Three (More) Lessons from 2018

In hindsight, launching the AlphaWealth Prime Small & Mid Cap Fund just before a near-half-decade de-rating in the domestic small cap market and a subsequent bear market, was not the greatest timing.

But, you don’t get to choose when opportunity knocks on your door. You just have to get on and make the best of it.

On the upside, good funds can be built in bad times as the pressure forces discipline. It also teaches lessons, of which I like to regularly look back and see what we have learnt (for better or worse, our experiences should make us more valuable over time).

For some past lessons (still mostly applicable) see the below articles (for some incomprehensible reason, I appear to really like the number five!):

Following this tradition of looking back and learning lessons (but breaking with the tradition of listing five!), I’ve pencilled three more lessons worth contemplating.

(1) Cash Flows Don’t Lie — Management Does

Not that all management teams that mislead investors actually lie outright. Some do so by omission. Other do so through attitudes of unrealistic optimism (or, rarely, pessimism). Even yet others try to shift focus onto metrics that make them look good and away from metrics and risks that make them look bad.

Some may not be outright lies but they certainly aren’t complete truths either.

Behind every listed stock, there is a business. And a business is just a collection of people working together in agreed manner to a common purpose. Groups of people have stories, and, thus, every listed business has a “narrative”.

Management often unpacks this narrative for investors in results, presentations, interviews and meetings.

But, like with anything in life, sometimes stories are misleading, and reality is either different or it could still happen differently when the story is about the future.

All figures in a company’s financial statements can be fraudulent or misleading. Despite this, the hardest (though not impossible) one to manipulate is that of cash and cash flows through a business.

Why?

Simple: other than the accountants, the bankers keep a record of this. Thus, the auditors can simply reconcile the bank statements (collected from the bank and not the company) back to the accounts of the company and see if things appear right or wrong.

The big picture here is that when “narrative” and “facts” diverge, rely on the facts. Not the management. And, in terms of “facts” that are often very revealing, cash flows are among the best.

When cash flows disagree with management, the odds are that cash flows are right.

(2) With Debt, Something Eventually Goes Wrong

Debt is often cheaper than equity. This is especially true for large listed companies and, thus, many of them borrow progressively larger amounts over time to enhance their shareholder returns (so-called “gearing” their Return on Equity).

The problem with debt is two-fold: (1) The more debt you have as a company, the more risk you are inserting onto the company’s balance sheet, & (2) Business is inherent unpredictable and risky and, no matter how great the company, given enough time, eventually something will go wrong somewhere.

And, when (2) happens, then (1) makes the downside and damage all that much worse. Sometimes exponentially so…

Be critical of the financial structure of companies and adjust for the risk of highly-geared businesses and business models.

This lesson becomes particularly true if one or more things is happening:

  • Management teams do not own much (or any) of the shares in the company they are managing: This means that they are borrowing on other peoples‘ behalf. They can then gear the company, hit their short-term targets and earn large bonuses. If anything goes wrong, they can walk away unscathed or, even better, they leave and its another management team’s problem. I.e. The agent-principal problem.
  • Groups are borrowing in safe locations and sending the capital into risky locations: Consider those companies borrowing in South Africa and building in Africa, like Angola, DRC and Congo. If the capital invested in those companies implodes (very possible, if not happening right now), then the Group still has to pay back their South African debts. I.e. Doubling-up on the downside risk.

(3) Many People Hide Laziness Behind “Buffet Quotes”

Time and time again, I encounter people who throw Buffet quotes at me to justify either their (in)actions or what they think I should be doing.

This is not to take anything away from Warren Buffet. He is amazing.

These people are not.

I won’t go into detail here but beware people who hide their laziness behind a barrage of Buffet quotes and witty anecdotes. This is often to obscure the fact that they haven’t done any real research on a stock or an investment.

Even after researching something thoroughly, you can still be wrong. I know from experience, and it hurts, but that is life.

But, at least doing the heavy lifting (meeting management, reading endless sets of financials, talking to players in the industry, doing a site visit or three, and building a financial model and valuation) can shift the odds in your favour that you are making an informed investment decision.

And then you can quote Buffet as much as you want.

With my tongue firmly in my cheek, until then, as Buffet says, “Never invest in a business you cannot understand”.

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