Quarterly Letter

“When you sit with a nice girl for two hours you think it’s only a minute. But when you sit on a hot stove for a minute you think it’s two hours. That’s relativity.”
– Albert Einstein

2020 has proven a challenging year for numerous businesses and individuals, Grey Owl Capital Management included. While most domestic stock market indices have fully recovered from the February and March Covid sell-off, many of our accounts are still down slightly on a year-to-date basis through the end of September. That leaves our relative position to indices and benchmarks worse off than when we wrote to you in early 2020. Nonetheless, our success in 2018-2019, bolsters our outlook today. The economy and markets are complex adaptive systems and investment processes need to adapt too.

At the beginning of the year, we described several process adjustments that led to outperformance in the 2018-2019 period. Today, a new examination of our process amidst the Covid pandemic has us enhancing our approach once again – this time to incorporate even shorter time horizons, specifically during periods of increased volatility. Our high-level objective is to provide a smoother ride through the ups and downs of the market and protect capital in times of volatility to avoid the cruel math of big losses.

While Covid is unique and the resultant economic and market volatility were and are extreme relative to most historical precedents, the lessons are applicable to less exceptional scenarios. Investment regimes are relative, just like Einstein’s description of the physical world. In any regime of elevated volatility, investment time compresses, and space expands. Price movements are faster and can stretch farther (in both directions) than during periods of relative calm. The most robust investment processes take this into consideration, and our aim is to do that going forward.

Continual Process Refinement

Before delving into our latest process improvements, it might be helpful to summarize what we discussed at the beginning of the year. In our January letter, we described a successful two-year period covering 2018 and 2019 where a series of adaptations to our investment process resulted in our model accounts outperforming relevant benchmarks while maintaining diversification and downside protection. The process changes were developed over several prior years and were aimed at adjusting the Grey Owl approach to the realities of the current economic, political, and investment market regime. During that time, what began as an almost purist value investor approach expanded into a much more holistic method of investment.

What are the environmental realities we adapted to? On the economic front, slower growth and more debt are the current reality. Politically, it is a normalization and expectation of government stimulus and intervention at the first sign of economic difficulty. Regarding financial markets, it means suppression of short-term volatility that inevitably transfers instability to less frequent, but more concentrated bouts of extreme price movement. In US equity markets, there have been six bouts of volatile drawdowns in the past 2 years: Q4 2018 (21%), April 2019 (8%), August 2019 (8%), September 2019 (6%), Feb/March 2020 (36%), September 2020 (11%). The end result being the S&P 500 is up just over 13% in the 2 years ending September 30. Annualized that is 6.6% per year with six drawdowns that averaged 15%. Importantly, this includes the spectacular recovery from the bottoms in March aided by $3T of government monetary and fiscal support.