From our Q4 2010 report:

“The foreign capital flow which is par excellence the great marginal buyer of Brazilian shares (investing directly or via funds) comes in hordes in search of the strong growth of the “New Brazil” (or the expectation that it will be sustained). As good Brazilians, we are rooting for this to happen. However, we do not like the idea of paying for it.

We prefer to be positioned so as to indeed reap, in part, the results of what the “New Brazil” has recently planted, like the few companies (10, 15, 20 at most?) with good business models, good management and governance, as well as dominant competitive positions, which the approximately 120 IPOs effected from 2004 on have brought us – provided the prices are attractive. And is there anyone who does not want to surf on the benefits brought by the demographic bonus, formalization of the economy, increased employment, credit, and income, some important micro/regulatory reforms, the organization of supply chains, etc.?

But paradoxically, on the other hand, as investors, we are interested in reaping what the “Old Brazil” planted years ago, with its ailments, inconsistencies, bureaucracy, protectionism, unorganized urbanization process and unpredictability, creating abyssal inequalities between the winner-survivors and the defeated, and historic barriers between leading, dominant companies, very often forced to integrate vertically (to survive the chaos of decades of totally unreliable supply chains), and the second tier, as well as between local players and potential international competitors, or between listed and privately-owned companies. There are entire sectors in the country in which one or two companies earn money and the others sink. And the fact that some sectors hardly operate or are obsolescent (for example: let’s combine the country’s port/highway system with its Byzantine tax system…) jeopardizes the competitiveness of several sub- sectors that interest us.

These market inefficiencies due to the country’s “historical incompetence” (and regional/sector incentives) help dominant companies to perpetuate themselves at the top, and not exclusively thanks to their own strategic/operational merit. Established players have a huge advantage over newcomers, and have been benefiting today from the operational leverage of the “boom in demand” in a country where supply is structurally compressed …

One of the great risks is to assume that this leverage will be perpetuated. The other is to get carried away with the phase the country is going through and the investor’s appetite to take strides longer than one’s own legs.”

Excerpts from the Q4 2010 report

“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett

“Most people are other people. Their thoughts are someone else’s opinions, their lives a mimicry, their passions a quotation” – Oscar Wilde

SAND CASTLES, CONCRETE WALLS – PART 2

In the last report we used as a backdrop the “Maginot Line”, the huge French fortification system skillfully bypassed by the German army in the Second World War, to start a discussion on three questions that we consider important for the decision taking process regarding value-oriented investments: the identification of sustainable competitive advantages (“economic moat”), the sense of security embedded in our convictions and risk perception (our behavioral “Maginot Lines”), and finally, the partial antidote for our ignorance – the requirement of a “margin of safety” (quantitative and qualitative).
In this edition, we try to reflect a little on the concept of an “economic moat”, the metaphor immortalized by Buffett to designate a “sustainable competitive advantage”, one of the sacred cows both for the strategy/competition theories and for classical methods for valuing companies.

Roughly speaking, an “economic moat” is a competitive advantage that is difficult to replicate, working as a formidable shield, a barrier against the entry of competition. Among the sources of competitive advantage most frequently mentioned we can highlight cost leadership (scale, processes, cheap access to resources and transport); intangible assets (brands, licenses, contracts, patents, etc.); positive external network factors (the usefulness of a product or service increases according to the number of users); and switching costs (the degree of client captivity).

To put it simply, from an investor’s point of view, if this competitive advantage or set of advantages is sustainable in the medium to long term, the companies that have them will tend (even if not necessarily) to obtain extraordinary profits, and returns on capital employed above the opportunity cost (creating economic value) – until market forces (through competition, innovation, replacement, regulation) eliminate this distortion.

One of the great challenges for the long-term investor is to assess the sustainability and potential durability of these excess returns, usually by identifying one or more advantages that are said to be “structural, inherent to the business”, as well as their magnitude and level of sustainability.

One of the ways most frequently used is very simple in theory: checking the company’s accounting documents diligently. If, after all the applicable adjustments are made, a company has proved historically to be capable of maintaining a high level of return on capital employed, recurrently and consistently, above its opportunity cost, and its profits above the industry average, one postulates (instead of the more obvious and conservative path of conjecture) that the company has some structural competitive advantage – especially when the industry’s level of competitiveness is perceived as relatively low. If we assume that companies and industries are usually complex bodies and ecosystems that operate with reaction speeds closer to transatlantic cruise-ships than to sailboats, it seems reasonable to assume that the performance record is a good indicator of what lies ahead.

But it’s not that simple…

The extraordinary results of “winning companies” end up strongly influencing the analysis of their supposed “structural” competitive advantages from the start. It’s amazing how we have an incredible capacity to build simple causal relationships in order to justify results, proficiently playing the role of prophets of the past. Spectacular financial performances inspire us to build almost epic narratives to justify them retrospectively and – more importantly – prospectively, though founded on vague, generic concepts, endorsed by the common sense, such as “brand”, “distribution”, “intellectual property”, “innovation capacity”, etc.

It is our understanding that the ideas of “economic moat” and “sustainable competitive advantage”, semantically close, should be used with greater zeal and moderation, so as to avoid a type of error that costs us a great deal: their posing as concrete tools to serve as a basis for taking investment decisions, as if they were true. There is nothing more lethal for an investor than to act based on deep convictions which are, in turn, backed by precarious “fundamentals” that are not expressed as precarious.

“ECONOMIC MOAT”

To us, as long-term investors, it is undoubtedly a challenging exercise to seek to visualize which companies and business models will be standing, firm and strong, in 5, 10, (20?) years, and will be capable of creating and returning significant value without incurring great operational, market, regulatory, agency and capital allocation risks.

As our oldest readers well know, from White Martins (Praxair) to Itaúsa, from Elevadores Atlas (Schindler) and Lojas Renner to Totvs, Ambev, Inbev or Berkshire Hathaway, the evaluation of a company’s capacity to maintain, perpetuate and even consistently expand its value creation process is crucial for our asset selection process and, to a great extent, our risk management.

But what characterizes a “sustainable competitive advantage” or an “economic moat”? Are we, investors, entrepreneurs or executives, really capable of identifying them, understanding them and judging them prospectively with the precision and conviction we desire?

Is it possible that, for a start, these concepts do not even have a life of their own – independent, for example, from people (shareholders, board members, managers) with powers to influence and/or decide, and their motivations and incentives, from their savoir faire, their processes and methods; from the organization’s culture (which sometimes varies among a company’s departments); from the business and regulatory environment itself; from the evolving trajectory of its business model; and finally, from the experimental dynamics and micro-schemes that in real life orientate a company’s discrete and intermittent path of development toward its ideal of perpetuation and expansion?

Curiously, Buffett himself crystallizes, reifies and isolates the “moat” concept much less than his biographers, fans and devoted followers: “We seek to invest in economic fortresses protected by unsurmountable moats.” (…) “I don’t want a business that is easy for the competitors. I want a business with a “moat” around it. I want an extremely valuable castle in the middle, and I want the duke responsible for it to be honest, hard working and capable.” (…) “I have a message for the managers of our businesses: do seek to broaden these “moats”. We want to throw crocodiles, sharks and alligators in the “moat” so as to keep competitors away.”

In short, although the “economic moat” concept reverberated in the investment world and gained huge prominence, we should point out this “little detail”: at carefully chosen occasions, Buffett himself took the trouble to mention, together with the defensive metaphor, the “valuable castle” to be protected and – perhaps even more important – “honest leaders (“dukes”), capable of increasing the size of the moat”.

More than that, when we observe Buffett’s discourse together with his practices, we get the clear impression that the weight that he himself attributes, in his investment process, to the “duke’s” capacity, honesty, commitment and alignment may be much greater than appears at first sight. And in our perception, “the castle”, “the duke” and “the moat”, besides being difficult to define and discern clearly as individual elements, are interdependent and inseparable concepts.

An entrepreneur, board member, executive (a “duke”) who is fully “capable” but not aligned or inadequately advised can destroy solid franchises, built in the course of a lifetime. Cases like that of the Bucksbaum family, then controlling shareholders of General Growth Properties, a shopping-mall administrator – and so many other empires that tumbled during the 2008 crisis, not because of operational problems, lack of financial sophistication or erosion of competitive advantages, but because of an “aggressive” incentive and capital structure (in hindsight easily called “irresponsible”) – well illustrate this phenomenon.

In Brazil, the great value destruction that left deep scars in shareholders of companies such as Sadia and Aracruz, companies with colossal “economic moats”, was the result of strategic, operational and/or capital allocation decisions, made by flesh-and-blood people, which proved “not to be quite right” – to put it courteously.

One may argue that these are distinct concepts: competitive advantage, “people”, with their incentives, ambitions, capacity for execution and capital allocation, strategy. But are they really? One wonders if it makes sense to evaluate a company’s perpetuation and value creation capacity, from the viewpoint of its shareholders, using as a prime reference the idea of a supposedly superior and unshakable positioning in a market or industry structure.

In his 1986 Letter to Shareholders, Buffett spoke about the economic moat of the subsidiary GEICO (insurance) in the following way:

“The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No- one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the ratio is almost certain to drop further. If it does – and if GEICO maintains its service and underwriting standards – the company’s future will be brilliant indeed.”

Please note that, in this paragraph, Buffett highlights 1) the direct relationship between Bill Snyder’s strategic view and leadership, GEICO’s economic moat and its expansion; and 2) the importance of GEICO maintaining its level of services and underwriting standards (in our opinion, fundamental in the value creation process, although they are implicitly perceived as “execution”). Curiously, an aspect that is not mentioned, but is absolutely crucial, is that part of the competitive advantage that translates into GEICO’s “cost leadership” comes from a particular innovative business model (the direct sale of insurance), carried out with discipline and efficiency. In our view, GEICO’s business model is one of the main drivers of the company’s “competitive advantages”.

To bring up another question: why, when we evaluate the existence of potential “economic moats” as foundations for the generation of extraordinary profits and returns, is the idea of the degree of competition in an industry implicitly more important than the quality and sustainability of the company’s business model, embedded in increasingly modular, flexible and global supply chains? Why is the profit pool commonly evaluated vertically (by industry or sector) and not horizontally (from the viewpoint of supply chains)? Within a network or ecosystem? According to the total (out-of-pocket) expense of potential clients (who says that clothes do not compete with refrigerators)? According to the total profit contribution per square foot of its clients’ sales areas? Does it make sense to be a preferential supplier of apparel to Wal-Mart and to be more concerned about your direct competitor than about ways to extract more value from your own giant client (or visualizing ways to avoid being squeezed “to death” by it), or avoid being bypassed by a procurement meta-outsourcing business model, without its own factories, such as the powerful Li & Fung?

Our viewpoint is as follows: perhaps the “economic moat” is more useful as a vague concept than as a powerful trait or concrete characteristic, with almost magical analytical properties, to be “found” and “weighed” by analysts and investors. It may be less tangible, discernible, independent and instrumental than the literature and the “specialized” communication media repeatedly proclaim.

Many articles and books take the “economic moat” concept as given. There are checklists to help identifying it and there is even an institution – Morningstar – that classifies companies as “without a moat”, “with a narrow moat” and “wide moat” (taking due “care” to reclassify the companies over time, as moats come and go).

We are pleased to see that companies like Itaú are classified as having a “narrow moat” – perhaps because they operate in what is seen as the banking sector of an “emerging” country. Music to our ears.
In fact, some years ago, Dell – with its innovative business model and overwhelming results – was classified by the institution as a company with clear sustainable competitive advantages, a “wide moat”. Over time (and with the company’s, and its shares’, negative performance), it was “duly” reclassified as having a “narrow moat”.

One might counter-argue that competitive advantages do not last forever, that they have expiry dates that vary from case to case, that the exceptions do not invalidate the rule. But we have the impression that sometimes, anxious to build shortcuts for our decisions, we ascribe to vague concepts, understood in isolation, explanatory properties which, instead of bringing us closer to our ideals of prediction and control, only support and crystallize unfounded convictions – or worse, base convictions on muddy slime that aspires to be concrete.

If, instead of embracing deep-rooted concepts such as competitive advantage as if they were given, blindly rushing to use them as “working tools”, we reflect a little on their potentialities and limitations, our impression is that we may achieve an important degree of freedom in evaluating potential investments.

We agree with Buffett: investing (in its narrow sense) is simple. But it is not easy. It is much more an art than a science, and less susceptible to little rules and checklists than it seems.

Considering that very often a good part of the value of a business is in its future, the challenge of evaluating the potential for perpetuation, expansion and self- diffusion of the value-creation process of a business is as important as it is difficult.

In this report, we call attention to the Buffettian medieval troika, composed of the “castle”, the “duke” and the “economic moat”. These are concepts that, besides being difficult to define and see clearly as individual elements, seem to work better, from the instrumental viewpoint, when understood as interdependent and inseparable. In the next report, we will explore the dynamics of this troika and will later return to our ideas regarding sense of security and margin of safety, which, for our purposes, intertwine with it.

Finally, instead of proposing rules of thumb of the type “the 5 killer shortcuts to identify sustainable competitive advantages”, we leave the reader with a kind of anti- checklist, i.e., a set of open questions, using as ingredients some of the concepts addressed in the text, with the mere objective of encouraging reflection on a subject that, despite its relevance and appearance of being concrete, has the consistency of sand.

MEDIEVAL ANTI-CHECKLIST

1) About the “Castle”: Are shareholders and investors really capable of defining clearly and lucidly what the crown jewels of their Castle consists of? When they are not, what sense does it make to invest in walls and moats to protect what is not necessary or what cannot be defended? Let’s take, for example, a retail company. What are the most important “assets”: Location? Brands? Channels? Relations with consumers? A well-oiled supply chain that is optimized in order to increase productivity and to grow along with the business? The organization’s key people? The method of extracting value from its supply chains? Its relative “positioning” in the supply chains? The method of extracting value from its customers? A pervasive meritocratic culture with a strong analytical and process bias that permeates the company as a whole (and not the more common case of feuds of excellence)? A sales force that is spectacularly well trained and motivated? It’s a long list…

2) About the Moat: Isn’t it possible that some well positioned companies, “entrenched” in their forts, are inflating the value of their moats and cannot stop investing in models and ways of doing business that have an expiry date? Is it possible that most fortresses said to be inexpugnable are, in the long term, doomed to become obsolete, to be bypassed, to be circumvented? Is the moat metaphor too defensive? Agility, flexibility, intellectual capital, productivity: these do not fit in well with the defined circumscription of castles, walls and moats. Although Porter clearly disagrees with this hypothesis: up to what point can operational efficiency and corporate culture be dissociated from “competitive advantage”? Up to what point is a particular organizational culture not a competitive meta-advantage? If the castle and the moat are always changing over time, one of the solutions might be to select castles in which changes occur more slowly and the future seems more predictable. But in a context of globalized markets, intangible assets, rapid gains in productivity and technology, innovations and constant redesigning of the supply chains, how can one commit to a rigid business format and model? On the other hand, how can one maintain the commitment and the focus that are crucial in obtaining operational efficiency? This is an important and increasingly common dilemma. Experimenting has a cost. Failing to experiment, ditto.

3) About the Duke: Who is the real Duke – the shareholders, the controlling shareholders, the Board, the Chairman, the CEO? Our impression is that the “right” answer varies considerably, and directly influences both the economic moat and the castle. Is it possible that, especially in corporations, the company managers take for granted (and as “given”) the capital to be allocated? It seems that the way in which the agents that lead the company see their own assets influences the way in which they see the wealth to be safeguarded by the castle, which, in turn, influences their perception of the nature and the dimension of the economic moat and the need to expand and deepen it.

Excerpts from the Q3 2010 report

“In order to block an invasion, concrete is better and cheaper than a wall of human bodies” – André Maginot

“Nothing is built on rock, everything is built on sand, but our duty is to build as if the sand were rock” – Jorge Luís Borges

SAND CASTLES, CONCRETE WALLS – PART 1

The Maginot Line was one of the most ingenious and extensive fortification systems ever built.

It was designed by the French State at the end of the nineteen-twenties and built in the thirties, with a view to protecting the country against another frontal invasion from Germany. The purpose of the Line was to act as a first, formidable shield that would at least delay the enemy’s advance, allowing the timely deployment of the French army for the conflict. It received the name “Maginot” thanks to the French press, which associated the gigantic enterprise, which took almost a decade, to the war veteran and then minister, André Maginot, who vehemently supported its construction.

It was not exactly a continuous “line” or great wall, but a defensive complex composed of three interdependent fortified belts, which stretched along the French border from Switzerland up to Longuyon, close to where it meets Belgium and Luxembourg. In all, there were over 100 forts, placed at intervals of 5 to 10 km and supported by smaller fortifications and bunkers. Both the forts and the bunkers were, in essence, underground: only the observation domes and the armament were exposed to the enemy.

The fortifications were protected by advance control posts, barbed wire, and anti-tank blocks built of cement and iron, in addition to minefields and ditches over 3 meters deep.

The larger forts, called gros ouvrages, had rotating towers, retractable steel domes, reinforced batteries at varying depths, and heavy artillery pieces. They were true underground citadels, with a capacity for up to 1,200 men, and equipped, at 30 meters from ground level, with accommodations, kitchens, refectories, generators, water reservoirs, ample ammunition magazines, and even small electric trains to transport soldiers, armament and ammunition between the sectors of a combat unit.

The Line was interconnected by almost 100 km of underground tunnels. In order to mitigate the effect of enemy actions using gas (chlorine, mustard, phosgene, etc.) like those carried out by Germany during the First World War, the forts had a modern filtering and ventilation system, which expelled the air from inside in the event of an attack, and also cleared the environment of cannon smoke and the smell from diesel-fueled machines.

However, despite all this technology, defensive power and war potential, the Maginot Line would come to be known in history as one of the biggest military, strategic and political blunders of all times, an extremely expensive white elephant that proved to be “absolutely useless” against the German Blitzkrieg of 1939.

Putting it briefly, instead of attacking the French fortifications directly, the Germans went round the Line. They ignored (once again) Belgian and Dutch neutrality. They took the hitherto impregnable Eben Emael fortress in Belgium (at that time, the largest and best equipped in the world, even possessing a “moat”, the Albert Canal). With the way open, they crossed the dense, semi-mountainous Ardennes forest (considered unsurmountable until then) with tanks, to come face to face with an astonished and still disorganized French army, and a panicking population. At the same time, they blocked the Allied front at Dunkirk, and in less than a month they were in Paris – a feat they had not achieved during the First World War. In just 42 days, France, whose army was viewed as “the best in the world”, was signing the armistice.

Retrospectively, the consensus is to declare that the Maginot Line failed because it was designed to respond to the battle technologies and strategies of the 1914-1918 war, which had been won by the infantry (“it would have been invincible in 1914”). For the “war of movement”, with air support and the use of tanks as independent moving units, it had become obsolete even before building had started.

However, from the operational viewpoint, it can be argued that the Maginot Line was, in general, successful: it did in fact prevent a frontal attack on France by Germany; and in its Alpine version it repelled Italy fairly easily. Very few fortifications were conquered and none of the gros ouvrages, the largest and best equipped forts, fell to the enemy. When, on June 25, 1940, there came the order to cease resistance, only the small La Ferté fort had been defeated.

But History was unforgiving. Before the German offensive, the Allied propaganda had turned the Maginot line into an “insurmountable great wall”. The people of France and England, and even some factions of their politicians and the military, believed in the impregnability of the French shield. A “Maginot mentality” was created, which gave the French a certain comfort and feeling of security. The confidence resulting from the protection to the perimeter, so formidable, concrete and tangible, seems to have helped to disarm, a priori, the French resistance.

Curiously, Hitler’s Germany had two great defensive systems destroyed by the Allied forces – the Siegfried Line (Westwall) and the colossal Atlantic Wall (from the French coast to Norway) – but these did not even come close to attaining the historical prominence of the French fortifications.

More generally, the Maginot Line won eternal fame as a metaphor for “a grand fiasco”. An “imaginary, mirage wall”. In short: the name “Maginot” ended up acquiring the broad sense of sinking a mountain of money in senseless defensive efforts for “retrospective prevention” of past crises.

Today, its forts have “alternative” uses, such as mushroom plantations, refuges for bats, or tourist attractions that hark back to a past of little glory.

As investors, what can we usefully extract from this period in history?

Coincidentally, in the New Yorker magazine with cover date of October 18, 2010 (just before this report was released), James Surowiecki, the author of “The Wisdom of Crowds”, went to the core of the question when he discussed the rise of the online film rental company Netflix in detriment to Blockbuster: “Blockbuster dealt with its thousands of stores as if they were a protective moat, when they were in fact the entrepreneurial equivalent of the Maginot Line. The so familiar ‘sunk cost’ fallacy only made things worse. Various studies show that, once decision takers invest in a project, they tend to continue investing because of the money that has already been committed. Instead of drastically reducing both the size and the number of stores, Blockbuster continued to bury capital in a bottomless pit”.

And the bottomless pit became a tomb – because on September 23 the company applied for Chapter 11 …

So as not to tire our reader, we will explore in the next report three ranges of subjects that interest us as investors: in the first place, issues such as entry barriers/competitive advantages, capital allocation (productivity, discipline, a conservative posture), our ability to estimate the magnitude and durability of the return on capital employed, the correct identification/monitoring of risks and value drivers, operational    efficiency,    organization    culture. Subsequently, we resort to the metaphor to rethink the sense of security that guides our actions as shareholders and executives, especially in times of calm. Our most deep-rooted beliefs and frameworks most often prove to be nothing more than sand castles. Finally, we conclude by addressing the margin of safety concept, our insurance against chance and our evaluation errors.

To acquire awareness of the fragility of our ways of understanding – even if we reinvest in them for years on end – gives us a precious degree of freedom, which lets us play the game without being played by it. Where we would like to find unsurmountable concrete walls underpinning our convictions, there are mere sand blocks that turn to powder with time and circumstance.

As Surowiecki illustrates so well, the retail business is no doubt a good example: “location, location, location” has been the sector’s foundation stone and strategy mantra for centuries. Today, opening stores in the “best locations” is no longer necessarily the best capital allocation. Worse than that, the sunk cost of the stores and the need to dilute their fixed costs sometimes become a great quicksand, absorbing capital and attention in the fierce competition with e- commerce. Asset becomes liability. And what was thought to be concrete, true and absolute crumbles like sand.

Enter Rospil.info (so far only in Russian), OpenLeaks (under construction), and no doubt plenty of others we still haven’t heard of yet. Here’s an interesting note on Rospil.info on the Financial Times, but since it’s a paid source here’s a free note by Good magazine. The still-to-come OpenLeaks is actually a dissidence of WikiLeaks – assuming they start “competing” for more, bigger leaks we’re better off with two of them. The trend is clear, the tools are widely available and tracking/ monitoring is very hard => regulatory hell.

We wonder how long before such initiatives find a vehicle in Brazil…

A little less than two years ago, the consensus among market players was that there was “extremely low visibility” for the next few quarters and that “the occasion called for caution”. Considering that the world financial system was close to the abyss, it was indeed advisable to adopt a conservative attitude – though at times like those in 2008, to have high-quality real assets at very low prices seemed to us a more attractive alternative than lending money to governments. The “low visibility” issue, however, is a matter that deserves greater reflection.

Is it true that, over time, investors really alternate between times of “excellent visibility” and “very poor visibility”?  Or is it possible that this is an illusion of the human mind, and in reality investors alternate between times in which they think there is greater or lesser visibility? We believe that the second alternative is the one that best describes the real situation: the future is uncertain by nature and what varies is our perception of it. As Warren Buffett once said: “Forecasts usually tell us more of the forecaster than of the future”.

Many market players live under the illusion that the future is foreseeable, and using worksheets where projections cover from 5 to 10 years, they end up perpetuating situations and circumstantial results, ignoring the natural business cycles. This is one of the traits of the human cognitive system: the tendency to attach greater importance to recent events than to older ones. It is natural, therefore, that in a crisis environment, negative aspects prevail over positive ones, and that at good times the opposite occurs. Perhaps even more worrying is the fact that events with fat-tail[1] characteristics start being neglected in analyses. In another curious trait of our cognitive system, Daniel Kahneman, who won the Nobel Prize for Economics in 2002, calls attention to the difference in individuals’ perception of gains and losses. An individual who loses R$50,000 tends to feel a negative impact greater than the positive impact of a R$50,000 gain.

All these aspects help to explain why the markets are doomed to alternate times of under-valuation and over-valuation. When the economic environment deteriorates, there is a general perception that “visibility” is lower, so that analysts and investors not only revise their projections downward (perpetuating low returns and results), but also their portfolios, usually in order to bring painful financial losses to a halt. During the process, prices start to better reflect the uncertainty of the future. When the economic environment improves and remains positive long enough, the opposite occurs and the visibility illusion appears again. All goes well until a new and “unexpected” adverse event occurs, and the cycle starts again. History shows us that turbulence and adverse events occur more frequently than investors would like: something always happens! That is why discipline and patience are necessary.

Just to illustrate some of the problems that are prowling around us at present: growing domestic inflation and interest rates in a rising trend; slack domestic fiscal policy, including the dangerous use of state-owned banks; default on the debt of several countries in the Euro zone; the sustainability of the Euro as a single currency; the possible mass adoption of mercantilistic policies (which lead to competing devaluations among the main currencies, rising protectionism and reduced world trade); rises in taxes worldwide; the “unexpected” rise in US debt (due to aid for bankrupt states); the Chinese growth model giving signs of  exhaustion; the ageing of the Japanese population and its impacts (difficulty in refinancing Japanese government securities); etc… As Ronald Reagan would say, “Government is not the solution to our problem, government is our problem”.

In the month of May, 431,000 new jobs were generated in the USA, of which 411,000 resulted from government hiring of temporary workers for the 2010 US census. How long will the government manage to support the US economy?

The thing is that, at present, there are a great number of possible adverse events that may trigger a reduction in “visibility” and in the appetite for risk worldwide. And when we look at the Brazilian market, we continue getting the impression that a great many asset prices already reflect optimistic expectations and there is little room for surprises. As Nassim Taleb said: “Beware of calm waters”… In this context, we continue waiting for clearer opportunities where we may allocate more funds safely, and meanwhile we receive over 10% per year in interest for being patient – which is not bad at all.

Where may we be wrong? One possibility, for example, is that Brazilian assets in general might accompany a possible appreciation in the US stock market, which in turn would occur only to offset the continuous issuing and loss of value of the US currency, and the loss of control over US inflation. Thus, the nominal appreciation of assets would only serve to keep the value of companies constant in real terms. We do not believe there is any justification for the Brazilian market as a whole to accompany this appreciation, unless Brazilian domestic inflation also gets out of control. And even if this happened, the risk/return ratio would not be worthwhile. According to Warren Buffett’s teaching in his fantastic article of 1977, “How Inflation Swindles the Equity Investor”, at times of high inflation, investment in equities is only the least mediocre alternative among many others. The perverse effects of inflation also impact companies’ results and investors’ gains. When adjusted for inflation, the gains, in real terms, tend to be very poor.

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

Q4 2009 report excerpts, part 2

“PERSPECTIVES”

Brazil

It is common for this section to be optimistic, where the managers explain why the future will be better, or at least like the past. Unfortunately, at least with regard to our expectations for our Funds’ returns, this is not the case. Results like those in 2009 are infrequent. The chances of seeing two years in a row similar to this one are very low.

In 2009 there was a fall in interest rates, the Real appreciated, and the country was in vogue, which – at least for us – was unprecedented. There is nothing to stop these factors from continuing (for one thing, because there is a certain correlation among them) and it would not even be extraordinary. But there are two problems that keep us awake. They are related to each other:

1. There is an almost unanimous feeling, internally and externally, that “now we’re off, this time it’s different”. This feeling is supported by the supposed validation of the thesis that “the global pneumonia is nothing more than simple flu” around here.
2. The big problem, of course, (and a direct consequence of the above-mentioned point) is the price base.

There is a great resemblance between the stock market at the end of 2008 and 2009: the sensation of inevitability of a trend and an almost unanimous opinion. These climates have proved mistaken in most cases.

We remember very well when IP was in its infancy, in 1989, and the Nahas case closed the stock exchanges in Brazil. We remember when President Collor froze bank accounts and investments in 1990, the Mexican crisis in 1994, the Asian crisis in 1997, the Russian one in 1998 and the Brazilian one in 1999 (the unforgettable “endogenous diagonal band” in the exchange rate). In all these cases, “this time it was different” and still “the house fell down”. Of these, the only one that seems to us to have had long-term effects was President Collor’s plan, which in fact has undermined the country’s credibility among many to this day.

Without fear of being repetitive, it is the changes in expectations that determine market fluctuations. Today, most people see the glass half full (or fuller). But there are more than enough reasons for a different view. Our growth has been supported by deficits in the balance of payments and in the fiscal balance, not based on savings or a measurable increase in productivity. The system remains jammed and very corrupt (for obvious reasons, it is impossible to state whether more or less).

No less important, in 2010 we will have presidential elections. Up to now, the economy and investors have allowed themselves the luxury of ignoring the relevant macroeconomic problems and the political risks. We have never seen a pre-election period involving a change of president with so much tranquility in the Brazilian capital market. Is it possible that everything has really changed, and that the political issue, so discredited and surreal, has embarked once and for all into a parallel universe? It would be marvelous, but in the end, “they” are the ones who define the rules, raise taxes, hamper the day-to-day routine. Like the androids of the film series “Terminator”, at each new film, precisely when the villain seems to be more harmless, he is much more dangerous. We have nothing to add to everything that is in the papers every day.  Except to stress and remind our readers that unfortunately political decisions do have an impact on the economy.

In line with this view, we closed the year with a high cash percentage. If the market continues to climb, we will still capture at least part of this rise. But the ideal scenario would be a crisis of expectations that would take prices back to levels where implied expectations were much worse than the present ones.  As a result, we could “put the turnstile back to zero”. As we have mentioned several times in the past, volatility is not a risk measurement. It is our great friend.

And what if we are wrong? We are running the risk of earning less than if we were more exposed. In fact, that is what happened this year. (…) Market timing is something we do not know how to do and do not intend to do. In the course of time, all those we have seen trying to do fine timing on a large scale, based on market “feeling”, have ended up being faced with the reality that, in the long term, this is a losing proposition. We do our timing as a consequence. We buy more when prices are low in relation to an expected reasonable value for the assets, based on well founded assumptions. We sell as the opposite starts to occur. Above all, before any other consideration, IP’s history of over 20 years has taught us that, to arrive in first place, first you have to arrive.

Global perspectives

We believe that the drastic changes at the global level have not yet ended. We continue to hold our view that current prices, in general, imply a more optimistic expectation than what experience and analysis of the interests involved recommend as prudent to follow. In fact, we see the governments of several countries (the USA in the lead) as great Madoffs, operating a great make-believe scheme. The story here is that future tax revenues will be sufficient to pay interest and all the “social” commitments. As in the Madoff case, it is much more convenient and pleasant to believe. But the truth is that the account hardly ever balances out. As in that case, the tendency is for there to be a disastrous ending for those who do believe (pensioners, long-term US Government security holders, etc.).

It is here that greater flexibility is most significant. (…) We do not propose to look at everything. On the contrary, we can reject everything that is less than optimal and concentrate on what we consider very good. At a time when it is even more difficult to find sound assets, with businesses carrying sustainable competitive advantages reflected in high returns on equity, managed competently and capably, at attractive prices, and when everything – even the traditional refuge in the dollar and in treasury paper – is questionable, this is a great advantage.

Our favorite cases continue to be independent of conventional classifications, such as by sector, geography or company size. However, certain sectors and certain geographical areas do have their biases, making them more attractive in certain situations.

In the course of the last few years, we have been trying to learn a little more about the health sector in the USA. Besides being the largest sector in the US economy, its complexity, segmentation and stratification make it the largest entrepreneurial laboratory we know of. The quantity of business models is virtually endless, given that in addition to vast diversity, the dynamism induced by the competitive, regulatory and technological aspects makes sure that there are always new models. At the very least, we have a wonderful tool gain, given that in many cases the models, or parts of them, end up being adopted by other sectors and/or in other geographical areas, giving advantages to those who have already studied and understood them.

Despite all the turbulence in the sector (in fact, thanks to it) generated by the Obama administration’s reform plans for the sector, this year we were able to reap some rewards from our effort, as in the cases of IMS Health (a position that we have already closed) (…); but we believe that there is still a lot of “juice” to be extracted from this fruit. The studies continue and it seems to us that, as in most cases, the media noise is helping to push down the prices of some assets more than could be considered normal.

Another sector that is still rather depressed (deservedly) in terms of asset prices, in the most developed markets, is the real-estate sector. It is difficult to know when growth will pick up, but it is certain that this will happen. Meanwhile, we continue to study the players, getting to know people and to understand the models and the “little tricks” of each sector/company.

Natural candidates are the businesses based on the pro-active and differentiated use of information. From our point of view, there are several attractions. Returns tend to be high due to the low levels of capital needed. The practical difficulty of implementation has historically been extremely high. Many companies have a vast pool of potentially valuable data, but the cases of those that manage to turn them into the great value creator they may represent are very rare. Those that set themselves up this way have a fantastic business, whose focus is the intelligent processing of information and which is “disguised” in companies classified in the most varied sectors, such as IMS Health (health sector), Amazon (retail), Google (media), Harrah’s (casinos), Co-Star (real estate), and Verisk (insurance), among others. In our traditional retail sector – an obvious candidate – despite our efforts we have found very few cases.

In short, we continue seeking companies with sustainable competitive advantages from a long-term perspective, which are able to generate value even in scenarios that are adverse for most, including those where changes in relevant paradigms occur. At the same time, we try to be on the alert for possible significant market distortions, caused by time imbalances or the application of models based on the adoption of assumptions that seem inappropriate to us.

It was also in this report that we first mentioned Buysiders.com to our clients, and we hope you all enjoy it.

In the “part 1″ we will highlight excerpts from the “Introduction” section of the report. Look for “part 2″ by Monday.

Q4 2009 report excerpts, part 1

“INTRODUCTION”

After a weak 2007 and a very bad 2008, we were pleased with 2009. Although the adjectives are in line with market behavior, as Neil Young says in one of his best-known songs, “Hey, hey, my, my (rock n’ roll can never die)“, “there’s more to the picture than meets the eye“. The restructuring of the research and management team – carried out in 2H 2008 – and, consequently, of the portfolios has been consolidated. The improvement in results, both from the quantitative and, more importantly, the qualitative point of view (addressed in the Q4 2008 report) has continued.

(…) In 2009 we had a good absolute and relative result, in a positive year for the market, when we usually have a good absolute performance but a bad relative performance. Above all, though we are very cautious and concerned regarding the market, we are very sure that we are doing the right things. As we stressed in the Q1 2008 report, we have no control over short-term returns, but we can and should control the investment analysis and management processes. Over time, the processes define the results. If we’re not yet where we would like to be in this sphere (the pot of gold is always at the end of the rainbow…), we have at least the conviction that we are evolving in the right direction.

Merge!

(…) a recurring event has been the participation of companies in our funds’ portfolios in large M&A transactions. Recently, Saraiva has acquired Siciliano, Itaúsa has acquired Unibanco (not to mention the Satipel and Porto Seguro deals), Odontoprev has merged with Bradesco Dental, and Totvs has acquired Datasul. At the other end, Globex was sold to the Pão de Açúcar Group. In the international front, InBev has acquired Anheuser Busch (Budweiser) and Berkshire is acquiring Burlington.

Two factors make this observation worthy of greater consideration.

In the first place, we have the historical observation that transactions of a “transformational” nature are risky.

If we take a broad universe of companies, there are many bad results. Daimler/Chrysler and Time-Warner/AOL are cases that spring to mind immediately as perfect examples of what may not work. On the other hand, the overall record of what Itaú and AB-InBev are today shows that we should not reject all operations of this nature a priori.

A positive indicator that seems to us to keep a good correlation with the transaction’s result is when the party that takes the initiative does so from a strong position, with a positive growth agenda. In these cases, it makes a difference to be at the right end. Even though there is usually a “premium” in relation to the acquired company’s recent stock prices, it rarely compensates the long-term investors who have “held the ice cubes in their hands”. It becomes a matter of timing, and it is not by chance that this is the category in which traces and evidence of insider trading are most commonly found.

In the opposite situation, “shotgun weddings”, where two weak parties that are under threat join together, usually lead to worse results.

Another potentially negative case is when large “depersonalized” corporations with weak governance end up being oriented, in practice, by their bankers and advisers. In such cases, what we end up seeing is an apparently unending series of senseless transactions with no effective “buy-in” by executives, generating progressive value destruction.

Another point is that in the great majority of banks’ and brokers’ reports that we see, and that are possibly the main drivers for price formation in the short term, the detailed models rarely incorporate the possibility of value destruction. The argument is that it is obviously an issue that “cannot be modeled properly”. But as we never tire of repeating, “unquantifiable” may be completely different from “irrelevant”.

How can one quantify a good management that knows how to select good alternatives and abandon those that are attractive but whose price cannot be justified (as in the case of Renner/Leader), and then efficiently manages the always difficult integrations? Our answer is that each case is different from the next one. We do (very simple) simulation exercises in order to have a range of potential values, and we invest most of our time in getting to know and understand the logic and the real incentives that motivate the managers, and the competitive market conditions within which the companies participating in the transactions operate; how the idea for the transaction arose and evolved, who their advisers are, and other qualitative factors. It is better to be approximately right than precisely wrong.

Dividends vesus Bonds

An interesting issue for those who believe in efficient markets was the situation between shares and bonds issued by high-quality global companies observed during a good part of 2009. Joseph Stiglitz, a Nobel Economics laureate, in his address to the annual meeting of the American Economic Association at the end of December 2009, fired a heavy attack at his colleagues who create models that depend on the assumption of rational behavior, when the real world insists on not fitting into this mold. During the 2H of 2009, many investors tried out their return to the markets (as they received redemptions from hedge funds or got tired of returns close to zero yielded by US Treasury securities), buying bonds.

At the height of the crisis, there were moments when fixed-income securities issued by some low-quality companies were traded at prices that seemed very low to us, but as the year advanced, that was no longer the case in most of the market.

When doing our calculations in the second semester, we could not understand the market’s logic. In several cases, the dividend yields on stocks were very close to the yields on bonds (obviously taking care to include only companies with the capacity to continue paying dividends in the future). Usually, dividends are relatively lower for the following reasons:

1. Bonds and stocks have 100% downside.
2. Bonds usually pay coupons and redemption of the principal in a given currency, fixed beforehand. On the other hand, the revenues and results of companies are generated worldwide, and the respective dividends are defined a posteriori. As there is usually a “desired” inflation rate in the systems, the current yield on the stocks of sound, growing companies should be lower, in terms of present value. In the present case, for those concerned about an acceleration in US inflation in the course of the next few years (as we are), at similar current yields, stocks of companies with quality businesses are relatively even more attractive. Obviously, the opposite reasoning applies to the hypothesis of deflation.
3. These companies pay out less than 100% of the profits for each financial year in dividends. The remainder is reinvested in order to generate increasing profits and dividends (while bond coupons are fixed).

In fact, shares of companies like Coca-Cola, Nestlé and Procter & Gamble appreciated well, and part of what seemed a distortion to us was corrected. But only part. Our philosophy cannot be reconciled with long-term fixed-income securities that carry fixed yields in dollars at the present levels, nor with stocks of high-risk companies at prices that imply optimistic scenarios that are not based on our vision of the world. We prefer to have cash or stocks of companies that are capable of generating cash, even in the most adverse scenarios, and that are trading at reasonable prices. Our experience is that even if there is zero return for some time, when opportunities finally appear, the returns more than compensate for the wait.

IMS HEALTH

IMS is another global business (nearly two thirds of its revenue come from outside of the U.S.) focused on information and intelligence on the health market, mostly the pharmaceutical industry. Its main products are information on prescription, sales and the market share of medical drugs, which can be sorted by micro- geography, medical specialty, distribution channels and other criteria. Its main customers are pharmaceutical laboratories worldwide such as Pfizer (the largest customer accounting for approximately 5% of revenues) and biotechnology startups. It is the leader in this global business and sells more than USD2 billion per year.

The nature of this business brings many desirable features:

– It requires little capex. The company has less than USD200 million in physical assets (net of depreciation).

– Very high barriers to entry. Gathering detailed information globally is a tough task. The way this information is organized, the statistical treatment and the training for its interpretation and use, and the trust conquered during 50 years make a big difference.

In addition, the company features positive financial data:

– During the past eight years the company repurchased its shares aggressively, reducing the outstanding figure from 300 million to 180 million. The average price of these acquisitions was nearly USD18 – already adjusted to possible dilutions. Considering that the trading price in the period stood between USD15 and just over USD30, the acquisitions were made at a good price. The practical effect is that those who held their shares increased their participation in future earnings at good prices. (On September 30 the price was USD15.35).

– In general, between 2001 and 2008 the company:

— Generated USD2.8 billion of cash from operations

— Invested USD1.5 billion in its own business (investments + acquisitions + software), managing a USD1.2 billion increase in revenue (productivity of approximately 75% in a business that has on average 15% to 20% cash margin).

— Paid nearly USD2.3 billion to shareholders, of which USD2.1 billion was paid through repurchases (net of issuances) and USD170 million in dividends.

— The difference was “settled” in a debt increase amounting to approximately USD1 billion. It is important to note that this is a long-term financing at a low cost and with comfortable guarantees, which is payable with the company’s cash generation.

— The Enterprise Value (shares’ market value + net debt) was USD8 billion in 2001. Today it is USD3.5 billion. Meanwhile, earnings and cash generation more than doubled from USD130 million to USD310 million, and from USD190 million to USD450 million, respectively.

Obviously, such data leads us to think that something could be wrong. What is the “counter-case”?

We have been investigating this closely, contacting the company in the U.S., its offices in Brazil and their clients. We have also hired consultants that specialize in the sector. We identified four main points:

First, the turmoil in the health sector, particularly in the U.S. That is a fact, but the impact is not negative and perennial on all the participants. Given the projected changes for the sector, it is valid to think that information is highly valued in turbulent markets.

On one hand, the big pharmas are the largest clients (and these will lose their billion-dollar contribution of many blockbuster drugs in the next 3 years), on the other IMS has thousands of them, with annual revenue per client averaging more than USD500 thousand. Its clients include most producers of generic drugs and many promising specialty manufacturers in areas such as oncology, in addition to many regional companies (small and medium-sized) in emerging economies that have grown faster than the giants in more mature markets.

There is an interesting point, balancing the lack of visibility in the U.S. health policy. The company’s largest shareholder is Ariel Investments, with a stake amounting to approximately 7% according to the most recent available information. An article published in the Wall Street Journal shortly after Obama’s election is worth remembering: “Tuesday’s election transformed John Rogers from an obscure money manager who eats at McDonald’s every day into a confidant of the world’s most-powerful man, come January. Mr. Rogers is chairman of Chicago-based Ariel Investments, the largest African-American-owned investment firm in the country… Mr. Obama spent Wednesday – his first day as president-elect – at Ariel’s downtown Chicago office, huddling for six hours making calls and planning.” Ariel’s stake in IMS is the sixth largest in its fund, and it keeps growing while the five largest decrease.

Second, we identified that the company is trying to accelerate growth by creating more customized, higher value-added services, in line with the track record of the top management, who came mostly from IBM. However, the success of this initiative has been small, so far. The company hasn’t yet netted large, strategic contracts, in line with “helping companies use the precious data it supplies to jointly develop global market strategies”. But given current prices and implicit multiples, not only are investors not paying for the project but there is also a discount due to the risk of value destruction.

We are still unconvinced about this issue. Today this is where we allocate most of the margin of safety, which we believe that exists in the shares’ price.

Third, we have the omnipresent technology risk. Theoretically, the dissemination of online systems could be a threat. And they certainly are. E- prescription programs, where doctors prescribe through systems that are integrated with pharmacies, can facilitate competition. However, “facilitate” may sound like an euphemism. In fact, it would make possible something that was previously deemed impossible. But we have serious doubts whether it is feasible. Also, obtaining the data is just part of the story. Having the clients and getting them used to the products and standards is different. The more ambitious IT programs in the health sector have so far failed in terms of results (in general that is a great business for suppliers). We will get there one day, but we have lower expectations than the market in general. Barriers are not only technological. They have to do with semantics, standards, and processes. In the end, they are linked to interests, incentives and cultures. And as we know, that is much more difficult to change.

Ultimately, an annoying, albeit not eliminatory aspect is the low level of insider ownership. The company doesn’t have a clear owner, although some of its main executives have a relevant part of their net worth committed to IMS. This has an obvious impact on business and it would not be reasonable to expect from the company a level of commitment and focus as seen at AB InBev, for example. On the other hand, this has been the case for years. And while some benefits of a more incentives-prone structure are lost, we do not find evidence of this being something harmful, as seen in many other cases. Conversely, the considerable repurchase of shares throughout the years is nothing short of surprising under these conditions. Once again, the size of the position in Ariel Investments is an upside. Even if it does not act proactively as a controller, it certainly soothes risks linked to a potential agent conflict on the part of the executives.

(…) In addition to all the issues above, the market may be exaggerating the uncertainties in the U.S. market because the company is headquartered there, although this business is global. (…).

LINKS

The official press release

With IMS Deal, Healthcare is Back on Top – WSJ’s Private Equity Beat blog

How do You Get Out of IMS Health – Barron’s (on what could be TPG’s exit strategy – independence is a very important feature of IMS’s business model, so pharma cies. are out of the picture. But who said TPG won’t try to go public with IMS in a few years?)