Greenwood Investors letter to investors for the first quarter ended March 31, 2016.
Dear GreenWood Investor:
Results this quarter were volatile as our Italian stocks, which all generate the lion's share of their revenue outside the country, were dragged down in the second worst performing index in the world (Chinese domestic stocks were the worst). While many funds talk about sophisticated-sounding strategies which aim to reduce volatility on a short-term basis, largely because their month-to-month investors judge them on lower volatility, we've never discovered a single volatility reduction strategy that doesn't magnify absolute returns through leverage.
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The leverage in our results comes from the grossly undervalued nature of the investments. Because on the whole, they are very well run, have very limited fundamental downside, and have numerous value-generating events in their near future, our medium and long term returns are competitive with strategies that use leverage. We will never use leverage, however, because this only magnifies the risk of sudden, unpredictable and significant permanent losses.
Many think low-volatility asset classes are safer, yet every once in a while, unprecedented volatility (>6 standard deviations) hits these assets, almost like clockwork. The 7-8 standard deviation move in 10-year treasuries in the fall of 2014 is one of thousands of recent examples. According to Jamie Dimon at JP Morgan, that move was only supposed to happen once every three billion years according to standard volatility models.1 Three billion year periods are occurring more and more frequently as volatility models have routinely been unable to predict future risk. The illusion that volatility equals risk is perhaps one of the most dangerous in the financial world because it falsely temps many to assume lower volatility allows them to, or even forces them to, magnify the lackluster returns through using margin debt.
Your author firmly believes that one must either accept volatility on a short term basis, or accept the risk of large permanent losses on a long-term basis. Or perhaps a third option: no returns. It seems like a solemn result for the enterprising and optimistic investor.
How does Greenwood Investors respond to volatility?
To us, the question is not, "what is the stock's beta, or relative volatility?" We have never targeted a beta level, even though on a whole, our portfolio has been very conservative (with a beta of 0.60 at March 31). Rather, the more relevant question is how do we respond to volatility? One of the key requirements for successful investing is having right temperament to respond rationally to this volatility. During the quarter, not only were we unshaken by the volatility, but were able to take advantage of a few buying opportunities. We now have our largest holding in EXOR at a particularly great price at a particularly great time- a move I've been waiting to make for a while now. Prior to the quarter, the market was insisting we pay a record low discount for the group of assets EXOR holds. When we purchased more in the quarter, it was trading at a record high discount over over 40%. As you well know, we love its underlying investments in Fiat-Chrysler, Ferrari, CNH Industrial and now PartnerRe. We collected our thoughts on the company in an update posted on our website in February.3 We responded to the volatility opportunistically, and thanks to our overly transparent process, our investors responded very well too. We have had no clients reduce their investments, have seen multiple additions to accounts and subscriptions, and are welcoming a handful of new clients as we speak. A warm welcome to our new friends!
It was a big quarter for the growth of GreenWood Investors in numerous ways. Just last week your author made his first short presentation to a group of sophisticated European investors at ValueEspana in Madrid. Of course the presentation is available to investors in The Grove and a brief memo will be posted later today or tomorrow.
One of the first books a young enterprising investor reads is the Art of Short Selling by Kathryn Staley. Even if one doesn't intend to borrow shares or bonds to sell them short, viewing ideas through a skeptical lens has always been a very important part of any analytical process. It's actually the reason why the downside potential in a worst case scenario is one of the most important parts of the security selection process we’ve developed. In the past our biggest mistake we've made on investment ideas, which we have since corrected, has been failing to appreciate just how ephemeral a company's access to capital can be. If there's a chance the company will need to access capital markets in a contrarian or distressed situation, it has generally not been wise to bet on those market conditions improving. Evaluating a long idea though the lens of a short seller has the obvious benefit of preventing us from missing this again.
We very rarely short securities, particularly equities. Given one of the pillars of our process is to consider the risk-adjusted return profile of every investment, the unlimited upside of equities often means we need to find businesses going obsolete or bankruptcy candidates. Additionally, because we specifically shun “crowded,” trades as part of the process, and most endangered businesses have a very heavy short interest, we very rarely find a short that satisfies these relatively undemanding criteria. Our first equity short in a long while is in a business that is facing severe headwinds in all core divisions, and we believe will need to be bailed out by its government within the next year. In the most optimistic scenario, we believe the company is worth what it currently trades for on a sum-of-parts basis, while ignoring the headwinds the company is already facing this year. Simply flowing the current operating environment through its operating divisions, and because of ballooning liabilities, we believe the equity has no intrinsic value if we look to the company’s 2016 results. Core operating losses will substantially surprise sell-side estimates when the company reports financials. Even if the macroeconomic environment improves substantially, we don’t believe the equity has much upside opportunity as a result of specific impairments at the company. Regardless, on a short-term basis, a few select long positions will face even further magnified upside opportunities in the event the global macroeconomic environment shifts to top gear.
The discussion of the short opportunity leads me to a broader topic of why we have focused over half our efforts on European opportunities over the past couple of years. Because sell-side analysts in Europe still use management's guidance in order to determine their own “estimates,” which are seldom based on any particularly sophisticated financial models or analyses, these “estimates” typically miss the forest for the trees. By way of example, when the management team of Rolls Royce withdrew its guidance for the financial year, consensus “estimates,” became widely divergent with the low end at less than half of the top end of the spectrum, and the average figure reflects a very confused and depressed environment for the year ahead.
The opposite can be said for our recent short position. Investors have still pinned their hopes on an outdated medium term profitability target which is no longer achievable. Rather than add a few points of operating margin profitability, operations have swung the other way by an even larger magnitude. Because the company has remained quiet for considerable period of time, analysts have not yet been warned of the financial repercussions of the current environment which is which is causing the company to generate considerable losses in its core operations.
American sell-side analysts are typically much more skeptical in their analyses of a company, and depend on their own fundamental assumptions. Most do not rely on management's guidance, and in fact always question it. As a result, a sell-side horde in America typically crowds out areas of inefficiency in the marketplace. We will always have domestic investments, and in fact we are conducting diligence on far more domestic companies now than we have in the past. However, we will always seek a confused or absent consensus. We have joined many of our smart friends that have dealt with this domestic reality by evaluating domestic companies that are under-followed by Wall Street.
Our risk-adjusted return profile remains at a historically unprecedented level, and as we’ve discussed in the past, this has frequently led to outsized future returns. We have significantly reduced our exposure to cyclical businesses (they are now only a quarter of the portfolio), and our portfolio as a whole has a far more attractive profile than any individual security we hold. I’m quite excited for the months and quarters ahead, and I’m honored that our new investors are as well. Thank you all for your trust and support!
Steven Wood, CFA