Insights

We believe that the primary investment task for most families and long horizon investors is to preserve their wealth’s purchasing power and grow it at inflation-adjusted rates through all types of economic, geopolitical, and financial cycles. To achieve this objective, such investors need to maintain the long horizon perspective, both in constructing their portfolios and in assessing the performance of such portfolios. As one structures a portfolio for long investment horizons, what becomes clear is:

1. 1. that the portfolio needs to be structured in such a way that it can effectively deal with varying environments,
   2. that it shouldn’t be dependent on the status quo continuing forever, and
   3. that it shouldn’t be dependent on the ability of the investor/manager to time the market’s directions successfully.

So how would we go about doing that? With respect to geopolitical risks, as we detailed in Portfolio Construction: Problems driven by high US concentration and overvaluation of US equities, one needs to construct portfolios that are diversified globally and across sectors and industries.

The Cycles of Economic Expansions (Stability) and Busts (Instability)

The economic and financial environments go through cycles of expansions and busts. Economies go through a benign period of growth associated with healthy growth in economic output and overall societal wealth, driven both by demographics and technological advances. During the period of secular boom, economic fundamentals improve. However, during the latter part of the boom, that period of stability itself starts to breed instability. This is the process that Hyman Minsky defined as the Financial Instability Hypothesis.

The prolonged period of stability experienced by society has similar effects as being high on dopamine; you do not want the feeling to end. The result is an ever-decreasing willingness to accept slowdowns and an almost complete lack of willingness to accept economic and financial contractions.

After a prolonged boom, the economic fundamentals that drove the secular boom start to decelerate. Such deceleration and the reduced willingness to accept it cause policymakers on the monetary and fiscal sides to resort to financial engineering. Governments engage in debt-financed spending while central bankers practice loose monetary policies. The longer the previous boom lasted, the stronger the response from policymakers to try and extend the boom, even in the face of the deceleration in economic fundamentals.

This process results in debt buildup, and the policymakers are able to prolong the expansion in the “wealth” of the society. However, this part of the expansion is unsupported by true economic fundamentals. By the time the malinvestment is exposed, you end up with a society with too high debt and too high a paper value of wealth, neither of which are supported by the underlying fundamentals.

The only choice at this point is to let the excesses correct themselves by allowing the bubble to deflate or to continue onwards, leading to an inflationary bust. This is best put by Ludwig von Mises when he stated, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.“

It is essential to understand that this is a multi-decennial process. Indeed, even from the point where the debt buildup starts, it usually takes a decade or more for instability to spring up. The efforts to keep up the economic growth and financial wealth eventually fail as we end up with excessive leverage. The economic bust takes the form of debt deflation or a debauchment of the monetary system. If one is particularly unlucky, you can have both in quick succession. As the economic contraction completes itself, it sows the seeds for the next round of the secular boom.

Economic/Financial Seasons (Cycles)

One can think of the economic and financial environment described above in terms of seasons with the boom represented by summer and the bust represented by winter. A benign growth environment represents the economic summer, while the winter is the period of instability – deflationary deleveraging or the inflationary bust.  

Creating an All-Seasons Portfolio

To construct a portfolio that can survive and thrive through these cycles, one needs to combine assets that do well during the secular boom, i.e., risky assets, with assets that come to life during periods of instability, i.e., defensive assets. We need to ensure that those defensive assets do not exact too high a cost during the secular boom. Below, we review the various key assets and how they are likely to behave across various environments.

Equities – The boom time asset class. Equities are positively levered to economic booms. Indeed, much of the returns from equities have been earned during such periods. An important point to remember about inflationary periods is that stocks do not act as a good hedge against inflation. As discussed in our article The True Nature of Equities: Are Stocks A Good Inflation Hedge?, for stocks to serve as a hedge during such periods, the underlying RoEs need to increase in the same proportion as the increase in the discount rate. As detailed in that note, RoE of US businesses has been highly sticky around the 11.5% mark and has shown no tendency to rise during inflationary periods.

Over the past 221 years, US equities have compounded at an annualized inflation-adjusted return of 6.6%. As we hypothesized earlier, equities do not provide a hedge against inflationary periods. This is further confirmed by data. During inflationary periods, stocks lost purchasing power at an annualized rate of -4.9%. Excluding high inflation periods, US equities generated a real annualized return of 8.5%.

Bonds – Hybrid asset class. Bonds are positively leveraged to economic booms as such periods are usually associated with declining interest rates. Significantly, expansionary periods are associated with low corporate defaults such that there is overcompensation for corporate risk.

Bonds, especially high-quality sovereign bonds of the reserve currency issuer, are a truly hybrid class of assets. Such bonds generate good outcomes during deflationary times as the nominal value of the principal rises in value. Note that this statement only holds as long as there is no default. If the sovereign defaults on its obligations to lenders, the outcomes for investors will likely be rather poor. By their very nature, debt deflations are associated with significantly elevated corporate default rates. What that means is that corporate bonds are not a good asset class to own during deflationary times.

However, bonds are a truly awful asset class to own during inflationary times. Over the past 150 years, US Treasuries have resulted in a loss of purchasing power of -8.5% annualized during inflationary periods.

Reserve-neutral Monetary Assets: Gold – A truly all-weather asset class. Monetary assets are useful to own during deflationary periods as they do not carry credit risk, and their value rises in relation to the deflated value of all other assets. In a fiat currency regime, gold can double up as a safe keeper and even enhancer of value during deflationary periods while also acting as an excellent store of value during inflationary periods.

Reserve-neutral monetary assets like gold provide a good hedge against inflationary periods as the higher money supply raises the nominal value of such assets.

Commodities – Pro goods and services inflation. Commodities and equities of such businesses provide one of the most effective hedges against goods and service inflation. Commodity companies have generated much of their positive returns during inflationary and secular boom periods while losing purchasing power during deflationary periods.

The trouble with 60/40

“People often confuse complex ideas that cannot be simplified into a media-friendly statement as symptomatic of a confused mind.” – Nassim Taleb, Fooled by Randomness

The idea of the 60/40 portfolio has its appeal in its simplicity. However, we believe it to be simplistic as against being simple. As discussed earlier, stocks do not provide a hedge against inflation. At the same time, bonds tend to perform the worst during inflationary periods. A portfolio that combines the two, no matter the kind of backtest results you have on your hand, does not pass the muster of being sensible. Such a portfolio will result in a significant loss of purchasing power during inflationary periods.

It’s also important to understand what could happen during debt deflations. As things stand currently, we have an extreme amount of debt that has built up, both at the government and at the private sector levels. If a deflation were to pan out after such an excessive leveraged boom, we would expect both equities and bonds to suffer large losses.

Combining High and Low Return Assets to generate High Returns

The asset allocation approach we suggest combines each one of these asset classes and does so at meaningfully large weights to defensive assets. There are two counteracting and crucial points that one needs to understand about this portfolio construction process. Ignore either of these rules, and you will have difficulty sticking to such a portfolio.

• The reason the combination of a high return asset, equities, at just a quarter of the total with much lower return assets ends up generating returns in line with equities is because of the differing return profiles. Some of these lower-return assets generate much of their returns during periods of poor returns for risky assets.
• And therein lies the even more important second rule. During benign high growth environments, the All-Seasons Portfolio (ASP) will not generate anywhere near the kind of returns that will be generated by equities or portfolios constructed to do well during boom periods. It is crucial to understand and digest this rule.

The All-Seasons Portfolio (ASP)

The all-seasons portfolio construction approach we have discussed is informed by two other investors/authors – Artemis Capital Management and Calderwood Capital Research.

Dylan Grice[1], in October 2020, talked about constructing the Cockroach portfolio by equally combining equities, bonds, cash, and gold. The study period For Mr. Grice’s work was 1973 to 2020. He found that in that time period, which included one of the longest and best bull markets for US equities and bonds, the Cockroach portfolio held itself very well, compared both to US equities and to the 60:40 portfolio.

Separately, Chris Cole at Artemis Capital Management wrote[2] the tour de force on constructing portfolios that perform well in all environments. Mr. Cole stated that the current economic expansion, the largest bull market in American history, has resulted in a significant overallocation to risky assets. An important point the paper makes is that a defensive asset that is countercyclical and makes profits opposite to the business cycle is a worthy addition to a portfolio, even if it loses money over the full period. Their solution to a multi-generational portfolio is a portfolio that has roughly equal allocations across equities, bonds, gold, commodities trend, and long volatility strategies.

Historical Evidence: Performance of All-Seasons Portfolio Over the Past 150 Years

“The longer you look back, the farther you can look forward.” – Winston Churchill

The reason we make the efforts to look as far back in history as possible has to do with the idea that the farther back in history can we look back, the farther we can look forward. Financial markets and economies go through cycles that can sometimes be extremely long-term, extending over several decades. By looking back over the past 150 years and longer, we try to ensure that we capture the effects of at least two of the longest of those cycles.

To verify the historical outcomes of the portfolio construction process we laid out earlier, we set up an empirical study wherein we combined the four asset classes, namely global value equities, bonds, monetary assets, and commodities, with each basket assigned a weight of 25%. This is the All-Seasons Portfolio for the Conservative Investor. The second portfolio has a 33% exposure to global equities and a 67% exposure allocated equally across the four buckets within the ASP Conservative portfolio. This is the All-Seasons Portfolio for the Aggressive Investor. Please refer to the Appendix for details on the data and index construction process employed by us.

The table below shows the risk and returns of the All-Seasons Portfolio, both for the Aggressive and Conservative investor, as compared to that of the US equities, global equities, and the 60/40 portfolio over the past 150 years. Note that this is constructed entirely via asset class level index returns. We have no way of capturing the impact of value-added/reduced from the active management of portfolios. In the Appendix, we have provided much more nuanced details around the performance of these assets and other key asset classes, segmenting the returns over different environments.

Over the past, nearly 150 years, the asset allocation portfolio has generated returns that are pretty much the same as that of the US equities. What is important, though, is that it has done so with much less risk than the equity portfolios. The Sharpe ratio, a measure of returns per unit of risk with risk being defined as standard deviation, is superior for both the ASP baskets as compared to equities as well as the 60/40 portfolio. Returns per unit of drawdowns are significantly superior to equities.

In the second half of the table, we provide absolute return outcomes over one, three, and ten year holding periods, both in nominal terms and in inflation-adjusted terms. We believe that the 10-year holding period applies to most investors as against the 150-year time period that may come across as too distant.

In nominal terms, i.e., change in portfolio values without adjusting for inflation, both the ASP portfolios generated positive returns in each of the 10-year holding periods. And there were 138 such periods in our study. However, as against nominal returns, we think most investors should be concerned with real returns, i.e., inflation-adjusted returns. When the inflation-adjusted return of the portfolio is positive, it tells you that the purchasing power of the wealth has grown. On an inflation-adjusted basis, both the All-Seasons Portfolios perform significantly better than the other portfolios. Nearly 98% of all such 10-year periods had positive real returns for both the portfolios.

The chart below shows the drawdowns for the ASP Aggressive, global equities, and US equities. As is seen, the ASP has shallower drawdowns and, in most cases, faster recovery periods.

The chart below shows the excess returns for the ASP and the 60/40 portfolio. Excess returns have been defined as returns over the US Treasury bills. An important element that comes across here is that the ASP’s excess returns are far more stable than that of the 60/40 portfolio. ASP’s excess returns have averaged at 6.1% annualized over the entire period of the study and at 7.2% annualized since 1920.

The chart below shows the 10-year rolling Sharpe Ratio for the ASP Aggressive. The ASP’s 10-year rolling Sharpe Ratios have been relatively steady around the 0.55 mark, which is the full period average and the average since 1920.

 

Our approach : Highly selective assets

Note that this section details our products and approach. If you are not interested in this part, please skip to the Appendix for additional details about the empirical study.

Our approach to asset allocation for multi-generational portfolios takes a little different tack. For the Conservative Investor, we construct a portfolio that is equally allocated across equities, bonds, commodities, and monetary assets. For the Aggressive Investor, we increase the equity exposure to 50% and proportionately reduce the other exposures.

Importantly, we take a different route to constructing each one of the asset class exposures. Utilizing our experience in assessing businesses from equity and bond investors’ point of view, we have supplemented some of the asset classes with businesses that have exposure to that asset class. Our strategies are designed to construct resilient investment portfolios through economic environments, including “tail risks” of inflationary and deflationary episodes.

To that end, we offer three primary strategies: a global equity allocation strategy, a global valuation-driven multi-asset allocation strategy, and a private credit strategy. Below we briefly summarize our approach in each one of these areas.

Equity allocation strategy. The Global Moats Fund (GMF)/Global Moats Investments (GMI) are our core equity allocation strategies. As we have highlighted previously, US equities are significantly more overpriced than international equities. Notably, the market capitalization weight of the US equities at nearly 60%[3] within the total global indices is much higher than US’s GDP weight of 25% (16% on PPP basis) within the global GDP. Additionally, investors across the globe have an overallocation to domestic equities.

To that end, we designed GMF/GMI as truly global equity portfolios allowing investors to reduce country concentrations within their overall equity allocations. At the same time, by being extremely selective about the quality of businesses we invest in, we expect our businesses to survive and possibly thrive through all kinds of economic outcomes.

Global asset allocation strategy. The Global Select Value Fund (GSVF) is designed to be a global asset allocation strategy. GSVF combines equities, fixed income, monetary exposures, and commodities within a well-designed mix to construct an investment portfolio that is resistant to economic shocks. We take a highly selective approach to building each one of the components of the portfolio. Further, the Fund looks to maintain a highly diversified book.

• • The fund’s equities book comprises the highest quality asset and natural resource owners and operators. Note that our equity book at the GSVF does not include a core equity strategy. To that end, we recommend combining GMF/GMI with GSVF with the mix, depending on the investor’s risk preference.
  • Our fixed-income book is usually comprised of sovereign bonds and corporate bonds backed by assets that ensure the safety of our principal. When bonds are unattractively priced, we take a different route to our fixed-income book, supplementing it with ownership of businesses with fixed income like cash flows and operating within high-quality regulatory frameworks. Please note that it requires us to take our eyes off mark-to-market changes and instead focus on the underlying cash flows of the businesses we invest in.
  • Our monetary position is mainly comprised of gold as we consider gold as the highest quality of “money” ( and currencies). We build our exposures here both via ownership of physical gold bullion (stored separately for us) and via ownership of the highest quality of gold miners. We also look to understand and own alternative forms of risk-neutral assets.
  • Lastly, our commodity exposures are largely built via ownership of the highest quality of commodity producers spread across energy, uranium, metals, and agricultural resources with each type of commodity exposure diversified across countries.

Private credit strategy. In a world of financial repression, fixed-income investors usually have to settle either for poor returns or expose their portfolios to substantial credit losses. Even then, the pickings are rather slim. To that end, we set up a private credit strategy that lends against real assets. Our portfolios are currently focused on aircraft and realty assets. We lend monies only against assets that we carefully select, are of the view that they represent high-quality and highly desirable assets that will retain value even during the worst of deflationary periods, and look for a substantial capital cushion to ensure that our capital is well protected. Our private credit strategies allow us to generate significantly superior fixed income returns and do so with much lower credit risk.

[1] A stealth flight from cash, Popular Delusions, Calderwood, 29^th October 2020

[2] The Allegory of the Hawk and Serpent, Artemis Capital Management, January 2020

[3] As evidenced by the MSCI All Country World Index wherein US had a 60.63% weight as of June 30, 2022.

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Appendix

Quantitative Notes

Data Sources and Process of Construction of Asset-Class Indices

Global Equities

The data for our work was sourced from IMF, OECD, Factset, and Jorda-Schularick-Taylor Macrohistory database. In most cases, rates of return from 1870 to 2015 have been sourced from Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics. Forthcoming. Data after that is sourced from IMF, OECD, and Factset. We have used the investment returns from the perspective of US investors in 16 advanced economies. The countries and the data periods included  Australia (1871-2021), Belgium (1871-2021), Denmark (1875-2021), Finland (1896-2021), France (1875-2021), Germany (1875-2021), Italy (1875-2021), Japan (1886-2021), Netherlands (1900-2021), Norway (1881-2021), Portugal (1875-2021), Spain (1900-2021), Sweden (1875-2021), Switzerland (1900-2021), U.K. (1875-2021), and USA  (1875-2021). The index is constructed on a GDP-weighted basis with the index weights rebalanced every year with relative GDP weights of the countries included in the index used as the index weight.

US Equities

From 1802 to 1824, total return data is sourced from G. William Schwert, Indexes of United States Stock Prices From 1802 – 1987. From 1825 to 1874, data is taken from William N. Goetzmann, Roger G. Ibbotson, Liang Peng – A new historical database for the NYSE 1815 to 1925: Performance and predictability. The index used by Goetzmann et al. is a price-weighted return index. Further, the authors reported dividend yield in two ways – A low dividend return estimate by totaling dividends of all firms where prices were available in the preceding year, and a  high dividend estimate which was calculated by using dividend and prices of those firms where dividends were available for two years and price was available as well. As the authors state, they may not have found dividend data of all firms for which they had prices and thus, the lower dividend estimate almost certainly represents a lower bound. In the absence of any good solution for this problem, we have just taken the average of high and low dividend yield estimates to calculate our total returns.For the period 1874 to 2016, data is taken from JORDÀ-SCHULARICK-TAYLOR Macrohistory Database. Since 2017, data is taken from Factset.

Bonds

Annual total return data from 1926 onwards is taken from Ibbotson SBBI Data. For the period 1874 to 1925, data taken from JORDÀ-SCHULARICK-TAYLOR Macrohistory Database.

Monetary Assets / Gold

Between 1879 and 1933, the US was on a gold standard which meant that ownership of the currency itself represented ownership of Gold. Between 1933, the US operated on a quasi-gold standard wherein gold transactions were limited to official transactions with other Central Banks – the US continued to define the dollar in terms of gold. For this period, currency cannot be said to represent ownership of gold. However, with private ownership of gold restricted, the best proxy for monetary assets ownership during this period is also the US T-Bills. With the dollar moving away from convertibility in 1971, it is from 1971 that we have used gold prices as representative of unencumbered monetary assets. From 1874 to 1979, gold price return was used. From 1879-1971, T-Bill returns have been used to represent monetary asset ownership. US T-Bill rates for the period 1874-1925 were taken from JORDÀ-SCHULARICK-TAYLOR Macrohistory Database. From 1926 to 1971, T-Bill return data was taken from Ibbotson SBBI data. Gold price data from 1874 to 1978 was sourced from Nick Laird. Gold price data from 1874 to 1977 is sourced from National Mining Association. Gold price data from 1978 onwards reflect the continuous futures prices and is sourced from Norgate Data until 2020 and from Investing.com thereafter.

Commodities

Commodity returns data is sourced from AQR, Commodities for the Long Run.

Value vs Growth

Value vs Growth spread is from Kenneth French’s website 3 Factor returns from 1926 onwards. The Value vs Growth spread has had an annual trend return of 4.6% between 1926 and 2021. For the period of 1874 to 1926, we have assumed the value vs growth spread to be 4.6%.

Gold Miners

For the period between 1903 to 1928 and 1937 to 1939, the index was constructed using the stock price of Homestake Mining. For this period, the dividend yield of the S&P 500 is used as a proxy for the dividend yield of the gold mining index. For 1929-1936, Homestake Mining and Dome Mining stock prices were used to construct the Gold Miners Index. Dividend yields of the two stocks were used to calculate the Index’s total return. For the period between 1940 to 1993, the index is constructed using the Barron’s Gold Mining Index. For the period between 1994 to 2004, the index is constructed using the NYSE Arca Gold Miners Index. For the entire period between 1940 to 2004, the dividend yield of the S&P 500 is used as a proxy of the dividend yield of the gold mining index. From 2005 onwards, the Index is constructed using the NYSE Arca Gold Mining Total Return Index. Data Source: Homestake Mining stock prices have been estimated from the stock price chart sourced from Longwave Group. Homestake Mining dividend yield, Dome Mining stock prices and dividend yield have been sourced from the Longwave Analyst report dated January 2, 2009. Barron’s Gold Mining Index data was sourced from Nick Laird. NYSE Arca Gold Miners Index price data for 1993-2004 was sourced from Investing.com. Thereafter, both the price data and total return index data was sourced from Factset.

Commodity Equities

The commodities equities index was constructed internally. Data used for the construction of the Index was gathered from FACTSET Global database. A company to be included in the Index construction needs to have price and fundamental data (i.e., shares outstanding) for each year of the Index construction. Data was collected for a period of 37-years (1985-2022). The price and fundamental data were available from 1985 onwards, so the Index was constructed since 1985. The following filters were implemented for the construction of the Index: Market capitalization – For the latest year i.e., 2022 the market capitalization criteria used was greater than USD 2 billion, and then subsequently deflated by 3% each year historically. Investment universe – Globally, all the countries were included in the Index construction. Industries included – Steel, Precious Metals, Other Metals/Minerals, Oilfield Services/Equipment, Oil Refining/Marketing, Oil & Gas Production, Oil & Gas Pipelines, Integrated Oil, Gas Distributors, Contract Drilling, and Aluminum. Industry classification is based on the classification provided by the FACTSET Global database. Financial data lag – A lag of 3-months was used on all the financial data. After applying the above filters, we were left with approximately ~1355 unique stocks for the period considered. The Index was first established in April 1985 based on the data available at that date. The Index is rebalanced on the last trading day of the month of April every year. The Index is constructed using the market capitalization-weighted methodology in which the constituent stocks are weighted based on their market capitalization. The weight of each stock is calculated by the ratio of its market capitalization to the sum of the market capitalization of all constituent stocks. Also, in the case of stocks in the Index getting acquired or de-listed, the stocks were sold respectively on their last trading day and were not replaced by any other stocks, the pay-out from the sale was held in cash till the next portfolio rebalancing date. For the period prior to 1985, The Commodities Equities index has been estimated based on a regression model that used our commodity returns index and the global equities total return index as the independent variables.

US CPI

US CPI data is sourced from the Federal Reserve Bank of Minneapolis. Data from 1800-1850: Index of Prices Paid by Vermont Farmers for Family Living. Data from 1851-1890: Consumer Price Index by Ethel D. Hoover. Data from 1890-1912: Cost of Living Index by Albert Rees. Data from 1913-1977: Consumer Price Index (CPI). Data from 1978 to present: Consumer Price Index for all Urban Consumers (CPI-U).