Dear Co-Investors,
The NAV of the Business Owner Fund was €526.35 as of 30 December 2022. The NAV decreased 47.6% since the start of the year and increased 430.5% since inception on 30 September 2008. The compound annual growth rate since inception is 12.4%.
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A Health Update
When I sent out my Q2 factsheet in early July, I announced that I would shortly be sending out my first half letter. I have never pre-announced a letter before. I did so on this occasion as the fund’s performance was bad, and I thought you deserved to hear directly from me what I made of it… ASAP.
As days turned into weeks, and no letter fluttered into your inboxes, many of you reached out to ask if you had missed it or whether everything was ok. Many more of you did not reach out and assumed perhaps that making an early dash for the beach was a higher priority for me than communicating with my investors.
As those of you who reached out to me directly know, I had a medical emergency. Under normal circumstances, I would have kept the episode to myself and would have had a decent chance of doing so given that I was in the hospital at a time of year when people tend to be offline in any case. Alas, this was not possible thanks to the pre-announcement of the letter. On balance, I preferred people to understand why the letter was delayed rather than perhaps assume it was simply not a big priority for me.
Obviously, it does not make sense for part of my investor base to be fully up to speed on my health whilst the remainder is either partially or completely in the dark, in particular given the ongoing dependence of RV Capital on me, notwithstanding the recent addition of Andreas to the company. So, to level set everyone, this is what happened.
What Happened
In early July at the beginning of the Zurich school holidays, I collapsed outside our home and vomited blood. I called an ambulance, but the paramedic pointed to the hot weather and suggested I wait it out. After collapsing several more times in the night, I went to our local GP in the morning. He immediately sent me to the emergency room of a local hospital. I underwent an endoscopy, which revealed that there was a tumour bleeding in my stomach. Two days later, I underwent surgery and had the tumour removed.
The surgery left me pretty beaten up as it could not be done with a laparoscopic procedure. Initially, I had four separate tubes coming out of me, and I could not move without considerable pain. Amazingly, eight days later, I was discharged from the hospital and left under my own steam. Initially, I was weak and had pain after eating, but by the end of the school holidays in mid-August, I was virtually back to normal. It was as if I had been away on a very unconventional vacation and was now back.
I have since received a full analysis of the tumour. It was a gastrointestinal stromal tumour or “GIST.” GISTs are very rare and, in a piece of good fortune, considered less dangerous than the more common sarcomas, which are typically associated with stomach cancer. A further piece of good fortune was that the tumour could be completely removed and had not spread elsewhere in my body. However, it was malignant.
Based on the tumour’s size and mitotic rate (the rate the cancer cells are dividing), oncologists can predict the likelihood of the tumour recurring. At 5.5 cm, the tumour was quite large (bad), but at under 1%, the mitotic rate was low (good). The upshot is that the probability of the tumour returning is 3.6%.
If investing teaches you anything, especially in a year like 2022, it is that low-probability events sometimes materialise. However, considering where things stood directly after the first endoscopy, this feels like a lottery win.
I am not undergoing any further treatment and just need to go for a check-up every six months. Given the low probability of the tumour recurring, my oncologist said he would not have recommended any further treatment. In my case, however, Imatinib, the main treatment for this type of tumour, would be ineffective in any case as I lack a gene mutation that the drug acts upon. As such, the question of whether to undergo chemotherapy is moot.
Since mid-August, life has been back to normal.
Have My Priorities Changed?
Life may be back to normal externally, but a reasonable question is what is happening internally.
There was a 48-hour window between the results of the initial endoscopy and the operation when, frankly, I thought it was game over. They were, no doubt, the most difficult two days of my life. Since then, things have been very much on an upward curve. Physically, I was weak after the surgery, but emotionally, I felt reborn as the news when I woke up was that I had the prospect of making a full recovery. As a doctor friend pointed out, it is much easier to recover from a big operation when you have the prospect of a return to full health, so the physical side of things did not bother me much.
A legitimate question is perhaps whether the episode, in particular in that 48-hour window, caused me to reset any priorities, in particular, in the context of an investor letter, as it relates to my work.
The answer is no. I never wanted to be one of those Dads whose biggest regret is not having seen their children grow up. By working from home since 2006 (long before Covid!), I felt that I had been able to strike a good balance between family life and work.
I also had no regrets about having dedicated my career to investing. I derive an enormous amount of pleasure from it, in particular from the relationships I have formed over the years with my investors, company managers, and peers.
In those darkest hours, relationships with family and friends were not a thing I thought about, they were the thing. Nothing else came even close to making it onto my radar. My overwhelming sense was sadness that I would not get to see how those relationships develop in the future. It was a bit like watching a really good movie and being told you had to leave midway. I am I get glad to see how the movie continues, and I am glad I get to continue to play the role I was cast in.
Lucky or Unlucky?
Lest you were thinking that this in-depth discussion of my health is a plea for sympathy after last year’s performance, let me reassure you this is not the case. I consider myself lucky. It was lucky that the tumour started to bleed. Otherwise, it would not have been discovered. It was lucky that the emergency did not happen a week later when we would have been on vacation and likely not had access to such good healthcare. It was lucky that Andreas had started at RV Capital less than two weeks prior to the emergency providing me with peace of mind that the company was in good hands. And most of all, I was extraordinarily lucky that my family and closest friends dropped everything to rally around me in my hour of need.
Health and Privacy
I realise that a transition from matters of life and death to investing may be a little jarring. Let me at least attempt a segue with a brief discussion on the ongoing debate on privacy as it relates to health data.
Privacy continues to be a hot topic in society at large and at some of our investments. Within the area of privacy, there is no area “hotter” than health data. There are, for sure, important and legitimate reasons for keeping health data private. For example, people with an underlying health condition may be discriminated against when seeking a job or a partner. However, these arguments already get plenty of airtime. Having laid all bare, I hope to have earned the right to air some of the counterarguments.
First, at a population level, we would have far better health outcomes if health data could be collected (with appropriate safeguards, of course) and analysed. For example, it is not known what causes GISTs. I can imagine we would be a little wiser if the profiles of everyone who has had a GIST could be compared against each other.
Second, in my admittedly narrow experience, everyone has some medical condition or other. And most of the time, they are intensely embarrassed about it. Of course, it should be everyone’s own choice whether they wish other people to know about it or not. However, if we were a little more open about our frailty, it would perhaps allow us to recognise our common humanity more easily. It is a cliché that there is more that unites us than divides us, but it does not do any harm to be reminded of it more frequently.
Third, by broadcasting my condition, I expect to increase the chances of hearing about relevant research or novel treatments. All my letters elicit thoughtful feedback. I am certain this one will be no different.
Fourth, if life ultimately comes down to forming meaningful relationships, the corollary is to avoid superficial ones. To the extent, a potential employer or partner is put off by a medical condition, perhaps it is better to find this out sooner rather than later. Yes, this is easy for someone in the privileged position of an investment advisor to say. However, there are nearly always options even if they are not immediately apparent.
Carvana: A Post-Mortem
The performance of the fund was very disappointing in 2022. I always thought that a drawdown of 50% or even higher was possible, even inevitable, but I did not anticipate it happening in such a comparatively benign stock market environment.
I wrote extensively about the reasons for the poor performance in my half-year letter, concluding that it was a mixture of poor judgement and poor luck. Six months on, more details have emerged. For some companies, I would now err more towards "judgement" whilst for others, I would err more towards "luck". I do not think the overall conclusion would differ though. As such, I will not redo the exercise here.
An exception is Carvana. I acknowledged Carvana’s problems in my half-year letter but on balance remained optimistic that it could overcome them. Since then, the situation has deteriorated further. The company has made considerable progress in lowering costs. However, any benefit has been negated by the deterioration in the economy and the used car market, as well as the rapid increase in interest rates. From today’s perspective, Carvana’s future as a going concern is in the balance. If it is to survive, it will likely come at the cost of substantial dilution to existing shareholders and a permanent loss of capital. Things may yet work out, but I prefer to assume the worst and, I hope, be positively surprised.
What Went Wrong?
Carvana has always been a company that divided opinions. On the one hand, were the bulls who pointed to the large, untapped opportunity to sell cars online, the superior customer experience compared to offline, and the potential competitive advantages to the dominant online player. On the other hand, were the bears who argued that the unit economics did not work, the Garcias were crooks, and the financial reporting was fraudulent.
Given the collapse in the share price, the bears will, with some justification, be patting themselves on the back. For what it’s worth, I do not think these are the reasons for Carvana’s problems. The unit economics work as Carvana has demonstrated in its most mature markets. I met with Ernie Garcia and his senior management team in December and continue to be impressed by their integrity, ability, and energy. If Carvana is doomed, they certainly did not get the memo. And finally, it seems unlikely that Carvana overstated its financials as it never reported a GAAP profit in any case.
Where did Carvana go wrong then? It is difficult to say from the outside, especially as the situation continues to develop, but my sense is that the company was simply too aggressive. It went hell-for-leather in virtually every aspect of its business. This is most obvious in its financial structure where it used too much debt. It is also apparent in its operations: it tried to carry almost every type of car in inventory, it extended its logistics network into nearly every corner of the US, and it provided financing for nearly every type of customer. As a counterpoint, CarMax, in over 30 years of operations still only provides financing to prime customers, outsourcing subprime customers to third parties. A more cautious approach would have been to start with a narrow range of inventory, markets, and customers and, having profitably scaled in one niche, gradually expand outwards.
Was the ultimate cause “hubris” then? Perhaps, whereby an “excess of ambition” seems a fairer assessment. The company was never under the illusion that what it was attempting was easy. Perhaps even this is unfair though. If it was possible to fail by being too ambitious, it would also have been possible to fail by being too cautious.
In hindsight, a go-slow strategy of building up one market at a time sounds appealing. However, given the obvious benefits to scale, it is easy to imagine scenarios where this too could have led to failure. Had a more aggressive player got to scale faster or had the positive unit economics of single markets attracted a behemoth such as Amazon before a sufficient lead could be built, Carvana would have also failed. Ultimately, it was a question of finding the right balance, and Carvana appears not to have. It was near miraculous what it achieved, but unfortunately, there are no prizes for near misses in capital markets.
Why Did People Fall for It?
I have read several comments along the lines of how come so many supposedly smart people “fell” for the Carvana story. If you thought Carvana was an obvious fraud, this is a legitimate question. However, if the root cause was poor execution, then it was far less apparent from the outside. After all, it was not even clear to the insiders. From a financial perspective, all the key metrics moved in the right direction right up until they did not.
How Can Carvana-esque Mistakes be Avoided in the Future?
The most obvious lesson, which is unfortunately not a new one, is to steer clear of companies with too much debt. It was wholly inappropriate for a company that was loss-making and had huge capital outlays ahead of it to be carrying any debt. What Carvana should have had was a huge buffer of net cash. As is so often the case, Warren Buffett put it best:
Almost anything can happen in financial markets. The only way smart people can get clobbered, really, is through leverage. It's the one thing that can prevent you from playing your hand. All the hands we enter look pretty good. But you have to be able to play them out.
Some of you have asked me whether the Carvana investment is indicative of the type of investments to expect in Business Owner going forward. I cannot rule out further mistakes in the future. In fact, they are inevitable. However, I can assure you that we will not knowingly get into this type of situation again.
A further lesson is to approach astronomical growth rates with a healthy dose of scepticism. Growth at acceptable returns on capital is fundamentally a good thing. However, it is also a risk. Growth places enormous strain on any organisation. And, the greater the growth, the greater the risk. It is difficult even for capital-light businesses to scale rapidly. Myspace ultimately failed because it could not keep up with the growth in users. However, for companies that have real-world infrastructure, it is an even greater challenge. Ultimately, scaling a logistics network, a lending business, a sales organisation, and multiple inspection and refurbishment centres (“IRCs”) all in parallel likely proved to be too big a challenge for Carvana.
The final lesson is to approach companies with negative cash flows with more caution. Negative cash flow can be a good thing - many good investment opportunities require building infrastructure and hiring staff ahead of demand. However, negative cash flow can also result from a lack of operational discipline. From the outside, it is not always easy to discern which is the case. A feature of the market downturn of the last 12 months is that many companies whose losses were supposedly driven by growth investment have seen losses increase – not decrease - as growth has slowed down. The costs proved stickier than expected, and, as a result, the loss of revenue went straight to the bottom line.
Will Carvana Change How I Invest?
At a high level, the answer is “no”. The strategy of the Business Owner Fund, as you know, is to buy great businesses run by honest and talented managers at a cheap price. I wrote this in the first fact sheet of the fund back in 2008, and, with some slight modifications, it remains in the current factsheet. I remained convinced that this is the right way to invest.
At a micro level, the answer is “of course”. Since the fund started, I have constantly sought to become a better investor. This meant permanently revisiting questions such as which countries or sectors to explore, and what the characteristics of a great company, manager, or price are. This intellectual journey is documented in these letters. It is worth remembering that at the fund’s inception, nine out of the ten companies were German small caps. Today, there is just one. Every investment has changed how I invest. When something worked, I did more of it, and when it did not, I did less. Carvana will be no different in this respect.
What makes Carvana somewhat different is that it is the first investment that has led to a near-total loss of capital. Prior to 2022, there was not a single investment that came even close to this type of loss. In fact, I am hard-pressed to recall an investment that had any kind of meaningful loss versus our initial purchase price. As such, it seems appropriate that Carvana triggers perhaps a more radical re-think than other investments. In no particular order, here is how I am thinking about some of these questions.
Near or Longer-Term Earnings Power?
When the fund started, I was very much focused on the immediate and tangible when valuing companies. I looked for a low price to tangible assets or a low price to current earnings power or, ideally, both. Over time, I realised that some of the best investment opportunities are in companies that are capital-light (making them unlikely to trade below their tangible net asset value) and are investing towards the long term (depressing near-term earnings and making them unlikely to trade on a low earnings multiple). Carvana likely represented the apex of this development in that it was the first company I invested in with high near-term losses.
My preference is still to invest in companies that are investing for the long term. However, where this is the case, I would certainly avoid companies with debt so that under all circumstances, as Buffett puts it, they get to play out their hand. Furthermore, I would insist that losses can be “turned off” at short notice should the need arise.
Earlier-Stage or More Mature Companies?
Somewhat related to the former point, I have also drifted towards younger, less established companies over time. When the fund started, it was made up solely of relatively old, mature companies with well-established business models and operating histories. Here too, Carvana represents the apex of this development given that it is a relatively young company whose ultimate unit economics were and are up in the air.
Investing is a forward-looking activity, and, as I have written extensively about in prior letters, the right approach is to invest in companies that have a tailwind from change, not a headwind. It would be a mistake in my view to restrict my investment universe to the “old economy”. That being said, there is a spectrum between “old” and “new”. It is not binary. It is not clear to me from today’s perspective whether Carvana was too early in its development to be able to make a proper judgement on its long-run economics. I do not expect Carvana to disappear (though current shareholders may well be heavily diluted). It will be fascinating to see how its business model plays out in future years. I will however bring a higher degree of scepticism to companies that are earlier in their life cycle.
“Loss-Making” or Profitable Companies?
My thinking about the importance of operating earnings has also evolved over time. Att the start of the fund, all the companies were solidly profitable. More recently, this has been mostly but not always the case. I described the reasoning for this shift in my 2018 letter on subscription economics. In this letter, I argued that all elements of the P&L, not just marketing spend, can have an investment element to them. Where this investment is profitable, it makes sense. In fact, the higher the better.
I stand by this argument, however, what was missing was a discussion of the disadvantages of investing heavily in growth, or, more pertinently, the benefits of operating profits. An operating profit provides a company with a margin of safety, for example, in the case of a market downturn. It lends a company optionality, for example, to buy back stock or to acquire a company, should the opportunity arise.
Furthermore, the need to make a profit is an important disciplining factor in companies. Companies with a pass on making money are far more likely to have bloated cost structures and inefficient processes. The decline in the tech sector over the last 12 months has brought this point into sharp relief.
Heightened scrutiny of operating losses as well as perhaps a deeper appreciation of the value of solid operating earnings in the present mean that companies with low or even negative earnings are less likely to feature prominently in the fund going forward. It is a type of investment that I would not categorically rule out though.
Low or High Growth?
All things being equal, growth is a wonderful thing provided a company is deploying capital above its cost of capital. That being said, it also has its drawbacks. The earnings and hence share prices of tech companies were decimated across the board in 2022. In virtually every case, the root cause of companies’ problems was trying to grow too fast or, less charitably, a loss of financial discipline. Almost no company was immune. Even Amazon overhired. Beyond a certain point, growth is difficult for even the most well-run companies to handle.
The last year is also a reminder that long periods of success at companies can create complacency and sow the seeds for a subsequent decline. I am a fan of the companies that we invest in and love to see them being successful and report back to you on how well they are doing. Going forward though, I will be more vigilant toward whether success in the short term is creating risks in the longer term.
In Defence of Doing Things Differently
One of the dilemmas that all fund managers confront is that investments are judged retrospectively. When an unconventional investment works well, it appears original and clever. When it fails, it appears reckless and stupid. Carvana clearly falls into the latter camp. When this happens, questions inevitably get raised about whether the manager has "gone off the reservation" or fallen victim to "style drift".
This strikes me as a good moment to remind investors that my investing style has always been “drifting” or, as I prefer to think of it, “evolving”.
As I described in my ten-year memo, I made my first investments in the early 2000s in the aftermath of the dot-com bubble bursting. I noticed that many of the former dot-com darlings had fallen so far that they were trading below the net cash on the balance sheet. I bought many of them without much further analysis than that. It was a crude methodology, but it was effective thanks largely to how rich the opportunity set was at the time. Since then, I have been constantly refining and (I hope) improving how I invest.
It led us into new and profitable areas such as larger companies (BMW), the US (American Express and multiple others), tech companies (Google), big pharma (Novo Nordisk), earlier-stage companies (Trupanion), and China (Baidu), to name just a few. All these investments were viewed as highly controversial at the time. “Where's the edge of a German small-cap specialist in large-cap tech or China?” was a refrain that I frequently heard. Crucially, all these investments worked well, in some cases spectacularly so. For example, Trupanion increased more than 15-fold from our first investment to our last sale. Carvana may not be typical of a Business Owner investment in that it did not work. It is however typical of a Business Owner investment in that it was made in the spirit of trying something new.
RV Capital’s 2023 Annual Gathering
RV’s annual gathering will take place this coming weekend in Engelberg. Demand to participate was as strong as ever, and not everyone could be accommodated – RV too does not want to grow too fast or, perhaps more aptly, to get out over its skis (though it is amenable to getting on them!).
If you did not make it this year, please try again next year. As a reminder, all the live sessions will be live-streamed from my YouTube channel. There is no need to register. Just click on the link at 9:00 a.m. CET on Saturday morning. If you wish to ask a question, please use the chat function alongside the live stream.
Several of you have asked about connecting with other participants ahead of the event. As part of your registration, you were automatically added to a group chat for the event. I would encourage you to post who you are and what you are looking for there. You can then connect with interested parties and, as necessary, continue the discussion offline.
I wish everyone who is traveling to Engelberg safe travels, those of you who are watching online happy viewing, and everyone a healthy and fulfilling 2023.
