SVB & 5 DIMENSIONS OF EQUITY FRAGILITY As bull turns to bear on Wall Street, the market mentality is shifting to "what can go right" for a stock to "what can go wrong". The best investors I've worked with have always have a keen sense of what can go wrong (in any regime)
and are more focused on the asymmetry of the bet (i.e. making $2 when right and losing $1 when wrong) than misplaced confidence in the probability of the bull case. This humility usually comes from years of getting punched in the mouth and experiencing a wide range of outcomes.
I like to play the game on individual stocks of "how can I lose 50% here". To me this is a game of disqualification. If I can assess, with a somewhat reasonable probability, that I could lose 50% in a situation, I'm not very likely to be involved
(outside of a few select situations where I anticipated 100%+ upside, and kept sizing very small). If I think there is a low chance of losing more than 25% with a chance of 50%+ upside, that is where I have made large bets.
So when thinking through this mental game of "how do I lose 50%", what matters? To me, it is three big buckets. the nature of the business the cash cycle valuation levels
the nature of the business. - How durable & hard to kill is the business? - Would customers care if the biz went away? - What are the returns on invested capital and durability of those returns? - How predictable is revenue? Warren Buffett's love of banks is kind of ironic
to me. For an investor who loves great businesses that could be "run by a ham sandwich", banks are an interesting choice. When you own a share in a bank, you own own a sliver of equity between the assets & liabilities.
Should these assets become impaired (say...bonds whose value declines due to rising rates) or declining deposits force a sale of assets, that equity can be wiped out. Combine this ever-present existential risk with ROE's that are just "meh" and low organic growth, and banks
haven't exactly been a hotbed of hedge fund long activity. the cash cycle In general, good things happen to cash flowing businesses and bad things happen to cash burning businesses (this is not deterministic, but win rates are higher when FCF is present).
if I am looking at an equity that generates cash even in a risk case, it is generally harder to see 50%+ downside case. That cash continues to build on the balance sheet and accrete to equity. valuation A starting point of extreme valuation alone is enough to lead to a 50%
move. When the difference between current valuation and 10-year average valuation alone is enough for a 50% move down in the stock, that's an initial sign to me valuation has reached an extreme level (there are always exceptions).
5 DIMENSIONS OF EQUITY FRAGILITY Given these 3 buckets, on a stock by stock level, what analysis do I want to do to assess how "fragile" the equity is to a 50%+ correction. REVENUE QUALITY. What is contract duration? What is customer concentration?
Is there inflation support / pricing escalators in the contract? How durable is the customer base / what is bad debt exposure? What are the macro externalities to revenue generation / how bad did revenue get in prior recessions?
Ultimately, the question is how predictable is revenue, irrespective of the macro environment. MARGIN STRUCTURE. How durable and predictable is profitability? Have margins stayed stable & rising? How big have margin moves been in the past? A margin moving from 20% to 10% can
be a big issue for a stock, as EPS can get cut by 50%+ in that instance. BALANCE SHEET. The balance sheet matters a lot in the risk case. In a hypothetical with two similar businesses pre-debt, a 20% EBITDA cut on the levered stock matters a lot more to the equity than the
company with no debt, all else equity (the levered stock is likely to maintain option value). Bad balance sheets create fragile equities. EXTREME VALUATION. See TDOC. I like the current vs. 10-year check as a very rough first cut.
CASH FLOW / POTENTIAL FOR DILUTION. If a business can be cash generative through the economic cycle, that protects the downside in the equity. Bad things happen to equities when cash flow goes positive to negative and there is a funding gap that needs to be met.
Hope this framework is helpful in assess downside in your stock selection and avoiding those 50%+ moves down. I wrote more on assessing your downside here last September: https://t.co/pMC3cTJWtD