It is my pleasure to report the results for the 12 months ended June 30, 2016.
Andrew Jackson lost his place on the $20 bill to Harriet Tubman; Donald Trump became the presumptive Republican presidential nominee; Elon Musk thinks we are living in a simulation game; the U.K. voted to leave the E.U., only to begin Googling “what is the E.U.” and “what does it mean to leave the E.U.” hours AFTER the results were announced. As a result, Athena Capital Partners’ NAV is up 15.2% (15.9% on constant currency basis). On a time-weighted basis (i.e. internal rate of return taking into account the time of contributions from July 13, 2015 to June 30, 2016), the portfolio returned 18.8% in its inaugural year, while remaining at least 40% cash at all times. During the same year, the S&P 500 lost 0.03% and the TSX Composite lost 3.35%.
How We Did It
In honesty, the first year turned out to be a bit better than expected, especially given the poor returns of the overall market. While I will certainly strive to achieve even better results in future years, it is not expected that such results will repeat itself very often.
When we started out, I outlined three founding principles for Athena Capital Partners: Proudly Cheap, Fiercely Independent, and Exceptionally Patient. In my first letter to you, I explained in further detail how we select the securities in our portfolio. Looking back, it is indeed by strictly adhering to these principles that ACP generated the returns that it did. The biggest contributor to the return is Transocean Partners (NYSE:RIGP), the details of which I set out in that same first letter. We started to build our position in RIGP when oil price tanked from $110 in mid-2014 to $45 in August 2015, with no sign of slowing down its freefall. The market became so fearful that blood started to fill the streets, and, in our independent opinion, RIGP started to trade well below its cash and contracted cash flow value, despite street consensus views to the contrary. Subsequently, the price of oil continued its fall, to a low of $28 in January 2016, dragging down RIGP along with it, from our first entry price of $10 a share to below $6 a share. After triple checking our thesis to ensure that it is still valid, we simply kept buying the security as it became cheaper and cheaper – after all, getting a dollar bill for 99 cents is satisfying, but getting it for 60 cents is a consummation devoutly to be wished! True, in the depth of the doom and gloom, no one could say with certainty when the price of oil might recover, or even how much lower it might go before it stabilizes. But patience, as Aurelius Prudentius would surely agree, is a heavenly virtue, especially in trying times. Even the most pessimistic bears would have to agree that the world is not going to completely wean itself off of oil in the next 10 years, which means that RIGP’s assets are still going to be worth something beyond the end of its contracts in three years. Had the market decided to stay foolishly fearful, we would have been more than happy to wait out the three years and let the cold hard cash speak for itself when RIGP either re-contracts or divests its assets. For one reason or another, crude oil had a speedy recovery, and so did RIGP, generating a 75%+ return including dividends over our 10-month holding period.
While it often may not appear or feel so, nothing lasts forever. In fact, as Jared Diamond insightfully observes, the very attributes that initially lead to dominance usually also become the seeds of destruction. Examples abound over the past 50,000 years of human history. The abundance of game and forage in sub-Saharan African led to the rise of the human species, but also obviated the need to develop agriculture, inhibiting its growth. Confucianism served the Chinese Imperial Dynasties so well as to preclude alternative forms of government, society and life, such as republicanism, capitalism, and the scientific revolution. The Treaty of Versailles designed to perpetuate peace in Europe ended up sowing the seeds for Nazi fanaticism and eventually World War II. The rhyme of history is astounding. It is in the same vein that the dramatic cratering of oil prices forced out much of U.S. shale production, leading to constrained supplies and a sharp reversal in oil prices. While we do not claim the benefit of a crystal ball to call the zenith or nadir of any trend, we do know that the sky is darkest before dawn. As a result, we shall continue to go against the grain, so long as our independent judgement concludes that the proverbial grain has gone too far and the price has become undeniably cheap compared to the intrinsic value of the security. For, to completely misquote Swinburne, no life lives forever, and even the weariest river, eventually winds somewhere safe to sea.
While the final result was satisfactory, as I explained in my September letter last year, we made many mistakes during the year. Fortunately, most were errors of omission. There have been more times than I care to count that days or weeks after I pass on a name (always after thorough due diligence), the firm in question is acquired by a competitor or private equity at mouth-watering premiums. Could we have done significantly better had I had the foresight to join the party? Yes, absolutely. However, I would always much rather have a big pile of errors of omission than a single error of commission. Letting “The Perfect One” slip away is painful, but much less so than marrying the wrong one and have “till death do us part” become a goal to look forward to. While I cannot promise that I will never make a mistake again, I do promise that I will emphasize avoiding the landmines that are littered across the value investing field more than getting to the finishing line faster by taking additional risks – after all, dead men rise up never, and survival is the first step of success!
Eyes of the Beholder
Like beauty, value is in the eyes of the beholder. In the world of value investing, there have been two main categories of targets. The “cigar-butts” and the “compounders”. When the founding father of value investing, Benjamin Graham, first formulated the strategy, he focused on poor quality businesses trading at steep discounts. In the same way that picking up a cigar butt on the sidewalk may only give you one last puff, but since it was free, that puff is all profit. Benjamin’s most well-known and much wealthier student, Warren Buffett, however, gradually turned away from the cigar butts and famously quipped that he would much rather “buy a great business at a fair price than a fair business at a great price”. Their philosophical differences eventually strained their once idyllic relationship, but that is another story for another day.
The debates, however, rage on today. Most of the legends in value investing are of the Buffett school, and focus on great businesses with strong moats capable of compounding their profit and equity value over long periods of time. At least part of the reason is that as markets invariably become more democratic and efficient, with the advent of computer trading algorithms and ever decreasing transaction costs, the free money that used to proliferate in Graham’s days are now few and far between. It is safe to say that it is simply impossible to manage a billion-dollar fund by looking for the shiny $20 bill on the street.
That is not to say that finding compounders are easy, let alone finding them at “fair prices”. James at Young Money penned a brilliant post on how difficult it is to identify true compounders (as opposed to Ocwen and Valeant, two faux-compounders) ex-ante, no matter how “obvious” they might seem ex-post. In addition to James’ observations, we believe it will be increasingly difficult for businesses in general to establish and maintain unsurmountable moats.
The reason is simple. Technological innovation has accelerated to the point where “disruptions” are now the norm rather than the exception. It took the Rothschilds generations to establish themselves as the kings of finance, during a time when news and ideas traveled at the speed of your fastest horse. It took Rockefeller less than two decades to stamp out competition and establish Standard Oil as the oil king, and making himself the richest person in U.S. history, during a time when railroads and telegraph are revolutionizing the transportation of both goods and ideas. Today, it took Netflix less than three years to drive Blockbuster into bankruptcy – in fact, it took only 25 years for Blockbuster to go from opening its first store in Texas to going bankrupt. For better or for worse, we live in an age where the electromagnetic waves of twitter feed travel faster than the seismic waves of earthquakes, and news no longer need to “travel” at all – from Damascus to Dallas, Facebook Livestreams bring you the events as they happen, when they happen. How long did it take newspapers, one of Buffett’s favorite businesses with a moat, to dominate a locality? How long did it take the Internet to completely dismantle it? How much time and money went into securing the concession to operate municipal taxicabs? How much time and money did it take Uber, Lyft, and Didi to obliterate them? And this is not the story of silicon in computers destroying its brother silica in sand. In fact, the great businesses of the early 21-century that destroyed whole industries are being toppled themselves. Remember the days when Microsoft was feared, reviled, and subject to anti-trust investigations around the world? Remember the days when Blackberry enjoyed such a classic niche monopoly with strong competitive advantages in the enterprise mobile market that they laughed at Apple for trying to break in?
To be clear, this is not a verdict against the existence of sustainable competitive advantages or businesses with durable moats. The concerns are that whatever competitive advantages one may enjoy at any point in time, they are much less sustainable today than they were 100 years, 50 years, or even 10 years ago. More importantly, the train is only accelerating from here. With the abundance of venture capital and crowdsourced capital, the proverbial kid in the garage can develop the product, go to market and grow to the minimum viable size faster than ever before. It sometimes appears to your humble and cynic managing partner that the only competitive advantage a Google or a Facebook has is its deep war chest that allow them to acqui-hire talents before they become a real threat. Needless to say, the value of a moat is directly proportional to how long it can be expected to last. Paying a “fair price” for a moat that ends up lasting half as long as expected is the same thing as buying a Hyundai for the price of a Lamborghini – the car will still run, and you might even save some money on the gas, but it will not be your proudest achievement.
Fortunately for us, our partnership is small enough that we still can take advantage of the overlooked and underpriced security to generate above-average risk-adjusted returns. While the “smart money” looks for the goose that may or may not lay the golden egg, we will be happily hunting for the “50% OFF” sign in the produce lane.
Empire Builders vs. Money Makers
In our very first letter, we discussed the importance of aligned incentives between executives and shareholders. It is sadly too often that executives of public companies focus on enriching themselves than generating returns for shareholders. Unfortunately, it is a rare sight indeed to find a firm or a CEO that is truly aligned with shareholders. After all, it takes billionaires and controlling shareholders like Elon Musk of Tesla/Solar City/SpaceX, Larry & Sergey of Google, Mark Zuckerberg of Facebook, and Warren Buffett of Berkshire to completely forego a salary. More often than not, executive compensation is tied to the top line of the firm, not the bottom line. Even executives with the straightest moral compass could fall prey to the allure of the prestige that comes with steering a large company.
It may not come as a surprise, but as can be seen in the charts below, firms that expand their asset base fastest generate the worst returns, while those that spend them judiciously or return them to shareholders outperform the market.
Unfortunately, such success stories are truly the exception and not the rule. More importantly, I will readily admit that I cannot predict with any degree of certainty the success of such transactions ex-ante. As a result, we will focus on firms that choose the slow but steady route, i.e. those that focus on building and improving their own business and only pursue acquisitions opportunistically, when the price is right. In fact, we would prefer those businesses that have a track record of divestitures. Such firms send us two messages: (1) the executive team is not fond of accumulating assets to build and empire, and (2), they are willing and able to unlock value for shareholders when an empire builder comes along. As William Thorndike’s stories in his book The Outsiders undeniably show, astute capital allocation is by far the most important predictor of value creation.
The Path Forward
After sounding the alarm on valuation last quarter, the North American markets continue their relentless pursuit of a new all-time high, Brexit-Shmrexit be damned. In fact, we believe the market was so overheated that ACP made a grand total of ZERO purchases in the last three months. Your portfolio currently consists almost entirely of high dividend paying stocks, thereby naturally reducing the “duration” of the portfolio. With the uncertainty in Europe putting the Fed’s plan to raise interest rates on hold, there is no telling how much higher the market can go. It is not easy to watch the little green numbers tick on the screen while 40% of the portfolio sits in cash earning peanuts, but it is times like this that tests our discipline and self-control. After all, as the Chinese proverb teaches, water can support your canoe (if it is calm), but can also capsize it (if it is treacherous) – it is only when the tide goes out that we see who is swimming naked. Looking ahead to the next 12 months, we will continue to abide by our three foundational principles, and only deploy your capital when we independently conclude that a bargain may be had. Otherwise, we shall remain patient and vigilant.
As you are well aware, Athena Capital Partners’ name pays homage to Mssr. Shouren Wang’s philosophy of knowledge and action in one. It is only fitting that I end the first year with another of his pithy remark: the difference of victory and loss is entirely in your power to hold your mind steady. If your mind is clear, nothing further needs to be explained.
胜负之决, 只在此心动与不动. 此心光明, 亦复何言!
Athena Capital Partners