Dear Partner,
In the second quarter of 2022, Woodbridge Capital Partners I, LP (the “Partnership”) returned -18.37% while the S&P 500 returned -16.10% (with dividends reinvested). Since its inception in April 2020, the Partnership has returned 117.7% compared to the S&P 500’s 47.1%.1
The U.S. stock market entered a bear market this quarter, which is commonly defined as a 20% decline from the recent peak. The main theme used to justify the selloff is that rising interest rates will hit stocks with a one-two punch of making them less attractive relative to bonds and reducing corporate profits by slowing the economy.
In response to the COVID-19 pandemic and to counteract the effects of a shuttered economy, the Federal Reserve and Congress took unprecedented measures, the most important of which were to reduce interest rates to zero and provide stimulus in the form of checks to every American. It has become clear that the measures they took, and the duration for which they were maintained, were excessive. The result has been significantly more money chasing a supply of goods constrained by shortages and bottlenecks, and, unsurprisingly, rising prices.
Of course, it is much easier to look back and criticize than to look forward and act. The job of trying to maintain economic stability is not one that I envy. Economics is not a science like physics, where the results of an experiment can be determined with precision from an initial state. During the depths of the pandemic, the risk of doing too little seemed to outweigh the risk of doing too much. Moreover, for most people, I believe a little inflation is better than a little unemployment.
However, what makes inflation so dangerous, and why it must be stamped out with vigor whenever it rears its head, is that inflation expectations feed into themselves, and the situation can quickly spiral out of control. This is almost what happened in America 40 years ago, but then Fed Chairman Paul Volcker broke the back of inflation by dramatically tightening monetary policy, allowing interest rates to rise to 20%. The result was the worst recession that had been experienced since the Great Depression. His decision was costly, but it proved to be the right one.
Many see a parallel between the situation faced by the current Fed Chairman, Jerome Powell and that faced by Volcker. Many worry that rising interest rates will, as they did in 1981, throw the economy into a recession, or worse, that we are only just entering into a new era of inflation similar to that of the 1970s, a decade in which inflation averaged more than 7%2 and the total return for the S&P 500 after adjusting for that inflation was -12.7% (even worse if you consider taxes on nominal gains).3 With the gathering of all these dark clouds on the economic horizon, why, might you ask, do we continue to have 100% of our capital (more than 100%, actually, as we have borrowed a small amount to buy even more) invested in stocks?
First of all, stocks are real assets, with cash flows that derive from providing a good or service for which people are willing to exchange a portion of their income. Over the long run, we expect stocks to be relatively protected from inflation. Whether inflation is 2% or 6% over the next decade, I do not believe it should have much effect on corporate earnings. In fact, it did not matter in the 1970s. What caused the 1970s to be a lost decade for investors was multiple contraction. The PE of the S&P 500 fell from 15.8 to 7.44 as soaring government bond yields caused investors to demand a higher yield on stocks. If the market PE had remained stable, the real return on the S&P would have been over 6%, not far from the long-term average. The following decade – the 1980s – was a bonanza for investors as bond yields fell back down to earth and the market PE returned to about 15. The chart below from Robert Schiller’s excellent book Irrational Exuberance shows the relationship between the market’s PE ratio and returns over the following decade.
I believe it is unlikely that we will see as high yields on government bonds that were seen in the 1970s and early 1980s, or as low PEs on stocks. If we do, then history makes it clear for us what we should do: buy a lot more.
Currently the trailing 12-month PE of the S&P is about 19, but that does not strike me as unattractive on an absolute basis. It is somewhat higher than the historical average, but below average relative to the 25 PE of the last 30 years. Compared to investing in the 19th and most of the 20th century, trading is easier, transaction costs are lower, liquidity is greater, information is more accessible, and tax-advantaged retirement vehicles such as IRAs and 401Ks have been introduced. In addition, American businesses are less capital-intensive, which should allow them to distribute a greater portion of their earnings.
Needless to say, I believe Woodbridge’s portfolio of companies is an even better investment than the S&P 500. We believe that most of our investments, when compared to the S&P 500, have intrinsic values 2-3x greater than their current prices. This is a large disparity and one that we have seen only once before — during the depths of the COVID-19 pandemic. For this reason, Kyosuke and I have significantly increased our personal contributions to the fund.
In the short term, a recession from rising interest rates and the removal of government stimulus is possible. In fact, with first quarter GDP down 1.5% and second quarter GDP estimated to be down a similar amount, we are probably already in one. But our investment strategy is underpinned by the fact that intrinsic value can not possibly change as capriciously as price. This is as true for the market as it is for an individual stock. Day-to-day changes in the intrinsic value of the market are basically nil. Even a truly exogenous event like the COVID-19 pandemic changes the value by maybe a few percent – not even close to the 30% by which the market fell. This is because intrinsic value is based on the present value of all cash flows from the present to the infinite future and the earnings of the next year or two constitute only a small part of that value. That is why year-forward returns from the day that the S&P 500 enters a bear market have averaged 22.7% since WWII, double the average annual return over the same period.5 Trying to time the bottom is foolish and, if you wait until the situation has resolved itself, it will probably be too late. Perhaps this can be best illustrated by an anecdote.
On March 17th, 2020, Columbia University completed its evacuation of campus, of which it had informed students only two days prior. In the weeks leading up to that point, the administration went from insisting the school would be unaffected, to making classes virtual for the rest of the semester, to “everyone that can leave must do so immediately” – a group that included Kyosuke and I. Things had gone from bad to worse very quickly, and, in that first week that I returned home, the headlines only got bleaker as case counts rose and the COVID-19 virus spread. Many people I knew had lost their jobs overnight and government officials were urging people to shelter in place for a yet indeterminate amount of time. People speculated that millions would die. The pandemic was just beginning, and yet, the bear market it had caused was already over. The S&P 500 hit its bottom on March 23rd. And it was up 75% over the next year. The point of this story is two-fold. First, short-term market fluctuations are simply unpredictable. Second, the best time to invest tends to be when fear and uncertainty are at a maximum.
Downturns such as the current one afford a special opportunity to active investors because, although the market as a whole may be down 20%, that is just a weighted average. There are many companies down by much more than that. Several of the companies we own are members of that category, and that has contributed to our recent underperformance. We are constantly reviewing new information and revisiting our theses. At this point, we remain confident that their market price declines are not at all warranted. If that changes, we promise to be honest with you about any mistakes.
For the reasons mentioned, Kyosuke and I continue to position the fund aggressively, heeding Buffett’s advice to be “fearful when others are greedy and greedy when others are fearful.” Of course, stocks may fall further from here, in which case we will look pretty stupid – but we will not let that fear paralyze us.
As always, we thank you for your patience and your trust. If there is ever anything you would like to discuss, please feel free to reach out to us. If you haven’t noticed, we take our job of managing your investment very seriously.
Best regards,
Jesse Flowers & Kyosuke Mitsuishi
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR
2https://fred.stlouisfed.org/series/CPIAUCSL
3https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
4https://www.multpl.com/s-p-500-pe-ratio/table/by-year
5https://www.marketwatch.com/story/those-who-buy-stocks-the-day-after-the-s-p-500-enters-a-bear-market-have-made-an-average-of-22-7-in-12-months-11655224023