The risks behind the returns - Annual report, 2023
Originally published in the 2023 Cymbria Annual Report.
Dear partner,
Investment performance can be measured in returns…all else being equal. But often, all else is not equal. We believe returns are typically flawed measurements because they have the benefit of hindsight and don’t reflect the risk required to earn them. Two investments with the same return that needed to take different levels of risk aren’t fair comparisons. Even if a well-intentioned investor attempted to weigh the risk taken against the return achieved, it’s likely they would use a standard investment industry measure of risk (and the most non-businesslike interpretation they could find).
We won’t waste your time proving the industry’s risk metric is non-businesslike, but at the individual security level it’s just the company’s share price volatility relative to that of other stocks. At the portfolio level, the normal measure is benchmark risk – a comparison of how different one is versus the average. Try that risk measurement on the best businessperson or entrepreneurs you know.
Instead, we’ll state how we believe a businessperson would look at the risk of an investment. They would:
Say risk is the potential for permanent loss of capital.
Ask “How much money could we lose, and what is the probability of that loss, and what are all the things that may happen that could lead to these negative probabilities?”
Look at company-specific risks such as increased competition, management competence, profitability compression and the business’ underlying valuation relative to their assessment of its true worth.
Unless an investor thinks a stock is a piece of paper whose value moves up and down each day instead of the opportunity to own a piece of a business, they’d likely agree that conventional industry risk definitions, such as standard deviation and Sharpe ratios, are for those who don’t care to view their investments as businesses.i The truth is that we’re thankful for those who only see share prices and not the businesses behind them. We need those people to make a market. We need people to be dazed and confused. We need people to be buying and selling stocks based on non-business fundamentals. Without them, it would be tougher to achieve differentiated views on businesses. Said another way, investing would be much tougher if all investors were businesspeople buying businesses, as we are at Cymbria.
A businessperson would never think that a business’ risk is tied to the daily movement of its share price, something dictated by what other people arbitrarily think the business is worth, against the equally crowdsourced ups and downs of the stock prices of a large group of companies. Absurd indeed.
Seth Klarman, a highly successful investor, captured the essence of the difference in the following statement: “Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”
Approaching investing and the real risks to investing like a businessperson should allow an investor to sleep at night. Simply focusing on the return potential or not understanding the real sources of risk dramatically increases the ultimate risk to investing – running out of money before you die…or having substantially less capital in the future to meet your many needs.
Had you entrusted us with your capital over 15 years ago when we began, the following graph lays out what a $50,000 investment in Cymbria looked like at the end of every calendar year.
Cymbria Class A aNAV – Growth of $50,000
Nov. 4, 2008 to Dec. 31, 2023
Cymbria Class A aNAV performance (annualized): 1-year: 16.08%, 3-year: 9.83%, 5-year: 8.86%, 10-year: 12.01%, 15-year: 14.31%, since inception: 13.63%.
This 15-year period covered in the preceding chart spanned a great financial crisis, European sovereign debt crisis, U.S. debt downgrade, deflation fears, a pandemic that shut the world down, an inflationary spiral, fears of a recession and wars (just to name a few of the lowlights). In spite of these significant headwinds, trying to generate returns while paying attention to risk resulted in your $50,000 investment in Cymbria at inceptionii turning into more than $345,000 today. I’m sure the events of the last 15 years caused a few restless nights, but hopefully your investment in Cymbria wasn’t one of the things preventing you from sleeping soundly. As managers and your fellow co-owners of Cymbria, we believe we achieved these returns without taking many of the risks we see others take when investing in the market.
Although pleasing, those results are now history. It isn’t lost on us that on a go-forward basis we must continue to be worthy of your trust. Our approach to managing your hard-earned savings won’t change in the future. We will continue to pay attention to risks when trying to generate returns for you. Let’s talk about a few of those risks.
Risks associated with the fundamentals of a business
As businesspeople who buy businesses, we think it makes sense to begin a discussion about risks with real-world business examples. The most important part of evaluating a new business is the assessment of the real risks each one could potentially face in the future.
Our goal is to buy growth and not have to pay for it, which in practice often means buying future growth at a discount. Said another way, our goal is to purchase a business for a price that’s much less than its future worth. For the vast majority of our investments, the type of growth we’re trying to buy for a big discount is in free cash flow. Free cash flow can best be thought of as the money an owner can take out of the business each year, or what’s available to reinvest back into the business for further growth. For simplicity, one can measure the potential discount by looking at the potential free cash flow per share in the future relative to today’s stock price.
The risk we try to mitigate is being wrong about that future growth. Among the questions we ask ourselves include how can we be wrong about the future revenue growth or margin potential of the business, management’s competency or returns of future capital investments that the business makes? To protect against these future risks, we do the hard work you would expect us to do.
For example, before we made an investment in Lincoln Electric,iii a global manufacturer of welding products and electric vehicle chargers, here is a non-exhaustive list of the due diligence we performed:
Read: Lincoln Electric annuals, competitor annuals, sell-side analyst reports
Interviewed: Experts, management teams
Attended: Multiple factory tours, several industry conferences
Created: Several in-depth financial models
Delivered: Several presentations to Investment Team members
(Note: For those interested in learning more about our thesis on Lincoln Electric, you can read our fourth-quarter 2023 commentary.)
The idea is to do the work so you can’t disprove your idea about why the business should grow in the future. The months we put in before investing in a business are the price we pay to sleep well at night. Going through the items above can leave you with the impression that all an investor needs to do to account for potential risks is mechanically follow a checklist. That couldn’t be further from the truth. In our observations, successfully accounting for risk in an investment can sometimes involve a deep understanding of psychology, statistics/ probabilities, politics, law, history and relationship management, just to name a few.
The passage of time with an investment also introduces new information about the company or its industry that can make all of the above work obsolete. New challenges, competitors, technologies, economic backdrops, management teams or unanticipated acquisitions could all await Lincoln Electric’s future. The assessed business risk is never a constant. Every day, Lincoln Electric’s competitors are attempting to convince customers to switch to them. Business is ground warfare and subject to continuous change. Relying solely on all of our work at the initial due diligence stage would be naïve. On day two, new information and learnings must be added to all this work. The new learnings need to be tested against our initial and evolving understanding of the business, its prospects and its risks. And that’s the easier part.
All this information and work will form our view of the business. This view and the resulting evolving view must continually be contrasted with the view of others. If we make an investment because the prospects are great but currently not well understood by others, and the risks are viewed to be low, then we could have an interesting investment. But as time passes and others start agreeing with our view, then those low-risk and exciting growth prospects work themselves into a higher stock price and possibly a higher stock valuation.
A high stock price and valuation would confirm the view (our proprietary insight) we had on the business. This validation now introduces risk into the investment that didn’t exist at the time of our purchase. The business risk could still seem low and the prospects for growth could still seem great, but others sharing those views means the stock price would likely factor in that future growth. Additional ownership stakes in the company, whether by us or someone else, would be buying that future growth at full price or close to it.
Psychological risks
Let’s spend more time on the human condition now and discuss risk mitigation as it relates to psychology.
We call the belief that you can buy future growth at a discount an “insight” or a “proprietary view.” The foundation of an insight is a differentiated view about a business than what’s reflected in the current share price. Simply stated, the market sees one thing and we see another. A non-comprehensive list of circumstances that led to the majority of our insight generation over time includes the following:
We have reason to believe that a business’ situation is about to change for the better. A new product or entry into a new market is being undervalued. A new management team’s capability might be underestimated. It could also be a change in industry structure or a business’ capital-allocation policies. There are too many changes to list here. The key point is that the market mispricing change has been the source of the majority of our ideas over time.
We are placing different weight on information than the market. A good example of this was laid out in the Q4 commentary on Lincoln Electric mentioned earlier.
We can understand a complex investment opportunity better than others. Our successful investment in Apollo Global Management was an example of this.iv
We can have a different time horizon allowing us to take advantage of time arbitrage. We believe our holding in AMETEK is an example of this.v
We can be trading with forced sellers. EdgePoint’s launch of its prospectus-exempt Canadian oil & gas portfolio was built around this idea.vi
We can be taking advantage of extreme negative market sentiment.
A unifying thread of the ideas above is the willingness to look different from the crowd. Our patience, discipline and conviction can sometimes make us look out of touch. However, you can’t outperform the market by looking like the market. Most investors are wired very differently in that they want to look the same. Safety in numbers, right?
Humans have existed for almost 200,000 years and during this time we’ve primarily focused on survival – hunting, gathering and loss aversion. This resulted in our brains evolving a certain way. More specifically, Homo sapiens concentrate on the present and rarely, if ever, use our brains to imagine a future different than the past. No time to think long term; the short-term and all-consuming priorities of eating and not being eaten stand in the way. With this as a backdrop, human behaviour is understood more easily, especially as it relates to the stock market. Our history leads us to fear immediate loss and take comfort in following the crowd. If we had to imagine a scenario for which the human mind is most ill-equipped, it would be something close to the stock market. Noisy, confusing, extremely volatile and full of risks. The market requires participants to make decisions in the absence of perfect information. Over shorter periods, it can defy logic. Its raw material is money, the modern-day hunter-gatherer’s proxy for basic needs like food, shelter and clothing. The market is unsympathetic and perfectly designed to feast on emotion. Bottom line is that it’s filled with obstacles preventing the human brain from making objective and insightful decisions.
We believe that history has shown on repeated occasions that the comfort an investor gets from investing with the herd comes at the expense of future underperformance.
The following is a list of examples of herd mentality. Getting caught up in any one of these scenarios would have caused material losses in your portfolio.
1970s: The “Nifty 50” were the 50 largest businesses that had big moats around their businesses and seemingly only went up in price. The herd mentality was that they were the only businesses you had to own because they only ever went up in price. Turned out to be wrong.
1970s: The world was running out of oil, so buy oil. Turned out to be wrong.
1980s: Japanese companies were the best compounders in the world, so they were the only ones you had to own. Turned out to be wrong.
1990s: Emerging markets always grow faster than developed markets. Therefore, just buy emerging market companies. Turned out to be wrong.
1990s: Dotcom boom. The internet is changing the world. All you needed to own was companies tied to the future of the internet. Turned out to be wrong.
2000s: U.S. residential real estate never goes down in price. Turned out to be wrong.
2010s: Emerging markets story again. China is the place to be. Turned out to be wrong.
The last few years have made their contribution to the list of investing “certainties.” Examples include unprofitable technology companies like Peloton or WeWork, the cryptocurrency rollercoaster or even reaching for yield in fixed income by locking into long durations and negative returns. Only time will tell which trends will join the list of beliefs that turned out to be wrong, but the price paid for “peace of mind” often dictates an investor’s potential return.
What’s our conclusion? We believe that one of the best mitigators of risk is a well-thought-out insight about a business, and not just buying something because a lot of other people own it.
Risks associated with predicting the future
The future is uncertain. As such, people should be skeptical about their ability or someone else’s ability to predict it.
We think every one of the businesses you own in Cymbria is a good idea or we wouldn’t own it. However, we also know that at least one of our ideas is going to be wrong.
To mitigate the risk of being wrong, we try to diversify the portfolio by business idea. We do this by attempting to stay away from obvious correlations and non-obvious correlations. Obvious correlations, by definition, are easy to see. Having 50% of a portfolio invested in banks would be noticed by the most casual of observers.
The tougher correlations to find are the non-obvious ones. Finding them involves thinking and acting like a businessperson who owns a collection of businesses (and not just stocks). If you owned a collection of businesses, you would ask yourself questions like:
Which of my businesses would be negatively impacted if the price of energy doubled overnight because of an unexpected event in the Middle East? Which would benefit?
Which of my businesses would be negatively impacted by interest rates rising to 7%? Which ones would benefit?
Which of my businesses would be negatively impacted from global supply chains being broken? Which ones would benefit?
Which of my businesses would be negatively impacted if AI is adopted at a slower rate than expected? Which one of my businesses would benefit from AI being adopted quickly?
We will own businesses that are exposed to these risks. The idea, however, is to ensure that not too much of the portfolio is negatively exposed to any one of those non-obvious correlations.
You’ll be pleased to know that Cymbria is extremely diversified by business idea. Your holdings span the gamut: from uranium stored in Saskatchewan vaults, to Japanese manufacturers of ball bearings, to European manufacturers of ingredients that reduce methane produced by cattle, to a company that insures against floods in New York City. This diversification helps us mitigate risk in the pursuit of pleasing long-term returns.
The best investment measure – Time
The investment approach that guides Cymbria and EdgePoint has been around for more than 50 years. A lot of people have used it to add value over the decades. It’s interesting to note that we don’t know of a practitioner of this approach who has subsequently decided to abandon it in favour of another way of doing things. We think the reason people stick with it is because it’s proven to work over the long term. One of the main reasons we think it works is because our approach takes into account genuine risks when trying to generate pleasing returns.
Thank you for your trust. We will continue to work to be worthy of it.