We closed 3 successful investments in the last quarter: Robert Half International (+60% in 2 years), Kakaku.com (+84% in under a year) and Urban Outfitters (+82% in 2 and a half years). While Robert Half and Kakaku rewarded us from the outset, it was Urban Outfitters that gave most of our clients their first real taste of what it means to be a long-term investor, despite being a fairly short-lived investment.
We are long-term investors. This means that we make an investment with the understanding and the expectation that it may take 5 to 10 years for our thesis to play out. At Bellwood Capital, our clients have not yet been invested for 5 years, so their investments are still in the early stages. Those stocks that have been sold have either exceeded our expectations very quickly, or in some cases have seen their investment thesis change. The temptation to judge any individual investment a success or a failure after year 1 or year 2 is immense (people are naturally inclined towards short-termism), but it would be a mistake to do so. Urban Outfitters demonstrates this well.
We started investing in US apparel retailers late in 2015 – notably The Gap and Urban Outfitters. Their stock prices had fallen following a period of weakness in US retail. The common sentiment was that Amazon was killing the bricks-and-mortar retail industry. These were not popular stocks.
Our investment process, however, is not based on sentiment, stories or popularity, but rather on the presence of certain preconditions that have a direct causal link to long-term returns: Good sustainable return, consistent profitability matched by cash flows, strong balance sheets, all combined with attractive valuations. We concluded that these companies met our preconditions, and were priced for good returns on the back of the negative sentiment.
Unfortunately that sentiment was about to become much worse. Within a couple of months, Urban had fallen nearly 30%. The consensus was that US retailers were doomed. Many sentiment- or story-driven investors would have agreed that these were failed investments, and sold their shares amidst the onslaught of negative press and falling share prices. Psychologically, holding a stock in the face of what seems like a mountain of disconfirming “evidence” is extremely difficult.
This is where having a strong process and an understanding of the drivers of return is critical. Return = Sustainable Return + Revaluation. Sustainable Return is the fundamental performance of the underlying business – its quality. Revaluation is driven by investor sentiment, which is often irrational, unpredictable and volatile. In the short-term, return is driven almost entirely by revaluation, which is why short-term returns are so unpredictable.
If a stock drops by 30% in two months, it is unlikely that the sustainable return of the underlying business was -30%. As time passes though, sentiment tends to ebb and flow, cancelling itself out, while sustainable return compounds and contributes more and more to total return. Over very long periods of time, annualized revaluation tends towards zero, while total return tends towards sustainable return. When a stock returns 1 000% over a decade or two, it is most likely that the vast majority of this would come from sustainable return.
The best long-term returns come from buying high sustainable return businesses at low valuations (implying negative sentiment), holding them for the long-term and selling them if they become too overvalued. While sentiment is completely unpredictable in the short-term, the probability is that if we give our investments enough time (5 to 10 years) they are likely to experience the full range of sentiments and resulting valuations. This provides us with the opportunity to buy some very good businesses cheaply, benefit from their sustainable return and sell them expensively should the opportunity arise at the other end of the sentiment scale.
The key to executing this strategy successfully is to overcome the emotional hurdle that arises in those cases when irrational sentiment moves further in the wrong direction. This means differentiating between sentiment and sustainable return. The ability to do so is one of the best edges any investor can have. Having a strong process and an understanding of the drivers of return is the critical difference between success or failure in this regard.
Having lost 30% off the bat on Urban Outfitters, we retested our investment case against our process (which involved much internal debate and consternation) and concluded that the fundamentals of the business had not changed. The business had no debt, remained profitable, was returning large amounts of capital to shareholders (a form of sustainable return) and was likely to grow revenues in time. Further, the valuation was more attractive than before. Instead of selling we invested more at the lower prices.
Before the end of 2016, Urban had nearly doubled (sentiment had improved!) and we were far less concerned about our investment, perhaps even feeling the job was done. The stock was trading around fair value, we trimmed a few overweight positions, but we were happy to keep holding the majority of our shares. Up to this point, most investors would agree that losing 30% off the bat wasn’t too bad given that the stock doubled quite quickly after that.
By June 2017 the stock had fallen more than 50% again, and was now 20% lower than in December 2015. Sentiment towards retailers was rock bottom, not only in the press, but in our office too. In aggregate we were down nearly 40% on Urban Outfitters after 18 months. At this point, any normal person would feel that Urban was a failure. We weren’t immune to the pervasive negativity either, but we stuck to our process, retested our thesis and bought more shares in Urban at these prices. This wasn’t a comforting decision per se, but it would have been impossible without a strong process.
Over the next 12 months, Urban rallied 187% from its low. Now overvalued and priced for weak returns, we decided to sell the stock for an aggregate profit of 82% in 2 and a half years (27% p.a.). Urban Outfitters has been a successful investment for us, but it wasn’t a smooth ride and it required a lot of patience and intestinal fortitude.
Now consider the bigger picture: This was still only a 2 and a half year investment. We are making investments with a 5 to 10 year horizon. Sentiment and revaluation have provided us with unusual opportunities to buy Urban cheaply and sell expensively in a short space of time. Sustainable return was a lesser contributor to total return (contributing roughly a quarter) – though this would have become more meaningful in time.
While some of our investments will run their course quite quickly, like Robert Half, Kakaku and even Urban, many of them will take longer. Fortunately they won’t all be as challenging as Urban. Some of our best investments will deliver excellent returns over several years without becoming expensive (NetEase and TSM are good examples of this) but they too will have their ups and downs along the way. What is important is that in each case we are making investments that meet the preconditions set out in our investment process, and that we give them enough time.
To reap the rewards of long-term investment we need a strong, unemotional investment process and, at times, patience. This is what it means to be a long-term investor.