Lessons From Sam Presti

In June, the Oklahoma City Thunder won the NBA Championship. In my mind, it was one of the most well-deserved success stories in recent memory. Their General Manager, Sam Presti, has built two (actually almost three) title contending teams in his 18 years as GM.

Imagine for a moment what it must be like to run a professional basketball team in Oklahoma City. They are technically the third smallest market in the league, ahead of only New Orleans and Memphis, but they are arguably less “famous” than those two. In other words, if you were a budding super star, a young belle of the ball coveted by all the teams in the league, where would you prefer to live, New York, L.A., Miami, Chicago? Or… Oklahoma City?

Thus the built-in handicap of being in a location much better known for petroleum exploration: star players generally want to play under brighter lights. Unlike the L.A. Lakers, who can attract the services of LeBron James, The OKC Thunder must rely on draft picks, player development, opportunistic trades, and a culture/ethos that can keep the homegrown stars home.

Building a high functioning organization in any business, any industry, share many common denominators. Sam Presti has done it, with one metaphorical hand tied behind his back no less. I have watched many hours of his marathon pre- and post-season press conferences over the years, mesmerized by how similar his philosophies are with value investing[1]. To wit:

·       Instead of splashing out for flashy free agents or make blockbuster trades, he opts to collect draft picks, then nurture the young talent that come from those picks. Instead of chasing hot stocks or trying to get allocations to hot IPOs, we value-oriented folk prefer to find hidden gems that are initially ignored by the collective, then patiently wait for them to flourish.

·       Instead of chasing players that are coveted for their statistical output in the hot strategy du jour (e.g. 3-point shooting), he focuses on players that can stack quality possessions (e.g. tenacious defenders that can force turnovers). Instead of recycling the same valuation metrics to determine if a company is mispriced (e.g. P/E ratios), I try to gleam if there are hidden or buried intangibles that have a high probability of becoming cash in the future.

Perhaps most poignantly is his mantra that to be exceptional, one must be willing to be the exception. And its inverse: to be an exception, one must be exceptional. To beat the S&P 500, to be exceptional, we must aspire to be an exception and compose our investments in a way that is substantially different from that powerful benchmark. Success is never guaranteed. Luck and uncertainty remain untamable wildcards. Best any of us can do is to play the odds the rational way through relentless self-improvement and humility and wait for the breaks of the game to favor us on occasion. The OKC Thunder’s 2025 NBA championship trophy is proof that it works, and it is why I was so enthralled by their incredible season.

His pre- and post-season pressers are Must See TV for me

I’ll share one last lesson from Sam Presti that has stuck with me, actually a lyric formally attributed to the band A Tribe Called Quest – but I hadn’t heard of it until he quoted them:

“Scared money don’t make none.”

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[1] On the flip-side, ex-Philadelphia 76ers GM Sam Hinkie, upon his resignation in 2016 after losing a power struggle, leaked a self-serving letter that name-dropped investing luminaries like Buffett, Munger, Seth Klarman, and Howard Marks. Hinkie is a perfect example of an empty intellectual, a belly full of read knowledge but unable to translate any of it into actual results; and when held accountable, lashes out with highfalutin words. He has not held another management position in the NBA since.

Look Who’s Back. Back Again.

As I’ve written several times before, presidents and partisan politics have no correlation to economic prosperity generated by corporate profits over the long run. Dimensional Fund Advisors periodically updates their helpful chart showing just how irrelevant who is sitting in the White House is to the S&P 500 Index:

Source: https://www.dimensional.com/us-en/insights/how-much-impact-does-the-president-have-on-stocks

And with three presidential elections in Incandescent Capital’s nascent history, maybe a chart of how your money has grown with me through three different administrations is closer to home:

Incandescent Capital returns since inception

As you can see, basically: politics don’t matter. Because corporations are not in the “business” of politics – they are in the business of adjusting to whatever the public policies are. At least, successful corporations worth investing in are. However the winds may blow, they set their sails profit-wards. This goes for us portfolio managers as well.

Most importantly, election day came and went, thankfully, once again, without any widespread unrest. The Trump administration redux will have less surprises for the world this time around. We can probably expect two things with high probability: less regulation, and more chaos. Keynesian animal spirits have been on full display in the days after November 6th, with the stock market expecting more unchecked growth and lower taxes. But on the flip side, the bond market has sold off, with yields rising on expectations of more inflation and higher deficits.

Look. It’s all mostly uncertainty and noise. Bottom line is, I urge you to not make economic decisions based solely on politics. I’ll remind you with the same anecdote I shared in my letter four years ago to-date:

“In 1951, I proposed to my wife. And my father-in-law was the most conservative guy in Nebraska except maybe for my dad. My father-in-law said, ‘I want to have a talk with you.’ So I went over to his house to have a talk. And he sat there and he said, ‘Warren,’ he says, ‘I just want to absolve you from any worries. You’re going to fail. And the reason you’re going to fail – my daughter may starve to death and you’re going to fail, but I’m not going to blame you – it’s because the Democrats are in and they’re all Communists.’ I listened to this thing for three hours. I have seen people make economic decisions based on their political feelings and it is not the way to do it.”

-Warren E. Buffett, February 2017 ¹

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¹ https://www.cnbc.com/2017/02/27/billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box.html

A Little More on the Present Value of Future Cash Flows

In an earlier post I laid out why it mathematically makes sense all securities, equities and bonds alike, decline when interest rates rise. Essentially, the cumulative value of future cash flows become less valuable in the present because the risk-free alternative has become more attractive. Instead of earning 0% in completely safe bank accounts, you can now earn over 3%. That makes folks less interested in taking a particular risk for 5-6% returns, and would perhaps demand 9-10% returns for equivalent risk.  

At first blush, a 5% difference seems modest. But consider how it affects security prices. If we invest $100 in a security that will earn us $5, that’s a 5% return. But if we want to sell that security right now, when investors demand a 10% return, we’d only be able to sell it for $50. Obviously I’m simplifying a lot¹, but at the core, that’s how interest rates can nosedive the value of a security from $100 to $50.   

Nevertheless, it is largely irrelevant to us, the patient investor.  

Because if we ignore the price movements and don’t sell, and the security delivers its cash flows year in and year out, the value still accretes. The cash piles up irrespective of day-to-day interest rate movements and we continue to earn our return! If we put our $100 investment in a lockbox and don’t bother stressing about its present value on a regular basis, the only thing we care about is the cash it’s generating for us: the $5 annual return. And whether it can potentially grow to $6, $8, $12, and beyond in the years ahead.  

We cannot control interest rates, nor can we control the perception of market participants. What we can control is the accuracy of our analysis and the decision to buy or sell based on what the market is offering².

Our holy grail is an environment where interest rates are at or near a peak (thereby weighing on prices but without the prospect of further declines) and other investors are indiscriminately fearful (thereby demanding a higher rate of return, which further weighs on prices). When we invest in this environment, we get to own not just the intrinsic value of capable corporations growing their per-share values over time, but also the possibility of a lower interest rate future and improving investor sentiment that could pull forward even greater returns.

This idea, in essence, is why we value investors shouldn’t sweat the macro. Interest rates and elections and geopolitics and the animal spirits of markets will always be unpredictable. Good businesses purchased at reasonable prices will endure. Accordingly, I increasingly think of us as collectors: We collect enduring assets that benefit from time.

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¹ Don’t @ me, bond people.

² Simple, but not easy. I’m by no means saying this business is a walk in the park and everyone else is stupid.

One Equation To Rule Them All

For about, let’s say, 13 years now, since the economy emerged from the Great Financial Crisis, U.S. equities have been in a relentless bull market. 2020 provided a shocking reprieve, but the velocity with which it roared back essentially made it feel like a brief nightmare on a hot summer afternoon that you wake up from and realize, oh wait, I just fell asleep on my hammock in a tropical paradise. The bull was gored, but trillion dollar government handouts provided a turbocharged shot of morphine.

Well, now the drug has run its course, and there is no more on the horizon. Interest rates, particularly housing mortgage interest rates, have spiked seemingly overnight to levels not seen in 13 years as the central bank tries to contain inflation. This has been the missing ingredient in killing the bull market. Interest rates are intrinsically and inextricably tied to all security valuations. Like a see-saw, when rates goes up, prices must come down.

Slowing growth has also spooked erstwhile euphoric market participants, particularly those who piled into high-multiple tech names. For the first time in many, many years, Facebook, Apple, Amazon, and Netflix in particular are decelerating rapidly. This is primarily a function of their size, as they are now either so big they’ve run out of markets to grow into and/or they’ve accumulated too many enemies and/or they no longer attract the finest talent because they’re perceived to be soulless Goliaths more driven more by corporate interests than by the change-the-world ethos they were conceived from. And because of their sheer size, they have an outsized influence on the S&P 500 index.

Let’s quantify this double-whammy. A central tenant in fundamental equity valuation is the calculation of its so-called terminal value, whereby a stream of cash flow is divided by a percentage figure derived from subtracting its growth rate from its cost of capital (which is directly tied to interest rates). So now we have cost of capital rising and growth rate slowing, inflating the denominator of this formula which deflates the resulting terminal value. In other words, this all makes sense. The market is acting perfectly rationally by declining.

Terminal Value = Free Cash Flow / (Cost of Capital - Growth Rate)

I continue to believe the most comparable period to today’s market condition is the Nifty Fifty in the ‘60s rather than the 2000 dot-com boom and bust, although there are admixtures of both present. The tech giants of today mirror the Nifty Fifty: absolutely dominant companies who grew at such consistent paces that investors eventually (mistakenly) believed there is no bid too high. Similar to today, inflation then took hold, followed by rapidly rising interest rates, which pulled down security valuation across the board. The companies remained dominant, but their stock prices retreated and took years to recover. The dot-com era was in contrast riddled with mostly profitless companies with no path towards said profitability. This, though, describes large swaths of the crypto/Web 3.0 ventures. It does appear to me the vast majority of those will eventually fail as most do not actually generate any intrinsic value to society.

A fair sidebar question would be, if I am so steely convinced about this, why not go net short? And the answer is because the market is a forward discounting mechanism, i.e. every day, everyone is trying to figure out where rates will stabilize and by extension, where security prices should settle. As certain as I am that as rates go up, prices will go down, I’m just as uncertain how this is reflected day-to-day in the market. Predicting this movement is the purview of the short-term speculator, the trader who attempts to game the voting machine .

Also, I could be wrong! Macroeconomic stuff like interest rates are notoriously difficult to predict. Is it possible inflation quickly subsides later this year, leading to less rate hikes? It's certainly not impossible. There are always contra-indicators that inject just enough prognostic doubt in the short-to-medium term. And there's always the human element, prone to bouts of irrationality. The prospect of churning our portfolio and incurring capital gains taxes and trading fees in light of this much uncertainty seems like folly.

Contrary to many market participants, I’m feeling mostly sanguine (and edging towards enthusiasm) about this correction. It’s unhealthy for markets to become untethered to fundamental realities and pose as the world’s biggest casino. It distorts capital allocation which distorts incentives which distorts true, real growth in productivity and innovation. Companies that don’t produce sufficiently differentiated or necessary products or services to generate sustainable profits don’t deserve capital. Certainly, some speculation is necessary in cutting edge projects, e.g. biotech, but not in perpetuity. A return to a mostly rational market is good for humankind in the long run. 

How/When/Should A Tiger Change Its Stripes?

It is fair to ask of your portfolio manager: if growth has resoundingly beaten value over so many years, why persist against the grain? Why the insistence on a strategy that appears handicapped? Why not adapt to a new normal?

Fact is, it’s not that simple. Publicly traded growth stocks attract primarily speculators. And if there’s one thing I will never endeavor to be, it is that of a speculator. A speculator cares not about the underlying fundamentals of a company, only how/when its stock price will rise. These “investors” are behind every bubble’s dramatic formation and destruction, and over the long run, their odds are no better than a run-of-the-mill casino game.

And yet, there have been spectacular growth stocks that deserved every penny of their erstwhile inflated valuation and more. I am referring to, of course, Google (Alphabet), Apple, Facebook¹, Amazon, and Microsoft, et. al. They are truly wealth creators of epic proportions. Over the past 12 months alone, they accounted for over $250 billion in bottom-line profits. They actually earned it and their share prices reflect their profitability, fair and square².

Their success has caused a ripple effect of investors looking for the next companies that can generate seemingly endless growth. This guessing game of who will be the next trillion dollar market cap behemoth is a rising tide that has buoyed the entire technology sector, which in turn, as it inflates, come to constitute and contribute to an ever bigger portion of the S&P 500. 

It is a difficult game to play because it’s not at all obvious. Assuredly, there will be, in the long run, a whole chunk of losers that get outcompeted, just as assuredly there will be a smattering of ridiculous winners, all of whom trade at nosebleed valuations. I have nothing inherently against investing in growth, but right now, there is no margin of safety and I have no edge. Case in point is our saga with BlackBerry. My thesis, pinned on their turnaround growth, has thus far failed to pan out, but we still enjoyed outsized profits thanks to internet message board speculators driving up their stock. We got lucky. But any investment program dependent on luck is by definition irregular and unsustainable.

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¹ To be clear, however, I am not a fan of Facebook’s destabilizing societal impact. It’s improbable I will ever invest in them (in their current form), as it would feel icky to root for such a company and share in their profits.

² https://www.axios.com/earnings-largest-companies-tech-giants-77de0e35-e3b3-42d6-9dd4-b56bb4064ea1.html

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On the flip side, the more that non-tech names continue to contract, the more their opportunity grows. As capital chases the ephemeral, it ignores the businesses that build and make “real” things. Without affordable capital to build and make, they won’t. Which leads to shortages, which leads to higher prices, which leads to bigger margins and profits… which should eventually lead to, once again, more capital. 

The canary in this coal mine are semiconductors. Once a boom-or-bust cyclical, the redheaded stepchild of sexy tech that could never attract consistently affordable capital, persistent shortages are now endemic. Building new semiconductor plants are expensive and years-long, and supply fell far behind the demand curve. As capital gushes back towards the industry, semiconductors and companies that comprise its value chain have been some of the best performing stocks in recent years. 

To wit, the Philadelphia Semiconductor Index (SOX) went pretty much nowhere from 2002 to 2016, dramatically underperforming the broader Nasdaq 100 for 14 years:

But from then on, it has more than held its own, especially over the past year and a half:

Until humans can simply upload our consciousness and live solely in The Matrix metaverse, we will need mundane, earthly things. We’ll need to get around in cars and trucks. We’ll need electricity and the power plants that generate them. We’ll need buildings to live and work in, and we’ll need banks to finance them all. These necessities ensure the long-term durability of our portfolio companies, while capital’s cold-shoulder has made their equities cheap. If the story of semiconductors is instructive, this won’t last forever. 

A Little Bit of “2020” Hindsight

Rudyard Kipling once wrote, “If you can meet with Triumph and Disaster / And treat those two impostors just the same,” which pretty poetically summarizes my feelings about our past five quarters. From the early days of 2020 to the very depths of our worst drawdown that troughed on March 23rd, we saw our portfolio’s marks decline by nearly -50%. But then from thereon out to the end of Q1 2021, a period that spans only one short year, it rallied over 175%.

Practitioners of Modern Portfolio Theory, of which most sophisticated institutional investors are at least part-time, would downright faint at that level of volatility. For they make one key assumption: volatility = risk. Bluntly put, that is an analytical shortcut. It actually works serviceably most of the time. Risky security issues are typically volatile! But not all volatile securities are risky. And as a corollary, not all volatile situations are risky.

That was what we were facing in March of 2020: a volatile situation erupting from the first global pandemic in a hundred years. The key to decoding whether it was truly risky or not was our collective response. Do our governments hem and haw and wring their hands and ostrich their heads in the sand? Or do we unleash the full forces of monetary and fiscal stimulus while pouring in whatever resources it takes to develop vaccines in record shattering time? Very early on, it became clear it would be the latter¹. America would respond. And with that insight, volatility became less risk and more reward².

Through it all, the composition of our portfolio was little changed³. We earned our returns not through frantic trading nor furtively chasing “what worked”, but simply by staying steadfast and assertively increasing the ownership in our favorite, most familiar businesses at increasing discounts. Buy more of the same when prices are low sounds simple and unsexy. But I submit that it is not at all easy. It requires having a depth of confidence that can only come from the accumulation of knowledge and scars after following or owning a stock for years, which is needed to buffet against the psychological forces that threaten to overwhelm rational thought during periods of great tumult. It actually has nothing to do with any pompous notion of courage –– sometimes the right course of action is to sell in a proper panic if the situation warrants it –– and everything to do with, again, to quote Kipling, keeping your head.

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¹ However, if one mired oneself in political Twitterverse, one might very well have missed the forest for the trees given the rancid partisan rancor. Social media does not equal reality – a patently obvious statement but totally worth slapping on a sticky note on your desk.

² (Getting on my footnote soapbox here.) The development of four (and counting) effective vaccines against SARS-CoV-2 in less than a year is nothing short of a scientific miracle and a shining example of human ingenuity when facing a global crisis. Had COVID-19 emerged in, say, 1819, it would probably have slowly burned through the world population, mutating and spreading and exacting a multi-year death toll rivaling any of the great plagues in human history. We in America are indescribably fortunate to be first-in-line to be inoculated against this disease. But as of this writing, it is still raging in countries such as Brazil and India where access to vaccines remain extraordinarily scarce, so I cannot help but feel despondent toward those of us who reject vaccination because of, I dunno, political or conspiratorial or devil-may-care reasons while literally billions of people elsewhere would give anything to get vaccinated to escape humanitarian crises. It’s the epidemiological equivalent of the old admonishment, “don’t you know there are starving children in Africa?” when you waste food, except way more serious and way more sad.

³ Although you may recall my chagrin in my annual letter for not being sufficiently aggressive in investing in new names that I have long admired but never found the right valuation to enter into. It’s unclear whether or not our current returns would have been boosted if I did, but it’s more probable we missed out on steadier, longer term gains that those stocks would have provided in the coming years.

CoVID-19

This is probably the most important quarterly memo I’ve written since our inception. Let’s cut to the chase – here are some of what I’ll be addressing:

1. Why the market is down
• COVID-19 has shut down the economy
2. Why we are down more than the market so far
• Liquidity has dried up, investors have fled financial stocks, but I am stepping up our purchases in anticipation of an inevitable recovery
3. Why we must stay the course
• We have been waiting for this moment!
4. Why this time is (not) different
• This is not the financial crisis
• We’re betting on humanity and betting on America

Why The Market Is Down

“The only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory.”

- Roosevelt, 1933

COVID-19 has forced most of the western world into lockdown. Business has essentially stopped, but bills continue to come in. A business’s expense is another business’s revenues. Once a business cannot generate revenues, it cannot pay expenses, which impacts the revenues of another business which cannot pay their expenses, and so on and so forth. What we are now experiencing is akin to an automobile crash pileup, where the lead car brakes suddenly and all the cars behind crash into the one ahead of it.

Financial markets have reacted with a panicky speed never before seen. It took less than 20 trading days to drop -20%, whereas the average and median time historically has been 255 and 156 days, respectively¹. The VIX index, which measures volatility and is colloquially known as the “fear index”, spiked to 82.69, a record high that surpassed even the 80.74 number that marked the scariest days of the 2008 crisis. I never thought I would see that record broken within a single generation.

Terror is feeding upon itself. The SARS-CoV-2 virus deserves every bit of gravity and seriousness it has generated, but we cannot lose sight of the fact that it is imminently beatable. We have swung from too laissez-faire to national panic virtually overnight. The rational response is in between. We must treat the virus seriously enough to enact policies that do not overwhelm our hospital systems. But we also must not burn down the house to kill the termites.

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¹ https://theirrelevantinvestor.com/2020/03/09/the-fastest-bear-market-ever/

Why We Are Down More Than The Market So Far

Firstly, we own mostly stocks that were under-appreciated by the market going in, and their under-appreciation only widens during times of broad panic. During times of terror, people rush to the safest, most liquid asset on the planet: U.S. dollars. As a result, there have been reports of liquidity problems throughout all kinds of financial markets. There have been days when all asset classes outside of cash — stocks, bonds, gold, even bitcoin – declined simultaneously, a truly rare phenomenon². The smaller, more obscure or more unpopular the security, the wider the bid/ask spreads, and the more intense the sell-off³. Most importantly, our declines are not the result of any of our companies deteriorating due to idiosyncratic factors.

Secondly, a significant portion of our portfolio are in financial stocks, and financials have sold off more than twice as furiously as the wider market as the fears of 2008 looms large in investors’ memories. Fears of laid-off people skipping mortgage payments, fears of businesses skipping loan payments, and fears of a frozen market that will force banks to mark down assets to a level where they become insolvent. However, as I will explain in greater detail below, this time really is different, especially for banks.

Banks have sold off more than twice as much as the broader S&P 500

And finally, I am increasing our stakes and adding new investments in consistent, methodical increments, which will inevitably make our short-term results look worse as long as stocks continue to decline. But on the flip side I also anticipate our recovery to outpace the market, perhaps significantly, once it takes hold. And it will take hold; we just don’t know when.

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² https://www.nytimes.com/2020/03/12/upshot/markets-weird-coronavirus.html

³ https://www.wsj.com/articles/low-liquidity-fueled-hidden-flash-crash-in-junk-bonds-11578661200?mod=hp_lista_pos2

Why We Must Stay The Course

“What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

- Buffett, October 2008⁴ 

To put it bluntly, this is what we have been waiting for. Nearly every quarter, I lament the endless bull market that has made outperformance so difficult for value investors like myself. Sure, we’ve experienced some harrowing dips along the way, but all have snapped right back within a few months, never once really threatening to derail a decade-long bull run. But now, in a violent fashion, the bull has definitively died and we will enter a deep recession. Finally.

I began my investing career in the wake of the 2008 financial crisis. I experienced first-hand how bear markets are where true wealth is created. Bear markets wash out the weak. The weaker companies, the weaker investors, they are forced to fold in an environment where consumers are more discerning, where bankers clutch their purses tighter, where capital is hyper averse to risk. The grittier ones survive, and when things inevitably bottom and start turning upwards, they are there to reap the spoils, the extra market share vacated, and emerge exponentially stronger.

Without a doubt, things look scary and terrible right now. When you open your statement, you will probably experience a jolt of cold sweat, an atavistic fight or flight response. This is perfectly normal, but let me assure you, individual stock prices right now do not accurately reflect any semblance of reasonable value. What they reflect is a fire-sale value. It reflects that fear you feel, of scared sellers overwhelming buyers.

There is no reliable method to pick market bottoms during recessions, but one saw is inviolably true: stocks always bottom well before the recession is over. If you don’t stay the course and pull out to wait for rosier economic indicators, you will miss out on massive gains. The graph on the right shows the return on stocks from the bottom of each bear market until the official end of each recession. Such returns average an astonishing 64% compared to long-term annual returns of 9.8%⁵.

Another way to look at it is what that long-term annual return would degrade to if you miss just a handful of the “best days” in the market. Missing just 10 of the biggest up days reduces your annualized returns by 2.7%. And missing the 50 best days… you might as well just leave your money in a checking account. Translated into dollars, if you invested $1 at the beginning of 1992 and held until the end of 2019, you would have $13.66. Missing the 10 best days nets you only $6.82, and missing the 50 best reduces that all the way down to $1.31.

Source: Goldman Sachs Portfolio Advisory Group “Rebalancing and Market Entry in Down Markets”; Bloomberg

According to data compiled by Charlie Bilello of Compound Advisors, -20% bear markets occur, on average, every 4.4 years, -30% every 9 years, and -50% every 20 years⁶. And yet, through thick and thin, stocks reliably outperform every asset class in the long run. To enjoy long-term returns that equity securities offer over fixed income, the price of admission is volatility—sometimes mind-numbing, cold-sweat inducing, vomit-reflex engaging volatility.

With that said, I will not put us in a position where we would risk margin calls. In other words, we will always be net cash positive. In this environment where prices gap up or down by double digit percentages with no fundamental reason, anyone on margin could get involuntarily liquidated by their broker. Enough money can be made with no leverage whatsoever, and besides, careful use of options, hedged or covered or in-the-money ones provide us with plenty of asymmetric return opportunities.

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⁴ https://www.nytimes.com/2008/10/17/opinion/17buffett.html

5 https://www.wsj.com/articles/how-i-learned-to-stop-worrying-and-love-the-bear-market-11585301582?mod=mhp

6 https://compoundadvisors.com/2020/the-price-of-admission

Why This Time is (Not) Different

What causes economic recessions? Traditionally, it is caused by an imbalance between allocated resources (capital and labor) and resulting productivity (profits). In other words, resources that do not produce profits. That results in losses in capital and layoffs in labor. For example, dot com bust happened because too many then-newfangled internet companies had no pathway to profitability and yet sucked up large amounts of capital and labor. The process of reallocating those resources into actual, productive endeavors is what eventually digs us out of a recession. 

In 2008, the financial crisis was precipitated by overinflated real estate prices. Capital and labor poured into the housing sector, building more homes and generating more mortgages than was needed by magnitudes. Eventually the mortgages could not be paid, which led to foreclosures, which drove down real estate prices, which halted new construction. The value of mortgage-backed securities collapsed, which decimated the banks which held large amounts of such securities, which led to a huge pullback in lending activity, which caused the intense recession. Digging out of it required a long and arduous process of reallocating the substantial amount of resources previously dedicated to housing and banking.

This time, it isn’t the popping of an asset bubble that is driving capital losses and mass unemployment.  It is, instead, an artificial halt to the economy. Instead of the invisible hand of free markets working to reallocate resources from unproductive sectors to productive sectors, it is a deliberate act of government policy to stop the spread of a pandemic. Once the pandemic is under control, labor and capital will mostly return to where they were needed prior to this recession. People will eat at restaurants again. People will travel again, probably even on cruises again. This is self-evident.

Compared to 2008, all the excess labor and capital left the housing and mortgage industries permanently. People were buying houses they could not afford by borrowing money that banks should not have been lending. Once that popped, all those people needed to go find real jobs or start other businesses that are actually sustainable. That created a prolonged period of pain.

Another significant difference is the government’s response. Typically in asset popping recessions, the government can be reluctant to step in and bail out those who had wasted all those resources to no end. The right thing to do is to let failure percolate, allowing painful memories to fester, which will discourage the same bubble from forming again. 

This time, since the government is directly “responsible” for the cause of the recession, they are 100% incentivized to bail out whomever is necessary. Already, over $2 trillion in stimulus have been approved to enter the economy to bridge us past this pandemic. The Federal Reserve immediately cut rates to zero and are committed to buying however much assets as necessary to keep liquidity and credit flowing. 

This difference cannot be emphasized enough: there is a bright green light to print money and hand it out. If the $2 trillion is spent and we are all still quarantined, they will print another $2 trillion, and it will again be overwhelmingly bipartisan. Of course, the mechanism by which this payment transfer is effected will inevitably run into snags as handouts of this size have never been attempted before. But the incentive is there and it is unwavering. That’s the key.

In this sense, we are experiencing a “crisis” more similar to World War II than any other typical recession/depression/panic, where the majority of citizenry and governments drop business-as-usual and participate in a joint effort to defeat a common enemy. WWII, of course, was also the definitive event that jolted the U.S. to slough off the Great Depression once and for all. 

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How does this affect fundamental valuation of individual stocks? Without a doubt, earnings this year for most corporations will decline dramatically. But for most corporations, especially those that will survive this pandemic, one or even two years’ worth of earnings is merely a blip in the overall calculation of intrinsic value.

Intrinsic Value = Present Value + Future Value. PV roughly equates to tangible book value, e.g. cash on hand, owned assets, working capital, etc., minus liabilities plus current earnings. FV essentially equates to the accumulated future earnings stream from now until Judgment Day. What this recession will impact most skews much more towards PV than FV. It will certainly damage near-term earnings. It will surely damage the tangible book value of banks who will have to deal with troubled loans. But if you own shares in a company that will survive this crisis with no loss of reputation or human talent or brand value – in other words, no loss on their ability to generate profits in a normal functioning economy – it will continue to enjoy a long and growing tail of future earnings stream. The importance of FV in almost all typical going-concern operations far outweigh the importance of PV.

Another way to think about this is to invert: which kind of companies are unlikely to make it? It is companies that were already weak going into this crisis. Companies that were perched on a tipping point and needed some good luck to make it. Companies that are heavily indebted, whose intrinsic value are actually held by bond holders rather than equity holders. In cases like these, this recession will wash them out like every other recession. This time would not be different for them.

The major holdings in our portfolio, if my assessment about this being a maximum one to two year event with heavy and eager government support throughout, should all comfortably make it to the other side. Their intrinsic value may be nicked by temporary losses and mark downs, but that’s why I purchased our shares at discounts to intrinsic value. In other words, when I invested in our companies, I already baked in the certainty of future recessions and unknown catastrophes. I have not and never will invest in anything based on “blue sky” scenarios.

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Some Extraordinary Commentary on a Specific Stock

The biggest contributor to our decline this past quarter was, by far, CIT Group. CIT, if you recall, is a mid-sized commercial bank with about $50 billion in assets, which entered the quarter as one of our top two positions. Shares went from $39.71 to $17.26 during March, but that doesn’t even account for the true magnitude because in late February it traded as high as $48 per share before hitting an intra-day low in March of $12.02 per share. That, if you’re morbidly curious, is a -75% drawdown. Ouch. The KBW Bank Index (BKX) over the same period of time (late Feb. to March lows) “only” drew down -49%.

The proximate reason for the shellacking of bank stocks is the fear of investors who believe we might be reliving the 2008 meltdown nightmare. However, banks are dramatically different today than they were twelve plus years ago. First and foremost, they hold much more “buffer” against losses now thanks to an rule called Basel III. Basel III forced banks to keep more capital on their balance sheet to defend against unexpected losses. How much more? Prior to 2008, banks routinely borrowed up to 30 times their capital base. These days, it’s down to around 10 to 12 times. This dented their earnings power post crisis, but it has them well protected coming into this pandemic.

Additionally, banks are now playing lead roles in recovery effort vs. being lead villains in 2008. Government guaranteed loans from the $2 trillion stimulus will be underwritten and distributed by banks to help businesses pay their bills and debt. Banks can then securitize these loans, plug into the Federal Reserve, and dump the credit risk onto the Fed’s balance sheet, which may be able to accommodate up to $4 trillion⁷ in such guaranteed low interest loans. This mechanism should theoretically act as a bridge for companies who otherwise would default on loan payments to get to the other side of this crisis intact.

With regards to CIT specifically, there were no fundamental reasons for it to decline with such a velocity outpacing the rest of the financial sector. The only probable explanation is their history, which saw them succumb to bankruptcy by the financial crisis – perhaps institutional memory had folks dumping CIT in fear of a redux. However, as I’ve explained in my annual letters, CIT is a completely different beast these days. Back then, they were encumbered by a mish-mash of random assets, including subprime lending, manufactured housing loans, aircraft leasing, etc. They weren’t even a bank holding company! Today, they are a legitimate, regulated, vanilla nation-wide commercial bank with an investment grade balance sheet, pure and simple.

Furthermore, as recent as 2017, CIT was required to undergo annual “stress tests” administered by the Department of Treasury⁸. The stress test scenario envisioned a prolonged, 9-quarter recession with double-digit unemployment and a nearly flat yield curve. In such an environment, CIT would suffer cumulative losses of -1.8% of assets, or just under a billion dollars⁹. It hurts, but it is a fraction of the $3.5 billion discount to book value CIT is currently trading at. In other words, shares are priced as if the losses will be over 3.5x the severity of the financial crisis. This is not to mention the fact that CIT is an even stronger bank today than it was three years ago.

Don’t just take my word for it. In light of these facts, insiders acted aggressively to buy stock on the open market. Twelve members of the board of directors and the management team spent over $1.6 million of their own money on CIT shares last month, with the two largest blocks coming from the CEO and the CFO. In a nutshell, the very people who are evaluating the company’s risk in real-time are the most bullish.

And so: I’ve been adding to our stake all the way down, which has temporarily made our results look rather dour but has me quite excited about the potential returns on the upside. I don’t typically disclose this much detail about individual stocks in quarterly letters, but during this extraordinary time, it is only fair to be transparent about my most aggressive moves so you understand I am making my decisions with rationale and logic rather than that four letter word h-o-p-e.

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⁷ https://www.nytimes.com/2020/03/26/business/economy/fed-coronavirus-stimulus.html

8 The requirements were changed in 2018 to only stress test banks with over $100 billion in assets.

9 https://s2.q4cdn.com/496078316/files/doc_downloads/regulatory_disclosures/7438aee2-cc0f-479d-6005-0a64fe25a385.pdf

To Sum Up

It is an extraordinary time to be living through right now, both as an investor and as a regular human being. I am in awe of the might of humanity aligning together against one objective: beat COVID-19. From the doctors and nurses on the front line, to the restaurants, grocers and essential workers working to feed us, from the scientists and researchers who have dropped everything else to focus on this virus, to the career government employees responsible for crafting policy and guidance that will help bridge us across these tough times – heroes one and all, but individually destined to be unsung.

Our companies have stepped up in kind, doing what they can. Our banks will be front-line distributors of loans and grants that shore up business cash flows and keep people on payroll. GM has retooled plants and leveraged their formidable supply chain to build ventilators and masks that will literally save lives. Dish is donating spectrum to T-Mobile and AT&T to ensure there will be enough bandwidth to communicate on and even giving free Sling TV access for 14 days to ease the burdens of quarantining. BlackBerry is providing 60 days free access to remote workplace tools that have become critical for white collar workers. Added together, the reputation of our companies will surely be strengthened on the other side of this crisis.

Soon the infections will peak, and soon we will have antibody tests to administer far and wide. Soon there will be targeted therapies that will save a majority of even the highest risk cohort. And then, there will be vaccines, and then it will be over. Although the timing is unpredictable, victory is inevitable. I will never understand the pessimists who bet against humanity and against America, those who may achieve a temporary thrill when their contrarian bets pay off once per decade but spend the rest of the time reliving past glories and hoping for future doom.