“Through changes various, through all vicissitudes… We make our way” – Aeneid
“Must you dance every dance with the same fortunate man?” – Sinatra in Changing Partners
Well it’s been quite a start of the year! Suddenly the unbeatable rise of Mr. Market has come to a halt on coronavirus fears and oil wars. More than dwelling on these causes and their effect on the market, we’ve written this post to ponder on how to think about times like these and how to benefit from them.
Survival first: We believe that investing is an exciting, ever-evolving game which we are lucky enough to call our profession. As in any game, defense wins championships, and investing is not the exception. While this may sound unexciting, safety of principal is of the utmost importance, after all, it remains our entry ticket to this exciting game. While being overly aggressive gathers highlights, it is generally the better-balanced team (between offense and defense) who wins. Taking it one step further, in Antifragile, Taleb discusses how to to avoid being a turkey, and even benefit from hidden risks or extreme events. While beyond the scope of this writeup, we believe that whoever takes care of the downside first will eventually figure out how to reap benefits on the upside. This is really the cornerstone of investing: before winning, we must ensure we do not lose first.
Only we can answer where we are – Last year we met a very renowned value investor whose words really hit home. When asked about the direction of the market, he discussed that although he is always looking for opportunities across sectors and has a great idea of the market as a general, he avoids making forecasts for the market as a whole. However, he told his story during the Internet bubble, mentioning that in 1999, it became extremely hard to find attractively valued businesses to buy. For us, the three main lessons are: 1) we can have a great idea of where we are in the cycle by the number of investment opportunities we find and the over-valuation of those companies we are very interested in; 2) (as Howard Marks would say) we cannot predict, we can prepare and 3) as LeFevre would say in Reminiscences of a Stock Market Operator, “if you don’t know who you are, the stock market is an expensive place to find out“.
The practicality of finding individual investment opportunities is way larger than that of trying to predict what the sector, the economy or the market will do in a certain period of time. In times when companies within our circle of competence are richly valued, it is best to start accumulating some cash and viceversa (i.e. preparation). We believe this is a way simpler yet more powerful technique to achieve superior performance over time. Moreover, we emphasize that an investor should focus on reasoning and finding gaps between price and value, not debating whether he is right or wrong in public forums. Sure, cross-checking our theses with other thoughtful investors is valuable, but, as Taleb would say: “There are two types of people: those who try to win and those who try to win arguments. They are never the same.”
What a business is worth changes. But does it change that fast? – Time after time, Mr. Market has proven it’s long-term efficiency, and how crazy it can get in the short term. In spite of the recent news, business values change very slowly, and it is best when we take a long-term view in our analysis. In this excellent post, the Brooklyn Investor makes an exercise on what happens as we remove full years of earnings to DCF calculations. The answer is that even if we completely erase 4 years of earnings, we still have 85% of the business value intact. Obviously, there are some important assumptions there, but since value estimates are in theory a set of discounted cash flows from perpeuity, it makes sense that it is in that perpetuity where we find most of the value. To that effect, it is very likely that for investors with a long-term view, a bad 12-18-24 months will not change the picture a whole lot.
“In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” – Charlie Munger
Taming our instincts – A late bull-market has the unavoidable characteristic of feeding upon investors’ complacency. “So what if I am paying 45x earnings?” “You’re missing the paradigm shift!” Well… we do until we don’t. Just as we can leave the floor and repel the laws of gravity for extended periods of time, the market can keep on rising regardless of fundamentals for some time. Hitting new highs everyday feels good when we check our balances; that dopamine rush definitely overcomes the voice in the back of our head which tells us we might have gone overboard in terms of valuation.
Now, investing is definitely a game of balancing ideas that run counter to each other. From our experience, there is no single rule that helps in beating the market (that is what makes it so interesting). However, just as we discussed above, there are some rules that eventually apply and govern market prices, such as prices following business fundamentals. We have learned over the years that leaving an excellent business run its course, even beyond reasonable parameters of valuation is generally better than selling them for the sake of purchasing cheaper yet less wonderful businesses (due to taxes and lost compounding effects).
And yet… how, when and why to sell? In a bull market, it is never easy. However, going back to our discussion with the famous investor, during a steep run in price one can start to feel irrationality creeping in the sentiment for a company. While a company could continue delivering outstanding results, it is in the subtleties that one start detecting a widening gap between a well deserved premium and an optimism fueled by a “never-can-lose attitude”. This is more an art than science, but as a rule of thumb, a company trading way above a conservative estimate of value should trigger at least the question as to what is the driver of that increase in price. There could be two sources of a re-pricing: growth in earnings power and/or what the market is willing to pay for that earnings power. What has driven ours? Answering this accurately can lead to a better decision for our portfolio.
Fear is NOT intuition – A final piece of advice from Arnold Van den Berg. After we develop experience, our intuition develops, providing valuable insights even from a subconscious level. However, it is key to remember that this usually takes years to develop and that in investing, going against our gut is generally the profitable bet. At times like this, unless we’ve gone through similar patches, the will to sell everything and take refuge in cash is likely to be 1) a product of fear, not intuition; 2) more costly due to taxes and lost opportunity costs. For this there is no other way than to follow the Delphic maxim “Know thyself”.
The last 2 bullets discussed here open the door to an interesting topic that keeps gathering importance when talking about investing, namely, behavioral finance. This field basically recognizes that “traditional” financial theory describes investors as being completely rational, when in fact, they are not (although we like to think we are…). Anyway, perhaps this is worth exploring on a different post.
We finish with a quote from the breathtaking Gulag Archipielago. You will notice some similarities with Kipling’s If.
“With the years, armor-plated restraint covers your heart and all your skin. You do not hasten to question and you do not hasten to answer. Your tongue has lost its flexible capacity for easy oscillation. Your eyes do not flash with gladness over good tidings nor do they darken with grief.
For you still have to verify whether that’s how it is going to be. And you also have to work out- what is gladness and what is grief. And now the rule of life is this: Do not rejoice when you have found, do not weep when you have lost.” – Aleksandr Solzhenitsyn in The Gulag Archipielago
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