- John Reed
“Trying to figure out whether your core values are relevant in today’s world is a real struggle. We are told we can’t be a stick stuck in the mud, but we also can’t be shackled to out-of-date beliefs due to commitment bias. So which is it? All we can do is continually update our principles with new data, test them, and use a Bayesian approach. It’s not easy, but it’s the only way we know of updating our thinking in a rapidly changing world.”
- Hancock Brower
Last week I wrote about how we approached our thinking at Nintai Investments by using a first principles approach. We’ve believed for a while - and seen evidence to reinforce this thinking - that this way of looking at the world provides us with a strong framework for analyzing long-term trends.
All that being said, I have found there are times when first principle thinking can lead you astray. The first large area of weakness is when the first principle thinker has little or no knowledge of the subject matter. In these cases it is possible for the person to get the entirely wrong end of the stick. Solid thinkers will realize in these cases that the first principle approach will be more powerful in asking pertinent questions than identifying basic building blocks of the subject matter. For instance, I’ve seen several brilliant first principle thinkers make terrible suggestions for improving the US health care system. In general, this is because the individuals have distilled first principles into facts that might seem as underlying the industry, but are rather far off from reality. As an example, some of the best minds have simply missed the fact that the US healthcare is made up of three distinct parts - federal and state social insurance (Medicare, Medicaid, etc.), for-profit corporations (Merck, Anthem, etc.) and not-for-profit organizations (Catholic Health Initiatives, Blue Cross Blue Shields, etc.). Any first principle has to address this very unique structure and how it might be improved. Ideas such as Medicare For All or a fully deregulated capitalistic health care system fall far from the basic realities of the current system.
The second large area of weakness - and one that matters a great deal to traditional value investors - is when facts begin to emerge that fundamentally alter your first principles developed over time and experience. As an example of this, I have lived in a capitalistic system that has always operated under the principle that higher risk means higher rewards. This means that - in general - longer term bonds yield more than short term bonds (longer term agreements bear the higher risk of inflation than shorter term) or individuals/companies/countries with lower credit quality pay higher interest rates than those with great credit. Yet, we live in a time where the yield curve is not only inverted, but two additional facts are present.
- As of the end of June 2019, the 10 Year US Treasury yield sat at 2.05% versus the Greek 10 Year at 1.98%. It’s hard to imagine the markets are trying to tell us the Greek government’s credit quality is better than the United States’.
- As of the end of June 2019, there is $13T of sovereign debt yielding a negative interest rate. Negative interest rates? To this degree, this hasn’t happened in the history of modern finance.
For many value investors (as well as economists and political consultants) first principles such as “higher risk/higher reward” have been falling like dominoes over the past decade. Yet, as I break down these realities down to their basic fundamental assumptions, they still make no sense to me. However, the old ways of doing things (analogies - like when I built out my first company) sometimes simply aren’t around anymore.
To better understand what this means as a value investor, let’s break down the facts related to the $13T in negative interest rates. Utilizing first principle theory, we want to ask questions that will better define the main facts behind the theory - and practice - of central banks utilizing negative interest rates.
- What is causing governments to issue debt at negative interest rates?
- What impact does this have on the sovereign debt markets as well as larger overall debt markets?
- What could cause this policy/market trend to end?
Question 1: Negative interest rates (as a government policy) were used by Sweden in 2009 when its Reserve Bank cut its overnight deposit rate to -0.25%. The European Central Bank was next when it lowered its deposit rate to -0.1% in 2014. Since then other countries in Europe and Japan have employed negative interest rates. Countries have employed negative interest rates for two reasons – trying to head off a deflationary cycle and to lower the value of their currency. In the former case, countries hope to stimulate lending (banks would rather lend - even at extremely low rates - than pay the Central Bank to hold their money) thereby heading off deflation. In the latter case, negative interest rates will weaken demand the country’s respective currency. A weaker currency will strengthen export demands and stimulate the economy.
Question 2: Certainly the greatest impact for most investors has been the stretch for yield. One of the side effects of that is seeing Greece 10YR yields be less than US 10YR yields. I don’t think anyone would confuse the fact that the United States sovereign debt has less risk than Greek sovereign debt. The second major side effect is that European and Japanese banks have seen their bottom line negatively impacted. Forcing banks to pay for parking their cash at the Central Bank - combined with low lending rates – is a recipe for decreasing earnings. As much as we would sweep these events aside, the bottom line is the $13T in sovereign debt and Greek/US yield abnormality are the reality of the markets as of today. Ugly facts are indeed still facts.
Question 3: The question is how this ends or - even more broadly - does this end? Obviously a stronger economy or rising inflationary rates will put an end to the negative rate environment. But what if the economies don’t improve? What if the United States dips into recession and its rates go negative? Then what seems like an anomaly becomes a new standard. The principle of higher risk/higher reward might become - for an extended time - irrelevant.
Have Our First Principles Become Outdated?
So what’s a value investor to do? Are we destined to see this become a true “it’s different this time”? Or are we in a New Economy that was promised in 1999-2000? Have first principles – so long accepted in our capitalistic system – gone the way of the dodo? Or will we return to more classic economics that have driven capitalism since the time of the Dutch trading empire and Italian city states in the 15th and 16th centuries?
At Nintai Investments, we take a long-term view and see a middle-path going forward. The 2007- 2009 market crash and ensuing Great Recession fundamentally changed the way governments and their institutions see themselves in a capitalistic system. The interdependencies of the markets – along with risk whose depth and width is far broader than just three decades ago requires that sovereign nations find new solutions and roles for themselves going forward. Does this overturn the entire capitalistic/socialistic approaches that have driven US, European, and Asian economies over the last 50 years? We don’t think so.
But it does alter some of our first principles that have driven our thinking since getting into the business world all those years ago. We think some of the major assumptions we took for granted such as Keynesian economics (priming the pump), increasing multilateral approaches to the integration of the world economy (lower tariffs and international supply chains), and thoughtful, data-driven decision making will be altered or eliminated going forward. For instance - as an institutional investor - the very act of allocating capital continues to evolve. The long-term view continues to get shorter in length and decisions are increasingly made dependent on information from millisecond-driven social networks. Yet, increasing amounts of investors want nothing to do with high-fee, under performing active management. We see a current active managers have been swimming against only getting stronger. Has our first principles of patient, long-term investing based on valuation and margin of safety disappeared? We don’t think so. But it certainly continues to evolve.
In these topsy-turvy times, it seems like our guiding first principles have been eliminated as quickly and efficiently as the 1978 one-game playoff Boston Red Sox. However, we think it’s too early to write off some of value investing’s first principles. The bedrock concepts of value investing – valuation, margin of safety, and risk mitigation have not disappeared. But how we achieve these – and the frameworks we use to get there – have certainly changed in the last decade. Being able to adapt and evolve – while maintaining your first principles – has always been the mark of a great value investor. Whether it be Warren Buffett’s move from cigar-butt investing to great companies at fair prices or Nintai’s shift from quality balance sheets to hyper-quality balance sheets, if we don’t adapt then we die. By developing applying first principle thinking, the move along your own investing continuum doesn’t have to be - in John Foster Dulles’ classic phrase - an agonizing reappraisal. A well devised approach - as remarked on by Mr. Reed and Mr. Brower - can make evolution to your first principles as smooth as possible. In today’s raucous world, you can’t ask for anything more.
As always, I look forward to your thoughts and comments.