How to separate the wheat from the chaff

Dear investors,

Each season presents a different challenge for stock market investing. When markets are rising, in a euphoric mood, the risk is joining the general optimism and overpaying for stocks. Especially since the perception of what is expensive or cheap changes slowly when the price of everything rises for a long period. Some less expensive stocks can be mistaken for a real bargain. Today, that's not the difficulty we're experiencing.

Brazilian stocks have been cheap for some time. Few people disagree with this statement, but most still prefer not to buy for fear of how long it will take for the stock market to rise again. We have a different view. We believe that it is impossible to reliably predict trend shifts and prefer to keep our funds' capital allocated to stocks at this time. In any case, the decision to allocate capital to the stock market is less relevant than selecting which companies to invest in. Which brings us to the main question: how to choose what to buy during bear markets?

Looking purely at current prices and comparing them to their historical averages, there are a number of seemingly attractive stocks. However, the macro environment responsible for all the pessimism in the market creates real risks for businesses in Brazil. So, the challenge today is to identify high-quality businesses whose shares have fallen along with the rest of the stock market, but which will withstand the unfavorable environment and continue to generate good results or are well-positioned to capture the market recovery, which will come sooner or later.

There's no definitive answer to how to do this. Each investor develops their own unique practices, even if they follow similar investment philosophies. We'll describe the general principles of the methods we use to select our investment theses.

Screening investment ideas

Finding good investment opportunities is like panning. We need to move a lot of rocks to find a little gold. There are many sources of ideas: mapping companies that meet certain quantitative criteria, newspaper articles, conversations with market professionals, large purchases by insiders (executives, board members, or company controllers), and industry cycles we've tracked over the years. However, there's no quick and easy way to identify good opportunities. When we start analyzing any business, we already know that the chance of investing in it at the end of the process is slim. It's more likely to be a rock than a gold.

Effective work is highly dependent on quickly ruling out bad opportunities. As soon as we identify a business that seems interesting, we check for any major problems. If there are, the thesis can be dismissed without wasting time evaluating the company's positive aspects. There's always the possibility that we're dismissing a good, less obvious opportunity. However, it would be incredibly inefficient to spend the time necessary to be as certain as possible that every thesis that seems bad actually is. What we want to do is invest our finite time studying what seems most promising.

At the same time, we're committed to expanding our knowledge of companies and businesses over the years. Sometimes we find interesting companies that are a bit pricey, or with a specific problem that seems solvable. In these cases, the thesis may not be viable for immediate investment, but it may still be in our best interest to learn about the business so we can act quickly if it becomes a good opportunity in the future.

There's a fair amount of subjectivity in this screening process, enough so that pure intellectual curiosity plays a significant role in defining how we allocate our time. The profession is part practical, part academic. The pragmatism of seeking efficiency in the analysis process coexists with a certain creative anarchy, necessary for us to evolve intellectually and develop investment theses not yet visible to the entire market.

In day-to-day life, implementation is more practical than it seems. Each of us is free to pursue ideas in whatever way we choose, until we identify an opportunity with a reasonable chance of success. We discuss each idea in weekly meetings, and those that seem promising move on to the next stage.

Intermediate analysis

Each economic segment has its own dynamics, which we seek to understand before judging a specific company. The quality of the business category is as relevant as the quality of the company itself. Generally, reasonable companies in very good segments perform better than excellent companies in very poor segments.

The analysis is largely qualitative, based on microeconomic principles. We look for segments that meet important societal demands that are unlikely to diminish over time. Less aggressive competitive environments increase the chance of good returns. Pricing power with customers is desirable to avoid suffering from cost fluctuations that cannot be passed on. Cyclical businesses are not necessarily bad, but if the cycles are very erratic and wide, it can be a problem. Regulatory dependence is a risk, as we know how unpredictable political interference is. In short, the list of things that may be relevant to evaluate is long. The fundamental questions we want to answer are: what makes a business good and what could ruin it.

The challenge with this analysis phase is being efficient in using time, first addressing the factors that are easiest to analyze and have the greatest impact on the business. There's no rule of thumb for how to do this. The process is heuristic, which is the fancy term for quick decisions made almost instinctively based on experience and knowledge accumulated over years of analyzing companies.

Once we understand the sector's logic, we look at the company and determine whether its fundamentals are attractive. We want to invest in chronically profitable businesses that have survived macroeconomic crises without significant difficulties and are well-positioned competitively within the industry.

If the business looks good, we move on to form a preliminary opinion on its intrinsic value. Estimating a company's value as accurately as possible is laborious, but having a rough idea of the reasonable value range is relatively quick and sufficient to judge whether the current share price has a good chance of being attractive.

The compilation of these qualitative and quantitative analyses is presented for discussion with the entire management team, and we decide whether it makes sense to approve the thesis for the final stage, which involves a much greater dedication of time.

Detailed analysis

The theses we decide to examine in detail already have a reasonably high level of quality. The scenario in which the business would be successful and generate a great return on investment is usually already clear, but we don't yet have a well-formed opinion on the likelihood of it materializing. There's a bias toward focusing only on the desired scenario and seeking arguments that reinforce its rationale (confirmation bias). This is dangerous, because it's not the plausibility of the success scenario that makes a good investment opportunity; it's the improbability of the company's success plans being thwarted by some risk factor.

Mapping and thoroughly understanding the risks inherent to a business is the most complex step in the analysis process. There's an academic line of thinking that argues that the risk of investing in a stock can be measured by the volatility of its market price, but we believe this method is simplistic and insufficient. Business risk isn't reducible to a simple quantitative measurement, as it encompasses the entire spectrum of possible future scenarios in which the company would suffer permanent damage.

The concern with process efficiency, which existed until then, ceases to be important at this stage. What we want is to minimize the risk of error, even if this involves redundant analyses, digressions in studies, and lengthy philosophical discussions. We can spend months studying a company until we reach the level of knowledge we deem adequate to make a decision, or until we conclude that this adequate level is unattainable and give up on the opportunity, recognizing our ignorance.

As we deepen our studies, we seek to identify issues in the thesis. There are always risks, and we want to prevent any from going unnoticed as much as possible. After mapping, we select those that could have a significant impact on the company's intrinsic value and consider the likelihood of each one materializing. The process involves several analyses, discussions, and reflections until we reach a consensus on whether the business's risk level is tolerable or not.

It's also critical to thoroughly analyze the company's competitive environment, paying particular attention to its competitive advantages compared to other companies in the sector and how sustainable these advantages are (the famous "moat"). Companies in a highly favorable competitive position have an easier time. They attract the best professionals, can raise capital more cheaply in the market, and withstand pressure in negotiations with suppliers and customers. This is exactly what we want: to invest in companies that won't face major difficulties.

In parallel with the qualitative analysis, we work to estimate the intrinsic value of the business (valuation). This involves developing financial models with cash flow projections, simulating various scenarios, identifying the variables that most impact results, and refining our understanding of how these variables may behave in the future. Although the calculations are accurate, the result of this process is far from precise. Ultimately, what we have is a range of possible future values, distributed around a mean that we use as a value benchmark. The range of variation around the midpoint also matters, as the attractive price for us is one that is below the estimated future values for the vast majority of simulated scenarios. The difference between this attractive price and the midpoint of the value estimates is what we call the margin of safety.

In general, the entire management team ends up getting involved in the analysis and discussions of the theses that reach this final stage. It might not be necessary, but it's almost inevitable. The most interesting theses naturally arouse more curiosity, and the desire to get involved is reinforced by the fact that we all have a large portion of our personal wealth invested in our equity funds.

Investment decision

Once the evaluation cycle is complete, there are three questions we need to answer: i) would we like to own shares in the company? ii) what is the limit price we are willing to pay? iii) what percentage of the fund's portfolio would we like the thesis to occupy?

The basic logic for answering the first two questions is the same as that for purchasing any product. Whether you want to buy or not depends almost exclusively on whether the product meets your minimum quality requirements. The maximum price depends on how much you value the product, based on your assessment of its quality. What makes the investment decision more delicate is that assessing quality and value is much more laborious, the amount of capital involved is large, and there are thousands of other investors trying to make better decisions than you. You can only buy what someone else is selling, and one of you is wrong in your price assessment.

Determining the weight of each thesis in the portfolio is a problem more specific to investments. We consider three elements: the relationship between potential gain and potential loss for each thesis, the absolute amount of capital we are willing to expose to the risks of each company, and our degree of confidence that our investment decision is correct. The principle is to maximize the relationship between potential gain and potential loss while maintaining prudence in risk management.

Our decision-making process also involves some formalities that ensure discipline. Once the analyses are complete, we hold a long thesis debriefing session. At this stage, everyone is well-informed about the business, and several informal discussions have already taken place. Even so, we see value in reserving a few more hours of undivided attention for a well-structured general review. Once this is done, we write a memo summarizing the business's main characteristics, the most relevant risks, a valuation view, and a recommendation for action. The entire team reads the memo and provides comments. When necessary, we hold further discussion sessions. Finally, we prepare a final version of the memo with the practical decision to invest or not, at what price, and up to what percentage of the portfolio.

We're not fans of bureaucracy, but in stages where the cost of error is very high, establishing protocols helps prevent the human mind's tendency to ignore details when the general perception is that everything is fine. The practice of summarizing complete reasoning in writing also improves decision-making quality. Writing enhances logical reasoning skills, just as doing calculations on paper enhances your mathematical ability. As a bonus, having written records of the analysis process and decisions allows us to evaluate past decisions and identify areas for improvement.

We believe that good investment decisions depend on good people implementing good methods. We focus on the quality of decisions because the return on each individual thesis is a poor measure of an investor's competence. There are rational and prudent theses that yield negative returns, and there are irresponsible theses that yield excellent returns, due to the random factors of the business world. However, we believe that achieving good returns over long periods depends more on skill and discipline than on luck.

Note that our stock selection method is organized quite simply. Over the years, we refine one point or another in our daily activities, but there are no great mysteries to the activity. There are several goals in life that can be achieved through simple, well-known methods, if executed with great discipline. We like practices like this: simple and effective.