AOF’s Q2 Letter to Shareholders

Dear Partners,

What originally was supposed to last three weeks has turned into a long-term disruption. What did last only three weeks was low stock prices, as the market has (rapidly) once again become completely disconnected with reality. The economic backdrop is the worst it’s been in decades — unemployment is astronomical, the amount of debt that is needed to be taken on is unprecedented, consumer spending is way down, etc. Warren Buffett didn’t heed his own famous words “be fearful when others are greedy and be greedy when others are fearful,” as it’s reported even he didn’t buy at the trough. Unfortunately, for the most part, neither did I, as I thought the economic impact of the virus would be greater than in 2008, indicating that the market back in March and April still had a ways to fall. I’m not wrong in that assessment, but the market doesn’t seem to care. I wrote in my last investor letter how the drop in the prices of some companies was not at all justified — now I say the opposite. The rise in the prices of most companies are not at all justified, especially with the rise in COVID cases throughout the United States since mid-June.

I must note that other events around the world that were important before COVID have been put on the back-burner. The trade deal between the US and China, the US presidential election in November, and escalating tensions between Iran and the US are all deemed not important in the face of this virus.

Philosophy

I’m sure I’ll look back on this time as a defining moment in my investment career. My risk framework is becoming more defined, as I experience some losses. My definition of value, which for some time has been very rigid, is loosening to include traditional “growth” stocks (more on that below). Saying that, a few core value tenets remain — strong normalized earnings power, strong cash flow, competent management, and an eye for future growth. The construction of the portfolio will eventually have 7–10 long holdings, but as of now, once again, I’m doing something by doing nothing, as I’m waiting for the economic realities to puncture the markets balloon.

By “growth” stocks, I mean companies that traditionally are put in the growth bucket, but to me can still be considered value. This allows me to look at industries that are often overlooked by value managers. A great company is often excluded from a value managers’ portfolio because the traditional financial metrics price it way too high. Two of my core value tenets mentioned above — strong normalized earnings power and eye for future growth — play into this new look on value. If I think a company is relatively underpriced compared to its future earnings power, then why should I listen to what the traditional value ratios are telling me? By blindly following those metrics, many value managers have been left behind, but I don’t intend on being one of them.

Successes

The large cash position I had built was only put to work in two stocks, which was only 1/3 of the cash pile. I went all in on Trevali Mining Corp., a pure Zinc miner with assets in Canada, Africa and Peru. The company first caught my eye in 2018, when the Zinc price was at its highest over the past decade. The stock was trading around $1.25 then, but has since fallen to $0.06. The fall in the stock occurred for two reasons. First, Trevali significantly overpaid for an asset in Africa that has since been impaired, with new management coming in at the beginning of 2019 to rectify the mistake. Second, the Zinc price has dropped significantly, especially during February/March, as global growth reversed. I explained my rationale behind going all in on Trevali in my company write-up, so I won’t delve into why I bought it in this letter. So far, it seems I’ve bought it at its trough, and with Zinc prices on the way up, I might add even more to this position.

In addition, I liquidated one holding, which was the clear winner for my portfolio. If you had told me that an investment in mid-January would double by mid-June, I would’ve fully invested into that position. Lovesac, a specialty furniture store, was bought at $12.90 in January and sold for about $26.10 five months later. I originally was going to keep it for longer because my initial research indicated it was an undervalued growth stock, with fantastic products, of which a lot of their revenue was derived online. However, after digging deeper, I exited this position for several reasons, explained in my write-up of the company. We shall see if this was the right call in a few months from now.

Failures

Because I thought the market would continue to fall back in early April, I didn’t invest the vast majority of my large cash holding during this quarter. Should I consider not investing the majority of my cash pile a failure? Based off of the returns I would’ve achieved had I invested in the companies I wanted to, yes. However, to dwell on what could’ve been will always blind you to the opportunities in front of you.

My biggest mistake, however, was that I committed the sin of investing on the fear of missing out. I had started to figure that the market was going to continue going up no matter what, since the FED and other governments kept pouring in trillions to offset the negative economic impact of the virus. With that reasoning, I took a full position in one of my consumer discretionary stocks I’ve been watching for a long time. That has only gone downwards since I bought it. Good news is, I plan on holding it for a few years, during which time it could turn out to be a shrewd investment. This isn’t a short, there’s no holding cost, I just could’ve entered at a better time.

Outlook and Conclusion

Throughout the lockdown, I’ve been asking myself the same question and coming up with different answers. What industries will benefit the most coming out this time?

1. First, as most other investors reasoned, companies that derive most of their revenues from online are well insulated, and will benefit from a shift in consumer demand towards online shopping, rather than in physical stores.

2. For the first time ever, governments, society and investors are in agreement about the future of renewable energy. A few factors in the past few months have contributed to this alignment, and it’s picking up steam

3. I want to avoid real estate, as I believe some office space may become obsolete as companies are realizing they don’t need to pay so much for an office when most of their workers can work from home.

More research, and probably some new investments, will be revealed in the next quarter letter. Never before has there been so much uncertainty, or opportunity. I am forever on the look out for the best opportunities, and will act when necessary.

Regards,

Matthew