Annual Letter to Partners (Financial Year 2021)
Dear Partners,
I hope that you and your loved ones remain healthy and well. Although the power that inflation wields on deflating the value of your capital is somewhat cliché, it can still be unsettling to consider that many of the things you seek to expend your capital on are likely to cost as much as 2x-3x more in over a decade and about 4x-9x more in over two decades. In thinking about purchasing power erosion, it is important to consider aspects beyond what published inflation rates would suggest to compensate for the evolving nature of needs.
Portfolio Commentary:
Financials – Banks and Insurance
Banks – In general, we do not think that the intrinsic values of the banks have depreciated much in the long term. In the short term, the revenues and net interest margins may take a hit due to low-interest rates (close to zero), and defaults on bad loans will likely increase under the current economic conditions. However, we think the loose monetary policy of today will benefit the banks in the long term with its excessive printing of money since banks are always the first beneficiary of easy money. Having endured the annual stress tests, banks are also in much better financial shape than they were during the Great Recession of 2008.
Resolute Forest Products Inc. (“RFP”)
As of December 31, 2021, the market price of RFP was US$15.27 per share, up 133.5% from the price of US$6.54 at year-end 2020. Having said that, it is quite comical to us how a commodity stock can be hammered beyond all logical comprehension. RFP paid a special dividend of US$1.50 a share in 2018, and it was trading as low as US$1.17 per share in April 2020. Back in March 2020, the company announced that it would buy back 15% of its common shares for US$100 million. At the lowest price of US$1.17, the whole market capitalization would be approximately US$99 million. In other words, instead of buying back 15% of the company with US$100 million, it could repurchase 100% of the company. RFP shares have since recovered a very healthy 1,205.1% to US$15.27 as of December 31, 2021.
When the stock is that cheap, if you don’t own any shares, a rational investor should back up the truck and buy every share that is offered in the market. But what makes it difficult for some investors to buy is not the rational side of his mind but more the psychological aspect of it. In the stock market, you are bombarded with noises that affect a person’s rationality. It can get radically altered. Stock prices can move unrelated to the fundamentals of a business. During a bull market, you may see several stocks trading at anywhere from 50 times going to more than 100 times earnings, and conversely, there can be several stocks sold at 10 times earnings going down to below five times earnings. The fundamentals of the company are ignored and, instead, investors are transfixed on the price movements of the last couple of years. Then new narratives are written most convincingly on why these are the new paradigms, and why they are not worth giving weights and considerations to what the assets are worth and what the company can earn over several years. I remember talking to one value manager in 1999 when the tech stocks were in full bloom. He said, “I have a family to feed and I will keep losing assets if I don’t accept the new headlines and paradigms. Sticking to buying companies that are undervalued is not the way to be successful in the long run”. He changed his philosophy before the tech stocks were about to go into a severe decline over the next couple of years.
One question that keeps popping up is regarding the current crop of tech companies like Facebook, Apple, and Alphabet. Based on the current interest rate, they are not overvalued. We also admit that we totally misjudged the valuation of these three companies 10 years ago. Metaphorically speaking, when we thought it was worth US$100 per share, in fact, it was worth closer to US$200 per share. Unfortunately, we also made some mistakes in evaluating mediocre companies. When we thought a company’s share was worth US$100 per share, it was actually closer to US$60 per share.
Despite the price of RFP trading at US$15.27 per share, it is still quite cheap. Let us look at a few facts. The shares may be able to get back close to US$400 million in duties (approximately US$5 per share), but the earning power over the next two years is most likely to be more than US$3 per share annually and the lumber prices may stay elevated for a while because there is an imbalance between supply and demand in housing that may take a few years before it comes back into equilibrium. Meanwhile, it is making money hand over fist.
One caveat though is that the value of RFP depends so much on lumber, a commodity business that is prone to a boom and bust scenario.
Every dog has its day.