Value Investing

François Rochon Returns 50% With Huge Gain On VRX

François Rochon, a famous canadian value investor discusses Giverny Capital’s annual letter to partners for 2013, called a ’20th Anniversary of the Giverny portfolio’ by the fund itself.

François Rochon

For the year ending December 31st 2013, our portfolio’s return was 50.2% versus 38.9% for our benchmark. Both returns include a gain of approximately 8% due to fluctuations in the Canadian currency. So in 2013, we have outperformed our benchmark by 11.3%.

Since our inception on July 1st 1993, our compounded annual growth rate has been 15.5% versus 8.3% for our weighted benchmark, representing an annualized outperformance of 7.2% over this period. When we exclude the effect caused by the appreciating Canadian currency since our inception, which represents an annualized increase of 0.9% since 1993, our portfolio has returned 16.6% annually versus 9.3% for our benchmark. Our long-term and ambitious objective is to maintain an annual return that is 5% higher than our benchmark.

The Artwork on Our Letter

Since 2004, we have illustrated the cover of our letter with a copy of an artwork from our corporate collection. This year we selected a photographic artwork by Gabor Szilasi entitled “Giverny”.

The Giverny Portfolio (in Canadian dollars): Returns Since July 1st 1993

Giverny Capital François Rochon
François Rochon

The Giverny US Portfolio

We have been publishing the returns of the Giverny US Portfolio, which is entirely denominated in US dollars, since 2003. The Giverny US Portfolio corresponds to the American portion of the Giverny Portfolio. In 2013, it realized a return of 40.6% compared to 32.4% for our benchmark, the S&P 500 (INDEXSP:.INX). The Giverny US Portfolio therefore outperformed our benchmark by 8.2%

Since its inception in 1993, the Giverny US Portfolio has returned 1893.7%, or 15.7% on an annualized basis. During this same period, the S&P 500 has returned 512.7%, or 9.2% on an annualized basis. Our added value has therefore been 6.5% annually.

Giverny Capital 2

We outperformed the S&P 500 for a sixth consecutive year. No single stock alone was a factor for this outperformance and, when we looked to our performance attribution for 2013, we noted that seven out of our top ten holdings outperformed the S&P 500.

Giverny Canada Portfolio

We introduced a portfolio that is 100% focused on Canadian equities in 2007. This corresponds closely to the Canadian portion of the Giverny Portfolio. In 2013, the Giverny Canada Portfolio returned 49.4% versus 13.0% for the S&P/TSX, therefore outperforming the index by 36.4%.

Since 2007, the Giverny Canada Portfolio has returned 208.6%, or 17.5% on an annualized basis. During this same period, our benchmark had a gain of 29.3%, or a gain of 3.7% on an annualized basis. Our annual added value was therefore 13.7%.

Giverny Capital 3

Our primary Canadian holdings performed very well in 2013. The all-star in our portfolio was Valeant Pharmaceuticals, which rose 96%. Dollarama (+50%) and MTY Foods (+54%) also excelled.

For six out of the last seven years, the Giverny Canada Portfolio outperformed the TSX. It is also worth repeating that our Canadian portfolio is very concentrated and has little correlation to the TSX. So the relative performance, whether positive or negative, will therefore often be high.

2013: The year of the “triple play”

Legendary investor Peter Lynch always emphasized the importance of being patient: “Frequently, years of patience are rewarded in a single year”. The year 2013 was such a year. We could qualify it with the baseball term: “triple play”. Our 50% return includes three components:

  • An earnings growth rate of 15% for our companies with an additional 1% from dividends
  • An increase of the average Price to Earnings ratio (P/E) of our stocks from 14x to 17x
  • A currency gain of 8% linked to the drop of the Canadian dollar from 0.99$ to 0.94$.

We believe our return for 2013 was justified. It reflects a return to a more normal valuation level for our holdings. We went through a period from 2006 to 2009 where we had to cope with a P/E compression for our stocks and a huge rise in the Canadian currency. As we stipulated in our annual letters during those years, we believed those events were temporary in nature and were not justified by our long term fundamental analysis.

Yet, it would be unrealistic to extrapolate our 2013 return into the future. In the the long run, the number one factor influencing a portfolio’s return is the overall intrinsic value increase of the companies owned. But we believe that our stocks are still undervalued and that the Canadian dollar is still overpriced by 10 to 16%. So the next few years could also bring additional rewards to the intrinsic value of our holdings, but not at the same level as this year.

 

Since 1993, the cornerstone of our investment philosophy is based on Benjamin Graham’s book “The Intelligent Investor”, first published in 1949. In it, Graham wrote: “In the short term, the stock market reflects the irrationality and unpredictability of human investors. But in the long term, it reflects adequately the intrinsic value of companies”.

Over the last two decades, we have been witnesses to strange market movements and numerous irrational behaviors from investors (the list would be too long to mention here). But in the end, the strangeness cleared up and common sense prevailed. If there is one thing that we have learned since 1993 is that market fads come and go but fundamental principles endure.

 

Twenty years of the Giverny Portfolio

 

I started to manage the Giverny portfolio in July 1993. So we celebrate our twenty year anniversary with this letter. Results over those two decades have been more than satisfactory. But most important, I’ve learned some valuable lessons which should be useful in enhancing portfolio values going forward. Last summer, I wrote in my Gazette column an article highlighting the ten most important lessons learned since 1993. You will find the article in Appendix A at the end of this letter.

 

I would like to emphasize the most important lesson of the last twenty years: It is futile to try to predict the stock market over the short run. All previous lessons are useless if you try to predict the stockmarket over the short run. I have heard people say hundreds of times that they were waiting to buy great companies because they had negative views on the short-term direction of the stock market. Owning great businesses, managed by great people and acquired at reasonable prices is the winning recipe. The rest is just noise.

 

The stock market and Bridge

 

Investing in the stock market has similarities with the game of bridge. As you probably know, a member of the Giverny Capital team, Nicolas L’Écuyer, is a great bridge player. He was Canadian champion six times. To succeed in bridge, you have to be able to combine logic and rationality. Another important point: in duplicate bridge, the points are never given in absolute terms but relative to what others have done with the same hand being played. As with the stock market, what counts is the result relative to the average.

 

Nicolas likes to say that two things are important in bridge: to have a plan to play the hand and always favor the play that has the best chance of success. The fact that a particular decision has worked or not at a particular time is irrelevant if the thought process was correct. In other words, if a play has a 75% chance to be the right one, do not blame yourself when it does not work (which will be one time out of four times). In addition, when playing in a bridge club where players of various levels of play are present, it is interesting to look at the results at the end of the evening. Very often, the best team plays for 60% and the worse one for 40%. The difference is not that large.

 

An analogy applies to the stock market: managing a portfolio of equities requires a specific plan (a philosophy of securities selection) and a decision-making process that favors the better odds. If we look at the history of the stock market in the long run, stocks have returned 10% per year compared to roughly 5% for bonds and 3% for treasury bills. So to be 100% invested in equities is the most favorable statistical approach. Some will tell you that a portfolio thus formed will be more volatile and more “risky”. Obviously, it is true that an equity portfolio will fluctuate, sometimes widely as we saw in 2008-2009. But it is not really “risky” if its owner is patient and allows enough time for the odds to play out in their favor.

 

As important, we have to accept the 60-40 rule. To be wrong (or not totally right) 40% of the time can produce excellent results in arenas such as bridge and the stock market. In fact, we stipulated many years ago in our “Rule of three” that we have to accept that one year out of three, we will underperform the index and that one stock purchased out of three will not perform as expected. If one studies the

table of the Giverny portfolio since 1994 (excluding the half-year of 1993), we observe that our portfolio has underperformed the S&P 500 six years out of twenty, the equivalent of 30% of the time. To be aware of this fact is vital so we can be psychologically prepared for the inevitable periods when we will have results that are worse than average. We have to accept from the start that it is impossible to be always the best in that field even if one is competent and loaded with motivation and efforts.

 

It is important to realize that our “Rule of three” is not linear and totally unpredictable. Some of our partners would love to know in advance the years we will underperform so that they can wait on the sidelines. In the long run, the stock market will eventually reflects the intrinsic values of the companies owned. But all temporal parameters are unknown. Few investors, professional or not, can do better than the average. In our opinion, one simple but crucial quality is needed: humility. Humility is needed to recognize that we can’t predict the economy and the stock market (and why even try with politics?) Humility is needed to recognize that, even with our own stocks, we can’t know in advance which ones will do well and when they are going to do well.

 

Nicolas would add that one key to succeed in bridge is to play often so odds can eventually win over luck. Persistence eventually trumps luck!

 

The Flavor of the Day for 2013

 

Many of the financial (and less financial) assets that we labelled “flavor of the day” in the last years have turned sour in 2013. Bonds lost value as interest rates increased. The price of gold is down 34% since its 2011 high. The Canadian Dollar has started to fall to a level closer to its Purchasing Power Parity or PPP (as evaluated by the OECD). Even housing prices in Canada show signs of getting back to more reasonable levels.

 

So where are we seeing popularity (and consequently danger)? Recently, we have observed the popularity of some new names in the technology field. A dozen or so years have passed since the tech bubble crash of 2000-2002. A new generation of young investors, and some older ones with “young memory”, have become infatuated with outstanding companies with a great potential future but that trade at high P/Es in the stock market. Facebook and LinkedIn are good examples but we could also add Netflix and Tesla Motors, the terrific electrical car manufacturer.

 

These are all outstanding companies with great CEOs. But in the stock market, it does not guarantee outstanding investment results if one pays a too high price for them. With an average P/E of more than 100 times for these four stocks, we would advise prudence.

 

Here is a little table on the new “Fantastic Four”

 

Company

Quote1

EPS 2014

P/E 14
Facebook

68

$

1,25

$

55

Netflix

446

$

4,10

$

109

LinkedIn

204

$

1,58

$

129

Tesla Motors

245

$

1,90

$

129

Average        

105

 

We could add a few words on Twitter, which came public last November. The stock quickly flew away

 

(!) and now has a $30 billion dollar market value1. The company is not yet profitable so we could not include it in the preceding table. Analysts estimate that the company will have $1.2 billion in revenues

in 2014. So theoretically, if the company had a 25% net margin level that would translate into $300 million dollars in profits. At its present level, the P/E would then be the equivalent of 100 times this hypothetical scenario. As for the four other securities mentioned, we would advise caution.

 

Owner’s Earnings

 

At Giverny Capital, we do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.

 

Since 1996, we have presented a chart depicting the growth in the intrinsic value of our companies using a measurement developed by Warren Buffett: “owner’s earnings”. We arrive at our estimate of the increase in intrinsic value of our companies by adding the growth in earnings per share (EPS) and the average dividend yield of the portfolio. This analysis is not exactly precise but, we believe, approximately correct. In the non-scientific world of the stock market, and as Keynes would have said:

 

“It is better to be roughly right than precisely wrong.”

 

This year, the intrinsic value of our companies, as a whole, rose by 16% (15% from the growth in earnings and 1% from the average dividend). Despite changes to our portfolio during the year, we consider this growth in earnings to appropriately reflect economic reality. The stocks of our companies rose approximately 42% (without the effect of currency). As for the S&P 500, the underlying earnings growth of its companies was 7% (9% including dividends) and the total return of the index was 32%.

 

 

    Giverny     S&P 500  
Year *** Value * Market ** Difference Value * Market ** Difference
1996

14%

29%

15%

13%

23%

10%

1997

17%

35%

18%

11%

33%

22%

1998

11%

12%

1%

-1%

29%

30%

1999

16%

12%

-4%

17%

21%

4%

2000

19%

10%

-9%

9%

-9%

-18%

2001

-9%

10%

19%

-18%

-12%

6%

2002

19%

-2%

-21%

11%

-22%

-33%

2003

31%

34%

3%

15%

29%

14%

2004

21%

8%

-12%

21%

11%

-10%

2005

14%

15%

0%

13%

5%

-8%

2006

14%

3%

-11%

15%

16%

1%

2007

10%

0%

-10%

-4%

5%

9%

2008

-3%

-22%

-19%

-30%

-37%

-7%

2009

0%

28%

28%

3%

26%

23%

2010

22%

22%

0%

45%

15%

-30%

2011

17%

6%

-11%

17%

2%

-15%

2012

19%

23%

4%

7%

16%

9%

2013

16%

42%

26%

9%

32%

23%

Total

867%

903%

45%

259%

317%

58%

Annualized

13.4%

13.7%

0.3%

7.4%

8.3%

0.9%

 

*          Estimated growth in earnings plus dividend yield

Since 1996, our companies have increased their intrinsic value by 867%, or about a tenfold increase. Meanwhile, the value of their stocks has increased 903% (including dividends but without currency

 

 

7

 

effects). On an annualized basis, our companies increased their intrinsic value by 13.4% and our stock returned 13.7% per year. The similarity between those two numbers is not a coincidence. During this same period, the companies comprising the S&P 500 increased their aggregated intrinsic value by 259% and saw their stock prices rise by 317%. Market performance and corporate performance are rarely synchronized over the course of a calendar year. But as more time passes, the synchronization between the two inevitably begins to reveal itself.

 

Over 18 years, our portfolio has realized a return that is 5% higher than the S&P 500 primarily because the underlying companies in our portfolio have increased their intrinsic value at a rate that is 5% higher than the average. This is how we plan on continuing to reach our performance objectives in the future, rather than trying to speculate on the highs and lows of the market or trying to read the tea leaves of economic or political trends.

Five-year Post-mortem: 2008

 

Like we do every year, we go through a five-year post-mortem analysis. We believe that studying our decisions in a systematic manner, and with the benefit of hindsight, enables us to learn from both our achievements and our errors.

 

The year 2008 was tumultuous, which is an understatement. We have never seen so much pessimism as in late 2008 and early 2009—to a point that many questioned the very survival of capitalism. Peter Lynch liked to say that the most important organ in the stock market is not the brain but the stomach. To have the right temperament toward stock quotes was vital during the 2008-09 crisis. We witnessed incredibly irrational behaviors on the part of many investors, even from seasoned investors.

 

At Giverny Capital, we did not panic. We stayed 100% invested in stocks and we made new purchases to the best of our capabilities. We also tried, with little success, to rally investors to our noble cause. I was interviewed in the Montreal newspaper “La Presse” on February 14th 2009 and I labelled the market environment as the “Opportunity of a generation” (in French, it is a little more poetic since it rhymes). We even set up a web site to encourage stock purchases and organized conferences ( www.occasiongeneration.com). It was so popular that we had to cancel many conferences because of a lack of registration.

 

New buy in 2008: Omnicom

 

We bought shares of Omnicom in 2008 at $24. The big ad firm was on our radar for more than 15 years (yes, we are patient people). In 2008, we bought shares at approximately seven time normalized earnings, a level we believed to be at least a third of its intrinsic value. We held on to the stock for five years and sold it this year at $64 after it announced its merger with Publicis. We had a return of 167% for an investment that we believed had very low risk. In fact, we believe the stock is still undervalued today but we chose to invest our capital in another company that we believed to be even more undervalued.

 

Mistakes of 2008

 

In 2008-09, there were lots of great bargains. Many outstanding companies were trading at a third – even a fourth – of their fair value. Some of our own stocks like Carmax, Disney, American Express and Wells Fargo, went down to such attractive levels. We made additional share purchases but not to a level we should have. We would have shown fortitude if we had sold some our then more stable blue chips like Johnson & Johnson, Wal-Mart and Procter & Gamble to cash in on such opportunities. To

sell a stock that trades at 66 cents on the dollar to buy a similar stock that trades at 33 cents on the dollar is an intelligent transaction. It is pointless to be too severe in castigating ourselves. But we could conclude that our lack of opportunism has cost us something like 10% of missed returns over the last few years.

 

Our total return since 2008

 

The good news, however, is that the Giverny Global portfolio had a total return of 141% since January of 2008 (before the start of the great bear market of 2008-2009), which compares to a total return of 54% for our benchmark.

 

Our Companies

 

“In my books, I’ve always placed the emphasis on the importance of the management team in selecting companies… and yet, I didn’t do it enough”

 

– Philip A. Fisher

 

 

 

Section for Giverny Capital’s partners only

 

 

 

 

 

 

 

 

The Podium of Errors

 

“There’s no way that you can live an adequate life without many mistakes. In fact, one trick in life is to get so you can handle mistakes”

 

– Charlie Munger, Vice-Chairman of Berkshire Hathaway

 

 

 

Following in the “Givernian” tradition, here are our three annual medals for the “best” errors of 2012 (or from past years). It is with a constructive attitude, in order to always improve as investors, that we provide this detailed analysis. As is often the case with stocks, errors from omission (non-purchases) are often more costly than errors from commission (purchases)… even if we don’t see them on our statements.

 

Bronze Medal: Tripadvisor

 

As you can imagine, I spend a great deal of the year on the road visiting companies, attending conferences and meeting partners. Having had all sorts of hotel experiences over the course of the past decades, I really like to be able to choose hotels which can make my travels more enjoyable. I discovered the website Tripadvisor a few years ago and became a loyal fan. To paraphrase an American Express advertising, I never leave home without vetting out my destination on Tripadvisor ahead of time. The company also owns another very useful site called webseatguru.com which helps you choose the best seat on any commercial flight.

 

 

Tripadvisor went public at the end of 2011 and I was very impressed with the company’s financial performance after reading the prospectus. Unfortunately, the stock rapidly climbed to $45 and was trading at 30 times its earnings. Then, in the fall of 2012, the stock tumbled by 33% to $30 and I seriously thought about buying it. The P/E seemed reasonable (20x) for a company with a dominant brand that was growing at 20% a year. Yet, as often the case, I decided to wait for an even better price. And the stock surged by 180% in the following year and is now trading at $84. It’s too bad that I didn’t convert my admiration into profits as it would have paid for a few five star hotels…for both you and me.

 

Silver Medal: Buffalo Wild Wings

 

You are likely surprised to find Buffalo Wild Wings in this section about errors as we have quadrupled our money since becoming shareholders. Difficult to ask for more? Well, it could have been better.

 

In the middle of 2012, the company had a disappointed quarter due to a substantial increase in the price of chicken wings that weakened gross margins. True to its typical myopia, Wall Street punished the stock which dropped by 24% thereafter.

 

We had a 2% weight on this stock in our portfolio at that moment. We thought about doubling our holding, believing that these margin problems would be temporary. I decided to go to Minneapolis to meet the executive team at BWW to look into this. I was (yet again) highly impressed by their vision and game plan for the company. I came back convinced that we should not only keep our shares but that we should add to our position. But I didn’t act on this conviction and when the stock started to climb, I waited on the sidelines. The stock doubled over the next 15 months. If we had had twice the weight in our portfolio, we would have been even more rewarded this year.

 

Gold Medal: Church & Dwight

 

Church & Dwight was first known for its Arm & Hammer brand, the baking soda often placed in our refrigerators to capture odors. About 15 years ago, the company decided to develop an ambitious growth plan by developing new products for Arm & Hammer and also by acquiring new brands. In 2001, the company purchased Carter-Wallace which has many brands including Trojan (the famous condoms), Nair (to remove superfluous body hair) and First Response (the pregnancy test).

 

As soon as 2003, I could observe the success of this strategy. In only five years, EPS increased from $.26 to $.62 and the stock was trading at $11 (or a P/E of 19x). I hoped that the stock would drop to a more interesting level which never really happened. In 2013, the company generated $2.89 in EPS, meaning that the company grew at an annualized rate of 17% over the course of the last decade. The stock is now trading at $61, a gain of 455% in 10 years (19% annually). And the P/E increased rather than decreased.

 

This was a great error because I understood the nature of the company’s product and brands (allow me to

make a juvenile joke by mentioning that Trojan is an ideal repeat business).  Additionally, after following the

 

company closely for five years, I also realized by 2003 that the company was led by a brilliant team dedicated to serving and creating wealth for its shareholders. I don’t have any excuses to even mention and this error is certainly in the gold camp.

Conclusion: the Missing Gene Hypothesis!

 

We’ve repeated on numerous occasions throughout the years the importance of having a good attitude towards market fluctuations in order to realize returns that are above the average. We like to repeatedly cite the wise words of the great money manager John Templeton: “It is impossible to produce superior performance unless you do something different from the majority.” This something different, in our opinion, is to be able to buy stocks without being affected by the opinions and behaviors of other investors.

 

Over the course of the last 20 years, we have noticed how few market participants actually achieve this. Warren Buffett even said a few years ago that the capacity to have a good attitude towards stock prices might be an innate trait not acquired with experience (or good arguments). This statement made us think about another way to look at things.

 

Clearly, the capacity to do better than average is not just linked to intelligence, work or financial resources (if this were the case, all the great financial institutions would achieve it). We came to the conclusion that those rare investors who are able to do better than average over a long period of time might have something that others do not have.

 

Actually, it’s the contrary; they are actually missing something that is present in others: the hypothetical “tribal gene”. Like animals, our genetic code was developed over hundreds of thousands of years, with the primary objective being survival. As humans, we learned early (more than 200,000 years ago) that living in a tribal unit offered protection. Following the tribe became a survival instinct well-entrenched in the core of our being. This unconscious instinct is extremely powerful, primarily in moments of crisis or when our survival is in jeopardy. So, when stocks tumble and those around you sell in a panic, it’s almost impossible for someone with an intact genetic code to resist the tendency to follow the tribe towards a safe haven (in this case, towards the liquidity of cash).

 

From our empirical observations, it seems that some members of our species are immune to this call of the herd. They can go left when the rest of the tribe goes towards the right. Their attitude isn’t influenced by the behavior of the tribe. Their genetic code seems to not have the “tribal gene”. It’s difficult to evaluate what percentage of humans have this particularity but it’s a minority. And it’s probably those who eventually become creators (artists, scientists, writers, entrepreneurs, etc), as the act of creation requires the capacity to make something new and to forge a new path different from others. To create is to go where there was nothing before. Creating is the antonym of following.

 

Such a theory, which is of course impossible to prove, probably sounds arrogant despite that not being our intent. We are simply on a quest for learning.

 

Subjectively, we believe that our team at Giverny Capital doesn’t have this tribal gene. This line of thinking enables us to answer the question of why we didn’t panic during the crisis of 2008-09 and remained optimistic while nearly all others sought refuge.

 

Many decades ago, Warren Buffett told a group of students: “To succeed in the market, be fearful when others are greedy and greedy when others are fearful.” This simple phrase captures the essence of success in the market.

 

 

To Our Partners

 

Using rationality, along with our unwavering optimism, we trust that the companies we own are exceptional, led by top-notch people, and destined for a great future. They should continue to prudently navigate the often troubled waters of the global economy. Furthermore, the valuation assigned by the market to these outstanding companies is very similar to the valuation of an average company in the S&P 500, despite the fact that our companies have better growth prospects than average. Therefore we consider the appreciation potential for our portfolio, both in absolute and relative terms, to be well above average.

 

We also want you to know that we are fully aware of and grateful for your votes of confidence. It is imperative for us to not only select outstanding companies for our portfolios, but to also remain outstanding stewards of your capital. We certainly like to achieve good returns (and have developed a taste for it), but it must not come at the cost of taking undue risk. Our philosophy to favor companies with solid balance sheets and dominant business models, along with purchasing these companies at reasonable valuations, is central to the risk management of our portfolios.

 

We wish a great 2014 to all our partners.

 

 

François Rochon and the Giverny Capital team

See full PDF here.