2015 was one of the most challenging years we’ve faced as a value-oriented manager. Our investment style, broadly classified under the banner of value investing, was out of favor during the year and suffered almost double-digit underperformance compared to growth investing. The Russell 3000 Value Index was down over 4.0% while the Russell 3000 Growth Index was up over 5.0% in 2015. This bifurcated market was made worse by company-specific setbacks. However, we believe our portfolios are coiled for success. While we were down 6.0% during the year, our portfolios look priced to deliver double-digit percent average annual returns over the next several years.
While our results were weighed down by value weakness in general, a series of non-correlated negative events struck some of our individual holdings. Poorly-timed new investment commitments and missed opportunities to monetize gains didn’t help. Each year brings its own surprises–that’s why investors should build diversified portfolios–however, 2015 brought many challenges together at the same time. Our largest winner (GE, up over 23%) righted some of the wrongs. We weren’t alone in our struggles.
The following are some of the greatest investors in the world, all of whom we deeply respect, and all of whom struggled mightily in 2015:
We do not share this list as if to say, “hey, we weren’t as bad as them.” We take responsibility for our year. We do share the list, rather, because it is informative. The fact that so many of the world’s greatest investors had tough years as a group, compared to a small gain from the S&P 500, should make it apparent that there was a structural challenge for value-oriented, long-term focused, research-driven, business owner type investing.
I am reminded of a day on the golf course with my brother David. He struck a brilliant 5-iron shot, the fruit of his implemented swing changes, a good twenty yards over the green and into a lake. Frustrated, he looked to me for what I think was sympathy. Instead, I stated, “Great shot.” Indignant, he asked if I hadn’t just seen him put it in the water. “Focus on the process. Not the outcome. You just hit a 5-iron twenty yards longer than you ever have. Don’t worry about the outcome on this one attempt. Keep getting the process down and the results will come.” And so, I say the same thing now about our investment approach.
If an investment strategy worked year in and year out it would be pursued by everyone and cease to work as investors bid away its advantage. The fact that value investing doesn’t work every year is the reason it works long-term. The value premium, historically an extra 2.5% per year on average above growth stock returns, still exists and will assert itself again. And so we stick to the process. We can’t promise a certain return in any given month, quarter, year, or even a string of years. We can only promise to deliver a repeatable process that logically should lead (and historically has) to superior long-term performance.
We manage a relatively concentrated portfolio of individual common stocks–20 at year-end. This number of securities sufficiently reduces the risks of under-diversification while allowing each position to meaningfully impact portfolio performance. We had seven securities that declined more than 10% during 2015. The companies struggled for reasons unrelated, which makes their 2015 clustered occurrences so unusual. We’ll discuss two of our largest detractors in detail and have a few other notable mentions with specifics below. But the point is, we believe last year’s largest detractors will be tomorrow’s biggest winners.
2015’s performance, in our opinion, is transient. There is no doubt that the intrinsic values of some of our businesses have been impacted, but the companies’ stock prices have fallen far more than those business values. Because we intend to own them for the next several years, if not longer, the respective troubles should dissipate and disappear altogether in time. When they do, we expect the securities to return to levels that will still represent double-digit returns from our original commitments.
First, despite numerous calls for an imminent recession in the United States over the last several years, we noted again last January that “the current economic landscape is favorable to growth.” The U.S. economy did in fact grow in 2015. Today, we are watchful that the industrial weakness in the U.S. economy doesn’t spread into other sectors. Our baseline expectation is that the U.S. economy will expand over the next few years. Though, there is an elevated risk of recession due to the downturn in the oil & gas sector, the strong U.S. dollar, and international weakness. The fact that housing starts, new home sales, and auto sales continue to make new highs gives us some comfort that a more widespread downturn remains unlikely. That bodes well for stocks in general and our portfolio in particular.
Second, we nailed the Federal Reserve rate increase. We stated in January that the September meeting would be the earliest that the Fed would move. We noted in September that we thought the Fed would raise rates in December. At the Federal Reserve’s December meeting, the Fed raised rates for the first time in nearly a decade.
Third, we stated that broad stock markets were priced for low returns and alas, the S&P 500 delivered a paltry 1.4%. We think the stock indexes–and investors in passive index funds–will earn somewhere between 4% and 6% per year on average over the next ten years–a far cry from what our portfolio of individual common stocks is priced to deliver.
We got these big picture themes right.
As stated above, we do not promise a certain return in any given month, quarter, year, or string of years. We instead promise to methodically and repeatedly follow a logical process to find good companies at good prices, to research them diligently, and to buy them when we think the chance of losing money long-term is low and the probability of better-than-market returns is high. As golfing great Sam Snead said, “forget your opponents; always play against par.” Likewise, we focus on letting our process work long-term.
We believe our individual company research and security selection will deliver higher long-term returns, net of all fees, than can be achieved by investing passively. We also strive to manage business cycle risk, through both our company research and our proprietary economic research. Combined, we expect to outperform the broad markets by at least a few percent per year, on average, across market cycles. “Across market cycles” is key. A market cycle encompasses an economic boom as well as an economic recession; it contains a bull and a bear market.
Since Black Cypress’s inception in 2009, the S&P 500 has returned over 15% per year. Markets are yet to experience a negative year and there has not been a recession in the U.S. to date. Not only have broad market indices not experienced a material and persistent downturn, growth stocks have outperformed value stocks since 2009. And yet we’ve more than held our own (we’re still ahead of both market indexes and value managers as a group since inception) in an unfavorable environment to our investment approach.
We expect the headwinds