2016 Annual Letter
We had a good year in 2016. Most of you had returns of __%, compared to a 12% gain for the stock market. In addition to strong returns, we made a large investment in Transdigm - perhaps the most well-run company in the S&P 500 - and used a strong market to sell off some of our positions for large gains.
Overall, we had decent business performance in the aggregate. On a business-by-business level, this decent performance was comprised of excellent years for Transdigm and Autozone somewhat offset by weaker-than-normal results from Berkshire Hathaway and Exxon Mobil. Looking forward, we are positioned in defensive equity investments and large cash balances. This means that while we would most likely strongly outperform a down market, and generate handsome returns in the long-run, we will also significantly lag a rising market in the short-run.
In this report, I will give an overview of the transactions that we made over the past year and discuss in detail the performance of this year’s portfolio companies within the context of the current state of the markets as well as of our broader investment strategy. Last, we will look ahead to 2017 and examine how our current portfolio would perform in a range of possible future market conditions.
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 we are selective about the stocks we own.
Activity in 2016
At the end of 2015, we held a roughly __% cash position with large investments in Berkshire Hathaway, Exxon Mobil, and Norfolk Southern. In 2016, in the face of a relatively strong stock market (and the attendant expensive stock prices that comes with this, especially for industrials) our largest moves have been to sell off some of our positions. In most cases, I am willing to sell off at least a portion of an investment if it hits my estimate of fair value. In 2016, many of our investments not only hit but also exceeded fair value, so I used those opportunities to sell some stock and raise cash. Let’s take a look at our current holdings and go through the moves we have made over the past year:
Portfolio Actions:
Sell off our entire Norfolk Southern position
Sell part of our Berkshire Hathaway holdings
Sell part of our Exxon Mobil holdings
Buy a full position in Transdigm
Diversify our cash into short-term bond funds (SHV, SHY, VGSH, IBDJ)
We used a large price drop in the beginning of the year to buy a full stake in Transdigm, and the stock now makes up __% of our total assets. Besides Transdigm, I didn’t see any other attractive opportunities to make investments in during 2016.
In the case of Norfolk Southern, we sold off our entire position as it reached my estimate of fair value and because it would do poorly in a weak economic environment (which we will inevitably face at some point in the longer term). In the case of Berkshire Hathaway and Exxon Mobil, we had originally made very large initial investments due to what I perceived as tremendous value and low risk; but recently, as the prices of the stocks increased to fair value, we took the weightings down to around __% of assets from the initial positions of __% and __%, respectively. We did not sell the entire investments when they reached fair value (as we had done with Norfolk Southern) because these companies would survive, and even prosper, in a weak economic environment. I will talk later in the letter about how we are positioned for the future and why I feel comfortable holding some positions at or even above fair value.
Additionally, this year we started making investments in short-term bonds. The different tickers under the cash and fixed income section are for funds that hold short-term government and corporate bonds. All the bonds that we own mature in two years or less, which minimizes our exposure to loss: even if interest rates rise significantly, our initial principal will be safe. Preservation of principal is, as I’ve said before, my first goal with these investments, while optimizing for interest income is a secondary goal -- we could make more interest than we are currently making, but doing so would involve assuming a large interest rate risk (the value of the bonds could plummet with higher interest rates) or credit risk (the parties to which we are lending may default on payment). Instead, we are currently taking very little of either.
Business Performance
We now own four main positions – Berkshire Hathaway, Transdigm, Big Oil (Exxon Mobil and Chevron), and Auto Parts (Autozone and O’Reilly) – along with a small investment in Colfax, as well as a large chunk of cash and short-term bonds. Looking back to the previous year’s performance, in 2015 our businesses gained on aggregate in intrinsic value (my assessment of their value irrespective of short term movements in stock price), but the prices of their stocks fell. In 2016, however, these businesses not only continued to increase their aggregate intrinsic value but their stock prices also increased, in some cases even more than the gain in value. The disproportionately large change in valuations is what really supercharged our returns this year. For example, Berkshire Hathaway and Exxon Mobil increased their intrinsic business values by single- digit percentages, but the stocks went up by more, __% and __%, respectively.
Over time, our returns will approximate more closely the yearly gains in intrinsic business value, so intrinsic value growth is the most important factor to consider. However, as I discussed in last year’s letter, we are also positioning ourselves to outperform in a down market, and so an important aspect of that is to own shares in businesses that will hold their value even in weak environments. So, for those companies whose markets were weaker than usual (Exxon Mobil’s and the oil market, specifically) we’ll also judge their ability to weather downturns. With all of that in mind, my goal is for each of our companies to be increasing their intrinsic value by at least 10-12% per year over time. In weak years, these companies might grow slower than that, but I hope that over time strong years can average the growth rate out to hit double digits overall.
With that lens, let’s take a more in depth look at how each of our large positions performed on a case-by-case basis with respect to their intrinsic value:
Transdigm
Transdigm had a terrific business year, from the standpoint of both its stock price and intrinsic value. Even still, the stock’s excellent __% gain was eclipsed by its even larger ~30% gain in intrinsic value. Over the full year Transdigm outperformed the S&P 500 but underperformed its aerospace and defense peers. However, because we more than doubled our position not at the start of the year but a little later, in __ (when prices were low), our results outpaced the full year’s results, giving us an even larger gain than the __% increase in stock price for the year: the stock is up __% from when we bought more stock.
If you read my writeup on the company, you know that Transdigm leverages its stable earnings to make acquisitions and grow its value much faster than its organic growth rate. While most acquisitions that companies make typically end up in sub-optimal outcomes, Transdigm has a knack for doing them very well, both from a sourcing standpoint and their ability to integrate them effectively into their business. The company made three large acquisitions in 2016, leading to ~30% growth in earnings power even while the aerospace market grew a little slower than it normally does. Transdigm’s ability to grow its value at outsized rates, even if the environment is a little softer than normal, is why we haven’t yet sold a share and don’t intend to.
Berkshire Hathaway
Berkshire Hathaway’s stock this year performed almost exactly like its industrial peers (General Electric, 3M, United Technologies, and Siemens as a few well- known examples). The company increased its intrinsic value (which is estimated by a fundamental analysis of its insurance assets and earnings from its industrial subsidiaries) by around 8%. While that growth isn’t as high as our 10-12% annual target, it is close. More importantly, it is an excellent result in an environment where many industrial conglomerates saw their earnings decrease, some by 20% or more.
Berkshire’s ability to outperform its peers in weak environments is why we continue to hold a position even though it trades at my estimate of fair value. I think it can compound its value by that 10-12% target over time, as well as post excellent results in times of stress.
Exxon Mobil
For Exxon Mobil, the low oil price environment has caused the company to materially underperform the stock market. That said, it remains a fundamentally attractive investment opportunity due to its operational excellence and defensive nature, which is evident in the way it has materially outperformed the energy sector overall.
In 2016, Exxon shares increased in value by __% compared to 12% for the stock market. This gain, however, comes off a low base at the end of 2015, which means that we have made a less-than-desirable return on our investment since its inception. The good news is that the company has steadily increased its intrinsic value by about 5% per year since we bought it. Again, similarly to the case with Berkshire Hathaway, that performance is below the 10-12% gain in intrinsic value that I look for; in this case, however, the oil market is exceptionally and historically weak, and it is a testament to Exxon’s financial strength and shrewd management that it was able to add any value at all. Over time (think years and even decades, not quarters), I expect periods of low prices to roughly balance out periods of high prices. When prices are low, Exxon will add a little value (certainly less than our 10% target), but when prices are high the company will add tremendous value, most likely even more than the 12% top-end of our target. Holding shares is painful for now, but once the cycle turns -- as it always does -- we should be rewarded handsomely for our patience.
That said, I would have liked to be able to sell more of our Exxon shares and pick up beaten-down energy assets when prices dropped significantly earlier this year. In last year’s letter, we talked about holding relatively stable investments so that if markets deteriorated, we could sell those shares at a small loss and pick up other companies that had much larger decreases in price and were thus cheap to buy. This is exactly what happened with Exxon compared to other energy companies. However, as I have also written about at length in the blog post on my website, there weren’t many other companies whose managements I trusted to run their companies as conservatively as they ought to be run (and indeed, many companies did struggle, many even to the point of bankruptcy) and who also operated very efficiently – two absolute requirements for me to hold shares of energy companies. We did do a small amount of this type of trading, as we sold some of our Exxon shares and bought Chevron shares, a move that has done very well, but again it was a fairly small one. I can’t help but feeling that we missed an opportunity to be more aggressive.
Autozone
Autozone lagged the S&P 500 by a few percentage points this year. The company’s earnings increased by a robust 13.1%, and have increased by an even better 15.1% annually since we bought shares in ____. However, because the stock entered 2016 somewhat overvalued, its shares lagged those earnings increases, with the share price growing only __%.
I don’t think shares are cheap by any conventional, backward-looking metric, and I even believe that low oil prices have probably boosted the company’s earnings in the past two years. However, looking forward, we will most likely hold shares unless the valuation becomes prohibitively expensive – after all, I am happy to hold shares in a well-run business that’s growing at a good rate and that will excel in times of weakness, even if it currently a little more expensive than normal.
2017 Outlook
We have spent some time looking back on 2016, but I want to finish this letter looking out at the year ahead of us. This year’s returns have been great, but let’s look at where are we now, and what we can expect looking forward. To answer this question, we need to examine what the market looks like more broadly and how we are positioned relative to that.
The State of the Market
Last year, I wrote about how consumer-facing stocks (think of companies like Coke, Nike, or Procter & Gamble) were generally very expensive, while some industrials (think railroads or oil and gas companies) looked relatively inexpensive. Since I wrote that at the end of 2015, this dynamic has shifted, with industrials up 18% while consumer staples are up 4% -- those companies that were most undervalued have roughly reached fair value, while those that were very expensive have stayed very expensive.
Looking broadly across the market, it is hard to argue that any sector looks cheap; in fact, the market overall looks relatively expensive by any objective measure. Valuations are high, although not at 2000 tech-bubble type of levels. Stocks trade for what I estimate at around 25x their true earnings power, which is certainly higher than the historical average of 16x, although low interest rates mitigate their expensiveness to some extent.
In addition to looking at quantitatively-based valuations for stocks, I think it is as important, if not more important, to look at broad investor sentiment. In doing so, we see investor sentiment mirroring the high quantitative valuations of stocks. When the stock market is cheap, investors are generally fearful, discounting any good news and magnifying the latest perceived economic disasters, be they from Greece, China, or the oil patch. When the market is expensive, investors are hopeful and greedy, ignoring bad news and focusing on all the positive things that are ostensibly right around the corner.
Today, it is precisely such a state of over-excitement, looking at the market with rose- tinted glasses, which is the case.
Investors are excited about what they perceive to be the new, more business-friendly administration; the possibility for less regulation; a stronger economy leading to higher interest rates (but not rates that are too high, as that would be bad for stocks!); stronger oil prices; more manufacturing at home; lower taxes; and the list could go on. In short, investors are looking towards the future and they like what they see. We have had an enormous positive change in sentiment, and that has led to a huge increase in the valuation of stocks, as well as of other assets.
How We Are Positioned
As many of you know -- and as I emphasized at the beginning of this letter -- we are bottom-up, fundamental investors: we will make an investment if I am convinced it will be lucrative over time, no matter the level of the stock market in the short term.
Nevertheless, we are also, unfortunately, prisoners to the short-term environment. In an environment where everyone thinks that the good times are going to last forever, it is difficult to buy stocks at large discounts relative to their intrinsic worth.
Some of the costliest mistakes made by investors are when they become impatient and impulsive at times when stocks are expensive and investments are difficult to source. After all, it is very difficult to stay disciplined and watch other people make money hand over fist while you sit around with large cash balances and make small gains. It is very easy to fear underperforming the market and talk yourself into changing your fundamental assumptions, so that an investment you’re looking at irrationally seems cheap and you buy high-priced shares. This usually leads to losing enormous amounts of money when the next recession hits and valuations inevitably tumble.
It is exactly at times like these, when most market participants are excited and carefree, that investors need to be on the lookout against making costly mistakes. It is easy to get sucked into the hype; instead, we will be vigilant and patient.
We will never go to an overly-conservative 100% cash position, of course; after all, you can see that we still do own large investments. But the important thing is that each one of our large investments is the type of company that will survive, and even prosper, during market downturns – indeed, from late 2008 through early 2009, when the S&P 500 dropped 54%, each of these companies outperformed the market by at least a 10% margin. This is why we sold all of our Norfolk Southern shares but only trimmed our investments in Berkshire Hathaway and Exxon Mobil: I want to be invested in companies that will not seriously suffer in an economic downturn: I want to own solid assets that can use market weakness to create value. Berkshire Hathaway and Exxon Mobil are perhaps the two most solid assets available.
No two downturns are alike, but our portfolio companies' performance during the 2008- 2009 period suggests that we are setup to dramatically outperform a down market. If stocks go down 50%, and even if the companies that we own went down 40% on average (for reference, they dropped 20% on average in 2009), our total portfolio would go down only 25% due to our large cash holdings, all of which would mean a 25% out- performance of the market. However, this safeguarding also means that we will almost certainly dramatically underperform if stocks go up. We could easily see a situation where stocks go up 20% next year and our portfolios are up only 5%, or are even flat.
You can’t be positioned to both outperform a down market and to outperform a strong one.
Looking to The Future
My biggest goal for the near future, as simple as it seems, is to not make any big mistakes while ensuring handsome returns in the long-run. If the stock market presents us with a great opportunity, either because of a special situation or a lower market in general, I will be decisive in seizing it. If, however, sentiment stays overwhelmingly positive and stocks head higher to even more overpriced levels, we will stay largely on the sidelines. We will not chase its performance in hopes that our short-term returns look better. We will wait patiently to find investments that will pay off in the long-run. Short-term underperformance is the price we will pay for the opportunity to keep our capital secure and available to make lucrative long-term investments.
I also want to make it absolutely clear that we are not positioned how we are because I think the stock market is going to crash next week (remember, no one can consistently time short-term market movements). I have positioned us in defensive investments and large cash balances because I believe that is the correct way to maximize long-term returns. Conventional wisdom calls for more money invested in stocks so as to achieve higher returns over time, but when there aren’t lucrative investments to make, I believe that conserving capital is actually the correct way to maximize returns. That is why we hold so much cash - it is not a decision based on fear of the market; it is an allocation meant to make us the most money over time. After all, after a 50% loss it takes a 100% gain to get back to where you were, and so avoiding big losses is key to compounding at high rates.
For now, we may look overly conservative, but at some point, be it three months or three years, markets will fall and we will go back to making large investments. The important thing to remember is that we’re always looking to maximize our returns over the long term, and that sometimes the market dictates that the best way to do that is to act conservatively for certain periods.
Conclusion
2016 was a good year by almost any measure. First, we made a large investment in Transdigm; this has already lead to big returns this year, but more importantly should also deliver outstanding returns for many years to come. Second, our other companies performed reasonably well, especially considering a tough economic environment. Third, we used some market strength to sell shares when we could receive fair value. Last, we handily ______ the index.
We are certainly now positioned to be able to take advantage of any market weakness. The flip side to that is that we will almost certainly underperform a rising market. With an economic recovery into its eighth year and a stock market that looks objectively expensive, I like the way we are positioned defensively -- investors are generally excessively-sanguine about the economy, earnings, and stock prices, which is exactly the time we should be most worried about committing to large investments. We will almost certainly underperform if the market rises strongly in the next year or few years -- as I mentioned earlier I expect we might trail the market by 15% if it goes up 20% -- but history suggests that sooner or later we’ll get our chance to profitably deploy our excess cash. That will be the time to switch from being conservative to aggressive and use our excess cash to make lucrative, long-term investments and generate handsome returns.
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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