Grey Owl Down 2% in 2011 “Lessons Learned”

Executive Summary
Despite expecting dull economic growth and market outperformance by high-quality companystocks in 2011, we did not give our own macro analysis enough credence. We expect 2012 tobe a lot like 2011: slow economic growth in the US, market volatility driven by political events,and issues in Europe and China (with the potential addition of Japan) continuing to play out.We begin 2012 continuing the portfolio “high-grading” process we started in late 2011. This isnot an epic shift in our approach. Rather, it is a reflection of our increased conviction that the“macro” overhang will continue for many years.
2011 Review
Entering the year, we thought we had designed a portfolio strategy to deal with ourexpectations for a muddling economy, generally extended valuation levels, and the reasonablechance for exogenous shocks coming from Europe, China, or Japan: higher quality names madeup the bulk of our portfolio, and we held a significant cash position. However, we also heldexposure to really beaten up names that we thought were fully washed out and could providemeaningful upside and/or significant and rapid return of capital because of catalyst(s) or a veryhigh yield. We even added additional investments in this category during the year. To date, sixof these ideas have worked, but eight have not. Unfortunate timing and, in two cases, too bigpositions further tipped the balance against us. In addition, while the market was range bound,as we had anticipated, the range was tighter and whipped more frequently than we everimagined likely. In fact, from early August through the October 4
the market low, there were 106% to 10% swings in the S&P 500’s price level. The daily volatility in 2011 was so extreme thatthere were a full 30 days where the percentage gain or loss was greater than 2% (which was thefinal tally for the year). Thus, we did not trim exposure enough when the cycle was up, nor didwe put enough cash to work when the cycle was down.In aggregate, and as expected, our high-quality holdings performed very well during the year.Our pharmaceutical basket (Abbott Laboratories, Novartis, and Pfizer) showed sizable positive gains. Abbott and Pfizer ended the year up 21.77% and 28.77% respectively, while Novartis wases sentially flat. We were net positive on the insurance front with Markel showing nice gains,which more than made up for the fact that Berkshire Hathaway showed a modest loss in value.This was despite steady gains in Berkshire’s business fundamentals (detailed in our thirdquarter letter)and the rally that occurred early in the year after the stock was added to the S&P500 index. Long-term technology holdings, Microsoft and Western Union, were flat for theyear, while second-quarter purchase Lexmark provided a mid-teen return. Rounding out ourhigh-quality holdings, services firm Copart ended the year up 28% while consumer staples
juggernaut Proctor & Gamble was up 7%. We did manage to ignore at least half of WarrenBuffett’s well-placed advice against pruning flowers and watering weeds. Regarding theflowers, early in the year we sold Altria Group and VF Corporation (both of which could becategorized as high-quality companies). The stocks went on to post 27.66% and 50.92% annualgains respectively.In contrast with the high-quality portfolio returns cited above and our own high-qualityholdings, low-quality and more mixed strategies performed poorly. Our own low-qualityholdings generated a negative return in aggregate. This appears to be the case across otherlow-quality portfolios as evidenced by the plethora of traditional “value investors” withnegative returns in 2011. Of the 70 investment recommendations made by Barron’s roundtable in early 2011, the average return was -7.6%.

Given its large position size, Transocean had, by far, the biggest negative impact on ourportfolio for the year. We missed the opportunity in early 2011 to sell the stock (or at least trima portion of our holdings) in the low to mid-80s. The thesis we articulated in our second-quarter 2010 letter had, in many ways, played out. Unfortunately, the stock ended the year at$38.39, well below our cost basis and well below the $69.51 price level at the beginning of theyear.We made an error not correctly categorizing the position. As you may recall, on April 20, 2010an oil rig exploded in the Gulf of Mexico while working the Macondo prospect. The rig wascontracted to British Petroleum, but was owned by Transocean. Prior to the Macondo disaster,Transocean was much closer to a high-quality company than a low-quality company. Itcommanded high profit margins, had low earnings volatility, and for the 10-year period endingin December 2008 had a beta less than the market. It did (and continues to) carry significantdebt, which expanded with the GlobalSantaFe acquisition in late 2007.
Transocean was not atrue “high-quality” company in the GMO parlance, but it was close. (While Transocean hadhigh profit margins, low earnings volatility, and low market beta, it did not have low leverage.)However, after Macondo, which introduced significant earnings volatility, crushed near-termoperating margins, and increased the stock’s beta
The median was -7.8% indicating that one or two large negative outliers did not skew the average. to well above the market’s,
it surely becamea low-quality company. The correct response on our part would have been to re-categorize theposition as such. This would have had two portfolio management implications: First, it wouldhave limited the position to a smaller holding and required a greater discount to fair value (i.e.margin of safety) than a high-quality holding. Second, we would have managed the positionmore aggressively by trimming our exposure as the price appreciated. Instead, we continued tothink of Transocean as the company we had invested in during 2007, prior to Macondo.
Lessons Learned

While we believe the core of our investment process is immutable and eternal, eachenvironment is different. A stock will always be a piece of a real business and the intrinsic valuewill always be the discounted stream of future cash flows. However, in some environments itdoes not pay to invest in companies whose future cash flows have a wider range of possibilities.The economic environment (real world volatility) makes it much harder for these companies tohit the upper end of their potential cash flow range AND market volatility makes it less likelyinvestors will give the company the benefit of the doubt before execution is complete. This isespecially true when the market is several years into a bull-market rally. At this stage in themarket cycle, the number of stocks participating in rallies typically becomes fewer and high-quality companies tend to outperform.We are now engaged in an effort to label investments as either high-quality or low-quality usingGMO’s four criteria and to revisit these categorizations on both a regular basis (e.g. quarterly)and also as the individual business changes. While our estimation of the variability of outcomesand the margin of safety have always informed our position sizing this has been somewhatqualitative. There will always be a qualitative aspect to portfolio management, but this newprocedure should add an additional level of rigorous risk-management to our alreadyconservative process.We are currently devoting more research time to looking for investment opportunities in high-quality companies. We expect this type of investment will continue to outperform as wediscuss in our 2012 roadmap below. Importantly, this type of investment has the addedbenefit of being able to compound tax-free for long periods of time and does not incur the taxand trading “friction” that is inherent in well-managed, lower-quality positions.
full letter below:

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