Making dollars and sense - Annual report, 2024

Originally published in the 2024 Cymbria Annual Report.

Dear partner,

As investors, we’re in the business of taking risks. You entrust us to put your capital to work in areas where the future isn’t certain, in order to pursue pleasing returns. There are tens of thousands of ideas and we must pick the ones that we believe make the most sense. What does “make sense” mean? The answer has two parts.

First, we determine why the market will look at a business more favourably in five years than it does today. Said differently, how will a business be bigger in the future than it is today and why aren’t we being asked to pay for that growth today? A positive change inside of a business is the catalyst that gives us the opportunity to buy future growth for free. Having a differentiated view about positive change and being right about it can lead to very pleasing returns.

Second, we must have a well-calibrated sense of future regret. What do you think are the odds of the positive change playing out, and what is the cost of being wrong? Is the cost of being wrong equivalent to jumping off a two-foot ledge where a poor landing might mean a sore back for a week or is it like jumping out of a plane? There are obvious things that can make an investment as risky as skydiving. For example, investing in a business that has too much debt or is projected to generate years of negative free cash flow (i.e., profits). However, there are risks beyond the glaring ones. We would contend that in the stock market, the non-obvious risks have cost investors way more money than the obvious ones.

An example of a non-obvious risk is groupthink. Consensus thinking can be seductive. What makes it so tempting is the warmth that it brings investors. The warmth, of course, is generated from being at the centre of the herd. History has shown that being at the middle of the flock might seem comforting, but it’s never a good place to be. Around the time your authors were born, the Nifty 50ⁱ was raging. These 50 companies were dominant and trusted household names. Some were practically monopolies and perceived to be invincible, stable growers. The market believed nothing could ever go wrong with them, and therefore, there was no price too high to pay for them. The problem was everyone believed the same thing. There was no future growth for free with such companies since everyone had built the consensus into the price. The price you would have paid for the comfort of owning the Nifty 50 in 1969 was losing most of your money within five years. In this case, the crowd didn’t have a well calibrated sense of future regret.

Today, we see that the crowd has again circled up and formed a consensus – the idea that investors don’t need to have unique views on businesses and can just “buy the market.” This uptick in optimism is a relatively recent phenomenon because of investors’ short-term memory.

Caution – hibernating bears

The easiest (but not necessarily the best) way to measure how a market is doing is looking at its biggest and most influential stocks. While the list of companies has changed since 1877, the U.S. stock market has had 4 secular bear markets and 5 secular bull markets (including the one we’re in).

In general, investors exhibit something called “recency bias” that tends to give more weight to what’s been happening lately. For example, there’s a generation of investors that’s never seen a secular bear market like those mentioned in the previous chart. They also probably expect central banks to bail them out of any potential future bear markets because it’s something they’ve seen over the last decade and a half.

Based on recent investor experiences, it’s no surprise that many feel comfortable owning the entire market through index funds. Index funds look great in secular bull markets but tend to yield less favorable outcomes in secular bear markets.

Index funds 101

So, what’s it like to own an index fund? Here’s a simple, yet reasonably accurate description:

1. Choose an index (the category of companies you want to invest in)

2. Own all of the stocks in that index at proportions equal to relative market capitalization (size) as each price moves up and down

3. Ignore:

   • Company quality – you own them all, whether good, bad or average

   • Management teams’ (in)abilities and (in)competencies

   • Accounting departments’ aggressiveness or conservativeness

   • Future prospects – profit margins can be going up or down

   • Underlying valuations – shares can be overpriced, underpriced or fairly valued

Index investors don’t have to worry because they’ve enlisted their trust in nobody to oversee those investments.

Bull markets don’t last forever. So how would someone who’s asked to manage money defend the decision to invest in an index fund if they were already several years into a secular bear market? It would probably go like this:

Geography and history lessons

It might seem like we’re picking on a straw man, but how many countries in the world could you just own a basket of their representative stocks and earn pleasing returns over the long term?

So, is indexing only a “free lunch” in the U.S.? Does the less-than-pleasing success in other countries put doubt in the minds of indexers? Or is it just easier to ignore?

What’s required for the average of all equities in a country’s market to earn pleasing long-term returns? It’s a long list, but we’d suggest things like a certain level of productivity growth; consistent, reliable and predictable rule of law; and some disinflation with flat-to-lower interest rates over that time. These would be a few of the ingredients to create a rising tide that could lift all boats. Perhaps that will happen over the next decade. But then again, perhaps it will result in future regret.

Breaking from the crowd

Investing is risky because the future is uncertain. As mentioned earlier, we believe the best way to deliver on the trust you have placed in us is to have:

1. A well-reasoned view of why we’re buying a business at a price that provides us with some element of future growth for free; and

2. A well-calibrated sense of future regret.

We work every day to build a collection of businesses where we weigh each one’s potential for growth against the possibility of regret. Let’s walk through an example in your portfolio to bring these concepts to life.

Jones Lang LaSalle Inc.ⁱⁱ (JLL) does three things. First, it helps facilitate leasing as a commercial real estate broker. It primarily helps large tenants find office, industrial or retail space around the world. It’s the second largest in the world at doing this. Second, it helps owners buy and sell commercial buildings, as well as finance them. Again, it’s the second largest in the world at doing this. Third, it functions as an outsourced service provider for landlords and tenants. For landlords, it helps manage the building by organizing services like security and property maintenance. For tenants, it takes care of all their real estate needs such as laying out new space, optimizing the use of energy in their space or helping consolidate unneeded space.

We’ve observed over time that some of our best ideas have multiple drivers about how a business can grow that are additive (or better yet, multiplicative) to one another – a convergence of ideas. When we first bought JLL, it was an example of a combination of opportunities to buy growth for free.

Renovation in progress

First, the opportunity to buy growth for free can often start with a misguided fear about a business. This was the case with JLL. COVID-19 created a work-from-home (WFH) movement that led to a decline in demand for office space. This drop hit JLL’s office-leasing division, which was the biggest portion of its commercial-leasing business. The market had priced JLL as though WFH was going to be permanent.

We had a differentiated view. We saw quantitative evidence that WFH was leading to lower productivity levels for large companies. Additionally, we heard about cultural problems within companies of all sizes created by the WFH movement. The first companies that moved to WFH during the early stages of COVID-19 were the household-name technology companies. In late 2023, we were beginning to see early evidence that these “tip of the spear” companies were asking their employees to return to the office. In 2023, JLL’s leasing business fell by 15%.

Our view was that the decline would be short lived given the positive change we were seeing from some of JLL’s largest tenant clients. Since then, our view has played out. Its leasing business will likely be up by mid-double digits in 2024 and, even after this growth, it will still be 15% below where the business was pre-COVID. What’s more is that many major city centres have run out of Class A real estate.ⁱⁱⁱ COVID-19 put the brakes on new supply, but now tenants’ demand is increasing from employees returning to the office. Class A was the first space to go as companies wanted to entice their workers to leave home for more-attractive office space. JLL is well placed to capitalize on this long-term supply/demand imbalance.

The second major idea inside JLL was the increasing importance of access to industry data. If your advisor on a lease or purchase/sale transaction doesn’t have an informational advantage, then you’re at a disadvantage in the negotiation. The commercial real estate brokerage business has spent most of its history as a fragmented regional business. For example, the top five players only represent 28% of global sales activity. Recently, two large players have separated themselves from the pack from an informational-advantage perspective, and JLL is one of those two.

To put its informational advantage into context, JLL values US$3 trillion of real estate per year. Doing that requires unparalleled data granularity on everything associated with a property. JLL also manages four billion square feet of real estate for clients, which gives it great insight into the quality of buildings it manages. Finally, it facilitates about US$1 billion a day in purchase or sale transactions. For every winning bid, there are about six losing ones. If you’re thinking about selling your building, do you want to be advised by the company that values trillions of dollars in real estate, manages billions of square feet and knows who the buyers are that lost out on their last offer…or do you want to go with your old university buddy who works for a small regional firm and knows none of that? JLL’s informational edge should continue to be a market-share tailwind across all its business lines.

The third material idea inside JLL had to do with its entry into a new business called Work Dynamics. Its entry into this business represented a positive change for JLL. The simple idea behind Work Dynamics is that companies that don’t specialize in real estate should outsource all their real estate needs. Think of Procter & Gamble (P&G), which has office, manufacturing and distribution locations around the world. Its core competency is marketing the likes of detergent and toothpaste to consumers. A real estate specialist can help P&G minimize its real estate needs, save on the operations of every facility, figure out where the next best place to build a new factory is and contract its construction faster and cheaper than P&G can. In fact, the low-hanging fruit on the efficiency/cost side is so great that JLL’s typical Work Dynamics deal involves receiving a share of the savings it brings to customers. From an opportunity perspective, only 30% of the world’s top-100 firms in the world have outsourced their real estate needs. Additionally, the world’s top-five real estate firms (of which JLL is one) only have 5% of that 30%. So, the percentage of firms outsourcing their real estate needs should grow from 30%, while the top real estate firms should grow their share of that 5% base.

Beyond the opportunity for growth, JLL could receive two additional benefits from their Work Dynamics business. First, Work Dynamics embeds JLL with its customers, allowing JLL to cross sell and gain share in leasing and capital markets. Second, Work Dynamics is a less-cyclical business than JLL’s traditional leasing and transaction businesses. If JLL’s profitability incrementally changes from being cyclical to stable, the market may assign a higher valuation multiple to the overall business. For context, JLL’s “recurring” revenue today (including Work Dynamics) is over one-third of its business – up from around 5% five years ago.

Now let’s look at the math behind this investment. Your cost on JLL is close to US$154 per share. We believe that the combination of ideas noted above should result in JLL having close to US$27 in free cash flow per share in 2029 (if not sooner). Free cash flow is a proxy for profit that you could put into your pocket if you owned 100% of the business. Traditionally, JLL has traded at around 14x free cash flow. So, 14 x US$27 = US$378. At the time of purchase, we thought we were buying something that could more than double in price over the next five years: US$378 free cash flow vs. US$154 cost. That would represent a return of greater than 15% per year on your JLL investment. Additionally, recall that the market may be willing to assign a higher multiple to the business if the portion of its recurring revenue continues to increase (i.e., the business becomes less cyclical). If that happens, the percentage returns could be even higher. Since we purchased your stake in JLL, the share price has moved up in a pleasing fashion. We continue to believe that returns from this higher point are still likely to be very attractive.

Checking the foundations

So, we just covered the first part of our approach: how we get growth for free as a result of positive changes. Now let’s move to having a well-calibrated sense of future regret. What could cause us to be wrong with your JLL investment and what are the repercussions of being wrong?

The biggest risks facing JLL are from a recession or the chance that interest rates increase materially from here. A recession would cause a decline in the cyclical part of JLL’s business, which represents about two-thirds of its revenue. A spike in interest rates would cause a decrease in the purchase and sale portion of JLL’s business, which represents about 25% of its business. Either situation would likely result in JLL’s share price falling from here. If the risks come to pass, the important question is, “Are they survivable?” Are we jumping off a two-foot ledge and risking a hurt back for a week or are we jumping out of a plane and risking much more if our parachute doesn’t open?

Make no mistake, JLL’s share price will decline from where it is today if there’s a recession or much higher rates. However, we put it in the “sore back” bucket rather than the “chute didn’t open” one. The reason is that JLL can survive a downturn. It has a strong balance sheet and a business model that should generate positive free cash flow (profits) under both scenarios. Furthermore, many of its smaller competitors will suffer more than JLL in a recession or higher rate environment, allowing JLL to potentially exit a downturn even stronger.

Although the idea of JLL getting stronger in a trough is a positive sentiment, the reality is we would wish we had sold our stake before the downturn even started.

Constant recalibration

Each one of the ideas you own inside Cymbria has risks that could lead to future regret. We guarantee that some of those risks will come to fruition and lead to at least a temporary loss. Unlike those willing to invest blindly in a broad market, we try to mitigate this reality by diversifying your portfolio as much as possible by business idea. Too much correlation inside the portfolio to the same idea or risk can lead to displeasing returns. We have written extensively over the years about our attempts to diversify the portfolio. You can find our thoughts here and here.

As shareholders in Cymbria, you hold ownership stakes in 40 to 50 companies, including EdgePoint Wealth Management and three private businesses. There are one or more positive changes inside each business that we believe has allowed us to buy growth for free. Whenever the Investment Team finds a new opportunity, we compare it against the ones we currently hold. This helps ensure that investors have a portfolio that makes sense – one that’s made up of ideas that best balance the likelihood of growth against the level of risk we take on by owning it.

Thank you for your trust. We will continue to work hard every day to be worthy of it.