Below is a short excerpt from my Q3 letter to investors of Woodlock House. I thought you might find it a useful reminder to help in today's markets.
Note: I haven't updated any of the charts or return figures, so they are not exact as of today. I used Koyfin to make the drawdown charts.
Also, I own all three stocks featured below.
Drawdowns: A Key Feature of Big Winners
A drawdown is how much a stock price declines from its peak before it recovers.
Drawdowns are part of the life of every investor. Invariably, if you own a stock for a long time, you are going to have to sit through several.
Ever since I wrote my book on 100 baggers (or stocks that return 100 to 1), I’ve been intrigued - some say obsessed! - with the stock price drops of even the best performing stocks. I like to look back at these winners and see the depth and duration of these drawdowns. It’s always somewhat surprising – and instructive.
A few examples from the book, which was published in 2015:
Apple from its IPO in 1980 through 2012 was a 225-bagger. But you had to sit through a peak-to-trough loss of 80% — twice! And there were several 40% drops.
Netflix, which has been a 60-bagger since 2002, lost 25% of its value in a single day — four times! And there was a four-month stretch where it dropped 80 percent.
And Berkshire Hathaway, the best performing stock in the study, was cut in half four times.
What I found affirmed what Peter Lynch once said: “The real key to making money in stocks is not to get scared out of them.”
Indeed. Knowing this, I can be more circumspect about drops in my own stocks. As long as the underlying business continues to perform within a band of expectations, I am better off staying put.
Let’s look at a few of our positions and their recent drawdown history.
Dino Polska, our Polish grocer, has been a great business. Over the last three years, Dino has been earning more than 30% on its equity and reinvesting to open new stores. Since 2020, the number of stores has doubled.
The current drawdown, as I write this, is about 25%. It is the fourth drawdown of at least 20% in the last three years. And yet, if you just sat on it you enjoyed a 17% annual return to now, or 61% in total.
Dino Polska: Drawdowns Last Three Years
The rational mind hunts for reasons for these declines. Our brains want a narrative. And so we find reasons, or make up reasons. But do they matter? This latest drawdown, for example, seems sparked by an earnings report showing significantly slower growth than the same quarter a year ago. Should we give such weight to quarterly results? Rarely do they matter. It is not the first time Dino has had a “soft” quarter. It won’t be the last.
And yet, Dino has been a rewarding investment. Again, a 17% annualized return over the last 3 years, despite four 20%+ drawdowns – including the current one.
Shares of Evolution, our online gaming company, have had a much worse time. The current drawdown is 33% and it has gone on much longer than Dino’s. The high was hit back in April 2021, from which it fell more than 50% to a low hit last October. And yet again, if you just sat for the whole three years, you enjoyed a 21% annual return or 78% in total.
Meanwhile, the business has earned €4.5 per share over the last 12 months, an increase of 200% from what it earned in 2020. The stock has gotten cheaper, now trading at just 21x trailing earnings and just 16x next year’s consensus guess.
As a capital-light business, earnings are a decent proxy for free cash flow here. Evolution has generated about 1 billion euros in free cash flow over the last 12 months, converting a mouth-watering 57% of sales into free cash flow.
Return on invested capital was a strong 27%. Evolution has over 500 million euros in cash and no debt. Management and the board own 12% of the company.
Evolution AB: Drawdowns Last Three Years
Brown & Brown
One more: Brown & Brown. We’ve owned shares of this insurance broker since the inception of our fund in January 2019. Since that time, the stock has returned about 21% annually, or 149%. Yet, it has not been a smooth ride. Take a look at the chart below.
That giant crater is 2020, the year of the pandemic. The stock lost nearly 35% of its value, from peak to trough in 2020. It took almost a year to get back to the peak. Brown suffered a few more drops of more than 20%, recently ending a 26% drawdown that lasted a year and a half.
Brown & Brown: Drawdowns Last Five Years (Jan 2019 through September 2023)
It is one thing to say that stocks suffer declines and you have to sit through them. It is another thing to actually see it visually presented like this. (And it is another thing still to experience them firsthand!) I don’t think people quite appreciate how “normal” it is to have frequent and severe drawdowns. And keep in mind, these are high performing stocks getting whacked.
Not only do the best stocks suffer frequent (and lengthy) drawdowns, but the best investors also suffer drawdowns that would surprise most.
The aforementioned Peter Lynch, for example, had four severe drawdowns during his Hall of Fame run at Fidelity. Even though he returned a mind-boggling 29% annually, he had many drawdowns during those years, including three of more than 20% (one of which was a hair-raising 42% drop in 1987).
Peter Lynch: Number of Drawdowns While Running Magellan
In summary: There is no defense against drawdowns if you are committed to a long-term, ownership approach to stocks. (Peter Lynch, by the way, was highly diversified and had a high turnover rate in his career – but still). In fact, I would go so far as to say that the ability to sit through drawdowns with equanimity is a source of outperformance. It is a competitive advantage over those that can’t.
Postscript: Reflecting on the above, I like how I used only 3- and 5-year charts. We're not talking about long periods of time here. Even so, the number and severity of drawdowns were significant. And the overall return for simply holding on was attractive.
Thank you for reading!
Published: October 9, 2023
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