Horos Asset Management 1Q20 Commentary: The Importance Of Mental ModelsJacob Wolinsky
Horos Asset Management commentary for the first quarter ended MArch 31, 2020.
We finished what has been one of the most challenging quarters we have ever experienced, both professionally and, of course, personally. Therefore, I would like to start by thanking you for your great trust in our work and wishing you all the best in these tough times.
I would also like, if I may, to express my congratulations and gratitude to the rest of the members of the Horos team, for the great effort they are making, so that our service and work can continue to be carried out as normally as possible. You can count on our dedication and rigor to be the same as always.
This quarter has been characterised by a sharp market downturn, as a result of investors’ panic and increased demand for liquidity, in the face of economic uncertainty due to the coronavirus pandemic. Thus, Horos Value Iberia fell by -35.1% compared to -27.6% of its benchmark index. On the other hand, Horos Value Internacional was down by -30.2% compared to -19.6% of its benchmark index.
In this quarterly letter, I would like to try to do my part to explain the severity of the market crash. But, most importantly, in an exercise in transparency that goes beyond previous letters, I will devote the bulk of this letter to discussing, in great detail, the changes we have made to our portfolios in order to mitigate potential risks and increase their upside potential to all-time highs.1
We are convinced that we have an outstanding investment opportunity ahead of us. We are also proud to be able to say that in March, one of the worst months for the stock market on record, we had net inflows from our co-investors.
Javier Ruiz, CFA
Chief Investment Officer
Horos Asset Management
We should not, like sheep, follow the herd of creatures in front of us, making our way where others go, not where we ought to go. – Seneca
The severe and sharp market downturn this quarter is a result, on the one hand, of the impact that the coronavirus pandemic and the consequent government actions are having on economies around the world. On the other hand, as markets operate as complex adaptive systems, the uncertainty about the scale and duration of this impact triggers a disproportionate —non-linear— reaction from investors, who liquidate their assets all at once and cause a panic-selling feedback loop.
We at Horos have tried to adapt and take advantage of the situation by exiting or reducing our exposure to the few portfolio companies with a higher liquidity risk to weather the current environment (offshore drillers and the stainless steel company Outokumpu), as well as to those investments with relatively lower upside (such as IWG, LSL Property Services, Alphabet or Alantra Partners), in order to increase our exposure to overly punished sectors or companies. Specifically, we have significantly increased our investment in the shipping and infrastructure sector for liquefied natural gas and crude oil (Teekay Corp., Teekay LNG and Golar LNG), as well as in businesses with the capacity to deal with this crisis, such as Catalana Occidente, Sonae, AerCap and Naspers.
Additionally, this quarter we benefited from the positive performance of uranium (Uranium Participation Corp. and Yellow Cake), caused by the forced shutdown of major mines due to the coronavirus outbreak. Likewise, our long-standing investment in Clear Media was taken over at the end of March, delivering a capital gain of 80% since our entry in the second half of 2019.
The importance of mental models
A mental model is simply a representation of how something works. – Shane Parrish
Charlie Munger, Warren Buffett’s longtime business partner, is possibly one of the most complete investors in history and therefore a model to consider when improving our analytical and decision-making skills. In particular, Munger has always been known for using a multidisciplinary approach to deal with any problem he faces, including the investment process. To this end, he has relied on the basics of the most important academic disciplines. This aspect is very relevant, given that if we focus all our efforts on mastering a single discipline, our mind will try to torture reality to fit our limited knowledge set.
To a man with only a hammer, every problem tends to look pretty much like a nail.2
But which disciplines are the most essential? Although knowledge is unlimited and any help is welcome, it is true that some of them can be more useful to us when analysing companies, the industries in which they operate or the functioning of economies and markets. Specifically, we at Horos rely, without being exhaustive, on economics (for example, the Austrian Business Cycle Theory and the Liquidity Theory as theoretical frameworks for understanding the formation of cycles), behavioral psychology (biases and heuristics and their impact on investor behaviour), philosophy (stoicism and its relationship with value investing), mathematics (the concept of convexity and its Talebian application to improve the risk-return ratio of our portfolios), statistics (the Kelly Criterion to concentrate, given equal upside, on those investments in which we have the greatest conviction) or biological evolution (complex adaptive systems as a model for understanding how markets work).
We have discussed some of these mental models in the past and how we apply them. For example, the concept of convexity led us to invest in uranium through the vehicles that buy and store it, instead of purchasing shares of the major producers of this commodity (read here). You have also heard us talk about the importance of behavioral psychology in improving our investment process (see here). Today, I would like to focus on complex adaptive systems, as they help explain some of the recent market action.
What do biological evolution and markets have to do with each other?
Evolution and economics are actually two different examples of a larger phenomenon called complex adaptive systems. – Michael Shermer
In his recommended book The Mind of the Market3, the writer and scientific historian Michael Shermer shows the undoubted similarities between how biological evolution and economies work, as both are complex adaptive systems that arise from simple interactions between their elements —whether species or economic agents— in seeking to ensure their survival and that of their offspring. In fact, Shermer proposes to merge both disciplines under the name of Evolutionary Economics.
The dynamics of a complex adaptive system can be understood by looking at the behavior of drivers in traffic situations.4 Let us imagine an urban road where many vehicles regularly move. Let us also imagine that one day there is an accident and the authorities force drivers to move more slowly than usual when they reach the area. Little by little, a queue of vehicles is formed as they slow down and those that lag behind, without even knowing the reason, find that the road is heavily congested. A small interaction —a lower speed zone— has triggered a traffic jam.
Let us further elaborate on the problem. Now, a second group of drivers who usually use that route learn about the traffic jam by radio or by any mobile app and decide to use, as one would expect, the typical alternative route. As everyone starts to use this second route, another predictable bottleneck is created. Finally, this is where things start to get complicated. A third group of drivers gets on the road, faced with the choice of whether to take the first or the second route. What decision will they take? Will they think it may make sense to take the first because, with the existing information, the other drivers will choose the second? Or, maybe they will go further and come to the conclusion that if everyone thinks the same, it will be better to choose the second option as the rest will opt for the first one? Or, maybe, after much thought, they will come to the conclusion that it is better to stay at home and telework?
Read the full letter here.