Dear Partner,
In the fourth quarter of 2022, Woodbridge Capital Partners I, LP (the “Partnership”) returned 3.83%, bringing its total return for 2022 to -30.82% while the S&P 500 returned 7.56% and -18.11% for the quarter and year, respectively (with dividends reinvested). Since its inception in April 2020, the Partnership has returned 104.6% compared to the S&P 500’s 50.5%.1
This year, investor sentiment changed dramatically. The S&P 500 had its worst year since 2008. Treasury bonds and investment grade corporate bonds, typically viewed as some of the safest investments and often used to add diversification to stock portfolios, had one of their worst years in history.2 Crypto crashed, too, with Bitcoin falling 64.3%.3
I am sure few investors will remember this year fondly. The poor returns on stocks and bonds can be mainly attributed to interest rates, which the Federal Reserve has raised aggressively in order to combat inflation. And the pain may not be over yet. Although there are some signs that inflation is cooling, it is still too early to tell. Monetary policy is generally held to work on a lag, a phenomenon that was first researched and written about extensively by famed economist Milton Friedman. That is why the Fed’s job of raising interest rates to a level that neutralizes inflation, but does not cause unnecessary and potentially severe economic damage, is so hard.
It also means that we likely have not seen the full impact of higher rates yet on corporate earnings and unemployment. Fortunately (or unfortunately, depending on the source of your income), there is such a shortage of labor in the United States that the number of available jobs could decrease significantly before causing a meaningful increase in unemployment. For corporate earnings, on the other hand, there is no such cushion, and we would not be surprised to see them decline in 2023. For some of our companies, we can see this taking place already. However, as we have said, the value of a stock is the present value of its cash flows from now to infinity. Making investment decisions based on speculation about what the next quarter or year might hold is almost always counter-productive.
The business cycle has been a historical constant and is perhaps an inherent feature of free markets. Most companies operate with some degree of fixed costs, also referred to as operating leverage. When demand decreases, often companies cannot adjust their operations perfectly and immediately. The result is a decline in earnings. Companies which have high fixed costs or produce outputs for which prices fluctuate (like oil, steel, lumber, etc.) are usually most sensitive. Basing investment decisions on the basis of either peak earnings or trough earnings would be foolish. We try to look through the cycle and make our investment decisions on the basis of what we believe are a company’s “normalized” earnings. Moreover, a company that is expected to do well and increase its earnings over the next year or so can still be a bad investment. Likewise, a company that is expected to do badly and see its earnings decline over the next year or so can be a good investment. In investing, the determining factor is always the price you pay.
The companies that we are invested in are all priced like they are going out of business. In fact, they started out the year very cheap, and now they are absurdly cheap. Though allocations have changed somewhat, most of the positions we hold as of the end of 2022 are the same ones that we held at the beginning. So, why did our stocks underperform the S&P 500 by such a wide margin this year?
Part of the difference can be explained by our decision to employ a small amount of leverage this year. One of the side effects of leverage is that it increases volatility by making performance in good years even better and performance in bad years even worse. Our decision could not have been more poorly timed, but we knew the market might continue to decline. When forced to choose between long-term profit or avoiding short-term underperformance, we will always choose long-term profit. In our estimation, leverage likely contributed around three percentage points of the underperformance this year, though we expect to recuperate those losses once leverage begins to work for us instead of against us.
There was also one investment we held for a short period of time, which we regret making. That was Activision Blizzard. We purchased the stock in April because we believed that Activision’s acquisition by Microsoft would be permitted by regulators. Microsoft is a major producer of video game consoles, but not a major producer of video games. As such, there should be little concern regarding anti-competitive effects of the merger. We were (and still are) confident that if the FTC attempts to block the merger, they will lose decisively in court.
However, the FTC has made a pattern in recent years of attempting to block mergers even when they have little chance of succeeding, and we failed to fully appreciate this fact. When it was leaked that the FTC was planning to sue, we exited the position. In the end, it became an issue of timing. Though we continue to believe that Microsoft will probably acquire Activision, it is unclear how long the process will take, and we did not want to leave our money tied up at a time when there are so many other great investment opportunities available. The position was small, but because we used options (in order to limit downside in the event the merger fell through), we realized a sizable loss. This contributed another roughly three percentage points of underperformance. We sold before the FTC announced their suit, but to add insult to injury, the stock is actually up since then. This wasn’t our first mistake and won’t be our last, but we have learned a lesson in sticking to our circle of competence.
To what can we attribute the remainder of our underperformance? In truth, I do not have a good answer. One could argue that because our stocks trade at lower multiples of earnings the present value of their cash flows should be less sensitive to interest rates. However, things did not play out that way. Our basket of unloved stocks became even more unloved in 2022. You may be beginning to wonder why we are so confident that our stocks will ever stop being unloved. The reason is because, at the end of the day, money talks, and the companies we own have and/or make a lot of money (relative to their market values). As long as management’s interests are aligned with those of shareholders, they will put that money to work until investors have no choice but to recognize the value of the stock.
Companies that have significant opportunities for reinvestment into their business may direct it there, which will hopefully increase earnings, but one of our favorite things to see a company do is repurchase its own stock, which reduces the share count and again increases earnings on a per share basis. For companies that repurchase heavily, if the market does not respond to the company’s reduced share count by raising the value of its stock, the effect could compound rapidly, until there are no shares left to buy. This would, of course, be absurd, and long before that happens, someone will see the value of the business – whether it be a private equity investor, a competitor wanting to make a strategic acquisition, or insiders looking to take the business private. Even if none of those happen, the company can always pay (or increase) a dividend.
So, even if you are not taking advantage of lower stock prices by buying more, know that many of the companies you own are doing it for you. Though we might feel better when we see our stocks go up, it’s actually better for our wallets when they go down. And I would like to emphasize that both Kyosuke and I have virtually all of our liquid net worth in Woodbridge; whenever you’re losing money, we are sharing in those losses proportionately, and neither of us like to lose money. We are confident that the losses we have experienced this year are only temporary, and that the returns to patience at this point in the cycle should be very high.
I would like to reiterate a statement from our previous quarterly letter: the investment opportunities currently available are the best we’ve seen since the 2020 stock market crash. We remain confident that the Partnership will outperform the S&P 500 over the long term. If you ever have questions or concerns about your investment, please do not hesitate to reach out to us. As always, we remain committed to your investment success.
Thank you,
Jesse Flowers & Kyosuke Mitsuishi
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR
2https://www.cnbc.com/2023/01/07/2022-was-the-worst-ever-year-for-us-bonds-how-to-position-for-2023.html
3https://finance.yahoo.com/quote/BTC-USD/history/