Dear investors,
Each season presents a different challenge for stock market investors. When markets are on the rise, in a euphoric mood, the risk is to join the general optimism and pay too much for stocks. Especially since the perception of what is expensive or cheap changes slowly when the price of everything rises over a long period. Some less expensive stocks can be mistaken for a real bargain. Today, that is not the difficulty we are experiencing.
Brazilian stocks have been cheap for a long 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 not possible to reliably predict trend inflections and we prefer to keep the capital of our funds allocated to stocks at this time. In any case, the decision to allocate capital to the stock market is less relevant than the selection of which companies to invest in. Which brings us to the main question: how to select what to buy during low seasons?
Looking purely at current prices and comparing them to their historical averages, there are a number of stocks that appear attractive. 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 is no set answer as to how to do this. Each investor develops his or her own particular practices, even if they follow the same investment philosophies. We will outline the general principles of the methods we adopt to select our investment theses.
Screening investment ideas
Finding good investment opportunities is a kind of mining activity. 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 that we have followed over the years. However, there is 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 minimal. It is more likely to be a rock than a gold.
Effectiveness is highly dependent on quickly ruling out bad opportunities. As soon as we identify a business that looks interesting, we check to see if there are any major problems with it. If there are, the thesis can be dismissed without spending time evaluating the company’s good side. There is always the possibility that we are ruling out a good opportunity that is not obvious. However, it would be too inefficient to spend the time necessary to be as certain as possible that every thesis that looks bad really is bad. What we want to do is invest our finite time studying the ones that seem most promising.
At the same time, we are concerned with expanding our knowledge about companies and businesses over the years. Sometimes we come across interesting companies that are a little expensive, or have a specific problem that seems solvable. In these cases, the thesis may not be viable for immediate investment, but it may be in our interest to learn about the business anyway, so that we can act quickly if it becomes a good opportunity in the future.
There is a good deal of subjectivity in this screening process, enough so that pure intellectual curiosity plays a relevant 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 that are 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 want, until we identify an opportunity with a reasonable chance of being a good fit. 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 that we seek to understand before judging a specific company. The quality of the business category is as relevant as the quality of the company. Generally, reasonable companies in very good segments have better results than excellent companies in very poor segments.
The analysis is largely qualitative, based on microeconomic principles. We look for segments that meet important demands of society that are unlikely to diminish over time. Less aggressive competitive environments increase the chance of obtaining good returns. It is desirable to have pricing power with customers, so as not to suffer from cost fluctuations that could not be passed on. Cyclical businesses are not necessarily bad, but if the cycles are very erratic and broad, it can be a problem. Regulatory dependence is a risk, since 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 difficulty with this analysis phase is being efficient in using time, addressing first the factors that are easiest to analyze and have the greatest impact on the business. There is 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 logic, we look at the company and check whether the basic fundamentals are attractive. We want to invest in chronically profitable businesses that have managed to survive macroeconomic crises without major difficulties and that are in a good competitive position within the sector context.
If the business looks good, we move on to form a first opinion about its intrinsic value. Estimating as accurately as possible what a company is worth is laborious, but having a rough idea of what a 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 are 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 that we decide to look at in detail already have a reasonably good 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 still do not have a well-formed opinion about the probability of it materializing. There is a bias to focus only on the desired scenario and look for arguments that reinforce that this scenario makes sense (confirmation bias). This is dangerous, because it is not the plausibility of the success scenario that makes a good investment opportunity, but the improbability of the company's plans for success being frustrated by some risk factor.
Mapping and understanding in depth the risks inherent to the business is the most complex step in the analysis process. There is an academic line of thinking that states that the risk of investing in a stock can be measured by the volatility of that stock's price on the market, but we believe that this method is simplistic and insufficient. The risk of a business is not reducible to a simple quantitative measurement, as it involves 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 implies redundant analyses, digressions in studies and long philosophical discussions. We can spend months studying a company until we reach the level of knowledge that we consider adequate to make a decision, or until we reach the conclusion that this adequate level is unattainable for us and give up on the opportunity because we recognize our ignorance.
As we delve deeper into our studies, we seek to identify problems in the thesis. There are always risks and we want to avoid any that go unnoticed as much as possible. After mapping, we select those that may have a significant impact on the company's intrinsic value and consider the likelihood of each of them materializing. The process involves several analyses, discussions and reflections, until we stabilize an understanding of whether the business's level of risk is tolerable or not.
It is also critical to analyze in depth the competitive environment in which the company operates, with special attention to the competitive advantages it has compared to other companies in the sector and to how sustainable these advantages are (the famous “moat”). Companies in a very favorable competitive position have an easier life. They attract the best professionals, are able to raise capital more cheaply in the market and are resistant to pressure in negotiations with suppliers and customers. This is exactly what we want: to invest in companies that will not face major difficulties.
In parallel with the qualitative analysis, we work to estimate the intrinsic value of the business (valuation), which involves developing financial models with cash flow projections, simulating different 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. In the end, what we have is a range of possible future values, distributed around an average that we use as a value reference. The range of variation around the midpoint is also important, since 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 may not be necessary, but it is 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 part 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 portfolio would we like the thesis to occupy?
The basic logic for answering the first two questions is the same as that for buying 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 high, 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 the parties is wrong in their assessment of the price.
Defining the weight of each thesis in the portfolio is a problem that is more specific to investments. We take into account three elements: the relationship between potential gain and potential loss of each thesis, the absolute value of capital that we are willing to expose to the risks of each company, and our degree of confidence that we are correct in our investment decision. The principle is to maximize the relationship between potential gain and potential loss, while maintaining prudence in risk control.
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 setting aside a few more hours of undivided attention for a well-structured general review. Once this is done, we write a memo summarizing the main characteristics of the business, the most relevant risks, a view on valuation, and a recommendation on what to do. The entire team reads the memo and makes comments. When necessary, we hold more discussion sessions. Finally, we prepare a final version of the memo with the practical decision on whether or not to invest, at what price, and up to what percentage of the portfolio.
We are not fans of bureaucracy, but in stages where the cost of error is very high, establishing protocols helps to avoid the tendency of the human mind to ignore details when the general perception is that everything is fine. The practice of summarizing the complete reasoning in writing also improves the quality of the decision. Writing enhances the capacity for logical reasoning, in the same way that doing calculations on paper increases your mathematical capacity. As a bonus, having written records of the analysis process and decisions allows us to evaluate past decisions and look for areas for improvement.
We believe that good investment decisions depend on good people executing good methods. We focus on the quality of decisions, because the return on each thesis, individually, is a poor parameter for evaluating 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 having good returns over long periods depends more on skill and discipline than on luck.
Note that our stock selection method is organized in a very simple way. Over the years we refine one point or another in our daily activities, but there are no great mysteries in the activity. There are several goals in life that can be achieved through simple and well-known methods, if executed with great discipline. We like practices like this: simple and that work.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
