2018 Year in Review
Dear Friends,
In 2018, the Global Return portfolio declined 11.9%, net. 1 This marks our first annual decline since inception six years ago. We ended the year with 0% of assets in Cash and had a net market exposure of 100%.
Thankfully, I get to write this letter knowing what happens – that we rebound in January and by February we more than make-up our 2018 decline.
Yes, I actually dedicate an entire section – most of this letter – outlining what I did wrong and I’m even putting it on the internet (that place with a limitless lifetime) for anyone who wants to see it. With 100% of my money invested alongside our partners, I care deeply about identifying my weaknesses so I can improve our process and ensure our continued long-term, superior risk-adjusted performance.4
Please feel free to contact me if you have any questions about our technology or my risk management and investment strategy.
Respectfully,
Elliot Trexler
etrexler@globalam.com
646-838-8182
EVALUATING OUR RESULTS
Thankfully I have the greatest clients a fund manager could ask for. They’re intelligent, open-minded investors who understand that investing success is achieved over long periods of time; and therefore, investment results must be viewed on an equally long-term basis.
Because of this, when we had our first annual loss, as a result of December’s decline, our clients didn’t agonize. In fact, they knew – with hedges in place and cash on hand – we were prepared for the decline and ready to capture the opportunities it offered. Not one client complained. Better yet, several made additional investments and were rewarded handsomely by our subsequent rebound.
Ideally, we would be evaluated by our CAGR since inception. This is the best measure to use when evaluating our performance because:
1) It incorporates every monthly return
2) It spans both bull and bear markets, and
3) It includes both high and low volatility periods
In other words, it’s a time-tested and market-tested return measurement that represents the effectiveness of our investment process.
If an investor won’t evaluate Global Return’s process using a long-term CAGR, we’re not going to be good partners. My investment process, risk management, and even my psychological makeup, are all geared for long-term results.
CASH VERSUS STOCKS
In Q4 2018, our cash balance was the lowest it's been in four years. And in December we were fully invested and had no cash balance.
Some investors, including me, wish we were always fully invested. It's assumed that "...if we did this well with a cash balance, imagine how well we'd do if all our cash was invested." I can appreciate this sentiment and I’d be perfectly happy if we were always fully invested because this would imply ample opportunities are available. Yet, there are several reasons why I’ll keep cash when necessary.
First and foremost, I only want to invest our capital when the risk/reward ratio is in our favor. A thorough analysis of our returns shows that we incur very little risk and achieve superior results. Results like ours are only possible if I’m highly selective about when and where I allocate our capital.
Second, cash allows me to enter new positions, add to existing positions and capitalize on irrational volatility – all of which I did Q4 2018 – thanks to our cash balance. In fact, the volatility of Q4 2018 and our subsequent Q1 2019 returns demonstrate exactly why I’ll keep cash when it’s prudent to do so. But when we’re fully invested my hands are tied. To enter a new position, add to a winning position or capitalize on volatility, we must sell or reduce a holding, and this has negative ramifications.
Conversely, having the flexibility to maintain cash so that I can invest when low-risk, high-reward opportunities develop does benefit our clients and portfolio’s risk-adjusted returns. I’m also free to sell existing positions when they reach fair-value or become over-valued without being forced to reinvest the proceeds.
Our 6-year track record, and especially our Q1 2019 results, illustrate it's worth waiting for the right opportunities before investing; we can generate higher risk-adjusted returns. And with 100% of my capital invested alongside our partners, I'm committed to investing our capital only when I believe the risk-reward ratio meets my criteria.5
REVIEW OF OUR 2018 LOSS
Some of you may be surprised I’ve dedicated an entire section to discussing what I did wrong in 2018.
Why would I do this?
With 100% of my capital invested alongside our partners, and in anticipation of having a multi-decade future in investing, I care deeply about what I do right, what I do wrong and how to improve my performance.6 With that said, I can’t think of any other way to improve my performance than to review our results with a discerning analysis and use this feedback to adjust our investment process. So here goes…
At the end of November 2018 our portfolio was down 146 basis points, net.7 By the end of December the portfolio had declined 11.9%, time-stamping our first-ever annual decline.8
Throughout December 2018 and Q1 2019, I executed on our investment strategy and the results delivered as planned.9 By the close of Q1 2019, our portfolio had gained 19.3%, significantly surpassing any comparable benchmark or peer group, and we more than recouped our 2018 decline.10
In February 2019, we exited our largest position for a 22 basis points loss.11 And this is the mistake I’d like to review.
The Investment Since I don’t name specific holdings in our portfolio, let’s call this company ABC.
Our initial investment in ABC occurred in May 2018, and throughout the rest of the year we made eight additional purchases. By December 1st , ABC was our 2nd largest position, equaling 7.7% of the portfolio corpus.12
We invested in ABC because the company’s operating assets were worth significantly more than the stock price. I also believed that short-term and long-term catalyst would propel the company’s revenues, earnings and cash flow much higher. My investment thesis assumed our return would range from 30% (Base Case) to 50% (Bull Case). The Bear Case scenario assumed the stock could decline 30%, for which I assigned a 5-7% probability of occurring.13
Using the Bear Case scenario, and assuming our initial investment was 3% of our portfolio corpus, if the stock declined 30% our corpus would be impacted by only 90 basis points. Given the company’s operations, competitive advantages, my assessment of its value and the probability of the Bear Case scenario occurring, I was willing to risk 90 basis points to earn 90-150 basis points. Actually, I hoped the stock price declined because I wanted to buy more stock at cheaper prices, which would increase our risk/reward ratio.
What Happened
In the nine months we owned ABC, the company received eight upgrades and downgrades and at least as many analysts’ reports, notes and earnings revisions. We don’t invest in companies that are, or could be, subject to this much conflicting information, so this was a remarkable amount of activity for us.
The rating changes began immediately after our initial investment. Unbeknownst to me, four days before investing in the company, a local politician campaigning for a State office gathered enough signatures to place on the ballot in November’s election the repeal of a State law. ABC benefited from the would-be-repealed law; and unfortunately, the politician’s campaign was built on repealing the law and was gaining popularity.
When I valued the company, I didn’t do a Bear Case valuation that considered the loss of this revenue. Because this risk never occurred to me my analysis of the risks embedded in the company was incomplete.
Ironically, I don’t invest in companies that generate a large portion of their revenue from government agencies. ABC exemplifies exactly why: Elected officials rotate in-and-out of office and can change the laws that dictate how the government spends money. Hence, revenue derived from government agencies will always be at risk depending on who’s in office.
But I have one exception to this rule: I invest in companies in the infrastructure industry, such-as ABC. I make this exception because approximately 66% of infrastructure project costs are financed with State and local funds.14 And since “all politics is local”, I’m wagering that irrespective of whether Democrats or Republicans control the State Legislature, roads will be paved and potholes will be filled.
Valuation Methods
During the first three months we owned ABC it declined 16%. Though this decline was within my Bear Case scenario, I couldn’t assess the probability that the repeal would be approved. Nor could the local media, their polling estimates were showing a 50-50 chance of a repeal (not that I would make an investment based media polls anyway).
What was I supposed to do?
The way I saw it, I had two options:
1) Exit the position and wait until after the election to reassess the investment, or
2) Maintain the position until our Bear Case threshold was reached
Neither option was reassuring. But then I began to think about this company from a different perspective.
When I originally valued ABC, I used the discount to cash flow method because I was valuing the company’s operations and cash flow. However, because the company owns a substantial amount of physical property, I began to wonder if I should use a different valuation.
Switching valuation methods after making an investment can be troublesome because of what’s called the Framing Bias.15 Loosely speaking, this principle states that someone can arrive at a different conclusion and/or make a decision based on how information is presented. In other words, switching valuation methods might offer a better – yet false – valuation of ABC.
Was I considering a different valuation method hoping it would give me a reason to hold the losing position? Or was I responding to new information and appropriately adjusting my perspective?
I decided to include the second valuation method for two reasons. First, valuing tangible assets in present time is not nearly as susceptible to the Framing Bias as is valuing a 3-year or 5-year projection of cash flow. Second, I realized I should have valued the company on a per-unit basis from the outset.
Based on the new valuation method, and a re-valuation using the discount to cash flow method, I determined that our holding was trading significantly below its net worth. With each stock price decline, our margin of safety and our risk/reward ratio were increasing in our favor. Though the position had declined 16%, I trusted my analysis and added to the position.
The Rollercoaster ABC announced it would report its Q3 earnings just 7 days before the election. Though I wasn’t expecting an earnings surprise, I thought it prudent to buy put options for insurance. Thankfully these proved unnecessary.
The company reported earnings (on the day after what would be it’s 52-week low), sending its stock up 20% in one day. The following week voters decided to not repeal the tax and the stock gained another 10%.
At this point, the stock was our 2 nd biggest holding and was down only 5.4%.16 The impact to our corpus was a mere 42 basis points.17 After six months of wrestling with ABC I finally felt some relief.
Unfortunately, that relief didn’t last long.
Soon after the November elections, December happened. Over the next 15 trading days the S&P 500 dropped 17%. And so did ABC. I stuck to my investment strategy – seeing no change in the company’s fundamentals, I bought more stock.
Then, in the first two weeks of January 2019, ABC’s stock price rebounded over 17%.18 And because we had bought more stock this gain had a sizable impact on the portfolio.
Whew! I was starting to feel some relief again.
But like last time, that didn’t last long. The stock dropped 4.3% in one day on news related to a Congressional bill that would impact federal funds for infrastructure projects.19
That was it! I sold the entire position in early February for a loss of 22 basis points.20
What Happened?
By the end of Q1 2019, ABC rallied 35% to my price target.
Our capital, both mine and my clients’, was put at risk and received nothing in return – this isn’t how investing is supposed to work. Simultaneously, I invested a lot of time, energy and focus that could have been directed to a holding that generated us returns. In the end, what I have from this experience are the following lessons.
INVESTMENT EVALUATION
What follows is a review of what I did wrong and why I did it. I also include an overview of my decision-making process and why it was being impacted.
Binomial Outcomes
I don’t invest in companies where our returns are subject to binomial outcomes, such-as success or failure, or win or lose. By their nature, investments with binomial outcomes having opposing opinions of the facts where a singular event can shift the probabilities of the outcome; thereby, shifting the investment’s risk/reward ratio. To me, this is too risky because it’s not possible to prepare for every potential risk. Case in point: The risk that a local politician would gather enough signatures to place a repeal on November’s ballot.
Unfortunately, after the repeal was placed on November’s ballot, the results of our investment became binary. I should have immediately sold ABC stock and waited until after the election to revalue the company
Time Horizons
I was a “long-term” investor until our investment didn’t go the way I expected. Suddenly, I was a “short-term” investor, having sold the stock nine months after buying it.
One of the many reasons we’re long-term investors is that it ensures we’re not subject to – and can take advantage of – irrational volatility. I did this by adding to the position as it declined, which ultimately allowed us to sell at a near breakeven. And though I can count on two fingers how many times I’ve been affected by volatility; this was one of those times.
Valuation Methods
Because ABC is in the infrastructure industry, it has a lot of tangible assets on its balance sheet. And though I evaluated the company’s balance sheet, I never did a per-unit valuation of the company. Had I done this at the outset of my analysis, I would not have become so concerned when learned about the potential repeal and the stock began whipsawing. My concern drained my stamina causing me to sell the stock before our thesis could unfold.
Every prospective investment is valued with a Base, Bear and Bull Case scenario, but I’ve never used different valuation methods on the same investment. As a result of this experience, our investment evaluation process has been amended to consider whether more than one valuation method should be included.
Cognitive Dissonance
Because our investment process begins with and is built-on risk management, when a risk manifests, we’re prepared to handle it. But the experience with ABC was different. Every other time one of our holdings developed a risk, that risk didn’t threaten the intrinsic value of the company.21 Conversely, had the State law been repealed, ABC’s intrinsic value would have declined and caused us losses.
The ensuing discomfort I experienced is called Cognitive Dissonance – this is the stress that develops when people are confronted with new information that conflicts with existing information.22 In our example, the repeal of State legislation and subsequent reduction of ABC’s intrinsic value conflicted with my beliefs of ABC’s intrinsic value. Adding to this were the many conflicting upgrades, downgrades and analyst opinions.
When portfolio managers experience this type of stress, they’ll attempt to alleviate the discomfort, often using irrational measures like adding to the position just prior to the stock’s decline or selling the stock near its lows. I was worried that the longer I held ABC, the more likely I was to be impacted by Cognitive Dissonance.
They’re Cousins
Two additional biases I was concerned might influence my decision-making were the Overconfidence Bias and the Endowment Effect.
As the name implies, the Overconfidence Bias states that confidence in one’s own judgement is higher than warranted.23 My concern was that I wrongly believed that the downgrades of ABC were unfounded and that my analysis was the correct analysis.
The cousin of the Overconfidence Bias is the Endowment Effect, these two are similar but different. This bias states that once an investor owns an asset, the investor places a greater value on the asset than what it’s worth.24 As a result, the Endowment Effect can make it difficult for portfolio managers to sell a position even though its value has declined. Throughout our time holding ABC, I considered whether this bias was influencing me to hold the stock (hence the per-unit valuation); though subsequent data (the stock price rising) indicates this wasn’t the case.
Once the Overconfidence Bias has a grip on the portfolio manager’s mind, it’s very easy for the Endowment Effect to move in. Both these belief systems can have dangerous effects on a portfolio manager’s decisions. To the best of my knowledge, the only remedy for removing or reducing the influence these types of biases can have, is to create, and continually enhance, risk management policies and procedures.
Investment Conclusion
It’s important to acknowledge when our emotions could highjack our decision-making process. Not being able to do this is a significant barrier to successful investing. The combination of many factors – upgrades and downgrades, inability to forecast voter outcome, broad market declines, and a keen awareness for the potential of investor biases – was giving me decision fatigue. I was aware of the possibility that I could make an inadequate decision that wasn’t based on well-developed probabilities.
Paradoxically, it was at this point of awareness I had the opportunity to make a good decision. I sold the stock.
It’s true that after selling ABC it rose 35% to my target price, but we only know this after the fact. I can’t say how I would have handled the position because my emotions had me flying blind. Maybe I would’ve sold it for a profit and maybe not. I think I made the best decision on behalf of our partners and our capital because the decision to sell the stock immediately removed any risk to our portfolio and our capital.
I was wrong to not immediately sell ABC when it evolved into an investment with a binomial outcome. Had I exited the position in June when I learned of the repeal, I could have redirected 8 months’ worth of time, energy, mental focus, emotional stamina and our capital into a more promising holding. And maybe 2018 wouldn’t have been a negative year for us. Lesson learned.
CONCLUSION
I have no prognosis for what the market will do in 2019. As stock prices decline, the sentiment of my letters will change to bullishness. I like it when stock prices decline because this is when our Cash is most productive – I can buy more stock with less money. It should not be ironic that declining prices offer reduced risk and increased returns, which, after all, is what every investor wants.
Throughout 2019, I’ll continue investing in our management company’s technology infrastructure. I’m proud that we’ve built the technology we use; we don’t use any off-the-shelf standard financial data providers. I’m confident that our technology, combined with our investment process and risk management, give us a competitive advantage; and our risk-adjusted returns indicate this.
As always, please feel free to contact me if you would like to discuss our risk management strategy, our technology or how we invest.
Respectfully,
Elliot Trexler
etrexler@globalreturnam.com
646-838-8182
Appendix A
Appendix B
IMPORTANT DISCLOSURES
This document is confidential and intended solely for the addressee. It is intended for information purposes only and should be used only by sophisticated investors who are knowledgeable of the risks involved in investing. This document does not constitute an offer to sell or the solicitation of an offer to purchase securities and may not be published or distributed without the express written consent of Global Return Asset Management, LLC (“Global Return”).
An offer may be made only by use of a confidential private offering memorandum and only in jurisdictions where permitted by law. This information is not intended to be a description of the risks of an investment in any fund (the “Fund”) managed by Global Return or its investment strategies. This material is not meant as a general guide to investing or as a source of any investment recommendation and makes no implied or express recommendations concerning the matter in which the Fund could or would be handled. An investment in a Fund managed by Global Return is speculative and involves a high degree of risk. Funds managed by Global Return may also have limitations on investors’ ability to withdraw or transfer their interests in the Fund and no secondary market for the Fund’s interests exists or is expected to develop. All of these risks, and other important risks, are described in detail in the Fund’s private offering memorandum. Prospective investors are strongly urged to review the private offering memorandum carefully and consult with their own financial, legal and tax advisors before making any investment.
There can be no assurances that the Fund will have a return on invested capital similar to prior years’ returns, because, among other reasons, there may be differences in investment policies, economic conditions, regulatory climate, portfolio size, and expenses. The fact that the Fund or investors in the Fund have realized gains in the past is not an indication that the Fund or its investors will realize any gains in the future. Prior performance is not necessarily indicative of future results.
Investment returns and the principal value of an investment in the Fund will fluctuate so that an investor’s units, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance shown. Performance data current to the most recent month may be obtained by calling 646-838-8182. The Fund imposes a 2.00% redemption fee on units held 30 days or less. Performance shown does not reflect the redemption fee, and if it had, returns would have been lower.
An investor cannot invest directly into an index. Indexes listed include the following:
HFRI Fundamental Value strategies employ investment processes designed to identify opportunities which trade at valuation metrics the manager determines to be inexpensive and undervalued compared with relevant benchmarks. Investment theses are focused on the firm's financial statements in both an absolute sense and relative to other similar securities and more broadly, market indicators. Fundamental Value strategies typically focus on equities which currently generate high cash flow, but trade at discounted valuation multiples, possibly as a result of limited anticipated growth prospects or generally out of favor conditions, which may be specific to sector or specific holding.
HFRI Fundamental Growth employ techniques in which the investment thesis is predicated on assessment of the valuation characteristics on the underlying companies which are expected to have prospects for earnings growth and capital appreciation exceeding the broader equity market. Investment theses are focused on the firm's financial statements in both an absolute sense and relative to other similar securities and more broadly, market indicators. Strategies employ investment processes designed to identify opportunities in companies which are experiencing or expected to experience abnormally high levels of growth compared with relevant benchmarks growth in earnings, profitability, sales or market share.
HFRI Multi-Strategy Investment Managers maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH MultiStrategy managers typically do not maintain more than 50% exposure in any one Equity Hedge sub-strategy.
Barclay Equity Long Bias Index is recalculated and updated real-time on this page as soon as the monthly returns for the underlying funds are recorded. Only funds that provide us with net returns are included in the index calculation. The number of funds that are currently included in the calculations for the most recent months can be found in the footnotes below. Please note that the calculation for the number of funds is time-stamped and that the number of funds will continue to increase until all funds categorized within the sector have reported monthly returns.
1 All data as of December 31, 2018. Includes a Net Expense Ratio of 1.5%. See Appendix A for more information and Appendix B for Important Disclosures.
2 CAGR stands for compounded annual growth rate. Our inception date is January 1, 2013. Includes a Net Expense Ratio of 1.5%.
3 Return since inception, January 1, 2013. Includes a Net Expense Ratio of 1.5%.
4 Here’s my lawyer’s contribution to this letter: The “100% of my money” stated is my liquid net worth only.
5 Here’s my lawyer’s contribution to this letter: The “100% of my capital” refers only to my liquid net worth.
6Here’s my lawyer’s contribution to this letter: The “100% of my capital” refers only to my liquid net worth.
7 Includes a Net Expense Ratio of 1.5%. See Important Disclosures for additional information.
8 Includes a Net Expense Ratio of 1.5%. See Important Disclosures for additional information.
9Our Q1 2019 ended on March 31st 2019.
10Includes a Net Expense Ratio of 1.5%. See Important Disclosures for additional information.
11Does not include any expenses. The loss is calculated as the dollar amount lost divided by the portfolio corpus. Portfolio corpus is the amount of capital invested into the portfolio and does not include any gains or losses. See Important Disclosures for additional information.
12 Portfolio corpus is the amount of capital invested into the portfolio and does not include any gains or losses. Percent figures are calculated as total capital invested in the position divided by the portfolio corpus and do not include fees.
13 When investing, the Bear Case scenario should always have a small probability of occurring. If the investment has a high probability of developing a Bear Case scenario, why make the investment? A perplexing consideration of this scenario is how much the required rate of return should be adjusted to incorporate new, unexpected information that ignites a Bear Case scenario. In theory, each price decline could represent a proportional increase in the investment’s margin of safety and subsequent returns. However, because of the myriad of unforeseen reasons that can ignite a Bear Case scenario, it’s difficult to create universal investment policies and procedures that include adding to a holding in the Bear Case scenario.
14 “Public Spending on Transportation”. Congressional Budget Office. October 2018.
15 Tversky, A., Kahneman, D. The framing of decisions and the psychology of choice. Science. Vol. 211, Issue 4481. Pages 453-458. 1981.
16 Gross of any fees. See Important Disclosures for additional information.
17 Gross of any fees. See Important Disclosures for additional information.
18 Gross of any fees. See Important Disclosures for additional information.
19 Gross of any fees. See Important Disclosures for additional information.
20 Gross of any fees. See Important Disclosures for additional information.
21 Some readers might recall in our 2017 Year in Review, I discussed how Hurricane Harvey was a risk that manifest that I had not previously considered. Though Hurricane Harvey and the repeal of the State law were both unexcepted risks, they’re different because Hurricane Harvey was not going to alter the intrinsic value of that company; whereas, repealing the State law would have reduced ABC’s intrinsic value.
22 Festinger, L. “Cognitive dissonance.” Scientific American. October 1962.
23 Gerry et al., 2002.
24 Kahneman et al., 1991.