Fellow Partners,
The Phronesis Fund ended 2021 slightly down for the year. Per our agreement, no performance fees were paid in 2021. That’s how it should be.
A down year is never easy. How we face it is imperative to our long-term success. That is the focus of much of this letter.
My family and I remain the largest partners in the fund, and we continue to grow our position in the fund by investing additional capital alongside yours. We’re all on the same path.
You received statements on your individual positions in mid-January and our fund’s annual audit will be published to your accounts in the next few weeks.
We remain focused on long-term compounding in community with a wonderful group of partners. Over a 30-year time horizon an extra 2.5% annualized return doubles one’s total return; an extra 5% annualized return quadruples one’s total return. Compounding is an amazing force:
I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? Penny. So that’s the question. Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer, in this case, is simply astounding. Doubling a penny a day for 30 days gets you, who knows, $10,737,000 and change.1
Chuck Akre2
Our businesses
The partnership is currently invested in 17 positions which, I am pleased to say, is more focused than the 33 positions we held at the end of 2020. We have long believed in concentrating only in our best opportunities, and 2021 gave us openings to do so. This frees time to study our positions more closely and raises the bar for other positions to join this group.
These 17 positions include 15 traditional businesses and two unique forms of insurance. They are based in four countries throughout North America and Asia Pacific, though most compete globally. Only one of these businesses is in the S&P 500.
Despite substantial market volatility we have never sold a single share of 16 of these positions. For the 17th, we reduced the size of our position in 2021 as it enabled us to increase the size of other positions that were selling at much higher discounts to intrinsic value.
Our top five positions account for 55% of the fund. Our top 10 positions — which were 62% of portfolio assets at end-2020 — now account for 77% of the fund.
We currently have a modest cash balance and have been deploying capital into the declining market. We all like a good sale, and we’re in the midst of one.
While I pay minimal attention to sector-specific diversification (most things can be valuable at the right price), some of you will want to know that the fund has substantial holdings in the technology, industrials, and consumer cyclicals sectors, though I prefer to put it this way: we are invested in phenomenal business models. All of them include zero-marginal-cost dynamics (payment from new customers has extremely high margins) and sit within strong secular tailwinds, and most have elements of what I think of as “operating systems of the future” — underlying platforms that enable speed, scale, cost-reduction and revenue growth for their customers in areas such as financial transactions, restaurant management, digital commerce, entertainment and search.
We view our positions as fractional shares of businesses; as with 2020, those businesses had good years. Revenue grew an average of 50%. All but three of our businesses were free cash flow positive. Earnings were modest as most of our businesses are continuously re-investing in themselves. Some of our businesses raised more capital throughout the year, generally at very favorable terms. Only two businesses have net debt. In aggregate, we own healthy, growing businesses that could weather dry spells while pursuing their paths to long-term high structural margins.
In short: our businesses are harder-better-faster-stronger (couldn’t resist) than they were a year ago. We should be pleased by that.
As mentioned a few weeks ago, I would again encourage partners to increase their positions in the partnership to take advantage of present buying opportunities, and encourage potential partners to reach out.
Thank you to those of you who have already contributed additional capital — I believe we will be envious of some of the prices we are seeing today when we look back in five years’ time.
Macro
Why did we have a down year? In November the Federal Reserve shifted their perspective on inflation from “transitory” to “something more than transitory”.
The market rapidly began pricing in increases to the cost of capital and discounting business prices, roughly in the following order:
First, businesses that have never made money
Next, businesses that make a little bit today and might make much more in the future
Next, businesses that make a lot today but invest most of it in their own growth
Finally, businesses that make a lot today and distribute most of it to their shareholders
Our portfolio is weighted in groups #2 and #3 above and thus has felt the pain of the drawdown relatively early in the market pullback (I expect we’ll bounce back earlier as well but we’ll see — our strategy doesn’t rely on timing these sorts of things).
The carnage has been somewhat masked by the major indices which had pullbacks but have been supported by some of their largest (and thus most heavily weighted) companies. Here’s one way of looking at it: As of writing the NASDAQ composite index, comprised of roughly 3,000 stocks, is about 15% off its all-time high, yet the majority of stocks within the index have had much larger drawdowns (see chart below).
This pullback happened fast and is still ongoing. The speed was clarifying — in many cases our businesses had pullbacks without reporting any new information on business performance. That’s helpful. We had little-to-no new information to update our long-term perspective on these businesses. Sentiment, fear, and a healthy reduction in excessive optimism were the primary drivers.
Those who value businesses based on market sentiment, hopes of ever-higher prices (the “greater fool” theory), ever-expanding multiples or endless support from the Fed should be worried. We don’t. And we’re not.
What have we done? We bought larger stakes in wonderful businesses when valuations fell back into reasonable long-term ranges. We are continuing to zig while others zag.
More macro
If you spend 15 minutes a year worrying about the market, you’ve wasted 14 minutes.
Peter Lynch
An older and wiser friend recently reminded me that focus on the Fed’s actions was far lower in preceding decades — generally the territory of economists, bond and macro traders. That is no longer the case (somewhat regrettably) for good reason.
Over the past 40 years money has gotten cheaper, we’ve not seen sustained inflation, and the world’s major central banks have loaded up on assets — especially over the past 15 years (see chart below). The central bank controlled liquidity and behavior has become a substantive factor in assessing — at a minimum — a reasonable long-term purchase price for a business, as one must factor central bank movements, including the enormity of their assets and willingness to intervene in markets, into their valuation and risk calculus.
I have under-appreciated this dynamic in the past. One of its derivatives — inflation (especially wage inflation) — is the current primary factor as it relates to longer-term valuation impact on our businesses. We’re watching it closely — not for the headline news and numbers, but for shifts, if any, in longer-term structural dynamics.
What we paid
For two years the market was valuing narrative more than numbers. Now the market is valuing numbers more than narrative.
Paul Enright
The above dynamics are where purchase price matters substantially. The cost of money will go up (it cannot and should not be free forever). This reduces the present value of expected future cash flows. It creates some short-term pain.
But here’s what’s important: our valuation for our businesses does not assume anything close to 0% interest rates. Capital markets are currently pricing in a 1.75% Fed Funds rate by year-end. That would be just fine. Higher, too, would be just fine. There’s a limit, but we’re not riding the line.
We have never been interested in paying extremely high multiples, even for the best businesses. Consequently, we did very little net purchasing in 2021 until late in the year.
When did we start buying? When valuations came down substantially.
Have they come down further? In most cases, yes. But our focus is and remains paying fair prices for wonderful businesses. We don’t predict short-term prices or sentiment, nor do we believe we can time the bottom.
While the pain of drawdowns may continue in the short run, where our business hypotheses prove to be correct over time, our purchase discipline will be the bedrock of our long-term returns.
Timing
We typically hold our investments for years, and thus it can often take years to know whether we were right in our assessment of said investments.
I would encourage you to re-read our 2020 Fund Performance note. Our plans haven’t changed; what has changed as of late is the pendulum of the market, which constantly swings between maximum optimism (where we were in late 2020) and maximum pessimism (we’re closer to this end of the pendulum at present, especially in the longer-duration assets we tend to own).
From mid-2020 through mid-2021 the market loved companies with robust growth prospects and was willing to pay high prices to own them. In late 2021 many of these companies fell out of favor with the market, which is now unwilling to pay modest prices to own them. Where is ownership risk higher? As noted above, we like a good sale.
Enormous errors are made by managers and investors through implicitly playing to an annual clock. It is hard not to when nearly all business performance, investment performance, and remuneration report to this clock. That is one of the many reasons it is critical that I, as your general partner, am also a substantial limited partner. It aligns our interests as well as our time horizons.
But here’s the main problem with the annual clock: none of our investments know or care when December 31st rolls around. Acting as though they do will almost certainly hinder our performance. We focus on the long-term rate at which our capital compounds. We couldn’t care less how that overlaps with our planet’s orbit.
What won’t change
We seek to invest where the future is obvious.
Consumers shifting purchasing habits from offline to online. Media shifting from analog to digital formats. Ads served only to those most likely to buy. Automation subsuming repetitive tasks. Creators empowered to monetize their craft. Removal of non-value adding middlemen. Expansion of the digital asset ecosystem. Better, faster, cheaper.
Our success over the next decade will be primarily dependent on the speed and persistence of these trends and our ability to correctly identify and invest in those pulling them forward. It won’t make much difference whether interest rates are 0% or 3%.
Closing thoughts
This image of our partners has been the background on my computer since we launched the partnership (blurred to protect privacy, and updated only when we add new partners). It is the first and last image I see when I start and end work each day. That’s how it should be.
You’ll also notice the text at the top of the image. I recently made that addition amidst the substantial market volatility. It is amazingly hard to play a long game and only a long game. But that’s our aim. Seeing these words many times each hour of each day is my own form of encouraging myself in this direction. I hope it encourages all of us in the direction of calm, patient, long-term application of practical wisdom and first principles reasoning.
As always, please reach out any time. I enjoy hearing from you. Thank you for the continued opportunity to compound trust with you.
All the best,
John
Founder and Managing Partner
Perhaps as amazing as the results of doubling a penny a day for 30 days is where the real money is made. By day 5 the penny has grown to 32 cents. By day 15 it is worth a modest $328. Even at day 25 it is “only” worth $335,544. Those last 5 days are astounding.
