Uncertainty, Volatility, & Opportunity

{ Euclidean Q2 2011 Letter }


We believe the fundamental measure of Euclidean’s success will be the returns we deliver over the long-term. 

Our ability to generate these returns on your behalf obviously depends on the strength of our investment process.  It may be less obvious, however, that our ability to succeed is just as dependent on our ability to keep you connected to and aligned with the long-term nature of our aspirations. 

This is so because we all possess the same human tendencies that create erratic market prices.  It is natural to get excited by recent gains or depressed by recent losses.  It is normal to extrapolate recent conditions and assume they will persist far into the future.  The danger in these tendencies, however, is that they often cause people to feel confident and fearful at precisely the wrong times.

We believe Euclidean’s disciplined approach to investing reduces the risk of counterproductive behavioral traits influencing how we allocate capital.  Our approach, in fact, greatly depends on other market participants’ inability to fully manage this risk, thereby occasionally presenting us with opportunities to buy historically sound companies at very low prices.  Our approach alone, however, does not ensure we will be successful in maintaining good long-term relationships with investors.  Only our investor communications can keep you connected to and comfortable with how we measure success.

This is why we devote so much energy to these letters.

Price and Value – Two Different Things

Euclidean’s investment approach is focused only on two concepts: price and value.  

Estimating value, when it comes to the shares of individual companies, is always difficult.  Most students of valuation agree that a company’s value is equal to the amount of cash its owners could pocket over the company’s lifetime, discounted to the present.  The challenge is that a company’s future cash flows are not precisely knowable.  Unlike a bond, which has a contractual schedule of coupon payments, a company’s future earnings are uncertain in both magnitude and timing.

Price, on the other hand, seems like the easy concept because it is provided every day by the stock market for all to see. Because companies’ future earnings are always uncertain, however, the door is open for prices to be influenced by factors other than inherent business value.  This is why prices often swing wildly on a daily basis, even for companies for which there is no new news, and whose underlying values evolve over quarters and years.  These price fluctuations reflect the evolving moods of market participants as they cycle through feelings of fear, apathy, comfort, and exuberance.  We believe these price fluctuations also reflect that many market participants focus less on evaluating the businesses underlying the stocks they trade and, instead, focus on anticipating what other market participants are going to do in the days or minutes ahead. 

As a result, the stock market is an environment ripe for creating disconnects between market price and underlying business value. On one side, such as with the dot-com mania of the late 1990s, or with bank valuations in early 2007, prices can sometimes reflect gross over-estimations of companies’ underlying values.  On the other side – the side where Euclidean focuses – attractive opportunities often emerge to acquire portions of companies at very low prices in relation to the demonstrated character of their businesses.

This is why price and value are important concepts.  Value uncertainty enables price volatility, which in turn creates investment opportunity.  At Euclidean, we believe that understanding this relationship is a prerequisite for strong long-term investment performance. 

A Personal Example of Where Price and Value Diverged

We started a technology company in 1996 and, with many fantastic associates, built it over the following 10 years.  The company was named Employease, and to understand its business, think of Salesforce.com’s model of delivering software-as-a-service but applied to human resource applications instead of client relationship management applications.  Our experience with Employease shows how price and value can diverge. 

Presented below is how the private markets valued Employease at different times.  The first three numbers reflect the pre-money valuations Employease received in various venture capital financings.  The last reflects the value Employease realized when it was acquired.  All values are approximate. 

  1. 1997 - $5M valuation
  2. 2000 - $100M valuation
  3. 2002 - $30M valuation
  4. 2006 - $160M valuation

Given the above, it might surprise you to learn that Employease did not grow by 20X from 1997-2000.  Nor, did it experience a 67% decline in business from 2000 to 2002.  In fact, after an initial year of product development, Employease steadily grew across 36 sequential quarters.  In retrospect, it seems that Employease’s underlying business value increased in a somewhat steady way even as the private market’s expectations, and hence our market value, fluctuated wildly.  

How Euclidean Thinks About Price and Value

From our Employease experience, we walked away with a high-resolution picture that markets sometimes materially misprice the shares of individual companies. 

This set us on a search for a highly disciplined, data-driven way for finding opportunities to acquire companies’ shares at prices below their inherent values.  To do this, 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 most informative lessons on how to evaluate individual companies as potential investments and how to apply these lessons in the context of an evolving portfolio.

Through this search, we found a strong validation of some very common sense principles relevant to our discussion here of price and value.  We found that:

  1. Value – Companies’ intrinsic values can be estimated by examining the magnitude, consistency, and growth of their wealth-creating capabilities over a long period of time.
  2. Price – Companies’ future evolutions are highly uncertain; therefore, we found that it is best to wait for very low prices in relation to perceived value before making an investment. 
  3. Risk – While risk comes in many forms, we found that it is important to avoid companies with high levels of indebtedness because they have frequently failed to survive difficult environments with their business values intact.     

As these common sense concepts are embedded in Euclidean’s investment process, we can measure how these principles are reflected in our portfolio over time.  We do this by looking at aggregate, look-through, metrics on our portfolio and comparing them to the market’s average as defined by the S&P 500.  As of the end of June, we saw that our holdings:

  1. Have better cash generation engines.  Our portfolio, in aggregate, has generated long-term returns on capital that are almost 1.5x that achieved by the S&P 500. 
  2. Are more conservatively priced.  Our portfolio has a market value in relation to its long-term, consolidated, historic earning power that is approximately 50% less than the S&P 500.  Put another way, our portfolio’s pre-tax earnings yield is approximately two-times that of the S&P 500 and more than three-times the yield on long-term treasuries. 
  3. Employ less leverage.  Our portfolio has an aggregate equity to asset ratio that is more than 40% greater than the S&P 500.  One way to picture this is to appreciate that our average portfolio company owns a greater percentage of its ‘house’ than does the average member of the S&P 500. 

So, if you ever wanted to know where our confidence comes from, this is it.  We believe it can be fruitful over the long-term to purchase at half-price and hold a collection of conservatively financed companies that have proven to have better than average wealth-creation engines. 

How Opportunity and Risk Evolve When Prices Drop

Given the prior section and the logic we believe underlies our approach, how do you reconcile that Euclidean sometimes does not look so smart when examining our short-term results?  For example, the market value of our portfolio dropped 27% from September 2008 through February 2009.  We had a 15% drop from May through August 2010.  And, we are down year-to-date and lagging the market averages.  What should you read in to these periods?

Much like during those short-term periods when we have had materially higher returns than the market, we encourage you to read nothing into our short-term results and to measure us solely on how we perform over the long-term.  Here are two reasons why:

  1. A sound approach is still an imperfect one – Even though we believe the odds are on our side anytime Euclidean makes an investment, those favorable odds play out over years.  Just as a baseball player with a long-term batting average of .300 will sometimes go 10 or more at-bats without a hit, Euclidean will have periods where we misjudge intrinsic value for a concentration of our portfolio companies and have poor performance. Likewise, just as that baseball player will sometimes go 4 for 5, Euclidean will sometimes have periods where our portfolio companies do much better than we might have expected and will push up our results.  What matters isn’t what happens in any month or year (a game); what really matters is what happens across many years (a season or career).  
  2. Price and value frequently diverge in the short-term – As we discussed earlier, price and value are not the same.  Even in the context of a company whose intrinsic value is already under-appreciated, there is no reason to expect that the market may not first become even more pessimistic about the firm’s prospects and push its stock price down further before the levity of strong operating results pulls its stock price back up.  When this happens, the same companies our models liked yesterday become available for Euclidean to purchase today at even lower prices.

The Test – Should You Buy More As Prices Go Down?

For any given company, Euclidean’s confidence increases as the price at which we can purchase shares goes down.  So, when prices of the companies we favor – which are often the companies we already own – go down, our expectations of our future results go up.  This is why we wrote in our Q2 2010 letter that we expect our short-term results to look the most dismal at the exact times we will be making our best investments.   

This expectation may seem so obvious as to not merit comment.  What is so clearly logical in this instance, however, flies in the face of investors’ more common and illogical tendency to become more confident in future returns following recent gains and to turn pessimistic when they have recent losses.  Therefore, we thought we should share some evidence that logic, and not common practice, holds in this instance. 

Euclidean has a disciplined process for adding capital to existing, high-confidence, holdings as their prices decline.  To see how much we have been helped or hurt by this practice, we ran a test.   Our test was this: look at the 36 positions we have completely sold-out of since we started in August 2008.  We sought to compare the average price appreciation on those 36 investments using our practice of buying more as prices declined to what our returns would have been had we never added additional capital to those positions.  In this second case, we would simply have established each position at our initial purchase price with no impact (for better or worse) of future share purchases. 

Here are the results.  Since our fund inception, the average price appreciation (excluding dividends) of our 36 realized investments is +58%.   That average appreciation would have been approximately 11 percentage points lower if we did not purchase additional shares as prices declined.  This is common sense and as we might have expected.  Our overall performance would have been worse had we failed to act on the fact that – all else being equal – as price declines, opportunity increases. 

Goals and Expectations

We have talked about these expectations over time and formalized them in our 2010 year end letter.  As we want you to be very close to our long-term aspirations and measures of success, we thought we should make a habit of including them in future investor communications.  Here you go:

  1. We will be satisfied if Euclidean delivers gains that meaningfully exceed both inflation and the S&P 500 (including dividends) over rolling 5-year periods.
  2. We suspect Euclidean will look best during periods where the market is apathetic to pessimistic (when P/Es are flat to compressing).  Likewise, we expect to have trouble keeping pace with the averages during exuberant periods (when P/Es are expanding).
  3. We anticipate that during rapid market declines – when market participants scramble for liquidity and sell shares with little regard to individual companies’ strengths and weaknesses – we will decline with the market.  We also anticipate that when investors start searching again for the best companies offered at the lowest prices, our investment approach will show its strengths.   

We believe that the best market environment for Euclidean is one characterized by high price volatility coupled with long-term market prices that rise no more quickly than the rate of corporate earnings.  We also believe that volatile environments, however fruitful to Euclidean over time, will be emotionally difficult for investors who lack a very long-term investment horizon.

Operational Update

As we have communicated, we are in the midst of making our transition from Atlanta to Seattle and New York.  This transition will be complete before the end of July.  Over the next week, email will be the most efficient way to reach us.  Then, starting around July 18th, please update your records to reflect this information: 

Euclidean New York:  500 5th Avenue, Suite 1550, New York NY 10110       |    646-571-1670

Euclidean Seattle:  800 5th Avenue, Suite 4100, Seattle WA  98104             |    206-839-8586 

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We will be sending additional communications regarding updated contact information and partnership documents during the weeks ahead.  

Best Regards,

John & Mike