What's Free?

Disclaimer: All of this is speculation. Please do your own due diligence.

Let’s set the tone right. Here are some relevant quotes:

1. “Life's tragedy is that we get old too soon and wise too late.” - Benjamin Franklin
2. “Experience is making mistakes and learning from them.” - Bill Ackman
3. “Investing is a business where you can look very silly for a long period of time before you are proven right.” - Bill Ackman
4. “Invest in a business any fool can run, because someday a fool will. If it won’t stand a little mismanagement, it’s not much of a business.” - Charlie Munger
5. “The best thing a human being can do is help another human being know more.” - Charlie Munger

Not Much Changed

It has been over two years since my last memo. In that, I shared my thoughts on the turbulent journey that was to come, and my belief that interest rates had nowhere to go but up. Till now I haven't found the time nor the content worth reflecting on, as that directional trend has continued to play out since 2022.?

With how high and persistent inflation has been (and in some cases entrenched), it becomes that much harder to reduce it. As we know, inflation was driven by excessive liquidity available for cheap over an extended period of time since 2020. While it was obvious that central banks should have acted much earlier in raising rates, the unfortunate reality is that they didn’t. This only made inflation worse and has forced the central banks to act more aggressively. Without creating a severe shock through interest rates and restrictive monetary policy, it becomes an almost impossible task to combat inflation. And choosing to ignore inflation further is not an option if we want to live in a world with price stability, sustainable economies and growth without falling into a vicious cycle of value destruction. There has already been quite some impact from higher rates, but the road to recovery is long and may even involve the Fed changing their inflation target to something higher than 2% over time.?

Rising interest rates to the economy and markets is akin to how gravity treats objects flying high without support. While that may not have been conventional wisdom back then, it sure is now. Directionally, not much has changed since my last memo. But a lot will.

Navigating Turbulence

Allocating capital is one of the most difficult jobs for any business or individual if done well. Simply put, allocating capital is investing in a business/idea that will perform well and provide a meaningful return over time. The idea is simple, but its successful execution is anything but.?

During the low interest rate environment, we saw an endless stream of businesses and business models that flourished or at least appeared to vis-à-vis cheap capital. Unfortunately, those very businesses were finely tuned to only operate well within the bounds of that loose monetary policy. And the glaring issue here was that the economy by the end of 2021 was very different from the previous decade that businesses used to model or stress test their operations against. One can only imagine what happens to any business whose survival and margins are reliant on high capital expenditures and low interest rates, but has no free cash flow in sight.

Fast forward to today, businesses have become highly sensitive to cost. And given the interest rate risk, businesses are finally coming to terms with the perilous risks that exist and hedging any and every angle. Irrespective of what any given cost is associated with - cloud infrastructure, projects, stock based compensation, personnel, or even basic office supplies - management is keen to materially reduce that burden on the balance sheet. We have already witnessed this in the form of mass layoffs led by technology companies along with other industries thereafter.

Beyond that, valuations and multiples of businesses have succumbed to reality and started reflecting the bumpy road ahead. Incidentally, the IPO market has more or less been on a hiatus, as any company with an egregious valuation (which is what incentivizes IPOs and its roadshows) would become a laughable prospect come time for underwriting let alone price discovery in the open market. Gone are the days when a business can easily pull a lever and raise capital for any and every idea.

In such a turbulent environment, one may ask, “where do I invest?”, and still not believe or agree with the answer they receive. That is because the answer in such an environment is associated with taking advantage of fixed assets like bonds, arbitrage opportunities, and of course, businesses with a durable moat and free cash flow. However, this disbelief or disagreement with the answer is a function of inexperience and inability to adapt to the changing times. What seemed like a “normal” market over the previous decade was nothing but an illusion inflated by low rates that gave way to easy money. The “normal” was never easy.

Onshoring

Instability breeds change, and change is the only constant in life. Over the past 2 years, much has changed geopolitically ranging from supply chains to rising tensions between nations. Most notably, this has caused quite the dilemma for the globalized economies we all live in. What happens if nations that rely on one another to maintain a certain cost and standard of living for their economies become hostile?

We have already experienced this first hand when it comes to oil prices. Since the conflict between Russia and Ukraine, the global commodities market has become accustomed to extreme volatility. Oil companies that once had a supply glut problem are now experiencing the opposite. During 2020, the supply glut caused oil companies to shutter oil wells due to reduced demand. Since then, economies slowly reopened, but with an even higher level of demand than prior to 2020. The only issue is that the supply had already been constrained, which resulted in higher prices due to the supply/demand imbalance. In addition to that, the sanctions against Russia and consistent production cuts by OPEC and OPEC+ to maintain a certain price per barrel further exacerbated this. That paired with global shift and government policies to transition to electric vehicles will likely cause a strain for some time to come. For a moment, imagine that you ran an oil company: how would your decisions be impacted when the government is vocal about reducing oil consumption, creates policies that negatively impacts your business in the long term, and then asks you to increase supply to reduce oil prices because the SPR has been depleted and still not refilled. In any case, this is a very specific example of a market that once worked quite efficiently in a globalized manner, but has caused quite the shock over the past year. Looking ahead, we must assess the probability of whether this spreads beyond the oil market and its long term implications for the world. And the probability of that is incredibly high - perhaps a certainty.

I firmly believe that the past year has done nothing but accelerate onshoring across many industries. Countries have become wary of the risks that exist when the function of their economies relies on countries with competing interests. Globalization heavily relied on China, but we have seen much of that change recently. This shift has favored emerging countries like India and Vietnam for manufacturing and supply chain logistics. Meanwhile, nations have also started mandating and investing heavily towards onshoring many of the industries ranging from transportation, manufacturing vehicles, semiconductors, and even oil, to name a few. It is just easier to sleep at night knowing that the interests of one’s nation are safeguarded. As Warren Buffett once put it so aptly, “we will never be dependent on the kindness of strangers.”

Worth The Wait

Investing requires a certain kind of temperament that even I have found difficult to learn and become accustomed to. And along the way, there are bound to be mistakes that all of us will make. The important takeaway is doing some level of introspection, acknowledging the shortcomings, and ultimately, acting to resolve them. For instance, during the period of easy money, we saw endless touting of businesses that sounded novel and had incredible hype. Instant gratification was the name of the game. But those who are patient, diligent, and not easily impressed were able to sift through most of the risks. They quickly realized that these touts have no grasp on the fundamentals, have very different incentives, and are absolutely clueless to a reality that was awaiting to punish those very businesses. Everybody wants to get rich quickly, but nobody wants to get rich slowly.

A market that once had little to no bargains seems to have more of them today. And many of these bargains and opportunities today are tied to the overarching themes we discussed above. To be clear, those same opportunities and sectors were not even given a second look several years ago. But the times have changed and we must adapt. While the recovery from high inflation is a long road, I believe the time to act aggressively has arrived. Navigating through it will be no easy task; it requires quite a bit of patience and aggression when the time is right.

?All good things are worth the wait. What’s free?