Dear investors,
We ended 2022 with a return of -12.0% for the year, compared to +4.7% for the IBOV and -15.1% for the SMLL (small caps index). The accumulated return since the beginning of the fund, around 9 and a half years ago, is 1.163%, which represents an average return of 30.7% pa (vs. 9.2% pa for the IBOV):
During this period, we maintained our traditional strategy: identifying companies with resilient businesses and historically high profitability and buying their shares when the price was cheap. We started our buying season in the last quarter of 2021, when some shares reached a price level that already seemed attractive to us, and we have continued to carry out gradual purchases until this moment.
Knowing today the price trajectory of the shares we chose to hold in our portfolio, we started buying about three quarters earlier than would have been ideal. It doesn't seem to us that we overpaid on any of our positions, but it certainly would have been better to wait and buy the same shares at even lower prices than we initially paid.
Missing the best moment is one of the eternal fates of investors. As it is impossible to predict stock price movements over short periods, it is expected that the execution of buys and sells will always be sub-optimal. But even knowing this, it is always unpleasant to calculate how much better the execution could have been.
Taking advantage of this positive tone, we will talk in this letter about the difficulties of investing following a truly fundamentalist long-term philosophy and what we believe is necessary to do so successfully.
Macroeconomic uncertainty
When we read today's headlines, at first glance it may seem worrying; in Brazil, the new government has shown little concern with fiscal responsibility, increasing expenditures beyond the ceiling without clear counterparts in revenue, which may result in an increase in the public debt/GDP ratio, which is already at a very high level. high for an emerging country. Around the world, we have signs of deceleration in the main economies, resulting from more restrictive monetary policies by Central Banks after years of practicing low interest rates. Additionally, international economic relations have been revised after the geopolitical conflicts taking place around the world, which can lead to a reorganization of logistics chains taking into account stability and political predictability in favor of efficiency and economic productivity.
However, we have been through much worse periods and, even so, the shares have had good valuations in subsequent periods. Newspapers are full of explanations about what is happening in the economy, but it is much easier to understand the logic of the past than to predict the future. We are quite skeptical about the possibility of predicting macroeconomic movements, especially given the amount of random factors that affect the economy over time. Nobody foresaw the pandemic and the war between Russia and Ukraine, sources of a good part of the current macroeconomic problems.
As a rule, economists label these events as non-recurring and explain that their projections would have come true if these very rare events had not occurred. However, the issue is not how often does a pandemic or war with global geopolitical impact occur, but how often does any type of unpredictable event that has a relevant economic impact occur.
Random factors can be both bad and good. Sometimes a new technology comes along that greatly increases productivity in a particular industry. In other cases, a weather accident causes one country to have excellent harvests while others have poor agricultural productivity. The country of abundant harvests can benefit from GDP growth, favorable trade balance and appreciation of its currency, with no merit other than being in the place where it rained in the right measure. This already illustrates well the difficulty of working with macroeconomic projections. If you want additional convincing, at
our February 2022 letter we analyzed the hit rate of projections of macroeconomic variables in the expectations system, compiled by the Central Bank of Brazil. In short, it's far from good.
How to deal with uncertainty
Being aware of unpredictability is better than having the illusion that the future is predictable. If you have to choose a vehicle for a 100km race over unfamiliar terrain, it's better to choose a horse, which can go anywhere, than a Ferrari, which can only go on asphalt. Depending on the track, you may not be in first place, but you will finish the race.
The essence of the strategy for choosing investments is the same: without knowing what we are going to have to go through, the best decision is to favor investments in companies that are capable of continuing to operate in a wide range of possible scenarios. This requires your business to be adaptable to different macroeconomic scenarios or to operate in naturally stable market sectors.
Taking examples from our own portfolio, Multi is an adaptable business, as its expertise is to import ready-made products or components (in particular, from China), assemble and distribute them in Brazil, being reasonably agnostic to what the products in question. The company now deals with more than 7,000 items, with a portfolio profile that is quite different from what it was 5 years ago. Our thesis depends more on Multi's ability to continue executing the selection, import and sale cycle of new products than on the specific performance of the company's current products.
Whirlpool, manufacturer of white line products by Brastemp and Consul, is an example of an active business in a stable market. The white goods sector has a very slow technological evolution (think how much your refrigerator has changed in the last 10 years), where the brand is a very important decision factor for the consumer and cost efficiency depends a lot on scale. Thus, few companies dominate this sector in the world and we have not had major changes in the organization of this industry in recent decades.
The difficult side of this strategy is that businesses with this profile will not always have the best performance compared to other possible investments. In 2022, several companies linked to commodities had better results than our portfolio, but we resisted investing in these sectors because the risk linked to future falls in the price of commodities seemed relevant to us. In our imaginary race, if the first 50km were on the road, you would hate yourself for having chosen the horse and would only rejoice again when a stream appeared on the way to be crossed.
Although our two examples did not have their best year in 2022, they are solid businesses that continue to generate profits even in this bad environment and are well positioned to expand their results when the economic scenario recovers. The improvement will certainly come, although we don't know exactly when, as the cyclical character of the economy is well known. The question you might be asking yourself is: why hold or buy stocks during bear cycles, instead of waiting for the crisis to pass? Excellent question.
The pain of buying low
We like to buy stocks at prices significantly below what we believe they are worth. This is only possible during bearish cycles, in the midst of bad news and widespread pessimism in the market, when some investors stop believing in companies and decide to sell their shares at any price. Nobody is willing to sell us stocks at heavily discounted prices when the macroeconomic scenario is positive, the company is showing excellent results and the market mood is great. Buying too cheap requires facing negative scenarios.
There are those who say that the trick is to wait for the market to start to recover before buying, but the advice is as efficient as the recommendation to buy low and sell high. It would obviously be a good tactic if it were possible to know the exact moment in the economic cycle we are in today and if no one else in the market was as aware of that moment. In real life, opportunities to buy very cheap disappear when macroeconomic uncertainty dissolves. It is this problem, of pinpointing the exact timing of economic cycles, that makes us long-term investors.
It is easier to estimate with some precision how much it will rain over the next 5 years, based on historical averages of rain over time, than to reliably estimate how much it will rain in a specific week a few months from now. Likewise, it is easier to estimate that a company should generate a certain level of results over 5 years than to guess what the result will be for a specific quarter. Therefore, our investment theses assume that we will remain positioned for a long period, which makes it likely that we will go through both good and bad macro moments. With the expectation of navigating this entire cycle, it is much more favorable to buy during stress scenarios, when prices are lower, and have the patience to wait for things to improve. It sounds simple, but it's harder than it looks.
drop resistance
It is rare to be lucky enough to buy at the exact moment when the price trend is reversing, so that the stock does not go up until after the purchase. When you buy in the midst of crises, it is more common to have to watch your stock fall for some time. This requires both analytical skill and a good deal of psychological toughness.
On the analytical side, doing a good job of evaluating the real value of the investee company is what gives security to remain positioned in a thesis. If you know something is worth around 100, you buy it for 70 and see the price drop to 50, you may regret not waiting longer to buy it all at 50, but you have the comfort of knowing that 70 was still a good price (this example summarizes our current state). Without this benchmark of real value, investing would become an agonizing game of chance.
Even with this analysis in hand, maintaining the investment means seeing price drops day after day, amid a flood of negative news and several people saying that this is one of the worst crises of all time and that there may be no recovery, as “this time is different”. Not letting yourself be shaken by excesses of emotion and remaining purely rational in these periods is a test of discipline and temperance. It is necessary to step back from everyday life and look back to understand how history unfolded over the course of other crises. The reasonable expectation is usually less extreme than the newspaper headlines preach: there is always something different in each case, but the same dynamics of economic cycles has been observed countless times. As Mark Twain said, “History does not repeat itself, but it rhymes”.
This practice becomes easier with time. Today, after almost 10 years investing through Ártica Long Term, we tend to like times of crisis, as they are precisely the moments when we manage to invest in new theses at very low prices.
tendency to act
Executing a long-term, fundamentalist investment strategy is also difficult because our instincts are adapted to react quickly to each new stimulus in the environment, not to navigate through a cycle that develops slowly over several years.
In turbulent times, the temptation is to move too much. Most investors shift their portfolios nervously, reacting to every new newspaper headline. It may even seem diligent to move with each new development, since it is part of the job to incorporate new information into the analyses, but it is not every day that something comes up that will really impact the result of a thesis in the long term. In most cases, the impact of news is overestimated and unnecessary moves are made, making the investment strategy incoherent and increasing transaction costs.
Doing nothing is not easy when it opposes our impulses. Calmly waiting for market turmoil to pass, observing the despair and frantic movement of the market, requires self-control analogous to that needed to go on a diet. In theory, losing weight is easy and doesn't require any action: just don't eat. The hard thing is to stay still and starve.
The way to counteract instinctual impulses is to rely on pure rationality. We know that a country's economy depends on such a large set of agents, has such complex governance and is impacted by so many random events that it is not easy to lead it, in a voluntary and planned way, in any direction, for the good or for bad. Save for the effect of major events that happen from time to time, things tend to change slowly. So, there is a certain dissonance in suddenly changing your mind about the future at all times.
lack of feedback
Another difficulty experienced by long-term investors is the low amount of feedback they will have over the years on their own investment theses. Unlike learning to play a musical instrument, where every mistake is immediately apparent and a new attempt can be made shortly thereafter, an investment thesis can take years to prove itself right or wrong. A fundamental investor will typically run only a few dozen theses in his lifetime. With that, the possibility of empirical learning is quite limited, which makes trial and error a bad method to learn to invest.
Investing well requires an almost academic life, of continuous studies and a conviction derived from accumulated knowledge and rationality, which is different from the conviction we have when executing something that we have done hundreds of times and seen the same result over and over again. It is necessary to maintain this “academic conviction” in order not to let the instinctive side prevail at critical moments and to be able to continue acting rationally and consistently. Napoleon Bonaparte said that the military genius was the one who managed to act average while everyone around him was losing his mind. We believe that same logic applies to the investment world.
Prospects for the Arctic Long Term FIA
We bought most of the stock we currently own over the past 5 quarters, going against the general market. We are aware of the current macroeconomic risks, we have even explored some of them in our last 3 letters, but because we bought our shares at such low prices, we have good prospects for returns even if the economic environment takes a few years to recover. As there is still a lot of uncertainty regarding the new government, in particular the impact that its policies will have on the yield curve, it is not clear whether we will see any recovery throughout 2023. However, Brazil gravitates towards centrist policies a few decades ago, so we continue to consider this scenario as a base case. The public's own reaction to unorthodox government moves tends to influence them to take a more lenient course of action.
In any case, we will remain attentive to the evolution of the country's economy, monitoring whether the deterioration predicted by so many actually happens, but without allowing ourselves to be influenced by the extremism of political discourse that has persisted since the time of the presidential campaigns. We remain confident in relation to the quality of the companies we have in our portfolio today and the return potential they carry. As our biggest test of faith, we made a substantial volume of new equity capital contributions in Ártica Long Term throughout 2022, accompanied by several people who have already invested with us for some time and some new investors that we had the pleasure to welcome. welcome. While several equity funds had massive waves of redemptions, Ártica Long Term ended the year with around R1TP4Q 70 million in net funding.
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