“However beautiful the strategy, you should occasionally look at the results.”
– Sir Winston Churchill
Black Cypress had a strong 2016, delivering a 24% net-of-fee return for its partners. For comparison, the S&P 500 returned 12%. Since inception nearly eight years ago, Black Cypress has outperformed broad stock market indices, other hedge funds, and long-only “value” managers.
Performance was solid across our portfolio last year. Baker Hughes (up +43%), FMC Corporation (+47%), Halliburton (+62%), and WESCO International (+52%) were among our best performers. These companies were discussed in our year-end commentary last year as well, but for their poor performances in 2015. Though, we noted that we felt they would be “tomorrow’s biggest winners,” and they were.
The fact that four dishonorable mentions in 2015 would become our four best performers in 2016 warrants more than a passing glance. It showcases the value of our concentrated, research-intensive approach and demonstrates the genuine knowledge and therefore analytical advantage we gain through our work.
We spend a considerable amount of time studying businesses and their stock values, and that bears fruit in numerous ways. But relevant to today’s discussion is how our research efforts create and sustain conviction.
The market in January and February of 2016 punished industrials, material, and oil-related names, companies that we started buying in late 2015 after substantial declines had already occurred in the sectors. These declines made for ripe long-term investment, in our opinion. But the selling didn’t let up after we initiated new positions. The drumming continued.
WESCO International fell 30% from our purchase price to just $36 while FMC dropped to $34 per share, down 32% from our initial commitment.
How should an investor react to what feels like the market’s relentless punishment, screaming that you are wrong, continually selling your names down? Well, it depends.
How well does the investor know their companies? Is the ongoing research effort still yielding positive confirmation of the thesis or have cracks appeared? Has the selling created better opportunities elsewhere?
Without in-depth research at one’s side, an investor is apt to respond like a deer in the headlights. The overwhelming majority of “active” managers own 60, 70, or more stocks. It is extremely difficult for a portfolio manager with that many investments to have deep, company-specific knowledge that provides the conviction to hold ground or buy more. That’s why we invest in 15 to 25 individual companies at a time; it offers adequate diversification, allows a meaningful return contribution from each position, and doesn’t dilute the research effort across too many names.
Just one year later to the day, WESCO is now trading for over $70 per share (the per-share value we targeted for the stock in our commentary last year) and FMC is trading for over $60. We bought more of each early last year and were handsomely rewarded for our research and conviction.
But conviction also helps you know when you’re wrong and can prevent a mistake from morphing into a blunder. Take our position in the Gap, another company we discussed in last year’s January commentary.
We purchased the company’s stock because we saw a general weakness in retail that we expected to abate. We liked the Gap in particular for its plan to restructure the store base and revisit the style and fit of its brands. We initiated a position at $31 per share and ultimately sold the stock in 2016 for a 10% loss.
We count this loss as a small victory. At one point in 2016, Gap traded for $17 per share, down 47% from our purchase price. The position was a discussion point at client meetings for obvious reasons. Our thesis and expectation for a turnaround in retail, coupled with Gap-specific improvements, was not playing out per our expectation. But we knew the business well enough to know that while we were wrong to expect a quick turnaround for retail and the Gap, $17 per-share did not reflect a fair price for the company’s stock. We waited patiently, collected $0.92 per-share in dividends, and sold Gap stock months later when it rose to $27. A 10% loss admits mistake; selling at $17 per share would have been a blunder.
The above highlights our value-oriented, long-term focused, research-intensive, business-owner type investment approach.
Value-oriented: We don’t just look for great businesses, we wait patiently to buy them at a price where we should limit losses if we are wrong (the Gap) and gain outsized returns if we are right (WESCO).
Long-term focused: Predicting the short-term is nearly impossible, but stretching the time horizon provides clarity.
Research-intensive: Appropriate conviction and a genuine informational/analytical edge can only be gained through deep, original insight.
Business-owner: Stocks represent actual ownership stakes in companies and are not merely flashing prices to be guessed and wagered on.
While this form of investing suits our natural inclination, we implement it because it is logically one of the best ways to repeatedly deliver excellent investment performance over time. Knowledge builds conviction; it’s why our approach works.
May Black Cypress, its partners, and all our families have a blessed 2017.