Spring 2021 Portfolio Update
Every six months Dan and I write a letter to our clients to explain what they own and why they own it. Today we published our Spring 2021 Update, which is excerpted below. To read the entire letter as well as past letters, head over to the Letters section of our website.
As always, the goal of this letter is to explain what you own and why you own it. Our objective remains unchanged: to avoid the permanent loss of capital while maximizing the increase in the long-term, after-tax purchasing power of our funds. Put another way, we aim to build an indestructible long-term compounding machine.
Our method is to value the businesses behind stocks. We think and act like long-term business owners. Valuation is all about cash in and cash out. Warren Buffett has boiled the process down to three questions:
How much cash will you get?
When will you get it?
How sure are you of 1 & 2?
Most investors follow this process when buying private assets, like real estate. But many throw it out the window when buying public securities. Stocks are one of the few assets people get more excited to buy the higher prices go. Likewise, many panic and sell because prices fall.
We approach the stock market exactly like we’d approach buying a rental property.
First, we analyze the asset’s competitive position. Is the property in a safe, up-and-coming neighborhood? Are the schools good? Are there lots of high-paying jobs nearby? Is supply constrained?
Next, we estimate the distributable cash the asset might produce. We focus on normalized rents and expenses over 5-10 years. Maintenance can be lumpy, making some years appear less profitable than others (like when a roof gets replaced). In the stock market, investors often value businesses as if these one-off expenses will reoccur in perpetuity. We look through these fluctuations to understand the asset’s normalized earnings power and try to use mis-pricings to buy at bargain prices.
Next, we consider growth. We want to own assets likely to earn more in 5-10 years than they do today. A well-kept apartment in a desirable, supply-constrained neighborhood should be able to raise rents a few percent each year. We like that type of pricing power.
An asset’s long-term return will approximate the sum of its earnings yield and growth rate. Earnings yield is the ratio of distributable earnings to price. It’s the inverse of the price-to-earnings ratio. Lower prices make the same earnings more attractive, and vice versa. That’s why investors should cheer lower prices.
Real estate investors can also make money flipping a property for a gain (or loss). This is akin to a stock's valuation rising or falling. We try to buy businesses at valuations more likely to go up than down, but predicting how valuations might change isn't really our game. We're most concerned about paying a low price to maximize our earnings yield. A higher valuation is the occasional cherry on top of an otherwise smart buy.
If price paid is the “cash in” part of investing, then dividends are the “cash out” component. Ultimately, rental properties and businesses are worth the present value of their future dividends.
It’s important to note the difference between dividends and earnings. Dividends are the fraction of earnings distributed to shareholders. Earnings that aren’t paid out are retained and reinvested. Companies retain earnings to try to increase their capacity to pay bigger dividends down the road. They can do this by reinvesting in their existing business, making an acquisition, paying down debt, or repurchasing shares.
Although retained earnings aren’t deposited directly into investor’s accounts like dividends, they’re just as valuable. How much cash a business retains and how well they reinvest it determine its growth rate. That’s why we focus on a business’s normalized earnings power and reinvestment opportunities, not merely their current dividends.
Cash in and cash out might sound simple, but it’s not always easy. Valuing even the simplest assets requires assumptions and judgments about the future which could prove false.
We confront this challenge in two ways. First, we aim to understand what we own. Knowledge and experience make estimating normalized earnings easier. We do our own research using primary sources, like S.E.C. filings.
We prefer to own simple, predictable, and profitable businesses because we understand them best. Buying a stock without understanding the underlying business is like buying real estate based on nothing but its price and address. That approach doesn’t make any sense to us.
Second, we maintain a margin of safety by using conservative assumptions and preferring low valuations. Pricing for perfection is a good way to go broke. Rather than seeking brilliance, we focus on avoiding stupidity.
Buying simple businesses with competitive advantages at undemanding valuations is the best strategy we’ve got. The hardest part is waiting for one of these “no-brainers” to come along. Fortunately, we don’t need many good investments to achieve good returns. One or two ideas a year is plenty.
Our patience paid off last spring when investors panicked and prices crashed. We acquired pieces of businesses we like, admire, and understand at prices we felt more than compensated for the pandemic's uncertainty.
Since then, panic has given way to greed. The market averages are near all-time highs, and enthusiasm for stocks has soared. We remain optimistic but paranoid. If last spring was a time to be aggressive, this spring is a time to be conservative. We will move forward, but with caution. Though we can't predict what will come next, we can prepare by ensuring our investments maintain a margin of safety.
We believe our portfolio remains conservatively valued relative to its long-term earnings power. We own a collection of simple, predictable, and profitable businesses run by skilled capital allocators whose incentives are aligned with our own. Many carry net cash on their balance sheets and several are non-cyclical.
We expect our portfolio's earnings to hold up better than the broad market's in a protracted recession. In a continued bull market, we’d expect our portfolio’s earnings to continue to grind along and produce satisfactory returns.
Attached to this letter, we’ve written more about each of our businesses to explain why we own them, how they’ve performed, and our expectations for them. We also explain each of the recent changes to our portfolio.
But first, we’d be remiss if we did not thank you for your continued support and trust. Investment managers can only afford to be as patient as their clients allow. Your patience and trust contribute as much to our success as anything we do at Eagle Point Capital.
We are grateful to you for supporting EPC’s long-term approach to investing. Our clients have proven themselves as exceptional and stoic investors, which provides us all with a significant competitive advantage. We are honored that you entrust us with your capital, and we are proud to be your investment partners.
Please contact us (matt@eaglepointcap.com or dan@eaglepointcap.com) with any questions about your account or your investments.
If you know any like-minded investors who would enjoy this letter, please forward this to them or put them in contact with us.
You can expect to hear from us again on or around October 1, 2021, with another portfolio update. In the meantime, you can read our previous letters and blog at www.eaglepointcap.com. We encourage new readers to join our mailing list to receive future updates.
Best,
Matt and Dan
To read the rest of the letter, click here.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.