We are long-term investors. With each passing day this declaration sounds more and more quaint in today’s investment environment. We live in a world of real-time news, Snapchat, Facebook, TikTok, and Instagram. These social media platforms compete for our attention along with cryptocurrencies, a 24-hour news cycle, and commission free trading. It’s a continuous challenge to stay focused and to fight the need to jump to whatever’s next. The never-ending barrage of news and information can leave one feeling overloaded and trapped in a never-ending cycle information consumption. Being forced to feed at the all-you-can-eat information buffet does have consequences. For example, an investor will see high quality thoughtful decision making erode and replaced by “fomo”, fear of missing out. Pretty soon focusing on the short-term becomes the default mind-set.
Despite all the temptation in today’s financial markets, we continue to believe that the path to delivering attractive investment returns, and compounding capital, is to take a long-term investment approach. Saying something and living it every day is extremely hard. We are fallible and at times have failed to maintain a long-term outlook on a particular investment. In several circumstances, we’ve sold due to changing or eroding business fundamentals, or when there was a change in the competitive landscape. In other cases, there was simply an error where we misjudged the quality of the business. These have occurred in the past and will occur again in the future. As strange as it sounds, errors in judgement are part of the investment process. No one bats a thousand.
There is another type of error we’re less tolerant of and are striving to reduce. These are errors that occur due to a failure of imagination. What does this mean? On the surface investing can appear to be all about numbers and profits. However, there is a much larger variable that determines success – the ability of an investor to imagine a future or outcome far beyond what others see. This has nothing to do with building a better spreadsheet, it has to do with the other side of our brain, the place where imagination, creativity, and vision live. It has to do with asking questions others are not. Thinking about the company and its growth in way that other are not.
In most cases we’ve owned wonderful companies that meet all our criteria of quality, but we ultimately sold due to what we believe was over valuation. In many of these cases the valuation appeared extreme if viewed through a traditional valuation lens. However, applying a dose if imagination and vision would have yielded a different answer and a different outcome. For example, we previously owned Mastercard (MA) and sold the position after enjoying a 129.6% return over 4 years. In the ensuing 9 years since our sale the stock has delivered a 25.11% annualized return. A similar type of post-sale return has occurred for CarMax (16.21% over the next 11 years), Microsoft (32.25% over the next 7.5 years) and Pool Corp (31.65% over the next 10 years). That was a painful sentence to write. In all circumstances a failure to think about the company differently and see its progress through a different lens result in a premature sale.
The key question to ask is – “how do we improve and do better”. How do we improve our process and use these past errors for learning and not self-flagellation?
Today we have evolved our process to where we ask question about what could be. We ask, “if we’re wrong on this holding to the upside by a magnitude of 5X or 10X, how would that occur?”
To be clear – this is not about blindly holding and hoping. This is about forcing imagination into the process to tease out a vision of what could be.
Thankfully, we have been successful in imagining a different future for a number of holdings and have enjoyed the benefit of being long-term shareholders. Keep in mind, it’s not just a long-term patient mindset that’s required. A critical element is the confidence in one’s investment judgement to withstand the eventual decline in price while on the road to long-term returns. No one said investing is easy.
As evidence the following charts are offered up. Each chart shows the drawdown (decline from a new high) the stock experienced over the stated time frame. For example, the first chart shows Lab Corp, a holding since October 2003. During this period, we have enjoyed a return of 850% (vs. SP-500 return of 338%). However, to enjoy these returns we needed to endure one drawdown of 50%, three drawdowns of 30%, and a 20% drawdown. Had we not had the confidence in LH’s business model, competitive position, and faith in leadership, it would have been easy to sell on any of these price declines.
The same patience was also required to hold Apollo (APO). We purchased the position in June 2015 and have enjoyed a total return of 280% vs. 123% for the SP-500. Or said different, a 23.36% annualized return over the 6.3 years we’ve held the stock. During this time, we’ve experienced one drawdown of 35% and three drawdowns of more than 25%.
Why raise this point? Where is all this going?
In a year when the broader market is up more than 20%, and the March 2020 COVID lows fade into the background, it’s easy to get complacent. It’s easy to get lulled into the view that markets always go up.
We spend no time forecasting the economy or estimating when we believe the market will decline. All we know for sure is that it will decline in the future. We also know that the stock price of the companies we own will also decline. When this time arrives, we will need to steady ourselves, maintain the discipline of long-term shareholders, check and re-check our analysis, and hold the course because we’ve imagined a bigger or better outcome. When this day arrives owning a portfolio of high-quality durable companies will be critically important. This thinking also applies to our real estate portfolio – we must have attractive locations, conservative financing, and high quality tenants. Lastly, our private equity portfolio is required to meet to meet the same standards as our public company portfolio.
In summary, we’re aiming to build a diversified portfolio of public and private investments that are durable and can withstand whatever comes next.
Through the third quarter our average equity portfolio generated a +15.2% return.
We did not add any new positions during the quarter and eliminated one position.
We sold Hill-Rom after the company received an acquisition offer from Baxter International. We held the position for just over 12 months and generated a 64.8% return during our holding period.
The broader market continues to grind higher despite a slew potentially negative issue. There is the pending corporate tax increase, transformational changes in the Chinese economic landscape, and the Federal Reserve’s imminent reduction in monetary support. The extent and potential impact of these is unknown, all we know is that they’re not positive.
As we entered the fourth quarter several newer vintage technology companies experienced material declines in their share price. In some cases, they were unable to meet lofty growth projections, in other cases the business models turned out to be less impressive than initially thought. The carnage is now sufficient to where we believe opportunities are beginning to materialize. We’re actively working on new opportunities and our pipeline is robust.
As the portfolio continued to appreciate through Q3 2021 and into Q4, we have actively trimmed positions that grew beyond our risk tolerance. As a result, our cash balances have grown, and are above average.
Fixed Income Update
Our fixed income portfolios continued to build on solid returns from Q1 and Q2, with the average portfolio generating a positive +4.2% year-to-date.
In total seven fixed income positions have been called away in 2021 thus far, we added two new positions. As painful as it is to remain under invested, we remain disciplined and await a more attractive fixed income environment.
There were no new real estate investments completed in Q3 2021.
We continue to evaluate three opportunities in our pipeline and expect to have more information to share in the coming weeks.
A more detailed description and update can be found in the “Real Estate Update” included with this letter.
We completed one new private equity investment in Q3 2021.
At the end of the quarter, we completed the acquisition of 21 Sonic Burger franchises in Salt Lake City, UT. We’re enthusiastic about the growth opportunity in Salt Lake City where the plan is to add an additional 15 stores. We have a strong team in place to both operate the existing stores and development of new stores. We will have a detailed update at the end of Q4 2021.
A detailed update on our other current holdings can be found in the “Private Equity Update” included with this letter.
As we approach the end of 2021 and reflect on the strong results we’ve enjoyed thus far, it’s worth repeating the concluding remarks from last quarter.
It is easy to become complacent when results have been strong. Be assured the whole Carmel Capital team remains vigilant and steadfast in our commitment to deploying capital with the discipline and analytical rigor required to drive attractive returns.
Carmel Capital Partners is an SEC registered investment adviser. Carmel’s investment advisory services are available only to residents of the United States in jurisdictions where Carmel is registered. Nothing in this material should be considered an offer, solicitation of an offer, or advice to buy or sell securities. Past performance is no guarantee of future results.
Any historical returns expected returns [or probability projections] are hypothetical in nature and may not reflect actual future performance.
General Disclaimer: The information provided represents the opinion of Carmel Capital Partners and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific investment advice and should not be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation.
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