Oct, 29, 2018

Scorecard # 23 – Fear and Courage

Fear and Courage

The Value Fund gained +4.4% in Q3 and is up +9.9% for the nine-months ended September 30, 2018.  Year-to-date the S&P/TSX Total Return Index has gained +1.4% and the S&P500 is up +10.6% (+13.7% measured in Canadian dollars – the Value Fund’s reporting currency).  Currency moves lowered our returns in Q3 but have helped us modestly in 2018.

Before diving into a portfolio review, the October market selloff is worth discussing.  As of October 27, the S&P/TSX is down -7.4%, the S&P500 -8.8% and the Nasdaq -10.9% for the month.  So why are we so sanguine?  It isn’t just due to the fact that we are faring better than the major indices as we have during past pullbacks (we are down -5.5% this month).  The real reason is that as longtime students of the market we have seen this movie play out before and plan to take advantage of it.

Every day for the past decade, CNBC, BNN Bloomberg and others have paraded a stream of intelligent guests voicing strong opinions about the equity markets’ next move.  Occasionally their predictions were right.  Often they were wrong.  In our opinion, they are all missing the point and playing the wrong game (but it does make for entertaining TV).

When asked about the current market selloff and our prediction of the future market direction we simply shrug and admit that we have no idea.  We also believe wholeheartedly that no one else does either.  That may not make for great television – but we believe it to be true.

In order to be a successful equity investor, one must: (i) be able to accept the fact that markets will do crazy things from time to time and (ii) be able to keep one’s wits about one when they do.  Volatility is the price one pays for equity-like returns.  With risk-free (treasury) yields averaging about 2% since we launched the Value Fund, you could have invested $100,000 without any worry and watched it grow to ~$114,680.  Instead, we have taken the bumpier ride and even with the recent decline have grown it into ~$178,670.  Even with the occasional severe pullback, we are still much farther ahead.

Notes:  All returns and Value Fund details are as of September 30, 2018, based on Class A units and are net of all fees.  The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.

Notes:  All returns and Value Fund details are as of September 30, 2018, based on Class A units and are net of all fees.  The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.

We also know that when markets are frothy, it is best to avoid folly.  In bull markets, it is tempting to invest in Bitcoin and emerging industries such as the Canadian cannabis sector, especially when everyone else seems to be making money doing it.  At the risk of missing out on all the fun, we have been and will remain disciplined.  While the cannabis sector will certainly grow, current valuations led us to conclude that it will end badly for most “investors”.

There is a concept in cycling that has been adopted by famed value investor Tom Russo that resonates with us – namely the capacity to suffer.  There will be times when our prudent value investing approach will be out of step with the markets and we will experience the pain of looking foolish for ignoring expensive and/or poor-quality stocks.  But our long-term and patient approach when things aren’t going our way serves us well when panic returns.  The ability to endure short-term pain (be it psychological, emotional and/or physical) often leads to long-term rewards.  Buffett has often said that temperament is more important than intelligence in investing.  Fortunately we were wired a certain way that happens to be helpful in the investing arena.

We can’t predict when markets (or individual stocks for that matter) will correct.  But we do know for a fact that they will.  Markets continuously oscillate between greed and fear, albeit with varying frequencies.  We also know that over the long term, markets rise due to inflation and the accumulation of retained earnings.  That is a rising tide that we wish to take advantage of for many years to come.

“Prediction is very difficult,

especially about the future.”

Niels Bohr– Physicist, Nobel Laureate

While we can’t time short-term market moves, we do know how to value certain businesses, how to spot a bargain and how to take advantage of them when they appear.  Plunging markets provide the environment in which great opportunities (the seeds of future capital gains) are found.

In a declining market, we are able to acquire additional earnings power for each incremental dollar invested.  Accordingly, lower stock prices actually reduce the riskiness of an investment.  When the market is down 7-10% from its peak, certain stocks that we track can be off significantly more than that.  And when they are, we pounce.  For long-term investors, widespread fear is our friend.

Portfolio Review

In Q3 we closed out our position in Express Scripts (Nasdaq:ESRX).  We have previously laid out our investment thesis in detail. Given our familiarity with the company, our conviction on the M&A situation and our assessment of limited downside risk, we made a large bet (6.8% weighting) that the acquisition by Cigna (NYSE:CI) would successfully close.  Once all regulatory and shareholders approvals were obtained, the deal spread narrowed significantly and we fully exited the stock.  We ended up with a +23% return on our Express Scripts investment in just over five months.

During the quarter, we also fully exited our previously-undisclosed position in Williams-Sonoma (NYSE:WSM).  Our investment thesis was straightforward.  In late 2016 the stock sold off significantly due to fears of emerging competition in furniture and home goods from online competitors Amazon (Nasdaq:AMZN) and Wayfair (NYSE:W).  With the economy healthy and the housing market in good shape, we viewed the selloff as overdone and acquired the stock at $48.52 per share.

Our view was that WSM’s strong brands (including Williams-Sonoma, Pottery Barn, West Elm, etc.), physical stores and customer loyalty would enable the company to successfully fend off these emerging online competitors.  Importantly, WSM has also fully embraced online selling for consumers that prefer that option.  Over 50% of the company’s sales are through its online (higher-margin) channel.  The company’s debt-free balance sheet also gave WSM the ability to maneuver.

Fast forward 20 months and the company delivered revenue growth, decent margins and increasing dividends.  The market rerated the stock and we sold out in August at $71.21 per share.  Our overall gain was +52.3% with dividends included.  Even today, the market remains enamored with fast-growing but unprofitable online companies such as Wayfair.  We find the valuation discrepancies mindboggling:

In addition to our sales of ESRX and WSM, our top three contributors for Q3 were Berkshire Hathaway (NYSE:BRK.A) +14.7%, Cisco Systems (Nasdaq:CSCO) +13.1% and Visa (NYSE:V) +13.3%.  Our laggards for the quarter were Wells Fargo (NYSE:WFC) -5.2%, S&P Global (NYSE:SPGI) -4.2% and Booking Holdings (Nasdaq:BKNG) -2.1%.  Subsequent to the quarter we have trimmed a few existing positions and started adding a few new names that have been selling off steeply in October.  We will save a discussion of these latest moves for a future newsletter.


I recently had the pleasure of attending an investment conference in Toronto where the keynote speaker was Bill Browder – the author of Red Notice which is one of my favourite books on the investment industry.

Red Notice is a gripping and sad but true story about corruption in post-Soviet Russia and the author’s quest to deliver justice to the family of his former accountant Sergei Magnitsky.  Mr. Magnitsky was murdered by the Russian state while wrongfully incarcerated in prison.

The book reinforced in my mind why we avoid investments in countries like Russia, China and Saudi Arabia that fail to embrace the rule of law.  Beyond taking in the book’s investment lessons, I was inspired by Mr. Browder’s courage in trying to right a grave injustice despite his long odds and powerful adversaries.  To date, he has been successful in getting a “Magnitsky Act” enacted in the US, Canada and several other countries to punish those responsible.

Unfortunately Mr. Browder’s fight has come at a tremendous personal cost.  His considerable security detail is a stark reminder that Mr. Browder will likely live the rest of his life in constant fear of being killed by the Russian state.  I highly recommend Red Notice to finance and non-finance professionals alike.

We recently updated the Bookshelf section of our website with some of our favourite reads.  We are voracious readers at GreensKeeper but can’t read everything. If you come across something that is noteworthy, please drop me a note.

October 27, 2018

Michael McCloskey

President & Founder

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