tag:blogger.com,1999:blog-53783552274619892132024-03-18T13:03:34.986+07:00The LT3000 BlogEclectic musings on value investing, business, economics, and lifeLyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comBlogger116125tag:blogger.com,1999:blog-5378355227461989213.post-48614141814812711692022-02-24T11:18:00.011+07:002022-03-02T19:54:50.261+07:00Russia update - the road to war<p>I thought it would be worth penning a few further thoughts on the current Russo-Ukrainian situation, as my thoughts have evolved somewhat in recent days, coincident with recent events which are changing rapidly. While the situation in the Donbass has now been (somewhat) resolved - though the potential for disputes about the resultant borders remain a potential source of near term conflict - the longer term issues have not yet been resolved, and indeed there is a growing risk of an escalation into an all out Russo-NATO hot war. These issues may or may not lead to a major short term escalation extending up to the point of a nationwide Ukrainian invasion, but irrespective of that, they will continue to linger and lead to potentially longer term escalation and conflict. Given the graveness of the situation, it believe it is important the issues are properly understood. (please read footnote)* <span></span></p><a name='more'></a><p></p><p>Many have argued that Putin is attempting to recreate the USSR and seize territory, but that is not his ambition. Instead, Putin's ambition and bottom line is that Ukraine not become a member of NATO, and perhaps also not a de facto member that is armed, funded, and backed by NATO, irrespective of formal membership (the latter is a much riskier situation in the short term, as that is already increasingly the status quo). I recognized this in past comments, but may have underestimated the degree and urgency with which Putin feels the need to address these issues - particularly now that Ukraine has recently floated the idea of acquiring nuclear weapons. It appears increasingly clear that Putin is willing to go to war to prevent the aforementioned from happening.</p><p>Putin has made larger demands of NATO, but I think this reflects the classic negotiating strategy of asking for more than you are willing to settle for, granting you room to compromise. I am persuaded that Putin would be willing to settle for a guarantee of Ukraine not becoming part of NATO and its permanent neutrality, and perhaps also recognition of Crimea (though this is less important if the Ukraine does not become part of NATO). In exchange, Russia could guarantee Ukraine and other states' territorial integrity. The problem that emerges is that the the West is not willing to negotiate with Russia and grant them any concessions, which makes the probability of a diplomatic solution relatively low.</p><p>Why does Putin care so much? For several reasons. Firstly, Russia sees NATO as a potentially offensive military alliance, not a merely defensive one. As I tweeted recently, when you see a spider (Russia) you may feel fear, but amidst the surge of emotion and adrenaline it is easy to forget that the spider also fears you. Secondly, the Ukraine has previously stated an intention to retake Crimea by force and its pursuit of NATO alignment is partly aimed at facilitating that goal. Russia is not willing to relinquish Crimea as it is a militarily strategic peninsula for them, and if a NATO-backed Ukraine were to attempt to do so, it could lead to a Russia-NATO war. Putin does not want this, but he is also unwilling to put Russia in a situation where they would be forced to relinquish Crimea to avoid war.</p><p>Thirdly, Putin has made reference to the historical cultural affinities of the two countries. This is not because Putin wants to reconstruct the USSR, but because it is a particularly sore spot to see one of its historically closest friends becoming influenced by and allied with what it sees as an offensive enemy military alliance. They don't like it any more than the US would like Canada becoming allied with an expansionist Russo-China led military alliance. The West's willingness to expend efforts to go as far as intervening in Ukrainian politics, arming, funding, and training the Ukraine military and pushing for its incorporation into NATO, is seen by Russia - to use a Commonwealth colloquialism - as "taking the piss", and has made Putin angry. Putin can tolerate it in other countries, but in its closest historical ally, it is seen as intolerably aggressive and disrespectful - contemptuous even, of Russia. </p><p>The other relevant factor is that Russia has now amassed a large and powerful army with advanced weaponry, to the point where it is not obvious that NATO would be able to win a NATO-Russia war fought in Europe, as Scott Ritter discusses <a href="https://www.youtube.com/watch?v=XvJ5lYPTN3U&t=1002s">here</a>. This increased military strength is not being respected by the West or translating into an increased willingness to negotiate/compromise, and this is forcing Putin into considering military escalation. As Scott Ritter said in the above interview, Putin has been saying "hey I'm talking over here, pay attention" for some time, and if you continue to ignore it and say "Putin, we don't care what you want", at some point you get punched in the face. And to some degree, the West has left Putin with no other options besides sitting idly by while Ukraine militarizes and allies with NATO. The problem, as I pointed out in my past piece, is that both sides see the other as the aggressor, and this is a recipe for run-away escalation that can eventually boil over into outright conflict.</p><p>There are three ways in which you can resolve a conflict. The first is compromise; the second is one party submitting to the other's demands; and the third is conflict. It has been said that historically, whenever you have moved from a unipolar to a multipolar world, there has been war. The likely reason is that the prior unipole grows accustomed to forcing the other party to submit to their demands and never felt any need to compromise. However, if the other party becomes strong enough to resist such submission, they may no longer be willing to tolerate it and insist on compromise. But it is often politically difficult to move towards a willingness to compromise. The outcome is conflict.<br /><br />There is a risk of this template playing out in Ukraine/Europe. Russian demands are not that unreasonable - simply precluding Ukraine from joining NATO and securing its permanent *neutrality*, while they would also prefer the recognition of Crimea. We may not like it in the West and prefer Ukraine join NATO, but if we were to compromise and say, ok we will grant that, but that's where it ends, there would be a potentially permanent resolution to the tensions and peace. Unfortunately, the West is not willing to do that as it does not feel it justified to compromise with Russia to any degree - indeed it believes the very idea of it to be abhorrent. It is also increasingly difficult politically, and will become even more so as Western moderates are pushed out for merely suggesting such a possibility (witness the recent resignation of a senior Germany army general after suggesting as much).</p><p>The West is also persisting with its belief that sanctions are a way to "deter" Russia, but they are more likely to escalate the situation than de-escalate it. The reason is that they reflect an extension of the belief the West has that it is both able to and justified in bullying Russia, but Putin has already made it clear that he is unwilling to be bullied. Consequently, such measures are likely to have the opposite effect of deterrence and make Putin even more resentful and determined to take assertive action to demonstrate his unwillingness to bullied, and strengthen Russia's security interests.<br /><br />I am concerned about how events could evolve from here - not necessarily just in the short term, but also over the medium to long term, because I now believe it is increasingly clear that *Putin is willing to go to war to prevent the Ukraine from becoming militarily allied with the West* - it is one of their *red lines*. Meanwhile, the West is not respecting that fact nor the strength of Russia's military, and seems determined to press ahead with the armament of the Ukraine. Is Putin justified in this approach? Probably not. But that is irrelevant. Wars are about conflicting interests and perspectives, not right and wrong. Taking a moralistic rather than pragmatic approach is very dangerous.</p><p>The risk in the short term is that Putin assesses that the longer he waits, the stronger the NATO-backed Ukraine military will become and that it is therefore necessary and desirable to act sooner rather than later to minimize the bloodshed. The intention would be to deal damage to Ukraine's military infrastructure and make it clear Russia will not tolerate Ukraine militarizing and allying with NATO; its preparedness to use military force to ensure that; and demand assurances they will not ally with NATO in the future in return for peace. This is particularly the case now that the Ukraine has floated the possibility of acquiring nuclear weapons, which may act as a catalyst/final straw for Putin. I believe it is very unlikely Ukrainian territory would be seized/annexed, however - particularly if Ukraine acceded to Russia's demands, because territorial acquisition is not Russia's ambition.</p><p>I am concerned that the West's unwillingness to compromise with Russia and make some reasonable concessions for the sake of peace may lead to war. I understand that Ukraine's security needs to be guaranteed, but there are ways in which this can be done without arming the Ukraine in potentially offensive ways, or allying it with NATO. A diplomatic solution is still possible, but it will require a much greater degree of respect amongst the West for Russia's military capabilities and security interests, which seems unlikely to be forthcoming. A large part of what Russia is trying to do at present is command that respect and extract the said concessions/compromises, and Putin feels he has no alternative than to display that military strength in the furtherance of that ambition.</p><p>It is an unfortunate and dangerous situation. The current situation is not without hope for a peaceful resolution, but the room for optimism is declining. </p><p><br /></p><p>LT3000</p><p><br /></p><p><i>*This article was written on the morning of 24 February, Singapore time, and was nearing completion when the news wires flashed about Russia's invasion of Ukraine. Further research had caused me to become more pessimistic about the risks, including Putin's menacing 21 February speech, though I did not expect something of this magnitude to erupt, and so soon. It should go without saying that Putin's actions in the Ukraine are horrific, and justify unequivocal condemnation. Events have also caused me to re-evaluation some of the conclusions/analysis outlined in my 28 January article. </i></p><p><i>I derive only small solace from the fact that Putin's actions have surprised many people, including Ukraine itself, who were expressing skepticism about the likelihood of an invasion only days before it took place, as well as many/most people in Russia. The lack of domestic media "preparation" of Russian audiences for an action of this scale, coupled with Putin's apparent agitated emotional state on 21 February, suggests this may have been a rash decision (more limited military action in the Donbass may have previously been planned). It is also possible more sweeping action was long under contemplation, consistent with US intelligence; there appears to be more dissent than would be typical within the Kremlin, which is one reason US intelligence may have been unusually effective. <br /><br />Only time will tell, and more answers may come in time. In the meantime, we can only hope a swift end to the conflict can be achieved.</i></p><p><br /></p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-31521076496824884152022-01-30T09:51:00.028+07:002022-01-30T14:58:18.053+07:00Neil Young vs. Rogan/Spotify, Meta Values, and Pluralistic vs. Authoritarian Societies <p>This will not be a long blog article, as I only wish to make one simple point, and doing so does not require a long exposition. However, I believe the point to be of absolutely vital importance, and is too frequently overlooked in today's tortured political discourse and latest skirmish de jour. And its import extends well beyond the proximate instantiation at hand. <span></span></p><a name='more'></a><p></p><p>Neil Young recently made headlines by demanding Spotify remove Joe Rogan's podcast from its platform, on threat of Young pulling his catalog from the service. Young did not want to support and associate with a platform he believed to be actively spreading damaging misinformation - specifically some recent episodes/guests that expressed divergent (and quite possibly false) opinions on vaccines. </p><p>Young's stance has been controversial. Many have condemned it, while many others have congratulated Young for taking what they believe to be a courageous, principled stand for what he believes in. However, what is often overlooked in the debate - particularly from those in the latter camp - is the role/importance of what I will call "meta values" or "meta principles". Indeed, to my way of thinking, how one feels about this issue should have nothing at all to do with how one feels about Rogan and/or the specific episodes/guests in question. I haven't even seen them (though I have seen many second-hand commentaries about them), and consider their content totally irrelevant to this debate.</p><p>The much bigger picture is this: In any large and diverse society (and even in smaller and less diverse ones), it is inevitable that there are going to be people that have different views, perspectives, beliefs, values, and priorities. In order to peacefully co-exist, you need to find a way to accommodate these differences without resorting to violence and/or perpetual Balkanization, and you basically have two choices about how you might go about organizing society to achieve that outcome. </p><p>The first is to adopt a pluralistic, traditionally "liberal" society that respects people's differences, and right to differ. You show tolerance towards others having beliefs, values, and priorities that may differ from your own, whether they be religious, ethical, cultural, artistic, political, or otherwise. You grant people basic rights, and allow them to make their own choices about how to live, provided they do not infringe upon the rights of others. This principle of freedom being restricted only insofar as it infringes upon the rights of others is succinctly encapsulated in the famous quote attributed to John Stuart Mill and/or Oliver Wendell Holmes that "your right to swing your fist ends at my nose".</p><p>The second alternative is to adopt an authoritarian approach where you force everybody to conform to the same set of beliefs, values, and priorities, and punish/outlaw dissent. The latter is a necessary part of the package, because if you do not represses dissent, it is not possible to enforce a perpetuate orthodoxy. It doesn't have to be done via the means of brutal dictatorship, however - in many traditional societies, conformity was instead enforced through means of social ostracism. In modern day society, it manifests in the form of "cancel culture"; guilt by association; and banishment from the internet. However it is accomplished, the underlying approach is to show *intolerance* towards differences, with the goal of enforcing a general conformity. </p><p>Those are your two options: tolerance and pluralism, or intolerance and conformity. There is no middle ground. And *tolerance* is a broad concept that extends well beyond merely superficial differences in skin colour (which sometimes <i>correlate </i>with different values, beliefs, and cultural preferences), or only involves substantive beliefs when it pertains to religion. It relates to *all* differences in life philosophies and beliefs people may have, and for whatever reason. </p><p>The reason I take exception to people like Young is that what he is doing is fundamentally incompatible with the meta values of a tolerant, pluralistic society. At base, what he is attempting to do is strongarm Spotify into taking down the world's most popular podcast, which would not just deny Rogan a voice (and living), but also the rights of millions of people to listen to it, simply because <i>he </i>doesn't agree with what was said. It reflects authoritarian instincts, and though Young does not have the power to take authoritarian actions, he is setting an extremely poor example through his conduct, and contributing to the attempted normalization of societal values that are fundamentally illiberal in nature. And in the long run, that is a danger to our ability to sustain a tolerant, pluralistic society. <br /><br />By all means Young, disagree publicly with Rogan - as vehemently as you want. Ridicule him all you like. But recognize that other people are entitled to an opinion too, not just you, and that learning to live with and respect the rights of people you disagree with is part and parcel of living in a free society. In a pluralistic society, you ought to care about and respect the rights of other people, not just your own, and Young cared nothing of the rights of Rogan, Rogan's listeners, Spotify, and even his own fans. And trying to use your own (limited in this case) power to force the world to be more the way you want it to be, other people be damned, is fundamentally authoritarian in its philosophical orientation. </p><p>A liberal, tolerant society has always been difficult to achieve and sustain, and has historically been the exception rather than the rule. One of the reasons why is that human beings are hubristic and are always overconfident they are right, because people "don't know what they don't know" (and can't). Consequently, the world is forever populated by people that are inclined to say "this is what I think, I <i>know</i> I am right, and I therefore insist that everyone else thinks like me. Moreover, if you don't, I <i>know</i> you're a bad person, and that grants me the moral justification to infringe upon your liberties". It is pretty hard to sustain a liberal, tolerant society when people think like that, and especially if they are able to acquire sufficient power to actuate that philosophy. </p><p>It is a myth that authoritarian regimes and all the human suffering and repression they have entailed have mostly been the result of malevolence. For this reason, I am not a huge fan of the quote "power corrupts, and absolute power corrupts absolutely", because it implies that malevolence is the primary danger with authoritarianism. In fact, it is the self-righteous hubris of people that is the primary danger - people <i>think </i>they are in possession of all the answers, and feel <i>entitled</i> to <i>force </i>everybody to conform with their views for the greater good of society. Stalin passionately and wholeheartedly believed communism was a moral good and its success of vital importance to the future of humanity. If you believe that, hiding the fact that central planning had lead to a collapse in agricultural productivity - so as to not discredit communism in the eyes of the world - and allowing 6m people to stave to death instead of requesting international assistance/aid, seems morally justified. After all, in the bigger picture of the future of humanity, 6m deaths is a small price to pay. So is sending dissidents to the Gulags. You have to crack a few eggs to make an omelette, right? <i> </i></p><p>The way I see it, how you feel about Young's recent actions should have *absolutely nothing* to do with your view on Rogan or any of his guests, and whether you agree or disagree with them, because this is actually a question of meta values and what sort of society we want to live in: a liberal and tolerant one, or authoritarian one where a small handful of powerful people enforce an ideological orthodoxy on the rest of us? If a liberal, pluralistic society and culture is to be maintained in the long term, short term expediency should *never* be used as the basis for annulling meta values. It is such meta values enshrined into our institutions that leads us to let (who we think is) a murderer go free if due process of law is not used to prove a conviction beyond reasonable doubt. In the long term, it is more important that meta values be respected than justice fail to be served in this one particular instance. </p><p>Indeed, this is what it really means to take a *principled stance*. Contrary to what Young and many of those who have supported his actions believe, taking a principled stance is *not* about advocating for expedient short term outcomes by brute force. That is the antithesis of being principled - it is instead the ad hoc exercise of power for short term ends. What being principled is about is <i>being willing to tolerate a suboptimal short term outcome for the sake of the preservation of long term meta principles. </i>It is saying, we *must* let the said murderer go for the sake of principle, even though we may detest having to do so. </p><p>It is disappointing the degree to which civics education has deteriorated in recent decades, and how basic understanding about the foundational philosophies and meta values that have underpinned the West's historic economic and cultural success have waned. That this is the case has become very evident in our increasingly polluted and bitterly acrimonious political discourse (indeed, it is one of its primary causes). These values are *time tested* - indeed they built the wonderful world in which we currently live. If pluralistic and tolerant society is to be preserved in the long term, they need to be revitalized.</p><p><br /></p><p>LT3000</p><p><br /></p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-56029805507468334282022-01-28T17:40:00.068+07:002022-01-29T11:19:35.159+07:00Demystifying Putin: US vs. Russia geopolitics - the real story<p>In recent months, Russia has once again been in the headlines for all the wrong reasons, with
the US and Western media loudly proclaiming (since November) that Russia is
planning an imminent invasion of the Ukraine, though Russia has repeatedly denied that fact and it's not exactly clear what Russia is waiting for, or what advantage it could expect to derive from lying about its intentions at this point (the whole Western world expects an invasion and the US has pulled embassy staff from Kiev). <span></span></p><a name='more'></a><p></p><p><o:p></o:p></p><p>Putin is generally portrayed in the Western media as a constant and unpredictable menace, whose
actions defy any rational explanation, and who poses a meaningful security threat to the world. What the hell is he doing; what does he want; and why is he seemingly so hell bent on wreaking havoc and fermenting conflict, despite all the sanctions and international condemnation such actions entail? Some people have resorted to
explanations that Putin wants to reconstruct the USSR, and likened his activities and putative designs on Ukraine to Hitler trying to seize the Sudetenland. That many serious
people in the West seem to believe this highlights the extraordinary degree of
misunderstanding that currently exists amongst Western audiences, and the amount of misinformation they have been subject to.</p><p>Strong opinions coupled with limited knowledge are the basis for ideology, not sound thinking and decision making. Most Western audiences are not even aware of the difference between the Donbass and Ukraine proper, and that the Donbass fought a war of independence against the Ukraine in 2014, and under the Minsk Accords is now semi-autonomous. Any forcible reincorporation back into Ukraine proper by the Ukrainian military, which Russia feared was being planned (with US aid and military armament, by the way), would be more of a breach of international law than Russia stepping in to aid its defense, and no one seems to much care about what the people who actually live in the Donbass want (independence from the Ukraine). Who would be invading who? But more on that later.</p><p>I have been investing in Russia since 2014 and have done quite a bit of work and thinking on these issues, and at this point feel compelled to write a blog
article about it, because it has more than just investing implications - a better
understanding amongst Western audiences might also reduce the probability of mutual
escalations that could - at worst - eventually lead to WW3 between NATO and Russia (likely allied with China). Fortunately, I am not that
pessimistic, but I do believe pervasive misunderstandings in the West, as well as some of its ulterior motives, are driving a policy approach that is significantly increasing mutual tensions and needlessly increasing the risk of war.</p><p><o:p></o:p></p><p>When you properly understand the situation, it becomes clear that Putin's actions are not mystical
or unpredictable at all - they make perfect sense, and frankly, in many
situations they are even justifiable. In many if not most cases, Putin is behaving in exactly the same way - if not in a much more reserved fashion - than the US would (and has) behave(d) if and when the shoe was on the other foot. To the uninitiated, all this may feel like Kremlin propaganda, but please do bear with me for a while.<o:p></o:p></p><p>It is important to recognize that we all have a very significant "home team bias" in assessing geopolitical phenomena, and if you want to properly understand the situation, you need to see it from both sides. You also have to get away from the reductionist assumption that the world is comprised of "good guys" and "bad guys". In political conflicts, people always perceive themselves as the "good guys" and the other as the "bad guys". A more mature mutual understanding is necessary if diplomatic solutions are to be reached, as is a willingness to *compromise*, rather than engage in domineering behaviour. </p><p>There are two broad areas I would like to address in this piece. The first
is a discussion of some of the bigger picture reasons that help explain not
just ongoing Western - and particularly US - tensions with Russia, but also Sino-US tensions, and a broad range of other conflicts the US has involved itself in (and which also explains the seemingly bizarre behaviour of North Korea). This will provide the necessary context to understanding the second area I will address, which gets into the specifics of recent Russo-US/NATO tensions, and also what is happening on Ukraine's border, and why.</p><p><o:p></o:p></p><p> <o:p></o:p></p><p><i>The bigger picture background</i><o:p></o:p></p><p>When I was a child, my mother used to talk of the "common
denominator". When there were sibling squabbles where it was hard to
discern who was to blame, mum would default to the heuristic "who seems to
be the common denominator". If one sibling always seems to show up in
disputes, there is a decent chance that their behaviour has at least something to do
with the emergent conflict. The US seems to have a habit of embroiling itself
in political conflicts and wars all around the world. Prima facie, the US
appears to be the common denominator. Why is that? And why, incidentally, when the US turns up as it did in Iraq
to putatively "liberate" the people, does the US often encounter stiff grass roots resistance? Don't they know the US is there to help? Why does nation building fail? And why does antipathy towards the US and West often reach such extreme levels that it can fuel terrorist activity. </p><p>The likes of George Bush would have you believe that people in all these countries hate the
US because of what it stands for, its values and its freedoms, etc. That is
total hogwash. It has absolutely nothing to do with that. In my view, the underlying reason for all these tensions and conflicts is
that the US State Department has a longstanding policy of *targeted regime
change* around the world, which is a policy approach that became entrenched
during the Cold War era via the doctrine of "containment". </p><p>Under the said doctrine, rather than outright war with the USSR and the potential mutually assured destruction it could entail, the US would seek to prevent communism spreading via targeted interventions - both overt and covert - and it did. Overt interventions included most obviously the Vietnam War, but there
were also many covert interventions, which included backing domestic insurgencies by providing (for eg) arms and funding. Some of these interventions are widely known (e.g. the Bay of Pigs invasion of Cuba), and some
not. For example, I think it quite likely the CIA had a hand in the
ousting of Surkarno in Indonesia, and installation of Suharto in 1965. Surkarno
was inclining strongly communist by 1965, and the official narrative that communists
launched an attempted coup against Surkarno, justifying a counter military
coup by Suharto, makes little sense. Suharto went on to purge Indonesia of about 1m
communist sympathizers. But I digress.</p><p><o:p></o:p></p><p>Since the Cold War ended, the US State Department has not abandoned this
approach (institutional reflexes are hard to change), though it has pivoted to
targeting regime change in countries it deems important to US national security
interests. It is now more covert in its approach, however, and seldom
explicitly acknowledges this is its underlying strategy (which also makes it
much more hazardous to take US foreign policy rhetoric at face value, because there is often an ulterior motive). Indeed, after a long period of
unipolarity associated with Pax Americana, the US has come to feel it has the
right to define the terms on which it co-exists in the world with other
countries, and it feels it has the right to weaken, destabilize or ferment
regime change in countries it believes to be a threat to the US's national
security interests. And this inclination is fundamentally where all the tensions
come from, whether it be with Russia, China, or any other body politic around the world. And it often results in the US "picking sides" and intervening in domestic conflicts, so as to increase the chances of a resolution of the said conflict in a way that yields a new regime more compatible with US interests. <o:p></o:p></p><p>US interventionalism is often done under the guise of "spreading
democracy" and securing "human rights", and it might even be
the case that such actions are for the greater good of humanity in the long term
(at least if the interventions had a tendency to succeed, which for the most
part they have not; why will be discussed later). However, it also seems apparent that the US has
historically been much more concerned about spreading democracy and human rights in
countries/regions that happen to serve the US's geopolitical interests, such as
securing reliable access to hydrocarbons (hence its interest in the Middle
East; the US is not interested in "stealing" Middle Eastern oil, as
it is sometimes claimed, but it is interested in ensuring geopolitically compatible regimes exist that won't choke off supply a la the 1970s OPEC oil
embargo). And it is also more interested in spreading (pro Western) democracy in regimes that
are seen as posing a potential military threat to the US in the long term (for
instance, China and Russia).<o:p></o:p></p><p>Whether or not one thinks this is a good thing or a bad thing for the world (I certainly prefer democracy and human rights), it is *absolutely predictable* that this approach to the conduct of foreign policy would lead to conflict, because US regime change ambitions come into direct conflict with the interests of incumbent regimes in the said countries. And they will fight hammer and tooth to prevent themselves from being deposed. Indeed, for such people, the outcome of this realpolitik can often be a matter of life and death. This dynamic is absolutely a major contributor to rising US-Sino tensions, as well as long-standing US-Russo tensions. The US wants China to become a democracy. The CCP, unsurprisingly, does not want that.</p><p>As I have blogged about in the past, if you are an authoritarian leader/regime, there are two threats to the continuation of your incumbency: the first is a purely domestic insurgency; the second is a foreign-led regime overthrow, such as what happened to Saddam Hussein. Incumbents have much more control over the former, and if they lose power by this means, then they only have (even in their own eyes) themselves to blame. However, it is much harder to ward off foreign-backed regime change when you live in a world with great powers with military strength that surpasses yours (particularly when they are allied into large and powerful blocks like NATO), and who have had a historical tendency to use a combination of political, financial, and military means to ferment such changes. It is a very important vulnerability of these regimes, they know it, and for that reason, it is taken with utmost seriousness. </p><p>This, incidentally, is behind North Korea's seemingly bizarre and irrational behaviour. To the uninitiated, "Rocket Man" Kim Jong-Un seems completely unhinged, but I see things very differently, and instead see his actions as carefully calculated. You and your extended family do not keep absolute control over an entire country for multiple generations by being stupid and unaware of the dynamics of power. Kim Jong-Un understands that the biggest risk to the perpetuation of his regime is a foreign-backed overthrow. Consequently, he very deliberately wants to persuade the world that (1) we have a lot of dangerous weapons; and (2) we may just be bat shit crazy enough to use them if you fuck with us, so leave us alone. And he has succeeded with this ambition. It has had the desired effect of deterring foreign intervention to overthrow his regime. On the bright side, it means that North Korea is actually not a threat to the world at all, nor are many other so-called "rouge" countries. Though they are often cast as aggressors by the US State Department as as way of justifying the US's aggressive foreign policy agenda, in actuality the primary motivation for armament in these nations is to *deter/prevent a foreign-backed regime overthrow*. And the US absolutely hates it because it does, in fact, inhibit their ability to engineer regime change. This is ultimately where the tensions and oft-mutual escalations come from, and is absolutely critical to understand.</p><p>The 2003 Iraq invasion was also a very significant development in this regard, and for the uninitiated, offered a brief peek behind the US State Department curtain.
Even in the US it is now widely acknowledged that falsehoods were
perpetuated by US officials to persuade the US public to back going to war with
Iraq, and at the very least, the US misrepresented the degree of confidence it had
that Iraq was in possession of WOMDs - saying we "know" they have them, and "know" where they are (they didn't).
However, people also acknowledged that Saddam was a "bad guy", and so
not too many tears were shed. The outcome seemed ok, despite the dubious premise/means.
However, as I will discuss, the long term consequences of the invasion have extended well beyond Iraq's borders.</p><p><o:p></o:p></p><p>The following is an <a href="https://www.youtube.com/watch?v=TPrl4k6CAYU&t=1132s">excellent speech</a> given by former
UN weapons inspector Scott Ritter in 2002, on the eve of the invasion. During
the 1990s, Ritter made more than 50 visits to Iraq, and presided over what he
persuasively argues was a highly successful disarmament program, which by 1998
he believed was 95% complete. Then, seemingly inexplicably, the US
unilaterally pulled all arms inspectors out of Iraq, instead of allowing the
process to complete. Had it completed, Iraq would have become compliant with
all UN security resolutions, and an invasion/deposing of Saddam would have become much more difficult to justify to the international community. He makes a strong case that the ultimate intention of US
foreign policy was always regime change, and WOMDs were being used simply as a convenient premise/lie to pursue that underlying ambition. He was subsequently proven right. I highly recommend you watch it,
because it significantly bolsters the credibility of the arguments I am making here,
which otherwise might strike one as been imbued with a degree of conspiracy
theory. <o:p></o:p></p><p>This is just one example of the US playing fast and loose with the facts in order to justify covert State Department agendas. For instance, Ritter (one of the most qualified people in the world to comment on this, by the way) has also argued that there is no solid evidence Assad actually used chemical weapons against his population in Syria, which was used as the basis for US military intervention. Rebel groups claimed as much because it was necessary to recruit Western support (they know what buttons to press), but typical checks and balances used to ensure evidence was not fabricated false-flag evidence were suspended. It would appear the West was willfully blind because they wanted Assad out, and this was too good of an opportunity to pass up - backing a domestic insurgency that might very well succeed. Is it any surprise that leaders like Assad don't tend to be too fond of the US or too trusting, and tend to view the US as an aggressive and militaristic power bent on imposing its will on the world at gunpoint? And is it any surprise Russia backed Assad? What Putin is trying to do is resist US-sponsored regime change, because it's a matter of self preservation for him. And he is seeking allies that can assist with that ambition.</p><p>Iraq was the most explicit and militaristic regime-change intervention the US has undertaken in the post Cold War era, but there have been many other such interventions of a more indirect nature. The typical modus operandi is to ferment domestic discontent (e.g. via sanctions, or funding pro-Western "seditious" media); providing support to domestic rebels (arms and funding); and/or using alleged human rights violations as a pretext for military intervention, as was the case in Syria. The US/NATO also took sides and militarily intervened in Bosnia and Kosovo, and also bombed Belgrade (Serbia) in the late 1990s - something the Russians took close note of (bear this in mind whenever people claim that NATO is purely defensive in orientation, and so Russia/Putin has nothing to fear from NATO expansion). </p><p>The US also intervened in Libya (and Afghanistan of course); and though the US has not invaded Iran, it has put significant pressure on it via heavy sanctions, which can lead to domestic instability (as it has long attempted to do in Russia, and has also started to attempt to do in China as well - unsuccessfully). Ritter has argued persuasively (see his book "Deal Breaker", for eg) that Iran was never a legitimate nuclear threat, and US domestic policy towards Iran has long been oppressive and unreasonable (he has totally changed my view on this issue; I now realize that in the past when I was talking about Iran, I had no idea what I was talking about; much the same way most Westerners today talk about Russia).</p><p>The legacy of the US invasion of Iraq and deposing of Saddam has been very significant - just not the legacy that was hoped for. While Western
audiences looked on approvingly as Saddam was deposed, other
quasi-authoritarian leaders of the world looked on in a concerned fashion and said "that could be me next". It highlighted a need for rapid armament, including ideally the acquisition of nuclear
weapons, which are the ultimate defense/trump card. And it lead to a much greater degree of suspicion of US institutions (given it's willingness to fabricate a false pretext for invasion), which extended to those of Western donor organizations and media. This is one reason why restrictions on Western media (including social media) have become more common in these countries, and why countries like China have recently become more hawkish with respect to foreign-ownership restrictions of educational institutions/entities (witness the collapse in overseas listed Chinese education stocks of late). As US foreign policy has become more aggressively anti-China, China has moved to bolster its ideological defenses.</p><p><o:p></o:p></p><p>Overall, US policy actions over the past several decades have failed to make the world safer, and have in fact had the direct opposite effect. Even if you agree with the US's intentions, it is hard to find the outcomes agreeable. US "nation building" attempts have failed everywhere - including most recently in Afghanistan - and the world is now arguably more authoritarian and militaristic than it was before Iraq. Aggressive US foreign policy is also leading to greater co-operation amongst authoritarian countries, united by their need to defend themselves against attempted US-backed regime change. This is already resulting, for instance, in greater cooperation between China and Russia, and the greater prominence of the CSTO (Collective Security Treaty Organization), which was recently deployed to put down an attempted coup in Kazakhstan (which may or may not have had foreign backing - that remains unclear at this point, but Russia understandably has its suspicions given the coincidental timing, and it has contributed to the recent escalation in NATO-Russo tensions). </p><p>But this is just the impact on leaders. What about the governed populations? Wouldn't they welcome liberation? That has been the assumption and justification used for many US incursions that otherwise could be seen as militaristic occupations of other countries in breach of international law, and it is an argument I have a lot of sympathy for. After all, if you are only holding on to power through domestic repression, you don't really have an ethical justification for retaining that power - you're merely a thug holding a country to ransom through force (though in many cases, domestic leaders actually enjoy significant and legitimate popularity - Putin being one such example). But even if liberation was the intention, very seldom has that been the outcome. Soldiers in Iraq frequently spoke with dismay about how they were being attacked by people they were there to help. What gives?</p><p>There are many reasons, but one of the most important is that (1) the incumbent regime will naturally resist such interventions and fight for their survival, meaning violent conflict/warfare is inevitable; and (2) the said warfare almost always leads to the lives of ordinary people being heavily disrupted, extending from heavy destruction of local economies and property, to the objectionably-euphemistic "collateral damage". People may not understand all the issues and long term consequences, but they do understand that ever since the US showed up, everything in their lives seems to have gone to hell (more than anything else, people just want to live a safe and predictable life). Unsurprisingly, this has not tended to be a very effective strategy for winning "hearts and minds" (and to the contrary, it often ferments such an extreme degree of hatred of the US that it congeals into organized terrorism). It is understandable why people would be embittered by loved ones being killed and their already-meagre possessions being bombed to rubble, even if it was for the long term greater good. </p><p>This is particularly so because people are always (endowed by evolution) instinctively distrustful of foreigners and their intentions in the first place (because they are an unknown quantity that could pose a danger), and who wants to be bossed around at gunpoint by a bunch of foreigners "for your own good"? This is why in Vietnam, the US thought it was fighting communists, while many of the Vietnamese thought they were fighting a hostile invading force that was napalming their villages with impunity, and butchering their countrymen by the millions (and it didn't even stop Vietnam from becoming communist - what an absolute tragic waste of human life). I can't imagine the degree of hatred they must have felt towards the white man, and it is a credit to the country they have managed to forgive us and move past it as the decades have passed, but many others around the world have not yet done so for their own experiences of US-inflicted militaristic injustice. Add to that the fact that the US has a reputation of pursuing foreign policy in a way that places absolute primacy on its own geopolitical interests, and its no mystery why local populations may be cynical of US intentions. </p><p>That's the big picture. And it is vitally important to understand. Western "aggression" can come in different forms; the declaration of conventional war by US/NATO against Russia or China is indeed very unlikely, but it is not the only form of aggression that Xi and Putin fear. Indeed, think about how Russia's (very modest) intervention in the 2016 US presidential election (posting on US social media; taking out US$150k of Facebook ads; and releasing hacked DNC materials which actually *increased* democratic transparency) was widely labeled "Russian aggression" and "undermining US democracy". If we consider that aggressive, how would you expect other nations to consider the US funding and arming rebel groups; funding seditious political activism and media; and sometimes even engaging in outright military intervention? The double standard and hypocrisy is laughable in its magnitude. </p><p><o:p>It is absolutely critical to understand this background before proceeding to any analysis of the specific circumstances in respect of US-Russo relations. The latter will now follow. </o:p></p><p><o:p><br /></o:p></p><p><i>Russo-NATO relations </i></p><p>As is now widely known, Russia has long objected to NATO expansion. NATO is a Cold War era military alliance, and after the dissolution of the USSR, its raisen d'etre ceased. However, the West did not disband NATO, though they did provide verbal assurances to Russia it would not be expanded. Russia even asked to join NATO at one point, but was rebuffed. Sorry buddy, this club ain't for you.</p><p>Since that time, NATO has been steadily expanded and pushing closer and closer to Russia's borders, notwithstanding the said assurances, which the West is quick to point out were not in any way binding. To the West's way of thinking, who is part of NATO is none of Russia's business, and it is a defensively-oriented alliance besides. But from Russia's perspective, they wonder why a Cold War era institution targeted specifically at Russia continues to exist; denies entry to it; and then keeps being aggressively expanded towards its borders. It comes off as unnecessarily aggressive, and implies the West may have some undeclared motive, and moreover it gives the West greater power to bully Russia and intervene in domestic conflicts - which we know from the prior discussion the US is wont to do. It raises legitimate security concerns - particularly given, as noted earlier, the fact that NATO has intervened in domestic political conflicts before and bombed Belgrade in 1999.</p><p>All that would need to happen to assuage Russia's fears and reach a permanent peace without risk of escalation would be for both Russia and NATO to declare the Ukraine (as well as perhaps a handful of other border states) neutral territory, like Finland is and has happily been for decades. But the West is hell bent on avoiding that, and wants as many territories surrounding Russia incorporated into its military alliance as possible. Why is that, exactly? And don't you think it might pay to show at least a tiny bit of regard to what a neighbour with 4,000 nuclear warheads and a powerful military finds acceptable?</p><p>It is important to understand that both Russia and the US/NATO have inherited a legacy of
distrust from the Cold War, and as a result, the Russians trust the West about as much as as
the West trusts Russia. Most Westerners think "Russia should just trust us, because we are the good guys". But would Westerners "just trust" Russia? Most of the leadership in both the US State Department and the Kremlin grew up during a period where the other side was a mortal, existential enemy, and on both sides it has been difficult to shake the instinct of viewing the other side with suspicion, if not as an adversary. Understanding this foundation of distrust alone helps clarify some of the
confusion - particularly because much if not most of the time, what Russia is asked to accept from NATO is something that the US/West would *never* accept from Russia, were the shoe on the other foot. Indeed, if the actions were reversed the West would again be declaring Russia the aggressor. That is a problematic hypocrisy.</p><p>For instance, how comfortable do you think the US would be with Russia forming a military alliance with Canada, and then stationing Russian military bases and offensive missile systems on the eastern US-Canadian border, with capabilities of striking NYC or DC within 5 minutes? Do you think the US would be enthusiastically preaching about how Canada is a sovereign nation entitled to enter into any military alliance it pleases? Or do you think the US would perceive this as very aggressive, if not an existential risk? How about if Russia had backed a coup in Canada, that threw out a pro-US govt and installed a pro-Russian one, as the US did in the Ukraine in 2013/14 (see below)? And how would it look to the US if the US responded by moving troops to the border (within its own territory), and Russia then proceeded to declare this a totally unacceptable hostile escalation, recruited the international community to encircle and condemn the US and cut it off from the global economy, and called for a yet greater militarized build up of troops on the Canadian-US border. This would be seen as extremely aggressive - almost tantamount to a declaration of war. Yet this is not too far removed from what NATO/the US is doing to Russia, and we seem to believe *any* concerns at all Russia might have about this to be *completely unreasonable*, and do not believe *any* degree of compromise, no matter how small, to be tolerable. </p><p>Indeed, we don't even need to speculate about how the US would feel and react to a foreign military alliance emerging within its "sphere of influence". In 1962, the US, under JFK, almost took the world to nuclear war over Russia forming a military alliance with (sovereign) Cuba and stationing missiles there. Russia was also doing this *in response* to the US having already deployed missiles in Turkey (the crisis was resolved when JFK quietly agreed to dismantle those offensive missiles in Turkey, though he never admitted it to the US public for fear of looking weak - then, as now, any sort of compromise with Russia is seen politically unacceptable; that uncompromising approach from the US almost lead us to nuclear war, and could eventually lead us to war in the future as well if US attitudes don't change).</p><p>From the Russian perspective, a lot of what the West/US does appears very aggressive, and this is even before taking into account the seditious regime-change behaviour the US routinely engages in. This has the potential to lead to a dangerous situation where both sides perceive the other to be the aggressor, and their own actions a necessary defensive response, which in turn are interpreted by the other side as yet further aggression. Unchecked, this can lead to tit-for-tat escalation that increases the risk of it spiraling into an all out war. Needless to say, we should be trying a lot harder to avoid this than we are. Indeed, it sometimes seems as if Western leaders are trying their absolute hardest to provoke WW3 - it's unfathomably dumb.</p><p>In the West, we have long enjoyed the comfort and benefit of Pax
Americana, and have never felt the insecurity that comes with living in a world
where you coexist with non-aligned great powers that are much stronger than
you, and have both the potential willingness and ability to subjugate you, so we
struggle to empathize. The closest the US has come to understanding this feeling is the creeping anxiety it is now starting to feel as it observes China grow ever stronger. The same insecurities Russia and other nations habour of not being fully in control of their own destiny are starting to manifest amongst Westerners, and when they do, it is amazing how quickly high-minded liberal idealism is thrown out the window. Suddenly, things look very different when your own security is in question. </p><p><o:p></o:p></p><p>All of this is not to mention the fact that Russia was invaded <i>twice </i>during the 20th
Century by Western powers, having been betrayed by its former ally Germany (a
liberal democracy prior to Hitler's seizure of power, incidentally - democracy is no iron
clad protection against fascism). Defending these invasions came at the
devastating cost of *26m Russian lives*, not to mention contributing (in the
aftermath of WW1) to growth in populist support for communism, which had a
legacy of devastating Russia's development for three quarters of a century. So let's not
forget that.<o:p></o:p></p><p>The biggest contributor by far, however, is Putin's fear - which I actually think is well justified - that the US is pushing for regime change in Russia, and he is pursuing a strategy of self-preservation. He does not want NATO and the US to grow strong enough on Russia's borders that they could easily covertly supply a domestic insurgency with military aid and troops by sneaking them across the border. Meanwhile, the US does not want to compromise and declare the Ukraine independent because it would, in fact, make it harder for the US to back the said insurgency, which is exactly what it wants to be able to do. And this, ultimately, is why the Ukraine is such a battleground state.<o:p></o:p></p><p>Russia has repeatedly raised concerns, but the response it typically gets approximates "fuck you, we will do whatever we want". This total disrespect for a nation that has 4k nuclear warheads has lead Putin to conclude he needs to declare some "red lines" - no offensive missiles and military based deployed on its border in places like Eastern Ukraine - *and* to offer a credible threat that he is willing to defend those lines with military force. By failing to compromise with Russia or respect their security concerns, and thereby rendering any Russian diplomatic outreaches a total waste of their time, the West has forced Putin to make it clear he is willing to use military force in order to get anyone to listen to him. He does not want conflict, but he is also not willing to continue to be treated with contempt.</p><p>The West continues, for the moment, to say "fuck you Putin we will put as many missiles and military forces on your border as we damn well please". At some point, this approach from the West could trigger a war - especially if it tries to call Putin's bluff and thinks it can violate his red lines without consequence. I hope it does not and I am optimistic it will not escalate to that, because I think the West is actually taking Russia's threats more seriously than it is prepared to admit. Nevertheless, the West's aggressive and uncompromising approach is needlessly creating the conditions that could lead to mutual escalation into war - particularly if Putin is backed far enough into a corner with severe enough sanctions (for e.g.) where he has little alternative but to go to war (after all, The Japanese bombed Pearl Harbour due to a US navel blockade that cut of their supply of oil; they had no choice).</p><p><br /></p><p><i>The Donbass (Ukrainian border) situation specifically</i><o:p></o:p></p><p>Finally, this brings us to an analysis of the present situation and recent border tensions. The hysteria began in November when US intelligence sources claimed Russia was amassing troops on Ukraine's border and preparing an imminent invasion, which Russia denied and has continued to deny. Even if we assume for the moment the US State Department is not just looking for another excuse to try to pressure Putin's regime, US intelligence is probably derived mostly from US Ukrainian embassy staff, and those desk jockeys most likely get their information from West Ukrainian government officials (and, in all likelihood, the New York Times). </p><p>The Ukrainian presidency is currently held by Zelensky, whose is a Ukrainian nationalist and is aggressively anti Russia. He has been lagging badly at the polls and would benefit politically from provoking a minor incident with Russia (though not a major one/all out war - just enough that he can say "I told you so"; justify taking actions to satisfy his nationalist base, and secure US political favours). His predecessor did likewise several years ago, sailing war ships into the Azov Sea and deliberately failing to respond to Russia's repeated communications seeking clarification of their intentions. When the vessels were impounded (without bloodshed), he declared it an act of aggression by Russia and used it as a pretext to declare a state of emergency a month or so out from an election, granting him sweeping powers such as suspending the rights of assembly, amongst other things. Western commentators, played like a grand piano, dutifully condemned "Russian aggression in the Azov Sea".</p><p>In addition, the Ukraine is also the recipient of US foreign military aid so benefits financially from a perceived threat from Russia, and it is also opposed to the commissioning of the Nord Stream 2 pipeline (which, by the way, is a shorter and more direct route, and therefore more economically efficient and environmentally friendly, while also bypassing a potentially politically unstable country and thereby enhancing EU energy security), as its commissioning puts billions of dollars of transit fees paid by Russia to the Ukraine at risk. It is notable that Hunter Biden received a US$600k board seat at a Ukrainian energy company. One might reasonably question whether those "generous" board fees reflected deep expertise in all things Ukrainian energy, or rather an ability to extract political favours from Washington. I guess we shouldn't be surprised that the US has so vociferously opposed the Nord Stream 2 pipeline.</p><p>Anyhow, the background to
the current border tensions date back to 2014. In late 2013/early 2014, there
was a coup/revolution in the Ukraine, which resulted in a
democratically-elected pro-Russian president (Yanukovych) being removed from
power, and a pro-Western government installed in its place. This occurred after a widespread uprising in <i>West</i> Ukraine, centered on the
capital Kiev. While the coup had grass roots participation from many
Ukrainians, it mostly reflected the opinions of those in <i>West </i>Ukraine,
who are mostly ethnically Ukrainian and generally pro-Western, and it did
not represent the universal opinion of all Ukrainians - including large
ethnic Russian minorities in the far east. At the time, the Ukraine was a politically fractured nation, virtually divided down the middle between East and West in its political preferences, with a juxtaposition starker than that of California and Texas.</p><p><o:p></o:p></p><p>Furthermore, the US was a active supporter the uprising, expressed enthusiastic support for "freedom fighting" Ukrainians, and were caught plotting what government to install in the Ukraine in the infamous
leaked "Fuck the EU" audio recording between the US State Department
and US Ukrainian ambassador, which did not go down well either in Russia, or in
the pro-Russian eastern parts of the Ukraine, who felt disenfranchised. The situation worsened after the new administration attempted to disallow the official use of Russian, despite the fact that many people in the far east were Russian speaking.<o:p></o:p></p><p>The result was a separatist uprising emerging in the Far East (Donbass). The Ukrainian military wanted to put down the rebellion, while Russia provided military aid to the separatists. A ceasefire/peace deal was eventually reached with the Minsk Accords, brokered by France and Germany. The Minsk Accords - which carry the force of international law - provided for a significant increase in self-governance. The compromise was essentially to grant the Donbass quasi-independence, without it needing to be officially recognized as a separate country.<br /></p><p>Since that time, the Ukraine has failed to implement the Minsk Agreements, due to its political unpopularity and a rising tide of Ukrainian nationalism, which even has some fringe neo-Nazi elements to it. This has lead to periodic flare ups, though peace has been mostly maintained. The trigger for the recent movement of Russian troops was the Ukraine procuring advanced drone technology, paid for by US military aid, and using one of the drones in the Donbass. Importantly, such drones were used successfully last year by Azerbaijan to recapture territory after a 30-40 year frozen conflict. Russia did not intervene, but will have been put on alert when the Ukraine proceeded to procure similar technology.<br /><br />In my view, the most reasonable interpretation of events is that Russian intelligence believed that Zelensky may have been planning an invasion of the Donbass (a la Azerbaijan) - potentially with US backing - to forcibly reincorporate the territory into Ukraine proper, to satisfy Ukrainian nationalist demands, boost his poll ratings, and to the extent US backing was involved, to also help facilitate NATO inclusion and the installation of NATO missiles and military bases on the Russian border, though the latter is far more speculative (though I'm sure Russia suspected as much). Russia decided to move troops close to the border to deter such an action by signaling a willingness to intervene. It is important to emphasise that such an action by the Ukraine would be in breach of international law, and would be a de facto invasion. This is something that is almost never acknowledged in any of the discussions on this issue.<br /></p><p>As I alluded to in my opening section, it is notable that amongst all the great power sparing over the Ukraine; all the copious commentary amongst pundits; condemnations of Russia and "we stand with the Ukraine" rhetoric, no one ever thinks it important to consider what the people who actually live in the Donbass want. They fought a war of independence against the Ukraine, and want to be independent of the Ukraine. Russia *defended* the Donbass against the Ukrainian military (or more accurately, helped the Donbass defend itself), and did not annex the territory.<span style="font-size: xx-small;">1</span> </p><p>Yes, technically it is Ukrainian territory because as part of the compromise agreement reached with the Minsk Accords, Donbass' independence was not officially recognized, but on a de facto basis from the standpoint of the people who actually live in the Donbass, it would be seen as the *Ukraine invading* and *Russia helping to defend them*. And it was the potential for *Ukrainian aggression* in violation of international law that prompted Russia's troop deployments. Very few people understand any of these nuances, and they are of crucial importance. </p><p>The other thing that is seldom taken into consideration by Western audiences is the growing tide of Ukrainian nationalism, and the fact that the Donbass is populated by Russian minorities. The potential for ethnic conflict against these minorities is real and growing - particularly with growing fringe neo-Nazi elements of this Ukrainian nationalism, as noted. Russia therefore also has some concern around protecting Russian minorities against ethnic violence should reincorporation occur. It would not be the first time the US/West has failed to understand local realities/nuances and had its interventions precipitate massive ethnic violence, resulting in many people being imbued with a sense of hatred and betrayal towards the US for supporting the people that perpetuated all measure of atrocities against them.</p><p>Where are we now? The risk of a Ukrainian incursion into the Donbass appears to have declined because Russia's troop deployments have had the desired effect. It has deterred a Ukrainian invasion, particularly because the US appears to have made it clear to the Ukraine behind closed doors that it will not have its back if they invade Donbass, perhaps both recognizing Zelensky's potential inclination to launch such an invasion, and fearing it could escalate into an all out war with Russia if it were dragged into it.</p><p>Ukraine nevertheless continues to play up the threat of Russia to Western audiences, while offering contradictory statements to domestic audiences. They were nevertheless recently forced to backpeddle after the US and some other countries pulled embassy staff, however, which the Ukraine condemned. Extracting US military aid and opposition to the Nord Stream 2 pipeline were the goals, not causing a panic that triggered a mass exodus of foreigners. They have recently clarified that the threat situation has not changed, Russian troops have been near the border since April, the troops are actually not literally on the boarder, but several hundred kilometers inland at a Russian military base that was built years ago. </p><p>Very encouragingly, there was a <a href="https://www.kommersant.ru/doc/5181563?from=glavnoe_1">recent news article</a> that suggested the US had started to pressure the Ukraine into implementing the Minsk Agreements, and that the Ukraine was perhaps starting to acquiesce. As I <a href="https://twitter.com/LT3000Lyall/status/1486259605827043333">tweeted</a> a few days ago, if this is true, it is *hugely bullish* Russian assets as it would mean the risk of immediate conflict would basically fall to zero, though I noted that few (foreigners investors in particular) would grasp its significance. It took a little while but Russian asset prices started to move sharply higher not long afterwards. It may well have been that in combination with Russia's military build up, Ukraine's exaggeration of the threat had backfired and lead to the US genuinely believe an all out Russian invasion of the Ukraine was coming, and taking measures to defuse the risk of war. If so, Putin will have accomplished his aims in securing the Donbass' independence and security, an no military intervention would be necessary (Russia's diplomatic efforts may also have been more successful than Western commentators are prepared to acknowledge). It still does not resolve longer term simmering tensions between NATO and Russia, but it may deescalate the situation near term.</p><p>We will have to wait and see. However, broadly speaking, I see three potential conflict scenarios:</p><p>*The Ukraine invades the Donbass. The likelihood of a Russian response is practically 100%, but the conflict is unlikely to extend beyond Donbass (incidentally, Biden's much criticized remarks noting a qualitative difference between an incursion on the Donbass and Ukrainian proper are 100% accurate; he has been forced to walk it back for political reasons, but it is very encouraging he said it in the first place as it means he does seem to understand the situation described above. This is perhaps why the Biden administration now appears to be pushing the Ukraine to implement the Minsk Agreements; maybe Putin got through to him, though of course he will never admit that publicly to US audiences as he would be politically crucified). I think this risk has now fallen significantly given the Russian military presence and US-Ukrainian dialogue, though Zelensky could always do something imprudent/stupid.<br /><br />*Secondly, US & NATO allies continue to heavily arm the Ukraine, and Russia concludes it is inevitable that the Ukraine will eventually try to seize the Donbass with (covert) NATO backing. Putin fears the longer he waits, the harder it will be to secure the Donbass and the bloodier the eventual conflict will be, and feels that in the long term it is better to annex the Donbass now (or secure its independence) than wait. This is the scenario I have been most concerned about from an investment perspective over the past several weeks, as it would entail inevitably brutal sanctions. It would likely result in very little bloodshed though as it is unlikely at this point that the Ukraine will want to go to war over the Donbass; they will inevitably lose. In addition, there will be no local opposition - indeed the locals will likely overwhelmingly support Russia taking this action. </p><p>However, the probability of this scenario has now significantly fallen, because the likelihood of the Ukraine implementing the Minsk Accords - on account of US pressure - has now gone up. Furthermore, if the US public is opposed the the US involving itself in yet another war, this approach from the US makes political sense for Biden. He will also be able to claim credit for averting conflict by claiming his threats of tough sanctions successfully deterred Russia from invading, while he works behind the scenes to give Russia what it wants.<br /><br />*Third, NATO encroaches into Eastern Ukraine and begins to deploy missile systems and military bases in violation of Russia's now declared "red lines". In this case conflict between Russia and NATO will likely occur, as at this point I think Russia has had enough and will be willing to go to war to defend these red lines. However, *the West is not* - at least for now - and I think Russia's threats - though they will not be acknowledged publicly - have been noted privately and are seen as credible, and so I don't think NATO will dare do that in the foreseeable future. I see this risk as being off the table for quite some time, but it is a long term risk and a tension that will likely resurface again at some point.</p><p><br />Overall I think the risk of conflict has fallen significantly in recent days, assuming that news reports about the implementation of the Minsk Agreements are in fact true, and there is follow through from the Ukraine. That remains to be seen. Events are fluid so my assessments may be proven off base in the future, and these are complex issues where the capacity for analytical error is high, but this is my best analysis and assessment of the current situation. I hope some readers found it useful, and I especially hope it can contribute in at least a very small way to reduced tensions/risk of war between the two blocs.</p><p><br /></p><p>LT3000</p><p><br /></p><p>1. Russia did annex Crimea, but that was an unusual situation. Crimea hosts Russia's highly strategic Black Sea navel base, and was on long term lease from the Ukraine. After the Ukrainian coup, Russia feared Ukraine would be incorporated in NATO, Russia's lease invalidated, and access to this highly strategic military base denied. There was no invasion per se because the Russian military was already there. The annexation happened pursuant to a referendum which attracted 95% support (Crimea is overwhelmingly Russian). While some have argued that number cannot be trusted, no international body/institution or Western politician has ever dared request an internationally supervised re-vote, because they know what the result would be and it would risk legitimizing the annexation. It was a breach of international law, but it is highly unlikely to recur because no other part of the Ukraine (or broader ex Soviet Union for that matter) holds a comparable degree of military significance. If Russia was after territory it could have annexed Donbass as well, but it chose not to.</p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-70357058886331114512022-01-20T10:35:00.022+07:002022-01-31T07:31:45.554+07:00Taking (slight) issue with Graham's "weighing machine"; and unpacking "intrinsic value"<p>In this post, I thought I'd kick off the new year with some minor sacrilege, by taking slight issue with some of Ben Graham's most-quoted ideas. Ben Graham very famously asserted that "in the short run, the stock market is a voting machine, but in the long run, it is a weighing machine". However, when subsequently asked what the specific mechanism was by which stocks were, in time, pushed towards their fair, weighted value, Graham was unable to specify one (though a quick Google for the specific quote did not yield a source I can supply here).<span style="font-size: xx-small;">1</span> He also advocated for the disposition of positions after a specified holding period, should the said appropriate re-weighting fail to transpire (2-3 years from memory).<span style="font-size: xx-small;">2</span> As I will discuss, this is not a policy/framework I agree with. <span></span></p><a name='more'></a><p></p><p>Though Graham's insights were profound for his time, and his thinking remains exceedingly useful, on this issue I see things somewhat differently. In my opinion, in the short run, the market is indeed a voting machine, but in the long run, the market is also a voting machine. The market is always a voting machine, though the number of available ballots to cast is influenced - amongst other things - by Fed policy and the liquidity environment (when the Fed prints money, there are a lot more buy votes that can be cast, and vice versa). Furthermore, the long run is comprised of a series of sequential short runs, and whatever the relevant moment in time - now or in the future - it is the short run for those actively investing at the time. There is no magical transition point where the short run becomes the long run.</p><p>Nevertheless, fundamentals and "intrinsic value" absolutely do matter in the long run - indeed in the very long run, they are <i>all </i>that matter to aggregate investment results. As a long term value investor, if you get the fundamentals and your value assessments right (and do not do anything stupid along the way, such as being scared into untimely liquidations; i.e. have the right "temperament"), your realized returns will steadily trend towards those of the underlying businesses you hold relative to the prices you paid for them, and the "votes" of the investment community will become increasingly irrelevant to your reported marked-to-market investment results. How do we resolve this apparent inconsistency?</p><p>The answer requires a preliminary understanding of the fact that stocks have intrinsic value (at least those companies that can reasonably be expected to pay out at least some cash in the future); and that the "intrinsic value" of a stock - on my definition - is simply the present value of future <i>distributed </i>cash flows, with the discount rate being the market-clearing cost of capital on long duration assets (which I have argued in the past is ever changing and often volatile). Alternatively (and perhaps superiorly), the intrinsic value to <i>you </i>is the discount rate you apply to those cash flows that reflects some combination of the return you would like to earn, and the opportunity cost of your capital (the next best available opportunity). In this latter respect, the level of intrinsic value may therefore differ between investors depending on their own costs of capital (personally, I focus less on "intrinsic value", and more on my estimate of the IRR-based cash flow return I expect to earn over time from holding an asset). </p><p>Many investors incline towards assessing intrinsic value based on cash flows at the corporate level. However, I think that only makes sense if you own either a controlling interest in a company, or at least one with significant potential influence (or where you are confident management will implement optimal capital allocation choices). If you are a small minority holder without any capacity to influence the capital management policies of a company, you are stuck with whatever capital allocation decisions management makes on your behalf, both good and bad. Consequently, for minority investors, I think it makes far more sense to value a stock based on the present value of future <i>distributed </i>cash flows - after all, that is the cash you get in <i>your </i>pocket, so it is what the stock is intrinsically worth <i>to you. </i></p><p>Importantly, this means that assessing the likely capital management decisions management will make in the future is as important to assessing intrinsic value as the business itself. You can offset a lot of (slow and steady) organic cash flow generation with one or two large capital allocation mistakes (witness the outcomes AT&T investors have endured over the past decade, for instance).</p><p>What the existence of this (practical) intrinsic value means is that, as time goes by, more of your initial investment will convert to cash-in-your-pocket as companies earn profits and pay out dividends, while the "discount rate" embedded in your valuation will steadily unwind, ultimately translating into your return (assuming no analytical errors have been made). Consequently, in the long run, what happens to the share price becomes increasingly irrelevant to your overall returns as more and more of your investment converts to cash; i.e. potential is steadily translated into actual. <i>This </i>is ultimately why in the long run, value investing works regardless of prevailing market prices. The "weighing" component of your return - cash in your pocket - manifests over time even if the "price" component remains forever hostage to market votes.</p><p>This view stands in contrast to how many investors see value investing, and the mechanism by which value investors putatively generate their returns. Many if not most investors believe that value investors make their returns by buying a stock at 8x, waiting for it to re-rate to say 12x, and then selling it and buying something else at 8x, etc, and to be fair, there are definite elements of this approach evident in Ben Graham's thinking. This often gives rise to the belief that value stocks need a "catalyst" to generate a return, and don't generate "compounding" returns. After all, if it stays at 8x, how do you make money?</p><p>But arguments such as these implicitly ignore the very existence of intrinsic value - i.e. that there are actually cash flows associated with holding the asset, which justify its price (or should). Indeed, the right to receive future cash flows (dividends) is the very thing that gives a stock value in the first place, and it is those entitlements that are traded in the open market every day. You can exchange $27 in cash today for the right to receive the future per share dividends AT&T pays (for example), or if you're an existing holder, you can trade out those dividend rights for US$27 in cash today. At base, that is really all that is happening in stock markets, and what investing is all about (or should be). If you get your analysis right, and buy a stock on an attractive dividend-based IRR, you can earn a quite satisfactory (and compounding) return without any multiple re-rate whatsoever. You simply hold the stock, collect the dividends, and compound your money over time by reinvesting those dividends.</p><p>What differentiates an asset with intrinsic value from one without (such as Bitcoin) is that <i>assets with intrinsic value will generate value/put cash in your pocket over time even if you can never sell them</i>. Consequently, you can "buy to keep", and are not reliant on the asset's resale value to yield a satisfactory return. Indeed, you are free to completely ignore the price and deem it a total irrelevance, aside from the potential it may offer you to buy more or sell opportunistically at an advantageous price.</p><p>With this context understood, let's delve into the question that befuddled Graham about the specific mechanisms by which stocks seemingly move towards their intrinsic value over time. The first mechanism by which prices may rise is simply that there are a lot of investors constantly circling around in markets looking for bargains, and if something is genuinely cheap, it is probably only a matter of time before someone (or a group of someones) discovers it, buys stock, and pushes up the price. This may give the appearance of being a "weighing" process, but at base it is actually still voting, and there is no inevitability it will happen. But given a long enough passage of time, it is probable that at some point people will vote "correctly" enough to push the price to levels that approximate or exceed fair value.</p><p>However, a second and perhaps more relevant mechanism by which it can happen is that companies pay dividends, and when companies do, their holders will have additional cash resources at their disposal which they may use to purchase more shares. Some will not, of course, for a variety of reasons, but a portion of the investor base likely will - particularly if the stock is cheap - and if they continue to reinvest their dividends over time into the purchase of ever more shares, the forces of compounding will eventually manifest and be sufficient to start pushing up the share price. Moreover, the greater the disparity between intrinsic value and the share price, the more quickly this process can reasonably be expected to occur, because reinvestable cash distributions relative to the company's share price/market cap will be correspondingly larger. If a company were to get forever cheaper, eventually the dividend yield would rise to 10%, 15%, 20%, and 25% etc, and there would simply be too much reinvestment demand to keep prices that low indefinitely.</p><p>It is the existence of distributed cash flows that generates a necessary linkage - within a wide range to be sure - between what price a stock can realistically trade at for any sustained period of time, and its underlying intrinsic value. If a stock were to fall to 1.0x earnings, 0.5x earnings, or 0.1x earnings, for instance, any amount of dividends and/or buybacks would quickly create a vast excess of buying power in the market over the supply of available shares that would overwhelm any ongoing negative "votes". This is why, over time, as per share business value accumulates, the share price will of necessity eventually be dragged up along with accumulating intrinsic value; "weighed", as it were. But it will continue to trade in a wide range round that value, the price always hostage to short term votes.</p><p>By contrast, assets that lack any distributable cash flows (which include buybacks as well as dividends) do not have any mechanism to enforce an ultimate linkage between the share price and underlying intrinsic business value. Such stocks can (and often do) remain perpetual voting machines, for sometimes extraordinary lengths of time, if not indefinitely. But people do not cast votes in ways that wholly disregard the likely capacity and willingness to pay future dividends/institute buybacks. This is why Berkshire, for instance, always traded fairly close to intrinsic value, despite never paying a dividend and only recently instituting buybacks of consequence. Investors knew that Buffett would eventually buy back stock if the stock got cheap enough, and cast their votes accordingly. </p><p>However, suppose for the moment they hadn't cast their ballots in such a way, and Berkshire had traded down to ever cheaper levels. What would have happened is that Buffett would have bought back loads of stock, and that would have created the necessary transmission mechanism between underlying intrinsic business value and how the share price traded. In other words, <i>irrespective of the voting behaviour of market participants</i>, Berkshire's share price would ultimately end up tracking underlying value over time, and thus give the appearance of acting as a "weighing machine".</p><p>However, a problem emerges when there is no such connection/transmission mechanism between intrinsic business value and the underlying stock price because there are no distributed cash flows, nor any reasonable likelihood of them. This is a problem that has manifested in many value stocks in markets such as HK, Japan, and South Korea, where many family run companies have had a tendency to stockpile cash on balance sheet for years or even decades on end, rather than paying it out or buying back shares. In such cases, stock prices remains forever dependent on the whims of investors' voting behaviour, because there is no causal mechanism by which the share price can interconnect with its underlying business value. And many value investors in such markets have discovered, to their dismay, that the promised weighing machine never seemed to arrive, even after a decade or more. </p><p>Graham seems to have resolved this issue by simply declaring an arbitrary time-based cut off point for holdings, beyond which he would simply sell the stocks (for instance after 2-3 years had elapsed). However, a better approach, in my view, would be to understand the above mechanisms by which intrinsic business value is transmitted into share prices, and to define value based on the level of <i>distributed cash flows</i>, rather than at the corporate level. There would then be no need to dispose of stocks after an arbitrary period if they had not gone up, provided sufficient cash was being distributed (or was likely to be distributed); while stocks with poor capital allocation yielding intrinsic values to minority holders far below intrinsic business value to a controlling party, might be more readily avoided at the very outset.</p><p>Incidentally, it is often argued that such stocks are cheap and are merely awaiting a "catalyst" for investors to "recognize the value". But the problem with this way of thinking is that it ignores the fact that capital allocation is itself an essential ingredient of intrinsic value, and especially when you define intrinsic value in the way I have - the discounted value of future <i>distributed </i>cash flows. When companies are managed in this way, they are actually <i>actively destroying value </i>through poor capital allocation choices, and share prices should reflect not just underlying business/balance sheet value, but also an assessment of the likely value creation/destruction that will be entailed by future capital management choices as well. This "present value of future minority shareholder wealth destruction" absolutely should be included as part of the valuation process, and if a company's capital allocation choices have been poor in the past and are likely to remain poor in the future, in many cases the problem is not a lack of a catalyst, but that the stock is not actually cheap in the first place. </p><p>Graham has made an immeasurable contribution to the modern day value investment cannon, and unlike most investors/commentators today, made unique contributions to the field rather than merely copying and implementing what those before him had done. He virtually single handedly birthed the very notion of value investing. However, sustained investment success comes to those who think for themselves from first principles, rather than who devote themselves slavishly to the preachings of others, and Graham did not have the luxury of standing on the shoulders of giants, as those that came after him did.</p><p>This can be seen quite clearly in the evolution of Warren Buffett. Though Graham accelerated the development of Buffett's investment thinking immeasurably, and for that Buffett remains eternally grateful and feels forever in Graham's intellectual debt, Buffett did not forever slavishly devote himself to a set of ideas as if it were timeless gospel. He instead took what was useful of Graham's teachings, thought for himself, and developed his own ideas atop the foundation Graham had laid. I think a willingness to do so is an essential prerequisite to sustained investment success.</p><p><br /></p><p>LT3000</p><p><br /></p><p><i>Postscript: Subsequent to publication, a Finnish blog reader helpfully emailed me the specific sources/quotes referenced in the first paragraph: </i></p><p><i><br /></i></p><p><i>1. <span lang="EN-US">“</span><span lang="EN-GB">The rediscovered Benjamin Graham” by
Janet Lowe (1999) pp. 139-140, Testimony before the committee on banking and
currency, United States senate, March 11, 1955</span></i></p><p class="MsoNormal"><span lang="EN-GB"><i>Senator:
[How is the process of value appreciation of undervalued securities brought
about?]<o:p></o:p></i></span></p><p>
</p><p class="MsoNormal"><span lang="EN-GB"><i>Graham:
”That is one of the mysteries of our business, and it is a mystery to me as
well as to everyone else. We know from experience that eventually the market
catches up with value. It realized it in one way or another.”<o:p></o:p></i></span></p><p><br /></p><p>2. <i>Ibid, p263</i></p><p><i>"You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn't met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price."</i></p><p><br /></p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-50823247432943340772021-05-13T13:00:00.041+07:002021-05-13T13:50:45.155+07:00Tech, inflation, and the tyranny of the numerator<p>Over the last three months, market inflation fears have increased - and not without good cause, given the increasing number of companies reporting supply shortages, cost pressures, and price increase, and the recent US CPI print coming in at 4.2% - which has pressured the share prices of tech/growth stocks in particular (and to a lesser degree, the broader market). US 10 year treasury yields have risen from 0.9% to 1.7% this year, in fits and starts, and tech and other narrative-driven growth stocks have come under pressure with sell-offs correlating with higher inflation concerns and rising treasury yields.<span></span></p><a name='more'></a><p></p><p>This behaviour has confused some investors, who often argue that stocks are real rather than nominal assets, and that tech companies ought to have the ability to pass through inflation into higher prices. The most common explanation you hear for the correlation between rising treasury rates and inflation expectations, and falling tech stock prices, is that high multiple growth stocks have longer duration cash flows, such that when discount rates increase, the valuation consequences are larger than for shorter duration "value" stocks. While this is somewhat true in theory (it would only apply to higher <i>real </i>discount rates, not nominal ones), in my submission this is not the real reason for the financial market behaviour we have been seeing.</p><p>Financial market asset pricing is a real world, concrete thing, not an abstract academic one, and greater cash flow durations associated with growth stocks is a theoretical rather than practical construct. In the real world, asset pricing is determined by one thing and one thing alone: the concrete interaction of demand and supply in financial markets. It is therefore factors that change demand and supply that drive prices rather than the fundamentals per se, and consequently, it is how inflation impacts demand and supply that will determine financial market outcomes. </p><p>When people argue that stock prices "shouldn't" theoretically fall due to them being real assets (true but only to some extent - mostly for capital light businesses; see my post <a href="https://lt3000.blogspot.com/2019/08/why-pe-multiples-are-justifiably-lower.html">here</a> on why inflation leads to lower P/E ratios and increases effective real tax rates), they also make the same mistake as when people argue the economy is weak so share prices shouldn't be going up; or that earnings/growth is strong so stock prices shouldn't be going down. These perspectives all suffer from what can be described as the "tyranny of the numerator" - the idea that the only or primary driver of asset prices is peoples assessment about the level of cash flows. But the denominator - the cost of capital, which is determined by the forces of demand and supply - often has a much larger practical impact on asset pricing than numerator effects in all but the very long term. </p><p>While fundamentals, earnings, growth, the economy, and returns on capital etc of course all matter a great deal to what stocks are "worth" long term, asset prices are highly sensitive to perturbations in the cost of capital, and the cost of capital in turn is highly sensitive to perturbations in the demand and supply for capital, just like the price of oil is highly sensitive to ever-changing demand and supply conditions. Furthermore, core fundamentals tend to change relatively slowly, but the cost of capital can fluctuate wildly in the short term, and it is variations in the latter that is the primary determinate of asset price volatility. </p><p>The cost of capital I'm describing here is also not an academic WACC that goes into investors' DCF valuation models, but rather the outcome of the real world interaction of demand and supply in financial markets. In the aggregate, investors have a certain amount of "liquidity" (cash and readily available liquid investments like bonds and stocks) at their disposal, and they have a certain menu of liquid assets they can invest in (cash, T-Bills, bonds, stocks, etc). The interaction of these two forces of demand and supply is what determines the aggregate level of asset pricing. Numerator effects are still important (what are the cash flows), but denominator effects determine the multiples with which those cash flows are capitalized, which has an outsized role in price fluctuations. </p><p>Investors can and do compare the cash flow numerators amongst different assets, and size up their relative attractiveness. Investors might determine they want to sell a bit of Google and add a bit of Facebook, or sell some bonds to increase their ETF allocations, etc. Consequently, numerator effects have a significant influence on the <i>relative </i>valuations of assets/asset classes. However, this process cannot be extrapolated to the emergent <i>absolute </i>level of asset pricing in general, where denominator effects often play a more decisive role. Individual investors can choose to own less Google and more Facebook, or more/less bonds and more/less ETFs, <i>but they have to hold something</i>. </p><p>The cost of capital falls and asset prices rise when there is excess liquidity - i.e. a situation where there is too much cash chasing too few financial assets/places to park that capital (this is the financial/asset price equivalent of real economy goods and services inflation, where there is too much money chasing too few goods and services). This can create a bull market which has little to do with investor expectations per se - on either the economy, earnings, growth, or much of anything "fundamental". It can simply reflect the forcing function of the weight of excess liquidity. This reality is often overlooked, leading to sometimes puzzling moves in financial markets to those suffering from the tyranny of the numerator.</p><p>Investors like Grantham for instance, look at rising markets and historically-high valuations and conclude that it is because investors are too optimistic on the economy and earnings (numerator effects), or surmise that there is an "everything bubble", when in fact this situation can exist even if everyone is bearish and pessimistic on the outlook for returns, simply because there is too much capital chasing too few assets, and the ever-volatile market clearing cost of capital has fallen. It is strongly arguably that you cannot have an "everything bubble"; the capital market overall simply reflects the market clearing price of available liquidity and the availability of investable assets, and at a system level, investors have to own something. You can therefore have bubbles in certain assets or asset classes, but not in the capital market as a whole. Excess liquidity will drive asset prices up <i>regardless </i>of whether people are bullish, bearish, or believe asset prices are cheap, expensive, or should or should not be going up. </p><p>This is particularly the case when the returns to holding cash are negative in real terms. Sure, you might prefer 10% equity returns. But if the market is only offering you 5%, your choice is to either accept the market-clearing return of 5%, or get nothing (or -2% real in cash). You can wait and hope markets offers you 10% in the future, but if the market clearing cost of capital remains at 5% (or worse, declines to 4%, or 3%, etc), every year you wait loses you 7%+. You have priced your capital out of the market, just like an employee who wants $30 and hour but where the market rate is only $15, is unable to get a job, and so gets nothing. </p><p>Holding cash is "prudent" in some respects, but in other respects, you're simply taking a bet that markets will offer you a better return in the future than they do right now. It's a gamble you may win or lose. Because of this - and the fact that the longer investors wait without the cost of capital rising, the more money they lose - the forcing function of excess liquidity will act to drive asset prices up, because those that wait get penalized/suffer (and may be subject to redemptions, for instance, for underperforming), and so one by one, investors and available liquidity is slowly drawn/forced into the market.</p><p>As I have noted in the past, the world does not owe capitalists a high return on capital, and there is no rule of the universe that says the market clearing cost of capital in the future will resemble what happened to be the average market clearing cost of capital in the past, any more than the market clearing price of oil ought to reflect the average demand and supply curves in past eras. It doesn't work that way. Times change, and the demand and supply balance changes with it. The cost of capital is not fixed, but constantly evolving to reflect ever changing real world conditions. It's a volatile, practical concept, not a fixed, academic one. Investors who suffer from the "tyranny of the numerator" often overlook this fact, positing a fixed cost of capital and attempting to attribute all changes in financial market prices to changing assessments of the numerator. But that's not the way real world financial markets work.</p><p>Consequently, the real reason rising inflation is a risk to asset pricing - and tech and growth stocks in particular - is because of the fairly dramatic impact it could have on the market clearing cost of capital as compared to the status quo ex ante. It could cause a significant change in the demand and supply balance, and if it does, the level of prevailing asset price equilibrium will significantly change. </p><p>At present, the Fed is printing US$120bn a month to buy treasuries, as it has been doing since the onset of the pandemic. Meanwhile, the US government is running large fiscal deficits, driven by (amongst other things) large stimulus cheques being mailed out to the broader populous. For the first time since the 1970s, this represents the Fed monetizing the fiscal deficit in size, and engaging in de facto "helicopter money" policy via fiscal intermediation. When consumers receive their stimulus checks and go out and spend the funds in the real economy, that is functionally equivalent to helicopter money.</p><p>This US$120bn per month expansion in the money supply has flooded financial markets with extra liquidity. In the absence of this QE/deficit monetization, every US$120bn of US government fiscal stimulus injected into the system would need to be offset by US$120bn of liquidity being withdrawn from financial markets by investors/institutions acquiring US$120bn of new primary treasury bond issuance. However, because the Fed is printing and funding the fiscal deficit directly, no such offset exists and US$120bn a month in additional liquidity is being created and pumped into financial markets. If there is not enough newly issued financial assets available to absorb this liquidity creation, asset prices will have a tendency to rise as the demand for financial assets will exceed the available supply. <br /></p><p>This happens by the mechanism of investors competing with each other to get rid of cash. System cash levels increase by US$120bn a month. The money comes from a combination of (1) bond market investors selling bonds to the Fed, and now having cash in their accounts looking for alternative investments; and (2) stimulus checks funded by the Fed, which consumers can spend and/or deposit in their RobinHood or CoinBase accounts and use to participate in financial market speculation.</p><p>As this waterfall of cash has cascaded through financial markets looking for a home, it has started to flow into every nook and cranny, pushing up asset prices. Investors desperate for any sort of return on their cash will hunt high and low looking for any reasonable place to put their money, pushing asset prices up across the board. This is the "denominator effect" of an excess supply of liquid capital in action, and the apparent bull market it creates can have little to do with people's view on the economy, earnings, and valuations per se (though rising prices can themselves temporarily improve economic fundamentals and have a favourable psychological effect on markets). And the denominator effect of a precipitously falling cost of capital is amplified because the real return on cash is now negative, so at a system level, the base cost of capital is now in some respects zero or even less than zero.</p><p>The financial sector is in the business of manufacturing new financial product to absorb excess financial market liquidity, and once again it has dutifully responded. This is why investment banks are currently generating record earnings. This has manifested of late primarily in the form of a SPAC IPO boom, as well as rampant other tech stock issuance, which has absorbed hundreds of billions in liquidity. This increase in supply is another reason why tech stocks have started to come under a bit of pressure of late - some excess liquidity has being absorbed. However, the SPAC IPO boom has still been inadequate to absorb all of the liquidity being created by the Fed. This is why we have seen spillovers into a new cryptocurrency boom, as well as an NFT boom, etc. There is too much capital chasing too few places to invest, so new assets are being manufactured to absorb the excess - including phantom digital assets.</p><p>This dynamic has gone on for some time already and has pushed asset prices in certain parts of financial markets to extremely high levels, with the speculative excesses concentrated in tech/thematic growth areas of the market, as well as crypto. Consequently, from this starting point, any perturbation in the environment that pushes up the cost of capital and tips the system from one of an excess liquidity to one of shortage (at the margin), will lead to a radical decline in asset pricing. Suddenly there will be too many financial assets chasing too little liquidity - the opposite of the prior situation, which will create a tendency for prices to fall rather than rise, as capital starts to be rationed. <i>This will happen regardless of the "fundamentals", like growth rates, profitability, etc.</i></p><p>The decline in aggregate asset prices this would trigger would have little to do with investor expectations, or long term fundamental concepts like cash flow duration, or the ability to raise prices with inflation. These concepts matter long term to value investors, but they don't impact financial market asset pricing over the timeframes that most investors care about. </p><p>So why are tech stocks the most vulnerable? Because in parallel with the above general dynamics in asset markets, the tech/software/thematic growth sector has been the overwhelming recipient of liquidity largess in recent times, which has led to exponential gains and driven prices to extraordinary heights, driven by the liquidity flywheel dynamics I have discussed in <a href="https://lt3000.blogspot.com/2020/07/market-inefficiency-liquidity-flywheels.html">past posts</a>. High-profile cheerleaders like Cathie Wood of ARK have contributed to a gush of retail money rushing into speculative growth areas of markets, while other growthy managers have also ridden momentum-driven returns to large inflows. </p><p>The inward rush of liquidity has manufactured giddy headline returns, driving yet more performance-chasing inflows in a world with too much capital and too little available return, pushing prices to the stratosphere. Most of these gains have been attributed to disruptive innovation, growth, and accurate foresight of secular trends, whereas in reality they have been almost entirely driven by liquidity. </p><p>Consequently, if the liquidity balance were to change, the areas of markets that have been the disproportionate recipient of these liquidity excesses would logically be the most vulnerable to a re-equilibriation. All asset prices will suffer, but areas of excess will suffer the worst. <i>This </i>is the real reason why tech/growth share prices have been highly sensitive to developments with respect to inflation and bond yields of late - investors are aware of the degree to which excess liquidity has inflated valuations, and the degree to which prices could fall should we see a liquidity "regime change".</p><p>Importantly, system liquidity has <i>not yet meaningfully tightened </i>(the size of the fiscal deficit has increased vs. constant Fed purchases, absorbing some additional liquidity, but overall the Fed is still printing aggressively) but investors are anticipating/fearing it could, which may lead to a catastrophic bust. Volatility has been high, because investors are torn between not wanting to jump off the momentum train too early on the upside, but also not wanting to be caught in a liquidity downdraft, driving heightened sensitivity to new data points. In addition, as noted, the SPAC IPO boom, as well as the manufacturing of alternative speculative assets - crypto, NFTs, etc - has also absorbed some of this excess speculative liquidity, which has contributed somewhat to the recent pull back in pricing as well. </p><p>So how exactly will higher inflation change the market clearing cost of capital? First and most obviously, it will likely force the Fed to change policy course. If inflation were to rise to >5% and start to become entrenched in that range amidst a self-sustaining cost-push spiral, the Fed would need to raise rates, stop printing money, and maybe even begin to shrink its balance sheet. The prior net injections of liquidity would turn to a net withdrawal. Even if it were to simply stop printing and not shrink its balance sheet, financial markets would then need to fully absorb large primary government bond issuance to fund record deficits, which would push up treasury yields and absorb a growing amount of the system's excess liquidity. If the Fed started to shrink its balance sheet - we could see capital markets going from being in an excess liquidity position to a shortage (at the margin), leading to a substantial spike in the market clearing cost of capital. This could have devastating consequences for asset prices in areas of prior speculative excess - even before considering likely second-order consequences.</p><p>The issue with inflation is that it is difficult to get started, but once started, it can be equally difficult to stop. This is because there are many prices in the economy that are contractually or regulatorily linked to CPI. If CPI increases, many prices reset to reflect higher inflation (e.g. regulatorily allowable prices/returns on infrastructure assets, etc). This can lead to a cost-push environment where high CPI leads to compensatory price increases that sustain that high CPI. In addition, in an environment of increasing labour shortages, bargaining power can shift to employees who can demand pay rises to compensate for higher inflation. If expectations for 5-10% annual pay increases to offset inflation become entrenched, it can get to the point where breaking the back of inflation can become extremely difficult; companies keep raising prices to offset the higher cost of labour, in a vicious circle. A weakening USD would also increase the cost of imported commodities and manufactured goods. Only a Volcker-esque dramatic tightening and a devastating multi-year recession would break it. </p><p>Is it possible that the Fed would sit by with 0% rates and continuing QE/money printing even with inflation at 5-10%? Anything is possible, but the Fed is currently required to target inflation, and it will be difficult to justify continuing to print money if inflation rises significantly above its 2% target for a sustained period. In addition, at worst, a checkmate situation can develop where rising treasury yields in response to higher inflation leads to an increase in the fiscal deficit, as financing costs rise. If the Fed tries to buy even more bonds to control the increase in rates, it can lead to even higher inflation by monetizing an even higher fiscal deficit. This is how hyperinflation happens in emerging and frontier economies - a lack of fiscal restraint and rising financing costs lead to accelerating fiscal deficit monetization by the central bank to avoid default. I am not that pessimistic, but I do believe the Fed will not be able to ignore inflation printing at 5% or more and will be forced to take at least some action. </p><p>However, even if the Fed does not change course, higher inflation can still lead to asset prices dropping significantly - particularly in real terms - via other means. Inflation reduces the real value of nominal assets like cash and fixed rate bonds, which get inflated away if rates remain low and inflation rises. As the real value of the liquid capital stock declines relative to the stock of real assets, the <i>real</i> cost of capital will rise as the demand and supply balance changes, and given the sensitivity of asset prices to the cost of capital, this impact is likely to exceed the impact of higher nominal earnings - particularly because the associated economic fallout will pressure real ROEs. </p><p>These dynamics would eventually drive up both real and nominal market-determined interest rates and costs of capital (e.g. on corporate bonds), and this can have a profound impact on the valuation of the levered-asset complex - notably real estate and private equity - because the carry cost of assets goes up. It is not a coincidence that if you track property rental yields by country and by decade, there is a high degree of correlation with interest rates. That's because interest rates reflect the financing "carry cost" of property. If rates are 3%, you can borrow at 3% to fund a purchase, and so have a self-funding property at a 3%+ rental yield. At 10%, you need a 10% yield lest you run significant negative cash flow.</p><p>The challenge for asset prices is that if inflation goes from 2% to 7%, mortgage rates charged by banks might go from 2% to 7%. Yes, your rent might now increase by 7% a year instead of 2%, but it will take 10yrs for the nominal rent to double at 7% per year, whereas your funding costs can go up 3.5x from 2% to 7% in a short space of time (even if holders have long term fixed rate financing, the <i>marginal </i>buyer would need to pay 7%, and asset prices reflect the marginal buyer's willingness and ability to pay).</p><p>Leveraged assets cannot run that degree of negative carry. Consequently, the price of the assets could go down by 60% even though in theory, the property is a real asset that is inflation protected (this is also not to mention that significant economic fallout associated with a rise in rates and decline in asset prices can and often will lead to significantly reduced real earnings/rentals). This is an example of how asset prices are determined not theoretically, but by the practical interaction of demand and supply, and the availability of liquidity and credit relative to the availability of assets.</p><p>The whole structure of financial markets and asset pricing - from bonds, to stocks, real estate and private equity - now reflects a widespread expectation and equilibrium asset pricing environment that assumes inflation and rates will remain perpetually low. Irrespective of what impact inflation theoretically "ought" to have on asset prices, if inflation and rates meaningfully rise, a huge cat is going to be thrown amongst the proverbial pigeons with significantly negative consequences. </p><p>I've discussed in <a href="https://lt3000.blogspot.com/2020/05/coronavirus-update-from-unknown-unknown.html">past blog articles</a> about known unknowns and unknown unknowns, and major sell-offs typically occur when a new unknown unknown emerges - a risk factor not previously factored into investor expectations and positioning, and which create a sense that we are moving into uncharted territory. An outbreak of inflation will likely be one such instantiation, and it is difficult to imagine that it will not have fairly dramatic consequences for asset pricing and the economy were it to occur.</p><p>Will it actually happen? I don't know, and don't think anyone can know for sure. However, what we can say with assurance is that the risks are very significant, and in my assessment, the Fed is showing an unhealthy degree of complacency with respect to these risks, that is now beginning to cross the border into outright recklessness. The Fed's policy settings are the same today as they were in March/April 2020 at the absolute peak of the covid crisis, and yet at present the US economy is booming; labour and input cost shortages are rife; and a large number of companies are talking about significant cost pressures and intentions to increase prices. It is quite remarkable the Fed still believes ultra-emergency policy settings are required in this environment. Yes, there are "risks to the outlook", but there are always "risks to the outlook", and that does not justify taking extreme measures "just in case". </p><p>The Fed is playing with fire, and if they get this wrong and inflation goes to 5-10%, they will likely engineer one of the worst recessions and financial crises in the past 100 years. It seems to be a remarkable misjudgment of the risk and reward associated with the current policy course. Given that central bank behaviour - as well as fiscal excess - has become steadily more and more extreme over the 13 years since the GFC, as complacency about inflation risk has grown, it was perhaps always only a matter of time before things were eventually pushed too far. If this trajectory continues, whether it is this cycle or the next, we are likely to eventually end up with high inflation environment with meaningful fallout. It may take such an outcome for central banking to undergo some much needed reform.</p><p><br /></p><p>LT3000</p><p> </p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-33303243652717320582021-04-23T13:52:00.102+07:002021-04-27T10:18:26.157+07:00Elon Musk; Simulated Universes; Moore's Curse; The Fermi Paradox; Mars colonization; and Technological Hubris<p>Overall, I'm a fan of Elon Musk. He is smart; articulate; a great innovator, engineer, and entrepreneur; an incredibly hard worker; and in many ways a very inspirational figure - someone willing to try bold new things and tackle difficult problems. Oftentimes controversial, to be sure, but a net force for good in the world. The world needs more people like Elon Musk. As I've commented in the past, Musk is the virtual embodiment of George Bernard Shaw's quote: "The reasonable man adapts himself to the world: the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man". Musk is the paradigmatic unreasonable man.<span></span></p><a name='more'></a><p></p><p>However, as I've also commented in the past, while progress may depend on the occasional, unlikely success of the unreasonable man, more often the unreasonable man is forced to adapt themselves to reality. One of the reasons why opinions on Musk are so divided - apart from his sometimes controversial approach to business and regulatory compliance, and his "fake it till you make it" tactics in building Tesla - is that he comes across as an absolute genius to those of limited technical understanding, but to domain experts, some of what he says/believes seems to be highly questionable, if not at times borderline fraudulent/wilfully misleading. </p><p>In my view, the truth is somewhere in the middle of the two extremes of opinion - adulation and skepticism/condemnation. Without doubt, Elon is a fantastic entrepreneur; engineer; and business builder. A lot of what he has achieved has come from successfully raising capital (as well as investing in his own), often at what are de facto negative costs of capital; hiring a lot of smart people; and then inspiring them with BHAGs (Big Hairy Audacious Goals). He has also managed to inspire customers and charmed his way to receiving special treatment from regulators, as well as generous EV subsidies/policies, which have worked to his advantage. He is clearly a very competent engineer and creative problem solver, but his breadth of technical and scientific knowledge is not without its limits, and is also constrained by the fact he works 100 hours weeks. He has learnt a lot about electric cars and rockets, but he isn't necessarily an expert on other areas of science, and like everyone, he has blindspots.</p><p>One of Elon's greatest strengths is also his greatest weakness - his tendency to view things through the prism of sci-fi, and one sometimes gets the sense he may have read a little too many sci-fi books for his own good. On the positive side, a sci-fi frame of reference allows him to dream of possibilities others don't, and pursue innovations others wouldn't. He dares to be unreasonable, and sometimes through a combination of good fortune and sheer force of will, may succeed in innovating his way to actualizing those ambitions. But many other times he won't, and will end up pursuing ventures doomed to fail right from the start, because he analyzed things through the prism of sci-fi rather than economics and energetics.</p><p>As cool and powerful as technology is, <i>economics have always trumped technology, and always will</i>. The reason we don't have flying cars is not because we lack the technological capabilities as a species to make it happen. It's because of economics, including energy economics (energetics). It is simply far easier and more energy efficient to roll something along the ground than it is to elevate it and sustain that elevation. The costs of doing so far exceed the benefits. </p><p>A couple of people can push a car along a flat even surface up to a speed of perhaps 5-10km/hr. How many people would it take and how much energy would it require to lift a 2MT car just one meter above the ground and carry it at a speed of 5-10km/hr? Orders of magnitude more. That's why we don't have flying cars (other practical issues exist too, including noise pollution and safety, but economics is the main barrier). We don't have an unlimited amount of energy, and it's far from free.</p><p>This is the same reason why commercial air travel speeds have plateaued at around 900 km/hr, and the supersonic carrier Concord went out of business. It's not due to a lack of technological capability (fighter jets fly much faster than that). It's because 900 km/hr is aerodynamically the most energy efficient cruising speed. Concord's flights were 50% faster, but they cost 3x more. Most people were not prepared to incur the extra cost. An hour of human life spared of inconvenience/discomfort has a finite value, and the market for people willing to spend thousands of dollars to avoid it was too small. </p><p>Aside from financial economics, energetics - which includes the all-important concept of energy return on energy invested (EROI) - also appear to be unduly de-emphasized or omitted from Musk's sci-fi-addled world view. It creates blindspots and causes him to incur errors of judgment, in my view - both in business, and with respect to metaphysical speculation.</p><p>Elon, for instance, has argued at several public appearances that we are most likely living in a computer simulation, and that the probability we are living in a "base" universe to be one in billions. What's his reasoning? Elon's argument basically boils down to the following: we have seen very rapid increases in computing power over the past 50 years, and our ability to simulate worlds via computer games has exponentially improved. If you extrapolate any pace of continuing development forward, it is only a matter of time before we will be able to simulate whole universes, as well as entities operating within those universes. If you assume that - once in a position to create such environments - we would in fact do so (seems likely), and would reach a point of being able to do so before becoming extinct (likely in Musk's view), then it is highly probable we would birth simulated universes - perhaps many of them. Furthermore, simulated entities within those simulated universes would themselves simulate universes. As a result, you would end up with billions upon billions of simulated universes, and the probability you were living in the base universe would thus become extremely small.</p><p>This might sound superficially persuasive, and particularly if you are sci-fi minded, or a philosophically minded academic. But as soon as you understand some real world practical constraints, the plausibility of this argument rapidly falls to pieces. Of course, anything is possible. It is possible, for instance, that the energy and physics of the base universe are so completely different to ours that such constraints do not exist. But if you're going to assume that, you can't justify the argument by reference to progress in our microprocessor, AI, and computer game technology, and you might as well just argue "God made it that way". I will proceed on the basis that the putative base universe is at least somewhat akin to ours.</p><p>So what are some of the problems with this reasoning? They center on "Moore's Curse". This is the idea that Moore's Law and the remarkable, exponential improvement in computing power we have seen over the past 50 years, has caused people to believe that exponential progress in computing and technology is some kind of inevitability that we can extrapolate forward ad infinitum. But this is a fundamentally flawed assumption, even for compute - let alone many other domains that are often falsely analogized to Moore's Law, such as progress with the reduction in costs of batteries and solar panels. Indeed, it is yet another example of the oft-seen error of "naive extrapolation".</p><p>Moore's Law has changed the world, but the total improvement in computing power we can hope to ultimately extract from Moore's Law is subject to some fundamental physical limitations. The vast majority of improvement in computing power and speeds has come from simply making transistors smaller (Moore's Law, in its original/literal interpretation, is doubling transistor density every 2 years or so). This allows us to pack more of them onto a chip, and being closer together, for them to communicate and transfer electrons amongst their circuitry more rapidly. However, the problem is that there is only so small you can make transistors before you start running out of atoms. We are already getting down to the scale of some 5-7nm, with 3nm nodes already under discussion. To put this into perspective, <i>1nm is the width of about two silicon atoms</i>. We are already rapidly approaching hard limits on the degree to which we can extract further gains in computing power from miniaturization.</p><p>Ok, so for supercomputing applications, then why don't we just make chips bigger (while keeping the smaller transistors)? Why not make them the size of say football fields, once we hit our limits at the scale of the small? Little known is that the maximum size with which chips can be made is also subject to some fundamental limits, and at commercial scale, chip sizes have so far not exceeded about 800mm2, and that limit is unlikely to change (for scaled & cost effective solutions at least). </p><p>One of the fundamental constraints is the speed of light and how fast electrons can move. Modern processors operate at 4-5GHz, or 4-5 <i>billion </i>operations per second, and even on a small chip, there are several km of complex wiring pathways, which sometimes result in electrons having to weave there way through complex pathways as they cascade through multiple transistors. If you make the chips physically larger, electrons have more distance to travel, and that takes time (as well as energy). Processor clock speeds have started to top out in recent years for this reason, and speed gains have started to focus on things like architectural improvements, or the efficiency with which chips are wired so that the electrons have less distance to travel, on average, to perform necessary operations. Increasing the physical size of chips would therefore require clock speeds to be reduced, offsetting the whole point of increasing sizes, while total energy consumption would also rise significantly. </p><p>There are also manufacturing challenges. A very small wafer defect at the atomic level can render a chip faulty, and such defects occur with a certain degree of frequency. The smaller you make chips, the less likely there is to be a defect on any given chip and thus need to be discarded, but the bigger you make the chip, the more likely a defect becomes, and this likelihood (and hence the cost) goes up exponentially. This limitation might be able to be overcome with better manufacturing techniques, but it also might not be.</p><p>What about 3D cubic chips? Setting aside the issue of whether it would even be technically feasible to manufacture a 3D cubic chip at the nanometer scale - very far from a given - the limiting factor here is heat dissipation. Microprocessors generate heat, and a cubic chip would find heat dissipation a major challenge due to its low surface area relative to its volume. Already, high-spec 2D GPUs for home gaming rigs require cooling fans to be installed to avoid overheating. However, even if 3D was not a limiting factor - which it very likely is - it too would eventually run into fundamental 3D size constraints.</p><p>What about distributed architectures, or wiring multiple chips together, rather than making individual chips better, and processing computations in parallel. This can and is already being done, and promises further significant gains. But even here, there are fundamental constraints in the speed with which distributed chips can interconnect with each other. </p><p>The upshot of these realities is that in the not too distant future,* humanity is going to be confronted with some fundamental constraints on how much additional computing power we can derive - from traditional computing methods at least - and face the once unthinkable reality that we may have reached the limits of this technology. Just because we have seen exponential growth in computing power and cost reductions over the past 50 years, <i>does not mean that that pace of improvement can be forever extrapolated into the future, or indeed any improvement at all beyond a point</i>. </p><p>We are likely to be able to prolong the gains for a while yet by moving to different architectures, increased GPU offloading, etc. Quantum computing is postulated by some as the next generational leap, but that technology appears highly speculative at present and mostly appears to have emerged precisely because people understand that the limits to conventional computing are rapidly approaching. While nothing about the future is assured, there is not a low likelihood that at some point the amount and speed of computing power humanity can harness will top out, rather than keep increasing exponentially.</p><p>If that is the case, Musk's assumption that we can extrapolate forward gains in computing/simulation power ad infinitum could well be unsafe. And how close are our current computing technologies - where transistors are already being packed together 20 atoms apart - to being able to simulate a universe? Our most advanced supercomputers can barely simulate perhaps a square centimeter of atomic-level molecules, fluids etc and all their interactions. It's too computationally intense. Can you imaging the truly astronomical (literally) amount of computing power and energy that would be required to simulate an entire universe, let alone billions of them?</p><p>Furthermore, it is important to remember that any subsidiary simulated universes created by simulated beings themselves would still need to be processed on the base universe's computing hardware. If we created a computer simulated universe today, and the entities within that program created computer programs that simulate yet more universes, the processing of all of those universes would have to take place on our silicon. This makes the argument for billions upon billions of stacked universes all the more implausible.</p><p>I'm aware some explanations of quantum phenomena argue that one of the reasons for quantum superposition is that the wave function only collapses into a specific value once observed in order to conserve hardware resources (render only what needs rendering). But this applies at the quantum scale, not the atomic/molecular level and above, and even simulating the latter is extraordinarily computationally intense. </p><p>When these limits are taken into consideration, it leads one more towards the conclusion that the probability we are in a simulation with billion to one odds (there need to be billions of simulated universes for those odds to be true) to actually be very low, because the computing and energy resources needed for that to be true are astronomically large. For Musk's assertion that the probability we are in the base universe to be one in billions, you would probably be talking about energy requirements above all the energy currently available in the known universe, maybe billions of times over, and that's assuming it is even physically possible to build computer chips that are able to handle that many equations in the first place, which in all likelihood it's not (for the reasons already described).</p><p>The universe is really big, but once you start thinking mathematically and in orders of magnitude, it is not so big compared to many other mathematical phenomena. The size of the universe is something like 8.8 x 10^23 km. You "only" have to add 23 zeros to 8.8km. When you a talking about stacking orders of magnitude of additional computing power on top of one another, the size of the universe's available energy resources suddenly doesn't appear that large by comparison. Such is the nature of exponential math (this is why the number of potential chess games exceeds the number of atoms in the universe).</p><p>One of the reasons people get this and many other issues so wrong is that humanity is suffering from an affliction of technological hubris. Technology has driven many seemingly-miraculous changes to our lives over the past several centuries, but that does not mean there are no fundamental limits to what technology can do for us. It also doesn't help that many people don't understand how technology actually works - they just observe what appears to be exponential improvement in some areas, like compute, and then extrapolate that forward.</p><p>No amount of scientific and technological understanding will make energy generation more than 100% efficient (the law of conservation of energy makes it impossible). No amount of scientific knowledge will make it more energy efficient to carry a car than push it along the ground. <i>These are fundamental physical limitations which technology cannot overcome, and there is nothing we can do about it</i>. People have become too confident that technology can solve any problem, given enough time and will. </p><p>A sci-fi rather than energetics mental framework has manifested in many of Musk's other views and business ventures, from hyperloop experiments (a niche solution for point to point routes at best, and a hugely wasteful and inefficient mode of mass transportation for everything else), to his enthusiastic, unchecked embrace of solar energy, and ambitious goals with respect to Mars/space colonization. Musk is talented, but no amount of talent can overcome fundamental energetic limitations. </p><p>One of the issues that has puzzled and slightly unsettled Musk is the famed Fermi Paradox, which poses the question, if the universe is so big, there must be other intelligent alien species, perhaps billions of years ahead of us in technological development; they should have colonized the universe by now, so why haven't they and why can't we see them? If Musk and other philosophers came at the problem from the standpoint of economics and energetics - which people who discuss the Fermi Paradox seldom do, because they are Sci-Fi geeks - the problem might be somewhat less perplexing.</p><p>In my view, what people should do with the Fermi Paradox - but almost never do do - is simply begin by asking, is space colonization even technologically possible? It is simply assumed that with enough technology it could be done, but that could well be an unsafe assumption. Maybe even with perfect understanding of all the laws of physics, it simply wouldn't be possible to do it. Scientists and philosophers have proposed all manner of bizarre and exotic explanations, but in my view, the fact that it simply can't be done is by far the most likely explanation (though it may not perfectly explain why we can't detect radio waves).</p><p>One of the fundamental limiting factors for both life and civilization is energy. The ability of both to either survive and grow, or wither and die, is crucially dependent on it, and more specifically, on one key metric: the "energy return on energy invested" (EROI). If it takes an organism more energy to find food than the energy that food yields, it will starve to death. If the organism enjoys an energy surplus, it can grow and develop (in modern times, maybe outwards). </p><p>From a civilizational standpoint, an energy surplus (beyond the calories we need for our bare survival) is necessary to allow us to manipulate the laws of physics to our advantage. The average citizen in developed countries indirectly consumes 200 times the their BMR (Basal Metabolic Rate) in energy to sustain their modern lifestyle, primarily delivered via fossil fuels. Without this energy, our standard of living would resemble Medieval peasants, at best (probably a lot worse, at least until the population was radially shrunk through war and famine). And the sustenance of this energy surplus requires we have methods of generating a high "energy return on energy invested". </p><p>We have to expend energy, for instance, to find, drill and develop an oil well, transport the oil, refine it, etc. All of that takes energy. And for it to be worthwhile and sustainable, you need to get back more than 100% of the energy it took you to extract the energy. If it is less than 100%, you will run out of energy trying to procure energy, and your civilization will "starve" to death for lack of energy. For this reason, we will stop using oil long before we run out. We will stop using it when the EROI of finding, extracting, processing, and transporting it falls below 1 (or more economically competitive energy sources displace it).</p><p>For the modern oil industry, the energy return on energy invested averages about 10x. It has fallen from 20-30x over the past half century or so as we have depleted easier to recover reserves and have had to replace them with more expensive (and thus energy intensive) sources. This metric will continue to decline over time. If - for our energy sources/technologies overall - it ever falls below one, our civilization is doomed, <i>irrespective of how technologically advanced we are</i>.</p><p>This energy calculus applies to all forms of energy, including solar. While estimates vary, estimates for the gross EROI of solar panels seem to be about 4x, but this falls to closer to 1.6x with storage. That is also likely the EROI under fairly optimal conditions (solar panels are more efficient in some locations than others, and we build them in the most efficient locations first), and it is unlikely the storage metric includes more than the cost of dealing with night-and-day intermittency and short term weather variations. This low EROI reflects the significant energy that needs to be invested in extracting and producing all the raw materials that go into solar panels and batteries, as well as the energy invested in manufacturing and installing them, and the highly disbursed nature of solar energy. </p><p>If this metric were to fall below 1x, no amount of technology, government subsidies, evangelizing or high-minded ambitions to decarbonize the world's energy system, would make it possible. It simply couldn't be done (or at least, we would have to consume more fossil energy installing solar panels and battery infrastructure than we would get out of them, which would make the entire exercise pointless).</p><p>When Musk thinks about solar, he thinks of it in terms of daily insolation from the sun (W/m2), and the amount of available land area. But those are only some of the constraints. The other constraints are the availability and cost of producing raw materials, including many rare metals that go into batteries etc, the economic and energy cost of which will go up exponentially as we try to scale solar and battery capacity to several orders of magnitude above where they currently are.</p><p>Musk recently said that China could "easily" power itself on solar. But again, he is thinking only in terms of land area and insolation. One of the biggest challenges with solar energy is <i>not </i>the daily fluctuations - night and day, and weather variations, though those fluctuations are already very costly to deal with. Instead, the main problem is with <i>seasonal variations</i>. Outside of equatorial regions, many of the world's most heavily populated regions receive only about one third of the solar energy during winter as they do during summer (that's why it's winter), while energy-intensive heating demand also significantly rises in the winter. Storing enough energy during the summer to get through the winter would require astronomical amounts of energy storage. It is not at all clear that the energy return on energy invested would be above 1 if we tried to make this happen (in this regard, the energy economics of wind are superior to solar, as it does not suffer this degree of seasonal variation in energy output).</p><p>To avoid large-scale seasonal storage, long distance transmission from hemisphere to hemisphere, or from equatorial regions, in theory could be feasible, but would come at a huge infrastructure cost, and entail significant transmission losses (which increase with distance), not to mention major geopolitical challenges. It is unlikely Europe, for instance, would want it's entire electricity network held hostage to stable geopolitical relations with North Africa.</p><p>Because storage on the scale needed to smooth seasonal variations is orders of magnitude uneconomic, self-reliance in China (and Musk was talking about China supplying its own needs through its own solar) would require that solar capacity be overbuilt by a factor of at least 3 relative to average annual energy availability, so that it could produce enough power at the low point of the year to meet peak energy requirements, coupled with there being enough redundancy to handle weather and other variations. That would require the commitment of truly massive levels of resources that would quite likely render the endeavour uneconomic in an energy sense (EROI < 1). The above estimate of a 1.6x EROI would decline to about 0.5x with a 3x overbuild. Even a doubling in total system efficiency would make it a marginal proposition, at best. Musk does not seem to have any real appreciation of these potential practical fundamental limitations (or at least hasn't admitted it publicly).</p><p>Now, I'll grant that it is possible we come up with creative technical solutions to address these problems. Maybe we find a way to install pumped hydro storage facilities at massive scale, for instance. We have also not yet reached the limits of our technical competencies in battery and solar production, and it is true that these are not fundamental limitations in the way the level of solar insolation is (although they do have fundamental minimum raw materials needs, and you can only reduce the energy inputs that go into raw materials procurement and solar and battery production so far via efficiency improvements). They are somewhat amenable to improved technical solutions. However, there is no guarantee that we will be successful, and saying that overcoming these challenges would be "easy" is foolhardy. It might be possible, at an extremely large cost, but it also might not be. We don't actually know.</p><p>This analysis is also relevant to Musk's universe-colonization ambitions, and indeed, to the Fermi Paradox referred earlier. Right now, our civilization - on earth - is facing an incredibly daunting challenge in trying to make our energy consumption sustainable - <i>under ideal conditions</i>. Doing so in space or on other planets will be <i>orders of magnitude</i> more difficult and energy intensive, and achieving any sort of EROI above 1x might well be impossible - <i>even with perfect knowledge of the laws of physics</i>. The reason this possibility is seldom considered is that humanity is currently afflicted with technological hubris.</p><p>In my view, by far the most likely answer to the Fermi Paradox is that colonizing the universe is simply not possible, because energy and other necessary resources are too sparsely distributed throughout the universe, and the EROI is below 1, such that any advanced civilization that attempts to do so in a self-sustaining/replicating way is doomed to fail. It might even be quite a bit worse than that - it could be the case that energy and resources are so sparse (including on earth) that it is difficult to sustain the type of high-technology civilization we currently have even one's home planet for more than a fleeting period of time - perhaps less than a millennia. Such civilizations may quickly run out of key resources, and then collapse back into more primitive, subsistence modes of living. Bleak? Yes, but not necessarily untrue (I'm not quite this pessimistic on humanity's prospects though).</p><p>Even on Mars - a planet that will be orders of magnitude easier for humanity to colonize than any other planet in the universe - the challenges are formidable and the odds of success are extremely low. The solar insolation received on Mars is only 0.4x that of Earth. If we can only barely make the EROI economics work on earth, how can we reasonably expect to do so on Mars, and particularly in an environment where dust storms can often engulf the entire planet and take solar panels offline for extended periods of time? Mars' atmosphere is also only 1% as dense as on earth - so forget wind power - and there are no hydrocarbons because there are no remains of dead plants and animals from past eons to dig up and burn for energy. Where is Mars going to get it's energy from? And a lot of it will be needed, because the average temperature on Mars is -60 degrees Celcius. Nuclear is possible, but unless there are large domestic uranium reserves, uranium rods will have to be imported from earth, and that could well be prohibitively expensive (energetically as well as financially). And what will Mars export back to pay for it (which it would have to do in the long run if it wanted to be "self sustaining")?</p><p>This is not to mention many other challenges. There is no magnetic field on Mars. Consequently, there is nothing to deflect the constant barrage of harmful gamma radiation emitted from the sun, which wreaks havoc with human DNA. Already small amounts of much-less-dangerous UV radiation routinely give people skin cancer on earth. Early settlers will likely be beset with cancers and have very short life expectancies, even ignoring everything else. We can't even cure cancer on earth. How are we going to stop it on Mars? Mars gravity is also only 0.375 of Earth's which will lead to many health problems. We will need vastly improved bioengineering technologies for the environment to be even remotely survivable long term. And there is very little oxygen on Mars (96% of their 1% atmosphere is CO2), and transporting it in canisters from earth, or trying to produce, collect and transport it in sufficient quantities on planet will require huge amounts of resources/energy.</p><p>Some of these problems may not be impossible to solve, but they could be, and at best the costs and energy requirements of doing so will be astronomically high, and most likely in excess of what is both economically and energetically feasible, and supportable by Earth's economy and resource endowment. And even if I'm wrong, all of this will only get us to Mars. </p><p>The next leap will be several orders of magnitude more challenging again, and probably impossible, particularly because as Musk himself points out, you cannot escape Newton's Third Law in space propulsion - you need to power rockets with <i>ejected matter</i>, not pure energy (such as electricity stored on batteries; electric rockets are impossible). Distances are vast, which require very high speeds, and you need as much energy to slow down as you do to speed up. It is doubtful space colonization is energetically feasible even with perfect levels of scientific and technological understanding. If this is indeed the case, there is no Fermi Paradox.<br /><br />I hope I'm wrong, and I don't necessarily think it's a bad idea to try, even if the odds of success are low, because it would be an incredible accomplishment for humanity if we could pull it off. But I'm not very optimistic, and perhaps much more relevantly to current day to day life and investing, I think investors ought to have a much more level-headed and realistic view on the limits of technology, and temper any Sci-Fi inspired optimism with a sound understanding of economic and energetic limitations.</p><p><br /></p><p>LT3000</p><p><br /></p><p><i>*Post-publication clarification: Twitter discussions post-publication have revealed to me that my comment "in the not too distant future" here is unclear and subject to misinterpretation. This statement is relative in nature and is intended to be viewed in the context of Musk's argument we can extrapolate forward gains in computing power to the point of eventually simulating universes. It is not meant to be construed as an argument that we are very close to hitting the limits today in our ability to improve computing performance from a practical standpoint. </i></p><p><i>There are still many avenues for improving compute performance, including improved architectures and moving away from general-purpose CPUs to more specialized chips optimized for specific tasks, and significant gains will likely continue for at least another decade or two (and maybe longer), and will have significant practical value. My point is that in the very long run, physical limits will eventually kick in, and you cannot extrapolate forward exponential gains in computing power indefinitely. </i></p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-30650293083282996002021-04-17T12:45:00.049+07:002021-04-18T15:35:54.677+07:00Crypto-mania is back: Crypto vs. Fiat, and why newer isn't always better<p>After a multi-year hiatus, cryptocurrency has recently stormed back to the fore, with Bitcoin breaching new highs above US$60k, along with a resurgence in a multitude of other crypto currencies, whose aggregated market capitalization has now run up to some US$2tr.<span></span></p><a name='more'></a><p></p><p>While opinions vary on Bitcoin, we have seen particularly enthusiastic endorsement emanating from the technology/software industry, including many high-profile industry figures. Some Silicon Valley companies like Square and Tesla have purchased Bitcoin at the corporate level, and Paul Graham even went as far as likening Turkey's recent crypto ban to banning the microprocessor in 1976. To these folk, Bitcoin is obviously the way of the future. This zeitgeist recently prompted someone to ask on Twitter, why are so many intelligent & capable software people so quick to embrace Bitcoin and the "future of money" with little in the way of critical thinking and only a cursory understanding of the issues?</p><p>The answer, I believe, is that these folk have - based on many decades of experience - a strong predisposition to believe that anything that is both *new* and *digital* <u>must</u> be superior to prior "old world" solutions. And that is understandable, because that's usually been the case with most areas software has touched. However, there is no inevitability that will always be the case in all situations. In addition, these folk understand software, but often their understanding of economics, monetary systems, and markets is much more lacking, which creates blindspots.</p><p>Instead of uncritically embracing the hype, let's take a step back and think through the issues. There are really only two potential applications/needs cryptocurrency might hope to fulfil, aside from functioning purely as instruments of speculation: (1) to function as a currency/means of exchange/payment, displacing/acting as a (superior) alternative to fiat currencies; and/or (2) to function as a "store of value". The default presumption is that - owing to putative problems/shortcoming associated with fiat currency (some true, some imagined) - Bitcoin et al are unquestionably superior - indeed a natural evolution towards next-generation solutions. Unfortunately, the reality is a lot more complicated than that.</p><p>Let's start with #1. The primary limitation Bitcoin enthusiasts attribute to fiat currencies is the ability for central banks/governments to increase the supply over time and thereby depreciate their value. However, despite what many merely assume, it is not necessarily desirable for a currency to have the attribute of sustaining 100% of its purchasing power over a very long period of time, and it is especially undesirable - nay disastrous - for currencies to <i>increase </i>in value (for the reasons explained below). Fiat's currencies' greatest weakness (their ability to be depreciated over time) is therefore also their greatest strength. Undeniably, they are at risk of government abuse and excessive depreciation, but the tendency for them to not appreciate, and at least slightly depreciate over time, is in fact a feature, not a bug.</p><p>Fiat currency has no intrinsic value, and in functioning as a currency, its primarily role is simply to facilitate economic activity/commerce/exchange by *temporarily* holding/transferring value long enough - and with sufficient predictability - to facilitate productive and efficient economic exchange. Without such an exchange medium, people would be forced to resort to barter, which is highly inefficient. Fiat currencies are a *tool*. They have no fundamental value - they instead facilitate the more efficient exchange of things that do have real value (labour, capital) in the real economy.</p><p>For a currency to function well, it is absolutely essential that it is neither too abundant <b><u>nor too scarce</u></b>. Either situation can destroy the efficient fulfilment of a currency's role with attendant negative economic consequences - some very severe. If a currency becomes too abundant and it leads to hyperinflation, it fails to hold its value long enough to facilitate efficient exchange. People/merchants begin to refuse its acceptance for goods and services, as they are no longer able to predict what goods and services they will be able to receive back in exchange. Often in these situations, local merchants start to refuse the local currency and resort to using more stable foreign currencies, like the USD or Euro.</p><p>This is fairly well understood. However, what is less well understood is that a currency being *too scarce* is just as potentially damaging, because it can lead to hording and a reluctance to engage in economic transactions. In economic systems, one person's expenditure is another person's income. Consequently, if somebody decides to save instead of spend, they deprive somebody else of income, and lower the level of aggregate demand in the economy. If enough people do that at the same time, the outcome will be a depression, as the loss of income from higher savings feeds on itself in a "doom loop" (people cut their spending in response to lower incomes; businesses lay off employees and cut investment in response to weaker demand and lower profitability, etc). This is the classic "paradox of thrift" Keynes identified as the cause of the Great Depression, and the downward spiral it can lead to in the absence of stabilizing Keynesian fiscal stimulus (the government acting as the "spender of last resort") can result in unspeakably bad depressions with devastating consequences.</p><p>For this reason, a currency should *never* be something that causes people to regret using it to purchase goods and services because it subsequently appreciates in value. If it does, then it is failing to fulfil its role as a facilitator of commerce and is creating the risk of triggering unnecessary depressions. And yet this is precisely the problem with Bitcoin. A well known meme has circulated for years about a guy who bought a pizza with Bitcoin in circa 2010. Had he instead held on to his Bitcoin, it would now be worth hundreds of millions of dollars.</p><p>A currency is functioning well if when you want to buy a pizza, you buy a pizza and never think twice about the currency you used to pay for it. The currency is practically invisible - you think about the pizza, not the means of exchange. The only reason you should ever regret buying that pizza is if you observe your waste line growing. The *pizza* is the focus of the economic transaction, not the currency which is used to pay for it. How many people bought a pizza in 2010 using USD, and today regret doing so? A "currency" that punishes people for using it to purchase goods and services is one of the most <u>disastrous</u> and dangerous currencies you could create. In all likelihood, it's adoption would swiftly plunge the world into an economic depression the likes of which we have never before seen. </p><p>For this reason, fiat currencies are deliberately <b><u>not</u></b> designed to appreciate in value. At the very least, the money supply needs to be increased in line with GDP to avoid this outcome, lest a growing level of economic activity chase a finite amount of currency, entrenching 2-3%+ annual price deflation (and more if currency is horded, which is likely). The world experienced deflation, repeated depressions and recurring bank crises during the 19th Century, because we adhered to "hard money" ideas and had not yet figured out that it is essential currencies are not too scarce and do not appreciate over time. The utter human carnage that was the Great Depression was the final straw that ushered in a more enlightened period of monetary understanding (subject to abuse, yes, but which overall has been far more successful than the monetary regimes of the pre Great Depression era, in promoting economic stability, growth and human welfare). We learned through hard and painful experience that the hard money approaches now being enthusiastically embraced by the crypto community are <u>economically disastrous</u>.</p><p>The other important role of currencies is that they have *predictable exchange value*. While holding their value in the very long term (over decades) is less important, holding their value over shorter periods of time is absolutely critical. If you sign a contract to sell your house for $1.0m that settles in six weeks time, it is essential that you have confidence that the amount of goods and services you can buy with that $1.0m will be approximately the same in six weeks time as it is today. If it could only be $0.5m, it exposes you to tremendous, and potentially life-changing risk. The unpredictability of the exchange value (in terms of goods and services) of such a currency would render it far too risky and impractical to use for transactions of consequence. This is why in less developed countries with unstable local currencies, large transactions are often denominated in USD. Bitcoin and crypto also fail spectacularly in this regard, due to their hyper volatility. </p><p>In short, for a currency to function well, you need it to be not too scarce, not too abundant; be widely accepted; and to have predictable exchange value. This facilitates commerce. The ideal situation is fairly close to what central banks in developed markets have achieved in recent decades - largely stable prices with a very modest pace of deprecation of perhaps 1-2% a year. This depreciation discourages people from hording cash, and yet the pace of depreciation is very modest such that it does not impair the predictability of cash's exchange value. It is ideal/optimal for encouraging commerce and exchange.</p><p>Though new and digital, Bitcoin is therefore an <i>inferior </i>currency to pre-existing systems, with many structural problems/flaws. Yes, I know it seems difficult for many to grasp that something new and digital might actually be an inferior solution to an already solved problem, but with the context properly understood, that is in fact the case. Bitcoin could function as a sideshow supplementary currency, but it would be utterly disastrous if it became the primary unit of account and means of exchange/contracting in modern economies, and would almost certainly precipitate a devastating depression.</p><p><br /></p><p>The second potential role Bitcoin could fulfil would be to function as a long term store of value, and here some of the arguments proffered are (at least superficially) somewhat more plausible. Right now, it is not possible for somebody to earn money, store it in cash - either physically in a box, or in a bank account given negative real (if not nominal) deposit rates - and have the same purchasing power available to them in 20-30yrs as they have today. There is no mechanism of long term storage via means of cash. Bitcoin and cryptocurrencies might therefore be argued as as providing as solution to this unmet need. </p><p>Fiat currency does not store value in the long term because that is not its primary purpose. Fiat currency is intrinsically worthless, and is therefore not a repository of value, but merely an efficient means of exchanging real world value. It functions as a "suspense" account of sorts - I will exchange item X of value for fiat with Y, because I predict that when I walk down the road to store A, they will exchange item Z of value for that fiat. The fiat itself is worthless and does not store value, but it is predictable others will accept it in exchange for value, because others will likewise do the same. </p><p>Nevertheless, people do want to save and store value over time. On a system basis though, how is it that value is actually stored, and indeed, what exactly is value? When analysing these issues, one cannot content themselves with the micro, but must look at the macro, because fallacies of composition emerge if one extrapolates the micro to the macro (such as Keynes' paradox of thrift already discussed).</p><p>It is important to remember that both fiat and crypto currency are a figment of our imagination, and nothing tangible of value actually exists or is stored. Value exists in the real world of atoms, and currencies - fiat or crypto - are merely means of allocating, transferring, and co-ordinating that value. At a system level, value/savings/capital ultimately derives from human effort that has been expended in the past that has a replacement cost, and which has accumulated/been organized in a manner that allows us to more effectively meet human needs and desires than was the case prior to those efforts.</p><p>That's a mouthful and is perhaps best illustrated by way of example. Say for instance I were to build a hydroelectric dam. Billions of dollars worth of human effort would go into building it, from detailed engineering, to direct materials production such as concrete and steel, to complex engineered products like turbines and all their components, as well as considerable amounts of physical construction labour. Deriving further up the chain, effort has gone into discovering and digging raw materials out of the ground, like iron ore, and processing and refining those inputs into finished intermediate products like steel.</p><p>All of this takes tremendous human effort - what we often call "work" - and the outcome is a hydro dam that can produce useable electricity very efficiently, which can be used to increase human welfare/productivity, and better meet our needs and wants. This represents accumulated value, or "installed capital". It is a store of value because replacing all that effort entails a real cost, and the installed capital generates real value/utility to human beings from low-cost electricity generation. Furthermore, it is highly predictable that that utility will exist in the future (so long as humans want and need electricity).</p><p>At a system level, *that* is how value is stored, and wealth accumulates. Paper money or crypto currency that merely represent 1s and 0s on distributed computers, in and of themselves store nothing. It is the *real world stock of accumulated capital* that backs financial claims that legitimately store value. Without them, both fiat and crypto currencies are utterly worthless, and no value is stored aside from the inter-temporal exchange value discussed in the prior section of this article (intermediating between goods X and Z). Large scale storage of value, at a system level, therefore must derive from real world things that have a predictable ability to generate real world value for human beings in the future. </p><p>Nevertheless, it is true to say that people will always demand human labour, and will be willing to exchange labour for something they predict will allow them to cash it in in the future for other humans' labour, and at present people are currently unable to store and time shift an hour's worth of labour on a risk-free basis over multiple decades by holding cash. They will instead be chiseled by inflation over time, and maybe even negative deposit rates. The closest approximation they have is lending money to other people - either directly (via purchasing bonds etc) or indirectly via financial system intermediation, who will (hopefully) pay you back by expending remunerated labour and repatriating you the proceeds. This exposers savers to credit risk/default. Does Bitcoin not potentially plug this gap?</p><p>At a theoretical level, it is arguable it indeed could, but then so could anything. I could designate a magic toilet roll as a store of value. As long as people are willing to exchange labour or items of real world value for this magic toilet roll, because they believe others will likewise accept it, it could function as a store of value. But it is important to remember that the magic toilet roll itself does not store any value. In order for you to take money "out" of the magic toilet roll, someone else must be willing to simultaneously put it in. For this reason, in reality there is no value stored in the some US$2tr market cap of digital currencies whatsoever. Nothing actually exists that can be taken out, anymore than if my magic toilet roll was valued at US$2tr. In order for any of this US$2tr to be taken out, other investors must put an equivalent amount in. But, it is also true to say that so long as people are willing to do so, it can de facto function as a store of value.</p><p>While granting this theoretical point, however, there is the much more difficult pragmatic point for the Bitcoin bulls to overcome: how many people are actually buying Bitcoin to store a stable amount of value for 20-30yrs, and how much human demand actually is there for this outcome? And are there not already other and potentially superior means of doing this?<br /><br />I am yet to met someone who - saving/investing on a 20-30yr time horizon - is targeting a zero real return. Most people, when they put money away for the long term and to save for retirement, are desirous of obtaining a return on their investment and compounding their money over time. This can be achieved by buying income producing real assets, such as the hydroelectric dam I mentioned (via, for instance, purchasing shares in a company that owns a hydroelectric dam/s), and reinvesting the cash flows. It cannot be done owning an asset that functions purely as a putative store of value that generates no income (aside from speculative profits, which are an altogether different thing).</p><p>Moreover, what fraction of the people that are actually buying Bitcoin today are doing so because they hope/think it will simply preserve purchasing power for 20-30yrs, without generating a meaningful return? The truth is that the vast majority of people buying Bitcoin and other cryptocurrencies are doing so because they hope/expect to reap massive windfall capital gains. So the rationalization proferred to justify Bitcoin's growing presence bears no resemblance to its actual de facto usage.</p><p>In truth, cryptocurrencies' primary function today - and in my opinion, in the future as well - is simply to function as vehicles for speculation. Human beings like to speculate/gamble - always have and always will. Wanting to get rich - and ideally as fast as possible and without a lot of physical effort - is a virtual human universal, and humans are drawn like moths to a flame to domains they feel offer this possibility. This is the primary driver of crypto enthusiasm, even if all manner of rationalizations are proffered to justify the crypto ecosystem. The real justification is good old fashioned human greed. Few, if any, holders are buying it to store value. They are buying it to try to get rich quick.</p><p>This is also not to mention the fact that less-speculative (though still occasionally speculation-prone) long term store-of-value alternatives to fiat currency already exist, such as gold. Gold - a genuinely rare, beautiful and lustrous metal - has fulfilled this role and been desired by humans for thousands of years. Someone genuinely motivated by risk aversion and storing value would stick to a tried and true method rather than a speculative and novel approach. And if one insisted on digitization, there would be nothing to stop a gold-backed cryptocurrency assuming the throne and displacing Bitcoin, which would marry the best of both worlds. But there is limited interest in this, because it would remove the possibility of rampant speculative profits, which is the primary motivation for crypto enthusiasm. </p><p>There are also a menu of different fiat currencies to choose from - the world does not have just one fiat currency - and investors can substitute currencies with higher inflation risk for those with lower risk, as often happens in high-inflation less-developed countries, where their economies and banking systems become partly/highly dollarized. Solutions already exist, and for most people most of the time, they are good enough.</p><p><br /></p><p>So what could be the boom's undoing? It's hard to say. The typical downfall of most speculative manias is the capacity to add supply. Dot.com IPO mania was felled by a flood of new junk IPOs that eventually sated and overwhelmed demand. Something similar is happening with SPAC IPOs at the moment - so long as there is appetite, the financial industry will continue to manufacturer more SPAC IPOs until the market is glutted and prices collapse (the irrationality of SPACs in not in the primary issuance, but in the secondary buying; without enough secondary buyers, the whole game is up).</p><p>Non-fungible tokens will inevitably collapse because of the capacity to add supply. New NFTs will continue to mushroom, while artists often take a 5-10% cut every time the asset turns. A good way to envisage this is buyers of NFT walking into a room with suitcases of cash, while artists are walking out another door with suitcases full of cash representing their 5-10% turnover cut. The whole system functions like a Ponzi scheme because there must be a continuous influx of new money in order to offset the accelerating leakage, and with new NFT supply being rapidly added, it is only a matter of time before supply overwhelms demand.</p><p>For crypto in general, the same thing will happen, as more and more crypto currencies are manufactured. But Bitcoin seems to have (so far) succeeded in entrenching itself as the gold standard and differentiating itself from the long tail of other currencies, and the supply of Bitcoin itself cannot be increased. This could result in the Bitcoin bubble inflating for a lot longer than would otherwise be the case in many bubbles. That being said, Coinbase is clipping 0.5% every time Bitcoin turns, and has a market capitalization approaching US$100bn - investors current estimate of the present value of future clippage, or suitcases of cash walking out of the door. But that may not be enough to slow things down.</p><p>How high could prices go? It's anyone's guess, because prices are driven purely by demand and supply, and demand is partly a function of price increases. However, the total amount of global wealth was estimated by Credit Suisse to be some US$360tr at 2019 year-end <span style="font-size: xx-small;">1</span>. It has probably increased since then - let's say to US$400tr. The total market cap of crypto, at some US$2.0tr, is therefore now already about 0.5% of total global wealth. </p><p>Could it go to 5%? Anything is possible. History cautions against trying to call the peak of human speculative excess - things can be taken to utterly unimaginably absurd extremes. But in the long run, I must say it is very difficult for me to imagine crypto settling out even at 2.5-5% of total global wealth levels, let alone anything higher. US$2tr in combined market cap also also represents about US$250 per global capita - including children and people from less developed countries in Africa etc. There is still room to run further in the short term - there always is - but on the long sweep of things I wouldn't be investing today with the expectation of making 100x your money.</p><p>I used to believe Bitcoin would likely eventually go to zero. I no longer believe that. My prediction now is that we see repeated waves of speculative excess - huge giddy run ups, followed by spectacular collapses; long periods of disinterest/sideways action; and then renewed eco booms. People will always like to speculate, and the smaller the market cap gets after any bust, the less buying will be required to support and push up the price. After a bust, at some level the price will get low enough for a number of people to step up to the plate and bet on another boom that windfalls them 20x. And the cycle will repeat. It doesn't make a lot of rational sense, but then again nor does Vegas.</p><p><br /></p><p>LT3000</p><p><br /></p><p>PS I have disabled the comments section to this blog as it has been overrun by spam. Apologies for the inconvenience to legitimate commenters. </p><p><br /></p><p>1. <a href="https://abcnews.go.com/Business/half-worlds-entire-wealth-hands-millionaires/story?id=66440320">https://abcnews.go.com/Business/half-worlds-entire-wealth-hands-millionaires/story?id=66440320</a></p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-34511677115074177302020-11-11T21:24:00.003+07:002020-11-12T10:02:01.050+07:00Unravelling value's decade-long underperformance (and imminent resurgence)<p>In a recent (generally excellent) podcast with Inside the Rope with David Clark (#78), John Hempton discussed (amongst other things) value's past decade of underperformance, and opined that the primary driver was the fact that the pace of technological change had accelerated, such that we have seen an unprecedented level of disruption to traditional business models. Value investors have apparently spent a decade naively riding doomed low-multiple companies like the Myers of this world into oblivion. <span></span></p><a name='more'></a><p></p><p>This is a very commonly expressed view/belief, and intuitively it feels right. The danger with intuitively-satisfying beliefs though is that they can discourage you from looking for evidence to confirm whether those intuitions are in fact true. It seems true, so it must be true, right? A surprising amount of the time, the answer is no. Just because something is intuitive does not mean it is correct (after all, it was intuitive to pre-modern humans the world was flat, and it's not very intuitive we evolved from primordial sea creatures), and as Mark Twain once noted, "It ain't what you don't know that gets you into trouble, it's what you know that just ain't so". The story of the emergence of the scientific method is a story of humans starting to demand evidence instead of merely relying on our unsubstantiated intuitions.</p><p>Cliff Asness of AQR has undertaken a <a href="https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead">comprehensive systematic quantitative</a> analysis of this argument to determine whether this intuition is correct, and found absolutely no evidence to support its veracity. Contrary to popular belief, there has been no degradation in returns on capital or earnings for value quintiles, which would substantiate the existence of excess 'disruption' in value as compared to historical averages. In fact, value portions of the market have actually done slightly <i>better</i> on these metrics vs. long term averages over the past decade. Asness' analysis concludes that the primary driver of value's underperformance has simply been value getting cheaper and growth getting more expensive, as has been the case in every past cycle where value has underperformed (of which there have been many).</p><p>It is very easy to forget that disruption is not a new thing. It's been going on for as long as the forces of creative destruction have operated in capitalist economies, which is to say for at least as long as stock markets have existed. Technology and the competitive landscape has always been evolving, and upending certain business models. The automobile industry disrupted the horse and proverbial buggy whip industries. Electricity and the incandescent lightbulb disrupted kerosene lamps and candles. Growth of low cost manufacturing in Japan, Korea and other emerging markets disrupted many traditional manufacturing industries in the US in the 1970-80s, from appliance and automobile manufacturers, to steel producers and textile millers. Retail has been through many eras of disruption. such as the emergence of the category killing Wal-Mart big box discounters of the world, who disrupted the dominance of traditional department stores (who had previously disrupted smaller independents). </p><p>The only constant over time has been continuous change, and value has always faced the headwind of certain companies/industries being disrupted - often fatally. It's not a question of 'do some cheap stocks end up getting cheaper - perhaps all the way to zero - and justify their cheapness', but rather, to what extent does that happen in the aggregate, and to what extend does the lower entry multiples for these stocks compensate for that risk, including not only the benefit of higher dividend yields/more rapid cash flow paybacks, but also the benefit gained from exposure to situations where disruption fears prove excessive and stocks recover. Hempton's argument is that the <i>pace</i> of change/disruption has accelerated, but Asness' quantitative analysis does not support that assertion - at least from the perspective of it having a tangible impact on value stocks' <i>aggregate</i> fundamental performance. </p><p>Furthermore, it is a major mistake to assume the impact of disruption is confined merely to low multiple stocks (or even felt disproportionately by value). Kodak was a very highly rated, high quality company up until the late 1990s, as was Blockbuster video rentals. That didn't stop them from being disrupted. Indeed, it is actually often the highest quality and highest rated companies that have the most to lose from disruption, as they have both high valuations with very long duration payoffs <i>and</i> very high profitability. This means not only do they have a long way to fall if anything goes wrong (and even the <i>fear </i>of disruption can crush these stocks, whether or not it actually transpires), but their fat margins also act to invite disruption by creating an outsized opportunity for would-be disruptors. One of the reasons Uber exists is that taxis were previously morbidly overpriced, and one of the reasons we have not seen (and are unlikely to see in my view) fintech disruption of the banking industry is that lending spreads are already very thin, and the industry highly capital intensive (onerous regulatory capital requirements) and not especially profitable, so there is little opportunity/reward for doing so.</p><p>Examples abound of formerly highly-rated franchises that were part of the high multiple growth and quality parts of the investment universe that suffered massive disruption and falls from grace, <i>and the tendency of a not immaterial minority of highly-rated quality/growth stocks to fail to live up to their expected potential and suffer major de-ratings has been a fundamental driver of the long term underperformance of high multiple stocks as a group</i>. The idea that it is the value portion of the market that is most exposed to disruption is therefore a case that is far from made - intuitive though it may be. By the time fallen angles end up in value bucket, it is right to say that the probability of catastrophic disruption has materially increased, but on the flip side, by this stage the stocks have already handed major losses to their prior growth/quality holders, and have now already de-rated to the point where investors have very low expectations of the company's future, and offer high dividend yields/more rapid cash flow paybacks as risk mitigations. And if the market is <i>wrong </i>about the inevitable future demise of such companies, longs stand to make many multiples of their investment.</p><p>I have argued many times on this blog that one of the core reasons that value investing works is that investors systematically overestimate their ability to predict the future. Now sure, we have the J.C. Penny's and Sears of this world that slide slowly but surely into bankruptcy, as their low multiples long predicted would happen. However, you also have examples such as electrical appliance retailer Best Buy that was predicted to follow a similar trajectory, but which instead managed to successfully reinvent itself, leading to its stock rising 10x as its future prospects were reassessed. More recently, stocks like Fedex have risen 150% from lows of below 10x earnings as fears of Amazon disrupting their network advantage have abated.</p><p>A decade ago, investors believed Microsoft was being disrupted by mobile, Apple & iOS, Google Docs and Android (Hempton even blogged about how he went short at the time after watching a Youtube video where someone's dad was totally baffled about how to use their latest version of Windows). The stock traded for as little as 7x earnings at the time. Suffice to say investors' predictions of Microsoft's imminent demise (a value stock at the time, I might add - something today many people forget) were more than a tad exaggerated - as well reasoned as that case seemed at the time. The same can be said of Apple, which was losing money and widely believed to be heading for the bankruptcy courts in circa 2000 - again quite reasonably based on what was knowable at the time - and the stock accordingly traded for less than its net cash. We know how that ended. Yet another example is the very industry Hempton discusses he is buying at present on the podcast - the tobacco industry. Long thought to be a dying industry and priced as such, it went on to be one of the best performing industries in the world over the past 30 years (I agree with Hempton here and am also long BAT, and blogged about it <a href="https://lt3000.blogspot.com/2019/01/the-art-of-worldly-wisdom-smoking-and.html">here</a>).</p><p>So sure - there are individual examples of low multiple stocks being disrupted all the way to zero, <i>as there always have been. </i>As Buffett will tell you, the US textile industry got disrupted all the way to zero during 1970-80s from cheap imports. But there are also plenty of examples of stocks going up 10x or more as those disruption fears failed to materialize as expected, <i>and with this degree of asymmetry the probability of the market being wrong doesn't need to be very high to generate a favourable return expectancy</i>. A century of quantitative evidence from market history suggests investors tend to underprice stocks with the most apparently assuredly poor future prospects, and over price those believed to have the most assuredly promising prospects, and underestimate tail risk (both upside and downside), and there is nothing in the past decade's market experience to suggest that has fundamentally changed. </p><p>Further evidence of this stems from the multiple studies that have been done on net-nets - the worst of the worst in terms of business quality and future outlooks (the outlook is so assuredly bad investors are not even willing to pay a price above net working capital net of all liabilities). As a group, such stocks have substantially outperformed over time. However, very interestingly, when studied have been done where investors were given the opportunity to choose the 'best of a bad bunch', choosing only those that were profitable or paid a dividend for instance, the results were much <i>worse</i>. Taking out the 'worst' of the worst lead to inferior returns. Why? Because if it's obviously bad to you, then it's obviously bad to everyone else as well, and the stock will be priced accordingly, with the probability of unexpectedly favourable change underestimated, leading to greater scope for a major re-appraisal of its prospects if conditions do unexpectedly improve. And <i>occasionally</i>, that happens. Most of the time it doesn't, but sometimes it does, and occasionally you end up with an Apple (which was a net net circa 2000).</p><p>One of the difficulties investors struggle with is the asymmetry. I've blogged about several value stocks on this blog before. Lot's of them haven't worked out particularly well, although in most cases they are flattish or only modestly down (inclusive of dividends). However, some of them like Fortescue are up 500% including dividends. The issue with value stocks is the high dispersion of outcomes - lots of stocks deliver mediocre outcomes, and handful go down a lot, and then some deliver very extreme payoffs. This makes it difficult for investors to learn the right lessons as they will often have bad outcomes on individual positions even if the overall ex ante return expectancy was high, and critics of the approach will always be able to point to individual situations which didn't work out in an attempt to discredit the methodology. Pointing to specific value names that got disrupted all the way down to zero as a reason why value investing is flawed and doesn't work is doing precisely that.</p><p>So if accelerating disruption is not the cause of value's underperformance over the past decade, then what exactly is? The simple answer is because cheap stocks have got cheaper while expensive stocks have got more expensive - a trend which has radically accelerated over the past 24 months or so (barring the sharp reversal we have seen over the past few days). However, the more complex and interesting question is <i>why </i>and <i>how </i>that has happened, the answer of which requires that we go all the way back to value's last period of significant underperformance in the late 1990s, as well as understand the important role liquidity flywheels (discussed in detail <a href="https://lt3000.blogspot.com/2020/07/market-inefficiency-liquidity-flywheels.html">here</a>, and a recommended pre-requisite to the below analysis) and investor psychology play in long term secular market cycles.</p><p>It is worth emphasizing at the outset, however, that the tendency for value to lag markets for significant periods of time is not itself historically unusual, and happens whenever a market environment exits where expensive stocks get more expensive; cheap stocks get cheaper; or some combination of both (as we have seen this cycle). Over the past 50 years, it has happened three times in US markets - in the nifty-fifty bubble of the 1960s-early 1970s, in the 1990s dot.com bubble, and over the past decade. In other words, it has happened approximately once every 20 years or so. The only thing unusual about this cycle has been its length and magnitude, which has been somewhat worse than past cycles.</p><p>The fundamental causes have been the same. You start with a market environment where value has done relatively well, and multiple dispersion has reduced. If multiple dispersion is low, it actually pays to own higher quality, higher growth companies, as you're not paying much extra for these benefits. Subsequently, there is some sort of new trend/theme that emerges which leads to a cohort of companies performing unexpectedly well operationally (robust profitability and rapid growth), and their stocks perform exceptionally well, as they benefit from a combination of a reasonable starting multiples, operational prosperity/growth, and then a significant lift in trading multiples as their success becomes more widely appreciated as it is promoted by brokers and the media, and investors start to extrapolate and price in continuing growth and prosperity forward into the distant future. </p><p>In the nifty-50 bubble it was high quality US blue chips that benefitted from a strong economy in the 1960s and low interest rates, as bonds lost their appeal and investors substituted high quality blue chip stocks which had reliable earnings power and steadily growing dividends. The stocks did so well for so long as multiples rose and rose from 10-20x to eventually as high as 60-80x that they became known as 'one decision stocks'. In the 10-15 years that followed, they were a total disaster as multiples reset back to 10-20x and the stocks fell 80%. In the 1990s it was the emergence of personal computing, software (enterprise and personal) and the internet, which produced some spectacular secular winners such as Microsoft, Cisco, Oracle, Intel, and Dell. Investors made a fortune in tech during the 1990s, until the tech wreck where the NASDAQ fell 85%; and post-GFC, it has been smartphones, social media, cloud computing and enterprise SaaS, e-commerce and various online consumer marketplaces, which have produced this cycle's cohort of secular winners such as the FAANGs and SaaS leaders such as CRM. </p><p>What all of these cycles have in common is that the initial bout of outperformance was fundamentally justified by emerging secular trends and reasonable starting-point valuations, but subsequently, as a liquidity flywheel was set in motion that drove rapid multiple expansion over many years, the trend ended up being carried to morbid excess. What happens is that fund managers that due to good luck or good foresight owned those secular winners early report great numbers, and great numbers attract inflows. Those inflows are then invested in the same names, pushing share prices higher still. </p><p>Investors' greed and get-rich-quick instincts are piqued by strong and consistent performance, and particularly when buttressed by an exciting thematic narrative that seems to justify the strong gains and promise more to come, and with results appearing to validate that assessment. More sector-based funds are birthed and promoted to cash in on this growing investor enthusiasm, and as more and more money flows in, prices get pushed ever higher, further validating the narrative, emboldening investors, and dulling risk aversion. And because investor greed is insatiable and accelerates alongside prices, this self-perpetuating cycle can go on for a long time - many years - fermenting a bubble. As is often the case, Buffett said it best when he said "What the wise do in the beginning, fools do in the end".</p><p>It is sometimes said that the definition of a bull market is a random market movement that causes investors to mistake themselves for financial geniuses (ARK's Cathie Wood is a great example of an investor suffering from that affliction at present). Powerful and prolonged liquidity flywheels cause many investors to mistake their significant gains for investment prowess and accurate foresight of secular trends, when in fact they are being driven by the forces of liquidity. I can articulate every single secular disruptive trend Cathie Wood espouses just as persuasively as she can. But I'm not under any illusion that these fundamentals are what is driving current share price gains. Wood would have been loaded up on AOL in 1999 talking about how the internet was going to change the world.</p><p>Anyone that has invested in a successful growth company during a secular <i>bear</i> market will understand this - such companies can deliver outstanding results year after year after year and the stocks can still go sideways/down. There are market-leading companies I know in Africa that have grown at 15% a year for the past 5-10 years, with high returns on capital and growing dividends, and yet seen their their stocks fall cumulatively by 50% (from about 10-15x earnings to 2.5x earnings) simply because frontier markets have suffered outflows, and accordingly there are more sellers than buyers for the stock, and price declines trigger yet more sellers (redemptions), so stabilisation/equilibrium proves elusive. For often surprisingly long periods of time, it is liquidity which drives market prices, not fundamentals. Anyone that owned Amazon during 2000-03 where the stock fell 93% will also know this. </p><p>As a liquidity driven boom roles on year after year, investors become increasingly skeptical about the role of valuation, for the simple reason that valuation has proven to be a poor predictor of share prices in recent history. Stocks that looked expensive just kept going up (due to liquidity, which is why they were expensive in the first place), so investors - many of which lack decades of experience - come to believe that focusing too much on valuation is a bad idea. Investors will also point to a handful of big secular winners like CSCO and MSFT (in the 1990s) and AMZN this cycle and note they were 'always expensive' and that it was a mistake to pass them up simply because they didn't trade on low multiples. They will then use this logic to justify paying almost any price for companies of vastly inferior quality, ignoring how unique and uncommon companies like AMZN are, so long as stock prices keep going up and validate the narrative. They are right that valuation is not a good predictor of share prices, but are wrong about why. They think it is because it is growth and business quality driving returns, when in fact it is simply liquidity. Nifty-50 investors learned this the hard way when the same high quality businesses with the same high quality and defensive operating results they had always had fell 80% in the 1970s.</p><p>As the boom roles on and the market capitalisations of favoured names mushroom, people lose all sense of scale, or at least choose to ignore it. In less heady times, investors worry that very large capitalisation stocks have less room to grow and so hence offer comparatively limited opportunities for large share price gains. Late in a liquidity driven boom, large market capitalisations are seen as no obstacle to continuing sustained outsized returns, because such companies are capable of driving rapid growth 'at scale'. The problem is that the world is large but it is not infinitely large, and trees don't grow to the sky. </p><p>For instance, Zoom Communication's peak market capitalisation was recently about US$200bn. Even to trade on a relatively high 20x earnings, it would need to earn US$10bn after tax. Are investors aware of how few companies there are in the world that actually make US$10bn? It's about as much money as Coca-Cola and Visa make, for instance - two of the world's finest enterprises. <i>Very few companies make more than US$10bn, because that is a lot of money, and the world is not infinitely big</i>. And yet I'm convinced most of the people buying Zoom at those prices actually expected to make very large and rapid returns, because, ya know, the company is growing really fast.</p><p>This sort of foolishness was widespread in the dot.com bubble. Near its peak, one analyst pointed out that AOL's market capitalisation already priced in more than everyone in the entire world having an internet connection. Investors weren't paying attention to the inevitable limits to growth because growth was really fast right now, and looked likely to remain fast in the foreseeable future, and well, ya know, the internet was going to be huge. This was able to happen because investors were so preoccupied with how much money they were making and how big of a growth opportunity the internet was going to be that they stopped doing any valuation math. Why? Because any argument that a stock was too expensive led to the 'wrong' investment decision being made over the past 5yrs+ as prices kept going up.</p><p>As the boom roles on and liquidity mushrooms, a wave of second-tier IPOs emerge, greeted by rampant investor enthusiasm, as investors seek to catch the 'next' secular winner (like the 'next Microsoft' in 1990s, or the 'next Amazon' in our times). Investors will justify paying virtually any price for companies like (for e.g. Sea Ltd), ignoring competition and operating losses, 'because Amazon lost money in the early years too'. At this point, it doesn't matter that the huge gains these stocks are enjoying represent pure speculation and hope about future prosperity, despite the comparative lack of it today or any realistic assurances it will actually materialise in the future. Risk aversion dissipates because such a long period of rising prices and rapidly growing top lines make the risk of loss seem remote.</p><p>Peter Lynch observed that it's always incredibly dangerous in markets when investors say company Y will be 'the next X'. In his experience, Y almost always blew up, and in my view that is because outsized success requires a unique and unlikely alignment of stars that occurs infrequently, and is also often the result of a lack of competition leading to an early advantage. The dot.com bust for instance may have helped Amazon a lot by cutting off access to capital to new emergent competition for many years, giving it time to solidify its lead. That doesn't happen in an environment where a million startups are getting funded and VCs are throwing billions of dollars at anything with a large TAM. When you have half a dozon companies all throwing billions of dollars at becoming the 'Amazon of South East Asia', a far more likely outcome is that they all fail and simply end up incinerating cash battling it out amongst each other for market share, just like the ill-disciplined airline industry of old.</p><p>At the late/extreme stages of a cycle, it can often reach the point where investors liquidate other assets wholesale in order to increase participation in the boom. This is usually the point in the cycle where multiple dispersion really starts to accelerate, and value funds not only lag from a relative perspective, but also begin to report poor absolute returns as well, as redemptions force sales and drive down prices.</p><p>In the late 1990s, the exact same argument was made about accelerating disruption being the justified cause of value's underperformance. Value funds' multi-year lagging returns led to them being discredited and suffering redemptions, as investors sought better returns elsewhere from managers that 'got' the new world order. Value funds were being shuttered left right and center, and Warren Buffett had one of his worst relative years ever in 1999, underperfoming by about 20%, to much mockery and condemnation that Buffett had become too old and was out of touch with the brave new world. Computers, software, and the internet was going to change everything. Value investors just didn't 'get it'. The truth, however, was that the starry-eyed growth crowd just didn't get it, and performance differentials were simply due to a rampant liquidity flywheel driving multiple dispersion to extreme levels. </p><p>A lot of investors today like to argue that the current tech cycle is different because the FAANGs today are powerful and monstrously profitable businesses, whereas in 1999 we had Pets.com and Webvan. But this is a major false equivalence. Today's FAANGs should be compared to 1990s secular winners such as Cisco, Microsoft, Oracle, Dell, and Intel etc, which were also monstrously profitable, and compounded earnings at 30-40% pa over a decade, while multiples levitated to 80x. These were globally dominant companies delivering rapid growth 'at scale' (as people like to celebrate today with FANGs), and were poised to benefit from (and dominate) the coming revolution in computing, software, and the internet. Fortunes were made in these names, and that is why there was an appetite for low quality IPOs - everyone wanted to buy into the 'next' Microsoft. Pets.com or Webvan should be compared to low quality IPOs like Nikola today, which people are buying because they want to buy into the 'next Tesla' - not to Google.</p><p>Value funds were left for dead during the late 1990s not because value stocks performed particularly poorly or were disrupted, but simply because they didn't own these high fliers. This mirrors the performance of value this cycle up until about 18-24 months ago, where the results in absolute terms hadn't been that bad - they merely lacked the spectacular gains of some of this cycles secular winners. However, a tipping point typical of late cycle excess began to emerge 18-24 months ago where we began to see outright liquidations of anything non-tech in order to get more tech exposure, compounded by the coronavirus, which has only hastened the rush into secular tech winners and away from everything else. This has lead to rapidly falling multiples for value and exponentially higher multiples for tech.</p><p>The other thing the late stages of this cycle have in common with the dot.com era is reckless excess in the conduct of monetary policy. In 1998, the Fed overreacted to the Asian Financial Crisis and slashed interest rates at a time a mature tech boom was already well under way, which helped propelled tech stocks to their final ludicrous heights. We have seen much the same thing happen as a consequence of extraordinary monetary stimulus/QE during the covornavirus downturn. </p><p>Of course, we know how the last cycle ended. Just as value investing was being declared well and truly dead, the NASDAQ proceeded to crash 85% and value investing enjoyed a resurgence. The bust happened for predictable reasons. The first thing was that investors forgot what happens every cycle - a boom leads to a massive flood of capital into an industry, and when this happens, <i>supply and competition increases, which eventually drives down growth and profit margins. </i>Investors believed there would be so much growth in software, compute, and telecoms/the internet that no amount of capital would be too much to overwhelm demand, and that industry players would be immune from the prosaic forces of competition and cyclicality that ailed the 'old economy'. They were wrong. Way too much fiber optic cable was built, for instance - so much that it took a couple of decades to absorb, despite the extraordinary growth in internet traffic we have witnessed. Instead of mushrooming growth and rising margins, we instead saw slowing revenue growth and a collapse in margins, as supply overtook even the torrid pace of demand growth, and competition heated up. This then led to a need to reign in costs and slow capex, as happens in every cyclical downturn, which led to cascading revenue pressures throughout the technology supply chain.</p><p>An analogous situation today would be Nvidea. Nvidea is a great company, with innovative products. However, it trades at 80x cyclically-high earnings, because people believe there will be so much growth in AI and other high-performance computing workloads that rapid growth and high margins will be forever unstoppable (as they thought with Intel in compute, or Cisco and networking kit, in 1999). However, as great as Nvidea is, it's growth is leveraged to the <i>second-derivative </i>of HPC/AI workloads - i.e. the <i>rate of growth </i>in the <i>rate of growth</i>. If there is merely a slowdown in the rate of growth in AI compute (i.e. it's still growing, just at a slower rate), Nvidea's revenues and earnings will fall. In a serious tech cyclical downturn, their revenues could halve and profits drop 75%. If the stock fell 90% it would still be on 32x P/E in this environment. That's pretty much what happened to Cisco and Intel.</p><p>The other thing that happened was that the stock market worked in fulfilling its capital intermediation role. If there is insatiable appetite for anything tech which drives valuations higher and higher, the financial industry will manufacture more product to sate that demand, which included a flood of tech IPOs. Eventually there was so much new IPO product it was able to absorb and overwhelm the wave of buying liquidity. We are seeing the same thing today. In the past on this blog, I talked about how there was a VC bubble unmatched by the stock market, and this was why we were seeing so few tech IPOs - the valuations would not stand up to the scrutiny of public markets. That has now changed - the IPO/listed space has become as/more frenzied than the VC space, and this has led to a flood of tech IPOs. As more and more IPOs come to market, not only is more capital raised to fund yet more product development and hence more competition, but there is simply are greater supply of stock to sate speculative demand. Secondary issuances, and continuing copious SBC (stock based compensation) and insider selling serve to further continuously increase supply. At some point, the force of supply will start to overwhelm demand, and that happened in 2000. And it led reflexively to an escalating cyclical downturn as tighter access to funding slowed IT spend, which had cascading impacts through the supply chain.</p><p>As the tech bubble burst, suddenly formerly-discredited value investors didn't look so silly anymore, and good quality companies making stable earnings and paying solid dividends also looked more appealing now that tech stocks weren't going up hundreds of percent a year, but instead handing investors losses of 80-90%, all while paying nothing in the way of dividends. Money started to move back into value, and the prior liquidity flywheel regime reversed with a vengeance. Suddenly value funds were posting great numbers and sidestepping major wipe-out tech sector losses, and so started getting accelerating inflows, and all that new money was plowed into low multiple stocks, and there were few sellers. Prices kept rallying and the cycle continued. This lead to a spectacularly good decade for value (and particularly EM value, where many markets went up >10x from extremely expressed and under-owned levels at the turn of the millennium, as money had previously rushed into the US tech/large-cap and the USD, and away from EM after the Asian Financial Crisis and a collapse in oil prices to US$15/bbl).</p><p>By circa 2010 (2012 for EM, 2014 for FM, and 2006-12 ish for DM value) we had come full circle. Value had outperformed over a full cycle with let risk, like it usually does (and <i>without </i>owning the 1990s cohort of secular winners, I might add), but multiple dispersion had now significantly decreased, to the point of being unusually low. I recall reading Grantham's quarterlies at the time, where he observed that multiple spreads were unusually low, and that in particular, that there was an unusually low multiple premium being awarded to super-high-quality in the US. </p><p>What had actually happened over the prior decade was something of a bubble in value strategies (as bizarre as that might seem). On account of their strong performance over the past decade, too much money had flooded into traditional value strategies, which resulted in multiple differences being arbitraged down too much. It resulted in a number of extremely mediocre investors such as Whitney Tilson amassing large funds merely on account of being in the right place at the right time and getting lucky - buying low multiple stocks at the right time. They too fell into the trap of letting a liquidity fueled secular bull market in value cause them to mistake themselves for financial geniuses. As market conditions became more challenging for value post GFC, many have blown up, and in so doing, proved themselves to have merely been beneficiaries of favourable market conditions in the prior decade, rather than in possession of genuine investment skill (and also demonstrating that it can take up to 20 years to truly assess the capability of an investment manager - i.e. through a full <i>secular</i> market cycle). The value players with genuine skill are those that have invested through a <i>full </i>secular cycle and come out with good numbers, even if recent numbers have been poor (such as Platinum in Australia).</p><p>The pendulum has swung back the other direction since circa 2012 as a new wave of tech structural growth winners emerged from the wreckage of the dot.com bust and GFC. Valuations were more than sensible in 2012 - they were cheap. Google for instance traded at just 12x earnings ex cash in 2012. It was a bargain. Visa traded for just 15x. As Grantham accurately observed, high quality was very cheap. On account of their quality, growth, and low valuations, these stocks predictably did well - much better than value stocks which by then were expensive relative to high quality on a quality-adjusted basis. After the trauma of the GFC, and the low interest rates that emerged in its wake, investors also started to seek out safety and yield-substitutes, which triggered the beginning of a secular upswing in demand for high quality defensive equities, and particularly defensive growth. It made sense - for a while. </p><p>However, at some point we veered down the same road we always do - valuations rose, driving strong returns. That has lead to performance chasing inflows, driving multiples up further, and so on and so forth. So here we are again, approaching the end (perhaps) of yet another swing of the secular pendulum, where virtually the entire world is long mega-cap tech and other software names, the USD, and defensive high quality (healthcare, staples etc) and defensive secular growth, with valuations near record highs; triple digit P/E ratios have lost their shock value (as have P/S ratios of >30x); all while other parts of the investment universe are generationally cheap with low single digit P/E ratios and 10% dividend yields - some of the greatest value dispersion we have ever seen in market history, period. </p><p>In my view, value investing is not dead - it's just spent a decade going from fully priced to cheap while other market sectors have gone from fair-to-cheap to very expensive. The commonalities today with 1999 are very stark. Oil and energy is very depressed, just like it was in 1999 when The Economist published its famous 'drowning in oil' cover. Parts of EM are very depressed, including currencies, much as they were in 1999 after years of a strengthening USD and the fallout from the Asian Financial Crisis; value is discredited and value funds are shutting down, just like in 1999, and today, everyone owns the USD, tech, and US large cap quality stocks, just like in 1999. And in both cases, the boom has been aided and abetted by Fed monetary excesses. </p><p>That said, we are arguably still are not yet at the level of valuation crazy we saw at the peaks of 2000 (although that's debatable), and we have far more monetary stimulus and lower rates now than we did back then (not debatable). As a result, it is always possible the bubble inflates to even more epic proportions for several more years, with stocks like Google and Facebook ending up at 60-80x earnings, although I wouldn't bet on it. On the other hand, the size of the aggregate market caps now in absolute terms are already much more extreme than in 2000. I'm not sure when a reversal will happen, and whether one is already underway, but in my view it is inevitable that the pendulum will swing back the other way at some point, because such forces are absolutely inherent to how financial markets work - as little appreciated as they often are. Always have been, and always will be in my view.</p><p><br /></p><p>LT3000</p>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-82057934325842201172020-07-28T13:52:00.001+07:002020-07-29T10:54:19.854+07:00Market inefficiency, liquidity flywheels, asset class arbitrage, and Hong Kong LandConventional 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, <i>and</i> also price assets correctly <i>relative</i> to one another.<br />
<a name='more'></a><br />
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 <i>structural </i>and <i>behavioural</i>, rather than <i>informational</i>, which is why I believe it will always exist, and provide ample opportunity for the well-heeled.<br />
<br />
The efficient market hypothesis (EMH) misses one very important point - <i>the majority of security/asset-level investment decisions are not made by the ultimate owners of capital, but instead via their appointed intermediaries</i> - 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.<br />
<br />
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).<br />
<br />
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 <i>asset classes</i>, 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.<br />
<br />
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 <i>persistent</i>, 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 <i>amplify </i>rather than moderate these inefficiencies.<br />
<br />
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 <i>same underlying assets </i>being valued at very different levels with very different costs of capital, and use Hong Kong Land as an example.<br />
<br />
<br />
<i>Liquidity flywheels</i><br />
<br />
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 <i>the</i> 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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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, <i>and </i>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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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, <i>and</i> 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, <i>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. </i><br />
<br />
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.<br />
<br />
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 <i>this process is inherently self-sustaining, not self-correcting</i>, 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.<br />
<br />
Liquidity flywheels are one of the most important forces in markets, and one of the most under-appreciated. <i>They are also the fundamental reason why momentum strategies work</i> (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, <i>provided </i>one has a reliable means by which to determine when momentum has turned, because when momentum reversals happen, they happen big and fast.<br />
<br />
<br />
<i>Different prices and costs of capital for the same asset</i><br />
<br />
Another important consequence of these institutional forces is that radically different costs of capital (and hence asset valuations) can emerge for the <i>very same assets</i>, 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 <i>same assets</i>), 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.<br />
<br />
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 <i>unleveraged </i>real estate holdings.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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%.<br />
<br />
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).<br />
<br />
The cost of capital for listed equities is higher because equities are volatile, and <i>in general</i>, 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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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%, <i>without </i>having to bear the risk of explicit volatility/drawdowns.<br />
<br />
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, <i>but instead cash and bond yields</i>, 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 <i>exactly the same assets</i>, just with different packaging, and the packaging can change the cost of capital dramatically. <i>This is a very clear refutation of the EMH.</i><br />
<br />
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.<br />
<br />
<br />
<i>Conclusion</i><br />
<i><br /></i>
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
<br />
<br />
LT3000<br />
<br />
<br />
Disclosure: I do not own shares in HKL<br />
<br />
<br />
<i>*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.</i><br />
<br />
<br />
<i><u>Postscript</u>: Just as this note was going to press, I noticed that HSKE-listed Dongfeng Motor (489 HK) - a company I blogged about in 2018 <a href="https://lt3000.blogspot.com/2018/02/bargain-stocks-in-hkchina-no-brainer.html">here</a> - 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)."<br /><br />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.</i><br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-82290343877308793502020-05-11T19:15:00.000+07:002020-05-12T12:15:12.107+07:00Coronavirus update: From an unknown unknown to a known unknownOn March 17th, I blogged some thoughts on the coronavirus outbreak; its significance; and how I was seeing the outlook. While we are still far from the end of this crisis, at this stage events appear to be playing out largely in line with the analysis and predictions outlined in that article, so I haven't felt much need to pen an update. My views were generally considered wildly optimistic at the time, but recent events suggest it was more a case of investor sentiment being unreasonably bearish than my views being unreasonably optimistic.<br />
<a name='more'></a><br />
I've also been very busy analysing stocks and taking advantage of the market volatility (you don't get given buying opportunities of this caliber very often - somewhere between once a decade and once in a generation - so you absolutely have to make the most of them), so I have been allocating less time to writing/blogging. Given the pervasive impact of covid-19 on economies and markets at the moment, blogging about any other topic has also seemed somewhat superfluous.<br />
<br />
Nevertheless, I thought I would add a few thoughts in this post. For me, one of the most predictable and amusing things we have seen since markets bottomed on 23 March has been the widespread dismay, confusion, consternation, and even anger expressed by many market commentators and investors about why markets are rallying in seeming defiance of the fundamentals, and 'decoupling from the economy'. Don't investors understand what's happening out there in the real economy? Haven't they seen the payroll numbers? Don't they know earnings are going to drop a lot? Etc etc.<br />
<br />
This reaction demonstrates just how little investors seem to understand about how markets actually work - both on the way down and on the way up. I'm not using hindsight bias here - in mid March I publicly said I thought markets were bottoming on both Twitter and this blog, and on March 25, two days into the recovery, I Tweeted "[t]his is about the time in the recovery where you'll hear a lot of people coming out and saying bear market rallies are common, and we will surely go back down and retest the lows, as effects of shutdown will continue for months etc... No such guarantees I'm afraid. Lows are likely in". I'm aware that calling markets is generally a fool's errand, but I also believe that markets are not equally unpredictable at all times. This was a unique situation, and there was ample evidence sentiment had reached bearish extremes, and that investors had likely significantly overreacted. It was not that hard to predict that markets - for both technical and fundamental reasons - would likely revert to a far more rational assessment of the outlook in due course.<br />
<br />
Fully unpacking the various issues at play here is difficult because it requires what I call '3D thinking', which does not lend itself to simple narrative exposition. This is because understanding why A leads to B requires you understand C, but understanding C requires that you already understand how A leads to B, etc. This article was written and re-written, and in the end I gave up and decided to just focus on a few pieces of the puzzle (sorry!).<br />
<br />
What I want to focus on in this article is the important and underestimated role 'unknown unknowns' play in market turmoil, and the widely overestimated importance of 'known unknowns'. I also critique the idea markets are 'ignoring the fundamentals' - they are not; they are just paying attention to different fundamentals than many people think they should be, but the same fundamentals the market always pays attention to during recoveries (and correctly so). Finally, I address some of the perils of 'reasoning by analogy' rather than from first principles - something I've blogged about in the past.<br />
<br />
<br />
<i>Known unknowns vs. unknown unknowns: the real reason markets crash (and don't)</i><br />
<i><br /></i>
In every major market sell-off in history - and every major buying opportunity - there has always been a pervasive sense that 'life as we know it has changed'. When the downturn is viewed from a comfortable historical distance and with the benefit of hindsight, people invariably look back and say, 'gosh investors were so silly to sell stocks down to those levels; if it was me, I would have been smart and rational enough to know it was a great buying opportunity, and bought when others were selling'.<br />
<br />
However, prospectively and in real time, when every new crisis comes along, people invariably react by saying '<i>yes but this time <u>really is different</u> - we haven't seen anything like this before; this is truly unprecedented</i>'. However, what is overlooked is that <i>every major crisis/sell-off in the past has felt (and been) that way to the investors experiencing them at the time</i>, which is precisely why the sell-offs were so violent in the first place<i>. </i>A sense of disorientation emanating from a lack of historical precedent/easy past analogies to draw on is exactly what creates the pervasive sense of fear necessary to occasion a major crash.<br />
<br />
The hindsight observer has the benefit of knowing how things subsequently played out with respect to that specific case/downturn/sell-off, which creates a known precedent which can inform their future judgments, should similar circumstances recur in the future. When they look back on past crises, they therefore have a playbook for how crises of that particular nature work, and are then able to fool themselves into believing they would have been in possession of such a framework at the time, and reacted rationally. However, this perspective overestimates the level of visibility investors had at the time had who did not benefit from such a precedent.<br />
<br />
This is the very definition of hindsight bias - overestimating how much was known/knowable at the time in light of new information that subsequently emerges. In the 1970s, an OPEC oil embargo, which tripled oil prices virtually overnight, and lead to double-digit inflation and treasury bond yields, was also unprecedented. The world economy was fundamentally dependent on OPEC oil, and the supply had just been choked off. The world as we knew it had changed. After the dramatic and tragic events of September 11, it was also widely believed that the world had changed forever, and that the old rules may no longer apply. The GFC was similarly 'unprecedented' in many ways. The point is, it is <i>always </i>unprecedented, because it if was not, markets would not go down anywhere near as much. You'd have 10-20% ish corrections - sure - but not the 40%-esque meltdown we saw during 1Q20, which was one of the largest and fastest market crashes in financial history.<br />
<br />
The error is in believing that it is <i>known unknowns</i>, including known risks/headwinds to the economy, that drive major market sell offs/panics. It is associated with the well-known bias of 'generals fighting the last war': investors believe the next market downturn will look just like the last or prior downturns, and they believe markets will react in the same way. And knowing how those downturns played out, investors feel confident they will be well positioned to navigate the downturn and profit from <i>other </i>investors being irrationally pessimistic.<br />
<br />
But markets don't work like that. The additional comfort the above would-be bargain hunter derives from knowing how similar cycles have played out in the past will also be felt by would-be irrational sellers, who are apt to behave far less irrationally the next time a similar downturn occurs, having already been aware of the risk of its recurrence and prepared accordingly. Cyclicals and financials, for instance, have remained cheap in recent years, despite a long bull market, precisely because investors have feared another recession that looked a lot like past recessions, and thus avoided such names. <i>Known unknowns do not drive major market panics</i>, because the necessary degree of fear, anxiety, confusion, disorientation and outright panic is unlikely to be sufficiently present.<br />
<br />
It is instead the emergence of <i>unknown unknowns </i>- new and novel risk factors that investors were not previously aware of and had not factored into their expectations/risk appetites, that drive crashes. A crash occurs because it triggers a <i>rapid and synchronous</i> de-risking of portfolios, as people react to the new, unanticipated risk factor, and reposition their portfolios to reflect the increased degree of uncertainty, including the endogenous uncertainty associated with extreme asset price volatility itself (i.e. regardless of its cause, many investors cannot/will not tolerate extremely high degrees of volatility/price declines, and this creates the feedback loop necessary for a crash to occur - i.e. when selling and falling prices beget yet more selling, as de-risking accelerates).<br />
<br />
Investors get scared, and they decide to increase their cash allocations from (say) 5% to 20%, to 'preserve capital' in the face of the newly-uncertain environment, and 'prepare for future opportunities amidst the coming downturn'. They do this because they believe an abundance of caution to now be warranted given what has become an extremely uncertain/risky outlook, and also because they mistakenly believe that because the economic fallout is likely to last quite some time, that markets will also inevitably continue to go down/remain weak for a long time to come as well. Ego, 'future opportunities' will be significant, and cash will allow them to take advantage of them.<br />
<br />
The problem with this perspective and behaviour is that it is classic 'first-level thinking', instead of the more desirable second-level thinking necessary in markets (hat tip Howard Marks). What investors fail to understand is that <i>it is precisely the synchronised move to higher cash allocations and a more defensive positioning mirroring their cautious outlook </i><i>- which they themselves were very much a part of - </i><i>that caused the market to crash in the first place</i>. If everyone increases cash allocations from 5% to 20% at the same time, markets will crash, regardless of the cause. And that has absolutely been the case, from retail to institutional investors, to insurance companies and other institutions alike (QBE Insurance, for instance, recently came out and said they had "materially de-risked the investment book including exiting all equities, emerging market and high yield debt"; HK Exchanges similarly exited 100% of its equity exposure in March and early April).<br />
<br />
The thoughtful market observer would ask the question, so what happens next? Most of these investors don't plan to continue to hold 20% cash indefinitely. They are looking to re-deploy it back into equities at a time they perceive to be more opportune. What they really mean when they say that is 'when the outlook is less uncertain and they feel more comfortable', but what they overlook is that sellers will also feel more comfortable at this point; however, the important practical point is that it means they will be future <i>net buyers</i> of equities. Furthermore, they have already sold as much stock as they want/need to sell in order to feel comfortable with their remaining exposure in the face of what they expect will be considerable economic fallout in the medium term. Given their already very cautious outlook, it is therefore unlikely they will sell a whole lot more in the future.<br />
<br />
What has happened at this point is that <i>a previously unknown unknown has now become a known unknown</i>, and consequently is now already factored into investor risk appetite and market positioning, and so it ceases to have much impact on market prices. And this is true regardless of whether the underlying economy is weak or not, because the economy does not drive stocks prices - demand and supply do. At this point, and in contrast to the intuitions most recently-scared investors harbour, a further market crash actually becomes extremely <i>unlikely</i>, and those sitting in cash hoping for more of the same are very likely to have their hopes dashed.<br />
<br />
This is why markets almost always bottom well before the real economy, and recover in a manner that confounds most investors. Right when the majority of investors have just finished selling down, raising cash, and positioning themselves cautiously and in preparation for the 'coming downturn' and the 'buying opportunities' sure to emerge therefrom, markets start to rally and the opportunities they had hoped and expected to encounter swiftly disappear. The buying opportunities are not created by the economic downturn per se, but investors <i>preparing </i>for the economic downturn by raising cash.<br />
<br />
They are left high and dry holding a bunch of cash. They are confused, and perhaps even angry at the market for behaving so irrationally, and ignoring how bad things are in the real economy. They claim investors are ignoring economic realities. They say the rally must be a dead cat bounce. They say bear market rallies are common and investors are being fooled by it. They say investors are too optimistic on the speed of the recovery. They say it's because investors are overly acclimated to 'buying the dip', etc. They use every excuse they can muster to avoid admitting to themselves the sad reality that they may have sold at the bottom, just like patsies do every bear market. What they are really doing is <i>hoping </i>markets go back down so they have a second chance to buy stocks as cheap as they were recently trading, but with so many cashed-up investors similarly hoping for a further pull back, such an outcome is inherently self-defeating. There is simply too much cash on the sidelines waiting for an opportunity to buy the second dip for markets to go down enough to retest their lows.<br />
<br />
There never has been, and never will be, a law of the universe that dictates that stocks will go down just because the economy remains weak, and the actual truth is that markets almost never go down much - if at all - when investors are already cautiously positioned for a known unknown, and are already holding a lot of cash in preparation for a difficult and uncertain future. <i>They go down a lot when people go from being aggressively positioned to defensively positioned en mass, because they were not previously expecting future turmoil/economic stress, and they now are. </i>Once people are defensively positioned, markets are apt to rise because the selling pressure of people moving into a defensive position abates, and there is far more latent buying lying in wait (i.e. all the cash people raised to take advantage of buying opportunities), and too few sellers left.<br />
<br />
Every single time there is a recovery from a major economic shock/market sell-off, the same thing happens; people react with the same credulity, and believe the market is ignoring the fundamentals. Throughout the substantial 2009 market recovery from the GFC lows, there was widespread skepticism about the durability of the rally. Didn't people know that the economy is in a mess and it is going to take years to recover from it? Yes, they did, <i>and that was the whole problem</i>. It was no longer an unknown unknown. The economy contracted throughout 2009 and unemployment continued to rise, and yet stocks continued to rally, not only through 2009, but for the next decade.<br />
<br />
<br />
<i>Is it really accurate to say markets are ignoring the economy?</i><br />
<br />
This brings me to my second critique - the idea that the market is ignoring the 'fundamentals' at the moment. While the cash-is-king bears would love this to be true, the reality is that this is simply not the case. What the market is actually doing is what it always does during market recoveries from crises/crashes - <i>ignoring lagging/co-incident indicators that suggest bad things are happening in the economy that were already widely anticipated to occur during the panic, and instead focusing on the leading indicators which are pointing to an improving medium term trajectory</i>.<br />
<br />
Furthermore, <i>even if</i> conditions get every bit as bad as anticipated, but they stabilise at those terrible levels, the <i>degree of uncertainty </i>still declines, as fear of the unknown is replaced with tangible knowledge of how bad things actually will get. If you're convicted of a crime but are awaiting sentencing, while your 'sentence' might be bad, there is also some comfort in knowing exactly what it is, so you can accept and deal with it, and don't have to worry about unlikely worst case outcomes. This is a large cause of the well-known 'sell the rumour, buy the fact' dynamic in markets as well. In markets, people can tolerate things being bad; <i>what they can't tolerate is extreme uncertainty</i>.<br />
<br />
Everyone expected the economy to take a massive hit and unemployment to surge on account of the lockdowns in March. Panic about the absolute carnage that would befall global economies on account of widespread government lockdowns is what drove many asset markets down 40% in the space of 4 weeks, and many individual stocks down by as much as 80%. Sell-offs of this magnitude are extremely rare, and do not happen if investors aren't expecting something approaching Armageddon. It is therefore not surprising newsflow confirming that a lot of these things happened in April - notably disastrous US payrolls - has had no additional negative impact on markets.<br />
<i><br /></i>
What has actually been happening over the past six weeks or so of market recovery is that investors have been reacting not to the economic downturn that was already widely expected and priced in, but instead to growing evidence that the duration of the downturn and the breadth of severe impacts may have been meaningfully overestimated. For airlines, the downturn has so far been every bit as bad as feared, but for many other companies, earnings have proven far more resilient than many investors assumed they would. This is because - as I discussed in my original article - in actual fact large parts of the economy have remained relatively unaffected, and we now have unprecedented ability to work and shop online in the modern era. There has also been a 'headline' bias - no one was writing news stories during March about countries and states that are <i>not </i>locking down (except Sweden).<br />
<br />
Reporting season has aided in this regard, as a void of corporate silence has been replaced with hard facts about the degree of impact companies are seeing in their business, along with post balance-day trends. Generally speaking, results and recent trends have been less bad than previously feared, and most companies are reporting that the nadir was seen in early April, and a steady recovery has been building thereafter, aided by fiscal support which was significantly underestimated. Commentators not acknowledging this reality have been utterly consumed by confirmation bias.<br />
<br />
Furthermore, pulling up a bit, it cannot be ignored that the trend in new infections and deaths has been declining almost everywhere. It is no coincidence that markets bottomed on 23rd March, only two days after new case volume peaked in Italy, after which it has exhibited a very substantially declining trend. This outcome is being mirrored almost everywhere, with varying degrees of lag. Social distancing policies have worked, but it hasn't been just that. Even in nations without hard lockdowns, like Sweden, are seeing similar trends, while many states/countries without large-scale public transportation and/or dense populations have seen case volume and total deaths come in way below the expectations that existed <i>even at the time lockdowns were instituted</i>.<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhepIQdaqjnTkIyFKQJR16IuhlzbOSBnKyvkw2VlJD5d9xu5nq0iF-EZQgrgT3c7k_gM85srSMuHcq1RUYM4ZUvN30Kiot4KtGzW9TtsGmLyMtiOvPC8xY7ywdVwO-ZUOZqIqStnpFWx_Y/s1600/italy+3.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1200" data-original-width="1600" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhepIQdaqjnTkIyFKQJR16IuhlzbOSBnKyvkw2VlJD5d9xu5nq0iF-EZQgrgT3c7k_gM85srSMuHcq1RUYM4ZUvN30Kiot4KtGzW9TtsGmLyMtiOvPC8xY7ywdVwO-ZUOZqIqStnpFWx_Y/s320/italy+3.jpg" width="320" /></a></div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg6KuThXjlmc0qG3OPHVPS8FTzHCqTFOIcPEvzGUAf3Wy1vopVpZiAajGqMyDCcFoNC25g28sQ1aSJ_wjkmX17IH4dDp7u7Nzw_5sBkzwlRvanQPL_w7QK79uRDohjukf9F8gXbowbvdTg/s1600/italy+4.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1200" data-original-width="1600" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg6KuThXjlmc0qG3OPHVPS8FTzHCqTFOIcPEvzGUAf3Wy1vopVpZiAajGqMyDCcFoNC25g28sQ1aSJ_wjkmX17IH4dDp7u7Nzw_5sBkzwlRvanQPL_w7QK79uRDohjukf9F8gXbowbvdTg/s320/italy+4.jpg" width="320" /></a></div>
<br />
<a href="https://www.worldometers.info/coronavirus/country/italy/">https://www.worldometers.info/coronavirus/country/italy/</a><br />
<br />
This likely reflects a combination of the overestimation of many mechanisms of community transmission (i.e. countries/states where private commuting occurs instead of the use of mass public transportation seem generally less affected), as well as voluntary behavioural changes and increased sanitation practices in workplaces (face masks, temperature screening, testing, etc), which is something I discussed in my original blog article. Evidence is also emerging that a disproportionate amount of transmission in cases leading to death has been happening within the hospitals themselves (there isn't a lot of social distancing in hospitals), as well as in nursing homes (see John Tepper's <a href="https://medium.com/@tepper_jonathan/ground-zero-when-the-cure-is-worse-than-the-disease-3c513d91393d">excellent article</a> on this - a must read). This is important, because it appears likely that the prevalence of community transmission has been meaningfully overestimated, which will contribute to the spread of covid-19 being managed in less economically destructive ways in the future.<br />
<br />
Estimated death rates have also continued to plummet as we have increased testing, due to the highly-predictable 'denominator effects' I discussed in my original article. Initially thought to be 3-5%, death rates have now been revised down to closer to 0.3-0.5%, and even that may prove to be an overestimate. Singapore, where very widespread testing is happening, has seen 18 deaths from 18,000 cases - a death rate of just 0.1%. This has two implications. Firstly, it means the lethality of the virus is an order of magnitude less than previously thought; and secondly, it means the number of people that have already contracted the disease is an order of magnitude more than originally thought as well. That means we are coming off a much higher base of virus penetration, which will make it easier to bring case volume and deaths down, and mean there will be a larger than anticipated degree of herd immunity in place to help moderate the severity of second waves.<br />
<br />
To see what people thought a few months ago, one need only look at the hysterical musings of people like John Hempton, who after reading a bunch of academic papers and convincing himself he had a 'substantial edge' over the market in understanding covid-19, was calling for hundreds of thousands of deaths in Australia without radical action, and was publicly calling PM Scott Morrison a mass murderer for not doing enough. Australia's death toll as at 10 May has come in at 97 thus far - <i>three </i>orders of magnitude less than Hempton's expectations. Hempton made money shorting the market in March, but did so because enough people - policymakers and other investors - made the same mistake he did. He was right for the wrong reasons. It was this degree of hysteria that was driving markets in March. People really thought the virus was going to kill 3-5%+ of the people it infected, including policymakers, whose extreme policies largely reflected that error of judgment.<br />
<br />
Anyone who has studied statistics 101 should have been alert to the dangers of extrapolating from small, unrepresentative sample sizes - in this case, the death rate emanating from the subset of people sick enough to visit hospitals and get tested, rather than the entire population of people infected with the disease. The latter statistic could only be ascertained by a randomised test of a representative sample of the population, and all such tests to date have revealed much wider prevalence than previously expected (and hence a much lower average severity rate). Some antibody tests suggest as much as 15-20% of the population may have contracted it in parts of Germany and Italy.<br />
<br />
However, as is often the case in environments of heightened emotion, people failed to reason rationally, relying too much on anecdote and not enough on hard data/statistics - a common psychological failing of human beings, whose intellect evolved to facilitate complex social interactions, not mathematical/statistical nuance. The world is a big place and the population is genetically diverse. There will always be someone, somewhere, who is young and healthy, and has an atypically severe experience with the disease, whose story can be told via the mass/social media. But we have long known that anecdote is a poor substitute for representative data.<br />
<br />
The reality is that as bad as covid-19 is from a public health point of view, the data is not turning out anywhere near as bad as people initially feared, and anyone who does not believe this has important implications for the likely severity and duration of this covid-19 induced economic downturn is kidding themselves. Remember, this downturn has not been caused by covid-19 per se, but our policy <i>reaction </i>to covid-19, which has contained some flawed premises. The crisis is entirely man-made, and can be largely undone just as easily by reversing such policies. And as case numbers and deaths have declined, lockdown policies have already started to be relaxed almost everywhere.<br />
<br />
Most companies report that activity levels bottomed in early April and have started to steadily recover since that time, aided also by fiscal stimulus measures starting to be felt. Oil demand has started to recover as commuting demand is slowly returning. Even several consumer financing companies in the US have said that the level of delinquencies has started to decline, after peaking in early April, as consumers begin to receive stimulus checks, and being home-bound, are unable to spend money on travel and entertainment, and so are committing funds to debt reduction instead.<br />
<br />
China has seen a veritable V-shaped recovery, with many companies operating in the region saying that their factory production is back to near full capacity, and while end consumer demand has not fully recovered in all places, it is rapidly on the way there, <i>despite a significant demand shock to the country's export sector, as lockdown policies in the rest of the world have come into effect</i>. Consider this slide from Adient's 1Q20 calendar quarter for instance. People that say 'we have no playbook for how the economic recovery will look', but we actually do - just look at China.<br />
<div class="separator" style="clear: both; text-align: center;">
</div>
<div class="separator" style="clear: both; text-align: center;">
</div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLhjsWlNepfa9rUJJWCIRb7kgrE_tpSxs9rbbe_eE7gU9FY1JNkt0B00ei7NXXn8XQhA-nX1IFZvRGu-aPxBZLWTRh5fHFeURzjuaonxykTWivyFtPAci4Z2kQ4HxyFHRnjljOPZanxL4/s1600/adient+4.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1200" data-original-width="1600" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLhjsWlNepfa9rUJJWCIRb7kgrE_tpSxs9rbbe_eE7gU9FY1JNkt0B00ei7NXXn8XQhA-nX1IFZvRGu-aPxBZLWTRh5fHFeURzjuaonxykTWivyFtPAci4Z2kQ4HxyFHRnjljOPZanxL4/s320/adient+4.jpg" width="320" /></a></div>
<br />
<div class="separator" style="clear: both; text-align: center;">
</div>
During market recoveries from significant sell-offs, markets have never focused on how bad things presently are, but instead trends in the second-derivative and leading indicators, and for good reason: the stabilisation of activity at the bottom, and 'green shoots' of initial recovery, are extremely important because of (1) the way the economy works and the way economic actors behave; and (2) the degree to which it reduces psychological stress/uncertainty.<br />
<br />
With respect to #1, if you are a company and you see your revenue falling, you react by cutting opex and capex, and increasingly go into survival mode and seek to preserve cash. If your revenue keeps falling, you will keep cutting opex and capex more, and the problem of course is that your opex and capex is somebody else's revenue. This creates a downward self-sustaining cycle in the broader economy, which if left unchecked can spiral into something resembling the great depression.<br />
<br />
This is why signs of stabilisation and initial recovery - even if very modest - are so important. Once corporates see their revenue start to stabilise and tentatively improve, <i>they will stop cutting capex and opex further, and may even very tentatively start to increase it</i> - of the 10 projects they cancelled, maybe they will go ahead with 1 that they were previously very reluctant to cancel. Once the curve turns, the self-sustaining forces on the downside flip into self-sustaining forces driving a recovery. As capex & opex starts to turn very slightly up, corporate revenue starts to improve, and then they start to rehire and restart projects, etc. This is why leading indicators are so important.<br />
<br />
The second reason is that the degree of uncertainty for investors radically diminishes. When you enter into a downturn and the economy continues to worsen, investors feel like they are walking into a dark tunnel, and the further they walk in, the darker and scarier it gets. They know, intellectually, that the tunnel has a finite duration, but they don't know how long the tunnel is and how dark it is going to get. So long as it keeps getting darker and darker, anxieties worsen. There is a lack of any sense of hope, and it becomes easier for investors to entertain worst-case scenarios, and start to view them as base case likelihoods. 'What if the tunnel goes on not just for hours, but for days, weeks, months, or even years?!', 'What if the tunnel has no end at all!?'. 'What happens if I'm actually walking around in circles and don't realise it!?" 'What if there are strange creatures or undiscovered species of monsters lurking in this tunnel'!?<br />
<br />
However, at some point, a very faint light at the end of the tunnel emerges. At this stage, the psychology changes. Now sure - there is still a hell of a lot of really dark tunnel to walk through, which is a real drag (i.e. the economy is going to remain extremely weak for quite some time yet), but now not only is there a renewed sense of hope, but one can also start to form a more sensible and realistic assessment of how dark it is likely to be and for how long, when before one had no idea. The degree of uncertainty diminishes, which allows investors to more rationally assess and quantify the probable economic damage, and the realistic degree of impact on companies' earnings and balance sheets, and increasingly wild speculation about improbable worst case scenarios also tends to ease up. And owing to the market's propensity to significantly overreact in the short term, in almost all cases, such rational assessments reveal that markets have been massively oversold.<br />
<br />
People forget that stocks are long duration assets. If a stock drops 40% from 20x earnings to 12x earnings in a market crash, the market has just subtracted <i>eight years </i>worth of profits from the valuation. If the company comes out and says, yeah earnings were down 50% in 1Q20, and we think we will operate at a small loss in 2Q, before recovering to 75% of normal profitability in 2H20 based on trends we are already seeing in our revenues and costs, with a full recovery likely during 2021-22, it is not hard to see how investors could start to reconsider whether such a dramatic repricing of the stock was truly justified. Commentators that therefore say "but the economy is still so bad"; "but their earnings are going to be way down in 2Q", "but unemployment and the economy are going to remain weak for a while yet", therefore completely miss the point. The types of share price declines previously exhibited required things be much much much worse than that to justify.<br />
<br />
Investors will look through short term earnings pressures and price the impact in a rational manner <i>provided </i>some critical threshold of uncertainty is not breached. When uncertainty is high enough, investors panic and sell and sometimes, no price seems too low. However, when uncertainty declines back below this critical threshold, investor behaviour becomes far more rational, and when that happens, markets are apt to sharply rally from deeply oversold levels. That is exactly what we have started to see in recent weeks/months, as the degree of uncertainty has moderated.<br />
<br />
<br />
<i>The dangers of reasoning by analogy</i><br />
<br />
A final point worth discussing about recent market experience is the danger of reasoning by analogy - something I blogged about last year, and which is a very frequent cause of poor judgment in markets (and in life). One of the reasons so many investors have been paralyzed by fear during this downturn is that they have no way of thinking other than by analogy, and there are no analogies to draw on with respect to how to invest through a pandemic and government lockdown, so they have defaulted to one of two positions - both flawed. Either they say that because this event is completely unprecedented, the amount of uncertainty is so high that no reasonable basis for forming any assessment on the outlook exists; or they default to comparing the downturn to the GFC or even the great depression, because - well - um - stocks and the economy went down a lot then too.<br />
<br />
There are multiple problems with this approach. Firstly, an aside on uncertainty: the reality is that the future is <i>always </i>uncertain; it just <i>feels</i> more uncertain to investors at certain times. <i>This is because, as noted, the primary risk in markets is <b>not</b> known unknowns, but unknown unknowns</i>. Six months ago, the outlook felt more certain, but little did we know that covid-19 was about to emerge and wreak havoc with the global economy and financial markets. <i>Risk comes from the fact that unknown unknowns exist in the world, and by definition, such unknowns cannot be foreseen. </i>The outlook therefore might feel more or less uncertain to you, but that is an illusion. And even if the outlook for the economy is in fact objectively more uncertain today than it was six months ago, that does not mean the outlook for <i>markets</i> is more uncertain or riskier than normal, because covid-19 is now a known unknown.<br />
<br />
Furthermore, the amount of opportunity that exists in markets is directly proportional to the level of uncertainty or perceived uncertainty that exists, because markets/people <i>hate </i>feeling uncertain. That is because investors/people are not comfortable thinking in terms of probabilities - they like black and white, yes and no answers - something I have also blogged about in the past - and if they can't feel sure they know what is going to happen, they don't feel like they can act. But that is not rational - you can weigh the probabilities, and you <i>must, </i>because there is no other way to operate in markets - <i>at any time</i>. And as a buyer, the more uncertain the outlook the better, because the market systematically underprices assets in an environment of uncertainty. Using a high level of uncertainty as a justification for sitting on one's hands may sound sage and prudent, but it is actually foolish.<br />
<br />
But I digress; the more important point I want to make here is that the idea that one cannot form reasonable judgments about the outlook and the probabilities in the absence of analogies or historical precedents is flawed. The truth is, the very best opportunities in markets - whether they be at the market, industry, or individual stock level - always exist in situations where there are novel events or changes happening that render past analogies obsolete. It disorients investors and makes them uncomfortable investing. That is how stocks get very cheap. Great investors are the ones who are original thinkers and are able to reason from first principles <i>without </i>requiring the crutch of analogy. This is something Warren Buffett has obliquely mentioned, when he said he seeks out in successors a very rare trait, which is an ability to think about and anticipate risks that have never happened before. In other words, people that think independently from first principles and don't rely on analogies with the past to form useful judgments.<br />
<br />
While I might yet still be proven wrong in my views, my article in March was an example of reasoning from first principles. None of those views were based on analogies with what happened in the past, but instead an analysis of the present situation, and the best evidence that was currently available. While it is possible I simply got lucky with my views, as a general rule I believe it is wrong to believe reasonable judgments cannot be formed in the absence of analogy. Indeed, this is exactly the process I follow with individual stocks. The subject matter is different, but the process the same. <i>Being a good investor is fundamentally about the ability to form reasonable judgments in the face of uncertainty and incomplete evidence. </i>If you can't do that, you will feel compelled to wait until the uncertainty is resolved and all the evidence is in, but by that stage the opportunity will no longer exist. The default to lazy, analogy-laden thinking will not work in novel situations, and it can also lead you astray in other situations where analogies lead to important nuances being missed.<br />
<br />
Because no pandemic analogy exists, but people feel they need to have one, a lot of investors have defaulted to analogizing the GFC or even the Great Depression. The extent and duration of stock market decline during these periods has often been used as a guide to what we ought to expect this time. One major brokerage firm published a chart showing how the stock market decline was progressing in time relative to those seen during the Great Depression, with a clear implication that this was in some way useful in assessing the outlook for markets at present. This is completely foolhardy. Anyone can say, for e.g, in the GFC markets went down 50% and it took 18 months to bottom, and so in this downturn markets will go down 50% and take 18 months to bottom. The problem is that the nature of this downturn has almost nothing in common with the GFC at all.<br />
<br />
One of the potential consequences of the widespread use of lazy and inappropriate analogies is that people's intuitions on the potential shape and speed of the recovery may be very materially off. I have seen many people argue that oil demand will not recover until 2022-23. I've seen people argue that there will be radical and permanent changes to peoples lifestyles, including people working from home long into the future instead of at the office; and staying home and using online services for everything instead of going out. And yet recently reopened cruise bookings for August has surged 600%. This view reflects a combination of profound myopia and a misapprehension of human nature. The truth is, people are <i><u>desperate</u> to get out of the damn house</i>, meet with friends and family, resume hobbies, and go on vacations. While hesitations will persist for a while out of concern for health and safety, it is human nature for risk to be normalised over time, and for people to learn to adapt to the presence of risk. Huge numbers of people die every year from dengue fever in Asia. It doesn't keep people paralyzed with fear. They accept the risk and get on with their lives.<br />
<br />
In my view, there is no sound basis to automatically assume the recovery will necessarily be as slow and drawn out as the recovery from the GFC. It might be, but it's just as likely to be much faster than people expect, because this is not a financial crisis or even a covid-19 crisis - <i>it's a government policy/lockdown crisis that is man-made, and therefore can just as easily be reversed as it was engineered</i>. This crisis had a simple cause - the government forced people to stay home, where many people couldn't work and couldn't go out and spend money. When they go back to work, it stands to reason that productivity and consumer spending will rapidly revert to near normal levels, as we are already seeing in China.<br />
<br />
Indeed, if people insist on using an analogy, the one they should be using is what is happening in the Chinese economy at the moment! That is absolutely the best analogy we have to draw on, because they are about 2 months ahead of the West in terms of the infection curve, the economic lockdown hit, and the ensuing recovery. No doubt people will be inclined to say 'but China is different', and yet they are seeking an analogy, and are using analogies far less instructive in its place.<br />
<br />
When people look back at this sell off many years from now - particularly investors that did not live through it - they will say 'this was a very obvious buying opportunity; if it were me, I would have been smart and rational enough to buy, because it was obvious the economic impact was only going to be temporary; next time there is a pandemic that tanks markets 40%, I'm going to buy by the truckload'. The problem is that the next event that causes a 40% market crash will not be a pandemic. The next time there is a pandemic (unless it's materially more virulent and deadly), markets might only fall 10-15% because investors will know the playbook and so it won't be as scary. It will be something else that cause investors to believe 'life as we know it has changed'.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-50757988694532894922020-03-17T10:11:00.003+07:002020-03-17T11:27:10.501+07:00Coronapocalypse - some thoughtsOver the past few weeks, markets have witnessed a legitimate 'black swan' event with the emergence of the covid-19 pandemic, which has resulted in a catastrophic collapse in global equity markets of a speed and severity that has rivaled - if not exceeded - that seen during the GFC panic.<br />
<a name='more'></a><br />
While initial covid-19 news emerged in late January about a growing Chinese outbreak, which caused an initial 5-10% market sell-off from previously buoyant early-2020 highs, the selling eased and markets recovered during the first half of February, as the spread sharply slowed in China in response to aggressive containment measures. There have been multiple outbreaks in the past, including MERS and SARS, which both proved to ultimately have a far more benign impact than initially feared, and covid-19 appeared to be following a similar trajectory. However, from late February, news of the virus' rapid international spread triggered further sharp declines in markets, and these accelerated after news emerged about the effects in Italy and Iran being much worse than expected, including tales of healthcare facilities being overwhelmed, which were exacerbating death rates.<br />
<br />
This was then followed by a slew of accelerating and increasingly aggressive containment measures being announced across the Western world (and some of the non-Western world), which began with the cancellation of large events, before moving on to work-from-home measures; travel restrictions; forced 14-day self-quarantines on arriving international visitors; full regional lockdowns; the cancellation of major sporting events such as the NBA; to finally the complete closures of public areas, including retail venues and restaurants, with accelerating implications for short term economic activity. Famous people have started to get infected, accentuating the sense of powerlessness. Every single day over the past 1-2 weeks has seen the news go from bad to worse, and falling asset prices and escalating economic effects have, in turn, given rise to fears that this may cause cascading liquidity/bad debt/unemployment effects that could morph into an all out financial crisis.<br />
<br />
If that wasn't bad enough, markets have also been hit with a "one two punch" (hat tip Buffett) of a breakdown in OPEC+ supply discipline, with the cartel announcing that in an environment of rapidly falling oil demand, that they would not only not cut production further, but actually significantly increase supply, by perhaps 2-3m bbl/d. This is a separate and distinct event/shock from the covid-19 impact, as it was far from inevitable falling oil demand would lead OPEC+ to not only not cut further, but actually significantly increase supply. Oil prices have collapsed 50% to US$30/bbl, which will have significant consequences for the oil production sector (in particular the US shale sector, and its associated sizable high-yield bond sector), as well as the currencies, budgets, external accounts, and economies of the many oil producing countries in the world. Many will be forced to draw down on sovereign wealth funds to support government spending/social programs, exacerbating selling pressure in financial markets as they liquidate assets. In other words, the world has seen not one, but <i>two </i>shocks in sharp succession, which is an extremely rare occurrence.<br />
<br />
So what is an investor to do in this sort of environment? Stay calm and behave rationally. It is an easy environment for investors to become emotional/irrational, as not only is uncertainty rife and markets in free fall - something that makes investors emotional at the best of times - but in this case the impact is amplified by the real and visceral fear investors feel for their own health & safety. But what is called for is a calm and dispassionate assessment of the facts. I do my best to provide one below.<br />
<br />
There is no question that the impact on economic activity in the short term is going to be very severe, although some of the claims I have seen about the global economy essentially coming to a complete standstill are a vast exaggeration. At the front-end of consumer-facing retail and leisure, that will be the case, but large parts of the back-end global economy will remain relatively unaffected. Agricultural production, for instance, along with food processing, transportation, and retail, will not be affected. Most mining activity, processing and distribution, and construction activity will continue, particularly as China gets back on its feet and stimulates to support economic activity, and fiscal stimulus to counter the effects of the economic fallout through infrastructure spending rises in the West. The healthcare industry will most certainly continue to operate (19% of GDP in the US). Services delivered electronically, along with back-end fulfillment, will continue, as will service industries where employees can telecommute/work remotely (the world has unprecedented ability to do this in the modern era). Government salaries and services will largely continue. In addition, ignored at present is that economic activity is already quickly ramping back up in Asia - particularly in China - and large parts of the developing world with youthful demographics are likely to be relatively less affected, given that the disease disproportionately affects the old.<br />
<br />
Nevertheless, there is no doubt that consumer-facing front-end industries such as retail, restaurants and leisure - particularly in the West - as well as the tourism and travel supply chain, are going to be very badly impacted in the short term. The airline industry, in particular, is facing it's worst downturn in history. With more and more countries implementing 14-day mandatory self-quarantine measures for international arrivals, international passenger traffic could fall close to 100% for at least a month or two - a downturn of unprecedented severity. Domestic travel will be less catastrophically affected, but will also likely still significantly decline as people defer non-essential travel.<br />
<br />
However, it is important to remember that the ultimate impact of covid-19 will be a function not just of the <i>severity </i>of the effects, but also their <i>duration</i>. The impact is going to be severe, but there is a decent chance the duration of that severity does not exceed more than a few months. An overlooked reality in that regard is that <i>the worse the short term severity, on account of more and more extreme containment measures (such as NYC's decision to shut all bars and restaurants), the shorter the duration will be</i>, because extreme social distancing measures will inevitably result in a dramatic decline in the virus' average R0 (the average number of new infections each infected individual occasions) compared to the status quo ex ante, which was thought to be about 2.3.<br />
<br />
Right now, with the world swept up in panic, there is an intuitive feeling amongst investors that not only is the impact on the global economy cascading from bad to worse, but also that a continuing uncontrolled spread of the virus appears inevitable from here. But that is assuming the worst of both worlds, and it does not seem justified. The spread will rapidly slow from here on account of these measures, and we have already seen in places like China that when extreme social distancing measures are enforced, the case load can rapidly decline, with a lag of perhaps 1-2 weeks.<br />
<br />
Aside from government measures, human behavioural responses are also not to be underestimated. As people adapt their behaviour in response to safety concerns, people wearing masks; sanitizing their hands; and being highly sensitive to the presence of sick/coughing individuals nearby, and making efforts to keep a safe distance from strangers, could well (at a guess) halve the R0 by itself - particularly due to the widespread media coverage covid-19 has garnered. In my view, the most likely outcome from here by far is that lockdown efforts result in the volume of new cases starting to rapidly slow 1-2 weeks from now (the approximate lag duration between real case volume and diagnosed case volume).<br />
<br />
Furthermore, <i>provided healthcare facilities are not overwhelmed</i>, the death rate appears relatively low. To date, South Korea has engaged in the most extensive testing (under-diagnosis is still a major issue in most markets), and the death rate in South Korea has been 0.6%, and even there, denominator effects are likely still overstating the death rate. Many people say they do not trust Chinese statistics, but South Korean statistics are highly credible. Death rates have been much worse in places like Italy primarily due to a late response and lack of adequate healthcare infrastructure, and it is the (appropriate) fear of the latter that has driven extreme measures in recent weeks in the West to contain the outbreak. That ought to be successful, for the reasons noted, such that death rates should be able to be contained at levels not too dissimilar from South Korean levels, which is about six times as bad as the seasonal flu (0.1%). The flu is also more contagious than covid-19.<br />
<br />
In time, if needed, more sensible and less destructive containment measures might be devised and implemented. For instance, covid-19 spreads primarily through droplets emitted by people when they cough and sneeze, that are either inhaled while airborne, or which come into contact with surfaces which are later touched, and transmitted when the toucher rubs their nose or mouth. n95 masks are effective at filtering such airborne droplets. While for the moment, there is vastly inadequate production capacity, a simple and effective containment measure would be to simply require everyone to wear a mask while in public, instead of cancelling all public events/spaces. In most places in developed Asia, the simple combination of masks; temperature screening for all entering public spaces; and aggressive containment of identified cases and people they have associated with, have been largely effective in dramatically slowing the pace of transmission. Given the success we have already seen with containment in Asia, it appears likely to me that investors are being far too pessimistic about the ability of containment efforts to also work in the West at present.<br />
<br />
The other important difference to GFC-type downturns from the perspective of the likely duration of the impact vs. its severity, is that a short term exogenous shock has different medium to long term effects than a downturn driven by the collapse of a bubble. When a bubble bursts - such as the US housing bubble during the GFC - demand falls from artificially-high levels to a more sustainable level, and a large measure of that decline is <i>permanent </i>(albeit there may be some short term overshooting effects)<i>.</i> After the US housing bubble burst, housing construction and the mortgage financing supply chain, as well as all the consumer spending the prior rapid increase in leverage was supporting, had to revert back to more sustainable levels. The bubble excesses were not coming back (growth eventually resumed, but from a lower sustainable baseline).<br />
<br />
A shock-induced hit to demand is different. As soon as the virus is contained and life normalises, demand will rapidly bounce back to prior levels - indeed it may even overshoot to the upside as pent up demand is released (e.g. people that deferred holiday plans take their postponed vacations; postponed conferences/events take place; and people that postponed buying a car or other consumer goods go out and buy them). The recovery will very likely be V-shaped in nature, which is very different to the post-GFC environment. It is being overlooked at present, but <i>a severe and long-duration downturn is much worse than a severe but short-duration downturn</i>.<br />
<br />
Second-order cascading liquidity effects are also already being discussed and discounted, but people are exaggerating the risks here in my view. Prior to the GFC, many corporates and financial institutions were relying on short term paper, and money markets seized up. Due to the GFC experience, very few financial institutions and large corporates now rely on short term money markets to fund their operations, and most operate with large liquidity buffers and long dated debt maturities. This means there is much more <i>time </i>before pressures/debt market disruptions will impact funding. Short term debt markets might close, but that won't impact most companies for quite a while due to the presence of the said liquidity buffers, which included not just cash, but committed bank revolvers, which many companies are now in the process of drawing down.<br />
<br />
Funding pressures in the banking system also seem unlikely, as not only are banks now much more liquid than pre-GFC, due to a combination of much higher regulatory liquidity requirements and management prudence (reflecting cultural change in the post-GFC era), but central banks are also implementing substantial liquidity support. After an initial spike, interbank rates have recently sharply fallen in the US for this reason. Furthermore, very significant fiscal stimulus is coming. There is a very good chance, for instance, governments provide financial support to airlines - the US has already suggested this, and I would expect the EU to follow in the not too distant future as well.<br />
<br />
With respect to the banking system, while bad debts will increase, the magnitude of the hit to the credit-worthiness of their borrowers will depend on the <i>duration </i>as well as the severity of the downturn. Banks in the US and Europe have lent conservatively over the past decade, and interest rates and hence debt serviceability burdens are low. Most of their borrowers will therefore be able to manage through a 1-2 month hit to their incomes, and banks can and likely will provide short term forbearance measures on repayments. One of the risks is IFRS-9, which requires banks to front-load provisions on the basis of an expected credit loss model. This could force banks to take large upfront provisions, discouraging lending and pressure capital. However, European regulators have already said they are considering granting temporary capital relief to banks (relaxing capital ratios), and importantly, we are not coming out of a period of rapid credit growth. When credit growth goes from 20% to 0%, the economic effects are substantial, but when they go from 2% to 0%, much less so.<br />
<br />
While there is much talk of debt levels being extremely elevated, this is a vast oversimplification. What has really happened is that <i>government </i>debt has significantly increased in the post-GFC era, but government bond yields have collapsed to zero, and while high government debt could be a problem long term, it is most certainly not a problem at present. Meanwhile, private sector debt intermediated by the banking system has been falling for 13 years in both the US and Europe relative to GDP. Household debt in the US, for e.g., has fallen from more than 100% to only about 75% at present. Banks, individuals, and to a lesser extent, corporates, have been deleveraging for 13 years. Furthermore, not only has debt to GDP fallen, but interest rates are also at record lows, such that the <i>debt servicing burden </i>is now actually at very low levels by historical standards.<br />
<br />
There are pockets of excess, to be sure. Debt levels in the private equity space, for instance, have mushroomed. However, this debt is well structured, being covenant light, long term, and low cost, while the private equity industry has US$1tr of committed 'dry powder' (funding commitments clients have either provided or are obligated to provide when called, which is not yet invested). While private equity is arguably in a bubble, it is not a bubble that will quickly unravel.<br />
<br />
The outlook for oil appears more challenged in the short term, as the combination of falling demand and rising supply ought to continue to pressure oil prices, and in the worst case they could easily fall to US$20/bbl or less. However, even here, it is not impossible OPEC+ comes back to the negotiating table. The demand outlook has rapidly worsened over the past week or so, and Saudi Arabia's response appears highly emotional. Russia's stance was more justified - they merely wanted to maintain existing cuts (rather than cut further), noting accurately that cuts to date had merely resulted in increased shale supply, and that it was too soon to assess the magnitude and duration of the covid-19 impact on demand. They did not want to suspend existing agreed cuts. Saudi Arabia, by contrast, were initially pushing for aggressive additional cuts, but angered by Russia's lack of co-operation, appear to have reacted emotionally, throwing their toys out of their cot and responded by saying they will instead begin to pump as much crude as possible starting from 1 April (likely about 2m bbl/d above their current production of about 10m bbl/d, at maximum capacity).<br />
<br />
Sheiks don't like not getting their own way, but once their arrogant temper simmers down a bit, it is possible they could come back to the table - particularly because in Russia's case, one of the reasons they did not want to cut was that they felt it was premature to assess the demand impact, but the week or so since that stance was maintained has seen the demand outlook rapidly worsen.<br />
<br />
If that does not happen, it seems probable oil prices will fall further and a rapid supply response from the shale patch will be forced. OPEC+ can ramp production up by perhaps 3m bbl/d, but shale produces something in the order of 6m bbl/d, and most of it is uneconomic below US$30/bbl. Importantly, shale wells have rapid decline rates, so you have to continue drilling in order for production to not rapidly decline by >20%/pa. If prices fall to US$20/bbl, you'll probably see US shale production halve in the next 24 months, absorbing all of OPEC+'s excess capacity, while it is probable global demand has recovered from the covid-19 hit and reached new highs comfortably within this timeframe, as trendline global growth in demand continues to exceed 1m bbl/d pa. In the meantime, an increase in inventories, tanker storage by oil speculators/arbitragers, and increases in government strategic stockpiles, might help absorb some of the excess supply. Bankruptcies in the shale patch nevertheless seem likely, and there will be some hits to the high-yield debt space here. However, the losses do not seem likely to be large enough to be systemically destabilising.<br />
<br />
What does all of the above mean for markets? It is important to remember that the outlook for markets is not the same as the outlook for the economy. The US had one of it's worst recessions in history in 2009, and yet stocks had one of their best years in history in that very same year. Market prices are not driven by the economy per se, but instead a combination of liquidity and emotion, because these are the factors that drive the demand and supply for stocks, and that is what set prices (the economy can effect liquidity and emotions, but ultimately it is the latter factors which determine prices).<br />
<br />
At present, we have record levels of global liquidity, as central banks slash rates to zero or less, and revert to rapid QE money-printing. However, that liquidity is not yet finding its way into stock markets as there is a sharp divide between risk/volatility tolerant capital, and risk-averse capital. The world is drowning in risk-averse capital, and central banks are creating more of it by the day, while the availability of risk-seeking capital is collapsing as people flee risk and hold more cash/bonds.<br />
<br />
But how sustainable is this situation? It is likely that the magnitude of the sell-off has been amplified by two factors. Firstly, in an era of very low interest rates, people have 'reached for yield', and one manner in which they have done so is by increasing their stock allocations - particularly to yield stocks perceived as being relatively low risk (i.e. REITs, utilities, consumer staples, and other 'low volatility' stocks/sectors/ETFs). Money that would typically hold bonds rather than stocks is risk averse capital that is not cut out for the volatility that befalls equities from time to time, and a lot of this money has likely been panic-exiting.<br />
<br />
Secondly, the widespread media coverage and the fear felt by the 'man on the street' has likely resulted in a larger than average amount of redemptions from end investors as well. This has created a major liquidity squeeze, forcing managers to dump shares to meet redemptions. On top of that, we have likely been witnessing rapid deleveraging of market players with leveraged books (along with margin calls), as well as fund managers increasing their cash allocations as their fears about the outlook grows, and as buffers against further upcoming redemptions.<br />
<br />
That's a lot of selling and a lot of liquidity stress in a short space of time, but it can't last forever. The most skittish money will leave first, and during turbulent times, stock moves into 'strong hands', as they say. Deleveraging will end, redemptions will slow as anyone that is going to panic and pull all their funds is likely already doing it, and fund managers can only increase their cash allocations so much (often they are restricted by mandate as to how much cash they can hold). Furthermore, the more markets fall, the larger investors' cash and bond allocations become relative to their equities allocation simply because equities have fallen in value so much. This will eventually cause some investors to increase their exposure to equities - particularly as interest rates fall lower still.<br />
<br />
Even if you're a fund manager who is bearish on the outlook, if you're maximum allowable cash allocation is 10% and you've already gone to 10%, and redemptions stop, you will stop selling. <i>And investors often forget that market prices can rise not only due to an increase in demand/buying, but also due to a decrease in supply/selling</i>. The latter is usually the primary means by which markets rebound from the depths of a panic/downturn - selling lets up and prices start to rise. In time, rising prices leads to an increase in demand, as confidence builds and buyers start to return.<br />
<br />
In other words, at some point the amount of liquidity in the volatile equity space will stabilise, and the volume of selling will then abate, and at that point, markets will stabilise/start to recover even if the economy continues to weaken, because for stocks to go down, there has to be a new source of fear that triggers a new wave of selling. That requires either increased liquidity stress, or the news to get <i>much worse, </i>triggering even more people to sell in fear. If the news doesn't get much worse - it just remains bad - the impetus to sell more declines.<br />
<br />
It is for this reason that markets will bottom not when coronavirus economic impact is at its worst, but when the crescendo of worsening news is at its peak. Over the past week, the news has continued to go from bad to worse at an accelerating pace, as the situation has worsened in Italy; the speed of new cases has accelerated around the world; famous people have been infected; and then more and more extreme containment measures have been announced, from restrictions on large events, to travel restrictions, to complete lock-downs; to now forced closures of retail and entertainment venues. That escalation in bad news has given people a new reason to panic more every day.<br />
<br />
However, it is going to be hard for this acceleration in bad news to continue, because we have already basically reached the practical limit to which social distancing measures can be implemented (closing bars, restaurants, and retail establishments, such as in NYC), so the pace of shocking new headlines about such measures will have to slow. Meanwhile, the large temporary rallies we have seen during this downturn highlight how upside sensitive markets are to even a whiff of good news - a situation that likely exists because there is a record amount of cash sitting on the sidelines at present, which is a latent source of demand. As noted, it is hard to see how such aggressive containment measures will not result in a slowing in new case rates becoming evident in 1-2 weeks time, and any headlines that suggest the rate of spread may be slowing will likely cause markets to very violently rally.<br />
<br />
The reason for the violent rallies we have already seen on a few occasions on the way down is easy to understand technically, because at present we have a 'multiple equilibria' situation: we have record amounts of liquidity on the sidelines which is looking to enter the market, but a wholesale reluctance to buy while prices are in free fall. What this means is the second investors feel prices might be set to rise, they will rush to buy, while when prices rise, the impetus to sell relents. In other words, demand is a function of price (demand increases as prices increase), and supply is also a function of price (supply increases as prices decrease). We should therefore expect extreme volatility for this reason.<br />
<br />
Although it is impossible to know, my intuition is that we are very close to - if not at - the bottom. Indeed, there is already some good news starting to emerge in Asia that is being ignored by Western-centric investors. China, South Korea, Taiwan & Singapore for instance have all had success in containing the virus, and economic activity is rapidly recovering in China - one of the world's largest and most important economies, which drives significant demand for commodities and construction materials - which is very important to the economic outlook for commodity-exporting countries. There is more to the world economy than merely the US and Western Europe these days. It is surprising that no one currently seems to think that the rapid recovery the Chinese economy is experiencing is of any importance.<br />
<br />
New anti-virals are also being worked on around the clock which could significantly mitigate the worst symptoms, and hence meaningfully reduce death rates, with some people optimistic antivirals could start to become available as soon as April. Vaccines will eventually follow but will take much longer. Right now, investors have assumed no such mitigations/treatments will become available, so this is a major upside risk.<br />
<br />
It is often said that the four most dangerous words in the investing world are "this time is different", but perhaps the most important are "this too shall pass". In times of crisis and uncertainty, it is easy for investors' time horizons to shrink to mere months. However, taking the long view, human societies are resilient and adaptable - history proves that, and while humanity and the global economy are in for a very difficult few months, we will find ways to manage the impact, adapt, and get through this.<br />
<br />
Good investing is a lot like sailing. When you set out to sea, you should not assume perpetually calm conditions even if all you can see is blue sky and calm in every direction. You should anticipate the occasional storm, and when you find yourself in a storm, while it is tough and uncomfortable, you should reassure yourself that the storm will eventually pass. We have currently entered a storm. One should have prepared themselves in advance by paying prices with a suitable margin of safety that reflect the fact that storms will happen from time to time; if you have done so, there is no need to panic when a storm arrives. The storm - while violent - will eventually pass.<br />
<br />
If there is any good to come out of covid-19, it is that it has exposed a radical lack of government preparedness in the West for necessary pandemic response. For instance, if we had stockpiled n95 masks in large numbers, containing the virus would be easy - simply hand them out to all and insist that everyone wears one in public. The cost of doing that would pale in comparison to the economic costs now being incurred on account of that lack of foresight. In the long term, exposing this lack of preparedness might result in a change of behaviour, and better preparedness for future pandemics that could be much more catastrophic - for instance a highly contagious disease with death rates of 20%.<br />
<br />
We should prepare for public health emergencies like this is in the same way the military prepares for war. You don't start building aircraft carriers only after war is declared - you need to be in a state of perpetual readiness that recognises that anything can happen at any time. The Western world has been caught completely unprepared, which is a failure of leadership - yet another that can be added to a very long list. With a bit of luck, this covid-19 episode will result in a change in behaviour and much better preparedness in the future.<br />
<br />
In the meantime, stay safe.<br />
<br />
<br />
LT3000Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-86426288314608587302020-02-29T14:03:00.000+07:002020-02-29T14:59:31.476+07:00Dynamic vs. static analysis, and what the US shale and technology sectors have in commonOver the past decade, few industries have incinerated as much shareholder capital as the US shale oil and gas (O&G) sector. Attracted by the substantial technology-driven structural growth opportunity the sector promised, and its putatively low costs and attractive well-level IRRs much-touted by management, investors initially flocked to the sector, but have since been badly burned, as losses have mounted; debt levels skyrocketed; and share prices plummeted.<br />
<a name='more'></a><br />
Investors were right about one thing though - US shale has been a remarkable secular growth story. New technology has unlocked vast new reservoirs of oil and gas, and propelled the US from being a significant net importer of O&G to now being a growing net exporter (the US is still a net importer of oil, but is now a net exporter of gas, primarily via newly-commissioned LNG projects), while also restoring the US to the station of the world's largest oil producer. However, while investors were right about the growth potential, they have been wrong about the profitability outlook, and as a result, have realised considerable losses, this tremendous structural growth story notwithstanding.<br />
<br />
So what has happened exactly? Given that well-costs are low and IRRs putatively so high (often claimed to be >50%), why hasn't the sector delivered better outcomes for investors? I hope to explain why in this post, and in the process also explain (1) the perils of static vs. dynamic analysis; and (2) why the experience of the shale sector actually has a lot of relevance to the much-hyped, loss-making tech sector - sectors most believe have nothing whatsoever in common. I believe the latter could well be heading for a significant fallout on par with what has/is now happening in shale.<br />
<br />
The fundamental problem with respect to the shale companies has been this: while it is true that the shale companies have attractive <i>well-level </i>unit economics (i.e. if you compare the marginal costs of well completion and production vs. the marginal cash flow such wells generate from product sales, the IRR on that marginal capital spending is indeed attractive), there are also very considerable <i>support costs </i>that need to be set off against that 'contribution margin'.<br />
<br />
You need to buy or lease land; drill out that land and prove up reserves; build a bunch of processing and logistics infrastructure (or sign contracts with third parties to provide such infrastructure); and you need to finance all of that expenditure upfront, often through the use of a significant amount of interest-bearing debt. In addition, you need to absorb all the various corporate central head office costs associated with running a large organisation and publicly listed company - a C-suite doesn't come cheap. All of this costs money. Consequently, while it is true that the well-level IRRs touted by management have been high, the all-in returns on capital after all of these support costs (which are relatively fixed) are included have been very poor, and often below the cost of debt. This is why the well-level IRRs management have touted to investors for so long have borne little to no relation to their reported GAAP earnings/ROICs.<br />
<br />
So what do you do if you have attractive marginal unit economics with high incremental IRRs, but large fixed support costs that are overwhelming those unit-level returns? <i>You increase volume</i>. This ought to work right? After all, the marginal unit economics are demonstrably attractive, whereas the support costs are relatively fixed (or at least scale less rapidly than volume). As you ramp up your drilling & completion and increase production, the amount of contribution margin ought to rise, and economies of scale and group profitability will kick in, right? As volumes rise, group ROIC should trend closer to well-level IRRs, as fixed costs shrink as a proportion to total revenue, right?<br />
<br />
Wrong. The problem with this perspective is that it relies on what I will call 'static analysis' rather than 'dynamic analysis'. Static analysis holds everything else in the world constant, and assumes nothing changes in the future or is any way influenced by the behaviour of either yourself or any of your current or future competitors. If you use static analysis, you will conclude - seemingly reasonably - that if you drill out more wells and produce more oil and gas at high incremental IRRs, while support costs remain relatively fixed, you will inevitably become very profitable.<br />
<br />
The problem is that in the real world, <i>the world is dynamic not static. </i>All else is not held constant, and the actions and reaction-functions of economic actors focusing on the micro-level factors in their own businesses can change emergent macro factors in unanticipated ways. In the case of the shale sector, what actually happened dynamically is that as individual shale O&G producers pushed to ramp up volumes in order to enhance fixed-cost absorption, the supply of oil and gas rapidly increased, which resulted in a significant decline in O&G prices. Every single producer held every other producers' behaviour constant, and assumed only their own would change, and what was rational at the level of the individual turned out to be irrational at the level of the collective.<br />
<br />
Producers were initially thinking, we are producing from 50 wells, and if we get that up to 100 wells, based on the great unit-level well economics we are currently seeing, and our current support cost structure, we will be able to make decent returns, so lets push production up to 100 wells. However, by the time production hit 100 wells, commodity prices had fallen, such that contribution margins per well had fallen to offset the volume gain, with well-level IRRs falling from (perhaps) 60% to 30%. So what do they now do? They say, well gee it's unfortunate - we've worked really hard and made great operational progress, but the 'external environment' has proven less favourable than expected. Never mind - if we are able to pump 200 wells instead of 100, we will be able to make up for the decline in well-level IRRs, which after all are still quite attractive. We just need to grow a bit more than we thought to 'make it up on volume'. So they ramp production up further. The problem? This further exacerbates the level of oversupply, and pushes commodity prices even lower. This is how the entire shale industry has found itself - to borrow Jim Chanos' wonderful phrase - on a 'treadmill to hell'.<br />
<br />
This perfectly explains why US shale O&G producers have remained so hell-bent on increasing production volumes over the past decade, despite falling commodity prices (it is to a large extent <i>because </i>of falling commodity prices). A lay observer might be inclined to ask, why on earth are shale producers rushing to produce as much of their non-renewable reserves as fast as possible in such a low pricing environment? Why not just sit on the valuable resource and wait for a better pricing environment? The answer is that they have very considerable fixed costs (including debt servicing), and they will therefore bleed to death if they wait. They need whatever contribution margin they can get to try to defray these fixed costs. Contrary to popular opinion, it is therefore not purely a function of the companies being run by a bunch of 'oil men' who just want to 'drill baby drill' because they like drilling. It's due to economic necessity, because the alternative is bankruptcy.<br />
<br />
Now what I find most interesting about the above is that there is another sector at present suffering from exactly the same economic forces, and the fallacies associated with static vs. dynamic analysis: <i>the loss-making technology/software sector - particularly Unicorns funded by VC </i>(note, this does <i>not </i>include technology/software companies with business models that are proven to be profitable, although such companies can still be harmed by the actions of other industry actors, in much the same way profitable O&G companies have been harmed by the shale sector). There are many listed examples as well, however, such as companies like Wayfair, Uber, and Carvana. (Indeed, my <a href="https://lt3000.blogspot.com/2020/02/afterpay-touch-more-expensive-solution.html">recent post on Afterpay</a> uses a dynamic analysis to counter the prevailing bullish narrative that is based primarily on a static analysis; most of the considerable criticism I received for the piece from APT bulls on Twitter also used arguments grounded in static analysis).<br />
<br />
While on the surface, fast growing but loss-making tech companies might seem to have little in common with US shale producers, the economic parallels are actually quite striking. The only difference is that the market is currently red hot on fast-growing tech companies, regardless of the current state of the P&L, because investors are still using static rather than dynamic analysis to assess their prospects, much as they were many years ago to assess the prospects of shale producers, prior to the sector's recent implosion.<br />
<br />
The similarities are as follows: Investors - at the direction of company managements - are focused almost entirely on revenue/volume growth and the <i>unit economics, </i>or <i>contribution margin </i>associated with additional volumes. The level of support costs, including corporate overhead, R&D, and marketing etc, are generally ignored, as is the aggregate level of group losses such support costs are occasioning. This is how companies like Wayfair have been able to multi-bag despite reporting larger and larger losses as they have grown. The support costs are seen by investors as being largely irrelevant, as it is believed they will shrink in relative size over time as revenue growth and contribution margin most assuredly continues to rise. Indeed, it is often argued that you should value companies like Wayfair on a multiple of gross profit (even Bill Miller has made this argument).<br />
<br />
Uber, for instance, advertises extensively in its presentation materials the great 'contribution margin' it makes on its ride business. However, notwithstanding the putatively fabulous unit economics the company enjoys, the company still loses about US$1bn a quarter a decade or so after its founding. It turns out R&D, marketing, customer service, and the various other support costs necessary to sustain operations are quite expensive (incidentally, there are almost no companies in the world that don't have robustly positive gross margins and trade at low multiple of gross profit; investors outside of tech do not look at gross profit multiples because they are aware that without the associated SG&A costs, those gross profits and contribution margin could not be delivered).<br />
<br />
Like with shale, if one uses static analysis, you can create a bull case for these stocks despite the current state of their P&Ls, because you can argue that as these companies scale volumes and contribution margin off a support cost base that will grow less rapidly than revenue, significant operating leverage will kick in down the track. <i>If you hold everything else constant</i>, including in particular the actions not only of current but also future competitors, then the bull case is plausible.<br />
<br />
The problem though is that - as was the case with shale - the world is dynamic not static, and you cannot hold everything else constant. It is as naive for these companies and their investors to believe that the rest of the world - including the many well-resourced incumbents many of these companies seek to disrupt - will sit idly back and allow the said company to capture a large TAM ('total addressable market') uncontested, as it was for shale producers to believe that their own significant ramping up of volumes would not impact end commodity prices.<br />
<br />
In reality, as more tech companies with great 'unit economics' but large overall losses attempt to drive revenue/volume growth to increase 'contribution margin', recoup fixed costs, and hence pursue a 'path to profitability', what is likely to happen (and indeed already is) is that competitive intensity will significantly increase and drive a decline in contribution margins that offset that volume growth. This can manifest not just in the form of outright price discounting, but also escalating customer acquisition costs, and the increasing prevalence of various promotional offerings (including 'free delivery' and the like), which are sometimes included below the gross profit line (e.g. Uber's 'driver incentives'). While the companies no doubt couch such offers in terms of 'enhanced customer value' and 'driving engagement', in reality it is simply a form of discounting; the phrase 'buying market share' has long existed in business, and this iteration is no different.<br />
<br />
There is no surer sign this is happening that when the companies continue to push out their estimate for when they will reach break even/profitability, or see profitability/margins decline even though volumes are rising, as has recently occurred with Wayfair. And even hitherto profitable companies can be adversely affected. Take Latin American e-commerce company MercadoLibra, for instance. A few years back, the company was robustly profitable and making operating margins of some 20%. Today it is more like -10%. Why? Because there are several very aggressive competing e-commerce companies attempting to ramp volumes to recoup fixed costs, and just like in any industry, it is hard to be smarter than your dumbest competitor. It is no different from profitable incumbent oil companies suffering declining profitability because a bunch of shale companies are desperately trying to ramp up volumes and 'contribution margin' to cover their fixed costs.<br />
<br />
The only difference is that instead of investors seeing what is happening for what it is - a price war that is a symptom of excess supply/competition and ugly industry economics akin to the airline industry in eras past - they are instead content to believe the fiction that this is primarily an 'investment in future growth' and being 'long term greedy'. In reality, these companies are losing money for the same reason shale producers are - there is too much supply because too many companies and too much capital jumped into the sector to capitalise on 'secular growth'.<br />
<br />
After the 2000-03 dot.com bust, people widely questioned how it was that so many smart investors managed to convince themselves that the normal laws of economics did not apply to internet companies. Well, something very similar is happening today. Tech investors are content to pay outrageously high prices for technology companies because they believe they are immune from the normal prosaic forces of supply and demand, and that both competition (both current and future) and a rapid influx of capital into the industry will not drive down returns in the way it has in the past in <i>every industry and in every instance it has ever occurred, </i>just as the laws of economics would predict.<br />
<br />
LTV/CAC metrics provide deceptive comfort to companies/investors about the wisdom of incurring hundreds of millions of dollars of losses in order to grow, because they assume that the LTV is locked in rather than merely a hypothetical based on a static analysis of how things look today, rather than a dynamic analysis of how LTV could look in the future, and evolve in an environment of increasingly saturated markets and more and more competitors desperately trying to ramp up volumes to recoup fixed costs. It is exactly analogous to shale O&G companies assuming that their efforts at rapid volume growth would have no impact on the end commodity price. After all, the LTV of their wells were very high relative to their WAC (well acquisition costs). So what could go wrong? Why shouldn't investors value them based on LTV/WAC metrics?<br />
<br />
As I have argued for some time now, I think a fairly epic bust in the technology sector is coming, that could well rival the scale of the dot.com bust, although with the worst effects being seen in the VC/private space rather than the listed space (although the latter will also likely be badly affected). In many cases, valuations have reached utterly absurd levels for loss making companies with unproven business models, which rely on static analyses that are highly questionable in a dynamic world. As I have argued in the past, consensus expectations for these companies are that they continue to enjoy rapid revenue growth <i>and </i>rising profitability, whereas I think in reality what we will see is decelerating top line growth and falling profitability/widening losses. For those that are paying attention, it is apparent that this is already starting to happen.<br />
<br />
Furthermore, there are signs that an incipient reversal in the liquidity flywheel* that has propelled the growth of the VC 'asset class' in recent years is already underway, as Softbank has failed to raise external capital for its Vision Fund 2. If the liquidity flywheel decisively turns, a fairly catastrophic bust could happen in the VC space, and it remains to be seen if it will be of sufficient size to tip the US (and perhaps select other Western countries as well) into recession. The magnitude of the percentage losses realised by tech investors will likely be as large as those realised by shale O&G investors over the past cycle, in my view, if not larger.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<i>*A 'liquidity flywheel' is the name I give to the dynamic where fund inflows result in capital being deployed by those funds in a manner that contributes to the price of the assets they already own being pushed up, thereby contributing to strong apparent returns. The strong reported returns then act to drive additional inflows in a self-reinforcing fashion. This is how you end up with worthless, loss-making companies like WeWork attaining a valuation as high as US$47bn. </i><br />
<i><br /></i>
<i>Liquidity flywheels create an 'unstable equilibrium' that can go on for a long time, but eventually turn, and when they do, a discontinuity event happens and the whole movie is then played out in reverse (and usually on fast-forward). Liquidity flywheels are a fundamental contributor - perhaps the most important contributor - to boom-bust asset price cycles in markets. </i><br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-17821350932330670532020-02-06T18:52:00.001+07:002020-02-07T09:41:37.876+07:00Afterpay Touch: a more expensive solution to an existing, solved problemAfterpay Touch (APT AU) is a stock that has acquired a cult following in recent years. The shares have risen spectacularly, and catapulted the company's market capitalisation to an astonishing A$10bn - almost 40 times trailing revenues (there are no earnings - the company lost about A$40m last year on revenue of $260m).*<br />
<a name='more'></a><br />
To the uninitiated, APT is an ASX-listed fintech 'buy now pay later' (BNPL) payment system/platform, that styles itself as a replacement to traditional credit cards. The value proposition from the customer side is that consumers can use APT to purchase goods/services and pay back the amount in subsequent fortnightly installments, and unlike credit cards, do so interest free and without any pesky credit card fees. They have been adding a lot of merchants to their network, as well as consumers with APT accounts, and this has created a putative two-sided network flywheel effect that has caused investors to salivate about the possibilities - particularly as they begin to pursue international expansion.<br />
<br />
The company's presentation materials are replete with stories of multi-trillion dollar addressable markets (indeed, in the company's FY19 results presentation, you have to get about 30 slides in before you get to any meaningful financial information, whereupon you learn that they lost money in FY19). The company seems to envisage itself disrupting the traditional credit card industry, and becoming a conduit through which trillions of dollars of consumer payments are made the world over.<br />
<br />
Going by the company's share price, a lot of investors evidently believe them, and have bought into the story hook line and sinker. There is only one problem with the bullish narrative, though: the company's core product is actually a <i>more expensive solution to an existing, solved problem, that actually makes the world a worse rather than better place</i>. Long time readers of this blog will know that I'm a skeptic of many putatively disruptive 'Valley' businesses, but I will acknowledge that at least most of them are attempting to make the world a better place, and offer better products/services at lower prices, even if most of them are losing money trying to do it. APT is different, and I find it very difficult to think of any 'disruptive' business models that have succeeded where their product is a more costly and inferior solution to existing alternatives, for obvious reasons.<br />
<br />
Furthermore, the very factors which caused the company to enjoy some initial success in building out its network <i>do not scale</i>, and are also exposed (as I will discuss) to considerable regulatory risk. Indeed, as the company gets larger, rather than becoming more valuable and entrenched as network-effect businesses typically do (and APT's share price anticipates), it will actually increasingly undermine its merchant value proposition, and make the fundamental structural weaknesses of its business model impossible to ignore - potentially bringing the whole house of cards tumbling down.<br />
<br />
I will acknowledge one thing, however: from the consumer's point of view, <i>APT is clearly a great product and in many respects better than a traditional credit card</i>, for a very simple reason: there are no fees, and it allows you to borrow to pay for purchases without incurring any interest (although the rewards programs associated with many credit cards need to be forgone). APT and the bulls belabour this point ad nauseam. The problem though is that this is not the end of the story, as the issue is <i>not</i> the consumer-side experience, but the fact that APT charges merchants 4%+ to accept APT payment. Indeed, the AFR has reported that APT charges merchants a fixed 30c transaction fee, plus a 3-7% sales commission (while APT's accounts indicate it averages to a bit over 4%), which is significantly more than merchants typically pay to accept credit cards (which ranges from about 0.6% for large merchants to 1.5% for small merchants, in Australia according to the AFR), or cash (0%).<br />
<br />
APT might at first appear to be saving consumers money (and be perceived that way by consumers), <i>but somebody has to pay for this 4%, and that somebody will ultimately be the end consumer</i>, because merchants will have no choice but to raise prices to recoup this 'APT tax'. The bulls attempt to deny this fact, but denials make no economic sense (at scale). Most retailers earn in the vicinity of 5-10% operating margins, and the industry is not going to settle for seeing more than half of its profitability stripped away and passed on to APT. And it makes no sense that a product as simple as APT's would, in competitive free markets, allow it to capture more than half of the entire retail industry profit pool.<br />
<br />
In the long term, equilibrium industry margins are determined by the complex interaction of a number of forces, including demand and supply, competition, industry cost structures, and the cost of capital. If 5-10% is the economic level of margins for the industry, that is where it will stay, and just like if labour and rental costs were to rise and need to get passed on to end prices to preserve industry margins, so it will be if merchants have to pay a 4% APT tax on turnover. The mechanism might be implicit rather than explicit ("our margins are under pressure - let's bump prices up slightly and see if they stick"; rather than "let's put prices up specifically to compensate for the APT tax"), but the outcome will be the same either way: consumers will ultimately end up paying.<br />
<br />
It is staggering that the APT bulls actually believe it is feasible the world will move to a situation where merchants the world over will be paying a 4% transaction tax to the likes of APT; retailers won't put prices up to compensate; and that this is somehow innovative or disruptive, and will represent an improvement to the world as compared to the status quot ex ante. The reality is that this is a much <i>worse </i>world - a world where everyone pays much more for goods and services than they otherwise would, so companies like APT can pocket a massive, parasitical middleman fee.<br />
<br />
Why then, you might ask, has the company achieved a degree of success/scale to date? For two reasons: (1) at a small scale, its platform does offer early-adopting merchants some meaningful benefits that offset the high transaction costs; and (2) APT's contracts with merchants have restricted their ability to impose a transactional surcharge when accepting APT payment. The former factor above contributed to merchant's willingness to acquiesce to the latter, but it is very likely that both of these two factors are fundamentally unsustainable.<br />
<br />
It doesn't take a particularly deep level of thinking to see that the putative benefits for merchants are a fallacy of composition that don't scale. APT and the bulls are always quick to emphasise that APT allows merchants to boost their sales, but there are only two mechanisms by which this can occur. Firstly, an APT merchant can cannibalise the sales of competitors who do not accept Afterpay. From the consumer point of view, APT is a superior payment option than using a credit card/cash, so if Merchant A accepts APT and competing Merchant B does not, consumers might decide to shop more frequently with Merchant A, allowing Merchant A to pick up market share at Merchant B's expense. However, the benefits of this don't scale. It's only a matter of time before Merchant B decides to accept APT as well, and then the cannibalistic effect disappears, but the 4% transaction fees do not.<br />
<br />
The second way APT can boost a merchant's sales is by providing consumers with yet another means by which to outspend their income. If a customer lacks the cash or credit card balance to purchase item X, without APT they will have to go without. With APT, they can now 'afford' to buy it. While in the short term this will indeed boost merchants' sales, the ultimate effect is merely to pull forward consumers' purchases, and so in the long term drives no sustained benefit.<br />
<br />
Consequently, what we are left with is simply a more expensive solution to an existing solved problem. What is that solved problem? Fast, convenient, secure, and inexpensive electronic payments, and ready access to unsecured credit lines for customers (credit cards). If you think about it at a high level, the first payment system in modern times was cash. Cash has (and still has) its advantages - for a start, it's free (no transaction fees), and relatively fast and simple. However, it has some disadvantages - particularly in the modern era: you can't use it to buy things online; and you also can't use it to buy big-ticket items that require consumer credit, which you are able to afford by paying back over time, but don't have the cash to pay upfront for today.<br />
<br />
Credit cards were the solution to this, as well as other use cases (e.g. for people travelling). In the past, credit cards had several attendant disadvantages, however. They were not only more expensive (requiring the acquiring of merchants; payment terminals; etc), but also importantly, they were <i>slower to process </i>than cash. However, with continued innovation, most of these disadvantages are now disappearing. The emergence of 'tap-pay' credit and debit cards which can process transactions virtually instantaneously has been particularly material, and is both convenient for customers and important for merchants, as it reduces queuing times at checkouts. Lower cost acquiring solutions (e.g. Stripe) are also emerging, and not ending up with a pocket full of coins is also a significant convenience benefit for customers. Credit and debit cards still cost more than cash, but the many advantages and convenience have increasingly outweighed them.<br />
<br />
Not surprisingly, this has resulted in credit and debit cards increasingly becoming a superior solution to cash, and is why Visa and Mastercard have thrived in recent years, as the market share of credit/debit card payments have risen, while cash's market share has fallen. Furthermore, V/MA's global 'payment rails' represents infrastructure that other fintech companies can build upon to offer new innovative financial products, and at relatively low cost (V/MA transaction fees are only in the ballpark of 10bp; most of the cost of traditional credit card fees are split between banks and merchant acquirers, as well as funding the cost of rewards programs).<br />
<br />
In other words, <i>fast, secure, and affordable digital payments, as well as on-the-spot consumer credit, is already a solved problem</i>. And now along comes APT, and wants to provide a similar solution at triple the cost. It doesn't make any economic sense. The reason there is so much confusion is that (1) from the consumer perspective, they falsely believe they are saving money (as the APT costs are hidden and incorporated into retailer prices); and (2) many merchants testify that they have benefited from APT, but as discussed, this was due to the early-adopter cannibalisation, and consumption pull-forward effects. What this means is there is an incredible lack of clear thinking and prevalent misinformation with respect to APT's business model and its likely ultimate effects.<br />
<br />
There are signs, however, that things might be set to change. The AFR <a href="https://www.afr.com/companies/financial-services/afterpay-hits-back-says-it-s-not-a-payments-system-20200206-p53ybm">has reported</a> that the RBA is looking into measures that would prohibit BNPL providers such as APT from denying merchants the right to impose surcharges. The policy discussion has arisen in response to advocacy from consumer protection groups, <i>as well as merchant associations</i>, who unlike the stock market, understand the situation for what it is, and argue correctly that it results in a lack of transparency and market failure (consumers perceive the product to be free, when in actual fact it is extremely costly, and this is resulting in consumers making suboptimal decisions, and stifling the emergence of lower-cost alternatives). While the bulls have recently been celebrating and back-slapping as APT has surged above $40 - a valuation that requires the company earn and distribute $2bn a year sustainably by 2026 to generate a 10% return - about 10x the company's current <i>revenue</i> - the emergence of an existential risk to the viability of the company's business model has been ignored.<br />
<br />
The thing that irked me most - and prompted me to write this article - was the fact that APT is lobbying hard to oppose this RBA policy measure, and the shameless, self-serving misinformation the company has served up to oppose the policy absolutely needs to be countered (contained in the article previously referenced). It is important to emphasise here that no one is proposing that merchants <i>must </i>impose a surcharge - merely that they have the freedom to do so. Why is APT so rabidly opposed to their merchant customers having such choice? If the product is so great and it delivers so many benefits to merchants, as APT claims, then surely the merchants would choose of their own volition to not impose one for commercial reasons, right? In that respect, APT's protestations speak volumes about the extent to which APT's management recognises that the success of its business model hinges critically on its ability to continue to impose hidden transaction cost on customers.<br />
<br />
In the article they make many spurious arguments, including that the merchant costs should be compared more to what Facebook or Google charges for click-through sales leads, rather than alternative payment platforms (a laughable claim); and that the RBA's mooted restrictions would "stifle innovation, compromise consumer choice, and reduce competition". This latter argument is so bad, and so shamefully self-interested, that I think it has crossed the line into outright unethical conduct by APT management, because the the truth is the <i>exact opposite </i>to what APT claims.<br />
<br />
It is absolutely <i>vital</i> to the emergence of increased competition (which is a key driver of innovation), and hence enhanced customer choice (and value), that there is price transparency, and that there are avenues for competing payment platforms to proliferate and offer more attractively-price alternatives. Let's be very clear again: <i>it is customers who are ultimately paying the 'APT tax', and customers paying in cash (or with a credit card) are also being forced to pay it. </i>From a consumer protection perspective, it is vitally important that this tax does not become systemic and entrenched, and leave customers with no choice but to pay it - <i>even if they are not an APT customer</i>. By making the cost transparent and explicit, you allow consumers to make a more informed and efficient choice about which payment methods are the most optimal/cost effective. Consumers can ask themselves, ok I like APT, but do I like it enough to pay 4% more? <i>That is the right question to have customers ask</i>.<br />
<br />
Indeed, I might even be prepared to go as far as arguing that regulators should <i>insist </i>on merchants imposing a surcharge (although importantly, restricting the magnitude of that surcharge to the actual cost borne from external payment providers). That would allow room for innovative and lower cost payment systems to emerge, <i>because you would give consumers a reason/price incentive to change</i>. Currently, that price signal is lacking, which is one reason why we have emerged with a global duopoly with V/MA. The way things currently work, where fees are hidden/built in to prices that all customers pay - even those paying cash - the system tends towards the creation of monopolies and excessively high fees. I for one really hope regulators address this situation.<br />
<br />
But if regulations change, and merchants have the freedom (but not the obligation) to impose a surcharge, will they choose to? The answer, I believe, is quite likely yes; it will likely start slow, but a trickle will eventually turn to a torrent. Why? Because those that impose a surcharge for APT will have an important cost advantage over those that do not, and will therefore be able to offer all customers lower prices. And if surcharges start to appear here and there, it could quickly become an industry-wide trend. This will particularly be the case as the touted 'merchant benefits' start to fade, for the reasons previously discussed.<br />
<br />
If surcharges indeed do become a trend, the consequences for APT could be quite catastrophic. Their product will now be revealed to be what it has always been - a more expensive solution to an existing, solved problem. Furthermore, 'adverse selection' could also become a serious issue for the company, as the customers that can afford to pay you back will probably opt to pay cash or via credit card, as they will enjoy lower prices by paying that way (avoiding the surcharge), while only those heavily strapped for cash would agree to pay the surcharge. This could result in APT ending up with a portfolio of low-quality payday loans that suffer very significant defaults.<br />
<br />
Time will tell. I am a generalist covering all industries and countries, and have only spent a couple of hours researching APT, so I might be mistaken or have missed something. I am not short the stock, because for reasons discussed in past blog posts, I believe shorting is dangerous in a world of ample liquidity and irrational exuberance, as many Tesla shorts have recently had to once again relearn the hard way. Many sensible people were wiped out shorting worthless dot.com stocks too early in 1999.<br />
<br />
I would not be at all surprised to see APT eventually fall >90%, however, and it's also not impossible it goes to zero (although much less likely than merely a >90% loss). One suspects that if APT were come to be seen as a payday lender with weak underwriting discipline, rather than a hyped-up conquer the world fintech payments platform/network, which a shift towards APT transactional surcharges could quite easily lead to, it wouldn't trade at 40x sales.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<i>*It is also notable is that about one third of the latter were late fees charged to past due borrowers, which APT book as revenue <u>prior to collection</u> - even though the collectability of late fees from delinquent borrowers ought to be considered questionable. This is very aggressive accounting. </i><br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-13916986400228081422020-01-31T06:46:00.003+07:002020-02-06T21:25:15.363+07:00Facebook - the bear caseFacebook is currently a stock beloved by both growth and value investors alike. It is an esteemed member of the FANG club - an aristocrat of the modern digital era. Everyone seems to own it. I don't like it. I think the stock is much riskier than most investors appreciate - particularly at this point in the cycle. (I am a day late in publishing this article, as the stock is down 6% to US$210 post its 4Q19 results - albeit this is small fry compared to the aggregate potential downside; I <a href="https://twitter.com/LT3000Lyall/status/1220870529936048128?s=20">tweeted</a> the WSJ Casper article referenced below over the weekend, and in related comments referenced the risks to Facebook, and began writing this post on Sunday. Unfortunately I was too slow to complete it).<br />
<a name='more'></a><br />
The things to like about FB are trivially obvious. Unlike most of it media-industry brethren, its content comes from UGC (user generated content) and is therefore produced for free by its billions of active users, and the company is then able to sell ads against the significant traffic this UGC generates. The persistency of its UGC is also supported by the well-discussed (read 'excessively discussed') 'network effect'. Furthermore, the amount of money it can make from selling digital ads is being supported by rising digital advertising penetration, as well as the company's ability to target users, due to its trove of user data. The company has become a putative duopoly with Google in the online digital advertising space, and is seen as a reliable, incumbent FCF compounder. Investors own the stock as they think (1) the company can keep growing at high rates; and (2) the company's earnings and growth outlook is low risk, as it is supported by durable, structural drivers.<br />
<br />
As is always the case in markets though, obvious merits are well known and well priced in. To make money in markets you have to prod for outcomes that are less likely but still possible, and are not being priced in, and I think there are many things to be legitimately concerned about for FB in this respect at the present time. As I have pointed out many times in prior posts, it does not matter that the below analysis might not be a base case likelihood. <i>It only matters that it is a not-negligible potential scenario that is being excluded from investors base case return expectancies. </i>That is enough to conclude the risk/reward associated with owning the company is poor.<br />
<br />
Although FB is a large and important company, the core drivers of its value are actually extremely simple: (1) the number of users it has and the amount of time those users spend on its platforms (what I call 'eyeball-hours'); and (2) the degree to which it can monetise those eyeball-hours through selling digital ads, which is a combination of the ad load (number of ads per hour), and the average rate card (cost per ad). The ability of the company to successfully customise/target ads to specific demographics also contributes importantly to the latter. The company's cost discipline also matters, but is a somewhat less interesting and important issue on a stand-alone basis than the company's revenue outlook. If revenues grow a lot, costs matter less; if revenue disappoints, they matter a lot more.<br />
<br />
With respect to #1, the company's global DAUs/MAUs continue to steadily grow. However, the company has already captured the vast bulk of the world's high-value users - those that can afford a smartphone and access to the internet, and can afford to spend a lot of money on products and services advertised on its online platforms, justifying the ad spend. However, just as important as the number of users is <i>the amount of time they spend on the platform </i>(the other important determinant of eyeball-hours), and transparency on this all-important metric is significantly lower.*<br />
<br />
One of the problems/headwinds for the latter is something I have discussed in <a href="https://lt3000.blogspot.com/2019/03/is-another-tech-bust-coming.html">past blog articles</a> - the increasing saturation of the 'attention market'. Although tech investors are accustomed to believing in limitless growth horizons, the reality is that there are only 24 hours in a day, 7 days in a week, and 52 weeks in a year, and so there is a finite amount of available attention for the world's online media companies (encapsulating social media, gaming, streaming, and other sinks for our attention) to compete over. Furthermore, the penetration of 3G/4G-enabled smartphones around the world is now high - particularly amongst affluent/high value users. The void of previously unused attention of people around the world waiting at bus stops, or queueing at the bank or airport, has now been filled. In other words, the available eyeball-hour market has now already become largely saturated.<br />
<br />
One of the important consequences of this is that future growth in the attention market is going to become 'zero sum' in nature, as the amount of white space uncaptured attention disappears. This is an important change vis-a-vis the past, where all new online media companies could simultaneously grow by capturing some of this previously unutilised attention. If there is one thing that is virtually certain, it is that new and interesting online apps/ways to spend our time will continue to emerge over time. The recent rapid ascent in TikTok, for instance, is a case in point worth noting. Out of nowhere, it has come to capture a not-negligible portion of the attention market. That innovation will continue is a given, and has always been the case, but what has changed is that from here, the success of one new platform will become <i>cannibalistic </i>and come at the expense of the success of another, rather than being merely additive to the overall attention industry.<br />
<br />
On some metrics, the effect this is having on old-hands like Facebook is already becoming tangible - at least with respect to the company's core Facebook platform (i.e. excluding Instagram and WhatsApp & Messenger). The below infographic is something I shared on Twitter a month or so ago, and is interesting on many levels. It highlights that FB's core Facebook property has already entered into a fairly rapid decline in usage in recent years, and an important contributor to this has likely been the increasing saturation of the attention market, and cannibalistic effect of competing social media and other mobile application platforms beginning to be felt. This is a problem not just for Facebook's all-important eyeball hour share, but also for its network effect flywheel, as it depends on UGC. Less visits equals less UGC, which leads to less frequent visits (and scrolling dwell-time), as there is less UGC to consume, leading to even less visits, etc.<br />
<br />
<iframe allow="accelerometer; autoplay; encrypted-media; gyroscope; picture-in-picture" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/2Uj1A9AguFs" width="560"></iframe>
<br />
<br />
Luckily for FB, they were smart enough to buy Instagram for a song ($1bn), and Instagram is still on the up and up, keeping FB's combined user metrics on a positive incline. However, the rapid recent decline in the core Facebook platform's visit frequency nevertheless serves to highlight that now that the attention market has been saturated, permanent incumbency in the social media space/attention market - let alone permanent growth - should not be automatically assumed. New platforms will always be launched - the Instagram, Snapchat and TikTok's of tomorrow - and the market will continue to mutate, evolve, and fragment, and at present the popularity of the core Facebook platform is clearly trending in the wrong direction - particularly because history suggests that once a platform's popularity is past its peak, comebacks are rare.**<br />
<br />
The bulls may acknowledge that the attention market is becoming increasingly saturated, but they will counter by arguing that FB's attention is still significantly under-monetised. A major component of this argument is pointing out that the company's US ARPU is still substantially above the ARPU generated in international markets. <i>However, what if the actual truth was not that FB is under-monestising abroad, but rather that it is actually <u>over-monetising</u> its US user base</i>?<br />
<br />
Relevant in this regard was an excellent recent WSJ article about VC-backed online mattress company Caspers (see <a href="https://www.wsj.com/articles/casper-has-big-dreams-but-wall-street-is-waking-up-to-losses-as-its-ipo-nears-11579861802">here</a> - paywall). Like a large number of hyped, VC-backed Unicorns, Caspers has been growing rapidly, but chalking up considerable losses. The article notes that one of the challenges the company has faced is that almost all of its key business functions are outsourced (most notably all mattress procurement/manufacturing), while the company is sourcing customers by paying for online ads. All of these business functions are easily replicable, and hence the company has seen the emergence of hundreds of immitators sourcing products from the same suppliers, and competing for the same Google keywords and Facebook demographics. This had driven marketing and CACs through the roof, hammering profitability.<br />
<br />
All these companies are losing money, as FB and GOOG are capturing all of the value. It makes sense - if you can buy and have delivered a mattress from a third-party manufacturer for say $200, and sell it online for $400, it makes sense not just to pay FB and GOOG $20 to acquire a customer, but also $50, $100, $150, and ultimately $200. Indeed, it even makes sense to pay $250 if you are being valued on revenue growth rather than profitability, as most VC-backed Unicorns are. Growth at all costs is their mantra.<br />
<br />
Market and economic history is replete with examples of companies and industries that grew rapidly but incinerated capital, because if supply grows faster than demand, and companies lack any sustainable competitive advantage, it doesn't matter how fast demand grows - everyone loses money. This has happened in everything from railways in the 19th Century; automobiles in the 1920s; fibre-optic cable in the late 1990s; wireless networks in the 2010s (at least with respect to new investments to upgrade networks, which have not been monetised); solar panels in the early 2010s; shale oil & gas in the 2010s; and more recently, in cannabis and lithium. Stocks typically surge as investors anticipate a boom in demand, only to collapse later as supply grows faster than demand and losses mount.<br />
<br />
Companies like Caspers are no different, and their large losses also reflect their extremely low level of organisational competencies. Caspers is not a mattress company. They have no manufacturing; no mattress technology; nothing. All they do is get manufacturers to to produce mattresses for them; set up an online storefront; and then spend a tonne of money branding and marketing those mattresses through online channels. <i>They are simply marketing businesses. </i>Because they have very little value-add; no unique organisational competences; and no competitive advantages, they don't have the necessary ingredients for robust economic returns - namely, <i>being able to do something other people/organisations can't easily do. </i>They are facing lots of competition from other well-funded start-ups willing to lose money, and it is therefore no surprise they are losing money. Anyone can pay to buy ads online, and brand and sell products manufactured by real companies with real capabilities (designing and manufacturing mattresses, which requires some skill and installed capital).<br />
<br />
In an era of unprecedentedly loose capital market conditions in the VC space, there are many, many companies like Caspers out there - essentially online marketing businesses that while growing fast, are losing a tonne of money, because they have low quality business models that are easily replicated, and there is an excess supply of capital in their industry chasing growth. This is unsustainable, and when the VC funding spigot is turned off - which will happen when the very high return expectations of their end investors are inevitably disappointed, dampening the appetite for more (particularly from investors such as large pensions/endowments that can ill-afford the losses) - a large fraction of these businesses will fail, and massive consolidation will occur (much as occurred in 2000-03). Indeed, there are some signs we may already be reaching this point, as the WeWork blow-up has severely damaged Masayoshi Son's credibility, which is reducing his ability to raise additional capital.<br />
<br />
This time is seldom different. Every single growth boom in history that has featured a vast number of new entrants supported by a wave of capital all vying for a slice of the pie, have eventually seen the pace of supply growth outpace demand; mounting losses; and an eventual severe downturn that leads to mass bankruptcies and eventual consolidation. It happens every time, without exception.<br />
<br />
The reason I discuss the Caspers of this world here, however, is that the risks relate not just to Caspers, but also to the likes of Facebook, as it has been an important marketing and customer-acquisition channel for the said loss-making start-ups. How much of FB's ad revenue is driven by wastefully-unsustainable marketing dollars being thrown around by VC-backed startups desperate for growth without any regard for profitability is unknown, but it could well be substantial. Caspers alone is spending more than $100m a year on online marketing. <i>Facebook's revenues are the other side of the unsustainable marketing and CAC expense line items of the said loss-making VC-backed Unicorns. </i><br />
<br />
What this means is that in a severe retrenchment in VC start-up land, a very considerable amount of online advertising spend could suddenly disappear, as many of Facebook's key customers suddenly substantially reduce their online ad spend. Furthermore, when end markets eventually consolidate (e.g. if Caspers ends up the winner by raising IPO capital and buying out all of its competitors for close to zero), there will also be less bidding competition for key words (relevant also for Google) and key ad slots, which could reduce prices as well as bidding volume.<br />
<br />
How much of FB's US ARPU is being driven by unsustainable CAC spending is unknown, but there is a notable gap between FB's monetisation in Europe and the US & Canada ($13.21/quarter vs. US$41.41/quarter, respectively, in 4Q19), despite Europe also being a relatively high-income region. The bulls have argued this is due to FB being under-monetised in Europe and the RoW (FB's global average was US$8.52/quarter in 4Q19), but the gap could also reflect FB being heavily <i>over</i>-monetised in the US, reflecting rampant Valley financing of worthless tech start-ups willing to spend billions of dollars on Facebook and Google ads to acquire customers and sustain rapid top-line growth at any cost.<br />
<br />
When you think about it, US$41.41 per user in the US & Canada - a user base that includes kids with limited financial resources - is a staggering amount of money. It would have to influence several thousand dollars of incremental annual product and services spend a year, for every single user (including kids, and the many very light users of FB), for that to be sustainable and economically justified. That's a tall order to sustain, let alone grow at rapid rates, and it is entirely possible inflated Unicorn CAC spend is a key reason the metric is so high.<br />
<br />
If in a major tech bust, FB's US ARPU was to fall to European levels, the company's revenues and pre-tax earnings earnings could fall catastrophically, by as much as US$20bn, reducing pre-tax income from US$30bn to US$10bn. Impossible you say? FB's revenue was only US$56bn (vs. US$71bn in 2019) as recently as <i>2018</i>, and US$40bn (US$30bn less than current levels) as recently as <i>2017! </i>US$10bn is also about as much money as the company was making in 2016, and the company's cost base has meaningfully inflated since then, as compliance/content moderation spending has grown (although there may be some downside flexibility in a bust scenario given how much costs have risen).<br />
<br />
One of the major mistakes investors made in the late-1990s tech bubble was to ignore the cyclicality of IT capital spending. It was argued and believed that the secular growth trends driving rising internet adoption and networking would be so strong that it would overwhelm any conceivable cyclical factors. People were wrong. There was a collapse in corporate IT spending for several years; fiber networks were so significantly overbuilt that excess capacity remained for as much as 10-20 years post bust, wiping out many leveraged long-distance fiber companies and forcing consolidation; and online dot.com advertising spend (less important/systemic at the time) also collapsed.<br />
<br />
Analogously, today investors are assuming the secular trends towards higher online activity and digital marketing are so strong that cyclical factors can be ignored, and yet (1) advertising has always been a notoriously cyclical industry, as marketing spend is one of the first things companies cut in a recession when they need to shore up cash flow; and (2) digital marketing has now already grown to a relatively large share of total global advertising spend, which means the extent to which secular growth drivers (digital spend rising as a percentage of total advertising spend) can overwhelm cyclical factors (the aggregate rise and fall of marketing spend through all channels) is also naturally declining.<br />
<br />
If we go through a severe tech VC/Unicorn bust, which I think is virtually inevitable and have called for multiple times on this blog, I think investors could easily be surprised by the extent to which this dents FB and GOOG's marketing revenues (the trends discussed in this article are also relevant to GOOG's marketing revenue, but unlike FB, it has a more durable long term core business monopoly, and also has a valuable and rapidly growing cloud business (supported by its AI capabilities), YouTube, etc, which make it less risky than FB long term, but still very vulnerable short term).<br />
<br />
If FB's ad revenues were to unexpectedly <i>drop </i>by say 20% - particularly if FB is unable to get its cost base under control, as it continues to invest heavily in 'content moderation' to comply with increasingly strident calls for online content moderation by regulators - the company's earnings could easily halve (increasing the stock's P/E to 50x), and the stock could be absolutely massacred. If it fell to 15x reduced earnings that would be a 70% decline. Sound impossible? <i>A 20% drop in the company's ad revenue would only take its top line back to levels seen in 2018, </i>and a fall in the multiple will be amplified by the current level of crowding into tech names, and the false expectations many holders have (that FB is a 'low risk' structural grower immune from cyclical risks). Falling prices also kick into gear various self-reinforcing psychological and momentum/flows forces, which is why historically, the gravity of the bust is usually inversely proportional to the gravity of the preceding boom. And all this is before considering any fears that may emerge about FB losing market share to other competing social media platforms such as TikTok.<br />
<br />
At this point, I will inevitably be asked, does that mean I'm short FB? No it doesn't. I don't like shorting stocks for reasons I have discussed in <a href="https://lt3000.blogspot.com/2018/08/the-real-cautionary-tale-of-david.html">past blog articles</a>, and more importantly, I never have 100% confidence that any of my views are right. That's not the way I think/invest; I don't form a fixed view of what I think is going to happen in the future, and then invest on the assumption that I am right, which is what most investors do. The future is radically indeterminate, and trying to predict the shape of future online ad spend is extremely difficult, and it would be foolish to try to do so with any degree of certainty - particularly for a generalist, non-specialist such as myself, that has not dedicated any serious research time to the issue. I have spent a small fraction of one percent of my research time thinking about these issues, as I am focused on uncovering promising opportunities in unusual corners of global markets, and don't waste my time on areas that are already well picked over/expensive/crowded.<br />
<br />
I instead consider a variety of potential futures, to form a probability distribution of sorts, and then look at what's priced in/generally believed. In the case of FB, I see a situation where everyone is long and has signed up to the view that this is a bulletproof structural growth story, and that this will inevitably remain the case for many years. <i>They might be right. </i>But I am much less sure, and have concluded from my analysis that there are important risk factors that appear to be under-appreciated by investors. That's all I need to know to know the stock is not a buy on an expectancy basis - I don't need to know for sure what happens. However, if I short the stock, I <i>do </i>need to know for sure what's going to happen, and also need to be sure the stock doesn't go parabolic in the interim - something that happened in the dot.com bubble and wiped out many short sellers who were forced to cover (and is currently happening with Tesla), <i>even though they were ultimately right in their fundamental views.</i><br />
<br />
So I won't be going short, but I definitely won't be going long.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
<i>*Also notable here is that time spent on messenging apps is of considerably lower value than on Facebook and Instagram, as it is very difficult to effectively monetise the former. </i><br />
<i><br /></i>
**<i>Incidentally, the other notable collapse in web traffic has been from Baidu - another popular stock owned by many value investors, which appeared cheap relative to Google, but which never succeeded in making and distributing any cash of note, as it squandered its prosperity on many loss-making upstart ventures - perhaps because it recognized vulnerabilities in its core business that most investors overlooked, which are now becoming manifest. Unlike Facebook's share price, however, which has continued to rise and rise, Baidu's has sharply declined.</i><br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-65768177096141303932020-01-30T18:24:00.002+07:002020-01-31T04:25:07.683+07:00Learning the wrong lessons; style drift; and why smart value investors underperformThere are many things that separate the great value investors from the poor to mediocre, but aside from simply being better or worse at valuing companies (table stakes for a good value investor), one of the most important is that the former tend to reason from first principles - i.e. from things that are true by definition in the long term - and implement a disciplined and consistent process informed by those principles; whereas poor to mediocre value investors attempt to draw far too many 'lessons' about how to invest from recent market experience/outcomes. Quite often, the belated incorporation of these 'lessons' into investment decisions results in untimely 'style drift', with a shift towards strategies/sectors/stocks that have worked well in the recent past, rather than those that are most likely to work in the future. This untimely vacillation all but ensures long term underperformance.<br />
<a name='more'></a><br />
For instance, a value investing newsletter I subscribe to recently published a list of 'never sell' stocks - regardless of price. Yes, this from a service that purports to be value oriented - an investment strategy that is defined more than anything else by its price vs. value ethos. (I don't mean to pick on them - I'm a subscriber, and they are smart, open to debate, and have some great content which I enjoy reading, but this 'quality over price' ethos is something I disagree with strongly, and is so emblematic of a lot of what I've been seeing in the world of 'value' everywhere I turn lately, that I couldn't help writing something about it).<br />
<br />
Predictably, the list of stocks is populated by high quality, resilient businesses with capable management that have delivered steady growth and high returns on capital in the past, while maintaining solid dividend payouts. However, they also have another very important thing in common: the stocks have all performed exceptionally well over the past decade not only due to their quality/business performance, <i>but also because they started at reasonable multiples, and have experienced a decade of multiple expansion - typically from about 15x to closer to 30-50x (less for some lower-multiple industries)</i>.<br />
<br />
The combination of solid growth, good dividends, and an incessantly rising multiple is always a heady combination in markets, and has ensured a decade of fabulous returns. However, the most important psychological outcome of this experience has been that <i>any decision to sell/reduce such stocks over the past decade - due to the exercise of 'price discipline'/'value consciousness' - has proven - ex post - to have been the wrong one</i>. Consequently, the lesson the newsletter has drawn from this experience is that it is a mistake to sell good businesses, regardless of price. You should buy good businesses and never sell. Why? Because the past decade of market experience proves it.<br />
<br />
The problem is, multiples don't always rise, and the conclusion also ignores both market history and important first principles. Markets go through long, secular cycles that can last a decade or more, and strategies that have worked well over the past decade are often amongst the worst performing during the next, <i>because expanding multiples invariably inflated returns during the prior prosperous decade</i>. This has a corrosive effect on future returns for two reasons: (1) firstly, starting-point FCF yields are significantly less than the prior decade; and (2) in the long run, multiples are subject to mean-reversionary forces, and the higher the starting-point multiple, the more likely it is that multiples fall rather than rise in the coming decade.* (Another important contributor is that high-performing, high-growth sectors attract a lot of capital and new competitive entrants, which drive down future RoEs).<br />
<br />
The past decade was not the only one where high quality compounders came into favour, and where it eventually came to be argued that quality ought to take absolute precedence over price. It happened during the 1960s-early 1970s with the 'Nifty Fifty' - the so called 'one decision' Blue Chip stocks, where valuations got as high as 60-80x earnings. The stocks subsequently fell 80%. It happened again in the 1990s, where not just tech stocks, but Blue Chips such as Coke and GE traded up to 40x earnings. Coke subsequently fell 50%, and took about 15 years to return to its prior levels, while GE - the archetypal 'never sell stock' of the 1990s - is currently 80% below its 2000 price levels.<br />
<br />
During all these boom periods, good business performance was supercharged by substantial multiple expansion, and investors failed to disaggregate how much of their quality, 'compounding' return was coming from non-repeatable multiple expansion which had driven <i>down </i>future return potential, and how much was coming from actual underlying business performance (something which incidentally is also frequently more mean-reverting long term than people think - GE is a case in point). During each of these episodes, years and years of rapidly rising prices caused investors en mass to learn the wrong lessons: that quality was paramount and price secondary, and that you should never sell. In all cases, such stocks delivered disastrous performance in the decade that followed.<br />
<br />
The underlying dynamics are best highlighted by a simple mathematical example that takes the emotion out of it, and thereby facilitates more rational thinking. Take a hypothetical company that trades at $15.00 and earns $1.00 (15x trailing P/E). Let's assume this is a great 'compounding' company that earns a 15% RoE; pays out 50%; and grows at 7.5% a year. If you bought this stock, and 10 years later the stock traded at 35x earnings, your realised return including reinvested dividends along the way (assuming a steady geometric rate of share price appreciation) would be a cool 19.3% a year. The stock would rise to $72.14, while $7.07 in cumulative dividends would have been received along the way. A five-bagger! Any decision to sell/trim along the way would appear to have clearly been a mistake.<br />
<br />
However, what would be the outcome if the company delivered the exact same operational outcomes and growth during the next decade, but this time the multiple fell from 35x back to 15x? The answer is just 0.9% a year compounded, <i>including </i>reinvested dividends along the way. The same company delivering the same RoE and growth would experience a 'lost decade' simply due to multiple compression. Earnings would rise from $2.06 to $4.25, but with the multiple falling to 15x, the stock would be just $63.72 a decade hence - 11.7% <i>below </i>the price 10 years earlier. $14.58 in cumulative dividends received and reinvested during this period would salvage - very marginally - a positive total return.**<br />
<br />
Ten years is a <i>long, loooong </i>time in markets. It has a tremendous impact on investor psychology. 10 years of rising prices and rising multiples is insufferable for many investors to 'miss out on', and it is equally insufferable to hold a position that goes nowhere/down for 10 full years as well (there are many 'compounder' businesses, from a book value, RoE, and dividend per share perspective in HK/China that have gone sideways/down for 13 years, as multiples have fallen from 20x to 5x; predictably, no one views these stocks as 'compounders'; merely 'value traps'). When multiples are falling, the psychology around stocks <i>completely </i>changes. Risks are scrutinized more than opportunities. Patience is punished rather than rewarded. People come to believe that it doesn't really matter how great the underlying business is because the stock never goes up and it lacks a catalyst - after all, 10 years of market experience proves it (at this point, people also once again argue price doesn't matter, but at the opposite end of the spectrum for opposite reasons).<br />
<br />
If for whatever reason multiples were to contract throughout the 2020s for the high-quality, never-sell stocks referenced, I can easily imagine the very same investment newsletter reflecting in 2030 on the experience of the past decade, and the poor returns earned from many of their core long term holdings, and concluding that 'price matters'; 'a good company does not equal a good stock'; and 'when prices are high, a whole decade of great operational achievements may be neutered by a high price'. I can imagine vows being made that in the future, far more attention will be paid to price, because price ultimately determines your return, not business quality. This would no doubt inform investment allocation decisions being made at the time.<br />
<br />
See the problem here? The fundamental issue is that lessons are being drawn from the market action, rather than first principles that will <i>always </i>work in the long run, as they are axiomatic (true by definition). Drawing such false lessons will cause investors to make untimely changes to their style preferences, favouring sectors, geographies, and attributes (e.g. quality) that have worked well in the recent past, and eschewing those that have experienced a long period of poor outcomes. This results in investors buying high and selling low, and in the process, delivering returns that underperform the operating results of the companies they own during their holding periods (e.g. when you sell a stock at a loss even though the company has been profitable during your period of ownership).<br />
<br />
Furthermore, value investors of this ilk can further compound the damage they do to themselves by being late to identify a new market segment that has done very well (such as technology/software over the past decade). After missing a lot of the early gains, they go and do research on the stocks, and then belatedly realise these are actually great businesses they would like to own, and that the market's enthusiasm is justified. The only problem is that the price is a little too high for comfort. Accordingly, what they often decide to do is put those stocks on the watch list, and hope they are given an opportunity by 'Mr Market' to buy those stocks at a less expensive price in the future.<br />
<br />
This is a very dangerous approach, because if you simply buy these expensive, rising stocks straight away, you'll at least be jumping on the momentum train and will make money so long as the current multiple expansionary trend lasts, which in the short run is quite likely (momentum is a real thing, as it is driven by the flows flywheel I have referenced in past research - performance begets flows; and flows performance - and intend to discuss in more detail in future posts).<br />
<br />
However, if you wait until the stocks start falling to buy (after no doubt beating yourself up for 'missing' further up-moves beforehand) in a process I describe as faux contrarianism,*** there is a much higher risk that (1) the fundamentals have already started to deteriorate, unbeknownst to you, so the value investors end up buying off the smart money in regular contact with management that rode the stocks all the way up and are starting to exit - a risk amplified by the 'many eyes' and extensive brokerage coverage these stocks have often by now attracted; or (2) you have bought in the early stages of a flows-driven momentum reversal, in which case you may well end up owning the stocks all the way down during the multiple de-rating phase, while having failed to own them all the way up. This can also decimate performance, and is the fundamental driver of the well-known 'performing chasing' phenomenon that contributes to much underperformance amongst active managers.<br />
<br />
At present, a clear sign that a value investor is being unduly influenced by what has recently worked is if they have wound up with most of their top positions in software/tech names trading at high valuations. This didn't happen overnight. Instead, they have been slowly and steadily seduced, by years of market action, into thinking these are the best stocks to own. No doubt, they started slow, and as the stocks they bought quickly moved up after purchase, they became emboldened by positive reinforcement to add more, and then even more. This goes on for a while and they end up loaded up in popular, expensive, crowded names at the peak of the cycle, despite believing themselves to be contrarian value investors that go against the crowd (the same thing happened in the late 1990s).<br />
<br />
Furthermore, the above is particularly the case if the said investors have also underperformed over the past five years. <i>If they have owned tech/software over the past five years, they should be massively ahead of the index</i>. If they are not, they have loaded up their portfolio in expensive quality/growth compounders very late, and are performance chasing - even if they don't themselves yet recognise it. Unfortunately for many of these investors and their clients, they will probably only realise what has happened after a secular change in market momentum/flows dynamics occurs, and they end up substantially underperforming as the cheaper, lower-quality stocks they eschewed and once owned surge ahead. They will be left to reflect on what went wrong. No doubt, they will then pivot back to what worked well during their recent period of underperformance - cheap/unloved companies.<br />
<br />
What investors should be doing is focusing <i>not</i> on what has worked in the recent past, but what <i>must </i>work over time on a first principles basis, and that requires a clear-headed understanding of the following: when you buy a stock, you are buying one thing and one thing alone - <i>the right to receive the future dividends and other cash distributions the company makes. </i><i><b>That's it</b></i>. The only difference between me and Buffett/Berkshire with respect to Coke is that when Coke declares and pays a dividend, BH gets a big slug of cash deposited in its bank account, and I do not. Accordingly, any investment case that is not able to be justified based entirely on the dividends it is likely to pay out over the long term is not value investing (for instance, if a stock is on 50x earnings, it has to pay out 100% of earnings to yield 2%, and grow dividends 8% pa into perpetuity to deliver a 10% return).<br />
<br />
Now sure - quality, competitive advantage, management, etc, contribute meaningfully to <i>what those future cash distributions are. </i>At a practical level, they are therefore an absolutely essential part of security analysis and the valuation process. But once a sufficiently accurate assessment of what those cash flows will likely be is made (which is the entire intellectual skill set involved in value investing), <i>100% of your future buy and hold forever returns will be driven by how the price you pay compares to the actual cash paid out in the future (in magnitude and timing), and the IRR generated therefrom. </i><b>Double the price, and you halve your return - it's that damn simple</b>! It is startling to see value investors arguing that 'price doesn't matter' when it determines 100% of your future return! It is a clear sign that we may be approaching the late stages of this growth/quality bubble.<br />
<br />
Value investing sounds simple, and in many respects it is - <i>intellectually</i>. Many investors are drawn in by this simplicity early in life, seeing an opportunity to accumulate great riches with relative ease. However, the issue with its implementation is <i>emotional </i>- markets can go years and years without validating your process and delivering outcomes that converge with long term expectancies, and it is the rare investor that can resist the mentally corrosive effects of this negative reinforcement, and avoid learning the wrong lessons the market is repeatedly trying to 'teach' them. Many value investors view themselves as immune from these emotional tugs, but they are wrong. Just because you are prepared to buy a stock that has recently fallen 20% (particularly if it is associated with faux contrarianism)*** does not mean you are immune from these corrosive emotional drives, which are much subtler and run much deeper than most investors generally appreciate.<br />
<br />
Investors also confuse ex post outcomes with ex ante probabilities - what actually happened compared to what could be realistically foreseen at the time. When you look back at a growth stock compounder that has risen and risen over the decades (such as Google), it is tempting to believe it was obvious all along, but that is often hindsight/survivorship bias. People today forget that in the late 1990s, Yahoo was one of the largest market cap companies in the world, as investors believed Yahoo was destined to be what Google has today become. Had it done so, people would today be arguing that it would have been a mistake to sell Yahoo in 1999. That's hindsight bias.<br />
<br />
As Buffett has opined, it is often not intellect that differentiates the successful value investors from the also-rans. The analysts at the subscription newsletter I reference are smart. It's instead temperament, and an ability to resist the forces of style drift <i>over very long periods; </i>maintain a rigorous (and sound) process with price discipline through thick and thin; <i>and not lose confidence in an approach merely because it has not been validated by market prices in recent times. </i><br />
<i><br /></i>
It's a tough balancing act, because most of the time in life, if the world is giving you negative feedback, <i>you probably are doing it wrong or aren't very good</i>. If you try to play football and you keep getting knocked out and hospitalised, the world is trying to tell you something, and the world is probably right. You suck at/aren't cut out for football. There is therefore a fine line between being stubborn and ignoring feedback, and being tenacious and disciplined.<br />
<br />
The key to success in value investing is not just discipline and consistency, <i>but also being very good at valuing businesses, </i>just like the key to being a good footballer is not just an ability to get back up after a hard hit, but actually having both the physicality and necessary skills to excel at the game. If you're not good at valuing businesses, you will deliver mediocre to poor results over time, regardless of your temperament. However, even if you are smart and capable enough at valuing businesses, you will still underperform over time if you allow the market to teach you the wrong lessons.<br />
<i><br /></i>
<br />
LT3000<br />
<br />
<br />
<i>*I discussed in a recent post how the structural force of excess savings has pushed down interest rates and returns on other financial assets (although also discussed how this is also potentially part of a very long term political cycle). However, even acknowledging the above, there is currently a record-high level of multiple dispersion - the world's most expensive stocks have never been more expensive relative to the world's cheapest.</i><br />
<i><br /></i>
<i>**It actually gets even worse than the 0.9% return I mentioned, as that is prior to the inevitable occasional blow-up that happens in a highly rated, highly favoured stock. Sure, these events are unlikely, but across a portfolio of say 10-15 such stocks, it will probably happen to at least one of them. Almost on a daily basis at the moment in Australia, a highly-rated, high quality stock is selling off 20% on a profit downgrade. Gentrack - a popular SaaS story amongst 'value' and growth investors alike - has recently plummeted 70%. The de-ratings are so severe because if instead of growing, earnings fall 50%, suddenly the stock isn't on 30x forward earnings but 70x, while the future growth outlook is also revised down. Losses of 75% can happen extremely easily/swiftly with such stocks, and represent a <u>permanent loss of capital</u>. If only one out of your never sell portfolio of 10-15 stocks has this happen at any time over an entire decade, the overall returns from your portfolio are likely to be meaningfully subpar <u>even if</u> multiples don't decline.</i><br />
<i><br /></i>
<i>***I call this faux contarianism. The investor sees themselves as going against the crowd in buying a stock that has recently fallen, but they are buying a popular, expensive stock that has been mostly rising over the past (say) five years; has merely become slightly less expensive/popular; and are relying on a highly-consensus assessment of the historical strengths of the business (already well known and priced in), rather than understanding and reacting to new information that may be calling that prior assessment into question. Real contrarianism involves focusing on areas of the market that are genuinely cheap and neglected, and have typically already delivered poor outcomes for many years, but have underappreciated mean-reversionary/recovery potential. </i><br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-81390180993112025912020-01-24T16:30:00.004+07:002020-01-24T17:38:13.998+07:00Extrapolation; Technology One & SaaS; Affiliated Managers Group; margins of safety; and growth bubblesOf the many causes of market inefficiency and investor misjudgement, there is perhaps no more important contributor than investors' tendency towards excessive extrapolation. This is borne - I believe - of investors' general overconfidence in their ability to predict the future (a theme I have discussed in many past blog entries).<br />
<a name='more'></a><br />
In the short term, extrapolation is not wholly unjustified; after all, a company that is prospering, and is in the right place at the right time with great management and a favourable industry backdrop, will in all likelihood continue to experience continuing growth and profitability in line with market expectations in the short term (and vice versa for companies experiencing adversity). The issue however is not what happens in the short term; it is that the market invariably extrapolates current trends <i>far further into the future than can be realistically foreseen at present. </i><br />
<br />
Take a company like Technology One (TNE AU), for instance - a company I finally got around to spending an hour or so looking at this morning (I don't mean to pick on TNE; it's just I've been meaning to write an article on this topic for a while, and TNE for some reason prompted me to do so). It's a great company that is performing well, and has a good medium term growth and profitability outlook. The company sells ERP software which was initially sold as an on-prem solution, but is now well advanced in migrating its customer base to a cloud-based SaaS offering. The company is focused on niche verticals including local governments, and education and healthcare institutions, and has a 20 year track record of successful growth and execution, and is winning in the marketplace by focusing on a simple to use, integrated ERP suite focused on certain key niches.<br />
<br />
The company has been winning business off incumbents such as SAP and Oracle, by offering a more cost effective solution for certain verticals, and has a robust presence in Australia and is now expanding into the UK (where it is still loss making, but is exhibiting decent traction, with sales building and losses declining). Notably, the company highlights that customers can be migrated onto its product suite in as little as two weeks (it is often argued that enterprise software is highly 'sticky' due to the complexity and cost of migration, but TNE seems to have bridged that gap for customers).<br />
<br />
The company also continues to invest about 20% of its revenue into R&D (albeit starting from FY19, about 50% of that is now capitalised), underpinning the continuing roll-out of improved feature sets for customers, while also incrementing add-on products that it can up-sell to its existing customer base. Customer retention is some 99%, highlighting the current product-market fit and strong customer value proposition of the company's offering. In short, this is an archetypal SaaS play, with wonderful unit economics; recurring cash flows; a scalable business model; and ample opportunities for growth, both domestically and abroad. The company notes that historically it has doubled in size every five years, and it is guiding for a repeat in the next 5 years out until 2024.<br />
<br />
Sounds like a great story right? It is, but here is the problem: the stock trades at 45x trailing earnings (even with 50% of R&D capitalised), and simple math demonstrates the tremendous degree to which current trends have been extrapolated well into the distant future - far further than can be realistically foreseen. Let's assume the company can in fact double its earnings over the next five years, and also pay out 100% of earnings along the way, reflecting its strong balance sheet and the cash-generative nature of its business (software companies are often argued to be 'capital light', but this assessment overlooks the cost of acquisitions, which are sometimes needed to ward off competitive threats and to sustain growth; in TNE's case, however, their growth has been largely organic in the past). What will have to happen for the stock to deliver merely a 10% compound annual return over the next 5 years?<br />
<br />
As noted, I will assume earnings will increase from $58.5m in 2019 to $117.7m in 2024e. The dividend yield in year 1 will be 2.5%, which means the company's market capitalisation (currently $2.66bn) will need to rise by about 7.5% to deliver a 10% 1yr TSR, placing the stock on 42.6x earnings one year hence. If this process is iterated for the five year period to 2024, the stock's market capitalisation will need to increase to $3.75bn by 2024 (assuming no stock issuance/dilution), with the stock's P/E coming in at 31.9x 2024 earnings.<br />
<br />
Sure, the outlook for the next five years is great, and in all probability the company will continue to grow nicely during this period, but that's already more than priced in. To deliver only a 10% return - not 20-30% - the stock will need to not only double earnings over the next five years, but also still trade on 32x earnings at the end of this period - about a 3% FCF yield. Furthermore, even though it is <i>highly likely </i>they will succeed in executing on their growth plan over the next five years, it is not <i>guaranteed</i>. The investor of today therefore has to take all the risk of any execution missteps or unexpected changes to the competitive landscape; macro environment; and all the other vicissitudes that can impact businesses over time for five full years, without any meaningful risk premium. In this respect, the strong visibility the market has on the company's next five year growth outlook is a negative, as those expectations have now already been baked into prices.<br />
<br />
Furthermore, for the stock to trade at 32x in 2024, there will need to continue to be a very favourable growth outlook for the <i>next </i>five years after that. Indeed, if we extrapolate out the same 5yr math to 2029, and assume they double earnings again to $236.7m and continue to pay out 100% of earnings, the market cap will need to rise to $4.95bn by 2029 to deliver a total return of 10%, which would price the stock on 21x earnings in 2029. But to trade at 21x in 2029, there will still need to continue to be a favourable outlook for the five years after that - albeit with moderating growth of 5-10%.<br />
<br />
The problem is, the future 10-15 years out cannot be realistically foreseen with this degree of certainty, and a lot can change in a decade. Even if this is the most likely outcome, other outcomes are possible, and the further one extrapolates out into the future, the more likely it is that investors' base case vision of the future will prove erroneous. As the company gets larger, it will increasingly saturate its core markets like Australia, and have to rely on riskier growth in newer markets where it is a later entrant, and where more well-established competitors are likely to already be in place by the time they get there. This introduces the risk they will have to do what many putatively 'capital light' SaaS businesses need to do to sustain growth - make expensive acquisitions to buy their way in to new markets (this works when your scrip is materially overvalued, as it has been for many SaaS companies in recent times; less so when more realistic valuations prevail).<br />
<br />
Furthermore, the company competes not only with traditional incumbents like SAP and Oracle, but also other hypergrowth new-SaaS companies such as Workday, which with its core HCM vertical increasingly penetrated, is pushing into ERP fairly aggressively to sustain growth. It is not realistic to expect incumbents to not continue to invest heavily in expanding and improve their own cloud/SaaS product sets to compete with new entrants - particularly as those new entrants grow in size and so become more than a marginal nuisance. Other newer players like Workday will also very likely continue to aggressively expand their feature set and product scope, and continue to drive customer acquisition without regard to near term profitability.<br />
<br />
As TNE grows, it will therefore likely increasingly bump into rising competition from other SaaS players and provoke an increasingly aggressive competitive response from incumbents, while as TNE's own ease and speed of platform migration highlights, switching costs are starting to decline. Furthermore, TNE has been winning new business partly because it has lower prices, and there is no assurance competitors do not respond with more aggressive pricing of their own in the future as well.<br />
<br />
In other words, the world of SaaS is unlikely to prove immune from competitive/pricing threats in the long term, and while TNE is on the right side of these pricing/competitive dynamics at present, there is no assurance that 10-15 years from now that will still be the case, and investors will still be content to ignore the risks. With so much investment going into the software industry at present, we will continue to see more and better solutions to the various software needs of enterprises proliferate, with increased integration, ease of use, and ease of migration. Furthermore, we are in the steep section of the S-curve at present of enterprise cloud and SaaS-based software adoption, but trees do not grow to the sky, and as markets become increasingly saturated, the low-hanging growth fruit will start to disappear, and price competition for new work could easily heat up (while competition for renewal work could also accelerate as the level of 'white space' declines).<br />
<br />
SaaS companies will also have to continue to invest aggressively to keep leveling-up their feature sets to ensure they are not surpassed by competitors. SaaS investors often back our R&D and software development spend, as well as customer acquisition costs, when valuing SaaS companies, arguing that those costs are relatively fixed and represent an investment in improved functionality that will drive higher revenue growth in the future, while the costs will shrink to comparative insignificance over time as revenue growth compounds. But keeping up with the competition in terms of feature sets will remain table stakes for all SaaS companies long term - particularly as the ease of platform migration rises (platform migration is itself a software problem that can be solved with software solutions). There will always be ambitious new start-ups trying to push their way in with better, cheaper solutions, much as TNE itself is doing to SAP and Oracle. It is notable how in the tech hardware business, companies like Samsung that spend a fortune on R&D are not given such credit by investors, even though that R&D drives future revenue growth, because investors have long recognized that if they don't spend this money, they won't keep up with the competition long term.<br />
<br />
What happens if 5-10 years from now, TNE's growth is slowing down; their feature sets have been replicated by competitors; Workday is pushing very aggressively into their space, cutting prices to win new business; and retention rates are starting to slip from 99% to say 90%, requiring they up the level of spend on new feature development and marketing, and cut prices on some renewals to keep business? It would not take much for the narrative to change and multiples to fall to 15x or less as revenue growth stalled; cost growth accelerated; and competitive risks increased. That would wipe out a decade of returns from strong business performance. Think it can't happen? Microsoft, which traded at 80x earnings in 1999, traded at as little as 7x earnings a decade later. <i>Investors systematically underestimated the capacity for major unexpected change to occur over long time horizons. (</i>Growth bulls will try to point out that MSFT made a successful come-back, but that was a comeback from being a <i>value </i>stock not a <i>growth </i>stock; investors were at that point excessively extrapolating the company's <i>near-term challenges and uncertainties </i>too far forward).<br />
<br />
In short, all the risks and asymmetry with stocks like TNE is to the downside. Everything has to go right for 10 years for the company to merely deliver a 10% return, even assuming a high period-end multiple above 20x (a less than 5% terminal FCF yield). This is the opposite of a margin of safety; a margin of safety allows a lot of things to go wrong, and one to still enjoy an ok outcome, with asymmetry of outcomes skewed to the <i>upside</i> rather than the downside. In the case of TNE, anything less than everything going right operationally for 10yrs+ will result in a poor outcome, and such surprise outcomes happen with much greater frequency than many investors are willing to believe.<br />
<br />
We have seen similar things happen recently with Gentrack (GTK AU) for instance - what seemed like a bullet-proof software story to many has seen its share price decline 65% in the past six months, and the stock still trades at 25x adjusted earnings. Given enough time, something will often go wrong in the competitive or macro environment. What this means in practice is that the real return expectancy is usually substantially less than the hypothetical 10% we are talking about with TNE, because there is always a small probability of catastrophic and permanent losses with these types of companies, <i>and there is no commensurate asymmetric upside risk.</i><br />
<br />
Now, by way of contrast, let's look at a stock at the other end of the spectrum - a value stock suffering from excessive extrapolation of current negative trends far further than can be realistically foreseen - something like Affiliated Managers Group (AMG US). AMG is an agglomeration of interests in various active asset managers, spanning equities, fixed income, and to a lesser extent, alternatives. Their equities affiliates are engaged in a range of strategies, including quant and growth strategies, but they are generally overweight fundamental value, which has been struggling in recent times, as sexy SaaS stocks like TNE have galloped to higher than higher multiples.<br />
<br />
AMG is also a 'capital light' business, but it trades on only 6x cash flow (down from 20x only a few years ago - highlighting how rapidly people's extrapolated appraisal of the future can change), because instead of steady net inflows, it has been experiencing run-rate FuM outflows of some 10% in recent times. The challenges active managers are facing from the rise of passive investing, as well as fee compression, are no secret, and have been contributing to AMG's FuM pressures, along with poor relative performance across some of their value and quant affiliates' strategies. Many now believe the entire active management industry to be in structural decline. Surely AMG is a value trap? It may look cheap, but earnings are likely to decline into perpetuity, right?<br />
<br />
Firstly, it is important to realise that AMG earns its income to a large extent from top-line revenue sharing agreements with its various affiliates, which significantly limits the degree of operating leverage at the AMG level. In other words, all else held constant, a 10% decline in FuM and associated base fees will only reduce their EBIT by a little bit more than 10%. Secondly, not all of the company's FuM is created equal, and a disproportionate amount of their recent outflows have been coming from failed quant strategies at the likes of AQR, which was very low margin business.<br />
<br />
However, thirdly and perhaps most importantly, stock markets are currently priced to deliver perhaps 5-7% returns over time, and with AMG on an earnings/cash flow yield of 16% (vs. TNI's 2%), this means that their earnings have to fall 6% a year into perpetuity order to generate a 10% cash flow return (while TNI's has to rise by 8% into perpetuity). If markets rise by say 6%, and say 5% net of base fees and other costs payable by the funds AMG's affiliates manage, AMG will therefore have to experience about 10% annual perpetual run-rate outflows to deliver a net 5% decline in FuM and earnings each year, and hence deliver less than a 10% return (assuming gross alpha is zero). Most of its earnings are also free cash flow, and are therefore available for use to buy back shares and pay dividends (or make selective acquisitions, which the company does from time to time; the company also has a modest amount of debt that it will also need to pay down).<br />
<br />
Will that happen? In the short term, it very well could - indeed <i>probably</i> will. However, extrapolating this out over 10-20 years is quite another matter, as there are a lot of other potential outcomes. It was only a few years ago, after all, that FuM was still growing and the stock was trading at 20x! People couldn't predict the future then, and they can't predict the future now. For a start, value could come back into fashion at some point, in which case their underperforming value manager affiliates could make a meaningful comeback. Indexing, which made a lot of sense when it was only a small portion of the market, is becoming an increasingly large portion of the market, and that is starting to create inefficiencies certain active managers - particularly the entrepreneurial types that AMG likes to partner with - may be able to exploit. This includes most obviously the increasingly large gap between the price of stocks included in indices, and those excluded, but also the outsized share price moves that are now sometimes occurring for stocks being included/dropped from the indices.<br />
<br />
This will make outperforming the index easier in the future, for managers not constrained to invest only in the largest index-constituent companies. And many allocators are likely to want to diversify their exposures across both index and active managers, due to the growing risk of crowding into the same index names poses. While fee compression and a migration to indexing will no doubt continue in the short run, there is a very good chance it does not continue into perpetuity. Furthermore, the company is also beefing up its alternatives and fixed income business, and some of its products and investor base segments are growing. If certain of its affiliates/segments do remain in structural decline, they will become of lesser significance to group earnings over time as other areas grow.<br />
<br />
AMG is the opposite of TNE. The most likely <i>base case </i>outcome in the short to medium term is a continuation of current poor operational trends, but that is now not only priced in for the short term, but also extrapolated out over the long term as well, <i>far further than can be realistically foreseen at the present time</i>. There is a margin of safety because things have to not only remain bad for a long time, but get <i>meaningfully worse </i>than current trends in order to make less than 10%. Meanwhile, if conditions were to ever unexpectedly improve, the stock could dramatically re-rate. For instance, if outflows were to ever stabilise, or flip to even modest net inflows, the stock could easily swiftly rerate to 10-15x cash flow, which would be a double from current levels. This means that the <i>asymmetry </i>around base-case outcomes is skewed to the upside, rather than the downside.<br />
<br />
This highlights an additional point worth mentioning - aside from issues of long term fundamental value, there are also technical advantages to investing where expectations are so low, and poor performance has been extrapolated so far into the future: because investors are extrapolating 10% run-rate outflows for AMG far into the future, they will likely only need <i>one quarter </i>of meaningfully reduced outflows for this assumption to be called sufficiently into question for the stock to sharply rally. For instance, if outflows slow to only 5%, suddenly the prospects would be for flat earnings before buybacks (as 5% outflows offset 5% market growth), rather than 5%+ declining earnings. 6x would seem too cheap, and the stock could quickly rally to 8-10x - a 50% move. Another stock I purchased in August of last year - Signet - has for instance recently near tripled off its lows after one to two quarters of slightly 'less worse' operating performance.<br />
<br />
The same is true in reverse for the likes of TNE. Regardless of what actually happens over 10yrs+, if they merely have <i>one half </i>(TNE reports bi-annually) of slower than expected revenue growth or margin pressure, the stock could get bashed. Investors are now expecting a doubling in earnings every 5 years, so even one very temporary period that causes investors to doubt the surety of that outcome could cause the stock to drop 10-20% or more (incidentally, when stocks react violently to short term outcomes like this, commentators often ascribe it to excessive investor short termism, whereas in reality it usually reflects the excessive degree of extrapolation baked into prior prices; the pricing error was usually more in the prior valuation, which embedded an unrealistically high belief in the predictability of the future, rather than the new sharply revised valuation, which is often more realistic).<br />
<br />
<br />
<i>Why is excessive extrapolation so pervasive, and how does it contribute to growth bubbles?</i><br />
<br />
Why is this tendency towards excessive extrapolation so widespread, and why do investors have a systematic tendency to overprice stocks with the best medium term outlooks, and underprice those with the worst (or perceived worst)? There are many contributing factors, and they also explain why markets seem to go through recurrent growth bubbles from time to time, where multiples expand over many years, only to subsequently recede. We are currently in the midst of one such growth bubble.<br />
<br />
One reason is simply because buying/promoting stocks with good businesses and good outlooks is simply easier than getting involved in messy/complex situations like AMG, and investors' time horizons are also relatively short. One of the easiest things to do in markets is identify a great company with a great outlook that trades on a high valuation. Anyone can easily understand and elucidate the merits of a hot SaaS company like TNE, and pitch why they are such great companies with such a fabulous growth outlook. But pitching such stocks is the equivalent of identifying a 2% yielding AAA bond by explaining why the bond is so safe and reliable. Sure, of course its 'safe' and 'high quality', but that's obvious, and that's why the price is high and the return potential is low.<br />
<br />
<i>There is very little skill involved in identifying a good company to invest in trading at a high price; everybody can (and does) do that, which results in prices of great companies getting bid up to the point where future return potential is poor. The </i><i>real skill in investing is identifying things that are <u>not</u> obviously good, where prices and expectations are too low, and the crowd is ignoring it, but which has overlooked potential</i>.<br />
<br />
So one reason people focus on high quality growth companies that are expensive, is simply that it is so easy. However, another important contributor to this long term overpricing dynamic is that the cash flow return expectancy math I highlighted for TNE (and for Amazon in a <a href="https://lt3000.blogspot.com/2019/05/berkshire-hathaway-succumbs-to-tech.html">prior post</a>) does not work in the short term if multiples do not decline, or continue to rise. If TNE for instance continues to trade at 45x, the stock will deliver a 17.5% return (15% earnings growth plus 2.5% dividend yield), while if the multiple goes to 50x over the next year, it will deliver a 30.5% return. <i>High returns will continue so long as multiples continue to rise, and this can go on for many years. </i>When investors' time horizons are relatively short, spanning only a few years at most, they are inclined to focus only on the medium term earnings growth outlook and expectations for changes in multiples, rather than full-cycle, cash flow based return expectancies, and also disregard the small risk of a major loss.<br />
<br />
However, expecting high returns from such stocks is a 'time horizon fallacy of composition'. In the long run, returns <i>must </i>be driven by the level of cash distributed by companies relative to their prices, and because all growth in the long run must trend down towards sustainable levels (nominal GDP growth of 4%), high growth stocks must eventually see their growth slow and their multiples normalise. Only in the short run can returns be driven by cyclical multiple expansion, and the bubble aspect of such pricing dynamics derives from the fact that the high returns generated in the short term (say 30%) are being driven by future returns being repriced down from say 7% to 5%, whereas the 30% returns are invariably perceived as being driven by the operating fundamentals (earnings growth). By definition such a divergence cannot be sustained long term and at some stage must be corrected.<br />
<br />
This also helps explain how markets can and do go through recurring 'growth bubbles'. While on average, over the long run, high multiple glamour/growth stocks have underperformed, they can still significantly outperform for periods while their multiples are expanding, and these phases can be elongated by several positively-reinforcing feedback loops that can sustain momentum for a long time. A growth bubble happened for instance in the the US in the 1960s-early 1970s with the so-called Nifty 50; again in the late 1990s with technology names and large cap, high quality blue chip compounders (GE and Coke traded at 40x); and has also happened in the 2010s.<br />
<br />
What seems to happen is that you start from a point where growth companies are perhaps underpriced relative to their quality, or at least not overpriced. That was the case in 2010, as the 2000-07 period had been a fabulous decade for value, and the flywheel effect of inflows chasing styles that had worked well in the post-dot.com-bubble era had driven major inflows into value funds, resulting in substantial and excessive multiple convergence between high and low quality companies, and high and low growth companies. By 2010, GMO was discussing how very high quality companies in the US were remarkably cheap, and multiples did not reflect superior quality and duration.<br />
<br />
As those superior companies grow, and their multiples eventually stop going down (a residue of the last growth bust), and perhaps also aided by an economic or industry-specific upswing, they start to deliver good returns, and great returns attract a steadily-growing amount of media, broker, and investor attention. Fund managers who don't own them start to lag the index. Brokers start picking up coverage and promoting them, and the media writes more stories about them. They start to attract more eyeballs, and a growing narrative vortex starts to monopolise investor attention, and draw it away from 'less interesting' areas of the market.<br />
<br />
As prices rise and multiples expand, investor enthusiasm grows and is validated by the price action, and more and more extravagant views of the companies' future potential start being envisaged and priced into the stocks, while risk aversion dissipates, as the lessons of the prior growth cycle are slowly forgotten. People that buy the stocks derive comfort in the fact that prices quickly rise after their purchase. Endorphins are released, and endorphins are the chemicals in our brain that tell us to 'do more of that'. Positive reinforcement builds, and after a while, such stocks become viewed as reliable 'compounders', while the substantial contribution to returns coming from multiple expansion is generally overlooked or not given serious consideration. Those that decide not to buy (or sell 'too early') them kick themselves for 'missing' such stocks, and vow to buy them as soon as they experience any pull back, or eventually capitulate and buy them anyway at much higher prices.<br />
<br />
Furthermore, cyclically rising multiples become self-reinforcing not just due to the psychological and crowding effects they engender, but also due to the second-order impact on liquidity. If you're long a bunch of growth companies with rising multiples, you'll deliver great reported returns in the short term. Great reported returns lead to more inflows, and as those inflows are put to work in the same stocks, they tend to drive multiples higher still. This becomes a liquidity flywheel that can drive a perpetuation in existing momentum for many years, and drive valuations to extreme levels. This is fundamentally where 'momentum' comes from, and as Soros says, the only time that betting against the current momentum works is at inflection points, which are comparatively rare occurrences in markets. Most of the time, the 'trend is your friend', and for this reason, most of the time it will pay (and feel more comfortable) to align yourself with current market momentum, even if over the long term, inflection/reversal points more than offset the gains from riding such momentum.<br />
<br />
What you end up with is what Buffett said often happens in market cycles - what the wise do in the beginning the fools do at the end. People increasingly focus only on growth and growth potential, and rising 'compounding' share prices, and ignore the level of prosperity already baked in to prices. Valuation 'ceases to matter'. This dynamic can continue for an indefinitely long duration - essentially for as long as multiples continue to rise, which can be as long as a decade or more. But sooner or later, multiples stop going up, and then the whole movie gets played in reverse (on fast-forward).<br />
<br />
The other problem is that cheap stocks such as AMG with the best risk/reward characteristics are also the ones that are invariably very obviously imperfect and have clear 'known unknown' risks attached to them (whereas in markets, the biggest risks are actually the 'unknown unknowns'; known unknowns are invariably already priced in). That means they come attached with greater than average 'reputation risk', because if money is subsequently lost on such stocks, it appears as though it was lost for reasons that should have been obvious at the time of purchase. This, in turn, raises questions about the judgement of the investment manager or financial adviser in the eyes of clients. Falling prices/multiples also amplify the narrative about the structural challenges such companies face, and result in poor short term returns that significantly understate underlying cash-flow based returns.<br />
<br />
In addition, as I have discussed in past blog entries, the payoffs are lobsided and uncomfortable. If you buy a TNE, the most likely outcome in the near term is the company continues to do just fine and the stock goes up. However, if you buy a portfolio of TNEs, over time, a minority of those positions will disappoint and meaningfully de-rate (such as Gentracks' recent 65% de-rating). This is the general mechanism by which high multiple stocks underperform as a group, over time. However, in an environment of rapidly expanding multiples, this normal dynamic is neutered/offset by multiple expansion across the board.<br />
<br />
When a growth bubble goes on long enough, investors learn the wrong lessons. After a decade of accelerating multiple expansion amongst growth companies, people are drawing the lesson that it is important to focus on growth and quality, and to own 'compounders', and that near term valuations are less important. However, and as soon as multiples stop going up and start going down, the music stops, and 30% returns suddenly become 0% or less, and can remain at zero or less for a long, long time. Cisco, for instance, grew EPS 6-fold in the 20 years post the dot.com bubble, but the stock is still one-third below its dot.com high as its multiple overhead was so substantial that even two decades of growth and a boom in global internet adoption/networking was not enough to offset it. <i>There is nothing worse for long term compounding than sustaining major permanent losses on positions, or locking yourself in to very low returns over several decades, as many investors did in the late 1990s in hyped growth/technology sectors. </i>Buying exciting growth companies on high multiples is not the best way to compound your capital in the long run.<br />
<br />
If multiples start to decline, the liquidity flywheel can just as easily go into reverse, as high-multiple growth investors report poor returns, suffer outflows, and are then forced to liquidate positions to meet redemptions, driving further underperformance. Value managers then start to outperform, and start to attract more inflows, and multiple convergence then replaces multiple divergence. That happened during 2000-07, and will almost certainly happen again at some stage. When, I don't know, but multiple divergence is currently at record levels, and stocks like Tesla now have a larger market capitalisation than Volkswagen (who sells about 30x as many cars as Tesla).<br />
<br />
Very few investors seem to be able to avoid being caught up in a long-running, fashionable growth vortex. I've noticed self-described 'value' managers of late that have their top 5 positions in software and other growth companies trading at 30-50x earnings. The question I would have is, why are you spending so much time looking at the most expensive, picked-over, and over-owned portion of the market when there are so many areas of neglect out there where promising opportunities reside? The likely answer is that like most investors, they can't help but be drawn in by the growing magnetism of rapid growth; rising share prices; and all the media attention and hype the software industry has attracted, or avoid the compulsion of FOMO.<br />
<br />
Value investing requires one go against the crowd; ignoring popular and expensive stocks and sectors which are performing well; take a long term view; and be disciplined in only buying stocks trading at a low price relative to their likely future distributable cash flows, while insisting on a margin of safety. That seems to be very hard for most investors to do - particularly when so much money is being made so quickly in hot corners of the market.<br />
<br />
SaaS stocks have performed very well for many years, as their merits and growth potential have become increasingly well known - nay, <i>eulogized</i>. A growth reversal is coming at some point. I don't know when, but valuations are now stretched. I would be wary of investing in funds that have very large software/tech exposure at present. There will be a time to own such companies, but it is not when they are as flavour of the month as they are today.<br />
<br />
<br />
LT3000Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-90114686868357471582020-01-12T16:37:00.001+07:002020-01-12T18:39:07.900+07:00Demystifying post-GFC economics; the problem with scarcity; interest rates; long political cycles; and the end of historyThe post-GFC era has given rise to widespread investor confusion, as macroeconomic and market outcomes have deviated from the received economic wisdom about what 'ought' to have happened. Old hands have been particularly wrong footed, as their tried and true mental and financial models about how the world operates, which worked so well during 1980-2007, have failed them. Traditional monetary policy has stopped working, and many economies (e.g. Europe) have remained sluggish and unresponsive to very low, or even negative, interest rates. Low rates were supposed to stimulate investment and consumption, and yet both have remained weak. "Unprecedented" unconventional monetary stimulus (in quotation marks as very similar policies were tried - with similar results - in Japan during the 1990s) in the form of QE has been undertaken, but despite this vigorous 'money printing' which was expected by many to result in inflation, we have had disinflation bordering on deflation, with inflation stubbornly refusing to rise towards central bankers' 2% trend-rate goal.<br />
<a name='more'></a><br />
Government deficits and debt-to-GDP have risen markedly, and yet long government bond rates have fallen precipitously, in many instances into negative territory - something many previously deemed impossible. Aren't the 'bond vigilantes' supposed to enforce fiscal discipline, and drive up interest rates as the credit-worthiness of governments declines? And despite the general sense of malaise, including often extended periods of weak growth, stock markets have continued to rise, defying widespread calls over the past decade for imminent doom.<br />
<br />
Bonds and stocks were also supposed to move in opposite directions, as falling rates signalled deteriorating growth, which was good for bonds but bad for stocks, and vice versa. Many traditional 60/40 stock-bond portfolios are structured on this basis, due to the putative diversification benefits that derive therefrom. And yet stock prices have risen even as bond yields have fallen. Some have concluded from this that 'the bond and stock markets are telegraphing very different messages' (i.e. the stock market that growth is strong and improving; bond markets that it is weak and deteriorating), when in reality they may well be telegraphing a third common variable that has been missed. And more than anything else, there has generally been a pervasive sense of ill-ease; that something is amiss; that surely the Fed and other central banks are singularly to blame; and that unintended negative consequences inevitably await.<br />
<br />
So what's going on here, and why has everyone got it so wrong? If you don't understand something, its invariably because you are looking at reality through a false prism, and there is something wrong with the mental models you are using to interpret reality. What has happened is that a lot of investors - many of whom pride themselves of being independent thinkers - have unwittingly accepted a lot of conventional economic wisdom uncritically, without thinking more deeply about what might be happening. The process calls to mind Keynes' famous quote: "Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist". And instead of going through the laborious and uncomfortable process of reexamining long-held beliefs, most of these investors have instead contented themselves with simply blaming the Fed, while preparing for the inevitable doom that surely awaits.<br />
<br />
I have been giving these issues a lot of thought over the past decade, and I have reached a very different conclusion about what is happening. While the intellectual influences that have contributed to the perspective I outlined below are diverse, and a lot of it are also my own original insights, the Japanese economist Richard Koo has probably contributed more to the development of my thinking of these issues than any other singular source (I highly recommend his book The Holy Grail of Macroeconomics; Dumas' book Bill From the China Shop was also highly influential to me when I read it in 2008). With the mental models I am currently using, which I hope to outline below, there is nothing at all surprising or unusual about what we are currently seeing; indeed, it is exactly what we ought to expect. Some potential/speculative futures are discussed towards the end of the article.<br />
<br />
<br />
<i>The problem with scarcity</i><br />
<br />
Traditional economics is premised on the fundamental notion of scarcity. This extends to both the consumptive and investment realms, where: (1) consumer wants are considered infinite and always in excess of the financial resources of consumers (which in turn reflect resource constraints in the real economy), requiring those wants be rationed down to the highest priorities; and (2) businesses always have a larger number of investment projects they would like to undertake than the available supply of funding, which requires capital be rationed (which in turn ensures capital has an appreciable cost).<br />
<br />
When these criteria are met, traditional monetary policy (and a lot of traditional economic theory) works just fine (and continues to work today in most of the emerging world). If the economy is sluggish, the central bank can lower rates, making access to capital more affordable, and because access to capital was previously a constraining factor holding back demand, the release of this constraint will boost the economy. When rates fall, consumers are able to borrow at more affordable rates to finance their (now slightly less) constrained consumptive desires, while businesses' access to affordable capital rises, allowing them to finance more investment projects, and quicker. Both investment and consumption can therefore be reasonably expected to rise if the cost of capital is lowered (particularly because investment is also linked to the level of consumptive demand - higher consumptive demand requires additional supply-side investment/capacity to meet that demand).<br />
<br />
However, if this increase in demand exceeds the ability of the real economy to supply it, inflation will occur. This is what is known as 'overheating'. If the economy is at risk of overheating (or is overheating), the central bank can rotate the stimulatory dial back down, making capital more costly. Businesses are then forced to defer investment activity (typically by paying down debt and steadily accumulating retained earnings from operating cash flow, until they are able to afford to invest in those new projects from internal savings), while consumers are forced to defer debt-fuelled consumption for the same reason, and perhaps pay down debt accumulated in the past cycle as well. Aggregate demand cools, slowing the economy and reducing inflationary pressures (the Philip's Curve works for this reason). The central bank can then loosen rates once again, and the cycle continues.<br />
<br />
Aside from central bank intervention, free market interest rates are also expected to behave in a similar fashion, and drive similar outcomes. If the supply of savings exceeds the demand to borrow those savings to consume and/or invest, aggregate demand will weaken, and interest rates will fall. This will lower the cost of capital, encouraging businesses to borrow to invest, and also encouraging investors to take more risk, as 'risk-free' rates of return decline. It also makes consumptive borrowing less costly for consumers, and encourages banks and other financial markets to supply more funds to such borrowers, as alternative high-return uses of capital moderate.<br />
<br />
Aside from stimulating the greater use of aggregate savings on the demand side, traditional economics also argues that lower rates reduce the incentive to save, and therefore also act to reduce the aggregate supply of savings (and simultaneously increase consumption, on the basis that consumption is income less savings). Consequently, as rates fall, both the demand to utilise savings will increase and the supply of savings will decline, resulting in a shortage of savings that results in market interest rates rising. The same works in reverse, it is argued - as rates rise, demand for savings to finance investment/consumption declines, while the supply of savings rises as the incentive to save increase (also slowing consumption). This slows the economy (falling investment and consumption), and the growing excess of supply should lead to a decline in interest rates.<br />
<br />
This model may seem superficially good and reasonable, but the problem is that the model assumes the existence of perpetual scarcity, which is an unsound assumption - particularly with respect to investment demand, and also the 'incentive force' on saving behaviour. More pointedly, <i>underpinning this model is the assumption that the propensity to save will always fall short of the propensity to invest and/or borrow to consume</i>, which implies that savings are always necessarily scarce, which is a fundamentally flawed assumption.<br />
<br />
Keynes noted long ago the 'paradox of thrift' - for any one individual, saving is a good and prudent thing, but from a systemic point of view, saving subtracts demand from the economy, because one person's spending is another person's income. If everyone suddenly saved 50% of their income, the economy would collapse. In order for those savings to continue to circulate in the economy, they have to be used either to finance real capital investment by businesses (either via equity or debt financing), or they need to be borrowed and consumed by some combination of other consumers or the government. If such savings are not utilised, they will plunge the economy into a deflationary depression.<br />
<br />
The assumption of perpetual scarcity is most sound with respect to the consumptive realm. Most people would indeed like to consume at rates significantly above their current level of consumption, but are unable to do so as they are fiscally constrained. However, even here, the assumption is imperfect and to some degree problematic. Firstly, the assumption breaks down at the individual level as somebody gets richer. No matter how rich you are, you can only drink one beer at a time, eat one meal at at time, and fly on one jet at a time. The definition of being rich (to me at least) is when you are 'making it faster than you can spend it'. You go away on an expensive vacation, and by the time you come back, you're investments have passively earned more than you have spent many times over. Wealth compounds but time does not. When rich people surpass this threshold, the assumption of scarcity-constrained consumption breaks down, because past this point, they cannot help but save more and more money (unless and until it is donated to charity).<br />
<br />
In economic parlance, the 'marginal propensity to consume' declines precipitously as income and wealth accumulates. Furthermore, the demand for consumption-related debt from the affluent also disappears. If you're already rich, why would you need or want to borrow money to finance consumption? This can have systemic (and political) consequences when income and wealth inequality increases materially, as it has in the developed world over the past 40 years (more on this later). It can easily end up resulting in a situation where those who would like to consume more don't have the money, and those that have the money do not want to consume more. Traditional economic models pay absolutely no heed to these critically important 'distributional effects'.<br />
<br />
In addition, the assumption that the median person can and will inevitably borrow more and save less as interest rates fall (the latter due to a 'reduced incentive to save') contains within it many flaws. For a start, debt needs to be paid back (or at least people can't sustainably go deeper into debt or be allowed by banks to carry negative equity to their death bed), and more importantly, most people aspire to retire at circa 65 and enjoy 20 years or more of retirement, and are therefore desirous of accumulating retirement savings (as well as enjoying a debt-free retirement), to fund not only living costs, but the likelihood of escalating healthcare costs/needs as they age.<br />
<br />
While the traditional model may well work for those in early adulthood, those in the latter half of adulthood are likely to seek to accumulate savings and reduce debt (at least the sort not backed by assets, such as investment property), regardless of the level of interest rates. Indeed, falling rates make it <i>harder </i>to accumulate savings for retirement, by both reducing the benefits of compound interest during the accumulation phase, and reducing the level of investment income generated by a given amount of previously accumulated savings during the distribution phase, requiring a larger nest egg be accumulated in the first place. Low interest rates could therefore just as reasonably be expected to <i>increase </i>savings rather than decrease them.<br />
<br />
The model that lower rates decreases the incentive to save (and vice versa) therefore ignores real world realities - people do not live forever, and need to save for retirement and time-shift their consumption, and they need to do this regardless of prevailing interest rates. And demographic considerations - where a long period of falling birth rates result in the median age moving into the late 40s or above - could reasonably be expected to result in a significant increase in the propensity to save and decreased propensity to borrow and spend that is noticeable at the aggregate level.<br />
<br />
The degree to which these dynamics are not understood by people that should know a lot better is as astounding as it is disappointing. In the post GFC era, we have heard repeated claims from central banks and policymakers around the world that 'banks are not lending' in response to stagnant or declining consumer debt. It has always been assumed that this is because the banks lack the capacity to lend (inadequate capital or liquidity), or because they are being excessively risk averse (to some extent true after the trauma of the GFC, but not to the extent claimed). The assumption that a lack of supply of funds has been the source of the problem has laid behind a lot of central bank policies designed to boost bank liquidity. However, no thought has been given to the situation where a lack of <i>demand </i>for credit may be the primary issue - consumers may simply have no desire to borrow money and go further into debt, while the rich have already maximised their consumptive desires and have no need or desire to borrow. In other words, contrary to policymaker belief, there is no scarcity of supply of borrowable funds - there is actually a lack of demand.<br />
<br />
However, the most significant problem with the scarcity model is how it pertains to business investment. Real capital investment (distinct from secondary portfolio investment, where one investor merely exchanges cash for stock, and the vendor stock for cash, which results in no net cash absorption) does not take place in a vacuum; instead, businesses invest capital only where they see an economic reason to do so - particularly in countries like the US where companies are generally run with a focus on RoE and shareholder value maximisation. In such countries, companies will not borrow money to make additional investments/add capacity - even at very low rates - unless there is a compelling business rationale. If not, they will just use excess FCF to pay dividends/buy back stock. After all, if your existing factories are only operating at 70% utilisation, why one earth would you want to build a new one?<br />
<br />
This can easily result in a situation where growth in consumption is weak due to growing inequality, demographic factors and consumers savings for retirement, which leads to a reduced need for further corporate investment, regardless of interest rates or the availability of funding. <i>In other words, access to finance ceases to be the constraining factor; it is not that companies lack access to capital, but rather they do not have a sufficient number of worthwhile capital projects to invest in.</i><br />
<br />
The causes for reduced demand for capital investment - particularly relative to to the growing availability of capital supply - actually runs a lot deeper than just this. Aside from the factors discussed above, the need for new capital investment is generally driven by three factors: (1) population growth; (2) the emergence of new technologies that are capital intensive to roll-out; and (3) the actual roll-out of #2.<br />
<br />
Population growth is fairly self-evident. If population is growing either through natural increase or net migration, more of everything is needed. This will drive a certain degree of ongoing investment. It is no coincidence that economies with a lot of net migration (US, Australia, Canada, UK, etc) have performed 'better' than those without (in quotation marks because per capita statistics often tell a very different story), and that Japan has performed the worst, given the viciously and unprecedentedly negative demographics the country is facing. On a per capita basis, Japan has actually grown only slightly more slowly than Western peers over the past 30 years, but because it's population is shrinking, the excess of savings and the weakness in investment demand dynamics has been by far the most pronounced.<br />
<br />
More interesting are #2-3, which can be thought of as comprising two axis on a 2D plane that drives investment cycles. In order to have a major capital investment cycle, there first needs to be the emergence of a new technology that is capable of providing a new product or service, or providing an existing product or service more efficiently (and which is also capital intensive to roll out). Secondly, you need to roll that technology out to reach a saturation point of the installed base, which depending on the technology, can often take many decades. This dynamic is best highlighted by way of example.<br />
<br />
Let's say the railroad is invented. That's the invention. The next thing you need to do is take maximal advantage of this technology by rolling out railways across the country/world to the point where further penetration of the technology no longer adds any value and so is therefore not required. That requires a tremendous amount of capital investment, in steel production, locomotive production, and construction activity and the like, and it will take a very long time. However, at some point, you will reach a saturation point where you have built enough railways. At that point, the investment demand will revert to sustaining levels, unless a radical new technology capable of improving it arises. At that point, there would be another major investment cycle as obsoleted capital stock is replaced with upgraded capital stock.<br />
<br />
Another example is air travel. Global RPKs are still growing at some 5% a year, aided by continuing growth in low-cost carriers and rising incomes in the developing world. This continues to drive the need to produce more planes to meet this demand. This trend will continue for a long time as emerging country consumers become richer. But at some point, no matter how rich you are, you don't want to do any more air travel. The constraining factor for many affluent people is no longer the cost of travel, but how much time they want/need to spend sitting in an uncomfortable seat at 40k feet being capitulated around the world at 900km/h. At some point, no matter what people's incomes, the demand for more investment air travel will stop. At this point, scarcity will cease to function. No more airports, Boeing factories, or net aircraft fleet investment will be required beyond sustaining requirements, <i>unless there are major new innovations. </i>If a new plane was invented, for instance, that was twice as fast and a half the cost (very doubtful this will occur), you would then need to retrofit the entire existing fleet, which would drive another significant investment cycle.<br />
<br />
In short, if the pace of technological innovation slows down, there will be less need for major retrofitting capital investments, as saturation levels are reached. Today, we have some investment cycles in new technologies - notably in cloud computing infrastructure and associated implementations, as well as software development across a variety of fronts. Regulatory-driven investments into renewable energy is another source of capital demand/absorption (trying to colonise Mars also seems to be an excellent way to - shall we say - 'absorb a lot of capital'). However, in general, outside the world of software and ICT, <i>the pace of technological development has rapidly decelerated </i>- particularly in more capital-intensive fields - which has coincided with an increasing degree of saturation of developed-market material consumer wants (as oppose to services demand). Most consumers now have enough clothes, food, appliances, cars, and other toys.<br />
<br />
Furthermore, technological innovation today is also increasingly making the material world more efficient, and contributing to the consumption of <i>less </i>resources. In the past, more was the order of the day. More cars. More clothes. More food. More stuff. Now, ICT and the rapid development in computing power is helping us to do <i>more with less</i>. The sharing economy improves resources utilisation, and IoT/AI will continue to drive radical enhancements in the efficiency of resource usage across a variety of industries. This is further contributing to savings outstripping investment demand.<br />
<br />
Finally, one other thing that has been exacerbating the increase in total capital supply in an environment of declining demand/need for capital is rising life expectancies, which I blogged about <a href="https://lt3000.blogspot.com/2018/02/life-expectancy-and-cost-of-capital.html">here</a>. While the thesis is hard for many people to accept, and encountered some scepticism, all you really have to do is consider how much capital Warren Buffet or Charlie Munger could have accumulated had they passed away aged 65, and compare how much they have actually accumulated at ages 85-95. Capital compounds geometrically, and when you combine increasing inequality with rising life expectancies, you increasingly have the capacity not only for very large fortunes to accumulate, but for the aggregate supply of savings/capital to mushroom alongside that fact (although in the case of Buffett, charitable donations are resulting in the recirculation of some of those funds). Buffett bemoans the lack of worthwhile places to allocate his US$130bn cash hoard, but his geometric accumulation of capital, along with many others, is a core reason why. There is increasingly simply too much capital/savings, and not enough worthwhile places to invest it. Many investors don't like to accept it, <i>but the world does not owe you a high return on capital</i>.<br />
<br />
What it all adds up to is that capital scarcity has been declining, as the supply of savings has increased, while the demand for the use of those savings to finance investment and/or borrowing for consumption has fallen. In other words, savings have ceased to be scarce or a constraining factor holding back economic growth. <i>There is no - and never has been - any guaranty savings/capital will always be scarce, and hence able to command a high return, and a lot of the confusion investors are experiencing gives way as soon as that reality is understood. </i>Indeed, none other than Karl Marx once said that in the long run, interest rates would go to zero as the capitalists would run out of things to invest in, and at that point there would be no choice but to redistribute the capital. To some extent, he is right and that is what is happening and - irrespective of intermediate cycles and whether we have or have not already reached that point - will probably inevitably occur in the very long term, as the global population peaks, and we reach a technological plateau (although we are still a long way away from that point globally).<br />
<br />
Some people believe in exponential technological progress. I'm more in the S-curve camp. This is because while the level of accumulated human knowledge and data continues to increase rapidly, the human capacity to absorb, assimilate and integrate that information - at the individual level - is finite and time constrained. The more we discover, the harder and longer it takes for people to discover meaningfully new insights. People cannot spend the first 60 years of there life learning all the prerequisites they need to make new discoveries. They need to make a living. We have already reached the point of radical specialisation, which introduces its own set of problems, as increasingly 'range', or combinatorial insights from multiple domains, is required for breakthroughs. Furthermore, 'science' can only take as so far, as we remain constrained by the laws of physics/nature. To the extent I am right about this, it seems inevitable that the long term sustainable rate of interest will trend towards zero in the long term (or even be negative, if savings remain in structural excess), although as I note below, there is ample capacity for volatility on the way through.<br />
<br />
<br />
<i>Making sense of what is happening</i><br />
<br />
With the above context in mind, we can finally begin to find ready explanations for a lot of the phenomena that has confounded investors over the past decade which I referenced in my first three paragraphs. The above analysis makes reference to an excess of savings, but technically this claim is inaccurate, in the sense that - international imbalances aside - in the aggregate, <i>net </i>savings must equal investment (with net savings a composite of gross savings by some economic participants, less net borrowing by other economic participants, including most notably, governments). In other words, any gross savings in excess of investment demand must be dissipated by governments and/or consumers dissaving. Whether the propensity to save is tending to exceed the propensity to invest/borrow can only be inferred from the direction of interest rates, but the tendency of interest rates to continue to decline as debt levels rise, is strong evidence that excess savings is the push/causal factor; rising debt levels the outcome.<br />
<br />
Because consumers have generally been reducing their debt burdens in the post-GFC years, and corporates have not needed to borrow to finance investment, it has generally fallen on the government to do the borrowing. In the absence of this 'borrower of last resort', the economy would enter a downward spiral leading eventually to depression. The latter would ultimately achieve the same thing - balancing net savings and investment - but through a much more painful route: crushing savings by hammering corporate profitability - a key source of savings - and mass unemployment, which thwarts consumers' ability to save, while forcing the government into deficit anyway by having their tax income crater. This is precisely what happened during the Great Depression.<br />
<br />
Knowing this, it is easy to see why government bond rates have fallen even as government debt levels have risen. The answer is that most observers have misunderstood the direction of causality. The government is being forced into borrowing to absorb excess private sector net savings - just as it has had to do in Japan since the 1990s. This is why investors such as Kyle Bass, who don't understand this stuff, have been calling in vain for a government debt crisis in Japan for years and years to no avail. The push factor has been too much net savings - which has pushed down interest rates - and the 'pull' factor government borrowing to absorb those excess savings. Furthermore, even in the pre-GFC years, the prime mover of the debt/housing bubble was <i>not</i> consumers' desire to borrow, but instead the push factor of excessive global savings, which created huge demand for yield assets that had the effect of pushing down rates and promoting the relaxation of credit standards that induced people to borrow. The speculative appetite to borrow and buy houses only came later once the boom was well established.<br />
<br />
In addition, QE does not have the same effect has 'helicopter money', but instead actually has the counterproductive effect of making the existing savings glut imbalance <i>even worse</i> (which highlights how extraordinarily ignorant central bankers are to the dynamics outlined above - they have completely misdiagnosed the problem). Helicopter money would be received by the average consumer and spent. It would stimulate aggregate demand, and would eventually be inflationary. However, QE doesn't operate this way; the CB instead purchases bonds off wealthy individuals, corporations, investment funds, and banks. The prior owners of these assets were either wealthy individuals who are already consuming at their maximum desired level, or the middle class (via investment funds) who are saving for retirement. <i>These funds were therefore already in the 'investment' bucket, and therefore destined for reinvestment into other alternative financial assets, rather than reallocated to consumption, and the 'trickle down' effect has only been modest</i>.<br />
<i><br /></i>
What happens with QE is that these entities wind up with a whole lot of newly minted cash instead of bonds. What they do with that cash is not spend it, but look for alternative investments. That has the effect of pushing down interest rates and driving up asset prices, and percentage cash allocations fall via the mechanism of the price of other assets going up, rather than absolute cash holdings going down (because when this cash is used to buy stocks or other assets off other investors, the cash simply moves to the vendor's account, in something of a pass the parcel as investors try to trade out cash for something more appetising), and ultimately the cash just ends up being held as excess reserves by banks, held on behalf of their customers. <i>This is why QE has not been inflationary</i>. In order to be inflationary, the funds would either have to be consumed, or used to fund real capital investment, but the latter will only happen if real capital investment is capital constrained, which is is not.<br />
<i><br /></i>
Access to capital had already ceased to be a constraining factor for economic growth, and that is why we have not seen more investment and inflation. Instead, US corporates have continued to return more and more capital to shareholders via buybacks - the exact opposite. US corporates literally have access to far more capital than they know what to do with. Most of the borrowing that has occurred and has been stimulated has gone to finance of M&A (notably via private equity), rather than finance new capital stock, which is the 'worst' type of increase in debt. The amplifying effect of QE on the excess supply of capital has, however, likely contributed meaningfully to the VC unicorn tech bubble, which has been a short term economic stimulus, but one with dubious long term durability.<br />
<br />
Meanwhile, negative bond rates are also much easier to fathom when you understand the impact of QE in combination with negative short term policy rates, which we have seen in Europe. For reasons we have discussed, QE simply results in investors holding more cash, which results in banks ending up with excess reserves, as the said investors have to park the cash somewhere. When short rates are (for e.g.) -0.5%, banks have to pay the central bank 0.5% a year to hold the funds for them, which means they will look for any and all ways to 'get rid of the cash', in a sort of pass the parcel with other banks. If you have to pay -0.5% on excess deposits, and are desperately trying to get rid of cash, buying bonds at a -0.2% yield seems like a much less bad idea than it otherwise would.<br />
<br />
Low but still positive long rates of say 0.2% also make a tonne of sense when you realise banks have a zero risk-weight on government bond holdings, and can fund those purchases at -0.5%, or at worst, 0.0%. They are doing that, however, because there is no consumer or business demand for credit capable of absorbing their excess cash reserves. <i>They have no where else to put the money</i>. Yet authorities continue to say, gee banks aren't lending - it must be because they don't have enough liquidity - so let's do more QE so banks have more funds they can lend. The end result is to massively exacerbate the excess of liquid savings looking for any sort of home possible.<br />
<br />
This is how you end up with the environment we have seen: relatively weak growth in investment and consumptive demand; falling consumer debt; rising fiscal deficits and government debt burdens; falling interest rates; and rising asset prices. It's also how you end up with a breakdown in the historical inverse correlation in the performance between bonds and stocks - they are both going up as capital has ceased to be scarce and a precipitously falling cost of capital is driving up the price of everything. And the truth is, as high as asset prices have gone so far, it is not inconceivable that we could end up with the biggest asset bubble of all time the way things are going - eclipsing even the dot.com bubble (as I argued <a href="https://lt3000.blogspot.com/2017/11/all-set-for-biggest-equity-bubble-in.html">here</a>). It seems to be a logical outcome should the current trajectory continue, as rates go to zero or below, and the huge excess of liquid savings desperately seeks out any and all sources of cash flow return, driving asset prices to the stratosphere.<br />
<br />
This explains also why market have done so well, despite sluggish growth, and this being one of the most hated bull markets of all time. General expectations have been for an imminent economic fallout and major bear market for a decade now, as the unintended consequences of experimental monetary policy comes home to roost, and yet it hasn't happened. Many investors have suffered badly betting on disaster while stocks have risen and risen, and then risen some more. There is no euphoria (outside of certain spots in tech) - markets have gone up not because people are wildly bullish, but because investors have increasingly been dragged - kicking and screaming - into stocks as there has been no where else to obtain a reasonable return, as bond yields have plumbed new lows.<br />
<br />
<br />
<i>The end of history? How politics <u>might</u> alter the trajectory</i><br />
<i><br /></i>
Over the past decade, investors have failed to grasp the above dynamics, and in general have been awaiting an inevitable 'normalisation' of interest rates. Had they grasped the above, they would have realised that low rates were not merely reflecting central bank behaviour, but more structural forces, and were likely to have gone to zero regardless of central bank policies (although probably not negative). And the proof is in the pudding - rates that are 'too low' are supposed to lead to inflation, and they haven't, and if we don't have inflation, then it is hard to argue that rates are 'too low' (QE is a different question). Too low on what metric? Certainly not too low such that it has resulted in excessive demand for capital relative to its supply - that would have been inflationary (although, without doubt, QE has been a bad policy and has created more problems than it has solved).<br />
<br />
Furthermore, investors would have been a lot more reluctant to hold a lot of cash; short stocks and bet on a crash; and short government bonds on called for a government debt crises, had they understood these dynamics. With the fundamental driver being a structural excess of savings, made worse by central bank policies, the likelihood of an equity and asset price bubble of unprecedented proportions, coupled with zero/negative interest rates, was far from impossible, while the likelihood of a spike in government bond rates and widespread government defaults was exceedingly remote.<br />
<br />
However, one thing I have noted recently is that after a decade of being wrong, many investors are now finally coming around to the view that rates are going to be low forever <i>right when some of the conditions that have underpinned the status quo are - for the first time in a decade - at risk of changing course. </i>As usual, investors are behind the curve. Declaring that rates are set to remain forever low at this point (as opposed to it being merely possible/probable) seems to me to somewhat akin to Fukuyama's famously inaccurate call in the early 1990s that we had reached the 'end of history'.<br />
<br />
While I do think the general trajectory of rates will be towards zero in the long run, much as has been the case in Japan to date, I think there is nevertheless a risk of intermediate periods of turmoil where rates do go meaningfully higher, driven by an escalation in inflation. However, the mechanism by which this might occur, and hence the source of the risk, seems poorly understood to investors, because it derives from the <i>political </i>rather than <i>economic </i>sphere, and will require a change in course.<br />
<br />
It seems to me that a clue as to the potential fundamental chink in the armour of the 'low forever' thesis lies in something I referenced relatively early in the article: the fact that the vast majority of consumers are in fact still subject to scarcity and are under-consuming relative to the level at which they would prefer to, <i>coupled with rising political trends towards populism</i>. They may not want or be able to borrow more, but they would sure prefer to consume more, given the opportunity - particularly experiences (travel) and various other labour-intensive services.<br />
<br />
Capitalism is great for driving innovation and efficient resource utilisation, but it has an important Achilles heel, which is that it tends towards increasingly extreme wealth inequality over time - a tendency which is only being exacerbated at present by trends in technology. Taken to a large enough extreme, wealth inequality will eventually crash the entire system, much as it did in 1929. Imagine, for instance, that Warren Buffet came to control close to 100% of national income and wealth (I always like to use an extreme example to highlight an immutable principle that continues to apply when scaled down to a more realistic level). Aggregate consumptive demand would collapse to virtually zero, and you'd have an unimaginably bad depression.<br />
<br />
Capitalism is great for the <i>supply-side </i>of the economy, but a sustainably healthy <i>demand-side </i>requires that the level of income and wealth inequality not be allowed to become too extreme, lest consumers cannot afford to purchase goods supplied by the owners of capital. The supply-side determines the <i>capacity </i>of an economy to produce goods and services, but the demand-side determines the <i>actual </i>level of goods and services demanded and produced (up to the economy's capacity limit, demand creates supply in the economy, not the other way around, as the Austrian school of economists falsely believes). If those with all the money don't want to consume, and those that want to consume don't have the money, the economy will collapse. This fundamental limitation of free market capitalism is poorly understood by a lot of economic conservatives.<br />
<br />
When wealth inequality reaches extreme levels, there are only three ways the imbalance can be resolved. The first is a 1929-32 type depression (wealth inequality last peaked in 1929) which wipes out all the banks and most companies and hits a giant reset button. The second is a swing to left wing economic policies (as opposed to centre left) that leads to a combination of income/wealth redistribution, improved bargaining power for labour, and eventually inflation; and the third - somewhat counter intuitively for many I'm sure - is a long period of negative interest rates. Any of these outcomes are theoretically possible. Without regulatory intervention, 2008 could easily have morphed into a #1 reset, but the actions of the authorities decisively ruled that option out. Instead, we have so far gone down the road of #3.<br />
<br />
It is common to hear people argue that low/negative rates are exacerbating wealth inequality, but that is not in fact true. In the short term and on paper it may initially appear that way, as low rates induce asset prices to rise, <i>but these rising asset prices reflect a fall in the prospective returns on capital, which in the long run is a negative for capital accumulation/compounding, and a negative real return on capital in the bond market actually acts as a de facto wealth tax, which is a form of redistribution</i> (as wealth and income is transferred from wealthy bondholders to governments, who spend and redistribute money to the middle and lower income classes). If rates stay negative for a long time, a very substantial amount of wealth will be redistributed over time in this manner. <i>In this respect, contrary to common perception, negative interest rates are actually part of the solution, rather than part of the problem.</i><br />
<br />
However, while #1 seems very unlikely, and #3 appears the most likely to me, #2 is also possible, and the risks in that regard have risen meaningfully in the last few years, right when most investors are finally capitulating to the conclusion that rates are destined to remain low forever. We are already starting to witness a rise in populism, and although this has superficially been associated with 'right wing' populism, in actuality - as I discussed <a href="https://lt3000.blogspot.com/2019/02/the-real-reason-populism-is-rising-in.html">here</a> - this mislabelling actually reflects an incipient inversion in the traditional left-right political spectrum.<br />
<br />
In the past, the left was the party of the working classes/labour, and the right the party of business. However, in modern times, the left has been captured by the liberal, rich elite, and has let its focus drift to identity/minority issues, and the priorities of rich liberals including climate change, while abandoning its traditional mainstream working class voter base, which traditionally economically conservative parties have started to swoop in and capture. Trade barriers, and policies to restrict immigration to improve the bargaining power of labour, for instance, have traditionally been left wing policies, as they are good for labour and bad for capital/business. Ultimately, however, the label doesn't matter - it's the actual set of policies and their effects which are important.<br />
<br />
However, while populism has only taken a mildly left turn to date (economically), there are no assurances it will stop there, and we could quite easily see a move much further to the left in coming years. Bernie Sanders and Elizabeth Warren, for instance - two leading Democratic contenders - have campaigned for radically higher taxes on the rich, including wealth taxes as high as 8% on billionaires, in the case of Sanders (Warren advocates for 3%). Jeremy Corbyn's UK's policy prescriptions were also more left wing than any prescription we have seen in the Anglo-sphere in quite some time. While none of these candidates have a critical mass of support yet, with populism on the rise the future trajectory of policy remains highly unpredictable.<br />
<br />
Stepping back from the contemporary political fray, it seems to me the bigger picture, long term causal meta could well be this: <i>right wing policies are good for supply but - in the long run - bad for demand (due to rising inequality), while left wing policies are bad for supply but - in the short run - good for demand</i>. When you've had too much left wing policies, as was the case in the 1970s, you end up with a stagnant economy and high inflation. This gives rise to a desire for change amongst the electorate, which takes expression in ballot box outcomes. In the case of the late 1970s/early 1980s, discontent with the status quo resulted in the election of Thatcher and Reagan for this reason.<br />
<br />
Initially, when policy swings to the right, it is good for growth; the rich get richer, sure, <i>but the poor and middle classes also get richer</i>. That is because in a stagnant economy with high inflation, underinvestment happens, and a lower cost of capital and more investment is desperately needed. There is too much demand and not enough supply. However, with right wing economic policies, after a long enough time, supply catches up and overtakes demand, at which point you start to see downward pressure on interest rates as the supply of compounding, reinvestable savings starts to outpace capital investment needs. Falling rates result in rising house prices and ultimately induce the middle class to go on a borrowing binge, and this continues - perhaps for 2-3 decades or more - until the middle class cannot afford to take on more debt (or no longer wish to do so). That point was reached in 2008 in the US/Europe, and is at/approaching that point in Australia at present.<br />
<br />
After this point, a continuation of right wing economic policies results in the rich continuing to get richer, <i>but now the poor and middle classes start to stagnate and get poorer</i>. This happens as the deleterious effects of rising income inequality more than offset ongoing (slower) growth. This results in an inevitable rise in political tensions, as growing grass roots discontent leads to increasing desire for change. It also explains why today's elite is so unable to comprehend what is happening and why populism is rising - from their perspective things are great - never better. Their incomes and wealth continue to mushroom. But large parts of the population are getting left behind. It also explains why 'outsider' candidates such as Trump have found such appeal, as traditional candidates are all part of the elite - the rich who have been getting richer - and therefore have ceased to understand and represent a growing proportion of the electorate, or cater to their growing sense of malaise.<br />
<br />
If my model is right (and it is admittedly still speculative and unproven at this point), it seems to me the next step in this long cycle would logically be for a swing back to the left, and in my view it has already started, as trade and immigration tensions have risen (which are policies designed to improve the bargaining power of domestic labour). As noted, an initial swing to the left is bad for supply but good for demand - particularly coming from a point of significant inequality - and in the initial stages of a swing left, the rich get poorer <i>but the poor and middle class get richer</i>, as wealth and income is redistributed from the rich to the poor. Furthermore, coming from a position of already sufficient/excess supply, a decline in trend-rate growth in supply does not manifest as an issue for some time, because there is already an output gap to exploit. However, if the swing to the left last long enough and goes far enough, you eventually get to the point where demand overtakes supply, and you end up with inflation, rising rates, and eventually stagflation. <i>At this point, the rich get poorer, and the poor and middle class get poorer too</i>. At this point, the populist impulse becomes to swing back to the right, and the process starts all over again.<br />
<br />
We see these kinds of oscillations between left-wing and right-wing populism in South America all the time, where the cycles are much shorter. In the West, we have had a long 30-40 year swing to the right (economically), which is longer than the investment careers of most investors alive today, so people are ill-prepared for the consequences of any major systemically-important political shift, and are unlikely to envisage the potential consequences. Indeed, as Jacob Mitchell of Antipodes said recently in an interview, a whole generation of investors has been taught to 'ignore politics', but he noted that that perspective might increasingly be the wrong position to take in the future. I completely agree with him in principle (although how that its actioned, I'm not so sure). What also remains to be seen is whether the various structural factors tending towards lower rates, including the effect of technology, outweigh the economic effects of changing political policies. On that I do not know.<br />
<br />
The mechanism that more left wing policies that are stimulatory to demand (and ultimately inflation) will likely take will probably be a combination of significantly higher fiscal spending, as well as a more aggressive push for higher taxes on the rich - particularly in the form of wealth taxes, which have been relatively rare tax to date. There is a very substantial and growing opportunity for politicians to campaign to the middle classes about the injustice of the current system and the need for radical redistribution, and surveys indicate that Millennials are a lot more pro socialism and anti capitalism than prior generations, and also own relatively little capital (and generally can't afford houses). People that don't own any capital are usually less supportive of capitalism than those that do.<br />
<br />
In the US, free universal healthcare and free university education will probably be the initial volleys, including also potentially UBI. It is quite possible it does not stop there, however, until meaningfully negative economic outcomes manifest (which will likely take a while), as the dynamics of politics is such that one always needs to promise more/something different from the incumbent to get elected; the tendency towards entitlement-inflation therefore well entrenched for this reason.<br />
<br />
One of the reasons productivity growth has slowed down in recent decades is that a larger and larger portion of the economy is being subsumed by less and less productive sectors, such as education and healthcare, where costs continue to mushroom. There is still rapid innovation and productivity growth happening in software and ICT, and to a lesser extent manufacturing, but the portion of the economy this encapsulates has become smaller. If the government continues to expand significantly in size; government deficits rise high enough; and wealth and other income taxes on the rich increase sufficiently, it is entirely conceivable we could end up in a world where a scarcity of capital returns, and inflation increases - as unlikely as that may now seem/feel (including to me). This is particularly the case as baby boomer's are now starting to retire, and so are starting to pass their point of peak savings activity in the lead up to their retirement years, while the fiscal burden of state-guaranteed pensions will also continue to escalate in coming years as well.<br />
<br />
What ultimately ends up happening is anyone's guess. Predicting the long term outlook for interest rates is particularly difficult, as one scenario is redistribution via negative interest rates for an extended period of time, while the other is via inflation and radically higher rates - both opposite ends of the continuum! The former could also be expected - initially at least - to potentially lead to one of the biggest equity bubbles of all time (if not the biggest), while the latter could lead to asset price carnage even worse than the early 1970s.<br />
<br />
I feel very fortunate that my investment approach does not rely on predicting macro outcomes such as these, or variables such as interest rates. I plan to keep doing what I always do - find stocks trading at low prices relative to their likely future distributable cash flow. A margin of safety, and low prices/rapid cash flow payback is always the best hedge against an uncertain future.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-29521542089298064592019-11-10T11:06:00.002+07:002019-11-10T12:12:39.485+07:00How much cash should you hold? The case for being fully investedOver the past decade, a number of highly-regarded value investors with attractive long term track records have lagged the major benchmarks, and not just over one or two years, which can reasonably be expected to occur to any investor from time to time, but over stretches as long as 5-10 years.* There have been many reasons for this, including the much-discussed outperformance of 'growth' over 'value'; the rise of index funds; and markets becoming more competitive. In some cases, it has also been due to previously celebrated investors having only assembled their prior robust track records through a combination of luck and concentration, and having been subsequently revealed to have been far less proficient investors than previously believed (e.g. Berkowitz; Tilson; Ackman). However, one important contributor to many quite excellent investors' underperformance has been the simple fact that global indices have risen more than expected (by many) over the past 10 years, and these investors have held high levels of cash throughout this period - often 20% or more.<br />
<a name='more'></a><br />
Although I admire many of these investors, I have long questioned the wisdom of holding so much cash, and my typical position is to be fully invested at all times (provided I am able to find sensible things to hold, which I always have been). The way I think about it is, if the market's expected return is say 5-7% (driven off earnings yields), then the opportunity cost of holding zero-yielding cash for any extended period of time is very substantial, even if your stock picks are no better than average (I would rather have a 'fair' return than no return, although fortunately I've never had to settle for fair). If the market return is say 6.0%, and you hold 20% cash, then the market component of your portfolio's expected return will fall to 4.8% (in the low/zero interest rate world in which we live; if interest rates were higher, market expected returns would likely also be higher, so the same principle would apply). And if markets rise by meaningfully more than this as they have over the past decade, because multiples expand, your degree of lag will increase commensurately. If markets go up at 15.0% a year, you'll make only 12.0% a year even if your stock picks match the market.<br />
<br />
Platinum is an example of a fund that has been hurt a lot by this. They have an exceptional long term track record, and are (deservedly) highly regarded, but over the past 5-10 years they have lagged the market (they have generated about 90% of the market's return) - something which has attracted much comment/scrutiny - most of it unfairly negative. However, throughout this period they have held about 20% cash, as well as various index/stock shorts/hedges. The invested portion of their FUM on the long side has therefore outperformed, despite the significant underperformance of value over the past decade. Their stock picking has therefore remained excellent, on average. But that stock picking prowess has been applied to only about 70-80% of their FUM, because it's been diluted by their hefty cash holdings.<br />
<br />
Now I'm of course aware that we happen to have been in a bull-market for equities over the past decade (or for US equities at least), and I'm also more than aware that markets don't always go up. If markets had gone down during this period, cash would have aided rather than detracted from performance. But I'm not using hindsight/happenstance here, as I hope to argue below that a strong case can be made that on average, over the long term, through multiple bear and bull cycles, holding large amounts of cash will be a losing proposition. I also practice what I preach, as I have been fully invested for the entirety of my so-far 20 year investment life, through good markets and bad.<br />
<br />
The key point is that so long as markets are trading at a reasonable earnings yield that is well above bond yields, which they still are, the longs will win over time, because those earnings will be distributed to shareholders over time (dividends and buybacks), driving sustainable returns. The 'carry cost' of cash is high - it is essentially the market earnings yield forgone (5-7% at present, and significantly higher earlier in the decade, prior to multiples experiencing a decade-long increase).<br />
<br />
The rationale usually proffered for holding large amounts of cash is that it gives you the opportunity to take advantage of any market downturns to acquire cheap stocks (or buy more of your existing holdings on the cheap). The cash has 'option value', it is argued. However, that option is very expensive, and there are alternative and better ways of taking advantage of intermittent market volatility and the opportunities it throws up, in my view. Provided correlations fall short of 1 (I'll discuss this later), a much better way is to have exposure to a wide variety of <i>good </i>ideas (i.e. without compromising idea quality) across a number of different countries, industries, and individual companies, and then take advantage of less-than-perfectly-correlated volatility to actively rebalance. When stocks are doing well somewhere, but poorly somewhere else (or a doing very poorly somewhere, but only modestly poorly somewhere else), there is an opportunity to actively cycle more capital into the more oversold areas. You don't need a lot of cash in order to do this - just agility.<br />
<br />
For instance, in the early part of 2018, a lot of value stocks in the US performed very well (alongside a strong USD and US economy), but several emerging markets got hit very hard. I reduced my exposure to my US value plays and reallocated more into EM, including some selective picks in Indonesia. In the second half of 2018, Indonesia rallied hard. Some of my value picks there rose 50%, while the US suffered a significant sell-off, particularly in December. I sold down some of my Indonesian positions and significantly increased my US exposure in December.<br />
<br />
I also blogged about a few examples in real time (I blogged twice on Turkey bullishly, both coinciding exactly with the lows, where I upped my exposure; I have subsequently reduced), and also explained my long thesis on Eurobank after it got disproportionately beaten up last year. In a subsequent blog post, I discussed how I was reducing my Greek banks exposure in favour of Italian banks, after the former had surged and the latter had heavily sold off. Unicredit is up 30% since then and the Greek banks are up 10%-ish. I've recently trimmed, and have been buying into other names that have come way down - including Indonesian thermal coal stocks which are down 50% over the past 12 months, as many other new ideas which I'll omit to mention as I'm still buying. You can do this all day long in markets if you have a broad mandate, are nimble, and correlations are significantly less than 1, which they are most of the time. From a distance, it might appear like I'm trading or market timing, but I'm actually just responding to a repricing of the fundamental risk-reward odds by adjusting the size and location of my bets.<br />
<br />
But what if correlations do go to 1, and everything goes down significantly at the same time? It happens sometimes. It happened in the GFC for instance - equities everywhere fell 50%, and there was nowhere to hide. The issue is that while these events do happen, they are - at least to this degree - <i>extremely infrequent. </i>Meanwhile, the cost of missing out on an expected return of say 7% a year while you wait for such opportunities to occur, over any sustained period of time, can become very substantial due to the effect of compounding. 7% a year compounded doubles in approximately a decade. You would need everything, everywhere, to simultaneously go down by 50% once every decade, just to offset these lost gains, but drawdowns of this nature and magnitude are much rarer than that. They have historically happened only about once every couple of generations (prior to the GFC, the Great Depression was really the last episode; lots of stuff did well in the 1970s, as oil and commodities rallied and oil-dependent economies did very well).<br />
<br />
The above also assumes you would deploy all of your cash near the bottom - something that is fairly unlikely. Indeed, people that like to hold cash usually end up retaining far too much of it for too long during downturns. After all, if you haven't deployed it by the time markets are down 30%, why would 50% be the magic number? No doubt you would either deploy it too early or hold it too long, waiting for further falls that fail to materialise. Even in an idealised situation of deploying all your cash at the very bottom, it is unlikely the gains you will make will offset the opportunity cost of spending many many years missing out on the market's underlying earnings yield of 5-7%+.<br />
<br />
Consequently, the only way holding a lot of cash will work to your advantage is if there is a major, synchronous, correlated global market decline, <i>and it happens relatively soon after you elect to hold a lot of cash</i>. But this means you are essentially making a major bet on a market fallout happening, where the base-rate probability of it occurring is low, and the odds overall aren't in your favour.<br />
<br />
I have discussed in past blog posts how the GFC has had a profound impact on investor behaviour. It has caused many investors to go from underestimating the probability and frequency of crises, to radically overestimating both dimensions in the post-GFC years. Post GFC, everyone became a macro expert. Disquiet has prevailed about central bank actions, and other recurring sources of macro anxiety - from strains in the EU/Eurozone to the sustainability of China's growth - have imbued investors with a constant sense of foreboding. The fundamental problem is that when everyone expects another major bear market, and holds a lot of cash in anticipation of deploying it during one, the said downturn becomes self-defeating - market's can't and don't go down very much for very long when everyone is chomping at the bit with cash looking to buy. Large cash balances held in anticipation of a downturn is likely one of the key reasons why we haven't had a meaningful and sustained bear market in the US and other major indices so far.<br />
<br />
Furthermore, even if such a decline does occur when one is fully invested, one can still meaningfully benefit in the long term. How? If you own a portfolio of stocks that pay decent dividends, and/or own companies that routinely buy back their own stock (or buy back shares opportunistically when their stocks get oversold), you can benefit from market declines by reinvesting dividends at higher future rates of return, and/or from companies buying more stock for you via buybacks. Indeed, the rational long term investor ought to vastly prefer <i>lower</i> prices to higher prices, <i>because if prices are low enough, getting rich is easy</i>. It's high prices that are the enemy of wealth accumulation. This is another advantage of being 100% invested - it hedges the risk of markets going <i>up</i> a lot and staying up, which for the long term investor, is by far the biggest <i>downside </i>risk (discussed in <a href="https://lt3000.blogspot.com/2017/02/why-i-worry-more-about-melt-up-than.html">this post</a> in more detail).<br />
<br />
Imagine for instance that tomorrow, for no fundamental reason (e.g. nuclear war), stocks were to open 80% lower than they traded on Friday. Coke no longer traded at 25x earnings, but instead at 5x, and furthermore, it stayed at 5x thereafter. Let's say you were fully invested prior to this drawdown. You lack 'cash', so you can't take advantage of this decline by buying stock at bargain basement levels, right? You're saddled with an 80% 'loss'. Catastrophic right?<br />
<br />
Not so fast. At the moment, Coke pays a 3% dividend, and also buys back something in the order of 1% of its shares a year (i.e. distributing its 4% earnings yield). At its new price, which now represents a 20% earnings yield, its dividend yield would have risen to 15%, while the company would now be buying back 5% of its shares each year. In the long run, you would significantly benefit from this reality, and if it stayed at 5x, you'd eventually become very rich simply by reinvesting the dividends (and enjoying the compounding 5% buybacks), because you would now be able to compound your money at 20% a year into perpetuity, instead of merely at 4%.<br />
<br />
For every $1,000 invested, if the stock stayed at 25x and you made 4% a year, you'd end up with $3,200 by year 30. If by contrast, your $1,000 dropped to $200 (5x P/E), and <i>stayed </i>at 5x, with dividends reinvested and 5% annual buybacks continuing, you'd end up with <i>$47,500 by year 30</i>. You'd have $47,500 at a 5x P/E, instead of $3,200 at a 25x P/E. No P/E 're-rating'/recovery would be necessary to make a fortune. Furthermore, your annual dividends would now be $7,100 a year, instead of merely $100. While this might seem counter-intuitive, it simply reflects the power of compounding money over long periods of time at high rates of return instead of low rates of return. Compounding at 20% a year instead of 4% easily trounces a higher level of starting invested funds (in this case, $200 after the 80% decline, instead of $1,000). <i>The biggest long term risk to investors is <b>not </b>markets going down. It is markets going <b>up</b> a lot and pricing stocks at more and more expensive levels which thwart the opportunity for meaningful future gains. </i>Ask government bond investors at the moment - they will glumly tell you how higher prices in the short term portend very miserable long term outcomes, as yields approach or submerse zero.<br />
<br />
But what if you can't find any even modestly-good ideas? Ought you then not hold cash? If it's your own money, sure. It's better to keep your money than do something dumb and suffer a permanent loss of capital. But if you're an investment manager, I believe the responsible thing to do is to simply return the capital to your investors. Can't find a sensible way to invest 30% of the funds you have? Then return that 30%. This would be functionally equivalent to a company like Apple which had (say) 30% of its market cap in cash, deciding to buy back 30% of its stock. It allows investors/shareholders to gain exposure to the good parts which they want exposure to (Apple's cash generative business, or the good ideas you can find as an investment manager), without investors having to tie up a significant amount of additional capital in low-yielding cash as part of the bargain. The latter is something most investors do not want to do, and in any case is something they can do for themselves, without paying the investment manager a fee for the privilege. That, incidentally, is exactly what Warren Buffett did in the late 1960s when he found himself short of ideas.**<br />
<br />
<br />
LT3000<br />
<br />
<br />
<i>*Indeed, there are times when you should actually be happy your investment manager is underperforming. Those are times when there is a wild speculative orgy going on in a meaningful portion of the relevant index. Underperformance during these sorts of periods is actually a sign of discipline, and the manager's unwillingness to do anything stupid that could put their investors capital at risk of a major, permanent loss, merely for the short term benefit of the manager's P&L and headline numbers. </i><br />
<i><br /></i>
<i>The wise investor considers not just the level of headline performance, but the nature of those returns, and how much risk is being taken to generate them. Investing is a little bit like driving down a foggy road. The road might have been straight for quite some time, but a wise driver knows that visibility is poor and there could be a sharp curve in the road at any moment. The reckless driver, by contrast, puts their 'pedal to the metal'. So long as the road remains straight (i.e. currently extrapolated growth trends in markets continue), the latter driver might appear to be the 'better' driver, because they are progressing towards their destination at a faster rate. But if an unanticipated swerve in the road happens, they will careen over the cliff, with their investment passenger in tow (without seat-belts).</i><br />
<i><br /></i>
<i>A long term<b> </b>track record through multiple market environments (i.e. multiple 'swerves' in the road) is therefore far more impressive/instructive than any short term performance assessment throughout a singular stretch of straight road. And what is 'long term' should be defined by the number of swerves, not an arbitrary number of years. It is for this reason that a lot of performance commentary that focus on the recent underperformance of managers such as Platinum, in full disregard of their long term track record, and the multi-year, uni-track nature of markets we have seen in recent times, is very misguided. I suspect many underperforming value managers with excellent long term track records, such as Platinum, will quickly redeem themselves as soon as the next curve in the road emerges, while many current go-go tech growth heroes that currently look like geniuses will end up looking anything but. Platinum will not, however, ever recover the performance headwind suffered from their decision to hold large amounts of cash over the past decade.</i><br />
<i><br /></i>
<i>**It is also, incidentally, what I believe Berkshire Hathaway should be doing today as well with its >US$100bn (and growing) cash hoard - albeit that unlike investment managers, Buffett is not charging fees on this balance. BH has started to slowly buy back stock, but should be doing a lot more in my view (and likely will in the future). It took a long time, but BH has finally gotten too big to find sensible ways to redeploy all of its capital.</i><br />
<i><br /></i>
<i><br /></i>
<i><br /></i>Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-39060393411236644452019-11-08T09:44:00.002+07:002019-11-08T10:08:56.070+07:00Free speech; Mark Zuckerberg; and online 'misinformation'I've been intending to write a post on free speech for quite some time. I've made several attempts, but it never quite crystallised in the manner I had hoped (I find that if I do not write a post start to finish in a single sitting, it never quite seems to get completed; my curiosity moves on to other matters, my thinking evolves, and when I return to the issue my preferred means of expression changes and necessitates a re-write). There was so much I wanted to say, but I struggled to find a way to present all of my arguments in well-structured manner that was not overly contorted or lengthy.<br />
<a name='more'></a><br />
However, Facebook CEO Mark Zuckerberg recently gave a truly excellent speech at Georgetown University, which eloquently outlined a lot of the core principles I fundamentally believe in that underpin a lot of the analysis I wished to present. I was highly impressed, and recommend people view it. He has made my job a lot easier, as he has already summarised a lot of the foundational principles in an an eloquent and concise manner, so I thought I would merely content myself to add just a few supplementary thoughts in this post. As I noted in a recent Tweet, the world is lucky to have such an enlightened moderate at the helm of such a powerful enterprise.<br />
<br />
<iframe allow="accelerometer; autoplay; encrypted-media; gyroscope; picture-in-picture" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/2MTpd7YOnyU" width="560"></iframe>
<br />
<br />
In recent years, the West has seen an unprecedented (in modern times) cultural assault on the principles and values of free speech. The zeitgeist at present is that the principles of free speech are mostly being espoused by the 'alt right' to justify hate speech and the spread of misinformation, and this perspective has been amplified by the election of Donald Trump, which is widely regarded in liberal circles to have been primarily enabled by the spread of misinformation online/via social media, including via 'Russian trolls'. Many believe the spread of online misinformation is allowing the rise of 'fascism'.<br />
<br />
The reception to Zuckerberg's speech - particularly from the US political left - has been remarkably hostile (but not surprisingly so in light of this cultural shift), given that it is basically an espousal of traditional Western liberal democratic values. Core to the accusations Zuck is facing is that he is not doing enough to counter online 'misinformation', and particularly with respect to his stated refusal to censor political ads, or statements made by politicians containing misinformation. Democrat Kamala Harris, for instance, has been calling for Trump's Twitter account to be banned.<br />
<br />
There are many causal factors underlying this opposition. One is simply the common human tendency to place short term pragmatism/expediency ahead of more universal principle (something I originally blogged about <a href="https://lt3000.blogspot.com/2018/01/why-is-society-becoming-so-polarised.html">here</a>). It may well be the case, for instance, that in the short term, promoting free speech does in fact help Trump get re-elected. If you think avoiding Trump's re-election is more important than anything else, you might be willing to say the core principles of Western liberalism, such as freedom of expression, ought to be curtailed, because the ends justify the means. It suffices to say that the 'ends justify the means' approach has paved the way towards (and perpetuated) tyranny many times throughout history. The Founding Fathers were extremely wise to enshrine free speech protection in the constitution, knowing all too well that special interest groups would repeatedly seek to curtail free expression in the name of expediency when it happened to suit their interests.<br />
<br />
However, the more fundamental point I wish to make in this post is that a core component of these criticisms of Zuck tie in very closely with a lot of the analysis I presented in yesterday's post on the human tendency towards (and the dangers associated with) binary, black and white thinking. <i>The attacks Zuck has endured all rest on an implicit belief that the world is simple and black and white, </i>rather than nuanced, complex, counter-intuitive, and often contradictory. If you believe the world is simple and black and white, you will also believe that there is a clear and obvious dividing line between what is 'misinformation' and what is not. And if it is obvious something is misinformation, then the case for disallowing its dissemination is much stronger.<br />
<br />
The problem is that in the real world, often what is misinformation is not so clear cut, and it can be extremely difficult to distinguish between misinformation and merely differences in opinion, or opinions that are merely unorthodox/non-consensus. And as Zuck points out, granting centralised authorities the power to decide what is misinformation and what is not has historically had the effect of denying people a voice, and reinforcing existing power structures - something liberals and progressives putatively oppose (railing against patriarchy, white privilege, etc). The fundamental issue is: who gets to decide what is misinformation, and how are you so sure that that power will always be exercised in a manner you approve of?<br />
<br />
When analysing things from a principled perspective, it always helps to consider how it would look if the shoe was on the other foot. If your principles are sound, they should apply irrespective of which way the partisan or expediency chips fall with respect to any particular issue - it should work in both directions. If it works only in one direction, one is prioritising short term expediency over universal principle. Consider the issue of climate change, for instance (which I also discussed in yesterday's post), and imagine a different world with different social power structures. Imagine a world where Trump supporters were in control of social media platforms, rather than Valley liberals; AOC had just been elected president; and calls for the restriction of the spread of online misinformation were coming not from liberals, but from conservatives.<br />
<br />
You could imagine these commentators criticising Zuckerberg for not doing more to counter the online spread of misinformation around climate, which had enabled someone like AOC to get elected. Extinction Rebellion protests were disrupting economies, and the spread of misinformation about how we were in a climate emergency and the world was going to end in 12 years if we didn't take radical action to reduce carbon emissions to zero, were a major threat to the health and prosperity of the global economy, and global poverty reduction efforts.<br />
<br />
If Zuck gave the exact same speech, he would be criticised for not taking down these memes. Furthermore, he would be criticised for political ads, and allowing extremists left-wingers like AOC to spread misinformation about a coming climate emergency in order to win votes. Such misinformation ought to be banned. Free speech has its limits, people would argue. If enough misinformation spreads online, really bad outcomes can befall the world, such as misguided efforts to completely ban fossil fuels and carbon emissions, so its is absolutely necessary to take radical action. The ends justify the means, and pragmatism need to trump principle.<br />
<br />
See the problem? Who exactly should be tasked with deciding what is misinformation and what is not? And how would liberals feel if social media platforms were controlled by Trump supporters, and they blocked AOC's Twitter account due her being deemed to be spreading misinformation about climate? They would view that as tantamount to fascism, and yet that is precisely what they are demanding Zuckerberg do to Trump in the name of countering fascism. The truth is, what passes as 'fact' and 'misinformation' is often simply a matter of disagreement - you think your ideas are factual, and the people who disagree with you are spreading misinformation. And how are you so sure you're right?<br />
<br />
Centralising the power to decide what views are acceptable speech has many attendant problems. For a start, it paves the way for malevolent actors to control the dialogue/media/narrative to entrench their own political power or personal interests, or promote their own political views. But it doesn't need to be that bad. Even if centralised authorities/social media platforms do not end up abusing their power for personal political gain, what will most likely end up happening will be a 'tyranny of the majority', where <i>orthodox </i>views are considered information, and <i>unorthodox </i>views (which are often misunderstood) are considered misinformation. As someone who routinely finds error in orthodox, consensus opinion in many fields, and whose intellectual development has benefited greatly from the absorption of diverse insights from people with a range of opinions and political persuasions, this troubles me deeply.<br />
<br />
If we proceed down this path, we will end up creating an echo-chamber of conformity, where innovative thought becomes impossible. You have seen this happen in the Islamic world. Orthodox religious views held by the majority are considered fact, and unorthodox dissident views are considered misinformation (or 'heresy'). It suffices to say that this is not the best path towards a liberal, free, and pluralistic society. People need to be free to hold and express opinions - even inaccurate ones. To be sure, Western liberal democratic values have their problems. It's by no means a perfect system. But we need to be <i>very </i>careful that we do not rush to throw the baby out with the bathwater.<br />
<br />
The basic problem here is that all human beings have biases. Human beings do not perceive objective reality, but merely their imperfect <i>interpretation</i> of reality. Reality is far too complex for any one individual to fully comprehend, and so what human beings do is use 'mental models', or simplifying heuristics, to filter reality, and reduce the level of complexity down to a manageable level.<br />
<br />
Mental models act as a lens or prism through which people view the world and make judgements, and how somebody interprets inputs/events, and the associated conclusions they draw, will to a large extent reflect whatever assemblage of mental models they have amassed throughout their life (as well as their personal interests). Given the same set of inputs, people that reach similar conclusions on issues generally have closely overlapping mental models (and/or interests), while those who disagree generally have very different mental models, and hence 'see' very different very things.<br />
<br />
Mental models per se are not the problem - indeed they are indispensable in helping us function in the world and make decisions. <i>However, the problem emerges when human beings forget that they are viewing the world through a prism, and are not seeing objective reality - merely their interpretation of reality</i>. When you believe you are seeing objective reality rather than merely your own error-prone interpretation of reality, it is all too easy to conclude that people who disagree with you are stupid or have malevolent motives, rather than seeking to understand why they see things differently than you.<br />
<br />
That is not to say that some mental models are not better than others, nor that there is no objective reality. Properly applied, the scientific method is a relatively effective mechanism for separating fact from fiction, by demanding beliefs be <i>tested</i>, and be capable of making repeatable, accurate predictions. The problem is that our understanding of reality is still incomplete, and the conclusions of science continue to evolve as we discover new insights. Our mental models are incomplete <i>maps</i>, not the terrain, which omit details and have errors and missing sections. And without freedom of speech, or with an insistence that we already have complete and accurate maps, it is impossible for us to improve these maps over time, and better understand the terrain.<br />
<br />
While individuals are subject to biases, the same true to an even greater extent of groups. Indeed, psychology, biology, history and contemporary observation all suggests that groups tend to <i>amplify</i> bias and promote the emergence of groupthink, rather than moderate it (unless what is being described as a 'group' is actually set of decentralized individual nodes). There are many reasons for this. Human beings are 'social learners', which means a large amount of learning takes place through the observation and imitation of other human beings, and a lot of this happens subconsciously, through the uncritical absorption of norms, customs, values, and beliefs.<br />
<br />
This can be seen in the fact that more than 99% of people who are religious are the same religion as their parents/communities. If people were rational, independent learners, they would research all the religions and then choose independently which one they wished to adhere to (if any), but people seldom behave in that manner in practice. Genuinely independent thinkers are vanishingly rare.<br />
<br />
Indeed, some observers - such as Noah Harari (author of Sapiens) - have argued that homo sapiens ability to engage in mass collective delusions was a critical survival advantage over other, more rational homo species (such as the Neanderthals, who had larger brains), because it allowed large numbers of individuals to coordinate their behaviour, and behave in individually irrational ways for the collective benefit of the group. The more cerebral and rational Neanderthals were no match for raving hoards of irrational, fanatical human beings. Homo sapiens seem to have had the optimal mix of rationality (creative problem solving) and irrationality (the ability to co-ordinate in large numbers and do things that are individually irrational for the perceived good of collective - for instance risking one's life in a political uprising, or charging into battle on the front lines).<br />
<br />
Because we are social learners that take refuge in consensus opinion and societal norms, widely held beliefs will therefore tend to reinforce and amplify the biases present in other individual members of the tribe, rather than moderate them, which can lead to a sort of runaway bias inflation, or 'narrative bubble'. This is fundamentally where the much-lamented 'madness of crowds' comes from, in my submission. More moderate biases present in individuals can be amplified and allowed to grow unchecked in a group context, leading to a runaway bubble that can be completely perplexing to outside observers looking on from a safe distance in either space or time. This dynamic explains not only financial bubbles, but many other things as well, from suicide cults and mass political ideologies/movements, to contemporary outrage/cancel culture on liberal US university campuses.<br />
<br />
In the Soviet Union, they really thought that people who subscribed to capitalist ideas were mentally deranged. They sent them to correctional institutes for re-education. It seems bizarre to us now, but this is what happens when you get a runaway narrative bubble, and biases amplified by groupthink. What is consensus opinion becomes mistaken for fact, while dissident views are considered misinformation. This is exactly why censoring free speech to remove perceived 'misinformation' is so dangerous. It is how repression/tyranny is born.<br />
<br />
In the past, I have expressed concern on Twitter about the trend towards social media censorship. I do not think this reflects express political motives on the part of social media executives. I think it reflects genuine bias and groupthink within their 'trust and safety' departments, which causes them to mistake their political beliefs/opinions/mental models for fact, and confuse contrary opinions with misinformation. I am relieved to see that Zuckerberg has realised the potential danger associated with this trend, and his influence might result in this concerning trend being nipped in the bud. It has taken some courage on his part to stand up to the overwhelming opposition he has faced within the hotbed of Californian liberalism, and his courage and wisdom should be applauded.<br />
<br />
The only things which keep humanity's tendency towards irrational groupthink and runaway narrative bubbles in check are external constraints and the forces of decentralisation, and free speech is an important component of the latter (as are individual rights and political autonomy/diffusion). The Soviet Union (and Communist China) both eventually collapsed as their ideological bubbles were in such discord with reality that the gap between the ideology and reality eventually become too large to deny. They eventually reached the point of <i>radical disillusionment, </i>which is necessary for the collapse of narrative bubbles. Ideologies are tenacious, but they do have a breaking point - the point where the level of visible disconfirmatory evidence simply becomes too overwhelming. However, that can take a very long time, and it can require a lot of unnecessary suffering in the interim, and in the absence of external constraints, in a highly centralised society they can persist almost indefinitely.<br />
<br />
One of the key safeguards against this tendency is decentralization. All individuals and groups have their own biases, but due to some combination of chance and insight, some individuals and groups will have mental models more closely aligned with reality than others, and those individuals and groups will tend to prosper more than other groups (there are of course other contributing factors as well, such as genetics; superior access to resources, etc). This allows better ideas to percolate from the bottom up over time through natural, evolutionary forces. Centralization thwarts this process. This is why private sector entities are usually far more efficient and adaptable than government and quasi-government entities (and monopoly enterprises are also less efficient and adaptable than those subject to competition). Private enterprises (excluding monopolies) are subject to market discipline; monopolies, and government and quasi-government entities are not.<br />
<br />
Nation states are by definition centralized, but one of the protections against the dangers of centralization and political monopoly has been competing individual nation states (or individual states with sufficient political autonomy within a political union, such as in the US). Core to the collapse of communism in both China and the USSR was the comparative US example. The US grew much richer and more powerful, and the gap eventually became so large that it was undeniable that its economic system was superior. It helped hasten the point of radical disillusionment within these societies, and catalysed change from the outside. If the world had only one country, and it became the USSR, Mao's China, or Kim's North Korea, there would be no such outside, decentralized catalyst for change.<br />
<br />
In addition, one (of many) of the keys to the US's success has also been the devolution of a lot of autonomy down to the individual 50 states. This allows different states to implement different policies. Some states will do better than others, and people and business will migrate to those states that do better. Poorer performing states then come under pressure to up their game and reform. It creates some necessary competitive tension, which is a necessary counterbalance to the formation of narrative bubbles, which in the absence of competitive tension will always arise over time. Political centralization and monopoly are the enemy of these dynamics, which is also one reason why I oppose moves towards more centralized, global government (in this respect, I think projects like the EU are a step in the wrong direction, as policy diversity is essential to progress).<br />
<br />
Another important example of decentralization is capitalism itself, as opposed to central planning. Different businesses are set up by different people/groups with different biases, but some will be less biased than others (through chance or insight), and therefore make better decisions. Those businesses will grow, and subsume the resources previously controlled by weaker businesses, which will fold. Other businesses will also then seek to emulate businesses that are succeeding. Over time, a more rational society better aligned with reality emerges, and prosperity increases.<br />
<br />
Freedom of speech is the decentralization of ideas. Without doubt, it has its problems and imperfections. But it has stood the test of time. It is worth remembering that the spread of misinformation and propaganda is not something new - it has been with humanity since the dawn of mass communication. When the printing press was first invented and commercialised, elites and the Catholic Church opposed the spread of books as they feared the broader populous could be easily mislead by bad, heretical ideas and the spread of propaganda.<br />
<br />
What actually happened was that books and the democratication and decentralization of information ended up liberating Europe from the dark/middle ages, freeing Europe from yoke of Catholic oppression, ushering in the reformation, the enlightenment and age of reason, the French Revolution, and ultimately the industrial and information revolutions that have lead to modernity. That is a formidable track record. Those that oppose the decentralization of information and democratization of ideas would do well to ponder that fact.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-3414729076587879462019-11-07T17:14:00.001+07:002019-11-07T20:04:49.975+07:00Contrarianism; ESG investing; coal; and climate changeIt is widely acknowledged in the investment world that one need think and act in a contrarian manner in order to achieve outsized returns and differentiated results. However, despite many claims to contrarianism and 'going against the crowd', its actual practice is vanishingly rare, and the core ingredients that drive effective contrarianism are also often misunderstood. It is not simply a matter of having a disagreeable personality, and disagreeing for the sake of it, or buying a stock simply because it has gone down. Much of what passes for contrarianism these days is actually what I describe as 'faux contrarianism' - buying expensive stocks that have recently become slightly less expensive, but where the fundamental view on the company remains very much in accordance with recent mainstream opinion (and often fails to comprehend new, emergent negative developments which have driven the recent share price decline, but are not yet apparent to all).<br />
<a name='more'></a><br />
Market sentiment is like water to fish. Its the medium investors are currently swimming in, without recognising its existence. It's the collection of assumptions and beliefs about reality and the outlook that form the prism through which people assess the prospects of companies and value them. Genuine contrarianism is not about valuing companies while looking at them through the same prism as other investors (in these situations, if you reach a different opinion you've probably missed something), but rather stepping further back to recognise what type of water investors are currently swimming in, and assessing the validity of those widely-held contextual assumptions, which are often mistaken as 'truth'.<br />
<br />
In my opinion, the essence of genuine and effective contrarianism lies in a deeply-rooted belief/understanding <i>that the world is not black and white, but instead shades of grey, and is filled with infinite nuance and complexity</i>, and as a result, future outcomes will routinely surprise mainstream popular opinion informed by overly-simplistic generalisations and thinking in absolutes. Human beings are generally time staved, and also incline lazy. It's an evolved trait to not waste energy and work any harder than one needs to (which is why it can sometimes feel challenging to get oneself to the gym). We therefore vastly prefer simplifying heuristics that distill the world down into binary assessments of good and bad and right and wrong, that facilitate easy decision making. The problem is that although these heuristics result in easier decisions, they often result in poorer decisions as well.<br />
<br />
We see the use of simplified heuristics in a lot of popular fiction. In traditional action hero movies, the heroes are ridiculously good in every way, and the villains are ridiculously evil. This dichotomy is also reflected in many traditional religions, which draw a clear and bright line between good and evil. We like these simple and clear dichotomies - it makes things clear cut and the world seemingly easily intelligible. However, reality is often not like that - it is often complex, grey, counter-intuitive, and contradictory.<br />
<br />
The (excellent) recent movie <i>Joker </i>was an example of a movie which bucked the general trend, and delved into this complexity, bringing nuance to something which most would consider as clear as day - that the Joker is pure evil. The movie humanised evil, by tracing an origin story of a protagonist subject to various traumas that make his subsequent evil deeds far more relateable, and showed that the origins of evil lie in the mental vulnerabilities that are present in all of us, to varying degrees. Subject to enough trauma and psychological hardship, most people will eventually snap, and find solace and personal validation in the infliction of harm on others. The desire for revenge is a hardwired human trait (and is a manifestation of our usually-constructive instinct towards reciprocity); an 'eye for an eye, tooth for a tooth' after all is a dictum inscribed in the Old Testament - it's an ethos that has been with humanity for a long time. Subject to enough suffering, any human will eventually feel a desire to take 'revenge on the world'. This is how you end up with high school shootings.<br />
<br />
This humanisation of evil lies at the heart of the movie's controversy, as it throws into disarray a lot of the simplifying heuristics people use to draw a simple and easy distinction between good and evil, and common reductionist views of their underlying causal factors (to a large extent it's not a matter of 'good people' and 'bad people', but different circumstances and life experiences). It also manifests repeatedly in political conflicts. One side might consider the other to be violent rebels or terrorists, while the other side sees themselves as valiant freedom fighters throwing off the yoke of oppression and injustice. Both sides consider themselves to be good, and the 'other' to be evil.<br />
<br />
We see the same sort of simplistic, binary thinking manifesting in the investment world all the time, and it is generally characterised by the excessive use of generalisations and absolutes. Examples include 'bricks and mortar retail is dead'; 'EVs are displacing ICEs'; 'ride hailing will put an end to private vehicle ownership'; 'Millennials don't buy stuff anymore, they buy experiences'; 'coal is dead'; 'Europe's banks are all insolvent'; 'banks are all black boxes and are hence uninvestable'; 'Greece is bankrupt'; 'China is nothing more than a giant leveraged bubble that will explode'; 'Russia is bad'; 'Africa is the hopeless continent'; 'Trump is stupid and everything he says is by definition wrong'; 'free trade is always best in all circumstances'; 'you're either for immigration or against immigration'; 'China is evil'; 'shopping mall REITs are all going broke', or 'malls in tier 1 cities will be immune from online threats; malls in tier 2 cities will go bankrupt', etc. What all of these types of claims have in common is that they are all absolute, black and white assertions, and are hence easy beliefs to not only hold and act upon, but also communicate/sell (which results in the memes spreading far and wide and self-replicating into consensus opinion - the water in which investors swim). But they are also all generalisations that lack any sort of nuance, or leave any room for complexity or uncertainty.<br />
<br />
As a contrarian, one should be instinctively skeptical of overly generalized claims such as these, because the world is almost never as simple and clear cut as these statements proclaim. Even if they are right in direction, they are seldom right to such an extreme degree, or with such a high degree of certitude about future outcomes (EVs might in fact eventually displace ICEs, but as I have discussed in <a href="https://lt3000.blogspot.com/2019/08/investing-in-low-conviction-stocks.html">past blog entries</a>, people are likely too confident this is inevitable). From an investment perspective, you should always be alert to such mainstream views, because they very often signal where attractive investment opportunities may reside - on the other side of these narratives, where popular beliefs have been overly discounted; nuance ignored; and other potential outcomes discarded.<br />
<br />
In order to be a contrarian, having a core belief in the fallibility of simplified generalisations, and an instinctive aversion to binary, reductionist thinking, is half the battle won, <i>because it will cause you to be willing to seek out and listen to contrary arguments; test the veracity of widely-accepted claims against new evidence/data that emerges; and generally keep an open mind</i>. Conversely, if you believe the world is simple and black and white, you'll find this virtually impossible, because you'll believe yourself to already be in possession of all the answers.<br />
<br />
Often, active open-mindedness is all that is needed to develop a far more nuanced, balanced view than the general consensus, and it is from this place that contrarian views naturally spring (often what is contrarian is actually having a more <i>balanced</i> view, far removed from the extremes/absolutes harboured by the mainstream). The reason people do not behave this way is not temperamental per se, but because they think the truth is obvious and further scrutiny of their existing views is therefore unnecessary. <i>This is the fundamental cause of confirmation bias</i>. But as Mark Twain put it, it often ain't what you don't know that gets you into trouble; it's what you know for sure that ain't so.<br />
<br />
<br />
<i>Enter ESG, and the ethics of coal mining</i><br />
<br />
The latest in the long and continuous string of fallacious black and white thinking to envelop the investment world has been the emergent wave of so-called ESG investing (environmental, social & governance).* The flaw is not in the principle or idea of ESG investing (after all, what is usually good for employees, customers, and broader society, is generally good for business in the long term as well), but instead the manner of its typical execution, which precedes on the assumption that the world is simple and clear cut, rather than complex and contradictory, and that businesses/industries can therefore be easily put into ethical and unethical categories.<br />
<br />
Armed with this belief, the ESG crowd has proceeded to categorizes stocks and industries as either 'good' or 'bad' in an extraordinarily blunt way entirely lacking in nuance. 'Coal is bad'; 'fracking is bad'; 'solar panels and wind farms are good'; etc, are obvious examples. The 'coal is bad' view is perhaps the most widely held, black and white position in the ESG community; it is the archetypal climate villain. No ESG investor would be caught dead owning a coal stock.<br />
<br />
But is it really that simple? Is the world really that black and white? Let's deconstruct the issue in a more nuanced fashion. My views here will be regarded as 'contrarian', and yet in truth they simply reflect the acknowledgement of easily-ascertainable facts drawn from a variety of disciplines, that are accessible to anyone willing to look and think a little more broadly and deeply. It is an example of how contrarianism is borne of little more than simply keeping an open mind and being willing to listen to and integrating multiple perspectives.<br />
<br />
The first problem is that the ESG community does not differentiate between coking coal and thermal coal. Iron ore and coking coal are the two essential ingredients in blast-oxygen furnace steel production, and a source of reductive carbon is essential to the chemical process. Without coking coal, you don't have steel, and without steel, you don't have modern industrial civilisation.<br />
<br />
Steel is the unsung hero of the modern world. Steel is essential to everything from transportation infrastructure (shipping & ports, railways, cars and trucks, aeroplanes; tunnels and bridges); industrial machinery that powers the world's manufacturing economy; agriculture and food production (tractors and farm implements; and food processing infrastructure); high rise buildings (structural steel-reinforced concrete); mining (excavators, crushers & grinders, pipes); electricity (power transmission, power plants), and everyday home appliances. Without steel, the modern world would not exist, and we would be transported back to the pre-industrial era (I highly recommend Vaclav Smil's book <i>Still the Iron Age: Iron and Steel in the Modern World </i>for a fuller analysis).<br />
<br />
So explain to me how investing in coking coal is unethical? If no one invested in coking coal, there would be no new steel production, and the resultant collapse in global economic activity would impoverish billions. While the developed world would somewhat muddle through for a while (as they have large installed bases of steel and can recycle existing steel via electric arc furnaces), it would deprive poorer economies with limited installed bases of steel of the opportunity for economic development, causing poverty and reduced quality of life by the billions.<br />
<br />
Properly understood and framed in this way, it could reasonably be argued that it is far more unethical to deprive this life-giving industry of appropriate funding until a scalable, cost effective alternative is developed. By all means, invest in upstarts trying to come up a new way to make steel. But not investing in the current steel supply chain until that technological inflection point is reached is not only not ethical, but doesn't contribute at all to solving the problem. It might sound good. But it's a simplistic, black and white assessment borne of ignorance (and a desire for pious PR optics).<br />
<br />
What about thermal coal? While there are technologically viable alternatives to coal-fired power generation (natural gas gen, and nuclear), at the present time approximately 40% of the world's electricity is generated by thermal coal-fired generation. If coal mining ceased today, the world's electricity consumption would drop by perhaps 30-35% (some of the slack would be picked up by underutilised gen), which would wreak absolute havoc. It is no exaggeration to say millions of people would die and it would be a man-made humanitarian tragedy unprecedented in modern times.<br />
<br />
Again, by all means, invest in companies developing or scaling cost-effective alternatives. The way to ethically invest in climate is the way Bill Gates is doing - invest risk capital in upstart technology companies trying to develop better solutions. You'll probably lose most of your money, but you'll at least have a shot and making a meaningful positive difference. But avoiding investing in companies providing essential, life-giving services in the meantime, merely because we don't like some of the side-effects, when no scalable, viable alternatives are yet in place and able to pick up the slack, is not ethical and it's not solving the problem. Carried to its logical conclusion, it would tank the global economy as the availability of affordable energy disappeared, and such a backdrop is unlikely to represent a supportive funding environment for speculative new-energy technology companies.<br />
<br />
Furthermore, as anyone who has studied historical energy transitions knows, they can happen only very slowly in the best of cases, because the size of the world's energy needs and energy infrastructure is simply so massive. Think of it like this: imagine you were to level the US - destroying all houses, buildings and infrastructure - bridges, railways, etc, but keeping the current human capital stock intact. How long would it take you to rebuild the entire USA? You have a relatively finite supply of qualified engineers, architects, and construction workers, as well as annual run-rate capacity for raw materials production, which is currently designed for incremental annual additions to the accumulated build. It would probably take 50 years to rebuild what currently exists - maybe more.** You simply couldn't do it any faster than that. You wouldn't have the raw materials inputs, or sufficient qualified human capital. The state of the world's current energy infrastructure is roughly analogous (long dated existing contractual arrangements also further complicate the task - you may have built a coal power plant with 30 year project financing debt, and sold long term power purchase agreements to local utilities; none of this can be easily undone in the short term).<br />
<br />
This is why talk of reducing carbon emissions to zero by 2030 via 'green new deals' is completely unrealistic, as is migrating the world completely off coal within this time frame (2040-50 is more realistic for the latter). For the former, even if scalable, affordable technological solutions were to exist - which they currently do not - you simply couldn't do it. The scale of the undertaking is too large. There is not enough nickel, lithium and cobalt to produce enough batteries for a start. So sure, work on/invest in alternatives, but in the meantime, the world absolutely needs a continuing supply of thermal coal to keep the world's electric grids humming, and provide cost effective, reliable, and affordable energy to billions of people, while also helping to finance R&D into new technologies. Suggesting we ban thermal coal mining any time in the foreseeable future is therefore an absurdity.<br />
<br />
Furthermore, overlooked is the fact that some of the largest contributors to reducing pollutants and carbon emissions over the past few decades has actually been the steel and coal power industries! This is because the industries have invested heavily in new technology and efficiency improvements, which have yielded tangible gains. Modern HELE (high efficiency, low emission) coal-fired thermal generators, for instance, with installed scrubbers and electrostatic precipitators, now emit almost no particulates, sulphur, or nitrous oxides. Virtually the only thing coming out of the coal stacks of these plants is Co2 and water vapour (steam) - a remarkable accomplishment. Furthermore, their heat efficiency has risen from some 30-35% to closer to 45%+, which means they now generate significantly more useful electricity relative to the amount of carbon released/coal burned, which means their Co2 efficiency has also significantly risen. These appear to have been highly ethical, win-win investments.<br />
<br />
These efforts and successes have been meaningfully under-appreciated, and it is arguable that the industry needs <i>more </i>not <i>less </i>investment to continue to drive further innovations to reduce coal gen's environmental impact. What the ESG crowd should be doing is investing selectively in coal and coal-gen companies that are investing in such innovations and are committed to improving efficiency. But this would require nuanced thinking. It is much easier to simply say 'coal is bad' and avoid it.<br />
<br />
This is also before mentioning the important but fundamental reality that coal feedstocks, at about US$2.50/MMBTU, is the cheapest, most reliable source of base-load power that exists (outside of the US, where for the time being, a glut of natural gas has rendered CCGT natural gas gen competitive with coal), and coal is also relatively easy to transport (not requiring complex and expensive pipeline and LNG infrastructure), such that its increased use in the developing world could promote a significant reduction in poverty by the billions (and indeed already has). Only a privileged, high income developed market do-gooder could believe that slowing global carbon emissions by a fairly negligible amount ought to be a greater priority than alleviating hunger, disease and poverty by the hundreds of millions in place like Africa, where nearly a billion people still live without electricity (the electrification ratio is only 42% in Africa). It's easy to be in favour of a policy when you're personally immune from the consequences.<br />
<br />
Instead, the ESG and environmental crowd is opposing coal and promoting solar energy in Africa - one of the most expensive and unreliable sources of energy, for the world's poorest people. By refusing to invest in new coal mines, they will also contribute at the margin to increasing the cost of coal and hence raising the cost of coal-fired electricity in these nations, which will make electricity less affordable for some of the world's poorest people. By all means, promote substitution of coal-fired gen in the developed world, but to oppose the use of coal in the developing world ravaged by poverty is - to put it mildly - not particularly ethical (particularly because the prosperity ESG investors currently enjoy was built on the back of cheap and plentiful energy in decades past).<br />
<br />
As can be seen, even something as seemingly obvious as 'coal is bad' is not so straight forward. The world is a complex place. Contradictions and two-sides of the debate almost always co-exist, because the world is mostly one of <i>trade-offs</i>, not absolutes.<br />
<br />
<br />
<i>Climate change - black and white?</i><br />
<br />
All of the above stands even if one takes for granted the fact that carbon dioxide emissions and global warming are serious long term issues, but even this supposedly black and white issue appears far less clear cut when one delves into the details. I've spent a lot of time researching this issue of late, and believe the current state of the popular climate narrative is a fascinating case study in how even the most seemingly obvious examples of a black and white, open and shut cases, are often in fact far more complex when you get into the weeds. Permit me a fairly lengthy digression here, but I think the implications and lessons are important enough to warrant extensive comment.<br />
<br />
Like most people, before I took the time to do much research on climate change, including seeking out and listening to contrary arguments, I took climate change orthodoxy at face value. After all, Co2 is a greenhouse gas and we've been emitting a lot of it; the climate seems to be warming a bit; and the scientific community appears (at face value) to be fairly unanimous in saying that this is happening, and is a problem/potential problem. It seemed pretty simple and obvious - what was there to dispute, really? And surely if there was any uncertainty, we should adopt the 'precautionary principle'. Usually a open-minded contrarian, in this case I didn't think any further work was particularly necessary.<br />
<br />
However, like most, I hadn't taken the time to really properly understand the issues or listen to both sides of the debate, relying instead on popular caricatures/straw-manning of the arguments of the so-called 'denier' camp. Even I succumb to mistaking the water we are swimming in as reality from time to time. What prompted my willingness to look was an increasing realisation of the toxic incentives associated with activist movements - something I blogged about <a href="https://lt3000.blogspot.com/2018/10/activist-excess-incentives-and.html">here</a>. There is a sort of domino effect when you reach these sorts of realisations - they prompts you to ask, what else have I bought into uncritically, and how am I really sure this is true? And the more research I did, the more surprised I became as to what I found. Indeed, I've come to believe that the current climate change orthodoxy could well be one of the most profound correlation vs causation errors in modern history.<br />
<br />
One tendency I have noticed is that experts in their field are often deeply contrarian or skeptical about their own field, and see all the problems, biases, and institutionalised folly that occur in their own industry, but are they bafflingly quick to assume the orthodox views in other domains outside their areas of expertise are assuredly accurate. It's like reading a story in the paper - when it's something you personally know a lot about, you're often appalled by the inaccuracy of the reporting, but when it's something you know little about, you assume that it's 100% accurate.<br />
<br />
Steve Keen and Jeremy Grantham are two prime examples. Both are hyper-contrarians in their own areas of expertise, but have championed climate change orthodoxy with almost religious zeal, without applying even a modicum of the critical thinking they are famous for in their own disciplines. I find the juxtaposition almost comical. But the truth is, the financial industry has no monopoly on folly and irrationality. Indeed, the more I learn about other fields, from healthcare and psychiatry, to academia and the toxic dynamics of institutionalised activism, the more I realise that the tendency to folly and irrationality is a human universal, and if anything, the financial industry is far better than average.<br />
<br />
The origin of the current climate change orthodoxy lies in arctic ice core records, which over a 400k year history, showed a clear correlation between historical temperatures and atmospheric Co2 levels. Coupled with the fact that Co2 is known to be a greenhouse gas (as it is capable of absorbing reflected long-wave infrared radiation), it seemed more than reasonable to infer that fluctuations in Co2 levels were likely driving these temperature changes. It seemed to be a sound hypothesis, and this hypothesis was popularised by Al Gore's <i>An inconvenient truth</i>. And as popular opinion goes, so goes politicians, government funding, and the PR departments of corporations and institutions.<br />
<br />
The problem is that as any good scientist should know, correlation does not mean causation, and you don't take a hypothesis at face value. You need to scrutinize it, and test it. Indeed, in order for a claim to be scientific, it needs to be falsifiable (one should always be able to answer the question, what piece of evidence would cause you to change your view?; if you can't answer that, your view is not scientific but ideological), and also capable of making accurate predictions.<br />
<br />
What is remarkable is that over the past 30 years, we have emitted far more carbon dioxide than predicted (due primarily to rapid growth in China and other parts of the developing world), and yet temperature change has undershot even the low end of projected increases in mainstream climate models (the leaked 'climategate' emails also revealed consternation amongst the alarmist fraternity about the fact that the climate wasn't warming as much as it should be, and revealed coordinated efforts to obfuscate that fact). Sea level rises have also been far less than was predicted, and despite claims that more extreme weather and famine would befall the earth, catastrophe experience and reinsurance prices have significantly declined over the past 15-20 years, and real food prices are also at record lows. This new data, and prior failures of prediction, suggests that at the very least, alternative perspective should be considered, but the problem is that existing orthodoxy can become so ossified into existing institutional arrangements that, in combination with bad incentives and the 'institutional imperative', responding adaptively to new evidence can prove nigh on impossible.<br />
<br />
So what's the potential correlation vs. causation error I reference? A closer look at the historical arctic core data reveals that Co2 levels actually <i>lagged</i> temperature increase by approximately 800 years - an important fact obscured by Al Gore's deceptively simple rhetoric. The explanation lies in the fact that approximately 98% of earth's carbon dioxide is dissolved in the oceans, and only a small percentage resides in the atmosphere. As sea temperatures rises, the oceanic solubility of Co2 declines, which results in oceans venting Co2 into the atmosphere at the ocean's surface. Meanwhile, when temperatures decline, solubility increases, resulting in greater Co2 absorption. It takes approximately 1,000 years for the oceans to fully circulate (bringing water from the very depths of the deepest oceans to the surface, where atmospheric Co2 exchange can happen), which broadly corresponds to the 800 year time lag between changes in temperature and the resultant change in atmospheric Co2 levels. This dynamic suggests it is more than plausible that it could have been temperature driving Co2 levels, rather than the other way around.<br />
<br />
Now of course, there are also feedbacks, because Co2 is absolutely a greenhouse gas. Consequently, rising atmospheric Co2 levels caused by an initial warming (generally caused by long-cycle variations in the earth's orbit, which is the driver of ice-ages - see <a href="https://www.youtube.com/watch?v=XjdT-NdSoWM&list=PLqqA1nvQRBbkwxtHHQ2xeOcAm5tfoVa-Y&index=3">here</a> for an excellent explanation) can amplify and prolong the level of prior warming in a positive feedback loop. However, <i>the initial correlation data, coupled with knowledge that Co2 is a greenhouse gas, says nothing about the magnitude of this positive feedback</i>. It could be large, or it could be small. <i>And this is the absolutely critical issue</i>. Is the feedback effect large or small? It's not a matter of whether Co2 has a greenhouse effect. Of course it does. It's a matter of whether the warming effect of trace 0.04% atmospheric carbon going to 0.05% is large or small.<br />
<br />
Here we once again see how the penchant for binary, simplistic thinking has hijacked the debate. The theory goes, you either think Co2 is a greenhouse gas or you don't. If it's a greenhouse gas, then obviously global warming is happening due to rising Co2 levels. In order to deny climate change, you need to deny that Co2 levels are rising due to human activity and that Co2 is a greenhouse gas, and yet we know with a high level of confidence that both of these things are true. Consequently, anyone that doubts the warming narrative is either stupid or engaging in motivated obfuscation. However, note how <i>absolute and binary </i>this view is, and that it pays no heed at all to the relevant issue: the <i>magnitude </i>of the warming effect. And will the impact accelerate or attenuate as Co2 levels rise?<br />
<br />
The wonderful truth is that the evidence that has emerged over the past 30 years or so since the carbon hypothesis initially gained traction seems to suggest that the warming effect of Co2 has been radically overestimated, and that climate sensitivity is relatively low. During the 400k year ice core period, fluctuations in atmospheric Co2 of about 100ppm correlated with huge temperature swings of 5-10 degrees Celsius (10c near the poles, but likely closer to 5c near the equator) - see <a href="https://www.youtube.com/watch?v=uE-zY0roNfw&list=PLqqA1nvQRBbkwxtHHQ2xeOcAm5tfoVa-Y&index=1">here</a>. If the climate was that sensitive to carbon dioxide levels, we would do well to panic. However, we have seen Co2 levels rise by 100ppm over the past 100 years or so, and yet temperatures have only increased by about 0.5-1.0c during this period. Furthermore, as noted, carbon emissions have accelerated over the past 30 years as China et al have industrialised, and yet the level of warming has shown no signs of meaningful acceleration (it has risen a bit this decade, but stagnated completely during the 2000s). This provides meaningful evidence that it was primarily temperature driving the change in Co2 during the ice-core period, with a small level of positive feedback, rather than the other way around.<br />
<br />
There are also people that believe the level of claimed 0.5-1.0c temperature increases has also been overestimated, because in many cases it fails to adequately adjust for the 'urban heat island' effect, which can affect thermometer readings. Urban areas tend to be hotter than rural areas, as concrete, steel and asphalt absorbs more heat than natural environs. Consequently, as cities/regions/countries increasingly urbanise, local temperatures will rise for reasons completely unrelated to global climate trends. Tropospheric temperature measures suggest less warming has happened than terrestrial measurements suggest, and there is also evidence that institutions such as NASA have re-written the global temperature record, revising down historical temperature readings, which has had the effect of increasing the amount of apparent subsequent warming. They have done this because confirmation bias is a powerful thing, and when the historical record didn't confirm with their belief system (less warming than expected), they decided that the historical temperature readings must have been flawed/biased in a certain way and made various 'adjustments' to correct those 'errors' (see <a href="https://www.youtube.com/watch?v=cSrfyAjcq-o&t=18s">here</a>).<br />
<br />
Furthermore, a very very important but little known dynamic of the greenhouse effect of Co2 <i>is that the warming effect of a linear increase in Co2 declines exponentially (logarithmically)</i>. If you double Co2 and get (say) 2c of warming, you then need to <i>double </i>Co2 again to get another 2c of warming, and so forth. This is why the IPCC's conclusions are cast in terms of a 'a doubling in Co2 will drive a 1.5-4.5c increase in temperature' - note they use the relative standard of <i>doubling </i>instead of talking about the absolute impact per unit of Co2. That is because the impact diminishes as the Co2 stock rises. This is <i>massively </i>important, because atmospheric Co2 levels are rising in a relatively linear fashion, and will continue to slow down over time as the global population peaks around 2050; the developing world steadily completes its S-curve industrialisation over time; and our energy use becomes more efficient (as it has in the developed world), which is a trend that owes itself to capitalist cost efficiency incentives as much as it does to government environmental policy.<br />
<br />
The reason for this exponential decline in warming is that a 'saturation effect' is at work. Trapping infrared radiation is somewhat akin to blocking incoming light with a curtain. As the curtain gets more and more opaque, you eventually get to the point where not much light is coming into the room, so if you keep doubling the thickness of the curtain, at some point the level of incremental light being blocked starts to become relatively negligible. It has been estimated that as much as 87% of the potential warming effect of atmospheric Co2 has already been realised (see <a href="https://wattsupwiththat.com/2014/08/10/the-diminishing-influence-of-increasing-carbon-dioxide-on-temperature/">here</a>; also see <a href="https://www.youtube.com/watch?v=8-zaQWAaPAg">here</a> for a decent explanation of the science of infrared absorption). It is also worth bearing in mind that life would not have been able to evolve on earth over billions of years if the climate was radically unstable, so there is already prima facie evidence for relatively low climate sensitivity, and the diminishing return effect of Co2 warming is likely one contributing factor as to why. Without it, runaway and irreversible cooling and warming could happen, making life on earth impossible.<br />
<br />
<i>It is accepted scientific consensus that this logarithmic decline in the warming effect is how Co2 infrared absorption works</i>. It is testable and measurable, and is in the IPCC reports (albeit it is buried in the interior). Even if one cares to disagree with all my other points, it is very hard to disagree on this point, as this is absolutely mainstream, accepted science known with a high degree of certitude. Importantly, most people's intuitions/beliefs are that if you increase carbon levels linearly, you'll have a linear to exponential increase in temperature, and yet the <i>opposite</i> is in fact true - you will get an exponentially <i>diminishing</i> level of warming over time. This alone means that the magnitude of the risks we are facing is perhaps an order of magnitude less than what many people intuitively think it is.<br />
<i><br /></i>
So here we have a major<i> </i>gap between mainstream perception and the underlying reality, that is easily ascertainable from information in the public domain, and yet very view people are aware of it. Why? Because they haven't been looking for it, or felt the need to seek contrary opinions. In markets, you don't need inside information - there is plenty of useful outside information out there for the taking if you're prepared to look for it, and it is not hard to find if you do. With respect to climate, every single argument I have made above is not my own novel work or insight, but instead derives from a wide array of highly credentialed scientists with 30-40 years of experience in their area of expertise, who have publicised their arguments. They may be in the minority (particularly in their willingness to speak publicly on the issue, and risk the associated reputational and career consequences), but that does not mean they are wrong. We know from markets that the consensus is often wrong.<br />
<br />
William Happer, for instance, is a Princeton physicist who has built carbon dioxide lasers. His <a href="https://en.wikipedia.org/wiki/William_Happer">Wikipedia profile</a> includes the following excerpt: "<i>Happer is credited with a key insight in 1982 that made adaptive optics possible: there is a layer of sodium in the mesosphere, at around 90 to 100 km of elevation, which could be lit by a laser beam to make an artificial guide star. His idea was tested successfully by DARPA but classified for possible military applications</i>". I'm willing to bet he knows a lot more about the science and dynamics of carbon dioxide that Greta and her ilk. He has pointed out for years to anyone prepared to listen how the warming effect of carbon declines logarithmically, as have many other scientists, and as previously noted, it is included (begrudgingly) in the IPCC reports. <i>But no one listens because people believe they already know all the answers </i>(see <a href="https://www.youtube.com/watch?v=zcsSn7ehZ1g&t=954s">here</a> for an excellent interview with Happer).<br />
<br />
Furthermore, it gets even worse (or better, depending on your perspective). There is actually a growing amount of evidence that rising Co2 levels and mild planetary warming are actually having a net beneficial effect on the world and the environment. Satellite evidence confirms that global greening is happening (see <a href="https://www.youtube.com/watch?v=j5M1qtN62yk&t=671s">here</a> for an excellent presentation by Matt Ridley on this point). Co2 is plant food, and is an absolutely essential ingredient in photosynthesis. Commercial greenhouses pump in Co2 to artificially raise levels to 1,000-1,500ppm, which is more optimal for plant growth (vs. atmospheric levels of 400ppm). Anyone can conduct this experiment to prove it. Plants evolved in (and are hence adapted to) an environment with significantly higher carbon levels than currently prevail, and as carbon levels have started to rise, carbon-starved plants have been flourishing. Agricultural productivity has risen and real food prices are at record lows. A more carbon-rich atmosphere also promotes improved drought resistance amongst crops, improving food security.<br />
<br />
The Cambrian explosion also occurred when carbon was at 7,000ppm - something that perhaps ought not be a surprise, considering that all life on earth is carbon based. Even today, life appears to flourish most vigorously in warm, energy-rich environments (e.g. tropical rainforests; tropical coral reefs are also the most vibrant).<br />
<br />
It is merely asserted by the green movement that pre-industrial levels of Co2 were at optimal levels, but no evidence for that is provided. Meanwhile, there is meaningful evidence that we are currently living in something of a carbon drought, and higher carbon levels could well be a net positive for the world. Even Elon Musk has said that he believes the world could do with a little more carbon. Indeed, at 150ppm, plants start to die. We were getting dangerously close to that level a few centuries ago, with carbon levels troughing at as little as 200ppm in recent cycles, because over eons, carbon has been slowly sequestered and trapped in the form of hydrocarbons and other marine deposits/sediments. In what is the most supreme of supreme ironies, <i>had humans not intervened to release this sequestered carbon by burning fossil fuels, all life on earth would have eventually ceased </i>(with some predicting that it could have occurred as little as 5m years from now - on an evolutionary timescale, human beings' industrialisation arrived just in the nick of time).<br />
<br />
While these latter points are grounded in very basic first-principles scientific realities, and are easily testable, the implications are almost impossible for the green movement to accept, because environmentalists have been conditioned by past experience to perpetually cast human beings in opposition to the health of the environment. That is understandable, because a lot of human economic growth in the past has come associated with industrial activity that has in fact polluted streams, groundwater, and the the air over time. It seems almost inconceivable that we could be so lucky as to enjoy a 'win win', where burning fossil fuels to release Co2 would be both good for human economies, <i>and </i>good for the environment (note that Co2 needs to be differentiated from genuine pollutants such as particulates, sulphur, nitrous oxides, etc, which are damaging and ought to be - and increasingly have been - sequestered; Co2 - <i>analogous to oxygen for humans</i> - is frequently mislabelled a '<i>pollutant</i>'). But the evidence appears to suggest that could well be the case!<br />
<br />
In a rational world, that reality would be greeted with <i>unmitigated joy</i>. However, in the real world, amongst the professional environmental activist community, it is greeted with fear and trepidation. The reason is simple - these people's livelihoods and reputations depend on their being a climate emergency to agitate against. Specialist 'climate scientists' livelihoods also depend on large government grants to fund climate change research as well. If concern about climate change goes away, so do billion-dollar government research grants, and hence their large and reliable incomes.<br />
<br />
Indeed, I always find it amusing how people argue that anyone opposing climate change orthodoxy must be biased by funding from the fossil fuel industry (when in fact, all the major oil companies now embrace climate change orthodoxy, as they have already comprehensively lost the PR battle and they know it; and most of the skeptics not only enjoy no such funding, but also frequently suffer very real reputational and career consequences for stating their views publicly),*** while they ignore the biasing effect billions of dollars of government research grants might have on the objectivity of professional climate change research. Qualifying for grants is a highly politicized process, and they are handed out with the tacit expectation that the conclusions that come back are 'on point'. If you come back with inconvenient conclusions, you risk compromising future research grants. The outcome of much of this research is therefore decided even before it starts.<br />
<br />
Should we therefore be surprised that a majority of professional 'climate scientists' agree with climate change orthodoxy? Bear in mind that until the multi-billion-dollar feeding trough of climate change funding emerged, there was no such thing as specialist climate scientists. There were geologists, meteorologists, physicists, ecologists, marine biologists, and chemists, etc, but no climate scientists. The latter are a bunch of self-selecting people that deliberately chose to enter the field to specifically make a career out of researching climate-change related issues, whose livelihoods and relevance depend on the flow of funding continuing. If you pay a bunch of smart people a lot of money to find evidence for X, you should not be surprised that they come back with evidence for X, irrespective of whether X is true or not. Relying on a numerical consensus when the financial incentives and resources are hugely imbalanced is like a rich plaintiff in a court case hiring 99 lawyers, while the defence has 1 pro bono lawyer, and then arguing that 99% of professional lawyers believe the case for the plaintiff to be correct. They are hired guns with a vested interest, not objective observers.<br />
<br />
It's the same fundamental reason why Buffett always stated that if he were a conventional corporate CEO considering doing an M&A deal pitched by a Wall St bank, he would hire another firm to pitch him <i>against </i>doing the deal, and put both on a contingency fee (so the second bank gets paid if the deal <i>doesn't </i>happen). Buffett is well aware that if you align the incentives of a bunch of smart people towards a particular outcome, they will come back with very convincing arguments. <i>Don't ask a barber if you need a haircut</i>, he noted. Well, the state of climate science research is structurally very similar, and no one is getting paid to dispute the narrative. To the contrary, people are routinely fired or scorned for the mere expression of doubt. That means that any vocal opposition should be accorded at least 10x its normal weight on account of the personal costs of doing so. If people are speaking out even at great personal cost, they must really really passionately believe in what they are saying. (Buffett's discussion of the 'institutional imperative' is also very relevant to the how NGOs, universities, and government departments frame their climate commentary and research as well - who wants to risk publishing/saying anything against the narrative? That's not how institutions behave, as there is no upside to the risk-averse people populating these bodies; only potential downside).<br />
<br />
Furthermore, the oft-quoted 97% consensus is also a misleading statistic, because 97% of climate scientists agree that 'climate change is happening and it is due to human causes'. Notice that this is a bait and switch, and completely irrelevant to the pertinent issue, which is the <i>magnitude </i>of the change, and whether it is dangerous or not (or indeed, potentially beneficial). <i>I'm in the 97%. </i>I think change is happening due to human activities. I just think a sound case can be made that it is not only mild, but quite likely net beneficial as well.<br />
<br />
<br />
<i>Concluding remarks</i><br />
<br />
So why is contrarianism so rare? It is rare not only because it is intellectually hard (it requires constant, active open-mindedness), but also because of incentive problems, and the personal costs involved in invoking the ire of the tribe. The stock market is one of the few areas of the world where pure truth always wins in the end, and where being a contrarian can seriously pay off. However, most areas of life are political to at least some extent (and often to a considerable degree), and getting ahead therefore depends as much on social perceptions and personal relationships as it does on truth.<br />
<br />
We are a co-operative, social species, and in tribal times, ejection from the tribe was a death sentence. Human beings are therefore acutely attuned to what is deemed socially acceptable, and few people are prepared to risk invoking the tribe's wrath by taking a contrary view. These inclinations are hardwired, and are one reason for the 'herding' that observably occurs in financial markets (many financial market participants also face political constraints, from bosses to clients and media PR risk, and truth only wins in the long term - in the short term the market is a voting machine). Look at what happened to Peter Ridd - he lost is career and reputation for standing up for what he thought was right. Even if he is right, which I suspect he probably is, there is no vindication. He doesn't get his job and career back. He invoked the ire of the tribe and was ostracised.<br />
<br />
The same thing happened to James Damore at Google, which I blogged about <a href="https://lt3000.blogspot.com/2017/08/james-damore-vs-google-archipelago.html">here</a>. I felt instantly sympathetic, seeing a kindred spirit - a contrarian, independent thinking prepared to reason from first principles and do battle with conventional thinking. He was unmercifully fired and pilloried in the media for expressing views in a measured way that are very likely correct. The much less noble and deserving-of-sympathy Martin Shkreli also discovered to his detriment the perils of invoking the tribe's antipathy. Individual rights only go so far, even in modern day society. If he was aware of the personal risks of doing so, he might not have acted in such a brazen, loathsome manner.<br />
<br />
I feel extremely fortunate to work in a job where I get rewarded for discovering truth. As I work for myself, I also need not fear being fired for the expression of politically unpopular or controversial beliefs. I feel extremely lucky - as an instinctive contrarian, I could easily have found myself in Peter Ridd or James Damore's position, were I to have worked my way into an alternative profession - and found myself alienated, condemned, and ejected by the tribe for espousing unpopular views. It is partly for this reason that I feel a responsibility to share some of the politically unpopular insights I have, because if it's not people like me, then who can we rely on to do so?<br />
<br />
What does the above analysis mean for the outlook for coal? Does it mean it is positive? Not necessarily - particularly for thermal coal, which in the long term the world can survive without (by substituting to natural gas). Over the past 50 years, the environmental lobby has destroyed the nuclear industry in most of the developed world, despite it being a highly promising technology which is the most affordable, scalable, and reliable source of <i>carbon-free </i>base-load electricity generation we have (and despite the occasional high-profile mishap, one of the safest as well). In the 1960s, it was believed that nuclear energy would by 2000 render electricity 'too cheap to meter' (a cautionary tale on the perils of techno-optimism and excessive extrapolation, as well as the capacity for bad ideas to be tenacious, and activist groups to drive society-wide own goals). If the environmental lobby can destroy the nuclear industry, it can certainly destroy the coal industry as well (likely by forcing a substitution to more expensive - excepting the US for the time being - but still easily affordable natural gas).<br />
<br />
The outlook will hinge on what happens in the developing world. If the developing world is pressured into using natural gas/alternatives, thermal coal's <i>long term </i>future could be relatively weak. However, counterbalanced against this will be the long duration of energy transitions, as noted, coupled with likely underinvestment in new mine capacity, which could support prices. Despite the uncertainty, I nevertheless remain fairly optimistic about coal's outlook in developing markets, given that coal will likely remain meaningfully cheaper than natural gas, such that there will be a competitive cost advantage for economies that embrace coal, and historical precedent suggests that most emerging markets will favour affordability and economic development above all else. In addition, while China's coal-burn is unlikely to increase, it is unlikely to meaningfully decrease, as I believe China will not wish to increase its share of natural gas in the energy mix above 20%, as they have limited domestic reserves, and given the state of geopolitcal relations, are unlikely to want to rely on countries such as the US for imported LNG for their energy security.<br />
<br />
The other thing that could occur - albeit that it is a low probability event - is economies like the EU completely destroy the competitiveness of their industrial sectors through escalating carbon prices (which have risen from $10/MT to $25/MT this year), resulting in another economic crisis, substantial unemployment, and significantly higher living costs, which eventually trigger a backlash at the polls. The Yellow Vest protests in France were a potential indication of what could be to come across the European continent if policymakers continue down their current misguided trajectory.<br />
<br />
Overall, I am not very optimistic the current climate change narrative will reverse itself, however. Indeed, recent trends indicate that the level of hysteria continues to grow, rather than recede. It is possible that we are in the manic stages of a popular narrative bubble, which will imminently reverse, but it feels unlikely to me as there is so much government/institutional/financial momentum behind the movement, and government-backed movements don't mean revert. They keep trending in the same direction unless and until a major crisis/discontinuity event occurs. Bad ideas can be extremely tenacious (witness the long term damage done to the penetration of GMO seeds in the EU, for instance, by the environmental lobby, in flagrant disregard of the scientific evidence).<br />
<br />
The current climate change hysteria is not only a fascinating example of how dysfunctional our institutions can become, and how widespread mass delusions can spread (even many famed 'contrarian' investment managers fully sign on to climate change orthodoxy) - particularly when issues become politicised, and where bad incentives are involved (as Munger said, he's been in the top 5% of his age cohort his entire life in understanding the power of incentives, and he has always underestimated them). When viewed in combination with recent ESG trends, it also highlights how the general belief in the world being black and white and simple comes with all kinds of attendant risks of poor judgement and misguided actions. ESG-based funds are now eschewing anything seen to be contributing to 'climate change', having consigned it to the evil bucket, even though the state of the science is still unsettled to say the least, and in spite of the very considerable positive contributions the industry makes to global economic and socioeconomic welfare, including global poverty alleviation. And the worst part about it is that it is doubtful they will ever change their minds.<br />
<br />
On a final note, I wish to emphasise I could well be wrong in some or all of my analysis. These are complex issues. I always consider <i>all </i>of my opinions provisional, and open to change in the face of new or better evidence/arguments/insights. If someone is able to convince me I've made a mistake, I'll be more than willing to change my mind.<br />
<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
<i>*A cynic might argue that the rapid rise of ESG is less a reflection of the financial world suddenly growing a social conscience, and more the industry's latest attempt to overcharge investors for poor performance, in the face of rising fee and flow pressures from passive vehicles (if you don't have any alpha to sell to investors, why not roll the dice and try ESG instead?)</i><br />
<i><br />**Incidentally, this is pretty much what China is currently in the process of doing. They are building an entire modern economy from a standing start in about 50 years. This is what accounts for their outsized and unprecedented use of construction materials like steel and cement, as well as (to some extent), their rapid accumulation of debt. In the long run, replacing this aggregate construction demand will be a challenge, but at US$10k GDP per capita, there is ample room for consumption and services to grow to fill the void, and as the bears obsess about the demand-side risks, they forget about the tremendous supply-side progress that continues to unfold (and still has a long way to go).</i><br />
<i><br /></i>
<i>***For instance, lifelong ecologist and Great Barrier Reef researcher and enthusiast Peter Ridd was recently fired from James Cook University for disputing - with evidence - claims that the putative environmental destruction of the GBR was being misrepresented (by organisations that are recipients of substantial funding from the Australian government, who have a vested interest in exaggerating the GBR's plight), and arguing the reef was actually in good health. He recently won a lawsuit against the university for wrongful dismissal. The university, to its shame, is appealing the decision, at a great waste of public money. You can help fund Ridd's (considerable) legal costs on his <a href="https://www.gofundme.com/f/peter-ridd-legal-action-fund">GoFundMe campaign</a>.</i><br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-38001166889182095352019-09-02T17:10:00.000+07:002019-09-02T18:54:59.442+07:00A duration-bubble or a low-volatility bubble?I'm a fan of Antipodes Partners, and always find their commentaries insightful. In the company's latest investor update (see below), founder and CIO Jacob Mitchell provides a number of useful insights, but one of the arguments he makes is that investors have been 'chasing duration' to an unprecedented extent in the post-GFC era. Slide 7 is quite revealing. Mitchell's full presentation runs from 5.50 to 22.00 (all of which I recommend), with the relevant section for this article on duration running from 10.05-14.45.<br />
<a name='more'></a><br />
<iframe allow="accelerometer; autoplay; encrypted-media; gyroscope; picture-in-picture" allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/H3jo6yWgaoo" width="560"></iframe><br />
<br />
It's an interesting argument. However, I'm not convinced Jacob's characterization of today's bifurcated markets as being primarily a function of investors chasing 'duration' is entirely accurate. I think what has really been happening is that in the post GFC era, investors have been chasing asset classes/factors/styles which have (or are perceived to have) <i>low volatility/drawdown risk</i>, and concomitantly eschewing those with higher volatility/drawdown risk. It has little to do with duration per se, in my view. After all, per 11.15-14.45/slide 8 of Mitchell's presentation, the duration of the cash flows associated with ownership of European bank equities is longer than many of the low-yielding debt instruments used as a comparison (in an otherwise very good argument).<br />
<br />
The origin of this more than decade-long megatrend lies in the wreckage of the Global Financial Crisis (GFC), which was a formative event for an entire generation of investors and asset allocators. It was a 'return shock' of tremendous proportions, where pretty much anything exposed to equities was down 50% or more on a marked-to-market basis in as little as 6-12 months. Furthermore, unlike the dot.com bust, there was nowhere to hide. In 2000-02, lots of old-world value sectors/stocks surged as tech stumbled, and emerging market equities also boomed during 2000-2007. The GFC was different - 'correlations went to 1', as they say, and equities everywhere tanked. Many value guys were also heavily exposed to financials and suffered badly. This GFC experience has cast a long shadow, and has had significant implications on how markets have functioned ever since.<br />
<br />
It has always been the case that meaningful portions of the investment world cannot afford to sustain large mark-to-market (M2M) drawdowns, but the GFC and a number of other developments I discuss below have meaningfully amplified this behaviour. Insurers, for instance, are required to mark equity investments to market, and large drawdowns can therefore pressure regulatory capital and imperil rating-agency product ratings, which can in turn impair their ability to write new business (or even continue as a going concern).<br />
<br />
As a result, insurers remain focused on high-grade fixed income securities, almost irrespective of yield and fundamental risk/reward, due to the relatively low associated M2M risks, and the extent of the GFC drawdown has caused them to allocate even less to equities, and particularly high-risk equity exposures. However, as sufficient yield has become increasingly had to come by in the QE-addled post-GFC period, they have sought to supplement their fixed income portfolios with increasing allocations to 'alternatives'. These initially included hedge funds, but in more recent times, the preference has migrated towards private equity and venture capital.<br />
<br />
Pension funds have behaved in a similar manner post-GFC - albeit not to the same extent, and they retain much larger equity exposures. In theory, pension funds ought to have the best ability of all market participants to withstand short term M2M volatility and invest in long-duration assets such as stocks, to match off against their long-duration liabilities. However, the duration of pension funds' liabilities usually exceeds the duration of the employment tenures of most of the people running them, and no one wants to preside over a significant portion of the assets backing their pension liabilities declining by 50% on their watch. Because many organisations saw exactly that happen to their equities exposure in the GFC, a major aversion to equities in general, and more volatile/economically-sensitive sectors/regions/style factors in particular, has developed.<br />
<br />
In the post GFC period, hedge funds were initially seen as an attractive alternative asset class, as they promised to provide equities exposure with downside volatility protection - particularly because several hedge funds succeeded in not only protecting capital during the GFC, but also profiting mightily from 'the big short'. However, due precisely to many of these funds' focus being on hedging downside volatility/drawdown risk, they have also relinquished most of their returns over the past decade as well. GMO's research has shown that the long term return on writing cash-covered put options on market indices has been about the same as the market's total return. The implication of this is that you have historically needed to give up 100% of your expected return being long equity indices in order to hedge the downside by buying index put options. With equity indices - particularly in the US - having risen incessantly over the past decade, hedge funds have accordingly delivered poor returns for this reason, exacerbated by limited alpha generation and high fees.<br />
<br />
The GFC also had the effect of causing many active managers to move from under-estimating the likelihood of crises before the GFC, to dramatically over-estimating the likelihood in the GFC's wake - particularly because the GFC set in motion various regulatory/policy/behavioural responses designed specifically to prevent a recurrence (including much tighter banking regulation, and much more conservative lending). The GFC catapulted to fame and fortune many hedge fund managers with relatively short track records that had successfully bet on disaster. Funds flooded into these managers. But their poor subsequent records - as they have continue to bet on myriad other macro blow-ups which have not occurred - indicate that they were mostly just lucky pre GFC, rather than prescient. Many copy-cat macro-oriented hedge funds also emerged that tried to be the next Paulson or Burry, who bet heavily on various crises occurring which did not. This 'generals fighting the last war' approach cost their investors a lot of money, and discredited hedge funds. Investors fled.<br />
<br />
With hedge funds disappointing, and with yields on fixed income instruments - the ultimate asset class providing a refuge from 'volatility risk' - declining to a mere pittance (if that), money has instead rushed into private equity and venture capital. This is intriguing, because private equity is essentially little more than leveraged equities exposure - albeit with greater ability to influence management behaviour and capital allocation - while venture capital is also involved in the riskiest equity bets of all - funding start-ups, most of whom are destined to go to zero. It appears to be a strange place for investors to seek out low-risk returns.<br />
<br />
However, the risk investors are seeking to avoid is not fundamental/valuation risk, <i>but mark-to-market drawdown risk </i>- particularly over shorter time horizons (by the time things blow up, the management teams in charge of making making asset allocation decisions may have already retired with their bonuses safely banked). The advantage PE/VC 'asset classes' have over traditional equities is that they don't need to mark their positions to market every day/month/quarter, and are therefore able to manufacture the illusion of returns without volatility - something that has considerable practical value for many of their volatility-phobic investors. Tech VC also has the further advantage of being able to mark the carrying value of their investments to the latest capital raising valuation - even if they are the only fund participating in such a raising.<br />
<br />
However, the impact of this volatility-phobia has not just been a reallocation of funds from equities into 'alternatives', but also into equities exposures that promise returns with relatively limited volatility/risk. This has included a rotation into 'bond proxy' equities such as consumer staples, utilities, etc; dependable structural growth stories such as large cap tech; and safe jurisdictions without Fx risk such as the US; while avoiding sectors subject to macro sensitivity or other uncertainties, and jurisdiction with greater political, economic, or Fx risk.<br />
<br />
This aversion to volatility/risk has also often been effectuated through the use of ETFs coupled with 'smart-beta', 'risk-parity' and 'factor-based' investment strategies, while investors have also favoured active managers delivering performance with limited drawdowns. This volatility-phobic trend has been accentuated by robo-advisers and other algorithmic asset allocation strategies, which all seek to optimise the same equation - relatively high returns with relatively low 'risk', with risk defined as volatility/drawdown risk (i.e. the classic 'sharp' ratio). And the algobots assess these characteristics using historical data series.<br />
<br />
What this has meant in practice is that equity market 'factors' that have been delivering good returns with relatively limited volatility/drawdowns have been attracting more and more money. These inflows have then in turn contributed to further strong returns with comparatively limited drawdowns (as when markets swoon, incessant inflows moderate the size of the drawdown vs. factors experiencing outflows, which fall even further in market sell-offs). This flywheel effect has accentuated and prolonging pre-existing market momentum (kickstarted by a flight to quality/low-volatility in the risk-averse climate of the GFC's aftermath), and tricked algobots into believing certain 'factors' such as 'growth' and 'quality' have better enduring risk/reward characteristics than other factors such as 'value', when in reality, it merely reflects a bubble in flows.<br />
<br />
An prime example of the folly is 'low volatility' ETFs - ETFs that invest in 'low volatility' stocks, which have grown significantly in popularity. Imagine if a significant fraction of the stocks comprising low-vol ETFs came to be held by 'low-volatility' ETFs. What would happen if the stocks suddenly spiked down and became highly volatile? Two things: (1) the ETF would have to sell them, because the stocks are no longer 'low volatility'; and (2) the investors in the low-volatility ETF would experience highly-volatile outcomes. They would say, 'this is not what we signed up for', and pull their money out. In combination, this could drive a crash in 'low volatility' stocks. It would be hard to design an ETF more foolish and prone to a total blow up. But until that inflection point is reached, so long as more money keeps flowing into low volatility ETFs, the stocks will perform well and won't go down, as the inflows continue to support their 'low volatility' performance.<br />
<br />
Incidentally, this is one of the fundamental problems/dangers with 'big data' in the investment world. Big data in markets is different to big data in, say, baseball (I highly recommend the book 'Big Data Baseball', which is Moneyball on steroids). Big data in baseball makes it possible to more and more accurately appraise the true value of individual players (which as discussed in the book, has hitherto sometimes been hidden), but although it may affect player selection and on-field strategies, it does not ultimately affect those underlying contributions/attributes. Furthermore, virtually 100% of what happens during a baseball play has happened before - often thousands and thousands of times. Algos are great at analysing this sort of voluminous data and sifting out hidden relationships/patterns invisible to mere mortals. In these sorts of contexts, big data can have a huge impact, and make the market in baseball players (and on-field strategies) far more 'efficient'.<br />
<br />
Financial markets don't work that way, because the return and volatility data sets are backwards looking, and the algos cannot anticipate discontinuities, or something happening that has not happened before in the datasets. History, and our data collection to date, has simply been too short to account for the myriad of all possible outcomes. If there had already been 500,000 housing bubbles and busts, maybe the data sets could predict future bubbles and all the relevant factors, but there haven't been. There had never been a national housing bust in the US before the GFC, so it wasn't in the data, and was therefore invisible to the bots. If you asked the algos in 2005, they would have told you a nationwide crash was a 10-sigma event almost impossible to occur. But they were wrong, as the past data sets reflected ex post outcomes, not ex ante probabilities in a novel situation. It's like setting baseball 'big data' bots to work when they only have three pitches worth of data. If all three pitches have been strikes, then the bots will think a strike happens every ball.<br />
<br />
Furthermore, the very behaviours these bots drive can actually change the future probabilities in a reflexive and (to the bots) unpredictable way. The very belief that a nationwide housing crash was a 10-sigma event was a key contributor to the <i>creation </i>of the housing bust (as it caused ratings on MBSs to be far too high, enabling an excessive flow of credit into the sector). It was an active contributor, not just a failure of passive prediction. In much the same way, the algobot search for high returns with low volatility/risk is creating a situation where the stocks with the best best returns potential and with the lowest risk actually reside in the exact same stocks the bot algos eschew, and vice versa.<br />
<br />
It hasn't just been algobots driving a bubble in low volatility, however. The behaviour of both end investors and active equity managers has also reflected these megatrends. Aging demographics means that there is a large cohort of investors approaching retirement age in development markets, and the GFC was a major shock to the retirement accounts of many of this cohort. They can ill-afford to see 50% of their retirement savings wiped out again on the eve of their retirement. This large class of capital is therefore now very sensitive to volatility and drawdown risk, and this risk aversion is impacting not just their asset allocation, but also their selection of asset managers and the types of equity exposures they are prepared to run: they have shifted funds into managers delivering steady gains with low volatility, and away from those with variable returns, and/or have allocated funds to ETFs or 'smart beta' ETFs with similar dynamics. But it is this very behaviour, writ large, that has been driving the high returns and low volatility in the fist place.<br />
<br />
End-investor behaviour has also affected the behaviour of active fund managers, because a long-standing issue for equity managers has always been that they are only able to be as patient and volatility-tolerant as their end investors. If their investor base cannot 'wear' downside volatility, these organisations will actively avoid asset classes, regions and sectors that expose their funds to meaningful short term drawdown risk. They will do this because even if buying cheap but volatile stocks will lead to a better long term outcome for their investors, it represents an unacceptably high business risk. If they suffer massive redemptions, they may go bust or (from the perspective of the individual PM) be laid off long before the point of reversal arrives.<br />
<br />
Exacerbating these trends further, the world of institutional funds management has been consolidating over the past decade, as more and more money has flowed into passive strategies, and fee compression has emerged. Many smaller shops have folded, and many large managers have been merging in order to reduce costs (and therefore fees). However, this has resulted in larger and larger funds, and more and more money flooding into the same large-cap structural growth or quality/low-volatility names, pushing up multiples further.<br />
<br />
All of these forces in combination have resulted in crowding into the same, now highly-expensive segments of the market, and the wholesale abandonment of other sectors, and in my submission is the real reason we see the wide disparity in multiples and return profiles Antipodes has ably referenced. Its not that investors aren't prepared to look for structural growth in 'less obvious places' - it's that they aren't prepared to/can't afford to weather short term drawdowns.<br />
<br />
Sure, dividend yields on European banks in sound financial positions are now 7% (on 50% dividend payouts), vs. close to zero for junior debt instruments owed by those same institutions. But if you buy the stock, you might be down 5-10% in a day on a marked-to-market basis (as occurred in August), whereas that will not happen for a held-to-maturity debt instrument (debt instruments can be accounted for as 'held to maturity' by financial institutions, and hence not marked to market (unless 'impaired'), but there is no such thing as 'held to maturity' for equities). <i>It's not about duration - it's about mark-to-market volatility risk</i>. GE and Siemens offer structural growth in less obvious places at a much lower price? Sure, but you might be down 5-10% in a day if people worry about the outlook for global growth, or the size of GE's LTC insurance reserves.<br />
<br />
This is how you end up in a world where many markets are expensive, and nominal long bond yields are approximately zero, but you can still buy some stocks on extraordinarily low prices - often market leading companies with long term growth potential with dividend yields of 10%, but which happen to be cyclical or subject to some other form of uncertainty that is inducing share price volatility. It makes no sense, until you recognise that most investors simply can't weather the volatility, and algobots will dump stocks exhibiting poor short term Sharp ratio optimisations in a self-reinforcing manner. It's also how you end up in a world where the vast majority of value investors with great long term records are underperforming the indices - sometimes by a sizable margin.<br />
<br />
The result is that there are now extraordinary opportunities emerging in global markets for the volatility-tolerant long term investor. The world has a vastly excessive abundance of low-volatility capital, but a growing and acute shortage of high-volatility capital. Like all opportunities in markets, however, the magnitude of the opportunity is proportional to the challenges of successfully exploiting it <i>at scale</i> - it is in this respect that markets are both highly inefficient, <i>and </i>offer no free lunch (something the academics missed). The opportunity is large because it's hard to attract a lot of money at the moment to implement such a strategy - most of the funds doing so are currently suffering redemptions. If it were easy exploit, the opportunity would disappear. That's how markets work.<br />
<br />
Personally speaking, I have the good fortune of being a small-time manager with a low cost base and my own permanent equity capital invested, and only need a handful of loyal, long term investors to make a decent living. As far as I'm concerned, the current environment is a wonderful opportunity if you're fortunate enough to be in a position to exploit it.<br />
<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-3497757726407931372019-08-29T17:16:00.003+07:002019-08-29T18:00:15.045+07:00How worried should we really be about an inverting yield curve?In an interview a few years ago, Elon Musk responded to a question on what had enabled him to innovate so effectively by saying: "I think it's important to reason from first principles rather than by analogy. The normal way we conduct our lives is we reason by analogy. [With analogy] we are doing this because it's like something else that was done, or it is like what other people are doing. [With first principles] you boil things down to the most fundamental truths... and then reason up from there". (He might also have added that, unlike many others, he has not been constrained by the need to generate a positive return on capital, but I digress).<br />
<a name='more'></a><br />
Musk's comment resonated with me immediately, because reasoning by analogy is something we see a lot in markets, and I have never found such arguments persuasive. They always felt dubious to me, even if I could not articulate exactly why. Musk's comment clarified perfectly for me what the fundamental problem with them was. They were not based on first principles.<br />
<br />
A clear example of reasoning by analogy in markets is the frequent anxieties expressed about an inverting US yield curve. In cycles past, an inverting yield curve has often (though not always) preceded a recession, so investors view such inversions as particularly ominous. A widely subscribed belief in the inversion's predictive value can and has had market implications - an inverting yield curve contributed to the 15% market crash US markets experienced in December 2018, which proved to be a false alarm. By 2018 year-end, surveys revealed that a majority of investors expected the US to fall into recession in 2019. Instead, the US went on to print 3.3% GDP growth in 1Q19, and markets surged. More recently, the US yield curve has inverted again, which has contributed to another savage decline in US and global markets in August.<br />
<br />
While you often hear concerns expressed about an inverting yield curve, it is much rarer to encounter a good first-principles explanation of <i>why </i>it has preceded past recessions and <i>why </i>we should be so concerned. Most investors reason purely by analogy, and are content to note that an inverting yield curve has been associated with past recessions. But as Keynes once said, if you do not know the underlying causal factors driving past experience, you are in no position to know whether present conditions are sufficiently similar to render past experience a useful guide.<br />
<br />
One of the most common arguments made is that the bond market is more efficient than the stock market, and the bond vigilantes see recession coming before the equity guys. Baloney. Bond markets are buying 30yr government bonds at negative yields at present. Not very smart/efficient. Equities, being lower down in the capital structure, are also at the 'sharp end of the whip', so to speak, in terms of upside and downside exposure. If any market should sniff out trouble/risk first, it should be the equity market. There is no sound reason to believe the bond market is more efficient than the stock market, in my opinion.<br />
<br />
The best first-principles explanation I have been able to uncover as to why a yield curve inversion has preceded many past recessions (and I would love investors to educate me in the comments if they have a more insightful explanation) is that in decades/cycles past, many banks/financial institutions borrowed short term wholesale money, and lent it long. In other words, there were many financial institutions running loan-to-deposit ratios (LDRs) meaningfully above 100%. So long as such institutions were able to borrow in the wholesale market and on-lend with healthy spreads (i.e. with a positively sloped yield curve), they did so, and grew their loan books (and profits) vigorously.<br />
<br />
However, when short term rates rose sharply and began to exceed long term rates, the lending spreads of these institutions were sharply squeezed. Even if they had taken measures to protect themselves from interest rate risk on their back book (which sometimes they hadn't), the spreads on their new loan originations sharply deteriorated. This, predictably, resulted in a sharp slowdown in new credit origination, which in turn triggered an associated reduction in aggregate economic demand, and thus meaningfully slowed economic activity - particularly because virtually all recessions in the post-war period were preceded by years of double-digit system credit growth.<br />
<br />
However, in the post-GFC period, a lot has changed. Interbank and other short term wholesale funding markets were severely disrupted following Lehman's collapse (whose own collapse was driven as much by a liquidity crisis - its short term funding lines dried up as counterparties lost confidence - as it was losses on the asset side of its balance sheet). The cascading effect on funding markets resulted in liquidity crunches and near-death experiences for many other financial (and non-financial) institutions dependent on short term wholesale money to fund their balance sheets/operations, and necessitated massive Fed intervention/bailouts to avoid large portions of the financial system collapsing.<br />
<br />
The legacy of the crisis has been not only a voluntary change in bank behaviour (once bitten, twice shy), but also a significant tightening in banking regulation, including much stricter liquidity coverage requirements. Very few systemically important financial institutions are today running their businesses with any meaningful reliance on short term wholesale funding markets. Today, the vast majority of US financial institutions rely almost exclusively on deposits and (where necessary) longer term wholesale funding instruments, and the system LDR (loan to deposit ratio) in only about 70%. Indeed, the banks have (and have had for a while) excess deposits, and for the major banks at least, many of these deposits cost nothing or close to nothing (well below short term Fed rates).<br />
<br />
It is true that QE has contributed meaningfully to this excess liquidity/deposits/reserves situation, and one might reasonably attempt to argue that banks will stop lending if they can make 2-2.25% on their excess reserves parked with the Fed if the yield curve inverts. But this ignores the fact that (1) most banks have been (and continue to) lend at rates significantly above the US 10yr (new mortgage rates are currently 3.9% in the US, for .e.g, vs. 1.5% for the 10yr), and unlike Japanese banks, US banks are managed for shareholders and RoE maximisation); and (2) <i>US banks have been sitting on excess deposits/reserves for the entirety of the post-GFC period, and have been unable to find a useful place to lend them</i>, even in a world with a meaningfully positive yield curve. That was almost never the case pre-GFC in periods of economic expansion. That's why LDRs remain so low; excess reserves so high; and credit growth so anaemic (see below). If credit growth is already slow and banks already aren't lending much, then an increased incentive to keep funds parked with the Fed will have limited effect, <i>because that's already the status quo</i>. <br />
<br />
This brings me to another important point - the level of pre-existing credit growth. Over the past decade, private sector credit growth in the US (ex fiscal) has been very modest. This is extremely important, because it's hard to have a significant slowdown in credit growth triggered by an inverting yield curve, and the associated aggregate demand ramifications, if pre-existing credit growth has been modest.<br />
<br />
It might surprise many people accustomed to reading bearish prognostications about the outlook for the US economy and the level of aggregate system debt, but US household debt to GDP has actually <i>fallen</i> over the past decade, from about 100% of GDP at the time of the GFC, to just 76% at present, and credit growth has continued to lag nominal GDP growth throughout the recovery, including the recent fiscally-induced acceleration (US household credit growth was just 2.3% in the year to 1Q19). The data is easily accessible for those who care to look. Both banks and households - chastened by the GFC - have borrowed/lent very prudently in the crisis' aftermath. This means there is less capacity for a sudden slowdown in credit growth due to tightening lending spreads, as loan growth is already modest. And US consumer spending - let it be remembered - drives about 70% of US GDP.<br />
<br />
Corporate credit growth has been somewhat higher, and is therefore more of a risk, but credit growth has still been only a middling 7%, and at 52% of GDP, is not unreasonably high. After a dramatic decline during and post GFC, corporate debt-to-GDP has slowly risen back to its pre-GFC levels, but corporate debt was not the cause of the GFC, and interest rates (and hence debt servicing burdens on corporates) today are significantly lower.<br />
<br />
Furthermore, the complaint we have heard most often over the past decade has been that US companies have been buying back too much stock and <i>not investing enough</i>, rather than investing too much, and with a few exceptions (e.g. shale activity), most of the over-investment that has occurred has been localised and equity-funded (VC funded tech). US corporates have been significantly under-investing over the past decade relative to the availability of credit (and their reinvestable profits), and so by extension, corporate investment is unlikely to sharply slow due to a reduced marginal appetite from banks to lend (shale being a probable exception here). Furthermore, even if financial institutions were to start rationing credit to businesses at the margin, falling sovereign yields have created a large class of financial institutions such as life insurers and pension funds that are <i>desperate </i>for yield, and so it will be relatively easy for creditworthy (and maybe also non-creditworthy) businesses to issue bonds at low cost. And this is before mentioning the many alternative 'credit' funds being set up at present to search high and low for any sort of yield. In such an environment, a generalised lack of access to credit to finance investment seems far fetched.<br />
<br />
One of the key things that has changed in the developed world in the post GFC period, which many investors are still yet to have wrapped their heads around, is that we have moved from an environment of capital scarcity into a period of capital abundance. This has turned many of the prior economic relationships that existed in decades past (and which still prevail in emerging markets today) on their head. Richard Koo's excellent book <i>The Holy Grail of Macroeconomics </i>has a Yin/Yang model that discusses this in more detail, which I highly recommend (drawing on Japan's now three-decades of experience in having transitioned to an excess-capital position). Sure, when capital is scarce and needs to be rationed, a change in long rates that dramatically slows lending growth from vigorous levels can absolutely be expected to slow the economy. But that is not the world in which we are currently living (in the developed world).<br />
<br />
All told, an inverting yield curve could prove to be far less predictive than it has in the past, and there is a decent chance that many of those 'reasoning by analogy' will be surprised by the resilience of the US economy, and its continued refusal to behave as it supposedly ought to. That does not mean there are not other important risks to the economic outlook (I have discussed the risk of a VC blow up in prior blog posts, for e.g., and the trade war also continues to impact corporate investment activity), but in isolation, betting on a recession merely because the yield curve has inverted appears to me to be a risky proposition.<br />
<br />
I would love to hear from anyone who could critique this perspective. The anxieties (and algo bot reactions) to an inverting yield curve keep tanking markets from time to time, and if people are wrong about the predictive value of the indicator in the current environment, there is potentially significant money to be made on the long side buying into these sell-offs.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-1996593678103886042019-08-15T14:56:00.001+07:002019-08-15T16:43:19.995+07:00Investing in low conviction stocks; jumping the gun on EVs; and TennecoIt is fashionable amongst the value investing community these days to hold a concentrated portfolio of high conviction ideas. Indeed, any other approach is usually greeted with suspicion, if not outright disdain. And yet, in my experience, often some of the very best investment opportunities exist in areas of the market where one is intrinsically capable of only <i>low </i>levels of conviction, extending to situations where a zero is a reasonable possibility. Obviously, smaller position sizes and a more diversified approach is warranted with such situations, but on a portfolio basis, they can yield a portfolio with very agreeable risk/reward characteristics - indeed uniquely so I would argue, given how few value investors are adopting such an approach in today's world.<br />
<a name='more'></a><br />
An example at the moment is automotive component supplier Tenneco (TEN US), whose stock has been decimated and fallen to just 2x earnings (closer to 1.5x recently). Why is it so cheap? Three reasons: (1) they have a lot of debt, partly due to the ill-timed acquisition of Federal-Mogul last year, which despite being partly equity funded, has significantly increased the company's leverage; (2) global auto sales have declined this year, pressuring earnings and leverage ratios, and investors are also fearful about an impending recession in the US/globally exacerbating the company's plight; and most importantly (3) a significant portion of the company's business is making engine components for internal combustion engine (ICE) vehicles, including powertrain components.<br />
<br />
It is now a widely-subscribed belief that electric vehicles (EV) are set to imminently displace ICEs, which means that Tenneco will likely be disrupted before it is able to successfully deleverage and return capital to shareholders - particularly if a recession happens in the interim. Should an EV transition occur, ICE suppliers such as Tenneco will also be the first affected, and the impact will be exacerbated by the company's high operating leverage. Once EV production ramps up, it will still take 10-20 years to gradually replace the existing installed base of vehicles, which will defer the impact on after-market players for an extended duration (including gasoline refueling stations, and also the impact on oil demand), but TEN's powertrain business is leveraged to the pace of <i>new</i> ICE construction (not the parc). While surviving for now, in the eyes of many, TEN appears to be on death row.<br />
<br />
One of the keys to identifying investment opportunities is to always be prepared to challenge widely accepted notions by considering the other side of the argument, and being willing to ask, what happens if people are wrong? People forget that the really big moves in markets are driven by <i>changes in opinion</i>. What is currently widely known and assumed to be true about the future is invariably already embedded in current valuations. (This is one reason why broker recommendations are so frequently wrong and are best used as contrary indicators - they succeed in writing lengthy and eloquent reports that are best viewed as explanations for why a stock is already cheap/expensive, rather than guides to how one should position themselves today).<br />
<br />
I was previously also of the view that EVs were inevitably set to dominate the future, but I actively sought out contrary arguments, and having done so, I am now convinced that many investors may have jumped the gun, and are too confident that a transition from ICEs to EVs is inevitable. I emphasise the word <i>may </i>here, because I don't hold this view with conviction - I just believe there is a larger probability than is generally accepted. And when stocks get cheap enough to be priced like options, a reasonable probability - even if significantly less than 50% - can still be sufficient to justify an investment case.<br />
<br />
Elon Musk has been absolutely central to popularising the notion that a full conversion to EVs lies in our near future. Tesla's early premium models - the Roadster, Model S, and Model X - showed the world that EVs could not only be environmentally friendly, but also high performance and downright cool as well. His PR offensive has been extremely successful (too successful for Tesla's own good - it is now facing a wave of EV competition). It has lead to the hasty preparation of regulations in many markets mandating steadily increasing EV penetration; a surge of investment by traditional automakers into the electrification of many of their models; and has convinced the majority of the investment community that a full transition to EVs is only a matter of time.<br />
<br />
The problem is that despite all the hype, it is still yet to be proven that EVs can be produced profitably, at scale, <i>for the mass market.</i> Tesla has proven, I believe, that they can be viably produced for the <i>luxury </i>market, because the premium prices of these vehicles provides much more margin to work with (and because Tesla has shown that EVs are capable of extraordinary performance). But the mass market is an altogether different question.<br />
<br />
Tesla's ambition was always for its Model 3 to be the model that ushered in mass market adoption, but on an unsubsidised basis, along with practically necessary add-ons, on-the-road prices are still in the vicinity of US$50k - about double the cost of a new ICE vehicle of comparable size/specs. And despite this rich price tag (and the contribution from Tesla's more profitable luxury models; recent cost-cutting measures bordering on desperation (closing dealerships); and in the opinion of some - aggressive accounting), Tesla is still unprofitable, and in the opinion of many credible observers, destined for eventual bankruptcy. The inconsistency of widespread EV adoption now being considered inevitable by the investment community, and the leading player in the segment fighting for its survival, has apparently been lost on many (and it is also interesting to consider whether any eventual demise of Tesla will cause widespread assumptions around mass-market EV adoption to be revisited).<br />
<br />
Furthermore, this lack of cost competitiveness also exists before considering the reality that if EVs were to go mainstream (nearly 100m vehicles are produced globally each year, compared to about 300k by Tesla at present), the world is going to need a lot of automotive-grade batteries, and a lot of batteries will require a lot of lithium, cobalt, and nickel. The sort of scale required could well result in the cost of these raw materials increasing many multiples from current levels. A significant fraction of the world's known cobalt reserves are located in the DRC (Democratic Republic of Congo) - a destination not renowned for its political stability or predictable mining industry regulations. The battery is already by far the most expensive component of EVs - costing at least US$10-15k, and cost reductions here are <i>not </i>subject to Moore's Law type declines (microprocessor performance and cost improved because transistors were made exponentially <i>smaller</i>, allowing more of them to be packed onto a given surface area, but there are physical limit to how much energy can be stored in the chemical atoms of batteries; you can't make electrons smaller). Produced at scale, there is a good chance the cost of batteries would rise rather than fall, as raw materials costs spiraled.<br />
<br />
Musk makes the (fair) point that one ought to not just consider the price tag of EVs, but the 'total cost of ownership', and it is true that electric vehicles cost less to power than ICEs. The cost of electricity is higher than gasoline on a cost-per-raw-unit-of-energy basis (as electricity has already absorbed conversion losses at the point of generation), but EVs are much more efficient at converting electric energy to kinetic energy than ICEs are at converting the chemical energy in gasoline into kinetic energy (heat losses are significant), more than offsetting this disadvantage.<br />
<br />
However, balanced against this point is the important issue of battery longevity. As anyone who has used a laptop or smartphone for an extended period of time can attest, battery performance degrades over time. The Nissan Leaf's battery performance reportedly degraded by as much as 60-70% five years after purchase. While efforts are underway to improve battery longevity, it is not yet clear if they will be able to extend the practical life of the vehicles beyond 10 years, without a battery overhaul being necessary. This is an important issue, because most mass-market second-hand ICE cars are worth less than US$10k after 10 years, whereas that is the likely minimum cost of a new battery pack. In practice, this would mean that it would not be economically viable to undertake such an overhaul, and EVs would have a practical useful life of perhaps half that of an ICE. This would represent a meaningful (if not total) offset to the 'lower cost of ownership' Musk speaks of.<br />
<br />
What about regulations? Both EU and Chinese regulators have pushed hard to accelerate the adoption of EVs, imposing mandatory EV sales targets (as a percentage of total sales) in the case of the latter, and aggressive average fleet emissions reduction targets in the former, which will likely require rising EV penetration to meet. China's policies likely also partly reflect geopolitical motivations as well (to reduce its reliance on imported oil).* While these regulations might seem destined to hasten adoption, as we have seen with solar subsidies, it is one thing to force-feed a small minority of the system average onto a structurally more expensive platform, but it is quite another to roll it out to the entire system, which is orders of magnitude more expensive.<br />
<br />
As we have seen with the recent Yellow Vest protests in France (as well as the general tide of rising populism), there is a political limit to how much of a decline in living standards you can force onto the electorate in the name of environmental protection - at some point the cost becomes too burdensome and people revolt at the ballot box. How will the broader population feel about being forced to spend a minimum of US$50k on a new car? And will Germany really want to bankrupt its economically important auto industry by forcing them to sell cars people don't want and can't afford?<br />
<br />
It is also worth remembering that in the entire history of advanced civilization, there has never once been a transition to a technology platform that is less economically and energetically efficient than the prior model. In this respect, EVs are attempting a transition that is unprecedented - at least with respect to the current state of technology and relative cost structures.** Now, the world has also never been (or needed to be) more concerned about the impact of human activities on the environment either, so things could change. It is also possible that the heavy investment now going into EVs and batteries will yield significant innovations which change the current comparative cost calculus. However, it is far from guaranteed that these efforts will be successful.<br />
<br />
In short, the investment community appears to have jumped the gun on EVs in my opinion. Widespread adoption may well happen, but we do not yet have sufficient evidence to declare it a fiat accompli, as most in the investment community now have.<br />
<br />
What is most intriguing about this is that if markets are wrong about the coming EV transition, a company like Tenneco is likely to not only survive, but thrive. The company is a world leader in clean-emissions technology, for instance (what passes as 'high tech' these days is somewhat bewildering - writing some simple software that allows someone to manually go to a restaurant, pick up food for you, and take it to your door, is considered high tech, when coming up with the most sophisticated emissions-reduction technology in the world - a feat of advanced engineering - is considered old hat). If the EV transition fails because it is discovered to be uneconomic, by far the most likely Plan B around the world will be to force tighter ICE vehicle-emissions standards onto car producers. Tenneco will be exceptionally well positioned to meet this demand, particularly because auto companies are all preoccupied with rapidly building out their electrification capabilities at present, and are neglecting investment into ICE engine components (and are increasing outsourcing). There also aren't too many Silicon Valley start-ups racing to raise capital to invest in more efficient ICE engine technology either.<br />
<br />
Future outcomes are also not binary, and it is also quite possible - if not likely - that hybrids emerge as the preferred platform, as a compromise solution which are cheaper than full EVs (but more expensive than pure ICEs), but are more environmentally friendly than pure ICEs, and still allow for significant reductions in average emissions. Hybrids will also ease some of the challenges of full EV adoption (range anxiety; a lack of recharging infrastructure; and the customer inconvenience associated 20-40 minute charging times compared to a few minutes to refuel). This future will also be a good one for Tenneco as well, as core ICE engine components will retain their relevance. And all of this is before mentioning the fact that Tenneco also has a DRiV division that focuses on ride-control/suspension and after-market products that are immune from EV disruption risk (although they are not large enough to support TEN's group debt burden in isolation).<br />
<br />
All told, Tenneco looks to have a good risk/reward to me, because there is a <i>decent chance </i>the consensus view is wrong. But do I have conviction? No I do not. I don't hold the above views with any certainty - I merely think it is a possible scenario, whose probability is being underestimated. And it would be silly to have conviction in the outlook for company with high leverage, and where technological disruption could well lie in the company's future. Tenneco could well ultimately go to zero (or be required to issue so much new equity that it dilutes existing shareholders to something approximating that). But this lack of conviction and high risk profile does not make TEN a poor investment on a risk/reward basis - merely one that needs to be appropriately position sized on account of its large idiosyncratic risks.<br />
<br />
Opportunities like TEN are rife at present, because they fall between the cracks of the investment approaches/styles/philosophies that are currently widely practiced. Obviously, the growth and high-quality crowd are going to be uninterested in a stock like TEN, as will the momentum and macro crowd, given the current state of markets and prevalent macro anxieties. But intriguingly, the vast bulk of value investors are also uninterested, as the majority of them insist on high-conviction and concentration, often quoting Munger in defense of such an approach (the tremendous irony here is that Munger reportedly purchased TEN around the turn of the century when it was very cheap, and made a tonne of money). Consequently, companies like TEN face an almost complete absence of willing buyers at times like these, and can therefore fall to extraordinarily low prices.<br />
<br />
This highlights yet again the importance of adaptability in markets. Where the best opportunities happen to reside is always changing, and a flexible approach is essential. There are times when a concentrated approach focused on high quality stocks makes sense, and there are times - like the present - where it makes much less sense. This is something I wrote about in more detail in my article on <a href="https://lt3000.blogspot.com/2019/01/fishing-where-cod-is-and-mungers.html">fishing where the cod is</a>. Fixed rules about the appropriate level of concentration therefore don't make a lot of sense to me - <i>the appropriate level of concentration reflects the nature of the present opportunity set </i>- and dogmatic adherence to certain rules like 'we don't invest in cyclicals'; 'we don't invest in companies with high leverage'; or 'we don't invest in capital intensive industries such as auto suppliers', doesn't make a lot of sense to me either. As always, flexibility and the capacity for independent and original thinking are essential to success in markets.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<i>*Incidentally, those bullish on the LNG market, and particularly US exports of LNG, based on an expectation China will significantly increase LNG imports in coming years (as they substitute domestic coal for clearer natural gas), may be overlooking geopolitical risks to this view. If you were China, given the current state of geopolitical relations between China and the US, would you really want to rely on US LNG imports for your energy security? This is one reason I own China Shenhua Energy - China's largest and lowest-cost coal producer (the main reason is because it is very cheap).</i><br />
<br />
<i>**When energetically more efficient, transitions also often happen relatively fast - after the invention of the automobile, the horse was almost completely displaced within 20 years. Tesla has now been in business for about 16 years, and EVs still represent only about 1% of global automotive sales. </i><br />
<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-14973467967751439052019-08-14T11:41:00.002+07:002019-08-14T11:57:46.227+07:00Why P/E multiples are (justifiably) lower in periods of high inflationThe history of financial markets makes it abundantly clear that empirically, P/E multiples have sharply compressed during periods of high inflation. This has confounded many observers, who argue that stocks are real assets, and therefore that P/E multiples ought not change during periods of high inflation. Indeed, seemingly confirming the theory, nominal EPS growth has been significantly higher during periods of high inflation. US Market EPS growth, for instance, was much higher in the inflationary 1970s than the relatively low-inflation 1980-90s, despite much poorer economic and financial market performance. The latter occurred because multiples sharply compressed. Is this a major inefficiency?<br />
<a name='more'></a><br />
It's not. The observers who argue P/E multiples should not justifiably significantly decline during periods of high inflation have missed two important points: (1) P/E multiples are multiples of <i>nominal</i> not real earnings; and (2) the impact of taxes. Allow me to explain.<br />
<br />
Suppose a company is earning a 10% RoE in a period of zero inflation. Both its nominal and real RoE is 10%. It is not growing, so it pays it all out as a dividend. Suppose the company trades at 1x book value, or 10x earnings (and a 10% yield).<br />
<br />
Now let's take exactly the same company earning the same 10% real return on equity, but this time posit an environment of 10% inflation. The company's nominal RoE should now be 20% (to preserve the same 10% real RoE). Because the real RoE is the same, the company should still trade at the same 1x book (ignoring the impact of taxes - see below). However, this is now 5x earnings. In addition, in order to preserve the company's real asset base at a constant level, it will now need to retain half of its earnings, to grow its book value 10% a year (in line with inflation), reflecting nominal increases in working capital in line with inflation, as well as the higher nominal replacement cost of fixed assets as they depreciate and are replaced. The company's dividend payout ratio will accordingly drop to 50%, and it's dividend yield will remain the same - 10%. This is also a real yield, as dividends will rise 10% pa (20% nominal RoE x 50% retention rate), offsetting the impact of inflation.<br />
<br />
This is the same company earning the same RoE, and yet the P/E multiple in the first scenario is 10x, and in the second 5x. The error made by observers is in using <i>nominal</i> P/E ratios instead of <i>real</i> P/E ratios. What ought to be done to work out a real P/E ratio, is to subtract the rate of inflation from the nominal RoE to derive the real RoE, and compare that real RoE to the company's P/BV. The formula should be as follows:<br />
<br />
P/E real = Price-to-book / (Nominal RoE - inflation), or equivalently:<br />
P/E real = Price-to-book / Real RoE<br />
<br />
In our first example (10% RoE with zero inflation), we derive:<br />
<br />
1.0x / (10% - 0%) = 1.0x / 0.10 = 10x<br />
<br />
In our second example (20% nominal RoE with 10% inflation), we derive:<br />
<br />
1.0x / (20% - 10%) = 1.0x / 0.10 = 10x<br />
<br />
In other words, while it is true that <i>real </i>P/E ratios should not decline during periods of high inflation (before adjusting for taxes - see below), it is absolutely true that <i>nominal </i>P/E ratios should decline - indeed meaningfully so. It is amazing to me that no major academic I am aware of has ever recognised this reality and why, nor have most commentators, including many heavyweights of the investment world. It is merely insisted stocks' earnings are real and hence P/E ratios should not change.<br />
<br />
This exercise is not purely theoretical, in a world where low inflation now prevails. A serious valuation mistake made by many investors based in developed markets when they invest in high-inflation emerging markets, is to seriously misprice stocks by not taking into account inflation differentials. Places like India have been an obvious example. I have seen many typically first-rate DM investors argue certain stocks in India are cheap at 20x P/E, because they are growing at 15% a year with 15% RoEs (3x book), but that growth was being struck in an environment of 6-7% inflation. The real RoE was closer to 8-9%; real EPS growth was 8-9%, and the real P/E was therefore closer to 35x. Would they pay 35x for a company with a 8-9% RoE in the US/Europe?<br />
<br />
The difference between perceived value and actual value has been reflected in substantial currency depreciation over time (the Indian rupee has fallen from 40 vs. the USD to 70 since 2010, due to elevated inflation differentials, <i>not </i>mean-reversionary currency volatility), which unsurprisingly given the valuations paid, has yielded poor returns over the past decade on a dollarized basis. "Our stock picks have performed well, we merely lost money on the currency", is a common refrain. Well, of course you did! You also see the same mistake made whenever you read a headline that says 'EM markets trade at a significantly lower P/E to DM', implying that that makes EM cheaper. Until you adjust for inflation, you cannot make such a proclamation.<br />
<br />
The same is also true in reverse. Banks in the EU and low-inflation markets such as South Korea, for instance, have lower RoEs of 8-10%, vs 15% in places like India and Indonesia. But because inflation is so low in those former markets, the real RoEs are actually not that dissimilar. And yet banks' P/BVs in India/Indonesia are 2-5x, whereas they are closer to 0.5-0.7x in Europe/SK, as investors labour under a 'money illusion'. It's as if bond investors compared nominal bond yields/interest rates in Turkey of 15% vs. 2% in the US without taking into account the impact of widely variant rates of inflation. It's foolish, and yet the practice is fairly widespread.<br />
<br />
The second reason why P/E multiples ought to decline in a higher-inflation environment (and <i>real</i> P/E multiples this time) is the way taxes on investment profits/capital gains are typically levied. Typically taxes are payable on <i>nominal </i>gains, instead of the more appropriate <i>real </i>gains.<br />
<br />
Consider again our initial example, but let's now also assume capital gains and dividend taxes are both 20%. In the first example (10% RoE; zero inflation), the nominal and real pre-tax return is 10%, and the after tax return is therefore 8% real and nominal. However, if inflation is 10%, nominal returns are now 20%, yielding a nominal after-tax return of 16%, <i>which is only 6% real</i>. When inflation is high, the implicit tax rate on real returns significantly rises, and this justifies not only lower nominal P/E multiples, but lower <i>real </i>P/E multiples as well.<br />
<br />
This is a long-standing problem with the tax system. In my opinion, taxes on investment profits (both capital gains and interest - dividends alone are less of an issue) should only assess taxes on the real portion of the gain, netting off the change in CPI during the relevant period from the return. However, in practice this has not occurred and is unlikely to occur, which means lower real P/E multiples are also justified in high-inflation periods. When the nominal-to-real P/E adjustment is also made, it is clear that in combination, <i>very significantly </i>lower P/E multiples are economically justified in periods of high inflation - particularly for investors subject to high rates of capital gains taxes.<br />
<br />
Intriguingly, the reverse is also true. We are currently living in a low-inflation world (in developed markets). That means the quality of the nominal RoEs being reported by companies is now much higher than it has been in the past, and despite that fact, <i>nominal </i>RoEs are currently also high in places like the US relative to historical standards (although this is partly offset by a higher portion of offshore earnings deriving from high-inflation economies - this is perhaps one reason why nominal RoEs are meaningfully above historical averages). <i>This means significantly higher nominal P/Es are economically justified viz-a-viz historical averages</i>.<br />
<br />
It is interesting that this reality is almost never taken into account by market observers/strategists, who simply compare current <i>nominal </i>P/Es to historical averages, without taking into account the fact that rates of inflation have significantly fallen. They then simply conclude markets are expensive because nominal P/Es have risen above historical averages. Perhaps low inflation is one economically-justifiable reason why nominal P/Es are above historical averages?*<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
*<i>That is not to say markets are not expensive. In many sectors/markets, they are. However, they are less expensive than they first appear relative to historical averages on account of lower inflation.</i><br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.comtag:blogger.com,1999:blog-5378355227461989213.post-37893274146707136762019-08-14T10:05:00.001+07:002019-08-14T10:35:22.822+07:00Why profits matter (and value investing is not dead)We have currently reached the point in this (unusual in many respects) cycle where many investors/commentators have started to question whether profits no longer matter, and also whether value investing is dead. As is often the case, the arguments put forward in the affirmative derive mostly from recent market experience/outcomes, rather than reasoning from first principles. Hyper-growth (and generally loss-making) tech companies have seen outsized share price gains (or when privately-held, significant valuation up-marks), with many recent IPO vintages also seeing triple digit gains, despite the absence of any profits either in the past or foreseeable future, in echos of the dot.com bubble. Meanwhile, many profitable and cash-generative companies with low growth, and especially with (even marginally) falling earnings/revenues, have been absolutely massacred.<br />
<a name='more'></a><br />
Shunning the former and buying the latter stocks has been a generally losing strategy over the past several years, as profits have stagnated/declined for many constituents of this group and multiples significantly fallen, whereas loss-making companies have galloped ahead as sales have rapidly grown and P/sales multiples have also dramatically expanded. Quite naturally, given the propensity of investors/commentators to extrapolate recent experience forward, it is now an increasingly subscribed belief that profits (and particularly near term profits) don't matter, only revenue growth.<br />
<br />
This line of thinking is a bubble, and in the sober light of the eventual bust, will be acknowledged to have been as such, in my view. In truth, profits are vitally important, not only because that is the only means by which stocks ultimately generate returns for investors (as Buffett has said, in the aggregate, investors cannot take more out of the market than what companies collectively earn - a truism that is indisputable on a first-principles basis), but also because profits (and losses) are absolutely vital to the healthy functioning of a capitalist economy, and indeed are the ultimate test of whether a company is doing anything worthwhile at all. Allow me to explain.<br />
<br />
If you think about what it is that companies ultimately do at a base level, it is to attempt to combine scarce inputs (capital and labour) in a way that generates an output of greater value than the sum of the combined inputs. They attempt to fulfil the equation 1 + 1 > 2.<br />
<br />
Companies that succeed in transforming a given level of inputs into outputs of greater value (in the form of useful or desirable goods and services) will be profitable. This is important, because it ensures a net inflow of resources (profits, the monetary value of which reflect claim-checks on society's resource inputs) into such companies, which are 'adding value' by utilising society's scarce resources efficiently. This allows these companies to reinvest those resources and expand (or for mature companies, to sustain their current existence while paying returns to owners - freeing those excess resources for more productive re-deployment elsewhere).<br />
<br />
Conversely, companies that use resources inefficiently, and produce less output value than the value of their consumed inputs - where 1 + 1 < 2, so to speak - will be unprofitable. This unprofitability is equally important to the healthy functioning of a capitalist system, as it deprives the said companies of reinvestable resources, and will ultimately lead to bankruptcy. When this ensues, it may be painful for some of the individuals involved (e.g. the employees who lose their jobs), but it ensures the scarce resources these value-destructive enterprises were consuming are freed up and are able to be redirected to organisations able to use resources in more productive and socially useful ways.<br />
<br />
This bottom-up process is an important component of why capitalism drives economic growth and rising living standards over time. The process allows a growing share of society's resources to be steadily redirected to the control of companies/individuals able to utilise them most efficiently, and in ways that maximally satisfy unmet needs or wants. No foresight or central planning is needed - it happens in a spontaneous, algorithmic way very much akin to Darwinian evolution in nature. And an important corollary is that failure is as important as success to a thriving capitalist economy. It ensures resources are not perpetually tied up in wasteful and inefficient activities (this is also why low taxes and small government is good for economic growth - it hastens the flow of resources to productive managers of those resources subject to market discipline).<br />
<br />
However, something very interesting has happened over the past decade or so: this process and the normal market discipline imposed by the need for profitability has broken down in many areas of the economy (those touched by VC-funded tech), as loss-making companies have not only been allowed to survive, but also rapidly grow, while resources have increasingly been drained away from profitable companies. While the growth of many loss-making tech enterprises is often seen as healthy 'disruption' typical of Schumpterian creative destruction, the real truth is that many of these enterprises are actually value destructive. In many cases, they have only grown because an extraordinary amount of capital has flowed into venture capital (VC) and other (predominately) tech based funds, which have allowed their investees to not only sustain their existence in spite of large losses, but continue to rapidly grow, when market forces ordinarily would have resulted in their swift bankruptcy. It doesn't matter if 1 + 1 < 2 if investors are prepared to keep tipping exponentially more money into the business. You can still survive, and indeed grow rapidly, so long as the funding spigot remains on.<br />
<br />
The conventional wisdom is now that profits don't matter for hyper-growth tech upstarts, because acquiring scale (users and revenues) ought to be given due priority, and a 'path to profitability' can be sought later, aided by economies of scale. Now I'll accept that there are some instances where this reasoning is valid - winner takes all/most platform companies with scalable economics, for instance. Another seemingly obvious example would seem to be many SaaS businesses who are providing genuine economic/productivity benefits to their customers/the economy, where the cost of customer acquisition is being expensed upfront, but where the unit economics (in terms of the lifetime value of customers relative to the cost of their acquisition) are highly attractive. However, <i>the issue here is actually not the lack of profits, but the accounting</i>. Accrual accounting is supposed to match expenses with revenue, and there is a serious 'matching' problem with writing off the full cost of customer acquisition up-front for these businesses. The CACs actually ought to be capitalised and amortised over the period of expected customer activity (the same way life insurance companies capitalise policy acquisition costs). If this accounting approach was undertaken, many supposedly unprofitable SaaS businesses would actually be robustly profitable.<br />
<br />
However, this 'it's just the accounting' calculus does not apply to a large number of other upstart tech companies/Unicorns, including many online e-commerce businesses, as well as various online service segments such as ride-hailing. Here, the absence of profits (and indeed, the existence of large losses), is actually a serious issue, because it calls into question whether the companies are in fact generating any economic value at all, or are merely giant engines of value destruction. To the extent that this is the case, what we are actually witnessing with these companies is not healthy disruption/innovation, but instead simply a giant <i>misallocation of capital </i>- something that is a hallmark of almost all bubbles.<br />
<br />
I have <a href="https://lt3000.blogspot.com/2019/05/uber-delusion-and-ride-hailings.html">written about Uber in the past</a>, and it is an archetypal example. The company recently reported its 2Q19 results - its first as a listed company - and true to form, the company booked another quarter of negative <i>adjusted </i>EBITDA of some US$650m - extending a long period of sizable losses without any clear trend towards improvement. This is before including the cost of recurring and economically material stock-based compensation expenses (albeit this line-item was inflated well above-trend in 2Q19 on account of significant crystallised gains following the company's IPO).<br />
<br />
I discussed in my Uber article why the ride-sharing business may very well be consuming more resources than the value of the output delivered, given the inherent economic inefficiency of the average punter being chauffeured around town when they could drive themselves or use alternative forms of transportation. The loss making nature of the business is providing false price signals to the economy about the resources required to provide the service, making it appear to be a more efficient choice, when in fact the cost of the service is not being reflected in the price paid. Market share and resources are therefore being misallocated. The taxi business has long existed (ride-sharing without the online interface), but has been consigned to niche applications because of the inherent economic inefficiency/cost of two people sitting in a car instead of one. It is a waste of society's scarce labour resources, unless there are good reasons why someone can't drive themselves (intoxicated; short trips in built-up areas like NYC with a scarcity of parking; travelling or heading to/from the airport, etc).<br />
<br />
While the bulls argue Uber's losses reflect a 'lack of scale' - an argument made despite the fact that the company has been in business nearly a decade, and has already has acquired tremendous scale - the truth is probably more that the lack of profits reflects the fact that the business model is actually consuming more resources than the value of the economic output it is producing. That reality has required that they price their service below the cost of its provision in order to grow, which is why they have lost more and more money as they have scaled. If the above were not true, they would be able to provide the service profitably <i>and </i>grow. Even if there was vigorous competition, the industry ought to be able to operate at at least break even levels. The same can be said of Tesla. They have built many great cars. I've been in a Model S - it's very cool. But the company keeps burning cash because the cost of the inputs continues to exceed the value of the output.<br />
<br />
This is why profits matter. <i>It is evidence that the product/service is economically viable, and that the value of the output exceeds the cost of the inputs.</i> Many investors today are currently impressed with rapid rates of revenue growth, regardless of the state of the bottom line, but as far as I'm concerned, <i>high rates of revenue growth are a complete irrelevance and are unimpressive if a company has not demonstrated that that revenue growth is in conformance with the equation 1 + 1 > 2</i>. If that equation is not met, then rapid revenue growth does little more than destroy more and more value at a faster and faster rate. <i>It's not worth anything. </i><br />
<br />
At base, what the current zeitgeist of ignoring profits and focusing only on revenue growth in upstart tech businesses is enabling is not a hyper speed of innovation and economic growth, but rather simply the widespread misallocation of capital (and labour). Furthermore, the consequences have not just been the excess allocation of capital to value-destructive enterprises, but also the concomitant draining of capital from profitable, value-creating enterprises, not only through reduced access to funding (lower share prices), but due to lower sales/market share/profitability.<br />
<br />
Suppose you're a profitable business meeting the equation 1 + 1 = 2.5, but new well-funded entrants come in with 1.3 + 1.3 = 2.0 economics. The new entrants will underprice you and take market share, which will pressure both your revenues and your profitability (as you need to reduce prices to stem the loss of market share, and suffer operational deleverage as volumes fall).<br />
<br />
What ought to happen is that the latter company ought to fail, but instead, as funding markets shower more and more money on your loss making competitor, it continues to grow and take more and more market share off you. Your profitable enterprise suffers falling sales and profits, and on account of the widespread perception that your company is being 'disrupted', it also suffers a massive decline in its trading multiples. The net effect is to deprive your company of investable resources.<br />
<br />
Something akin to this has been happening across an array of industries, from automobiles (Tesla vs. traditional automakers), to e-commerce/retail and streaming/traditional media, and dovetail into the second much-discussed trend in recent times - the apparent 'death of value investing'. There have been many causes for the record underperformance of value vs. growth in recent years, but one much under-discussed cause has been the fact that profitable, cash-generating 1 + 1 > 2 companies have been forced to compete - to an unprecedented degree and for an unprecedentedly long time - with loss making, 1 + 1 < 2 companies, who have been taking market share and pressuring profits.<br />
<br />
Much as with the dot.com bubble and its subsequent unraveling, where many 'old world' value businesses were left for dead and considered destined for disruption/the dustbin of history, only to stage dramatic recoveries in the following decade, a likely consequence of the coming tech wreck will be a significant resurgence in the performance of many 'value' stocks, as their sales, market share, and profitability recover as 'disruptive' competitors go broke, and their multiples dramatically recover.<br />
<br />
When will the reckoning occur? It is impossible to say, but it will occur when the funding bubble bursts, and companies are forced to once again fund themselves from operating cash flow. Much as in the dot.com bust, there will likely be widespread bankruptcies at this point, along with disillusionment and a much-overdue questioning of many now widely-held assumptions. Once again, we will probably be reminded that the old rules do still do apply after all, and that this time wasn't different.<br />
<br />
What will be the tipping point? In my opinion, it will be the point where the pace of cumulative losses across the upstart tech ecosystem starts to exceed the pace of new upstream fund raisings into tech/VC funds, as well as in the public IPO market. The reverse has been true in recent years - the pace of fund raising has exceeded cumulative Unicorn operating losses - with a major contributor being Softbank's outrageously-sized US$100bn 'Vision' Fund. Incredibly, Softbank has already blown through the majority (US$85bn) of this funding in only two years, and its deal-making spree has been a meaningful contributor to squeezing Unicorn valuations sharply higher at a time when other VC fund raising has also been active. Softbank et al's epic fundraising and investment splurge has absorbed all of the Unicorns' underlying losses, and then some.<br />
<br />
But the pace of operating losses continues to mushroom, and Softbank is now running out of money. As a result, Softbank is currently trying to hastily prepare a second US$100bn Vision Fund to keep the house of cards intact. Time will tell whether they succeed. The pace of IPO activity has also hastened, which suggests that even the flush private VC funding market is starting to struggle to keep pace with the rate of underlying losses its needs to fund, so it is starting to tap the public market.<br />
<br />
It remains to be seen how long the music will keep playing. However, as the amount of aggregate upstart losses grows (which must happen if all this VC funding is to be absorbed), at some point the equilibrium point will be reached where the pace of fund-raising falls short of these aggregate losses. This could occur, for e.g., if Softbank is less successful with its Vision Fund 2 fund raising than it hopes, and/or more high-profile IPO failures such as Lyft/Uber sour the market's appetite for Unicorn IPOs to the point where meaningful negative marks need to be taken by VC funds when they monetise their investments via IPO (notable also is that the listing of Uber et al will now expose a growing share of the Vision Fund's investments to potentially significant mark-to-market losses, impairing its ability to manufacturing paper gains by funding - sometimes as the sole bidder - up-rounds in its investees). At this point, capital will become scarce and Unicorn valuations will start to fall, as loss-making enterprises compete for scarce funding to keep the lights on.<br />
<br />
This will result in negative valuation marks being taken by VC funds/the Vision Fund, which will then in turn sharply dampen the appetite for investors to tip more more money to these funds (high apparent returns and 'low volatility' have been their chief attractions, particularly as pension funds, insurance companies, etc, try to replace lost income from falling bond yields with the illusory high returns/low volatility provided by private equity/VC vehicles - another disaster in the funded status of these investors' long-tailed obligations that is waiting to happen). The whole ecosystem will then start to quickly unravel, and an epic bust likely awaits the sector (my prediction is that investors in the Vision Fund(s) will ultimately lose the majority of their investment, and Masayoshi Son will no longer be seen as a visionary, but instead as a poster-child for this cycle's utterly irrational excesses).<br />
<br />
It remains to be seen when this happens, and what the broader macro implications are (i.e. if it's enough to generate a recession in the US), but it certainly promises to be interesting.<br />
<br />
<br />
LT3000<br />
<br />
<br />
<br />
<br />
<br />
<br />Lyall Taylorhttp://www.blogger.com/profile/18230748365980023462noreply@blogger.com