I was thinking about this year’s annual letter while on a visit to Dubrovnik last week. While other visitors were mostly interested in the details of where the show The Game of Thrones was shot, I was more fascinated by the city’s paranoia over the centuries and its relentless obsession about protecting itself from invasion by a perpetually looming and ever-changing list of enemies.
“Who can remember the most important rule?” the guide asked at one point in our tour of the city walls. “Always stay one step ahead of the enemy” he answered himself, after a pause for theatrical effect. The same message was repeated many times that day as we walked atop Dubrovnik’s six-meter-thick and 1,940-meters long fortress city walls.
Dubrovnik started building its walls in the eighth century and kept refining and adding to them over the centuries that followed. More layers and towers were added and the design continuously improved, in what our tour guide described as a “healthy level of paranoia” about an ever-changing enemy coming from the land, the sea, or from underneath, as the city is also earthquake-prone. They also built fortifications in the areas surrounding the city as early lines of defense. And because of this obsession, the walls survive intact to this day. Dubrovnik was always trying to out-think its enemies who were always trying to find clever new ways of taking over this strategically-situated trading hub.
There are many lessons that investors can learn from Dubrovnik. As their investment horizon increases, the economics of the underlying business play an ever-greater role in determining investors’ returns, especially equity holders. It is therefore vital for long term investors to understand the economics of the businesses they invest in and how they will evolve over time. Better economics (aka “good businesses”) are naturally preferable to lousy ones – but there is a catch. Good businesses attract competition and the more competitive an industry gets, the worse the outcome for companies operating in it and, by extension, their investors.
Economic theory tells us that all superior economic gains should be competed away over time, leaving every company earning a “fair” return equal to its cost of capital. It’s harder to outperform the market while owning businesses that earn cost of capital. That’s why we prefer to own ones that earn higher returns.
Economic theory, however, is wrong about the competition assumption. Not all businesses can be competed with. Some businesses have what are known as barriers-to-entry or, as Warren Buffett calls them, “moats.” A moat is some form of advantage that a business has that makes it hard for others to compete with it. Those advantages differ in how strong they are and how long they last.
A drug patent, for example, makes selling that drug by any other company illegal. But it does not prevent competitors from trying to develop similar or more effective drugs on their own. The patent will also expire in the future, so the advantage is not infinite in time. The higher the price that the patent owner charges, the more competitors will try to develop an alternative drug, increasing the chance that a competing product will enter the market sooner. With patents and with other advantages, managing one’s advantage is very important. The behavior of the moat-owner, such as how much they charge, can have an important impact on the incentives and ability of competitors to get into the market.
I would therefore argue that management teams at companies with a moat should make its preservation and improvement one of their highest priorities. They do that by following Dubrovnik’s most-important rule: Always stay one step ahead of the enemy.
We want to invest with management teams that are paranoid about the future. In Only the Paranoid Survive, Intel co-founder Andrew Grove writes:
“Business success contains the seeds of its own destruction. The more successful you are, the more people want a chunk of your business, and then another chunk, and then another, until there is nothing.”
But one tricky part of moat-preservation is that it is a dual mandate to both preserve the existing business and protect it, while also trying to anticipate new threats and prepare for them. Grove writes:
“The ability to recognize that the winds have shifted and to take appropriate action before you wreck your boat is crucial to the future of an enterprise.”
One of the most painful experiences that any investor can ever go through is an investment in a company that’s losing its moat. The fall can be swift and deep. In 2007, every other smartphone sold in the world was made by Nokia. Its market share gradually declined to 37% by mid-2010 and then plunged to 15% a year later and to below 3% by 2013. As you might imagine, it was a painful ride for investors. Nokia’s shares peaked at €28.60 in 2007 and bottomed at €1.37 in 2012; its market capitalization declining from almost €113 billion to a mere €5 billion in the span of five years. It is for this reason that at Mayar Capital we spend most of our time and effort trying to figure out the condition of our companies’ moats.
On the other hand, finding an emerging or improving moat can be extremely profitable for investors. Unfortunately, not only is it extremely difficult to spot an emerging moat, many end up being false starts that never make it to the point where they generate high returns. Betting on an emerging moat that never emerges can also be a very expensive mistake. That’s why we rarely try to do it at Mayar, preferring to instead focus our efforts on avoiding disasters.
But having a strong moat is not enough to protect investors, as the moat only protects the underlying business from some risks. There are many other sources of risk and disaster and thus having a moat is a necessary but by no means sufficient condition to protect one’s capital. Let me illustrate that by explaining to you how we think about the total risk of an investment.
We like to think of investment risk as a series of layers. At the core is business risk. This is the economic risk inherit in the underlying business. An example would be the uncertainty about the quantity and price of products sold next year. Some businesses are naturally riskier than others; compare Nestle or Unilever to an oil company or a technology startup. Business Risk also includes economic cycle risks that can be very important in cyclical industries. As you can see, while a moat helps protect a business from competition—an important force—it does not protect it from all sources of business risk.
The layer after that is Company Risk. This is a combination of managerial, operational, and legal risks that come from the actions that happen inside the company. It’s very diverse and includes things such as bad management decisions on production levels, hiring the wrong type or number of people, and lawsuits against the company caused by illegal practices. Unfortunately, this is one of the hardest risks for investors to understand and protect themselves from, as it involves qualitative and hard-to-measure aspects of the company such as culture and management’s ethics. It is also one where the interaction between its different components is more important than the individual parts. But it’s too important to ignore, and every investor should spend a considerable amount of time understanding it. This is an area where we’ve found checklists to be extremely helpful.
The third layer of risk I will call Security Risk. We use the word “security” here to mean stocks, bonds, and other securities issued by the company. Another way to think about this risk is of it encompassing the competing claims of different capital providers. An equity holder at a heavily-leveraged company faces much higher risk than a senior bondholder of the same company, independent of the associated business and company risks. A good business and good company can produce substantially decreased returns for their equity-holders, for example, if management issues too many shares to themselves and other employees, diluting everyone else.
The fourth layer is Price Risk. This is a function of the price being offered to the investor to acquire the security in question. For the same level of business, company, and security risk, a lower purchase price has less risk than a higher one.
The last layer is Market Risk, and mostly impacts publicly-listed companies, though overall market levels do tend to correlate with prices paid in private markets. This risk includes many things such as the liquidity of the security, or lack thereof; the volatility of the price of the security, a real risk if you need to sell it at some point in the near future; and the correlation between the security and the overall market level. Even good stocks fall when the overall market drops.
The different layers of risk described above also correlate with differing paces of change, and thus their impacts differ based on one’s investment horizon. Business Risk is the slowest to change, as most companies remain in the same business for all their lifetimes. Market risk, on the other hand, mostly impacts short holding periods of liquid securities and a long investment horizon can eliminate, or at least minimize, this risk.
The most important take away from the above is that risk is multifaceted and attempts to oversimplify it and fully quantify it give investors a false sense of security without increasing their understanding of risk or reducing the actual risk they are exposed to. The idea that the risks mentioned above will cancel each other out in a portfolio and that a simple number – beta, volatility, VaR, pick your favorite – will capture all of it strikes me as wishful thinking.
At Mayar we like to repeat the motto that we would rather be approximately right than exactly wrong. When analyzing each investment we make and our portfolio overall, we think of the different layers of risk both separately and in how their individual components interact with each other within each investment, and across the portfolio. There’s a lot of judgment and approximation involved and some of it is an art and some is science.
We therefore also don’t kid ourselves into thinking that we’ve covered every potentiality. Once we’re done, we add a layer of margin of safety on top. In civil engineering, they use something called a Safety Factor. Many structures use a safety factor of 1.5, which means that the structures are designed to withstand 50% more load that the expected load. A civil engineering professor that taught me many years ago used to call it the “I-don’t-really-know-what’s-going-to-happen factor.” It’s basically admitting that while we will do our homework to the best of our ability, we still need to add a fudge factor because we know that we cannot account for everything and we may be wrong about the things we did account for. While some confidence is required for good investing, a healthy dose of humility is an absolute necessity.
First published in Mayar Fund’s Letter to Partners – June 2017 (portions have been redacted)