Greenhaven Road Capital letter to investors for the second quarter ended June 30, 2015.
Dear Limited Partners,
We were fortunate to have another strong quarter of performance on both a relative and absolute basis. The fund is up 13.7% YTD vs. overall markets that have effectively languished year to date. As always, please view these results through the lens that short-term outperformance and underperformance is effectively random. If I told you we outperformed on any given day, you would shrug and say “so what?” That should be the reaction to any given quarter and even year. There is no attempt being made to beat a specific index or eliminate volatility. I am just trying to find the best investments I can and hold on as long as possible. My goal is to outperform your non Greenhaven Road investment alternatives such as cash and ETFs – not every single day, week, month, quarter, or year – but over a multiyear time period. As the investor John Paulson once said, “Our goal is not to outperform all of the time – that is not possible –we want to outperform over time.” For the investing legends who have actually accomplished this feat, the path was rarely smooth. For example, Charlie Munger underperformed the market by 37% between 1972 and 1974. If one were to view his performance only through that two-year period, you would question his competence and decision to leave his law practice. However, the same partnership that underperformed the market from 1972-1974 outperformed the market by almost 18% a year over the full 14 years of the partnership, an astounding accomplishment.
I continue to believe that our small size, long-term orientation, and stable capital provide advantages that will play out over time. In fact, when you compare the cumulative results of Greenhaven Road to the S&P 500 over the four-and-a-half-years of the fund, the results are quite favorable. After all fees and expenses, Greenhaven Road has compounded capital at just under 19% per year vs. just over 14% for the S&P 500, and just over 4% for the Barclays Hedge Fund Index. This is meaningful because of the power of compounding. The small differences year after year add up. The exact magnitude of 5%, 10%, or 15% of outperformance per year depends on the number that is being outperformed, but a reasonable rule of thumb is that an incremental 5% a year over a 30-year period will lead to four times as much money. Simply put, instead of having say $5M at the end of 30 years, if you got an extra 5% per year, you would end with $20M. In the event of 10% outperformance, the results are even more stark, leading to in excess of 15 times as much money at the end of 30 years. That base case $5M would be $75M in a scenario of 10% outperformance.
One of the drivers of outperformance in the quarter was Rally Software, which I profiled in some detail in the second quarter 2014 letter. The initial investment effectively doubled over the course of a year. A phenomenal investment. However, to me, the performance is less interesting than the reception the investment thesis received. As an opportunistic investor, I look high and low for ideas to invest in. One of the places that has been a fruitful source of leads over the years has been online investment forums such as Value Investors Club and Sum Zero. These are curated communities of “professional” investors where fellow members are allowed to ask questions and rate each other’s ideas. To have access to the flow of ideas, members must contribute ideas annually. Since Rally Software had not appeared in any value forum that I was aware of, I wrote up the investment thesis for the Sum Zero community to maintain my access. Let’s just say the Sum Zero community was not overwhelmed by the brilliance of my Rally Software analysis. In fact, my write up was ranked in the bottom 20% for expected performance among all ideas submitted. To be fair, my write-up was shorter than many because I am trying to find great investments, not write the longest and most detailed write-ups. However the community is also not limited to Warren Buffett, Charlie Munger, Bruce Berkowitz, and Monish Pabrai: a community where I would clearly be in the bottom 20%. The low rating serves as a reminder that my investing style is often not well received by the larger investment community. I am not going to win a lot of beauty or popularity contests. In a world filled with social media, blogs, and talking heads, there is a short term tyranny of the articulate. Those who can speak the most clearly and string together the most advanced arguments in the simplest terms are deemed the “winners.” The articulate get the most “likes,” “re-tweets,” “favorites,” and are voted the highest expected returns. Is there a connection between short-term popularity and long-term performance? I am skeptical. The data suggests that I am clearly going to lose the short-term battle of the articulate, but if investment performance holds up, the long-term war for performance appears winnable, and that is all I really care about.
Greenhaven Road Capital - Let Them Use Index Funds - The Case For Selective Management
Can we continue to outperform? Can we continue to beat index funds? I keep coming back to this issue, so clearly it haunts me on some level. Have we just been lucky? We will certainly have our down periods (quarters and years) at some point. The conventional wisdom is that index funds and ETFs are unbeatable. Active management is dead. The low fee structure of an index fund is insurmountable. But what is an index? Murray Stahl continues to put out really interesting research addressing these questions and others that I wrestle with, but with far more depth. This month, Murray delved into the existential question of what is in an index fund? (http://www.horizonkinetics.com/docs/InternationalDiversification_June2015.pdf) He points out that financial planners who want their clients to diversify in a low-cost way will often recommend that their clients own primarily U.S. domestic equities through something like the S&P 500 with a sprinkling of international through MSCI EAFE Index. This seems like a reasonable and prudent plan. It can even sound scientific if you recommend a portfolio with precise allocations such as 70% equities - with 73% domestic equities (S&P 500) and 27% international (MSCI EAFE). It can be back tested and can lead to fancy charts and a sense of certainty for the investor/client. Unfortunately, businesses and groupings are not as clear as they may appear. When you dig into the S&P500 as Murray has done, of the top 50 companies in the S&P 500, a full 44% of revenue is in fact from overseas and not from the US. When you dig into the “International” companies in the MSCI EAFE index, it turns out that 30% of their revenue is from the U.S. In addition to the buckets not being as neat as one would hope for, it turns out it is really hard to know what you own or why you own it when you own 500 of anything.
I cannot run a