It is said that during his trial for impiety (and at which he eventually was sentenced to death) Socrates uttered the famous dictum: “The unexamined life is not worth living.“. Since the recent turmoil in markets, here are a few lessons that we have gathered in the hope of remembering (and applying) them going forward.
- The best market timing tool is intrinsic value – When turmoil starts the correlation amongst asset classes increases significantly, making it even harder to distinguish winners from losers. With eye-grabbing media flooding our attention, it becomes hard to avoid emotional decisions. Something that is useful, however, is having updated estimates of intrinsic value. The rule is simple, if even under stressed conditions, current prices still offer a wide discount to our intrinsic value estimates, we turn the table and place the odds in our favor. While this has an elevated emotional toll, risk/reward ratios become more attractive. In the end, what we are trying to do is obtain a return as investors similar to the business’ rate of return on capital. If we do so at attractive valuations, the likelihood of this happening becomes greater.
- Price is the best protection – After trying out different investment vehicles, among them options, ETFs and cash, (and perhaps as a reflection of our optimism) we believe nothing provides long-term cushion and protection as paying a reasonable valuation for a business. Mostly this is because it allows the long-term compounding of money avoiding high transaction costs. Yes, prices will fluctuate, but over time, paying a fair price for a great business allows the obtention of a similar rate of return as that of the business ROIC. If the valuation job is done vaguely right, obtaining a good result is almost unavoidable.
- Be brave enough to hold cash – One of the recent trend we’ve seen among investors is the need to dance all dances and harships facing FOMO. It is our belief that some of the hardest, yet most useful words an investor can utter is “I don’t know”. While having north stars and beliefs is certainly useful, fluid situations like investing require openmindedness and the acceptance that we are taking decisions with incomplete information. Yes, probabilities and their respective updating is relevant, but it is also critical to understand the limits of our knowledge. Recognizing this and investing only when we have an edge may avoid large amounts of pain.
- If conviction is high, move (more) aggressively – Returns tend to be at their best when it is the most uncomfortable. Beating our primal instincts is definitely a challenge, yet it can be financially rewarding. Moving with confidence in our valuation is key. We highlight that while this is generally understood, more aggressiveness is better than little.
- Do not underestimate liquidity – We believe Stanley Druckenmiller puts it best: “Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity; most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”. We believe that earnings ultimately lead the market, however, it is very clear that liquidity does not have a marginal impact and it moves the market too. This comment, among others, have spiked our curiosity. This is why we wrote the article On Depressions’ Base Rates, to have an idea of what the implications may be based on history.
- Have a backup plan and be flexible – We believe that if a solid investment might be dependent on 3-5 key variables at most. If one of those changes, the whole thesis might crumble. Due to the interaction of sunk-cost fallacy and consistency bias, we might feel that all that work needs still to be rewarded by return. Here it is vital to remember that stocks do not know about us owning them, neither do they care. If something is not going as planned, or the facts change, it is key to have the flexibility of mind to say we could be wrong and avoid permanent losses of capital.
- Never outsource your thinking – With so much information floating around, it is hard to hear our own voice. However, investing is a solo game, therefore it is critical not to outsource our thinking and do it for ourselves. Always remembering that (paraphrasing Graham) we are only right if our facts and our reasoning are correct.
- Know your game – One of the great things about connectivity is the ability to share ideas and gather opinions freely and easily. Yet, as with information, it can become so abundant that we can hardly navigate through it. Between macro investors, private equity guys, bottom-up stock pickers, commodity experts and more, sometimes the desire to understand all their theses is significant. We advocate that knowing what our game is remains the key. It would be ludicrous to make Michael Jordan a soccer starter.
We are aware that this situation is still evolving, and we hope to add further lessons as time goes by. Also, if you have any particular lessons you would like to share with us, we’d really appreciate it!
Adastra Finance 