Reiteration Of Our Investment Approach

{ Euclidean Q3 2010 Letter }


Recently, one of our new investors asked if we would be willing to summarize our investment philosophy in a future letter.  As we have not tackled this since our 2008 year-end communication, we thought now was a good time to reiterate the essence of our investment approach. 

After all, a big part of our vision is to have a core of informed and like-minded partners with whom we grow a preeminent firm over time.  We want you to feel very connected to and comfortable with how we are managing your hard-earned capital. 

So, in this letter, we begin with some comments specific to the third quarter and then attempt to satisfy our new investor’s request.

The Third Quarter 2010

In our last letter to you, we wrote:

“… our best years are likely to result from the most uncomfortable and volatile market environments.  … we anticipate that our short-term results will look the most dismal at the exact moments we are making our best investments.” 

It is easy to make this kind of statement from the comfortable perch of outsized returns. Comments about markets ignoring companies’ intrinsic values come across as thoughtful when shared by an investor who has delivered strong recent results.  Those same comments, however, sound like “excuse-making” when made in context of poor performance.  As we have just completed our first period of market-lagging returns, we are happy we wrote our last letter when we did!

Kidding aside, we do strongly believe in the sentiment repeated above. The very human oscillation between fear and excitement is reflected in the markets and often causes assets to be priced too low or too high for long periods. Even in the context of a company whose intrinsic value is already under-appreciated, there is no reason to expect that the market may not first become even more pessimistic about the firm’s prospects and push its stock price down further before the levity of strong operating results pulls its stock price back up. 

During the quarter, the levity of strong operating results seemed at times to be exerting a weaker pull than the force of 'macro' fears (e.g., solvency of European banks, deficit concerns, unemployment). The Wall Street Journal recently published an article titled 'Macro Forces Stump Stock Pickers.' The article's premise was that market participants have been making top-down decisions, moving money in and out of the stock market as they rapidly vacillate between 'risk-on' and 'risk-off strategies. In this context, the article explained, there has been a historically high correlation between the price movements of individual securities as the relative differences in companies' operating results have been somewhat ignored.

Euclidean on Market Value

Euclidean's strategy -- which focuses on investing in under-valued and under-appreciated firms -- is unlikely to deliver strong relative performance so long as these historically high correlations persist. However, we believe that a company's evolving fundamentals will dictate its market value over the long-term. Thus, an environment where the market is making little differentiation between companies is one where we anticipate mispricings will emerge and grow. To be excited about this kind of environment (as we have been), you need to accept three things.

  1. First, you must embrace the idea that a company's operating results will dictate its market value over the long-term. Put another way, you need to believe that the strength of a company's business model, the consistency of its execution, and its ability to serve customer needs better than competitors, will ultimately determine what the company is worth.
  2. Second, you must view the market's daily up-and-downs as little more than a reflection of the very human, emotional ride across fear, apathy, and exuberance. By accepting the market for what it is, you would avoid the temptation to become anxious or excited by short-term market moves. 
  3. Third, you would sense opportunity when the market temporarily ignores the evolving, relative differences in companies' results. You would anticipate that high market volatility and correlation between share prices would present opportunities to acquire shares in certain companies at very low prices and, over time, sell them at a fair value. 

To us, these seem like simple concepts. Yet, most market participants' frenetic, 'risk-on risk-off', behavior shows they do not accept them. Maybe their investment horizons are so short as to force a constant effort to avoid monthly or quarterly drawdowns. Or, perhaps they fear we face era of macroeconomic and political upheaval that is so unprecedented as to make historically sound investing principles irrelevant. Either way, as you form your own views, we thought we would share another perspective for you to consider: 

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or Treasury bill yields fluctuating between 2.8% and 17.4%.... But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist... A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

- Warren Buffett, 1994 Berkshire Hathaway Shareholder Letter

Our Approach 

As you know, our mission is to bring a quantitatively rigorous and systematic approach to long-term investing. We pursued this mission because we had our own money to invest and were not comfortable with the short-term focus, risks of leverage, misaligned incentives, and reliance on qualitative analysis that in various combinations characterize today’s asset management options.

Our approach involved exploring the record of public companies' operating histories.  We hoped that, by digesting the quantifiable experience one could have obtained by investing in public companies over the past 40 years, we might we able to identify a promising, repeatable method for evaluating individual companies as potential investments.

After several years of developing our learning technologies and taking an unbiased look at the historical record, we found a strong validation of some very common sense concepts.  Specifically, we found the ‘highest batting average’ style of equity investment comes via companies with:

  1. High and persistent returns on capital.
  2. Long and consistent operating histories. 
  3. Conservative balance sheets.
  4. Market capitalizations that are very low relative to their demonstrated ability to generate cash.

Certainly, we are not the first people to make note of these qualities.  In fact, if you had 20 professional investors in a room, they might all agree that these are important concepts.  To understand what makes Euclidean different, please consider the following:

  • If you asked those 20 investors the best way to measure those concepts and express them mathematically, you would very likely get 20 different answers. The investors’ different answers would be shaped by each one’s ability to distill the right lessons from his/her own unique experiences investing in companies, sitting on boards, building businesses, and reading about others’ investing successes and failures. 
  • If you asked those investors how they would balance those concepts – perhaps, “How much would you flex on the conservative balance sheet requirement if a company was pristine in every other way?” – you would, again, be likely to get 20 different answers for the same reason described above.
  • Euclidean has made an effort to digest the available, quantifiable experience one could have obtained by investing in public companies across the past 40 years. This effort has allowed us to search for effective and persistent methods for using a company’s operating history and current valuation to evaluate it as a potential investment. 
  • Euclidean applies our findings in a systematic, non-emotional manner. That is, we adhere to the lessons we have been able to derive from history, with no modification based on the macro fear or thrill of the day. 

Given our reliance on distilling lessons from the past, one question we often get focuses on risks we would face if the future proves to be materially unlike anything we have ever seen. We reply that it aligns with our experience (and common sense) that:

  • Strong returns on capital are better than weak returns on capital.
  • Strong balance sheets are better than weak balance sheets.
  • Consistent operations are better than erratic operations.
  • Companies generally perform better as investments when they are purchased at discounted – instead of premium – prices.  

We believe these statements were true 40 years ago, are true today, and will be true in the future.  

But, can it really be possible to profit by simply adhering to these common sense principles? We think the opportunity for profit exists because most market participants spend so much energy trying to predict the unpredictable.  As they rapidly bid up and sell off shares to reflect their evolving sense of how developments in technology, regulation, interest rates, and other exogenous factors are going to impact their portfolios, Euclidean simply lays in wait.  We make no effort to time our purchases or predict the future.  We simply wait for historically good companies to be offered at very low prices, and then we get to work. 

Therefore, and this should now be obvious, Euclidean does not pay heed to prognostications that seem popular with highly paid market analysts, CNBC reporters, and stock newsletter writers.  Euclidean also does not attempt to make detailed forecasts of interest rates, the GDP, or the fortunes and misfortunes of economic sectors. We avoid these things because we believe that a company’s ability to efficiently generate cash and above-average shareholder returns is better understood by appropriately examining its operating history.  In our minds, almost all other information is at best a distraction and at worst misleading. 

After enduring this part of the Euclidean story a third time, a good friend said, “But macro developments, while perhaps unpredictable, will still impact companies’ operating results and, hence, their long term values!”  There is no question that he is right.  But, this does not mean that investing energy in trying to know the unknowable is helpful.  Rather, it means that you might prepare for an unknowable future by purchasing historically sound companies at very low prices such that negative future scenarios are already largely baked into their valuations.

Thus, if the market proves to be right in foreseeing some negative future development, then your downside may be somewhat limited.  On the other hand, if the market’s prediction turns out to be wrong or if the market anticipated something more severe than what ultimately transpires, you might have a real opportunity for gains. 

One benefit to this approach (one that prepares for, but does not attempt to predict, the future) is that it allows us to invest in a systematic and non-emotional way, proceeding with informed conviction on individual investment decisions even when the market consensus points in a different direction.  Another benefit is that, with a systematic approach, we can simulate how our investment process might have performed at different times in the past. 

These simulations gave us confidence to invest all of our energies in building Euclidean and to do three things that we hope you care a lot about.

  1. To invest the majority of our liquid net-worth alongside you in the fund. 
  2. To refuse to leverage the fund’s capital.  We are not comfortable taking unnecessary risks to goose returns or to smooth the volatility that is a natural part of generating attractive long-term returns.
  3. To take performance allocations only in years where you receive positive net returns that meet or exceed the total returns of the S&P 500.

*****

We believe our approach is a winning one, and we look forward to continuing to show this with strong performance during the decades ahead.

Best Regards,

John & Mike