Dear investors,
Mark Twain said that history does not repeat itself, but it rhymes. We have been experiencing a cycle of high interest rates in recent years, now coming to an end, which has caused the majority of the market to remain averse to investments in variable income for a long period. At the beginning of 2023, almost no one was considering allocating more capital to stocks. Even among professional investors, the common sense was to move in the opposite direction, as they understood that it made no sense to invest in the stock market with fixed income being so profitable. However, between the peak of pessimism about Brazil (March) and the end of the year, the stock market rose 30%. Once again, the moment of greater pessimism and higher interest rates proved to be the best time to increase the allocation of capital in variable income.
This same cycle of high interest rates that caused aversion to the stock market and preference for fixed income, precisely when the opposite would be favorable to investments, has already happened several times and is destined to continue repeating itself. Even knowing this, most people will behave the same way they behaved in previous cycles. Human errors have been repeated for thousands of years, not because they are unknown, but because human nature continues to be the same and chronically carries the same flaws that have been mapped since antiquity.
There are some things we can do to avoid being part of these collective mistakes. One of them is understanding how these market pendular movements unfold over time. We talked about this in the March 2023 letter. Another is to have a more realistic and philosophical approach to the future of the economy and the possibility of predicting it. It is this topic that we will talk about here, taking the opportunity to tell you about how some of our theses have evolved over the past year.
What defines history are unpredictable events
Economic projections always consider the information available at the time and the most likely events as components of the “base scenario”, which will be extrapolated from a certain period of time without additional considerations. There is no better way to quantify an unpredictable future, but the absence of a more effective method does not make it perfect. What tends to completely invalidate these projections are unpredictable events, either because they are unimaginable at the time of the projections or because they have such a low probability of materializing that they end up being discarded from scenario simulations.
History is full of events of this nature. In the recent past, the event with the greatest economic impact around the world was completely unpredictable: the pandemic. Before the crisis emerged, it was impractical to consider, in any financial model, the probability of a global pandemic occurring. Even more impractical was dedicating efforts to detailing the hypothesis about what would happen to each company if the unlikely pandemic materialized.
Likewise, it is not possible to predict and consider the different possibilities related to a wide range of factors that have a huge impact on economic models, such as technological evolution, results of political disputes, the outbreak or resolution of wars, massive fads, etc. We know that we will have surprises in the future, but we don't know when they will happen, how impactful they will be and whether the impact will be negative or positive. This element of randomness is impenetrable. There is no level of competence or effort that eliminates the unpredictability of much of what the future holds for us.
It is critical to absorb this fact of reality in all its breadth, as human psychology seeks to avoid the state of doubt at all costs, which generates the tendency to adopt coherent narratives as the “base case” and attribute a very high degree of reliability to it. bigger than it actually has. Thus, we replace the realistic state of uncertainty with the comfort of an illusion of knowledge about the future.
The most common risk of error in this quest to predict the future of the economy is to be satisfied with finding a narrative of events that seems coherent and feasible. Intuitively, this makes sense, but there are countless possibilities for future scenarios that are equally coherent and feasible. Imagining all these scenarios, weighing the probability of each one materializing and extending this type of analysis to sequential events over a long period is a task that quickly exceeds the level of complexity with which it is possible to deal. Therefore, from a pragmatic point of view, the best thing to do is to be realistic about the amount of uncertainty inherent in macroeconomic projections.
However, not everything is unpredictable
In this world full of randomness, there are points that are more predictable because they involve unchangeable factors or that move so slowly that they are unlikely to cause major surprises. It is these points of stability that we seek to identify and that serve as anchors for good investment theses.
For example, it is safe to assume that people will continue to travel between cities from time to time, without huge variations in the amount of trips taken over multi-year windows. There are few transport options for distances of hundreds of kilometers. In Brazil, the options are cars, buses or planes. Each mode of transport has different levels of comfort, speed and cost. The three have coexisted for many years and the number of passengers transported by each of them changes very slowly, making it reasonable to expect that demand for the three segments will continue.
In the bus segment, the size of a country's vehicle fleet is quite stable, as it meets travel demand spread across millions of passengers. Thus, the sale of new buses basically depends on the cycle of replacing old vehicles with new ones, motivated by the fact that old buses break down more often, causing higher maintenance costs and operational problems (such as a bus full of passengers breaking down in the middle of the road). ). Under this very simple logic, it is reasonable to infer that the older a given bus fleet is, the greater the chance of bus sales volume increasing in the near future.
This rationale was the basis of our investment thesis in Marcopolo, which manufactures bodies for new buses. No assumptions about political movements in our country, interest curves, expectations of local or global recessions played a relevant role in this thesis. We simply saw the Brazilian bus fleet getting much older than its normal level and inferred that future demand for new buses would be driven by the operational pressure that problems with old buses would cause. Once this configuration was understood, the conclusion that Marcopolo would benefit was a small step, as the company leads the sector and meets around half of Brazilian demand for new buses. This was the thesis that brought us the greatest return in 2023, with a price increase of more than 150%.
As a rule, the closer the premises adopted as a starting point are to the concrete world and the simpler the inferences made from them, the greater the chance of conclusions proving correct. Predicting that older buses will have more mechanical problems and that this will lead their owners to exchange them for new buses is much easier than predicting what politicians will do with the national economy over the years.
However, it was not always as pleasant as it is now to talk about this investment thesis, as we waited a few years for what we had predicted to happen. This brings us to the next point.
It's easier to predict what will happen than when
The scenario about Marcopolo that we described seems obvious in retrospect, but we bought our first shares in the company at the end of 2019. The fleet was already old at that time. We did not foresee the pandemic, which affected travel demand globally, something extremely atypical and unpredictable. After the return of the flow of passengers on intercity bus trips, we significantly increased our investments in Marcopolo. This was just before we published the October 2021 letter explaining this thesis. We still waited a year and a half, until the beginning of 2023, for the company to start substantially improving its results.
Even anchored in events with a high chance of proving correct, the moment the event materializes is an always present risk in investments. Without the pandemic, our investment would probably have become profitable much earlier and with an undoubtedly higher average annual return. If demand for new buses remained low for a few more years, the annual rate of return could become mediocre even if what we predicted happened at the end of the story.
The best thing we can do to deal with this temporal uncertainty is to understand the order of magnitude of the periods we may have to wait until the event takes place – in the case of Marcopolo, we knew that the old fleet would not survive a decade without renewals, but It could very well last a few more years – and demand, in the purchase price, a safety margin that makes the rate of return acceptable even in a long wait scenario, which we certainly did when allocating capital in Marcopolo shares.
There is a good deal of luck involved in investing at the ideal time. In two other relevant theses in our portfolio, we had different experiences. In Porto (formerly Porto Seguro), a leader in automotive insurance in Brazil, we predicted that the profitability of the business would improve following a price adjustment for vehicle insurance policies carried out in 2022. This already happened throughout 2023, a relatively short period that It didn't require any great conviction on our part to keep the thesis in the pipeline. In turn, our investment thesis in Multi (formerly Multilaser), addressed in the September 2023 letter, is still going through its trial by fire and may have some difficult months in the near future. It is also a thesis of resumption of former profitability, with a very significant margin of safety at the current share price.
This temporal unpredictability, even in extremely likely events, is what makes patience an important virtue in investments. The chronology of facts follows its own course, completely ignoring the way in which our desires evolve over time. Faced with the inflexibility of the world, there is no way out other than adapting to the facts and planning our investment strategies accordingly.
Some mistakes are inevitable
Due to these uncertainties related to either the occurrence of certain events or the moment in which they will materialize, it is impossible to develop an investment thesis in the real economy that is 100% guaranteed. Because the possibility of bad luck is as real as the possibility of luck. Which brings us to the case of another investment thesis: Blau.
Blau is a historically profitable pharmaceutical company with a good growth rate. One of its main medicines is immunoglobulin, which has a large part of its national demand coming from the Ministry of Health, which holds tenders from time to time. The production capacity of immunoglobulin manufacturers in Brazil is compatible with the country's total demand level, including the volume purchased by the Ministry of Health.
In 2023, the immunoglobulin tender required an atypically high volume, higher than what national manufacturers were capable of meeting. With this, the Ministry of Health obtained extraordinary permission to allow international companies, without registration with ANVISA, to participate in the auction. As a result, manufacturers with less rigor in their production processes and without the costs related to licensing at ANVISA won the auction and took away the entire volume of medicines typically supplied by national manufacturers. As a result, the volume manufactured in the country was all destined for the private sector, causing an atypically high level of price competition that deteriorated the segment's margins.
It was not clear even to companies in the sector why the bidding volume was so high, as it seems incompatible with the level of public health consumption for the period and there is an ongoing investigation to determine whether there were irregularities in these purchases from international manufacturers. This type of event is very difficult to predict and price. In principle, it could be attributed to any company that serves the public sector, but it is uncommon and always a negative surprise when it actually happens.
Due to this setback, the lack of visibility of how the next tenders will be conducted, and a poor outlook for the near future of the healthcare services sector as a whole, which is under financial pressure, we decided to greatly reduce our capital allocation in Blau. We still like the business, but we prefer to migrate most of the investment to companies with less associated uncertainty.
It is vital to consistently adopt a good method
Given the existence of these randomness in investments, even the best strategy executed perfectly will not bring good returns at all times. There will be good years and bad years. Only after long periods does it become clear which strategies work well or poorly. With economic cycles typically lasting 5 or 6 years, this ends up being the minimum period to judge the results of a strategy, considering that it has been applied consistently over that time. This raises two points of attention.
The first is that following the instinct to adjust the investment method according to results over short periods is completely ineffective. Not only does it tend to generate bad results, as the strategy that would have worked well in the recent past is unlikely to be the one that will bear good fruit in the near future, but changing the method frequently also makes it impossible to judge what actually works. It is as if a doctor, in search of an effective treatment, decided to test a different medicine on each patient. It would end up mixing non-random factors with random ones and making any attempt to analyze the data completely inconclusive.
The second point of attention is that investment cycles are very long. With luck, an investor will live through 10 or 12 economic cycles in his adult life. This is a very low number of opportunities to put an investment method to the test. Therefore, learning to invest empirically is a bad strategy. The best way is to study as many investment cases and past economic cycles as possible, so as not to use your own lifetime as a trial balloon to learn how to invest.
We adopted this strategy at Ártica from the beginning, more than 10 years ago. We selected an old investment philosophy, which has consistently generated good returns for past generations of investors, and we continually study to improve our methods little by little. In this way, fortunately, we have also managed to achieve good results over the years.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
