Our Biggest Winner and Loser Investments

{ Euclidean Q4 2010 Letter }

Certain information from this letter relating to individual positions has been redacted

We are pleased to write this third annual letter to our Limited Partners.   

In this letter we provide a review of 2010.  We then discuss certain investments as a means of explaining the strengths and limitations of our systematic approach to long-term equity investing.  Last, we share our expectations regarding Euclidean’s future performance.

Performance

  • During the 12-month period ending December 31st 2010, Euclidean returned +20.8% after fees to its investors.  During this same period the S&P 500’s Total Return (that is, the index return including dividends reinvested) was +15.1%.
  • A significant majority of the partnership’s 2010 realized gains have been long-term in nature.  We realized $870K in short-term gains at the end of December as one of our holdings was acquired prior to the first anniversary of our purchase.  We discuss this holding later in this letter. 
  • Since inception, our partnership has returned +73.9% while the S&P 500’s Total Return has been +3.0%.   These aggregate gains translate to annualized compounded returns of 25.9% and 1.2%, respectively.  We do not expect to maintain this level of relative out-performance over time and, later in this letter, we provide some perspectives that may be useful in setting your own expectations for Euclidean’s future results. 

Investment Activity

Our investment process, formed from taking an unbiased look at the past, systematically applies what might sound like an obvious principle.  The principle is that high batting average investing requires purchasing shares in companies with historically strong fundamentals when their shares are available at very low prices.  In practice, however, very low prices for historically strong companies only emerge when the market becomes pessimistic about those companies' future prospects.  Therefore, at the time of any of our purchases, the general consensus might be something like, “You would be crazy to buy that company!”

Sometimes the market's pessimism proves justified, and other times it proves misplaced.  All Euclidean attempts to do is purchase historically sound companies at very low prices such that negative future scenarios are already largely baked into their valuations.  Thus, if the market proves right in foreseeing some negative future development, then our downside may be somewhat limited.  On the other hand, if the market’s prediction turns out to be wrong, or if the market anticipates something more severe than what ultimately transpires, we might have a real opportunity for gains. 

Positions Sold During The Year

During the year, we sold completely out of 19 positions.  We held these positions on average for 17 months.  Of these positions, 15 generated gains (average gain of $975,000 and 73% total return) for the partnership, and 4 delivered losses (average loss of $190,000 and -13% total loss). 

We discuss some of our exited investments in the pages that follow to give you a sense of the types of companies we have been holding and also why we sold them.  Our biggest loser will be first.

MEMC Electronic Materials (-$430K loss, -23% total loss)

MEMC Electronic Materials, an S&P 500 member company, is engaged in the design, manufacture and sale of silicon wafers to the semiconductor and solar industries.  At the end of 2008, and following a drop from $75 to $15 a share, we were intrigued to see this company move toward the top of our models’ list.  After all, this was a powerful growth company that was helping pioneer the exciting solar industry!  Well, two years later, of the 19 positions we exited during 2010, MEMC turned out to be our biggest loser.  

At the time of our initial purchases, our models saw a company offered for $2.7B that had $2B in annual revenues and $400M in net income.  A P/E of approximately 7 for a high growth company like MEMC looked attractive to our models.  This was particularly so as the company had over $1B in cash, which exceeded total liabilities, and had generated very high returns on capital even as it rapidly grew over the prior several years. 

What transpired with MEMC reflects our models’ limitations in navigating an industry characterized by rapidly evolving technologies and fluctuating supply-demand dynamics.  During the years prior to our purchase, MEMC generated extremely high margins as the demand for its products greatly outstripped supply. Our analysis identified that very few companies ever attain returns on capital and margins like MEMC had delivered, let alone sustain them over many years as MEMC had done.   Those companies that had done so generally sustained materially higher valuations than we saw with MEMC.

The environment changed very quickly.  With the economic downturn, demand for MEMC’s products decreased at the same time new competitive capacity came on line to meet the industry’s demand.  As the supply-demand dynamic turned negative for MEMC, it was forced to sell fewer products at lower margins than in prior years.  What resulted in 2009 was a near halving of its revenue and an evaporation of its profits.  In 2010, the company showed some recovery but earnings and margins remained far lower than in the years before our purchases.

As each quarter went by and the company reported results that looked disconnected from the results of its past, our models gradually lost confidence in MEMC.  Even as the company took certain actions to improve its strategic position – by taking more control over its supply chain and diversifying into managing full-scale solar installations via its SunEdison acquisition – our models only saw a less consistent operating history, reduced earning power, and $400M in new debt.

It may be that MEMC’s current actions will set it up for success in the years ahead.  If they do, we are sure some of you will remind us about our untimely sale!  But our models cannot predict the future.  All they can do is look for highly understandable companies selling for large discounts to their existing bodies of work. Because MEMC no longer met the first requirement of having a consistent and understandable operating history, our models confidence in MEMC dropped and we sold our shares at a loss.  

{redacted text}

Our consolation prize is that this story allows us to highlight one of Euclidean’s advantages.

Consider how a successful value investor might do his work.  Among other things, he might read a company’s prior 10 years annual reports to understand the evolving nature of that company’s business.  If he determined that the company had an understandable operating history, a decent balance sheet, and a management culture that made good use of shareholder funds, he might then determine a fair price for its shares.  Finally, he might monitor the company to see how its fundamentals evolved and wait for the opportunity to purchase its shares at a big discount to what he believed was a fair price.

One challenge to this approach is that it does not easily scale.  Consider how many companies you could stay on top of in this manner.  Perhaps 50?  Maybe 100?  Even if the number is higher, is it likely that little {redacted text} would be on your list? 

Sometimes great opportunities are found in large companies that are widely known, other times they emerge in small companies, like {redacted text}, that few investors closely follow.  Given this, we believe Euclidean has an advantage as our systems automate the process described above.  By rapidly digesting the evolving operating histories of several thousand companies and comparing them to their market prices each day, Euclidean is well positioned to find those firms – regardless of size or popularity – with the greatest perceived divergence between the true value and market price of their shares.

Future Expectations

As we have had a strong first several years, it seems that many of our existing and prospective investors are getting more confident in Euclidean.  This is great!  We are excited about growing our business, and we love having happy partners.   Given our interest in maintaining your confidence over time, we thought it might be helpful to share our perspective on what success looks like and detail some of our expectations.  These expectations are informed by our experiences since fund inception and our ability to simulate how our approach might have performed across the past 40 years.

Four Key Points – What Success Looks Like and Expectations

  1. We will be satisfied if Euclidean delivers gains that meaningfully exceed both inflation and the S&P 500 (including dividends) over rolling 5-year periods. Please note that inflation, after hibernating for 30 years, may become a particularly relevant bogey during our investing lifetimes. 
  2. We suspect Euclidean will look best during years where the market is apathetic to pessimistic (when P/Es are flat to compressing).  Likewise, we expect to have trouble keeping pace with the averages during exuberant periods (when P/Es are expanding).
  3. We expect that during rapid market declines – when market participants scramble for liquidity and sell shares with little regard to individual companies’ strengths and weaknesses – we will decline with the market.  We also expect that when money starts searching again for the best companies offered at the lowest prices, our investment approach will show its strengths.    
  4. We believe that the best market environment for Euclidean is one characterized by high price volatility coupled with long-term market prices that rise no more quickly than the rate of corporate earnings.  We also believe that volatile environments, however fruitful to Euclidean over time, will be emotionally difficult for investors who lack a very long-term investment horizon. 

The Voting Machine

An important truth underlies these expectations.  This truth, powerfully uncovered through our machine learning process that examined domestic public companies over the past forty years, is that markets sometimes misprice companies’ wealth-creating capabilities for meaningful periods of time.  While our application of insights related to this foundational point may be new, we are far from the first people to make note of it. 

Seventy-five years ago, Benjamin Graham – the father of value investing – wrote that in the short-run, the market behaves like a voting machine but over the long-run, the market more closely resembles a weighing machine. Graham’s point was that fear, greed, and other emotions (the voting machine) can drive short-term market fluctuations that cause a disconnect between the price and true value of a company’s shares.  Over long periods of time, however, the weighing machine kicks in as a company’s economic performance ultimately causes the value and market price of its shares to converge.  

This is the crucial point underlying the expectations presented above.  When we purchase shares in a company, it is because our models have digested that company’s operating history and determined that companies with similar characteristics typically merit considerably higher market prices.  In this context, if we purchase shares and their price goes up, then all is well.  But, what about when we purchase shares and their prices quickly go down?  Could this be even better?

Our models certainly think so.  In the context of a company whose fundamentals remain strong, our machine learning process found that one should purchase additional shares as its share price declines. After all, it should align with common sense that if you liked a company ( {redacted text} ) then, especially if no financial information had since been filed that alters your views, you should like it even more when available at lower prices ( {redacted text} ). 

This dynamic is why we believe Euclidean will generally do better in markets characterized by flat to decreasing price-to-earnings ratios and why we believe we benefit from market volatility.  In both cases, we will be likely to have more opportunities to buy larger amounts of good companies at pessimistic prices.

Your Expectations

This brings us full circle in this letter.  Please consider our experience during 2010.  In April, we were up 15% for the year but then the ‘flash crash’ occurred and Euro-zone fears intensified.  Market participants became more pessimistic and, by August, our year-to-date return was negative.   Then, confidence grew that US economy was improving, and we ended the year with gains exceeding 20%. 

So, how should you feel about this year?  Should you be excited about the 20%+ return?  If you are excited about Euclidean’s year-end results, should you then also have been nervous during our significant mid-year drawdown? 

Please know that we believe performance matters.  We just think you should spend very little time seeking to gain insight from a single year’s results.  We suggest that you should neither be excited by where we ended the year nor nervous by where we stood in August.  Instead, we feel that just as our only rational expectation can be that individual companies will be priced fairly in relation to their financial performance over time, we should likewise only expect our systematic approach to equity investing to deliver attractive results over the long-term. 

Our results cannot be viewed out of context of Graham’s voting and weighing machines.  Thus, until we have a few 5-year periods under our belts and we have operated across a more diverse set of market environments, we encourage you to focus primarily on the logic of our systematic approach to long-term equity investing.  To this end, we are available to spend more time with you at your convenience.  We want you to be an informed Euclidean investor.  We think that if you understand our approach to investing and share the expectations we outlined on the prior page, we have a good shot at keeping you very happy over your investing lifetime.

Looking Into 2011

We are looking forward to 2011.  We have continued to slowly grow our investor base and – hopefully supported by these types of communications – believe we have a strong core of investors who are philosophically aligned with, and well informed of, our approach.  

*****

We greatly value the privilege of managing a growing portion of your assets.  If you have any general questions or specific feedback on the content or style of our communications, please call us at any time. 

Best Regards,

John & Mike