Why this, why now?

March was wild. April was arguably wilder. The last two months were textbook Fear and Greed. Even in “normal” times the pendulum swings wildly from fear to greed and back. But over the last few weeks it jolted violently.

We’ve been all about risk management for the past few weeks. We’ve reset a part of our portfolio in March, set some cash aside, and have been analyzing a working list of companies – some of which will make it into our portfolio. Almost everyone in the investment world would have loved to be more proactive. While the pandemic may have been predictable, the economic shutdown was a “Black Swan”. And it looks like the shutdown will have serious effects over the next 12 months.

Were we proactive or reactive? Both. We were proactive in some ways – our investment process is inherently risk averse. Of course, it depends on your definition of Risk. Our definition of Risk is not Volatility or Standard Deviation or Value-at-Risk or some other academically convenient measure. Our definition is simpler to define but harder to quantify:

RISK = Probability of permanent loss of capital times Size of permanent loss

So far, our Risk Management policy has been rooted in fundamentals. Specifically:

1. We have a definitive investment worldview.
2. We have some basic standards when selecting companies within our worldview.

We’ll briefly unpack these below. But this pandemic has added two new risk management tasks to our list:

1. Make sure companies have enough liquidity and can survive a deep recession
2. Size up and reduce exposure to another breakdown in US-China trade talks

We’ve already done substantial work on A. We need to size up Risk B – this seems topical, political and transient, but we’ve been living with it for almost 4 years now. It’s a real risk in this election year.

Have an investment worldview.

It may look like we’re trying to “catch winners”. But the intention is really to avoid losers. We don’t want to play the wrong sport. We always remember Charlie Munger’s quip:

“All I want to know is where I’m going to die, so I’ll never go there.”

Look, we like tailwind. Obviously, we like implicit momentums in investment themes that have staying power. But we mostly look at them as a way to reduce the two elements of Risk: probability of permanent loss and its magnitude. Phil Fisher, an investor whom Buffett admired, put it simply:

“The true investment objective of [company] growth is not just to make gains but to avoid loss.”

Have some basic standards.

We have an unofficial “stock screener”, which helps us prioritize our time. We have lean team, and there are only seven days a week. To make life easier for us, we like to do away with badly managed companies. Why wasted time on those? We look for 3 basic easily obtainable numerical characteristics:

1. Does the company generate Free Cash Flow?
2. Does the company have a high Return-on-Equity profile?
3. Does the company have too much debt?

The answers we like are: Yes, Yes, No. Right there, we eliminate terribly managed companies. Now, these rules are not binding. Occasionally, if a company is a dominator in one of our investment themes, we look at FUTURE Cash Flow and ROE. But we’re sticklers for low debt. We just don’t like highly indebted companies.

The last point about debt helped us out during this pandemic.

Do a liquidity test.

Things always go bad. Now we’ve even seen an economic shutdown. This was the real Black Swan event. Going forward, we need to make sure that our portfolio companies survive another lockdown. It’s reasonable to assume that this won’t be the last pandemic in our lifetime, or even in the next decade.

We did a Stress Test a few weeks ago to ensure that our portfolio companies had enough gas in the tank to ride out this storm. All of them did. Our stress test was a simple question: Can the company survive a full “down year” without relying on any external source of cash? We defined a “down year” as a 25% decline in annual sales. And then based on each company’s cost structure, we estimate how that would affect Free Cash Flow – the real bottom-line.

There were 3 companies out of 24 that we estimated would need to rely on cash on their balance sheet to ride it out. But let me repeat this – no company failed the test. We started trimming our positions in those 3 companies that were at the bottom of this “pretty safe list”. We did that partly because we wanted to raise cash to buy into some companies whose stocks crashed in May. These were companies we had already analyzed. But they were comfortable companies that had been trading at uncomfortable prices. Suddenly, within 3 weeks in March, their stocks were trading at significant discounts. We pounced.

Again, going forward, a liquidity or survival test will be a part of our process. We just don’t want to invest in companies that can’t survive a down year without external help. Chances are that with our basic vigilance on Free Cash Flow and Low Debt, we won’t have a problem.

The pandemic has forced us to add this extra security-check. We don’t mind because it’s a simple extension of what we used to do anyway. But there is another test we must add.

What’s our China exposure?

We have a 2.5-year track record, and in that time the single biggest risk has been the US-China trade war. Our worldview has manifested in our portfolio as a heavy weighting in technology companies. While that tilt has helped us outperform the broader US market through this pandemic, we’ve been having some flashbacks of Q4 2018 and Q3 2019.

The trade-war risk is mostly political. Yes, political risk is usually transient – it comes and goes. I guess that’s the point: if it goes, it can come back. In this case, the trade-war issue keeps coming back. We’ve been waiting for “a tremendous deal” with China for years. The main risk now is this: if Donald Trump’s reelection calculus suggests that an anti-China stance improves his chances, he will go all in.

If that happens, the stock market will crash. But technology companies, most of whom sell a lot of products and services to Chinese businesses and consumers, will bear the brunt. And our portfolio will suffer a lot more than the broader market. We can’t eliminate this risk. But we can minimize it as much as possible. Over the long-term – the next couple of decades – we’re confident our thematic worldview is the way to go. In the meantime, we want to ensure that:

1. Our portfolio companies can ride out the double risk of a Trade War + a prolonged recession.
2. Our portfolio performance isn’t dominated by election rallies, political catchphrases and “virtue signaling” to a base electorate.

The Covid-19 pandemic has heightened this political risk. The best thing we can do now is to:

1. Reduce our exposure to companies that generate a substantial proportion of revenue (20% or more) from China.
2. Reallocate that money to new investment ideas or existing portfolio companies with little or no revenue exposure to China.

I suspect the number and size of adjustments will be small. But we’ll go through the process so we can sleep well at night.

Many Happy Returns.