Hylland Capital June 2016 Letter to Clients
Below is a portion of our mid-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, etc. We manage each client's account individually, and therefore each client's performance is unique.
Due to these diverse holdings in your account, the S&P 500 index is really a poor benchmark as it represents only 100% U.S stocks. However it is used industry wide and a better suited, diversified benchmark does not exist to my knowledge. So until a better option comes around, you will see your performance compared to the S&P 500. Because of these differences, in years where the S&P 500 soars, your portfolio will certainly trail the index because of your bond and cash holdings. However, if the S&P 500 declines sharply, as it did during the first 2 months of 2016, you will be glad you hold those bonds! Our aim is not to “beat” any index, but provide you with a portfolio that allows you to achieve your financial goals while managing risk.
The performance YTD is even more astonishing considering 2016 started off with the worst opening 2 weeks of a year in stock market history. The S&P 500 fell about 13% from the highs at the end of 2015 through the second week in February 2016. Many individual equity holdings in your portfolio were down 20% at that time.
But no surprise, the best course of action was to do nothing – “Don’t just do something, sit there!” was a motto to live by during the volatile period.
Since then markets have recovered and as I write this letter, markets are within a few percent of all time highs once again. Interestingly, the stock market has never finished in positive territory after a year as dreadful of a start as we had in 2016. We will see whether we make history or repeat it over the final 6 months (We make no predictions one way or another).
Predicting the Future
For new clients, it may come as a surprise that we don’t offer predictions or forecasts on where the market is heading in the short term. That’s because we don’t know – and it is unlikely to matter.
Historically, the stock market sees 5% declines about 3 times per year, 10% declines once per year, 15% declines about every other year and 20+% declines every 3 or 4 years. The exact frequency or timing of these declines is of almost zero importance to a long term investor. Over the last 40 years we have seen inflation, deflation, recessions and depressions. We have fought in wars and been attacked by terrorists. We have had political scandals, economic crisis, been run by Democrats and Republicans, who have both given us record budget surpluses and record budget deficits. And yet, despite all of that, American business has an incredible track record of producing profits for investors. Over those exhilarating 40 years we have seen the Dow Jones Industrial Average rise from 900 in 1976 to over 18,000 in 2016!
That long term trend is what will provide us with significant increases in wealth over time - Not attempting to buy and sell around periodic 5% declines in the market (No one has yet appeared with the ability to consistently do that, and I will not be the first.)
The Joys of Compounding
Over time, even below-average market returns can grow into something spectacular. Below is a table showing the compound growth of $100,000 at different interest rates and duration of years.
To help highlight the true long term power of compounding interest, consider the history of the world’s most famous painting – the Mona Lisa, by Leonardo da Vinci. After da Vinci’s death the painting was inherited by da Vinci’s assistant, who sold it to King Francis I so he could hang it on his bathroom wall. In 1517 the painting sold for 4,000 gold florins, which was about 14kg of gold, or about $580,000 today. In 1962 (445 years later) the painting was appraised for a staggering $100 million dollars, without a doubt the most valuable painting in the world at the time. It seems as though King Francis made quite a good investment with his $580,000 in 1517, right?
Not so fast. If King Francis would have been so wise as to put that money away into an investment that yielded just 7% per year (roughly the average annual performance of the U.S. Stock market over its history) his $580,000 in 1517 would have been worth over 6.9 QUINTILLION dollars in 1962.
I only hope we can work together for the next 445 years! I look forward to putting King Francis’s investing record to shame.
There are a couple specific elements of your portfolio that I want to discuss in more detail.
First - low interest rates, and how we plan on managing your investment portfolio in a low interest rate environment.
As I write this letter, German 10 year bonds are being purchased at a negative interest rate for the first time in history and 30 year Swiss bonds are selling at a negative 0.004% interest rate. Buyers of those Swiss bonds today are guaranteed a loss over the next 30 years if they hold until maturity. (For the record, there has never been a 30 year period in which U.S. stocks have had a negative return. The longest period is from September 1929 through November 1954 – 25 years). Today, U.S. 10 year Treasury bonds provide a bit higher yield at about 1.6%, but still nothing to brag about.
If you purchase a 10 year Treasury bond today with the intent to hold it until 2026, you have no risk of capital loss (you may lose purchasing power to inflation, of course) whether interest rates increase or decrease. Your investment will be returned in total after 10 years plus you would gain some interest payments along the way. Maybe you only get a 1.6% return for 10 years, but it is not disastrous.
Where today’s low interest rates create a potential problem is when the buyer of that 10 year bond today needs to sell his bond before the 10 years is up.
On the secondary market, the value of that bond will fluctuate based on interest rates. If in 5 years interest rates return to their historical norm of about 4.5% for the 10 year Treasury bond, our hypothetical investor will only be able to sell his 1.6% bond for about 77 cents on the dollar (Because who would want to purchase a bond yielding 1.6% when interest rates are 4.5%? So the bond’s value must drop). If our investor purchased $100,000 in 10 year treasuries today, they will only be worth $77,000 in 2021 if interest rates climb to 4.5%.
This presents a big problem for investors who have been selling equities and moving that money into bonds with the thought that it will be “safe” until they need to sell the bond. The bond investment that was supposed to be a safe store of value gets cut by nearly 25% if interest rates only just return to normal in 5 years!
One potential answer is to only buy shorter term bonds, whose value will be much less affected by interest rate changes. But, if you thought the 10 year treasury yield was low, you may be shocked to see that a 2 year treasury yields only 0.7%!
So short term bonds have less interest rate risk, but offer much lower yields. Long term bonds have higher interest rate risk, but offer high yields. What is an investor to do?
We have a portion of your bond investment set up in what is referred to as a bond “ladder”.
Instead of just piling $100,000 into 10 year treasury bonds, we have split up your bond allocation into different maturities between 2018 through 2022. Each year, a portion of your bond investment matures, and is available for us to reinvest. When the 2018 bonds mature, they will be used to purchase bonds that mature in 2023. When the bonds that mature in 2019 are paid back, they will be reinvested in to bonds that mature in 2024.
This gives us some flexibility in reinvesting based on current interest rates and being able to extend maturity, while also reducing your interest rate risk for money you may need in the shorter term.
With this bond ladder, if interest rates rise we will be continually reinvesting the proceeds from lower yielding bonds into higher yielding ones. Unlike those who have all their money in 10 year bonds and are either “locked in” with the interest rate the bonds had at their time of purchase, or forced to sell for a loss if they want a higher rate.
If interest rates continue to fall, we have exposure to longer term maturity bonds with a higher yield, and we may also be able to generate some capital gains as well. (This specific 2018-2022 bond ladder has returned 3.05% YTD even though the highest yielding bond only yields 2.84%).
We are sacrificing a small amount of yield to execute this strategy and missing a potential for gains. With this most recent rally, you would have gained much more had I invested you exclusively in very long term bonds – long term U.S. bond funds are up about 13% YTD! Yet I will not participate in a game of the “greater fool”, where everyone buys negative yielding bonds not because of their investment potential (obviously, there is none), but solely because they think someone will pay more for them in the future. The game may continue on for a while, but we will be happy to be on the sidelines until it ends.
We have been successful so far this year taking risks on the equity side of the portfolio, and keeping our bond investment safer – that will continue.
The last topic of discussion covering portfolio management deals with the upcoming election.
By the time you receive our next letter the United States will have elected its next president. You will receive no updates from us about how one person or the other will impact your portfolio and we have no plans to make a single trade between now and then. That is because our investment philosophy is not subject to change based on who wins. Whether it is Clinton, Trump or a surprise candidate, buying quality companies at decent prices will continue to produce satisfactory investment results. It will take a lot more than one person, no matter his or her position, to ruin that.
It has been a great first 6 months at Hylland Capital Management, I hope you feel the same. But we have room to get better.
First is in the fees that we charge. One of the primary effects on your long term performance is the fees that you pay. Although our fee of 0.7% is below average, I would like it to come down. As Hylland Capital’s assets under management grow, fees will come down (This business scales fairly well) and you, the client, will benefit. If that is not a reason to refer a friend – I don’t know what is!
Second is my writing. This is my first letter, undoubtedly there are errors strewn about it. Malcolm Gladwell, in his book Outliers, frequently mentions the “10,000 hour rule” – meaning that you need 10,000 hours of practice to truly master a craft. Based on the few hours I have taken to outline, write and edit this letter, and Gladwell’s rule, you can look forward to a masterfully crafted letter in the year 3682.
Until then, don’t hesitate to contact me with any concerns that you have that I forgot to cover here.
Enjoy your summer,