2015 Annual Letter
Performance in 2015 fell below our targets. The stock market performed quite poorly, finishing the year close to where it started with a gain of 1.2%; most of you finished with returns of __%. In this report I will discuss in detail the performance of this year’s strong- and poor-performing portfolio companies within the context of the current state of the markets as well as of our broader investment strategy. Although returns this year fell below our expectations, we are nevertheless seeing positive signs and laying a good long-term foundation
Our Strategy
As I have maintained consistently, our strategy is to act like private market investors – find an excellent business and wait to invest until we see the potential for a 4x return over 10 years. I want to invest in a company that sells for half of what it’s worth but has strong business fundamentals: inherent competitive advantages, a growing market for its products, the right capital structure, and strong management. Of course, these kinds of opportunities don’t come around all too often, which is why you own a select number of stocks.
This past year I have done a great deal of analysis and sought out valuable advice from wise investors that I respect on the issue of investing defensively. The way to think about investing offensively vs. defensively is that if you’re invested offensively you hope and even over-rely on the market to go up, while if you’re invested defensively then a downward move in the market will provide you with great opportunities. Being defensive doesn’t mean that you won’t lose money, but it does mean that you will have the ability to sell more stable assets in order to buy beaten- down but intrinsically valuable ones at a good price.
I will use a couple of examples to illustrate how defensive investments protect against unfavorable business conditions.
Exxon Mobil is the biggest, best-managed, and most conservatively financed publicly traded oil company in the world. On the other hand the US frackers are small, generally debt-ridden, and risk bankruptcy if oil stays around these levels for a few more years. Exxon Mobil is a much more defensive selection than the US frackers, and it has greatly outperformed its more “offensive” peers in a tough market.
Berkshire Hathaway is widely diversified and sells mostly in developed, stable markets, while Colfax is much more concentrated and operates in much more cyclical end markets. A slowdown in the worldwide industrial economy has hurt both stocks this year, but Berkshire Hathaway, the more defensive selection, has held up far better.
This year, we have largely made defensive investments (you have only a very small investment in Colfax, the only investment that I would characterize as offensive).
Our two largest positions, Berkshire Hathaway and Exxon Mobil, are about as defensive as you can get, and we also carry a fairly large cash balance.
Playing defensively accomplishes two main things:
Blunts the effects of being wrong or early
Conserves capital
In last quarter’s report, I wrote about how I made the investment in Exxon Mobil too early and that we lost some potential returns as a result. However, imagining a counter-factual scenario can be illustrative for understanding the value of a defensive position: if we had made a sub-optimal offensive investment decision instead of a defensive one, results could have been much worse. Most of you are down around __% on your investment, but if we put it in MLPs or some of those small US drillers, we would have lost perhaps up to 80%. While our investment in Exxon Mobil should do well over time, if I would have put your money in an offensive investment, we very well could have had a permanent capital loss.
Playing defense also conserves capital for when great opportunities come – if some of those oil and gas companies that have gone down 80% are worth what they were two years ago, we could still sell our shares of Exxon Mobil, invest in shares in those companies, and make a total 350% gain (a __% loss followed by a 5x gain would get you to 350%). We may or may not get a chance to deploy some capital offensively in 2016. The key is to keep our options open, be patient, and have the capital available to deploy when necessary. As Charlie Munger has said “Successful investing requires this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself.” Right now we’re being patient, and we’ll have our opportunity – whether it is sooner or later – for the gumption.
The State of the Markets
The stock market as a whole is certainly not cheap, although if interest rates stay at current levels, then it isn’t expensive either – I would characterize the valuation of the market as generally reasonable, albeit maybe a little on the high side.
That said, there has been a wide divergence in the performance of industrial companies and consumer-oriented companies. A dramatic fall in prices for virtually all commodities is hurting industrial manufacturers particularly badly, but at the same time most developed countries’ economies have continued to do relatively well, which benefits consumers and companies whose products cater to them. Additionally, cheap commodity prices are further giving consumers a boost as their costs fall.
Overall, then, companies whose main customers are consumers are generally doing very well, while most companies related in any way to manufacturing or commodities are struggling. If you look at your portfolio, you will notice that most of your money is invested in industrial-leaning companies. The reason is that consumer-facing stocks are generally trading like the economy will always expand and gas will always cost $2 / gallon, while many industrial stocks are trading at a level that anticipates, too pessimistically, that the industrial economy will never recover. That presents us opportunities in select defensive situations like Berkshire Hathaway, Exxon Mobil, Norfolk Southern, and Transdigm, where an inevitable but perhaps gradual recovery in the industrial economy should allow us to reap great returns.
Business Performance
You can be the most patient investor in the world, but if the “conservative” stocks you pick turn out to be real losers then you can shoot yourself in the foot. Our businesses, however, performed well on aggregate, and in this section I’ll review the performance of each one.
Berkshire Hathaway and Exxon Mobil
Both companies had excellent years given the market conditions. While Berkshire Hathaway saw limited growth in its stock portfolio and industrial businesses, excellent results at the railroad and a couple of superb acquisitions probably pushed up the value close to 10% from one year ago. I quoted the value in the last annual report at around $150 / share, and it’s likely close to around $165 today.
Exxon Mobil really shot the lights out. It was one of only a couple of oil companies in the world that I am aware of having profitable upstream operations (exploring, drilling, and extracting hydrocarbons), while its downstream operations (refining oil and producing chemicals) also continue to be top notch. Furthermore, over the last year Exxon Mobil has thrived in an environment where small companies are scrambling to avoid bankruptcy and big companies are struggling to even fund their capital spending budgets. The company’s operational excellence provided cash for payouts to shareholders that yielded a healthy 5.6%, doing so while it continued to invest significant sums into its core business and keeping its debt levels low.
Norfolk Southern
Norfolk Southern (NS) had a tough year, with service problems and a commodity slowdown significantly reducing revenues and profits. I estimate NS’s value around $100-120, but it is currently being pursued by another railroad in a merger transaction. If the merger goes through at the current offer price, it could be worth ~$115 - 130 / share very soon. If it doesn’t go through, the stock price will almost certainly drop from its current level, perhaps towards somewhere into the $70s, although I still think it’s worth at least $100 / share in the longer-term. A merger would be a way for that value to be unlocked quickly, although the long-term success of our investment certainly doesn’t depend on it. The company’s assets are valuable, and it has tremendous earnings power, but its price performance over the short term will be determined by whether the takeover offer is accepted or rejected (potential merger announcements attract short-term traders who cause the stock price to fluctuate widely), so I will provide an update when we have some more clarity on that.
Transdigm
Transdigm, the airplane parts manufacturer, has performed extremely well this year. The company made multiple, very accretive acquisitions and also managed to grow its existing business significantly. If the acquisitions work out as well as I think they will (and Transdigm’s history has shown they should), the company is worth approximately 50% more than it was just one year ago.
Colfax
This has been the worst performer for us, although it is a very small position. In the context of the offensive / defensive framework, this is certainly an offensive investment, and that’s why we started off small – we can always buy into a bigger position if the price goes lower. Importantly, the low price is more of a result of weak end markets (i.e., the markets that Colfax’s customers play in) than competitive losses or mismanagement, meaning that both performance and the stock price should greatly improve when the industrial economy recovers.
Price Performance
As I mentioned at the start, we had a relatively poor year for price performance, both in absolute and relative terms. The biggest drags were from Berkshire Hathaway, down __%, and Exxon Mobil, down __%. That said, I would much rather have a decent gain in intrinsic value but a loss in stock market value than the reverse. The former certainly happened at Berkshire, and Exxon Mobil, too, will continue to create value for us irrespective of the price of oil, but we almost certainly won’t see that value reflected in the share price until the oil market as a whole meaningfully recovers – and it’s very uncertain how long that will take.
Norfolk Southern, Transdigm, and Colfax performed about how you would expect, given their business results. As I mentioned in the previous section, Norfolk Southern’s performance next year will largely depend on the results of the current merger proposal.
This group of businesses has certainly increased in value in 2015, and I expect the same thing in 2016. While stock prices will not reflect that value day by day, long- term returns will mirror gains in business value. For those reasons, I am pleased with our 2015 performance.
Conclusion
2015 was a challenging year, but the most important thing is that our big investments continued to build value. I expect steady growth for Berkshire Hathaway, Exxon Mobil, and Transdigm next year and in years to come. Norfolk Southern is something of a wild card, but even without a merger I expect better performance next year than we saw this year.
Many times, using a concentrated value strategy like we do can present volatile results, even if we’re predominantly investing defensively. Buying stocks that present good values for their price almost always entails buying shares in a business that has current problems. Our job as value investors is to determine if those are long-term, business-threatening problems or just a bump in the road. If they are indeed a bump in the road, then the low stock price that the problems inevitably create can be a tremendous opportunity for big gains if and when the problem is solved. Buying a few of these companies can mean low returns during this interim period, which is what happened for us in 2015.
Some investors don’t like periods of poor performance, so they’ll just buy shares in companies that are currently doing well with the expectation of continued good performance and higher stock prices. The problem with this approach is that they are usually paying full value or more, which simultaneously limits long-term returns and increases risk. These investors are buying $1 bills for $1.10 and hoping that someone will pay them $1.20. We’re trying to buy $1 for 50 cents. Short-term volatility will probably be a little higher, but the long-run upside is clear. We will not be fundamentally changing our strategy just because of one slow year.
As I outlined in my last quarterly report, the main lesson from 2015 was to have more patience and discipline. Over the past few years, I have continually increased the hurdle rate (or targeted return rate) for my investments – when I first started I would make an investment if I thought it would make us 10% returns; later, this increased to 12%, and now I have moved to 15%. I am seeing enough opportunities for 15% returns that it makes sense to be patient, invest defensively, hold cash, and wait for the big opportunities as opposed to making an investment every time I see that a merely mediocre company is slightly undervalued.
We will continue to invest defensively and wait for more of these “50 cents on the dollar” opportunities. I am continuously learning about new companies and evolving industry dynamics, expanding my horizons, and looking for more great businesses, but the theme of 2015 is to wait for the prices to fall to obviously attractive levels before investing. Looking to 2016 and beyond, if market conditions remain relatively stable, I am more than happy to hold our current investments and watch their value compound; and if there is volatility in the markets then we will take advantage of the big opportunities this creates.
Disclosure: Pursuant to the provisions of Rule 206(4)-1 of the Investment Advisors Act of 1940, we advise all readers to recognize that they should not assume that recommendations made in the future will be profitable or will equal the performance of past recommendations. This publication is not a solicitation to buy or offer to sell any of the securities listed or reviewed herein. This contents of this publication are not recommendations to buy or sell any of the securities listed or reviewed herein. Investing involves risk, including risk of loss. The contents of this publication have been compiled from original and published sources believed to be reliable, but are not guaranteed as to accuracy or completeness. Kyler Hasson is an investment advisor and portfolio manager at Delta Investment Management, a registered investment advisor. The views expressed in this publication are those of Kyler Hasson and not of Delta Investment Management. Kyler Hasson and/or clients of Delta Investment Management and individuals associated with Delta Investment Management may have positions in and may from time to time make purchases or sales of securities mentioned herein.
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