JRW Financial commentary for the third quarter ended September 30, 2015.
Dear Clients and Interested Parties,
The broad market, as represented by the Standard and Poor’s 500 index, fell (6.9%) for the quarter, with the other primary indices, the Dow Jones Industrial Average and the NASDAQ Composite Index, declining (7.6%) and (7.4%) respectively.
Since the March 2009 bottom, the stock market has experienced one of the strongest bull markets in history. Much of this march higher has been orderly without significant pullbacks or corrections. However, corrections are normal. Supply and demand dynamics, mixed with investor psychology, drive market prices over short periods. Over longer periods, compounding of per share business value takes greater precedence in the share prices of common equities. Volatility and downside price action is a fact of life when investing, and to some extent the low-rate, high-liquidity environment of recent years brought about complacency.
The 3rd quarter was rough on investors in public equities worldwide. I cannot tell you for certain why stocks went down, why volatility came back into the markets with substantial velocity, or whether the 4th quarter is likely to be similar to the 3rd quarter in terms of volatility and share price declines, or whether global markets will find some reprieve from the recent selling pressure. As investors, we have to be prepared with a portfolio that will prevent permanent loss of capital no matter the broad market conditions. I do believe we are so prepared.
JRW Financial – Refrain From Focusing On Performance Metrics Over As Short A Time Period
As always, I counsel you to refrain from focusing on performance metrics over as short a time period as a single calendar quarter because I believe that has the tendency to spur extreme short-termism. Declining account balances and unrealized losses do more to spur fear and agitation than rising account balances and unrealized gains do to spur pleasure and satisfaction. I recognize that in myself and I am certain it is the norm for the majority of people.
I wrote the following last quarter when our portfolios performed positively and outpaced the market:
As we stress time and again, quarterly and even yearly performance is not truly indicative of the quality businesses we own and the potential for compounding investment returns over a long-term time horizon. Our method of investment operations may be out of favor for significant periods of time, including most notably during peak bull market periods. But judged over long periods of time that encompass full market cycles, which is the time period on which we focus our investments, we believe our performance will outperform our benchmark, the S&P 500 index, as well as offer exceptional compounding potential with limited risk of permanent capital loss.
You’ll find that in both good market periods and bad, and after both positive and negative short-term returns for our portfolio, I will beat the drum on the same basic message: think long-term. My goal is to outperform the returns you could get from your hard earned money in any other conceivable way over a multi-year time period that encompasses a complete business cycle. We cannot and will not outperform (or even have positive returns) all of the time – but we are confident that we will do so over time.
Warren Buffett has stated that the stock market exists merely to make the buying and selling of businesses easier, not to assign value to those businesses. Thus, we do not sell businesses on the basis of declines in share price. We do not understand the line of thinking that says: “I own a wonderful business with a durable competitive advantage and significant prospects for compounding growth over the next decade. If only the price would go down, I could sell my shares.” That is the opposite of how we believe share price declines should be handled by long-term investors seeking to purchase premium businesses at discounts to per share business value.
Some of the businesses we own are priced significantly below the price at which we purchased shares. For some clients, this means an unrealized loss of some size, depending on the time period in which accounts were opened and purchases made. This is normal. When purchasing shares in great businesses, we try to buy well, meaning at a price that will provide us a margin of safety against permanent capital loss. Stock prices fluctuate over the short-term, sometimes dramatically, and oftentimes irrationally. If we buy at the exact bottom of a price range, it is sheer luck and not repeatable. Frequently, share prices will decline after purchase, and this should not cause worry or concern.
JRW Financial Core Equity portfolio
Let’s look at some representative examples from the JRW Core Equity portfolio for how stock prices can fluctuate. The following results are from the last year of trading:
- Google has traded as low as $490 and as high as $713
- Apple has traded as low as $92 and as high as $133.
- MasterCard has traded as low as $69 and as high as $99.
- Berkshire Hathaway has traded as low as $125 and as high as $152
- Outerwall has traded as low as $50 and as high as $84.
- World Wrestling Entertainment has traded as low as $9 and as high as $23.
- Interactive Brokers has traded as low as $22 and as high as $45.
- Chicago Bridge & Iron has traded as low as $32 and as high as $59.
I wish I had a crystal ball that allowed me the foresight to know when a stock would trade at its lowest and highest prices in a given year, because our approach to investing would be much different. However, neither I nor any other market participant I know has such a tool, nor the ability to forecast with precision the occurrence of these price events.
The market goes through periods where the baby, the bathwater, and the kitchen sink are all thrown out. For patient investors, these periods provide buying opportunities when corrected, but also provide heartburn in the short-term. I continue to stress patience with the businesses we own and I judge their worth to our portfolio in terms of business operations and not price fluctuations. It is not easy to sit and watch account balances decline significantly, but over a long enough period of investment, it is inevitable.
In general, our investment success or failure will be dependent upon three factors: the fundamental and durable nature of the underlying businesses we own and their economics, the skills and abilities of the management teams with whom we have partnered, and the margin of safety built into the purchase price of our ownership interests. Any of these could cause material harm to our investment thesis. The usual culprit is deteriorating fundamental economics of the business, which is why we spend the majority of our research time on the competitive landscape and the durability of returns on invested capital.
For value-oriented investors, returns are rarely smooth. However, the further out you extend your expected return period, I believe you will find the JRW Core Equity portfolio will compound your capital at substantially satisfactory rates.
JRW Financial – New purchase: Interactive Brokers Group
During the third quarter, we made one new purchase, two sales, and added selectively to businesses we already own. The new business we purchased in the JRW