2020 Annual Letter
To My Investors,
In the investment markets, 2020 was a truly dramatic year. At the height of the fear over the coronavirus pandemic, US stocks were down 30%, and from there they staged a rally and finished the year up 18.4%. Our stock returns were around __%, with most of your portfolios up __% after taking cash balances into account.
The biggest factor that influenced our portfolios this year was my focus on quality. Even during the significant economic contraction this year, every one of our portfolio companies maintained profitability, generated free cash flow, and had access to significant liquidity. In this letter we’ll take a look at what quality means to me, how owning quality helped reduce our true business risk this year, and how we could have even survived much worse macroeconomic volatility than what we actually faced.
Even though owning quality companies helped us weather the downturn and reduced business risk, we didn’t have a ____ year when you look at our returns. Of course, my focus has always been on the long-term intrinsic value creation at each one of our portfolio companies, and while many of our companies continued to create value, some had lackluster years. We’ll take a look at some mistakes I made this year that impacted our performance and talk about what I’ve learned from them.
As always, we’ll look in more detail at our trading activity for the year and the performances of the businesses that we currently own. Last, we’ll examine the current market environment, the relatively high valuations across some of our investments, and how I’m attempting to position us to earn strong future returns.
Business Performance - A Discussion On Quality
Quality, Generally Speaking
In previous letters, I described our strategy as follows:
My strategy is to find an excellent business run by able and honest management and wait to invest until I see the potential for at least a 3x return over 10 years.
Last year, I wrote that I would place extra emphasis on the quality of the businesses and management of the companies that we own. I made this decision not because I thought it would guarantee terrifically high short-term investment returns, but because I thought it was the best way to effectively manage risk, and effective risk management is the only way to generate the strong long-term returns that we seek.
It’s important to expand on my idea of what a quality company represents. In general, I find it easier to think of a quality company as one that avoids characteristics that are common in many failed businesses.
Here are the biggest things that I want to avoid:
Companies that regularly require large amounts of funding for operations
Companies that operate in very cyclical industries
Companies whose profits evaporate quickly with a slight downturn in their sales volumes
Companies run by anyone but the best managers
Companies with too much debt, especially with short-term maturities that limit flexibility
If we can successfully avoid those things, then even during an exceptionally weak economic environment, the companies that we own should be able to survive without impairing our investment.
Quality In Our Portfolios
This year, the coronavirus pandemic gave us a stress test for how high-quality our companies really are. There is no such thing as a perfect test, as any possible future recession can be different from the last, but we did get to see the effect of a stressed economy on our companies.
I am proud of the fact that every single one of the companies that we own was both profitable and free cash flow positive during March and April, when the economy contracted more sharply than it has in recent memory. Additionally, and just as importantly, each company that we own had significant access to liquidity. With cash coming in the door, a hefty cash cushion, and no large capital needs in the immediate future, each one of our companies could have easily survived a much longer and deeper economic contraction. This is critical to a sound long-term investment strategy, as it is only a matter of time until there is a deeper economic contraction.
The strength of our portfolio companies during a time of weakness is a testament to their business models, operational expertise, and financial structuring. A few of them - Transdigm, Magellan Midstream Partners, and Enterprise Products Partners - faced once-in-a-generation downturns in their respective industries, and yet each company still generated a profit each quarter of this year.
Transdigm’s business model of selling low value, niche parts shone through - they were able to raise prices to combat low volumes and adjust costs downwards to maintain profitability. And while many investors always assumed that Transdigm’s high headline debt load meant that they were at risk during a downturn, the company has proven that structuring the debt correctly - with no short-term maturities or maintenance covenants that could cause accelerated default - avoids bad outcomes in hard times if also paired with free cash flow generation.
Like Transdigm, Magellan and Enterprise also performed well relative to their peers. Both companies’ main businesses are in transporting energy products to end-consumers for a fixed fee. While oil prices plummeted and energy companies across the board started to lose money, Magellan and Enterprise’s customers still needed most of their energy products and paid their fees, providing each company with the revenue they needed to maintain profitability. Unlike their direct pipeline peers, both companies have conservative financial profiles and low exposure to many of the most challenged assets in the space.
The rest of our large investments - Constellation Software, Charter, Berkshire Hathaway, Google, and First Republic Bank - saw weak economic conditions but faced nothing out of the ordinary. Each company performed well and maintained profitability.
What If It All Went Wrong?
Our overarching strategy is to own high quality companies for the long-term. Our long-term returns will come largely from the price at which I’m able to buy these businesses, but as you’ve seen, the extent to which I can identify real quality will largely help determine the likelihood that we lose significant money on an investment.
Many of the stocks that we own were down significantly along with the stock market through March, which is to be generally expected during times of significant volatility. But if we focus on actual business risk, we can see that our portfolio companies did handle the weak economy caused by the coronavirus lockdowns very well.
Over the long-term, every company faces risk from competition, regulation, and organizational decay. Over the short-term, companies face risk of weak end markets and a shortage of liquidity.
So imagine a world where the government didn’t step in with trillions of dollars to stabilize the economy and financial markets? What might have happened if those weak economic conditions continued?
At each of the companies that we own, the earnings over the next few years could have been lower, but if our companies were generating profits during such a steep economic contraction, then it would be difficult for us to see a real impairment of our investment.
If Transdigm is generating profits even while passenger air traffic is down 90%, and given that it doesn’t have any material liabilities coming due for more than four years, it could have survived a worst case scenario.
Google’s earnings might have dropped on a year-over-year basis for a few months, but with plenty of cash flow and $100bb+ in cash on its balance sheet, then can a recession kill the company?
We could go through every single company’s metrics during those difficult times, but they all performed well. I’ve always considered my primary job as your investment manager to protect your capital from true risk - the risk of permanent losses of capital. In order to protect against those permanent losses, we need to own companies that will survive a once in a century economic storm.
Those three months this spring simulated a 100 year storm environment, and during those three months, everything we owned was performing well and was not in true danger. Without timely government intervention, that unstable economic environment could have extended for a significant amount of time, and 2020 could have been that true 100 year storm for the economy. The government might not always be able to rescue the economy so quickly. If we hit more difficult times, we’ll be ready.
Some Mistakes
Consciously choosing quality helped us tremendously this year, but I did make some obvious mistakes that hurt our performance. The two most prominent were my purchase of Wells Fargo in late 2019 along with a very large investment in the energy sector.
Wells Fargo
Wells Fargo is especially painful given that it goes against most of the quality guidelines that I just talked about - it was a turnaround situation with an obviously inept organization in a cyclical industry. I told myself that since the company hired a competent CEO that he could turn the situation around.
The new CEO didn’t make much progress in turning the situation around over the next six months after I bought our position. Once the markets turned downward in March, First Republic Bank, which is one of the best run banks in the US, was available at a price that I thought would roughly match the return of Wells Fargo over the next 5 or 10 years, even assuming that Wells fixed its problems. The choice was easy and we sold our Wells Fargo and bought shares of First Republic.
Energy - Magellan Midstream Partners and Enterprise Products Partners
As I mentioned in the previous section, Magellan and Enterprise maintained profitability throughout the worst of the energy downturn and outperformed almost all of their energy peers financially. Unfortunately, due to this year’s trends in the energy industry, being among the best performing energy companies doesn’t mean that you had a good year on an absolute basis.
Unless oil and natural gas prices increase meaningfully, Magellan and Enterprise’s earnings will likely be 10-20% lower over the next few years than what I had previously estimated. Given current conditions, these companies are certainly worth less than they were a year ago.
When I bought these, I ignored one of my guidelines on quality, which is to avoid industries that are too cyclical. Timing the swings and estimating what the true earnings power of a company in a cyclical industry such as oil and gas is notoriously difficult, and it’s easy to be too optimistic, as I was.
To make this error larger, I didn’t just buy a position in these companies, I bought a big position. Coming into the year, I had put ~12-14% of your portfolios in Magellan and Enterprise. Owning them in that size is what compounds the initial mistake - not only does it mean a larger loss on an absolute dollar basis, but additionally when the stocks dropped enough to become truly and obviously inexpensive in March, we couldn’t aggressively buy more shares because we already owned too many of them.
I am looking to reduce the size of our position if I can get what I consider a decent price for our shares. I’m not going to sell these companies indiscriminately given that they are still producing significant earnings and the stocks trade at a discount to very pessimistic assumptions of those earnings, but at the same time, there are much easier and better places to make money with less risk.
Both my purchase of Wells Fargo and the large position in Enterprise and Magellan were very avoidable mistakes. Both of those investments didn’t fit into the quality guidelines I laid out. And while you can’t always get everything you want, Wells Fargo was an avoidable mistake as was buying Enterprise and Magellan in such large size.
It’s important to note that just buying all of the best businesses at any given point of time is not a strategy that is likely to work. I not only need to find high-quality businesses, but I need to find them at a great price in order for us to earn strong returns. Markets are generally efficient and quality companies tend to trade at premium prices which decrease expected future returns. So usually we buy shares when some aspect of a business’s operations seems challenged, but when I have some insight that the problem will be resolved over time or is too minor to matter over the long-term. My version of quality investing is to be willing to accept less and less obvious problems over time and only invest when the problems are quite minor.
This means that I will put money in ideas that don’t check every single one of the high-quality boxes, but hopefully we will be able to avoid the big obvious problems. So, for example, you won’t find us owning a huge position in an airline, an industry which has shown to go bankrupt or need government financing during downturns, but you might still see us owning a little bit of Magellan or Enterprise, which made it through a downturn, albeit with slightly lower earnings.
Trading Activity
Relative to most years, we had a lot of trading activity in 2020. I tend to not do much if markets are up, but I trade actively if markets are weak.
Early in the year, I sold our entire position in Brookfield Asset Management. In last year’s letter, I mentioned that I wasn’t particularly pleased with some of the company’s activities. Subsequent events confirmed those feelings for me, so I got rid of our position. The good news is that we received an attractive price for our shares.
Our other activity was mostly concentrated in the February / March period when the markets were down significantly. Our major actions for the year were to sell our Wells Fargo position and use the proceeds to buy First Republic Bank, initiate a position in Google, deploy some of our cash, and rotate some money from some of our investments that held up better into those that were more beaten down.
All told, these actions helped our returns tremendously, with all of our trading contributing roughly 9% to our returns this year. Said another way, if your investments were up 11%, then if I instead simply held the portfolio that we came into the year with and didn’t buy or sell anything, they would have been up only 2%.
Hopefully this shows you that market downturns aren’t to be completely dreaded. Given our style, which is to have some cash sitting around and to own high quality companies, when markets are melting down, that’s a tremendous opportunity for us to deploy money at very good rates of return. I didn’t take any huge risks by buying companies that would have been bankrupted if the economy didn’t turn immediately. I just bought solid, well capitalized companies that were too cheap. Our investment accounts would be worth much less without all of the volatility.
Of course, there’s no guarantee that we’ll always come out ahead after a weak market or that stocks will recover quickly like they did this year. But our strategy of buying stocks during market meltdowns has worked well for us and most of our great investments have come during those times.
Business Performance
In this section, we will examine how our investments have done this year. I will focus on business results, as our long-term returns should track closely to the gain in intrinsic value of our portfolio companies.
Constellation Software
Constellation continues to execute its playbook of running its large stable of software companies well, generating lots of cash, and using that cash to acquire more software companies and drive free cash flow growth.
The company is now our biggest holding. We have held it for almost four years, and in that time our share of earnings has increased by ~107%, good for a 21.4% annualized gain. Constellation’s margins were somewhat higher than they usually are, I suspect due to some adjustments made for the pandemic, but even without those higher margins, earnings are up ~18.5% per year.
The company has a proven process for acquisitions that I expect will continue to drive intrinsic value growth over time, although it will be likely at a lower rate than the 18.5% we’ve enjoyed over the past four years.
Future Challenges: Our biggest obstacle here is price. The companies that Constellation owns are niche and difficult to compete against, and its M&A process should continue to create significant value. But Constellation trades at ~35x free cash flow, while the companies that it owns are worth perhaps 15x. The company will need to deploy large amounts of capital accretively for many years in order for us to earn a great return from these prices.
Transdigm
We discussed Transdigm’s ability to weather the coronavirus downturn in commercial aerospace earlier in this letter. Transdigm makes niche parts that are required for a plane to fly and face little short-term competition, so they have been able to increase prices to offset some of the volume declines and also flex their expenses down to keep their profit margins relatively high. Their defense business is also performing well this year, which is providing steady cash flow.
While Transdigm is still generating significant cash flow given the circumstances, if you value the equity on a multiple of this year’s depressed earnings, the value of our stock would be down by about half since last year.
Transdigm’s earnings power should recover over the next few years, and if earnings get back to their peak 2019 levels in, say, 2023, then they’ll still be up by ~17% per year since our initial purchase.
Transdigm also announced another fairly large acquisition in November, which should add somewhere around $20 of value per share to the company.
Future Challenges: In order for our investment to work from today’s levels, we’ll need the commercial aerospace markets to recover. I don’t believe that everything will magically go back to normal once the vaccine is distributed, as there could be some issues with retirement of older planes or a more permanent reduction in business travel. My belief is that at some point in the next 5-10 years, air travel demand will go back mostly to the trend that it was on before coronavirus, but there is certainly some uncertainty around that.
Charter
Charter is the second largest provider of cable services in the US, and it has performed exceptionally well in the 2.5 years we’ve owned it. All of the key variables have moved in the right direction - more customers, higher revenue per customer, higher margins, less capital expenditures, and less shares outstanding as a result of frequent share buybacks. As a result, our share of earnings has doubled in the time we’ve owned it, which comes to a 32.5% annualized growth rate.
Going forward, our share of free cash flow should continue to increase if Charter can continue to gain internet customers, raise prices and margins, and return capital to shareholders via share buybacks.
Future Challenges: Charter has a great network and a management team that operates its assets well. It should continue to take market share over time, but the biggest risk that it faces is a new entrant that provides in-home internet and takes some market share, limiting Charter’s growth. The most likely new entrants are the mobile companies that will start offering 5G, which can potentially be used for in-home internet.
Charter has already successfully competed against fiber internet offerings from the mobile companies, so it should be in a good position to compete effectively, but I will have my eye on the situation.
Energy Pipelines - Magellan Midstream Partners and Enterprise Products Partners
Magellan and Enterprise have not performed well given the weak oil and gas environment.
We have owned Magellan for ~3.5 years, and during that time our share of earnings, after taking our reinvested distributions into account, are up ~44%, good for an 11% annual increase. The problem is that I significantly overpaid for our initial stake, so that even with this relatively good performance from the business, we have still lost money.
We have owned Enterprise for about a year and over that time our share of earnings is about flat.
These companies are still producing solid earnings and cash flow - Magellan should earn close to $5 / unit in free cash flow once drivers head back onto the roads, and Enterprise should earn close to $2.50 / unit, so the stocks are currently trading at ~12% forward free cash flow yields. As I mentioned before, if they trade closer to a price that I think represents fair value, we’ll sell a good chunk of these positions down.
Future Challenges: We have discussed the challenges at length. For our investment not to work from today’s prices, we would need to see a prolonged earnings decline, which would be most likely to happen if the US energy markets remain depressed for years. Given the world’s demand for hydrocarbons, it is my belief that we will continue to see some production activity from the US, especially in the best basins where Enterprise and Magellan largely conduct business.
Berkshire Hathaway
Berkshire continues to perform well for us. Since we initially bought shares seven years ago, the intrinsic value of the company has compounded at about 12% per year, and the stock has made a similar return. Going forward, I expect annual gains in intrinsic value to be somewhat lower than that.
Future Challenges: Berkshire is so diversified and so financially conservative that it’s difficult to see a large amount of true downside. The biggest risk for Berkshire is that the company deploys capital at subpar rates of return and shareholders end up making a mediocre return. This risk is magnified, in my opinion, as Berkshire has made some large errors in capital deployment over the past 6-7 years.
Due to this risk, I have been very pleased to see the company start to buy back its stock in meaningful quantities this year. Given Berkshire’s diversification, buybacks effectively buy a broad range of businesses at a relatively attractive valuation. Buybacks might not make shareholders huge returns, but they should help to surely and steadily increase intrinsic value for the remaining shares over a long period of time.
First Republic Bank
We have had a good start to our investment in First Republic. We bought shares in March at a very attractive valuation when owning a bank looked quite scary. First Republic, however, is quite different than many other banks. First, it has very low historical loan loss ratios, so low that in some quarters they spend more on postage than on loan losses. Second, First Republic has historically grown its business at mid-teens rates organically. Most banks grow at maybe 2-4%, but First Republic spends time, money, and effort to treat its customers well, and that has led to strong growth historically.
Since we bought our shares, First Republic has continued to do what it does well - write good loans and grow its business. While other banks were setting aside huge amounts of capital for loan losses, First Republic saw almost no stress in its loan book. And in those first nine months, it has grown its assets per share, which is a proxy for the growth of the total bank, by 12.2%. Earnings have also grown, albeit less quickly than assets due to lower interest rates.
Over a long period of time, I would expect our return to correlate strongly with the growth in assets / share. Of course, what we care about are earnings, but earnings are mostly a function of assets and interest rates, with higher interest rates generally leading to higher earnings, and vice versa. So if in 5 years interest rates stay very low, then our share of earnings will probably lag the growth in assets per share somewhat, while if interest rates increase then our share of earnings should be a little bit higher.
Future Challenges: First Republic’s biggest weakness is that its return on equity is decent, but not high enough to support its current valuation. My view is that the company is investing significant sums in order to grow, and at some future point when its growth slows, these investments will subside, and profitability will increase.
For now, my main concern is that the bank keeps servicing its customers well and growing the business at high rates. At some point, we’ll need higher profitability for our investment to work well.
We also bought Google in March. There is not much to report here yet. Earnings have been roughly flat due to some advertising weakness due to the shutdowns.
I expect that the core advertising business will continue its long-term growth trajectory over time. We will also get some more details on its important, high-growth cloud infrastructure business starting next quarter.
Future Challenges: Google’s biggest challenges are likely around regulation, with the US government currently looking at their business practices. The company also faces some “hollowing out” of search, where people search for more things in an app instead of through Google’s search engine, as people do when they search for a product on Amazon, for example. Whatever happens with these risks, it’s difficult to see a world without Google’s search engine in frequent use.
The other risk is around capital allocation. The company spends significant sums on startup companies that haven’t shown an ability to generate much in the way of revenue. It also has ~$120 billion of net cash on its balance sheet, which goes past being financially conservative and is just plain inefficient. Google has started to repurchase a meaningful amount of stock, and I hope to see a continuation of that plus a rationalization of its startup spend if results continue to be poor.
Future Outlook
As I think about the “challenges” portion of each company’s discussion in the last section, the common theme that I see is related to valuation. Many of the businesses that we own sell for higher than normal valuations, and in order for us to make strong returns going forward, they will need to continue to execute their business plans extremely well for many years into the future.
For our investment in Constellation to do well from here, for example, we need the company to deploy lots of capital into M&A at high rates of return over many years. At First Republic, as I mentioned, we’ll need continued asset growth for a few years, then at some point we’ll need a marked improvement in profitability.
Where do these generally high expectations leave us? It’s difficult to predict, but I’m quite comfortable in saying that if we continue to hold our current portfolio, then we won’t see anything close to the 15-20% gains we’ve enjoyed on our stock portfolios over the last 8 years. I would guess that our returns will lag the increase in intrinsic value that our companies produce.
That being said, I still think our portfolio can deliver us attractive returns, but in the current environment, attractive returns over the next 5-10 years might be closer to 8% than 18%.
One way to combat current high valuations and high expectations would be to more aggressively trim or sell some of our positions, keep the proceeds in cash, and wait for a more attractive environment, like we saw in March of this year, to deploy the money at lower valuations.
I do some of this selling when the conditions make sense, and in fact your cash balances are higher than they have averaged historically, but I generally believe in being mostly invested in stocks. I made a large mistake a few years ago when I thought that stocks looked too expensive, I held a huge cash position, and in hindsight I missed some obvious opportunities to generate good returns.
Another barrier to larger scale selling in the portfolio is taxes. If we were to dump some of our positions because they look a little too expensive, we might only get 80 cents on the dollar after taxes. I’d much rather continue to own a good business that’s building value over time, even if it’s a little overvalued, than sell the stock, lose a significant sum to tax, and hold the money waiting for another good idea that might take a while to reveal itself.
As long as valuations of our companies don’t look outrageously high, and they don’t today, I’m more inclined to keep most of our position. If business performance is not quite as good as I think it will be and we make 6-8% instead of 10-12% on them, then that should still be a pretty good result for us over time.
We do have higher cash balances than normal due to a lack of interesting opportunities. If we do get lower valuations in the future, we should be able to deploy that cash at good rates of return, much as we did earlier this year.
Conclusion
All in all, we had an okay year in 2020. We own a collection of high quality businesses that have shown their ability to weather a significant downturn. And while we deployed a significant amount of money into the market in March at good returns, our positions in Wells Fargo and energy hurt our results for the year.
Given relatively high current valuations, our forward returns are likely to be lower than they have been for the last 7 years, although I believe that the companies we own can still generate attractive returns for us.
My goal is to protect and grow your capital over the long-term. I won’t chase hot stocks or unprofitable companies. I’ll continue to invest in good companies at reasonable prices. If I can’t find these opportunities, like I can’t right now, then we’ll be patient until I see the next opportunity. No matter what the future holds, I believe we’re well positioned to make strong returns over the long-term.
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