After two strong months, equity markets have finally dipped back down. This isn’t to say that I want equities to go down, but I would like to reconcile the fundamentals that we are observing with market price action and the strong beta during the past 2 months was a conundrum. When the market is weak as are fundamentals, it makes sense to me (and the reason why our current portfolio has generally outperformed during down months). This month was particularly interesting as I wasn’t expecting it to be down, especially after the previous two months. Looking back at history, December is seasonally a strong month. In the last 100 years, the S&P 500 was up 75 times in December, the most of any month (in case you were interested, September was the weakest, up only 47 times. Note: these statistics ignore magnitudes and is just frequency).

Here’s another bit of trivia: in the last 100 years, the S&P 500 has only had 5 instances of 2 or more consecutive down years: 1929~1932 during the first half of the Great Depression, 1939~1941 driven by the US involvement in World War II that lead to capacity constraints and sharp declines in private consumption and investment, 1946~1947 (though total return in 1947 was up), 1973~1974 through the oil crisis, and 2000~2002 during the post-IT bubble crash. So, it’s a relatively unusual event. However, when it did happen, the subsequent years were generally worse than the first year. Of course, we’ve also had single years of steep declines only to recover quickly in the following years; the global financial crisis of 2008 would be one such example. And, of course, “past performance is not indicative of future results” (despite the fact that we obsess about past performance [in fact, that’s the basis of algorithmic trading]).

 

So, I won’t make any predictions of 2023 based on historic returns. But, as I have been continually observing throughout 2022, fundamentals obviously do not look very good. And despite 2023 being “the most anticipated recession in history”, most of Wall Street is expecting 2023 to end on a better note. I keep hearing about “the tale of two halves” starting with the first half weakness and second half rebound (in varying magnitudes). Since Wall Street strategists are notoriously imprecise, I’m now almost inclined to believe the opposite; maybe the first half of 2023 ends up being better as rate hikes slow and softer macro data excites the market about a cutting cycle (despite the Fed governors explicitly spelling out that they won’t start cutting rates during 2023). Even during the past week, after all of that table-pounding, there still appears hope that macro data will be weak enough and/or disinflation is sharp enough that they start cutting this year. I suppose they might; but that’d be yet another about-face by a central bank that’s already lost quite a lot of credibility, so I’m inclined to bet they won’t. In the second half, after corporate earnings really start to deteriorate (while this may be hard to believe, bottom-up EPS estimates for 2023 are still up nearly +10% with another +10% in 2024, according to Bloomberg), we may start to see not only earnings forecasts fall but multiples contract, getting us to that 2nd year double-digit decline that has happened during past multi-year market downturns. This scenario, by the way, is exactly the opposite of what I thought 3 months ago (when I thought the first half would be weak with a possible rebound somewhere during the second half), but now that consensus is saying the same thing, the contrarian in me starts to think oppositely.

​

But in all honesty, though, I have no idea. We’ve done next to nothing with the portfolio for the past 3 months, but that’s not out of indecision … it’s still defensive, domestic, and less cyclical. We continue to watch when the timing might be appropriate to bring the portfolio more balanced. I was initially thinking (hoping?) that it’d be by the middle of this year. But given my observations above, I think there is a greater chance that it’ll be later than I initially had forecast and maybe even pushed out to 2024. But, then again, who knows. Who could’ve predicted a war in Europe, inflation levels not seen since the early 80s, US interest rates approaching 5%, the weak showing of Republicans during the 2022 congressional races (and taking 5 days to choose a Speaker), or that Japan would beat both Germany and Spain in the World Cup. So, we will continue to manage the portfolio with what we do know, but always prepare for a change in economic outlook.

​

I wish everyone a safe and prosperous 2023!

​

Masaki Gotoh

​

===

​

“Doesn’t anyone do due diligence anymore?” – Financial Times Opinion piece by Brooke Masters on Theranos and FTX, Nov 30, 2022.

​

Another small but sad event during 2022 was Trevor Noah left the Daily Show. I was a big fan and, while I only watched it occasionally, I really enjoyed his monologues and interviews. The one positive is that he’ll be back on the road doing more stand-ups around the world. So, during the holidays, I watched the most recent show on Netflix titled “I Wish You Would”. I have to admit, it wasn’t his better material … but it was fun to watch him on stage again. Anyway, in his bit (which I won’t elaborate on), he talks about a word he heard while in Germany, “schadenfreude”. I’ve never heard of the word. According to the Cambridge Dictionary, it means “a feeling of pleasure or satisfaction when something bad happens to someone else”. He goes on to say that, despite how bad the meaning of this word is, we’ve all experienced a little schadenfreude. For me, the crypto collapse would fall under that category.

 (Before I go any further, let me caveat by saying that I am neither a momentum investor or a quants manager; they are all fine strategies, and I am not suggesting that any investment strategy is superior or inferior to another)

 
Except for a very small stint buying Softbank warrants during the IT bubble (which I only had the courage to hold on to for just 2 months [though I tripled my investment]), I’ve never been good at buying momentum. I missed most of the IT bubble, the real estate boom, the FAANGs, and, of course, cryptocurrencies. The latter was the most difficult for me to comprehend, no matter how hard I tried. I can understand excessive valuations or loss-making businesses that, if extrapolated far enough, were not expensive. I remember the time when real estate was in full stride during the mid-2000s and my finance friends would say to me “you think it’s a bubble because you’re not long”. I’ve remembered that comment to this day. While they’d say so conceitedly, they aren’t entirely wrong. Whom am I to say? Even if you did buy at the peak, you’d probably still be doing pretty well. If you bought Nasdaq in Mar 2000, it’d still be a double even AFTER the 2022 correction (though your IRR would be just +3%). I can even understand SPACs, although the downside risks seemed much higher compared to IPOs than the upside of lower listing costs. But when it came to crypto or meme-stocks, they seemed, at least to me, no different from a ponzi scheme or, at best, buying so that you could sell it to someone else later at a higher price, which is a very nice way of saying the greater fool theory. Sure, I understand the potential benefits of the blockchain, but that seems like a far cry from replacing fiat currency. It’s become a religion. And words like “speculative” or “bubble” don’t make sense to those with faith.
 
And, so, I admit, there is a small feeling of smugness when I think about the downfall of crypto. And, yes, I know it’s sinful of me to feel that way. That’s schadenfreude.
 
Psychologically, I can understand the attraction to financial assets that go up so much so quickly. Even now, after bitcoin had fallen 75% from its peak, the price is still 21.5 million times the first bitcoin mined in 2009. And I can understand the ease at which one may invest in financial assets without doing much work, whether it be momentum or contrarian. My wife, for example, wants to buy Rakuten (the Amazon equivalent in Japan) in her personal account. She has no idea how much it’s worth, why they had to issue a 10% US$ bond maturing in just 2 years, or why they are selling off profitable assets. She doesn’t know what discounted cash flows mean or the difference between good and bad corporate governance (Rakuten being the latter). We, as a family, are just very heavy users of Rakuten and have been more so over time with a variety of their services. We shop nearly exclusively at Rakuten for online purchases, we have a Rakuten bank account, we generally use Rakuten Travel for domestic family vacation trips, I have some casualty insurance via Rakuten Insurance, I tend to use Rakuten Pay for cashless payments, and I even fill my gas using the Rakuten Car app. So, she wants to buy. I haven’t stopped her (though, if I had a choice, I’d wish we could buy the bonds as I’d bet Mikitani-san will pull out of the mobile business if he had to choose that vs destroying his empire). But even in this case, who am I to say? Maybe they can turnaround the mobile business (or, at least, decide to write it off, in which case, I bet that the stock will go through the roof)? Or maybe Rakuten Symphony actually works, and it can cover the mobile losses. But if I were to invest my own money, I’d certainly be doing my due diligence to the best of my ability to make that choice, especially for a complex business like Rakuten.
 
So, when I read stories about Theranos or FTX or other deals in the venture or private space where big, famous money managers ride (or drive?) the bandwagon with little DD work, I’m confused. Isn’t DD supposed to be our job? Of course, the target outcome is to pick the best investments to create a positive risk-adjusted return. But there are going to be times where we don’t. And such periods could be longer than expected. Therefore, what must be absolutely resolute is the process by which we each invest and manage the franchise. Admittedly, it is much easier for TriVista, being such a small firm with a single strategy. But we still spend a significant amount of time reevaluating the process of investments, operations, and compliance, whether it be through regular internal audits or irregular reviews. In terms of investor relations, we scrutinize our materials or our commentary on whether we are relaying information accurately, particularly as it pertains to our investment philosophy and process. The definitions are not always straight-forward. When I say “value”, for example, it does not mean PBR (though it could). “Quality” is even more vague, though ROIC is a good starting point. But we shouldn’t ever waver from that philosophy and must always invest how we said we would. While some of her claims feel outlandish to me, I don’t think ARK has deviated from their philosophy (at least from what little I know about them and what I read in the WSJ). And, so, while their strategy is probably as distant as can be in the fundamental space from ours, I respect her decisions.

​

It seems easy and obvious to simply act as one said they would. But I’ve seen many managers fail to do so, particularly as they grew assets or during long periods of underperformance. They can still talk the talk but can’t walk the walk. And that’s the reason why continued due diligence is necessary both from the outside via potential and existing investors and from within, and for both investment and operations (arguably, the latter is more important). Anyone who has seen our ODD pack will know that we’ve always taken it very seriously and do not simply check the boxes. Every one of us is minutely involved in the internal audit of every division. When it comes to the investment process, I make sure that our investors know exactly what we are doing and why, making their due diligence process easier. That is why, every quarter, we provide the IRR of every name that we’ve invested in since inception, and we also provide more detailed qualitative information on an annual basis. And when it comes to management of the business, the due diligence should be similar to that which we do with our possible investee companies. Is management acting in the best interest of its franchise? Are employees satisfied and turnover low? How good is disclosure? And, in our industry, not only are we acting as good stewards, but more fundamentally, are we acting as fiduciaries of the fund investors? It is the single most important due diligence item that should be addressed, but I think some people may have never understood or lost track of our purpose. Which is why an FT article with such a title needed to even be written.

​

We may not always make the right choice, but each choice is well thought out based on our investment philosophy and our Code of Ethics. That much, I can promise.

​​

​