Farnam Street Investments letter to clients for the month of January 2016.

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“Far and away the best prize that life has to offer is the chance to work hard at work worth doing.” - Theodore Roosevelt

January marks 6 years in operation for Farnam Street Investments. It’s been an outstanding experience so far! It can be paradoxically both daunting and comforting to engage in your life’s passion every day. Knowing it’s the first few miles of a marathon is a little intimidating, especially when you’re not quite certain where the course will take you. At the same time, we’ve known from Day 1 that the bricks we’re laying in these early years are the foundation of something special, and we have a lifetime to build it right. We want to enjoy the journey and not just rush for the destination.

Thank you to everyone for your support along the way. We’re blessed with a truly incredible client base. Here are some pictures from Farnam Street Investments' Annual Bash in October. It was such a privilege to thrown on the aprons and serve everyone up a fun time. It felt more like a family reunion than any stuffy “business lunch.” Thank you for coming and making it special.

https://goo.gl/photos/avz41Hmv8uGxjGBk8

Farnam Street Investments - Market Update

“What The Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect...and an uncomfortable digestive period is likely now…The Fed is a giant weapon that has no ammunition left…It was The Fed, The Fed, The Fed... in my opinion they got lazy…and it is time to go back to fundamental analysis ...and not just expect the tide to lift all boats...and as [The Fed] tide recedes we are going to see who is wearing a bathing suit and who is not.” - Former Dallas Fed President Richard Fisher, January 2016

2015 was an interesting year in the markets, though it’s possible you didn’t notice. The median stock in the Russell 3k, which comprises 98% of U.S. equities, ended the year down over 20% from its 52-week high. That means at least half of the stocks in the US had losses greater than 20%-- the definition of a bear market. So how come there wasn’t more media attention and why did the index basically stay flat for the year?

A handful of large stocks (in particular Facebook, Amazon, Netflix, and Google) effectively carried the index and kept it from sliding with the majority of stocks. Remember that the indexes are “market-cap weighted,” meaning the bigger the company, the more the impact on the index. When just a few performers do all of the heavy lifting, this is called bad “market breadth.” Poor breadth has historically lead to the index crashing not far behind as the stallions run out of steam and catch down with the rest.

The 4 stocks (FANG) saw their market prices grow 60% during the year while their earnings only grew 13%. This implies very high expectations for the companies’ future prospects. A “P/E” multiple is one measure of how high expectations are. One way to look at it is how many years it would take for the business to earn the amount you just paid for it, if it brought in a steady state of last year’s earnings every year going forward. Here are the trailing twelve month P/E’s for 2015’s 4 big movers:

Facebook (107x), Amazon (950x!), Netflix (307x), Google (32x)

It will take an investor almost 1000 years for Amazon to “break even” if it continues with its current earnings rate. We’re patient, but that’s a little much for even us. People are willing to pay that many multiples because they believe the earnings are going to grow. You really need a rosy future for earnings to grow that much and allow for a good investment return. Any hiccups along the way and expectations (and your investment) come crashing down. We operate on the other end of the spectrum. We’d rather buy a company at 5x earnings or less if we can. Then even a mediocre future can create good investment results. A lack of 5x P/E companies available in the market left us no choice but to be in safe cash.

Based on the start of 2016 so far, it looks like our patience may be well rewarded. As of this writing on January 13th, Facebook is down -8.8%, Amazon -13.9%, Netflix -6.8%, and Google -7.5% in just 2016. We are perfectly situated to take advantage of opportunities that are emerging every day the markets tick down. If things get really bad, expect a call from us requesting you send more money, because that will be the time to invest and really get rich. You’re always welcome to preempt our call as well.

Farnam Street Investments - Yarak, Profit First, and Automation

“A fat wallet is the enemy of superior investment results.” - Warren Buffett

Yarak is a falconry term of likely Persian descent that describes when the bird is in a state of hunger (but not to the point of weakened), super alert, and laser-focused on the hunt. When in this state, the bird has incredible clarity, energy, and singularity of purpose towards its most important objective: hunting to feed itself. The bird is the purest expression of its genetic hunting potential when in yarak.

If you’re a successful small business person, which includes many of our clients, how can you harness the yarak phenomenon and put your business in a state of hyper-focus and readiness to hunt? There’s a simple trick to do just that. Most businesses hustle to create revenue, pay out their various expenses, and with any luck, there’s a little profit leftover for the owner. Here’s what we learned in business school for about $120k in combined tuition: Revenue - Expenses = Profits. It makes sense. But it is exactly backwards if you want to succeed. The process you should follow is:

Revenue - Profits = Expenses

Don’t wait to see if there’s anything leftover. By carving out the profits before anything else, you create a constraint on the resources available to go toward your expenses. This constraint unlocks your creative juices to meet clients’ needs, streamline operations, and only allocate to the expenses which truly generate value for your customers. There’s no room left for fluff and bloat. Difficult decisions on how you should run your business become obvious.

People will often make big, lasting life changes when they’re confronted with an existential scare like a heart attack. A key ingredient of yarak success is to manufacture a “fake heart attack” for your business. To do this, you need to shunt your profits out of the business and into an account that is difficult to access and generally ignored. This will put the money “out-of-sight and out-of-mind,” and when you look at your company’s shrunken operating bank account, it will create a yarak-like sense of urgency that would otherwise be clouded by a large cash balance. No longer fat, dumb and happy, maybe you make that extra sales call or hold off on that unnecessary expense. Everyone wants to run a tight ship, but the best way to harness your entrepreneurial verve is to tie your own hands. It will

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