October – December 2008
January 22, 2009
This large outperformance, relative to the Sensex, gives us no satisfaction – we are in negative return territory with the collateral damage that it does to the power of compounding.
Don Quixote: Dost thou see? A monstrous giant of infamous repute whom I intend to encounter.
Sancho Panza: It’s a windmill.
Don Quixote: A giant! Canst thou see the four great arms whirling at his back?
Sancho Panza: A giant?
Don Quixote: Exactly!
– From Man of La Mancha, Miguel de Cervantes
This was a play that was performed in my old school, Campion. Little did I know that later in life, unlike Don Quixote, when confronting the stock market mirage which makes windmills look like giants, I would hesitate to charge. Armed with cash and looking at dwarf like valuations, surely this must be the time to charge into the stockmarket! Except for one missing ingredient in the perfect recipe – the windmills are working furiously and corporate earnings and cash flows are facing devastating headwinds.
Would not an investor, however, pay a high price when there is a ‘cheery consensus’ that the windmills have stopped working, or better still, have changed direction? Would there not always be a missing ingredient in the perfect recipe – in this case, skyrocketing valuations? What about the folly and futility of timing stock market bottoms?
The simple answer is – I don’t think that we have reached the point of maximum pessimism. The more, well, not complex, but longish answer is that we are hardwired to make probability misjudgments at extremes – a 10% probability is often assigned a zero probability and a 90% probability is confused with certainty. There is such a danger at this point, I believe, of confusing low probability events with impossible events. Furthermore, we are hedged with a decent equity exposure to capture upsides if fears of further earnings downgrades prove to be misplaced and stock prices suddenly run up. For the largely mythical, truly long-term investor, however, there is no question that asset values and capitalized normalized earnings power are going at huge discounts.
Forced sellers are to be found amongst bankrupt banks and hobbled hedge funds. In fact Lord Keynes wrote: “I do not draw from this conclusion that a responsible investing body should every week cast panic glances over its list of securities to find one more victim to fling to the bears.” The sight is not pretty – if this is Lord Keynes’s beauty contest then I need to visit the eye clinic again.
We have added gold ETFs to the portfolio largely as a hedge against 1) financial collapse and 2) the overworked printing presses of the Federal Reserve. The Fed may stave off deflation through frequent sorties on helicopters, but the cost will be the rise of the monstrous giant – inflation. Buying gold ETFs has been an exercise in the realm of Insecurity Analysis rather than Security Analysis!
It is interesting to look at the capital structures of our portfolio companies. Most have modest to no debt. One company that has high leverage has renegotiated its repayment schedules with its bankers and we believe that it will generate sufficient operating cash flows to fight another day. Its equity must be viewed as akin to a long-dated call option. In all cases, there is sufficient asset backing and/or cash flows to justify higher enterprise values than are currently being placed by the markets. But please remember Ben Graham’s advice: “Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience trying experience.”