Before my career in investing I had a career in forestry, where I spent most of my time working on Vancouver Island and on Canada’s Northwest coast – to this day, the most beautiful part of the world I have ever seen. Even though forestry and investing are far more different than they are similar, more often than you might think, I find myself drawing parallels between the two.
A core element of a sustainable forestry project involves the engineering of high-integrity roads and bridges. Safe and reliable logging roads are a necessary piece of the forestry infrastructure, linking the resource with the market. Given these roads often involve traversing steep, potentially unstable terrain, sound design and construction are paramount.
One enemy of the logging road is the wear and tear caused by the passage of heavy trucks and equipment. The other is water. A stable road must accommodate the unobstructed flow of water from one side to the other. If no such passage is available, you can be sure water will find its way. Sometimes water will erode the road from the side or base. More often than not, and particularly when it arrives in a hurry, water will breach the roadside and wash over the surface, often taking a lot of the road material with it and rendering the road unstable or impassable.
The forest engineer’s solution to this is the culvert. A culvert is a simple tube of corrugated metal running perpendicular to and underneath the road from one side to the other. The integrity of a road is just as dependent on the placement of culverts as it is on the grade, the shape of the road surface, the materials used, and the construction.
And just as important as the placement of the culverts is the size. An experienced road engineer will allow for significant excess capacity here. The culvert is not sized just to accommodate the water buildup from a major rainfall or even the flowing water delivered by a spring thaw that quickly melts heavy winter snowpack. Instead, the culvert is sized for the 100-year storm, a once-in-a-century weather event for which only a channel of this throughput capacity could do the job.
In 99 years out of 100, the larger culvert would be considered overkill. But in that hundredth year, it’s all that matters. An overwhelmed culvert can cause a great deal of damage to a road. In more extreme cases, like in the case of a road climbing a steep valley wall, it can trigger landslides and devastate entire ecosystems.
The reasons to opt for the wider culvert are obvious. The reasons to choose a lower-capacity system really come down to cost. Despite representing a small percentage of the cost to build the road, and a minuscule percentage of the overall forestry project, larger culverts are more expensive. But the opportunity costs of not making that incremental investment are large. At Burgundy, we refer to this type of relationship as having a high cost of failure.
What lessons can investors glean from corrugated metal pipe? What is our equivalent of a wider culvert? At the end of the day, it’s about building the necessary safeguards into the investment process to provide overall resilience in the face of very rare events. At Burgundy, we refer to these safeguards as Margin of Safety.
There are several points during the evaluation of a business in which an analyst can find margin of safety. Since the factors that contribute to margin of safety are cumulative, it’s valuable to follow a consistent process.
First, we consider only those businesses we deem to be of the highest quality in the first place. These are businesses with an enduring competitive advantage that offer an undeniable value proposition to their customers. They are resistant to disruption, with a history of adapting to a changing world. These attributes must be demonstrated in a business’s financial results through high and defendable profit margins, high returns on capital, and strong balance sheets. And these companies need to be run by competent and trustworthy people.
Second, we make forecasts for these businesses using conservative assumptions for growth and profitability.
Third, we discount the expected future cash flows of the business to arrive at an estimate of its inherent value. The higher the rates used to translate future cash flows into today’s terms, the more conservative the assessment of the business’s intrinsic value. Despite record low-interest rates around the world today, we have maintained our models using discount rates of 8-10%.
Finally, upon arriving at a conservative assessment of the intrinsic value of a business we then look for an approximate 30% margin of safety as an added layer of insurance. In other words, we are willing to buy $1 worth of intrinsic value in a great business when we can do so at a price of about 70 cents or less.
It is through this framework that we make individual investment decisions. By following this approach, each investment decision may be thought of as a wider culvert. When building a logging road, however, it’s not enough to install one wide culvert at a single vulnerable point in the road. Instead, the engineers will design a coordinated system of culverts to facilitate the uninterrupted flow of water along its entire length. At Burgundy, our system is to construct concentrated but diversified portfolios, where both the merits of each individual constituent and the contribution to overall portfolio quality are clear.
The benefits to owning portfolios of resilient businesses are not always apparent in how things are valued in the marketplace at any given time. Long periods can pass when the investment in the wider culvert doesn’t seem to have been worth it. While we can’t say precisely how or when those benefits will surface, we can be confident that eventually, they will.
The other day, someone asked me what I thought could be the ultimate lesson from the COVID-19 crisis. My immediate answer was that this will prove a great reminder of the fragility of life and our need to cherish it along the way. Reflecting upon the investment implications, I think the answer can be found at the entrance to a wide culvert – the value of a bit of redundancy or slack in the system.
In business, there is a natural tension between optimizing efficiency and ensuring resiliency. In recent years leading up to 2020, the balance had shifted toward efficiency with everything needing to be ‘lean,’ ‘just-in-time,’ and run with an ‘optimized’ (debt-heavy) balance sheet in order to be efficient. That can work for a while. But this crisis has reminded us how very vulnerable we all are and how valuable a system of 100-year culverts can be in our lives, our businesses and our investments.
This post is presented for illustrative and discussion purposes only. It is not intended to provide investment advice and does not consider unique objectives, constraints or financial needs. Under no circumstances does this post suggest that you should make investment decisions based on the content. Past performance is not indicative of future results. Investors are advised that their investments are not guaranteed, their values change frequently and past performance may not be repeated. The information contained in this post is the opinion of Burgundy Asset Management and/or its employees as of the date of the post and are subject to change without notice. Investing in foreign markets may involve certain risks relating to interest rates, currency exchange rates, and economic and political conditions. From time to time, markets may experience high volatility or irregularities, resulting in returns that differ from historical events.
