Dear Partner,
In the second quarter of 2023, Woodbridge Capital Partners I, LP (the “Partnership”) returned 0.56% while the S&P 500 returned 10.32% (with dividends reinvested)1. Since its inception in April 2020, the Partnership has returned 119.5% compared to the S&P 500’s 76.0%.
When Kyosuke and I were still at Columbia (and while the longest bull market in history was still raging), we joked that we wished there would be a market downturn after we finished school so that we could buy stocks cheap as soon as we started making money. Ironically, that’s exactly what happened. Personally, I have been investing over 40% of my net income into the fund on a monthly basis. The bad part is that our performance has made it difficult for us to attract new investors, and we have grown more slowly than we had hoped. While this has been disappointing for us, a similar situation would have been nothing short of catastrophic for many other funds.
The way that Kyosuke and I have gone about starting Woodbridge is unusual for a hedge fund. Most funds are started by people who have spent years working on Wall Street and have made a lot of connections. They speak to investors before starting, usually large institutional investors like pensions, endowments, or funds of funds. When they do launch, they typically have millions (sometimes billions) of dollars under management. But they also usually have a lot of expenses: office rent, salaries, Bloomberg terminals, etc. From Day One, the pressure is on. If the manager performs well, they accumulate more AUM, and fees cover expenses. If they don’t, then investors, always chasing the manager with the best performance over the last month, quarter, or year, withdraw. When that happens, the fund has to shut down. But performance over such a short period of time is, in most cases, more a function of luck than ability. Even if all of your investment theses are 100% accurate, in many cases, a year is simply not enough time. And so, as a New Yorker article from 2014 explains, “Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared.”2
Legendary fund manager Joel Greenblatt did a study of institutional money managers for the decade 2000 to 2010. The study showed that 97 percent of those who ended up with the best 10-year record spent at least three of those 10 years in the bottom half of performance. 79 percent spent at least three years in the bottom quartile of performance. And 47 percent spent at least three years in the bottom decile. The best performing fund of all during the decade had an 18% compound annual return. But the average investor in that fund managed to lose 11% annually on a dollar-weighted basis by moving in and out at all the wrong times. When performance was good, they’d pile in, and when it was bad, they’d pile out.
As Greenblatt says, in order to beat the market, you have to do things differently than the market, which entails zigging when the market zags. But many managers simply can’t survive the zags. Add high fees into the mix, and you have a recipe for almost certain long-term underperformance. This is why in 2007 Warren Buffett made an open wager of $1 million to anyone who could choose a basket of hedge funds that would outperform the S&P over the next decade. Only one person took his bet: Ted Seides, founder of Protégé Partners, who had made his living picking hedge fund managers for his clients. Ted lost.
Buffett’s business partner Charlie Munger famously quipped: “Show me the incentive and I’ll show you the outcome.” For most money managers, mediocrity is more profitable than excellence (were they even capable of excellence). If the underperformance is modest, they can justify their continued existence through obfuscation and by moving the goalposts with irrelevant performance metrics. This way, the fees keep rolling in. Trying to outperform would probably derail their gravy train sooner or later.
This has all been a lot of tough talk from someone who is, himself, a manager of a hedge fund. And not just any fund: one that is down nearly 25% over the last two years. But part of the reason that Kyosuke and I got into the investment management industry is because we are so critical of it. We believe that Woodbridge’s ability to maintain a long time horizon is an incredible advantage, both with respect to our ability to make profitable investments and to our ability to continue as a going concern. Kyosuke and I expect to be investing for the rest of our lives, whether we have investors or not. Woodbridge is essentially a vehicle to invest other people’s money the same way that we invest our own, so it does not require a lot of marginal effort or expense on our part. Moreover, we see no reason why we wouldn’t continue to invest together. In the five years that we have known each other and worked together, we have never had an argument – at least not a heated one. Sometimes we disagree, but we leave our emotions out of it and continue to work through it until we have a course of action.
Regarding the economy, things are going well. Just this week, the June CPI report was released which showed the tamest monthly inflation in two years. The general view is that if the Fed approves another 25 basis point increase in interest rates at their meeting this month, it will be their last. And yet, unemployment remains historically low at just 3.6%, with millions more available jobs than available workers. The housing market has remained almost equally resilient, down less than 3% from its peak. Real GDP increased 2.0% in the first quarter. All good news for the stock market. But monetary policy works on a lag, and interest rates have risen rapidly. This time last year, the federal funds rate stood at 1.5-1.75%. Today it is 5-5.25%. The jury is still out on a soft landing for the economy, though we should all be glad to see the Fed take their commitment to stable prices seriously.
Currently, Woodbridge has five investments. They are all in the stocks of publicly traded companies. Our average investment has been in the portfolio for over two years. Since early 2022, we have employed a small amount of leverage in the fund. Our decision to use leverage was and is based on simple arithmetic: the return on our investments (over the long-term) will be greater than the interest that we pay to finance them. We believe leverage of around 10-20% of NAV enhances our return potential while introducing negligible risk to principal over the long term. It does, however, increase volatility, and it has in small part contributed to our underperformance over the last two years. If we make good investments, then leverage will have been a good idea. If not, well, then we have bigger problems.
Despite our performance, Kyosuke and I derive our confidence from the fact that we can plainly see how cheap the companies we are invested in are. Their businesses are strong and profitable, and they are using their cash to pay dividends, buy back stock, strengthen their balance sheets, and grow their businesses. But knowing exactly what’s going on inside the portfolio is both a blessing and a curse: a blessing because we understand the fundamental values of our investments, and a curse because we are exposed to the incessant gyrations of stock prices. Every day we lose thousands of dollars (on paper, of course), only to make them back the next. Or profit thousands of dollars in a day, only to lose them the next. It is truly the type of thing that if you think too much about, will drive you insane. But by keeping a level head, we can do very well. We will continue to be honest with you and ourselves regarding any developments in the portfolio. We feel very fortunate to have the investors that we do, and we thank you for your continued trust.
Thank you,
Jesse Flowers & Kyosuke Mitsuishi
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR 2https://www.newyorker.com/magazine/2014/08/04/money-talks-6