Author: Gabriel Grego, Zanshin Capital
Covestor model: Buffettian Value
Our performance since inception for the Covestor portfolio, through the end of 2011, was -3.8% while the S&P 500 was -4.72% in that period.
Despite the absence of meaningful upside for the year, we remain satisfied with our performance as the wild volatility of 2011 has allowed us to make a number of well timed and attractively priced acquisitions which, we believe, constitute the premise of future profitability.
Macroeconomic Commentary
Despite the best efforts of economists, clairvoyants, and astrologists around the world, making accurate, short-term forecasts about macroeconomic fluctuations remains a hopelessly futile exercise. The number of variables and unknowns involved in this activity is just too great for anybody (or any thing) to process in a comprehensive manner and a successful outcome is as elusive as ever.
However, even by the deeply unreliable standards of macroeconomics, 2011 has proven a particularly puzzling and unpredictable year, as managers of most macro funds painfully found out. The aftereffects of the 2008 financial crisis are still reverberating around the world and have precipitated a number of interventions by politicians, whose goals and motivations are not always fully clear (often not even to themselves) or consistent. If economics is difficult to predict, the psychology of politicians is even more obscure – hence the capriciousness of this 2011.
The year started optimistically as a vigorous rebound seemed around the corner. Unemployment levels were still high and the housing market still moribund, but a favorable GDP growth rate as well as remarkably improving corporate fundamentals gave concrete reasons for hope. By contrast, the second half of the year brought on a number of serious threats to the world’s economic stability in rapid sequence. While some of these threats, such as the aftereffects of the earthquake in Japan, were accidental, most were the result of foolish behavior by our leadership compounded by the fickleness and nervousness of the capital markets.
In the US, politicians brought the country on the brink of a fully avoidable default because of partisan reasons and caused a well-deserved credit downgrade. In Europe, a perfect mixture of southern-European extravagance and northern-European intransigence nearly caused a run on EU banks and sovereign debt. The crisis is still unfolding, but it already caused deep changes in the leadership of a few countries, spurred a wave of austerity measured across the continent and initiated momentum for structural changes in the EU economic governing mechanisms.
It remains highly speculative to guess how events will eventually unfold. A realistic scenario might include a continuation (or even slight acceleration) of the US recovery, stubbornly high commodity prices and a mild recession in Europe coupled with slower growth in the emerging markets.
Investing may be compared with seafaring. When operating in the financial markets, we are effectively engaging in a voyage carrying a valuable cargo to a faraway destination. The further away we manage to get, the higher our payout. There are two main approaches: some sailors focus on weather forecasting, trying to guess through meteorology the most propitious time to travel, with calm seas and clear sky. The trouble is that meteorology is inherently inaccurate, and sooner or later hopeful the sailors will get caught into a storm.
Value investors like us at Zanshin are not deluded about their ability to correctly guess weather patterns. Instead, we focus on the ship, trying to acquire a solid, reliable vessel with a powerful and sturdy engine and plenty of excess capacity. We only venture in the treacherous waters of the ocean with a ship capable to go through any storm. When a storm does arrive, value investors happily acquire extra cargo from fearful other ships which, caught in the midst of the storm with a fragile vessel, invariably try to unload their cargo at bargain prices as an extreme attempt to save their skins.
The world economy, the capital markets, and the whims of politicians are just like the weather: unpredictable. It’s much better to focus on the solidity of wonderful companies with the resilience to go through any market condition, rather than attempting to predict market swings. When markets do turn sour, far from panicking, value investors happily buy good stocks as their fearful competitors dump them at bargain prices.
Commentary on Zanshin portfolio
Our performance in 2011 generally tracked the S&P index tightly. While frustrating, as we are aiming to beat the index by a comfortable margin, this kind of market behavior is indeed a blessing in disguise. The S&P correlation index approached 86% at some point during the year, which means that 86% of a typical stock’s movement could have been explained by market-wide swings rather than fundamentals. In other words, most stocks moved in sync: in times of pessimism investors sold stocks indiscriminately and vice versa. Clearly, skillful stock picking is not rewarded with immediate gratification in this kind of environment. As it is often the case, what is frustrating in the short term can prove gratifying later on since, by definition, stock price fluctuations which do not reflect fundamentals invariably generate inefficiencies and, hence, buying opportunities.
By and large, we took advantage of late 2011 price volatility and occasionally low prices to increase our existing positions or initiate new ones. We believe that the attractive prices at which such transactions took place imply excellent profit potential later on as the macro situation stabilize and prices become more reflective of underlying fundamentals.
New positions
In August we purchased some shares of Jos a Bank, the US retailer of affordable formal clothing for men. We are well acquainted with JOSB, as we owned its shares for years before divesting about a year ago for reasons of fiscal optimization. The crisis this summer gave us a wonderful opportunity to re-open our position at a convenient price. This retailer is well run and enjoys a significant cost advantage vis-à-vis its competitors that translates into fatter profit margins and market share gains. The current number of outlets gives space for additional profitable growth and we love this company’s generous cash reserves and absence of debt.
Divestments
We exited our positions in Elbit Systems and Walter Investment in 2011. The former is an Israeli defense company that has been struggling with the cyclical nature of the industry. Demand has been dropping significantly as financially stretched governments cut back on their spending. In our opinion, the management has been less than forthcoming in its communication with shareholders during this difficult period and we did not appreciate this. Given the long lead times in defense cycles we believe that our cash could be more profitably employed as well. We sold the stock with a loss, and you may well call this an “unforced error” as I was fully aware of the dynamics of this company when I initially acted. I misjudged the ability of the management and strength of the firm’s competitive advantage.
Walter Investments was one of our best performing holdings and we decided to take profits once the management decided to undertake a huge leveraged acquisition outside of its core business. The numbers behind the transactions were not bad, but the additional debt put a new element of risk we did not feel comfortable with and changed the overall nature of the company to something very different from what we knew.
Comments on existing holdings
Virtually all of the companies in our portfolio have shown considerable gains in corporate profit in 2011, helped by an improving economy, a leaner cost base and increased exports. Financials in particular performed particularly well, with Wells Fargo and American Express both posting all-time-high earnings. The former keeps benefiting from the integration of its Wachovia acquisition, while the latter is reaping the benefits of the massive cost cutting it underwent in 2008 just as its affluent client base reverts to its usual spending patterns.
Our consumer staples holdings are also performing well, with Coca Cola and Nestle continuing their expansion into emerging markets.
Healthcare has been a little slower in 2011. Johnson & Johnson is still struggling with its production difficulties and product recalls. The company’s earnings are still sluggish. Both Baxter and Teva have posted decent results during the year, but investor sentiment turned negative, especially for Teva. The markets still fear the loss of Copaxone exclusivity (its flagship product) and are skeptical about management’s attempt to compensate through well-targeted acquisitions. 2012 should be a better year for Teva, especially considering a recent change in leadership.
Our energy holdings performed well overall. Exxon Mobil, our largest position, increased earnings at a staggering 40% rate, helped by higher oil prices, while its stock gained about 15% for the year. Still no significant upward move for Noble, our oil drilling company, but I’m hopeful the light at the end of the tunnel is getting very near, based on the positive developments in the company’s core businesses.
Our industrial holdings, Dun & Bradstreet and General Electric, continue posting nice increases in profits (see DNB and GE earnings). Their stocks were hit by negative sentiment in the third quarter, but they both bounced back nicely by the end of the year.
For 2012, save major macro shocks, our companies should continue to post good gains in profitability. Should the world’s macro situation further stabilize itself, we can reasonably expect some degree of multiples expansion as the market progressively acknowledges the solidity of those earnings. This will likely translate in significant capital gains for equity holders.
Conclusions
In 2011 Zanshin Capital made significant steps forward. I would like to thank the numerous investors that trust us with their funds and congratulate myself with the few who had the wisdom (and courage) to open an account during the 3rd quarter of the year. By choosing to be greedy when others are fearful you are already showing a keen understanding of the value investing philosophy and that bodes very well for your future gains navigating the high seas of the stock market.
Sincerely,
Gabriel Grego
