Q3 2024: Assuming the worst?

This update has been slightly delayed due to personal reasons. I've had some health issues, but I'm significantly better now. With the worst behind me, I'll try to translate my recent experiences into some stock-related thoughts. Of course, there are general lessons - that what really matters is family, friends/colleagues and personal relationships, not your stock portfolio. But others are much better at writing about this and expressing “life advice” so I'll stop there and move on to today's theme.

First, a brief update for the portfolio. For Q3 the portfolio is up about 32 percent and YTD it's up over 35 percent. I have increased my holding in Argent and added Primeserv is a new holding. Hopefully this is a portfolio that will survive and will be able to cope with most things that could happen. Valuations are overall low and the market positions strong. The financials (balance sheets) are extremely strong.

Take the “worst case” into account? Yes.

An important question is how much you should consider a "worst case scenario", in life, and in your investments. How healthy is it to almost assume the worst? Maybe I find it unusually easy to think negatively and see risks, but uncertainty is incredibly difficult to deal with, at least when you "know" that something is wrong, but you don't know what. Just as a stock has a trading halt, in some sense life is "halted" until everything has been explained. When it comes to health it is understandable, but the obvious risk is being too negative in stock choices and that some degree of uncertainty or lack of information could be accepted.

But my view is still that you really, every day of the week, should have the "worst case" with you and not turn a blind eye to difficult outcomes. Although it does not happen often, the consequence is great, and you must be prepared for the worst to happen. For my part, there are mainly three things that I think are extremely important to keep track of and that will dampen all worst-case outcomes in your investments:

• Only own financially strong companies. Setting limits such as a maximum of 1 x EBITDA in debt may sound nitpicky, and nowadays I can probably allow 1.5 x EBITDA even if it takes a lot. But it removes a huge amount of risk to think that way. And the fact that management does not work with debt says a lot about their overall risk tolerance. Cyclicals and debt are an especially toxic combination, a bit like Bonnie and Clyde, and some high-flying companies are just waiting to be caught, sooner or later.
  
  
• Don’t own companies in dictatorships or hybrid regimes. No matter how good or financially strong the company is, anything can happen in these types of countries. If a company has its main operations there, or are listed there, I am not comfortable owning them. The company does not fully control its own future, the power is rather with the regime. That’s unpredictable, at least for me.
  
  
• The most obvious risk is price related. Ok, this is not like the others really “permanent loss of capital” but a 70% loss requires a 233% gain. My view is that the valuation always should make sense in a 2-3 year time horizon and not depend on agressive future growth after that. You can’t rely on something that is uncertain and lies far ahead. Avoid excessive, lofty, valuations at all costs - even if that means that you avoid some future winners! A focus on non-cyclicals is also important since the products will be needed even in bad times.

You should take worst case into account, but not focus on that outcome alone. It’s easy to get a bit “paranoid”, ant then it’s hard to be a long-time investor if all you see is risks.

To be concrete, a worst case in a stock context (and for the world) is that China attacks Taiwan, through a blockade or something even more direct. The world economy will then be hit extremely hard and the effect would be the financial crisis 2.0 but worse. Some reading on the subject can be found in Rhodiums report, the Book Wealth War and Wisdom, as well as an article on market performance during years of war. I definitely think you should keep in mind that this can happen. Hopefully it won't, and maybe it’s unlikely, but you have to be prepared for it and own companies that could survive even such an event.

Survival is priority one

Just as people's health, when it comes down to it, is the most important thing, companies should think the same. Companies are quite an interesting creation. Unlike humans, they can in theory have an almost "eternal life", as long as they do not take great risks or get lost. There are listed companies with a history that stretches several hundred years and "still is going strong". The common denominator for such companies should be low risk-taking, sound owners and sound finances, combined with products that give value of some kind. Family companies are probably more often than other survivors.

To get a little "quasi"-philosophical, you should think about the purpose of each company you hold, and what is their first priority. I like companies that have the "mindset" that survival always comes first, and that they never compromise on that point and take unnecessary risks. An example of a company I own says this in their latest call:

If Karooooo doesn't make transformational acquisitions, why isn't the balance sheet leveraged? I don't think that's really our DNA. I mean one can get into very clever financial engineering where you start, but I don't believe we need to do that. And I'm quite prudent. If we look, we've been a public company as Cartrack before [JSE ]. We've always run a very clean balance sheet. I believe you only get debt if it's absolutely necessary. And we might have a few rainy days and we want to be well positioned. When COVID came, we continued growing. We weren't worried about the balance sheet. So we never know what's around the corner. And we don't want to be where, when the banks knock at our door, then we start panicking. We'd rather be -- we're very comfortable to remain in a net cash position as opposed to net -- in a debt position. However, we're not scared of debt, if it makes absolute sense. But I don't think we need to do it just to leverage our balance sheet so that we can engineer our balance sheet.

A healthy view, I would say. Perhaps this approach is a very good balance? That net cash is a normal situation (and 13 out of 15 companies in my portfolio have that) but that in certain situations you can be prepared to take on some debt if a special opportunity should arise, but only then. I could be too afraid of debt and too paranoid. Yes, It’s all about striking the right balance, but I really like companies, and leaders that see no debt (low risk) as the normal and desirable condition.

It should finally be noted that companies really think differently on this point. An example is Teqnion that thinks and talks a lot about survival but allows debt up to 2,5 EBITDA. Well, that’s quite normal, I know, and many companies allow more. But I am still much more comfortable owning companies like Argent, being about 5 times cheaper is one reason, but another reason is that they operate with net cash and use their (growing) cash pile for acquisitions instead of debt. Perhaps I am too cautious and defensive but still: net cash is king, not in every situation, but certainly in a crisis. Margin of safety is important in terms of valuation, but crucial in terms of debt.