Insights

Summary:

• The primary investment task is to preserve and grow client’s wealth at inflation-adjusted rates.
  • • • Needs to be done without taking undue risk of a “permanent loss of capital”.
      • Doing so requires combining various asset classes with differing risk-return profiles.
• Three problems inhibit the investors’ ability to construct robust portfolios:
  • • • Equities bubble. US equity markets extremely overpriced and are in bubble territory.
        • • Global equity portfolios have a disproportionately high exposure to US equities.
          • While US accounts for 25% of world GDP, it accounts for 57% of the world equity index.
          • US equities are priced for similarly poor returns as in 1929 and 2000.
          • Value stocks, on the other hand, offer much better prospects.
      • Bonds bubble. After a 40-year period of trending downwards, interest rates reached close to zero or went negative globally.
        • • Rates do not compensate investors for the risk of inflation.
          • Pricing of interest rates has been driven by the belief that inflation will not return.
          • Ignores the lessons of history – making the interest-rates bubble the biggest of our lifetimes.
      • Depreciation of cash. Extreme expansion in money supply with M2 stock being the highest in recorded history driven by an unchecked appetite to resort to QE.
• Constructing sensible equity portfolios:
  • • • The traditional 60:40 portfolio doesn’t account for the mispricing of both the equities and bonds simultaneously.
      • Investors need to, thoughtfully, consider risks and expected returns, and be willing to shun index benchmarks.

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N.B.: This note was sent to our investors as part of our 2020 Annual Letter which was circulated in January 2021.

 

“Investing is simple, but not easy.” – Warren Buffett

“Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.” – Bill Gross

At MAEG, the Firm’s mission is a relatively simple one; to provide sensible investment solutions to investors.

In a benchmark driven investment world, the investment management function’s primary task is frequently drowned in the noise of a short-term relative performance derby[1]. So, what do we believe is the investment function’s primary task? To us it boils down to preserving and growing our client’s wealth at inflation-adjusted rates, consistent with long-term returns of the requisite asset class, and to do so without taking undue risk of a “permanent loss of capital”.

The Anti-fragile Portfolio. The chart below illustrates the types of assets required to construct a portfolio designed to do well across different investment and economic environments.

Figure 1: An illustrative portfolio allocation

To build portfolios that are genuinely robust across market environments, we need to combine various asset classes, especially asset classes with relatively low correlations.

Three Problems: Investment and Economic Environment

As we survey the investment world, three problems inhibit an investors’ ability to construct robust portfolios that can generate healthy inflation-adjusted returns. One, the equity pricing bubble. Valuations for the broader equity markets we believe are priced for poor prospective returns – well below the historical real returns from equity. Two, the credit – fixed income bubble.  Interest rates are close to zero or negative in most advanced economies. Indeed, “real” rates are in negative territory for all significant economies, developed as well as emerging. And three, an unchecked appetite to resort to Quantitative Easing (QE). While the Coronavirus pandemic drove policymakers to engage in extensive stimulus packages and even more QE, the trend towards the depreciation of cash has been in place for much of the past two decades (indeed since centuries across various civilizations)!

Problem #1: Equity Bubble

Much of the US equity market is priced for very poor estimated 10-year returns. The mispricing is much more acute for companies thought of as “disruptors”, the so-called new economy businesses. Indeed, such companies have been priced for abysmal returns not just in the US but, by our estimate, globally. At the same time, a handful of businesses that own or operate high-quality assets or possess franchises not designated as “disruptors” are priced for healthy returns—a rather bipolar market behavior.

Overallocation to US equities. As we discussed here[2], over the last century, US equity markets were one of the two best-performing markets across all developed economies. As against using the average returns of all of those countries, the investment industry touts the US equity market returns as representative for overall equity market returns driving a larger share of investment wallets to equities. Of course, what is ignored, especially during periods of runaway bull markets, is the risk associated with such investments. As we showed in the article referenced above, there is nothing “normal” about equities’ downside risk. An important point relevant to investors with long horizons is that the really bad equity outcomes are associated with really poor economic outcomes. What that means is that just when the rest of an investors wealth and incomes are stressed, an investment portfolio would be  experiencing a large drawdown as well.

Whereas US equities accounted for 15% of the global equity market capitalization in the year 1900, the higher comparative return has driven that proportion to greater than 50% by 2016. Indeed, the US equity market’s weight has climbed even further, as evidenced by the MSCI ACWI Index, wherein the US accounted for 57% of the global weight as of December 31, 2020.

Figure 2: Relative sizes of world equity markets, 1900 vs. 2016[3]

If you are so inclined to bet on US equities’ continued superior performance, it might be instructive to think of the resultant global equity market capitalization mix. Indeed, a similar superior performance of US equities will result in the US accounting for nearly 80% of global equity capitalization over the next hundred years.

This will further accentuate the already wide gap between the US’s GDP weights and equity market capitalization weight. As is seen in Figure 3, the US accounts for only about 25% of  world GDP. When considered in purchasing power parity (PPP) terms, it accounts for about 16% of world GDP. If the developing world continues to grow faster- as is likely, that proportion is likely to decline further.

Figure 3: Global GDP Mix – Current Dollars and PPP (Source: Data from World Bank, MAEG’s calculations)

US Equities: Priced for poor expected returns. Since the Coronavirus crisis lows in March 2020, US equities have staged a recovery that is nothing short of astounding. Over the past nine months, US equities have moved up by nearly 75%. As managers focused on long-term investment returns, one of the most fundamental rules of investing is that you should expect to earn lower returns when you pay a higher price for a security. While it is indeed true that the lower expected return on equity securities may be higher still than that in fixed income securities, the absolute returns that one should expect do decline as the price being paid for a security rises.

The chart below shows the 12-year estimated nominal returns for the S&P 500. The critical point to note here is that the 12-year estimated returns for the S&P 500 are currently in the same zone as that experienced during the tech bubble and the peak just before the Great Depression.

Figure 4: Estimated 12-year nominal annual total returns for the S&P 500 [4]

Keep in mind that none of this means that equity markets have peaked and will start a decline anytime soon. Financial markets can stay irrational for longer than most rational investors estimates ! It does however mean that investment allocations require careful consideration and only to those specific pockets that are priced to earn 9%+ returns over holding periods extending to ten years.

Investment mispricing – Value vs. Growth and US vs. Rest of the World. Whereas the broader equity markets are priced for poor returns, there is an important mispricing that has developed over the past decade. New economy businesses are priced at extremely high valuations. At the same time, old economy businesses have been priced at the other extreme. This is seen in the extreme performance differential between “value” and “growth” stocks. As shown in Figure 5, value has sustained its worst performance against growth of the past 90 years. Notably, after sustaining an extended period of poor performance, the relatively poor performance accelerated further downwards over the last three years.

Figure 5: Value vs. Growth – Annualized factor returns (Source: Kenneth R. French, US Research Returns Data, French/Fama 3 Factors

Figure 6 shows the forecasted 7-year “real” returns for various asset classes as per GMO. As is seen, US equities are priced for much worse returns when compared to their international brethren. Off all asset classes tracked by GMO, Emerging Value is priced for the best intermediate-term returns.

In our work, we corroborate GMO’s estimates and similarly find US equities to be priced for much worse returns than other developed and emerging markets. At the same time, we see several high-quality businesses classified as old economy while possessing best-in-class industry positions being priced for very healthy investment returns.

Figure 6: Forecasted 7-year returns for various asset classes as of November 30, 2020 [5]

Problem #2: The Fixed Income Bubble

Fixed income has no income in it, with interest rates artificially pegged to the zero bound. At the same time, debt levels across corporates and sovereigns are reaching out to new highs.

At its core, ownership of a fixed-income security like a bond is similar to lending money to a borrower. When we lend money out, we essentially forego current consumption in favor of future consumption. Foregoing current consumption requires an incentive, a compensation for accepting consumption in the future over the present. The required lending rates are composed of four components that can be segregated in two primary parts as below.

• • Time preference component
    • • Compensation for inflation
      • Compensation for foregoing current consumption

• • Investment component
    • • Compensation for credit risk accepted
      • Excess investment return

Figure 7 shows interest rates in the US, Germany, Japan, and Switzerland. Having trended lower for nearly forty years, rates worldwide have reached close to zero or have turned negative. When interest rates are negative or close to zero, as is the case currently, the very first component of the required return, compensation for inflation itself, is questionable. When accepting such low rates, investors make an implicit assumption that inflation will stay close to zero or negative for extended periods. Of course, the idea of compensation for other components doesn’t even arise unless one is pricing a deep and extended deflation.

Figure 7: Interest Rates in Developed Markets [6]

One of the reasons driving investors in being willing to accept such poor returns, and in case of negative yields, even eager to pay a borrower for the privilege of lending money, is their belief that they can sell their holdings to someone else at even lower yields-most likely the Central Banks ! What has made the pricing of interest rates the most extreme in recorded history is the added belief that central banks will not allow rates to rise materially and most astonishingly- inflation will not return. This belief in the power of central bankers ignores the lessons of history. It also makes the bubble in interest rates one of the biggest  in our lifetimes.

While rates are continuing to stay in extremely low territories, debt levels have continued to rise. As per the Institute of International Finance[7], in Q3 2020, overall debt-to-GDP ratios jumped to 432% in developed markets and 250% in emerging markets, with China reaching 335%. Figure 8 shows the change in the debt-to-GDP ratio between Q4 2019 and Q3 2020. The Coronavirus pandemic has driven leverage levels to rise rather substantially.

Figure 8: Change in Debt-to-GDP [8]

Problem #3: Depreciation of Cash

Figure 9 shows the evolution of the US GDP, M2 Money Stock, and the M2 Stock-to-GDP ratio over the past six decades. Whereas the ratio pretty much oscillated around one for the first three decades, it trended lower during the nineties as the economy grew faster than the money stock. However, ever since the tech bubbles bursting, policymakers have found a new elixir in the form of an ever-expanding money supply. The result is that the money supply has grown much faster than the GDP. The coronavirus crisis has seen an extreme jump in the M2 Stock-to-GDP ratio, which now stands close to 1.6x, a far cry from an average of around 1x between 1960 and 2010.

Figure 9: US M2 Stock-to-GDP Rati [9]

This devaluation of cash raises significant risk around the value of money itself and gives rise to the possibility of changes to the monetary structure-either extreme inflation or extreme deflation. Further compounding the impact of asset allocation decisions is that as against providing compensation for such risks, cash today is associated with a negative real (and in come cases negative nominal returns), much like fixed income securities in many cases.

Constructing Sensible Portfolios in Such an Environment

As the discussion above highlights, the task of constructing multi-generational portfolios isn’t as straightforward as combining a bunch of assets or relying on the traditional 60:40 portfolios to do the job. Sensible portfolio construction in such an environment requires careful consideration of risks, expected returns and a willingness to shun index benchmarks.

As we searched for answers to the problems such an environment poses, we concluded that the right approach to portfolio construction is to combine a core equity strategy with an opportunistic asset allocation strategy.

The core equity strategy should ensure that it does not invest in any business with a poorly structured balance sheet or has a business model that depends on “free money” policies. On the other hand, the asset allocation strategy should identify and put together a basket of assets that have a high probability of surviving through varied economic outcomes and generate a healthy investment return in the interim. This belief is behind the launches of our two funds, namely the Global Moats Fund (GMF) and the Global Select Value Fund (GSVF). Later this year, we will be launching the Global Moats Fund US, which will cater to US-based investors. This new fund will invest much like the GMF while limiting its exposure to US equities to no more than 25%.

Global Moats Fund – The Core Equity Strategy

GMF invests in two sets of high-quality businesses. One, businesses that are not exposed to disruption or have deeply entrenched franchises, and are priced for a healthy investment return. Two, “disruptors” that have well-established franchises and are priced for a reasonable return.

Importantly, by investing in a selected basket of the highest quality businesses that have durable competitive advantages, clean balance sheets, and healthy corporate governance, we expect that the Fund will generate superior risk-adjusted returns across economic environments.

Keeping with our view of US equities being poorly priced, the Fund has much lower exposure to the US than other competing products. Over the past four years and seven months that the Fund has been in existence, it has had much lower exposure to US equities than the global equity benchmarks. Our exposure to US equities is limited to a handful of businesses wherein our estimated 10-year investment returns continue to remain well over 9%.

As a core equity strategy, we expect GMF to act defensively should a profound market dislocation materializes. The defensiveness of GMF is embedded into the businesses underlying the Fund. The highly desired nature of their products and services combined with a sound balance sheet will allow them to survive through deflationary deleveraging. Those with poorly structured balance sheets go astray. On the other hand, we expect our businesses to generate superior “real” performance during inflationary periods driven by a superior ability to pass on cost increases.

Global Select Value Fund – Global Asset Allocation Strategy

The Fund commenced on October 25, 2020. As an asset allocation strategy, the fund’s portfolio comprises multiple asset classes within an opportunistic approach.

Equity. The Fund’s equity allocation is comprised mainly of our deep value positions. The Fund employs a distinct approach to its equity investing that focuses on:

• Asset owners as against earnings-driven businesses: this ensures that there is significant realizable value even if the company goes bust
• Businesses that operate within the cheapest half of the cost curve: there is a margin of safety for the business as half of the industry’s capacity operates at a higher cost
• Business value driven by the source of value: Infrastructure Assets, Reproducible Assets (steel, paper, refining, etc.), Endowed Assets (REITs, E&P, Mining, etc.), and Regulated Assets
  • Bespoke valuation tools like replacement costs of assets (RCA), net asset value (NAV), liquidation value, etc. as against multiples based valuation heuristics.

Fixed-Income. In an environment of financial repression, the Fund has adopted an alternative approach to fixed-income investing. Instead of investing in fixed-income securities per se, we look to invest in a highly selective basket of businesses that own extremely high-quality assets that generate annuity-like cash flows; companies we refer to as Quasi-Fixed Income businesses. Our approach to this part of our portfolio is defined by our focus on:

• Owners of extremely high-quality assets:
  • Toll-like businesses that own the highest quality of the assets with strong balance sheets
  • Businesses that operate in asset-intensive industries (e.g. Ports,Airports, Telecom Towers, Transmission & Distribution and Pipelines) and have leading cost positions that, in our opinion, will sustain over an extended future
• Priced for reasonable returns with a minimum 10-year estimated “real” return of 6.5 % per annum
• Fixed income like cash flows

Gold, Long Vols, and Commodities. The Fund will maintain a core position in gold and gold equities. Additionally, while opportunistically investing in derivatives and futures that allow us to own volatility as a hedge against significant financial dislocations and serve as a hedge against inflationary outcomes.

With the devaluation of money raising risks around currency debasement, gold should act as an essential “antifragile” asset, a role that it has played rather effectively over centuries. We look to build this part of the book via ownership of the lowest cost gold producers who have a long life of mine assets and via ownership of physical gold with our gold separately held and stored for the Fund. Depending on the market environment and the required speed of action, we may also use futures contracts to achieve the desired outcome.

GMF + GSVF = A Bounded Downside Portfolio

Figure 10 shows the combination of GMF and GSVF. Combining the two should result in a portfolio that generates equity like returns over extended holding periods while limiting the downside. We recommend a combination mix of GMF at one-third and GSVF at two-thirds.

The downside limitation will become especially important as and when the three portfolio construction problems discussed earlier come home to roost. Figure 10: GMF + GSVF

Summary

The task of constructing sensible multi-generational portfolios has been rendered murkier by asset price inflations caused by the extreme expansion of Central Bank balance sheets and unchecked government stimulus packages. Cash itself has seen rising risks related to extreme money supply expansion and a consequent rise in the monetary system’s debasement.

In the wake of such an environment, investors need to be careful in their Asset Allocation decision and portfolio actions making highly selective investment choices that are associated with healthy estimated 10-year returns. GMF and GSVF are designed to identify specific pockets of opportunities and implement asset allocation choices that allow our investors to construct sensible investment portfolios.

Appendix

[1] “Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative-performance derby.” – Margin of Safety, Seth Klarman

[2] The Biased History that Drives Excess Allocations to Equities, Advisor Perspectives, Baijnath Ramraika and Prashant K Trivedi

[3] Source: The Biased History that Drives Excess Allocations to Equities, Advisor Perspectives, Baijnath Ramraika and Prashant K Trivedi

[4] A Good Response to a Bad Situation, Hussman Funds: https://www.hussmanfunds.com/comment/mc201220/

[5] GMO 7-Year Asset Class Forecast, December 18, 2020: https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-november-2020/

[6] Data source: Board of Governors of the Federal Reserve System (US) and World Bank via FRED

[7] Source: Global debt to hit record $277 trillion by year end on pandemic spending splurge: IIF | Reuters

[8] Source: Chart: Debt-to-GDP Continues to Rise Around the World (visualcapitalist.com)

[9] Data source: Board of Governors of the Federal Reserve System (US) and U.S. Bureau of Economic Analysis via FRED