It is always difficult to know whether you are in the beginning, middle or the end of a mania. What is knowable is if a company is profitable and if that company has a dominant market position. Whilst the profits and market position of a more stable company and industry may change over time, they are generally far more predicable than picking winners in a mania.
In the early 1900’s, there were hundreds of car companies. Only a few survived.
Cars changed the world, yet investing in the car industry has been disastrous.
Investing in things that will change the world is often far more difficult than most comprehend.
Today, there are countless EV car companies starting up. Many are in China. Knowing which ones will survive, let alone win the race is almost impossible.
It is often far better to buy stable companies.
There are only a few alcohol, paint and lift companies in the world. They are stable, profitable, predictable and boring. Sadly, many of the boring companies are expensive and are being priced more like bonds.
Is it better to pay 35 times earnings for a boring company that is not growing much, or is it better to pay 100 times earnings for a fast-growing company, which may or may not be a winner in its field? The former is possibly the least worst option.
There are some exceptions to the rule when investing in things that will change the world. Some of the Software as a Service (SAAS) companies are building network effects that are insurmountable. They have a huge platform for growth and the more they grow, the stronger they become due to having more data. The margin expansion that is still yet to come is considerable. The problem at the moment is many have years of growth already priced in. The eventual growth slowdown may lead to many years of lacklustre stock performance. When is unknowable.
Fundsmith’s famous three rules for investing are:
Warren Buffett’s favourite holding period is forever.
These two outstanding managers rarely sell and generally don’t trim.
Whilst these two managers similar views are important for reducing tax and trading costs, the issue it presents is potential overvaluation in a portfolio. Coke got to 48 times earnings in 1998. It took 17 years to get back to their highs. Are there lots of Coke style multiples in today’s market?
We think there are.
The question as to whether to trim for a retiree or pre-retiree needs to factor in valuation risk as part of portfolio management.
If you are a retiree or pre-retiree with a portfolio of overpriced assets, your wealth may be at risk.
The concept of buy and hold makes sense in most market conditions, however many do not have sufficient assets in retirement to ride the waves of markets when markets get to extreme levels of over valuation.
For someone in or approaching retirement, sequencing risk is enormous. If you retire at the top of the market, you may not get the retirement you planned. Multi decade long drawdowns have occurred in various markets throughout history. If you don’t plan or have a strategy for managing these risks, you may be severely disappointed.
Drawing down on your assets during market drawdowns can eat away at your capital faster than most comprehend.
One way to manage sequencing risk is to use a dynamic asset allocation to reduce exposure to potentially overpriced assets. A static asset allocation of 70/30 may not work as well as it has in the past with rates so low and asset prices so elevated. Using a dynamic asset allocation may be a more sensible strategy.
Knowing the fair value of your investments is paramount for this strategy to work.
The low returns on defensive assets makes this strategy potentially more difficult.
Valor generally invests a client’s entire wealth. This distinction over other asset managers who often only manage a fraction of a client’s wealth is important. It means we can more accurately match a client’s risk profile with more appropriate investments for their stage of life.
We aim to combine a preference for long-term ownership of wonderful companies, similar to Buffett and Fundsmith, with a dynamic asset allocation strategy. We have owned a number of the companies in our portfolio for nearly a decade. We simply trim around the edges of these companies when they rise above their long-term average valuations and add back to them when they dip below their long-term average valuations. This has meant we often outperform on the downside and slightly underperform on the upside when we are generally more cautious.
In 2018, we trimmed twice before the two market corrections in February and November, then reallocated back during the market dips. This led to a 5.5% return for our growth portfolio during a market down year.
In January 2020, we were trimming due to some of our holdings rising above their fair value. Our caution then led to our March performance of -2.9% in a -20% market fall.
Unfortunately, we were too cautious during the March 2020 crash and whilst we avoided most of the crash, we didn’t participate in the rally as much as we should have.
We find ourselves in another strong market rally today. The markets look expensive on most measures. Having some dry powder for likely market volatility at some point in time is probably warranted, particularly for those that are in or nearing retirement.
Before 2020, we have never owned gold. Due to the historic levels of monetary stimulus, we have replaced a portion of our defensive component in gold to protect against the enormous fiat debasement which appears to be occurring around the globe.
As Buffett suggests on how to become wealthy:
Close the doors. Be fearful when others are greedy and greedy when others are fearful.
We are observing a potentially unhealthy bout of greed in global markets today. Be careful out there…
Concentration and Portfolio Management
One of the most common mistakes I have seen in the investment industry is betting big on risky investments. Whilst this is quite fine if you are in your 20’s and have decades of future savings ahead of you, the older you get, the less time you have to make up for your mistakes.
Many have used the Kelly formula concept without really thinking about the permanence of the capital.
If you add in the complication of capital additions and withdrawals, the maths for the Kelly formula should change.
If you have permanent capital, then I think that the Kelly formula works. If you are adding to your savings over a very long period of time, then I think the Kelly formula is perhaps not aggressive enough!
The converse is true. If you have fickle capital, then the Kelly formula simply doesn’t make sense as large drawdowns on your portfolio will further complicate decisions as capital will be withdrawn during the inevitable weak periods involved with concentrated bets. You become forced to sell at lower prices. Add in illiquidity and you have a one-way ticket to the fund graveyard.
If you have a need to draw down from your capital, such as retirement needs, then the Kelly formula is not appropriate.
In the investment industry, there is often a disconnect between investment managers and the end clients, which are often retirees. Retirees have less ability to handle large drawdowns.
The Core Satellite Approach
A common approach to reduce risk is to use diversification. Many advisers use a core satellite approach where they have index funds as the core and add in some stocks or funds for some hopeful alpha.
In a world where everything is overpriced, does diversification work like it did in previous generations? If most assets are returning -1% to 3% a year, diversification probably won’t work that well if you need 5% net returns to live. If many of the global markets trade at 3 times the price of where they have been during periods of weakness in the past, then diversification may not help.
Others use unlisted assets to attempt to manage volatility. The main issue we have with unlisted assets is the transparency is very limited and leverage is often higher than what we are comfortable with. In a rising rate environment (something that hasn’t happened in many decades) are these vehicles able to maintain their returns? Are elevated prices for these assets riskier than their short-term volatility suggests? Are managers marking assets to reality? Has Brisbane Airport been marked properly to its fair value during Covid-19? Are new investors coming in at elevated valuations?
We live in a low return world where the future average portfolio return will likely be well below averages of the past. Doing what everyone else is doing probably won’t get most clients acceptable returns. This leads to the likely need for some concentration in assets which are either significantly better value or significantly better quality, or both. The question then becomes, how do you manage this concentration in a rational manner that doesn’t materially increase the probability of permanent loss?
Our Core Satellite Approach
Our Core Positions
Valor has developed a unique “Safety-First” investment philosophy. This philosophy is derived from the aviation principles. Aviation is the safest form of transport due to a philosophy that puts safety before anything else. This concept is foreign to most investment professionals who regularly commit unsafe acts in markets on a daily basis.
At the core of these principles is the certainty levels of different investments. The idea that Coke has a less risky business than a car company is not a difficult one to conceptualise. Coke sells cans of coke. A car company needs to almost reinvent the wheel every 3 years to remain relevant. The certainty levels over a 10-year period are far higher for Coke than a car company.
Valor ranks our investments with a certainty rating. We call it the “Safety Ranking List”. When we know with near absolute certainty that a company will sell more of what it does at higher prices in 10 to 20 years, the company moves up the list. The list changes at a glacial pace. The best companies in the world when rated by certainty are very close to the best companies on the list from 10 years ago. A few have moved up the list such as Amazon, Microsoft, Facebook and Alphabet, however Berkshire, Coke, Pepsi, McDonalds and Costco haven’t changed in many years.
Valor believes that you can concentrate far more into companies that are “safer” using our certainty comparison tool.
A second, yet equally important consideration of concentration is the balance sheet of a company. Some companies are far riskier than others due to their balance sheet. McDonalds may be one of the safest businesses in the world, but if they keep borrowing to pay dividends and share buybacks, then their safety degrades. This would move them down the list.
Valor has a capital independent investment philosophy. A company that is extremely unlikely to be forced to raise capital under duress is our preferred investment style. Berkshire with $138.9 Billion in cash is far safer than a company with debt. You can concentrate more in a capital independent company.
Thirdly, the fundamentals of the business are critical. The return on the businesses equity and the ability to reinvest capital are enormous considerations for safety. Higher growth and a long runway for this growth can actually build safety into an operation. A company that is growing at 20% per annum and is likely to continue doing so for many years can grow out of a number of mistakes. Whether you paid $300 or $350 a share for Alphabet all those years ago is less important due to its growth over the many years.
The slower the growth of the company, the more important valuation becomes.
Obviously, the management need to be outstanding for a company to be considered safe. Even great companies can be destroyed by terrible management.
Our Satellite Positions
At the other end of the spectrum are the riskier, yet likely higher returning businesses. You are highly unlikely to triple your money on Berkshire in a short period, however buying smaller risker businesses you can have significantly higher returns. We made 1350% return buying Magellan Financial Group. This is not a stock you can put large amounts of your portfolio in, however a 1% or 2% position is fine. A few dozen of these positions and you will likely do fine on average. Due to the asymmetric upside versus downside of stocks (you can make many times your money, yet the most you can lose is 100%), some allocation to these positions is rational.
Less certainty requires significant diversification.
Valor is also highly aware of previous periods of global history where markets have taken decades to return to previous highs. Thus, we have a few satellite positions that are likely to be fine under most conditions, yet provide asymmetric returns under difficult conditions protecting our clients from multi-decade market drawdowns. We own a few small positions in gold stocks for this reason. The current levels of global debt, particularly Chinese corporate debt and Australian household debt, zero to negative rates with structurally flawed fiscal and banking systems in Europe could lead to outcomes that are far worse than most expect. We believe having a few very small satellite positions in a portfolio to protect against this is not irrational.
Where most go wrong is concentrating into companies that should only ever be satellite positions.
Key Take Away
Be wary of managers that concentrate capital in open ended structures. Be further worried if a manager concentrates capital in an open-ended structure in companies that are not “safe” (high certainty and capital independent).
It is not uncommon to see managers with 7- 15% of their fund in a company like AfterPay or Tesla. They may be right and be praised for their gamble. We view these types of risky bets as irresponsible and are more likely to cause effects such as the Valeant debacle at some point in time. Whilst cowboy managers in high flying stocks may temporarily receive praise for their guesses, if you analyse the risks they are taking, they are acting like untrained crop dusting pilots flying past telegraph poles at 10 feet.
Berkshire released their 3rd quarter results on the weekend.
Key take away:
Berkshire remains a fortress. The balance sheet is pristine. The diverse cross section of businesses continues to churn out cash. Share buybacks are enormously positive for the shareholders over the long-term.
We live in a low return world.
Asset prices are high across the board. Government bonds trade below 1%. Cash is effectively zero. Net residential property yields are low single digits. Stocks have earnings yields of around 3%. Obvious areas to allocate capital are scarce.
A large percentage of people still think they can retire comfortably with an approximate 5% net return. The vast majority of people have calculated their insurance needs on a 5% net return. There are still a number of pension funds which require 7% returns. The problem with these assumptions is that we live in a world where expecting these returns is like sticking your hand in a bag of snakes and trying to pull out an eel.
Valor believes that intelligent investors have a few options on how to tackle the low return market conundrum.
Attempt to Avoid Stupidity
There have been lots of stupid areas to invest over the last decade. Valor has warned about a number of them.
The Iron ore bubble.
The LNG bubble.
The Aussie Banking bubble.
The disruption Fad.
Generally speaking, ignoring the crowds is often beneficial to your wealth.
In 2011, we spent a large amount of time dissecting the Chinese growth story. For those that looked, it was obvious that China was overconsuming steel and at some point, prices would revert closer to their long-term averages.
At the time, BHP was $48. We warned a number of clients who held the stock that our estimate of its fair value was closer to half its $48 price. BHP eventually fell over 50%.
China is still overconsuming iron ore.
We are confident that China will not permanently consume 50% of the worlds iron ore as they are only 15% of the world’s population.
Beginning around 2012, we observed the ridiculous Asian LNG prices of around $17 per million British thermal units. These prices were not congruent with the coming supply increase and likely arbitrage from Qatar gas prices (which were priced in cents not dollars) and US gas prices which had fallen precipitously down to around $2. It was quite obvious for those with a 5 to 10-year view that Asian LNG prices would trend closer to the $2 (plus transport and liquefaction costs) that existed in the US.
Woodside was $48. Origin was $14. Today Woodside is closer to $18 and Origin is closer to $4.
In 2015, we warned that the great Australian debt bubble would bring the Aussie bank shares down significantly from their elevated levels. The Aussie banks were trading at up to 3 times book value on solid Net Interest Margins (NIM’s). They were over-earning. We were confident that this was near top of cycle NIM’s and prices to book value.
Today, Westpac, NAB and ANZ are down around 50% to 60% from their highs.
We still expect that we will experience a full cycle in Australian property prices at some point, however the can has temporarily been kicked down the road. The can (household debt) will likely get bigger in the coming year or two and at some point, will break the foot.
Today, we live in a multi-bubble world.
Most assets trade at well above their long run valuations. Many believe that central bankers are omnipotent and it is becoming increasingly common to believe that deficits don’t matter. Whilst we agree that central banks are powerful, their magic works to a point and then stops working. Deficits don’t matter, until the point where they do.
The most egregious bubble of today is in the disruption fad stocks. That is, stocks that seemingly appear to be offering a new way of doing things and revenues are growing like wildfire. Some of these stocks will change the world. Many of them will come crashing back to earth like the Hindenburg airship.
The most obvious disruption fad stocks, in our opinion, are those that have structurally flawed business models. The food delivery companies, the buy now pay later stocks, the EV car makers and a number of the software as a service companies that offer difficult to differentiate services. Many of these companies are challenged businesses in highly competitive markets and yet trade at prices that require extreme levels of certainty of future outcomes.
The irony of the disruption stock fad is that a number of the disruptors are easily disrupted themselves.
Business moves faster today than in any time in history. The ability to take market share due to modern technological changes has never been greater. Brands can spring up from no-where in a matter of months not years. The Instagram influencer phenomenon has changed marketing dynamics. Small brands can eat into big brands like never before.
The connectivity of the world has led to disintermediation. The old gateways are no longer barriers to entry. The brands of the 1960’s had to get their foot in the door with the department stores. Today, you can start a business selling online in the matter of a few hours and sell through Amazon, Shopify or Ebay.
Due to the world changing Amazon’s of this world, many are projecting their success onto the next generation of disruptors. With history as a guide, the odds of success for many of these disruptors are likely low. The premium that many of them trade at is likely irrational. The few that do become “platforms” for growth are probably cheap today.
A number of the disrupters are likely frauds. As Jim Chanos recently stated:
“We are in the golden age of fraud”
If you are to buy into any of these loss-making disruption fad stocks, it is probably wise to diversify significantly.
Dynamic asset allocation
The 60/40 or 70/30 allocation portfolio has worked for many decades. Will it work for the next decade?
Source: Hussman Funds
In a world of expensive stocks and bond yields below 1%, the expected return for a 60/40 portfolio is probably below what most are expecting.
Markets have been volatile this year. One way to manage risk is to use a dynamic asset allocation philosophy.
“Be fearful when others are greedy and greedy when others are fearful.” (Warren Buffett)
When the market rises significantly, trim. When it falls significantly, add to the portfolio.
Very few do this well, so I caution you to think that this will work for most.
Valor successfully trimmed and added back to the portfolio a number of times over the years which has reduced our down periods when compared to diversified portfolios. Notably, in 2018 calendar year, we had a 6% return in a down market due to this strategy. In March this year, we were more active than usual and had an over 30% market outperformance on the downside due to our caution. Admittedly, we have missed out on some of the recently rally, however our caution will once again be rewarded.
Beyond dynamic asset allocation between the asset classes is a more nuanced approach, which uses individual investment valuations. A company like Berkshire Hathaway, due to its diversification, has relatively predictive operating cash-flows. It trades within a fairly narrow band of its valuation. Buying when it trades at the lower end and trimming when it trades at the upper end of its valuation range has been highly successful for our firm.
Dry powder reserve
The dry powder reserve is an extension of the dynamic asset allocation.
Valor believes that you should always have an amount of cash or short-term government bonds as a dry powder reserve. The amount is predominantly determined by your age, spending habits and your assets levels. It is also influenced by market levels compared to their long-term ranges.
If you are in retirement, then you need a larger dry powder reserve.
If you have high fixed spending needs, then you need a larger dry powder reserve. Someone who regularly spends $100k per annum, however under compulsion, could live off $30k per annum needs less than someone who regularly spends $100k but could only live off only $70k in less than desirable market conditions. The lower number is determined by your fixed spending needs.
Generally, the wealthier your become, the less dry powder reserve you need as a percentage of your asset levels. Warren Buffett needs a lower amount of cash on hand as a percentage of his wealth than you do.
Market levels over a long-term range should influence your dry powder reserve number. At the upper end of the range, you should have more dry powder as it can take longer for markets to recover to their previous levels from these peaks. Remember that it took 25 years for the market to recover from the 1929 peak. Japan in 1989, the US in 2000 and Australia in 2007 are notable peaks. We are likely at another peak for a number of markets.
Lower your Expectations
The last thing someone who has worked 40 years to generate a significant lump sum for retirement wants to hear is that they need to lower their expectations.
Unfortunately, there is no obvious way to materially increase investment returns on defensive assets. If cash is 1%, cash is 1%. If bonds are 1%, bonds are 1%. You can’t change that.
I’m bald. I have accepted that my hair is not going to grow back again. You need to accept that cash rates are not going back to 5% again soon.
Once you accept the reality of the situation, you can plan for the future with confidence. Those that attempt to reach for yield may be disappointed with a future that is less than what they need.
There are a number of “high yield” offerings popping up in the market place. Many of these are lending to distressed or subprime borrowers. When you realise that a good corporation can borrow for between 1.5% to 3% and mortgage rates are around 2.5%, the quality of a company that is forced to borrow for 7-9% is likely not where you want to be allocating capital.
Lending at high yields is done well by a few specialists, however most are not adept at the task. The best specialists in these areas take large amounts of equity or control of assets under distressed situations. If you are down the pecking order behind these specialists, then you are the patsy.
These are difficult times for investors. Those that have decades left of productive years of employment can dollar cost average over a number of cycles. Those that are nearing or in retirement have a number of headwinds.
Always have a safety-first attitude to capital allocation. With a primary focus on avoiding permanently losing capital and then calculating the upside, it is possible to sidestep much of the current market folly.
Live within your means and keep your fixed costs down.
Despite generally difficult investment conditions, there are still a number of assets that are more than reasonably priced and have many years of growth left.
Be careful out there…
All pilots routinely perform emergency procedures training. When we have an emergency that was unexpected, but well trained for, we perform that task as if it were a normal task. It becomes like a habit.
If a pilot experiences a near mid-air collision, you have a 2.5 second reaction time under a reversal procedure for a TCAS event (traffic collision and avoidance system). There is no thinking time. There is no room for error.
Not all emergencies are that simple and many require multiple tasks and time. Not all emergencies follow a script. A large component of emergency procedures is training methods to handle various types of emergencies without prescribed actions. We use first principles such as Aviate, Navigate then Communicate. We follow acronyms such as GRADE (Gather, Review, Analyse, Decide and Evaluate) and NITS (Nature, Intention, Time, Special instructions)
If untrained for an emergency, humans tend to get startle effect, panic, or mental overload. Many are unable to make rational decisions in a crisis. The human mind can only concentrate on about 7 items in the conscious part of the brain. During a crisis, there are often dozens of permutations and combinations. Without training to manage these situations, most cannot act or think rationally.
In the corporate world, there is little to no emergency procedures training. Yet corporate crashes are common.
In the last 20 years, there has been the Tech Wreck, the GFC and Covid-19. Within companies there are improper acts from managers that require action. Continual allocation of capital into loss making ventures. Emergencies happen regularly. Over the last 100 years, the stock market has fallen approximately 37% every 3.5 years.
So why do we not train managers in emergency procedures?
I believe we should.
CEO’s, board members, professional investors and others making key decisions during a crisis should have emergency procedures training. They should have an emergency procedures manual. They should do regular simulations on various scenarios to ensure they are up to date with the latest procedures.
The delay in raising capital by Rolls-Royce and Unibail have caused far lower share prices than otherwise needed to be if the leaders of these businesses acted decisively. The CEO’s of Rolls and Unibail got startle effect and their inaction has caused billions in losses for shareholders. Would emergency procedures training have reduced the losses? Possibly.
Valor continues to build our emergency procedures for investing through crises. Our emergency procedures manual includes when to realise a loss, how to handle various economic conditions (deflation, inflation, stagflation), poor management decisions. We are constantly learning how to evaluate company management in a crisis. Having these procedures allows us to make more informed rational decisions with less emotion during a crisis. The greatest organisations that have ever existed are continual learning machines. Valor strives to continually improve and learn from not only our mistakes, however from mistakes of others.
A number of companies with the highest dividends are likely melting ice cubes.
A dividend yield of 6% may look attractive, however if this dividend is being paid by a declining company with large debts, it may not last very long.
This is the most common mistake I see with dividend investors.
It is often far better to buy a slightly lower, yet growing dividend.
Valor strongly believes that the “best time to buy is the point of maximum pessimism”, as per Sir John Templeton’s investment thesis. The only issue with this thesis is that the pessimism is often warranted.
It takes considerable training and independent thinking to work out which businesses are in terminal decline and which are temporarily depressed.
After recent significant price falls, we recently attempted to analyse AGL. AGL has grown revenues at roughly double every decade for 20 years. If history were to go by, you would consider this a very good investment. The issue we found with AGL is the future is likely less rosy. Their reliance on coal fired power stations in a world of ever increasing renewables leaves them at risk of disruption.
New power technologies (wind and solar) are already cheaper than old generation coal and gas. The main issue with renewables is that when the sun is not shining or the wind is not blowing, they can’t provide base load power without storage. During peak renewables periods, that is, bright sunlight and good winds, increased supply reduces pricing levels. Whilst renewables have historically been a relatively small part of grid power, this wasn’t a problem. As renewables increase, they will eat away at AGL’s profits during these periods.
Over the coming decade, we expect an s-curve adoption of battery storage (both home storage and grid storage). When this happens, traditional electricity companies may have their profit margins further compressed.
For many years, Telstra was the perennial dividend favourite for retirees. Telstra is likely a melting ice cube.
With increased competition forcing pricing for internet and mobiles to fall, Telstra has been squeezed with rising costs. Their profit decline over the last 5 years tells the story:
A 5% dividend yield today may not compensate for profit declines of this magnitude.
The European banking index recently traded below 1988 prices. This extraordinary level of poor performance by a sector highlights the risks in investing.
In 2015, we took over a balanced portfolio that was well approximately 60% invested in banks and bank hybrids. This portfolio would have had enormous losses over the following years. This type of portfolio was not uncommon.
The direction of interest rates over the coming years has never been more uncertain. It is likely in the short-term that they stay lower. If the RBA pushes rates further lower, this compresses bank margins. Aussie dividend investors who have profited handsomely from ever rising bank dividends over the last few decades may be disappointed.
If we have even moderately higher rates in Australia, our extreme household debt levels would be tested, which may be a worse scenario for the banks. It is this bind, that lead me to describe the Aussie economy being in coffins corner: