Here’s an example of the times we live in: Company A is 10 years old. They employ 383 people. Despite revenues of $115 million, they lost $30 million in the last year.
Company B is 100 years old. They employ 18,000 people. They made almost $700 million of profits on $9.5 billion of revenue over the same time period.
Which company is worth more? For a brief moment, it was Company A, also known as Beyond Meat. Despite being small and unprofitable, Beyond Meat’s market cap topped that of Conagra (Company B). Who can make sense of that? Maybe plant-based meat substitutes are the future. Or perhaps pea protein burgers will be the next Olestra.
Even without the benefit of hindsight, one thing is certain: profits matter. And without them, Beyond Meat’s $14 billion valuation was nearly impossible to defend. (Not surprisingly, their valuation has since been cut in half.)
The most interesting developments to happen this quarter have centered on this idea: fundamentals matter—again. They always matter but sometimes narratives take over, causing investors to overlook things like cash flow, debt levels, and profits. In that environment, the best offense is a good defense.
And that’s the topic of this memo: defensive investing. It’s a topic born from a 1975 article in the Financial Analyst’s Journal which referenced Dr. Simon Ramo’s book Extraordinary Tennis for the Ordinary Tennis Player. Howard Marks explains:
Ramo pointed out that professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that an opponent can’t return.
Given anything other than an outright winner by an opponent, professional tennis players can make the shot they want almost all the time: hard or soft, deep or short, left or right, flat or with spin. Professional players aren’t troubled by the things that make the game challenging for amateurs: bad bounces, wind, sun in the eyes, limitations on speed, stamina or skill, or an opponent’s efforts to put the ball beyond reach. The pros can get to most shots their opponents hit and do what they want with the ball almost all the time.
But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost.
Investing can also be a “loser’s game,” where for most people, loss avoidance is a more successful long-term strategy than chasing winners. To quote Howard Marks again, “Avoid the losers and the winners take care of themselves.” That’s because successful investing is about durability—avoiding a catastrophic outcome that takes us out of the game. It requires a willingness to stand by and watch overvalued assets become more overvalued. Some of the missed opportunities will be genuine. Most won’t.
Consider WeWork. Until a few weeks ago, they were the darling of Wall Street and the biggest of the venture capital-backed “unicorns” (private companies worth more than $1 billion). They were valued somewhere between $60 and $100 billion. Then the IPO prospectus came out and everyone discovered that not only was the emperor without clothes, but his palace was a massively-indebted cash furnace full of self-dealing and weird behavior. The IPO was put on hold, the CEO was removed, executives were fired, and the company will be taken over by SoftBank at a $7.5 billion valuation. How are all of the pre-IPO investors feeling now? They took the stairs up and the elevator down. Lawsuits are forthcoming no doubt.
Uber’s stock is 30% below the IPO price. Lyft’s stock has been cut in half. It shouldn’t come as a surprise, considering both companies are unprofitable and their IPO prospectuses stated they might never be profitable. You wouldn’t know that from the amount of hype they received. But to the defensive investor, hype is an underappreciated marker of risk.
So is a reduction in standards. I read recently in the Wall Street Journal that ratings agencies are leaving “investment grade” ratings in place for many companies despite swelling debt. Morgan Stanley’s head of credit testified to the SEC saying, “if leverage were the sole criteria for ratings, many BBB-rated companies wouldn’t qualify for such high grades. Downgrade activity would be heavy.” Instead, they qualify based on assumed earnings growth, assumed synergies from acquisitions, and assumed deleverage. To the defensive investor, this sounds like the makings of a loser’s game where the best strategy for success is not to chase winners, but to avoid losers.
To determine whether it’s a winner’s or loser’s game, one of the best things an investor can do is to “take the temperature” of the markets. What are the valuations? Are investors paying attention to fundamentals or are they only concerned with a narrative? How much optimism is factored in to current prices? Do the assumptions about the future seem reasonable?
When we see high optimism, low risk aversion, lots of eager cash, and rosy assumptions, we become skeptical. We don’t want to risk the match on a potentially ill-placed shot that we felt forced to take. So we wait for normalcy to return. It can be difficult to watch prices climb higher in areas that are already overvalued, but price reverts to value—eventually.
And we mustn’t forget J.P. Morgan’s classic quote, “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.” Watching 20-somethings get rich (on paper) as the price of Bitcoin went parabolic in 2017 was hard, but not nearly as hard as the 90% loss that followed for those who chased what they thought was a winner.
At other times, when we see a lot of fear, high risk aversion and an unwillingness to part with cash no matter how attractive the prospects, we should play more aggressively. Even if our shots aren’t perfect, the court is now bigger and the net has shrunk. In other words, the odds are in our favor. Swing away.
It comes down to where we are in the cycle. Currently, we’re in the late stages of the economic cycle, with growth slowing to between 1.5 – 2%. Money has been cheap for a long time and as a result, many projects and businesses have gotten funding that otherwise wouldn’t in a normal environment. But as expectations for growth have come down, investors are once again looking for cash flows and profits as a means of resiliency.
Investors are starting to walk away from narrative delusions and position themselves more defensively. We think that’s a good thing. But it also means that a lot of yesterday’s winners will prove to be losers. Just yesterday I got an email from a friend with a list of two dozen secondary private equity offerings for sale. Every one of the opportunities was at or below its previous valuation, some by more than 80%! Instacart, Wish, Juul, Circle, Grab Taxi, Didi, Palantir—all at heavy discounts. The narrative is changing.
A final point; our strategy for investing is not to create wealth for our clients. Creating wealth takes concentrated risk, although compounding at market rates over enough time can certainly do it. Instead, our strategy is to grow and preserve your wealth. It’s why we spend as much time as we do researching the opportunity set and striking a suitable balance between risk and reward. By hopefully avoiding the losers, we’re able to stay in the game for the long-term. As I once heard, there are old pilots, there are bold pilots, but there are no old bold pilots. The same is true for investors.
Although we remain constructive on the markets and economy in the near term, we’ve shifted our factor exposure from momentum to quality. History suggests the quality factor could benefit from the current slowing growth environment and mounting margin pressures. This is timely as the momentum factor has recently experienced a reversal of fortunes that could take time to normalize from and recover. Quality, as a lower risk holding with exposure to companies with lower debt loads, consistent earnings and growing profitability—provides desirable characteristics during times of uncertainty.
If you have comments or questions, please let us hear from you. And have a great Holiday season!
Ashley Vice, CFA, CFP ®
 Excerpt from Howard’s book The Most Important Thing