Living through history: The Unprecedented Times of a Global Pandemic
As Sri Lanka (and much of the rest of the world) completely halted its economy, I found it difficult to navigate between risk and the important but unknowable.
What does it mean to deploy capital during these uncertain & unprecedented times? How should I think about real risk (loss of permanent capital) versus fear (irrational over-pessimism)?
Rather than make forecasts about unprecedented events, I decided to read about the Great Crash of 1929 by John Kenneth Galbraith, re-visit Benjamin Graham and David Dodd’s ‘Security Analysis’, and re-visit the teachings and lectures of Warren Buffett and Charles Munger. This helped me begin to think about how one should manage capital during a depression, how bad things can really get, and most importantly to revisit and appreciate the rationale, logic, and principles behind the controls of safety that are the main tools of a value investor.
This memo is my attempt to document how I thought about these matters during this unprecedented period.
In March, as the United States and Europe began to understand the spread of the virus, a few Sri Lankans started testing positive for Covid-19. Meanwhile, international and local financial markets plunged. Currencies and oil plunged and there was a huge swing to US Dollars, this had a remarkable impact on the yields of Sri Lanka’s sovereign bonds.
Meanwhile, in Sri Lanka, a full government-imposed curfew and economic lockdown were then put into motion. Sri Lanka like much of the rest of the world had completely halted its economy, the total devastation this would cause was still largely unknowable. This year the economy may contract, unemployment will rise, and exports will fall. All while the Government of Sri Lanka deals with its high debt burden.
Acknowledge what you don’t know and should not predict
Ben Graham always said you are right because your facts and reasoning are right, not because a crowd agrees or disagrees with you. So first I had to make sure the facts I had were correct.
Once I looked at the facts, from economic data like export/income figures, consumer expenditure, tax revenues, tourist arrivals to health data like rising confirmed Covid-19 cases, confirmed deaths, etc, I thought through what they mean with conservative assumptions.
I didn’t focus on things that are unknowable, instead, I tried to focus on what I know is important and what is knowable. A lot of things in this crisis are not predictable or knowable (like future currency exchange rates, commodity values, interest rates, stock prices, macroeconomic or political developments, and even the definitive date for the development of a vaccine). To me, this is about understanding your circle of competence and owning what you don’t know.
Here’s what I do know
The world is combatting the greatest health crisis in a century, the worst economic contraction of the last 80+ years, disastrous social consequences created because of the lockdown and if not for the spectacular intervention carried out by the major central banks of the world, severe financial panic and crisis as well.
Here is what I don’t know
I actively avoid making any form of macro predictions. Economics and markets are complicated systems and I personally think it is a waste of time trying to predict outcomes subject to human behavior and mass psychology. My job is to learn and absorb much of what is going on right now to be able to understand it as a business owner and not because I want to predict what may happen next.
So I turned to history to go back and understand what happened before the Great Depression of the 1930s.
The Great Crash of 1929
“There is no cause for worry. The high tide of prosperity will continue.” — Andrew W. Mellon, September 1929
In the Great Crash of 1929, Galbraith noted it was “easier to account for the boom and crash in the market than to explain their bearing on the depression which followed.”
This was largely due to the excessive deployment of margin loans on stock market speculation taken to incredible excess. What was harder to understand, was what led to the awful depression that followed the excesses of the 1920’s bull market and boom.
According to Galbraith, there were two remarkable events that needed explaining.
Why economic activity turned down in 1929
Why having started down, on this unhappy occasion it went down and down and down and remained low for a full decade
These questions were incomprehensible during the boom of the 1920s. The end of our current crisis has not yet been written and just like 100 years ago, I believe it is futile to try to predict how it will all exactly work out.
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”― John Kenneth Galbraith
I don’t know how it is all going to turn out along with the exact costs to the global and local economy. Rather than focus on the macro view, as a value investor, I feel it is my job to focus on the implications of a lockdown and prolonged contraction to specific businesses in my circle of competence that can withstand the crisis until it is eventually over.
What kind of risk am I taking on?
Am I facing real destruction of capital or a temporary to a medium-term setback in the business?
Covid-19, like all pandemics before it will end at some point and life, will go on as normal, although I have no idea when this may happen. Certain businesses with great long-term competitive advantages, great management, and strong financial structures will survive and continue to generate cash in the future.
Unlike the S&P 500 in the US (as of July 2020), which seems to have little bearing on current economic reality, Sri Lanka saw an almost 35% decline in the SL20 benchmark index since the start of the year. The Covid-19 situation brought about an unprecedented decline in market value to an already discounted SL20 index. Many of Sri Lanka’s strongest public companies were selling at historically low 10 year valuations and huge discounts to current intrinsic value.
Despite the bargains available, given the unprecedented crisis and uncertainty, my job is to primarily conserve and protect my capital by not putting it deliberately at risk of permanent loss before seeking an adequate return.
So I reflected on a few questions while performing my analysis
Are great businesses with good long term economics and competitive advantages selling at a discount to intrinsic value and future cash flows?
Has the intrinsic value of these great businesses deteriorated because of this crisis?
If the intrinsic value of these businesses has deteriorated because of the crisis, is this deterioration permanent or is it temporary?
Does a large discount to intrinsic value provide a sufficient ‘margin of safety’ in the case that things turn out to be worse than expected or the calculation of intrinsic value turns out to be incorrect?
Don’t focus on winning — focus on protecting yourself from what can go wrong
The wisdom of Graham & Dodd from ‘Security Analysis’
Security Analysis, despite showing statistics from almost a hundred years ago helped reinforce the principles that form the basis of value investing to me. The logical and rational explanations that precede each analytical tool in the book were wonderful to re-visit and read again. As Seth Klarman notes in his commentary — “Winning, in a sense, was accomplished by not losing. Investors could achieve a margin of safety by buying shares in businesses at a large discount to their underlying value, and they needed a margin of safety because of all the things that could — and often did — go wrong.”
Reading the book again gave me a renewed appreciation for the margin of safety principle. Personally, I think it transcends through time and reminded me of why I am so attracted to the Graham and Dodd school of thought.
Mental models are my guide
Investing is seeing out into the future, yet the future is unknowable. You only get paid for what is going to happen in the future and you don’t get paid for what happened in the past.
The past is only useful to you to the extent that tells you something about the future. Sometimes the past can give you some insights into the future, and other times it can not. Currently, given the extraordinary circumstances around this pandemic, there is not a lot the past can specifically tell me about this crisis and the exact consequences.
The wisdom of Charles T. Munger guided my thinking throughout investing in this crisis
Even before the pandemic, in my quest to acquire worldly wisdom, I spent a lot of time this year improving upon my thinking through the adoption of great mental models acquired through comprehensive reading and note-taking. Some of the most profound impact on my thinking this year is from the teachings and lectures of Charlie Munger.
Every analysis I perform now uses Charlie Munger’s 5 ultrasimple general notions in solving problems. The notions are built upon all the elementary ideas in most basic university courses (mathematics, accounting, engineering, psychology, biology, and economics, etc).
Here are the 5 helpful notions.
Ask the big ‘no brainer’ questions first (simplifying our problem: ask big obvious questions first with easy obvious answers)
Complete a numerical analysis of the facts
Invert the problem (find out how to destroy the business or how everything can go wrong)
Use the multi-disciplinary approach to view the problem (view the problem using all basic elementary ideas from university courses — psychology, biology, economics, etc.)
Look at Lollapalooza effects (really big effects from a large combination of factors)
I ran each of these 5 notions against everything I know about specific companies, using the facts I had at my disposal about the current crisis and conservative assumptions.
As the wise men in the old legend say “This too shall pass”
Most of the media coverage during this period has been overwhelmingly negative, the dire economic impact coupled with the health crisis has created devastating consequences all around the world. However, like all pandemics and crises before it, this pandemic will end at some point in the future.
In “Solomon’s Seal” by the English poet Edward FitzGerald, King Solomon entrusts a loyal minister to bring him a certain ring with magic powers. These magic powers King Solomon said were to enable the following — “if a happy man looks at it, he becomes sad, and if a sad man looks at it, he becomes happy”. King Solomon knew that no such ring existed in the world, but he wished to give his minister a little taste of humility.
To King Solomon’s surprise, his minister returned with such a ring. Given to the minister by a jeweler in one of the poorest parts of Jerusalem at the time, the gold ring had the following three Hebrew letters inscribed on the gold band: gimel, zayin, yud, which began the words “Gam zeh ya’avor” — “This too shall pass”. At that moment King Solomon realized that all his wisdom and fabulous wealth and tremendous power were but fleeting things, for one day he would be nothing but dust.
Like the wise old man in this old legend, it would be productive to keep one’s rationality in check by remembering that ‘this too shall pass’.
I underestimated the full extent of the pandemic back in March 2020, however, I stuck to strict standards in my value approach.
Personally, I think the remarkable panic seen on the Colombo Stock Exchange in May 2020 presented one of those few ‘once in a lifetime’ type opportunities. Some of Sri Lanka’s most wonderful businesses were selling at earnings multiples and huge discounts to intrinsic value not seen in 10–15 years.
My approach is to make a few high-quality big bets when the opportunity presents itself a few times a year and the opportunities presented in May were mouthwatering. Continuously learning and reading more about businesses in my circle of competence gave me the confidence needed to act when these businesses sold at these unprecedented discounts. It rained gold for just a few weeks, and I ran outside with a bathtub and not a bucket.
I believe I have a 20 shot financial punch-card in my lifetime. I need to make each one count and I’ve used about 5 so far.
This article was derived in large part from the material and inspiration listed below.
John Kenneth Galbraith: The Great Crash of 1929 (link)
Benjamin Graham and David Dodd: Security Analysis, 6th edition (link)
Peter D. Kaufman, Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition
A story about King Soloman and impermanence by Drinklings.coffee, Feb 2018 (link)