2020 Annual Letter
An interesting year to say the least. Supposedly starting (in this country) with a man arriving at a Washington airport in late February after a visit to Wuhan China. Not days passed before he was admitted to a local hospital and diagnosed with what was at the time a seldom known virus called COVID-19.
Speculation still remains on the origins of the virus and, as with previous pandemics, the definitive origin will most likely never be known. What is known, however, is that even those who had lived through a pandemic before could not have imagined the perils to come from the virus. Death, destruction, and economic downfall seemed to be what characterized 2020. Throw a presidential election into the mix and we have one of the most eventful years in the country’s history.
Thousands of pages could be, and will be, filled with descriptions of the havoc from last year. In this letter though, we’ll focus on that third point: economic downfall. In March of 2020 I wrote a letter to investors expressing my early thoughts on the pandemic’s impact on the economy and financial markets. In it I stated that the stock price of many companies had fallen drastically yet their economic fundamentals remained perfectly sound.
These drops in equity prices caused me to make a number of different purchases in companies who would undoubtedly be affected by the virus, but would not be severely harmed. While these companies the partnership purchased into remained perfectly sound, this could not be said for many other corporations.
As the possible dangers of the virus grew the government began to implement lockdowns to try and halt, or at least hinder, the spread of the virus. These lockdowns not only hurt a great number of businesses but also completely eradicated the economic fundamentals of countless corporations.
Such a rare and devastating event frequently gets termed a “black swan”, a term used to describe an unexpected and highly impactful event on societies as a whole. People more familiar with the term, though, are quick to point out that a worldwide pandemic cannot be classified as a black swan given the fact that pandemics have happened since the beginning of the human race. Swiss Re, one of the world’s largest reinsurers, ran a continuous ad in The Economist magazine based on this very premise.
However, what they, and many others, seemed not to have realized is that the pandemic was not the direct cause of the economic downfall. What brought the economy to a standstill was the government imposed restrictions and lockdowns that kept the money from flowing to consumers’ pockets back into the economic machine. And the nationwide lockdown, not the pandemic itself, was the true black swan.
Never in human history has there been such a reliance on global commerce in order to keep things moving. Pandemics of previous generations were somewhat limited in their spread as global travel was then a fraction of what it is now. Such impactful lockdowns then, have indeed never happened before in history and were in no way broadly expected by the population. 2020 then, with all its unprecedented events, was undoubtedly a black swan year; just as 2001 was.
The only thing that came close to the unprecedented lockdown was the stimulus the government provided to counteract the economic downfall that resulted from the shutdown. On March 15th, Jerome Powell, the Chairman of the Fed, cut rates to .25%. On March 27th the government signed into law a $2.2 trillion stimulus package. On April 11th stimulus payments started to arrive in citizens bank accounts. Each move served as an attempt to stop the free falling economy.
The result of these actions is that the federal debt as a percentage of GDP has reached its highest level since World War II, sitting at 129% at the end of the year. This has invoked a desire among many, particularly journalists, to point out that this is the highest our federal debt has ever been in any peacetime period.
But can we really consider 2020 a period of peacetime? As Mark Twain said, history doesn’t repeat itself, but it rhymes; and in my ways 2020 rhymes most with the years of The Great War and World War II. A time when all anyone could think and talk about was the battle going on among our nation. This battle though, unlike in World War I and II, was not fought against other humans, but against an invisible, silent, but just as dangerous organism.
Viruses over human history have killed vastly more people than any war or genocide caused by humans. The most dramatic being the black plague which in the 1300s killed upwards of 30 million people in Europe, as well as the 1918 Flu pandemic which killed more than 20 million people in a matter of 3 years.
A primary reason this pandemic caused such massive destruction though was because of the ill preparedness our nation faced. Because of the wars we have faced in the past, ones consisting of vast military spending and weapon improvement, our nation has spent decades preparing for those kinds of eventualities. We have an unlimited supply of aircraft, ammo, and other advanced military equipment capable of protecting us from virtually any national security threat from another nation. We don’t, however, have a vast infrastructure of medical equipment and processes to protect us from a worldwide pandemic that may break out. At least not yet.
We therefore spent the year scrambling to build equipment (ventilators), implement regulations (mask wearing), and alter our way of life, in order to fight this invisible killer. Were we to take these actions to protect ourselves from other humans or a rogue nation we would undoubtedly call it a war. Because a virus is simply a much smaller organism than humans, it only makes sense to define 2020 as a time of war.
The nation will have to pay a price for the massive amount of stimulus measures that were taken. Whether that is through higher taxes, runaway inflation, or unseen government intervention, there is indeed “no free lunch”. However, the price was paid in order to fight a war that we have seen only a few times in human history. Just as we paid the immense price to defeat Hitler and the Axis powers we will pay a price to defeat COVID-19. And while the price was large and controversial, it was not optional.
Now, enough macro, let’s talk micro. As mentioned previously the volatility in the stock market in the early part of 2020 provided an immense amount of opportunities for the investor in common stocks, which your managing partner was happy to take advantage of. The names of the securities will be omitted but the idea behind each purchase was the same.
When the price of a stock falls to a level that, when compared to the earnings of the company, would provide a substantial return on investment, we view this as the stock being undervalued. However, that latter part, the earnings of the company, is not an easy thing to determine. Out of the thousands of securities traded on the exchanges, relatively few have earnings that I believe I can reasonably predict will continue into the future at a similar or growing rate.
One of the biggest false premises that has destroyed numerous investors over time is to automatically assume that what a company has earned in the past they will continue to earn in the future. The key responsibility of an investor of course is to identify companies whose past earnings do give insight into the future prospects.
During times of an economic boom when corporate profits continue to rise at high rates compared to past standards it becomes expected that they will continue to rise at similar rates. Valuations for companies are then revised upwards by investors who have high expectations for future earnings. We have undoubtedly seen some of this over the past decade as corporate profits, along with the broader stock market, have risen steadily since the bottom of the financial crisis in March 2009.
11 years later, in early 2020, panic about the spreading epidemic brought a crushing blow to these expectations and caused the Dow Jones to fall 34% between February 14 and March 20th. What at the time seemed like a possibility of another depression caused reasonably justified fear about the state of the economy.
Quick actions by both Congress, the Executive Branch, and the Federal Reserve put a backstop to the trembling fears and what proceeded after the bottom on March 20th was a sporadic rise in the overall stock market. From the March bottom to the end of the year the stock market rose almost 60% as a flood of excess stimulus poured into financial markets.
The stimulus though goes beyond the sums of money sent to citizens and corporations. The first measure governments often resort to when facing a recession is to rapidly drop interest rates, a responsibility held by The Federal Reserve, our nation’s central bank. These measures directly impact the valuations of corporations as government bond rates are the first comparison investors make to equities.
This point cannot be overstated. If an investor can purchase a U.S. Government Bond (the safest possible investment) that is yielding 5%, then in order for them to consider investing in equities they must receive substantially more than the 5% they could get from the bond; perhaps a 7 or 8% return at least. If the Federal Reserve drops interest rates however, and Government bonds subsequently start yielding 1 or 2%, then investors will settle for equities that are yielding just 3 or 4% to get a higher return.
This, more than almost anything, is what has pushed equity prices up over the past decade. In 2020, the yield on the 10 year government bond got down to an astoundingly low .5%. Imagine lending someone $10,000 and only receiving $50 a year in interest.
Back to equities. A substantial portion of the fund’s returns in 2020 came from 3 investments made in the middle of March during this time of heightened fear. One a consumer products/technology company, another an entertainment company, and the third a financial services/credit card company. These activities are important to note for any partner of the fund as it shows we have no inclination or obligation to spread our investment activities over dozens of different investments; what professors call diversification and what others may call “diworsification”.
During the year almost 90% of the assets of the fund were in these three investments, which in no way bothers your managing partner. Although we put our funds in three different investments, I would have had no problem putting virtually the entire fund’s assets into just one of these companies, as their economic fundamentals remain as strong as any company's could be. However, these companies whose economics are so strong as to warrant such a concentration of our portfolio are very few and far between. Of the thousands of publicly traded companies on both the NASDAQ and NYSE, less than a dozen have such favorable businesses. Opportunities to invest in three of these companies at low prices will be very rare.
The propulsion of the stock market after the March low has caused a vast portion of publicly traded companies to rise to prices far out of our comfort zone for an investment. Towards the latter part of the year we engaged in a few arbitrage opportunities and investments in very small and much lesser known companies. (Refer to the Partners Manual for an understanding of our arbitrage activities).
2020 represented a rare year in which a large portion of the fund’s capital was put into larger companies, as our preference has been towards smaller, less followed companies whose prices are more likely to diverge from their valuation.
Current investors and potential investors should take note of this. While a large portion of our activities may be focused on one area such as small-cap stocks which we think are grossly underpriced, this does not restrict us from engaging in other investments which we think would be just as, or more profitable.
As explained in our Partners Manual, the purpose of the fund is to provide the greatest return while incurring the least amount of risk. This process can come in my different forms.
Any investment activities that diverge from our more common activities, and which have a material impact on the fund’s performance, will be clearly explained in this partnership's annual letter in order to keep all investors as informed as possible.
For any questions or concerns contact the managing partner at email@example.com
Partnership Returns Shown Below*
* Partners who invested money throughout the year may have returns that vary from figures stated above depending on the time of their investment.