If one studies the history of financial markets, a consistent theme emerges. Short-term fads tend to dictate short-term performance, but long-term performance is determined by value and fundamentals. There are periods where prices flat out do not make sense, either for the market as a whole or for individual stocks and sectors. The current investment climate is distorted for a variety of reasons. Historically low interest rates have investors taking on significant risks to chase yields. Anemic economic growth and a commodities depression has led to an earnings recession over the last several quarters. The most toxic political climate in my lifetime has created a great deal of uncertainty and concerns for the future. The regulatory climate is as challenging as any since the 1930’s, which raises costs and prohibits growth.
If one looks at the valuation of the S&P 500 or the Dow, I’d say that they are fairly valued to expensive. On an absolute basis they would be expensive, but in the context of the current interest rate environment things don’t look as bad. With that said, any increases in interest rates would likely call for a significant reversion to the mean, which could drop about 15-25% off some of the most popular stocks in the market. The indexes themselves would likely perform pretty poorly if that were to occur, and it is difficult to imagine returns greater than 3-5% per annum from current levels in index or mutual funds no matter what. If my choices were between index funds and cash, the decision would not be that easy. If my time horizon was 3 years or less, I’d be just as happy in cash or short-term bonds yielding very little. While the market itself is pricey, we are finding some of the best investment opportunities that we have seen in the last 10 years. This is the big benefit of value investing. We are able to focus specifically on areas that are out of favor and avoid the expensive ones. This can work against us over the short-term when market participants are focusing on a specific theme such as yield or consumer staples in a weak economy, but over the long-term it is exactly what should enable us for outsized returns.
If you look at our average portfolio, the price to book is between 0.6-0.8. This means that our portfolios trade at 20-40% discounts to their net asset values, or assets minus liabilities. You’d struggle to find another firm with anything close to those metrics. The S&P 500 has a price to book of approximately 2.7, so we are about 75% cheaper than the market as a whole. Our major positions are very profitable with a clear path towards higher profitability moving forward. Higher interest rates would benefit us greatly. In addition, we have covered calls working for us, which will provide a very nice income stream as the year progresses. For instance, AGO pays a dividend of 2.07% and trades at about 40% of adjusted book value. We have some covered calls at $30 that expire in January which are still going for $1.08 per contract. This means, that if the stock were to not move at all between now and mid-January, the option would make us another 4.32% beyond the dividend, while also giving us upside potential of 20%. There is very little risk in this position and I suspect that as more clarity comes regarding Puerto Rico, the stock should have no problem rallying above $30. In fact, I could say the same thing about all of our large positions as far as upside potential. These are all companies trading at 50% or less of a very conservative estimate of intrinsic value. I believe our returns over the next 3 years should be exceptional even if the market is only average, because the stocks we own are so incredibly cheap. One might think “well if the market is expensive, how can we still make money?” The graph below represents the performance of the Fairholme Fund run by Bruce Berkowitz between 2000 and 2003. I use this fund because it has similarities to us from a value investing standpoint although it doesn’t use cash-secured puts or covered calls, and TTCM wasn’t in business during these years to use our own performance. As you can see, the S&P dropped by nearly 25% and this fund made about 80%, for roughly 100% outperformance. This was accomplished via a deep value philosophy and concentrated positions. Berkowitz didn’t try to keep up with the average Joe or Jane, which hurt performance in the late 1990’s but paid dividends literally over the long-term.
Given the tumultuous and truthfully difficult last year for the markets, the industry is seeing tremendous outflows. Fortunately, that hasn’t been the case for T&T Capital Management as I believe we cater to an educated clientele which is focused on maximizing long-term returns and minimizing permanent losses of capital. This is important because numerous studies show that chasing short-term returns is the biggest reason why investors underperform. Even the best performing mutual funds have seen most of their investors actually underperform, because the investors would get in when the stocks were expensive and get out when stocks were cheap. There has been a great deal of publicity over pension funds halting their investments in hedge funds due to poor recent performance. While I don’t agree with most hedge fund fee structures, I believe this will be a mistake because the alternative for most will be just being long stocks and bonds in an overly diversified manner, which is foolish when the market is expensive. It is in these challenging conditions which plant the seeds for the greatest outperformance. I see no way possible that our key investments stay anywhere near current prices given their balance sheets and earnings prospects. I’m buying all the stock I can while things are on sale. In 3 years’ time I believe we will be celebrating our greatest period of performance relative to the index, but it won’t happen overnight. Those that can stay strong during these times will reap the rewards, while those that panic and focus too much on the short-term will continue swimming against the tide in meeting their investment goals. It makes zero sense to sell great businesses at massive discounts to liquidation value, let alone intrinsic value. As the earnings story continues to play out and short-term fears fade, I believe you will see a considerable surge in your account value. Obviously, there are never guarantees but I’m putting my money where my mouth is. As always, if you have any questions or if I can assist you at all, please don’t hesitate to contact me at 805-886-8140.