Adapting in the age of disruption

Staying the (misguided) course can be dangerous

We can ignore reality but we cannot ignore the consequences of ignoring reality”
– Ayn Rand

Last year was a tough one for investors, particularly the fourth quarter. There was virtually nowhere to hide. Unless you held cash, you likely experienced declines in annual returns. Although it always feels like an unusually difficult year when one is actually living through it, statistically speaking, from a long-term perspective, last year was perfectly normal. Here’s our take on the new normal and the need to adapt.

We began our 2017 year-end commentary 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 Mr. Market 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 noted 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 being disrupted.”
– 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 and 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 leap forward.

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 Pender blog. Used with permission.

Notes and Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.