Clipper Fund annual letter to shareholders for the year ended December 31, 2015.
Results of Our Investment Discipline
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy Read More
Clipper Fund investment discipline has built wealth for shareholders over the long term. Clipper Fund’s 2015 results exceeded the market averages and compared well with other investors. More important, 2015 performance built on the improved absolute and relative results achieved since 2010. Specifically, shareholder wealth in Clipper Fund increased a cumulative 6%, 54% and 77% over the last one, three and five years, respectively.1 As Clipper Fund’s managers, we have two objectives: to earn a satisfactory absolute investment return and to generate relative results in excess of the S&P 500® Index. In recent years, we have achieved both goals. Over longer periods, we have fired on only one cylinder as shown in the table below. Although we consider absolute returns paramount and more recent results satisfactory, we still have ground to make up since being entrusted with the Clipper Fund’s management in 2006. However, the fact each dollar entrusted to us since we began managing Clipper near the highs of the last bull market is now worth 62% more despite the real estate bubble, the financial crisis, the great recession, the euro crisis, and the collapse of many well-regarded financial institutions means at least shareholder wealth has grown during these unprecedented times.
Our focus on growing the absolute value of the funds entrusted to our care is driven in part by our significant co-investment. Our firm, our families and our colleagues collectively have more than $100 million invested alongside our shareholders.3 Our focus on absolute growth is also driven by our stewardship responsibility to Clipper Fund’s shareholders. Whether saving for retirement, a child’s education or some other purpose, shareholders are entrusting their savings to us with the hope we will help them achieve their financial goals by growing the value of their savings over the long term.
To achieve the goal of growing shareholder wealth over the long term, we invest exclusively in equities, using our timetested research approach to seek out durable, well-managed businesses that can be purchased at attractive valuations. Although at times the rate of growth we achieve may be faster or slower, our steadfast focus on equities combined with an investment discipline centered on research, careful stock selection and a long-term perspective has helped us increase the value of our clients’ savings.
However, we have not and will not retreat from our secondary goal of achieving returns that exceed the S&P 500® Index. As active managers, we know we will go through periods when our results trail the market, particularly when indexing and other momentum-based strategies are galloping ahead. We have been through such times before and have always emerged in a strong position. Recently, for example, the robust performance of a number of our large holdings, including Wells Fargo, Google (now renamed Alphabet, with Google just one part of its group of companies), Bank of New York Mellon, and Amazon.com, has driven strong absolute returns.4 At the same time, our decision to avoid a number of companies and sectors that have done particularly well but that do not offer investors sustainable long-term opportunities in our view has detracted from our relative results. Our decision to avoid these businesses rests on our experience, judgment and analysis, all of which indicate that in our opinion the companies are either overvalued or riskier than they appear. As has historically been the case, we believe the relative drag experienced by not owning such companies will reverse in the years ahead.
In the pages that follow, we will describe why we believe the combination of strong results at the companies we own, the faltering prospects of a number of widely held companies we have chosen to avoid and the opportunities presented by the stock market’s recent volatility (more about this later) should lead to strong results in the years ahead. While too short a period to extrapolate, we are gratified our results over the last three years exceeded the market and compared favorably to other equity managers. More important, despite these good short-term results, many of our large holdings and new purchases trade at significant discounts to the averages, positioning us well for the years ahead should these companies be appropriately revalued.
Clipper Fund – Market Outlook
Volatility creates opportunity, not risk: Fluctuations and economic and political uncertainty are the rule, not the exception.
From the lows of 2009 until the middle of 2015, the market raced steadily higher. In fact, by August 2015 the market had enjoyed its longest stretch without a 10% correction in more than 20 years and the third longest stretch since 1928. In short, this was an exceptional period. Since then, market gyrations have reappeared with volatility increasing throughout the remainder of 2015 and thus far in 2016. Having grown accustomed to a constantly rising market and low volatility, commentators and newspapers are using words such as rout, collapse and turmoil. Such sensational headlines generate considerable excitement compared to statements that might suggest a 10%-20% decline after a 200% gain should not be cause for alarm, though this more sober language is more accurate. While the market generates a positive return in most years, occasional negative years are inevitable. In fact, in one out of four years since 1928, the market has generated a negative one year return.
As an uncommon but inevitable part of the investment landscape, stock market declines present both risks and opportunities. The risks are emotional and the opportunities economic. The emotional risk is that investors become so nervous and fearful they sell their investments at depressed prices. The economic opportunity is that investors recognize the chance to increase future returns by buying more at lower prices.
To avoid the risk and take advantage of the opportunity, investors must remember declining prices are not the same as declining values. Shoppers understand this difference and generally welcome falling prices as the chance to buy more for less. With stocks, the principle is the same and yet many investors’ emotions lead them to react differently. Forgetting the wisdom of the adage “price is what you pay, value is what you get” they dread falling prices instead of welcoming them. Successful long-term investors must keep such irrational emotions in check.
The most effective way to combat such irrationality is to recognize that stocks represent ownership interests in real businesses and the value of a business is determined by the earnings and cash it produces over the long term. Because we tend to own companies for many years, we already incorporate a range of different economic and political environments into our valuations. After all, as Heraclitus observed more than two thousand years ago, “The only thing constant is change.” Today, for example, commentators cite the risk of falling energy prices, rising interest rates, a weakening Chinese economy, and the strengthening dollar as major concerns. A few short years ago, they worried about the opposite: high energy prices, near zero interest rates, China’s economic strength, and a weak dollar. We use this example not to minimize the importance of economic and political concerns but rather to highlight that such risks are a constant part of the investment landscape. What varies is investors’ perception concerning these risks. When prices are high, investors optimistically focus only on the positives. When prices are low, they pessimistically focus only on the risks.
In managing Clipper Fund, we are determined to be neither optimists nor pessimists but realists, focused on facts not emotions. While the macroeconomic factors discussed above can have an impact on earnings in the short run, the key driver of long-term earnings power is the durability of a company’s competitive advantage. In general, the various economic and political factors currently worrying investors and depressing prices have almost no impact on the long-term earnings power of the majority of companies we own.
By focusing on the steady and relentless growth in the earnings power and thus the value of our long-term holdings, we and our investors can tune out unsettling short-term price volatility. When the headlines emphasize turmoil and uncertainty, just remember in general the companies we own grow more valuable every day by serving new customers, expanding into new markets, developing new products, researching innovative technologies, and reinforcing their competitive advantages. Over the long term, this growth in value will drive shareholder returns. With such companies at the heart of our Portfolio, we intend to extend our record of growing the value of our clients’ savings in the years and decades ahead.
Clipper Fund – The Portfolio
Long-term compounders, quality on sale, the blue chips of tomorrow, and timely investment themes.
The core of Clipper Fund includes an exceptional group of companies with fundamental competitive advantages. The specific nature of each company’s competitive advantage can vary widely from economies of scale (Liberty Global) and geographic dominance (LafargeHolcim) to intellectual property (Monsanto) and brand equity (American Express and Activision, owner of brands such as World of Warcraft and Call of Duty). In some cases competitive advantage was built over centuries (Wells Fargo and Bank of New York Mellon), in others over decades (Berkshire Hathaway, CarMax and UnitedHealth Group), and in two extraordinary cases established in just a few short years (Google and Amazon). But whatever the nature or history of a company’s competitive advantage, the result is the same: the ability to earn strong returns over the long term.
Although the short-term stock performance of these core holdings may be driven by the vagaries of market sentiment, their long-term returns will be driven by the competitive advantages of their underlying businesses. These advantages are the key requirement for a business to become a wealth-compounding machine.
While we build and manage the Portfolio from the bottom up, analyzing and evaluating each investment on its own merits, we would highlight three key investment themes as the biggest areas of opportunity in the current market environment.
First, one notable aspect of the recent sell-off in stocks has been its indiscriminate and broad-based nature. As investors increasingly succumb to fear and panic, they tend to disregard fundamentals and sell across the board. As a result, we have the unusual opportunity to acquire or add to a select handful of wonderful industrial leaders at bargain prices. Such opportunities are rare and precisely our area of expertise. While pinpointing a single reason why the share prices of a number of these high-quality companies have faltered, some concerns mentioned earlier, including currency effects, slowing Chinese growth and general economic concerns, may play a part. Whatever the cause, these companies’ share prices have fallen significantly, allowing us to add to or build new positions at highly attractive valuations. We call this opportunity quality on sale. Importantly, while some of the factors mentioned might have a short-term impact on reported profits, none threatens the fundamental competitive advantages or durability of these companies’ underlying businesses. As an example, the prices of United Technologies, Monsanto and LafargeHolcim have each fallen more than 20% with the result that shares in these outstanding companies can be purchased at a discount to the average company. Even Berkshire Hathaway’s stock has languished to the point its shares now trade only slightly above the level at which management has indicated they would consider the shares sufficiently undervalued to begin a repurchase program.
A second area of opportunity is best captured by the statement today’s disrupters are tomorrow’s blue chips. Over the decades, we have often seen companies we considered disrupters underestimated and disregarded by investors who overemphasized the short operating histories and relative small size of these businesses while undervaluing their powerful and durable competitive advantages. But as disrupters relentlessly grow, perceptions change. Established competitors lose market share and disrupters become the new blue chips. Over the decades, we have seen companies such as Charles Schwab, once viewed as a fringe discount broker, become a trusted financial brand and Costco evolve from a niche retailer to a global retail giant. We have owned these companies for many years and continue to believe they have room to grow.
Today technology is accelerating the pace of disruption. This change is best seen by contrasting the history of a past disrupter Walmart with a new disrupter Amazon. Walmart opened its first store in 1962 and, with its everyday low pricing model, strong management and tight cost control, enjoyed real competitive advantages relative to the much larger and better regarded existing competition. Eighteen years later, the company reached $1 billion in sales and today has sales approaching $500 billion, dwarfing its competitors such as Kmart and Sears that have largely been left in the dust. In contrast, Amazon has disrupted entrenched competitors in a matter of years not decades. Remembering Walmart took 18 years to reach sales of $1 billion, we consider it astonishing that Amazon was selling approximately $95 billion worth of merchandise in its 18th year, almost 100 times more than Walmart sold during the comparable period in its history.
With Amazon achieving success at such a rapid pace, investors who were slow to study the company because of its short operating history not only missed out on its potential as an investment but also were slow to identify the threat it posed to so many other retailers. Companies ranging from Borders and Blockbuster to Circuit City and RadioShack have already filed for bankruptcy and many more are sure to follow. While extraordinary, Amazon is hardly a lone example. Companies such as Google, Netflix and Facebook have overpowered many traditional media businesses, Uber and AirBNB are challenging the taxi and hotel industries, and a number of new companies are using biotechnology to challenge traditional pharmaceutical businesses. The bottom line is technological disruption is rapidly changing the investment landscape, creating great opportunities for investors who can adapt and enormous risks for investors who cannot.
The third theme is our constant interest in those areas of the market most out of favor with investors provided the underlying companies deliver essential products and services that are difficult if not impossible to bypass. Today, two sectors fit the bill: financial services and energy. In each, we are interested only in those companies that will emerge from the turmoil in a stronger position. In the financial sector, for example, American Express, JPMorgan Chase and Wells Fargo have consistently generated strong long-term returns on equity even through the turmoil of the worst financial crisis since the 1930s. Each also took advantage of the chaos resulting from the crisis to grow market share and as a result all are enjoying record profitability despite being more conservatively capitalized. Looking ahead, although these companies are benefiting from today’s benign credit environment, earnings per share at each should still rise as regulatory, legal and compliance costs moderate, interest rates normalize and shares are repurchased at bargain prices.
In the energy sector, the steep decline in oil and gas prices has led to collapsing profitability, causing investors to flee the sector. In such a chaotic price environment, we have focused on the basic economics of supply and demand. Starting with demand, energy consumption continues to rise as cars are still driven, homes heated and electricity produced. In fact, falling prices actually increase demand as cheap energy leads consumers to drive more, utilities to switch from higher cost alternatives and industrial companies to add capacity where lower cost energy is available. As for supply, economics dictate sooner or later prices must rise high enough that companies have an incentive to produce enough energy to satisfy demand. Our research conclusively indicates the price required for companies to produce the amount of oil and gas needed may be almost twice the current price. Although such imbalances can persist for years because of factors such as geopolitics and costs incurred that cannot be recovered, eventually prices must adjust. Our long-term perspective allows us to build positions in specific energy companies now that will benefit from the eventual and inevitable price increases we expect. In selecting individual companies, we continue to focus on those businesses with the lowest cost positions in some of the largest energy fields in North America. We look for the combination of sensible management, a strong balance sheet, great geological formations, and leading technology that gives companies a global competitive advantage. Recent purchases that meet these criteria include Cabot Oil & Gas, Apache and Encana.
Clipper Fund – Risk is Value Destruction not Price Volatility
Diminished purchasing power is the key value-destroying risk facing investors today.
Because we focus on value instead of price, we do not consider short-term stock market volatility a risk. Instead, we define risk as long-term value destruction. For today’s investors, the potential loss of purchasing power on the dollars they save is one of the largest value-destroying risks they face.
Over virtually all periods of history, purchasing power erodes as prices for goods and services relentlessly rise. While this is a timeless concern, low current interest rates have made this a far greater risk for today’s investors than at any time in the last 50 years. To understand this risk, consider that in the last 50 years the purchasing power of a dollar has declined more than 85%. In other words, if someone had put a one dollar bill under the mattress in 1965 and took it out today, that one dollar bill would only buy about one-sixth as much as it did in 1965. Such statistics are given life when we consider back then a McDonald’s hamburger cost 15 cents, a gallon of gas cost 31 cents and a full year’s university tuition (including room and board) cost less than $2,500.
Over this same period, however, people who chose to save their money rather than spend it were paid interest on their savings at a rate that had a reasonable chance of offsetting rising prices and thus maintaining their purchasing power. Over this entire period, for example, interest paid on a one year savings bond averaged approximately 5.5%. While interest rates fluctuated enormously during this period, only in the last five years have they fallen below 4% and now stand near zero, their lowest levels in more than a century.
As a result, available interest rates seem unlikely to offset rising prices over the long term leaving savers, whether they are in bank deposits or government bonds, facing a high risk of diminished purchasing power in the years and decades ahead. As indicated by the amount of money pouring into both bank deposits and bond funds, savers seem unaware of the risk they are taking. Compared to such meager interest rates, the valuations of the companies we own in Clipper Fund are especially attractive. In fact, in a number of cases, these companies’ current dividends now exceed bond yields and are likely to grow in the years ahead.
At a time of increasing volatility, economic uncertainty and low interest rates, the long- term outlook for the durable, well-run and attractively valued companies that make up Clipper Fund remains strong. We are gratified the Clipper Fund’s performance has steadily improved in recent years and are committed to building on these gains. Based on the experience of our team and the characteristics of the companies we own, we remain confident about the future. As always, we are mindful of our responsibility and grateful for the trust you have placed in us.
Christopher C. Davis
President & Portfolio Manager
Danton G. Goei
February 5, 2016
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