Greenhaven Road Capital letter to the limited partners for the fourth quarter ended December 31, 2015.
Dear Limited Partners,
Two thousand fifteen marked our fifth anniversary as a fund. Over this five-year period, we have been able to outperform the S&P 500 and the Russell 2000 indices. Likewise, Greenhaven Road has returned more than 14% net of fees vs. 9% for the Russell 2000 and 12.5% for the S&P500 including dividends. Our three-year numbers are even better, with Greenhaven returning almost 50% more than the Russell 2000 and 35% more than the S&P500. For 2015 itself, we ended almost where we started -- the fund was up just over 1.5% for the year. This was in line with the S&P 500, and substantially ahead of the Russell 2000, which has a far greater overlap with our holdings. For those investors who joined the partnership later in the year, your statements will reflect a negative balance since we gave back gains over the course of the year. In keeping with our fee structure and agreement, I received no compensation because we did not exceed the 6% hurdle rate. In addition, with our high watermark, your funds will have to be restored before you pay any fees. As I write in almost every letter, we will have down months, quarters, and years. We cannot outperform every period, but hopefully over time our patience will be rewarded. As you will see throughout the letter, I think the fundamentals of the companies that we own are solid and over time our investments in these companies can realize significant appreciation.
Greenhaven Road - Efficient Markets?
There is a widely circulated belief that the market is difficult to beat because it is so efficient. I would argue that, over the short term, the opposite is true – the market is actually difficult to beat because it is incredibly inefficient and mis-pricings can be even more exaggerated in specific sectors. In 2015, if you removed the largest growth stocks (Facebook, Amazon, Netflix, and Google), the market actually declined 2.7%. In my mind, the volatility of the market is evidence of persistent mispricing. Simply put, over the course of a year, the high and low prices for many companies are so different that they cannot possibly reflect the value of the company over that timeframe. During any given year, the share price often zooms by the actual value of the company, only staying on fair value for moments.
Let’s look at a couple of simple examples of companies that make up the larger “market.” Hormel Foods has been in business for more than 120 years, selling a variety of food products, most notably Spam. In the last year, their overall sales are down slightly (less than 10%) and their earnings are up slightly (less than 10%). The 52-week low for Hormel was $50 and the 52-week high was $80. We don’t own Hormel, and I am not completely conversant in the demand drivers for Spam or the inputs. Share price should be some proxy for business prospects going forward and assets already owned. Did the business prospects and assets of this 120-year-old company really change by 60% from the lows of $50 to the highs of $80? Was Hormel fairly valued at each step along the way? Did the long term trajectory of Spam really change by 60% over 12 months?
Shortening the timeframe, a company that is on my watch list recently had a greater than 20% intraday swing in pricing and ended the day with virtually no price change. Did the company’s earnings prospects really vary that widely over the course of an eight-hour trading day with no significant news released? You can play this exercise out by looking at share price and profits over time, and I think you will also conclude that the variability in prices is far greater than the variability in business prospects over a day, a month, and a year. With all due respect to the academics, I don’t believe that markets are efficient, and the volatility - while painful - creates opportunity and also makes trying to outperform over very short periods of time a fool’s errand.
Greenhaven Road - Fundamentals Matter
Even though we outperformed major indices over a three- and five-year period, we did not outperform every quarter, month, or year. In fact, during our first year in existence, we underperformed dramatically. It doesn’t make it hurt any less, but we are in good company. A recent study by Research Associates looked at the 350 mutual funds available to investors in 1970; only 100 made it to 2014 with the other 250 funds closing or merging with other funds. Of the 100 that survived, 45 beat the market, but only three beat the market by more than two percentage points per year for the 45-year period. Even these three “superstar” funds that are in the top 1% of the funds from 1970 underperformed one-third of the time on a rolling three-year basis. What should you take from this? There are going to be times when you feel like a genius for putting a portion of your savings in Greenhaven Road, and there are going to be times when you don’t – and that is okay. What I want you to feel is comfortable in our approach, which is concentrated on our best ideas, patient (low turnover), value-focused, with a preference for smaller companies where we can have a greater analytical edge, with aligned incentives (this is my life savings and I only make money with you).
As valuations fluctuate from undervalued to overvalued with the briefest of pauses at fairly valued, the rock that I have to hold onto is fundamentals like the balance sheet, earnings, cash flow, growth, and product cycles. Over time our 50-cent dollars will appreciate, or at least afford us a great enough margin of safety that we should get our money back. That is why research matters and knowing what companies we own and why we own them matters. We will make mistakes, but our buy/sell and hold decisions will be grounded in fundamentals that over time do matter.
Greenhaven Road - Good Different & Bad Different
Included with this letter is a book that I read this past year, “Different: Escaping the Competitive Herd” by Youngme Moon. I will try not to spoil the book for you, but it does a great job of highlighting businesses that are intentionally different than their competitors and very successful. One business profiled is Ikea. When Ikea came along, they broke several rules of furniture retailing. Ikea doesn’t promise the furniture will last forever. They position it as a durable good with a life of a few years, greatly lowering the anxiety of the purchaser. According to the book, the average American will have as many wives as dining room tables (1.5) and has historically approached the table purchase with great apprehension. Ikea is different from traditional furniture retailers in multiple other ways, including the lack of hovering sales people. Ikea puts the burden on the consumer to transport the furniture home and assemble it. The company launched with only four styles of furniture, greatly reducing selection. Ikea was different in that it subtracted service, delivery, choice, and