2017 Annual Letter
Most of you had returns of __% in 2017, compared to a 21.7% gain for the stock market. This poor result was due to two reasons – holding large cash balances and, with the stocks that I did pick, generally underperforming the market. We had a few investment wins, but those wins were outweighed by a continued lag in our energy investments compared to a very strong stock market.
Our strategy has been to examine the values of individual companies and only invest when there is a high likelihood for excellent returns over time paired with a low likelihood of permanent capital loss. We do not invest in stocks just because it looks like they’ll go up next year. After a year of largely sitting out of the market and missing out on gains from growth stocks with huge momentum, a legitimate question to ask is whether we have the correct strategy. Should we continue to be cautious, pick value instead of growth, and wait for a better opportunity to deploy cash, or does it make sense to chase returns by doing the exact opposite? I strongly believe that we are generally doing the right things. However, I do believe our execution could be better. We will discuss this at length later in the letter.
We will also go over 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 into the future and think about what we are trying to accomplish going forward.
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 with conservative assumptions. This strategy is notable for what we don’t do: we don’t consider a wide range of mediocre businesses, we don’t buy stocks that trade for very high multiples of current earnings, and perhaps most importantly, we don’t invest just to look busy – we will hold substantial cash balances if I can’t find good investments.
Is this the right strategy? After last year’s results, it would be fair to ask this question. Since I couldn’t find lots of good investments, we held a lot of cash – somewhere between 35-55% of total assets for most of you. The market’s gains this year, fueled by optimistic sentiment and buoyed by frothy valuations, have meant that we’ve lost out on perhaps 7-12% of extra return due to these large cash holdings. Furthermore, we tend to own shares of “boring,” profitable companies that trade at low multiples of current earnings. This year’s rally has favored companies that are growing volumes and revenues at a high rate; these stocks trade at very high multiples of current earnings and price in many years of uninterrupted business success, leaving their prices susceptible to large drops in the face of minor business problems. Simply owning these growth stocks instead of value stocks - the “boring,” profitable stocks that will make us double-digit returns over time under most circumstances - would have given us perhaps another 10% of return this year. If we would have invested all of our money in growth stocks, we could have made around 25% instead of 5-10%. If we were to choose the stocks growing the fastest, we could have made even more.
So should we give up our strategy, invest all of our money in stocks, and then put it in growth stocks to boot? That strategy has worked enormously well for other investors who have pursued it over the past few years. However, chasing growth only works when markets are going up every year. If the stock market and the economy had performed poorly over this time period, losses would have been substantial. We will never employ a strategy that is dependent on the market going up over the short-term in order to be successful, because every so often the market goes down in the short-term. By a lot.
Going forward, those investors that continue to chase growth are doing so in the face of a historically expensive stock market. From current levels, stocks are likely to return 7% or less over the next 10-20 years. There is also a chance, largely dependent on interest rates, that the stock market returns materially less than 7% annually. Furthermore, if investors demanded a 9% return instead of perhaps 6-7%, then stocks would be worth roughly 40% less than they are now. Growth stocks would likely fall even more than the market as a whole. Abandoning our current strategy and pursuing growth would be absolutely the wrong move: expecting returns of 7% annually with the hope to strike it big with a 20% gain will never be a proposition I am comfortable with if it risks a 40% loss with your money next year.
So, if stock returns will be mediocre, and I count 7% or less annually as absolutely mediocre, then what are we to do? The good news is that the market is full of different stocks, and there are good long-term opportunities to be found. Although an expensive market makes those opportunities rare, if I can find enough good investments to fully deploy our cash at rates of return of 15% or more, then I will do that. However, if the market continues to be this expensive, we will most likely still have lots of idle cash. I would rather keep cash than risk huge losses.
My Execution
Having the correct strategy is important, but good strategy without execution is worthless. In stock picking, there are two important parts of executing a strategy: finding new companies worth investments, and buying those stocks in the correct amounts when their prices decline to an attractive level.
On the first front - finding new and interesting companies - I had a great year. I partnered on a project to find the strongest and best managed companies in the world, and I found 10-20 excellent companies with absolutely world class management. Expanding the amount of companies that I’d like to invest in is vital, since it lets an investor pick the best few out of a larger pool of options.
On the second front - buying stocks of good companies in the correct amounts when opportunities present themselves - I had a couple of blunders. We didn’t have any situations where I bought shares of a company and then its intrinsic value drop dramatically, but I did make some mistakes where I didn’t buy enough of something that I knew was excellent.
The first mistake, which occurred in 2016 but affected our results in 2017, was to not buy shares of Magellan Midstream Partners when the price was extremely low. We bought shares this year at a still excellent price around $___, but if I was alert to the opportunity when anything energy related was melting down in the beginning of 2016, we could have bought shares around $__. We could have made an extra __% on a position that makes up __% of our total investment. I could have understood the situation better, but I hadn’t done the due diligence at the point in 2016 where shares were at $__. That mistake has cost us 2-3% of return over the past two years.
The second mistake was with another position of ours, Nexstar Broadcasting. Earlier this year, the stock was extremely cheap at $__. I liked the price, but for no good reason I only made it a __% position across client accounts. I knew how good the business was and how cheap the price was, and I should have made it much bigger position. Instead I made it a __% position. Now the stock is at $78, and we’ve missed out on another 1.5% of portfolio return.
I will obviously always make mistakes, but these two mistakes were unforced errors - I had everything I needed in front of me but didn’t make the correct decision, and that cost us some performance. Going forward I will continue to strive to eliminate biases and keep improving my decision process.
Let’s take a look at some other portfolio actions I made in 2017:
1. Bought an increased stake in Transdigm after a vocal short-seller drove down the price in the beginning of the year. After our shares gained significantly in value, we pared that stake back around to its initial sizing at ~20% of the total portfolio.
2. Increased and reshuffled our energy investments. I have always said that Exxon Mobil should weather a difficult energy environment well and that we might get a chance to sell some Exxon shares in order to buy energy related stocks that were more beaten down. After a few years of holding Exxon, we finally got our chance and bought significant stakes in pipeline companies that transport oil and gas (including the aforementioned Magellan Midstream Partners). Our total commitment to the energy sector has increased from a ~__% position at the end of 2016 to a ~__% position at the end of 2017, and pipelines make up __% of that __%.
3. Bought three retail investments. During the year, we bought shares of O’Reilly Automotive, Ross Stores, and Dollar General. Ross and Dollar General shares quickly rebounded, and we sold them for a good gain. We have made money on ORLY as well and plan to hold it longer term.
4. Bought a diverse set of “Outsider” companies (I use the term “Outsider” because of a famous book titled The Outsiders about excellent CEOs who created value by thinking outside of the box). My aforementioned project brought my attention to lots of great companies, and we have bought a few of them when the stocks looked cheap. We own relatively small stakes in four of these companies – Constellation Software, Liberty LILAK Group, Nexstar Broadcasting, and Bank of the Ozarks. I expect each of these companies to produce 10-15% annual returns, although any one of them could return higher if good acquisition opportunities surface. Owning a basket of these should mean excellent returns as a group.
5. Trimmed our stake in Berkshire Hathaway. Berkshire has increased above my estimate of fair value, so I sold shares for those of you who have tax-advantaged accounts. Those of you with taxable accounts generally would not get fair value after tax implications, so we continue to hold shares, which should still provide a reasonably good return over time, perhaps around 8-10%.
We now own what I think of as five positions – Transdigm, Energy (encompassing investments in three midstream MLP’s plus Exxon and Chevron), Berkshire Hathaway, The Outsiders, and O’Reilly. As we have added more investments than we sold, our aggregate cash position has gone down from ~40% at the end of 2016 to 35% as of now. I hope that I can find new investments to add next year, but as we discussed before, if the market keeps going up it will be difficult to find more good investments.
Business Performance
Let’s take a look at how each of our positions performed with respect to their intrinsic value:
Transdigm
Transdigm had a year that would probably be considered good for most other companies but not quite up to par for their own standards. Intrinsic value increased by ~8.5%. The company hit a bit of a perfect storm of weak helicopter sales (oil and gas firms are big customers in this segment and have been cutting back spending), weak business jet sales, and double digit declines in revenue from one of its larger businesses (due to an industry wide shift from wide body planes to narrow body planes). Furthermore, the company was unable to close a usual amount of accretive acquisitions, most likely due to high asking prices from sellers because of a strong economic environment.
Even though this year wasn’t as good as previous ones, the company has still done very well over time. Since we first bought shares in ___, the intrinsic value of the company has increased by roughly 128%, good for 20.1% annual growth. All of the same value drivers still exist, and if the company meets its guidance for next year, which looks fairly conservative to me, intrinsic value should increase by 15-16%. If they can find some decent acquisitions then intrinsic value growth will most likely be much higher.
Energy
As previously discussed, we exchanged a large percentage of our Exxon Mobil shares for those of three midstream MLP’s – Magellan Midstream Partners, Buckeye Partners, and Genesis Energy Partners, with Magellan being by far the biggest position of the three. These companies transport oil and gas instead of exploring, developing, and extracting oil and gas like Exxon largely does. The transportation business is much more stable – over the past few years, returns on capital have only gone from around 12% down to about 11%, as opposed to upstream players (exploring, developing, extracting) who went from returns on capital of around 10-15% to actually losing significant amounts of money.
We finally made the switch to this more stable business as the price of the midstream MLPs significantly weakened, especially compared to Exxon shares, and I was ready to pull the trigger unlike in 2016. Cash flows at the MLPs should be stable and growing, and I would expect growth in intrinsic value to be 12-15% annually even if oil stays around $50 / barrel. In contrast, intrinsic value at Exxon increased around 6% annually since we have owned it starting in 2014. If oil goes back to $100 or higher, Exxon will do better, and shares would probably return somewhere in that 12-15% range. So low oil prices favor the MLPs (or at least the MLPs that we bought) over Exxon, and high prices probably mean roughly equal returns for the two. A small position in Exxon still strikes me as prudent, as it is an excellent company, well managed, cheap, and should provide very high returns if oil prices do go much higher. However, if I think the tradeoff between Exxon shares and various MLP shares gets even better, then we could sell the rest of our Exxon shares and buy more MLPs. Market conditions will dictate that.
Over the first two quarters that we owned Magellan, intrinsic value increased ~6-7%, which is good for a 12-14% annualized rate. Exxon, on the other hand, increased intrinsic value by around 6% over the whole year.
Berkshire Hathaway
Berkshire has had a good year, with intrinsic value up ~14%. Gains in value have come from a recovery in earnings at its railroad, strong growth at GEICO, a strong equity market, and huge cash generation at the parent company. I keep another measure of value that adjusts for stock swings and volatile yearly earnings at some of the subsidiaries, and that measure of intrinsic value is up closer to 10%. I would expect that intrinsic value should increase around 9-10% annually over time, which should provide a good after-tax return for those investors that still own it.
The Outsiders
This segment consists of our investments in Constellation Software, Liberty LILAK Group, Nexstar, and Bank of the Ozarks. My estimates of intrinsic value for Constellation, Nexstar, and Bank of the Ozarks are each up 20-25% annualized in the short time that we have owned them. I hope and expect to see continued excellent results from each of these businesses. Liberty LILAK is more of a turnaround (with support from the best cable investor and operator in history, John Malone), but better results down the line should lead to a significantly higher stock price.
O’Reilly Automotive
O’Reilly, along with retail as a whole, had a bumpy ride in 2017. Looking at the chart, you might be surprised to hear that O’Reilly’s earnings were up 13.6% last year. We were able to buy some shares when the price had fallen towards the middle of the year.
Aggregate Performance
With some of our portfolio tweaks and additions, I believe that we’re in position to see good gains in value at each of the businesses we own. Our businesses probably increased in value by ~10% on aggregate this year, and I would expect that number to be somewhat higher next year. Our returns should approximate those gains in value over time, so if our businesses can continue to increase in value by double digits annually, then we should see double digit returns with those stocks going forward. In comparison, remember that the stock market as a whole is increasing in value by ~7% per year and is trading well above historical valuation ranges.
Outlook
Stocks are not cheap, and if the market is up another 20-25% next year, then in my opinion we’ll be approaching bubble territory - stocks would be trading at multiples of earnings about halfway between levels from the market top in 2007, when they were clearly overvalued, and in 2000, when they were absolutely in a bubble. It is in times like these, where everyone is certain of how well the economy will perform and how strong earnings will be, that investors drive up asset prices and make the investment outlook the most uncertain. I would not be surprised if we saw some turbulence in the market over the next few years. Along with the market, any stock can go down 50% or more at any time, no matter how insulated it is from the economic cycle.
For me, I welcome volatility. If we keep our wits while others are panicking, we can make lots of money by buying when prices are cheap. This is what happened earlier this year with Transdigm - while everyone panicked and sent shares down 25%, we were buyers, and we made __% on those shares this year. If you own good businesses that can withstand volatility, then volatility can only help you - if you do nothing then the price will eventually recover and your gains will track intrinsic value growth, but if you have cash on hand and can buy then you can make extra returns.
Our high cash balances ensure that we’ll be able to take advantage of a general panic. However, a general panic can be frightening. If you don’t feel like you’re the type of investor that will be able to buy more when prices are falling, I would like to discuss your portfolio with you, as it may need an adjustment.
Conclusion
Although we ___ some money this year, I would not call our results a resounding success. When stocks are so expensive, I don’t necessarily worry about underperforming a strong market, but a couple of clear, unforced errors took our returns down a few percent.
Importantly, I believe that we have the correct strategy - focusing on value will make us miss some short-term upside if markets keep going up next year, but being fully invested in growth stocks is chock-full of risk. Buying excellent companies at discounts to value will provide good returns over time, even if it makes us look too conservative at times when we can’t find lots of accretive investments to make. I won’t be taking big risks with your money just to try to make lots of money in one year. I will keep my eyes on our long-term goals of compounding our account balances at a good rate of return over time while doing my best to protect your investments.
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.
[jetpack_subscription_form show_only_email_and_button="true" custom_background_button_color="undefined" custom_text_button_color="undefined" submit_button_text="Subscribe" submit_button_classes="undefined" show_subscribers_total="false" ]