2019 Annual Letter

Results

Performance information is available to qualified investors on request. Contact ir@philipequities.com.

Four Contributors to Performance

The investments discussed below were selected as representative examples of our investment process during 2019 and are not necessarily the fund's best or worst performing positions.

Micron

The fund initiated a position in Micron at inception, at $32.43 a share. It now trades for $53.86 a share. Micron is a core position that constitutes about 15% of the portfolio. One aspect of our approach that we believe differentiates Philip Equities is our willingness to accept volatility. Because many managers believe that higher volatility means a business is more risky, they validly but unsoundly conclude that a stock with volatile mark-to-market price fluctuations (often due to volatile earnings) is less valuable. Memory prices are volatile, which has led to high mark-to-market price volatility for Micron’s stock, and consequently, the investment community undervalues Micron. Like oil, DRAM prices are bound to continue to be volatile, but unlike oil, the oligopoly of Hynix, Samsung, and Micron has historically maintained supply discipline.

George Soros’s theory of reflexivity, which will be discussed in more detail later in this letter, is useful for understanding Micron. In the cognitive function, each of the three management teams attempt to understand the reality of future bit growth. In the participating function, each of these management teams announce their own future bit growth. There is no independent variable. The inevitable supply-demand imbalances will result in inflexion points (e.g. cutting capex), and positive or negative feedback towards equilibrium (but rarely remaining at equilibrium) will follow. This reflexive dynamic we believe may result in fluctuating but healthy margins. Furthermore, the 2 widely acknowledged, relatively new diversified demand drivers for DRAM lessen previously extreme cyclicality.

To return to the oil analogy, demand for kerosene was strong, but the automobile fundamentally transformed demand for oil. Similarly, as autonomous vehicles go mainstream, the demand for memory that they require will transform demand for memory. Even if autonomous vehicle technology does not thoroughly materialize and even under a pessimistic scenario of just 3% FCF CAGR, my downside analysis indicated a value floor well above my cost basis.

AerCap

At roughly 24% of the portfolio, AerCap is the fund’s largest position. The fund initiated a position in AerCap at inception, at $40.75 a share. The average cost has come to $42.18 a share, and it now trades for $61.47 a share. When the fund first purchased AerCap, it was trading for roughly 6.5x earnings, and ¾ the value of its airplanes. The business’s CEO, Aengus Kelley, who owns nearly $150 million in stock, has been selling AerCap’s airplanes for above book value and then buying back stock below book. As the largest aircraft leasing business, AerCap borrows at lower rates and purchases planes at lower prices than competitors. The average age of AerCap’s fleet has been decreasing while the average remaining lease years has been increasing. As per capita incomes converge, air traffic should substantially increase. Air traffic has doubled roughly every 15 years, and I expect it will double again within 20 years. This increase in demand should, in time, eat up oversupply, which is bound to occur from time to time. The business is consistently profitable, with a roughly 7.5% ROE at its low point during the Great Recession. AerCap is based in Ireland, where it enjoys a roughly 12.5% tax rate. Management is shareholder-oriented, as evidenced by the fact that they have bought back over 40% of the company’s stock in the last 5 years. Even under a pessimistic scenario of 0% earnings growth, my downside analysis indicated a value floor well above my average cost basis.

Apple

Apple was the fund’s largest position at inception. The position was initiated at an average price of $153.57 a share.

Users of Apple’s iPhone spend roughly 3.5 hours a day on their device, and many subscribe to Apple’s services. For Apple’s existing users, switching to another company’s phone is cognitively challenging, requires time, is less “cool,” and likely makes their over 1,000 hours a year on their phone less enjoyable. This creates a strong moat that should enable Apple to retain users and to continue charging a marginal premium to competitors. Furthermore, as per capita incomes converge, Apple’s install base will increase as it adds users in China, India, and elsewhere. It is widely acknowledged that Apple’s services and wearables businesses have room to grow. Apple's management has historically avoided large dilutive acquisitions, and they are returning cash to shareholders through stock buybacks that fall below my estimate of intrinsic value. Even under a pessimistic scenario of just 3% earnings CAGR with no multiple expansion, my downside analysis indicated a value floor well above my cost basis.

As Apple’s stock increased, and my estimate of its intrinsic value remained constant (assuming a constant discount rate) at roughly $380 a share, the position was trimmed at $222.84 a share to make room for increased positions in MOMO and YY, as these stock prices declined due to 3 transitory macro factors, and a new position in NOAH, as its stock fell dramatically due to a scary headline that should prove to be immaterial to its intrinsic value over a long period of time. The position was further trimmed at a price of $257.30 a share, from a core 11.5% position, to a less material 4% position. On November 15th, the remaining position in Apple was sold at $264.65 a share to make room for a new position in Macy’s. Apple now trades for $293.68 a share.

Tiffany & Co

The fund initiated a roughly 3% position in Tiffany & Co at inception, at $81.82 a share. Tiffany & Co is one of the strongest luxury consumer brands in the world. The brand is similar to Apple’s iPhone, or Berkshire’s See’s Candy, in the sense that the business’s gross margins will be durable for many decades. Additionally, Tiffany & Co has been consistently and successfully expanding internationally, and seems to have a strong opportunity to continue this trend in fast-growing emerging markets. While Tiffany & Co is the sort of business that should be successful regardless of management, the business’s management team currently seems particularly competent.

Even under a conservative scenario of 4% earnings CAGR, my downside analysis indicated a value floor well above my cost basis. Like all investments, I purchased Tiffany & Co willing to hold it for a long period of time; however, over the final weekend of October, it was credibly reported that LVMH offered to purchase Tiffany & Co for $120 a share. On Monday morning, October 28th, the stock was quoted at prices above the offer price, and I exited the investment in pre-market trading at a price of $128 a share. The logic was that (1) the fund did not have the capacity to block the takeover, and (2) while it was plausible that LVMH would make a higher bid, continuing to own the stock would be akin to a speculative bet concerning the outcome of the takeover, and Philip Equities is not in the business of merger arbitrage.

Fund’s Objective

The fund’s objective is to achieve strong long-term absolute performance while protecting investors from the risk of permanent loss of capital. However, avoiding volatility is not an objective, and avoiding years in which the mark-to-market prices of the fund’s holdings are temporarily marked down is also not an objective. The popular tendency to assess progress towards long-term outperformance by examining short-term, volatility-adjusted, absolute performance would distort the fund’s sound investment process and could trigger fear responses in limited partners.

In the thirteen years Peter Lynch managed the Magellan Fund, the S&P fell greater than 10% nine times, and all nine times Lynch’s fund also fell greater than 10%. Buffett has had two roughly 50% drawdowns in the last twenty years. Since 1900, the stock index has had thirty-two 20% or greater drawdowns.

From the perspective of compounding, my youth is an advantage; I intend to be compounding money half a century from now at age 75.

Unique Investment Process Explained

Overview

The first step to valuing a cash generative business that I intuitively understand is to make a big picture conservative judgment of its long-term earning CAGR, or free cash flow CAGR, which can then be discounted. The fund’s investment process consists of using significantly lower estimates than sell-side analysts and a significantly lower discount rate. Lower estimates are used in an effort to value businesses on a conservative basis; ultimately, the fund’s investment process requires a high degree of certainty that a business will meet or exceed the conservative estimates. This high degree of certainty is partially derived from low estimates, but more importantly, it is a consequence of having an intuitive understanding of the business. Due to this high degree of certainty, a lower discount rate is justified. Also, along with other supporting reasons which will be discussed later, this high degree of certainty is part of the justification for the portfolio’s concentration. Using this low and constant discount rate across all opportunities allows the concept of opportunity cost to be used most effectively.

I cannot value all businesses. If there is more uncertainty about one business relative to another business, instead of increasing the discount rate, estimates of the more uncertain business are lowered until certainty becomes roughly equal. This exercise, of lowering estimates until a necessary degree of certainty is reached, results in eliminating the vast majority of potential opportunities for two reasons. One, conviction that a particular business will meet or exceed any estimates is usually insufficient. And two, as estimates are lowered, the discount the business is trading at relative to intrinsic value becomes less and less attractive.

Furthermore, I am highly disciplined when it comes to staying within my area of competence, and recognize that I am neither the most intelligent person nor the most knowledgeable person, so the valuation of each business is approached with caution. This cautious approach means that few new positions are initiated, and there might even be years in which the fund initiates zero new positions. Due to the challenge of discovering even one or two significantly undervalued businesses in my area of competence in a given year, the flexible mandate to search globally across all sectors and market capitalizations is critical.

To purchase a business, I must intuitively understand a business, have conviction that the business will meet or exceed conservative estimates, the ballpark estimate of the business’s intrinsic value must offer a significant discount to its current price, and the asymmetrical risk/reward profile must exceed the other opportunities that exist in the portfolio and the watchlist (with a strong bias towards minimizing downside risk). Few opportunities meet this set of criteria.

Evaluating CAPM

As demonstrated, the fund’s investment process does not attempt to create a required rate of return through CAPM. CAPM uses historical price volatility to measure risk. The idea that a business is more risky, and consequently less valuable, due to a recorded wider range of prices agreed upon by market participants over a period of time, is not logically sound.

Furthermore, while there are clearly various material risks to investing in businesses, it does not seem obvious that equities should be the asset class with a risk premium. History reports no shortage of corporate and sovereign bankruptcies. Furthermore, history reports frequent and severe periods of inflation in which entrepreneurs, or people who own businesses, cope as they adjust prices, while rentiers, or those with fixed incomes, suffer. While I am not arguing that there should be a fixed income risk premium (though the argument can be made!), I strongly push back on the popular notion of equity risk premium.

As philosopher Karl Popper demonstrated in The Logic of Scientific Discovery, one failed test is sufficient to falsify, but no amount of confirming instances is sufficient to verify. Modern Financial Theory has been falsified in theory and in practice. Dogmatic views are expected because humans desire explanations for the unknown (i.e. doubt avoidance tendency); however, widespread dogma among above-average intelligence financial professionals concerning a falsified theory is a welcomed aberration that the fund’s investment process will exploit. It is important to note that the quality of genius-level intelligence and the quality of being exceptionally and consistently logical are evidently separate qualities, with the latter and not the former being a prerequisite for intelligent investing.

Long-Term Conservative Mental Model Explained & an Evaluation of Industry Norms

Another aspect of the fund’s investment process that is at variance with the norm is the use of big picture judgements of long-term earnings or FCFs CAGRs instead of attempting to predict cash flows with exactness. When considering a business’s intrinsic value, if one gets the big picture judgment roughly correct, then one’s estimate of intrinsic value will be in the ballpark. As John Maynard Keynes said: “It is better to be approximately right than precisely wrong.” This is especially true when one makes an investment with a significant margin of safety. Further details are superfluous because a ballpark estimate is sufficient to inform a conservative buy and sell decision. If understanding numerous and constantly changing details is necessary for a high degree of certainty that a business will meet or exceed conservative estimates, then I move on to another business that is easier to understand. As Buffett said: “If you have to closely follow a company, you shouldn’t own it.”

Short-term thinking and attempting to predict the future with exactness go hand in hand. With the exception of edge cases, such as credit card data, which is practically commoditized anyway, or illegal cases of acting on material non-public information, market participants have the same material public information. Due to this lack of informational advantage and the fact that minor adjustments to cash flows in a DCF model do not materially impact intrinsic value, attempting to generate outperformance through predicting with exactness seems to be a superfluous use of time and resources. Micron’s precise amount of CAPEX next year, or the amount of new airplanes, and the consequent change in lease rates for AerCap next year, or the change in the cost of iPhone screens for Apple next year, are details that might lead to the respective business beating or missing short term analyst estimates; however, investors generally cannot derive a legal edge through this form of prediction, and these details do not materially impact the intrinsic values of these businesses.

We often hear people discuss stocks and the market inappropriately. People make decisions based on what months are historically best and worst for the S&P, or if “growth” or “value” will outperform in the next year, or what stocks have the most “momentum.” The lens I use to filter out the noise is to ask myself if a particular factor is one an experienced and successful businessman would seriously consider before purchasing a piece of a private business to hold for a long period of time.

The fund’s investment process does not consider if a business will beat or miss analyst estimates for the upcoming quarter or year. It does not try to anticipate or predict transitory factors, such as precisely when a trade war will end. It does not use comparable analysis or precedent transaction analysis. It does not choose a multiple for a business’s earnings with the hope that the market will also choose that multiple. And it does not try to anticipate or predict how the market will price a stock in 12 months (or any period of time!).

As John Templeton astutely said: “If you want to have a better performance than the crowd, you must do things differently from the crowd.” Philip’s investment process relies on an acknowledgment of human fallibility, a deep understanding of reflexivity, an awareness of cognitive biases, superior big picture judgement of an unusually concentrated portfolio of businesses, and a uniquely disciplined temperament. On a micro level, the investment philosophy incorporates Solomon Asch’s 1951 Conformity Experiment demonstrating that people’s views of reality are heavily influenced by others, which leads to the view that there are bound to be opportunities to purchase pieces of businesses for obviously cheap prices. Importantly, on the portfolio level, the investment philosophy is cognizant that stocks are pieces of businesses that can be priced by temperamental humans at any extreme imaginable; consequently, the fund will be managed appropriately to survive all tail risks that may result.

Diversification vs Concentrated Investing

Andrew Carnegie in The Empire of Business discussed his reasoning on why it is most sensible to “put all your eggs in one basket, and then watch that basket” as opposed to scattering your capital and brains across various investments and ideas. Stanley Druckenmiller, in a 2017 interview at USC’s Marshall Business School, intentionally or inadvertently elaborated on Carnegie’s thoughts when he said:

“My idea of risk control is a little nonconventional. I like putting all my eggs in one basket, and then watching that basket very carefully. I don’t know what they teach at Marshall, but at most business schools they teach I think a lot of nonsense called risk-adjusted return and diversification. As a money manager, if you look at a normal portfolio, most people will make 70-80 percent of their money that year on two or three ideas even though they will have thirty or forty things in their portfolio. My concept was to put into those two or three ideas that I had the most conviction in.”

Warren Buffett, answering a question on diversification during a lecture at the University Of Florida School Of Business on October 15th, 1998 said:

“Once you are in the business of evaluating businesses and you decide that you are going to bring the effort and intensity and time involved to get that job done, then I think diversification is a terrible mistake to any degree. I got asked that question the other day at SunTrust. If you really know businesses, you probably shouldn’t own more than six of them.”

Philip Equities will generally hold eight to twenty-five cash generative businesses trading for significant discounts to intrinsic values, and the vast majority of the portfolio will often be concentrated in the top six or so positions. Concentrating the portfolio minimizes the opportunity cost of not investing sufficiently in the best ideas, and it avoids thinking being too spread, which can result in the permanent loss of capital due to an insufficient understanding of businesses.

Emotions & Cognitive Biases vs Reason

Due to our evolutionary history, humans experience emotions and are susceptible to cognitive biases, both of which are detrimental to successful investing. Thus, it is imperative that an investor remove emotion and cognitive biases from the investment process. It would be redundant to discuss the myriad cognitive biases since Charlie Munger already wrote an excellent essay on the topic titled The Psychology of Human Misjudgment.

Due to evolution, humans become distracted in periods of fear. Thus, when market participants become fearful, such as when the VIX rises significantly, they do not have their mental energy focused on properly valuing businesses. Furthermore, as social creatures, emotions are contagious, so fear breeds fear. Consequently, during high volatility emotional selloffs, stock correlations tend towards one as all stocks are sold regardless of their value. This creates opportunity for a hyper-rational bargain hunter. After a fear-induced selloff, correlations decrease, and the market closes the valuation gap. As a result of increased passive investing, and consequent panic indiscriminate selling of all stocks in the indexes from time to time, these selloffs should offer the discriminate investor enhanced rewards. From a neuroscience perspective, fear-derived opportunities will continue to be available for the intelligent investor to exploit so long as neurotypical brains continue to have biological responses.

Approach to the General Stock Market

Predicting general stock market or business fluctuations is not Philip’s area of focus, and frankly other market participants have informational advantages in this area; however, I have been a fierce student of George Soros’s theory of reflexivity for over a decade, so when determining whether to be 70% to 130% invested (30% of NAV being the fund’s self-imposed limit on borrowing to avoid forced sales during a panic), this theory, in addition to the discounts to intrinsic values that can be found in businesses, will guide the fund’s market exposure.

Reflexivity and fallibility are closely associated. Fallibility states the obvious: humans are flawed creatures with biases and inconsistencies, and thus, their perceptions are never entirely accurate. In social situations, flawed perceptions lead to at least partially flawed words or actions that change the reality that the participants are attempting to perceive. As Soros says, “In the cognitive function, the participants' perceptions depend on the situation; in the participating function, the situation is influenced by the participants' perceptions.” This creates a paradigm in which equilibrium is rare, and boom-bust sequences produced by positive and negative feedback loops (with inflexion points) dominate. Of course, this is a simple explanation of a complex and fascinating subject. I wrote a forty-five page paper on reflexivity while attending USC, and would be thrilled to discuss it further. An understanding of reflexivity will, on occasion, and with firm limits to ensure capital preservation, be a secondary tool that influences the fund’s market exposure, and, on rare occasion, the valuation of a specific business.

There is currently an example of an ongoing reflexive situation concerning the general stock market that the fund capitalized on in 2019. Consider the significant delta in future corporate earnings growth as a result of a Trump victory vs a Democrat victory (especially a Sanders or Warren victory). Consequently, as the probability of a Trump victory increases, the stock market should increase. Also consider that Trump is largely running on the economy, and the stock market is the go-to barometer for voters gauging the economy (not to mention that it impacts the real economy). Consequently, as the stock market increases, the probability of a Trump victory increases. As demonstrated, there is no independent variable. Thus, the stock market, and Trump’s odds of winning the election, can either take the form of a self-reinforcing positive feedback loop, or a self-defeating negative feedback loop. As Soros would say, future events are likely to be shaped by present expectations.

With the exception of my long-standing focus on reflexivity, the fund’s investment philosophy is by and large dedicated to concentrated value investing, with value being defined as a business trading at a significant discount to its intrinsic value. This definition of value is flexible and nontraditional because a business does not necessarily have to trade for a low price/earnings multiple, or pay a high dividend. For example, a business paying no dividend, and trading for 30x earnings, can be highly attractive relative to its intrinsic value, whereas another business, paying a 10% dividend, and trading for 5x earnings, can be unattractive.

My investment strategy as an ice cream (my favorite food), would be one scoop Buffet, one scoop Templeton, one scoop Peter Lynch, with Soros as the cherry on the top. There will be years in which I can discern a reflexive situation in the general stock market and/or stock-specific reflexive situations (the latter of which must also meet my value investment criteria to ensure capital preservation). In these years, this special understanding of reflexivity will enhance returns much like a cherry enhances an ice cream.

Evaluating Institutional Allocations to Young Emerging Equity Managers

Some folks have suggested that (1) institutions will discount the fund’s returns because they are on low AUM, and (2) that institutions will not invest because the manager is too young and not “institutional.”

I am confident that the investment philosophy and process discussed in this letter exemplify the kind of manager you desire to be associated with, and I do not intend to come off as defensive or confrontational; however, it is imperative to address potential objections head-on.

Should Returns Be Discounted If They Are On Low AUM?

A manager that generates returns in illiquid small-cap stocks cannot scale his or her operation; however, Philip’s process has been buying and holding a portfolio of large-cap and medium-cap stocks, and thus, would not differ with AUM in the billions. Plus, idea inventory should increase by the time AUM surpasses the low billions. To be clear, Philip’s top 6 positions are AerCap ($8.1 billion market cap), Wells Fargo ($227.5 billion market cap), Micron ($59.7 billion market cap), Alphabet ($922.5 billion market cap), Macy’s ($5.3 billion market cap), and Momo ($7 billion market cap).

Should A Manager’s Young Age & Lack of Institutional Infrastructure Be a Concern?

Warren Buffett was 25 when he launched his partnership; Kenneth Griffin as an undergrad at Harvard; Ray Dalio 26; Paul Tudor Jones 26; David Einhorn 27; Chase Coleman 25; Seth Klarman 25; and Edward Lampert 25. These managers were in their twenties and could not have been immediately “institutional.” Louis Bacon supposedly began with $25,000; Ken Fisher supposedly began with $250; John Paulson said that it took him over a year after inception to raise outside capital. Also, studies have demonstrated that emerging managers (funds with fewer years of track record) significantly beat more mature funds. One may argue that a younger manager has not been through market cycles. While this is a perfectly reasonable concern, I have been an avid student of history, with a particular focus on financial history.

Disparity in Consideration of Young Founders in Technology vs Investment Management

People who have founded technology businesses in their twenties include: Bill Gates, Steve Jobs, Mark Zuckerberg, Larry Page, Sergey Brin, and Pony Ma. Fortunately for society, the venture capital industry recognizes that young people without significant formal experience can create tremendous value for others. For example, Peter Thiel has a program called 20 Under 20 in which he invests in students under the age of 23. However, despite the enormous value young founders in the investment management industry have created for others, institutional investors and family offices inexplicably seem to not only take minimal positive action to seek out young founders, but also seem to ignore their investment philosophy, process, and performance. This creates valuable untapped opportunities for allocators.

Conceptually, founding a complex technology business is at least as challenging as successfully managing a concentrated value equity fund.

Benefits of a “Younger Equity Manager Allocation”

Some form of a “younger equity manager allocation” can be a wise diversification tool for an institution because a younger equity manager is likely to offer a unique area of competence that is difficult to obtain by investing in the significantly larger category of older equity managers. People in the investment community often joke about their middle school or high school child picking a winning stock. While an allocation to a group of middle schoolers is not recommended, this joke contains important and overlooked substance worthy of further consideration. Different generations are clearly exposed to different products and services in different doses, but the average age of managers who manage institutional money is probably somewhere between forty and fifty (and heavily skewed older). By allocating to a competent and conservative young equity manager, an institution can obtain valuable qualitative analysis in a differentiated area of competence, while still retaining the sound investment process and essential risk management found in the traditional investment shop.

Finally, a younger and financially wanting manager is naturally “hungrier” for outperformance.

Conclusion

I am cognizant of the reasonable concerns institutions have with regard to investing in young emerging managers; however, a hardworking young entrepreneur with a cogent investment strategy should be able to start a successful investment business in the United States of America. I hope you share this sentiment, and I would cherish the opportunity to create value for you.