Absolute Value Investing
We scour the world for businesses that we believe can return the cost of our investment plus an additional cash return in excess of our cost under a wide range of economic and business scenarios. We only invest in a business if we would be satisfied with the cash flows that business will produce as our only means of return. We do not speculate in securities, guessing that some other market participant will pay us more for our piece of paper than we paid. If we do not believe that a business can generate cash flows significantly exceeding our investment, we will simply not invest. Our view of risk is not price volatility, “beta” [1], or “tracking error” [2] as taught in many finance classes, but rather that our cash flow forecasts for a company do not materialize and we are unable to achieve a return of and a return on our invested capital. Competition, technological change, changes in demand, regulation, taxes, and countless other risks can all reduce the expected cash flows over the life of an investment. Much of our research process is focused on identifying and predicting the likelihood of these risks. Risk management at the individual business level is essential to successfully generating attractive absolute returns. For extended periods of history, markets have ignored significant risks that we respect and study. For example, we have long contemplated the risks from the rapid pace of technological disruption, rising interest rates, a global recession, and exposure to the Chinese economy. In bear markets like today markets seem to be focused only on such risks.
Technological disruption is often the enemy of investment returns. Free market capitalism relentlessly spurs innovation in the pursuit of profits. These profits are often taken from an incumbent earning excess returns that fails to innovate and maintain its value proposition to customers. All businesses are exposed to disruption, but the pace of change can vary significantly by industry. Currently, the semiconductor industry and social media platforms are two spaces that are changing rapidly. Rapid change invites innovative competition. For example, despite only being launched worldwide in 2018, TikTok has amassed more than 1 billion monthly active users and has put serious competitive pressure on existing social media platforms. When you add in privacy policy changes from Apple and Google, it is not surprising that social media companies Meta (Facebook) and Snap Inc (Snapchat) are down 60% and 79% YTD, respectively. In a rapidly changing industry, we only invest when we have a clear insight about which disrupter will be successful and when the price of that disrupter offers sufficient potential upside for the risk we would be taking as investors. We generally seek to invest our capital in companies that are not in rapidly changing industries, so we can more reasonably predict future cash flows. These industries are not immune to disruption, but the slower pace of change allows time for well-run incumbents to invest and innovate in an attempt to protect their competitive positions. The slower pace of change allows us to reasonably predict the cash flows we will need to have our initial investment capital returned to us. Our research process is nimble enough to avoid businesses that are being disrupted and to evaluate investments in both disrupters and more predictable businesses. The allocation of our capital is determined by the prices offered to us in each case. Following the large runup in the prices of disrupters in the last few years, the businesses in our portfolio are mostly in the beverage, convenience retail, insurance, and telecommunications industries, all of which are industries with slow paces of change. An ideal business has a low likelihood of disruption and a high growth rate.
We have long been wary of the near-zero nominal interest rates and negative real interest rates seen in the developed world for much of the last decade. For nearly all recorded human history, real interest rates have been positive, stemming from a fundamental human preference for consumption today versus tomorrow. Today, many companies, including a sizeable portion of the private equity industry — rebranded from the 1980’s leveraged buyout industry — have balance sheets that cannot support increased borrowing costs without a permanent impairment of equity value. As we highlighted earlier this year, more than three quarters of U.S. buyouts employ more than 6x Net-Debt-to-EBITDA of leverage [3]. For much of the past decade, we have assumed that our investments would have to refinance their debts at rates higher than the historically low levels at which they were borrowing. Currently, the weighted average leverage ratio of our portfolio is near zero. We believe the Fund’s portfolio holdings are well positioned to benefit from today’s higher interest rate environment by using their strong balance sheet to make acquisitions at attractive prices or from earning interest on their cash balances. Our low exposure to rising interest rate is an important reason for our relative outperformance this year.
Economist Paul Samuelson once quipped that the stock market has predicted nine of the last five recessions. Today’s global markets are once again flashing warning signs of an impending recession. While only time will tell if a deep recession actually materializes, market participants are pricing in the impact of a weaker economy on cyclical sectors. It is common for cyclical companies to lose most of their earnings or even report losses in economic downturns. We generally avoid cyclical businesses because of the inherent uncertainty in predicting cash flows, instead preferring companies whose profits are independent of the current economic cycle. While demand may be modestly lower for some of our companies’ end products next year, large drops in profits as the result of a recession are unlikely. In sharp contrast to cyclical companies, our beverage holdings are expecting the largest fourth quarter in history given the FIFA World Cup’s November scheduling this year.
*Source: GS US Consumer Staples Index[4], GS Consumer High Levered Index [5] 
*Source: J.P. Morgan iDex Global Autos Index (Total Return [6]), S&P Homebuilders Select Industry Total Return Index [7], PHLX Semiconductor Sector Total Return [8].
Another area of major concern today that we have avoided is China. The MSCI China is down 31% in U.S. dollars through quarter end and is down 54%since its peak in February 2021. Concerns about government intervention with its largest tech companies, the drag on economic growth from its COVID Zero strategy, and the evolving crisis in the property sector are weighing on both Chinese equity markets and the currency. We have long avoided investments in China because of our concerns over the government’s role in business and the rule of law. We saw first-hand through our firm’s sole Chinese investment in 2006 how inextricably linked business success and government favor were. We were fortunate in that investment to learn a lesson and earn a positive return. Over the years we have studied many luxury goods companies that have built huge businesses selling to the emerging middle and upper classes in China. For example, Switzerland’s Swatch Group earned 42% of its revenues from Greater China in 2021. In fact, much of the global growth in luxury goods over the last decade has come from China, but we see risks to this continuing. While we reasonably expect the Chinese economy and consumer class to continue growing, we cannot ignore the risks stemming from China’s highly levered economy, single-party government, declining demographics, a historical tendency to turn inwards, and geopolitical ambitions to its continued growth and development.
*Source: United Nations, Bank of International Settlements.
As absolute value investors, we spend a lot of time thinking about the real, perceived, and unknown risks to our companies’ cash flows. Technological disruption, higher interest rates, the economic cycle, and the future development of China are four risks that we have identified and actively avoided over the last few years given market valuations relative to those risks. We believe the Fund’s portfolio today is robust against a continuation of this year’s trends as well as a multitude of other risks that may await our future world.
[1] Beta is a concept that measures the expected move in a stock relative to movements in the overall market.
[2] Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark.
[3] https://www.economist.com/special-report/2022/02/23/alternative-fund-managers-are-increasingly-mainstream”>[3]https://www.economist.com/special-report/2022/02/23/alternative-fund-managers-are-increasingly-mainstream
[4] GS US Consumer Staples Index – an index composed of U.S. listed equities diversified across food & staples retailing, beverages, household products, tobacco, multiline retail, and personal products to provide a genuine exposure to the consumer staples sector.
[5] GS Consumer High Levered Index – an index of U.S. consumer stocks that have some of the highest net debt / EBITDA in consumer.
[6] J.P. Morgan iDex Global Autos Index (Total Return) – an index composed of 57 global companies involved in the automobile industry.
[7] S&P Homebuilders Select Industry Total Return Index – an index designed to measure the performance of the homebuilders GICS sub-industry category.
[8] PHLX Semiconductor Sector Total Return – an index composed of the 30 largest U.S. companies primarily involved in the design, distribution, manufacture, and sale of semiconductors.