State Of Portfolio and Lessons Learned

{ Euclidean November 2012 Letter }


We are writing this off-quarterly-cycle letter to provide an additional level of detail that you may find helpful as a Euclidean Investor.    

We have been running Euclidean Fund I for four years.  Despite the fund’s returns since inception exceeding the S&P 500’s total return, our performance has been poor across 2011 and 2012.  Given this, we wanted to provide you with perspectives we would value if we were in your shoes regarding the nature of our performance, the state of our portfolio and lessons we have learned.  

Two Year Look Back

After starting strong from 2008-2010, our portfolio has declined in value from the start of 2011 through October of this year.  This depreciation has not been driven by just a few holdings; it has been broad-based.  If we had avoided our ten biggest losers, our performance during this period would still be negative. 

Since the start of 2011, despite the portfolio’s decrease in market value, the majority of positions we have sold came with realized gains and, in aggregate, our exited positions have shown gains.  The implication, obviously, is that we are currently holding a substantial amount of unrealized losses in our portfolio.  This is important and begs the question of why Euclidean is maintaining positions in companies whose share prices have declined. 

Euclidean’s investment process, systematic as it is, simply grades companies against the fundamental measures we have found to be most predictive of subsequent long-term investment success.  If a company’s fundamentals decline such that, based on historical precedent, it no longer looks favorable at its current price, our models will have us sell that company, even if we are holding it at a substantial loss.  However, in general, our models have not had us sell these companies.   Our lens into history suggests that many of our down positions maintain attractive long-term investment prospects.    

Current Portfolio

As we have written to you, we believe the aggregate look-through fundamentals of our portfolio are attractive.  With regard to enterprise value, our holdings are collectively valued at only three times the amount of pre-tax earnings they have generated on average over the past four years.  This valuation comes in context of the S&P 500 as a whole having an enterprise value of 12.5-times its collective four-year pre-tax earnings.   This wide spread exists even though our portfolio companies have long operating histories and – in general and on average – look more attractive than the market as a whole when measured on long-term returns on capital, core balance sheet metrics (e.g., our portfolio companies, in aggregate, have more cash than debt), and revenue growth.  

We believe that the pessimism surrounding our holdings’ future prospects comes, in part, from broad economic and regulatory concerns, and in part from company-specific challenges resulting in near-team earnings and revenue deterioration.   For example, we own defense contractors in context of the looming fiscal cliff, healthcare companies in context of an evolving ObamaCare environment, and for-profit educators that are adjusting to challenging new regulations.  We also own retailers and technology companies that have had difficult recent quarters, and some that have significant exposure to the Eurozone slowdown. 

In situations such as these, when businesses experience setbacks and when the conventional wisdom is that difficult times are ahead for a particular industry, investors get very afraid.  This fear and pessimism sometimes causes investors to be unwilling to hold historically good companies at almost any price.  You can see this in action within Euclidean’s portfolio.  Viewing enterprise value in relation to trailing four-year earnings, our portfolio would be valued similarly to the market only if 75% of the long-term earnings power of our companies went away.   

This is a big reason we remain confident in our prospects for strong future returns.  The historic record seems unambiguous that, given our portfolio companies’ favorable balance sheets and long-term characteristics, it is unlikely that their collective futures will justify the current level of pessimism.  Finding those companies where fear is most overdone is what Euclidean seeks to do in a systematic fashion and, we believe, is the best way to compound wealth in the equity markets over long periods.

Lessons Learned

Here, we summarize three lessons learned from our first four years in the business:

1. The Level Of Commitment Required - After 2009, when Euclidean had robust returns, we wrote:

"There are high-profile examples of investment firms with very strong multi-year track records who quickly imploded.  And, there are legendary investors who have had difficult multi-year periods where commentators wrongly wondered if they had lost their touch.  The reliable clues to a firm’s future prospects will come not from short-term results but from the nature of their investment approach.”

We remember writing this and knowing it was true, even though we had yet to endure a difficult period of underperformance.  Now that we have lived through six challenging quarters, it seems that one of our most important learnings is how much commitment is required to adhere to an investment process when immediate-term feedback is not positive. 

Prior to this period, it was easy to imagine times in the past when our returns may have been similarly challenging (as, for example, they may have been in the late 1990s), and brush them off because of the strong long-term returns that seemed likely to surround those difficult periods.  Now, it is easier for us to appreciate why value strategies tend to do well.  The ride to long-term success comes with periods of volatility and underperformance that challenge one’s commitment to the investment process.  As many investors will not tolerate the ride, there are always seats remaining at the destination. 

2. Market Capitalization Dynamics – As we work to understand the drivers of our recent performance, we notice that Euclidean’s performance during 2011 and 2012 likely would have been significantly stronger if we had limited our investment universe to the S&P 500, and excluded all small and mid-capitalization companies.  This is an interesting finding.  Despite having the opportunity to ‘learn’ otherwise by digesting investment history going back to the 1960s, our machine learning process did not find it wise to choose companies based on their market capitalization.  Rather, our research found that a sound investment process seeks to buy the lowest priced companies – with no consideration given to their size – that have a favorable combination of earning power, returns on capital, revenue growth, and balance sheet strength.  

Moreover, our research presented clear evidence that any portfolio management rule that limits the investment universe is highly likely to materially and negatively impact long-term expected returns.  This makes sense as you are more likely to find the best investment opportunities if you examine more, not less, potential opportunities.  Therefore, that we might have done better in 2011 and 2012 looking at only a subset of the available opportunities makes this seem like an unusual period.  We do not think it will often be helpful to invest only in large companies, and we do not plan to prospectively constrain our investment universe.

3. Portfolio Management Practices – We have observed that Euclidean’s investment process has us generally buying companies as their prices are falling. Companies jump in confidence when, all else being equal, their prices drop.  This makes sense.  If you liked Wal-Mart at $75 a share, then you should like them even more at $50.

As we look back at our positions initiated in 2010 and 2011, even in those positions where we ultimately realized gains, we typically bought our position and then incrementally averaged down at lower prices in succeeding months.   It does appear that Euclidean would have performed better if our investment process had acknowledged the persistence of price momentum and had us establishing positions more evenly over time.  In 2013, Euclidean will explore this subject in detail and evaluate potential modifications to our portfolio management rules.  

Last Note

Euclidean’s investment process systematically applies a philosophy that seeks to purchase historically sound companies when great pessimism is reflected in their share prices.  We believe this process would have delivered satisfactory results across most long-term periods of the past and that it has the potential to perform similarly well over the long-term periods in our future.  The past six-quarters do not impact this point of view.  We cannot imagine managing your and our hard-earned assets in any other way.

While we have identified potential modifications to our portfolio management rules that may increase the consistency of our performance – and we will adopt those modifications if we can demonstrate they would likely have been helpful over long periods – our most significant learnings have come in appreciating what it means to adhere to sound investment principles over time. 

Today, we feel that our portfolio is very well positioned on a relative and absolute basis.  Outside of the depths of the financial crisis and the early 1970s when interest rates were much higher than today, we have not observed a time like this, when one could establish a portfolio of companies with cash-rich balance sheets and good long-term returns on capital that are priced as though three-quarters of their past earning power is going to disappear.  

*****

We greatly value the privilege of managing a portion of your 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