- A.A. Milne “Pooh Wisdom”
“Have you ever stopped to think that maybe you were wrong? Maybe, you only saw your point of view and you never once put yourself in the other person's shoes. Maybe, walking away from the senseless drama and spiteful criticism isn't the best thing to do. Maybe, for just once in your life you could wear another person's confusion, pain or misunderstanding. Maybe, your future doesn't require explaining yourself or offering an explanation for your indifference, but your character and reputation does. What if one day you find out that you didn't have all the information you thought you did?”
- Shannon L. Alder
Looking back over the past five years or so, I estimate that I’ve authored roughly 1,000 pages of writing in about 350 articles and one book on value investing. You would like to think that each page contains a nugget of wisdom or perhaps an entire article can change a reader’s life. But it really doesn’t work that way. Nearly everything I’ve ever written about has been discussed previously - whether it be about value, risk, discounted free cash flow or even my sentimental favorite about Abraham Wald and inversion (you can read the article, “Mutual Fund Survivorship: The Revenge of Abraham Wald”, here ).
So it comes as some surprise that I find myself in the same position as Pooh. I’m not lost because I know where I am. But where I am may be lost. In my comparably short twenty years of investment management, some things seem pretty familiar (slowing economic data, arguing over Federal Reserve rate policy, high deficit spending, etc.). However, I increasingly find myself at sea in conditions I’ve never witnessed - let alone considered. These include negative yields, tariff wars, and a Federal government that increasingly resembles a completely dysfunctional reality television show.
Some Things Remain The Same...
There are some things that have remained the same over the past several years as the markets have become increasingly volatile and upended. For instance, I remain strongly resolved in my investment strategy and criteria. I still believe finding companies working in a monopoly/duopoly environment and deeply embedded in their customers’ operations leads to long-term growth. I still believe companies generating high returns on capital and converting a significant percentage of revenue into free cash flow are the best investments over the long term. I still believe overpaying and not having a margin of safety creates the best odds for long-term underperformance. Finally, I still firmly believe partnering with moral leaders who are outstanding capital allocators is the engine that drives decades long market outperformance.
It isn’t just my investment criteria that have remained mostly consistent. Some market issues are the same today as they were decades ago. The battle between balanced budgets and deficit spending - while not as thunderous as in the Reagan years - are still fought out in the halls of Congress. The debate about the role of financial policy versus monetary policy echoes between 1600 Pennsylvania Avenue and the Capital just as strong as when FDR landed on the shores of Keynesism. The argument of when to raise or ease the Federal funds rate is as cantankerous today as when Bill Martin threatened to take the punch bowl away in 1955.
...But Some Things Are Completely Different
As we look out and see many issues that resemble the past, there are some conditions that are so strikingly new, investors (both individual and institutional) have no historical data to help them make informed decisions. For value investors, these issues are creating a deep fog which is nearly impenetrable in their complexity and novel nature. There are three which I believe have the capacity to create the next severe market dislocation.
Negative Yielding Debt
Let’s take negative yielding bonds for instance. Throughout history, people have saved by loaning the government their cash with the idea of getting their principal back plus interest. As of 2019, sovereign governments are being paid for borrowing money (or by inverting it: people are paying the government to invest their cash). This has been driven by desperate savers trying to find any safe option for their more liquid investments. Starting with Sweden and followed by other countries including Germany, $16 trillion in global debt is now being traded at negative yields. The impact of such conditions is relatively uncertain, but what we are learning about some of them isn’t pretty. For instance, Denmark is currently offering negative yield mortgages, meaning a bank will pay you to finance the purchase of your home. Many are realizing this model will provide an enormous pressure on housing prices (who wouldn’t borrow under these conditions? Who wouldn’t borrow as much as you can? The more you borrow, the bigger the check). As almost all market crashes are brought on by a.) easy credit standards b.) too much leverage and c.) and concentrated asset price inflation. Does no one see a potential problem here?
U.S. Debt Default
Regardless of your political affiliation, I believe it’s safe to say no net-saver has heard - or ever wanted to hear - the President of the U.S. say the federal government could simply renegotiate/default on its debt obligations in the case of a recession. In an interview in May 2016 then-candidate Donald Trump said:
“I would borrow knowing that if the economy crashed you could make a deal. And if the economy was good it was good so therefore you can't lose. It's like you make a deal before you go into a poker game. And your odds are much better.”
For over a century the U.S.'s debt has been the perceived as the rock of the global financial markets. Yet, over the past 10 years we have seen filibusters on increasing the debt limit (or as one pundit called it “a rolling, bumbling uninformed default”), and a downgrade by Fitch in 2011 by one notch from AAA+ (the highest possible rating) to AA+ with a negative outlook. In 2013, as a result of the aforementioned filibuster, rating agencies threatened to downgrade US debt credit rating again due to “political brinksmanship”. With the current administration we have seen an increase in financial and budgetary uncertainty. The 2017 tax cuts will add roughly $2 trillion towards our national debt. This allowed the President to follow up his renegotiate/default statement with his view to not worry about this new debt because “he won’t be around” to see its impact. Interest payments - as a percent of the total federal budget - will reach record highs through 2022.
Free Trade to Trade Wars
Another change has been the complete rejection of the post-WWII push for free trade and open markets with multiple trade wars and tariffs on friend and foe alike. New tariffs on Mexico, Canada, China and potentially all of Europe have injected enormous fear and uncertainty on where the world economy is headed and whether we are suddenly barreling towards a global recession. Just in the past few years we have seen the US scrap the NAFTA Treaty between the US, Canada, and Mexico with a new as-yet-proposed USMCA (United States, Mexico, Canada Agreement). China trade talks have been placed on hold as the US has pressed forward with wide-ranging tariffs on nearly every import into the US from China. Things have gotten ugly enough that President Xi was called “the enemy” (along with the Federal Reserve Chair!) in an August 2019 presidential tweet.
What This All Means
The question for investors - both individual and institutional - is where do we go from here? How do we take into account all of these changes into our investment strategies? As Shannon Alder said, what if we find out one day that we don’t have all the information we thought we did? To offset these concerns and worries, I suggest investors ask themselves the following questions.
Are My Goals Impacted By These Events?
I recently overheard a great comment in a conversation between two investors. The first investor asked the second what impact the President’s tweets had on his retirement strategy. The second replied “Not a damn thing. My goals haven’t changed a bit. My goal was to fully retire at 70. Has any tweet changed that? Nope. Have they helped me get there? If anything, they’ve made it harder.” Remember that for all the noise going on out there - whatever your goal is - stick with it. Keep your eye on that ball because it’s the only one that matters.
What Part of My Investment Strategy is Impacted By These Events?
Take a sheet of paper, divide it in half, on the left side put the major components of your investment strategy (invest in stocks with 10 year ROE > 15%, invest in companies with no debt, etc.) and then put the major issues happening in the market place (China tariffs of 15% on X products, $15T in negative yield bonds, etc.) on the right side. Begin by assessing exactly what impact the right will have on the left. Really drill down to what is a risk (an event with a defined % chance of happening) and what is an uncertainty (the chance of it happening can’t be quantified). Then ask yourself what changes you might need to make to keep up with your goals.
What Part of My Portfolio is at Risk?
After assessing the risk on your strategy, begin trying to calculate what effects these market events will have on your portfolio companies. Remember: some of these risks and potential outcomes are simply unknowable. We’ve never seen negative yield government bonds from Germany. We’ve never seen 15% tariffs on nearly all Chinese imports. The ability to see impacts from both an integrated level (how do US Chinese tariffs impact Germany’s 0% economic growth rate?) as well as time-wise (How long would it take to for a negative yield bond environment to impact the US housing refinance market? Two years? Three years? Five years?) can be very helpful as you try to calculate into the future.
What Steps Can I Take to Mitigate These Risks?
Finally, you need to ask yourself, how do I mitigate risks that I‘ve identified in these market conditions? If your retirement income is going to fall short by roughly 25%, what steps are a.) required and b.) possible to fill that gap? It will be essential to model in ranges simply because so many of this is based on unmeasurable factors – uncertainties not risks. Always remember that this planning and estimation is an art not a science. You are seeking a margin of error, not a bullseye.
The past decade has taken investors on a whirlwind tour. Starting with the 2007 – 2009 Great Recession and associated market crash, this has been followed by a 10 year bull market accompanied by sluggish growth and startling political instability. It’s been a period when investors have become remarkably complacent in nature, with the VIX achieving all- time lows. Since December 2018 volatility has roared back with dramatic swings in the markets, politics has become increasingly bellicose and unhinged from reality, and companies going on debt-fueled stock buy backs. As I’ve written previously, danger signs are flashing across the markets and the economy. In this time of uncertainty and economic "creativity", investors have all the reasons in the world to go back to their core values – investing in value not price - buying the tried and true, and deleveraging your personal and investment lives. Be like Pooh. When a crisis hits know where you are – and most important – know where you are going.
As always, I look forward to your thoughts and comments.
 The treaty has come under intense pressure after the US announced new tariffs on Mexico and Canada in a clear violation of the new agreement. In fact, it hasn’t even been approved by the United States Senate as of August 2019.