Greenhaven Road Capital letter to partners for the first quarter ended March 31, 2015.

Dear Limited Partners,

We are very fortunate to have had a strong start for the year. In a period where the overall markets were relatively flat, Greenhaven Road was up more than 8% for the first quarter net of all fees and expenses. Given the strong 2013 (+64%) and 2014 (+23%) performance, I suspect you are starting to look forward to opening your statements. Despite nine straight quarters of positive performance, we have by no means figured out a way to smooth out volatility or eliminate losses. The fund is being managed for absolute returns over a long time horizon (five-plus years) and we accept that volatility will come with that. We will have down months, quarters, and years. That is an unavoidable truth. The steady climb upward has been a combination of skill, luck, and environment – not a new strategy that deploys indecipherable derivative strategies or rapid trading. We have not eliminated losses, rather, the individual businesses that we own have continued to grow and the market has come to appreciate them more as reflected in their multiple expansion. Please think about your returns over multiple years, not a quarter or a year. With that said, we are certainly pleased with our results this quarter.

Greenhaven Road Capital: Small Is Still Beautiful

In my last letter, I tried to make the case for why little Greenhaven Road can continue to achieve results that are equal to or better than other funds with far larger resources. I even invoked my favorite Warren Buffett quote, “Anyone who says size doesn’t hurt investment performance is selling….It is a huge structural advantage not to have a lot of money.” The fact is, because we are a small fund, we can invest in small and even micro capitalization companies – we simply have fewer constraints. Think about it: If you run a $3B fund, a 2% position is $60M. Are you going to spend a lot of time looking at a $200M company even if it has no analyst coverage and a compelling valuation? The fact is microcap land is exactly where Buffett invested in the 1950s and ’60s when he was running his Buffett partnership – his highest return years as an investor. I read a lot, to the point where my wife has accused me of not talking. I assure you this is not true, I just don’t talk a lot. In all of my reading, the only place I have seen an analysis of just how small the companies were that Warren Buffett invested in his early days was done by a microcap manager Tim Eriksen of Cedar Creek Partners. According to Tim’s figures, which are most likely spot on, the Oracle of Omaha was not afraid to invest in the tiniest of companies in his early days.

For example, at the time he invested in Union Street Railway, the market capitalization of the entire company was less than $600,000. After adjusting for inflation, $600,000 equates to a market capitalization of less than $6M in 2015 dollars. As the chart below indicates, Union Street was the smallest market capitalization, but was by no means his only microcap investment.

Greenhaven Road Capital

These investments were not successful because they were small companies, but clearly Buffett was willing to go into the smallest crevices of inefficiencies. At times it feels lonely swimming in the waters we often occupy – but you can take some solace in that Warren Buffett was doing the same when he was running a small pool of money. I don’t think it is a coincidence that he also had his greatest returns in this period. Being small allows us to look for the Sanborn Maps and See’s Candy of today. The beauty of being small with a broad investing mandate is that we can also invest in larger companies when the opportunities arise there as well. We simply have fewer constraints.

My last attempt to convince you that small is beautiful is that if you look at fund performance, according to Kiplinger, Greenhaven Road has outperformed every single large cap mutual fund they have tracked in each of the last two years. The top funds were different in each year, but Greenhaven outperformed all of the large cap mutual funds in both one-year and two-year periods over the last two years. The results are similar for hedge funds with more than $1 billion in AUM.

Greenhaven Road Capital: ETFs – Penny Wise And Pound Foolish?

So hopefully we accept that small is actually an advantage to generate percentage returns, but what about index funds? A lot of “smart” money is flowing into index funds. Index funds are “in” – and active management is “out.” Well, if that is the consensus, it must be right. Right? As the largest investor in Greenhaven Road, I think about the advantages of index funds. The thought of giving money to a low-cost robot while I go sit on a beach sounds pretty good. Why lose my hair trying to invest when I could just watch the money pile up with an ETF strategy? Why go through the pain of active management if an ETF is really the best strategy? I think Murray Stahl of Horizon Kinetics had a really interesting analysis in his last quarterly letter. He pointed out that as money flows into the indices, they have to buy shares in every single company that comprises the index. Since 2006 more than $100B has flowed out of actively managed funds while more than one trillion dollars has flowed into ETFs. The direction of the tide is clear. Murray then goes on to look underneath the hood of some ETFs pointing out that as funds flow in, the ETFs are required to buy the shares of the components, good or bad. He then goes on to look at the growth and earnings of the 30 largest companies in the S&P 500 and the numbers do not scream “buy more S&P 500” to me. The companies in the index have benefitted from record high margins, record low interest rates, and expanding P/E multiples. The top 30 companies are growing at less than 5% and, if you exclude Google and Facebook, are growing revenue at 1% per year, and, at the end of the year, the index was being rewarded with a PE multiple of 19. So there is a combination of low growth, high valuation, and a variety of factors that could turn (margin, rates, and multiple) and dramatically impact returns going forward. I recommend reading the whole piece, which can be found on their website: (http://horizonkinetics.com/docs/Q4%202014%20Commentary_FINAL.pdf)

I am fundamentally a cheap person. My wife loves to remind me of when I wanted to install central air conditioning in our house by myself, despite having zero relevant experience – just to save the money. I figured out we could save even more by delaying the purchase of air conditioning, so I used that strategy instead and still have not personally installed any duct work. I understand the wisdom of saving on fees, but the strategy of “buy the market ETF, it has gone up in the past, and do it in the least expensive way possible” reminds me of the argument for real estate in 2004. It has gone up in the past, it will go up in the future. I just believe that the market is made up of individual businesses that serve customers, have employees, have costs, and operate in fluid marketplaces. Some of those businesses have brighter prospects than others because of product cycles, customer wins, mergers, and dozens of other factors. As a result, some of these businesses are overpriced and some are on sale. When we buy clothes, we don’t buy a slice of everything at Bloomingdales, regardless of price. When we buy groceries we don’t buy a sliver of everything in the store. When it comes to our savings, why should we blindly buy a slice of everything? I think we can do better.

See full PDF below.