It's hard to believe that a man is telling the truth when you know that you would lie if you were in his place.
-- H. L. Mencken
Dear Fellow Fool Funds Shareholder:
Before we begin this month's Declarations, I want to let you know about the Motley Fool Funds annual shareholder meeting, to be held at our offices at 2000 Duke St. in Alexandria, Va. on the 13th of July. The festivities will start at 4 p.m., and will include a fun program by Todd Etter, The Motley Fool's chief collaboration officer. The investment team will speak and take questions, preceded by Tom Gardner, co-founder of The Motley Fool.
One thing I wanted to do this year was give shareholders the chance to hear from a manager at one of our favorite investment companies, and we have hit an absolute home run. Tom Gayner, the president and chief investment officer of Markel Corp., has graciously agreed to come and speak. Tom is, quite simply, one of the best investors in America, and is both passionate and knowledgeable about his business and the insurance industry. He has long been rumored to be one of the leading candidates to take over investing duties for Warren Buffett at Berkshire Hathaway when the day comes that the Oracle of Omaha steps down. (Just run an Internet search on the words "Tom Gayner Warren Buffett" and prepare to be impressed.) Do I sound ecstatic that he's coming to our meeting? You're darn right I do.
By the way, there are thousands of people who receive Declarations who are not shareholders of one of the Motley Fool Funds. As this is an open meeting, you are more than welcome to attend. In fact, we would be delighted to meet you! If you're planning on attending, please reserve a spot by sending an email to RSVP@foolfunds.com by July 1st.
A man's got to understand his limitations
Early last month I accompanied a group of Motley Fool employees on a bike ride in western Maryland. I'm an avid biker, and as the weather in the Washington area had not been particularly cooperative during the preceding month, I was particularly excited to get in a good, hard ride. So, a few miles into our journey, fellow Fool Mike Gurtzweiler and I picked up the pace and hammered down the trail.
We were making the 16-mile ride from Frostburg to Cumberland, Md. As we entered Cumberland on the trail, we came to a corner and awaited the rest of our group. As we relaxed, a member of our support team rode up and said that the biking guide was concerned that we wouldn't know where to go once we got to Cumberland. Mike responded: "We didn't know where to go. But we did know where to stop."
So it is in investing. In James Montier's brilliant white paper "The Seven Immutable Laws of Investing," his final law is "Never invest in something you don't understand." This might seem like basic common sense, and yet investors commit many financially destructive errors simply through unwillingness or inability to recognize that they don't understand something. Warren Buffett very famously has a "too hard" pile, where he puts companies that are too difficult to understand. Buffett doesn't do this because he's stupid. Buffett does this because he is very, very smart. He uses the Gurtzweiler Rule for Investing: He knows where to stop.
Now, this is not to say that one must have perfect knowledge when one invests -- you'd never deploy a penny if that were the case. And since chance is involved, there is almost no way to eliminate the risk that something bad will happen. Bad outcomes in investing are not necessarily the result of bad decisions; you can go in perfectly aware of certain risks and properly discount for them, but they're still risks. And sometimes companies are affected by events that are wholly unpredictable.
How in the world can you own that?!?
Following last month's letter, I got a number of emails from investors asking how, if we consider ourselves value investors, we could possibly own XYZ company? (And by XYZ, I mean Under Armour.) After all, with a trailing P/E of about 50, under no circumstances could Under Armour be confused as a deep value stock. In order to justify its valuation, the company is going to have to grow at a healthy clip for a long time.
This is true, but to me it makes the mistake of conflating statistical notions with reality, which is a natural inclination. But is a company trading at a P/E of 5 really cheaper than another one trading at a P/E of 50? In 2007, many of the homebuilders were trading at multiples barely higher than 5, right before they were decimated by the housing crisis, sorting out that whole "lots of earnings" problem. It would be incredibly naïve to call them cheap. By the same measure, there is no price one might have paid for Coach in the 1990s that turned out to be too high -- and it was statistically expensive for most of the decade.
The reason is simple. Coach was a 1-in-500 quality company. The homebuilders, on the other hand, were largely, though not entirely, undifferentiated. In our shop, we make an attempt to qualify each company, ranging from break-the-mold great at the top to how-in-the-world-do-they-stay-in-business crappy at the bottom. For lack of a better term, we call this the "awesomeness continuum." (OK, the "for lack of a better term" part is false modesty. "Awesomeness continuum" is pretty sweet.)
The awesomeness continuum is essentially qualitative, and the further up the continuum a company is, the more libertine one can become about current price multiples. At the other end of the continuum are the traditional deep value stocks, what Benjamin Graham used to call the "cigar butts." We own a few of these, most notably Tokyo Electric Power, which has a list of risk factors as long and as wide as the eye can see. Unlike the awesome companies, with these it doesn't tend to pay to be patient. They're as icky and as hairy as can be, and the risks facing them are not only obvious; they are also real.
The thing is ...
Of course, whenever you pay up for a company, you're betting much more on its future than you are on its present. Where you can get crushed is putting a company way too high on the awesomeness continuum. To me, a Chipotle, or an Under Armour, or a Coach is an exceedingly rare quantity, and at some point each of them will slide down the awesomeness continuum just as almost every megacap technology company has eventually done. (Although Apple has defied the trend thus far.) Every experienced investor has made misjudgments. One of my notable offenses was with a women's fashion retailer called New York & Company, which I thought was a good-to-great company. It turned out to be a capital-destroying also-ran. When companies high on the awesomeness continuum disappoint, the market tends to react viciously. Conversely, when an investor buys a company low on the continuum and it progressively becomes more and more awesome, you can make a lot of money -- witness Apple's decade-long mastery of multiple computer and mobile device businesses.
We are willing to invest in firms that cannot be defined as classic "value" companies if we believe that the market has underestimated what they can do over time. We are willing to wait as their performance unfolds, even if there are valleys along the way. Having said all this, I can't stress enough that companies which defy conventional valuation measures are exceedingly rare. We won't buy them unless we're confident our analysis is right ... and even then we might not be.
Both the Independence Fund and the Great America Fund ended the month with substantial cash positions, a testament to the difficulty we have had of late finding companies that trade at prices we consider compelling. I hate holding lots of cash. As an investment, it's kind of pathetic since it offers, essentially, a guaranteed loss over time. Currently, it's about -3%, pre-tax.
Cash is a fine alternative when we're finding precious few investments that offer positive risk-adjusted returns. This isn't to say that promising investments don't exist; in fact, we do have some, and are finding more all the time. But they're in segments where the market is extremely pessimistic. Since the market lows in 2009, growth-type stocks, including smaller-capitalization names, commodity companies, and (especially) emerging-market companies have vastly outperformed large-capitalization companies. We have no problem at all with these sectors. In fact, over time, certain of these segments are where I expect us to make the most hay.
The good news is that while we find the pickings quite slim among small-capitalization American companies, some of the largest-capitalization companies are statistically cheaper than they've been in decades, in the U.S. as well as in other developed markets. This matters for both of our funds.
In January 2010 (see "Ask the Right Questions") I noted that Wal-Mart had produced an extremely commendable commercial result for the decade, and yet its shares lost 29% over the same period. Other megacaps worldwide have had similar experiences. We're finding plenty of opportunity in certain highly developed economies, like France and Japan, and we are fishing very actively in Germany. These markets have been slammed for obvious reasons that may worsen. These are countries with extraordinary production capacity and engineering capability, and many of their businesses export all over the world. Investors, so worried about "Europe," tend to forget this. When macroeconomic worries take center stage, awesome companies can suddenly be had on the cheap.
For the month of May, the Independence Fund lost 1.73% versus a decline of 1.97% for the MSCI World Index. The Great America Fund gained 0.42% compared to a loss of 0.42% for the Russell Midcap Index.
Both funds benefitted in two ways from their cash positions. First, the cash dampened the impact of a steadily declining market. And second, we had plenty of ammunition to add more shares of our favorite companies. While it's never fun to see your portfolio balance decline, taking advantage of these short-term undulations is vital to long-term growth.
We opened four new positions in the Independence Fund. One of the companies, Markel Corp., was already among the largest holdings in the Great America Fund. The other three companies -- which will remain unnamed for now -- represent miniscule investments for the fund. In our constant efforts to deliver better results, the team has begun adding a handful of names to the portfolio on a trial basis. Within a matter of weeks, more analysis and debate will determine which of these companies will grow to sizable positions and which will be sent back to the bench.
The vast majority of our purchases for the month were aimed at current portfolio holdings; as a truly meaningless metric, I can tell you that we purchased more than 100 shares of current holdings for every 1 share allocated to these new positions (among other reasons, this is meaningless because we purchased several hundred thousand shares of an Indonesian company trading for the equivalent of $0.32 per share). We also closed two positions, both French companies: CGG Veritas and Delachaux. In each case, events had already played out to our advantage and the benefits of remaining invested were greatly diminished.
As we've pointed out before, and will point out again many times in the future, monthly returns should largely or completely be ignored. What contributes to a single month's out- or under-performance as compared to a benchmark is inherently transitory. In the case of Great America, essentially all of the fund's monthly outperformance came from two stocks -- Level 3 Communications and Red Robin Gourmet Burgers, two beaten-down stocks that are beginning to enjoy the fruits of turnaround efforts that are far more than one month in the making.
For the month, Great America added two positions, one in a meaningful size, the other in a "tasting portion" on a trial basis. Great America now holds investments in approximately 50 companies -- a number which has been slowly and steadily growing since inception, when the total number of companies was closer to 30. As stock prices have come down recently, we expect additional opportunities that we've been keeping our eyes on to finally be close in on reasonable prices, and that number should continue to modestly grow in coming months.
Compared to the benchmark, May was Great America's best month in its very short history. This followed April -- which May tends to do -- which happened to be Great America's worst month of relative performance. Whether you're measuring by week, month, quarter, or year, a very good period of performance often follows a poor one -- and vice versa, of course. Don't be surprised the next time that pattern emerges here or elsewhere in the market.
The discussion of individual companies in this article is not intended as a recommendation to buy, hold or sell securities issued by those companies. The holdings of Motley Fool Funds may change at any time.