Hail Cash, for Cash is King!

In Fortress Balance Sheets, I talked about how my Aston Martin adventure has taught me that leverage is "the most dangerous gift in finance". In this unusual crisis, however, I am learning not only about the perils of leverage, but also the importance of cash. 

I now realise that it is valuable to have what may, in the normal course, be considered an obscene amount of excess cash. Several companies (e.g. Booking Holdings, which owns OTA Booking.com) are likely to see their revenues hit zero (note that this did not happen even in GFC). Such firms will still incur fixed costs as well as those variable costs, which cannot be cut quickly. So, firms will lose a lot of money. A strong net-cash balance sheet position allows a firm to comfortably weather this storm, without being forced to permanently dilute equity holders. And, perhaps most importantly, having an abundance of cash heading into a downturn can allow a firm to invest aggressively for the long-term at a time when a lot of other firms are fighting for survival. This is why, Facebook's USD 50 billion cash pile no longer seems excessive when you consider that the firm could potentially lose 25 billion this year alone.

Cash piles that seemed ridiculous only three months ago now seem anything but; so-called "excess" cash is now evidence of management's prudence. 

Fortress Balance Sheets

The most dangerous gift in finance is leverage. Over the last five years, I have frequently read, heard, or written words to the following effect: 

Excessive debt is a red flag. On the stock market, credit yields fantastic results if you are right, but produces equally destructive, leveraged losses if you get it wrong. So, leverage magnifies upside; BUT, it also magnifies downside.

Amidst the coronavirus turmoil, I have finally learned this from a first-hand experience as I have exited my investment in Aston Martin (at a notable 42.5% loss). One of my favourite adages says "When you don't get what you want, you get experience". And I have every intention of making this experience count. So, in this post, I will detail my experience and reflect on what I have learned.

Aston Martin Lagonda - the journey

My investment thesis was simple and I still believe each of the following is true.

- AML is a heritage brand with a notable following.
- Company has invested in good products, and is launching one new car per year.

- Exclusive specials, F1 participation, and mid-engine cars will elevate the brand.

- SUV (the DBX) broadens appeal, and should increase volumes.

Then why exit? One word: LEVERAGE. 

Aston Martin is a highly levered company (even after factoring in a recent rescue investment by Lawrence Stroll and the upcoming rights issue). When I invested in AML, I was aware that leverage magnifies the upside and the downside; but, I was mostly focussed on the upside, because the stock had been cratering, and the company looked incredibly attractive. 

However, despite believing in the long-term story, I am unsure whether Aston can survive amidst the challenging climate of the covid-19 induced economic disruption. As it shuts factories, revenues will fall, losses will grow, and the business will be pushed closer to the brink of default and bankruptcy. Equity holders can potentially get wiped in such a scenario. This is why I chose to sell my shares in AML and invest the proceeds in a compelling business with a far stronger balance sheet.

So what lesson did I learn from this experience?

You need a FORTRESS BALANCE SHEET, because it can allow a firm to weather a storm. I have taken an edited excerpt from a previous post to explain my thinking in more detail.

Risk = (Hazard x Vulnerability)/Capacity to Cope. This allows us to distinguish between a hazard or bad event and the factors that determine the level of risk posed by this event. A strong company, by which I mean one that is not using performance enhancing drugs (leverage), has a higher capacity to cope with a bad event, and may even be less vulnerable to a bad financial event. And, because bad things happen to good companies (all the time) a fortress balance sheet is non-negotiable.

I once said, "Predicting rain doesn't count, but carrying a coat does". To me, maintaining a fortress balance sheet is the equivalent of carrying a coat. In fact, a strong balance sheet is more than just a protective coat; it is also a weapon. A company which has a strong balance sheet will likely outlast a levered competitor and so will benefit from the levered company's demise. Furthermore, having cash on hand (or at least favourable access to capital markets) can allow firms to strategically acquire businesses that are on sale. So, a fortress balance sheet allows companies to bounce back stronger than they were before the crisis.

As a result of this experience, I am particularly sensitive to the importance of a solid balance sheet. I hope never to repeat my mistake of investing in a highly levered business. In good times I might end up seeming a stubborn fool; but, when the tide goes out (for it inevitably will), I don't want to be caught swimming naked.

And the crisis came.

This post has been a long time coming (the terrible pun was, of course, intended!).

"Sooner or later, bubbles always burst."

Last year, a good friend generously gifted me a copy of The Return of Depression Economics by Paul Krugman. In his accompanying note he reflected on the ‘historical insight and broader application’ captured in this marvellous book. Well, I’ve finally got around to reading it, and I couldn’t have put it better myself; the book is quite simply chock-full of ‘historical insight and broader application’.

In my post, I will attempt to capture some general principles and recurring themes pertaining to financial markets and investing. I will inevitably do Krugman’s rattling good book a disservice; but here goes…

#1 We keep reinventing the wheel.

People in finance keep on reinventing the wheel. I think there might be a pattern here: repackaging leads to enlivening – and a deathly ignition. We renamed the ‘third world’ as ‘emerging markets’ to make it sound more attractive to invest in. And we renamed ‘junk bonds’ as ‘high yield bonds’ for the same reason. And because words have power this rebranding drove up the relevant assets’ prices. The problem is that “the good opinion of markets can be fickle” because “today’s good press doesn’t insulate you from tomorrow’s crisis of confidence”. When tides turned, the former was – at least partly – responsible for the Asian crisis, and the latter ended badly in the US in 1989. People invent new, fancy jargon, hailing a good idea as the new genius rainmaker, only to rediscover that credit is credit – and risk is risk – regardless of what it is called. Similar things have happened repeatedly in history, and there is no doubt they will happen again.

#2 Moral hazard abounds.

“Modern nations...cannot find it in their hearts to let widows and orphans lose their life savings simply because they put them in the wrong bank, just as they cannot bring themselves to stand aside when the raging river sweeps away houses foolishly built in the floodplain”. This creates the expectation that governments will guarantee depositors’ money, and creates a situation of moral hazard. This sets in motion an obscene chain of events, which guarantee that the government will ultimately have to deliver on this promise, whether explicit or implicit.

#3 Bad things happen to good economies (all the time).

Risk = (Hazard x Vulnerability)/Capacity to Cope. Or at least, that’s what I was taught. Why is this relevant? Well, it distinguishes between a hazard or bad event and the factors that determine the level of risk posed by this event. A strong economy, by which I mean a fundamentally sound economy (and not one that is on a euphoric credit-binge, or which is overwhelmed by a false sense of indestructibility), has a higher capacity to cope with a bad event, and may even be less vulnerable to a bad financial event. However, if the event is significant enough, in terms of magnitude, then it can still wreak an incredible amount of havoc. This is why “bad things can happen to good economies”.

#4 Be wary when people say this time is different. It rarely ever is.

Just when a recession starts seeming like an impossibility, that is when it is most likely to strike “out of a clear blue sky”. As I mentioned in my post based on A Short History of Financial Euphoria, a sense of progress brings a (justified) sense of optimism. And then, even the most sensible investors (quite literally) sell their brains, unable to take a long view when everyone around them is getting rich. What once started as insightful optimism is transformed into mania – or as Krugman puts it, “hype springs eternal, and people [become] willing to suspend their rational faculties”. This is when people, having forsaken reason, start spouting nonsensical explanations for why this time is different. At this point, there is too much money chasing too few deals. Well, that is when you know a crisis is coming. Reality, time and time again, has shown that “all financial crises tend to bear a family resemblance to one another”.

#5 Because believing makes it so.

If people expect a recession and so consume less, other people earn less. So, they may be unable to make interest payments on existing debt, let alone borrow more money. And because one person’s spending is another person’s income, this would have a ripple effect. This deleveraging is part of the credit cycle. 

Similarly, a loss of investor confidence, results in falling asset prices, and falling liquidity. As losses mount, confidence falls further, and all the air can go out of the bubble. This can be particularly acute due to margin lending. The quantitative strength of the feedback loop matters.

This is why Krugman explains how there are panics and then there are panics. Sometimes a panic is just a panic: an irrational reaction on the part of investors that is not justified by actual news. Much more important…however, are panics that, whatever sets them off, validate themselves – because the panic itself makes panic justified. He later goes on to reiterate that “When an economy is vulnerable to self-validating panics, believing makes it so”.

#6 Permabears all over the place!

Paul Samuelson once quipped that declines in U.S stock prices had correctly predicted nine of the last five American recessions. I personally like to replace ‘declines in U.S stock prices’ with another phrase: ‘so-called experts’. You might think that this must make people risk-conscious – and if you do, you would be wrong. Because “ever since the 1930s there have been people predicting a new depression any day now; sensible observers have learned not to take such warnings seriously”.

Not only do permanently bearish, ominous statements become impotent, they also lead to bad decisions. People might justify being a permabear by saying “better safe than sorry” but, in the long run, they will just be left feeling stupid – and sorry. That is not to say that we should be blindly optimistic. Quite the opposite: investors must seek to be optimistic whilst approaching everything with a healthy dose of skepticism.

Expert Opinions: Signals vs. Noise

Today, when I read the news or browse through social media, I notice a deluge of confident expert opinions and ‘scientistic’ forecasts (too readily) available in our information age.

This is why I am fascinated by the reliability — or lack thereof! — of expert opinions and forecasts. This interest was further developed through my IB Theory of Knowledge presentation, which explored the extent to which it’s possible to make reliable economic predictions. I learned that we frequently derive false security from precise numerical forecasts, which are often based on data that can be conveniently measured rather than the most important parameters (which might be difficult or even impossible to measure).

Hayek’s speech titled ‘The Pretence of Knowledge’ further led me to conclude that economists can make directional predictions, not precise forecasts. Hans Rosling’s Factfulness even describes a quiz in which chimpanzees outperformed so-called experts. I learned that forecasts reported in the media are often made by overconfident pseudo-scholars — and even when made by a genuine scholar, forecasts are still bound by any model's limitations.

Yet thoughtfully developed predictive forecasts remain important for effective decision-making, which (particularly in the investing world) requires an implicit consideration of a necessarily uncertain future. Experts’ analytical, frequently imaginative statements about the future are powerful tools that allow us to build models and glimpse through a translucent lens into a potential future.

During my exploratory journey in the world of value investing, I have learned that investing requires us to distinguish meaningful signals from the cacophony, generated by experts and media pundits and amplified by social media, surrounding the global economy. I am certain that our ability to separate the wheat from the chaff — or, more appropriately, the signals from the noise — is what will determine whether or not we are able to generate alpha over a long period of time. 

As I once said Leave it to the Experts (Don't)!!!

Howard Marks' Latest Memo: You Bet!

I have read pretty much all of Marks' memos, and this one is one of the best yet. The key implication for (equity) investors, if I understand correctly, is that a great businesses can be a poor investment at the wrong price, whilst a terrible business can be a great investment at the right price. Instead of trying to identify winners, we must seek to identify - and capitalise on - 'mispricings'.