At Cobas we work with wide safety margins and that gives us a great deal of peace of mind.
Looking to the future implies doing so through assumptions, so we consider trying to foresee how the economy will unfold as an exercise of little use. We do believe it is necessary, however, to try to understand the context in which we find ourselves and look for support points to navigate in it in the best possible way.
In recent weeks, many investors have asked us questions about our outlook for the economy in macroeconomic terms, beyond the group of companies that make up our portfolios.
As everyone will know, it is not our job to try to second guess where the world will go in global terms, mainly because our investment process is completely bottom up, based on the quality of the businesses and how undervalued they may be with respect to our value estimate. In addition, they will understand that we do not have the ability to anticipate the future, so any opinion we may have would still be anecdotal.
That said, the theoretical framework we are working on is based on the ideas of the Austrian School of Economics, using it as a theoretical indicator to mainly try to gain our own impression focused on trying to measure which parts of the economy or companies are overheated, and thus try to avoid them.
Mainly, the doubts that our investors have been raising focus on the possibility of facing a future inflation scenario, as well as on the future growth rate of the global economy in a post-COVID-19 scenario. For this reason, we will try to put these two issues in context, without in any case trying to give any forecast about possible future events.
The Austrian School of Economics defines inflation as the increase in the amount of money (including fiduciary means), which is not offset by a corresponding increase in the need for money, thus producing a change in its target exchange value. The rise in prices (what we commonly know as inflation) only takes place to the extent that this new money drives demand for more consumer goods. This happens because, with equality of goods and services available in an economy, the increase of money in circulation should, theoretically, lead to a depreciation of its value in relative terms.
From here, there are too many variables that influence this process, and all of them are impossible to foresee, for example: Could COVID-19 generate a disruption in supply chains, balancing it towards a production approach that could make the price of productive factors more expensive? Can we expect sufficient growth in demand for it to boost prices in the future? These are two questions, like many others that there may be, which we could debate long and hard about without reaching any accurate conclusion, entering the field of speculation, which we like so little.
Therefore, based on the theory itself, we understand that the normal effect of the recent actions of central banks is that an inflationary environment is generated, although we do not know how, when, where, or how acutely it will occur. What we do know is that, given this possibility, pricing capacity becomes extremely important for a company. For this reason, we do evaluate how an inflationary scenario could affect our positions, trying to protect ourselves via businesses capable of transferring that inflation to their prices, either by clauses that protect them from it, or by simple pricing power resulting from good competitive position, for example.
Something that is clear so far is that inflation is not being generated in the real economy; however, we are observing how the price of certain financial assets has rebounded upwards with considerable virulence in recent weeks, although it varies depending on the market or sector considered. This situation may lead us to believe that the entire monetary injection that is being carried out by central banks does not stop flowing into the real economy.
A recent study carried out by BMO is based along these lines. According to which, a decreasing correlation is being observed between excess reserves and the M1 or currency in circulation (made up of cash plus deposits). As the Federal Reserve, via lower rates and QE (Quantitative Easing) leads to a direct increase in bank reserves, only a fraction of this translates into growth in the money supply and, therefore, potentially in consumption and investment. According to the study, today, every dollar of QE translates into an increase of $0.32 of money in circulation, compared to the $0.95 that flowed in the QE1 started in 2008.
Analysing the factors that may be behind this low growth in the money supply, the study we are referring to highlights two factors:
- Understanding the increase in the FED's balance as "loans of the future" (the economy is sustaining itself through debt), we have to understand that it is only possible to incorporate a limited amount of future consumption, via monetary policy, into the current period. There comes a time when current consumption does not provide sufficient profit to economic agents, regardless of how low interest rates are.
- Another factor that may be having an influence is inflation expectations. After many years of expansionary monetary policies without significant increases in the level of prices, economic agents seem to understand that these monetary policies will not produce inflation, so the current consumption momentum relaxes.
Now, we add COVID-19 to this, with the social distancing measures that it entails and its consequent slowing effect on economic activity. Likewise, it is possible to think that another reason for said phenomenon resides in the fact that, given that a good part of the economic agents left very poorly economically speaking from the Great Financial Crisis of 2008, today it is these same economic agents who, in a certain way, are rejecting all that money supply that is being served, seeking to avoid falling back into the same situation in the future. Likewise, it is possible to think that another reason for said phenomenon resides in the fact that, given that a good part of the economic agents left economically very poorly from the Great Financial Lastly, it is worth highlighting the possible influence of technology and the increasing efficiency of the different production processes, with their deflationary nature.
Consumption does not increase
We reach a situation in which the money supply increases, but without generating growth in consumption; therefore, savings mathematically increase (what is not consumed, is saved). This is precisely what may be causing the rise in the prices of financial assets, taking the valuations of certain types of assets to levels that, in our opinion, entail too many risks, given the need for them to meet the necessary growths that justify these expectations in the future.
All this supply of new money that is being created does not flow to the economy in a neutral way, but it does so in a determined way and according to specific mechanisms, following a relatively observable path. Said money first searches for the safest assets (government or corporate bonds in investment grade) and, as their prices become less and less attractive, it goes to assets with greater uncertainties, in search of better returns (equity "with bond characteristics", in terms of security of flows and coupons/dividends, such as utilities, pharmaceuticals or certain technology companies that apparently "guarantee" a large and steady growth of their flows in the future, although instead of distributing dividends, aspire to reinvest it in their own business at better rates of return). Again, as these assets tend to become more expensive (and for example their dividend yield decreases), investors will again seek attractive prices at the next level of uncertainty. It is a gradual process that requires time and, therefore, patience.
Our work in this respect, as we pointed out at the beginning, is limited to trying to understand whether or not assets are correctly valued, with the aim of avoiding those that could be inflated by the described monetary process, while always focusing our attention on businesses that we believe their fair value is higher than their current market value.
With regard to the economic scenario that we will face in a post-COVID-19 context, we tend to think that, once the effects of the pandemic are controlled and with it social distancing measures are alleviated, the world should gradually take up the activity levels of prior to its emergence. We have already seen a certain glimpse in Asia, as we showed in our May newsletter.
To a certain extent, this reasoning is based on the causes of the crisis. Unlike what happened in the Great Financial Crisis of 2008, in which the problem arose from the excessive leverage that was reached in the financial sector, one of the pillars of any free economic system, this crisis that we are now facing has emerged due to an exogenous factor to the economy, such as a pandemic, which has deprived us of the freedom of movement necessary to satisfy our consumption objectives. It is therefore conceivable that, as these freedoms are restored, consumption patterns gradually return to pre-COVID-19 normality. Furthermore, we must add the fact that, at a general level, both in terms of the financial sector and households, we are facing this crisis with a healthier financial position than we had in 2008.
The good news regarding our investments is that given the, in our opinion, great undervaluation in the prices of the assets that make up our portfolios, we do not believe that exaggerated growth in the cash flows of these companies is required to justify the valuations we are working with. This is precisely what we want to convey when, despite the evident volatility in the listed prices of these assets, we say that our portfolios are conservative. We work with wide safety margins and that gives us a great deal of peace of mind. We are convinced that, if things evolve reasonably normally, little by little the market will tend to more efficiently reflect the cash generation of our businesses and then provide us with the long-awaited revaluations that we all crave.
Meanwhile, together with the price factor, there are other characteristics in our portfolios that offer us the peace of mind necessary to navigate these turbulent times: around 15% of companies have net cash positions; close to 60% is trading at a Net Debt / EBITDA ratio <2x (and in those cases where said ratio may be higher, there are contracts that offer visibility of future FCF) and practically three quarters of the portfolio have controlling shareholders who are staking their equity along with ours. Combined with all this, today, after having invested in them for three years, we have a deep knowledge of our businesses and that makes us increasingly confident that, in time, the market will eventually recognise the real value of these assets, as it has always done in the past.
As we view it, looking to the future always implies doing so through assumptions, given the enormous difficulty of forecasting the behaviour of economic agents, and for this reason, we do not believe we are equipped to clearly answer these questions posed by our investors. What we are trying to do is explain the theoretical framework on which we base ourselves, something that can always serve as a basic reference when looking at the behaviour of the economy as a whole. However, we do believe that asking questions and asking ourselves any questions that may arise are healthy, and with that in mind, at the investor relations department we work with the aim of channelling our analysis team's message to you, investors, in the most transparent and honest way possible.
This article first appeared on GuruFocus.