S&C Messina Capital Management annual letter to partners for the year ended December 31, 2015.
S&C Messina Capital recently launched a hedge fund on September 1, 2015, that invests exclusively in the property and casualty (“P&C”) insurance sector, the industry to which Warren Buffett deployed the majority of his discretionary capital at Berkshire Hathaway over the past 50 years.
S&C Messina Capital makes long-term, concentrated investments in the best publicly-traded P&C insurance companies with potential to compound book value at above-industry rates for many years. The companies in S&C Messina Capital's portfolio compound shareholder capital by utilizing underwriting strategies and philosophies similar to those utilized by Berkshire in its core P&C insurance operations since 1967 when it acquired NICO, Buffett's first insurance company.
This unique fund adheres to a disciplined set of Ground Rules, as outlined in its 2015 Annual Letter.
A top priority of the fund's strategy is its emphasis on downside protection and preservation of principal, especially during turbulent and volatile markets. P&C insurance companies inherently have high allocations to investment grade bonds that provide a strong floor for market valuations. As an interesting reference point, during January 2016 when the S&P 500 saw a total return of -4.96%, the fund was relatively flat at -0.05% net of fees while being 100% long and fully invested; however, the investment team indicates that this outperformance doesn't mean much, especially over such short time periods.
S&C Messina Capital utilizes a disciplined value investing approach to buy compounding companies at attractive prices. More details on investment strategy, investment philosophy and investment team are available on S&C Messina Capital's website.
The fund has a rare but highly attractive fee structure that caters to long-term investors. Qualified clients are charged only a performance fee above a minimum return hurdle with no management fees; additionally, such performance fees are charged only when the fund is above its high watermark. The fund is very selective in choosing its investors, accepting only those who understand the strategy, accept its Ground Rules and have a patient, long-term view.
The fund has outperformed most hedge funds in 2016 year-to-date (March 31st) with a return of 3.84% net of fees. The total return from the S&P 500 during the same time period is 1.35%.
Despite this outperformance, S&C Messina Capital's investment team indicates that the fund's strategy is to be assessed over longer time periods and given the uniqueness of its approach, comparisons to other hedge funds (or long-only funds and mutual funds) may not make sense.
For instance, they believe that even though the fund owns equities of P&C insurance companies, the investment team views the fund as still being exposed to fixed income, cash and other asset classes on a moderately levered basis due to the investment portfolios of the P&C insurance companies themselves. Furthermore, the investment team believes that ownership of P&C insurance companies, when their underwriting is consistently profitable, provides a natural, cost-less hedge compared to options or shorting stocks and other assets.
To My Partners,
We started investing through our investment partnership, S&C Messina Capital Investments, L.P., (“the fund” or “the partnership”) on September 1, 2015.
Before assessing our performance in 2015 and providing a general outlook for the partnership in the coming year, 2016, I feel that it is necessary to establish some ground rules. These are rules, to which we, the General Partner and the partnership’s investment advisor, S&C Messina Capital Management, LLC, (“S&C Messina”) hold ourselves accountable.
Such rules provide an initial framework with which we measure our ability to manage and deploy the partnership’s capital. Thus, the ground rules provide a philosophical guide for the relationship between us and our investors. Prospective or current investors in the partnership who do not agree with these rules with respect to their capital invested in the partnership will most likely be disappointed and should not join the partnership.
S&C Messina Capital Management - Ground Rules
- Our goal is to outperform the S&P 500 on the basis of annualized total returns, including dividends reinvested, over a period of 5 years. Year-over-year performance is guaranteed to be lumpy and volatile, but over 5 years we aim to compound invested capital at a higher rate than what would have been achieved had such capital been invested in the S&P 500.
- As an intermediate assessment, every calendar year we will measure the annual total return for an investment in the partnership against the annual total return in the S&P 500. We will call it a “bad” year when we underperform the S&P 500. Conversely, we will call it a “good” year when we outperform the S&P 500. It is an absolute certainty we will have bad years.
- A minimum of 5 years is the length of time one should use when judging our annualized performance or compound annual growth rate versus that of the S&P 500. If the partnership does not outperform the S&P 500 over a period of more than 5 years, everyone, including myself, should start thinking about other places to put their capital. However, if there is a raging 5-year bull market, outperformance should not be expected.
- We would much rather outperform in any given year when the S&P 500 has declined, meaning we prefer being down -10% when the market is down -30% rather than being up 30% when the market is up 10%. We look down before looking up, prioritizing downside protection and preservation of capital over the long term.
- If the S&P 500 is up for the year to a degree approximating its historical averages, we are happy if the partnership achieves a positive return close to this figure. If the S&P 500 has an exceptional year, especially during a frothy, bullish period, we will most likely underperform for the year. The S&P 500 for the previous ten years has achieved an annualized total return of approximately 7% per annum. Historically, this figure has been approximately 10%.
- We cannot predict whether the stock market is going to go up or down. We cannot predict economic cycles nor changes in the general or global economy. We cannot predict when trading multiples will expand or contract. If you think the ability to predict the aforementioned is critical to a successful investment strategy, you should not join the partnership.
- We cannot guarantee results for members of the partnership. However, I can promise the following:
- Each P&C insurance company owned in the partnership’s portfolio will be selected based on its ability to compound shareholder value (represented by its book value per share and market price per share) over the long term;
- The partnership will only pay prices that are fair or discounted with a margin of safety relative to the intrinsic values of its portfolio companies;
- The risk of permanent loss of capital (not short-term mark-to-market declines in value) will be minimized by limiting the partnership’s ownership of P&C insurance companies to those:
- That have downside protection in the form of underlying book values backed by real, tangible assets (i.e. marketable securities, bonds, stocks and cash) that can be liquidated today at close to 100% of their marked values on the balance sheet;
- That have downside protection in the form of wide, competitive moats defending their ability to compound book value per share over long periods at above-market rates of return;
- That can be purchased at fair intrinsic values or below with a margin of safety, with such intrinsic values being estimated to the best of our ability by conservatively discounting long-term growth in book values per share;
- That we would be comfortable buying in their entirety (i.e. 100% of outstanding stock).
- I aim to have almost 100% of my entire net worth invested in the partnership alongside fellow members of the partnership. To further align incentives, “qualified clients,” as defined by our confidential private offering memorandum, may opt to pay a 0% annual management fee coupled with a high water mark and a 25% annual performance fee applied to returns above a 5% hurdle. In other words, we don’t get paid unless the value of your investment is above its high water mark and your investment has increased at least 5% annually.
S&C Messina Capital Management Performance for 2015 (4 months ended December 31, 2015)
For the 4 months ended December 31, 2015, the partnership achieved a gross return of 2.24% and a net return after fees of 2.10% versus a total return of 4.39% for the S&P 500. Assessments of performance versus benchmarks become less and less meaningful the shorter the time period. If these figures were representative of the full year 2015, comparisons would be more meaningful. If they were over 5 years, they would be even more meaningful.
S&C Messina Capital Management Outlook for 2016
We are very excited about 2016, as the year has begun with significant volatility in the markets. If the market continues to sell off aggressively and remain highly volatile for the rest of the year, this presents us with our ideal situation – the more aggressively the tide goes out, the more apparent it will become (hopefully) that the companies owned by the partnership have not been swimming naked.
If the tide continues to go out for the rest of 2016, it is in these types of market environments we most wish to shine – by (i) not going down as much as the general market in times of panic or pervasive bearish sentiment and (ii) being able to add to existing positions and initiating new positions in the common stock of the best P&C insurance companies at even cheaper valuations.
Indeed, prospective investors who choose to join our partnership now in these sorts of environments are heeding the contrarian adage of buying when there is blood in the streets. It takes courage for anyone to do so, especially if he or she is jumping in blindly. However, when joining the partnership, new investors who entrust their capital are engaging in a well-calculated endeavor, with eyes wide open, even if the sky seems to be falling. There are no blindfolds here.
As a duty to my fellow partners and investors in the partnership, with whom I have invested alongside, I do my best to mitigate their need for blind courage by methodically allocating the partnership’s capital to the best P&C insurance companies whose long-term fundamentals have not changed, irrespective of what Mr. Market is doing. If such long-term fundamentals have worsened, and I have misjudged the capability of a company to maintain strong fundamentals over the long term, then action needs to be taken to rectify my mistake by selling all or part of the partnership’s ownership stake in the company.
In the short run, the stock prices of such stellar P&C companies may not reflect their strong earnings power, but in the long run, as these companies’ underlying book values per share compound, share prices will increase to reflect the continuous creation of shareholder value. Otherwise, the unlikely scenario of a company’s book value per share continuing to rise year after year while its share price declines or stagnates below its book value per share will have occurred.
During this recent period of market volatility, some of the fundamentals of our portfolio P&C insurance companies have actually improved, with some having recently achieved close to record levels of underwriting profitability. But one would never know from looking at their stock prices.
We began the year 100% long and fully invested and remain so. For the month of January 2016, the partnership’s investments achieved a monthly net return after fees of -0.05% compared to the -4.96% monthly decline in the S&P 500. On a monthly basis, such magnitudes (i.e. +4.91%) of outperformance are impossible for us to repeat consistently and should not be expected going forward. Since the partnership’s inception on September 1, 2015, through the end of January 2016, the partnership was up 2.04% after fees compared to the S&P 500 which was down -0.79%, an outperformance of +2.83% by the partnership.
Notwithstanding the limited significance of the partnership’s short-term performance, the partnership’s companies retained their market values during January in one of the worst yearly starts for the S&P 500 in history. Most importantly, the long-term prospects of growth in underlying book values per share of the partnership’s P&C insurance companies remain fully intact, impacted very little, if at all, by the recent gyrations in the stock market or the gloomy outlook for the domestic and global economy.
Going forward, I plan to update members of the partnership on a semi-annual basis, with a half-year update coming out later this year.
Best regards,
Noh-Joon Choo
Managing Partner
S&C Messina Capital Management, LLC
