Introduction To Our Investment Beliefs & Approach

{ Euclidean Q4 2008 Letter }


John and I are thrilled to be writing this first annual letter to our Limited Partners.  

During the nearly 5-month period since fund inception on August 7th and ending December 31st, 2008, Euclidean Fund I, L.P. was down -11.81% while the fund’s benchmark, the S&P 500 Index, was down -29.13%.

Our Approach

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. Given this, and as this is our first LP letter, we wanted to reiterate what we believe in and the details of our approach.  We hope that the information here will help you feel connected to and comfortable with how we are managing your hard-earned capital. 

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.  Fortunately for us, most of you also felt that there had to be a different way.

Our approach was to develop new technologies to explore the seemingly infinite universe of models that can be built around public companies’ financial information. Using proprietary innovations in machine learning and information theory, and armed with a dataset of over 35 years of historical financial and price information for over 10,000 companies, we identified what we believe to be the most meaningful patterns shared by companies that outperform the market.  By embedding these patterns in our models, we are able to identify today’s companies that share these same historically fruitful characteristics.

We manage Euclidean Fund I by maintaining a portfolio of long-term holdings in approximately thirty companies selected by our models. The process of building and maintaining the portfolio is systematic.  While our models’ logic is complex, the companies that it selects typically have the following qualities:

  1. A history of large and consistent returns on capital.
  2. A conservative balance sheet and a high likelihood of surviving business setbacks or economic storms.
  3. A market capitalization that is very low relative to its historical ability to generate cash.

In managing Euclidean Fund I, we do not participate in the types of prognostications that seem popular with highly paid market analysts, CNBC reporters, and stock newsletter writers. Specifically, we do not:

  1. attempt to make detailed forecasts of companies’ future profits.
  2. evaluate qualitative factors about companies’ operations, businesses, or management.
  3. predict interest rates, the GDP, or the fortunes and misfortunes of economic sectors.

We avoid these things because we have compelling evidence that a company’s ability to efficiently generate cash and above-average shareholder returns is best understood by appropriately examining its operating history.

One benefit to this approach is that it allows us to oversee a systematic and non-emotional investment process, proceeding with informed conviction on individual investment decisions even when the consensus of marketplace analysts points in a different direction.  Another benefit is that, with a systematic approach, we can simulate how our models would 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 along side 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 think our approach is a winning one and we look forward to proving this with strong performance in the years ahead.  

Our First Year

2008 proved to be an interesting time for us to enter this business.  The markets have been impressively volatile with investor behavior driven by confusion, fear, and ultimately resignation.  As the ‘impossible’ occurred again and again (a decline in housing prices, oil dropping for a moment below $40, the demise of prominent financial institutions, etc.), individual and professional investors sold off equities in what has been the most severe market downturn since the 1930s. 

None of this fear or emotion, however, impacts Euclidean’s process. Our process relies on our models and systematic approach to invest in good companies at prices we perceive to provide a margin of safety.  Our process is emotionless and we believe a winning one.

There is, however, one way the recent volatility impacts how we invest your money; it is the extent that the environment presents us with good companies at meaningful discounts to our models’ estimation of their future ability to perform.   On this front, the recent markets have been very favorable to Euclidean. 

We have established holdings in 27 firms, all of whom have the merits of what our models view as strong returns on capital, consistent earnings power, and solid balance sheets. While these types of companies exist in all markets, we have had the opportunity to purchase them at discounted valuations not seen since the early 1970s. We believe our ability to act on these opportunities with a systematic approach – and unimpeded by emotion, fear, or greed – will yield satisfactory long-term results.

Our Holdings 

As our fund commenced on August 7th and as we invest for the long-term, it should be no surprise that we have not sold a share of stock in any company we have purchased.  Given this fact and that we plan to talk about how individual holdings have performed only after exiting those positions, this will be a lean section in our first letter.

This stated, here is some insight regarding the types of companies in which we have invested.  As of December 31st, we had 27 fully established holdings with the following qualities: 

  1. They have market capitalizations ranging from approximately $100M to $15B.  The average is $2.5B.
  2. 10 of the 27 companies are retailers.  We also have multiple holdings in other parts of the ‘Consumer Discretionary’ sector, the Energy, Healthcare, Industrials and Materials Sectors.  We also have one investment in an insurance company that classifies as a Financials holding.
  3. All 27 companies have the merits of what our models view as strong returns on capital, consistent earnings power, and good balance sheets.

The item to note in the above section is the significant concentration in retailers and the Consumer Discretionary sector of which they are a part.  Our models’ inputs are quantifiable information about companies’ historical results.  These models have found that the most repeatable method for selecting long-term investments is to buy companies with good characteristics that have been consistent over long operating histories, and are selling for a discount large enough to provide a significant margin of safety.   Our models believe that there are a number of retailers who match this profile. 

2008 Performance

More detail on our performance for the period ending December 31st 2008 is set forth below. Please see the footnote at the end of this letter for important information on these returns. Past performance is not indicative nor a guarantee of future returns. [a}

At Euclidean, our success is measured by our performance against the general market as defined by the S&P 500.  We focus here because we believe that the S&P 500’s long-term returns will be positive, and that with good relative performance versus that index over a long period of time, Euclidean’s investors will be rewarded with good absolute returns.  On this measure, our first five months were a success.

This stated, there is not a lot of information in a five month track-record, there is no joy in experiencing a decline in value, and there is no point in focusing on short-term performance with Euclidean. 

The good news is that during the five months since fund inception, we have not yet seen anything inconsistent with our simulated results. Those simulated results gave us confidence in the prospect of generating strong relative & absolute long-term returns. They are why we started Euclidean and invested the majority of our liquid net worth alongside you. These same simulations, however, also tell us that there will be years where we underperform. As a part of the Euclidean family, you should expect these periods as part of the normal cycle of successful long-term investing.   

Our Investment ‘Beliefs’

Given that this is our first letter to you, John and I thought it would be a good idea to share the beliefs that grounded our model development work and that bound all of our investment activities.  These beliefs, when held together, are not widely shared amongst the fund manager and Wall Street communities.  Some of our beliefs are most closely aligned with – and clearly greatly influenced by – the philosophies of certain leading value investors.  Others might be considered heresy even in traditional value investing circles.  Here they are:

  1. We believe the great effort put into forecasting markets and precisely estimating companies’ future cash flows leads to false confidence, emotional trading and deliberate speculation that, in turn, causes short and medium-term market inefficiencies.
  2. We believe companies have intrinsic value that sometimes diverges significantly from their market value and that this divergence creates the best opportunities for long-term investors.
  3. We believe the most reliable way to evaluate a company’s intrinsic value is to compare its past financial performance to ‘patterns’ in the historical record of all public companies’ historical financials that have been most strongly related to subsequent long-term outperformance. 
  4. We believe aspects of security analysis that have been generally thought of as qualitative (e.g., the strength of management, the extent that a company has a moat, the extent to which a company is ‘shareholder friendly’) can in fact be quantified and measured in companies’ historical financials.
  5. We believe that by innovating in the field of machine learning, it is possible to develop a systematic investment process that is scalable, repeatable and delivers consistent long-term outperformance.
  6. We do not believe in taking unnecessary risks.  We are therefore allergic to leverage. 

Our Operations

In the context of the recent Madoff scandal, it is important to note that we value third-party controls and feel strongly that you are entitled to validate that we have sound business practices.   We employ the following firms:

  1. Goldman Sachs – to be the custodian for your funds.
  2. ALPS Price Meadows – to provide independent administration & valuation of our portfolio.
  3. Spicer Jeffries – to provide tax and audit oversight for our fund.
  4. Northpoint Trading – to be our prime broker.

If at any time you would like information on any of these trusted partners, please let us know.  If you would like to get on the phone with one of more of them to validate that the assets you have and the performance you have experienced with Euclidean have been accurately represented to you, we will facilitate those calls.  We believe it is your right to have this level of visibility.

Related to this point, our plan had been to have the first audit of our fund at the end of 2009 and to include the ‘stub period’ of August – December 2008 in that audit.  Given recent events in our industry, we have decided it is in our partnership’s best interest to proceed with an audit now, commencing in January, on our initial five months. 

I would like to make one more detailed comment relating to Spicer Jeffries, our auditor, as you should be comfortable with whoever audits the firms with whom you invest. 

We evaluated pursuing a big four style accounting firm but we knew from our prior lives that would be a mistake. As a small and emerging firm, we would pay 3X the price for less responsive service than what we could get from a partner who focuses exclusively on small and medium sized funds. Such an arrangement would have violated the ‘value-orientation’ you see in every aspect of Euclidean’s operations! Moreover, Spicer Jeffries is immensely qualified to audit our fund. They have been in business for 25 years. The first 10 years, Spicer was part of Spicer & Oppenheim (formerly Oppenheim, Appel, Dixon & Co.), a firm based in New York and London who, up until their dissolution in 1990, had more securities clients throughout the United States than any other accounting firm. Then, during the past 15 years, Spicer Jeffries as an independent firm has served hundreds of clients across the entire spectrum of the securities and commodities industry. Reflecting the respect our industry has for Spicer, they were selected, along with four of the largest accounting firms in the United States, to implement FINRA's (formerly the NASD) Annual Audit Automation Pilot Program for securities broker-dealers.

Looking Into 2009

We are excited about 2009. In you and our other limited partners, we have attracted a solid core of like-minded, long-term investors. We are hopeful about finding additional partners who look a lot like you in the year ahead!

We had hoped to be able to tell you about our presentable new office space in this letter. True to our nature of seeking good assets for low prices, we had a deal to sublet offices from Morgan Stanley and pay $18 a square foot for $30 space. Alas, they decided just before Christmas to not lease the space. So, our search continues and if you know of any distressed landlords in Atlanta in need of tenants (which you would think wouldn’t be hard to find), please send them our way!

*****

It is an honor to be in business with you and we are enjoying every minute spent validating your decision to invest with Euclidean.  We aspire to maintain this privilege for many years.  If you have any questions, please feel free to call us any time.

Best Regards,

John & Mike

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