2022 H1 Letter

To My Clients,

Through the first half of 2022, our stock portfolios are down roughly 20-22%, while the stock market is down 20%.

I don’t usually write quarterly letters, but as the market is down significantly so far this year, I thought I would share a few thoughts on the economy, the outlook for the businesses we own, and a large mistake I made last year.

Altice – My Worst Mistake

Altice has been the biggest loser in our portfolios this year and also the biggest mistake of my career. I sold it in May for a roughly 60-65% loss. It was a 5-6% position for most of you, so I lost 3.5-4% of your portfolio’s value because of it. Going through historical investments, I believe this is the first time that any of our investments have incurred a loss of more than 1-1.5% of our portfolios’ value.

This is an especially frustrating mistake because it’s a type that I’ve made before and one I know not to make – Altice is a low-quality company with a lot of debt but in an industry I like. We have historically made effectively all of our money by owning the highest quality businesses. We’ve lost money when I’ve been enticed by a mediocre company trading at a cheap price, which describes what happened with Altice perfectly.

As I’ve written over my past few letters, I’ve been continually trying to increase the quality of the companies that we own. My mistake with Altice flew in the face of this strategy since I knew it was low quality from the beginning.

I might not have learned anything new, but Altice has changed how I am investing our money. While I have always tried to keep the quality of our portfolio companies high, I have increased the quality hurdle for new investments. In the last few months, I decided not to invest in two good companies that I previously would have been comfortable owning because they just weren’t quite great enough. They are very good companies and I think they’ll do well over time but going forward I’d like to stick to the absolute best and most predictable. Keeping a stringently high bar should help guard against mistakes like Altice in the future.

The decision to sell Altice wasn’t made in isolation. The stocks of all cable companies have fallen over the past year, and I sold Altice to buy more shares in Charter. Charter has better assets, is financed more conservatively, is managed better, and in spite of all this was trading at the same valuation as Altice last month, so it made sense to sell Altice and use the proceeds to buy Charter. I believe that we’ll make a good return from where we bought Charter while taking much less risk.  

One final note. If it makes you feel any better, and it might not, in my own personal account I make sure to own a much higher percentage of any idea that I deem riskier than normal. Altice was 5-6% of your portfolios but a little over 20% of mine.

I do this to add an extra hurdle to putting our money in any idea that has more risk than normal so that I’ll only enter one of these situations if I feel very strongly about it. I did feel strongly about this one, but I was wrong. I personally lost slightly over $___k on Altice. This is a substantial amount of money for me. Going forward, this will be a good reminder to not step into these higher risk positions. And structuring my own investments in this way helps drill that into my head.

Economic Environment

I don’t usually write about macroeconomics in my letters because the macroeconomic environment is impossible to predict, so there’s not much use talking about it. I repeatedly stress that my goal is to structure our investments so that we will survive through any type of weak macroeconomic period, even if I can’t predict when we’ll get one.

All these things are still true, but right now we are already in a weak macroeconomic period, which I think necessitates a discussion of how that changes my investment process and what might happen if things bet better or worse from here.

The current economic environment, frankly, does not look good. We have had high levels of inflation this year, which usually means that the economy needs higher interest rates to force inflation down to lower, more sustainable levels. Higher interest rates, in turn, almost universally reduce the value of cash flowing assets like stocks, bonds, and real estate. Interest rates have already risen sharply this year in reaction to the high inflation numbers, causing stocks to go down 20% year-to-date, and US bonds are even down 10%.

It is the central bank’s job to try to reduce inflation by slowing down the economy while not slowing things too much and putting us into a recession. There are, broadly, the three different paths that the economy could take over the next few years:

1.     Fed hikes interest rates too quickly, slows the economy too much, and we enter a recession quickly

2.     Fed hikes just enough, the economy gets a “soft landing” with low inflation and no recession

3.     Fed doesn’t hike enough over the next 1-2 years, inflation stays elevated, and the fed is forced to hike interest rates significantly at a later date, likely causing a very deep recession

If we get scenario 2, then everything is great and stocks probably do quite well from here. Even option 1 would not be so bad. Stocks could have more downside if we enter a recession, but it isn’t likely to be too deep, and stocks are already down significantly from their highs.

Scenario 3 is certainly the worst as it would lead to much higher interest rates and almost certainly an eventual deep recession. Because of this, if we continue to see high inflation, the market will expect even higher interest rates and stocks are likely to keep falling.

How Are We Positioned?

We have always been positioned to survive an inflationary period. That being said, we are long-term investors, not traders. I have set up your portfolios to survive a period of higher inflation and lower stock prices by holding some excess cash, trying to avoid the companies that will be hurt most by inflation, and owning some companies in sectors that should benefit somewhat.

Importantly, as economic variables are almost impossible to predict, I will not be speculating with your money to try to profit based on where I think the economy will go. I will not be selling all of your stocks because I think the economic environment looks weak. I will not be betting against stocks or buying risky options that would pay off if inflation stays high but that would lose money if inflation comes down. My goal is not to predict specific economic environments and make money by speculating on the outcomes but to make sure that our portfolio will survive any tough periods so that we can earn good returns over the long-term.

This discussion of survival is not idle talk. There are plenty of funds that are already down 50% or more this year and many more that will be down much more than that if we get sustained inflation. I consider it my top priority to make sure that we don’t suffer huge losses well in excess of those sustained by the stock market as a whole. It can be difficult or impossible to recover from these types of losses.

We will continue to own good businesses that will survive a tough environment. If inflation continues to go higher and markets go lower, our stocks will almost certainly go down and we will likely lose more money, at least in the short-term. Over time, however, the strength of the businesses we own should deliver strong results. And we have more cash to buy stocks if prices do continue to go lower.

Putting More Money to Work

The worst thing you can do as a long-term investor is to own too high of a concentration of risky assets like stocks or real estate and be forced to sell those assets as prices are dropping, which cements your losses.

I have always tried to set up your portfolios so that we have plenty of cash available to invest as prices drop. I usually have about 80% of your money invested in stocks and 20% in cash or short-duration US government bonds. I find that this broad allocation balances our goals of growing our money at a good clip over time while giving us some cushion and buying power if stock prices go down.

I don’t usually change the percentage of our portfolios that are invested in stocks by too much. I might change the percentage by 5-10% more or 5-10% less in stocks depending on the environment. But I don’t like to make any extreme moves. It is tempting to say that we should have sold some of our stocks last year when they looked expensive. These things look easy in hindsight. In the real world, everything is unpredictable.

Stocks also looked sort of expensive a few years ago, and we have made strong returns since that point. If I would have sold some stocks back then, then we would have done worse than we did, and that is even ignoring taxes, which would also be a large drag to returns for most of you. Buying and selling based on broad valuation measures sounds smart but is brutally difficult to execute in practice. My process is to stay mostly invested all of the time and to make sure that we always have some cash to deploy if prices fall significantly.

Over the 10 years through the end of 2021 holding cash has looked hopelessly conservative. But in tough environments like this, having cash available is of the utmost importance to long-term investment success.

We came into this downturn with slightly over 20% cash (Some of you keep your cash personally and send it to me if good opportunities arise. Others are consistently saving and adding to your investments. For both groups your accounts have less cash, but the principle is generally the same). I have put a small amount of that cash into stocks as the market has turned lower this year. However, I have been relatively restrained as I don’t think that the valuations of companies that I like are attractive enough to buy aggressively.

You all know that I invest by looking at specific companies. I mentioned the economy earlier in this letter because a chance of high inflation brings extra risk to any investments that I might make. In order to be compensated for this extra risk, I need to see higher returns than normal to put incremental money to work in stocks.

I see plenty of pretty good investments in the current landscape. However, I see very little that looks truly excellent. Again, given relatively higher risk in the current environment, and since most of our money is already invested in stocks, I would need something truly great to invest more of our money in stocks.

One way to frame the environment is that in late 2018 we had a scare where inflation was a little above 2% and people thought interest rates were going to go up a little. Right now, inflation is at 8%. And yet, valuations for most quality companies are higher than they were at the bottom of the market in 2018, while the environment is clearly worse today than it was then.

My intuition is to be a little cautious on capital deployment. There are a few things I’m looking at that would be interesting if they were down another 10-20%, but as of now I’m mostly just holding the great things that we already own.

Our Businesses

Besides Altice, most of the businesses that we own have had good years so far. They are generally growing, generating good profits, and investing those profits wisely by either buying back their own stock or acquiring other companies.

We do have a couple areas that bear watching. Charter is facing some increased competition although it is still growing subscribers, revenues, and earnings. Amazon’s retail unit overinvested in logistical capacity during the pandemic, and that will pressure profits for the next year or two. I believe that both issues are fixable, and each business should continue to do well over time.

As I mentioned earlier, we might have sustained inflation. I have taken great care to only own companies that will be able to pass along higher costs to their customers, a trait that is a necessity to do well during an inflationary period. If the central bank tightens conditions too much and we get an economic downturn, earnings across the board are likely to go down somewhat, although the companies we own exhibit the typical financial strength that I write frequently about – conservative financing, excellent management, and solid profitability even in a weak economy.

Over the short-term, perhaps 1-2 years, the prices of the stocks of the companies we own are likely to trade around based on the outlook for inflation and the economy. As I said before, if we get sustained inflation, the stock market is likely to go down, and we’re likely to lose more money in the short-term as well, even if our businesses are performing well. What is most important to us, as long-term investors, is that the businesses we own continue to prosper. If they do that then we’ll do well regardless of the environment.

Conclusion

We are, undoubtedly, in a difficult economic environment. Stocks and bonds are down significantly this year, as are our portfolios. If the environment continues to deteriorate, we are likely to lose more money in the short-term. Over the long-term, we will earn returns commensurate with the results of the companies that we own.

We have been prepared to survive an environment like this. The companies we own are high-quality and financially strong, and they are likely to stay that way even in a weaker economy. We own some investments that should hold up quite well in an inflationary environment, and we have avoided the most speculative types of investments that have already lost many investors significant sums of money. Crucially, we have excess cash that can be invested if valuations fall further. Valuations aren’t quite low enough to put that incremental capital to work, but things can change quickly.

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 great companies at reasonable prices. If I can’t find these opportunities, then I’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.