Second axiom of investing

We humans are buggy. World around us is messy. Most of the time, on most matters, we know nothing. Laying out money, hoping to get back more of it a decade out, seems daunting amidst such a complex context.

But there’s hope. Complex world doesn’t mean complex analyses, approaches and answers. Ironically, the way to prosper in a complex world is through simplicity. History reveals a few broad patterns that repeat, somewhat reliably (e.g. certain kinds of businesses stay good for long). These patterns guide odds. Since patterns and odds are fuzzy, we apply them with judgment and margin of safety, not blindly like an academic bearing back-tests. Sensible investing is about learning enough history, patterns and odds to sporadically find favourable situations and act on them with conviction. More importantly, it is about staying away when patterns and odds are indecipherable.

Most of the time, social systems are too messy to abstract from patterns and odds into universal laws and axioms. However, one axiom does form the foundation of all my investing – stocks are businesses. Naturally, anyone with a passing familiarity of markets knows that this axiom isn’t universally valid. At any point of time, stock price level and direction seem unrelated to underlying business. However, this axiom holds well enough, on average, over time, for me to think of stocks as businesses. I spend all my time figuring out whether I can understand the underlying business well enough to gauge what’s a safe enough buy-price relative to what the business is roughly worth. If this axiom were to break, my entire investing approach would collapse. That stocks are businesses is my first axiom of investing. It is true by definition and valid in reality, at least in a general sense.

Most of the time, this is the only axiom I need to get by. However, there is a second axiom that is central to my investing. I haven’t dwelled on it as much as I have on the first axiom. My second axiom of investing is – shareholders are last in line to get paid.

It isn’t coincidental that I am discussing the second axiom at a time when bank stocks in US are collapsing. When I act on my first axiom and try to gauge what a business is worth, I usually don’t worry about how much of that value accrues to shareholders such as myself. This is because 90% of businesses we own have zero debt. And debt levels are modest even in the remaining 10%. I don’t fuss about business value vs equity value. Since our promoters, like us, believe that optimal capital structure is one that permits sound sleep (finance theory be damned), second axiom is rendered redundant. In theory, I may be last in line to get paid, but in practice, there’s no one ahead of me.

The neighbourhood where second axiom becomes the #1 axiom is financial services. When debt:equity ratios approach 8x or 10x, second axiom supersedes first axiom. While shareholders are owners in theory, we become residual claimants in practice. Shareholders no longer own the business, we ‘own’ leftovers after everyone else is paid. With lenders, bondholders and depositors ahead in the queue to get paid, shareholders can barely see the front of the line.

Being last in line makes valuation extremely dicey. Note that valuation is always dicey. Given the range of outcomes across multiple variables between now and eternity, I have no idea what any business is worth. For very few businesses, I can gauge the lower end of that valuation band, below which I feel like I am getting a decent deal. If you forced me to share what a particular business is worth, my band of uncertainty is minimum +/- 25%.

Now, imagine what happens when there are ten others ahead in line for every one shareholder. Each of the others have a fixed claim, while I only have a residual, conditional claim. If I am wrong in my estimate of business value by 10%, I am wrong in my estimate of equity value by 100%. If my error is higher, equity value isn’t even zero, it is negative. Even after stock-price falls 90%, stock may still be massively overvalued.

I have always been mystified at how sanguine investors are in valuing lending businesses. It is jarring to see high PE/PB multiples for lenders who are neither trustworthy, competent, safe or special. Often, it is glaringly obvious that bad-loan provisions are grossly inadequate for their YOLO lending practices. A simple graph of lending yield vs provisioning is all it takes to spot outliers who seem to wield magic, although it is unclear whether in lending or accounting. Relatively new segments, lacking over-the-cycle experience and high workforce attrition are further red flags. Further, fickle funding can dry up on a whim, while loans cannot be called back for love or money. Even at low leverage, these are seriously risky businesses, selling a commodity (money) in a high competitive, fragmented industry. At high leverage, being last in line to get paid in this neighbourhood is a crapshoot.

So, I shamelessly use Western banks collapsing as an excuse to peddle my luddite views on sectors with high leverage. Margin of safety is essential even in unlevered businesses. When leverage is high, margin of safety needs to disproportionately increase, perhaps by an order of magnitude. Most important element of margin of safety isn’t valuation, it is business. In highly levered sectors, shareholders should apply a very high bar on trust, prudence, competence, multi-cycle experience and accounting. Since leverage automatically implies that financial safety-margin is low, business safety-margin has to be impeccable. People like us, who are last in line to get paid, simply cannot afford a blowup (or even a bailout where we are first to be wiped out). Even after restricting ourselves to impeccable lenders, disproportionate margin of safety in valuation is also required. Remember that small errors in firm value translate into massive swings in equity value in such cases.

I have two axioms – (1) stocks are businesses, (2) shareholders are last in line to get paid. First axiom is all about upside. As co-owners, shareholders can get immensely wealthy riding on the back of a Sam Walton, without doing any of the hard work. When we’re the only ones on the capital structure, it’s nice to tout the first axiom and strut around like we own the place.

The second axiom is a much needed reminder about the downside of being a shareholder. When there is a long line of people ahead of us, second axiom is the only one that matters. Shareholders aren’t owners, we are residual claimants of leftovers after everyone else has had their fill. In dicey businesses at inconvenient times, our claim can end up worth near-zero, as shareholders in Western banks are finding out now. Prudent investors are best served by remembering the second axiom, especially at convenient times.