Some sage once said there were bull market lessons and there were bear market lessons. In a bull market, you learn that everything you sold was a mistake while everything you bought was proof of how smart you are. In a bear market, you learn that everything you sold was a smart decision, while everything you bought was a mistake. Wise investors resist both these lessons.
In 2020, people learned a lot of bull market lessons. What will they learn in 2021?
I don't know, but I look forward to the investing season of 2021. I have a good feeling about it. I'm excited about my portfolio and I have a couple of promising ideas on deck that I'm working on and that have me jazzed. This is happiness for any investor.
Anyway, I hope you enjoyed the holidays. I most certainly did. I appreciated the quiet time, the time off from blogging, Twitter, Zoom calls and all the rest of it. Between Christmas and New Year's, I laid low. Reading, reflection, long walks and writing in my journal. A refreshing pause before 2021 walks in.
Now, I'm ready to get back to work. And I want to get back to blogging. Starting up again is always the hardest part. So, for my first post of 2021, I carved an excerpt from my Q4 letter, edited slightly. You'll find it below. A warm-up for 2021. Hope you enjoy it.
***
I read a lot during 2020, more than usual, probably because I was stuck at home so often. I recently finished reading a new book by Martin Sosnoff, which inspired me to write some of the ideas in this letter.
Sosnoff is a retired money manager with a career on Wall Street that spanned 60 years. I love his earliest books, Humble on Wall Street (1975) and Silent Investor, Silent Loser (1986) -- both written in colorful, pugnacious prose. In 2015, before he retired, I visited him at his then office on Park Avenue. I spent over an hour with him and enjoyed the conversation.
Anyway, he titled his slender new volume: Train to Outslug the Market (What to Do if Unafraid). Strange title... but when you are pushing 90, you do what you want. Though I don’t agree with Sosnoff on a lot of things, we share a preference for investing alongside owner operators. And we both loathe self-indulgent, greedy managers with token stock ownership and/or excessive options.
One of the other things I like about Sosnoff is how he uses his experience in collecting art to illustrate ideas about investing in stocks. They are not so dissimilar. Both activities reward patience and a strong stomach. (And, let’s face it, luck helps.) Both markets have histories full of seemingly improbable and extreme outcomes -- mind-boggling wealth creation (and, unfortunately, destruction, too). Both are also humbling to painful degrees.
Consider one of the more unforgettable anecdotes in Sosnoff’s book, which seems to wrap up all of the above with a bow on top: In 1982, the graffiti artist Jean-Michel Basquiat left the streets of New York to hole up in a basement on West Broadway and paint.
Sosnoff gets a call from a trusted art dealer, Mary Boone: “You better buy a couple. They’re $2,500 apiece.” Of course, he declines to invest, instead focusing on some new trendier art that’s come over from Germany.
“Well,” Sosnoff writes, “nearly 40 years later, one of these Basquiats sold at auction for $100 million. Sooo… I could’ve bought half a dozen Basquiats and made half a billion.”
Wow.
Two thoughts come immediately to mind: One, you really can get some crazy results from benign neglect -- just sitting on a good asset for a long time. And two, I doubt anybody holds on to a Basquiat that long if they are getting price quotes put to them everyday. The parallels with investing in stocks seem obvious.
I dream of what our portfolio might look like, say, ten years from now. I am confident we’re going to have a couple of giant winners that become outsized chunks of the portfolio. Maybe not a Basquiat, but one can aim high. The biggest challenge will be holding on. Benign neglect sounds easy. In practice, it isn’t. There is no escaping the ups and downs. Equanimity is key.
Art and collectible indexes generally show something like 6% returns over the last century. That hides stomach-churning volatility, the inevitable roller-coaster rides. And it hides the exponential returns in holding big winners. (And it hides the zeros).
The same is true with stock indexes. Most stocks are losers. The returns come from the big winners. My book 100 Baggers studied the best and my conclusions from that work inform our investment process at Woodlock House.
Can we put ourselves in a situation to net those big fish? I think the answer is yes. The easier way to tackle the problem is to invert the question. Meaning, let’s think about the businesses we’d want to avoid, that have no chance, or very little chance, of creating those kinds of special returns.
A partial list: Businesses that aren’t growing much. Businesses that generate poor or mediocre returns on capital. Businesses that use a lot of debt. Businesses that do not have ample opportunities to reinvest. Businesses without strong competitive advantages, or moats. Businesses run by shareholder unfriendly management teams.
Believe it or not, just this list takes out most businesses.
What is the central idea behind our portfolio?
Later Sosnoff criticizes the “pie chart” schemata so often used by investment advisors, where every position is neatly sliced and labeled and presented in a pie chart. “Intricate chop-chop of client portfolios raises the question,” he writes, “like what is the central idea therein?”
I love the question. For us, the answer is simple: An owner-operator culture is the central idea expressed in our portfolio. Boiled down to our essential raison d'être, that’s it. We invest with talented people who have skin the game. In other words, we invest in businesses where management and/or the board own a significant amount of stock.
Once we’ve checked this box, we look for several other attributes. We want
A business that earns consistently high returns on capital
A business that has the ability to reinvest and continue to earn those high returns
A strong balance sheet (we avoid financial leverage)
A businesses we can understand
An attractive purchase price
Those are the essentials, everything else is detail.
What About the Big Picture Questions?
What about the big picture questions, like where are interest rates and inflation going? Before I answer, let me lay a little groundwork.
On questions, the mathematician Cassius Keyser (1862–1947) wrote: “It is often said that a fool can ask a question which a wise man cannot answer. It is better to say that a wise man can answer questions which a fool cannot ask.” (I read a book of his essays, too, during the pandemic).
Keyser meant that it is not easy to ask a good question. It is easy to ask a pseudo-question. As a result, we spend a lot of time going round and round on questions for which there are no meaningful or useful answers.
Like Keyser, I try to focus my investing energies on questions where reliable and trustworthy answers can be found.
Another stickler about asking questions was Wendell Johnson (1906-1965), a famed psychologist and speech pathologist. His test for any question was to ask the following:
“What does the question mean on the level of non-words, on the level of observation and experience? That is, precisely what factual observations might I or anyone else make in order to answer it?”
Tough bird, that Johnson. (Yeah, I read a book of his too, another oldie titled Your Most Enchanted Listener.) Most questions dissolve into a puddle of unanswerable nothingness after applying his acid test…
The problem with a lot of big picture questions is you have to resort to guesswork about the future… which may be a fun thing to do while sitting around the fire with a brandy gabbing with a chum. Not so fun when trying to invest intelligently.
I don’t spend much time on questions about where the market will go, or what interest rates will do or whether inflation will pick up, because there are no ways to generate reliably useful answers. The mountains of errant forecasts by “experts” attest to this.
Still, we cannot ignore the big picture. For example, even if you’re just focusing on individual companies, you have to come up with a price you're willing to pay. To do that, you need to discount future cash flows to the present day. To do that, you need a discount rate -- which is based on interest rates. So you may not have an explicit forecast of where interest rates are going, but you have an implicit one in your discount rate, even if you don’t acknowledge it.
As a matter of fact, every investment decision is embedded with a number of assumptions about sales, profits, growth rates, etc., which embed further assumptions on the big picture questions. This is our dilemma.
So, how do we deal with such uncertainty?
Fortunately, there are some buoys bobbing out in the harbor that we can be mindful of as the good ship Woodlock House makes its way out to sea again in 2021...
With interest rates low already, I’d rather not own anything that may suffer unduly from rising rates. So, warning buoys encircle a bunch of stocks out there trading as “bond proxies” because they pay a nice dividend and are stable or slow-growing. They have done well, by and large. Yet these stocks, like bonds, would get hammered if rates rose. I’d rather avoid those.
Another warning buoy marks off companies that depend on rolling over sizable debt loads on a regular basis. As rates go up, they will find themselves paying up.
Moreover, if interest rates pick up, it probably means inflation is picking up, too. I’d rather avoid businesses that struggle during periods of rising inflation. Capital intensive industries tend to struggle more because they have to replace more of their capital stock every year. During a period of inflation, they will have to do this at higher and higher prices. Conversely, capital-light businesses with pricing power tend to fare relatively better.
In summary: While I’m not making any predictions about where I think interest rates and inflation go, I am trying to prepare for scenarios where both go up. If both stay the same or go down, I’m much less concerned. The ten-year Treasury is already under 1% and anything lower just makes equities more compelling. Valuations should remain generous for most businesses in such a case.
Besides, we can only do so much without cutting off our long-term return potential. At some point, big picture fluctuations are something we just have to accept, like the weather. They’ll be good weather and bad weather. Either way, we’re going through it.
Thanks for reading and I look forward to writing you again soon.
***
Published January 6, 2021
Please see our disclaimers