This article is excerpted from a letter of Lowell Capital, based in El Segundo, California, and authored by MOI Global instructor Jim Zimmerman, founder of the firm. Jim is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.
We believe the U.S. economy continues to expand steadily but there are certainly risks. We remain optimistic for modest earnings improvement in 2018 with a reasonable economic environment. Our earnings confidence faces potential challenges such as a more aggressive Fed, European debt problems, political struggles in the U.S, and continued global deflationary concerns, etc. Another risk is the over-stimulation of the U.S. economy which drives unexpected inflation and interest rate increases. As we have noted before, the U.S. equity markets have had several positive years of performance after the steep decline in 2008. It has been a slow but steady climb back for the U.S. economy. It is possible the slow pace of the economic expansion could mean that it may last longer than is typical.
On the positive side, global interest rates remain low. It is hard to be certain exactly why interest rates are so low. It could be several factors combined. It could be technology putting downward pressure on labor markets globally and it could be demographics and it could be several other factors. It is possible low interest rates could remain with us for an extended length of time. Nobody really knows for sure. However, we continue to believe that carefully selected equities provide one of the best options for investors to protect their purchasing power. The global economy remains fragile and the result is low interest rates as governments seek to support growth and employment. This could maintain a favorable environment for stocks versus fixed income securities. We believe fixed income securities offer very little value at today’s prices, with ten-year treasuries offering a risk-free yield of about 2.4%.
We believe most of the Partnership’s investments have 10% or greater unleveraged free cash flow yields. While we have little confidence in our ability to forecast the stock market, we are confident of the free cash flow yields that support our investments. We do a lot of work to try to maximize our confidence that these free cash flows are sustainable and reliable. This is what keeps us invested in carefully selected equities despite several consecutive years of positive stock market returns. We believe our large free cash flow yields provide a significant margin of safety for our investments, especially when compared to a 2.4% risk-free yield on ten-year treasury rates.
Our objective, at the end of the day, is to protect the purchasing power of the Partnership’s capital over many years. Holding cash may seem like a low- risk strategy in the short run, but over many years inflation is highly likely to significantly reduce the purchasing power of cash. As Warren Buffett noted in Berkshire Hathaway’s 2011 Annual Report, the purchasing power of the U.S. dollar declined a staggering 86% from 1965 when he started his investment partnership to 2011. It took $7 in 2011 to purchase the same items as $1 purchased in 1965. Our objective is to keep a large portion of the Partnership’s capital invested in businesses that provide important goods and/or services that customers will continue to want and need over time. We believe the value of the Partnership’s capital so invested should grow over time with inflation, and hopefully even more so, as customer demand is sustained or grows.
Good Businesses with Low Expectations
We are focused on investing in good businesses with low expectations (i.e., low valuations). For us, a “good” business is one that earns high returns on invested capital or where you don’t have to spend a lot of money to make a lot of money. We look at businesses where the total investment in tangible assets to run the business (i.e., net working capital plus the book value of property, plant, and equipment) are modest relative to the sustainable operating earnings or free cash flows. The business is not capital intensive. Businesses with high returns on invested capital tend to be strong generators of free cash flow. These are businesses that we like very much.
In terms of low expectations, our investments generally have valuations which are low and this helps reduce risk. The market does not expect much from the business in the future or is worried about current earnings or free cash flow sharply declining. These may also be situations where a business is simply misunderstood or undiscovered. Our experience is that if the business is able to exceed these low expectations or generate results that are less bad than expected, the stock price is likely to increase. Also, if expectations are low, when results are disappointing, the stock is likely to decline less than otherwise. We spend a lot of time studying these types of companies to try to get comfortable that their prospects are better than the market believes. Often specific businesses or industries get painted with a very broad brush – Wall Street gets lazy sometimes – and their valuations are driven down to what we find to be attractive levels. We think our focus on these out-of-favor companies and industries gives us an opportunity to earn better risk-adjusted returns than the general market.
Focus on Smaller Companies
We focus on smaller companies, searching for “low- risk, high-return” opportunities. We believe a few good ideas can drive the Partnership’s results. We believe the Partnership can generally achieve better risk- adjusted returns by uncovering a few small “gems” than by focusing on larger companies or macro issues which are much more widely covered.
Our focus on smaller, less-followed companies represents a potential sustainable competitive advantage for the Partnership relative to larger investment funds that must focus on much larger companies. Our empirical investment experience validates this belief, as our most successful investment positions have pretty consistently been smaller companies.
We are specifically looking for small companies that may appear risky on the surface but are actually much less risky due to characteristics such as: (a) cash-rich, “Ft. Knox” type balance sheets, (b) consistent free cash flows; (c) unique niches or business models; (d) very low valuations with minimal expectations imbedded in the stock price; and (e) honest and intelligent management teams that are highly focused on driving shareholder value. Most small companies do not possess any of these characteristics. We focus most of our attention on a handful of companies that we believe possess almost all of these characteristics.
Top Long and Short Positions
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