There are two stories here. One is about our continuing growth as more investors sign up to our compelling investment strategy. The other is about success and what we continue to achieve for those investors who have put their trust in us.
The Talguard Value Fund LP (“Talguard”) has tripled in size over the past 12 months.
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| The Stock Market growth has continued through the first quarter of 2017. |
Survival, and Growth:
The Stock Market (“the Market”) fell in the three months leading up to the Presidential Election in the U.S. This was followed by a recovery and growth that has continued through the first quarter of 2017.
In the short term (typically less than 2 years), the Market as a whole goes up or down. But investing in a general spread of stocks means that to recover lost ground, and then progress, requires remarkable performance.
Our view is simply that there is a better way: that the Market will reward those who take the time to understand more about the companies they invest in – not just in terms of their immediate outlook – but in terms of their ability to generate returns. Concentrating investments here will, we believe, provide the maximum payback, in good times and in bad.
Our fundamental investment principle is to seek out companies that have a proven history of generating consistent levels of cash flow.
Too often, companies without this singular capability are over-valued. Why?
Sometimes because they promise to introduce a ‘disruptive’ approach – to change the world in their favor, through a new business model, new technology or both.
Sometimes they have charismatic executives, capable of headline-grabbing. Some are just great at PR, and are seen to have perceived potential even with negative income or non-existent revenue.
But potential is not enough to survive. In the short term, companies like these have to either borrow against that future potential, or to issue more shares. Either way, they increase the potential volatility of their existence with leverage, or they dilute shareholders’ investments with follow-on offerings.
Companies like these have a high risk profile, which means that they often fail to survive a business cycle downturn.
Our way of doing things is different.
We look for companies that have high cash flow, particularly ones that accrete value to their shareholders through share repurchases. Of course, as well as leading to higher earnings per share growth, a factor that will necessarily lead to increases in stock value, these companies have the ability to pay consistent - and often growing – dividends.
Companies that can do this over a longer period of time are rare. If they can be found though (and we think our performance shows that we can), it is worth maintaining faith with them. Only very special companies can maintain this kind of performance over a run of ten years or so. But it is precisely these companies that will remain financially healthy during inevitable downturns – either a recession in a particular industry or a full-blown economic recession.
At Talguard, our investment style concentrates on long-term value investing, searching out solid investments that will remain strong in any market environment.
We choose to specialize too, in certain industries that have fundamentally attractive features for investment. We focus on these industries at the expense of others, ones that are characterized by huge turnover, are driven by potential rather than performance, and are highly price driven.
In the sections that follow, I want to look at the sectors we favor and our reasoning.
Financial Services:
The Financial Services industry in the U.S. is one where opportunities are balanced by the potential for regulatory change.
On the one hand, increases in interest rates by the Federal Reserve, the election of Donald Trump, and Republican majorities established in both houses of Congress seem to point to further growth. On the other, de-regulation might create issues that have been problematic before.
Discussions concerning legislative changes are in the air. These include the potential repeal or extensive revision to the Dodd-Frank Act of 2008 to loosen controls on financial institutions. The overall goal would be to help the flow of capital, making it easier for small community and mid-sized regional banks to lend.
Whatever happens and whatever opportunities emerge, there would be danger in a complete repeal of the Act.
Since the 1930’s, the financial system has been one that broadly separates investment banking from commercial banking activities. It was the fall of one piece of the legislation that created that system – the Glass-Steagall Act of 1933 that led to the real estate and derivatives bubble of 2008 and all the subsequent negative consequences.
In effect, the line between investment banks and commercial banks began to blur. Allowed mergers and acquisitions further muddied distinctions between commercial banks and investment firms.
Commercial banks began taking deposits, mortgages and other volatile assets and created highly levered and speculative vehicles for investment. The derivative market allowed still further complexity.
Complete repeal of the Dodd-Frank Act risks replicating some of the unwelcome activities of 2008. We believe that keeping a boundary between commercial and investment banking is necessary to prevent risk to individual banks and to the financial industry.
Finance and financial services is still replete with opportunity, without legislative change. We know that our choice of investment in this sector is solid, based on strong branded presence. More important is that the companies we have chosen have generated the kinds of cash flow and shareholder value that is the hallmark of a Talguard investment.
Pharmaceuticals and Distribution:
Somewhat unfashionable at the moment, the healthcare industry has encountered pressure from multiple fronts, particularly on its price structures. The pharmaceutical sector in particular is a regular target for public outcry.
But when a sector is out of fashion with the investment community, it often rewards closer scrutiny.
We know that there are highly profitable companies here that will survive the long run. We know that some of these both meet our stringent investment criteria, and yet are currently undervalued.
Of course, in recent weeks, the focus of attention has been on the Trump administration’s failure to repeal and replace the Affordable Care Act. It may be that a revised bill is brought forward to revive this mission, and a vote in the future is possible. This may create further opportunities.
But this is unlikely to happen in the short term. Bear in mind that it took the Obama administration a year to put together, negotiate, and pass its healthcare legislation. If and when new legislation emerges, implications for healthcare investments can then be evaluated. Anything before is highly speculative.
Information Services:
This is a profitable industry with many attractive qualities. Continuously low capital expenditure as a proportion of revenue is one. The fact that inherent barriers to change create high customer retention rates is another positive attribute.
Specific companies have created platforms where fees are paid each time a transaction is made that uses their product or service. Others have created essential enabling technologies, without which other commercial operations would cease to function.
All these factors make this an interesting sector.
Branded Manufacturers:
Strong brands are at the heart of strong businesses. Escaping from price-driven pressure, companies have prospered through the performance of widely trusted brands.
This performance is being maintained despite the efforts of price-driven competitors to disrupt markets. But it has led to some interesting valuations and hence investment opportunities.
And the fundamentals as we see it, are also attractive here.
Consistent and growing cash flows, and above average returns for investors, have come about because companies in this space can acquire or grow their way into new niches while maintaining pricing.
Manufacturers have shown consistent pricing power over the long run. Niche leading manufacturers have spent research and development and purchased competitors that are taking advantage of general increases in prosperity has led to growing markets for better quality products. If you look at the history of the three major segments of the supply chain, there are more cases of long term growth and survival within the manufacturer space.
Despite all this, the sector as a whole is not looked upon as one with potential, and that has produced some attractive valuations. Not for the first time, consumer pushback has created opportunities here.
Manufacturers, the first component of the supply chain, seem to have fared best. The commodity and retail components of the chain have not performed so well.
Transportation:
The railroad industry provides significant opportunities when the price is right.
Cutting through a morass of information to the facts reveals the following:
- In the U.S., there are only four major class A railroads. One is private
- There are two Canadian lines with usage in the U.S. and one regional class A line
The airline industry is fundamentally different, but with some big investment names taking positions here, it deserves some scrutiny.
On the positive side, there are only four national domestic airlines left in the U.S., capacity has been reduced, and fuel costs are down.
However, unlike the railroads, barriers to entry are much lower, and domestic competition is open to overseas carriers from the Middle East, Asia and Europe.
New entrants continue to attempt to disrupt the market. Norwegian Air has started to offer budget flights to Europe, and WOW Air from Iceland has followed suit. JetBlue, one of a cadre of regional domestic competitors has started offering a discount mid-level business class for its long haul domestic flights and the major carriers have followed suit.
There are approximately 5,000 airlines in the world: hundreds fly in and out of the U.S., and many more compete with U.S. carriers overseas. Foreign railroads cannot compete here, but new airline competitors are very likely.
Other reasons to be cautious of the airline sector include the large capital cost in replacing fleets, the influence of unions, pension obligations, and a continuous need to revitalize cabin interiors and structures. Even fuel costs can be a double-edged sword when hedged expectations go the wrong way. Airlines are subject to more headline risk and public relation situations due to the nature of its business. This is true of accidents, terrorist attacks, and individual customer incidents.
Ocean shipping is not a sector we like. We dislike the commodity nature of the business, in which switching costs are fairly easy and there is high capacity. There is also large capital cost for the ships.
Trucking has few barriers to entry and is subject to intense competition from a slew of large competitors, smaller regional competitors, and tens of thousands of “mom and pop” competitors. Trucks have to share the road, whereas railroads have a near monopoly on their tracks.
Transportation costs are much lower for railroads than trucks. In the last downturn, a number of trucking companies went bankrupt or had to find emergency capital to survive. Either way, it was not good for investors in trucking companies.
For all these reasons, railroads are our preferred sub-sector.
China:
China is an economic miracle, the fastest ascent of a large economy the world has ever seen, and one where changes happen very quickly. In the city of Changsha, a 57-story high-rise was constructed and finished in 19 days (USA Today, April 2015). In some ways, China’s business environment is more capitalist than the U.S.
However, investing in China is complex.
Structural concerns include the business and personal loans made by non-bank entities. This happens because the government does not allow lending for start-ups and small businesses. Chinese banks lend mainly to big projects. Some of these loans have experienced defaults, particularly with large real estate projects, and this has affected state-owned Chinese banks.
Some argue that the coastal A-list cities are immune to downturns, but the same arguments were made in respect of New York and Los Angeles real estate prior to the bursting the real estate bubble in 2008.
Changes are on the horizon. China’s manufacturing sector also has a lot of excess capacity and the Chinese government is attempting to strengthen domestic consumption, to balance export dependency.
Demographically, China’s one-child policy, phased out from 2015, will still bring about an older age profile in the population. Taking care of older people with a smaller proportion of the population of working age adults will be a huge challenge. The one-child policy’s legacy will decrease factory worker availability in the coming decades. Other countries, Vietnam in particular, are attempting to step into China’s role as the “world’s workshop”.
We have invested in a few companies that have generated outstanding returns in the past. For now, we bide our time and await further developments.
Investing for the Long Run:
Our world today is one of frenetic change, and nowhere is that more evident than in the world of investment management.
Today, the industry has the power to change things at the drop of a hat. But which changes should we make, and how often? Because we can change things quickly, should we?
Nagging doubts plague the industry. Should investments be more diversified? Should holdings change as circumstances change? Information arrives by the second. Will even quicker reactions bring results?
Without a consistent strategy as a foundation, investment management becomes little more than a frenetic quest for increasing speed of change. At Talguard, we have a different approach, one which is considered, consistent, and researched for the long-term.
So, while we know that most successful investments require time to generate high returns, the industry as a whole tends not to behave as though this is true.
Many equity funds hold over 100 positions in their portfolio. The average stock is held for less than three months. With the advent of algorithms and high frequency trading, turnover has become more pronounced. The industry as a whole is under pressure to make a quick buck, and if it can’t do that, to avoid losing one. Lots of action does not equate to success when it comes to investments. Activity becomes a smokescreen to cover lack of effectiveness.
Following this philosophy of frequent change means that a stock’s liquidity – one of its greatest assets – becomes a liability. Over-diversification makes it more likely that a fund underperforms compared to the market.
Faced with this, fund managers justify their performance by ‘closet indexing’, being close to often self-selected benchmarks.
Over-diversification is simply counter-productive, especially when a portfolio includes over 50 positions (Fundsmith/Bloomberg 2013).
The average equity fund holds 90 stocks; 20% of funds own an average of 228 stocks (Security Concentration Study by Professor Travis Sapp, Iowa State University, and Professor Xuemin ‘Sterling’ Yan, University of Missouri).
Investing in stocks should be similar to making an investment in a commercial real estate property. You’ll have a target list of features you want to see. You’ll want to look at returns, location, expenses, and other factors that might influence the value of the property. Even when you find what you are looking for, you would not want to overpay, and you’ll want to be sure there are no existential threats which might take the value of your investment dramatically down.
Keeping track on investments means constantly researching, learning, and reading about a company and its environment. The only way to do that is to do your homework and to not own too many positions.
Fewer positions and more comprehensive understanding of an investment and its environment is key for investing for the long run. That’s the Talguard way.
Interest Rates and Bonds:
Equities have so much more potential as an asset class than debt.
In the U.S., there has been a 40-year bull run for debt created by the Federal Reserve’s lowering of interest rates, and stocks have still outperformed. Interest rates have tumbled from mid double digits to around 4% during this period and U.S. Treasury bonds are now paying less than 2.5%.
For investors seeking yield, junk bonds may look attractive (at approximately 7% at the moment) but does that outweigh the risk, particularly over the long term? Junk bonds, also known as high yield bonds, have a high historical default rate and are often unsecured. Debt investors in our view have just the same risk as equity investors, but without the advantages.
What do we mean by this? Debt investments are capped on the upside when things go well. Not true for equity investors, who will gain returns many times greater.
But what about debt security? Assets used to secure debt are often sold at big discounts if there is trouble. Sometimes they are hard to liquidate. Look at what happened to mortgage investors who were left holding abandoned properties after the last financial crisis.
Quite simply, if you believe in a company enough to buy its debt, shouldn’t you be buying the stock instead?
U.S. Treasury Bonds may be ‘the safest investment in the world’ but you pay a lot for that safety, often your return is less than the rate of inflation. If long term interest rates go up even by a few percentage points, it will wipe out returns and some principal for existing Treasury Bonds. Therefore, these notes are not without risk.
On the other hand, there is our approach: properly researched and durable companies that generate large cash flows and can demonstrate their robustness.
Doesn’t that sound like a more sensible approach to risk?
Beyond the Third Wave and the Potential for the Future:
Of course, we need to be aware of the changes that make our world what it is.
Broadly, we have seen three important waves of change:
- the industrial revolution that so dramatically expanded production capabilities through the use of machines
- the productivity revolution that expanded food supplies, gave us new fuels and the soft technology that allowed us more time to think
- the information revolution that has brought immediate access to information and communication
We believe that the next phase will bring an exponential increase in our ability to use mental processes. Robotics will become a key technology. Replacement therapies will dominate healthcare. Life expectancy will increase.
We need to understand how these changes will offer commercial opportunity as they develop.
Artificial Intelligence and its Meaning for Humanity:
Artificial intelligence and robotics are already part of our world. Some see these advances as a threat, but it will be human interventions and human intelligence that creates and limits their use.
Could A.I. take over investing? There are already A.I.-centric investment funds, the outcome of those twitchy, high-frequency algorithms we discussed earlier. Are they working?
In 2010, the value of Proctor & Gamble stock fell 40% in a few hours. It recovered 38% of its value throughout the rest of the trading day. There was no rational reason for a fall so dramatic, and that’s why the price recovered. Algorithms will improve, but their logic is suspect. Lemmings follow other lemmings. We need to break free of the herd.
Replicating human behavior is not straightforward. Humans have the power to recognize brands. Brands in turn have a soft power that would be difficult for any algorithm to pick up. So too would be the emotional cycles that underpin business. If people feel things are going well, there will be more economic activity.
People have unique understanding, a feel, for this kind of emotion. Sometimes, individually, their reactions are irrational, but overall they react in ways that make sense, shaping and developing our world on the basis of billions of decisions. So far, no algorithm has been able to take all this into account. In fact, algorithms themselves have proved to be additional sources of insecurity and risk.
If A.I. has the interconnectivity and reach to be able to outdo and replace humans in all aspects of life, then stocks will be the least of humanity’s concerns. Humanity will be facing an existential threat to its own existence.
Politics and the Reality of the Stock Market:
Since the U.S. presidential election, there has been a lot of discussion about the immediate future, a lot of posturing and a lot of prediction about doom and gloom or a transformational outlook, depending on your point of view.
But since the election, the stock market has rallied.
Principally this was because the period of uncertainty leading up to the election was over. The outcome produced clarity, the smooth transition from one administration to the next, and the market likes clarity.
Of course, the market has now given back some of those gains in the last 30 days and it could continue to go down further. Political problems could produce more uncertainty. The market could drop. But are we at Talguard concerned? Emphatically no.
Short term volatility is not a problem, especially when you look at the power of economic creativity that survives and thrives in the U.S., thanks to the system invented by the Founding Fathers of this great trading and innovative nation. We have more global brands per capita than any other nation in the world. That’s no accident.
Does this fit our investment style? Yes. Concentrating on individual businesses and judging each on its own merits fits perfectly into this environment. Our strategy of seeking companies with specific qualities and waiting until prices fit our striking range also works.
The Talguard name underscores what we seek to achieve. Guard makes its point about guarding our investors’ assets. Tal is a reference to the talons of the bald eagle that symbolizes our nation. Like an eagle, we soar above our targets, striking quickly when the time is right. That is the essence of our concentrated approach.
The ‘Butterfly Effect’ has it that the sudden motion of a butterfly wing on the other side of the world can have a momentous effect elsewhere and effect many future events. It is that effect that defeats human attempts to understand the reason for everything, and will in turn undermine the same attempt of the part of human-invented algorithms. And so we simplify, we concentrate our intelligence and understanding, and we use time as a benefit, not a curse.
Endowments: Enabling Progress, Improving the Human Condition:
Endowments are a massive force for good. Investment funds set up by wealthy individuals, companies and institutions, from Henry Ford to Bill Gates, from Yale University to Warren Buffet, their income is invested to make really big contributions to solving some of the world’s biggest problems in health and wellbeing, in education and research, in science and understanding.
Before founding Talguard, I was a personal beneficiary of the opportunities these funds made possible.
I graduated from the Haas School of Business at UC Berkeley. I had the good fortune to study abroad for a year at China’s top university, Tsinghua University in Beijing. In addition to studying business, I took classes in Astronomy. I graduated with an MBA from the Anderson School of Business at UCLA.
I owe a huge debt to those who came before me, creating the endowments that helped fund these programs and institutions. Now, my respect and some of that debt of gratitude is being paid back through the successful investment strategy implemented through my company, Talguard.
Some Final Thoughts on Our Long Term Strategy:
Long-term and concentrated are two expressions we use a lot but they underpin everything we do and for good reasons.
Our approach takes advantage of compound returns while it reduces the burden of short term taxes, transaction costs, and volatility. Selling into a downturn (and locking in losses) becomes less likely.
Buying into a downturn – with all the advantages that brings – creates more opportunities.
It takes time to learn and understand a company. We often study 10 years of history, and our research is first hand, into both primary and secondary sources. You might be surprised what a relief it is to avoid short term Wall Street research and the relative insanity of ‘hot stocks’.
Our approach is necessarily contrarian. “Buy when there’s blood on the streets,” as one professional investor famously said. We are aggressive when others defend, and vice versa.
Another Recession?
At some point, there will be another recession, in the U.S. or globally. And the reality is that no one can predict when it will happen. Our strategy of investing in strong companies with a margin of safety is designed to insulate investors from events like these.
Companies with strong cash flow can weather downturns. Many of o ur portfolio companies actually saw their cash flow increase during the last two recessions. This gives us comfort not to panic like most investors during recessions. Not only do we not sell into downturns we start buying more when others are fearful.
With a ten-year horizon to investing, peaks tend to be higher, troughs less severe. High turnover strategies miss out on many benefits and miss out on many costs too. And the more positions you take, the worse the opportunity cost is.
Concentrated long-term value investing really works when correctly applied.
Correctly applied does not include roll-up strategies. Most roll-ups do not work out well for investors in the long run. Synergies do not materialize as promised. Integration of new companies creates new waste rather than cost reductions. When companies take over competitors larger than themselves, they encumber themselves with debt. Because it is ‘just debt’, they pay more than they should. They pay more than they should too, to banks and others who facilitate the transactions. Above all, many unravel when their size and complexity catches up with them.
Summary:
At Talguard, we are dedicated to an old craft, and we run on old principles. We don’t follow fashions or fads. We concentrate on methods that we know to work, and in markets where we know we can apply them.
That makes us a safe option, but not an unthinking one. We continue to question, investigate, research and explore. But everything we have found up to now confirms our methods, even in the current market with its long run of success.
We know there are opportunities out there. We know we can find them.
We aim to be the best investors of our generation. Thank you for your support in the past. We look forward to growing strongly as our success is increasingly recognized by investors.
Contact us today at investors@talguard.com.
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 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.
©2017 Talguard Investments LLC, all rights reserved.