Bonsai Investments

Bonsai Investments is a limited partnership established on June 30th, 2007 with a purpose of long-term capital appreciation through investment in capital markets (stocks, bonds, etc.). The name Bonsai was chosen as a symbol of the long-term nature of the fund. Bonsai, Japanese for "potted plant", originated in China (pen-zai) due to shrinking garden sizes, but the desire to capture a full landscape. Today Bonsai is considered an artform symbolizing patience and care, with some trees taking more than ten years to mature from sprig to finished work of art and living for decades after that.

Let's start with the general strategy of the Bonsai Investments fund. A person not interested in managing their own money would do well to purchase a mutual fund indexed to the S&P 500 and just hold, which is why I chose the S&P 500 as the benchmark to measure my performance.

The majority of investments held by Bonsai Investments will be undervalued equities, with a goal of buying stocks (companies) at 60-70% of my fair value estimate of them. I determine the fair value of a company based on future cash flows and historical valuations under the assumption that while stocks fluctuate somewhat randomly in the short-term, the long-term average will be very close to the fair value. It’s similar to a casino where in one spin of the roulette wheel, it can lose a million dollars, but over the thousands of spins that take place each year, the casino will profit almost exactly 1/37 (2.7%) of the bets placed down on the table. These statistics are why I hate putting more than a few dollars down on a roulette table. I’d rather be spinning the wheel.

Along with the financial aspects of investing, a judgment call has to be made based on the products/services offered and the management in place. Without either of these, a business’s long-term prospects are highly suspect. A great product, like Coke, can offset weak management, especially if there is the prospect of more talented management taking over in the near-future (for the record, I believe Coke currently has excellent management in place). And to a lesser extent, great management can sometimes offset a weak product. Although I think it’s funny, I don’t completely agree with the quote from the movie Tommy Boy when Richard says to Tommy, “your Dad could sell a ketchup popsicle to a woman in white gloves”. I’d rather see management sell her a pair of shoes.

Over the long-term, the strategy outlined above along with investments in long-term bonds should produce strong and relatively consistent results. In years that the S&P 500 is up, I hope to keep pace. When the S&P 500 has weak or even negative years, I hope to beat it by a wide margin.

Over the past 10 months, the US stock market and particularly the financial industry have experienced very difficult times. And while I can’t predict when better times will come, I know they will improve. Companies with high credit quality might have a few quarters of bad earnings and maybe even no profit at all because of bad loans or reduced demand, but the true underlying value of these entities, their balance sheets, should not be significantly affected. With balance sheets still intact, these companies will be able to invest in their businesses at pre-2007 levels and return to similar levels of profit. Once the earnings return, investor sentiment and stock prices will also return to more normal levels. Over the short-term, we just have to embrace market volatility as we experience what may be the best buying opportunity in 15-20 years.

“Buy umbrellas when it’s sunny, and sell them when it’s raining.”

Pure academics have written books about the estimated future returns of stocks and bonds, but I like to keep it simple with a formula that uses price, earnings, and inflation. Mathematically, the equation is: (earnings / price * 100) + the inflation rate. Today, I calculate (1 / 17.02 * 100) + 2.1 = 7.98% as the long-term future return of stocks in the United States. Compare this to the long-term return of government bonds of 4.28% (30-year government bond yield), and equities look particularly attractive. This doesn’t mean stocks will return more money than bonds in 2008, but odds are very good they will return substantially more money over the next 5 years.

Now, to contrast, here is a rough calculation of January 1st, 2000. The stock market traded at more than 30 times earnings, and the 30-year bond yield was over 6.5%. The estimated return of stocks was (1 / 30 * 100) + 2.1 = 5.43%, more than a full percent below the expected return of long-term government bonds at the time. The return since then is pretty dramatic. While the S&P 500 has had a negative return since then, an investment in the mutual fund BTTRX (an American Century mutual fund that invests in government bonds maturing around 2025) would have more than doubled with far less risk averaging over a 9% return.

Based on this formula, I don’t recommend an investment in all bonds or all stocks at any given time, but a combination of the two in a ratio favorable to the expected future returns. An analogy I love to use is a coin toss. I can’t tell you whether one coin toss will result in heads or tails, but I can be pretty certain that 1000 coin tosses will result in about 500 of each.