Our Vision For Euclidean

{ Euclidean Q3 2013 Letter }

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

During the past five years, we have developed a habit of returning to the same themes in our letters.  We have cycled among discussions on:

  1. How history informs our investment process
  2. Research results that inform our confidence and expectations
  3. Human behavioral biases that create the opportunities we seek
  4. Look-through earnings and individual positions that show our investment process at work

There really is not much more that Euclidean should write about.  We do not make predictions about the future of markets, interest rates, and the overall economy because we feel that we have no basis for doing so.  Moreover, dipping our toes into predicting what we believe is unpredictable would distract from what we believe to be true: that systematically investing in good companies at great prices has been and should continue to be a sound method for compounding wealth over the long term. 

We anticipate that we will continue to explore this belief through the same four themes in the future.  However, there is one important topic we have not spent much time on, and that is our vision for Euclidean.  Recently, several of our investors expressed an interest in understanding what we aspire to with this business.  We thought, therefore, it might be a good change of pace to paint a high-resolution picture of what success for Euclidean looks like.   In this letter, we share this picture with you in addition to providing details on the Fund’s performance and portfolio.

2013 YTD Performance

Year-to-date through September, Euclidean Fund I, LP has advanced 28.3% net of fees in the context of the S&P 500 delivering a total return of 19.8%.  Since inception, our partnership has returned +70.2%, comprised almost entirely of long-term capital gains, while the S&P 500’s Total Return has been +46.1%.  These gains translate into annualized compounded net returns of +10.9% and +7.6%, respectively.

Euclidean’s aggregate realized returns since inception have been long-term in nature.  For a taxable investor, this is very important.  From a federal tax perspective, and using current rates to illustrate the point, Euclidean’s 10.9% annualized return would result in a similar after-tax result as a 14.6% annualized return realized in a fund generating exclusively short-term gains. [1]

Despite our track record of generating gains that qualify for favorable tax treatment, we have had an unusual circumstance this year in that three of our holdings ( {redacted text} ) have been, or are in the process of being, acquired within the first year of our ownership.   Although these acquisitions bolster our reported returns, they are suboptimal for two reasons.  First, as more than 95% of Euclidean’s capital is in taxable accounts, it is particularly frustrating – to the tune of gains being taxed by an additional 19.6% – when an acquisition occurs within a few months of our position hitting its one-year anniversary.  Second, although it may feel nice when a holding jumps in market value by 25% in a single day, all three acquisitions occurred at prices at which our investment process would still have us holding our shares.  Put another way, it seems that in these acquisitions, the acquirers – not Euclidean – are the real winners.  They purchased good cash-generating companies for prices at which we would have preferred not to be sellers. 

Our Vision For Euclidean

When we discuss internally what success looks like for Euclidean, there are a number of perspectives we consider, ranging from your experience as a Euclidean Investor to our reputation in the marketplace.  In order to paint a high-resolution picture of these aspirations, we discuss them in six distinct ways. 

Our Reputation In The Marketplace

Today, the opportunity to marry data, sound thinking, and systematic process is being realized in almost every industry.    At Euclidean, our focus is squarely on applying this opportunity to long-term equity investing.  We seek the best lessons of history for evaluating the “goodness” and underlying value of individual companies.  Then, by embedding these lessons in a systematic investment process, we protect our investors against unproductive human behavioral biases.  Therefore, our aspiration is to become widely recognized as the most thoughtful and high-performing practitioner of history-based, systematic value investing.  

The Investors We Earn The Right To Work With

We have always aspired to work with smart investors who will take the time to understand our process and who have conviction that adhering to sound principles will yield good results over long periods.  During our first five-years, we have learned quite a bit more about the individuals and families who have these qualities and who prove to be most aligned with our systematic approach to value investing.

First, the right investors for Euclidean spend more time thinking about companies than markets. They embrace the idea that a company’s operating results dictate its value over the long term because, in most cases, their families’ wealth came from owning part of a successful business across several market cycles. This experience has caused our target investors to view the market’s ups and downs as little more than a reflection of human tendencies to alternate between pessimism and exuberance.

Second, these long-term investors have learned to be skeptical of Wall Street and refuse to invest in anything they cannot understand. Perhaps this is why our best investors, even though they generally are comfortable with math and technology, typically have not invested previously in quantitative or systematic strategies.  Their comfort with Euclidean grows as they appreciate that the contrarian nature of value investing makes it difficult to execute in practice and that Euclidean’s approach thoughtfully addresses some of value investing’s biggest challenges. These challenges fit into three buckets:  1) how do you best evaluate a company and its current price; 2) how do you evaluate enough companies to find truly favorable investment opportunities; and, 3) how do you separate from the crowd and proceed with an investment at the point of maximum pessimism. 

Third, the best investors for Euclidean want aligned relationships.  We have found it interesting that an important question for every one of our investors has been, “How much of your own capital do you have invested in the Fund?” Our surprise comes not so much from the question – we have the majority of our net worth invested alongside our investors – but that the question needs to be asked.  Apparently, our investors have come across many managers who do not invest heavily in their own funds and, rightly, they see the inherent misalignment and bad incentives that result.

So, our vision for success is to be viewed as the investment partner of choice for families and individuals who have these three qualities.  If you know any company-oriented, long-term minded skeptics who want to build long-lasting, aligned investing relationships, Euclidean would enjoy meeting them. 

The Returns You Receive

Euclidean exists to provide our investors with strong, tax-efficient returns over the long term. Success for Euclidean requires us to deliver double-digit, compounded net returns that exceed the market averages by at least what we have done across our first five-years.  Success also means keeping our investors aligned with our expectations, which might be summarized as follows. 

We feel that our only rational expectation is that individual companies will be priced fairly in relation to their financial performance over time.  Likewise, we aspire to deliver attractive results over the long term.   We accept that across intermediate periods we often will look more or less smart than we really are.  While it would be great to be able to predict whether a tough or fruitful period is around the corner, we have not found any reliable way to do so.  However, we feel that we are operating with the weight of history on our side, and we believe our investors will benefit as we adhere to our process during the years ahead. 

So, success comes from meeting our return aspirations and also from keeping you on the bus along the way.  To this end, we always will strive to keep your focus away from short-term results (be they for better or worse) and squarely on the long-term logic of our systematic approach to long-term equity investing.

The Experience You Have With Us As Your Investment Partner

If an investment manager does not deliver good returns over a long period, he will have a difficult time maintaining his business.  In this sense, returns trump all other aspects of an investor’s experience with a fund.  However, in the context of strong returns, we suspect that our investors greatly prefer knowing that they have a partner who cares about their success. 

To this end, we often imagine ourselves in your shoes and consider how we would want to be treated.  This is easy to do as both of us have most of our net worth invested in our own LP accounts right alongside yours.  This is what causes us to push for early delivery of K1s, to continually observe and evaluate each aspect of our investment process, to put a lot of thought into our investor communications, and to be highly responsive to any question you throw our way.  We want you to know that we never take you for granted and we hope you see us constantly earning the right to remain your investing partner. 

Success for us comes on those days when you tell your friends and peer families about Euclidean, and part of what you share is that Euclidean is run by really nice people who care about succeeding on your behalf.  Success will also come to the extent that, as we grow, you still see the same level of alignment, hustle, and responsiveness that you experienced with Euclidean during our early days.

Growth & Asset Size

Within our circle of competence – that of seeking history’s lessons and infusing them into systematic investment processes – there are many questions we would like to explore.   The answers to some of these questions have the potential to improve performance in our current fund, and others may lead to new ways we can serve thoughtful long-term investors.   For example, today, we invest only domestically and yet there is a large opportunity to apply our approach in other markets.  We believe that there are other investment objectives (other than the maximum, long-term, tax-efficient return objective we pursue today) that might appeal to our target investors, and that could be pursued in a manner consistent with our philosophy.  We also are interested in exploring how “the Euclidean Way” might work in areas beyond common equity, such as with corporate debt securities. 

While we look forward to earning the right to tackle these opportunities in the future, today, our energies remain focused on research that relates to the growth and performance of Euclidean Fund I, LP.  There are still many areas we seek to better understand.  As an example, we note that our performance since inception would have been improved – particularly so in 2012 – if we frequently rebalanced such that our capital remained more equally weighted across positions.  The questions we are exploring are: 1) would equal weighting have been generally beneficial across the past 50 years, or were the last five years unusual in this respect; and, 2) can you capture the potential benefit of equal weighting without – through the more frequent trading that equal-weighting requires – sacrificing so much tax efficiency as to erase the potential benefit to gross returns. 

By exploring questions like these, we aspire to deliver you strong long-term results and also earn the right to work with new investors.  However, our growth aspirations for Euclidean’s current fund are not extreme.  We know that large amounts of assets necessarily reduce a fund’s investment universe and, consequently, must reduce that fund’s long-term return expectations.

So, in terms of growth and asset size, we aspire to grow to approximately 5X our current assets under management and then stop actively seeking new investors for our current Fund.  At that time, our intent would be to enjoy, collectively, the higher compounding that comes from not gathering assets aggressively and to accept new investors only during those periods of pessimism when it is both most fruitful to invest and most indicative that any new investor truly is aligned with our approach.

Our Culture and Team

Today, our conservative nature has us generally working with partners and contractors instead of full-time employees.   Prior experience has seared in our minds the wisdom of maintaining a big margin of safety in our operating expenses, just like we do when we make investments.  However, as we attract new investors and grow the assets already under our care, we look forward to building a strong team of data scientists and a tight group of finance and administrative professionals. 

As we grow our team, we aspire to foster a culture of Mellow Intensity.  This dichotomy reflects both our big ambitions and our willingness to take the time to realize those ambitions in the right way.  We intend to foster this unique culture by nurturing the following Euclidean values.

  1. Great Energy – As our team grows, we want visitors to have a good feeling the moment they walk into our offices.  We will achieve this by employing only individuals who contribute significantly more energy to the team than they require from others.  This simple practice worked very well for us in our prior business.  We expect the result to be a high-energy environment that attracts the best people, makes Euclidean a great place to work, and provides a great impression to our visitors, prospects, and investors. 
  2. Innovation and Learning – Euclidean was founded on the notion that by learning from large bodies of experience and creating methods of systematically adhering to history’s lessons, there is an opportunity to deliver satisfactory long-term results.  This process of looking for new answers and embedding new findings into our process will never end.  Therefore, we will seek individuals who are passionate about new methods of searching for truth and who constantly question beliefs others hold as self-evident. 
  3. Investors First – We recognize that the great work we do and the environment we enjoy would not be possible without maintaining the right to serve our investors.  Therefore, we value putting energy into delivering not only great results but also a great client experience.   This experience involves aligning our incentives with our investors’ long-term goals, proactively keeping them connected to our thinking, quickly responding to any question they raise, and always behaving in a manner consistent with a commitment to re-earn the right to serve them each day.

There is no question that our ability to deliver superior returns over the long-run is the primary prerequisite for success.  However, on their own, great returns will not allow us to achieve our vision and become widely respected as the most thoughtful and high-performing practitioner of history-based, systematic value investing.  To accomplish this, we must also earn the right to long-term relationships with aligned investors and must constantly innovate on their behalf.  We must provide a great experience that makes our investors know they have a devoted partner in Euclidean, and we must foster a culture that protects that experience as we grow. 

This is the high-resolution picture we are working toward, and we hope you enjoyed getting a glimpse of it.  

*****

We greatly value the privilege of managing a portion of your hard-earned assets and want you to be an informed Euclidean Investor.  We are available to discuss the content shared here, individual positions in our portfolio, or any other questions you might have.  Please call us at any time.  We enjoy hearing from you. 

Best Regards,

John & Mike


We share these numbers because they are easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale. [2] [3]

It is important to note that Euclidean uses similar concepts but different measures to assess individual companies as potential investments.  Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth.  Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade-offs between measures, and so on.  These numbers should, however, give you a sense of what you own as a Euclidean Investor.  In general, higher numbers for these measures are more attractive.  The key measures are:

  1. Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields.  Earnings Yield reflects a company’s past four-year average earnings before interest and tax, divided by its current enterprise value (enterprise value = market value + debt – cash).
  2. Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) in the business. At its highest level, this measure reflects two important things.  First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders.  Second, it indicates whether management has good discipline in deciding what to do with the cash it generates.  For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy, will show lower returns on capital than businesses that do the opposite.  Return on Capital reflects a company’s four-year average earnings before interest and tax, divided by its current equity + long-term debt. 
  3. Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others.  High numbers here imply that the company owns a large portion of its figurative “house” and, all else being equal, indicates a better readiness to weather tough times.
  4. Revenue Growth Rate – This is the annualized rate a company has grown over the past four years.

[1] Assumes a federal long-term capital gain tax rate of 20.0%, the maximum rate on ordinary income of 39.6%, the Medicare surtax on investment income of 3.8%, and no state or local taxes.

[2] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials.  That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on.  Then, it sums those numbers with its pro-rata share of all other portfolio companies.  This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures presented here. 

[3] The S&P 500 measures are calculated in a similar way as described above.  The market values, revenue, debt, assets, earnings, etc., for each company in the S&P 500 are added together.  Those aggregate numbers are then used to calculate the metrics above.  For example, the earnings yield of the S&P 500 is calculated as the total average four-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).


Euclidean’s Largest Holdings as of August 15, 2013

In 2013, we established a practice of sharing our 10 largest positions.  We are sharing this information because a growing number of you have expressed an interest in talking through individual positions as a means of better understanding how our investment process seeks value.  Also, Euclidean aspires to grow such that next year our size would require us to disclose, via 13F filings, our positions 45 days after the end of each quarter.   We feel that adopting a practice this year of disclosing our largest positions with a similar lag will lead us nicely into our new requirements in the future. 

We are available to discuss these holdings with you at your convenience.  We are happy to explain both why our models have found these companies to be attractive as well as our sense of why the market has been pessimistic about their future prospects. 

Euclidean’s 10 largest positions as of August 15, 2013 (in alphabetical order)

  1. Deckers Outdoor – DECK
  2. DeVry – DV
  3. HollyFrontier – HFC
  4. Humana – HUM
  5. ITT Educational Services – ESI
  6. Jos. A Bank – JOSB
  7. Kirkland's – KIRK
  8. LHC Group – LHCG
  9. Maidenform Brands – MFB
  10. Synnex – SNX