2019 is off to a good start due to several uncertainties being clarified in the eyes of many investors and the Market. In my view, some of these uncertainties have been delayed but are not fully resolved. 2018 was down because the fourth quarter experienced a Market downturn highlighted by a December that was the steepest decline for the Market since the Great Depression almost a century ago. Our investments faced headwinds in the fourth quarter because of the current U.S. administration’s trade dispute with China, the Federal Reserve’s interest rate increase with a credit tightening stance, and the wear off of the tax stimulus. 2019 has seen a rally due to several reasons explained below.
Remember, this letter and the year end numbers are a snap shot in time. I view investments in the ultra long term. So if we are up one year I am not overly delighted, nor do I panic with a down year. You can pick any longer term period and we are most certainly up, such as the last 18 months or 2 years versus the Barclay’s Hedge Fund Index that we benchmark.
In this letter I will describe three of the largest topics in the economy today: the China-US trade discussion, the Federal Reserve, and business earnings. In addition, the division in politics has sharpened in recent times and the cloud of investigation continues to follow this Administration. The full contents of the Mueller Report is not currently made available to the public or even to Congress. If the Mueller Report is released in full it can cause market volatility and if it is not released it will cause an outcry from the Democrats which can also cause short term volatility. Regardless of party affiliation, I believe the American public has a right to read the complete Mueller Report to make a judgment for themselves after the American public has paid for a 22 month very high profile investigation. Every other special counsel report in history has been made public including Ken Starr’s report on the investigation of Bill Clinton, this should be no different. However, none of these factors have deterred me from continuing to hold our equity positions in cash flow generating companies. Regardless of which party is in power, American businesses have performed very well over time.
First off, let me repeat what I have told each and every one of you. I have not the faintest idea of what the Stock Market will do in the next several weeks or the next 12 months. What I am highly confident in is that over the long run, I fully expect the earning power of the businesses we invested in to grow over time. This creates a compounding effect. I have deemed compounding returns as the fifth fundamental force in the Universe.
More importantly, I am a firm believer in the prospects of the United States for the long run. Another market I find long term opportunities for investment is China. In addition, a small percentage of our portfolio is in Europe. Those are the three core markets that Talguard focuses on. However, we will consider quality investments anywhere on Earth or beyond. The majority will be in America. America is truly the land of bountiful opportunity and the system has produced tremendous growth. China will continue to have opportunities for investment.
Right now, we are more cautious in our approach as some of the risks mentioned above have just been delayed, not resolved. There are signs inflation has picked up. Technology and innovation across industries have been a great force against inflation. Look at the purchase of a vehicle. The average midsize sedan with a lot more features can be purchased for less inflation adjusted money than the same class of vehicle from thirty years ago. However, some Consumer Price Index ("CPI") categories have experienced high inflation rates. For example, health care and college costs have experienced inflation rates much higher than 2% a year in recent years. Healthcare costs as a percentage of GDP is now 18% and that is more than every other industrialized nation. For all that money spent on healthcare you would think the United States would have a better outcome but we currently rank 31st in the world for life expectancy, just ahead of Cuba at 32nd place.
Inflation is showing signs of picking up in other categories. For years since the Great Recession, branded manufacturers faced triple headwinds for increasing prices from a price conscious consumer, generic alternatives, and young start up brands. Recently, the winds have shifted and manufacturers have been able to raise prices faster than the pace of inflation.
On a grander note on leverage, there have been large amounts of debt borrowed by companies and governments in recent years. Central banks in industrialized countries have issued unprecedented rounds of quantitative easing. The United States federal debt level and deficits continue to climb and the current pace of borrowing is not sustainable. At some point the amount of debt level, the debt maintenance expense, and cost of borrowing needed will be too much if the current pace keeps up. The 2018 tax cut accelerated the debt balance increase and deficits. However, the federal debt and deficit in the U.S. is currently manageable and it does not hamper my opinion of America’s economic prowess.
Large amounts of debt have been borrowed by private equity firms and corporations due to low interest rates. Private equity firms have driven up prices for their acquisitions and often times have overpaid for acquisitions because they are competing with each other with this “cheap money”, also known as low interest rate loans. Private equity firms buy out whole companies by loading them up with a lot of debt and then they will try to reduce operating costs, sell divisions, and other financial engineering before taking them public again or selling the company privately. These are leveraged buyouts, a term that has fallen out of favor from the 80s. In my view, private equity firms should really be called “private debt” companies because they are all about borrowing high amounts of debt while contributing as little equity as possible. This creates operating leverage, or also known as “juiced returns” which is a real risk to the companies they own. This has also contributed to higher asset prices.
Take an extreme example, if you borrow at a rate of 90% debt to 10% equity to purchase an asset and the value of that asset goes up 10% then you have doubled your money. The problem is if the value of your asset goes down 10% then your equity is wiped out. In other words leverage works both ways. Leverage can juice your returns but it can destroy your equity quickly. Too much leverage creates a situation where it can hurt cash flows because the company has to service the debt with principal and interest payments. Most importantly, debt will eventually come due and the borrower will have to pay it off or refinance.
Corporate debt usually has maturities of less than 10 years. Many companies who take out loans also have multiple loans, known as tranches. Multiple tranches often due at different years means these companies are in the Market frequently to refinance. Most of the time this is not a problem. However, if credit markets seize up as they occasionally do such as in 2008, then the company is in trouble.
Furthermore, too much leverage often leads these companies to skimp on investing in growth or reinvesting cash to maintain the business, also known as maintenance capital expenditures. Retail chains are especially susceptible to this phenomenon where store floors get dirtier, burned out light bulbs are not replaced, paint fades, employee morale decreases, and the overall look deteriorates. It forms a vicious negative reinforcement cycle. A few examples include Toys R Us, Sears, and Mervyn’s. Online competition and big box competition certainly hurt these examples but much of their demise stems from taking on too much debt. The same is true of venture capital, there is too much capital chasing the next home run start up.
America and China Trade Dispute:
The Chinese economy has been slowing for several years regardless of the recent trade dispute with the United States. China’s economy is undergoing a large scale transition to a services economy. It is also a matter of size. Now that China’s GDP is so large, it takes many more billions to grow the same percentage. The law of large numbers is at work here. A structural effect of using debt to fuel growth is that it is dependent on government liquidity injections every time China’s economy slows. The problem with relying on government stimulus is that it is similar to a drug addiction, it takes stronger doses to have the same effect with each subsequent use.
In China’s defense, other central banks around the world have used stimulus as well. Central bank stimulus spur more financing for projects. A systemic concern to China has been the one child policy creating a smaller next generation population. Although the policy has been loosened to two children per couple, there will be a bottleneck effect in the next several decades. However, that does not mean there is no opportunity. Quite the contrary, there are untapped pockets of opportunity. Plus a slowdown will most likely create investment opportunities for long term investors.
I am a big believer in the Chinese economy in the long run and the outstanding opportunities there. China has created a competing economic system of what I call State Sponsored Capitalism where many major industries are dominated by large corporations with the Chinese Government as the majority shareholder. Economic zones and 5 year plans where certain areas get extra funding and less regulation have created sprawling metropolises. For example, look at the modern city of Shenzhen. Just a few decades ago it was a fishing village. Now it is a hub of manufacturing, research, development, and technology with over 12 million people. That is larger than any U.S. city. However, there has been room for private companies to emerge as well. The Chinese Government can push head long into new sectors by sponsoring nascent companies.
By the way, western countries have done this as well, look at the government subsidized agriculture, aerospace, and defense industries. The U.S. government gave lifelines to many banks during the Great Recession and it outright bailed out the domestic auto companies instead of allowing them to fail like a true capitalist system would. The auto industry bailout totaled $80.7 billion and U.S. taxpayers ultimately lost $10.2 billion on that bailout. The difference is that the U.S. government does not usually take a strategic role in decision making and will not be a majority equity owner of these companies in perpetuity. The Chinese government will often own the vast majority of the companies it champions and it will have a big say on business decisions.
China’s State Sponsored Capitalism has worked remarkably well to lift China out of its under developed status and millions of Chinese out of poverty. Let’s look back in history when China was invaded by Japan in World War II and by Britain and France prior to that with the two Opium Wars in the 19th Century. China also experienced a civil war between the Communist and Nationalist factions before and after World War II. These events left China’s economy greatly weakened. At the end of World War II, China started out with a lower GDP and less infrastructure than India. India is a democracy with full elections and adopted many western practices of capitalism following British colonial rule. India has approximately the same population as China plus they are neighbors so they are in the same relative region of the world. Many Indians speak English.
Fast forward 70 plus years and China now has an economy that is approximately 400% larger than India’s by nominal GDP, $13.5 trillion versus $2.7 trillion respectively. China has a nominal GDP per capita approximately 335% greater than India. Today 52.2% of China’s workers are in services with only 8.2% in agriculture. Compare that with India which has 46.6% in services and 16.8% in agriculture. In theory India should be well ahead of China today in both GDP and per capita GDP given its advantages and its embrace of Western ideals. However, that is not the case and China is far ahead. China is living proof that Western capitalism of economic growth is not the only one that works. China’s transformation has also been fueled by a mass migration of young rural Chinese people moving from villages and farms to cities and factories. This influx of young adults to the cities coupled with a low priced yuan transformed China to become the “workshop to the world”.
The reason the Shanghai and Shenzhen stock markets were down over 30% and 20% last year, respectively, was not just because of the Trade Dispute with the U.S. A bigger reason was that many of the valuations were simply too high. Most stock investors in China are individual retail investors, the proverbial “mom and pop” investor. Many treat the stock market as a gambling machine looking for quick momentum plays without concern for fundamentals. China’s opening of the Shanghai – Hong Kong link for Class A shares had also stepped up inflows of new capital. These factors helped contribute to an unsustainable rise in valuations.
My biggest concern for China in the long run is that the recent economic boom and build out has been heavily financed by borrowing at the national level and at the local level. Most reports on China’s debt to GDP only count national debt and misses shadow banking debt. Shadow banks are any entities large or small that lends money and is not an official bank. The U.S. has them too such as Fannie Mae, Freddie Mac, and small payday loan lenders. As you can see, shadow banks come in a variety of industries and sizes. China is unique amongst large economies because it has a huge amount of shadow debt that is not listed as part of national debt. China’s shadow banking industry loans outstanding is estimated to be approximately $10 trillion and it is greater than the banking industry loans outstanding. Shadow debt dwarfs China’s national government debt of $5.2 trillion.
China is at a fork in the road and can head down two paths in the long run. Will it end up like the U.S. where economic cycles can have deep declines with large short term pain similar to ripping off a band aid with relatively quick turnarounds with GDP growing again within a few quarters or a few years after a recession? Or will China head down the path of Japan which has been mired in stagnation for close to three decades now. Japan currently has approximately 250% of debt to GDP. It has very little room to combat economic slow downs. Japan has printed large sums of money and injected a variety of stimulus measures to spur growth and inflation but it has been of no avail. That is the danger of too much debt. Many argue that most of Japan’s debt is yen denominated and owed to its own citizens which helps prevent default. The issue here is that Japan’s population has been on the decline for over a decade and its strict immigration policy will ensure it continues to decline based on current birth rates. There won’t be as many citizens to refinance Japan’s national debt. It will be interesting which route China heads in the coming years or it may blaze a third trail that we have not seen, similar to how it blazed its own economic model of State Sponsored Capitalism.
The Chinese stock markets have bounced back so far this year due mostly to government stimulus and the potential for a trade deal with the United States. There is still risk here and more volatility can occur in the near future. However, there continues to be opportunities for long term investments.
The Federal Reserve and Interest Rates:
Interest rates play a significant role in asset prices. Interest rates act like gravity on asset prices. The lower the gravity, the higher assets can climb with the same cash flow. It is similar to why astronauts standing on our moon jump six times higher than on Earth with the same amount of energy. This is because our moon has one-sixth the gravity of Earth. The same is true of interest rates, lower rates reduces the gravity on asset prices for the same business cash flow thus driving up valuations. This is part of the reason we have had a 10 year bull market for asset prices. The concern now is where central banks will go with interest rates since they set national rates for their country. America’s Federal Reserve plays a central role in determining interest rates in America.
One of the other large overhangs in the Market, what many consider as a Sword of Damocles, has been the Federal Reserve’s push to “normalize” interest rates and ending its quantitative easing. I think the current Federal Reserve Chairman is highly intelligent and the Fed has done a fine job most of the time. However, it is my belief that the Federal Reserve recently caved to public criticism and pressure from President Trump. Consider that just a few weeks ago the Federal Reserve chairman and other Fed Directors came out and said there is much work to be done for interest rates to normalize. Then after direct criticism by the President, the Federal Reserve decided to change its stance and said it is now more market neutral signaling an end to its progression of rate increases.
More recently, the Federal Reserve Chairman did an interview on the 60 Minutes television program to assuage fears of caving to the President and insisting President Trump can not fire him. This is a remarkable set of events and an unprecedented turnaround in Federal Reserve policy after facing pressure from a President. Even with the Federal Reserve’s switch in policy stance, this President continues to criticize the Fed Reserve Chairman in an unprecedented manner. That is not healthy for the country.
The Federal Reserve was set up to be independent to the pressures of political winds and rightfully so. The Federal Reserve needs to reduce its balance sheet and interest rates need to go up so that the Federal Reserve has the opportunity to stimulate the economy when the next recession inevitably arrives. This is going to handcuff the Federal Reserve and strips it of dry powder needed to help combat the next recession.
The Chairman’s remark that things have changed based on lower inflation data is alarming. It is eerily similar to the old saying that this “time it is different”. History has shown that the business cycle is real. There will be periods of expansion followed by some contraction as excess builds up in one form or another. Excess forms in certain asset classes when quick profits are made and there is a pile on effect as many short term minded investors consider it easy and quick gains. This inevitably builds up into a frenzy and then the bubble pops.
As I discuss in detail in my last letter, asset bubbles come in all forms and sizes. Asset bubbles can be in the form of tulips as in the 1600s Tulip Bubble, they can be internet companies as in the 2000 Internet Bubble, and they can be collectibles as in the 1990s Baseball Card Bubble. Some are large and some are small in effect to the economy. Sometimes a bubble bursting does not cause a far reaching economic contagion such as the 2000 internet bubble. However, others times a bubble bursting produces a widespread contagion effect such as the 2007 and 2008 Great Recession. Once a contagion arrives, it spreads until the economy produces a fever and it boils over before recovery.
Business Earnings: America’s Continued Economic Prowess and the Opportunity in China:
I am a firm believer in the economic prowess of America and its businesses. We have developed a magical place to do business that has been unseen in human history. America has the physical infrastructure, economic infrastructure, world class universities, and the capital markets that have unleashed the human mind like never before. And America has done it in a very short period of time in human history.
Consider the following fact. A million dollars invested in the S&P without knowing anything about stocks in 1928 before the Great Depression would be worth over $850 million today. If you invested that same amount in gold it will be worth approximately $4.3 million today. U.S. stocks have outperformed gold by several hundred times. U.S. stocks have also significantly outperformed other asset classes including real estate, corporate bonds, and government treasuries. American stocks achieved this success even experiencing the Great Depression, two world wars, the Korean War, the Vietnam War, terrorist attacks, 12 regional conflicts, and 13 recessions. As you can see, investing in American stocks has been a winning strategy over the long run.
America has a remarkable system that has unleashed tremendous human potential. It has the right mix of infrastructure, educational system, entrepreneurial spirit, and freedom of thought process that has set up a national systemic advantage. America has also gathered an extraordinary number of creative minds and hard working people from other countries as they are attracted to the American Dream. The proof is in the pudding. America continues to be a top choice for people seeking opportunity and prosperity. For example, if you were to offer everyone an opportunity to move anywhere in the world free of cost and immigration restrictions, I strongly believe America would be the preferred choice for many people. Net migration continues to favor America. Furthermore, many of the world’s elite continue to send their children to American universities.
China has created its own form of capitalism that has yielded astounding results. As Napoleon famously said, “Let China sleep, for when she wakes she will shake the world.” China has not only awakened but she has roared and thunder shook the world.
Side Note On Reading:
I read a lot. One of the reasons I am thrilled with my profession is because if you want to do it well you need to read. I am reading to ascertain facts about companies. This suits my personality and love of reading and curiosity. I have a lifelong love of libraries and hope the concept of libraries will live forever in the age of digital books.
It was a magical day when my second grade teacher took me and my classmates to the city library, one of the best field trips I have ever had. I think it should be a requirement that all schools schedule a field trip to their local city or county libraries. I love the smell of books new and old. I have learned many great things from the treasure trove of books and publications I have discovered from libraries. In other words, many great things that have happened to me have happened in the library. I often tell people I read and think for a living and encourage everyone to have a lifelong love of reading.
In addition to reading, I spend numerous hours investigating companies and keeping track of companies we have investments in. It requires dedicated time and efforts. That is what many people get wrong about investing, they think they can just buy what they know or like and be done with. That is less than half the battle. Worst yet, some will invest based on short pitches from commentators on television or from the grapevine of their network without doing their own research. You need to learn about a company for yourself and understand what makes it tick. You have to understand the financials. You have to investigate how a company really makes its money. You have to look into whether a company has durable competitive advantages.
Spending a great amount of time reading about companies, their businesses, and their competitors is a full time occupation. This is the minimum and it does not guarantee success. Financial well being is similar to health well being. For the best outcome, you would hire a physician for your annual check up or a dentist for your teeth. You would not do it yourself. For many who have a full time occupation that is not in investing, it makes sense to have a professional to manage financial well being.
On a grander note on leverage, there have been large amounts of debt borrowed by companies and governments in recent years. Central banks in industrialized countries have issued unprecedented rounds of quantitative easing. The United States federal debt level and deficits continue to climb and the current pace of borrowing is not sustainable. At some point the amount of debt level, the debt maintenance expense, and cost of borrowing needed will be too much if the current pace keeps up. The 2018 tax cut accelerated the debt balance increase and deficits. However, the federal debt and deficit in the U.S. is currently manageable and it does not hamper my opinion of America’s economic prowess.
Large amounts of debt have been borrowed by private equity firms and corporations due to low interest rates. Private equity firms have driven up prices for their acquisitions and often times have overpaid for acquisitions because they are competing with each other with this “cheap money”, also known as low interest rate loans. Private equity firms buy out whole companies by loading them up with a lot of debt and then they will try to reduce operating costs, sell divisions, and other financial engineering before taking them public again or selling the company privately. These are leveraged buyouts, a term that has fallen out of favor from the 80s. In my view, private equity firms should really be called “private debt” companies because they are all about borrowing high amounts of debt while contributing as little equity as possible. This creates operating leverage, or also known as “juiced returns” which is a real risk to the companies they own. This has also contributed to higher asset prices.
Take an extreme example, if you borrow at a rate of 90% debt to 10% equity to purchase an asset and the value of that asset goes up 10% then you have doubled your money. The problem is if the value of your asset goes down 10% then your equity is wiped out. In other words leverage works both ways. Leverage can juice your returns but it can destroy your equity quickly. Too much leverage creates a situation where it can hurt cash flows because the company has to service the debt with principal and interest payments. Most importantly, debt will eventually come due and the borrower will have to pay it off or refinance.
Corporate debt usually has maturities of less than 10 years. Many companies who take out loans also have multiple loans, known as tranches. Multiple tranches often due at different years means these companies are in the Market frequently to refinance. Most of the time this is not a problem. However, if credit markets seize up as they occasionally do such as in 2008, then the company is in trouble.
Furthermore, too much leverage often leads these companies to skimp on investing in growth or reinvesting cash to maintain the business, also known as maintenance capital expenditures. Retail chains are especially susceptible to this phenomenon where store floors get dirtier, burned out light bulbs are not replaced, paint fades, employee morale decreases, and the overall look deteriorates. It forms a vicious negative reinforcement cycle. A few examples include Toys R Us, Sears, and Mervyn’s. Online competition and big box competition certainly hurt these examples but much of their demise stems from taking on too much debt. The same is true of venture capital, there is too much capital chasing the next home run start up.
 |
| Opportunities for long term investment trade between America and China will continue. |
America and China Trade Dispute:
The Chinese economy has been slowing for several years regardless of the recent trade dispute with the United States. China’s economy is undergoing a large scale transition to a services economy. It is also a matter of size. Now that China’s GDP is so large, it takes many more billions to grow the same percentage. The law of large numbers is at work here. A structural effect of using debt to fuel growth is that it is dependent on government liquidity injections every time China’s economy slows. The problem with relying on government stimulus is that it is similar to a drug addiction, it takes stronger doses to have the same effect with each subsequent use.
In China’s defense, other central banks around the world have used stimulus as well. Central bank stimulus spur more financing for projects. A systemic concern to China has been the one child policy creating a smaller next generation population. Although the policy has been loosened to two children per couple, there will be a bottleneck effect in the next several decades. However, that does not mean there is no opportunity. Quite the contrary, there are untapped pockets of opportunity. Plus a slowdown will most likely create investment opportunities for long term investors.
I am a big believer in the Chinese economy in the long run and the outstanding opportunities there. China has created a competing economic system of what I call State Sponsored Capitalism where many major industries are dominated by large corporations with the Chinese Government as the majority shareholder. Economic zones and 5 year plans where certain areas get extra funding and less regulation have created sprawling metropolises. For example, look at the modern city of Shenzhen. Just a few decades ago it was a fishing village. Now it is a hub of manufacturing, research, development, and technology with over 12 million people. That is larger than any U.S. city. However, there has been room for private companies to emerge as well. The Chinese Government can push head long into new sectors by sponsoring nascent companies.
By the way, western countries have done this as well, look at the government subsidized agriculture, aerospace, and defense industries. The U.S. government gave lifelines to many banks during the Great Recession and it outright bailed out the domestic auto companies instead of allowing them to fail like a true capitalist system would. The auto industry bailout totaled $80.7 billion and U.S. taxpayers ultimately lost $10.2 billion on that bailout. The difference is that the U.S. government does not usually take a strategic role in decision making and will not be a majority equity owner of these companies in perpetuity. The Chinese government will often own the vast majority of the companies it champions and it will have a big say on business decisions.
China’s State Sponsored Capitalism has worked remarkably well to lift China out of its under developed status and millions of Chinese out of poverty. Let’s look back in history when China was invaded by Japan in World War II and by Britain and France prior to that with the two Opium Wars in the 19th Century. China also experienced a civil war between the Communist and Nationalist factions before and after World War II. These events left China’s economy greatly weakened. At the end of World War II, China started out with a lower GDP and less infrastructure than India. India is a democracy with full elections and adopted many western practices of capitalism following British colonial rule. India has approximately the same population as China plus they are neighbors so they are in the same relative region of the world. Many Indians speak English.
Fast forward 70 plus years and China now has an economy that is approximately 400% larger than India’s by nominal GDP, $13.5 trillion versus $2.7 trillion respectively. China has a nominal GDP per capita approximately 335% greater than India. Today 52.2% of China’s workers are in services with only 8.2% in agriculture. Compare that with India which has 46.6% in services and 16.8% in agriculture. In theory India should be well ahead of China today in both GDP and per capita GDP given its advantages and its embrace of Western ideals. However, that is not the case and China is far ahead. China is living proof that Western capitalism of economic growth is not the only one that works. China’s transformation has also been fueled by a mass migration of young rural Chinese people moving from villages and farms to cities and factories. This influx of young adults to the cities coupled with a low priced yuan transformed China to become the “workshop to the world”.
The reason the Shanghai and Shenzhen stock markets were down over 30% and 20% last year, respectively, was not just because of the Trade Dispute with the U.S. A bigger reason was that many of the valuations were simply too high. Most stock investors in China are individual retail investors, the proverbial “mom and pop” investor. Many treat the stock market as a gambling machine looking for quick momentum plays without concern for fundamentals. China’s opening of the Shanghai – Hong Kong link for Class A shares had also stepped up inflows of new capital. These factors helped contribute to an unsustainable rise in valuations.
My biggest concern for China in the long run is that the recent economic boom and build out has been heavily financed by borrowing at the national level and at the local level. Most reports on China’s debt to GDP only count national debt and misses shadow banking debt. Shadow banks are any entities large or small that lends money and is not an official bank. The U.S. has them too such as Fannie Mae, Freddie Mac, and small payday loan lenders. As you can see, shadow banks come in a variety of industries and sizes. China is unique amongst large economies because it has a huge amount of shadow debt that is not listed as part of national debt. China’s shadow banking industry loans outstanding is estimated to be approximately $10 trillion and it is greater than the banking industry loans outstanding. Shadow debt dwarfs China’s national government debt of $5.2 trillion.
China is at a fork in the road and can head down two paths in the long run. Will it end up like the U.S. where economic cycles can have deep declines with large short term pain similar to ripping off a band aid with relatively quick turnarounds with GDP growing again within a few quarters or a few years after a recession? Or will China head down the path of Japan which has been mired in stagnation for close to three decades now. Japan currently has approximately 250% of debt to GDP. It has very little room to combat economic slow downs. Japan has printed large sums of money and injected a variety of stimulus measures to spur growth and inflation but it has been of no avail. That is the danger of too much debt. Many argue that most of Japan’s debt is yen denominated and owed to its own citizens which helps prevent default. The issue here is that Japan’s population has been on the decline for over a decade and its strict immigration policy will ensure it continues to decline based on current birth rates. There won’t be as many citizens to refinance Japan’s national debt. It will be interesting which route China heads in the coming years or it may blaze a third trail that we have not seen, similar to how it blazed its own economic model of State Sponsored Capitalism.
The Chinese stock markets have bounced back so far this year due mostly to government stimulus and the potential for a trade deal with the United States. There is still risk here and more volatility can occur in the near future. However, there continues to be opportunities for long term investments.
The Federal Reserve and Interest Rates:
Interest rates play a significant role in asset prices. Interest rates act like gravity on asset prices. The lower the gravity, the higher assets can climb with the same cash flow. It is similar to why astronauts standing on our moon jump six times higher than on Earth with the same amount of energy. This is because our moon has one-sixth the gravity of Earth. The same is true of interest rates, lower rates reduces the gravity on asset prices for the same business cash flow thus driving up valuations. This is part of the reason we have had a 10 year bull market for asset prices. The concern now is where central banks will go with interest rates since they set national rates for their country. America’s Federal Reserve plays a central role in determining interest rates in America.
One of the other large overhangs in the Market, what many consider as a Sword of Damocles, has been the Federal Reserve’s push to “normalize” interest rates and ending its quantitative easing. I think the current Federal Reserve Chairman is highly intelligent and the Fed has done a fine job most of the time. However, it is my belief that the Federal Reserve recently caved to public criticism and pressure from President Trump. Consider that just a few weeks ago the Federal Reserve chairman and other Fed Directors came out and said there is much work to be done for interest rates to normalize. Then after direct criticism by the President, the Federal Reserve decided to change its stance and said it is now more market neutral signaling an end to its progression of rate increases.
More recently, the Federal Reserve Chairman did an interview on the 60 Minutes television program to assuage fears of caving to the President and insisting President Trump can not fire him. This is a remarkable set of events and an unprecedented turnaround in Federal Reserve policy after facing pressure from a President. Even with the Federal Reserve’s switch in policy stance, this President continues to criticize the Fed Reserve Chairman in an unprecedented manner. That is not healthy for the country.
The Federal Reserve was set up to be independent to the pressures of political winds and rightfully so. The Federal Reserve needs to reduce its balance sheet and interest rates need to go up so that the Federal Reserve has the opportunity to stimulate the economy when the next recession inevitably arrives. This is going to handcuff the Federal Reserve and strips it of dry powder needed to help combat the next recession.
The Chairman’s remark that things have changed based on lower inflation data is alarming. It is eerily similar to the old saying that this “time it is different”. History has shown that the business cycle is real. There will be periods of expansion followed by some contraction as excess builds up in one form or another. Excess forms in certain asset classes when quick profits are made and there is a pile on effect as many short term minded investors consider it easy and quick gains. This inevitably builds up into a frenzy and then the bubble pops.
As I discuss in detail in my last letter, asset bubbles come in all forms and sizes. Asset bubbles can be in the form of tulips as in the 1600s Tulip Bubble, they can be internet companies as in the 2000 Internet Bubble, and they can be collectibles as in the 1990s Baseball Card Bubble. Some are large and some are small in effect to the economy. Sometimes a bubble bursting does not cause a far reaching economic contagion such as the 2000 internet bubble. However, others times a bubble bursting produces a widespread contagion effect such as the 2007 and 2008 Great Recession. Once a contagion arrives, it spreads until the economy produces a fever and it boils over before recovery.
Business Earnings: America’s Continued Economic Prowess and the Opportunity in China:
I am a firm believer in the economic prowess of America and its businesses. We have developed a magical place to do business that has been unseen in human history. America has the physical infrastructure, economic infrastructure, world class universities, and the capital markets that have unleashed the human mind like never before. And America has done it in a very short period of time in human history.
Consider the following fact. A million dollars invested in the S&P without knowing anything about stocks in 1928 before the Great Depression would be worth over $850 million today. If you invested that same amount in gold it will be worth approximately $4.3 million today. U.S. stocks have outperformed gold by several hundred times. U.S. stocks have also significantly outperformed other asset classes including real estate, corporate bonds, and government treasuries. American stocks achieved this success even experiencing the Great Depression, two world wars, the Korean War, the Vietnam War, terrorist attacks, 12 regional conflicts, and 13 recessions. As you can see, investing in American stocks has been a winning strategy over the long run.
America has a remarkable system that has unleashed tremendous human potential. It has the right mix of infrastructure, educational system, entrepreneurial spirit, and freedom of thought process that has set up a national systemic advantage. America has also gathered an extraordinary number of creative minds and hard working people from other countries as they are attracted to the American Dream. The proof is in the pudding. America continues to be a top choice for people seeking opportunity and prosperity. For example, if you were to offer everyone an opportunity to move anywhere in the world free of cost and immigration restrictions, I strongly believe America would be the preferred choice for many people. Net migration continues to favor America. Furthermore, many of the world’s elite continue to send their children to American universities.
China has created its own form of capitalism that has yielded astounding results. As Napoleon famously said, “Let China sleep, for when she wakes she will shake the world.” China has not only awakened but she has roared and thunder shook the world.
Side Note On Reading:
I read a lot. One of the reasons I am thrilled with my profession is because if you want to do it well you need to read. I am reading to ascertain facts about companies. This suits my personality and love of reading and curiosity. I have a lifelong love of libraries and hope the concept of libraries will live forever in the age of digital books.
It was a magical day when my second grade teacher took me and my classmates to the city library, one of the best field trips I have ever had. I think it should be a requirement that all schools schedule a field trip to their local city or county libraries. I love the smell of books new and old. I have learned many great things from the treasure trove of books and publications I have discovered from libraries. In other words, many great things that have happened to me have happened in the library. I often tell people I read and think for a living and encourage everyone to have a lifelong love of reading.
In addition to reading, I spend numerous hours investigating companies and keeping track of companies we have investments in. It requires dedicated time and efforts. That is what many people get wrong about investing, they think they can just buy what they know or like and be done with. That is less than half the battle. Worst yet, some will invest based on short pitches from commentators on television or from the grapevine of their network without doing their own research. You need to learn about a company for yourself and understand what makes it tick. You have to understand the financials. You have to investigate how a company really makes its money. You have to look into whether a company has durable competitive advantages.
Spending a great amount of time reading about companies, their businesses, and their competitors is a full time occupation. This is the minimum and it does not guarantee success. Financial well being is similar to health well being. For the best outcome, you would hire a physician for your annual check up or a dentist for your teeth. You would not do it yourself. For many who have a full time occupation that is not in investing, it makes sense to have a professional to manage financial well being.
Talguard’s Strategy and Objective:
Talguard Value Fund LP is a private investment fund that seeks to preserve and grow wealth by investing in the equities of companies with durable competitive advantages purchased with a margin of safety. The goal is to beat the Barclay Hedge Fund Index over the long run.
I am looking for a very specific type of company for investment. These companies are often #1 in their niches, have many years of consistent and growing cash flow, and certain other attributes. Most importantly, these companies often have multiyear catalysts that will generate value over time. Once identified, I will seek a discount to intrinsic value prior to investing. However, I rather invest in great companies at fair valuations instead of fair companies at great valuations. What I seek are often multiyear compounders.
Our portfolio consists of two groups of investments. The first group I call “Core Companies” that will often stay in our portfolio for the long run. These are great companies that I invest in either at discounts or at reasonable valuations. Core Companies have long term catalysts that can often span a decade or longer. For these Core Companies, holdings can be lowered when valuations are too high and they can be added on when prices take a dip.
The second group of investments that we hold is what I call “Opportunity Companies”. The Market usually has discounted these companies heavily either because of a short term weak earnings quarter or several quarters, an idiosyncratic sector selloff, or other very specific reason. I like to invest with a discount to intrinsic value here but I am also patient. Patience can result in Opportunity Company stocks providing a larger discount to intrinsic value.
As an emerging fund, we have a distinct advantage over large funds. We can be nimble while they often have to follow esoteric rules. Just because a well known fund is larger does not mean it performs better. In fact, a variety of studies have shown that emerging funds have often outperformed these larger funds. The most significant example is a comprehensive study produced by Nick Motson, Andrew Clare, and Dirk Nitzche, three finance professors at the City University of London. They surveyed 7,261 funds for 20 years from January 1995 to December 2014. They found that the largest 10% of funds returned an average of 7.32% a year for a total of 410.8% return over those 20 years. The smallest 10% of funds returned an average of 9.00% a year for a total of 560.4%. A $1 million investment in the largest funds category results in a balance of $4.1 million while the same investment in the smallest funds category results in a balance of $5.6 million. Of course, past performance is no guarantee of future results but the historical evidence is there.
A number of high profile large funds not only continue to underperform the Market over multiple years, but they have negative returns while the Market has enjoyed a near decade bull run. Larger funds do not necessarily translate to better results.
On a separate note, my strategy has an advantage that many emerging funds do not possess. Talguard has invested primarily in large cap and mid cap companies which mean our strategy is highly scalable. Many emerging funds are focused on small cap and micro cap companies. These emerging funds cannot take on too much more capital for their strategy investing in the same small cap companies because the float on those shares is much smaller. These emerging funds would alter the Market for shares of these small cap companies which means prices can go down significantly when they sell or up when they buy. In other words, micro cap stocks are more prone to big price movements from the buys and sells of a large buyer as compared with larger companies. Talguard has the advantage here because many of our investments have sufficient volume and liquidity when we buy or sell.
Summary:
I view each investable dollar as a soldier standing patiently on top of a mountain looking at the field. My soldiers comprise a patient army waiting for the right opportunity. When the opportunity comes, my army of investable dollars will attack.
At Talguard, we are dedicated to an old craft, and we run on old principles. I view owning stock as being a co-owner of the underlying business in that security.
We know there are opportunities out there. We know we can find them.
I guard and grow your wealth over the long run. Compounding returns over long periods of time is one of the most powerful forces in the Universe.
For potential investors contact us today at investors@talguard.com.
Dan H. Chen’s Background:
Dan H. Chen is the Founder and CEO of Talguard Investments LLC. He has a passion for equity investments and founded Talguard because he saw an opportunity to provide investors a concentrated long term equity solution based on his own unique experience and circle of competence. Dan has over 18 years of experience and is focused on seeking equity investments that generate compounding returns over the long run. Dan has a rich set of experience in both the “Buy Side” and “Sell Side” of the finance industry. He has experience investing in a wide variety of industries. He has direct experience in the equity, debt, and real estate asset classes. Because of his wide experience, he has seen why equities have proven to be the most successful asset class. Dan is a “Quality Investor”. He looks to invest in the equities of businesses that have certain attractive qualities such as being the leader in their niches and long term positive cash flow.
Prior to founding Talguard, Dan was an Investment Analyst in the portfolio management team at Ares Management. He was responsible for the evaluation and investment of Companies in business services, informational technology, real estate, industrial products, and consumer products. His team was directly responsible for over $10 billion of investments at the time. Ares Management is a private investment company that currently has over $100 billion of assets under management that invests in equities, real estate, bank debt, high yield bonds, and term loans.
Prior to Ares, Dan was an Assistant Vice President at Trinity Capital where he successfully led negotiations between multiple stakeholders in a variety of restaurant companies including the private equity buyout and restructuring of Burger King Corporation. Trinity Capital LLC is a restructuring company focused on the restaurant and real estate industries.
Prior to Trinity, Dan was an Investment Banking Analyst at Bear, Stearns & Co. Inc. where he was responsible for directly working with CEOs and CFOs, creating financial models and presentations and brainstorming ideas in advising the management teams of Fortune 500 companies. Dan was involved in the successful completion of 11 transactions totaling over $3 billion that included IPOs, secondary offerings, mergers, acquisitions, divestitures, and hostile takeover defense. Industries covered included Financial Services, Consumer Products, Consumer Services, Technology, Insurance, Health Care, Media, and Entertainment.
Dan has co-authored a book called "The Secrets Of Chinese Wisdom" with Amy C. Lee to teach people how Chinese sayings and wisdom from the past several thousand years have relevance to success in the modern world.
Dan received an MBA from the Anderson School of Business at UCLA as part of the fully employed program while at Ares Management. He received a Bachelors of Science in Business Administration from the Haas School of Business at the University of California at Berkeley. While attending U.C. Berkeley, Dan studied abroad at the prestigious Tsinghua University in Beijing and Beijing Normal University, graduating top of class.
Disclaimer Statement:
This document and information herein represents the views of Talguard Investments LLC and is not to be considered investment advice. The information herein should not be considered a recommendation to purchase or sell any particular security or financial instrument. There can be no assurance that any securities discussed herein will remain in the Talguard Value Fund LP.
This document does not constitute an offer to sell or a solicitation to buy membership interests in the Talguard Value Fund LP. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only.
Investment in the Fund will involve significant risks due to, among other things, the nature of the Fund’s Investments (as defined herein). Investment in the Fund is suitable only for sophisticated investors and requires the financial ability and willingness to accept the high risks in an investment in the Fund. No assurance can be given that the Fund’s investment objectives will be achieved or that investors will receive a return of their capital.
In making an investment decision, prospective investors must rely on their own examination of the Fund and the terms of this offering, including the merits and risks involved. Prospective investors should not construe the contents of this letter as legal, tax, investment or accounting advice. Prospective investors are urged to consult with their own advisors with respect to legal, tax, regulatory, financial and accounting consequences of their investment in the Fund.
I am looking for a very specific type of company for investment. These companies are often #1 in their niches, have many years of consistent and growing cash flow, and certain other attributes. Most importantly, these companies often have multiyear catalysts that will generate value over time. Once identified, I will seek a discount to intrinsic value prior to investing. However, I rather invest in great companies at fair valuations instead of fair companies at great valuations. What I seek are often multiyear compounders.
Our portfolio consists of two groups of investments. The first group I call “Core Companies” that will often stay in our portfolio for the long run. These are great companies that I invest in either at discounts or at reasonable valuations. Core Companies have long term catalysts that can often span a decade or longer. For these Core Companies, holdings can be lowered when valuations are too high and they can be added on when prices take a dip.
The second group of investments that we hold is what I call “Opportunity Companies”. The Market usually has discounted these companies heavily either because of a short term weak earnings quarter or several quarters, an idiosyncratic sector selloff, or other very specific reason. I like to invest with a discount to intrinsic value here but I am also patient. Patience can result in Opportunity Company stocks providing a larger discount to intrinsic value.
As an emerging fund, we have a distinct advantage over large funds. We can be nimble while they often have to follow esoteric rules. Just because a well known fund is larger does not mean it performs better. In fact, a variety of studies have shown that emerging funds have often outperformed these larger funds. The most significant example is a comprehensive study produced by Nick Motson, Andrew Clare, and Dirk Nitzche, three finance professors at the City University of London. They surveyed 7,261 funds for 20 years from January 1995 to December 2014. They found that the largest 10% of funds returned an average of 7.32% a year for a total of 410.8% return over those 20 years. The smallest 10% of funds returned an average of 9.00% a year for a total of 560.4%. A $1 million investment in the largest funds category results in a balance of $4.1 million while the same investment in the smallest funds category results in a balance of $5.6 million. Of course, past performance is no guarantee of future results but the historical evidence is there.
A number of high profile large funds not only continue to underperform the Market over multiple years, but they have negative returns while the Market has enjoyed a near decade bull run. Larger funds do not necessarily translate to better results.
On a separate note, my strategy has an advantage that many emerging funds do not possess. Talguard has invested primarily in large cap and mid cap companies which mean our strategy is highly scalable. Many emerging funds are focused on small cap and micro cap companies. These emerging funds cannot take on too much more capital for their strategy investing in the same small cap companies because the float on those shares is much smaller. These emerging funds would alter the Market for shares of these small cap companies which means prices can go down significantly when they sell or up when they buy. In other words, micro cap stocks are more prone to big price movements from the buys and sells of a large buyer as compared with larger companies. Talguard has the advantage here because many of our investments have sufficient volume and liquidity when we buy or sell.
Summary:
I view each investable dollar as a soldier standing patiently on top of a mountain looking at the field. My soldiers comprise a patient army waiting for the right opportunity. When the opportunity comes, my army of investable dollars will attack.
At Talguard, we are dedicated to an old craft, and we run on old principles. I view owning stock as being a co-owner of the underlying business in that security.
We know there are opportunities out there. We know we can find them.
I guard and grow your wealth over the long run. Compounding returns over long periods of time is one of the most powerful forces in the Universe.
For potential investors contact us today at investors@talguard.com.
Best,
Dan H. Chen
President
Talguard Investments LLC
Dan H. Chen is the Founder and CEO of Talguard Investments LLC. He has a passion for equity investments and founded Talguard because he saw an opportunity to provide investors a concentrated long term equity solution based on his own unique experience and circle of competence. Dan has over 18 years of experience and is focused on seeking equity investments that generate compounding returns over the long run. Dan has a rich set of experience in both the “Buy Side” and “Sell Side” of the finance industry. He has experience investing in a wide variety of industries. He has direct experience in the equity, debt, and real estate asset classes. Because of his wide experience, he has seen why equities have proven to be the most successful asset class. Dan is a “Quality Investor”. He looks to invest in the equities of businesses that have certain attractive qualities such as being the leader in their niches and long term positive cash flow.
Prior to founding Talguard, Dan was an Investment Analyst in the portfolio management team at Ares Management. He was responsible for the evaluation and investment of Companies in business services, informational technology, real estate, industrial products, and consumer products. His team was directly responsible for over $10 billion of investments at the time. Ares Management is a private investment company that currently has over $100 billion of assets under management that invests in equities, real estate, bank debt, high yield bonds, and term loans.
Prior to Ares, Dan was an Assistant Vice President at Trinity Capital where he successfully led negotiations between multiple stakeholders in a variety of restaurant companies including the private equity buyout and restructuring of Burger King Corporation. Trinity Capital LLC is a restructuring company focused on the restaurant and real estate industries.
Prior to Trinity, Dan was an Investment Banking Analyst at Bear, Stearns & Co. Inc. where he was responsible for directly working with CEOs and CFOs, creating financial models and presentations and brainstorming ideas in advising the management teams of Fortune 500 companies. Dan was involved in the successful completion of 11 transactions totaling over $3 billion that included IPOs, secondary offerings, mergers, acquisitions, divestitures, and hostile takeover defense. Industries covered included Financial Services, Consumer Products, Consumer Services, Technology, Insurance, Health Care, Media, and Entertainment.
Dan has co-authored a book called "The Secrets Of Chinese Wisdom" with Amy C. Lee to teach people how Chinese sayings and wisdom from the past several thousand years have relevance to success in the modern world.
Dan received an MBA from the Anderson School of Business at UCLA as part of the fully employed program while at Ares Management. He received a Bachelors of Science in Business Administration from the Haas School of Business at the University of California at Berkeley. While attending U.C. Berkeley, Dan studied abroad at the prestigious Tsinghua University in Beijing and Beijing Normal University, graduating top of class.
Disclaimer Statement:
This document and information herein represents the views of Talguard Investments LLC and is not to be considered investment advice. The information herein should not be considered a recommendation to purchase or sell any particular security or financial instrument. There can be no assurance that any securities discussed herein will remain in the Talguard Value Fund LP.
This document does not constitute an offer to sell or a solicitation to buy membership interests in the Talguard Value Fund LP. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only.
Investment in the Fund will involve significant risks due to, among other things, the nature of the Fund’s Investments (as defined herein). Investment in the Fund is suitable only for sophisticated investors and requires the financial ability and willingness to accept the high risks in an investment in the Fund. No assurance can be given that the Fund’s investment objectives will be achieved or that investors will receive a return of their capital.
In making an investment decision, prospective investors must rely on their own examination of the Fund and the terms of this offering, including the merits and risks involved. Prospective investors should not construe the contents of this letter as legal, tax, investment or accounting advice. Prospective investors are urged to consult with their own advisors with respect to legal, tax, regulatory, financial and accounting consequences of their investment in the Fund.
©2019 Talguard Investments LLC, all rights reserved.