October 29, 2016

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2016 Q3 Partnership Letter

Dear Partner,

Our net performance for Q3 was 9.8%, vs. indices (in order of relevancy for comparison) of: 4.6% HFRI Hedge Fund Equity Index, 9.0% Russell 2000 and 3.8% S&P 500. Our portfolio was market neutral on a beta adjusted basis for the quarter; our longs added 13.4% to returns while shorts detracted 3.6%. Our market neutral portfolio helps us focus on our business’s operations and ignore the headline driven, frothy stock market. “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” – Warren Buffett

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meson-capitalThis quarter saw markets reach back to all-time highs with the “Buffett indicator” of total market cap /

GDP in the US standing at 121% now. This has only been exceeded only once in history – for approximately 9 months at the peak of the 1999-2000 bubble and ensures low future returns for the market as a whole. We are not predicting a crash but feel very comfortable with our short book, which consists of companies that should do poorly in any economic environment over time. Our longs are businesses that are significantly undervalued and are set to benefit from macroeconomic and technological tailwinds. Our longs also have excellent governance by virtue of our presence as a large shareholder on the board directly or through proxy.

Confusing market environments like this call for a renewing focus on first principles – going down to the

“physics” of what drives the stock market. Last Q’s letter we visited why there may be no reason to expect interest rates to revert to their historical mean due to fundamental demographic and technology changes that are unprecedented in human history. Our strategy is carefully designed to be on the right side of these mega trends while protecting our capital in a wide range of different scenarios.

First principle #1 – humans and machines are good at different things. Business is still a highly social activity and ultimately no matter how much data one brings into a boardroom, decisions are still made on a social, in-person capacity. No quant fund will change out the board of a company, install great management and improve a company’s strategy with all the political and social hurdles along the way.

In contrast, a machine can ingest, analyze and interpret a vastly wider and deeper array of data than a human ever could.

First principle #2 – due to potential margin calls, large short positions are too risky. A key success factor for portfolio management on the short side is being able to endure “pain” – we have quantified this in some original research that we performed over the summer; which we will publish shortly. That caps the size of individual short positions and means that to get the appropriate exposures, more short positions are required. This means more data is required but we as humans have only limited time and neurons – this is where machines can help augment our strengths in pattern recognition.

First principle #3 – exponential price/performance drivers in technology exist. Ever since I was very young and reading Warren Buffett’s letters and Ray Kurzweil’s books, I have been fascinated by exponential trends. Technology entrepreneurs have been familiar with Moore’s law for decades – the doubling every ~18 mos of the price/performance of computers. Today these self-compounding technology trends are spilling over into fields that are not traditionally technology-driven. Witness

Amazon’s decimation of the retail industry thanks to its computing and robotics in hyper-efficient warehouses. The pace of change is only accelerating and transforming one industry after another – software is “eating the world” as Marc Andreessen said 5 years ago in a WSJ op ed.

Combining these principles, we conclude we want to do things that the machines cannot on the long side where we can take concentrated bets. On the short side we can use the machines to help us identify the ~2% lowest quality companies in the universe that are unlikely to benefit from or even survive the accelerating change in the market. We have been working lately to apply an increasing level of data science / machine learning to this area and will have more to disclose soon. This effort on the short side won’t knock the cover off the ball but it will give us the comfort to be concentrated for our entrepreneurial activist efforts on the long side. If the market ever takes a dive again we will be one of the few funds with purchasing power – which was an enjoyable position to be in back in 2009.

We still consider ourselves “value” investors but as Charlie Munger says “all intelligent investing is value investing”. One narrative we disagree with conventional value investors is that one can’t make money shorting because the market goes up over time. This is indeed true but the deeper dynamic is creative destruction, and the pace is accelerating with the average life of an S&P 500 company down from 30 years to 10 since WWII. For every Amazon success story for example, 100 retailers go bust. For every

Shake Shack there are 30 bankrupt ‘concepts’. The data shows that more stocks actually decline than rise over time – even more so in environments like today where overall valuations are so stretched.

The second area of disagreement is how easily incumbent companies can clone the products of upstarts

– especially when it comes to exponential technology changes. This is nowhere more apparent today than in the automobile market where numerous conventional value investors are long the big automakers GM, Fiat, BMW, etc. as they trade statistically cheaply. I will save the full details for another essay but I will make the bold statement that because of 1) the limited transferability of engineering from internal combustion drives to electric drives and 2) improvements in robotic manufacturing techniques – GM and BMW are FAR more likely to go bankrupt before Tesla does. For some historical context, the transition from steam to diesel trains in 1920-1940 is fascinating (https://fusionmx.babson.edu/entrep/fer/Babson2002/II/II_P4/II_P4.htm) – spoiler alert: none of the steam engine manufacturers survived the transition…

A Tribute to Ralph Whitworth and Gentleman Activism

The term activist investor is by no means a uniform character – there are as many tactical and personality differences as with the label entrepreneur. While we work to build our own unique approach, there are certain figures whom I greatly admire and who have shaped my thinking. The investing world lost one of those figures in Ralph Whitworth who tragically passed away last month at age 60, succumbing to cancer. Whitworth founded Relational Investors with David Batchelder in 1996, whom I had the pleasure to meet earlier this year. Whitworth was able to drive leadership changes at large cap, highly politicized companies including IBM, Home Depot, Waste Management, and in his final act – Hewlett Packard as Chairman of the Board.

Headlines about highly public activist campaigns over the last couple years have, in my view, led to a great number of pretenders entering the activist arena. Hedge Fund Research (HFR) lists only 71 out of 8,000 funds as activist but of

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