To my investors, I want you to know that one of my main missions in life is to prove to those who believed in me and in our team at Talguard that they were right.  The Markets are experiencing significant volatility and the defense I have been playing for months is working to our benefit.  I expect continued volatility in the coming months so we will continue to play defense until the time is right to go on the offensive.

COVID-19 and Rational Thought:
The recent virus outbreak that originated in Wuhan, China, dubbed the “Corona Virus”, and officially COVID-19, has dominated world headlines for months.  It rattled Chinese stock markets first and those markets have bounced back in a certain degree.  Whether there will be a pullback again remains to be seen.  The infection rate has slowed in China due to their drastic measures of implementing a mass quarantine of an entire province.  What is bizarre is that the initial quarantine had a four day warning period which meant over 5 million people were able to escape the quarantine zone prior to the borders closing for the Hubei Province.   Nevertheless, the drastic measures instituted in China including construction of 11 temporary hospitals in a week appeared to have an effect in slowing down the spread of COVID-19 within China.

The contagion has now spread to dozens of countries with hotspots in Japan, South Korea, Italy, and Iran.  COVID-19 cases have developed in all continents except Antarctica.  It has spread to the United States and I surmise the number infected will rise as more tests are done and milder cases are identified.  I wish our government in the U.S. including the Trump Administration and the CDC would push for more testing sooner.  We need more testing kits and other measures to identify who has the virus to better contain its spread.

The Korean Journal of Radiology stated CT Scan images can be an effective way to identify COVID-19 and is more accurate than X-ray images.  In addition, COVID-19 appears to be “radiologically milder” than both SARS (Severe Acute Respiratory Syndrome) and MERS (Middle East Respiratory Syndrome).  It is an alternative to the testing kits now which appear to not have the highest accuracy rates.   We need to be doing more to test who has the COVID-19.

Part of the problem of what has spread so much fear is the incubation period of COVID-19.  A person infected may not exhibit symptoms for up to 14 days.  Compare that with common flu strains which usually produces symptoms within four days of contracting it.  That is why it bewilders me how the U.S. and many other countries that have cases are not testing more.  People are out there who may have it and do not know it and that is pushing the spread of the virus.

Image provided by United Nations COVID-19 Response. People are out there who may have it and do not know it and that is pushing the spread of the virus.

According to Worldometers.com as of March 8, 2020, there are currently over 110,000 people have the virus and over 3,800 deaths worldwide and both are expected to rise.  Over 62,200 have recovered thus far.  Of the active known cases, approximately 38,000 are mild (86%) and approximately 6,000 are serious (14%).  The death rate has been the lowest in South Korea because they have been testing at a rate of over 10,000 a day.  The U.S. and other countries really needs to step up testing across the country.   Although more testing kits are being sent in the coming weeks, I find that Western governments have dropped the ball here.  We should follow the lead of China, Japan, and especially South Korea when it comes to testing.

It has caused stress on global supply chains and reduced travel in a significant way.  Economic activity, especially social activity and leisure activity have and will slow down if not grind to halt.  Cruises, flights, hotels, and amusement park stays are postponed or canceled.  Box office revenues for theaters in China and Italy have  been reduced by approximately 85% and 75%, respectively, for the first two months of 2020.

In theory, warming weather as we head into the spring and summer should help reduce the outbreak but there is no guarantee.  I do not think the panic and fear will subside until you see a worldwide slow down of the infection rate similar to what you are seeing in China.

We had another great year and we once again beat our competition, the average of over 3,000 private investment funds from around the world that comprise the Barclay Hedge Fund Index.   What has me even more excited is that we were able to achieve these results while playing defense.   Make no mistake about it, we continue to play defense with our portfolio.  We sold off some losers for the year so expect that in next year’s tax returns.  Our gains have been substantial and we kept almost all our winners.  We have held more cash on hand but have been able to make money with that cash waiting for the right opportunities.  We are looking at companies that held steady or even grew in the last recession.  As I have discussed in the past and I think it is worth repeating, we want to preserve and grow wealth over time.  Most importantly, my strategy is highly scalable as we continue to grow our wealth together.   

I strongly believe we are positioned well in case there is a downturn because I am cognizant of the recent run up in the Stock Market and many other asset classes.  However, that does not mean you want to sell everything and “head for the hills”.  I have heard from some people who have sold out or continue to reduce their equity positions out of fear of overvaluation.  My answer is that they would have missed out on substantial gains.  As mentioned, many of our investments have been compounding for years and as long as their durable competitive advantage stays with them, we will continue to own their shares.  I can not predict what will happen to the Stock Market in the next several days or months.  I can predict if those who hold the equities of businesses with durable competitive advantages over the long run will do well.  I am investing for the next 10+ years, not the next 100 days.

We did and will continue to make investments with what we always do, which is to invest in companies we deem to have durable competitive advantages, companies that treat shareholders fairly, and are reasonably priced.  Overall I seek to invest in “Number Ones”, which means I seek to invest in the equities of market leaders in their respective industry niches.

We head into the New Year and New Decade with a sense of optimistic caution.  Many things have gone right to create the current economic expansion that has resulted in a low unemployment economy.  America continues to innovate and it punches above its weight for worldwide brands.  Although it has been the longest expansion ever in American History at over a decade, it can certainly continue.  Look at Australia, which had an expansion for over two decades.  However, underneath the surface there are items that provide caution.

Central banks around the world have continued their long term Quantitative Easing (“QE”) and push rates lower, to negative in many countries.  This is not good news for commercial banks and other financial institutions that lend money.  In the long run, banks need to have positive rates to generate profit. They make money on the net interest spread and that continues to be compressed.  The constant QE and other monetary stimulus done by Central Banks are a danger to the world economy.  Central banks trying to stave off recession are only creating a larger asset bubble.  Eventually the piper is paid.

Negative yields over the long run are unsustainable.  No investor wants to be paid negative interest rates for the use of their capital.  This may happen for a period of time but I suspect governments that keep rates negative will experience a deflationary period that can create long term stagnation.  Look at what happened with Japan for the past three decades. Germany’s Bund (Germany’s government bonds) just crept back to positive but it is still near historic lows.  Some economists argue if there are a lack of alternatives, then people would accept this negative rate.  This makes no sense.  I do not agree there are no alternatives.  Central banks can choose not to expand balance sheets for example.  Federal governments can push for growth through fiscal policies.  In my mind sound fiscal policy is the engine that drives sustainable long term economic growth.  Monetary policies can alleviate strong term economic stalls but it is not the answer for a long term economic game plan for growth.   For example look at Sears, no amount of financial engineering could save that company because its core business was fundamentally flawed.  The core business is the fiscal policy.  Fiscal policy is what creates a better engine for sustainable economic growth. Monetary policy is more like a sound dashboard and accessories that complement the core fiscal policy engine.  Sound fiscal policies and monetary policies together dovetail to create proper incentives.  Wrong incentives lead to bad behavior.

Automation, artificial intelligence (“A.I.”), and robotics will decrease existing positions across all economic classes but it will hit middle income and lower income families the hardest.

Unemployment has been low but many are still underemployed or not in the job they want.  The American Middle Class continues to shrink.  Automation, artificial intelligence (“A.I.”), and robotics will decrease existing positions across all economic classes but it will hit middle income and lower income families the hardest.  For example, the biggest employer for American males without college degrees is the driving industry.  This industry includes truck drivers, cab drivers, ride-hailing drivers, and bus drivers.  Someday there will be A.I. driven vehicles that might take over most if not the whole industry.  It may not happen in the next several years but it has a great chance to happen eventually.

We concluded the first half of 2019 with a strong return.  We were able to rise despite playing defense by having more cash on hand now.  Make no mistake, I have positioned us so we are ready when opportunities arise.  The four major Market items of note are the U.S. and China Trade War, the U.S. Federal Reserve policy, corporate earnings, and the Debt Conundrum.  These are the same major factors affecting the Markets as I discussed in the last annual letter.  Before I get into it I want to note that if we find a good opportunity in a market leading business that we like, we will invest regardless of all the background noise.  Now on to the four points affecting Markets.

1. U.S. – China Trade War:
There is unlikely to be a permanent trade deal in the near future, especially one that gives each side what it seeks on a long term basis.  This will likely hurt the U.S. and Chinese economies in the near term.  Even if there is a deal, there is a possibility the next U.S. President will want to change it or get rid of it.  Due to the gerrymandering of our federal political system, the two parties have much less reasons to compromise.  This has happened in Congress for the past two decades and now it has moved into the Executive Branch culminating in the current administration’s all out goal of rubbing out previous administration policies.  This is likely to continue with the inflammatory political environment that we are in.

If you examine the history of tariffs in America and also other countries, the evidence is quite clear that blanket tariffs do not work.  It ultimately is a tax on the businesses and consumers of the countries that instigate the tariffs.  Free trade has tremendous benefits for recipients that are not seen as easily.  It produces savings across the board for consumers over the long run.  There is a reason rich cities and countries have practiced and pushed for trading.  All countries have used tariffs throughout history and they are in effect today.  That includes the U.S. and other western countries who push free trade.  The U.S. uses tariffs too for a variety of basic materials and finished products.  Plus the U.S. has mass subsidies for a variety of industries, the largest being the farm subsidies.  Besides subsidies, the U.S. government will commit to purchasing some of the products of these subsidized industries to prop up prices.

I spent time in Hong Kong and Mainland China and there were a few revelations.  China is way ahead of the United States and the rest of the world in the payments game.  China has the most advanced touch less payment ecosystem in the world and it has significant market participation.  Cashless and touch less payments are so embedded in Chinese society that street beggars have cardboard backed cutouts with payment ID codes on them so people can scan to give them money.

Many supermarkets and restaurants do not even accept hard currency.  It really hit home when our private driver stopped at a gas station to refuel.  At that convenience store, we picked up a few snacks and a store worker was standing in front of tall blue screens asking us to scan our products.  We were expected to pay with our mobile phone.  After some confusion, a worker behind the counter figured out we wanted to pay by hard currency since our mobile app we downloaded did not work so she waved us over.  It was not often people pay by hard currency she mentioned and she called our money “ancient money”. Contrast that with American payments.  It took years after Europe smart chip cards before U.S. retailers adopted the technology.  Many payments are still processed by a variety of methods.  Meanwhile in China, almost every consumer purchase is done digitally in consolidated apps and in touch less form.  America is far from integrating touch less payments and there are zero consolidated apps for payments.

China is also leading in a variety of consumer technologies.  It is a top two competitor alongside the United States in the race for artificial intelligence (“AI”).  It has a faster embrace of consumer robotics and as already discussed a faster embrace of payment processing.  China is now the main competitor to the race for 5G connectivity.  Whoever gets there first will have the opportunity to formulate the rules that future wireless apps and software are written on.  Most of the Chinese population skipped the lan line times and leapfrogged into mobile devices.

The Federal Reserve is trying to get ahead of a recession.

2. The Federal Reserve:
The Federal Reserve is now too much of an agent of the Market and its nonstop propping up of asset prices is a huge volatility trigger.  In December 2018, the Federal Chairman stated how it wanted to tighten credit.  Then after unprecedented criticism from a sitting President, the Federal Reserve reversed course and said they would be accommodating in keeping interest rates low.  Now the Federal Reserve communicated that they are going to cut rates.

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 31^st in the world for life expectancy, just ahead of Cuba at 32^nd 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.

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.

Hope you are enjoying the summer.  A big welcome to our new investors.  My goal is to preserve and grow your wealth.  My investment process is repeatable and scalable.