Dear Partner,
In the first quarter of 2024, Woodbridge Capital Partners I, LP (the “Partnership”) returned -0.03% while the S&P 500 returned 10.56% (with dividends reinvested). Since its inception in April 2020, the Partnership has returned 167.5% compared to the S&P 500’s 116.7%.
The US economy showed signs of slowing this quarter but appears to remain supported by strong fundamentals. The annualized real GDP growth rate was 1.6% for the quarter – below the long-term average but still healthy. Unemployment has remained below 4%, and consumer spending remained strong. The moderating of the economy was overshadowed by the firmer-than-expected inflation, with the latest CPI Summary reporting a 12-month price increase of 3.5%. Despite substantial progress from the 9.1% peak, inflation has stubbornly defied efforts to bring it down to the Federal Reserve’s long-term target of 2%. The combination of underlying economic resilience and lingering inflation has put into question the extent, if any, of the hitherto widely anticipated rate cuts this year.
Our companies’ operations continued smoothly this quarter with one making a very significant, positive announcement, which I’ll discuss later in this letter; however, our returns lagged the S&P 500 by a significant margin, around 11%. While we aren’t interested in analyzing quarterly price performance, we think the discrepancy between our performance and that of the market is, in part, a reflection of a broader trend worth noting, namely the increasing influence of a handful of stocks on the performance of the index as a whole.
Currently, the so-called Magnificent 7 – consisting of Microsoft, Meta, Amazon, Tesla, Apple, Alphabet, and the miraculously performing Nvidia – account for nearly 30% of the S&P 500. From the beginning of 2023 to the end of this quarter, this group returned ~142% in comparison to the S&P 500’s ~40%.4 If these mere seven out of 500 stocks were removed from the index, the S&P 500’s return would have been ~23%. The recent outperformance of larger companies relative to their smaller peers, though most evident for these high-flying megacaps over the last year, extends to beyond just the seven. Since the beginning of 2020, the S&P 500 Top 50 (a market-cap weighted index of the 50 largest companies in the S&P 500) has returned ~82% while the Russell 2000 (a market-cap weighted index of the 2000 smallest companies of the 3000 largest and a category that includes the stocks in which the majority of our portfolio is invested) returned just ~20%.
The implication here is that the market has become increasingly top-heavy, a trend we believe has been aided by a shift toward passive investing. Of course, this trend has had the opposite effect on smaller stocks as investment interest (and capital) has withered. We can see this in our portfolio. While the market is up since the end of 2021, the two companies that represent our largest positions have actually gotten a lot cheaper since then. In this winner-takes-all environment, we have found that the sort of bargains that could typically only be found in a bear market are now readily available. So, while frustrating in the short term, it represents a tremendous opportunity for those deploying capital with a long-term orientation. As Warren Buffett said, “the stock market is a device for transferring money from the impatient to the patient.”
Some other fund managers have noted the opportunities presented by this trend, as have the management of the companies we are invested in. Most of the companies we are invested in dedicate a large portion (in some cases all) of their free cash flow to buying their own stock, increasing our ownership share of the businesses without us having to pay a dime. Since our initial investment in our two largest current positions 3 years and 4.5 years ago, they have reduced their share count by 34% and 42%, respectively, increasing our ownership by 51% and 72%, respectively.
As I alluded to earlier, the holding company that represents our largest investment recently made a major announcement to further capitalize on their languishing stock: a planned spin-off of one of the six subsidiaries that comprise its core business. After the spin-off, the subsidiary – which accounted for about a fifth of the holding company’s EBITDA (a common profitability metric in the industry) in 2023 – will exist as a standalone public company but will still be owned by the shareholders of the parent, such as ourselves. On their earnings call just this past Thursday, management announced that the soon-to-be spun-off company should be worth around $11 per share (assuming 1 share is issued per 1 share of the parent company), according to analyst estimates. With a current share price of less than $17, we will effectively be receiving a 66% dividend.
To list a few of the reasons Jesse and I are thrilled with this spin-off: Firstly, the market will almost certainly ascribe more value to the subsidiary as an independent entity than within the parent company, as substantiated by the analyst estimates. If the parent company remains undervalued, we can simply sell the stock in the spun-off company and buy more stock in the parent company. Secondly, since the “dividend” comes in the form of the spun-off stock, we will not pay any taxes on it; instead, the cost basis for the parent company stock will be reduced by the amount of the “dividend.” As a result, we will only pay taxes upon selling (likely a long time from now) the parent company stock, the vast majority of which is already well into the lower long-term capital gains territory. Thirdly, the spin-off will be capitalized such that the parent company will retain plenty of cash to continue repurchasing shares.
Perhaps, at this point, we shouldn’t be surprised that the market responded to the announcement by summarily punishing the stock. Since the announcement, the stock has declined by 10%, and we have happily bought more.
With such attractive investment opportunities, Jesse and I remain confident that the Partnership will outperform the S&P 500 over the long term. We are grateful for your continued trust and remain committed to your investment success.
Thank you,
Kyosuke Mitsuishi & Jesse Flowers
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR
2https://www.bea.gov/data/gdp/gross-domestic-product