History As A Guide To Future Expectations

{ Euclidean Q1 2010 Letter }

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

There can be few fields of human endeavor in which history counts for so little as in the world of finance.  Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

 - John Kenneth Galbraith, A Short History of Financial Euphoria

Howard Marks

As we work to build a preeminent firm, we spend a lot of time looking at investors who built company cultures, investment track records, and communication practices that we admire. One such investor is Howard Marks at Oaktree Capital Management. 

On the surface, Oaktree and Euclidean do not have much in common. Oaktree invests primarily in distressed and high-yield debt, while we invest in equities. Howard and the Oaktree team embody the best of traditional, analyst-driven, in-depth research. They might be skeptical of our systematic, data-driven approach to investing.

Despite these differences, we look up to Howard because:

  1. He consistently writes insightful client letters.
  2. His investment philosophy has remained constant over decades. 
  3. His investment philosophy is sound and yet is uncommon.  In Howard’s letters we have found one of the best voices supporting some of our own black-sheep beliefs including his disavowal of market timing and assertion that macro-forecasting is not a key to investing success. 

As we write our letters, we are striving to define our own voice for expressing our investing beliefs.  Success for Euclidean depends in part on our developing a communication style as strong and clear as Howard’s and, through good performance, earning the right to consistently use it for many years.   So, please stick with us as we get there!

How do you stay the course when current feedback says you are wrong?

Howard is fond of quoting John Kenneth Galbraith and we first came across the quote shared at the start of this letter in Howard’s May 2005 Memo to Oaktree Clients. This quote relates to the best question we receive from current and potential investors, which comes in forms such as:

“What will you do when you underperform the market for an extended period of time?  Will you be tempted to tweak your approach?”

Or, the surlier

“It will be interesting to see how well you adhere to your model when you have your first bad year.”

This is a question we would want answered if the shoe was on the other foot and we were evaluating Euclidean.  It is an important question because it rightly assumes that it is easy to adhere to an approach when everything is going well, and it is human nature to contemplate trying something new when things go poorly. 

To make this point, imagine you ran Euclidean and had friends, family, and other people you respected as investors.  Imagine further that you found yourself in the middle of 12-24 months of delivering below average results.  

Even if you felt there was compelling historical evidence that your investment process was likely to do well over long periods of time, that short-term stretch of underperformance would not feel very short. The experience would be excruciating and you might be tempted to change your strategy.

Thoughtful investors wonder how we will behave when tested in this way.

Our Touchstone

As we shared in our 2009 year-end letter, one of the conditions we required to gain confidence in our investment approach was strong historic evidence that our investment process would have worked in the past. In our minds, we satisfied this condition by:

  1. Examining domestic public companies from the 1960s through today to search for what would have been the best process for evaluating individual companies as potential long-term investments.
  2. Simulating (or back-testing) how well a fund managed as we manage ours today would have performed if it had been started in the early 1970s and ran through today. 

In our simulations, we saw attractive, long-term returns.  We also saw that our simulated net performance outperformed the S&P 500’s total return (that is, the S&P 500 index return with dividends reinvested) over about 70% of rolling 12-month periods.  

Two things must be said about this simulated result.

  1. There are no guarantees that our actual go-forward performance will resemble these simulated results.
  2. If we perform as well as we could reasonably expect (that is, if our actual performance resembles our simulated performance) we will find that 30% of the time Euclidean will have underperformed the market during the prior 12 months.

It is easy to brush off that second statement. A 12-month (or greater) period of lagging the market average may look insignificant when examined in the context of a decades long back-test but it will not feel so insignificant when experienced in real-time. In fact, after 12 months lacking any positive feedback, it may be difficult to continue believing in what decades of history showed to be true. 

This is what Galbraith was on to and hints at why many investors discard sound investment principles at exactly the wrong time.

Think back to your own investing lifetime for examples.  In the late 1990s, after a few years of negative feedback and watching their neighbors get temporarily rich, many investors who once believed that profits matter discarded that belief and jumped into Internet stocks just before the bubble popped.  Likewise, in late 2008 and early 2009, many investors who once believed that companies have inherent value threw in the towel as the short-term (and in retrospect, what look to have been temporary) losses they were enduring became too much to bear. 

Behavioral finance theorists talk about this tendency to discard long-standing principles when they fail to yield short-term results as “recency bias”.  Wikipedia provides a simple example of how this bias affects people in their everyday lives:

If a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, they are likely to conclude there were more red cars than blue cars throughout the drive.

Perhaps this is why an approach such as ours can work over the long-term.  If it always yielded strong immediate term results, it would be easy to adhere to and, with more adherents, there would be more competition for the investment opportunities that we depend on.

During periods of negative feedback, market participants have repeatedly departed from history’s long-term lessons in hope of optimizing for Galbraith’s “incredible wonders” of the present.  We believe Euclidean’s investors will continue to generate long-term profits from others’ well intentioned but financially damaging departures from historically sound principles.

Individual Investments

Periodically in our letters we will describe certain investments as a means of painting a higher-resolution picture of our investment approach.  After all, it is one thing to talk in the abstract about high-returns on capital and conservative balance sheets, but it is often more helpful to describe these concepts in the context of a company that possesses them. 

When we choose companies to discuss in our letters, there is a temptation to pick ones where our approach performed wonderfully. And, as we talk about {redacted text} below, we have absolutely succumbed. 

However, to provide you with a more balanced view of the successes and challenges of adhering to our systematic approach, we will begin with a quick review of a situation where we currently do not look so smart. 

{redacted text}

When you think about Euclidean and these examples, we hope you will remember the following:

  1. The historical record gives us a foundation for evaluating companies’ inherent values.
  2. Our evaluations of individual companies values are probabilistic in nature and, therefore, imprecise.
  3. Our systematic approach to investing and portfolio management acknowledges this imprecision and is structured to allow favorable probabilities to play out over time.
  4. We seek to buy and hold when investors are pessimistic and over-discount a company’s solid historical results.
  5. We seek to sell when optimism returns and investors begin giving a company the benefit of the doubt on future performance.

*****

Please let us know if you have any thoughts or comments on this letter.  We look forward to connecting with you in the weeks ahead.

Best Regards,

John & Mike