Giverny Capital on Lessons from the Crisis

For a number of years I have followed Canadian value investor Francois Rochon who runs Giverny Capital. Rochon focuses on great businesses with durable competitive advantages. He looks for companies that are growing their earnings twice as fast as the S&P 500, which over the longterm he expects will lead to market-beating performance. $100,000 invested with Giverny on July 1st, 1993 would have grown to $984,096 vs. $342,349 if invested in the S&P 500.

In Giverny Capital’s 2009 Annual Letter to Partners, Rochon reflected on the lessons he has learned from the financial crisis, noting that some of these were already known.

Everything that cannot rise forever will someday stop. This certainly occurred with the speculation on derivative products, technology stocks in 2000, American residential real estate in 2005, Dubai real estate earlier this year, biotech companies in the early 1990s and with the price of oil in more recent years. These are just a few recent examples!

It is the nature of things that with every economic cycle, some businesses disappear while new ones are born. This reminds us of the cycle of life here on Earth.

Companies that went bankrupt all had faced a common pitfall: too much debt. The companies that withstand crises are most often the ones with solid balance sheets and with leadership that is prudent, trustworthy and devoted. Isn’t this perfectly logical?

Warren Buffett once said that investors should not be in the market if they are not willing to accept a temporary drop of 50% in the values of their portfolios. I always mention to our partners that that this was likely to happen once in their life as an investor—I knew it would happen but I didn’t know “when”.

Many investors who were on margin at the beginning of 2009 were forced to sell at the worst possible time. An investor who uses margin to invest can do well for 30 years and then lose everything in a single day of irrational market movements.

The irrationality of short-term market fluctuations makes derivative products extremely volatile (options, swaps, etc.) When many people try to sell these instruments at the same time, derivative products can become worthless overnight. When this is combined with leverage (debt), you end up with an explosive cocktail.

The good news is that the market, as Ben Graham wrote 60 years ago, ultimately renders an accurate assessment of the intrinsic value of companies over the long term. To remain calm and rational in the face of wild fluctuations in stock prices is, beyond the shadow of a doubt, the most significant quality an investor can have or try to have.

At the end of the day, in order to build wealth, there is a simple approach which we have followed for 17 years at Giverny Capital: investing for the long term in high-quality companies purchased at attractive valuations—investing in companies that will survive the crises of our civilization and the short-term irrationally of our economic system.

Rochon also likes to look back and assess his “best” errors of the prior year. This is a great practice and way to learn from your experience. Here is his Bronze Medal for 2009: BYD.

During the Berkshire Hathaway shareholder meeting last May, I listened attentively to Charlie Munger’s discussion of BYD, a Chinese company led by Wang Chuan-Fu. Charlie said with great admiration that “Chuan-Fu is a combination of Thomas Edison and Jack Welch: I have never met such a businessman.” When we consider that Charlie is 86 years old and that he has probably met the greatest businessmen of the last two generations, it’s an extraordinary comment. His words didn’t fall on deaf ears and I was instantly interested in BYD.

The company manufactures an array of products but the most important is a revolutionary battery used in electric cars. Based on this invention, BYD launched itself fearlessly into the car manufacturing business. As a fervent believer in the future of the electric car, I became enthralled with this highpotential company. Keep in mind that, with revenues of over $5 billion in 2009, BYD wasn’t exactly the new kid on the block.

My enthusiasm was cooled when I saw the company’s valuation on the market. The stock was trading at $15 on the Hong Kong market while the company only had EPS of $0.50 in 2008. A P/E ratio of 30 times seemed exaggerated in my mind. So being a persistent man, I woke up each morning to look at BYD’s closing price in Asia hoping that the stock had dropped so I could buy a stake in the company at a more reasonable valuation. This was in vain.

The company had an exceptional year in 2009. After nine months, BYD’s revenues climbed 39% and their new car division grew 50%. The company’s EPS has yet to be announced but it’s likely to have doubled to $1.06 for 2009 and analysts expect $1.84 in EPS for 2010.

The stock has soared 400% in a year, reaching its current level of $65. Sometimes, the artistic side of investing is to know when to let go, in a rare and exceptional moment, of market valuations and simply make a leap of faith based on an exceptional human being.

Here is the entire letter.

In addition, Francis Rochon was recently featured in Value Investor Insight.


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