Uncertainty and Risk
During the month we continued to take advantage of the market dislocation to build our portfolio with investments at highly attractive risk-rewards. A large proportion of these businesses reported in the second half of the month and we were pleased with each company’s evolution and its prospects for continued value creation. This leaves us extremely excited about the prospects of our portfolio going forward.
Uncertainty and Risk
A month ago the financial markets were in turmoil and major indexes had significant declines (especially in Europe). Brexit was a daily word in the headlines. Lots of unanswered questions were on top of investors’ minds regarding the future of the EU, the UK and the separation process. Clearly with so much uncertainty, this couldn’t be a good or even prudent time to invest. Or could it?
In this month’s letter I would like to address Somar’s views on risk and uncertainty.
- We view risk as the possibility of permanent loss of capital. This happens when the amount we pay for a business turns out to be more than the present value of the cash flows the business will generate in the future1.
- Uncertainty arises when there is a wide range of possible future outcomes with limited ability to quantify the probability of each one.
When the UK voted to leave the European Union, uncertainty rose: the number of potential scenarios grew and it became harder to estimate the probability and impact of each one of them. At the same time, market volatility rose and prices declined across the board, with high correlation among the stocks. Does this mean that risk increased at that time? Not necessarily.
- For businesses with little or no exposure to the UK economy, the decline of stock prices actually lowered the risk of investing in these businesses. We were able to invest at significantly lower prices2 in companies, whose future cash flows had not been materially changed.
For businesses with material exposure to the UK economy, a case by case analysis needed to be done. For each business, we ascertained whether the reduction of the stock price more than compensated for the reduction of cash flows in an adverse scenario. Somar’s strong fact-based analysis under different scenarios allowed us to do this accurately and in a short period of time for the stocks under our coverage.
After careful analysis, we concluded that the vast majority of the businesses that Somar follows saw the riskiness of an investment decrease after the UK vote and market decline. We reacted accordingly. These periods are welcomed by Somar as our methodology is particularly suited to take advantage of market dislocations. We look forward to more in the future.
We weren’t alone: 3 of our partners invested into Somar at the beginning of July. This ability to discern between uncertainty and risk is useful to both Somar as steward of your capital and to you as you make your decision to allocate between asset classes and to managers.
Meanwhile stock market indexes have recovered and market volatility faded with the VIX at year lows as I write this. Market consensus seems to be that now is safer to invest than a month ago. Incidentally, most of the questions over which investors and financial analysts agonized in the wake of the UK vote are still unanswered! Why then, does consensus believe it is less risky to buy into the market now at higher prices than a month ago at lower prices? Paraphrasing Warren Buffett: The future is never clear; you pay a very high price for certainty.
1 Conversely, we view risk on our shorts the possibility that the amount of cash we receive today when we short the business is less than the present value of the cash flows the business will generate in the future.
2 Incidentally for businesses with limited revenue coming from the UK but strong UK cost centers, their competitive position and margins actually improved as a consequence of the strong Pound depreciation. This means that their streams of future cash flows actually increased. We were actively buying these stocks in our portfolio.