IP report excerpts, vol. 3: Crisis

We return to the highlights of conceptual texts we wrote in 2008, a pivotal year for our company and for world financial markets. In this report, we discuss our use of the tried and true “roadmap” that our investment philosophy provides during even such periods of turmoil. In a nutshell, “In extreme situations, it makes all the difference to have very clear principles coupled with a simple, hands-on philosophy executed with discipline.”

Q3 2008 report excerpts on sticking to one’s investment philosophy

GOING FORWARD

Hungarian writer Albert Szent-György tells an interesting story, immortalized in a poem by Czech author Miroslav Holub.

At the end of the past century, a young lieutenant in the Hungarian army participating in military maneuvers in Switzerland sent a detachment on a reconnaissance mission by the Alps. Time passed by and the unit did not come back. It was very cold and the wind was merciless. The wind chill was getting worse by the minute. Snow soon arrived. Heavily. It fell non-stop for two days. And the detachment was still unaccounted for.

The lieutenant suffered, as he feared for the worse. He had deployed his own unit to a sad ending on the icy mountains.

On the third day, a welcome surprise. The group returned alive. Tired and weak. But safe and sound.

A delighted and curious lieutenant asked: “How wonderful, boys. God be praised! Where were you after all? How did you manage to get here?”.

- “Lieutenant, it was tough. We got lost, night fell and the snow came. We were terrified. We completely lost hope in surviving. But suddenly, one of the soldiers found a map in his pants’ pocket! A true miracle… Of course this calmed us down. We set the base amid the storm and withstood the blizzard. Then it was very easy: we analyzed the map to understand approximately where we were and we headed back here”.

Still curious, the lieutenant asked to see the map and analyzed it calmly. After looking carefully, he shouted: “Boys, this is the Pyrenees map, not the Alps…”

There are many ways to interpret this story. The one we deem most interesting to our goals is quite simple. At critical moments, when we quickly need to give pragmatic and effective meaning to situations that are new and potentially adverse, it is far more important to have “a” map on hand than “the right” map.

First, due to the peace of mind and calm that the “map” brings us, preserving our rationality and preventing us from hesitating when we need a clear mind in order to act – or even wait.

Second, because old, familiar references work very well as a starting point from which we build a new intelligibility, setting the route. This happens because of the leads that the new environment offers us, and the answers we reap by gradually interacting with the new surroundings.

The “map” is the base on which we let our “contextual intelligence” flow, making sense of cues brought by the new environment.

(…)

At IP, we are lucky to be able to draw on a simple “map”, which we take off our pockets on each and every occasion. Or better: it is usually more efficient in moments such as now, when the rationality of a battered and bruised market simply wanes.

Independence. Rationality. Patience. Discipline. Conservativeness. Long-term horizon. And the mandate to buy stakes in good businesses that have honest and competent managers, requiring a discount, a significant safety margin compared with its value. It can’t get any simpler.

In the words of Seth Klarman, the manager of Baupost Group and whose simple and to-the-point book “Margin of Safety” we recommend for those who do not mind spending $1,200-1,500 on it at Amazon or eBay (for this reason, it is the most-frequently stolen book from U.S. libraries):

“Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. (…) By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor – room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies.

Following a value approach won’t be easy for everyone, especially in today’s media- dominated, short-term oriented markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk averse strategy in a world where nearly all of us are, or should be, risk averse.”

In extreme situations, it makes all the difference to have very clear principles coupled with a simple, hands-on philosophy executed with discipline.

(…)

But every crisis has new components, and this one is no exception. This time there’s an aspect that makes it quite different for us as well: there’s no clear macro- economic model to be aimed at. It’s not like derailing emerging economies struggling to emulate the US. It’s the US drifting, and some of the core assumptions of its model shaken to the ground.

This is the closest we’ve got to the end of the world as we know it, at least from the investments stand point. Not because of the price swings or panicked faces, but because it exposed the systems flaws to a degree that makes it very likely that fundamental global changes will be made. That’s always dangerous territory, as for the need for change doesn’t necessarily comes attached with good solutions. A statement attributed to Venezuela President Chavez illustrates the risks we fear the most: “I nationalize strategic companies and get criticized, but when Bush does it, it’s OK.” Our take: really nasty people can build self-serving arguments and sell them to the masses under current circumstances.

And in addition to the expected increase in regulation in general, several of the traditional “ism’s” may stage a come back, haunting us. Interventionism, nationalism, protectionism. As well as beligerence. And we sould always keep in mind that regulated economies have also shown us their flaws and limitations.

It became crystal clear that markets didn’t work that well after all, although many will continue to defend the Efficient Market Theory, use VAR and to reel off Greek letters, just as some people still believe in witchcraft and other more controversial super-natural forces.

The better analogy we can come up with is the fall of the Berlin Wall. An era is over, the task is daunting. The world order will be revamped. The US will have to consume less and produce more, in a major way. We’re talking culture here. The financial system, a central cog will have to be redesigned, rebuilt and booted. The “awe” factor of the crisis here is a plus, but it is still likely that it will take time. The world map has changed.

The Western world lacks leaders with standing and clear, sensible vision. (…) All in all, it’s indeed difficult to coordinate a group when interests diverge, governance is terrible and the interdependent elements do not even share an understanding of how and to what extent they are interdependent.

Europe tries to sketch a coordination effort. But it seems a rather fragile institutional arrangement. On the other hand, Putin and the Chinese clearly are on a roll. They certainly can lead, but how good would this world be for “us”? And will the new US president be up to the task?

Most prices have come down. Sharply. Most deservedly so. The probability of tax increases in the US has gone up, as well as the magnitude of them. Production and consumption are likely to be rebalanced in a global level. A slowdown seems inevitable.

(…)

Zooming in on Brazil, besides the global drag effect (we don’t subscribe to decoupling – we believe globalization is inevitable, for good and bad) some corporate governance issues arised that unfortunately confirmed our fears that we’re still in stage 4 or 5 (at the most) of a 10 stages race.

(…)

SO, WHAT SHOULD WE DO?

As we lack a new “map”, we took our old one off the pocket.

Self-servingly enough, we believe the best solution is to have shares in the best managed companies, preferably high on intelligence, brands and systems. Asset light and nimble, and yet “entrenched” in their economic moats. There’s the obvious risk that we’re behaving like the man that only has a hammer: everything is treated like a nail. But our reasoning goes like that: those companies seem more likely to continue to generate returns in the new order, whatever it might be. It is way more difficult for governments to seize/run/tax them. They’re more fluid/mobile. They have revenues in multiple geographies and currencies. They depend less on discretionary credit. They are needed.

We choose to invest in “inevitable” companies. Businesses that do not need much capital. And have robust balance sheets.

In this credibility crisis that is affecting from banks to governments, companies to currencies, to enjoy some diversification through companies with solid franchises and competitive advantages and the capacity to make money in any new order is extremely desirable. When we can do it at attractive prices, it’s a no-brainer.

(…)

CONCLUSION

The ongoing world crisis, whose magnitude is unprecedented and whose effects are still uncertain, laid bare the excesses and the vulnerability of the capitalist system as we know it. Throughout this year, more than 10 large financial institutions worldwide, boasting venerable auras and grandiosity, proxies of stability and safe havens for many investors, died along the way. The crisis of confidence that ensued helped remind us how much the independent asset management model, when alignment is truly enforced, enables and strongly reinforces the possibility of choosing among counterparties.

FORGING AHEAD

Our “map” to traverse the coming periods is the same one we have always had. It is neither mind-blowing, nor creative. It is widely disseminated, and without any glamour.

Again: Independence. Rationality. Patience. Discipline. Conservativeness. Long-term horizon. And the determination to buy stakes in good businesses that have honest and competent managers, exacting a discount to their value. It can’t get any simpler.

In times like these it is easy to single out severe distortions as international capital flows, de- leveraging, redemptions and forced sales lead prices to disconnect completely from the value of assets. But it does not mean we will rush in. The moment calls for caution, provided that the dominance of these technical and psychological factors may leave things even more interesting for patiently-waiting investors.

But it is too naive to think that the market will surge when things start to improve. Price formation has to do with the balance between supply and demand for assets, and not with present results. And some of today’s prices already discount far more than the drop in forecasts for results. Thus, why shouldn’t we act?

What a legitimately scared market considers a loss, we see as an opportunity to exercise one of our very few (if only) but decisive competitive advantages: time horizon arbitrage. For those worried about the coming quarter, half-year or year, the uncertainty that we are witnessing is just unbearable. Not to mention that in true copycat fashion, being sensible now equates to selling at any price. It really seems that the “map” guiding everybody was printed backwards. At the best time to invest, they disappear.

(…)

We are witnessing a very delicate moment for the world. But by looking through the perspective that interests us the most as investors, we may be facing a historic opportunity to buy exceptional assets at very attractive prices. This is usually the seed of expressive compounded returns in the future.

Our proposition as an asset manager is to diligently invest the assets of third parties (and our own too) without being worried about consistently producing, year-on-year (much less month-on-month), the greatest returns in the industry or offer the smallest volatility in the market.

Our goal is to offer high absolute returns in the long- term, above the cost of opportunity of our investors, but always adjusted for the risk we are willing to take. And as our longtime investors know it, our vision of risk is much broader than the idea of “volatility”.

We see in the diligent search for great distortions, instead of leveraging, the best way to seek long-term results with low risk. In Buffet’s own words: “I like to shoot fish on a barrel. But I like to do it after the water has run out.”

Today and during its 20-year existence, IP remains bound by its values of rationality, ethics, discipline and conservativeness. And that is how we are going to manage the company and the funds in these new times, sure, as usual, that in order to arrive first, you need to arrive.

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