I hope this letter finds you and your family are well and safe. We are living through unprecedented times with large swings in the Stock Market (the “Market”) this year. Expect more volatility in the coming months due to the COVID-19 pandemic and the U.S. Presidential Election. The defensive measures I put into place starting last year due to Market valuation concerns and increased at the start of this year has helped our Talguard Value Fund LP (“Talguard”) weather this global health crisis and subsequent economic storm that has affected all of humanity. In addition, the investments I made into quality companies I have been patiently waiting for when everything was selling off in late February through early March has benefited our fund greatly during the unprecedented rebound in the Market. New opportunities also appeared.
Our Talguard Fund has done well with a more balanced portfolio unlike the S&P500 which has depended on the tiny group of 5 technology stocks for its rebound. The S&P500 is a market cap weighted index. As it stands, the S&P500 is overly skewed towards the technology sector with a weighting of approximately 30% of the index. If you look at the S&P500 equal weighted index where all 500 companies are represented equally, that is still down (-4.1%) for the year-to-date through September 17, 2020. Our Fund being not dependent on anyone single sector has helped us in the long run.
I am optimistic we will continue to navigate these uncharted waters. Economic activity has continued to pick up and some pockets have surprised on the upside. Unfortunately, many in our country from different walks of life do not take this virus seriously. That is why the U.S. has over 40,000 new cases a day and it will likely get worst this fall as indoor activity picks up and as people get tired of social distancing.
COVID-19 is remarkable because it caused a greater part of the world to shut down than previous health crises. This is the first pandemic that effectively shut down great swaths of economic activity across the globe simultaneously. The 1918 Flu Pandemic and the 1980s HIV Pandemic did not do the vast shutdowns like COVID-19. Unlike recent flu outbreaks, COVID-19 has a longer incubation period once infected of up to 14 days. Worst still, COVD-19 is often asymptomatic. It is also the most deadly cold virus we know of compared to other cold viruses.
Another factor is that the U.S. shutdown was uneven across the country and it was never a full shut down. Every state had their own policy on a shutdown and the issue of wearing masks became a political issue. Now the U.S. has one of the highest numbers of infected people in the world and the highest death count. The fact is we have 5% of the world population but more than 20% of known infections and deaths. Much of this was preventable and it is one of the greatest self inflicted wounds our country has done to itself. It did not have to be this way.
What happened with the Stock Market?
At the start of this pandemic in the first quarter of this year, the U.S. Stock Market experienced one of the fastest asset price drops in history. The Stock Market went down over 30% in 4.5 weeks from February 19, 2020 until March 23, 2020. Many stocks of companies most affected by COVID-19 declined over 70%. The Talguard Value Fund fared much better during that period.
Since the lows of late March, stock prices had a record fast rebound. The Stock Market climbed back to near all time highs within just five months. To give you context, the Stock Market declines for the 2000-2002 and 2007-2009 recessions took 28 months and 18 months, respectively, to decline from peak to trough.
The rebound in the Stock Market this time around has been even more dramatic than the dip. It took years for asset prices to recover from previous recessions and this time it look just 5 months. This is not to say that the Stock Market will not dip again. It can go down again but I am highlighting the velocity and size of movement in such a short period of time. Our defense for Talguard became our offense on the way back up and the result is that we continue to beat our competition in the Barclay Hedge Fund Index of over 3,000 other funds and we are beating the S&P500 this year.
The current Stock Market comeback gives onus to the idea that short term thinking just does not work in creating large long term wealth. For example, many investors believe in the adage “Sell in May and go away”. The adage is based on the notion that the Stock Market tends to do poorly from May to October in any given year. Yes, we are still in September, and October is coming up right before the U.S. Presidential Election date of November 3, 2020 so there is time left for another downturn. However, if you followed that advice and sold a lot of your stocks or even all of your stocks during May 2020 you would have missed some of the largest gains in decades. A profound example is the month of August, which is historically one of the worst months for stock returns but this August was one of the greatest returns in the past 30 years for any month.
This also brings me to the point of technical analysis and short term chart reading. If it is so successful how come these technical experts did not predict either the drop or the subsequent rise? Also, if technical analysis works so well, why is it that the most successful stock investors use fundamental analysis as the foundation on how they pick stocks? The answer is that fundamental analysis and investing in the stock of quality companies at reasonable prices for the long run is the best method to realize large compounded returns. To me, this is the best way to build vast, enduring financial wealth.
The COVID-19 pandemic has accelerated certain trends and created a few new ones. One accelerated trend is the tendency for Americans to cocoon in their homes. This has benefited the stay-at-home economy, and it has been reflected in the stock prices of home entertainment, communication services, and home improvement companies. It has also brought to bear the desire for food delivery for meals and groceries. A side benefit for consumers is that it is no longer just pizza anymore. Now all sorts of restaurants are offering deliveries and have partnered with food delivery companies to offer their food at a discounted delivery price. However, food delivery companies are still money losing operations. Delivering hot meals is hard work and costly. Even grocery stores are now offering deliveries for a small flat fee so there is added competition here.
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| The housing and home improvement industries greatly benefited from the current COVID-19 pandemic. |
Another accelerated trend is technology. The future of software will be pushing into adaptive algorithms, specifically artificial intelligence (“A.I.”). The future of hardware will be more robots and machines that are A.I. friendly. It has large implications for a number of industries such as vehicles, restaurants, healthcare, leisure services, and manufacturing. The acceleration of A.I. and robotics are less obvious right now but this pandemic will push more industries to utilize A.I.
Asset Prices and Short Term Momentum Stock Mania:
We are in an asset bubble that in some ways resembles the 1990s internet bubble but in other ways it is not the same. In the 1990s, many of those internet companies had zero sales. If entrepreneurs had a good story to tell, they could achieve many rounds of venture capital funding and go IPO. In this economic cycle some of the hottest stocks are companies that either have negative cash flow or even no sales at all. This resembles the 1990s internet bubble.
In other ways, this downturn is vastly different from the 1990s internet bubble. Technology and internet stocks have led in both cycles. However, tech companies are a lot more profitable this time around. Plus technology now plays a bigger role in every industry than the 1990s.
Although some valuations are reasonable, we are in a bubble for a certain group of companies in the Stock Market. I am referring to the momentum stocks. Some of these stocks have been propelled way too much and their stock prices are on a rocket ship trajectory upward. It is all about the momentum and have zero basis in fundamental economic activity. A momentum stock is one where the velocity of price change causes investors and traders to pile into that stock even more, which creates a feedback loop.
There are several reasons that have caused the bubble in these momentum stocks.
This bubble has been created by easy monetary policy from Central Banks around the world and fiscal stimulus from Central Governments around the world. Central Banks pushed down bond yields to historic lows and it flooded the Market with more liquidity so struggling companies can stave off defaults on their loans. Central governments injected stimulus to individuals and households. These have helped propel stocks and all other asset classes in the current rebound.
The rise of mobile apps for stock trading has drawn a large crowd of new investors. Many of these people may not have ever invested in stocks before so they are new to the game. Some are young adults coming into the workforce. Some are people who love to gamble. Casinos and major sports were shut down for a while which helped push this gambling crowd to look for alternative ways to place bets. Sometimes they buy stocks that they do not even know what the company does. Many found it in the form of short term trading in the stock market. The advent of mobile trading apps that have zero commissions and a video game-like interface has made it easy for this gambling crowd to trade stocks. The common theme for this group is that they favor short term speculation hoping to score huge profits in a short amount of time.
I am very happy more people are participating in stocks. The issue I see is so many are doing what investors did in the 1990s for internet stocks and the mid-2000s for real estate properties. They are speculating on asset appreciation without doing much homework on the financials and fundamentals. Many have no clue what they are buying. Three examples come to mind.
One is Hertz which filed for bankruptcy in May 2020, yet its stock started to rally several hundred percent while in bankruptcy! Hertz management were just as surprised, and tried to get the bankruptcy judge to approve a special stock sale in bankruptcy to take advantage of their stock’s surprising rise. Hertz withdrew their stock offering proposal after the judge cast concerns on it. The stock should be closer to zero rather than several dollars a share.
Another example is the USO forward contracts. Many speculated in the rebound of oil but they did not know USO at the time only represented near term contracts that already expired. WTI crude went negative $37 per barrel. WTI was paying people to haul away the oil! Not only did these USO investors did not understand the nature of their contract, they also had no idea their investment could go negative.
A third example but not least, let’s not forget a group of stocks I like to call “zero baggers”. These are companies that have zero revenue yet they were able to go public and are valued at over $30 billion! This makes zero sense in the long run. It is akin to the “eyeballs valuation” that 1990s internet companies received. “Eyeballs valuation” means those companies’ stocks were valued based on how many people were looking at their site while discounting or completely disregarding traditional metrics such as sales, operating margin, and net income margin. So now it is about having a story to tell which is why the term “Story Stocks” is used recently, no need for revenues or making a profit. I like to use a different name, I call these “Fairy Tale Stocks”, they are soothing as a bed time story but most are a fantasy when it comes to ever generating enough profit to justify their valuations. Even if these companies can somehow generate revenues and profits, it will take a lot to justify their valuations. It is a tremendous risk that is to be avoided.
It all looks so easy right now. You have social media day traders who have millions of followers saying things such as “stocks always go up”. That is the most stupid thing I have ever heard. A word of caution is that history rhymes most of the time. In other words, the causes for manias are different but the fundamental cycle of mania has remained consistent throughout history. And right now, it is a pure speculative mania for some sectors of the Market and some specific stocks. The story of many of these “Story Stocks” will not end well for their investors. I won’t even into the speculative other crazes such as the amount of Special Purpose Acquisition Companies (“SPACs”) or the unbelievable valuations thrown at the current “hot” initial public offerings (“IPOs”).
Let me ask you a question. Why do businesses exist? The ultimate answer is to make money. Yes, you want socially responsible companies and management teams so that all stakeholders are rewarded. However, if a company never makes money it will eventually wipe out its shareholders, the stock price will be worth only the liquidation value of its assets less liabilities. Often times, that means a stock price of zero. This is because the Company will most likely file bankruptcy which takes two routes called a Chapter 11 or Chapter 7 bankruptcy. In a Chapter 11 bankruptcy, the lenders agree to eliminate a portion or all of the debt owed to them in return they receive equity. A Chapter 7 bankruptcy means the Company liquidates and the debt holders get whatever they can. Either way, and most of the time the current shareholders are wiped out.
Why Long Term Investing Is Better:
My answer to those who believe that stocks always go up is that stocks can go down as well. Momentum can go both ways and when there is negative news that causes a momentum stock to go down, the momentum can cause it to go down really quick and deep. Worst yet, many of these momentum speculators borrow money to purchase assets in a practice known as margins. That is incredibly dangerous because debt can juice your returns when things go right but they will crush your investment just as fast if things go wrong.
My answer to those who believe that stocks always go up is that stocks can go down as well. Momentum can go both ways and when there is negative news that causes a momentum stock to go down, the momentum can cause it to go down really quick and deep. Worst yet, many of these momentum speculators borrow money to purchase assets in a practice known as margins. That is incredibly dangerous because debt can juice your returns when things go right but they will crush your investment just as fast if things go wrong.
I prefer a long term compounding game. I want stocks of companies with durable competitive advantages purchased at a reasonable price. If you pay too much it will cost you on returns and opportunity cost. Look at some of the tech companies that survived the 2000 to 2002 stock market crash. If you bought at the top of that cycle, it took over 15 years to get back to breakeven for many of those tech stocks. Some of those tech stocks still have yet to recover their losses. Plus, if you instead use the same pot of money to invest in other quality companies who had a reasonable valuation at that time, you would have seen a positive return over the same 15 years.
The Technology Industry – Software Tech, Hardware Tech, Bio Tech, and Fin Tech:
I am highlighting the technology sector because the Pandemic has put a spotlight on the sector. This is because the tech sector as a whole has had a flat net income during the pandemic versus the same period last year. Compare this with many other industries have been pummeled with some industries such as cruise lines have effectively loss all revenues. Plus many believe tech is going to help lead us into the future. When I refer to tech, I include traditional technology of software and hardware, biotechnology, and financial technology (also known as “fintech”).
I am highlighting the technology sector because the Pandemic has put a spotlight on the sector. This is because the tech sector as a whole has had a flat net income during the pandemic versus the same period last year. Compare this with many other industries have been pummeled with some industries such as cruise lines have effectively loss all revenues. Plus many believe tech is going to help lead us into the future. When I refer to tech, I include traditional technology of software and hardware, biotechnology, and financial technology (also known as “fintech”).
Technology is spreading into every facet of life and every industry. In my view, technology will push into new frontiers and several countries are clearly in the lead, especially for artificial intelligence. Those two countries are the United States and China which are head and shoulders ahead of everyone else. Japan, South Korea, and Germany round out the top 5 in the world. Big tech from the U.S. and China are developing such a huge lead that it will be interesting to see how it goes.
U.S. tech companies follow a mission driven mantra. Create a large idealistic vision and focus really hard to be the best at that main business such as search engines, social media, online retail, smartphones, and apps. Chinese tech companies have been vertically and horizontally integrated in their approach. Look at U.S. review sites such as Yelp for restaurants and Tripadvisor for travel. They focus on their mission statement and stick to their single field of expertise. In China, a company like Meituan started with restaurant reviews but it vertically integrated with restaurant reservations and deliveries. Meituan then pushed into related industries in a horizontally integrated manner. Chinese companies want to create a spider web to snare the consumer into a mindset that they are indispensable. U.S. companies are more siloed into their core expertise. Although technology will become ever more important and prevalent, many of these companies’ valuations are overpriced at the moment.
Non-Tech Industries – Everybody Else:
What about everyone else? The non-tech companies are many because they cover a wide variety of industries. The outlook for these industries and their respective stocks are a mixed bag. Some companies in these industries have suffered enormous loss of revenues during this pandemic. Many of these companies have had to borrow massive debt and/or issue additional equity, both of which are terrible for current shareholders. Eventually the debt has to be paid. I do not understand the concept of raising “liquidity” to sustain their cash burn rate, you are literally giving them money to burn it! It is pure value destruction. Even with a vaccine some of these industries will not see an instant return to pre-pandemic revenue levels anytime soon.
What about everyone else? The non-tech companies are many because they cover a wide variety of industries. The outlook for these industries and their respective stocks are a mixed bag. Some companies in these industries have suffered enormous loss of revenues during this pandemic. Many of these companies have had to borrow massive debt and/or issue additional equity, both of which are terrible for current shareholders. Eventually the debt has to be paid. I do not understand the concept of raising “liquidity” to sustain their cash burn rate, you are literally giving them money to burn it! It is pure value destruction. Even with a vaccine some of these industries will not see an instant return to pre-pandemic revenue levels anytime soon.
At the same time, there are non-tech companies that are doing well in this pandemic. In addition, not everything is currently in a bubble. Some companies have reasonable valuations, even some technology firms. It depends if you know where to look. Plus many of these companies are adopting technology or even developing their own in-house technology. These companies might give the Tech Sector a dose of its own disruption medicine.
So as we head into the fall with the Presidential Election nearing the finish line and a cautiously optimistic chance of a COVID-19 vaccine coming, where do we stand with different parts of the Market?
I am optimistic the next opportunity for positive gains will most likely come from non-tech industries. Tech company stocks already had a massive run up. Drug companies are hard at work for a COVID-19 vaccine which is for prevention. They are also hard at work to create new drug cocktails to treat people who have contracted the virus. Healthcare professionals have also discovered better techniques to prevent death for severe patients.
All of this means each passing day will bring us closer to putting this awful COVID-19 pandemic behind us. This will be great news for all of these sectors that have been hit so hard by this pandemic. I like companies in non-tech industries that have been able to avoid taking on massive amounts of debt to survive this pandemic. This is because valuations in some of these industries are still attractive.
I am optimistic the next opportunity for positive gains will most likely come from non-tech industries. Tech company stocks already had a massive run up. Drug companies are hard at work for a COVID-19 vaccine which is for prevention. They are also hard at work to create new drug cocktails to treat people who have contracted the virus. Healthcare professionals have also discovered better techniques to prevent death for severe patients.
All of this means each passing day will bring us closer to putting this awful COVID-19 pandemic behind us. This will be great news for all of these sectors that have been hit so hard by this pandemic. I like companies in non-tech industries that have been able to avoid taking on massive amounts of debt to survive this pandemic. This is because valuations in some of these industries are still attractive.
What’s Next:
I am cautiously optimistic that we will have several approved COVID-19 vaccines. China has already been inoculating over tens of thousands of people even though their vaccines have not cleared Phase 3 trials. They have given their vaccine to people who are not in any hotspots as normal Phase 3 trials are suppose to do. Phase 3 data for U.S. and European drug companies will start to roll in by this fall, most likely November.
I am hopeful more than one vaccine will make it to U.S. government approval and cross the proverbial finish line. The world needs it. We will need more than one vaccine approved because one company alone can not make enough doses to control the infection rate for the whole world. What efficacy rates these vaccines will have is another question.
An approved vaccine is the major factor that will get our society and the rest of the world back to normal. A number of scientists and doctors have stated that fourth quarter of 2020 is the earliest a vaccine will be approved. Even when a vaccine is approved, billions of doses need to produce for people around the world. This is likely not to happen until mid 2021 at the earliest, even with Operation Warp Speed where drug companies are preparing doses of their trial candidates now. If their vaccine is approved they would have doses ready. If their vaccines fail then they just eat the cost of making these does now but you do save time. However, these drug companies are not making enough of these premade doses to cover the entire population or even just the U.S., let alone the rest of the world.
We do not need to get everyone inoculated to have a meaningful dent in lowering COVID-19’s infection rate. We do need to get enough people to take the vaccine or have enough herd immunity so that COVID will no longer pose as much of risk for mass mortality. Furthermore, we need people to actually take the vaccine if one becomes available. Only 38% of U.S. adults took the flu vaccine last year which means 62% did not. Right now, a recent survey stated only 35% of U.S. adults are planning to take a COVID-19 vaccine if it becomes available.
In the meantime, expect another surge in COVID-19 cases this fall and winter as lower temperatures, rain, wind, and snow cause more indoor activities. At this point we have to accept America will keep spreading the virus. Too many people do not wear masks or social distance enough, and there are countless large gatherings. Furthermore, young children are often seen as not needing a mask but they can catch and spread COVID-19 as well, especially since they are more often asymptomatic. As you can see, the virus only cares about spreading and sustaining itself with no regards for our own timelines or personal beliefs. At the end of the day, this virus spreads to humans of all ages and ethnicities.
What is amazing to me is that despite the huge self inflicted wound on the COVID-19 response and the tremendous social unrest, the U.S. is still the leading destination for stock investments and debt investments in the world. Europe’s stock markets and many other regions’ stock markets have not recovered to the extend ours did.
The U.S. and China will be battling each other in a trade war, intellectual property war, and technology war for the foreseeable future. Militarily, there is going to be tension as well. The concern is that a mistake or intentional military strike can happen which would cause a real physical confrontation between the two superpowers. I am hoping this does not happen because it will not be good for either country. The only ones this will benefit are rival nations to the U.S. and China.
In regards to the 2020 U.S. Elections, I am not concerned about its outcome for stocks in the long run. In the short run, the Stock Market will most likely react depending on the outcome. For example, Joe Biden has already stated he wants to increase the corporate tax rate which could hurt stock prices. However, Joe Biden has pledged to do massive infrastructure spending that will help industries involved in roads, buildings, and utilities. If President Trump is re-elected, some might perceive as a risk to drug companies with his recent legislation on price cap controls. Then again, President Trump has continued to push for more defense spending. The outcome of the Senate and House of Representatives could have short term implications as well.
History has shown that the Stock Market has gone through booms and busts with Presidents of either party. I find it better to evaluate how different administrations will affect industries or companies specifically on a microeconomic level. Furthermore, our companies have done well in the long run no matter which party holds the White House.
My biggest concern is the large amounts of quantitative easing by Central Banks around the world and the multi-trillion dollar run up in our federal debt levels. Right now the U.S. is pushing north of 100% debt to GDP. We are still a far cry from Japan’s 250% level but we are entering higher risk territory. We can not keep printing money and run a huge federal deficit year after year. Eventually there are implications to the reserve currency status of the U.S. Dollar and inflation risk with household economic stress.
It is one thing to do well in good times. However, the key to real successful investing in the long run is to avoid total losses. If your investments can survive systemic downturns and idiosyncratic bad news you will live to fight another day. None of our investments went to zero in the February and March 2020 downturn. In fact, our Fund held much better than the Stock Market.
Conclusion:
My investment strategy has helped us avoid the industries that got hit hard during this COVID-19 pandemic. I look for companies that can weather previous downturns and even grow during downturns. That is the bedrock of our portfolio. Then I evaluate how each individual company would hold up in this specific downturn because no two recessions are the same. I proceed to make investment decisions accordingly.
My goal is to survive the one year that no one else does. This is that year.
Therefore, we will continue to play defense while being cautiously optimistic. Note the road ahead is long for a recovery. Just look at China where they were able to take draconian measures to limit its spread in Hubei Province. Lockdowns have been lifted but a variety of economic activities are below pre-pandemic levels. Weekday activities have come back significantly but weekend activities are still down suggesting many are focused on going to work and doing essential activities. Exports have been surprisingly strong for China but imports have declined suggesting an uneven recovery. Overall though, China’s has been the economy closest to full recovery.
France, the UK, Germany, and some of the other European countries are suffering a record increase in cases. The U.S. continues to have north of 40,000 new cases a day. This pandemic is not going away anytime this year especially with the fall and winter coming. There is no way most restaurants and gyms can have outdoor facilities in colder parts of the world. It is way too cold, windy, rainy and snowy. At the same time, the entire global drug industry and every government on Earth is focused on defeating COVID-19. If drug companies are like battleships, then every single cannon and missile the world has is trained on this wretched virus.
It will take time, but I am optimistic we will eventually overcome COVID-19. This is because I have always believed in the ingenuity of humans. I also believe in humans’ ability to love and to understand things A.I. can not, such as instinctively knowing what is a good brand. That is why I believe in us and that is what sets us apart from A.I.
Until next time, I hope you and your family stay safe and happy.
Best,
Dan H. Chen
President
Talguard Investments LLC
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 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.
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