Dear Reader,
I am publicly posting our annual investor letter detailing some of our operation mindset, holdings and performing for the year 2016. Until now, only our clients held this information and a few that requested it when the announcement of the letter was made earlier in 2017.
This year is no different, our 2017 letter will be sent automatically to our clients only. The letter will not be posted online until after 2018. If you would like to receive it before, please contact us directly here.
Enjoy it and make sure to visit our blog: Sonoman Rx and website: Sonoman Investments.
2016 Letter
SONOMAN INVESTMENTS LLC
1198 Venetian Way, Miami Beach, Florida 33139
Phone: (305) 934-9069
2nd ANNUAL LETTER TO SONOMAN INVESTMENTS CLIENTS
Market Performance During 2016 It must be highlighted that 2016 represented a volatile year. The beginning of 2016 showed signs of negativity and poor thoughts on the economy, followed by one of the most disputed political elections the United States has ever seen. Many publicly traded companies reached ultimate highs or levels not seen since the great recession. This must not be interpreted as great investing and, even less, as progress. Great speculation follows the actions the new President Donald Trump is capable of during his presidency, which have already fueled a market rally right after November’s election. Investors are betting heavily on Donald Trump to ease bank regulations, the possible lowering of taxes for corporations and on the Federal Reserve to increase interest rates further, among many other things. Financial markets are rushing for the day the Dow Jones reaches an ultimate high of 20,000 points and beyond, irrespective of consequences. The future may sound unstable, even when your accounts have reached double-digits performances, but as it was once said, “Be greedy when others are fearful and fearful when others are greedy.” We are fearful, but, in a vigilant sense.
Our quest for new investments is limitless. We have found many interesting companies, but unfortunately, they do not trade at adequate levels. We are sitting on the sidelines, browsing and purchasing additional shares of businesses already present in our portfolio due to depressed prices.
The market is trading to what we consider overvalued levels. This does not mean that there are no opportunities; it just makes it harder to find them. We would like to keep buying more of what we already own, but many of these businesses are selling at greater prices diminishing our margin of safety. Due to this, cash quantities are at a high level, but it should not generate distress. The money will be put to use at the right time; we do not know when, and there are no plans to make a prediction either.
Despite the aforementioned, newcomers and current loyal customers should have enjoyed this nice wave. Your investments are worth more today than a year ago. The oldest account under Sonoman Investments LLC is my own with over two and a half years, which is still considered, in my book, a very short-term performance, but still a good one. Newer accounts were created within just a few months. We are confident your money, alongside mine, will grow exponentially at an adequate compound rate.
Activities During 2016
While I type this, there are 7,364,599,328 people in the world and counting. Compare this to the year 1927 at merely 2,000,000,000 people. Statistically, there is a birth every 8 seconds versus a death every 11 seconds. The United States alone has a population of 326,625,791 people, an increase of 20 million from 2010. The world is growing at a pace of over 1% annually. Given the imminent increase of the world’s population, the need for basic needs will increase by mere demand, as will the use of medicine for the sick as life expectancy increases.
As stockholders, it would be wise to invest in a company that can supply these requests. For this reason, we own Walgreens stocks. Walgreens is a company well-positioned to meet these demands. Even with a high competitive environment, it is the largest purchaser of prescription drugs and other health and wellbeing products. Approximately 75% of the population can find a Walgreens within five miles of their house. They process over 750 million prescriptions a year. Walgreens reached $117 billion in sales during 2016 and employs over 400,000 individuals. In 2016, their war chest held a little over $9 billion in cash, putting them in a strategic position to acquire new businesses if the opportunity arises.
Another demand with increased population is for products in the consumer sector and real estate. We believe the state of the economy has improved drastically in comparison with 2009. Today, the housing market has reached pre-recession levels and with this, comes new construction and infrastructure remodeling alongside it.
Consequently, in our portfolio we hold USG, which is the leading manufacturer of building materials for new residential and new nonresidential construction projects.
Wal-Mart, Macy’s, Bed Bath & Beyond
We have expanded our portfolio to the retail sector by investing in companies such as Wal-Mart, Macy’s and Bed Bath & Beyond. The latter has seen its price tumble from a high $80 per share to a low $38. These companies are victims of progress, and they are learning the new direction of the retail industry the hard way. Who do you blame for this new progress? Amazon! Amazon has changed the game. Jeff Bezos, the CEO of Amazon is an innovator when it comes to online retailing. He saw a major flaw in the lack of online sales and the poor investment capital companies were spending on online presence. Brick and mortar locations got hit with less foot traffic, stagnant inventory and decreasing sales. What Steve Jobs did for the cell phone industry is what Jeff Bezos is doing for online retail.
So why invest in retail? In order to be in business, you have to be either an innovator, have a great product, or be cheaper than the rest while maintaining a level of quality. It is established that Amazon is an innovator with a great product (online platform) that sells a multitude of things at a cheaper price. Unlike retail stores, Amazon doesn’t necessarily own real estate, which adds to the value of companies, especially Wal-Mart, Macy’s and Bed Bath & Beyond. The major flaw in Amazon, and they seem to have realized this, is their margins.
When you compared the income statements of these four companies the margin comparison is major.
Retail companies are leveling the playing field. Wal-Mart went ahead and bought Jet.com (A major online retailer very similar to Amazon). Macy’s is using their website to their advantage alongside their credit card by offering better discounts and even inventory not found in stores and only online.
Bed Bath & Beyond has been more strategic than the others. BBBY has expanded their business by acquiring Christmas Tree Shops, BuyBuy Baby, Linen Holdings and many more. In 2011, the company had 258,000,000 shares outstanding, and they proceeded with stock buy backs (This happens when a company buys their own shares).. The stock price ranged between $50 to the high $80s before plummeting since 2015 to a low $40 today. Toward the end of 2016, Bed Bath & Beyond successfully bought over 100 million shares. Today’s count reached 153,000,000. They have had massive stock buy backs, reducing their outstanding shares and buying at a cheaper price every month since 2015. The company has $600 million in cash and $6.5 billion in assets with no debt except until 2015, when they took a $1.5 billion loan for share repurchase. This capital was injected for stock buybacks given the low interest rate levels banks are offering on loans. Bed Bath & Beyond has the potential and margins to remain competitive. The market value today is the same as the assets they hold. This could possibly make them a target for another company to try and make a private equity offer.
Amazon is still a great company, and their sacrifice on profits has taken them to new heights. We have not discarded Amazon as an investment; however, today’s price has not made us pull the trigger.
IBM
IBM today is not the same company it was when they started, neither is Microsoft or Oracle. IBM was a pioneer, but the technology world is always evolving. They have invested in all types of tech-like diskettes to CD-ROMs, from massive computer systems to personal PCs. The company still has a major inflow of cash from all of their businesses, and they are looking for the next hit. Ultimately, what was their core business will slowly disappear. IBM has the capital and research capacity to innovate.
Coca-Cola
We have increased our positions in Coca-Cola. There has been heavy criticism on sweet drinks and their link to obesity. It is unrealistic to blame soda as a large contributor to the obesity problem in the United States. Coca-Cola offers a wide range of can and bottle sizes. The calorie count is always shown based on the size of the bottle being served and the serving size hardly reaches 10% of your daily caloric intake. We believe this factor alone is not to cause major concerns about the company’s financial position.
The most important reading I have ever done regarding Coca-Cola was by Charlie Munger in Practical Thought about Practical Thought. He introduces a challenge via a question, “How do you turn a $2 million start-up into $2 trillion?” You will likely turn to mathematics and cash flow projections to decide at what rate of return you can achieve this massive number or lean toward your own academic studies as the true base of your exploratory research. Charlie’s genius suggestion is to invert, to step out of your own academics and explore multiple sciences and different views. To the man with a hammer, everything looks like a nail.
Now, it is 1884 and you could be given two million dollars to invest in a new non-alcoholic beverage business. You will name it Coca-Cola. You have 15 minutes to make your sales pitch in order to receive funding. What do you say?
The answer goes like this: It will be very hard to sell this much beverage to reach such numbers. Coca-Cola needs to be turned into a legal trademark. We will start in Atlanta and eventually reach the rest of the United States. Soon, after great success in the U.S. the product will be launched to all the corners of the world. The beverage needs to be appealing to all countries, nationalities, religions, etc.
If by 2034, close to eight billion people will roam the planet, it should be easier if our product is consumed worldwide. Our sales will be bigger than in 1884 simply based on the world’s population.
Now, in the field of biology, we know most of the consumers Coca-Cola is looking to serve are composed by a large percentage of water. The human body must ingest sixty-four ounces or eight, eight-ounce servings. If this new product can satisfy at least 25% of the necessary water and other watery products, we can safely assume that by 2034, Coca-Cola will serve 2.92 trillion eight-ounce servings.
To start out, we need a beverage that looks similar to wine and champagne rather than just sweet water. This will give it the look and feel of an expensive drink without the price tag. We need publicity without publicity; the psychological effect that when you see someone else drinking, you would want to do the same. We can call this the social proof factor.
Finally, the most important factor is how often will consumers come back to the beverage? The answer lies in a psychological factor called after-taste. The product should not have an after-taste, we can go ahead and drink many servings if we want and not feel revolting. We should be able to drink it at anytime of the day and with all types of meals. Ultimately, this can be enjoyed by all ages, in all types of social gatherings.
You see, even though sales of Coca-Cola are an important factor for the business, the psychology, biology and chemistry play a bigger role. People will not stop drinking Coca-Cola just because someone says you should stop. There has been no proof of a major health hazard drinking it anymore than excessively consuming any other product.
Today, Coca-Cola Co pays over $6 billion in annual dividends. This number has increased every year for over twenty years. Occasionally, we will look for investments in sales, mergers, tenders or offers that are made publicly. These investments might take longer to realize, but could help our performance in a down market. At the moment, we have no position on such investments, but we are on the lookout.
We made new investments in companies that are somehow related to media and the entertainment industry called Liberty Media. Liberty Media is a group that operates in a matter similar to Berkshire Hathaway (another one of our holdings), they own multiples enterprises and subsidiaries. We have also invested in the food related industry, under Chipotle among others. It is extremely difficult to buy at the bottom of a down market; hence, we save our time and energy in seeking the best acquisitions. Our investments were made solidly on valuation of the company. We will try and secure more of these investments if they keep dropping in value; it is actually an advantage for us since we can acquire an additional amount of shares at a lower price.
Companies we let go: We released our positions with Correction Corporation of America or currently known as Corecivic Inc. Corecivic is in the business of private prisons in the United States. The company went from a service provider to a REIT structure (REIT stands for Real Estate Investment Trust). They design, build and finance their own facilities where they hold a large percentage of today’s prisoners. When we invested in Corecivic in late August, we began buying at around $16 a share. The former attorney general Sally Yates and a group of individuals criticized the conditions in private prison versus government ones. They campaign heavily on the idea of bringing an end to privatization of jails. This created panic and pushed the price down to a low $13 per share and over a 15% dividend yield. Based on our research, we concluded that the transition of bringing private jails to government sponsored will bring additional government budget tensions and the infrastructure was simply not there for an easy and smooth transition. President Donald Trump opposed the views of Sally Yates and the price increased to $21 per share.
We diminished our position in the financial industry by selling Bank of America at around $16 a share and putting our money only in two banks, JP Morgan and Wells Fargo. We believe these two companies have a strong financial position and will materialize profits, particularly with talks of higher interest rates. Wells Fargo just had a stint with their middle management and the cross selling of products across some of their branches. This will hurt them in the short-term but management will take corrective action against this. There is a saying that more money has been stole with the point of a pen than at the point of a gun. Unfortunately, this will not be the last time you will hear about a scam, greedy corporate management or irresponsible behavior at the corporate level. Corruption has been around for many years, and it will not disappear because we want it to. The idea is to detect it early on and put a stop to it before it becomes uncontrollable and the damage creates economic instability.
We let go of Fluor Co at the beginning of 2016.
Last but not least, we sold off our stake in McDonalds at around $129 a share. We believe this price reflects an overvaluation of the company. We know McDonalds is a great enterprise and they are well off and their vision towards the changes in consumer behavior will strengthen their position. They have the capital and management skills to push the company to new limits. We are monitoring McDonalds and if their share price should falter again, we will be a buyer. We are waiting for the right opportunity.
Our portfolio ranges within many industries such as consumer staples, discretionary, retail/wholesale, basic materials, industrial products, multi-sector conglomerates, computer/technology, finance, business services, construction, and oil & related industry.
This brings us to our next subject.
Results for 2016 In 2016, accounts under the portfolio performed slightly better than the general market. The S&P500 traded at the beginning of the year at $2043.94 and closed off $2,238.83. This represents a gain of $194.89 or 9.54%. These numbers are excluding dividends. If we consider dividends, the yearly return for the S&P500 was 11.96%.
The compiled table below only reflects the performance of accounts active for that entire calendar year:
Although two years is entirely too short of a period from which to make interpretations, what evidence there is points toward confirming the intention that our results should be relatively better in moderately declining or static markets (when stock prices are depressed due to bad sentiment on the market).
The basic question that will arise is the fluctuation on performance between accounts. Some performance will be relatively better, in some cases, due to when the funds were received or when the account was open. Nevertheless, all accounts are invested in the same portfolio at approximately equivalent weights.
We increased our position in many of our holdings and invested in companies that significantly dropped in price. We will not be like other companies that are tempted to predict a bold new direction and performance percentage. We will resist that urge and stay on course. Our basket of growth is far from complete.
Many of these investments will keep dropping in price; hence, our performance on the short-term might be affected if we don’t buy at bottom markets (it is not our goal to time this).
Today, our largest position in a single company represents between 10-15% of the entire portfolio. We try not to exceed 25%, but it is not a rule. During any purchase of a security, our main interest will be to have the security do nothing or to further decline in price rather than increase. This might sound contradictive to the purpose of investing, but what would you rather have? One stock of Coca-Cola going from $40 to $60 (50% return or $20) or an increased position (amount of shares owned) at $40 or less and gradually see our investment grow (let’s say 7% annually)
We have made great progress, perhaps not in investment returns, but in the accumulation of shares within a company. This is a great metric; we try and buy more pieces of the pie, below are your company holdings and your respective share count up to June 2016:
In a formal and easy manner, these are some of the points which we think are relevant to take into consideration when looking at your account. Via our blog (blog.sonomaninvestments.com), newsletter, or any other form of communication, we have and continue to convey our investing philosophy.
If you come across any questions, we invite you to please contact us!
Alex Lopez O’Bryan
Managing Member and Chief Executive Officer