Horos Asset Management commentary for the fourth quarter ended December 31, 2020 discussing an approach to the Austrian Business Cycle Theory.

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Q4 2020 hedge fund letters, conferences and more

Dear co-investor,

Finally, a very difficult year for everyone has come to an end. I can add little to the encouragement and gratitude for your trust that we have shown you in our previous letters. May the arrival of the vaccine be the turning point we all wish for our lives.

Indeed, that turning point seems to have already come to the financial markets, with equity indexes experiencing a strong recovery in the last months of the year. This time it was the most cyclical and smaller, less liquid companies that outperformed. Thus, Horos Value Internacional returned 26.3% in the quarter, compared to 11.9% in its benchmark index. On the other hand, Horos Value Iberia posted a return of 27.9%, outperforming the 22.8% rise of its benchmark.

However, we continue to believe that the companies we own in our portfolio, mostly cyclical and smaller companies, have a high upside potential. As you know, our exposure to the commodities sector is a significant feature of our funds. It is therefore very important that you understand how we analyze this industry and select the companies in which we invest. This is what we will be devoting the bulk of this last letter of 2020 to, including an account of our investment mistake in offshore drilling companies. As we always say, in order to improve our investment process, we must detect the mistakes we make and learn what decisions/reasons led us to make them, in order to reduce the chances of these situations occurring again.

My best wishes for 2021.

Yours sincerely,

Javier Ruiz, CFA

Chief Investment Officer

Horos Asset Management

Executive summary

Cycles will never stop occurring. - Howard Marks

The arrival of the COVID-19 vaccines may be marking a turning point in our lives and in financial markets, which have already begun to price in an expected economic recovery. In this new environment of less uncertainty, the stock performance of the hardest-hit sectors and investment themes over the last two and a half years has been outstanding. These are companies with more cyclical businesses and those with a smaller size and liquidity. Our funds have not been immune to this recovery, as they have strong exposure to these companies, which have been so badly affected by the dynamics we have mentioned in previous letters. However, we still see a very high upside potential in our portfolios, where we can highlight our exposure to the commodities sector. For this reason, we dedicate the current letter to explain our analysis of this industry, through tools such as the capital cycle analysis or the Austrian Business Cycle Theory, as well as to comment on some of our historical and current holdings in this area, so loved and hated by the investment community.

Additionally, we will discuss the most significant changes to our portfolios. Among others, we can highlight that in Horos Value Internacional we exited our position in Qiwi, after the regulatory uncertainty in its business increased, as well as KKR, due to its good performance. On the other hand, we initiated two new positions in the quarter. Specifically, we invested in the podcast hosting company Liberated Syndication, as well as in GAMCO Investors, the historic asset manager with an excellent track record in value investing. In Horos Value Iberia, we sold Sonae Capital, following the improvement of the takeover bid launched by the Azevedo family, and added Ence, after the announcement of the sale of 49% of its energy division, unveiling significant value in the company, while at the same time reducing its debt.

The history that always repeats itself

Look back over the past with its changing empires that rose and fell, and you can foresee the future too. - Marco Aurelio

The team that Alejandro, Miguel and I form, have had—as the co-investors who have been with us a long time know—a generalist profile when it comes to approaching investment. By this I mean our willingness to invest in any sector or geography, as long as the company meets the requirements we require to be added to our funds. Thus, throughout our professional career, our portfolios have included stocks belonging to sectors as diverse as technology, real estate, finance, retail and commodities, as far away as Japan (when nobody wanted to know anything about its stock market, back in 2012), the United States, Hong Kong, Russia and even Colombia.

In order to be able to cover this vast investment universe, it is vital to have tools or mental models that help us understand how markets work and identify potentially exploitable inefficiencies. In the first quarter of 2020 (see here), we talked about the most relevant mental models that the Horos team uses. In particular, we relied on complex adaptive systems to understand the mechanisms behind the market excesses, as well as the sharp market decline (and subsequent recovery), as a result of the uncertainty associated with the Covid-19 pandemic and its impact on the world's economies. On this occasion, I would like to delve into another mental model, which is essential to our work and will help you understand our significant exposure to the commodities sector of the last few years: the capital cycle analysis.

The capital cycle analysis is the conceptual framework that can serve as a guide in our study of industries with businesses and products, in general, little differentiated and therefore more likely to suffer major cycles. Hence, it is a very useful tool for investing in commodity-related companies. This analysis, popularized in recent years by Marathon Asset Management in the wonderful (the best?) investment book Capital Returns, focuses particularly on the study of the supply behavior of each sector, as this is the predominant force in the different phases of the capital cycle.1

Capital cycle analysis, however, focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast.2

To better understand this, let's look at the four phases that make up these capital cycles in the commodities sector:

• Boom: the market environment is positive for the industry's producers (supply), as there is an unsatisfied demand in the market, which causes a rise in the commodity prices and a return on the invested capital of the producers that is higher than its cost. The boom phase usually coincides with significant stock market gains of the companies in the sector.
• Investor optimism: the prospect of large returns attracts new capital, increasing the current supply, by exploiting areas with higher extraction costs (in the case of mining, for example, producing the lower grade deposits, now profitable), and increasing the future supply, by developing new projects that will come into production years later. The industry's discipline is lost. In this phase, companies usually trade at very demanding valuations, discounting all the good and very little of the bad to come.
• Depression: optimism and lack of discipline lead to an excess of supply (and competition), usually exacerbated by demand that is weaker than initially expected. This imbalance triggers a collapse in commodity prices and returns on capital fall below its cost. The depressed phase is accompanied by sharp declines in the stock market value of companies in the sector, as it cannot be otherwise.
• Investor pessimism: low returns lead to a drastic reduction in investment in current supply (closure of less efficient deposits/mines) and future supply (no money whatsoever allocated to the exploration and development of new projects), as well as sector consolidation. Unlike in the phase of investor optimism, in this stage the companies trade at depressed valuations, discounting all the bad (permanently low commodity price scenarios, with consequently value-destroying capital returns) and none of the good (capital discipline sows the seed of future recovery). The lack of supply-side investment tends to drag on to the point of triggering an imbalance that supports supply, starting the cycle with its boom phase again.

Therefore, we clearly see the power of supply in the formation of these cycles and how vital it is to know what phase the sector is in, to try to take advantage of the periods of investor pessimism and boom in the cycle.

Note, additionally, the relevance of other mental models that can help us to complement the above analysis, belonging to the field of behavioral economics. Overconfidence (especially when forecasting prices or project development times), optimism (fueling the overconfidence just mentioned), anchoring bias (extrapolating the current market situation into the future, without analyzing the expected supply and demand dynamics), cognitive dissonance leading to the rationalization of irrational beliefs (prices will not fall) in the face of contrary evidence (increased competition and excess supply in the future) or inside view (thinking, for example, that my mining project will see the light of day in 5 years, when the history of other projects in the industry says that the average time is 8 years), among many others, can help us understand and anticipate the irrationality that most company executives in these sectors, as well as investors, continually incur in injecting capital at the worst times—when everything is going well and can only get worse—and draining it at the best times—when everything is going badly and can only get better.3

High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending.4

However, although the capital cycle analysis that we have described, supported by behavioral economics, is very helpful in navigating with certain guarantees of success the ups and downs of cyclical industries, we have another—more global—theoretical framework for understanding the formation of capital cycles, both at the industry and macro level: the

Austrian Business Cycle Theory.

An approach to the Austrian Business Cycle Theory

There is nothing more practical than a good theory. - Jesús Huerta de Soto

I am aware that this section may be difficult for the reader to follow, although I have tried to simplify the underlying idea as much as possible. If you prefer, you can jump to the next section, "The commodity supercycle", where we apply the theory exposed here.

The Austrian Business Cycle Theory (“ABCT", from now on) is possibly one of the most interesting models developed by the Austrian School of Economics. Some economists point to the scholastics of the School of Salamanca in the 16th century (Francisco de Vitoria, Martín de Azpilicueta, Diego de Covarrubias or Luis de Molina) as the origin or precursors of this school of economics.5 However, its foundation, as such, dates back to 1871, with the publication of Carl Menger's Principles of Political Economy. Later, during the last century, economists such as Ludwig von Mises, Friedrich von Hayek or Murray Rothbard, made the school more notorious. In Spain, we also have great scholars who belong to or are related to the Austrian School, two of whom stand: Jesús Huerta de Soto and Juan Ramón Rallo. Precisely, these two economists have written two essential books to better understand the ABCT: Money, Bank Credit, and Economic Cycles (by Jesús Huerta de Soto) and A Critique of Mises' Monetary Theory (by Juan Ramón Rallo).6

It is not the purpose of this letter to go into detail on the work (and differences) of these authors, nor to write twenty pages developing the ABCT. However, it is necessary to understand its essence in order to put it into practice in our subsequent analysis of the commodities sector. Basically, the Austrian Business Cycle Theory states that cycles are aggregate miscoordinations between the consumption plans of savers and the production plans of investors or entrepreneurs.7 Why do these miscoordinations occur? Because of the widespread liquidity degradation of economic agents, through the indiscriminate abuse of the maturity and risk mismatch. In other words, borrowing through short-term financing to invest in long-term maturity assets. This lack of coordination and liquidity degradation is magnified through the banking system, which acts as a financial intermediary facilitating this mismatch.

Why does the banking sector operate in this way? Basically, for three reasons. First, because it is very profitable to arbitrage the interest rate curve, taking on short-term debt (for example, by creating demand deposits or borrowing from other financial institutions) in order to invest in the long term (usually by granting loans to individuals and companies that mature in the distant future), due to the term spread that normally exists (the longer the term, the higher the interest rate) to compensate for the risks associated with longer maturities. Second, because, although banks take an excessive and unsustainable risk with this approach, they can always count on the lender (and buyer) of last resort: the central bank. Third, because the central bank itself, through its monetary policy, encourages banks to engage in this maturity mismatch.

An illustrative example of the maturity mismatch is the following:

To help understand the role of the bank as a financial intermediary (and oversimplifying), let's imagine that an average citizen, named Julian, wants to lend ten thousand euros to his brother-in-law so that he can buy some machinery he needs for his new business. His brother-in-law promises him that in two years he will pay him back those ten thousand euros, plus an additional four hundred euros as interest for the time spent and the risk incurred. If Julian had that money in savings, he could decide not to use it for two years and lend it to his brother-in-law, so there would be a temporal coordination between his savings/consumption plan and his investment plan (two years). However, Julian does not have that money available or prefers to spend it, so he turns to his mother to lend him those ten thousand euros, charging him two hundred euros in interest at the end of those two years. Julian lends this money to his brother-in-law and, if everything goes as expected, at the end of the second year he will have pocketed two hundred euros for his role as financial intermediary (ten thousand four hundred that his brother-in-law will return to him, minus ten thousand two hundred that he will give to his mother).

So far there is no maturity mismatch and the risk comes from his brother-in-law not paying back in due time and at the right conditions. Let's now imagine that Julian's mother tells him that she will lend him the money, but that she may need it in three months to buy a car. In that case, if Julian goes ahead with the financial transaction, he begins to take a clear liquidity (and solvency) risk because his mother may demand the money before he gets it back. If so, Julian will need someone to lend him ten thousand euros (plus interest) within three months, in order to be able to pay his mother back.

Well, this is exactly what banks do, but with much greater mismatch and liquidity risks, always taking for granted that they will be able to refinance their debt—thanks to the fact that, ultimately, they can be rescued by the central bank. This would mean that Julian could, as a last resort, always turn to his father if he could not get anyone to refinance him, to repay the debt to his mother if she needed the money before he could get back what he had lent to his brother-in-law.

This persistent mismatch carried out by the banking sector—and other very important economic agents, such as the so-called "shadow banking"—leads to the classic flattening of the yield curve, encouraging agents to take on more debt in order to develop longer-term and, therefore, more illiquid investment projects (let’s imagine that Julian's brother-in-law takes advantage of this decline in long-term rates to ask him for money for another, now more attractive, ten-year project) and consequently discouraging long-term savings. However, and this is the key, there has been no coordination between the plans of savers and those of entrepreneurs. Savers are providing short-term funds because they want to consume in the short term (remember Julian's mother and the car). Entrepreneurs (Julian's brother-in-law), however, find long-term financing through the banking system (Julian), as if such coordination did exist (ten-year business project). This lack of coordination can go on for some time, increasing the risks taken by the banking sector, making it more fragile and unstable as well as generating competition bidding up for the resources of economic agents, which often leads to inflation and, on occasion, asset bubbles.

How do we get to inflation? On the one hand, entrepreneurs are focused on new long-term plans that are further away from the end product (projects that take years to complete, such as developing new machinery, a capital good, for the more efficient manufacture of automobiles). On the other hand, savers, as we have mentioned, have short-term consumption plans (the purchase of the car is planned now). As they make these plans, the demand for the goods already produced or consumer goods rises, causing inflationary pressures, since not enough consumer goods are being manufactured to meet current demand (the entrepreneur is investing the credit in developing new machinery, not in speeding up automobile production). This inflationary pressure is further exacerbated as new projects compete with the rest of the agents bidding up for the same factors of production (labor, capital, raw materials). If there were temporal coordination between savings and investment, these factors of production would be allocated to projects demanded by the savers according to their time preferences, and this pressure would disappear.

Since this does not happen, all stages of production compete for the same resources, triggering inflationary processes of the first (e.g. wage and commodity price increases) and second order (wage increases allow more products to be demanded and, in addition, bottlenecks take place in commodity industries, given that supply cannot meet the growing demand, which causes commodity inflation). In addition, unless central banks try to prevent this, interest rates rise, as economic agents also compete for bank credit in order to carry out their consumption and investment plans.

Eventually, the mismatch between short-term savings (and funding) plans and long-term investment projects becomes unsustainable, as many of these projects prove to be unprofitable. A (desperate) phase of struggle for liquidity begins, as agents seek to refinance their debt so as not to be forced to abandon their business plans. However, financiers become more cautious in this environment and restrict the supply of credit, which puts upward pressure on interest rates, worsening the financial situation of businesses. In order to be able to repay part of the debt, businessmen proceed to abandon investment projects with poorer prospects, initiating a fall in the demand for factors of production (layoffs begin and the demand for commodities falls). However, the liquidity in the system is not enough to sustain the rest of the projects that businessmen were struggling to maintain, and the depression phase begins, which may be more or less pronounced. In this phase, companies go bust, its assets are liquidated and the demand for factors of production plummets, with prices falling across the board (deflation) along with interest rates (lower demand for credit).

It is at this point that the huge risk taken by the banks with the mismatching of maturities becomes apparent, as they find that their assets (loans) lose a large part of their value (the projects they back go bankrupt or generate less cash flow than expected). Moreover, since they operate with massive leverage, a small loss in their assets' value can wipe out all of the entity's equity. This is why most banks carry out large capital raises at the worst possible times, to help them avoid bankruptcy, and are forced—to a greater or lesser extent—to be bailed out by the central bank. This is one of the reasons why, historically, we have been averse to investing in the financial sector. The maturity mismatch, together with the massive leverage, makes the financial sector (especially the banking sector) a fragile and unsustainable business in the long term, with a few honorable exceptions in our portfolios, such as S&U, AerCap or Catalana Occidente, where prudent management of maturities and leverage makes them excellent businesses. I will leave, as a reflection, whether banks would take so much risk, which is so detrimental to the economy due to the lack of coordination and cycles they generate, if there were no such central bank as there is now.

Lastly, the depression phase forces a restructuring of the different stages of production in line with the savings/consumption plans of the economies. This is a painful process of recapitalization, although necessary for the economy to begin its recovery phase as soon as possible. Hence, most interventionist policies by central banks or governments contribute negatively to this recovery by distorting the behavior of economic agents and maintaining a situation of recession or stagnation over time.

In short, as we have just seen, the Austrian Business Cycle Theory helps us to have a more global view of what may be driving the supply and demand of commodities, as well as their prices, while the classic analysis of the capital cycle focuses exclusively on the industry's supply, failing to explain what underlies demand and price formation. This is especially true in synchronized commodity cycles, where prices move in unison and where the dynamics specific to each commodity lose much of their relevance. The latest commodity supercycle is a clear example of this phenomenon.

Read the full commentary here.

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