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All I want to know is where I’m going to die, so I’ll never go there.” — Charlie Munger
Mr. Munger clearly thought through his mortality and created a clever approach that many would find useful. In applying this principle to some of the biggest obstacles of investing, we look to confront the possible problems with investing in a security and how to manage each of them. I am going to label the largest issues of investing the Ds. The first is debt, the second is drawdowns, and the third is disgust. Let’s start with the one that is the topic of the day: debt.
In financial analysis, there are key pieces of information that help investors understand the ability to pay debt obligations; they include solvency ratios, cash flow and debt service metrics, short-term liquidity ratios, and the capital structure and associated risk factors. All are necessary to make informed decisions on an entity’s ability to pay. From my standpoint, on the debt side, I want to know how much is due, when it must be paid, the size and frequency of the interest due, how much income covers these obligations, and, very importantly, what assets are available or put up as collateral for the debt. As a rule, banks will lend money to creditors when interest coverage ratios exceed 1.25, meaning income will pay whatever is due with a margin of safety of 25% or more. If a business is smaller and has fewer assets, or if it belongs to a highly competitive industry, you want a higher coverage ratio, tending towards 2.0 or greater. If a business has assets like real estate, equipment, or receivables that have not been borrowed against, they may be used to pay off debts, and this needs to be understood as part of the cash flow and liquidity ratio analysis. Just looking at absolute metrics of debt does not tell an investor about the ability to pay debt, or over what period. Understanding the nature of the debt profile of any borrower is a critical factor in analyzing a potential investment.
When evaluating equities, it is important to consider where the price is relative to its historical trading range. In finance, a drawdown is the percentage decline in the value of an investment or portfolio from its highest point (peak) to its lowest point (trough) during a specific period. A good rule of thumb to use is fifty percent, which tells you that in any one year, a stock will fluctuate by about half of its price. I would note that this does nothing in terms of understanding what you are getting for the price you pay. The analysis of why you are paying this price and having a basic investment premise is what matters when considering allocating capital to any asset. Classifying what the competitive advantage is relative to its closest rivals- meaning, is it a low-cost provider, does it have a strong brand, patents, network effects, restricted government licenses or property, etc.- is really what you need to put at the top of mind versus a simple metric like how much am I paying.
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Finally, let’s turn towards disgust. Owning the stock of any individual company is difficult because, in many cases, most of the time the stock will retreat or not move much. If you look at the history of many companies that have earned shareholders tremendous rewards, there have been periods when they fell by large percentages. Examples include Amazon, Microsoft, Apple, Facebook, and Google. As this is the case for the most successful companies, just consider what it might be for smaller businesses that do not possess the strengths that these global champions have built. Most businesses are working towards becoming bigger, more efficient, more profitable, and more valuable. It does not happen in a day, a week, a month, or even a year. It happens over three years, five years, ten years, or longer, and during this time you are going to see the stock go down. It is why having conviction, faith, and trust that the management teams understand what they are doing, and just as importantly, have a large financial incentive to grow the business into a valuable enterprise. Yes, disgust is part of investing, but you must overcome it to reap the benefits of the risk you take when owning stocks.
Spanning the Globe: Europe Burns as Bond Yields Widen Out Across the Pond
Over the last few weeks, protests across the major Western European countries have shown increasing discontent with economic conditions in the region. Much destruction of property took place in high-profile areas of London, Paris, and other major cities in Spain, Portugal, Italy, and Albania. Societal discontentment has implications for national and regional government policy and financing costs for governments, businesses, and citizens. In looking at ten-year bond yields across Europe, they have risen approximately 30-40 basis points in the last month and 70-100 basis points in the last year. Germany is considered the strongest economic country in the bloc, and the ten-year bond yield is 3.50% in that country. France and Italy’s ten-year yields trade at around 4.40%, while Spain’s comes in at 3.90% and Portugal at 3.80%. Greece’s borrowing costs sit at 4.20% as of this writing. As a basis for comparison, US ten-year bond yields are a touch under 5%, but that is a bit misleading, as that yield has jumped about one percent in the last month. I would note the US change is for reasons not related to country protests.
An important question that needs to be asked is related to energy policy in any country. Energy is a critical input in many parts of the economy, so if a country’s energy policy makes it more expensive to do business, it trickles down and will affect inflation numbers and policies related to interest rates. In combination with regulatory policies toward financing and banking, well, one can make the argument that some regions lean more toward self-destruction than constructive enablement.
Europe has long been an exceedingly difficult region for investors to earn higher risk-adjusted returns. Let’s just say it is an economic environment where capitalists are not given priority. A few prominent examples that come to mind include the legal history and treatment of large technology firms in the search and advertising area, as well as the current approach to large energy companies. In case you were not aware, in the UK, the largest integrated oil companies pay a windfall profits tax of 78%, called an energy profits levy, on drilling in the UK or on the UK continental shelf. If you put yourself in the place of an investment firm that manages quite a bit of capital, is this where you would want to own companies?
One follow-up: I mentioned the Brazilian elections in a prior blog post, and how the preliminary result would be a move towards a freer market approach with Lula losing power. Naturally, Lula reversed many years of election results with a surprise, some would say a questionable victory, and that dream of less government and a heavier market-based economy is now gone. Remember that quote about Brazil always being the next great country? Yes, we know why. The Bovespa index dropped 20% the next day.
Y H & C Investments Firm Update- Challenging Month As Tech and Hyperscalers Face Skepticism-
October is historically a challenging month in markets, and this year proved no different. The capital spending cycle related to the artificial intelligence buildout continues to escalate. Investors are looking at the hyperscalers and see debt-related financing building up and are concerned about those with balance sheets unable to support the heavy expenditures with internally produced funds. With this spending comes financing questions across the corporate landscape, and the demand for capital has placed upward pressure on costs. Any interest rate-sensitive sector, especially real estate, housing, automobiles, and leasing, faces higher costs in the debt markets. Looking ahead, the last few months of the year are typically strong for investors. With the mid-term elections taking place imminently, having those in the rearview mirror should be helpful.
With respect to our ownership, large positions in health care, integrated oil, consumer discretionary, and real estate have reported good numbers. Next week will be important as many of our holdings report their results. I would point out that the area that has seen selling across the board is real estate. Companies with excellent leadership and large businesses have been sold off indiscriminately. It puts investors in a tough position, as you are looking at unrealized losses knowing the assets and leaders managing the assets are high quality. The commentary from across the industry is that conditions are improving, with pricing power that will strengthen over the next few years as supply is being absorbed. When you have companies with millions or billions of dollars of unrealized gains on the balance sheet, it means the leaders have created a lot of value for a long time. Currently, there are situations where the market is tossing them away.
Consistent with this idea, for a long time the energy sector has been the market whipping boy. Technology has been the star sector. Over the last year, for any number of reasons, investors have piled into energy, and the group is now viewed favorably, and the whole complex has moved higher. To benefit from the mood shift, you had to be willing to stick with these stocks as they were shunned. I would make the argument that real estate-related holdings are in the same predicament. The question is how long do you have to wait, and is the juice worth the squeeze?
In the small and microcap areas, during October I attended what I consider the two best microcap conferences, LD Micro in Los Angeles and Planet Microcap, this one in Toronto. It was good to catch up with many friends who either run these events, are excellent investors, or are company executives. I had good meetings with several companies where the investment years ago was headed in the right direction from an operational standpoint. Currently, the microcap and small cap areas have been under selling pressure, which is consistent with the broader market sentiment. However, when a business performs, eventually investors notice. I classify my meetings into a few categories. I am really looking for situations where good things are taking place in a business that investors either don’t care about or are not paying attention to. If they occur in larger companies with fifty million or more in revenue and a well-considered capital structure, that is a nice starting point. Often, they are smaller than this, which makes it a more unstable investment circumstance, clearly requiring more caution. I was at an investor dinner where I met another RIA owner who was younger and later introduced him to an executive who runs a company in which we are invested. He asked about the company’s prospects and was interested but then wanted to discuss valuation, which is understandable. I explained to him that what was important was what is going on with the business and any deal or exceptional circumstances that might be taking place. The valuation will change based on how those play out and the kind of inflection that subsequently happens. I don’t think he agreed, but that is what makes a market.
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Interactive Advisors GARP Models-
In October, the Concentrated GARP model had a good month as the holdings were up 6.69%. The result is a little misleading, as the largest position benefited from market speculation that it is being considered for a buyout. It is a massive payment processing company and when you can buy them cheaply good things have a chance of taking place.
In Long Term GARP, the monthly performance was also strong, up 11.50%. Like the concentrated model, the largest position in financial services, a well-known software-as-a-service business, benefited from the capital flows out of artificial intelligence names towards software businesses. Time will tell, as always, for both models.
For more information on the models, click below-
https://interactiveadvisors.com/yhc-investments?portfolio=concentrated-garp
https://interactiveadvisors.com/yhc-investments?portfolio=long-term-garp
Thank you for reading the October update. If you have any investment questions, please reach out to me at information@y-hc.com. I really appreciate your interest and thank you for your valuable time.
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