Investors’ Letter forMarch2015The fund was up and beat the global index by a percent in March. More generally though, markets remain at elevated levels – testing the stamina of short sellers in particular. Let’s explain how we see it.
There are plenty of good companies – ones that you would want to own for decades and which have superior economics – but they are 25-40 percent overpriced – and 50 percent higher than where we are excited to buy them.
There is more nonsense in this market than we have seen since dot-com. The two centers of market nonsense are China and Biotech, but the nonsense is widespread.
Our default position is long quality stocks, short nonsense – but it is increasingly difficult to buy quality (it is not cheap) and equally hard to be short nonsense – because nonsense is still going up – and there is a point where you have to be stupid to stand in front of the freight train.
[drizzle]At one level this is standard top-of-the-market behavior. In most big bull markets the silliest stocks go up hardest as the bubble peaks. In the dot-com era it was considered a negative for a company to have earnings. If it had “earnings” you had to value it on normal metrics. If it didn’t you could use new-fangled metrics like page-views. This was nonsense – but people believed it.Today the nonsense is a little more subtle. We know biotech companies that are testing drugs that have been tested before and failed. We also know companies testing widely-available substances as drugs (which are almost certain to fail but if they do succeed it will be impossible to charge high amounts for the pills). These have market caps in the hundreds of millions and they seem to go up more or less continuously. They are guaranteed to fail.Shorting biotech during its strong run-up has been costly – and so we have had to cut our position. In many instances the promoters are the same people who previously promoted Chinese reverse mergers we shorted to near zero in 2011.We will make money shorting biotech promotes one day – but not today – and we cannot predict the timing of when that day will come. So we have re-aligned our short portfolio and, on the visit to China described later in this letter, found some non-Chinese listed (but China exposed) additions to the portfolio.Differences to the dot-com bubbleThis differs somewhat from past bubbles.
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The dot-com boom was strange – during 1999 value stocks were not expensive – and continued to get cheaper. Buying breweries in New Zealand at 9 times earnings was not a way to make money in 1999 – as they bottomed at below 7 times earnings. [No we are not kidding – John bought a huge number of New Zealand value shares during 1999.
But if you retreated to buying value stocks you did really well over the next four to five years. The trick in 1999 was simply to avoid the heat – avoid it by miles. It didn’t matter whether you bought Wells Fargo or DB Breweries (though the NZ brewery was better). All that mattered was you avoided tech or anything with a website (such as a newspaper or a dot-com). The insane bits of the market were truly insane – but much of the rest was cheap.
As long as investors could put up with underperforming badly in 1999 they were fine. [Many a fund manager found their clients were leaving and decided to get-on-the-dot-com-wagon rather than risk another six months of underperformance… However dedicated value managers had their glory years immediately after the dot-com bubble.]At the risk of stating the most infamous four words in markets (“this time it’s different”) we will state that this time it is harder. If there were large sections of the market that were cheap, that we understood, we would just retreat there – but, with limited exceptions, these are farless plentiful.There are some exceptions. We do not mind Telecom stocks. We flat-out-love some European aerospace – which competes with American companies and whose economics have improved dramatically with the stronger US dollar.If we could short stocks at will without too much risk we would. But almost every short-biased fund in the market has been severely beaten up by market movements – and we will stay as short as we can without incurring such risk – but we are going to stay no shorter. And we will limit our exposure in those truly bubbly sectors which continue to offer (i) the lure of manufactured yield or (ii) excessive discounting of disbelief. We could fill the entire portfolio with suspect biotech stocks – but we would not be able to manage the risk. We figure at some stage this will change and we will make a lot of money short-selling – but that time is not now.ChinaWe have spent a while (falsely) believing the biotech sector could not get much nuttier. It kept going up when it made no sense.But just to remind you how crazy things can get John went on a tour of China. Part of this trip was an organized study of the recent anti-corruption campaign in China (visiting politicians, bank officials who police money laundering, people who run auction houses, real estate developers). The rest of the tour was private work (travelling with one other person who spoke fluent Chinese) mostly observing companies we believed to be suspect.We will explain how nutty it was with some anecdotes.ChiNextChiNext is a NASDAQ style exchange attached to the Shenzhen stock exchange – but with lower listing standards. It is also the hottest stock exchange in the world – with almost every stock chart looking hyperbolic.We met a local fund manager who assured us that careful research suggested that 40 percent of the companies listed on the exchange literally did not exist. [This is like the Chinese reverse mergers in the USA in 2011.]That did not worry them though: “we have the other 60 percent to choose from”.