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Intelligent Investing Newsletter 5/18/2018

Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community.
— Warren Buffet, chairman's letter, Berkshire Hathaway annual report, 1986

 

We hope that the sound of this drum has not completely worn out in your ears.  It has been a difficult environment to exercise caution.  With strong gains in the indexes last year, and a fairly resilient market so far at the first half of this year, the patience of investors are truly being tested.  We would like to speak on a few principles that I hope keep you grounded in our process. 

 

1.    If being patient and contrarian was easy, it would not be hard

Upon first reading, this statement borders on insulting our common intelligence by too blatantly stating the obvious.  It is in the most plain of statements though that often form a platform on which understanding can be built.  Markets behave the way that they do because of their ability to persuade and influence participants into group thinking and herd mentality.  If they were ineffective at getting large numbers to think and behave the same, they frankly would not be dangerous. 

 
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Excess expressed either in fear or greed would be curbed by independent thought.  However, through media and obsession with reference points (think index returns) large swaths of people become galvanized around the same central “facts.”  These facts or rather confidence in one’s handling of these facts shape behavior.  Behavior armed with confidence becomes resilient behavior as group thinking creates a self-fulfilling prophecy.  During these times, competing concerns are marginalized, and caution is looked to be synonymous with ignorance.  This phenomenon in investing is the very reason markets swell and fall with such volatility.  To truly be insulated in thought and to not be moved by this growing force is extremely difficult and necessary for a prudent investor.  Again if it was easy to do, than independent thought would keep markets fairly balanced.  Balanced with respect to pricing of both opportunity and risk. 

 

2.    The Role of an Investor

Dovetailing off of the prior point, let’s highlight the role or mindset of an investor.  It is to see the pricing of both opportunity and adverse circumstance in a security or an investment and move when opportunity is mispriced (risk is low).  This is misunderstood by most.  If something goes up, this does not tell you whether or not someone did a good job in pricing risk.  The analysis is upon the price paid and the outcome received.  This distinction is difficult but needed to win long-term and to stack the odds in our favor. 

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Consider a pair of dice.  Let’s use some basic odds and this metaphor to flush out this concept.  The chance of rolling a 4 and a 4 also known as a hard 8 is 1/36 likelihood.  There are 36 possibilities on a pair of dice and this combo is 1 of those 36 occurrences.  This is in contrast to say rolling a 7 which has 6 of the 36 occurrences (highest probability).  Now let’s say someone wants to pay us different amounts or multiples based on a hard 8 being rolled.  We lose if it is the other 35 occurrences and we win if it is this one occurrence.  Now many would say, I would not bet any amount of money on that because the odds are so low.  Well I could certainly understand and do not encourage gambling, but for our purposes, realize that it is the price of the payout that determines the rational choice.  Said another way, we would want to only place money on this particular role when we are compensated well above the odds of its occurrence. 

So sticking with our example, if someone says they will pay you three times the amount you put up, your answer is a resounding “I’ll pass, but thanks!”  Four times or even seven times the amount you put up and you should still pass.  You see the expected value of your bet of say $1 is $.09.  In order to make this attractive you need a payout that exceeds the odds.  In our example you need at least 10 to 1 payout before you are interested.  The more the payout goes above 10 to 1 the more attractive the bet and the larger the margin of safety.  Your expected return climbs is positively correlated to the payout multiple.  In fact at certain multiples you don’t need that many wins at to offset and more than compensate for the risk of loss.

Now in investing, the payout is not represented in hard line numbers like this, but rather in the number of future year returns you’re willing to pay in today’s dollars.  This is measured through price multiples.  As a review, a business at the end of paying for everything it needed to sell a product or service has a sum of money left over.  This sum of money is known as net income.  Now because the company is owned by shareholders, this net income is spread across all owners giving a unit of profit for each shareholder.  A share price of a stock, as it follows, is nothing more than a multiple of this profit.  Stock with $1 in net income and is trading for $20 is trading for twenty times last years income.  If someone is excited about your business, economy, future are short-term hype, they will pay you different multiples on your most recent results.  Now other times, if they are concerned for the business, economy, or negative sentiment, then perhaps they will only pay 10 times last year’s results. 

With this said, a conservative person, would want to take into account last year’s results as relative to other years results at the business.  If last year’s results were record results.  If last year’s results had favorable tailwinds in every aspect of their business: labor, transportation, raw materials, taxes, and credit.  Well… paying a high multiple would assume that none of those tailwinds turn into headwinds.  This would require a very high level of visibility to the future.  This could invite a lot of risk.  A high multiple on record results would truly lower the payout multiple a lot.  We could still get a nice return but likelihood of loss or impairment has increased dramatically.    

Investing should only be moving money into companies or investments when odds are heavily stacked in your favor.  Now every investment will not work out in a short period of time.  You might not roll a hard 8 for a while even if you’re getting paid 15 to 1.  However, consistent high probability placements of money will pay off over time. 

 

3.    Fearful When Others Are Greedy; Greedy When Others Are Fearful

This brings us to the last point.  We are not market timing at Criterion.  We are simply looking at the marketplace each day and looking for pricing that stacks the odds in your favor.  We do not care so much that a security goes up or down over this last year, but how consistently we can find investments that offered an entry point that provided a large margin of safety.  Meaning we underpaid for opportunity and thereby lowered the risk of loss and impairment.  If we can stack up 20 to 30 of these opportunities every couple of years, we are going to do well for our clients over the long-term.  Different season of the market will test this resolve more than others.  Certain season will price out risk adverse investors.  Over the course of a market that began a recovery nearly 9 years ago, this testing season is certainly upon us.  Lots of excess money has been sloshing around looking for any inefficiency in pricing.  Once those investments were exhausted, the money flooded into the areas already saturated in a final push to drive markets higher.  This much we are confident, this is not a fearful market made up of calculated cautious risk takers. 

This run up is in step with a market that has become more and more galvanized to one another through the use of index funds.  We believe that systemic risk is in the marketplace because of wide-spread adoption of these index instruments.  People’s ease of access to trading, daily monitoring, and obsession with index results daily, is not helpful nor does it build confidence in seeing future rational selling when business conditions turn.  Adding to this, household debt is back to 2007 records, corporate debt to GDP are at record highs, multiples on earnings are tied for record highs (on a cyclically adjusted basis are at levels only seen once before), corporate margins are at record highs, monetary stimulus has been green lighted for 10 years through record amounts of central bank lending, fiscal debt to GDP are at levels not seen in peace time era, and we are perhaps going to start seeing input pressure on materials, transportation and labor.  All these factors we list not to strike fear but to put into balance the odds we are being offered to participate in a late stage credit cycle. 

We are looking to put money to work eagerly, but not foolishly.  After 9 years, it can be difficult to recall the frame of mind when everything is bleeding red on every asset class.  Fear, panic, cash at any cost, quickly becomes group thinking almost in an instant.  All the headlines start highlighting the troubling stats that no one wanted to hear when times were good.  During those times the same clients that were pressing to get more and more in the market, they are sending emails asking for cash to be held in their account, “because you just don’t know where things can go from here.”  Patience and process is key.  We will own wonderful companies at prices that provided a margin of safety.  We will end up backing up the truck when others are counting their losses.  It takes time and discipline, but as we said before, if it was easy than it would not be difficult.     

 

-Zachary P. Herbert

CFA, Chief Investment Officer