Allan Mecham Arlington Value Capital 2016 letter to investors
Arlington Value Capital’s Allan Mecham On Value Investment … –
Arlington Value Capital Allan MechamI’m happy to report that AVM Ranger was back in the black in 2016. We ended the year with a gain of 29.1% (before fees) versus 12.0% for the S&P 500. I’m thrilled with this result (hopefully you are too), yet it’s akin to birdieing a hole in golf: it’s nice, but the 18-hole scorecard is what really matters.
Our longer-term scorecard is more satisfying: over 8.5 years AVM Ranger has compounded at 30.7% per annum (before fees) versus 9.1% for the S&P 500. Needless to say, 30% is not a hurdle rate we try to sustain, and the usual disclosure applies: we have no chance of maintaining this level of performance long-term. As a sanity check for those immune to my warnings, consider this: if we continued to compound at 30.7% for the next 30 years (we won’t), a 100k investment would turn into $307 million. That said, we hope our relative performance over the S&P will continue to add value to partners over time.
At the risk of being uninvited to parties based upon my dour warnings, it’s worth noting that even small margins of outperformance, say 4%, over long stretches produce dramatic wealth creation given compounding’s wonders (4% outperformance produces roughly 3x value over 30 years). Beating the market by 4% is a tall task, though a recent article stating that 60% of millennials trade on Trump tweets bolsters our confidence that we’ve got a fighting chance.
Arlington Value Capital – GENERAL COMMENTARY
Charlie Munger has famously espoused on the wisdom of figuring out what to avoid in pursuit of success. If you follow this wisdom then you’ll be comforted to know that Arlington abstains from trying to forecast and profit from market-moving events. This stance served us well in 2016, as it was a year that baffled the odds-makers: early in the year, whispers of rising interest rates incited market tremors and a sharp selloff, portending a dire outlook for the market (the market finished up 12%); further jolts occurred in June as “Brexit” stunned pros and pundits alike; and closer to home, outside candidate Donald Trump shocked handicappers by winning the White House in November. While the media does not portray President Trump as having a calm, predictable disposition, the market found comfort in his election: since Nov 8th, a halcyon market has steadily glided higher, having gained 11% through February. The events of 2016 reinforce my attitude to avoid an education in forecasting the old fashioned way, by experience: experience is what you get when you get what you didn’t want.
Our reaction to the noise around us was more muted. Other than taking a few toe-hold positions, we trimmed most holdings as prices rose and the risk/reward shifted. Our decision to pare back most holdings left us with a large cash position, tallying 25.5% at year-end. While I’m no fan of cash as an asset class (it has lost 97% of its value over the past 100 years), I’m optimistic that the position will be temporary. We have two advantages that stoke my optimism: our small asset base, and a philosophy that requires only a handful of ideas.
It’s worth adding: our cash position is not a “market call,” it simply reflects an absence of ideas that we find attractive. We’ve never made hay by hoarding cash in anticipation of market corrections; a quick trip down memory lane serves as a reminder that we entered both bear markets (2002 & 2008) fully invested. We prefer partial ownership in businesses over snappy trades that require gazelle-like instincts to dart away from any hint of danger. We think attempting to time markets (knowingly or unknowingly) is a fool’s errand and agree with Peter Lynch: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Arlington Value Capital – PORTFOLIO COMMENTARY:
Despite the drag-effect of cash, we still managed to produce solid results in 2016. For the most part, what hurt us last year helped us this year: MSC, DNOW, and LUK.
MSC has been besieged by stiff industry headwinds for the better part of 2 years. Amid these difficult conditions, MSC management has performed admirably. They have deftly managed the business by keeping a sharp eye on customers and costs. These efforts have produced outstanding results in the form of stable margins and growing market share, leaving MSC in a healthy position for future growth. MSC’s business is poised like a coiled spring, ready to unleash strong operating leverage should headwinds abate and business activity pick up—which appears to be happening in early 2017.
NOW Inc (DNOW)
Wayne Gretzky once said, “skate to where the puck is going, not to where it’s been.” My initial thesis behind DNOW—a unique competitive position to take advantage of distressed competitors, growing bargaining power translating into better economics, and technological advances that benefit DNOW’s customers and support drilling activity—may have seen me skate past the puck. While it’s probably too early to evaluate confidently, DNOW’s results and underlying economics have been disappointing. Tighter working capital management and pricing leverage have not materialized to generate the returns on capital we expected. Higher oil prices and a growing rig count are positive developments, yet if DNOW’s growing suite of products and services don’t translate into greater bargaining power, the business economics will likely fall short of our expectations. Given a rising stock price and our waning confidence, we chose to sell a large part of our position.
Berkshire Hathaway (BRK)
Sticking with the hockey theme: If DNOW was my attempt at a difficult tic-tac pass and deke finish, BRK was the quintessential open-net tap-in goal. Past letters have expounded on BRK’s unique qualities (they remain unchanged), which continue to produce impressive financial results: for 2016, BRK grew insurance float to over $91 billion, at negative cost (meaning BRK got paid to hold $91 billion), produced over $12,500 in pre-tax earnings per share, and had roughly $170,000 in investments per share, including over $85 billion in cash at year end.
Berkshire resembles a meat grinder that relentlessly piles up value year over year (and decade over decade). Over the past ten years, the two pillars of value, earnings from operating businesses and investments per share, have steadily grown at 9.0% and 7.8% respectively— impressive performance considering the enormous asset size. We think the current figures, combined with the likelihood of future growth, support attractive prospective returns for current owners.
Given that most of you know I’m a big fan of Warren Buffett, it’s worth emphasizing that BRK is not a museum piece that sits in the portfolio based upon admiration alone. Rather our position is anchored to value. When attractively priced we’ve done well buying it.
Arlington Value Capital - Cimpress (CMPR)