February 3, 2021
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Read our past Annual Letters HERE.
To the Clients of Evergreen Wealth Management, LLC:
I’m happy to share with you that, like our clients, our business had a very good year in spite of the many challenging headlines. One way in which we measure progress is simply the amount of the assets that are entrusted to our management. As a company, Evergreen Wealth Management (EWM) grew from managing $89 million to over $107 million in 2020. Since 2015, EWM has grown from managing approximately $20 million to over $100 million, a 400%+ increase. We’re proud of this and it happened without any formal marketing efforts. This means 100% of our growth can be attributed to word of mouth, introductions from our clients to their friends and meeting client planning objectives. To say we’re grateful for this would be an understatement.
Our goal is to manage the business efficiently and effectively – a task made quite easy as a result of the immense talent our team holds. We like to believe that if we focus on doing our job at the highest level, then our business success will follow. We pay very little attention to seeking new opportunities for ourselves, instead relying on the families we serve to tell others about the work we’re doing together when they have the opportunity.
In short, we spend our time doing what we are paid to do; planning and managing assets. Our long-term business success will be measured relative to our abilities to continue delivering on client planning objectives. To this extent, we have added resources since 2015 to continue improving the depth of focus and attention we give each account.
When I came to EWM in 2015, it was my sole focus to spend 80% or more of my time researching and communicating about the market and the investments we own. Believe it or not, this is not normal in the industry. Most of our industry colleagues spend many more hours marketing than they do researching and analyzing investment opportunities. When the Covid crisis hit in early 2020, my time spent in solitude researching investments exceed any other time in my career. Our Jr. portfolio manager, Andrew Nutter, did much the same, and as a result, added greatly to our depth of research in 2020, with countless hours of reading and researching. We loosely estimate that if you add up all the earnings calls, podcasts, letters, journals, books, newspapers, investment blogs, and accounting summaries we pored over, then we easily eclipsed 2,000 hours of active research on behalf of our clients. Of course, this does not include the ‘thinking’ time we spend after digesting such information. Many might look at this action as an act of labor, but for us it is a complete act of passion. Managing money is what we love doing. We literally skip into the office many days, amazed that we get to do what we love for a living.
The advisors and planners we work with also spent countless hours working with us to verify our investments were in proper alignment with client plans. Once this is agreed upon, they spend the time to communicate much of what we do directly with you. Because we work with such talented advisors, we are afforded the ability to maximize our time doing research. This value we bring is very unique within the retail investment industry; our business is uniquely set up to embrace and reward good thinking and good planning. Another unique element that is worth mentioning is our personal assets. We manage 100% of our personal assets and most of our extended family assets exactly the way we manage client assets. We eat all our own cooking. We are deeply yoked to you, our advisors and all our plans.
Famous investor Charlie Munger once said he spent 50 years reading Barrons investment magazine to only get 1 good idea. That good idea turned $10 million into $100 million. We believe all the time we dedicate to research and planning has continued to pay off in solid investment returns and will continue to build into our collective knowledge base for the benefit of our clients. It’s another form of compounding. And while the last 5 years have been very successful, we believe the next 10 years hold an amazing amount of opportunity for Evergreen Wealth Management, our financial advisors, and most importantly, our clients.
Notes about markets and wonderful companies
The markets were an extraordinary thing to behold in 2020. Had you told me a year ago that we would experience a pandemic, force businesses to close, and not fully resolve the crisis until mid-2021 then my advice would have been to get out of the market and hold cash. In hindsight, I can say that thankfully, we never advise timing markets because things that are out of our control can cause large swings of direction, both positive and negative. Nothing could be more true than this statement for 2020. From Covid shutdowns to government stimulus, so much was out of our control.
While the markets bounced around wildly in the initial stage of the pandemic, one constant held: wonderful companies continued to perform…well…wonderfully. This is not to say that all wonderful companies experienced stock gains in 2020. Quite the contrary, many wonderful companies saw factors beyond their control hurt their business greatly, but most were hurt for just a short time. Most well-run companies have been through hard times before and know how to adjust in times of stress. They maintain solid balance sheets which allows them to weather storms, regardless of what the market, government, or world throws at them. This is exactly why we aim to fill the portfolio with as many wonderful companies as we can identify.
Now, if you’re wondering how we identify these wonderful companies, and what exactly we think makes them so wonderful, then we would advise reading our in-depth article on Finding a Wonderful Company. Portfolio Manager Andrew Nutter did a tremendous job outlining exactly how we think about companies and how we make investment decisions. If you enjoy a deep dive into investment details, this article is a must-read.
Unfortunately, identifying wonderful companies is only one aspect of successful investing. Understanding a fair price to pay for companies is another aspect that cannot be overlooked. No matter how wonderful a company, it is vital to purchase their stock at a fair price. Purchasing Microsoft (a truly wonderful company) in December of 1999 at $60 would have been a mistake. From 1999 to 2016, the stock delivered zero returns. It was at $59 a share in 1999 and $59 a share in 2016. But that wasn’t the worst of it. By 2009, Microsoft had lost 75% of the value it had in 2000; it was a very bumpy ride with huge drawdowns. Over that time, profits increased from $12 billion to $40 billion, a 230%+ increase in earnings! Microsoft was a wonderful business from 2000 to 2016 and yet Microsoft stock was a terrible investment. This is a great reminder that buying a company’s stock at the proper price is a greater factor than finding the wonderful company in the first place. We have to do both. To this extent, we believe many wonderful companies exist in today’s market, but we continue to be disciplined in paying the proper price for such companies.
Notes on intrinsic values – paying a fair price
We often talk about something called ‘intrinsic value’ and paying a proper price for stock ownership relative to the companies fundamentals. Valuation and intrinsic value are more of a process for us than a precise number. It is a process that uncovers a potential range of outcomes for a stock. Most of you have entrusted your life savings and retirement journey to our stewardship. As such, I feel very compelled to give you a basic understanding of our philosophy on intrinsic value. While you have no reason to understand the nuance of investing (that’s our job), holding a firm grasp on valuation is what gives confidence in all market environments. Understanding valuation is the reason we can sleep very well at night even while storms are raging.
Imagine for a second that you wanted to invest in a lemonade stand business. This business was fairly predictable because for three years you saw your kids sell the same number of cups and take home about the same amount of cash each year. With this information, you could fairly closely predict the amount of cash that would land in your pocket over the next three years if they ran the business as they had been. For simplicity’s sake, we will say the business shuts down in three years. Let’s look at exactly how you would value such a business:
Step 1: Cash-In-Pocket Prediction
You estimate the likely cash-in-pocket over the next three years:
- Lemonade Stand Year 1 Cash-In-Pocket: $200
- Lemonade Stand Year 2 Cash-In-Pocket: $250
- Lemonade Stand Year 3 Cash-In-Pocket: $175
Step 2: How much would you be willing to pay to buy that cash?
- If I demand a 15% return on my investment for three years, I’d pay $410 to get the $625 cash
Step 3: Ignore the noise!
- Your crazy neighbor is considering investing. He likes to count the cups each day to determine what he thinks the stand is worth. Based on this thinking, he throws out some wild estimates of what he thinks the stand is worth. For example, he loves to predict how the weather will affect lemonade sales and changes his valuation as a result. But you know the long term history of the stand and just ignore his crazy predictions and equally crazy offers. That is, until one hot afternoon when he saw you selling cup after cup to hot thirsty customers. He started to do some math in his head and thought that if this continues, he could make more money than he initially realized. He makes you a great offer of $555 after only being in the business for three months. You quickly do some math and realize that his offer would be a 35% return for just three months of ownership. So, while you were content to own the stand for three years to receive a 15% return, your neighbor’s 35% offer is a much better deal. What do you do? You sell the stand and move onto other opportunities!
Prudent investing is done exactly like the simple example above. We spend countless hours understanding the business, estimating the cash flow that business may deliver, and then calculate a payment that will give us a fair return. We like to hold the wonderful company a long time, assuming it keeps paying us our estimated cash flow. Yet sometimes, the market gets a little crazy. When that time comes, it’s a wonderful opportunity to consider whether to accept the offer or ignore it and continue to enjoy the wonderful cash flow from our business. In this way, market volatility does not scare us. As long as the cash flow will continue as planned, then we are happy to let the market throw a temper tantrum. In fact, it would be wonderful for the market to try to convince us the business is worth nothing while it continues to pay us the cash flow. That would give us the ability to buy more shares and cash flow in the company at better and better returns. This is why we get excited when markets decline. We know the storms will pass and years of future cash flows will now belong to us at a discount.
This logic is not free of strife; it requires three key elements in order to maintain success over the long run. We must spend countless hours identifying wonderful companies, ideally companies that can continue compounding their business’ growth. We must be able to identify a reasonable rate of return that can be accomplished long-term in order to buy the business’ stock at a proper price. Finally, we must be able to ignore the market noise and remain focused on the business’ fundamentals. This final point is one of the toughest to commit to. But when times seems tough, we work hard to remain disciplined and focused on future cash flows and a fair value to pay. When sunnier days arrive, we will be rewarded.
Are values fair today?
On a stock-specific level, we see many companies trading at reasonable prices. Said another way, not much is cheap today, but much is reasonable. One of the lessons of 2020 was the uselessness of forecasting. A pandemic was in nobody’s forecast, nor was the worst economic contraction and the highest unemployment rate since the Great Depression. It is a much better use of our time to understand the companies we own, and spend time getting to know them even better, than to chase unpredictable data and make unpredictable predictions. Repeat that out loud ten times, please.
In 2020, a tremendous amount of government stimulus was added into the economy. Rough calculations seem to project a total of $10-$12 trillion will be injected before COVID settles down. This is around half of the overall annual economic output of the entire country! While we may debate the methods being used, the outpouring of funds is a necessary response to what occurred in 2020. Money theory is governed by the idea that: Velocity x Money Supply = Economic Output x Price Level. Said another way, if the velocity of money (speed of money movement) is halted, then you would expect a tremendous hit to our economy. When business activity came to a stop as a result of the virus, the velocity (think business activity) completely ceased for a period of time. This occurred both in the great depression and in 2008 (among other times to lesser degrees).
During the great depression in the 30s, the government responded to the events by removing money from the economy in many ways which amplified the problem and turned a recession in a depression. In 2008, the Fed was slow to fully understand the systemic risk unfolding and did not inject money quickly enough to stop markets and the economy from experiencing free fall. This time around, the problem was a bit more obvious. The Fed and the government responded quickly to the need and backstopped the economy.
Adding massive money supply in 2020 helped banks continue to function properly, markets to remain liquid, unemployed workers to get higher compensations, families to get temporary funds, and businesses to receive added cash. The choice was made to experience less severe pain in this crisis by attempting to spread the pain out and handle unintended consequences as they will likely arise in coming years. While this is probably the best action; it is far from perfect. Recall our equation for monetary theory: Velocity x Money Supply = Economic Output x Price Level. In 2020, the velocity of money dropped dramatically so the government offset this with stimulus (money supply) to keep economic output steadier. As the economy rebounds, we will see a large balancing act unfold. The government will need to balance increasing money velocity with commensurate reductions in the money supply. This is often much trickier than one would think and has many unintended consequences.
Having excessive amounts of ‘free money’ in the system that was not earned will eventually lead to inflation. Some inflation is good, too much is bad, and it is much too early to understand how the inflation story will play out. On one hand, if we see added bankruptcies and sustained high unemployment, then perhaps we do not see high inflation. However, if we see the economy bounce back faster than expected AND the government continues with larger stimulus programs, then inflation becomes a larger issue. The go-to move for pulling money back out of the system to prevent inflation is to increase interest rates and/or increase taxes. Both are obstacles to wealth creation and therefore are possible future headwinds for investing markets. Therefore, the government and Fed will need to walk a tightrope among stimulus, rates, inflation, and taxes during the next few years. For now, we remain in a bull stock market, with an accommodative Fed, and a stimulus-happy government since 2009. I doubt the bull market ends without extreme euphoria. Generally, governments are slow to reign-in stimulus programs and create a ‘melting up’ of markets into various asset bubbles. We have warned that melting up is a real possibility over the past few years and we believe this process continues for the near term.
For investors, it will be vital for their portfolios to remain rooted in the fundamentals and to ignore the market’s silly games. We will continue to remain focused on cash-rich companies that produce solid cash flows. In other words, we want to continue to invest in wonderful businesses. If we maintain our discipline to pay a fair price, then we maintain a high probability of continuing to produce a reasonable long-term return regardless of market conditions. Staying disciplined and keeping a close eye on fundamentals will remain a wonderful way to achieve long-term objectives.
Closing Thought
Warren Buffet offered up the key to long-term investing success in his 2000 annual letter. For those who know how to apply this thinking, long-term wealth generation becomes fairly straightforward.
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars. Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
It is with this bird-in-the-bush thinking that we frame our investing decisions. For us (and Warren Buffet), the bird in the bush is cash flow, just as the lemonade stand illustrated. As long as we own high-quality companies that produce (or will produce) consistent and rising cash flows, then we hold a high probability of long-term success. How long we must wait for success could depend on the price we pay, and so we aim to pay a very reasonable price for the cash flow. The lower markets go, the more excited we get to purchase the cash flow streams. We remain prepared for any future opportunities that may be created from market volatility. If the market continues upwards, then we will be happy to sell some cash flows at a higher price. If markets turn down again and afford us bargain prices, then we will gladly rotate into some new companies and capture future cash flows at a bargain price.
As we move into a new year, let me say THANK YOU! Our success is an equal part great team, great advisors, and great clients. We feel extremely blessed to get up every day and do exactly what we love doing. If we did not serve such great families, we would not love what we do nearly as much. It remains a tremendous honor to steward your hard-earned assets and continue helping you meet your long-term objectives. We look forward to a great 2021 and beyond!
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.