Tuesday, 28 July 2020

Market inefficiency, liquidity flywheels, asset class arbitrage, and Hong Kong Land

Conventional economic theory holds that the marketplace in financial assets ought to be 'efficient'. Large numbers of intelligent and diligent investors have access to largely the same pool of information, and are highly motivated to root out and exploit any underpricings that exist. It is believed this competitive process will inevitably drive assets to their fair value - i.e. those that accurately reflect their risk and reward characteristics, and also price assets correctly relative to one another.

If only the world were so simple. While this theory is seductive in its simplicity, it is also wrong in its simplicity. While much has been written about the role fear, greed, and various cognitive biases play in mispricings (also important), often overlooked or underestimated is the role structural institutional market factors play, which encapsulate traditional economic ideas of agency conflicts and information asymmetry. What is little understood - and I hope to argue in this article - is that market inefficiency is structural and behavioural, rather than informational, which is why I believe it will always exist, and provide ample opportunity for the well-heeled.

The efficient market hypothesis (EMH) misses one very important point - the majority of security/asset-level investment decisions are not made by the ultimate owners of capital, but instead via their appointed intermediaries - whether they be traditional active asset managers, or passive vehicles (which mechanically buy stocks in proportion to their index representation). The EMH implicitly assumes end investors are making direct purchases of individual securities; are fully informed about the idiosyncratic risk and reward characteristics of those individual securities; and are investing with time horizons that accord with the underlying duration of the cash flows of the assets they purchase.

However, in reality, most ultimate owners of capital are not making direct purchases of securities; are less than perfectly informed about the risk and reward characteristics of the underlying assets in the portfolio (only the realised returns and volatility outcomes from month-to-month); and are often investing with time horizons considerably shorter than the duration of the underlying assets - particularly for stocks (where durations average 50 years, compared to the typical time horizon of most investors, which is perhaps 3-5 years at most).

Ultimate owners of capital, or their direct appointed representatives (advisors or asset allocators), are at least one-step removed from grass roots individual security selection. Instead, they are more concerned with higher-level asset allocation decisions, which are influenced by perceptions of risk, reward, growth potential, and volatility associated with aggregated asset classes, which may be radically disconnected from the actual risk/reward characteristics of the individual securities comprising these larger clusters. They also often react procyclically to realised return and volatility outcomes, exiting assets classes that have exhibited poor returns and/or high volatility, and increasing allocations to assets that have performed well - particularly with limited downside volatility.

This has significant consequences for the way assets are priced, and at a system level, can result in truly massive levels of market inefficiency,* and this inefficiency can also be highly persistent, because the arbitrage forces that are supposed to correct mispricings are not only relatively ineffective in the short term, but frequently overwhelmed by structural flows-based feedback loops that have a tendency to amplify rather than moderate these inefficiencies.

More pointedly, markets have a structural tendency towards the emergence of what I describe as 'liquidity flywheels', which in my view is the largest and most under-appreciated contributor to market inefficiency ('liquidity' here is defined as 'liquid capital' that is available to be invested into various financial or real assets). Liquidity flywheels are discussed in the section immediately below. Later, I discuss how the distortionary impact of institutional asset allocation practices can lead to the same underlying assets being valued at very different levels with very different costs of capital, and use Hong Kong Land as an example.


Liquidity flywheels

What is a liquidity flywheel? A liquidity flywheel is a situation where inflows into an asset class lead to buying pressure that pushes up prices, leading to favourable apparent return and volatility characteristics in the said asset class. This favourable outcome then attracts yet more inflows, leading to yet more buying, etc. Conversely, poorly performing asset classes with significant downside volatility can lead to investor redemptions, leading to forced selling that contributes to yet further price declines, yielding even worse returns and even greater redemptions, and so on. This process can go on for years, and sometimes even for decades, and is a fundamental contributor - perhaps the most important contributor - to both major asset-class bubbles, as well as asset price busts and secular lows that lead to fire sales prices (which are 'anti-bubbles' driven by the same drivers of bubbles in reverse). The disconnect between the ultimate owner of funds and the at-the-coal-face investors actually engaged in individual security analysis is fundamental to this process, because end investors have little to go on other than realised investment returns and volatility, and it introduces both information asymmetries and agency conflicts that can drive radical market inefficiency.

An 'asset class' here can relate to a broad category such as 'venture capital' or 'equities', or (more commonly for equities), various classes of equities divided by geography, market cap range, style, sector, or factor. Industries or countries enjoying and/or expected to enjoy rapid growth, which are perceived as offering significant opportunities, are the frequent locus of inward liquidity flywheels, as people crowd into a theme to get 'exposure' to growth opportunities, and the price increases such flows engender have a tendency to be seen as validating the narrative, which acts to trigger yet more inflows.

A perfect example of a liquidity flywheel is what happened with WeWork, which saw its valuation get bid up to an astonishing height of US$47bn, even though the company was ultimately worthless, with little to show for years of operating losses other than the accumulation of billions of dollars of long term lease liabilities. It occurred because a seductive growth and new-economy disruption narrative, spearheaded by Masayoshi Son, resulted in the Vision Fund and other Venture Capital funds attracting large inflows, and the rush to put those funds to work drove the valuations of companies like WeWork sharply higher. That resulted in higher mark-to-market returns in the said VC funds, which lead to greater investor demand to pour money into VC funds to cash in on the boom. This lead to yet more money pushing valuations even higher.

The process also works in reverse for asset classes that get cheaper and cheaper over time. In theoretical EMH academic models, investors have access to unlimited capital, and if they spot a mispricing, they will buy undervalued assets, borrowing capital when needed frictionlessly at the 'risk free rate' to facilitate this process. However, in the real world, investors' buying and selling behaviour is constrained by the amount of capital they have at their disposal - both with respect to having too little cash, and too much - and their capacity to borrow is also constrained. Indeed, investors that borrow in size to buy cheap stocks are apt to be margined out and forced to liquidate their holdings - particularly because margin requirements are often increased by brokers as prices fall.

A fund manager might have a huge number of very cheap stocks they would love to buy, but if they do not have any available cash, they do not get to 'vote' on the market price by buying in the open market, as they lack the liquidity to do so - in the short term at least (longer term, you can reinvest dividends). Furthermore, if the said manager is suffering investor redemptions due to recent returns being poor, then regardless of the underlying managers' views on the long term attractiveness of individual securities, they will be forced to sell. It is therefore not uncommon for those most informed about the opportunities in undervalued securities to be actually selling them rather than buying, in direct contradiction to the EMH.

The opposite is also true for fund managers receiving large inflows - they must buy regardless of their personal views on the valuation appeal of stocks within their purview. It is perfectly possible they believe the stocks to be overvalued and yet still buy them in size, because they have to. Many fund managers are explicitly constrained in how much cash they can hold by their fund charter, but even for those managers that are not so explicitly constrained, if the said manager elects to hold a large amount of cash hoping for a better opportunity to buy, and markets continue to rise, they risk potentially catastrophic levels of underperformance, and so is a luxury they can ill-afford.

If the said manager runs a technology fund, their clients allocated them money because from an asset allocation standpoint, they decided they wanted exposure to the technology sector. If six months later the tech sector is up 50% and this individual fund is only up 10% because they are holding cash waiting for a better opportunity, the end clients are not going to be very happy, and in all likelihood will ask for their money back, so they can give it to a better-performing tech fund manager who is up 60%. As a result, institutions will also tend to buy regardless of price, and at the very least hold large index weight stocks in proportion to their index representation, to avoid the risk of underperforming.

What is notable about this process is how little all this buying and selling, and all the pronounced volatility in asset prices in drives (including major secular bull and bear markets), has anything at all to do with rational 'price discovery' in the traditional EMH sense. It explains why markets can be populated by highly intelligent, informed, and hardworking people, and also be grossly inefficient and absurdly volatile. Liquidity flywheels can go on for many many years, and are a frequent cause of long periods of underperformance for value managers, because it is the effect of liquidity flywheels that cause stocks to become undervalued in the first place, and there is no reason to expect a liquidity flywheel to suddenly reverse just because certain stocks have already become cheap. 

Much has been said about the dreadful performance of value over the past decade, and in particular the last few years, and while there are many causes for this (a topic for another blog post), what is most missing from the dialogue is a recognition of the fact that this is not unusual, and long stretches of value underperformance have happened many times before, and for largely the same reasons. It happened in the 1990s tech bubble, and it also happened in the 1960-early 1970s 'Nifty 50' bubble as well. Including the most recent tech/growth bubble, that is about once every 20 years. The major cause in all these cases was a liquidity flywheel that lead to certain parts of the market becoming extremely overpriced, due to a decade of procyclical inflows that drove multiples to the stratosphere.

The fundamental issue is that the ultimate owners of capital, or their immediate representatives (advisors and asset allocators), often make their asset allocation decisions on the basis of backward-looking return and volatility realisations, as without direct knowledge of the underlying securities, that is all they have to go on. And the important thing is that this process is inherently self-sustaining, not self-correcting, such that inefficiencies tend to get larger over time, not smaller (until an inflection point is reached, following which very dramatic reversals can happen), and the ability of investors to arbitrage these inefficiencies is largely absent.

Liquidity flywheels are one of the most important forces in markets, and one of the most under-appreciated. They are also the fundamental reason why momentum strategies work (until they don't) - something that the EMH also declared to be impossible, and yet which quantitative analysis of past market action clearly refutes. So long as there are liquidity flywheels in markets, momentum will be a strategy that works, provided one has a reliable means by which to determine when momentum has turned, because when momentum reversals happen, they happen big and fast.


Different prices and costs of capital for the same asset

Another important consequence of these institutional forces is that radically different costs of capital (and hence asset valuations) can emerge for the very same assets, depending on how they are packaged, and the differences are often not trivial. If the EMH held, the same assets should be priced in the same way, regardless of how they are packaged (they are, after all, the same assets), but in the real world, we often see very considerable difference emerge, and those differences can often go years, or even decades, without being arbitraged away.

Consider for instance a stock like Hong Kong Land (HKL SP). HKL has a market capitalisation of about US$9bn, and yet holds about US$37bn of real estate at its most recently appraised market value (end of calendar 2019). A meaningful proportion of HKL's real estate is super prime office buildings in Singapore and HK, such as the Marina Bay Financial Center in Singapore, and Exchange Square in Hong Kong. These are amongst the most desirable prime locations in HK and Singapore, and as a result almost always enjoy close to 100% occupancy and favourable ongoing rent revisions. The company has only very modest levels of debt (US$3bn), so high leverage is not the cause of the disconnect, and this modest level of debt is offset by the value of various development projects they hold, which are of a slightly larger magnitude to the company's debt burden. Assuming the latter two net, the stock is therefore trading at about 25c in the dollar of its unleveraged real estate holdings.

Now to be sure, it is possible that recent events - not just covid-19, but recent political developments in HK - have increased the risk of long term value erosion, should HK for e.g. lose its station as a desirable offshore financial center. However, this very large gap between HKL's stock market valuation, and the private market valuation of its assets, has persisted for a long time, and well before these recent developments. The stock is down some 50% from its 2017 highs, but even at its recent peaks, the stock was still trading at 50c in the dollar of the open market value of its prime real estate assets.

So why are the same assets attracting 2-3x fold differences in prices? It has a lot to do simply with the way the assets are packaged from an asset class standpoint, and the different costs of capital that apply to different investor constituencies and asset classes. HKL's super-prime real estate assets are valued on the books (and in the real world) at cap rates as low as 3% (and often closer to 2% net of costs and tax). In a world with zero interest rates, this is not an unrealistically low yield for super-prime assets with favourable trends in rent revisions, A-grade tenants, long lease terms, and an income stream that is inflation protected. Even a modest pace of 2% annual rental growth (below historical averages) would generate all-in after-tax returns of some 4%, which with inflation protection, is very attractive relative to bonds and other high-grade debt.

However, the issue is that active equity managers - who are the natural buyers of HKL stock - are not benchmarked against cash and high-grade bond returns, or even high-grade real estate. HKL, as a listed company, is part of the "listed equities" bucket (and more specifically, the "Asia ex-Japan listed equities" bucket), and the performance of the institutions that purchase HKL are therefore benchmarked against equity market indices, rather than cash or bonds. The average stock in Singapore and HK is currently priced (in my estimation) with an expected return of perhaps 10%, which is another way of saying the cost of (listed) equity in these regions is currently about 10%. If equity managers were to buy HKL and realise only a 4% return (which they likely would if the stock was priced at 1x book), but the index was to generate 10% pa, it would be of little benefit to the fund manager to argue to their clients that the returns are low risk and quite attractive relative to fixed income. The clients would say, we allocated you money to get "equities exposure", and you're only up 4% and the market is up 10%, and that is not satisfactory performance. Because HKL is part of the "listed equities" bucket, it is expected to deliver "listed equities" returns of 10%.

Consequently, listed on public markets, the assets that underlie HKL are priced with a cost of capital reflective of Singaporean and HK equities in general, which is a cost of capital that bears no relation to the cost of capital private buyers of prime A-grade real estate are subject to. Because HKL's underlying assets generate only perhaps 4%, this requires the stock trade at about one third of book value (ignoring recent declines which are covid/HK related). Another way to think about this would be to imagine a company that owned only 30-yr treasuries yielding (say) 3%. If the stock traded at 0.3x book, it would offer a return of 10% instead of 3%. The underlying assets and cash flow stream are the same, but the costs of capital are different (here, 3% for long bonds, 10% for equities).

The cost of capital for listed equities is higher because equities are volatile, and in general, the cash flows of businesses (averaged across all types) are much less dependable than those of real estate. The problem is that from a fundamental/operational perspective, stocks are not "more risky" by definition, because it very much depends on what type of assets the company holds. Individual companies can range from the most speculative, risky biotech startups or resource exploration company, to holders of some of the lowest risk, most dependable cash-generating assets in the world (A-grade real estate, franchised incumbent businesses with huge moats and steady cash flow streams). In this respect, the very idea that "stocks" in general are an "asset class" is deeply flawed - they are an aggregation of individual businesses with hugely variant risk profiles. However, in the world of industrial scale asset allocation, stock-level differences are typically lost in translation when large scale asset allocation decisions are made between 'listed equities', 'fixed income', 'alternatives', 'developed market equity vs. emerging market equity', etc, and then results are assessed against an overall equity benchmark.

The ultimate effect of this is that the cost of capital that is applied to assets can come to reflect less the idiosyncratic nature of the underlying assets, and more simply the asset class packaging. Put long bonds or high-grade real estate into a company and then list that company on the stock market, and suddenly the same underlying bonds or real estate are transformed into a "listed equity", and because a higher "listed equity" cost of capital is then applied to those assets, the entity will trade at a steep discount. Change the packaging, and suddenly you see the same assets trade at radically different prices.

Repackaging listed real estate into a REIT vehicle (Real Estate Investment Trust) can sometimes bridge this gap. There are funds that can invest in REITs and benchmark their returns to the overall performance of REITs, and/or other yield-based strategies/assets ('yield alternatives'). This can lower the cost of capital by changing the benchmark for comparison from stocks in general, to fixed income or a specific class of yield stocks. It is for this reason that companies like HKL will sometimes spin off real estate holdings into REITs to 'unlock value'. In an efficient market, there ought to be no such opportunity to 'unlock value', but in the real world where institutional realities can create large differences in the cost of capital for the same assets, the opportunity is very real.

But let's go further. Let's suppose HKL's yield assets were instead packaged into an unlisted/illiquid "alternatives" asset class manufactured by a private equity sponsor, which marketed the vehicle as a low-risk yield product that aimed to generate a superior yield to those available on bonds/fixed income. The assets could also be leveraged up to juice returns and increase the manufactured yield from 2-4% unlevered to perhaps 4-6% levered. The 4-6% yield could then be marketed to institutional investors and asset allocators looking for replacements for their miserly bond yields. When the basis for comparison becomes long bonds at 1%, rather than equity benchmarks, suddenly 4% looks good. The result? A 4% cost of capital is used instead of 10%, and the same assets are valued at radically different prices, depending on the packaging.

The reason this alchemy can work is that there is an institutionalised aversion to volatility. Volatility is not just uncomfortable, but it is a career/reputation risk to whoever decided to make such an asset allocation decision - i.e. a financial advisor, or asset allocator with fiduciary responsibilities. If somebody puts capital into HKL stock and the stock falls 20%, that looks bad. It looks like a 20% loss, even if the underlying assets are still generating the same cash flows as before, and the dividend yield of the stock has merely risen. This is where the duration mismatch issue rears its head - if one buys and holds HKL for 50 years, temporary share price volatility won't make a shred of long term difference - in fact share price declines will be positive, as dividends can be reinvested at a higher yield. However, in reality, the duration of the career interests of advisors and asset allocators is much shorter than that - they are concerned with how returns fare over the the next few quarters and years, how that looks to clients, and how that is likely to influence their compensation.

Consequently, the minimization of volatility/drawdown risk is highly prized, and by keeping the assets 'private', these "alternative" vehicles can provide investors with the comfortable and expedient illusion of a lack of volatility. HKL's stock price, for instance, has fallen some 50% in the past 3 years, as the market has repriced its assets from an expected return of perhaps 6% to 10%. The company's dividend has remained stable, with the stock's yield increasing from 3% to 6%. By keeping the assets private, however, you can report the underlying cash flow returns of 2-4% (leveraged up to 4-6%), and claim that the value of your assets has not changed. After all, the private market value of the assets has not fallen (it has not for HKL either). The end results is an attractive yield for clients of 4-5%, without having to bear the risk of explicit volatility/drawdowns.

The desire to avoid looking bad by suffering such a drawdown is what is driving a huge wave of money into private equity and other "alternative" vehicles, which are often just a repackaging of assets you can buy on stock markets, with higher leverage and much higher valuations, but with the ability to spare clients of the appearance of volatility/drawdowns. The cost of capital with this newfangled packaging is structurally lower because returns are not benchmarked against listed equities, but instead cash and bond yields, and other low risk yield alternatives. Because interest rates and bond yields are so low, 4% returns appear quite attractive (vs. say 1%). Investors are happy. They allocate more capital, because 4% beats their 1% cost of capital. Again, it is important to emphasise that these are exactly the same assets, just with different packaging, and the packaging can change the cost of capital dramatically. This is a very clear refutation of the EMH.

There are some arbitrage forces in markets that can help correct these differences, but they are highly imperfect. If HKL were smart, for instance, they would take advantage of the large arbitrage opportunity that exists between the private and public market costs of capital by selling some of their real estate assets and using the proceeds to buy back stock. Activist investors and corporate take-outs can play a role, but in HKL's case, it already has a controlling shareholder (Jardine Matheson), which forecloses the opportunity for activism.


Conclusion

It is important to understand that market inefficiency is structural and behavioural, not informational. Many investors attempt to invest on the basis that market inefficiency is informational in nature, and dedicate tremendous amount of time and resource to trying to come up with better information than the next guy. However, in today's markets, the primary source of inefficiency is structural/agency driven, and the way to exploit that is not to acquire better information, but to have a structure that allows one to engage in long term value arbitrage that other investors cannot (often taking the form of buying underlying assets that are actually low risk, but are priced as if they were very high risk because they are part of an asset class that is generally perceived to be high risk). This requires a wide and unconstrained mandate (by geography, asset class, etc), long term capital, a rigorously long term approach, and an extreme tolerance for volatility and benchmark variation, which requires patience and emotional fortitude that is sorely lacking in today's instant gratification world.

Outperforming in the long term is actually not very difficult, but it requires highly lumpy results, often marked by long periods of lackluster returns, punctuated by short periods of spectacular results, which happen alongside liquidity flywheel/momentum reversals, which are inflection points that do not happen very often. Furthermore, usually, the worse value is performing, the closer one is to the end of a liquidity flywheel bubble cycle (value had a woeful time in 1999, for instance), because value is the 'anti-bubble' expression - a Newtonian equal and opposite reaction - of liquidity flywheels driving bubbles elsewhere in markets. It is redemption flywheels that drive value opportunities, and redemption flywheels are often the result of investors pulling money out of unpopular areas of the market in a rush to get exposure to hot areas of markets.

Taking advantage of long term opportunities is extremely difficult for investors with the wrong structure and wrong investors, however, as massive redemptions will likely happen right when opportunities are most ripe, and not all funds will be able to survive the inevitable lean periods. Value funds shut down en mass in 1999, for instance, and the same thing has been happening of late. Lean cost structures and - ideally - large principal FUM participation from the fund managers is a must.

Outperforming in the short term with consistency, by contrast, is extremely hard. The best way to do it is usually a momentum strategy, which works most of the time, but occasionally yields disastrous results on sudden momentum reversals. Momentum is the polar opposite of value - it generates good returns most of the time, and disastrous returns a minority of the time.

The latter strategy is a more remunerative strategy for fund managers, however, even if it often leaves long term investors worse off, which is why it is more popular/common. While the good times roll, large performance fees are banked, and it is investors that are left with the losses when it all turns to custard. This is why value investing remains relatively uncommon, despite its long track record of success, and in my view a combination of agency conflicts, information asymmetry, volatility-phobia, and the desire for quick results, will all but ensure market inefficiencies continue, and considerable opportunities for long term value investors will remain for many generations to come.



LT3000


Disclosure: I do not own shares in HKL


*In my perception, a lot of investors confuse rising prices with increased market efficiency. Prices becoming more expensive, in general, has nothing to do with efficiency, even though it does have the practical effect of making value opportunities harder to come by. People also confuse the fact that value doesn't work in the short term - often for many years - with market efficiency. It is not the efficiency that makes it hard to outperform in the short term, but the inefficiency - prices are driven by flows, not fundamentals, often for many years, and so even very diligent and accurate valuation work can often not be rewarded by markets for years, leading to an erroneous perception of market efficiency.


Postscript: Just as this note was going to press, I noticed that HSKE-listed Dongfeng Motor (489 HK) - a company I blogged about in 2018 here - was trading up as much as 30% as the company announced it was planning an A-share listing on the frothy ChiNext exchange. A broker report noted (in an understated comment to say the least): "ChiNext-listed stocks are trading at high valuations (57x trailing 12-month PE average as of 27 July...), which should boost the valuation of Dongfeng's H-shares (trading at 2.8x FY20E PE)."

I cannot think of a better demonstration of many of the points raised in this article - different costs of capital for the same assets in different markets, and the effect of long term liquidity flywheel cycles. Positive liquidity flywheels have driven A-share valuations to extremes of 50-100x P/Es, and negative liquidity flywheel cycles have driven certain H-shares to as low as 2-3x. Dongfeng and H-shares generally (excepting the tech sector) are now 13 years into a liquidity flywheel downcycle, which started in 2007. Since my blog post, Dongfeng has continued to post strong operational results, earnings growth, and increased dividends. The stock has fallen from HK$9 to HK$5.


31 comments:

  1. Love this deep analysis, with two independent points supporting the thesis of structural EMH violations.

    (1) Liquidity flywheels make the market inefficient from a long-term value perspective, because shorter-term momentum dynamics exist for structural reasons decoupled from underlying asset values

    (2) The cost of capital in various assets is determined by a coarse-grained bucketing into leaky abstractions like “listed equities”, and there aren’t many participants capable of arbitraging when the specifics of an asset defy their category bucket, due to structural forces of short time horizons and fund management principal-agent problems

    I’m not familiar with the investment world. Are these insights known within some subcommunity?

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    1. Thanks Liron. Spot on. You said in two paragraphs what it took me a whole post to explain - well done.

      These views derive from my own thinking and observation, but I'm sure there are many other investors out there that have independently reached similar conclusions as well.

      Cheers,
      LT

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    2. Definitely agree with your view Lyall!

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  2. Another excellent gem of an article. Love your work and the details and efforts that go into each article.

    ReplyDelete
  3. These insights are known to practitioners. EMH is well known to professors and their students.
    In the real world, it is primarily liquidity that drives asset prices not fundamentals. If there is enough money attracted to an security or a particular asset class (gold/silver/bitcoin recently is a perfect example) for whatever reason, the price will go up due to supply and demand.
    This is also why many astute investors/traders use prices (and price only) to inform their investment decisions. Ultimately, it is the entry/exit price that determines one's P&L, not whether it is right or wrong (although this may be more appealing/rewarding to some)

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    Replies
    1. Without doubt, the view that the market is not efficient, and liquidity has a large impact on pricing, are well subscribed ideas within the investment community. However, my observation is that the focus with respect to market efficiency is often on heuristical biases, emotion and short termism/tracking error, while with respect to liquidity, the focus is mostly on the impact of the Fed & interest rates on asset prices in general.

      The more nuanced application of liquidity flywheel theory to the explanation of long cycles of value underperformance/outperformance; sector, style and asset class preferences, and its contribution to sector-focused booms busts, and anti-bubbles in value, etc, is less common, although as I noted above in an earlier comment, no doubt many investors do think along similar lines.

      Many attribute the strong share price gains we have seen in technology & growth/quality primarily to growth and the desirable nature of 'never sell' high quality businesses, and new economy disruption/growth, for instance, rather than being predominantly driven (at this stage) by liquidity flywheels and multiple expansion. While genuine growth is playing a role, it is overestimated. Similar rationales were used in the late 1990s, and in the Nifty 50 bubble. The leading quality growth stocks of these eras subsequently spent 10-15 years going down/sidewards after the liquidity flywheel reversed and multiple compression prevailed.

      Cheers,
      LT3000

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  4. Good post. I was quite confused before every time you mentioned liquidity, since I was thinking about the ability to buy and sell without moving the price too much (along the lines of market volume or bid-ask spread). This gives a better explanation.

    Very interesting time to invest right now. As you've said, "value is the 'anti-bubble' expression". I'm noticing that my US portfolio that is overweight banks and insurance firms now seems to be negatively correlated with the S&P 500 instead of being positively correlated with lower volatility. Hoping this negative correlation continues to apply when the tech bubble inevitably bursts. My biggest fear is that value ends up getting hammered alongside the bursting of the tech bubble, a la March 2020.

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  5. put aside everything and read your article. Great one (as always). Thx!

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  6. One observation is that HKL trades almost identically to Jardine stock, because of their controlling interest. Whether HKL management spins out the assets in the form of a REIT/alternative vehicle is up to Jardine (as you alluded to re: shareholder activism). Hence, for lack of a better word, there is a “control discount” affecting the valuation, in a similar vein to how many LICs trade below NTA. In this case, the control discount may be on the extreme side compared to the underlying value of the assets.

    On HKL itself, the company may face significant headwinds from falling rental yields, especially in light of the Hong Kong/China situation (who knows if Hong Kong will continue to be a financial hub in 50 years). However, falling global bond yields may eventually force asset allocators to place the company in a different bucket, and therefore cause a rerating.

    Great read as always!

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  7. You mentioned you don't own HKL. But if HKL has real-estate-level risk with 4x higher returns than real estate, what's stopping you from arbitraging that 4x factor by buying the stock?

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    Replies
    1. Fair question. I considered it, but the simple answer is that I'm spoiled for choice at the moment and I can find many things that are even cheaper. The relevant arbitrage for me is not between their book value returns of 3-4% and their market value returns of 10%, because my alternative cost of capital is not 3-4%, but things where I think I can make 20%+. That said I do have a small indirect exposure through Jardine Strategic, which I bought recently, which is even cheaper. It's a small holding only though because the dividend payout is low (1.5-2.0% yield), and the reinvestment return on retained earnings will likely be low (5-10%).

      Cheers,
      LT

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    2. This was the key question for me - it sounds like a buy from what you have said? Are there any other alternatives you’d flag to Jardine?

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    3. In general as opportunities, rather than alternative ways to gain exposure to hk land?

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  8. Lyall excellent post with deep insights, as usual.

    I do like your flywheel analogy, but I'm not sure I'd agree that it is under appreciated. Without wanting to sound overly critical (I think you know I very much value your posts), the way I see it, this is just market momentum by another name. Wouldn't you say it is pretty much what has been well understood for many years, as the driver of long cycles in markets. I suggest Templeton's well documented words "Bull markets are born in pessimism, grow on scepticism, mature on optimism and die on euphoria", are essentially an articulation of this very thing.

    Thinking in terms of control-systems, we could say that momentum occurs because as more market participants focus on price (as they are increasingly doing now), then the feedback error in the control system becomes positive, and therefore a magnitude amplifier. That is, if the measure of success is a price rise, then buying will trigger more buying. On the other hand, if the measure of success is the earnings yield, or the PV of future cash-flows etc, then the feedback error becomes negative. That is, a price rise will eventually trigger selling rather than buying, and so the system will be self correcting, and thus tend to "efficiency".

    I know none of this is new to you, but I'm just illustrating that there are many ways to think about market momentum.

    I suggest another way we can think about momentum is simply in terms of market sentiment. I think markets are not so much efficient at digesting all known information, as they are efficient at reflecting sentiment. In the past, I suspect momentum had shorter cycles and markets spent more time at "informational efficiency" because there was more opinion diversity. Momentum is the antithesis of opinion diversity - as it is essentially a manifestation of rising popularity (ie loss of diversity). Of course, fundamental factors feed into sentiment - but as the focus shifts more to price, and away from the underlying asset, then positive sentiment becomes self reinforcing.

    So then the question, if you accept any of that, is why are we seeing a loss of opinion diversity? This is probably quite a complex question, and I suspect it has much to do with social media. I once thought the internet would lead to greater market efficiency as information became more widely disseminated. Ironically, as information has become a commodity (thanks to its dissemination), sentiment has also become more widely disseminated.

    In short, sentiment has trumped information.

    The other irony of all this, is that whilst once fundamental smarts (IQ) provided outsized returns, I now suspect that “character smarts” (EI) will provide outsized returns. The catch is that you may have to wait a very, very long time to reap the rewards, and you may have lost all your clients before you get there.

    Ah money management, damned if you do, damned if you don’t…

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    1. Thanks Mars,

      I love Templeton's quote "bull markets are born in pessimism, grow on scepticism, mature on optimism and die on euphoria", but I don't believe it is the same thing that I'm arguing here.

      While he is right about this, it's also symptomatic of most investors ascribing market movements & inefficiency wholly to fluctations in investor emotions (fear & greed), which as I noted early in the piece, are important contributors to market dynamics, but ones that are over-emphasised relative to the structural market forces I discuss in this article.

      What I am arguing here is that bull market & even bubble excesses can be just as much a function of structural market forces and liquidity flywheels as they are explicit euphoria and greed. Witness the bull market we have seen over the past decade in the US, and this year since March. The majority of market participants have actually been bearish/cautious through most of this period. And yet markets have risen strongly, to a large extent due to incessant inflows from passive. This is not a bull market borne of the type of optimism and euphoria Templeton speaks of (outside certain individual names like Tesla etc). It's more borne of the sheer force of liquidity, which has overwhelmed general bearishness.

      So I do believe these distinctions are very important and much under-appreciated.

      Cheers,
      LT3000

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    2. Maybe. Don't completely disagree. Really just exploring the issue. But ask yourself this, if the market was divided in two, with Market A being that which is currently popular ('tech' + safe + steady + moatish) and Market B being everything else, then we would have two very distinct circumstances and drivers - as you have pretty much articulated.

      Would we then be talking about Market A being euphoric? I suspect so. I'm suggesting (though I my be wrong) that your flywheel cannot exist without corresponding sentiment. That's my sense, but I stress, I'm just exploring the issue - and am not 100% convinced myself.

      I still think Templeton's observation holds - as I suspect short a sufficient extraneous shock (which clearly we have not had yet, in fact quite the opposite in terms of the pre-existing dynamics) that the broad market will not correct until the excesses move beyond just specific segments. I sense.

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  9. Fascinating post. It begs the question of what prevents value to continue to underperform growth for another 10 years? What is needed for the flywheel to reverse? It seems 2-3yrs ago the argument was 'well value has u/p for such a long time....we should see mean reversion now'.....now it seems the argument could be formed that says 'well value has officially reached its greatest dislocation of all time'.... I am just not sure what that means for the reversal

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    1. Exactly my thoughts on this growth vs value debate. My guess is when the Fed engineered liquidity goes (Fed reverse QEs, v unlikely judging by bond yields) or some sort of unknown unknown take out the moment (like covid19). so, piling!

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    2. Hi Anonymous,

      I might explore this topic in more detail in another blog posts. However, the basic issue is that while liquidity flywheels can go on for a very long time, it's an unstable equilibrium long term, because if it goes on long enough, cheap/value stocks will eventually get so cheap their dividend + buyback returns can rise as high as 20%+. At some point, this will result in returns rising to above-market levels even with continuing multiple compression.

      When the returns start to beat the market, outflows slow & turn to inflows, then you can add multiple expansion to the 20%+ cash flow returns, and you start to see killers numbers, followed by more inflows, etc. So in the long run, it is not possible for cheap stocks to continue to get cheaper indefinitely. It can, however, go on for a very long time.

      When will it turn? Hard to say. However, you know you are getting closer to the end when the multiple divergences start to increase exponentially. In the growth/bubble areas of markets, prices have been rising faster and faster of late which is characteristic of the late stages of bubbles, and value multiples have been falling faster and faster as well. I think we are not too far away from the reversal point, but that is always difficult to predict.

      Cheers,
      Lyall

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  10. LT Would you please write about areas of the markets you find interesting, no need to suggest individual names, just beaten down areas.

    All the best.

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  11. Awesome post, always a treat to read. You’re probably the only person I’ve read so far that has made a convincing case for active outperformance of the market. Usually it’s endless nebulous suggestions that you can magically avoid downside and take upside, without any convincing reasons why. In particular, as a fairly new investor I find the idea that most just aren’t patient enough, and too willing to abandon the strategy at the worst moments a pretty real reflection of my experience. Once the covid crash was over, the waiting starts...

    I find cases like Dongfeng motor pretty curious.. is it simply a combination of the company failing to pay out profits in dividends or buybacks, alongside a persistently dropping shareprice driving more impatient investors out of the stock? (Of course, you’d probably need a crystal ball to figure out why, I suppose)

    I’m not entirely sure I buy the passive inflow explanation you mention further up - I suppose you include the vast majority of active management in that (hugging the index to avoid underperforming)? Once a passive investor buys a stock they hold onto it, thus largely removing it from the price discovery process.

    What’s your process for finding undervalued stocks? I sometimes just sort a list by PE and trawl through a bunch of financial reports hoping to find something interesting, but it seems a bit slow and inefficient, especially because a lot of those kinds of companies really are just kind of bad. Maybe I’m just being lazy xD.

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  12. Very valuable insights. Thank you. A quick question. If you're arguing that the market's valuation for reliable, fixed income assets is - in some ways - irrelevant, what's the downside of REITs. If they're reliably paying 5% it doesn't matter if they're more "accurately" valued by the market, right? Essentially it's an argument for fixed income instead of the thrills of market trades?

    Thanks

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  13. Fantastic as always. Which markets do you find has pushed down valuations in "value" stocks the most? In my opinion HK and Singapore exchange are pretty extreme. Also Italy..

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  14. Brilliant post, thanks for sharing!

    I have come to the same observations and conclusions on a theoretical and practical level. On a theoretical level, in addition to the points that you have mentioned, it might also be interesting to look into how momentum/liquidity flywheel moves the ultimate underlying in some cases. This is fascinating to see. In most cases though, it is rather a matter of multiple expansion as you have described due to shorter term capital allocation decisions and market structure.

    On a practical level, I came to the conclusion about a decade ago, that I can use this understanding for an attempt at "outperforming" by avoiding the structural deficits of the market. Value/Growth investment styles both pretty much look backwards instead of looking into the future. My point: undervaluation might not be as easy to spot as in the past as technological disruption was slower. I understand that my words are a bit of a "this time is different" type of argument, but on one hand, technology has created the basis for the liquidity flywheel that you mention and has accelerated the flywheel. Technology also leads to rapid moat destruction and meaningless balance sheets and past P&L accounts. The investors assignment should therefore be the assessment of the future development of cashflows of the underlying. That's arguably a more difficult assignment and in practice often associated (right so) with sloppy practices of short term forecasting at best and marketing parlait at worst. But this is my understanding of Buffetts famous Value and Growth are joined by the hip saying. In my view, trying to assess the outcomes and possibilities of an asset is crucial. In terms of real estate that is often a relatively simple task (compared to say a car manufacturer). In terms of HKLand portfolio, it would be difficult to establish an own, independent valuation of the assets for me (not living in HK), but maybe possible. I saw such a chance in another real estate company, the underlying on their balance sheet was way below the EV looking at the assets individually. Invested in the stock and was able to ride this upwards until the gap now is almost closed (maybe only a 20-30% gap left).

    In the "value investor and contrarian" camp, I still see too much disbelief about the disruption brought by technology. I am a contrarian at heart, but will be very cautious not to jump into sectors that might be in the process of being disrupted (i.e. I wouldn't invest in traditional car manufacturers). My approach is to find "value plays" that are less risky to be disrupted by technology. Residential real estate is one such asset class. Airports could potentially be another asset class. Agricultural land. Maybe telecommunication lines - but in that case I am not yet sure about the threats coming from the various attempts of big Internet companies to disrupt that field. Energy distribution lines is another field that is almost impossible to disrupt in the next years while energy generation could potentially be disrupted to some degree.

    While you rightly point out that the momentum is only partially due to emotions and other part due to structural points, it is still an emotional thing to find "cheap" assets with the prospect that for example British American Tobacco or China Mobile might look cheap now, but might get much cheaper in the future and hence it is very difficult or not advised at all to use leverage even at these potentially low levels to enhance the cashflows of underlyings that are already much higher than borrowed funds yields. I guess that is what you mean when it comes to the missing "liquidity" or potential for leverage for investors to invest in "cheap assets". Leverage cannot used as the momentum might push own longer than you stay liquid. Lots of food for thought. Thanks for the article and if you read it, Philip: Thanks for pointing me to this article.

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  15. I am really enjoying reading your well written articles. It looks like you spend a lot of effort and time on your blog. I have bookmarked it and I am looking forward to reading new articles. Keep up the good work.
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