A teacher asked the class the following question: “There are nine sheep in the pen, and one jumps out, how many are left?” Most got it right, and said eight are left. One boy said “none are left”. The teacher said: “You don’t understand arithmetic”. The boy said: “No, you don’t understand sheep”.

You can guess which ‘sheep’ were in his mind when Charlie Munger narrated this story at Wesco Financial’s annual general meeting this year. It has been an interesting year, so far. Some black magic has turned bulls into sheep that are now flocking out of the markets.

I’ve little to say on the markets because I don’t understand sheep. But I do understand arithmetic and I’ll talk about a few simple concepts. Understanding high school arithmetic, as Buffett says, is necessary and a sufficient prerequisite for investing. So you better not forget it.

Given below is a graph with line P which denotes the revenues of a company at different levels of output, if the prices remain constant. There are costs associated with production, a part of which are fixed costs (for example administrative overheads) and a part are variable costs that depend on the number of units produced (for example material cost). Let us assume all the variable costs are a linear function of output. The lines A and B denote the costs of sales for two companies A and B at different levels of output. As you can see, both the companies need minimum level of units sold to be profitable. Company A has lower fixed costs which makes it more profitable than company B.

Both A and B are operating at an output level n1. The operating profits of A are higher than operating profits of B. Now comes a boom in the industry. The sales of both the companies rise to n2 units. The profits of B (blue) rise faster than the profits of A (green), although in absolute terms they remain lower than the profits of A.

This simple arithmetic is behind many of the developments we are observing when moving from a boom to a bust. It describes why in the good times relatively weak companies show huge jumps in profits. These companies are, in Buffett’s words, “like the duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world”; but actually it’s the rise in demand, coupled with rise in output prices that’s the reason behind the growth in profits. And "only when the tide goes out do you discover who’s been swimming naked."

Similar equations drive superior results from speculative businesses funded heavily by debt. In that case too, the interest cost is fixed whereas the returns on capital vary depending on the business environment. Leverage adds to the returns accruing to the shareholder, by adding the excess of returns on the debt utilized in the business over the interest paid. This addition is magnified by the amount of leverage.

All the characteristics of an unattractive business like high capital requirements and low margins go on to help these businesses show hefty growth in profits and sometimes high return on networth due to excessive level of indebtedness. But such periods don’t last long. What you are witnessing now, is the end of one such period. The slowdown in business activity, lowering of volumes and cooling of the output prices, will hit the speculative businesses the hardest.

Its not surprising that in a year BSE SmallCap is down 70.59%, BSE MidCap index is down 67.46%. Many of the companies that are part of these indices will not live to see the next bull run. Many of the investors of these companies, having suffered losses beyond their psychological endurance levels, will no longer be interested in equities.

The lesson for the value investors is simple. They have to look beyond the analysis of simple changes in financial numbers. They have to be aware of the patterns in these changes and they should ‘expect’ these changes before they even take place.

The analysis of sensitivity of the financial numbers, to variables beyond the control of the business, is an important part of risk analysis. If you find an attractive stock, don’t salivate until you know how the various changes will impact the business. Will the business still be competitive if the dollar rises by 10%? Will the company still be profitable if steel prices fall 50%? Will the company be able to pay its interest if the interest rates rise by 2%? These are the questions you need to answer before you invest.

This also highlights the importance of margin of safety. In the graph shown above, the company A will not be losing money even if the sales fall to n0. By that time, the company B will be bleeding. Weeding out of weaker businesses is an integral part of economic cycles. They do the job done by forest fires in keeping the ecosystem vibrant. The downturns force the organizations to cut costs, to close down unproductive lines of businesses, to bring focus back to survival and growth. And that is the key to keep the economic system healthy.