More than dwelling on the causes of securities’ prices soaring, or daring to make forecasts as to the direction of the general market, experience has taught us to focus on investing, an activity defined by Ben Graham as “an operation which, upon thorough analysis, promises safety of principal and an adequate return.” In a market where safety of principal is overlooked for the sake of returns (note we left adequacy out of the line), we have found the greatest challenge an investor faces is emotional control.

Value investors know boom and bust cycles, read thoroughly about the origins of manias and depressions, understand the pyschological biases that affect us (even have a branch of economics dedicated to it called behavioral finance), and yet, succumb at the imperative fear of missing out (FOMO), jealousy and envy like any other investor. Even the great investors struggle with FOMO, as the Druckenmiller story goes. As you might recall, Druckenmiller knew valuations were very extended in the dot com era, and yet, he couldn’t keep himself from following the rally. His comments after the experience are insightful: “I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket-case and I couldn’t help myself.”

Buffett called it when he said “You can’t stand to see your neighbor getting rich. You know you’re smarter than he is and he’s doing these things and he’s getting rich.”. Munger also mentioned “Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”.

So what is an investor to do now? As Druckenmiller would say, we KNOW what to do already. As in life itself, the difficulty lies on execution. Below is our manifiesto, a reminder to ourselves of the principles that should guide our investment decisions going forward.

• As Buffett puts it: Rule #1: Don’t lose money. Rule #2: Don’t forget Rule #1.
• Only price can protect us. Insist on investing with a margin of safety.
• “Manage the downside, the upside will take care of itself.”
• “Many shall be restored that are now fallen and many shall fall that now are in honor.” – Horace Markets always provide second chances. Be patient.
• “The stock market is a device for transferring money from the impatient to the patient.” – Buffett
• “The world is full of foolish gamblers and they will not do as well as patient investors” – Munger
• Invest in things you know. Remember your circle of competence.
• Trust your valuation under conservative estimates, do not stretch it for the market price to make sense.
• If it sounds too good to be true, it most likely is.
• Remember base rates: how many times has a company grown revenues at xx% per year before?
• Use reverse engineering: what are the implied growth rates in the key variables that justify the price? Do these make sense?
• Never forget opportunity costs, make these a central part of your portfolio allocation.
• Never forget the best quality of having cash is optionality.
• Never outsource your thinking. Own your decisions (for good and bad).

In the current environment, it is likely that like us, you’re struggling to find operations that meet the two criteria laid out by Graham for investing: 1) safety of principal and 2) adequate return. We believe becoming the “Abominable No-Man” for a while (or an extended period of time) cannot be that bad, as it is within the normal scope of investing. At some point, valuations should make sense again (in general, we are not saying everything is overvalued now) and potential rate of returns should beat opportunity costs. We close with an invaluable Munger quote: “The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” (We just note simple is not the same as easy).

In this post we are compiling how Li Lu went about reading Value Line to invest in Timberland in 1998 (now part of VF Corporation) at a Columbia Business School lecture. We also share some personal tips we’ve gathered from personal experience to speed up your learning.

We love this lecture because it provides a window at how a lecture at Columbia goes and how the mind of a great investor works. Moreover, Li Lu’s attitude at the lecture is great: it challenges students, brings honesty to the table and demands quick wit and commong sense. He highlights that real value investors 1) thrive when being alone and having the chance to make their own decisions; 2) spend most of the time doing the job of an academic researcher with insatiable curiosity, wanting to know how everything works (businesses, politics, humanity, poetry). He also discussed how he, at the beginning of his carreer, read the whole ValueLine guide (which has about 3,500 companies), in the same way as Buffett did with Moody’s manuals.

The structure of a ValueLine report is simple. We have segmented one in three parts.

The first one has mostly descriptive tools, recent price, PE ratio, dividend yield and a graph with the price. On the left side we see the price projections made by the VL team and where the company ranks based on their Timeliness, Safety and Technical classification system, with 1 being the best score and 5 the worst.

The second part is where we can take a look at the historical data of the company at a quick glance. Each company has different metrics depending on its industry, for example there are some differences between an insurance company and a tech one and the fields available for each. However, the reports are mostly homogeneous and easy to compare between sector players. Important to note that on the left hand side we have market cap, number of shares and a snapshot of the capital structure. Moreover, in the small business description at the bottom, we have a summary of ownership (both from insiders and external partners). In our view, this is the main playground of any investor, as like Li Lu shows, this is where one can discard or become very interested in a company via simple mental calculations.

The third part has a write-up from the analyst, a brief score for the company’s financial strength, price stability, price growth performance and earnings predictability.

After getting acquainted with a ValueLine report, we can understand and follow through Li Lu’s tips. Here are his main highlights for a VL report:

• What is the first thing that jumps to you? Look at the valuation (if not good, do not go beyond. Note the case that Li Lu exposed applies to the fallen angels category.
• In this case the company was below book value, but what is in the book value? In this particular case, a big part of the working capital is inventory. Moreover, this report was available at the end of Q3 and in the retail segment, therefore we would need to check for seasonality. It may be that Q4 is strong and a good portion of it will be quickly converted into cash. Check also fixed assets and add all these to evaluate downside protection.
• Check the operating earnings and pre-tax earnings and compare vs. unleveraged capital needed by the business. Have the ability to calculate both these quickly. (Liquid assets + fixed assets = invested capital, a good proxy similar to the official Fixed assets + non-cash working capital). This should be done in a quick glance, something of 5 seconds.
• If the first two points are satisfactory, understand the reason behind the cheapness of the stock. Check how many analysts are covering the company.
• Check if the business has been steadily profitable and growing.
• Check the ownership structure. Check how much they own and how much they can vote.
• Understand the problems: in this case there were some lawsuits against the company.
• If after all these filters the idea is still interesting: you download every single piece of information and go through them all. This is done via the natural curiosity a true investor has.

Complement these Li Lu’s tips with Mr. Buffett’s take on the 11 characteristics of wonderful businesses.

As we can see, ValueLine provides a one-stop shop to answer many of the first questions that come to mind when looking at a business for the first time. Naturally, we recommend following along Li Lu’s comments on how to perform the analysis and size up the position. Needless to say, Li Lu’s fund went on to grab a shitload of stock (his words), which as he describes, went up close to 7x in the coming years. Li Lu closes that segment on the conversation suggesting that one should be able to go through an interesting company in less than 5 minutes in ValueLine, before going on and reading more data. Based on our experience, we would say that after reading many reports, it is feasible to do this quickly indeed. However, we also highlight that one starts becoming (as Buffett would sometimes call Munger) The Abominable No Man, as many companies that do not meet the requirements are discarded soon enough.

To close this article, we would like to pass on some personal tips we’ve encountered from reading VL reports.

• Go over market cap vs debt and WC: An interesting category (still, at least for us) is to check for potential net-nets. A quick glance into these lines would give an idea to figure out if this is feasible.
• Check ROE / ROIC (stability): For compounders, while a high ROIC/ROE is important, it is vital to see the historical trend. Generally, a stable figure should speak of an important competitive advantage.
• Check profit margin: in line with the previous bullet, it is vital to understand how a company is doing in terms of profits and understand how sustainable the trend is. If we see volatile trends, it will become very important to understand if there are any accounting tricks and/or capital structure changes.
• Check sales trend: While profits are easily manipulated in the short-term, this is not the case with sales. Always check that people are buying the company’s products/services at good growth rates.
• Check number of shares: It could be possible that most of the increase in profits stems from financial engineering. Checking that the number of shares diminishes is not bad on its own, but should be accompanied by the checks we described before.
• Check ownership by management (skin in the game): While many managers are paid via stock options, knowing that they are with us as investors for the long haul is important. VL includes this data in the business description, including main shareholders.

Finally, we encourage you to read our article on What is a value trap and how to avoid it, so you are well equipped to start your research!

Akre opens up the conversation discussing how he went from an English major without any finance knowledge to learning about investing. He touches upon reading John Train’s Money Masters of our Time, where one of the first at-lentgh Buffett interviews surfaces. There, Buffett outlines the characteristics of an outstanding business, the type that one can own over the long-term. While there are many ways to invest, and Buffett has certainly deviated from the long-term compounder approach over his carreer, we believe the approach is very interesting, tax-efficient, and rewarding.

The 11 characteristics of wonderful businesses according to Buffett

We classified the 11 characteristics based on where to look for them. We include additional thoughts for each classification.

Reading financial statements (income statement, balanche sheet, cash flows):

• They have a good return on capital without accounting gimmicks or lots of leverage
• They see their profits in cash
• Their earnings are predictable
• They have low inventories and high turnover (i.e. they require little continuing capital)
• There is a high return on the total of inventories plus plant.

Prices and multiples only tell a fraction of the story: regardless of whether you’re looking at a public or private firm, digging into a company’s financial information is crucial to make an informed investment decision (or recommendation).

While we are completely aware the “accounting” stuff is perhaps the least glamorous (okay, probably the most arid) part of the investment process, it can be very helpful to have some working knowledge of basic accounting principles and concepts. To understand why, simply bear in mind two things: 1) a company’s management still has an important degree of discretion when preparing their financial statements (whether public or private), and 2) public firms are constantly under pressure to achieve short term results, which goes against this idea of long-term compounding.

Comparing sector competitors and regulatory landscape

• They are understandable
• They have strong franchises and thus freedom to raise prices
• They don’t take a genius to run
• They are not natural targets of regulation
• Overall: the best business is a royalty on the growth of others, requiring little capital itself

Financial information must reflect the company’s strengths and competitive advantages. It is important to understand a company not in isolation, but in relationship to the environment on which it operates. What could be seen as a unique advantage may change in the future, as new companies are able to more efficiently replicate a particular technology for example, or as regulations limit a company’s pricing power.

Reading MD&A statements and annual report letters

• The management is owner-oriented (this needs to be reflected in the financial statements too)

Let’s keep it simple: Skin in the game.

Naturally, the 11 factors interact among themselves and are not isolated. For example, high ROIC is only sustainable if there is unregulated pricing power, focused management and good execution, all while warding off competitors (as naturally, a business earning high ROIC should have a target on their back). The implementation of this list seems pretty straightforward, however, it is a bit tricky, given that each business entity and the industry in which they operate are different.

To solve the issue of complexity, our experience suggests two solutions. The first one is insatiable curiosity, as knowledge generally compounds, patterns emerge and comparisons become clearer. With time, we get a very good sense of base rates (or the % of a population that exhibits a certain characteristic), allowing us to better understand what could happen in the future. For this, we recommend following Charlie Munger’s principles of forming an array of mental models, or proven methods / ideas that explain most of the dynamics in the world around us. A great place to start is listening to Charlie Munger himself (we recommend this 1995 speech: The Psychology of Human Misjudgment).

As we gather knowledge, we might fall victim of a false sense of expertise, or overconfidence. To overcome this (besides facing the humbling Mr. Market himself), we suggest incorporating the idea of the circle of competence, a concept we have written at length here. Here also is a video of Buffett answering the question on how to develop a circle of competence himself.

All of this sounds wonderful, yet, we dare to add one component which we believe is vital: reasonable valuation. Even the best business in the world is not worth an infinite amount of dollars. Our experience suggests that this is perhaps the hardest part of investing in a compounder. Most of these companies are widely followed and priced close to perfection nearly all the time. Therefore, patience is key in two ways: 1) To wait for the right entry point (generally investing at the average valuation range suffices) ; and 2) the patience to hold them for prolonged periods of time to allow the magic of compound interest multiply capital (in spite of natural gyrations of the stock market).

To spark debate and provide you with some of the companies we believe they can call themselves “wonderful”, we list the companies (tickers) below. We would love to hear what you think, or add some companies that you would classify as wonderful.

• FB
• MSFT
• CHKP
• EPAM
• VRSK
• COST
• MCO
• MA
• V
• MSCI
• AMZN
• ANSS
• BR
• SBAC
• AMT
• VRSN

• The best market timing tool is intrinsic value – When turmoil starts the correlation amongst asset classes increases significantly, making it even harder to distinguish winners from losers. With eye-grabbing media flooding our attention, it becomes hard to avoid emotional decisions. Something that is useful, however, is having updated estimates of intrinsic value. The rule is simple, if even under stressed conditions, current prices still offer a wide discount to our intrinsic value estimates, we turn the table and place the odds in our favor. While this has an elevated emotional toll, risk/reward ratios become more attractive. In the end, what we are trying to do is obtain a return as investors similar to the business’ rate of return on capital. If we do so at attractive valuations, the likelihood of this happening becomes greater.

• Price is the best protection – After trying out different investment vehicles, among them options, ETFs and cash, (and perhaps as a reflection of our optimism) we believe nothing provides long-term cushion and protection as paying a reasonable valuation for a business. Mostly this is because it allows the long-term compounding of money avoiding high transaction costs. Yes, prices will fluctuate, but over time, paying a fair price for a great business allows the obtention of a similar rate of return as that of the business ROIC. If the valuation job is done vaguely right, obtaining a good result is almost unavoidable.

• Be brave enough to hold cash – One of the recent trend we’ve seen among investors is the need to dance all dances and harships facing FOMO. It is our belief that some of the hardest, yet most useful words an investor can utter is “I don’t know”. While having north stars and beliefs is certainly useful, fluid situations like investing require openmindedness and the acceptance that we are taking decisions with incomplete information. Yes, probabilities and their respective updating is relevant, but it is also critical to understand the limits of our knowledge. Recognizing this and investing only when we have an edge may avoid large amounts of pain.

• If conviction is high, move (more) aggressively – Returns tend to be at their best when it is the most uncomfortable. Beating our primal instincts is definitely a challenge, yet it can be financially rewarding. Moving with confidence in our valuation is key. We highlight that while this is generally understood, more aggressiveness is better than little.

• Do not underestimate liquidity – We believe Stanley Druckenmiller puts it best: “Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity; most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”. We believe that earnings ultimately lead the market, however, it is very clear that liquidity does not have a marginal impact and it moves the market too. This comment, among others, have spiked our curiosity. This is why we wrote the article On Depressions’ Base Rates, to have an idea of what the implications may be based on history.

• Have a backup plan and be flexible – We believe that if a solid investment might be dependent on 3-5 key variables at most. If one of those changes, the whole thesis might crumble. Due to the interaction of sunk-cost fallacy and consistency bias, we might feel that all that work needs still to be rewarded by return. Here it is vital to remember that stocks do not know about us owning them, neither do they care. If something is not going as planned, or the facts change, it is key to have the flexibility of mind to say we could be wrong and avoid permanent losses of capital.

• Never outsource your thinking – With so much information floating around, it is hard to hear our own voice. However, investing is a solo game, therefore it is critical not to outsource our thinking and do it for ourselves. Always remembering that (paraphrasing Graham) we are only right if our facts and our reasoning are correct.

• Know your game – One of the great things about connectivity is the ability to share ideas and gather opinions freely and easily. Yet, as with information, it can become so abundant that we can hardly navigate through it. Between macro investors, private equity guys, bottom-up stock pickers, commodity experts and more, sometimes the desire to understand all their theses is significant. We advocate that knowing what our game is remains the key. It would be ludicrous to make Michael Jordan a soccer starter.

We are aware that this situation is still evolving, and we hope to add further lessons as time goes by. Also, if you have any particular lessons you would like to share with us, we’d really appreciate it!

Before going into the details, we would like to congratulate Rev on the excellent and timely work on having a transcript available so promptly, and obviously to Yahoo! Finance on a seamless transmission. Please find the link to the transcript here and the link to the whole meeting below.

Berkshire’s 1Q20 was marked by a precautionary stance: the company was a net seller of stocks, kept the cash pile up and halted repurchases in late February-early May, based on the average price of $214 reported. Buffett spent a great deal of time explaining certain base rates for Berkshire’s precautionary stance. (We also wrote about the key takeaways from Ray Dalio’s Debt Crises studies here, which also provides great insights on how things could play out) We highlight the following:

The comparison with the Great Depression of 1929 in terms of performance: Buffett spent some time comparing how after a period of bonanza, the DJIA was down by 83% in two years from the peak in September 3, 1929. Buffett mentioned “People did not think in the fall of 1930 they were in a great depression… they thought it was a recession.”

He also dwelled on the psychological effects of the depression and how long it took to recover: “So the Great Depression went on, and it lasted a very long time, but it lasted a lot longer in the minds of people that it did actually in its effects.”

“So take the years from 1920, 1930 or 1929 into the 1951, that was flat out a time of for a long time with no economic growth, and no feeling by people in terms about the wealth of the country, about what the American economy was worth, about all these corporations that were doing far, far, better than they were, all in all, but it took all of that time to restore in the market a price level that was equal to what it was 20 years earlier.“

Moreover, he discussed that we do not know how the current environment will play out: “If you think about the fact that we’re enduring a few months, and we’ll endure some many more months, and we don’t know how it comes out, and people in the 30’s didn’t know how it was going to come out, but they endured, persevered, prospered, and the American miracle continued.”

“And we’re doing a lot of smart things and we’ve got a lot of very smart people, but there are unknowns. And the unknowns that apply to the health aspect create unknowns in the economy. And we’ll have to keep evaluating things as we go along. I hope, like crazy obviously, that once suppressed that it doesn’t come back and that we readjust. But things don’t always work perfectly. That doesn’t mean there was a better course of action that would not… I would not go around criticizing people at all for what they’ve done or anything of the sort. I just think you’re dealing with a huge unknown. And I think that the degree to which it’s disturbed the world and changed habits and endangered businesses in the last couple of months indicates that you better, not be too sure of yourself about what it’ll do in the next six months or year or whatever.”

As usual, he discussed avoiding the probability of ruin: “You learned that you can have any series of numbers times zero, and you just need one zero in there and the answer is zero, and there’s no reason to use borrowed money to participate in the American tailwind, but there’s every other reason to participate.”

Keeping in mind the 20+ years it took for the DJIA to recover in terms of level, he made the following remark: “You know, at least in my view, you know that America’s tailwind is not exhausted. You’re going to get a fine result if you own equities over a long period of time… They’re going to outperform Treasury bills. They’re going to outperform that money you’ve stuck under your mattress. I mean, they are a enormously sound investment as long as they’re an investment and they’re not a gambling device or something that you think you can safely buy on margin or whatever it may be.“

More importantly, he closed his remarks on American equities with the following: “And with that, I hope I’ve convinced you to bet on America. Not saying that this is the right time to buy stocks if you mean by “right,” that they’re going to go up instead of down. I don’t know where they’re going to go in the next day, or week, or month, or year. But I hope I know enough to know, well, I think I can buy a cross section and do fine over 20 or 30 years. And you may think that’s kind of, for a guy, 89, that that’s kind of an optimistic viewpoint. But I hope that really everybody would buy stocks with the idea that they’re buying partnerships in businesses and they wouldn’t look at them as chips to move around, up or down.”

He discussed that he does not know the consequences of the shutdown, and the likelihood that there are mistakes along the way: “But what we do know is that for some period, certainly during the balance of the year, but it could go on a considerable period of time, who knows, but our operating earnings will be less, considerably less than if the virus hadn’t come along. I mean, that’s just it. It hurts some of our businesses a lot. I mean, you shut down. Some of our businesses effectively have been shut down.”

On why the cash positions may seem large but could be deceiving: “But we have hundreds of billions of wholly owned businesses. So our $124 billion is not some 40% or so cash positions, it’s far less than that. And we will always keep plenty of cash on hand, and for any circumstances, with a 9/11 comes along, if the stock market is closed, as it was in World War I—it’s not going to be, but I didn’t think we were going to be having a pandemic when I watched that Creighton-Villanova game in January either.”

We highlight Buffett’s discipline and constant evaluation of situations, something that is extremely hard to do due to loss aversion and consistency bias. He exited the airlines, as the landscape changed: “The airline business, and I may be wrong and I hope I’m wrong, but I think it changed in a very major way, and it’s obviously changed in the fact that there’re four companies are each going to borrow perhaps an average of at least 10 or 12 billion each.”

We close with what we believe circles very well the job of an independent, savvy investor and how we should approach the times we face:

“But if you’re going to look at the price of the stock and think that you have to act because it’s doing this or that, or somebody else tells you, “How can you stay with that,” when something else is going up or anything. You’ve got to be in the right psychological position. And frankly, some people are not really careful. Some people are more subject to fear than others. It’s like the virus. It strikes some people with a much greater ferocity than others. And fear is something I really never felt financially, but I don’t think Charlie’s felt it either. But some people can handle it psychologically. If they can’t handle it psychologically, then you really shouldn’t own stocks, because you’re going to buy and sell them at the wrong time. And you should not count on somebody else telling you this. You should do something you understand yourself. If you don’t understand it yourself, you’re going to be affected by the next person you talk to. And so you should be in a position to hold, and I don’t know whether today is a great day to buy stocks. I know it will work out over 20 or 30 years. I don’t know whether it’ll work out over two years at all. I have no idea whether you’ll be ahead or behind on a stock you buy on Monday morning, or the market.”

We are writing this post with the goal of compiling practical ways to handle and overcome this situation. Our view is that navigating through these hard times requires more than concentrated effort in one front, which is why we are taking a holistic approach and stepping away from only finance/investing ideas. We welcome any of your comments and suggestions, as the more robust the compilation of advice, the better for all.

Health First (Physical and Mental): Just as when there is an emergency in an airplane, the advice here is to focus on our health first, so that we have ability to help others. Only by being healthy we are able to focus on any other area in our lives. Some key suggestions to keep in mind:

• If suspicious of contagion, we should follow instructions from a health specialist hotline, available in several states. Most insurance providers fully cover Covid-19 in their policies. If this is not the case, public healthcare systems are also providing guidance and support.
• When healthy, following a routine is the best ally. Be it that we work from home or at our usual workspace, following a rountine provides structure to our organism, allowing it to recover and remain healthy. Supplements such as vitamins are good, but if unavailable, sleeping well is the best immune system booster.
• N95 masks are recommended, if not available, a regular mask is better than none. While not conclusive yet, several studies point towards much lower contagion rates and faster recovery times in locations where masks were mandatory.
• While a drink or two are important, some studies point out towards a heightened inclination to drinking and drug consumption during lockdown periods. The World Health Organization suggests that alcohol consumption could lead to “health vulnerability, risk-taking behaviours, mental health issues and violence.”
• Eating healthy is vital. We can all continue supporting our local community by purchasing food via apps or phone. Also, it is now a good time to iterate and gravitate towards healthier options, given the importance of a healthy immune system and the constraints of typical exercise options.
• Working out has been proven over time to reduce stress, boosting our immune system and keeping our fitness. It is now time to be open to new options, YouTube, Instagram and many other applications are a great way to get ideas without spending extra on gym equipment.
• Don’t overdo it. While being at home sometimes makes it easier to put in long hours of work, instead, we should try to make regular breaks doing things we enjoy. For example, after a couple of hours of work, getting up and walking around while listening to a couple of our favorite songs (this is not recommended to Pink Floyd, Dream Theater, or Godspeed Yo! Black Emperor fans, since many of their songs are about 20-30 minutes long…). This will allow to regain gocus and tackle problems with a fresh mindset.
• Going easy on our favorite treats. Similar to the above, we should try to not go on a full Netflix or YouTube binge; the same goes for social media. Let’s remember that most of these apps are designed to keep us hooked, so it is important to monitor the hours spent on these, especially at night, since they can affect our sleep cycle.

Work, Saving, Investing – We understand these are difficult times and that we are likely to undergo an adjustment period, where layoffs are a possibility. We believe that the following suggestions can help ameliorate the situtation and find solutions, even if they are outside the box.

• Building an Excel file, including two columns, what we have and what we owe is a simple yet powerful way to look at where we stand financially. In our view, banks understand what we’re going through and are likely to provide grace periods and debt financing before seizing assets and/or writting off loans. We believe on the snowball method, which implies paying off completely the smallest loan, and moving into the next one. This method saves a lot of money in interest payments.
• In our view, Covid-19 has accelerated some effects of digitalization, and are here to stay. That means some jobs are likely to remain remote, while people will find out that the scale of digitalization is a great asset to have. We believe that adapting to it is vital, without looking back.
• Some ideas to diversify revenues are: teaching online (platforms such as Udemy/Coursera share revenues with you while they provide the platform and scale), and selling products online through retailers like Amazon, MercadoLibre, etc.
• In investing, it is best to focus on the long-term prospects and valuations of specific companies, rather than making macro forecasts on the economy. As any value investor would recommend, let’s use Mr. Market’s bipolar attitude to take advantage of him, not to guide our investing.
• Cash is and will always be king: Remember, economic weakness across the globe was already underway before Covid-19 (sure the latter will only make it worse). In times of uncertainty, it is best to remain mindful of our cash outflows; we don’t really know what the economic landspace will be, so it is best to be prepared and hold some cash reserves.

Suddenly There Is Time to Connect: We still live in a high-paced world. However. Covid-19 has created at least some time to pause and think about the importance of connecting with ourselves, our family and loved ones. Let’s use this time wisely. Proximity is sometimes as simple as a text message and offering some listening time.

Expanding & Learning: While we understand these are stressful times, we also believe this could be a great time to follow our curiosity and read that book, take that online course or simply re-take that pending topic that we left.

• Following curiosity: With probably more time at our disposal, it may be a good idea to start learning something new like cooking perhaps; there are tons of YouTube tutorials out there. Also, it might be a good time read lots of different stuff, or if we feel we are not the “reading type” we can always develop the habit. As Naval says: “Read what you love until you love to read“

A Sense Of Purpose: As we pause and reflect, we believe that this is a time that can define us as inviduals and society. The most important question is who we want to be? A lending hand to those in need or a selfish being? A ray of light amongst the darkness or viceversa? A soothing voice amidst the noise or a worry-raiser? It is important to dwell upon these questions and decide.

We finish with a direct quote from Roman emperor Marcus Aurelius, from Meditations:

“It’s unfortunate that this has happened.

No. It’s fortunate that this has happened and I’ve remained unharmed bt it- not shattered by the present or frightened of the future. It could have happened to anyone. But not everyone could have remained unharmed by it. Why treat the one as a misfortune rather than the other as fortunate? Can you really call something a misfortune that doesn’t violate human nature? Or do you think something that’s not against nature’s will can violate it? But you know what its will is. Does what’s happened keep you from acting with justice, generosity, self-control, sanity, prudence, honesty, humility, straightforwardness, and all the other qualities that allow a person’s nature to fulfill itself?

So remember this principle when something threatens to cause you pain: the thing itself was no misfortune at all; to endure it and prevail is great good fortune.”

Gathering information from 48 depressions, defined as real GDP contractions of at least 3%, he categorizes depressions in two categories: deflationary (21) and inflationary (27). Dalio argues that we are currently facing a deflationary one, so we will focus our attention in that category for the remainder of this post.

We will avoid the use of charts from Dalio’s book, which we encourage our readers to purchase for a way deeper analysis. We fill focus however, on the key takeaways and some base rates that should be useful to keep in mind for equity investors, as directly stated by Dalio.

• The extent of the current crisis will depend greatly on the willingness and ability of policy makers – Dalio mentions that this effectiveness will ultimately depend on 1) whether the debt is denonimated in the currency policy makers control and 2) whether they have influence over how creditors and debtors behave with each other.

• Policy makers have four tools at their disposal – Dalio defines them as levers, or instruments that policy makers can pull to bring debt and debt service levels down relative to income and cash flow levels required to serve debt payments. These are: 1) austerity; 2) debt defaults/restructuring; 3) the central bank (CB) “printing money” and making purchases (or providing guarantees) and 4) transfers of money and credit from those who have more than they need to those who have less, (generally via taxes to income, property and consumption, although inheritance and wealth taxes can also be implemented). Since each lever has a different effect, it is in striking the right balance between them that can make or break a country. If combined appropriately, debt/income ratios decline at the same time that economic activity and financial asset prices improve, gradually bringing the nominal growth rate of incomes back above the nominal (debt) interest rate. Levers shift who benefits and who suffers, and over what amount of time.

• The characteristics of deflationary depressions: Policy makers respond to the initial economic contraction by lowering interest rates. But when interest rates reach 0%, that lever is ineffective. Debt restructuring and austerity dominate, without being balanced by adequate stimulation (especially money printing and currency depreciation). In this phase, debt burdens (debt and debt service as percentage of income) rise, because incomes fall faster than restructuring, debt paydowns reduce the debt stock, and many borrowers are required to rack up still more debts to cover those higher interest costs. These type of depressions generally occur in countries where most of the unsustainable debt was financed domestically in local currency, so that the eventual debt bust produces forced selling and defaults, but not currency or a balance of payments problem.

• Base rates for the bubble, how to detect them and a warning for early buyers: Seven signs of a bubble: 1) prices are high relative to traditional measures; 2) prices are discounting future rapid price appreciation from these high levels; 3) broad bullish sentiment; 4) purchases are being financed by high leverage; 5) buyers have made exceptionally extended forward purchases (e.g. built inventory, contracted for supplies) to speculate or protect themselves against future price gains; 6) new buyers have entered the market and 7) stimulative monetary policy threatens to inflate the bubble even more.

• The depression is real, not merely psychological: Some people mistakenly think that depressions are psychological, that investors move their money from riskier investments to safer ones because they are scared, and that the economy will be restored if they can only be coaxed into moving their money back into riskier investments. This is wrong for two reasons: 1) the process is driven by supply and demand of, and the relationships between, credit, money and goods and services and 2) debtors’ obligations to deliver money would be too large still relative to the money they are taking in. As this implies, a big part of the deleveraging process is people discovering that much of what they though of as their wealth was merely people’s promises to give them money. Now that those promises aren’t being kept, that wealth no longer exists.

• Eventually all governments print money, which benefits gold – typically governments with gold, commodity or foreign FX pegged money systems are forced to have tighter monetary policies to protect the value of their currency than governments with fiat monetary systems. But eventually the debt contractions are so painful that they relent, break the link, and print. As seen below, the average drawdown of FX vs gold is about 44%, ranging from -58% to -37%.

• Should printing money bring higher inflation?: It will not if it offsets falling credit and the deflationary forces are balanced with this reflationary forces. What is happening is that credit destruction is being offset by money creation. If the balance between replacing credit and actively stimulating the economy is right, the effect is not inflationary.

• What does this mean today and how is the market stacking up against the base rate?: Taking the S&P500 as the equity proxy, we have a market high of 3386 on February 19, 2020. If we assume a 50% drawdown from those levels, which is the base rate for deflationary depressions, the resulting index level is 1693. The most recent close is 2790, after some days of recovery. This would still imply a ~40% potential decline on average equity prices.

Given that depressions have lasted between 60 to 249 months (5 to almost 21 years) on average, this exercise is very good to put in context the recent recovery. While we are not in the forecasting business, we believe we could be in the very early stages of this development, with the future direction of the economy and equities more tilted towards further declines, based on the base rates. It typically takes roughly 5-10 years for the real economic activity to reach former highs, because it takes a very long time for investors to become comfortable taking the risk of upholding equities again. Moreover, as Dalio mentioned, “In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what is to come.“

Certainly not all asset classes, sectors and stocks should see similar results. Yet, we believe having an idea of how bad things can get is very useful to make the proper capital allocation decisions. As Howard Marks would say: You can’t predict. You can prepare. In the video, Dalio ponders on two key elements to navigate through depressions: the first one is diversification of assets, including alternative investments such as gold. In the second, Dalio discusses his idea that two type of companies generally thrive in these environments: 1) unleveraged companies with strong balance sheets and 2) the innovators, or companies that should benefit from new trends, demand and appeal.

VLO is the largest global independent refiner and the largest renewable fuels producer in North America. It operates in three segments: Refining (~96% of revenues), Ethanol (~1% of revenues) and Renewable Diesel (~3% of revenues). With 4Q19 data, VLO has 15 refineries for a 3.15 million barrels per day capacity and logistic assets that include 3,100 miles of active pipelines, 130 million barrels of storage and over 50 docks; its renewable diesel operations is expanding its capacity to 675 million gallons per year while the ethanol segment has 14 plants for a capacity of 1.73 billion gallons per year.

In our view, the market is pricing a reduction on the two main components of revenues: price and quantity. On one side, we have lower oil prices, which imply lower retail prices for refined products, and we also have coronavirus halting economic activity, creating a lower demand for refined goods. Now, before even daring to answer if VLO benefits from lower oil prices or not, we would like to address the most important question in these situations: Is VLO likely to survive a liquidity crunch? To answer this question we look at contractual obligations, debt maturities and derivatives exposure and contrast it against operating cash flow.

Contractual obligations

Going into the annual report, we find out that VLO’s contractual obligations are of around $15.7B for 2020. Out of the total amount, 91% comes from Purchase Obligations, which are defined as follows: “A purchase obligation is an enforceable and legally binding agreement to purchase goods or services that specifies significant terms, including i) fixed or minimum quantities to be purchased; ii) fixed, minimum, or variable price provisions, and iii) the approximate timing of the transaction.”

While we could argue that these obligations are likely to come down in hand with oil’s market prices, it is our opinion that it best to assume no changes to these requirements to avoid any negative surprises. The rest of the items are debt and finace lease obligations, interest payments, operating leases liabilities and other long-term liabilities.

Debt Maturities

VLO has a a combination of fixed and variable rate financing through a bullet structure, mostly focused on principal repayments after 2024. For 2020, debt repayments should be around $453 M.

Derivatives exposure

Valero used cash flow and economic hedges to carry out its operations. As of December 31, 2019, the company’s notional amounts are slightly tilted to a net short position in crude oil and renewable diesel, while being net long in corn. Without being a make-or-break item, we believe this hedging component should provide slight gains due to the drop in oil prices.

Cash requirements for the company in 2020 therefore include:

• Contractual obligations of $15,665 M
• Debt maturities of $453 M

which total $16,118 M.

Now, looking at VLO’s liquidity sources, we can see:

• Cash and equivalents of $2,473 M, which excludes $110 M used for VIEs (variable interest entities)
• Receivables of $8,904 M at 70% = $6,233 M
• Inventories of $7,013 at 60% = $4,208 M
• Prepaid expenses $469 M
• Borrowing capacity in revolver facilities of i) $3,966 M from Valero revolver, ii) $112 M from Canadian revolver, and iii) $50 M of a letter of credit facility. Please note we are excluding $1,200 M from an accounts receivable sales facility to be conservative. The total of these liquidity sources is $17,511 or 1.08x the total liquidity needs in 2020, with some leeway due to reduced inventories, receivables and the accounts receivable sales facility. It is also worth mentioning that VLO uses LIFO inventory, meaning that more recent goods (and least expensive) will calculate lower COGS and thus a higher gross margin, something we saw in 2015 and which we elaborate upon further in this note.

Just to provide some context to these numbers, the closing price of VLO on March 12, 2020 is ~$18,000 M. The company’s operating income for 2019 was $3,836 M, with consensus expecting 2020 to be around $4,700 M (which will likely change drastically). Using 2015’s oil correction as a reference, when EBIT fell 40% from 2014 to 2015, we can assume that EBIT could see something around $2,300 M, implying that consensus would miss by ~50%. Net debt for Valero stands at $8,339 M, for a Net debt / EBIT ratio of 2.2x using 2019’s figures or 3.6x using the adjusted 2020 figure.

Capital returns: Buyback activity + dividends

The company has been aggressive in terms of returning capital to shareholders via buybacks and dividends, spending $2,614 M in 2017, $3,077 M in 2018 and $2,269 M in 2019. Just to provide some context on the previous oil crisis (2015 and 2016), these amounts were $3,686 M and $2,447 M, respectively, up from $1,850 M in 2014. Something we highlight from the previous crisis is the increased activity (almost up 100% YoY) in share repurchases during 2015 when the oil price fell ~30%.

Pension expenses

Another aspect that could worry investors is that VLO’s pension fund is currently underfunded, as the table below shows. Moreover, interest rate sensitivity shows that a decrease in interest rates provides some headwinds in terms of incremental expenses.

How to value VLO (DCF, Net reproduction value)

VLO currently has a market cap of ~$18B, for an estimated dividend yield of over 7%, which we honestly prefer to see as a nice to know item, but does not play a fundamental role in our thesis. We find three ways to reach an estimate of VLO’s value. The first one is a distressed DCF exercise in which we assume a drastic loss in FCF for years to come (pretty much in line with the 2015-16 oil crisis). The second one is the use of net reproduction value to provide a floor to the value. The third is a back-of-the-envelope calculation of a PE valuation. Before doing that, we highlight that VLO is likely to receive a positive boost in gross margin during 2020 as it will have lower COGS on LIFO inventory keeping. Moreover, the derivative exposure for 2020 is net short on oil prices. Back in 2015, when closing prices of Brent went from $99.6 per barrel to $53.6, VLO’s gross margin surged from 4.5% to 8.4%.

DCF

Even during times of stress, VLO has proved it has a strong FCF conversion capacity. For our exercise, we are using a near 100% decrease in FCF for 2020, with only marginal recoveries to previous levels going forward. Please note that the last 4 years average FCF is $3,322 M. Our DCF assumptions lead to a value of around $56 per share. Part of what makes us be particularly wary on 2020’s FCF is the current degree of operating leverage. Back in the end of 2015, operating leverage was actually negative, not positive as today. This does not make us pessimist, but we believe a steeper contraction than in the previous oil shock is not out of question.

Net reproduction value

For this exercise we will discount the asset side of the balance sheet with a 40% to accounts receivable, a 50% to inventories and a 25% to PP&E. We then subtract net debt to have an idea of the reproduction cost of adjusted assets, which comes around $52 per share.

Multiples (back of the envelope)

As we mentioned before, doing a simple exercise with the P/E multiple, we can argue that the current 7.5x is very close to 2014 lows, only surpassed by 2011’s 5.7x. Assuming a 25% and 50% discount to 2020E EPS from consensus, we have some margin of safety vs. history. If we use the median PE multiple for 2020E earnings at a 30% discount, we get an estimated price of $53, or $38 using a 50% discount, which we consider would be a floor.

To conclude, VLO will have funding sources available to make it through 2020 without further capital injections. Moreover, contractual obligations and maturities for 2021 remain low as well. Looking at the valuation, we conclude that the company’s value per share ranges from $52 to $56 under very conservative estimates, representing close to a ~20% ETR with limited downside (~15%) at current prices.

“Must you dance every dance with the same fortunate man?” – Sinatra in Changing Partners

Well it’s been quite a start of the year! Suddenly the unbeatable rise of Mr. Market has come to a halt on coronavirus fears and oil wars. More than dwelling on these causes and their effect on the market, we’ve written this post to ponder on how to think about times like these and how to benefit from them.

Survival first: We believe that investing is an exciting, ever-evolving game which we are lucky enough to call our profession. As in any game, defense wins championships, and investing is not the exception. While this may sound unexciting, safety of principal is of the utmost importance, after all, it remains our entry ticket to this exciting game. While being overly aggressive gathers highlights, it is generally the better-balanced team (between offense and defense) who wins. Taking it one step further, in Antifragile, Taleb discusses how to to avoid being a turkey, and even benefit from hidden risks or extreme events. While beyond the scope of this writeup, we believe that whoever takes care of the downside first will eventually figure out how to reap benefits on the upside. This is really the cornerstone of investing: before winning, we must ensure we do not lose first.

Only we can answer where we are – Last year we met a very renowned value investor whose words really hit home. When asked about the direction of the market, he discussed that although he is always looking for opportunities across sectors and has a great idea of the market as a general, he avoids making forecasts for the market as a whole. However, he told his story during the Internet bubble, mentioning that in 1999, it became extremely hard to find attractively valued businesses to buy. For us, the three main lessons are: 1) we can have a great idea of where we are in the cycle by the number of investment opportunities we find and the over-valuation of those companies we are very interested in; 2) (as Howard Marks would say) we cannot predict, we can prepare and 3) as LeFevre would say in Reminiscences of a Stock Market Operator, “if you don’t know who you are, the stock market is an expensive place to find out“.

The practicality of finding individual investment opportunities is way larger than that of trying to predict what the sector, the economy or the market will do in a certain period of time. In times when companies within our circle of competence are richly valued, it is best to start accumulating some cash and viceversa (i.e. preparation). We believe this is a way simpler yet more powerful technique to achieve superior performance over time. Moreover, we emphasize that an investor should focus on reasoning and finding gaps between price and value, not debating whether he is right or wrong in public forums. Sure, cross-checking our theses with other thoughtful investors is valuable, but, as Taleb would say: “There are two types of people: those who try to win and those who try to win arguments. They are never the same.”

What a business is worth changes. But does it change that fast? – Time after time, Mr. Market has proven it’s long-term efficiency, and how crazy it can get in the short term. In spite of the recent news, business values change very slowly, and it is best when we take a long-term view in our analysis. In this excellent post, the Brooklyn Investor makes an exercise on what happens as we remove full years of earnings to DCF calculations. The answer is that even if we completely erase 4 years of earnings, we still have 85% of the business value intact. Obviously, there are some important assumptions there, but since value estimates are in theory a set of discounted cash flows from perpeuity, it makes sense that it is in that perpetuity where we find most of the value. To that effect, it is very likely that for investors with a long-term view, a bad 12-18-24 months will not change the picture a whole lot.

“In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” – Charlie Munger

Taming our instincts – A late bull-market has the unavoidable characteristic of feeding upon investors’ complacency. “So what if I am paying 45x earnings?” “You’re missing the paradigm shift!” Well… we do until we don’t. Just as we can leave the floor and repel the laws of gravity for extended periods of time, the market can keep on rising regardless of fundamentals for some time. Hitting new highs everyday feels good when we check our balances; that dopamine rush definitely overcomes the voice in the back of our head which tells us we might have gone overboard in terms of valuation.

Now, investing is definitely a game of balancing ideas that run counter to each other. From our experience, there is no single rule that helps in beating the market (that is what makes it so interesting). However, just as we discussed above, there are some rules that eventually apply and govern market prices, such as prices following business fundamentals. We have learned over the years that leaving an excellent business run its course, even beyond reasonable parameters of valuation is generally better than selling them for the sake of purchasing cheaper yet less wonderful businesses (due to taxes and lost compounding effects).

And yet… how, when and why to sell? In a bull market, it is never easy. However, going back to our discussion with the famous investor, during a steep run in price one can start to feel irrationality creeping in the sentiment for a company. While a company could continue delivering outstanding results, it is in the subtleties that one start detecting a widening gap between a well deserved premium and an optimism fueled by a “never-can-lose attitude”. This is more an art than science, but as a rule of thumb, a company trading way above a conservative estimate of value should trigger at least the question as to what is the driver of that increase in price. There could be two sources of a re-pricing: growth in earnings power and/or what the market is willing to pay for that earnings power. What has driven ours? Answering this accurately can lead to a better decision for our portfolio.

Fear is NOT intuition – A final piece of advice from Arnold Van den Berg. After we develop experience, our intuition develops, providing valuable insights even from a subconscious level. However, it is key to remember that this usually takes years to develop and that in investing, going against our gut is generally the profitable bet. At times like this, unless we’ve gone through similar patches, the will to sell everything and take refuge in cash is likely to be 1) a product of fear, not intuition; 2) more costly due to taxes and lost opportunity costs. For this there is no other way than to follow the Delphic maxim “Know thyself”.

The last 2 bullets discussed here open the door to an interesting topic that keeps gathering importance when talking about investing, namely, behavioral finance. This field basically recognizes that “traditional” financial theory describes investors as being completely rational, when in fact, they are not (although we like to think we are…). Anyway, perhaps this is worth exploring on a different post. 

We finish with a quote from the breathtaking Gulag Archipielago. You will notice some similarities with Kipling’s If.

“With the years, armor-plated restraint covers your heart and all your skin. You do not hasten to question and you do not hasten to answer. Your tongue has lost its flexible capacity for easy oscillation. Your eyes do not flash with gladness over good tidings nor do they darken with grief.

For you still have to verify whether that’s how it is going to be. And you also have to work out- what is gladness and what is grief. And now the rule of life is this: Do not rejoice when you have found, do not weep when you have lost.” – Aleksandr Solzhenitsyn in The Gulag Archipielago

For those interested, CHKP, among other companies, is part of our Investment Ideas section.