Quyn Capital Annual Letter 2020
A letter to my partners over what has been an extraordinary year.
“Yet if we confine our attention to American investment experience, there is some comfort to be gleaned from the last 57 years. Through all their vicissitudes and casualties, as earthshaking as they were unforeseen, it remained true that sound investment principles produced generally sound results. We must act on the assumption that they will continue to do so.” — Ben Graham, 1972, The Intelligent Investor
Introduction
Over the past couple of months I wrote 2 memos, Sri Lanka is for sale! I am buying and Living through history, which helped me document the truly remarkable events that occurred this year. In short, as the year progressed the Covid-19 global pandemic brought about the worst global health crisis seen in a century, while economies around the world experienced contractions not seen since WW2.
One of the consequences of which created a financial panic, both global and local, which I had never experienced before in my life (I was too young at the time to really understand the 2008 crisis). Having prepared to face such vicissitudes in life through the comprehensive reading of history and past panics, it was still extraordinary to witness and live through. The year 2020 seems to be anything from a ‘normal’ year.
Global panic
Once it became apparent that ‘fear’ dominated the news in March, due to the uncertainty of the implications of the pandemic, panic spread throughout global markets. It took an extraordinary effort by central banks around the world to put a stop to what was becoming a global financial panic.
With the virus still ravaging most parts of the world, I find it far too complex to figure out how it will all play out. I have proceeded to observe with caution however because US market values (like on the S&P 500) currently do not seem to reflect underlying economic reality, likely due to the action of central banks like the Federal Reserve. How long they (the Fed) can keep it up and what are the consequences if they continue to do so (or stop!) are tough questions to answer.
Personally, I do not think the global panic is all behind us, as the destruction of large parts of various economies continues until a vaccine or cure comes into existence. Prices of many companies on the S&P 500 reflect no margin of safety and discount from intrinsic value, all while interest rates in the US are near zero. As Ben Graham noted, over the long term, the market may come to reflect underlying value like a weighing machine, however, right now speculation is rampant and over-optimism runs the risk of a serious loss of capital. It does not look like the right time to be deploying capital in the US right now without extreme caution, analysis, and scrutiny.
Local panic
Extreme pessimism, coupled with political instability, a terrorist attack, and public debt issues, seemed to already discount many strong public companies on the local stock exchange at the beginning of the year. The Covid-19 pandemic, however, brought upon a panic that no one really could have seen coming. Once cases were detected in March and a complete lockdown initiated, panic and fear set in (both in day to day life and in the local financial sphere). As people turned to cash and panic buying, it brought about unprecedented declines in market value over the ensuing weeks.
The exchange was then closed down for 6 weeks, only to be open in May to another unprecedented decline. I watched as the newly implemented circuit breaker came into effect just 38 seconds after the opening of the market with an over 10% decline in the S&P SL20. At that point, it became apparent that the S&P SL20 had lost likely over 40% of its market value from the beginning of the year. Indicating that many of Sri Lanka’s best companies were selling for less than what they were worth 10 years ago.
Despite finding it difficult to navigate between risk and uncertainty, I thought the situation presented a ‘once in a lifetime’ type turn of events. I used this term last year as well, but the Covid-19 situation has far greater implications for our economy than the 2019 April attack, and hence, I looked harder for opportunities to allocate capital wisely.
I allocate capital according to the principles of the partnership outlined when each partner joined. I will mention them again below as they are worth re-visiting.
Our principles
- We behave like prudent businessmen, in the business of valuing and buying whole businesses, (even though we buy only pieces of businesses through stocks/shares, we think of ourselves as businessmen buying the entire business)
- We make sure to take on the least possible risk as our primary aim is to prevent the permanent loss of our capital before seeking any adequate return
- We shortlist only the best-capitalized companies that fulfill stringent qualitative and quantitative tests (eg. which include strong competitive advantages, large economic moats, good returns on capital, a long record of strong earnings and growth, a strong balance sheet, decade long dividend payouts, low levels of debt)
- We don’t buy any business that does not fulfill our stringent criteria, the market exists to serve us and not vice-versa
- We make our own conservative assumptions about future cash flows and growth, while also being prepared for the vicissitudes of life as prudent and pragmatic businessmen
- We pay no attention to market movements, analysts, brokers, or promoters and form independent opinions on the value of businesses based on facts
- We invest only on the basis of large margins of safety and clear discrepancies between price and intrinsic value (taking into account some estimate of deterioration in the business due to the pandemic) always ensuring we get more value than what we pay for on a case by case basis
I regarded this as very important and documented my thought process allocating capital during these turbulent times in Living through history.
Reflecting on panic
I do not doubt the uncertainties and risks brought upon by the pandemic are tremendous and unprecedented, but does that justify total panic? No.
Since our prospective return is directly proportionate to the price we pay, does that mean we refuse to value a business no matter how low the price gets? No.
In other words, is the Covid-19 situation so bad as to warrant that any publicly listed company bought will generate no cash for their owners now or in the future? No, I do not think so.
To me, these answers seems obvious. This pandemic will end at some point and life will go on. Millions of people rely on the services that some of our best publicly traded companies provide. Hence, some will continue to generate cash for their owners and my job is to intelligently figure out which ones. Ensuring they have large margins of safety in place and offer substantially better returns when compared to our risk-free alternatives such as a 5-year government-backed fixed deposit.
Don’t give up on Sri Lanka yet
I understand Sri Lanka is facing a very difficult series of challenges (debt repayment issues, political turmoil, and stagnant GDP growth, etc).
However, I maintain some optimism about the future of the country. This is because Sri Lanka has faced a multitude of problems in the past (civil war, racial riots, political and policy turmoil, natural disasters) but moved on ahead.
Between 2010 and 2018 in Sri Lanka, total GDP grew 58% from $56.73 billion in 2010 to $88.9 billion in 2018, GDP per capita income went from $2799 to $4102 in the same period. However, also between 2010 and 2020, it looks like market values on the S&P SL20 went almost nowhere (index: 2265, November 2020).
In other words, while market values indicate we are in 2010, there has been a very real amount of wealth and earnings created since 2010 by the end of 2020.
As value investors, our job is to buy far more value than we are currently paying for in these turbulent times. History and past experience tell us, sound principles produce sound results, despite the vicissitudes of life (both small and earth-shattering like this pandemic). In order to do my job as an effective capital allocator, I continue to believe in these sound principles.
Our Results
For 2020 our partnership has done better than the general market and the current 5-year risk-free rate (7.2%). The total return on the general market index (ATR) has declined by about -5.83% in 12 months to 7671. While the total return on the S&P SL20 index (STR) has declined by -20.28 to 3729. Most equity-based unit trusts and mutual funds did not beat the 5-year risk-free rate from January to September this year, according to the Unit Trust Association of Sri Lanka.
Our partnership with dividends re-invested amounts to a return of 19.81%* for the year. This is because I raised and deployed funds at the height of the panic and in what seems in retrospect, the bottom of the decline (it has since recovered from that bottom). However, I did not know this at the time, and simply just stuck to my value approach.
Interpretation of results
I am optimistic about the businesses we own. When prices go down I am ecstatic and the opportunities presented earlier this year were truly mouth-watering. This year we got the opportunity to buy some of Sri Lanka’s best businesses at ‘bargain’ prices. A combination that gets any value investor very excited for the future.
These businesses have decade-long runways ahead of them and significant economic moats that will produce real wealth for their shareholders. Even if they have to go through short-term setbacks (and they will), over the long term they will not just match the returns of the past but are likely to generate higher returns on capital than in the past.
Once again we focused the entire portfolio on a few very high-quality businesses at ‘bargain’ prices, while we averaged down on others we already owned. We have a concentrated portfolio with one business comprising of almost 45% of the total funds of the portfolio. I know it is counter to conventional thinking, but I think it is a big mistake not to load up on an incredible opportunity and hence acted with conviction based on facts and not fear.
Mistakes made this year
Looking back I underestimated the full scope of the pandemic in March, earlier this year. It has truly been devastating to the local and global economy. However, in April that I began to realize the full scale of this pandemic, and thankfully, I had the time to reflect and think carefully about my standards of safety and value before committing any capital.
As I wrote in my earlier memo Living through history, a look at historical panics, the great depression of the 1930s, and building on mental models helped put things into perspective.
Conclusion
I personally think I need to make a maximum of only 2–3 investments or generate a single good idea a year. The rest of my time is spent reading, thinking, and learning. I have no doubt I will likely remember the lollapalooza type events of this year for the rest of my life.
Successful investing requires periods of inactivity and patience.
Hence, I am confident in the long run, the returns on our partnership will match the returns of these incredible businesses. This is an exciting prospect for all our partners. I will be happy with a return that outperforms the risk-free government-backed fixed deposit over the long term. Our businesses bought have shown they are well capable of this feat.
I have disclosed as much of my philosophy and thinking as may be imparted without talking of individual issues. If there are any questions, I would welcome hearing from you.
Notes
*The letter initially presented a return of 8.26% for 2020, however, this figure turned out to be incorrect as it calculated returns based on a cost vs market value basis instead of how market values stood at the start of the year (01/01/2020) vs at the end of the reporting period (30/11/2020) for the partnership.
**The figures for the JB Equity Fund, ASPI, and S&P SL 20 between 01/01/2020 and 30/11/2020 were taken from the Unit Trust Association of Sri Lanka and can be found here.
