Khrom Capital Up 1.1% In H1 Amid Lack Of Compelling ValuationsVW Staff
Below are the net annualized returns of the fund over different time periods.
NET Yearly Returns:
Last 3 years: 24.3%
Last 5 years: 26.8%
Since inception (March 2008): 18.8%
Though rising asset prices have caused a decline in opportunities, we have found a few attractive investments that require a long-term perspective. One particular example is brokerage firms— businesses that charge their customers a commission to trade financial securities. Though we expect you are not familiar with these businesses because all your savings are surely entrusted with us (right?), you may have friends with brokerage accounts. What you will find when you survey a typical brokerage customer is that aside from paying commissions when they trade securities, there is usually a cash balance that sits in their account.
That is the first factor explaining why brokerage firms’ earnings are currently depressed. Monetary policies across the globe have converged over the last few years towards near-zero interest rates. Billions of cash and other interest-earning assets sit at the brokerage companies we own, currently earning close to nothing. Furthermore, non-existent interest rates also compress the income that brokers make on margin loans to customers. This causes the current financials of these companies to display only a fraction of their earnings power. But interest rates will eventually rise, and so too will the profits of the brokerages we own.
Another condition of the current market environment has been the reduction of volatility across asset classes, which has a severe dampening effect on trading activity. Volatility is at a historic low, i.e., trading volume has dried up. As market volatility reverts to the norm—it always has after every abnormally calm period—trading volume and, therefore, commission revenues at our companies will materially increase.
This tough environment can ironically be viewed as a positive for our companies, who have competitive advantages in their respective niches. In a climate of lower rates and lower trading volumes, it is harder for smaller-scale competitors to be profitable. Brokerage firms are largely fixed-cost businesses—expenses do not decline as interest income and trading commissions evaporate. And as if that was not enough to create havoc, new regulations have dealt an additional blow to this industry. Regulations have become more onerous each year throughout the world, which has increased the compliance cost of operating a brokerage firm. This twofold injury of decreased revenues and increased costs has further weakened already weak competitors, creating an opportunity for our companies to acquire them cheaply or simply wait until they close down.
When market conditions eventually return to average (or even above-average) levels, we expect our companies to earn substantially more than they earn today, and to have strengthened their market positions along the way. Today, the possibility of higher interest rates and trading volumes seems remote. We like investing at prices that assume these conditions will last forever, and expect to benefit when it becomes clear that this “forever” is shorter than most people think.
As the stewards of your capital, the course that we chart does not change based on transient market conditions. In fact, the reason we think our process should continue to outperform is because we focus on not changing it. When you become a limited partner, we hope it is because you want us to follow this simple process: analyze the range of total cash that a business will produce over its lifetime; allocate your capital to purchase those cash flows when they sell for a price that is likely to yield double-digit annual returns; do not allocate your capital to a business that is priced to produce less than that return.
That is our approach. It is conceptually simple, but the implementation is difficult. There is always the temptation to rationalize trading activity when inactivity is required. We try to always focus our analysis on figuring out the entire life of a business. This helps us avoid the game of basing our projected return on premises like, “we can sell this business later on for more than we paid for it because…” This sometimes works and can become tempting to play, but it requires us to rely on being bailed out by another buyer. Our investment program is to rely on the asset—not another buyer—for our returns.
We continue to build up intangible capital at Khrom Capital by studying businesses whose final destination we think we can predict. Over the years, the prices of these businesses will vary far more than the reasonable estimates of their lifetime cash flows. We remain excited about our ability to snap them up when the right price comes.
As it has been since inception, virtually my entire net worth is invested in the Partnership as I aim to compound my wealth alongside yours. I look forward to writing to you again at the start of the new year. Have a wonderful rest of the summer.
Eric E. Khrom
Khrom Capital Management, LLC