Hylland Capital's End of Year Letter to Clients - 2016
Below is a portion of our end of year letter to clients for 2016. Omitted is any personal information that would be included before this section such as client name, account balance, performance, mention of individual holdings, etc. We manage each client's account individually, and therefore each client's performance is unique.
Reporting year to date performance seems fitting for an end of year letter, but your returns from December 31st 2015 to December 30th 2016 are really no more significant than your returns from any other day this year until now. Over short periods of time (which includes one year time frames) markets are volatile and unpredictable. Your response to any single year’s reported performance should be similar whether we report returns above or below those of the S&P 500 for any given year (which will inevitably occur).
What will be significant is your long term returns over the next few decades, of which the returns of 2016 will play only a very small role. It is important that we keep long term goals in mind, and not get caught up focusing on any short term fluctuations over a given year. 2016 certainly tested our focus.
Despite the excitement, 2016 turned about to be extraordinarily average in terms of stock market performance. The year finished with the S&P 500 up 9.5% (not including dividends), compared to the index’s average annual rate of 8.1% since 1977.
The market experienced several “noteworthy” declines in 2016:
· The S&P 500 fell 10.5% from January 4th through February 11th,
· The S&P 500 fell 5.3% from June 8th through June 27th,
· And lastly, the S&P 500 fell 4.65% from September 7th through November 4th
Since 1900 the stock market has averaged a 5% decline 3 times per year and a 10% decline once per year. A frequency we nearly matched perfectly this year.
Think back to a few of the headlines in 2016:
· 2016 started so bad that on January 11th, clients of RBS wealth management were advised to “Sell Everything”.
· The U.K. voted to leave the European Union, leading to predictions of “cataclysmic collapse” and “total disaster”.
· The New York Times, Forbes and Bloomberg all called negative interest rates a “new normal”. In response, trillions of dollars in investments were locked up into investments that are guaranteed to have low returns over the next couple decades.
· President elect Trump shocked the world by winning the election. Reuters, CNN and CNBC all had headlines warning of a stock market crash.
The panic, excitement and emotions experienced in 2016 should be considered normal over the course of a year in the stock markets. These are the headlines in a very normal year. That means you should expect 2017 to be at least as exciting.
Predicting the Market
Of course, we make no predictions on the course of the markets over 2017. Many may find it strange that a business based on investing does not provide an outlook on those investments. This is for two main reasons; First, what the stock market does over the next few years means little in terms of your long term performance (as we will see in a later example) and second, because it is impossible to accurately predict short term movements in the markets.
Just how hard is it to forecast movements in the stock markets? Here is one example:
On December 5th 1996, then-Federal Reserve chairman Alan Greenspan made a now famous speech in which he warned of “irrational exuberance” in the stock markets. That day the Nasdaq index closed at 1,287. Despite the exuberance in the markets and the Federal Reserve chairman’s warnings in 1996, the Nasdaq would continue rising for more than three years, topping out at 5,048 on March 10th, 2000. We all know how this ended - the remarkable rise was met with an equally spectacular collapse.
Over the next two years, the Nasdaq would fall 78%, reaching a low of 1,114 on October 9th 2002 – just 13% below the original level of the index when Alan Greenspan warned of irrational exuberance.
Would an investor have been wrong to sell their stocks on December 5th 1996? The market was historically expensive and the Federal Reserve Chairman himself was warning about the risk in the market.
That hypothetical investor who sold in 1996 would have seen the Nasdaq climb 400% over the next three years. Undoubtedly questioning himself everyday on whether to get back in or stay on the sidelines. Even if the investor remained resilient and never reentered the market with perfect timing, the ensuing crash would have only brought the market back to barely below the level they sold! Five years of waiting to receive a 13% “return” – a performance that would have vastly underperformed even treasury bonds.
If Alan Greenspan and the massive team of Ph.D economists at the Federal Reserve can not predict the course of the markets over a period a several years, you and I should have no intention of believing that we can.
So, instead of worrying about short term movements largely outside of our control, we instead focus on setting up portfolios for long term success.
How we Operate
Our investment philosophy is simple: We prefer to hold quality investments, that we can purchase at a fair price, for long periods of time.
Over long periods of time stock markets will rise and fall, elections will be won and lost and wars will be fought and settled. Most of this will prove to be of no significance to the long-term performance of a well-constructed investment portfolio. As Warren Buffett said:
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a fly epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Within these long periods, many things can happen that we can not predict or control. One such example occurred this year with one of our investments and provides a valuable lesson.
Considering our performance year to date, you may be surprised to know that a stock that makes up a significant portion of your portfolio was the 5th worst performing stock in the S&P 500 in the month of June. [Company name removed for client privacy] was down more than 17% in that month alone.
In June, right after our mid-year letter was sent out, the world was shocked by the U.K’s vote to leave the European Union. The ensuing few days left investors in a panic, with stock market declines that rivaled the days after the attack on Pearl Harbor and September 11th. Hit hardest were financial companies like [Company]. Why [Company] fared so much worse than others is still not clear, nor important.
Your investment advisor, who you trust with your investment dollars, picked a company which underperformed 495 other companies in the S&P 500 in June. Rather than beg for forgiveness, I am here to tell you that this type of short term underperformance on portions of your portfolio, like we saw with [Company], are almost guaranteed to happen again.
To help show why, consider this example:
If you could go back in time 33 years ago and invest in one stock in the S&P 500, what would it be?
With hindsight, you would of course pick the stock with the best performance over the last 33 years, which would be Home Depot. Over the last 33 years Home Depot stock has produced returns well in excess of 10,000%. A $10,000 investment in the mid-1980s would become worth more than a million dollars in 2016.
You may assume that those 33 years holding Home Depot stock would have been easy and care-free. You could have simply sat back and relaxed while watching the money pour in, right?
You could not be further from the truth.
Over that same 33 years, Home Depot stock had 3 declines in excess of 50%. One decline of 65.9%, one of 69.7% and one of 55.6%. That means on 3 separate occasions, you would have opened up your account statement, or read your investment advisor’s end of year client letter, and seen the value of your investment cut in half (or less!)
In the worst decline, over a stretch of 771 trading days from December 1999 to January 2003, a million dollars in Home Depot stock would become worth just a hair over $300,000.
If the best performing stock over the last 33 years had this kind of volatility, how do you think other stocks fared? It is all but certain that we will not hold the best performing stock in the entire stock market over the next 33 years, so you can expect securities in your account to have AT LEAST as many periods with significant declines as Home Depot did.
This end of year letter comes as many stocks in your portfolio, like [Company], have recovered from mid-year declines. This timing is nothing but luck. It is easy to mask significant short term underperformance from mid-year in a paragraph of an end of year letter full of much better news. There will very likely be a time when this letter comes at a much less opportune time. A time when a significant holding like [Company] is in the depths of a short term decline. When you see that in a future letter, think back to the lessons of this letter and know that over the long term, we are well positioned but over the short term we are at the mercy of the market.
The Power of Compounding Interest
This long term focus is necessary in order to take advantage of our number one asset when it comes to investing, compounding interest.
Due to the effect of compounding interest, even average returns over the course of a few decades can amount to substantial increases in wealth.
The table below shows the growth of $100,000:
To better comprehend the power of compounding interest, let’s take an example from history:
The Palace of Versailles in France is famous for its awe-inspiring beauty. Originally built by King Louis XIII in 1623 as a simple hunting lodge, it was Louis XIV that made Versailles what we know today. Today Versailles consists of more than 720,000 square feet outfitted with all the furniture, gold and silver France could afford.
By very conservative estimates Louis XIV spent the equivalent of $2.8 billion in today’s dollars in 1710 to complete his additions to Versailles. Today the Palace is estimated to be worth about $50.7 billion.
It appears Louis XIV was able to construct something truly extravagant for his money, and turned $2.8 billion in 1710 into more than $50.7 billion today. At first glance, it may seem King Louis XIV was a better investor than he was King.
But not so fast.
Had King Louis XIV instead found a worthwhile investment for his $2.8 billion that yielded just 6% annually, his $2.8 billion in 1710 would have grown to be worth about $155,150,365,263,729,000 today. 155 quadrillion dollars today is roughly a thousand times greater than worldwide GDP. King Louis got the palace of Versailles, but could have had the whole world.
Lesson being, if you have $2 billion laying around, consider investing it with Hylland Capital Management before spending it on an extravagant building (Such as a football stadium – as the Oakland Raiders are proposing!)
Your Portfolio at Hylland Capital
Looking ahead, what should you expect to change in regards to your investment portfolio?
Since we have been covering stock market history extensively this letter, it should be noted that based solely on historical averages (this is not a prediction), we are well overdue for a decline in the stock market of 20% or greater. On average a 20% decline comes once every three and a half years. It has been four and a half since we experienced a 20% drawdown in the S&P 500, and eight years since the Dow Jones Industrial Average has had a 20% decline.
This means that when (not if) the inevitable decline comes we should not be surprised or panicked, but instead eager to act.
Interest rates have increased over 2016. A 10 year treasury bond now yields 2.5%, up from a 1.37% yield we saw in July but still half of where yields were in 2007. That means long term bond funds, which were the stars of the first half of 2016, are now down 15% or more since July. It also means that if rates continue to rise, even if just up to their historical norm, long term bond funds will continue to underperform.
We have maintained very little exposure in long term bonds in client accounts, which hurt us in the first half of the year and helped us in the second half. That reduced exposure will continue. Shorter term bonds in your portfolio that are maturing now can either be reinvested at slightly higher yields or will be reinvested in stocks when/if prices decline. I am looking forward to exchanging some low yielding bonds for cheap stocks should the opportunity arise.
The other headline for 2016 was the rush into passively managed investments by investors.
This year, investors pulled more than $280 billion from actively managed funds and invested more than $420 billion into passively managed investments, such as funds which track the S&P 500.
In 2016 the S&P 500 index switched out 29 companies which made up the index at the start of the year and replaced them with 29 different companies. This can be thought of as a “turnover ratio” of about 5.8%. That is, 5.8% of the original holdings were changed out for new holdings during the year.
This year, your investment portfolio at Hylland Capital Management switched out 0 of its holdings for other investments, a turnover ratio of 0%.
And yet, “active” managers like Hylland Capital will be criticized for “picking stocks”, while the committee members that decide on which companies should make up the S&P 500 will be praised for their “passiveness” despite them making more knee jerk reactions to market performance than we have.
Passively managed investments work because they reduce cost, have lower turnover (compared to most actively managed funds) and eliminate a lot of decisions that investors would otherwise have to make. However, that does not mean that we can not do the same at Hylland Capital. In fact, we can (as we have seen) construct a portfolio with lower costs and lower turnover than even managers who exclusively use passive index funds.
Over the long term, it is the reduction of fees, portfolio turnover and impulsive investment decisions that will lead to higher returns. For many, a passive index fund is the preferred choice to do this, but it is not the only choice.
I will limit the discussion of passively managed investments to here. If you are interested in further comments on this topic, see the article on our blog titled “Our Take on the Active vs Passive Debate”.
Charlie Munger once commented on Berkshire Hathaway’s long term success by saying:
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
“I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.”
Looking back at our performance over 2016, I think the lack of brilliance by your advisor is obvious. Your portfolio held 0 of the top 25 performers in the S&P 500, your largest single holding in your portfolio is an intermediate bond fund, which was down 3.14% for the year and you held the 5th worst stock in the S&P 500 in the month of June.
And yet, our results are very acceptable. I hope you agree that we have balanced out our lack of brilliance by avoiding making many stupid mistakes.
Most importantly, I think it is important to know that I “eat my own cooking” at Hylland Capital. I have nearly my entire savings in the same exact holdings that make up the portfolios of clients in Hylland Capital, though allocations may vary (such as a higher allocation to stocks compared to older clients), you and I hold the exact same stocks and funds.
I make no promises to what the future holds, but I can guarantee that we share the same fate.
As always, please do not hesitate to reach out whenever you have questions or concerns.
Happy New Year, and thank you for a wonderful first year at Hylland Capital Management.
Sincerely, Matt Hylland