Mutoro Group Partners, LP
“The surprise came at the conclusion of the event. The winner was revealed to be not a grandmaster with a state-of-the-art PC but a pair of amateur American chess players using three computers at the same time. Their skill at manipulating and ‘coaching’ their computers to look very deeply into positions effectively counteracted the superior chess understanding of their grandmaster opponents and the greater computational power of other participants. Weak human + machine + better process was superior to a strong computer alone, and, more remarkably, superior to a strong human + machine + inferior process.” – Garry Kasparov
“General rules in art are useful chiefly as a lamp in a mine, or a handrail down a black stairway; they are necessary for the sake of the guidance they give, but it is a mistake, once they are formulated, to be too much in awe of them.” – Edith Wharton
“Reality has a way of asserting itself.” – President Barack Obama
Dear Partner,
The Fund was up 19.19 per cent for 2016 net of fees and expenses. At no point in the year did we hold less than 40 per cent of our portfolio in cash; we began the year with roughly 60 per cent and finished with a similar amount. I mention our cash upfront because it is our biggest position and a useful starting point to review our investment process and how we manage risk.
By now you probably know my opinion on short-term results, i.e., let us not get too excited or despondent with them. Though I will mention that we had a more attractive result than most funds this past year, and we held proportionally more of an asset that earns nothing essentially and is regarded by many as a drag on performance. For the new reader, this may beget several questions: Did we benefit from the post-election rise in the markets? (We actually lost some of our earlier gains.) Why not acquire bigger stakes in the businesses we own? (We did when they were priced attractively.) Why not add more positions? (I did not find anything new and better priced than what we already own.) Does this mean we have a negative view on the markets or the economy in the near term? (It depends.) These are good questions, and we can discuss them briefly.
As I have said in previous letters, I believe investing done well is not about predicting the future, but about preparing for it. While I would like us to own businesses with strong competitive advantages and unit economics through the business cycle, I would prefer to acquire them at the lower prices that come with market and economic stress. However, we are not sitting on all this cash hoping for trouble. As a friend once observed, “On sunny days you don’t pray for rain just to test the strength of your umbrella.” That said, having a sense of the weather forecast is incredibly helpful, especially as clouds begin to cluster on the horizon and the pendulum of market sentiment swings toward overoptimism.
How do we know whether markets are moving toward overoptimism? I am skeptical of using any one trait to define a security or market, but some are more instructive than others. The most effective metric I have found for gauging the reasonableness of market valuations is known as the Shiller P/E, named after Yale Professor Robert Shiller, a Nobel laureate in economics. In brief, it involves taking the current price of the Standard & Poor 500-stock index and dividing it by average annual corporate earnings over the previous 10 years (as opposed to the typical activity of dividing current prices by forecasted earnings for the next year). According to this metric, only twice over the past century have stocks in the United States been more expensive than they are today: the 1920s and the late 1990s. Current prices are even higher than in 2007 on the eve of the financial crisis. A separate statistic is worth noting as well: The United States has experienced a recession every decade of the past century, except the decade we are currently in, so far. Perhaps this is just trivia; there is, of course, no rule that the nation in aggregate has to experience an economic slowdown before 2020. However, it is helpful to think of recessions much like the desires to sleep or eat; the longer it has been since you last experienced them, the higher the chances are you will feel them again shortly.
None of this necessarily means prices and earnings are immediately heading lower, nor that stocks will lag other asset classes over the long run. Equity markets could keep rising for the foreseeable future. Moreover, to be clear, this analysis only applies to U.S. equity markets; similar metrics for select European nations and other developed countries do not suggest as negative a view. For us, presently the most beneficial move is to have a conservative stance toward portfolio management (e.g., consecutive years of having roughly 60 per cent of our portfolio in cash), to also look overseas for opportunities, and to insist on substantial margins of safety in everything we do. When attractive opportunities present themselves, we will be very aggressive and happily have the capital to deploy; when they do not, we will happily do nothing and patiently search for better opportunities. The alternative route taken by most funds (i.e., carrying little or no cash), strikes me as unrealistic. I am baffled by anyone who assumes they can accurately time a turning point in the markets and sell out of stocks at just the right moment. I recall an analogy the writer Tren Griffin once made between investing and freeway driving:
With sufficient distance between you and the car ahead, you must react to what you see in the present moment, but you do not need to predict the actions of the driver ahead of you. If you drive only a few feet behind the speeding car ahead, you need prediction instead of just reaction; otherwise, you are going to crash.
Preparation trumps prediction. It is through your patience as partners that we can make unconventional but profitable moves with our portfolio.
If we think U.S. equity markets have swung toward overoptimism, should we be shorting individual securities? I believe that ideal targets for shorting in a potential market downturn are companies with highly capital-intensive businesses, poor unit economics, and strained balance sheets requiring regular access to capital markets. Such companies exist and at high valuations. They do not need to disappear for us to profit from their mismanagement or misfortune. However, I would rather purchase long-dated puts on these businesses to express a negative view of them, and you should not be surprised if we do. Still, we must step back and remember a spotless fact: Often the best short is cash.
The chart below depicts the makeup of the Fund on December 31st.
Portfolio Holdings
The almost 40 per cent of our portfolio that is not in cash is in the same four businesses we owned at the beginning of 2016. While all headquartered in the U.S., they are in very different industries and have very different customers, providing us with some necessary diversification. They are: Company A (a media company in captive markets; 17.8% of our portfolio), Company B (a software company with attractive network economics; 8.4%), Company C (a niche industrial manufacturer; 2.1%), and Company D (a highly innovative technology business; 9.2%). The one company we own that I have not discussed in these letters over the past two years is Company C. Though it is our smallest holding, I think it is as informative of any other as to what we look for in a business and worth discussing briefly.
In 2011, Company C, an American manufacturer of equipment used in the construction and automotive industries, attempted to purchase a competitor. The Federal Trade Commission (FTC) quickly challenged the acquisition on anti-competitive grounds. After a three-year investigation, the FTC forced Company C to sell the newly acquired business, citing Company C’s dominance in this and other markets. This dominance is evident from its earnings history. Over the past ten years, its total annual operating margins have averaged 24 per cent, its net margins 15 per cent. And this is not a story of declining margins. It has maintained profitability while increasing sales annually at a 6 per cent rate and boasting an average return on shareholders’ equity of 44 per cent. Also, the company is prudently leveraged with total net debt, including pension obligations, at 2.0x average operating income for the past ten years. All of this is excellent.
How does Company C keep competitors at bay? First, the market for its end-products is smaller than other industrial markets, limiting its attractiveness to larger, better-financed competitors. Second, it spends about 3 to 4 percent of its sales on research and development, whereas its direct competitors spend 1 to 2 percent, maintaining Company C’s lead in technological development. Third, Company C delivers equipment that is important to finished products but is a small portion of total production costs; this allows Company C to charge premium prices and maintain attractive margins. Lastly, the company seems to have the right management team in place. Of the 15 executives named in its annual report, the average executive joined 21 years ago and has been in his or her current position for at least five years. And they are focused on shareholder returns, smartly growing dividends and repurchasing shares when necessary. To be sure, a macroeconomic slowdown would hit near-term sales, but the company should remain profitable, as it did during the last recession, growing stronger coming out of it through buying smaller competitors overseas. We bought shares of Company C because it is an excellent business attractively priced relative to its long-term outlook. My mistake was not buying more of it faster; after our initial purchase, its price quickly and unfortunately rose above the boundaries I had set for our margin of safety.
At this point, it might be helpful to remind you why I use pseudonyms to discuss our business holdings. Every limited partner knows the actual names of the companies we own and also receives the investment memos on them I wrote at the time of purchase. The memos answer those two all-important questions: “Why am I buying this?” and “What is it worth?” I regularly revisit and attack the assumptions in those. But there are many readers of these letters who are not partners. Whether these readers would know our companies well, they have one thing in common, which is a social relationship with me. And it would not be surprising if they had strong opinions on these companies, as each one has been at some point unloved by the public. Unsolicited opinions are dangerous for us, especially if we value independent judgment; because even the well-informed might have different capital allocation priorities, coloring their views. You know this feeling if you have ever been a member of a book club: You gather with a group of peers of similar IQ and aptitude, yet are shocked at the vast and baffling spectrum of responses to literally the same text—not to mention the surprising lengths people can go to persuade you of their views. So I can spend my time analyzing our holdings instead of defending them socially, we use pseudonyms.
Using aliases also has another psychological benefit to our process. I think one of the most important tools to have in your mental kit is the idea that it is much harder to unlearn behavior than to learn it. I am happy to have learned and had trouble unlearning the idea that selectiveness matters. Warren Buffett once imparted:
I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better.
I do not have a specific goal for how many investments we will ultimately make; but if after five years, I am informing you of a Company Z, can we say that I have been selective? Perhaps. More likely, it would imply either more turnover or less concentration than we desire. If I were to unlearn the good ideas Buffett expressed above and break my principles, I better have a damn good reason for it.
Thank you for your continued partnership. I remain grateful for your ongoing confidence and support, and I continue to strive to deserve it. I am always available for any comments or questions you may have.
Sincerely,
Godfrey M. Bakuli
Managing Partner