THE PRICE OF DISCIPLINE.
“Rome wasn’t built in a day, but it burned in one.”
John Heywood
In previous letters, I’ve tried to explain how I think about scaling a new fund. Few managers get the opportunity to launch a fund de novo and their inception date leaves much to chance. Begin in 2009 and even a dart-throwing monkey will look brilliant. Start in 2021 and it would take four years to recoup your losses. Both managers may be of equal intelligence, but in the short term, their timing matters more than their skill.
Naturally, aspiring managers prefer to begin when odds are in their favor and bargains plentiful, i.e. a bear market. Unfortunately, this is when investors’ appetite wanes and their purse strings tighten, the only conditions in which bargains can occur. As a result, most funds are born during bull markets. Capital will always be raised when it can, not when it’s ideal.
I’m often asked if I care more about absolute or relative returns, to which I reply in jest, “yes.” As a reminder, absolute returns are an attempt to earn positive returns year in and year out, while relative returns measure performance against a benchmark, which is occasionally negative. In my experience, investors want relative returns in up markets, but absolute returns in down ones.
An example of an absolute return vehicle is real estate, where income is the primary objective and appreciation only realized after a substantial holding period. Equities are the inverse. Appreciation is their calling card and income an afterthought, (the S&P 500 currently yields just 1.25%). Most investors are aware that equities can go down 40% in any given year, but when held long enough, returns are usually positive and often superior. What they might conveniently forget is that your starting point matters (a lot).
If a manager started a small cap fund in March 1998, their returns would be negative until February 2009 (assuming average performance). Eleven years without a return would try even the most patient of investors, assuming the fund still had any. I refer to this as inception risk, and the only way I know to mitigate it is to invest over time.
Managers who hold cash are often accused of market timing, but my intent is to reduce the effects of timing, not magnify them. I could have created a benchmark-like strategy day one, but its odds of outperformance would be low and the world has enough of those already. Good ideas take time to source, and my aim is to deliver a portfolio of differentiated insights, capable of generating acceptable returns regardless of the direction of the market.
Lest you think I’m sitting on my hands waiting for a selloff, here’s how the fund has scaled year-to-date.
CAPITAL RAISED NET PURCHASES PERCENT DEPLOYED
JANUARY $2,502,000 $654,000 26%
FEBRUARY $3,537,000 $350,000 10%
MARCH $3,767,000 $530,000 14%
APRIL $3,792,000 $560,000 15%
MAY $3,992,000 $371,000 9%
JUNE $4,492,000 $845,000 19%
JULY $10,317,000 $3,130,000 30%
AUGUST $10,317,000 $423,000 4%
SEPTEMPER $10,817,000 $947,000 9%
TOTAL $10,817,000 $7,810,000 72%
It's probably a good time to bring up the first rule of investing, which is don’t lose money. Due to the nature of compounding, a 25% loss your first year requires 33% in year two to breakeven and a whopping 58% to get back to 9%, the long-term average. Avoiding a down year (or going down less) is extremely additive to returns.
Imagine you earned 15% a year but lost 20% every seventh year for 30 years, representing a ‘normal’ market cycle. Your average return would be 10%, but your actual return would be 9.6%. Now imagine your manager returned 10% a year, with no down years (I can’t achieve this but imagine it anyway). Again, the average would also be 10%, but the fund would trail the market 26 out of 30 years and the manager fired.
How many of you realized the second fund would beat the first by almost 200%?
Spreading out purchases to reduce inception risk is a cost I’m willing to bear (and as a reminder, I get paid on my returns). Consequently, the fund has averaged 51% cash since inception. Many of you appreciated this when the Russell 2000 fell 21% in the fund’s first 100 days. I suspect you may be less appreciative during its subsequent 39% rally.
Historically, my strategy has lagged during risk-on markets, as I’ve captured only 80% of the market’s upside. Conversely, I tend to look best (at least relatively) during selloffs as I capture 30% of the market’s downside (neither of which may be true in the future). The past six months has been the definition of a risk-on market. You’ve likely heard me say that 42% of the Russell 2000 is unprofitable. Since April 8th, the unprofitable components of the index are up 62%, while profitable companies are up just 35%. Guess where I spend the majority of my time.
And while my results are currently underwhelming, my stock picking has been respectable. The equities I’ve purchased are up 15% in nine months, which I find acceptable in all but the bulliest* of bull markets. I have a few unforced errors, but seven investments are up 40% or more. I’m trying to solve for the best risk-adjusted returns across a market cycle, not the ones that do best at extremes.
I don’t intend to allow cash to remain elevated indefinitely, nor do I feel pressure to chase or get invested at any cost. Next month, I will highlight the fund’s top 10 holdings to demonstrate how I’m discovering attractive investments amidst the froth.
As always thank you for your support.
Dan Walker
*Bulliest is not a word, but I struggle to find a sufficient adjective to describe the past six months.