We began our 2017 year-end
with a quote from Morgan Housel: “Since 1871, the market has spent 40% of
all years either rising or falling more than 20%. Roaring booms and
crushing busts are perfectly normal,” which turned out to be unintended
foreshadowing. We hoped we would not get our teeth get kicked in,
but it happened anyway. At least temporarily. Market swoons are inevitable.
When that happens, investors need to channel their inner Kenny Rogers:
“You’ve got to know when to hold ’em, know when to fold ’em....” After all,
your lifetime results as an investor will be mostly determined by what you
do during such turbulent times.
While we worry a great deal about the risk of permanent capital impairment,
we don’t take quotational losses too seriously when we believe the
fundamentals remain intact. Students of market history know that
has a long recurring history of manic-depressive behaviour, where he
suddenly changes his mind and becomes desperate to unload his holdings at
fire sale prices. This is perfectly normal.
Unfortunately, his moods swings can be super contagious. As a result, it’s
hard to resist herd behaviour and follow the crowd. As
in the midst of the panic, it pays to keep in mind the timeless adage,
“this too, shall pass.” Indeed, that truism held again. Since the year
ended, Mr. Market suddenly seems to be in a much better mood, and stock
prices have recovered to pre-correction levels in many cases.
The volatility driven by extreme fear in the fourth quarter had little to
do with long-term fundamentals in our view. The most important thing for us
was to maintain an even temperament and look for potential opportunities as
dispassionately as possible. This is easier said than done. If you are
wired like most folks (including us), your gut will tell you to get out or
at least reduce exposure to avoid further pain. But your gut would be wrong
in many cases. In his classic book One Up on Wall Street, famed
investor Peter Lynch offered this piece of advice: “The trick is not to
learn to trust your gut feelings, but rather to discipline yourself to
ignore them. Stand by your stocks as long as the fundamental story of the
company hasn’t changed.”
Value traps in the age of disruption and the need to adapt
“How did you go bankrupt? Two ways. Gradually, then suddenly.”
– Ernest Hemingway,
The Sun Also Rises
“I’m a terrified dinosaur… I’ve been living in this cozy world of old
brands and big volumes. We bought brands that we thought could last
forever and we borrowed a lot of cheap money because money was cheap …
You could just focus on being very efficient… All of a sudden we are
– Jorge Paulo Lemann, Co-founder of 3G Capital (April 2018)
We are increasingly cognizant of how today’s age of disruption can impact
value creation and the investing process (see prior commentaries
here). There is no question that embracing change, taking risks, and having the
courage to use today’s mature cash flows to fund new opportunities is not
easy. But staying the (misguided) course and maintaining the status quo may
be even more dangerous.
Defensive sectors that have historically been immune from disruption have
been hit hard in the markets, with many stocks tumbling as management team
after management team slash their respective outlooks. Steady-state
strategies focused on operating efficiency, financial leverage, and milking
cash cows made sense in a declining interest rate environment and where
there were minimal outside threats. That world no longer exists. Indeed,
many investors are finding that yesteryear’s “defensive stocks” may be just
as effective as France’s infamous Maginot Line in World War II.
Firms that have been mortgaging their legacy moats to fund dividends and
share repurchases while starving their business of innovation and marketing
are now paying a heavy price. We believe change is likely to accelerate.
Old business models are dying, usually slowly at first, and then suddenly.
On the other side of the disruption, new business models are displacing old
ones, slowly at first, and then suddenly. These are related themes, as
profit pools shift from legacy moats to new customer-centric business
models that are enabled by technology. These are uncertain times for those
unable to adapt, but exciting times for those who successfully take the
We look for founders and business operators who are adapting and willing to
reinvent themselves periodically. Likewise, we expect to adapt as well. Now
that markets have normalized into a more tranquil state, we are once again
looking for “needles in the haystack.”
However, in our view it is increasingly apparent that the best “needles”
are no longer found in the same haystacks of the past. When asked recently
why many traditional value managers have been struggling, Charlie Munger,
the vice chairman of Berkshire Hathaway Inc. and Warren Buffett’s long-time
business partner, humorously observed that they were “like a bunch of cod
fishermen after all the cod’s been overfished. They don’t catch a lot of
cod, but they keep on fishing in the same waters. That’s what’s happened to
all these value investors. Maybe they should move to where the fish are.”
What a novel idea! To increase the odds of success in a fast changing
world, one needs to embrace new ways of thinking and just as importantly,
discard old mental models when they no longer apply.
Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management.
He works alongside David Barr, Pender’s President, in setting the
direction of Pender’s overall investment strategy. This article first
appeared in the
blog. Used with permission.
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