In the latest post of our series on IP’s reports, we discussed the current investment environment in the Q4 2009 letter. We liken the current optimism and false sense of security to the sensation some visitors to the Yellowstone National Park feel: they’re awed by the place and how beautiful it looks, but forget or don’t know that a large area of the park is in the very crater of one of the world’s largest super-volcanoes.
It was also in this report that we first mentioned Buysiders.com to our clients, and we hope you all enjoy it.
In the “part 1″ we will highlight excerpts from the “Introduction” section of the report. Look for “part 2″ by Monday.
Q4 2009 report excerpts, part 1
“INTRODUCTION”
After a weak 2007 and a very bad 2008, we were pleased with 2009. Although the adjectives are in line with market behavior, as Neil Young says in one of his best-known songs, “Hey, hey, my, my (rock n’ roll can never die)“, “there’s more to the picture than meets the eye“. The restructuring of the research and management team – carried out in 2H 2008 – and, consequently, of the portfolios has been consolidated. The improvement in results, both from the quantitative and, more importantly, the qualitative point of view (addressed in the Q4 2008 report) has continued.
(…) In 2009 we had a good absolute and relative result, in a positive year for the market, when we usually have a good absolute performance but a bad relative performance. Above all, though we are very cautious and concerned regarding the market, we are very sure that we are doing the right things. As we stressed in the Q1 2008 report, we have no control over short-term returns, but we can and should control the investment analysis and management processes. Over time, the processes define the results. If we’re not yet where we would like to be in this sphere (the pot of gold is always at the end of the rainbow…), we have at least the conviction that we are evolving in the right direction.
Merge!
(…) a recurring event has been the participation of companies in our funds’ portfolios in large M&A transactions. Recently, Saraiva has acquired Siciliano, Itaúsa has acquired Unibanco (not to mention the Satipel and Porto Seguro deals), Odontoprev has merged with Bradesco Dental, and Totvs has acquired Datasul. At the other end, Globex was sold to the Pão de Açúcar Group. In the international front, InBev has acquired Anheuser Busch (Budweiser) and Berkshire is acquiring Burlington.
Two factors make this observation worthy of greater consideration.
In the first place, we have the historical observation that transactions of a “transformational” nature are risky.
If we take a broad universe of companies, there are many bad results. Daimler/Chrysler and Time-Warner/AOL are cases that spring to mind immediately as perfect examples of what may not work. On the other hand, the overall record of what Itaú and AB-InBev are today shows that we should not reject all operations of this nature a priori.
A positive indicator that seems to us to keep a good correlation with the transaction’s result is when the party that takes the initiative does so from a strong position, with a positive growth agenda. In these cases, it makes a difference to be at the right end. Even though there is usually a “premium” in relation to the acquired company’s recent stock prices, it rarely compensates the long-term investors who have “held the ice cubes in their hands”. It becomes a matter of timing, and it is not by chance that this is the category in which traces and evidence of insider trading are most commonly found.
In the opposite situation, “shotgun weddings”, where two weak parties that are under threat join together, usually lead to worse results.
Another potentially negative case is when large “depersonalized” corporations with weak governance end up being oriented, in practice, by their bankers and advisers. In such cases, what we end up seeing is an apparently unending series of senseless transactions with no effective “buy-in” by executives, generating progressive value destruction.
Another point is that in the great majority of banks’ and brokers’ reports that we see, and that are possibly the main drivers for price formation in the short term, the detailed models rarely incorporate the possibility of value destruction. The argument is that it is obviously an issue that “cannot be modeled properly”. But as we never tire of repeating, “unquantifiable” may be completely different from “irrelevant”.
How can one quantify a good management that knows how to select good alternatives and abandon those that are attractive but whose price cannot be justified (as in the case of Renner/Leader), and then efficiently manages the always difficult integrations? Our answer is that each case is different from the next one. We do (very simple) simulation exercises in order to have a range of potential values, and we invest most of our time in getting to know and understand the logic and the real incentives that motivate the managers, and the competitive market conditions within which the companies participating in the transactions operate; how the idea for the transaction arose and evolved, who their advisers are, and other qualitative factors. It is better to be approximately right than precisely wrong.
Dividends vesus Bonds
An interesting issue for those who believe in efficient markets was the situation between shares and bonds issued by high-quality global companies observed during a good part of 2009. Joseph Stiglitz, a Nobel Economics laureate, in his address to the annual meeting of the American Economic Association at the end of December 2009, fired a heavy attack at his colleagues who create models that depend on the assumption of rational behavior, when the real world insists on not fitting into this mold. During the 2H of 2009, many investors tried out their return to the markets (as they received redemptions from hedge funds or got tired of returns close to zero yielded by US Treasury securities), buying bonds.
At the height of the crisis, there were moments when fixed-income securities issued by some low-quality companies were traded at prices that seemed very low to us, but as the year advanced, that was no longer the case in most of the market.
When doing our calculations in the second semester, we could not understand the market’s logic. In several cases, the dividend yields on stocks were very close to the yields on bonds (obviously taking care to include only companies with the capacity to continue paying dividends in the future). Usually, dividends are relatively lower for the following reasons:
- Bonds and stocks have 100% downside.
- Bonds usually pay coupons and redemption of the principal in a given currency, fixed beforehand. On the other hand, the revenues and results of companies are generated worldwide, and the respective dividends are defined a posteriori. As there is usually a “desired” inflation rate in the systems, the current yield on the stocks of sound, growing companies should be lower, in terms of present value. In the present case, for those concerned about an acceleration in US inflation in the course of the next few years (as we are), at similar current yields, stocks of companies with quality businesses are relatively even more attractive. Obviously, the opposite reasoning applies to the hypothesis of deflation.
- These companies pay out less than 100% of the profits for each financial year in dividends. The remainder is reinvested in order to generate increasing profits and dividends (while bond coupons are fixed).
In fact, shares of companies like Coca-Cola, Nestlé and Procter & Gamble appreciated well, and part of what seemed a distortion to us was corrected. But only part. Our philosophy cannot be reconciled with long-term fixed-income securities that carry fixed yields in dollars at the present levels, nor with stocks of high-risk companies at prices that imply optimistic scenarios that are not based on our vision of the world. We prefer to have cash or stocks of companies that are capable of generating cash, even in the most adverse scenarios, and that are trading at reasonable prices. Our experience is that even if there is zero return for some time, when opportunities finally appear, the returns more than compensate for the wait.
Tags: ipreports, report, riskmanagement, yellowstone
