To: East Coast Asset Management Clients and Interested Parties
From: Christopher M. Begg, CFA – CEO and Chief Investment Officer
Date: April 22, 2014
Re: First Quarter 2014 Update – The Economy of Evolution
In our first quarter letter you will find our portfolio update and general market observations. Each quarter we highlight one component of our investment process. This quarter, in the section titled The Economy of Evolution, I will discuss business evolution and how some businesses are more fit for adaptation than others. I will illustrate a theme and new position in the portfolio that serves as a tangible example of the discussed concepts. As is our standard practice, client reporting, including performance and positioning, will be sent under separate cover.
After a year where we saw the S&P 500 return 32.38% and the MSCI World Index log a return of 23.53%, a rather lackluster start to 2014 seems like a reasonable outcome with 1.81% and 1.41% returns, respectively. There has been plenty of geopolitical noise from Russia to keep investors’ attention away from fundamentals and more tuned into these important human-interest stories.
I echoed a similar message in our yearend letter when I noted we were finding the overall market fairly valued. Fair value does not have us searching for an exit strategy as we view our portfolio of businesses as attractive on an absolute and relative basis. We feel many of these investments have a unique mispricing and/or secular market opportunity that should provide a margin of safety and compounding tailwinds as time evolves. Many of our businesses have been actively repurchasing shares, thus we continue to be rewarded with a larger per share ownership of future cash flows from this capital allocation. While new positions have proven more elusive due to higher valuations, we continue to use the inevitable whims of the marketplace to own more of our existing positions – businesses we know well, and are interested in knowing even better.
Praise of Folly:
An investment is worth the present value of all future cash flows produced over its lifetime. One would think a rational investor would then base decisions on estimating the stream of cash flows and assess confidence in a range of probabilities of their receipt. The truth is, an overemphasis on the superficial and on the temporary is the eternal preoccupation of the marketplace. Human nature often appears to react less with reason and more with a genetic inherited code that drives behaviors – fight or flight. Folly ensues as human nature weighs and measures inputs that then drive evolutionary instincts. I believe these behavioral responses can be modified if one is self-aware when foolish predispositions surface. Proper temperament is one of the most important attributes of the investor – breathing in reason before instinct.
With this type of behavioral observation in mind, the science of evolutionary biology has long fascinated me, particularly as it relates to why and how certain species make genetic modifications to maximize their fitness – food, safety, and compounding. I’ve previously written about how bees evolved their hexagonal honeycombs to maximize storage, how the nuthatch adapted its claws to be the only bird to walk down a tree headfirst, and recently have been reading how octopuses have evolved their mysterious camouflage traits. A creature’s phenotype is the collection of its traits, from its body shape to its behavior, while its extended phenotype is the stamp it makes upon its environment, such as beaver dams, beehives, bird nests, spider webs and mouse burrows. None of these attributes have specific genes, but genes clearly influence their construction. The extended phenotype of the investor is their portfolio and their record of protecting and compounding capital.