Perea Capital Partners annual letter for the year ended December 31, 2015.
Thank you for your continued trust. In the year ended December 31, 2015, Perea Capital Partners returned 12.2% net of fees and expenses. At this time, we are nearly fully invested.
Perea Capital Partners – Sources of competitive advantage
Each time we analyze a business, we must ask ourselves if it has a competitive advantage. All else equal, a business with one or more competitive advantages is likely to generate higher returns on capital over time than one without. Our own business at Perea Capital should not be spared when asking this question: after all, we aim to compound our capital at high rates over long periods of time, while minimizing any risk of permanent loss. In this pursuit, I believe that there are three primary sources of competitive advantage: more information, better analysis, and patience.
The first source of competitive advantage is more information. Each time we buy or sell a security, we must be confident that we know more than the person on the other side of the transaction. This is more likely when the security in question is small, illiquid, and less followed. For example, consider that Apple is valued at over $500 billion and has sixty banking analysts publishing reports about the company. The likelihood of discovering relevant incremental information about such a company is quite low. Even if we were to count the number of iPhones coming off Foxconn’s production line in Shenzhen, we might find ourselves in the company of several other determined analysts. Instead, we prefer to study businesses outside of the spotlight, where research can provide valuable information unbeknownst to the rest of the market. Simply put, we want to fish where nobody else is fishing.
The second source of competitive advantage is superior analysis. Because the consensus opinion is sometimes wrong, true understanding of a business can lead to outperformance even when the stock is large, liquid, and widely followed. Consider the case of Microsoft in 2011. The market consensus held the view that tablets and smartphones would render computers obsolete, and as a result, Microsoft’s dominance was at risk. The investors that correctly understood the breadth and resilience of the company’s franchise – from its suite of Office software to its Windows Server business – doubled their money over the following five years. Such superior analysis is rewarded even more handsomely in the case of smaller companies where fewer analysts are digging.
The third but perhaps most important source of competitive advantage in the stock market is patience. Because most market participants are focused on making money quickly, their judgment and estimates of a given company’s earnings power are highly influenced by its most recent results. Just as lottery winners believe they will be happy forever, market participants tend to extrapolate recent events forever into the future. In reality, it doesn’t take long for the happiness levels of lottery winners to revert to historical levels. The analogy in the stock market is that the value of a business is not determined by the earnings of its most recent quarter or year, but rather by the earnings it is expected to generate over its lifetime. Undue weight should not be placed on short-term results unless they truly are indicative of a company’s long-term earnings power. It is therefore important to understand not only the current economics of a business, but also its economics years into the future.
When undertaking such analysis, our goal is to discover securities that we believe will generate an attractive return on our capital with as little risk as possible. Not surprisingly, many others would say the same. But risk is defined differently by market participants with different time horizons. Consider the distinction between a trader and an investor. A trader buys a stock (a piece of paper) with the hope of selling it to someone else at a higher price. An investor buys a stock (a piece of a business) because its price undervalues the present value of the cash profits it will generate over its lifetime. With a six-month time horizon, a trader views risk as the prospect that a stock price declines. With a six-year horizon, an investor views risk as the prospect of overpaying for a company’s assets, earnings, or growth and permanently impairing capital.
Perea Capital Partners – Investment Philosophy
As long-term investors with patient capital, we are able to minimize the risk of overpaying for a business because we don’t have to chase the most popular stocks of the day. Instead, we are able to make heavily contrarian investments – positions that may be unpopular in the short term, but in the long run offer vindication in the form of a higher reward. The only risk that one mitigates when buying what everybody else is buying is the risk of looking foolish. On the contrary, companies that are en vogue tend to lack a margin of safety in their stock prices. We invest only when the price meets our return requirements and in the meantime will not lower these requirements (in other words, overpay). The times when investors believe it is acceptable to lower their return requirements tend to be the times when it is most imprudent to do so. These are times when the market is excited, stock prices are rising, and attractive investments becomes elusive. At the prospect of underperforming the general market or their peers, investors begin to relax the criteria by which they would buy a stock. In the short run the strategy may succeed, but in the long run it is destined for failure.
The reality is that most stock market participants are focused on the short run. It is easy to imagine the joy of winning the lottery, but more difficult to imagine the slow compounding of wealth over several decades. This common desire for instant gratification is both a function of nature and nurture and has been well researched. In the 1960s, Stanford professor Walter Mischel and his team of researchers tested the ability of children ages 3 to 5 to delay gratification in a series of experiments that became known as the “Stanford marshmallow experiment.” The study began by leading each child to sit alone in an empty room. The researcher placed two marshmallows (at other times, pretzels) on the table and told the child that he or she would return in fifteen minutes. During that time, the child was welcome to eat one of the marshmallows; if he or she waited for the researcher to return, the reward would be both marshmallows. In other words, the child could have one treat now or two treats in fifteen minutes.
Less than one in three children was able to delay gratification and earn the second treat. Some found it easy, while others tried to avoid the temptation by sitting on their hands or even smelling the marshmallow to satiate their desire. While the experiment itself was interesting, its most pronounced insights did not transpire until decades later as the researchers tracked the progress of these same children during adolescence and adulthood. They discovered that the children that were able to delay gratification (that is, those who waited for the second marshmallow)