Quarterly Letter

“You shall make the fiftieth year holy, and proclaim liberty throughout the land to all its inhabitants. It shall be a jubilee to you; and each of you shall return to his own property, and each of you shall return to his family. That fiftieth year shall be a jubilee to you. In it you shall not sow, neither reap that which grows of itself, nor gather from the undressed vines. For it is a jubilee; it shall be holy to you. You shall eat of its increase out of the field. In this Year of Jubilee each of you shall return to his property.”

– Leviticus 25:10-13

Knightian Uncertainty: “In economics, Knightian uncertainty is a lack of any quantifiable knowledge about some possible occurrence, as opposed to the presence of quantifiable risk. The concept acknowledges some fundamental degree of ignorance, a limit to knowledge, and an essential unpredictability of future events.”
– Wikipedia1

Dear Client,

The last few months have been a whirlwind for everyone. We provided a brief update on our initial thinking regarding the Covid-19 pandemic in early March. Quite a bit has happened since then in the world and within our client portfolios. We know more today than we did in early March, but in some areas not that much more. Below we discuss our performance, our thinking across multiple relevant areas from the virus to the economy to financial markets. Finally, we describe how we are currently positioned for the future and why we believe a conservative posture is warranted today.

Portfolio Performance & Structure

Grey Owl “growth” accounts finished the first quarter of 2020 down approximately 20%; in line with the S&P 500. Going into the Covid-19 pandemic, our portfolio had significant exposure to travel and hospitality businesses and financial services. Some of the hardest hit sectors, these positions negatively impacted performance relative to indices. While modest, our energy exposure hurt too. On the positive side, our focus on maintaining an “all-weather” structure helped as long-dated Treasury bonds and gold rallied during this period. Balanced and fixed income accounts performed much better, though those accounts incurred drawdowns as well.

When we became convinced the economic fallout from the pandemic and associated government reaction was likely to be as negative as anything we have experienced in our lifetime, we began a process of lightening equity exposure. Today, some of these sales look well timed. Others appear quite poorly timed. In truth, it is too early to pass useful judgment. Markets rarely (never) correct in a straight line. As liquidity constraints were relieved and the initial fear related to the virus passed, a reflex rally was inevitable. Technical analysts believe rallies recovering between 50-62% of the decline are “normal” in the context of a bear market. That is about where we find the market today.

Even if the stock market never revisits the March lows, there is still an argument for precautionary portfolio positioning. Yet, this goes against the grain. It is standard operating procedure in the value investing community during significant economic contractions and stock market corrections to point out that these events have always proven temporary. Similarly, the “buy and hold” crowd loves to highlight that if you miss the biggest up days your performance significantly suffers. (They fail to point out the biggest up days almost all follow even bigger down days.) In other words, just “stay the course” and everything will be fine.

While there is certainly some logic to these ideas, they ignore the way compounding works. If you are down 20%, you need a 25% gain to recover. If you are down 35%, you need a 54% gain to recover. If you are down 50%, you need a 100% gain to recover. From a psychological perspective, it gets harder to stay the course as the drawdown increases. Protecting the downside is incredibly important. In the current environment of Knightian uncertainty, the opportunity cost of missed short-term rallies and even missed sustainable gains seems reasonable to us in order to protect from further losses.