2019 Talguard Annual Letter By Dan H. Chen
by Talguard•Monday, March 25, 2019
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.
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.
2018 Talguard Annual Letter By Dan H. Chen
by Talguard•Tuesday, August 28, 2018
Dear Investors and Friends,
We had a terrific year. This is not only because of our outsized return. I am very satisfied because we outperformed both metrics that I measure Talguard against which is the Barclay Hedge Fund Index and secondarily against the S&P 500 With Dividends Index.
In the long run, I am ever confident in America’s prospects. Our children will live better than us. Relative to current interest rates valuations are not overly heated. However, if interest rates rise they are like gravity to asset valuations. For the past 40 years, interest rates have had a long term downward trajectory. The current interest rate gravity environment is so low it’s like an astronaut living on the Moon. Eventually that astronaut will come back to Earth and it will be difficult to adjust to the heavier gravity. That is the situation we are in with stocks and interest rates. I fully expect our strategy to outperform and really shine when a downturn comes.
Talguard’s Year:
Many of my ideas have proven correct and we substantially grew the value of our assets. The Market may go up or down but I fully expect the earning power of the companies in our portfolio to compound every year. Some volatility has returned to the Market in recent weeks. You will be happy to know our investments continue to perform well. The recent rumblings are potentially tremors for larger volatility at some point in the future. There are several market distortions that are affecting the bigger picture: stimulation from Central Banks and recent government policies resulting in interest rates that are artificially low, the rise of passive investment funds, the rise of leveraged investment funds, and the amount of worldwide leverage on a personal level and government level.
These factors will create outstanding opportunities for us when they arise. In the meantime, we continue to stay invested in the fantastic businesses that we own for our current capital. I treat investing in stocks as ownership interests in businesses, not as a pieces of paper with prices that go up and down.
Talguard’s Strategy and Objective:
Talguard Value Fund LP is a private investment fund that seeks to deliver superior returns by investing in the equities of companies with durable competitive advantages purchased with a margin of safety. The goal is to beat the S&P 500 Index and 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, 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. 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. For these 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. These are companies with many of the attributes as Core Companies but could be a step below. 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 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.
My strategy has an additional 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. They cannot take on too much more capital investing the same small companies because the float on those shares is much smaller. They would alter the Market for those shares.
We had a terrific year. This is not only because of our outsized return. I am very satisfied because we outperformed both metrics that I measure Talguard against which is the Barclay Hedge Fund Index and secondarily against the S&P 500 With Dividends Index.
In the long run, I am ever confident in America’s prospects. Our children will live better than us. Relative to current interest rates valuations are not overly heated. However, if interest rates rise they are like gravity to asset valuations. For the past 40 years, interest rates have had a long term downward trajectory. The current interest rate gravity environment is so low it’s like an astronaut living on the Moon. Eventually that astronaut will come back to Earth and it will be difficult to adjust to the heavier gravity. That is the situation we are in with stocks and interest rates. I fully expect our strategy to outperform and really shine when a downturn comes.
Talguard’s Year:
Many of my ideas have proven correct and we substantially grew the value of our assets. The Market may go up or down but I fully expect the earning power of the companies in our portfolio to compound every year. Some volatility has returned to the Market in recent weeks. You will be happy to know our investments continue to perform well. The recent rumblings are potentially tremors for larger volatility at some point in the future. There are several market distortions that are affecting the bigger picture: stimulation from Central Banks and recent government policies resulting in interest rates that are artificially low, the rise of passive investment funds, the rise of leveraged investment funds, and the amount of worldwide leverage on a personal level and government level.
These factors will create outstanding opportunities for us when they arise. In the meantime, we continue to stay invested in the fantastic businesses that we own for our current capital. I treat investing in stocks as ownership interests in businesses, not as a pieces of paper with prices that go up and down.
Talguard’s Strategy and Objective:
Talguard Value Fund LP is a private investment fund that seeks to deliver superior returns by investing in the equities of companies with durable competitive advantages purchased with a margin of safety. The goal is to beat the S&P 500 Index and 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, 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. 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. For these 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. These are companies with many of the attributes as Core Companies but could be a step below. 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 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.
My strategy has an additional 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. They cannot take on too much more capital investing the same small companies because the float on those shares is much smaller. They would alter the Market for those shares.
Health Care, Biotech, and Pharmaceuticals companies are providing very real benefits and services to their end users and to society. |
2017 Mid Year Letter By Dan H. Chen At Talguard Investments LLC
by Talguard•Tuesday, August 22, 2017
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.
General Thoughts On World Markets:
The Stock Market (the “Market”) has enjoyed one of the longest runs of positive gains in history. This has caused many investors to flock to popular stocks, often chasing companies that have negative net income, high leverage, and generally money losing enterprises. Many investors chase dreams and hopes that these companies will eventually turn a profit. Some of the popular companies are profitable but priced for perfection.
Margin debt has risen to much higher levels. Leveraged investments such as leveraged ETFs have higher risk for those who are exposed when there is a downturn. They will be hit the hardest when a down turn comes.
What caused this extended bull market? Starting with the recession and subsequent years, the U.S. Federal Reserve took the lead with lowering interest rates to historic lows and a historic purchasing of debt with its quantitative easing policy. Central banks in other countries followed suit. This period has made money cheap with low interest rates. These factors contribute to asset inflation.
If interest rates continue to stay low then current asset prices are still undervalued. However, if rates start reverting back to a historical average, then prices are highly valued.
Interest rates are like gravity to asset prices. We have operated in a low gravity environment similar to an astronaut making a jump on the moon. Sooner or later the astronaut has to come back to Earth and face the gravity he normally lives in.
Passive funds have also pushed up prices with their indiscriminate buying of all stocks in their respective indices. Many stocks have become overpriced relative to their intrinsic value. These passive funds are creating market valuations that will benefit patient active investors.
What is peculiar about the current bull market is that most major markets around the world have also enjoyed extended runs and there is relatively low volatility. The current productivity revolution continues with robotics and software algorithms. New methods to access previously hard to drill oil and natural gas along with the rise of hybrid/electric vehicles have pushed those prices far lower. Crop yields and animal herd efficiencies have created more supply. Underemployment and skill set mismatches have caused labor prices to trail historic increases. These forces have created a period of low inflation.
However, interest rates, volatility, and inflation may not stay low forever. At some point, the Central Banks cannot and will not hold on to the immense amounts of debt they purchased during the recession and subsequent years. When the Fed keeps raising rates and it starts selling off some of these notes, it will cause a head wind for stocks and other asset classes. The first phase of selling will occur in the coming months.
My value approach has outperformed the market and most other funds in a time when many are chasing growth and throwing caution to the wind.
I still find good bargains for quality companies in this current environment. However, I am cautious heading into this fall and I have positioned our partnership to be ready to take advantage of terrific opportunities that arise. I suspect there will be significant opportunity in the near future and we will be ready to strike and strike hard when the opportunities arise. It is a good time to invest in Talguard.
While we have performed well, I am more excited when outperforming the Markets during down turns. This is where my strategy of buying #1s with demonstrated cash flow and margin of safety will help us survive the one year that no one else does.
Why My Value Approach Works To Safeguard And Grow Your Assets In The Long Run:
The Wall Street Journal recently reported that many analysts are questioning the viability of value investing given the recent run up in the Markets. I disagree. It reminds me of the crowd following mindset of “this time it’s different”. Cash flow and value has proven to generate outsized returns for the long run. It is not what you make in the short run that counts, it is whether you can keep your gains in the long run that matters.
Value investing is the approach of finding great companies at reasonable to greatly discounted prices. This approach works because if you invest in the right companies at the right prices you have the opportunity to generate outsized long term returns. You reduce short term capital gains taxes and you can go to sleep at night knowing your stocks will survive during downturns, especially during financial panics. You can ride out the storm.
My goal is to preserve wealth and then to grow it. Preserving wealth is often the greatest concerns for wealthy individuals, families, and institutions. There is an ancient Chinese saying that wealth does not last past three generations. I want to help preserve and grow assets for the long run.
As you can see with the partnership’s outsized returns, value investing does not mean low returns during boom times. My strategy really shines in preserving wealth when during market downturns. So how do I do this?
I am an asset allocator and I treat myself as an owner of each company I invest in. I seek to find the best companies that have durable advantages and allocate according to their valuation and strength of business. I focus on market leaders that generate long term cash flow and treat shareholders well.
The way to preserve and grow wealth for the long run is to buy quality at reasonable prices. I seek to invest in quality companies that are number #1’s in their niches that have durable competitive advantages. I desire a margin of safety to ensure we sleep comfortable at night and that we will weather downturns when fear grips the Market. I like companies that generate lots of cash flow and then utilize that cash flow in a shareholder friendly manner. Downturns will come. It is those who survive those storms that will see the massive fruits of a future boom when the sun shines again.
It is a great time to be alive. The advancement of human ingenuity is advancing at a quickening pace. In our lifetime, we will see the discovery of more than twin for our home world. The advancement of the medical field will prolong our lives much longer on average than any previous generations in human history. There is a good chance we will detect some form of extraterrestrial life in our lifetime.
We will live older while retaining our health. Longevity has profound implications for investments. Eventually, technologies such as organ regeneration, implants, and next generation medicine will make its way onto the field.
So where does that leave us for our investments?
It is great news for Talguard investors. We will have many more years to compound returns. The power of reinvested capital compounded over many years is geometric. We will compound with many more years than any investors in previous generations.
Past Investment Examples:
I have learned a great deal from investors and other people throughout history. I have learned from the best through the power of reading. I read as much as I can every day. It is targeted reading that gives me the base knowledge about companies and industries that gives rise to my investments.
I seek to invest in #1 companies, I want dominant companies that will crush their competition. In the midst of the Great Recession and Financial Crisis, I invested in a leading financial services company starting in 2010. This Company is the ultimate toll booth company and had three separate decade-long catalysts that the market was missing. This investment generated a compound return of over 20% a year.
I never invest in companies hoping they will be bought out. If you invest correctly, buy outs are a natural course. Since all my companies are #1 market leaders in their niches they have attractive business traits that can attract acquirers. They also often have very little debt which makes them attractive to private equity firms and business competitors because they can borrow against the assets for the buy outs.
We owned shares of Precision Cast Parts before it was bought out by Warren Buffett and Berkshire Hathaway. Three other investments have also been bought out. Each investment was made after the Market pushed their stock prices down due to short term concerns. These investments performed well and coincidentally were bought out making us a nice bonus profit. I much rather have owned them for longer periods. Alas, most shareholders voted for selling out.
As mentioned, I never invest in companies hoping or predicting they will be bought out. That is not the way I work. I think long term for my investments. If they happened to be bought out then we move on with the proceeds to seek new candidates for investments.
Next I discuss some industries of interest below.
Financial Services:
I really enjoy reading about this sector. It houses a number of terrific companies with business models I find attractive. Payment Services has been one of my fortes and it has rewarded us with investments that have generated market beating results. Payment Services also has a lot going on from both ends of the tech spectrum. On the lower tech side, payment wire service companies have experimented with new fin tech services. On the higher tech side, you have loosely regulated new crypto currencies making headlines. I avoid these so called high flying crypto currencies. They are by nature highly speculative. I seek cash flow and durable competitive advantages. Crypto currencies provide neither.
Interest rates will go up at some point. In some areas they already are going up. Just ask any current home buyer who needs a loan. We do not know how fast and to what degree. A recession can reverse this course but rates will most likely not go down by the same degree similar to the past two economic downturns. Why is that?
It is because there is not as much room for the Central Banks to lower rates the next time around. Interest rates are at historic lows and near zero. As rates go up, the interest rate spread will benefit financial services companies and commercial banks in particular. With banks they are in the unique business of gathering assets and lending those same assets out to generate their profits. A lot can go wrong if they make too many bad loans. My investment approach of seeking quality companies is extra helpful when investing in this sector.
Will Amazon take over online retail? |
Retail:
There has been a lot of news about retail with many stocks in different subsectors getting punished. The investment world and many in the public at this time believe Amazon will take over all aspects of retail. Amazon is certainly a formidable competitor. I predicted 10 years ago that Amazon would one day over take Walmart in market cap, amidst the recession. It is now more than Walmart’s market valuation.
However, I make a case that Amazon will not take over the retail world. I define take over as owning more than 50% of all retail. The reasons are both structural and demographical. History shows that no retailer has been able to capture anywhere near a majority of American retail sales.
Many people forget or may not know, there was an “Amazon” in the United States. A century ago a company called Sears rose to dominate the American retail landscape. Sears became much more than being the largest retailer by revenues. Sears started or acquired some of the largest companies in a variety of niches. It had one of the largest insurers in Allstate, one of the largest tool makers in Craftsman, one of the largest warranty businesses, and one of the largest appliance makers in Kenmore. You could purchase from Sears a vast variety of items including clothes, toys, groceries, motorcycles, and even houses from its catalog. Sears also came to own one of the largest portfolio of prime real estate in the country. In 1968, Sears employed over 350,000 people. Sears never reached anywhere close to 50% of American retail spending. Sears targeted middle income and affluent customers which is Amazon’s core target market.
A young upstart named Walmart took over the mantle of largest retailer from Sears due to its ultra low pricing big box store concept. Walmart’s focus on price and the lower income customer propelled it to nearly $500 billion in sales last year. Even then, Walmart represents less than 8% of American retail spending.
Since then Amazon has overshadowed Walmart on market valuation even though Walmart still has over three times the sales and ten times the profit. Even with these behemoths, other retailers have existed and thrived.
Amazon has created the convenience and incentive with its concepts such as Amazon Prime to entice repeat shoppers. However, it still has several fundamental hurdles to reach the size of Walmart or Sears during its heyday in sales. Amazon’s core customers are primarily affluent who can afford Prime membership and many of the products it sells. There is a reason Amazon purchased luxury grocery store Whole Foods and not a discount brand such as Dollar Tree.
Amazon is targeting a wide array of industries and geographies. It is spending billions in India and Singapore. Amazon is pushing into groceries with Whole Foods. It is also making a push into auto parts, clothing, jewelry, and other consumer goods. Amazon has been purchasing airplanes, trucks, and warehouses. This does not even include its cloud services which Microsoft is growing at a faster rate. Any company getting into too many fields and actively managing them creates a real risk.
This current dynamic has created investment opportunities in this space.
Retail is an exceptionally tough industry to invest in. There is often very little to no switching cost. Online retail’s rise has pushed this to a new extreme since another store is a click away.
Due to online retailing, luxury retailers are in trouble for the long run. Affluent customers do not get much benefit from shopping at a luxury retailer’s online brand versus any other brand. Affluent customers pay for time and service. Part of their allure were posh stores with exclusive selections that affluent clientele like to visit. Online retailing has changed this dynamic. Luxury retailers do not provide any time savings to online shoppers. If nothing else it often takes them longer to ship products. The exclusivity of selection is not there either.
I like to take the road less traveled as a true contrarian investor. I am also cautious when it comes to retail. The retailers I have invested in are few. They also tend to have some business to business, wholesale component, and their own branded product lines.
An example would be my investment in PetSmart. It grew into America’s largest pet and pet supply retailer with zero leverage. It had a management team that had integrity. PetSmart has unique qualities that are impossible to duplicate online. For example, it operates the largest chain of pet hotels in its stores. It also has heavy pet food and trained expertise that many pet owners enjoy in person. PetSmart has clean, standardized stores. 40% of its products are private labeled or exclusive partnerships such as their National Geographic aquarium tanks. PetSmart had steady cash flow and its financial decisions over time made sense. A private equity consortium bought out our shares.
Overall, no one company will take over the entire retail landscape. If nothing else, a company that gets into too many businesses creates added risk for itself and its shareholders especially if their expected revenue is priced into the stock.
Talguard Value Fund LP 2017 Annual Letter
by Talguard•Monday, April 17, 2017
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.
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.
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