What We’re Reading (Week Ending 22 October 2023) - 22 Oct 2023
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 22 October 2023):
1. Margin of safety: Most important words in investing – Chin Hui Leong
Warren Buffett once said that “margin of safety” has been the bedrock of his investing success for decades. But what do these three words mean?
Let’s use an analogy: imagine you are an engineer and you are tasked to build a bridge that can withstand cars weighing 1,000 kg every day. How strong would you make the bridge? Would it be able to support 1,000 kg or 1,500 kg?
If you chose the first option, you are cutting it close. But if you chose the second option, you have grasped the concept of margin of safety.
In investing, margin of safety is about leaving room for error because you’ll never know what will happen in the future.
For example, think about the pandemic which shook the world three years ago, a rare and unpredictable event that had a huge impact on businesses and industries. Few, if any, could have foreseen or prepared for it. That’s why margin of safety is important; it helps protect your stock portfolio from unexpected risks…
…As a growth investor, I view the concept of margin of safety differently.
For me, the value created by a business is my margin of safety. On the surface, my approach appears to be at odds with the concept of margin of safety. Why place your faith on a business which is inherently filled with uncertainties? Yet, I would argue my approach is easier to apply.
Consider the contrast between value and growth investing.
In a value investing approach, as you have seen earlier, your task is to figure whether a business which ran into trouble is not not doing as badly as it seems. You are compensated, in this case, with a lower stock price. In comparison, when you pick growing businesses which are already doing well, all you have to figure out is whether it can continue doing well in the future. This business puzzle, to me, is easier to solve. Sure, you will pay a higher price at the start as growing businesses rarely sell on a discount. But if done well, the value which builds up over time will compensate you for the risk taken.
To share an example, take Chipotle Mexican Grill (NYSE: CMG), a US-based, fast-casual Mexican food chain.
In 2006, the business was generating less than US$6.3 million in free cash flow (FCF). Today, the food chain churned out US$1.25 billion in FCF over the past 12 months, some 200 times more than its 2006 level. During this period, its share count also declined by 14 per cent. Thus, on a per share basis, the company’s current FCF per share is over 230 times higher than 2006’s FCF per share…
…At the end of 2006, the stock was trading at US$57 or around 295 times its 2006 free cash flow per share, a valuation that cannot be described as cheap.
Fast forward to today: at a share price of around US$1,822, the free cash flow per share multiple has declined to 40.5 times, over 86 per cent lower compared to 2006’s level.
Yet, despite the drastic fall in this multiple, eagle-eyed readers would have noticed that shares today are 32 times higher compared to the end of 2006…
…If you compare the share price at the end of 2006 (US$57) to today’s FCF per share (US$45 per share), you would get a valuation which is less than 1.3 times. This is an extremely low multiple for the stock, giving you plenty of room for error.
And what drove the creation of this margin of safety? That’s right, it was the value of the business, signified by the growth of its FCF per share.
2. The Risks No One Is Talking About – Brian Richards
Generally speaking, risky investments are well-known to be risky, and most market participants have an eyes-wide-open approach to the risks. Perhaps positions are kept smaller, or are hedged, as a buffer. Contrast that with anything deemed “safe”—whether deemed so because of overconfidence, naivete, a low-looking valuation, or a psychological illusion. Its presumed safety can lull investors into a sense of security that prevents appropriate diligence or analysis.
Think about the role of bond ratings in the Great Financial Crisis, when investment-grade ratings were given to paper that turned out not to be investment grade. The U.S. Financial Crisis Inquiry Commission’s published report does not mince words:
We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms….
….As my friend Morgan Housel says:
Asking what the biggest risks are is like asking what you expect to be surprised about. If you knew what the biggest risk was you would do something about it, and doing something about it makes it less risky. What your imagination can’t fathom is the dangerous stuff, and it’s why risk can never be mastered.
It seems to me that managing risk is a process without an end, an art rather than a science. The key, I think, is to be humble about what risks exist (even in so-called safer assets); be upfront about the things you take as granted; to try to be mindful of your own behavioral biases (or the psychological illusions designed to trick your brain); and realize that the true risks are hard to recognize ahead of time. Equities that appear to be “safe”—such as the Nifty 50 in the 1970s, to many eyes—may be among the least safe of all; and those that appear risky may be among the most promising and potentially less risky than average.
3. Freight recession unlike any other in history – Craig Fuller
In 2000, freight brokerage was a cottage industry, representing a small percentage of the trucking industry — 6%. Fast forward to 2023, and freight brokers handle more than 20% of all trucking freight.
As freight brokerages have taken on a larger percentage of the market, they have reshaped the typical freight cycle.
In the early 2000s, it was uncommon to see a freight broker in the primary position of a shipper’s routing guide.
Back then, freight brokers usually handled freight that asset-based carriers didn’t want or that was priced too low for the carriers to make their margins. Freight brokers would also serve as a last resort if carriers had freight surges that they could not handle.
Since then, however, things have changed dramatically. As freight brokerages invested in technology and customer service, they began to offer a more compelling product than their asset-based competitors and took on a greater role in routing guides.
Today, it is common for multiple freight brokerages to be in primary positions in shippers’ routing guides, often as the top choice, beating out their asset-based competitors…
…As of April 2023, there were more than 531,000 active trucking fleets that own or lease at least one tractor in the U.S., according to Carrier Details, which provides trucking authority intelligence using data from the Federal Motor Carrier Safety Administration (FMCSA) and insurance registrations (available on SONAR).
Contrast that with 1980, when there were around 18,000 U.S. trucking companies…
…The current freight cycle has been different. In previous cycles when freight rates have been low, many of the weakest carriers exited the industry. While some of the companies that went out of business in 2019 — the last major down cycle — were quite large, such as Celadon and New England Motor Freight, most were small “mom-and-pop” companies that lacked the resources to stay in business.
In 2023, many people, including me, expected that as before, many small carriers would roll over and quickly exit the freight market as conditions became difficult. After all, we thought, when the freight economy slowed, high-quality loads for small carriers would dry up. It wasn’t just rates, but also load counts that dropped.
FreightWaves’ Rachel Premack reported in an April 28 article that the “number of authorized interstate trucking fleets in the U.S. declined by nearly 9,000 in the first quarter of 2023 …”
So while companies have certainly left the industry, small carriers overall have held on for far longer than many of us expected. The reason is that even as rates have declined — in many cases lower than 2019 rates — freight brokerages have kept many small truckers supplied with quality load opportunities…
…Newton’s law of gravity, a fundamental rule in physics, is commonly cited in commodity markets like trucking.
When capacity tightens and drives up rates, new entrants enter the market, flooding it with capacity and driving down rates.
The same carriers that entered the trucking industry to take advantage of high rates are now being forced to take much lower rates to keep their trucks moving.
In past cycles, when the freight market softened, we would see a massive purge in capacity. While there have been reductions, it has happened much slower than anticipated.
A key reason it has been so slow to churn out capacity is because of the proliferation of freight brokers.
In past down cycles, freight brokers would lose a large percentage of their volume, as shippers kept to a small number of core carriers in their routing guides.
But over the past decade, freight brokerages have positioned themselves in the role as a core carrier, enabling them to maintain load volumes, even in down markets.
So in this down market, most freight brokerages have maintained a high percentage of load volumes, even as rates fall.
The loads may not pay much, but brokers are able to supply carriers with loads that pay just enough to cover the monthly truck bill.
Carriers may be losing money, but that small amount of cash flow will keep them in the game longer than would be otherwise expected…
…According to SONAR‘s Carrier Details Total Trucking Authorities index, from 2010 to August 2020, the trucking industry added an average of 199 new trucking fleets per week.
From August 2020 to September 2022, the number of new trucking fleets exploded by an average of 1,124 new fleets per week.
The trucking market currently has 63,000 more fleets than the 2010-2020 trend line would suggest…
…Unless there is an acceleration in revocations (i.e. trucking companies shuttering their authorities), FreightWaves models suggest the trucking market has 78 weeks to go before capacity is back in balance with historical trends.
4. Where are all the defaults? – Greg Obenshain
A rapidly rising Fed funds rate has historically led to high levels of defaults as weaker borrowers get squeezed between higher borrowing costs and slowing growth. Just looking at the number of Chapter 11 bankruptcy filings, history would appear to be repeating itself in this rate-hiking cycle. Chapter 11 filings have increased even as the economy has thus far appeared to avoid a recession.
Usually, as the bankruptcy rate spikes, the high-yield spread also rises. But so far, the high-yield spread has barely moved.
If we just used bankruptcy rates to predict high-yield spreads, then we’d expect high-yield spreads to be 7.0%, not the 4.4% we see today. It’s not just small companies defaulting. Fourteen of the bankruptcies in 2023 have had over $1 billion of liabilities, including Mallinckrodt, Yellow Corp, Wesco Aircraft, Avaya, and Party City.
One reason we believe high-yield spreads haven’t spiked yet is the migration of lower-quality borrowers—those most likely to default—out of high yield and into the private credit market. According to Moody’s, the number of issuers with B3 debt has fallen as these issuers have departed for private credit. They do not mince words about this: “Ultimately, we believe the growth of the alternative asset managers will contribute to systemic risk. This group of lenders comprise both private equity and private credit segments and lack prudential oversight, as opposed to the highly regulated banking sector.”
The leveraged loan market, which can be thought of as the loan market rated by credit agencies, is now about as big as the high-yield market, at around $1.3 trillion. The private credit market, which can be thought of as the loan market not rated by credit agencies, is much harder to measure but is reported to also be over $1 trillion. And much of that growth has come from riskier borrowers…
…Where loan and bond amounts are available (54 of the 62), Moody’s has tracked $35 billion of loan defaults versus $26 billion of bond defaults. 30 were loan-only capital structures, 12 were bond-only capital structure, and 12 were capital structures with both loans and bonds. Of the 62 defaults listed, 37 were distressed exchanges and 19 of the distressed exchanges were for loan-only capital structures versus 10 for bond-only capital structures. Distressed exchanges, which are debt renegotiations conducted directly with lenders and outside the bankruptcy system, are often not captured by the default statistics and are not counted in the running count of Chapter 11s with which we started the article. This time is different in a way. Defaults are happening. They are just not happening where they used to, and they are happening in a different way (distressed exchanges) than they used to.
This does not mean that all loans are doing poorly. In fact, BKLN, a loan ETF with $4.4 billion of assets has returned 9.1% year to date as it benefits from higher underlying interest on its loans. But that fund holds more than half its funds in BB or BBB rated credit and less than 1% in CCC loans. It is not heavily exposed to the companies in the low single-B rating. That is where the most pain is likely to be. The rating composition of a market matters when considering defaults. And there has been a significant shift of low-rated credits to the private credit markets.
5. Buffett’s World War II Debut – Marcelo Lima
At this year’s Berkshire Hathaway annual meeting, Buffett did something I wish he did more often: he put up some very educational slides. The first showed the front page of the New York Times on Sunday, March 8, 1942, three months after Japan attacked Pearl Harbor. If you think today’s headlines are scary, you’re in for quite a shock…
…Buffett had his sights on Cities Service preferred stock, which was trading at $84 the previous year and had declined to $55 in January. And now, on March 10th, it was selling at $40.
That night, 11-year-old Buffett decided it was a good time to invest. As Buffett recounted, “Despite these headlines, I said to my dad, ‘I think I’d like to pull the trigger, and I’d like you to buy me three shares of Cities Service preferred’ the next day. And that was all I had. I mean, that was my capital accumulated over the previous five years or thereabouts. And so my dad, the next morning, bought three shares.”…
…Buffett successfully top-ticked the market at $38 ¼, with the shares closing at $37 (down 3.3 percent). This, he joked, “was really kind of characteristic of my timing in stocks that was going to appear in future years.”
The world’s greatest-investor-in-training would eventually see the shares called by the Cities Service Company for over $200 per share more than four years later…
… But the story doesn’t have a happy ending…
…From the 38 ¼ Buffett paid, the stock went on to decline to $27 (down nearly 30 percent from his cost!).
What Buffett didn’t say at the annual meeting is that he had enlisted his sister Doris as a partner in the idea of buying the shares. Every day on the way to school, Doris “reminded” him that her stock was down. (This story is recounted in the excellent book Snowball).
After enduring so much pain, he was happy to sell at a profit only a few months later, in July, for $40. “As they always say, ‘It seemed like a good idea at the time,’” Buffett joked.
Despite the ugly headlines, Buffett said everyone at the time knew that America was going to win the war. The incredible economic machine that had started in 1776 would see to it. So imagine, in the middle of this crisis, you had invested $10,000 in the S&P 500. There were no index funds at the time, but you could have bought the equivalent basket of the top 500 American companies.
Once you did that, imagine you never read another newspaper headline, never traded again, never looked at your investments.
How much would you have today? Buffett again: “You’d have $51 million. And you wouldn’t have had to do anything.”
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Chipotle Mexican Grill. Holdings are subject to change at any time.
