the strategy is to ensure that the purchasing power of its participants is increasing faster than the cost of living, i.e. what is often labelled inflation. True inflation is often significantly larger than what official statistical indicators suggest, as any individual already knows from experience. We aim to achieve this by applying two principal concepts:-
Have a base case scenario on how the value of money will evolve over the next five – seven years. All financial assets are measured in currency, hence understanding how the value of money will evolve is critical to appreciating how financial securities will be priced. This means understanding the conditions that are currently developing and how these fare for cash, bonds, equities, commodities and property assets.
Distinguish between the price and value of a financial asset. We remain primarily focused on purchasing the securities of companies that have:-
1. Dominant market position in their particular sector
2. Large barriers of entry
3. Strong balance sheets (little leverage)
4. Respectable returns on capital
5. Leading margins in their sector
6. Available at a large margin less than our estimated objective value
Though we appreciate our requirements seem demanding, and the difference between price and intrinsic value is not easy to calculate, opportunities do exist and particularly so within certain sectors at any one point in time. Furthermore, our results are likely to be more fruitful if we stay within certain fields where our methods are likely to be more accurate. We therefore rarely stray from these areas. It is for that reason we did not invest in financials or insurance companies during the last few years, though they were branded as being cheap.
For example, one investment strategy involves buying the stock of a company whose physical assets are worth more than the market price of the stock. This may seem ridiculous, but I can assure you it happens more often than you care to believe. Take for example Kingfisher, a well known DIY retailer primarily based in the UK. This company saw its stock value drop from a high just shy of 3 GBP, to a low of 1 GBP due to its exposure to the UK (and to a lesser extent European) housing market. Buying stock at 1.20GBP ensured you were buying the entire company for approx. 70% of its recorded property purchases (including deductions from depreciation)! Similar strategies were used for the purchase of Steinway’s Musical Instruments, whose price for a number of months was quoted at a ridiculous price relative to its balance sheet value.
4 Errors with hindsight
We include this section to balance all the great praise we give ourselves with an open discourse on some of our errors. We do this for a learning exercise, so we make sure we don’t do the same mistakes (yes, it was more than one!) again. The biggest whopper was that we should have invested even more when the bells were ringing at the start of 2009. But like everyone else, I was also scared I might be wrong. Career risk is behind everyone’s mind making them behave more like their peers so one does not stand out in case things go wrong. However, if more people agree with you, it does not make you more right. Interpreting facts correctly is what makes you more likely to be right. Nothing is for sure in this world - I tried to react assessing the probabilities of success: Conclusion: I undervalued them. Unfortunately, you will see me copy and paste this entry many times in the future. I will generally tend to under value than over value any asset to introduce a “margin of safety” that reduces the possibility of a permanent capital loss.
5 Macro factors
Our investment approach is not based on our beliefs on macro effects in a symmetric manner. We only apply them to our investment decision making process if they indicate a negative environment. They therefore play an important role in helping us appreciate how the different asset classes may perform relative to each other.
In summary, our principal macro thoughts are the following:-
Saving rates will increase in developed economies as asset price inflation will not be relied upon as heavily as it has in the past for wealth accumulation. This will come at the cost of reduced consumer spending. Greater uncertainty for job security and large debt positions will also act as catalysts to save. We feel asset price inflation has simply played too strong a role in GDP growth for developed economies for too long. This has stimulated large consumer spending due to the feeling of being wealthy in financial and property assets. The important fuel that was ever increasing bank debt has been firmly shut off for now due to careless lending leading to fears of capital inadequacy within the banking sector. This decreasing volume of debt is not supportive for asset prices. Hence the huge government support increasing the money supply and reducing the cost of money. Such an increase in currency will likely lead to a reduction in that currencies value in the future, a symptom of inflation. However, it is important to continuously follow different variables to see how the situation is evolving. In particular how:-
1. The velocity of that currency is evolving
2. How money with zero maturity (MZM) is evolving
3. Who is receiving the money being created i.e. how the transmission network for the financial system is working
4. Default rates for prime mortgages, also considering the distortionary affects of mortgage modifications
The government cannot support the economy in the manner it has in the last 12 months indefinitely. The question is how will it support itself when the drugs run out. We feel the debt that existed previously is still mainly there, acting as a weight to the economy, which implies growth rates cannot be strong. In this sense, we feel a strong affiliation with the PIMCO view of the world endorsed by Bill Gross – a new normal with weak growth for a number of years. As a result, we are even more pessimistic than usual when looking at the growth potential of franchises we may be interested in owning.
We thank you for your continued confidence in us.
Yours sincerely,
Alessandro Sajwani
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