Annual Letter 2020: One Year Has Passed

Annual Letter 2020: One Year Has Passed

In five days, Junto will turn one year old.

I think it’s safe to say that the first year of the venture did not turn out as expected. But what could anyone really expect?

One of the main lessons of 2020 is one that everyone seems to get reminded of pretty much every year. But this time it was especially evident: that attempting to forecast the market is a fool’s errand. Not a single market forecast in the world included a pandemic and the worst economic contraction since the Great Depression. And not a single market forecast included that in conjunction with an 18% increase in the S&P 500 index. Despite the ever-returning lesson, the bad habit of predicting market movements seems to remain with people whose livelihood depends on doing so. I’m glad that is not us.

The stock market is in a peculiar state as a result of what happened since the pandemic hit.

The first peculiarity is the fact that retail investors are not considered “dumb money” anymore. As lockdowns ensued from the crisis around the world, funds and institutions were hit by massive investor redemptions and a wave of budding punters started to engage in a frenzy of trading from their phones. While institutional flow still to this day takes up the majority of the market (by some estimates about 75%), the retail side of the market landscape showed to be very active and much more willing to reach short-term price discovery in certain sectors (green energy and tech) and individual stocks (think Tesla). Retail took the upper hand of swift market movements and the phenomenon was all led by better information availability, popularization of investing, and a vastly increased emphasis on short-term performance. Millennial investors became the infamous bunch. And, as it turned out, there is more to young investors than Robinhood and TikTok.

The other peculiarity resulting from 2020 is that companies that were able to make an accelerated shift to online business took off from the rest of the market just as the bottom hit on March 23rd. But it took the market a little shuffling the cards to get there. Take a company like Amazon – an indisputable beneficiary of how the world turned out to be. The market had its doubts in the beginning. Between February 19th and March 16th, the price per Amazon share took a dive from a high of $2,185 to a low of $1,626 only to go on a surging streak to a high of $3,552 per share until September 2nd.

These gains were far and few between. And, it just so happened to be the very companies whose market values took up a whole lot of the public stock market that benefited the most. The result was a rising S&P 500 with many hard-hit companies operating in the physical space (and notably small-cap businesses) struggling to keep up. The winning and losing components of the major stock market indices seemed to continue to diverge considerably.

As we approached the end of the year, that narrative changed partly as the price gains started to broaden out. The prices of industrials, banks, and retail woke up to the sound of a few vaccines being approved, and the market was quick to recalibrate its perception of future cash flows. People now talk about a “rotation to value” going on – as if capital is flooding out of things without any value and into things that have value. I’m not going to give my opinion of what happens from here since I, of course, don’t run a fool’s errand nor do I play the game of guessing how other market participants price assets. But, I do think the market’s consensus expects this “rotation to value” to continue in 2021.

What we can know is where we are. And in addition to that, how cautious we ought to be.

As the market stands currently, I think a strong economic recovery is baked into the price level. Corporate profits are expected to be higher than last year, short-term rates are expected to be stuck at zero, inflation is expected to stay low, the Federal Reserve is expected to keep providing liquidity to the market in a big way, and no adverse policy is expected before the U.S economy reaches full employment (which seems unlikely within few years). I have no opinion on whether such conditions turn out to hold true. But if they do, the current market may look high, may be high, but is perhaps not as high as it looks.

That being said, I think there are certain factors that might play out but are less accounted for. One is that money velocity might pick up to a significant extent as the result of massive money-printing as soon as people get the opportunity to spend it. If that is the case, it will put upward pressure on inflation. Another is that a lot of savings are allocated to the stock market which might not belong there under normal conditions. This might add a short-term selling pressure as savings move to consumption.

In his 2016 memo titled “On the Couch”, Howard Marks wrote:

In the real world, things generally fluctuate between “pretty good” and “not so hot”. But in the world of investing, perception often swings from “flawless” to “hopeless”.

My definition of the current market perception is… “hopefully flawless”.

As you will soon see, and perhaps already know, the Junto portfolio is currently 56% invested which means that I care little whether that flawlessness turns out to hold true. If you think that 44% cash is an excessive call option to hold, you will be exactly right. To make things worse, a 52% cash allocation is what I held throughout 2020 on average. One thing is being comfortable with the option I have today given few value opportunities. Another thing is not pounding harder at a great opportunity to scoop up cheap businesses back in March. While I did manage to do so to an extent, I did it while sucking my thumb.

As I’ve mentioned in previous letters, my cash position has nothing to do with market calls or me predicting a crash coming in the short (or even mid) term. In a perfect world, my cash allocation would always be 0%. But, my cash allocation has always been, will always be, a direct effect of what opportunities I find in individual stocks to buy below our estimate of intrinsic value with a satisfactory margin of safety. Nonetheless, I would argue that there are massive opportunities still to be found as long as one keeps looking in all markets. The market ebbs and flows, and valuations will go up and down because they always have. I keep hunting for value while learning in the process.

Between the launch of the Junto Portfolio on January 27, 2020, and today, January 22, 2021, the following shows the performance of the total portfolio including cash holdings.

Junto portfolio on January 22, 2021

There are a few points I want to emphasize. First, one year is far too short a period to form any kind of opinion as to investment performance. My own thinking is much more geared to looking at five-year performance, preferably with tests of relative results in both strong and weak markets. Second, while I seemed to beat the market in 2020 with a 52% cash drag due to favorable purchase prices, it is always my expectation and hope (which one is hard to tell) that I will perform relatively better than the market during slow or down markets, while I will have a hard time keeping up with aggressive bull markets like the one we’ve experienced for the past years.

General Motors was the biggest gainer. I managed to buy it at a screamingly cheap price in the middle of March. A lot of interesting news has emerged about GM recently, including the new electric product delivery system BrightDrop and GM Cruise’s team-up with Microsoft Azure to commercialize self-driving cars in 2021. GM’s intrinsic value is crystallizing and the company is worth a whole lot more than is still reflected in the market.

The laggard of the portfolio was GrafTech International, although it doesn’t seem all too bad looking at the return as displayed above. However, the price hit a low of $5.56 during the year, down 44% from my cost base. As the pandemic hit, steel production shrunk dramatically and so did the demand for GrafTech’s graphite electrodes. Some of the steel producers who had signed take-or-pay contracts with the company pressured renegotiations and some went bankrupt. The certainty behind GrafTech’s contracted cash flows for the next few years started wearing thin and that was reflected swiftly in the market price. Due to my small position and the company’s intact, strong competitive moat, I keep our ownership of the business as steel production ticks up and the trend towards environmentally friendly steel production continues.

Well, I got a bit ahead of myself here because there was a vital third factor I was meant to emphasize in terms of my investment results: Unrealized returns matter very little to me. I do not view my holdings as stock market wagers. My biggest gainer might as well have been another of my holdings, GM’s value crystallization might as well have been years into the future, and I might as well still have been down 50% from my purchase price in GrafTech.

In my holdings, I rather see an assembly of businesses that I own. And just like a private owner does not judge the progression of his/her business by the price any buyer is willing to pay for his/her on any given day, I do not judge my investments by price increases or decreases in the market within a 12-month time frame. This in no way diminishes the importance of the price of the holdings. Of course, prices matter the day I sell or intend to buy a bigger stake. I expect our holdings (as a group) to deliver major gains over a long period, but these gains will arrive in an unpredictable and highly irregular manner.

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