Loaded
Iceland could do no wrong in 2007. An island of 330,000 people, it had one of the highest per capita incomes in the world. It had produced several billionaires. The International Monetary Fund and the World Bank held up Iceland as an example of how to run an economy.
By March of 2009, just over one year later, all three of its banks had failed, its currency had lost 50% of its value versus the U.S. Dollar and its stock market was down 50% in its local currency and down 67% in terms of U.S. Dollars.
Asset managers exposed to Iceland in 2008 and 2009 got their heads handed to them.
Our day-to-day investment operations consist of two primary activities: stock selection and portfolio construction. We look for undervalued equities in the stock selection element of our business. In doing so, we analyze business models, assess management teams, and figure out what the business is worth relative to its publicly-quoted price. We’ve been doing this for nearly three decades now. We’ve analyzed thousands of companies.
In the portfolio construction element of our business, we assess what we call shared exposures. A shared exposure is anything that affects the value of two or more of our investments.
We are invested in three Brazilian financial services companies at the moment. The management teams and business models of these companies are not shared exposures because they are different and unique for each company. The Brazilian economy and the Brazilian financial services industry are shared exposures for these investments because they each affect the underlying value of all three investments simultaneously. If the Brazilian economy turns south, it will affect the value of all three investments. Our portfolio construction activities - that is, determining exactly which of the undervalued stocks we find that actually go into the portfolio - focus on finding and analyzing shared exposures in the portfolio.
This is a critical element of our investment operation. The relative priority of our portfolio construction activities has steadily grown as we have gained experience in the asset management business. Today, portfolio construction is every bit as important and adds just as much to our returns as the stock selection element of our business.
We believe many asset managers short shrift the portfolio construction element of the business. Some fail to recognize the importance of finding and analyzing shared exposures in their portfolios. Some don’t look for shared exposures at all.
Iceland had an enormous amount of debt in 2007. Iceland’s banks had been borrowing short-term and lending long-term, as most banks do. Their foreign lenders started questioning the quality of their loans and the ability of the Icelandic banks to repay their debts. In late 2008 and early 2009, the foreign lenders refused to roll their short-term loans to the Icelandic banks. That action caused the Icelandic banks to fail. The house of cards came crashing down. Foreign investors pulled money out of the country, which caused the currency to weaken and the local stock market to crash. Most Icelanders had substantial wealth tied up in either the local banks (which had failed) or the local stock market (which had crashed) or both.
As investors, having one investment with exposure to Iceland in 2008 and 2009 would have been a big mistake. Having multiple investments with exposure to Iceland would have been catastrophic. Shared exposures can cause much more harm to a portfolio than an exposure isolated to a single stock.
Remember, the important element of risk management is finding hidden risk before it becomes obvious to the masses. Once hidden risk becomes broadly obvious, it is too late; the masses reacting to the exposed risk destroys capital for anyone exposed to that risk. In Iceland, once foreign lenders and foreign investors saw the risk and acted, it was too late. Capital was destroyed.
A crisis like the one Iceland endured in 2008 is like leaving a loaded gun at a playground. A child picks up the gun and shoots his sister. Two things enabled the catastrophe. Someone first left a loaded gun at the playground. A child then picked it up and pulled the trigger. The former created the environment for disaster. The latter triggered the inevitable.
With Iceland, the environment ripe for disaster existed long before foreign lenders started pulling capital out of the country. Debt levels relative to its economy and debt service costs relative to its economy (two things we have written about extensively with respect to many of today’s economies) were far beyond the point of no return long before foreign investors started pulling capital out of the country. Iceland had no hope of painlessly growing out of its debt problem. The loaded gun was in plain sight. Disaster was inevitable.
Most market economies - emerging and developed economies alike - have experienced at least one major catastrophe in the last 30 or 40 years. Many have experienced more than one. In every one of these great investing disasters that we have analyzed, a loaded gun existed in plain sight long before the trigger was pulled. The primary goal of our portfolio construction activities is to find those loaded guns within the shared exposures of the portfolio and eliminate them.
We don’t need to figure out which kid is going to pull the trigger. We only need to recognize that a loaded gun exists. When and how the trigger gets pulled is far less important than the existence of the gun at the playground in the first place.
We do our best to avoid playgrounds with loaded guns.