What a start to the new year after a disappointing 2022! And, like during the strong Q4 of last year, I admit that I'm confused as to what drove this global strength. While the beta move was not nearly as acute in Japan as the US (MSCI US was up +6.2% vs MSCI Japan up +4.7%), the large cap+growth factor was significantly more noticeable in Japan. The spread that I often look at is the spread between MSCI Large Cap Growth index vs MSCI Small Cap Value index and, in the case of Japan, that dispersion was +4.1% while that for the US was only +1.0%. Even MSCI EAFE’s spread was only +0.9%. In other words, at least in the developed markets outside of Japan, pretty much everything went up in similar magnitude whereas, in Japan, it was concentrated among large cap, growth names. In terms of industries within Japan, it was the highly cyclical MSCI sectors such as Materials, Information Technology, and Consumer Discretionary that were strong and, not surprisingly, the exact sectors that were weak throughout 2022 (or at least up to Q3) and where we lack exposure. As such, the strongest factor returns came from mean reversion (short term and long term), growth, leverage, and high beta. Given the lack of company-specific newsflow in January (before Dec quarter results come in from February), our highly concentrated, defensive (low beta) portfolio significantly underperformed from these factor-led returns.
 
I do not like to dismiss such underperformance, especially as it has occurred 3 of the last 4 months (all during strong monthly markets). However, I have seen little, from a fundamental perspective, to change our views. In fact, the only fundamental change (on the margin) seems to be coming from the US via a surprisingly strong labor market and disinflation (or at least the expectation of moderating inflation). Maybe the US will be able to balance the fine line between slowing fundamentals with relatively healthy consumer spending in order to avoid a recession. Or maybe the China reopening will help keep the global engine running. Of course, in either such cases, that would mean interest rates probably remain higher for longer, refuting the expectation that the Fed will begin to ease during the second half of 2023. But, in the short run, what the Fed actually does really doesn't matter but what the market believes they will do going forward that does.
 

Masaki Gotoh

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“Clearly, as you move to being a public company, probably even more than growth, there is huge value based on predictability.” – Mark Pincus, CEO of Zynga.

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We were on the road again for a very short overseas business trip. When there isn't a pandemic ravishing the planet, we usually do 2 global trips a year to see existing partners and to develop relationships with new prospective investors. In order to make the best use of our time, we generally do just one city a day for about 2 weeks running. It's a constant daily cycle of waking up in the morning, attending meetings during the day, flying to our next destination, checking-in, going over emails that couldn't be answered by our smartphones during the day, getting to sleep, and repeat. We generally stay at the same hotels in each city and often know where we want to eat in advance (if time allows to leave the hotel).
 
While I am in my hotel room, I have the TV turned on the entire time, except when I go to bed, sometimes even while I sleep. In the morning, I usually have Bloomberg TV or CNBC running in the background. And at night, I usually turn the channel to USATV where it is almost always airing a Law & Order marathon. I don't remember when I first started watching this program, but it was definitely during one of these trips that I've been doing for over 10 years. It's probably because I like courtroom dramas that initially got me to stop channel flipping. But over time, it's become part of my routine. Each episode concludes at the end of the hour so I don't need to know what happened previously. The cast is largely the same (I particularly like Ice-T) and the plots are generally similar. They do mix it up occasionally, throwing us off in a typical whodunit fashion. But, unlike Agatha Christie, the ending isn't always satisfying, which adds to the suspense. But, by and large, the storyline is predictable. And there is a comfort in that, particularly for someone who only watches it during these twice-a-year stretches (and just during the US leg). I’m not looking for nail-biting excitement but something that could be running like background music while I do other chores. I’m not listening, and yet I am as I can generally guess what’s going on 30-min into the program, even if I hadn’t once looked up beforehand. This routine feels almost soothing (despite the morbid content of the program). So, there's a part of me that looks forward to entering the US and finding that channel after I check-in, and especially saddened when it isn't airing that day (my second choice is NCIS). I can’t say exactly what it is that I like so much about it, but I do. Seeing that it's now the longest running primetime live action television series (with regards to Law & Order: Special Victims Unit), I'm not alone.
 

Last month, I wrote my 44-page annual letter for our partners, detailing each of our investments in the portfolio and how they performed during the year. But I got to thinking about what we really mean by "quality", one of the two pillars of our investment strategy. And I came to the revelation that the sustainable competitive advantage that we so often discuss internally is actually just a framework to ascertain quality. But it wasn’t exactly what I “felt” about quality. Similarly, high ROICs vs its peers is a result of quality, but not the essence of quality. I came to realize that it is, for me (and thus for our strategy), the predictability of future earnings that defines quality. If a business can generate a very predictable earnings stream that will not be disrupted by outside variables, my valuation becomes more certain. Say, however, that the stock moves up and down for a variety of other factors such as sentiment of the stock, industry, or country, expectations of the change in stability (and thus a different earnings stream), or a possible new technology that disrupts this stability. Then we would have to assess whether such exogenous factors does change the earnings generation. The predictability has fallen but if we can understand the reasoning behind that event and its potential effect (or lack thereof) to the business, we can assess whether the stock is now cheap.

 
What would drive predictability of earnings? A company that has a sustainable competitive advantage means that they have a business that can sustain the cycles and slowly gains share over time. That competitive advantage shields them from potential disruptions by competitors or new entrants. During bad times, we can rest assured that they will not only survive but will thrive, especially as the industry comes out of the negative cycle. These are all reasons why future earnings can be more readily predicted. Or, for example, superior management with good governance protects minority shareholders from bad decisions that could also unsettle the stable cashflows, not to mention the positive optionality of improvements in balance sheet management via share holder engagements, which could help improve short term IRR and, possibly, long-term multiples due to a change in discount rates.
 
This stability also translates into our second pillar, "value" via a lower cost of capital. We, of course, confirm that this lower cost (or, equivalently, higher multiple) is not simply theoretical and that it has been historically proven. But, as I've mentioned in the past, it is the high stock volatility (as compared to the underlying business' earnings volatility) that provides the "value" component. Our models are based on forward estimates, each with its own theoretical probability of outcomes, just like real options. The more predictable, the tighter that band of possible forward estimates may be. Furthermore, a company whose competitive advantage is strong should, over time, generally lean toward the upper half of the range of forward probabilities, thus creating a continuous cycle of increasing fair values. Often times, the market gets complacent and makes excessive estimates that continue indefinitely (sell-side analysts seem to only know how to draw a straight line from the delta), thus causing the overshoot and our opportunity to sell. Most of the time, it’ll eventually come back and we repeat the process. For a company with low earnings visibility due to a poor competitive structure, the band becomes too wide to make a confident estimate. Such a company may be “quality” in your traditional definition. But if we cannot predict future earnings stream with a certain degree of confidence, we would prefer not to invest.
 
When I first developed our matrix that tries to quantify quality using qualitative variables, I tried to think purely from a competitive advantage analysis standpoint. But, over time, I edited the variables to reduce correlations among factors and attempt, at least as much as possible, to make orthogonal. One key variable with a relatively high weight that I added was "investor relations (IR)". A good business is meaningless if we can't obtain the data to value it. A high scoring in IR helps us model the company's future cashflows, thus adding to what I implicitly realized as part of the definition of quality. While the revelation was only recent, I suppose it was implicitly being absorbed in the model.
 
The definition of risk for a fundamental investor isn’t volatility. It is earnings visibility. It is predictability of what management may do under differing circumstances. And so, like those early mornings in the hotel room where I wake up with Law & Order playing in the background because I fell asleep with the comfort that I didn’t miss anything significant and what I watch the next day will largely be similar, so is the same of a high quality business.​

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