Dear investors,
There was a time when access to information was a major competitive advantage for investors. In 1815, while England and France were fighting the battle of Waterloo, banker Nathan Rothschild had his own network of spies to monitor the progress of the war and learned before anyone else that England had won the battle.
Having this exclusive information in hand, Nathan Rothschild began selling his assets on the London Stock Exchange. As everyone knew about their network of informants, they deduced that the reason for the sales was that the war had been lost and they began to sell their shares too, starting a wave of panic and rapid price drops. In parallel, the banker ordered several of his agents to purchase various assets at discounted prices. When the news that the battle had been won reached everyone, prices quickly recovered and Nathan suddenly increased his fortune.
Nowadays, the maneuver would not be so viable. Major events are quickly reported on various media channels and the time difference in which professional investors receive this type of news is not enough to constitute a relevant advantage. Furthermore, access to non-public information via spy networks and the like would likely fall into the category of privileged information, the use of which to operate in the market is illegal. Thus, today it seems to us that competitive advantage comes less from access to information and more from the ability, amidst the infinity of news and data, to filter what is relevant and not waste time with the rest of the daily noise. This filter involves being clear about what matters for stock market investment theses, a topic that we will cover in this letter.
What impacts the value of a share
What determines the intrinsic value of a company is the expected cash flow that will be generated by it over the years, discounted by the rate of return that an investor understands to be appropriate for the business's level of risk. This is the discounted cash flow method, used as a basis for pricing virtually any asset.
A characteristic of applying the method is that the cash flows generated in the distant future have a lower value than the cash generation in the immediate future, under the logic that a dividend paid in the future has to include in its value an adequate return for the entire the waiting time, while dividends paid immediately do not require any rate of return for the passage of time. In other words, R$ 100 paid now is, naturally, worth the same R$ 100, while R$ 100 paid 10 years from now, is worth much less than that today, because, considering a rate of return of 15% per year, R$ 25 invested today would be would make R$ 100 after 10 years.
However, even if the flows generated in the short term have a greater value than those generated in distant years, the total value of a company still depends substantially on the results that its business will produce over a very long time horizon. For example, a company that grows its profits at a rate of 8% per year (about 3% above inflation in Brazil), when evaluated with a discount rate of 15% per year, has only ~6% in its first year of results. of its total value. In the first 5 years, it would be ~27% of the total value of the business and, in the first 10 years, 47% of the total value. The conclusion of this example is quite simple: next year's result matters little to the intrinsic value of a company. Therefore, the next quarter matters even less.
Despite the conclusion, it is common to see the price of a share move several percentage points because of a quarterly result above or below what was expected by the market, or because of some news about politics or macroeconomics. What causes these price fluctuations is the fact that the market, in light of the new information, adjusts its projections of future results. In other words, the fact that a company has presented poor results in a given quarter, for example, causes several investors to reduce their expectations of results for their business in the several years to come. Carrying out the adjustment makes sense, as it is necessary to incorporate new information into investment analyses, but its impact is often exaggerated and we are interested in understanding why.
Why so much attention to the short term
Behind price volatility in the market is an exaggerated focus on the short term, which, in turn, is the result of a coalition of factors pressuring investors and financial market agents to keep their attention on upcoming events.
One of the main factors is the pressure from end clients (individual investors), on the agents in charge of looking after their investments (wealth managers or fund managers), to produce quick returns and avoid volatility in the value of their portfolio. Although most professional managers understand that investing in the stock market is a long-term activity, between following their true beliefs and complying with their clients' wishes to ensure that they will continue to be their clients, the vast majority prefer the second alternative. Thus, getting stock price movements correct in the coming months becomes the objective of most professionals working in the market.
As an offshoot of this dynamic, predicting the short term also becomes the objective that promises the most commercial success. For example, the research analyst who predicts the results of a company in the next quarter generally receives more praise from his peers and clients than the one who predicts the final state of a company in 5 years, since the time window is wide. too much for the prediction to still be in the minds of observers. Furthermore, 5 years have 20 quarters, which are 20 opportunities for the short-term analyst to develop and promote new theses, while maintaining the same thesis for 5 years yields much fewer topics for interesting conversations with clients.
Finally, the fact that the long term is much more uncertain also contributes to this excessive attention to the short term, since the human mind does not like uncertainty and seeks devices to escape the need to admit its ignorance (which also brings little success commercial). Thus, there is a strong bias to spend most of the time analyzing recent events, to project the near future with greater caution, and to assume that the distant future will simply be an extrapolation of this brief past and short projection, with a line of continuity that is intellectually comfortable to accept.
The problem with the practice of focusing exaggeratedly on the short term and projecting the long term through extrapolations is that it overly amplifies the weight of recent facts. If a company grew rapidly during a few quarters, for example, simply assuming that last year's revenue is the best starting point for applying an average growth rate going forward may overestimate the value of the business. If the investor assumes that the growth rate will continue to accelerate, the overvaluation could be even greater. The same dynamic applies to negative news and, as a consequence of the exaggeration of these adjustments based on recent facts, prices become more volatile than they should be, given that projections for decades of results would not be expected to fluctuate so much quarter to quarter.
Something interesting is that a study on psychology (McClure, Laibson, Loewenstein and Cohen, 2004) discovered that the human brain tends to value immediate rewards (eg: stocks rising in the very short term), perceived by the limbic system, more than larger and more deferred (eg: expectations of return on long-term investments), perceived by the frontoparietal system, because the limbic system has the ability to override the frontoparietal system, especially in stressful situations. In other words, the more stressed people are, the more value they attribute to the short term. This helps explain why there is so much focus on the short term by investors during periods of economic crisis.
What is the proper focus
Having pacified the point that the short term has limited relevance for stock investment theses, the problem remains of how to deal with the unpredictability of the distant future. A first step is to understand that not everything can be designed with enough assertiveness to serve as the basis for an investment thesis with a good probability of success.
Among these difficult-to-predict factors, some are quite important for a business (for example, the price of oil for oil companies), but it is vital to keep in mind that the level of importance of something has no correlation with its predictability, and there are several factors in the world that remain unpredictable no matter how much effort is put into creating intellectually elegant projections. The trap is believing that the complexity and elegance of predictions increase their chances of being correct.
For example, a few years ago, there was talk of a super cycle of droughts in Brazil, which would affect the electricity sector and agribusiness. At the time, rainfall had been below normal levels for years, energy generator reservoirs were low and agribusiness was suffering due to lack of rain. The projection was consistent with what had been happening and supported by long meteorological analyses. In the following years, a cycle of heavy rains began that filled reservoirs, generated super harvests and erased from memory the theories of prolonged droughts. This is just one example of several elaborate predictions that we have seen prove diametrically wrong over time.
I accept the fact that most of the future is hopelessly unpredictable, the job of a good investor is to find the few points that are both important to the success of a business and possible to predict with reasonable reliability. To do this, we usually start by studying a long past period. It is not enough to look at the results of a business in the last 2 or 3 years. We want to evaluate how the company has behaved over the last 10 to 15 years and look for points in its past that have remained unchanged or that have evolved according to a logic understandable enough to estimate how they will continue to evolve.
In Warren Buffet's famous investment case in Coca-Cola, a relevant factor was the understanding that people create strong habits of always consuming the same drinks. Interestingly, we don't like to eat the same things every day, but we tend to drink the same things for years and years on end. Therefore, it is reasonable to assume that the demand for Coca-Cola drinks is quite resilient and, consequently, so is its revenue level. This is an example of a factor that is stable enough to predict its continuation in the future.
No prediction is accurate
Note that, even in the Coca-Cola example, demand stability is only maintained over long time windows. In other words, Coca-Cola's revenue is not completely stable quarter to quarter, or even year to year. Every business has its fluctuations over time. So predicting quarterly results is not only a difficult goal, but it is also unnecessary. That's not what really matters.
In fact, short-term stability is not even a condition for establishing a good business. An example is our own investment case in Whirlpool, a company that owns the Brastemp and Consul brands and of which we have been shareholders for over 10 years. As household appliances have a long useful life, they are not recurring consumption items. Therefore, its demand is cyclical, varying with macroeconomic conditions and real estate launch cycles (people buy household appliances when they move house). Despite unstable demand, Whirlpool has not recorded losses in more than 20 years. Its profit margin fluctuates between high and low levels, but the average profitability is quite attractive and stable over long periods, which has guaranteed us excellent returns over the last decade, even with the broad macroeconomic instability that Brazil has experienced during this period.
Each variable has an adequate period to make estimates with reasonable reliability, which must be long enough to guarantee the necessary sample space for the statistics used in the predictions to be applicable, following the logic that it is easier to predict the result of throwing 1,000 data than the result of 10 launches, but not so long as to introduce the risk of qualitative aspects changing so much in this period that the logic of the projections becomes inadequate. In our experience, the ideal period for projecting business results is usually a few years.
Why a long horizon is suitable
Due to the very short term having low relevance to the value of a business and the period of greater assertiveness for quantitative projections usually involving a few years, we understand that an appropriate time horizon for preparing explicit forecasts is 5 years. This period is not applicable to all cases, as there are businesses that are predictable for a longer period of time (road concession companies, for example) but it is a good reference period that combines reasonable predictability and relevance to the intrinsic value of a company under analysis.
Consequently, when we invest in a new company, we are typically willing to hold its shares in the portfolio for several years. We can sell the position faster if the price rises to the point of exceeding what we understand to be the intrinsic value of the business or if our investment thesis falls apart due to some event contrary to what we expected, but we believe it is important to have expectations calibrated correctly : most theses take time to deliver the initially expected returns, and the exact moment this happens is unpredictable.
In the meantime, between the initial investment and the decision to sell, it is necessary to remember that the price and the intrinsic value of a share are different variables and do not always go together. We've talked about this at length on other occasions, and we're in good company in the position of assigning little importance to a stock's price when determining its true value. Benjamin Graham used the analogy of Mr. Market, a bipolar character who offered completely different prices for the same assets over time, depending on his momentary mood, and Warren Buffet echoes the same concept, saying that the market is there to to serve us, not to instruct us. Both advocate that investors should make decisions based on an independent assessment of the intrinsic value of each business, and not based on price fluctuations and their actions in the market.
This is a simple concept, which almost everyone agrees with and very few actually practice, as daily price fluctuations affect most people's psychology. The best way to deal with this is to buy shares with the real intention of holding them in your portfolio for the long term. When we buy a car, for example, we hardly intend to sell it a few months later for a profit. The purchasing decision is based on expected use over several years. Thus, if the market offers half the price you paid for the car the following month, you would hardly make the decision to sell it because the price fell (the famous “stop loss”) and you would simply continue using your car, with some regret for not having bought it a month later for half the price. Similarly, we buy shares with the expectation of receiving a certain cash flow over time (this is the intended “use”). As long as the business continues to be able to generate the expected cash flow, the rationale for the purchase remains.
The advantage of focusing on the long term
As obvious as the approach we've described may seem to us, it's an investment style that faces little competition. While most investors remain fixated on the short term and suffer the mood swings caricatured in Mr. Market, we prefer to keep our attention on longer horizons and react less intensely to day-to-day news which, for the most part, prove to be just noise, with no relevant effect in the long term.
Despite our position, we prefer that the market continues to behave in the same way, with a preponderant focus on the short term and causing exaggerated price fluctuations, as it is precisely these fluctuations that generate the investment opportunities that we seek to take advantage of over time. Fortunately, the continuation of this behavior does not appear to be at risk.
However, we hope to identify, over time, people who follow an investment philosophy similar to ours and can become investment partners for the coming decades. To date, we have the privilege of having an investor base that is very aligned with our management style, which has already gone through periods of turbulence with us and has had the necessary patience to reap good returns.
We remain optimistic for the coming years, due to the quality of the businesses we currently have in our portfolio and the discount levels that our current share price contains, when compared to our intrinsic value estimates. Over the course of our 10 years of investing, there have been few moments when the price of our portfolio has become as discounted as it is now.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
