The theory of the black swan

Until the seventeenth century, it was believed that all swans were white, and the existence of swans with black feathers was seen as improbable. The first European explorers reaching Australia in that era discovered a species of black swans in their voyage. The unexpected discovery of just one such bird did away with centuries of belief and changed the prevailing perception.

The theory of the black swan in relation to financial markets is an allegory of this situation and it was developed by the Lebanese philosopher and researcher Nassim Nicholas Taleb in 2007. He describes an unexpected event with a huge impact that must meet three requirements:

1. It is highly improbable: it is unexpected and there were no signs that it would happen.
2. Huge impact: it significantly affects society as a whole.
3. It is predictable retrospectively: only after it happens can we become aware of the unnoticed signs showing that the event could have been prevented.

Black swans have occurred with ever greater frequency as the world has evolved and become more complicated, making it difficult to predict rare events, strange situations that have a much greater impact than regular or ordinary events.

Examples of such surprising or unforeseeable phenomena include the crash of the New York stock market of 1929, the 9/11 attacks, the fall of Lehman Brothers or the Brexit referendum. I am not going to discuss whether the Covid-19 pandemic could have been prevented or not, but what is clear is that it has drastically changed the present paradigm.

As has been shown throughout history, such events tend to leave investors vulnerable and give rise to irrational panic that causes aggressive corrections in financial markets.

Fear ruled the markets in the first three months of 2020, with international stock markets posting one of the worst quarters in history.  Investors began the year leaving behind a 2019 that, in spite of growing trade tensions, the Brexit negotiations and geopolitical problems, was a positive year for financial markets. A number of benchmark stock indices had even reached record highs, and that was when the coronavirus emerged, shattering all that optimism.

The scale of the fall was unprecedented: Wall Street shares were plunged into a bear market (falls of 20% from the most recent high) in sixteen days, the quickest pace ever seen. In just a month, the markets began to show losses that largely equalled those of previous crises.  We have also seen a market recovery that led the Nasdaq index to even wipe out yearly losses. This shows how the market can leap from one extreme to the other. This complicated backdrop is underscoring more than ever the need for active management that can shield us from the background noise so we can have the temperance and patience to take advantage of the great opportunities available in the markets.

As we can see, a major player in these scenarios is volatility. It reached its highest level in Europe since records have been kept and in the United States, it reached levels near those seen in 2008. Ultimately, the market is a mechanism for discounting expectations related to the level of uncertainty, and this is a key factor.  Why is that? Because human beings prefer to have certainty about something negative than a possible piece of good news.

In the markets, there is never absolute certainty about things, but this unprecedented scenario has triggered a 180-degree turn and caused uncertainty to skyrocket, negatively affecting investor sentiment given the lack of clarity about the impact of the virus. This inability to predict the consequences and their scale has sped up the market contraction.

However, we have to manage our emotions in such situations and, above all, not panic. The irrationality of the market, when it falls in a random manner, allows one to take advantage of the opportunities created by investors’ over-reaction.

Although the market would sometimes appear to recognise only a few winners, now is not a time for winners. Maximising earnings is not the priority anymore; while buying earnings has always involved a possibly radical change in earnings in a short period of time, this is especially true now.

In times of boom and growth such as we have experienced in recent years, investors may lean towards investing in companies without especially concerning themselves with the type of activity they carry on, or they may even be ready to fund businesses that generate no money.   Conversely, in times of lesser growth, it becomes crucial to choose companies with a sound balance sheet that can withstand a slowdown.

At present, risks abound, and it is unquestionably difficult to devise company earnings forecasts when the global economy is under lockdown. Nevertheless, for a long-term equities investor, the important thing is to discern whether the reality of business is going to undergo a change that is as drastic as reflected in share prices. We can safely state that price trends have not been driven by the fundamentals, but rather by panic.

For us, the best haven is the long term. When a widespread selling panic causes losses as steep as those we have seen, the share prices of companies with solid business models and good fundamentals also suffer, but their intrinsic value is not as sharply affected. Investing in the long term furnishes a more sophisticated understanding of risk, and enables one to see when the situation is much less risky than the share price might suggest. 

Share prices of our portfolios at a P/E ratio of 4.7x in the case of Cobas Internacional and 6.1x in Cobas Iberia are an illustration of their tremendous undervaluation compared to their real intrinsic value. Meanwhile, business profitability (measured in terms of ROCE, the key indicator of business quality, as it calculates the return obtained by the company from the capital employed) stands between 25% and 21%, respectively, which is a clear sign of strength. And profitability of the cash flow (measured in terms of Free Cash Flow yield, a ratio that indicates returns in terms of capacity for cash flow generation) stands at 25.8% and 14.1%. This is quite positive, as both the strength of the balance sheet and the generation of cash flow are key variables and will define its future value.

At Cobas, we have prepared our portfolios for this situation, with companies that are less dependent on the cycle, with a solid and well-managed business. We invest in companies with a healthy balance sheet, many of them with net cash flow, thus giving them the ability to withstand and adapt to the new situation. In essence, companies with good fundamentals to sustain such future returns, as this is the only thing that will determine the value of the company.