4th Qtr. Newsletter – January 2022


If you stay in the running – if you have endurance – you are bound to win over those who haven’t.                                           

-Glenn Cunningham (1909 – 1988), athlete

From a young age, I have always had a love for sports and the story of Glenn Cunningham may be the front runner. As a young school boy, Glenn was in a fire accident at his school that devastated the lower half of his body. His legs were burned to the bone in some places and his toes were missing from one of his feet. The doctors said it was likely he would die and even if he were to survive, he would be a cripple throughout his life and would need amputation. However, Glenn refused to accept this. He was determined he would walk again. Slowly but surely and after two long years of rehabilitation, Glenn Cunningham began walking again. He did not stop there though. Eventually, he began to run. By the time he was an adult, this young boy who was not expected to survive, who would surely never walk and could only hope to run again, set the world record for the fastest mile run.  

One of the most well-known sports analogies to investing is probably the pitcher versus the batter in baseball. The pitcher represents the market, the ball is a particular company, and the batter is you. The market can throw you a lot of different pitches: curveballs, changeups, fastballs, knuckle balls, etc. You won’t have a very long career in baseball or in investing if you swing at every pitch. The beauty of investing is you don’t have to swing at every pitch. You don’t have to invest in that new, hot real estate deal or purchase a few shares of the latest IPO (initial public offering). You also don’t have to swing for the fences in baseball or investing. Ted Williams was arguably the greatest baseball hitter of all-time and still has the highest career on-base percentage in MLB history. Yet, after a lengthy 19-year Major League baseball career, he isn’t on the list of the top 15 career home run leaders. In investing, swinging for the fences can be compared to getting caught up in a new, hot trend. In the 1970s, it was the nifty fifty (a group of the 50 most popular large-cap stocks on the New York Stock Exchange). In 2000, it was the dot-com stocks. Today, the trend may include “meme” stocks or the cryptocurrency craze. Some will likely make out very well, but if history is any guide, I would presume a larger majority will strike out.

So what can we learn from these short accounts and how does it apply to investing? In sports and investing, finding the right strategy / game to play is just as important as how you play it. Glenn Cunningham knew his recovery wouldn’t happen overnight, it would take time. Ted Williams may not have been the strongest or fastest player to ever play the game of baseball, but he knew how to get on base. As investors, we are all on the same level playing field [stock exchange] – but – we seem to all be playing very different sports.

  • Speculating vs Investing;
  • Day Trading vs Buy and Hold
  • Value vs Growth
  • Diversified vs Concentrated
  • Domestic vs International
  • Large Cap vs Small Cap

We could argue that one approach is better than another and show historical data to support some assertion of why our way is “the best,” but it is important to remember there are many paths up a mountain. The approach Monarch has adopted is searching for growing, competitively advantaged businesses that trade at reasonable prices. If we plan to own shares in a company for multiple years (which is our hope so long as the fundamentals remain intact), the success of the investment will have far more to do with the economics of the underlying business than it will have to do with the company’s last stock price quote.

We consider ourselves owners of the businesses we invest in. In public markets this belief seems to be fairly uncommon. A majority of individuals are not concerned whether or not the businesses they own are likely to be around in 20 years. What they seem to care about is sector definitions, market capitalizations, daily stock price moves, etc. Several investors are keen on formulaic approaches and act as security renters rather than owners. There is nothing inherently wrong with this approach, but seeing things through the lens of an owner can bring about a different perspective. Suddenly, observations about markets or short-term stock movements matter less and recognizing the fundamental factors that define the business become much more important when viewing the business as an owner. Rather than paying attention to what the stock price has done over the last year or two, you become more attentive to how the company can create/is creating long-term shareholder value. Things like – what type of business plan does the company have, how profitable is or can the company become, what do the unit economics look like, what are the cash flow characteristics, how accountable and aligned is the management team, and how resilient is this business likely to be when trouble arises –  swiftly become top of mind.

We can use a core stock like McDonalds and the debacle it went through in early 2000’s as a historical case study of why viewing things through the eyes of an owner is paramount. In 1995, McDonalds had roughly sixteen thousand restaurants worldwide. By the end of 2000, there were approximately twenty-nine thousand restaurants, a 10% compound annual growth rate. However, same stores sales growth had only averaged about 1% from 1996 to 2000. McDonalds’ management team at that time was too focused on rapidly opening locations instead of focusing on the unit economics and maximizing the long-term profitability of each store. As a result, food quality and service times started to decline.

By 2001, the model was beginning to come apart: net income was declining and same store sales growth was falling and turned slightly negative in 2002. At this point in time McDonald’s stock was selling for ~10x earnings and there was a lot of negative sentiment surrounding the company. If you had bought the stock on December 31st, 1997 and still held it on December 31st, 2002, you would have experienced a -30% total return.

McDonald’s earnings quality had deteriorated, same store sales growth had stagnated for over half a decade, and relationships with franchisees were not great due to the company’s prior focus on growth over operational excellence and franchisee economics. Most investors would have probably given up on the company at this point and for maybe what seemed like good reasoning at the time. However, the question to ask was: was there anything structurally wrong with the company? McDonald’s was still the number one fast food brand in sales with convenience and price as two main advantages. The core economics of its franchised model were also so good that even with the problems being faced, McDonalds was still making money. 

Does this mean things were always bound to work out? No, of course not, and we could be having a different conversation today if some of the actions taken didn’t work out the way they did. With the benefit of hindsight, selling in 2001 or 2002 appears it would have likely been a mistake. In 2003, new management took the helm and changed the company’s strategy. Management drastically slowed new store openings and put the focus back on operations and pleasing the customer – “learning how to grow by being better, rather than being bigger.” This is the type of resilience we want with our companies, especially in times of crises, because at some point almost every company is bound to face problems.

We aspire to find management teams that embody that ownership mentality and are fixated on long-term shareholder value creation despite all the pressures from Wall Street to meet near-term numbers or quarterly consensus estimates. An executive team with skin in the game is one indication that incentives are aligned with long-term shareholders. If shareholders experience losses, it is highly probable that the management team will feel the pain as well (and often times to a larger degree). Take the company Lakeland Financial as an example. The CEO, David Findlay, personally owns nearly 200,000 shares or 0.78% of the total company. This amounts to over 9x his total compensation in 2020. Does high insider ownership guarantee a company will be successful? No, most certainly not, but what it does seem to indicate is management is aligned with long-term shareholders. 

By shifting your focus from a quarterly or annual horizon to a mutli-year horizon, it increases the impact of the changes in a company’s fundamentals on investment results from not only a psychological perspective, but a statistical one as well. There was a research piece put out by REQ Capital that examined the sources of long-term returns.  “Investors” or rather speculators who have a time horizon of a year or less don’t have to pay much attention to fundamentals or changes in fundamentals. With a time horizon of one year or less, changes in sentiment are almost entirely responsible for an investor’s return. Changes in the perception of the industry in which the company operates or political and macroeconomic sentiment would be examples of this. The dominant force over a three-year horizon is multiple expansion. As you continue to expand your investment horizon beyond seven years, company specific factors begin to account for the majority of returns (things such as reinvestment opportunities, the ability to deploy large amounts of capital at high rates of return, and management/company culture).

The following chart uses empirical data from the US stock market over the last 105 years. “Fundamental returns” (earnings per share growth + dividends) are separated from “emotional returns” (changes in the price to earnings multiple). The data show that even over rolling five year horizons, over 50% of an investor’s return comes from changes in the price to earnings multiple, or in other words “emotional return” is the main stock driver. As you expand your time horizon, fundamentals become the dominating force behind returns. However, even over a twenty year rolling time horizon, a little over a quarter of your return comes from changes in the price to earnings multiple. What is the takeaway here? Not only is buying “great businesses” important, but the price you pay is also a big determinant in the type of return you are likely to get. Buying incredible businesses at exorbitant prices is likely to be just as much of a failing strategy as buying businesses with awful economics at cheap prices. There needs to be a healthy balance between both business quality and price.

Historically, time is on your side when investing in the stock market. According to data from NYU Stern School of Business, over the past 95 years [1926-2020], the average annual return from the S&P 500 has been approximately 10% (before inflation is taken into consideration). However, this doesn’t mean an investor will see his or her capital grow by 10% in a straight line every year. There have been various three year and five year stretches where returns are essentially zero or negative. In addition, there is also volatility of returns. Over the last 100 years the market has historically declined at least 10% on average every eleven months. One has to be cognizant that over stretches of time, little or no return may occur and volatility should be anticipated.

Over the past few years, the stock market has fared well and recent returns always mold future expectations. Earlier this year there was a survey done by Natixis Investment that included 750 individual investors. The results revealed the surveyed individuals expected “over the long-run” (which was not specified in an amount of time) to achieve annual returns of 17.5%, after inflation. Does that seem rational? In order to see returns anywhere in that ballpark, either corporate profitability in relation to GDP must rise or interest rates must fall further. Neither of these is impossible, but the fact remains that the value of an asset cannot, over the long term, grow faster than its earnings do.

Newspaper columnist Jason Zweig and The Wharton Research Data Services ranked all U.S. stocks and exchange traded funds over the last ten years based on returns. In total there were 3,790 stocks and exchange traded funds (ETFs) that traded continuously over the 10 years ended May 31, 2021. Their findings revealed investors were more likely to lose money than compound it by 17.5% annually from June 1st, 2011 through May 31st, 2021 (and this is during the bull market of the last ten years). In my opinion, a 17.5% average annual return after inflation does not seem reasonable unless extreme risk is taken and even then, it appears to be based more on hopes and dreams rather than business profits and arithmetic.   

The purpose of the above is not to imply that we are bearish on where the market may be headed, but more-so that investors’ expectations may need to be reset. Since 1926, the stock market has provided a negative annual return one out of every four years. (For reference, over the past decade, the S&P 500 has only experienced one down year.)

We want to re-emphasize that our investment philosophy is based on a long-term horizon. The the chart below re-enforces the importance of that by showing 95% of all rolling 10-year horizons since 1926 have been positive for the U.S. stock market. Moreover, there has not been a single 20-year rolling period that has been negative.

When pondering upon where the market will go next year, we would also caution you to not take short-term market forecasts too seriously. The chart below shows the 2021 year-end targets from the largest investment banks, which were made at the end of 2020. With the S&P 500 currently at approximately 4,750, it appears that they were all a bit outside the strike zone. Keep this in mind when you see predictions for returns in 2022.

Rather than speculate on where the market will be at the end of 2022, our focus remains on looking for and investing in good quality franchises that produce durable, growing cash flows. Why? Because in sports, investing, and even life, having the resilience to stay in the game can make all the difference; just look at the life of Glenn Cunningham.

From all of us here at Monarch, have a Happy New Year!

  • Written by Adam Beard