Do You Know When You Are Winning?

{ Euclidean Q2 2010 Letter }

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

Often in business, it is obvious when you have won but it is not obvious when you are winning. 
 
This is because sometimes when the skies are darkest, when your recent financial results are showing negative trends, and when life is just a little less fun than it might have been before, your competitors are having it even harder than you. During these times, some of your competitors will go away and others will be impaired as they cut to the bone in order to survive. 
 
And so, when the sky clears and the environment for your business improves, the first thing you do is take a deep breath and think, “Boy, I hope I never need to go through that again.” But then you survey the landscape and realize that your business is the only one left standing. You are going to win your race.

*****

As you know, at Euclidean, we seek to acquire companies’ wealth-creating capabilities at prices below their inherent worth. To do this in a systematic, data-driven manner, we developed a suite of learning technologies to digest the quantifiable experience one could have gained by investing in domestic public companies across the past four decades. Through this machine learning process, we sought to uncover history’s lessons on how to evaluate individual companies as potential investments and how to apply these lessons in the context of an evolving portfolio. We believe that by unemotionally adhering to the lessons we can derive from history will prove fruitful for our investors and ourselves over time. 
 
Even as we invest systematically, however, we are passionate about understanding business and the many different ways that businesses make money. 
 
Every day we have the opportunity to consider companies that our models indicate are favorably priced in the context of a market that is immensely pessimistic about those individual companies, their industries, or both. We enjoy this activity more than you could possibly imagine. We also believe that, in addition to it being fun, staying immersed in the details teaches us things, helps us develop new questions to pose to the historical record, and prepares us to become better model builders & investors. 
 
In this context, we have watched the evolution (both in operations and market price) of many companies that suggest investors are often unaware of when a company is on the verge of ‘winning.’ Winning here meaning that a company is in the process of greatly improving its competitive position and setting the stage for strong financial results and market returns in the years ahead. 

In this letter, we share our own experience as operators relating to this topic and also describe a few companies we have owned that demonstrate the point. Last, we share our performance for Q2 2010. 

Our Own Experience - We Did Not Know When We Were Winning

As most of you know, before we started Euclidean, we spent over a decade helping to build a software-as-a-service company named Employease. When you think of Employease, think of Salesforce.com (NYSE: CRM) but for the Human Resource (HR) applications that a company needs to manage its workforce. 

Employease was founded on a kitchen table in 1996. We had our first clients in 1997 and began to rapidly grow. By 1998, the Dot-Com craze began to gain steam and we suddenly had very easy access to large amounts of venture capital. Unfortunately, so did our competitors. 
 
By 2000, the good news was that we had been growing at a rate of almost 50% each year and we had an expanding base of very happy clients. The stressful news was that we had dozens of competitors raising funds and building teams to challenge us in our goals. 
 
In this environment, we felt a lot of pressure to get big as fast as possible. Our competitors were launching significant advertising campaigns and paying above top-dollar for engineering and sales talent. Some competitors were even giving away their products for free with a belief that they could monetize their customer bases down the road. It was hard to compete with free. 
 
Then, the Dot-Com bubble popped. Capital became unavailable. We decided we needed to cut a third of our 150 employee staff in order to begin generating cash. We learned in a painfully high-resolution way that, in recessions, companies tend not to invest in new HR applications. On top of this, our revenue model was one where we were paid on a per-employee per month subscription basis. So, even though we retained a high percentage of our existing clients, when those companies began to cut staff, we had to sell new business just to keep revenues flat. 
 
We did not sleep at night. We had heartburn. We were fighting to survive and nothing about life felt very fun. Only later did we realize these feelings were really the feelings of winning. 
 
How could that be? 
 
Well, in 2003, the sun suddenly popped out from behind the clouds. Companies began hiring again and investing in the infrastructure they needed to manage their workforces. We had survived the recession by making hard, early decisions to preserve cash. We even managed to grow every quarter through the downturn and, when demand returned, we found ourselves well prepared to capitalize on it. 
 
As we looked around, however, we realized that all of our competitors were gone. For many, the consequence of launching big expensive advertising campaigns, paying above market rates for talent, and cutting prices, was going out of business. Others, still alive but impaired, ended up selling their businesses at fire-sale prices. 
 
Our company was the last one left standing. Our annual top-line growth accelerated back towards 50%, we began posting strong profits, and we ultimately delivered strong returns to our investors via the sale of our business to Automatic Data Processing (NYSE: ADP) in 2006. 
 
Even though the champagne popped on acquisition day in 2006, we really won our little battle by outlasting our competitors during 2001-2003. It had not been obvious when we were winning. And, the process of winning did not feel good. It was a struggle. 

What We See In The Data & In Our Portfolio

When we took an unbiased look at the operating and market price histories of domestic public companies over the past four decades, we found two cause-and-effect relationships. First, companies tended perform better over time if they had a long and consistent operating history, a capability to weather difficult times, and a track record generating strong returns on capital. Second, these companies tended to best perform as investments when they were purchased at very low valuations relative to their historic earnings. 
 
A qualitative perspective we might add after watching dozens of companies navigate the challenges of the past few years, includes: 
 
1) Companies with the characteristics described above are often well prepared to gain market share and win competitive battles during times of severe industry stress. 
 
2) Investors often do not appreciate when their companies are winning. At the exact moment certain companies are gaining the most ground on their competitors, they are sometimes offered at the lowest prices. 

{redacted text} 

It is helpful to remember that the process of winning is not always a comfortable one. We think this lesson is important to us as fund managers and to our investors as well. 
 
We suggest this because our best years are likely to result from the most uncomfortable and volatile market environments. Just as with Employease, {redacted text} we anticipate that our short-term results will look the most dismal at the exact moments we are making our best investments

Think back to when our portfolio’s market value materially declined during the end of 2008 and in early 2009. It may not have been very much fun to watch the ticker during those days. In retrospect, however, with every drop in market prices, our systematic process had us moving money into what our model identified as better and better companies at lower and lower valuations. As a result, the moment our short-term performance looked poor proved to be the same moment we were planting the seeds of substantial long-term gains. 

As we continue to operate in a volatile market, we hope that these perspectives – coupled with our commitment to consistently apply our investment approach – will inform and strengthen your confidence in Euclidean. 

*****

We value our relationship with you and aspire to maintain your trust for many years to come. To this end, please let us know if you have any thoughts or comments on this letter. We look forward to connecting with you later this summer. 

Best Regards, 

John & Mike