AOF’s Q1 2020 Letter to Shareholders
Dear Partners,
This has been an immensely challenging 2020 so far. First, most people (including myself) thought there was a strong chance WWIII would start between the US and Iran. Being a 24 year old American male legally obligated to register for the draft, I knew that if anything got worse my life could change forever. Thankfully, things have calmed down on that end. Arguably worse, though, is the outbreak of COVID-19, a virus started in an unsanitary meat market in Wuhan, China. Due to the mass globalization the world has experienced in the past century, the virus spread to every country in a matter of weeks. The world, for the most part, has stopped. We are truly living in unprecedented times. What we are living through now will go down as an important time in human history — hopefully we learn much through this and are better prepared the next time a pandemic hits.
Also unprecedented is the steep drop in stock prices. Some of the drops are warranted and quite easily understood — just look at cruise liners and airlines for starters, as their businesses have completely stopped. Some drops, however, appear to be overblown. Let’s start with the gold industry. Mines are isolated so they are still operating, interest rates are negative, gold is up ~10% Q1 2020, oil is significantly down (a high input cost for miners), yet most miners/royalties are down more than 25%. Companies that had very healthy balance sheets coming into this crises also have been hit, sometimes as much as companies with elevated levels of debt. Some of this just doesn’t make sense.
Opportunity
But with this crisis comes opportunity. Many of the companies that I’ve been watching have dropped, in my opinion, way too far. I’ve always said volatility is not risk, rather, a great entry point into a solid business for a good price. Right now, I’m not looking for companies that could double in 2–3 years — no, I’m looking for companies that have >3x upside in 2–3 years. Companies that, in my opinion, were already undervalued before dropping another 50%+.
Investment Philosophy
My investment philosophy, after being honed and tweaked the past few years, is focused on value. My views are in many ways very similar to my boss’ — small-mid cap focus, well capitalized business, run by smart management efficiently allocating capital. In many ways, however, my philosophy is different. For example, unlike him, I don’t mind debt, as long as its serviceable and the company has a history of smart capital allocations. I like the approach popularized by Verdad Capital[1] — take a private equity approach and apply it to public markets. I try to wait longer to enter, exercising patience as best I can and wait for my moment. By waiting and doing nothing, I’m doing something.
In addition, I seek to be more concentrated on my best ideas — well diversified, but not to the point where I’m diluting returns. Like the Bible[2] says, I like to have somewhere between 7 and 10 ideas, with some cash on hand to be prepared for any other opportunity that I find. Being concentrated in small cap value companies — that is how I’m positioning myself right now.
Portfolio Changes
Thankfully, I wasn’t nearly as exposed to the energy sector as I had been just months before. I got rid of most my oil stocks, as I don’t see any long-term growth in that industry. It is undergoing structural, not cyclical, change. Being on the frontlines of raising investor capital, I’ve been hearing more and more that allocators are eliminating those kind of investments through their ESG position (which, in many cases, I find outrageously hypocritical!). Less and less capital is flowing to energy, and if the pollution problem is to ever be solved, humans must move to cleaner energy sources. I know some of my fellow Texans would strongly disagree, but I believe that’s the reality, and I’m putting my money where my mouth is.
In addition, at the beginning of the crisis I converted 1/3 of my portfolio into cash, at an average of 10% loss. With that cash stack, all I would need is a 11.1% return to get back to what the levels were beforehand — I’m aiming much higher. I’ve identified a few stocks using a custom screener from Sentieo, based on what Verdad Capital (see below) describes as the most significant variables in indicating a dramatic rise in a post-crisis environment. A few of those areas I’m looking into are base metals, consumer discretionary, and construction. I believe those areas are supremely undervalued, and whose share price has been hit unjustly.
For example, let’s look at consumer discretionary. This industry, particularly retail, has been hit dramatically the past few years undergoing, just like oil described above, significant structural change. The main disruption has been e-commerce, mainly in the form of Amazon. The companies who have looked at this as an opportunity haven’t suffered as much, and in many cases thrived at the shift in consumer behavior. For example, Lovesac, a 5% holding of the fund, doesn’t have any retail/traditional brick-and-mortar stores. This furniture store ships directly to consumers, and has a limited amount of “showrooms,” where they display a few of their main products in a small window (think Tesla). This reduces rent (square footage), headcount, and the need to physically go to a store. They’ve been proactive in employing this new brand of online retail, allowing it to be more insulated from the impact of COVID-19.
Conclusion
I have been shaping and forming my portfolio slowly over the past few months, as I continue to build my knowledgeable of managing money. I am slowly getting rid of legacy companies I deem not good enough, and using my research and investment philosophy to shape the portfolio as I see fit. This will take time and a lot of research, so I ask for patience. There are many good opportunities out there right now, but I want to find great ones. This requires proper due diligence. Companies must be thoroughly screened and scrutinized before I make a decision. Risk controls must be put in place, and I am working on writing out clearly what they are. For any question about a holding I own, please feel free to reach out to me, I’ve written detailed write-ups for each. I thank you for your support, and look forward to serving you in the coming years.
Regards,
Matthew
[2] Ecclesiastes 11:1–2
