1H22 Investor Letter
Dear Investors,
Managed accounts declined in a range of -25.0% to -26.6% in the first half of 2022. As always, returns will vary based on the timing of onboarding and varying holdings so be sure to check your individual statements. For comparative purposes, the S&P 500 declined -20.6% in the first half of the year. The underlying theme for the first half seemed to be valuations of companies currently producing cash flows held up relatively well while businesses with cash flows anticipated further out in the future did not.
As I have hopefully made clear in the past, but will reiterate here, if the market is down over a relative shorter period of time, there is a decent chance I will be down even more given the strategy of investing in many smaller and/or off-the-beaten-path ideas. Believe me though, with my money invested in the same manner, I take no special joy in the declines aside from any potential opportunities it presents. It is also why I have only asked partners for a piece of their investable assets as I expect it will help make any drawdowns more tolerable until I hopefully prove out the strategy in the coming years.
To be clear though, optically these are poor results and it is not lost on me that returns have trended the wrong direction. And as the sole man behind the operation, it is also clear these results are due to my decisions alone. While it has been a bit of a wild period (when is the world not a wild place though?) given bouts of inflation, war, and fears of a possible recession, largely, there isn’t much else to say other than I have selected stocks whose market prices have not done well the past six months. The idea however is that as the underlying fundamentals of these businesses grow over time, eventually their stocks will follow suit.
After all, enduring market declines is indeed included in my job description. These drawdowns are guaranteed to occur periodically and I am getting a taste of one here early on in Shadowridge Value’s existence. With the exception of one situation (discussed below) however, I do not believe these price movements are much more than that…temporary price gyrations in the midst of a market sell-off, presumably as a result of some of the concerns I mentioned above that seem to be top of mind for investors.
However, this is not to say that no mistakes have been made. So, what has gone wrong?
You may recall in my 1H21 letter, I produced a list of common ways to lose money when investing in the stock markets. I noted how I aimed to avoid permanent losses by attempting to steer clear of the items identified. First and foremost, an absolute-returns philosophy seeks to protect invested capital (which is different than prices swinging around to show losses at certain times). However, I’d like to revisit that list and highlight what now appears to be a mistake that will potentially impair our capital permanently.
TCS Group, is a Cyprus holding company of the Russian digital bank (meaning it operates zero physical branches) better known as Tinkoff, which was founded by Russian serial entrepreneur, Oleg Tinkov. Unlike many financial technology, or “fintech” companies accepting massive losses and unclear economics at the expense of growing users, I thought Tinkoff had done an exceptional job of maintaining a healthy balance between growing its customer base and profitability. Utilizing its all-digital infrastructure, it benefitted from a lower cost base relative to incumbent Russian banks, an important feature in the relatively commoditized world of banking/lending. I also liked the management team behind Tinkoff and that there was no government ownership like many of Russia’s other leading companies. Below are several years of financial results/high level metrics which demonstrate why I found the business Tinkoff was building to be so compelling:
To my mind, business results were and have remained quite strong. Net income is growing nicely on a per share basis and management has shown they are cost-conscious and productive with owner’s capital (evidenced by the high return on equity). However, that simply hasn’t mattered given the geopolitical fallout stemming from the Russian invasion of Ukraine.
Our investment accounts own the Global Depository Receipts (GDRs) listed on the London Stock Exchange. As sanctions began to fall into place against Russia, the price of the GDRs fell precipitously and trading was ultimately halted by Western exchanges/clearinghouses at prices that are near complete losses.
Shares of Tinkoff do trade on the domestic Russian market (Moscow Exchange) at a price significantly above where the GDRs are marked at currently. In time, I hope to exchange the GDRs for the local shares (what are known as “ords”) and recognize some value, but I am unsure of the timing and am trying to get more information from our custodian, Interactive Brokers. Russia has also restricted foreign investors from selling their shares on the Moscow Exchange so there will be most likely be complications. Until there is some kind of resolution, I accept the near complete markdown provided by Interactive Brokers and for our purposes consider it a permanent loss (the kind I do my best to avoid).
Because of my unfamiliarity/hesitancy with Russian equities, I had allocated ~2.5% of managed accounts to Tinkoff, smaller than many of our other positions. In some ways, this appears to be an example of adequate risk control measures I had in place. With the benefit of hindsight however, I wouldn’t blame anyone for concluding the proper allocation to anything Russian was and always has been zero. Simply put, the turn of events, from the physical invasion and the resulting actions taken by the West were not events I anticipated in the slightest. As it happens, Tinkoff the company still has yet to be sanctioned itself (unlike many other companies in Russia), making it all sting a bit more.
So, what have I taken away from this experience? Which line item from the 1H21 letter’s “possible ways to lose money in the stock markets” would this fall under?
Revisiting my list, I think the bullet point stating “not understanding the business and/or the risks inherent to the business” best fits this scenario, particularly the latter half. In this case, I would revise it as “not understanding the risks inherent to the jurisdiction in which the business operates”. Or perhaps, it is simpler to add a new bullet point labeled “Geopolitical conflict/risks”. Either way, my list of mistakes/ways to permanently lose money in the stock market has regrettably grown.
Thinking about it, I do believe there was an element of bad luck at play here too so I am careful not to learn all the wrong lessons. As I mentioned, Tinkoff the business has performed exceptionally well through 2021. How things play out from here with a heavily sanctioned Russian economy is less clear, however. Could our holding in Tinkoff still work out? It is possible. Am I expecting it to? Not really. However, completely ruling out the potential for a positive outcome would not show a healthy appreciation for probabilities.
Returning to the 1H21 letter, I guaranteed you that I would make mistakes in due time. I also wrote that there were three main goals when mistakes were made; 1) to not lose too much when they occur, 2) to recognize and correct the error, and 3) to learn from it going forward. Regarding the first two, I believe the error has been recognized (but not corrected given the current trading restrictions), and I did not lose too much (after all, I should be able to recover from a 2.5% loss over time). Pertaining to number three, here is what I have learned, was reminded of, and how I will adjust my actions going forward.
First, it serves as a strong reminder that anything can happen in the markets, and in the world for that matter. An ongoing war in Eastern Europe was not on my radar, nor did I think it would come to an all-out conflict even as momentum for it was building, but it is occurring all the same. This unpredictability is why I try to find resiliency in the businesses I invest in. I believe businesses with a compelling customer value proposition, sound balance sheets, and owner-oriented management tend to build in resiliency. I touched on the latter two topics in more detail in the year-end 2021 letter. Unfortunately, even resilient businesses can lead to losses in the right circumstances as Tinkoff has proved.
Second, I now have a healthier appreciation for the nation in which a company operates. In this most recent example, it is clearer than ever why Russian equities trade at a discount to other regions of the world. The speed of implementation, as well as the magnitude of the sanctions placed on Russia has made it clear that if a country isn’t aligned with the western world, it runs the risk of being isolated from the rest of the world’s economy for committing unsavory acts. I would like to avoid being materially impacted by that possible outcome in the future.
My focus will remain global, but going forward, I will not be expanding positions in, or making new investments in countries that are “adversarial” to the US military and its allies. I realize this isn’t exactly a technical definition and it is a bit nebulous, but as someone who once studied international relations, the idea is to stick to countries that or more or less aligned with US interests. As for where I will continue to openly invest, think North America, Western Europe, Australia, New Zealand, Japan, South Korea, Singapore, and Israel for starters. That leaves plenty of opportunity.
Now, we do also have some existing exposure to China which I think is rightfully considered a geopolitical rival to the US. At the same time, I also think it would be overly simplistic to assume what has happened in Russia/Ukraine will occur in China/Taiwan, despite it being a distinct possibility. Under the revised framework however, the modest allocation (~5-6% at cost) we have to China will not be added to going forward.
Third, and perhaps this one is most controversial, but sometimes resorting to long-term thinking may betray or diminish the value of interpreting events (aka reality) as they truly unfold on the ground. I am reminded a bit of the WWII story where Army surveyors were studying maps and deliberating on where to cross a river without any resulting action, when a General walked up and mentioned where he had just crossed it in practice. In special circumstances, perhaps it may be better to capitalize on my agility and react to the reality on the ground than assume an outcome is secured just because I am viewing things with a long-time horizon. The map is not the territory.
The Portfolio
Now with a declines of ~25% for the first half, and Tinkoff only responsible for ~2.5%, that means many other stocks we own are down as well. But as I mentioned in the beginning, I believe this is all part of the process of a market drawdown and don’t want to hastily draw many conclusions based on price movements when I expect the businesses to continue building their futures.
I suppose it is possible I didn’t realize some of the “pull-forward” effects that would benefit certain businesses coming out of Covid and we may have to wait longer as any beneficiaries revert back to pre-covid growth trends. I can live with that. It’s simply a great reminder to remain patient, try to get a sense for where in the business cycle a company is, and always let the opportunities come to you. I will continue to demand what I believe are attractive entry points, exercise independent thought, avoid getting too excited by opportunities or discouraged by downward price movements, and be flexible/willing to change.
The below graphics display the top five holdings as of the end of June. KPG and SHVA were highlighted in the previous letter and in keeping with tradition, I will have a more detailed discussion of the portfolio holdings and the investment theses in the year-end 2022 letter.
By using modest concentration, I am shooting for elevated, but lumpy long-term returns as opposed to a smooth, but market-average like return. As always, thank you for your support. If you have any questions, please don’t hesitate to reach out.
Sincerely,
Brett Dorendorf
Managing Member
Shadowridge Value LLC
