You Better Start Swimmin' or You'll Sink Like a Stone
The times, they are a-changin'
A few of the things I’ve read recently have had similar themes and messages. I thought it might be useful to share some of my thoughts here. The first thing was an interview with Gautam Baid from Compounding Quality about his new book. In the interview Gautam talked a lot about lessons he learned from market crashes.
Survival is #1, Profit is #2
The main takeaway is that the key to success in investing is long-term survival. Gautam offers a few thoughts on how to survive. These include:
Invest in high quality-businesses led by high-quality managers
Don’t get scared out of stocks when they’re down
A study of past manias and crashes should be part of every investor’s body of historical knowledge
In a bear market, good news is sold into, and bad news is hammered
There is lots more great knowledge in the interview. I highly recommend you check it out. Please don’t take this to mean that I think we’re about to see a market crash. I have no idea. I know that we will see another one, but I’m not even going to begin to guess if it’ll happen this month or this decade. History shows us that it’s foolish to even try to predict these things.
What I will say is that I agree with Howard Marks’ most recent memo “Further Thoughts on Sea Change.”
The Environment Has Changed
Howard takes us through the history of fiscal policy for the last 40 or so years and argues that the most significant thing that’s happened over that time period is that between 1980 and 2020 interest rates declined by 2,000 basis points.
Think about that. He makes the point that every investor who has come into the market since 1980 has only seen falling or very low interest rates.
More recently, since 2008, we’ve seen rescues from 2 financial crises, aggressive stimulus and interest rates at or near zero. That’s a long time for the economy to see such extraordinary measures.
Marks uses a lot of data to support his argument that the next few decades are not going to be like the last few. He also worries that many investors have learned the wrong lessons during this long, period of relatively easy money. I think he’s right.
It seems that investors are largely expecting things to go back to the world of low rates and high growth. Recent surveys and predictions say that the Fed will start cutting rates next year (example #1, example #2). They also expect that long bond rates are near a peak. I’m not sure why the markets expect that.
A download of 1 year treasury yields and some basic spreadsheet skills will tell you that the average 1-year treasury rate between the beginning of 1962 and the end of 2000 was 6.7%. The median rate was 6.2%.
Today, a the 1-year treasury yields 5.3%.
I used the 1-year treasury simply because it’s considered by most investors to be the risk-free rate. Most other interest rates follow the 1-year treasury, so pick a different measure if you want. You’ll find the same thing. Relative to history, interest rates aren’t high. They’re just back to normal.
This Isn’t the First Time Investors Learned the Wrong Thing
In an annual letter, Seth Klarman described 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”
Considering that to be a successful investor you have to survive, and that the environment we’re investing in is likely fundamentally different than many of us have seen before, here are 5 lessons from Seth’s letter I think are worth keeping in mind.
Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
The government – the ultimate short- term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
Seth also gives a list of false lessons that investors took away from 2008. Here are a few of my favorites:
Excess capacity in people, machines, or property will be quickly absorbed.
Office real estate anyone?
Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
The government can indefinitely control both short-term and long-term interest rates.
What To Do
None of this really matters or changes my investment philosophy. In fact, it bolsters it. I look for high-quality companies, run by great people that can survive a downturn. I try to avoid high amounts of debt in the companies I invest in. I try to be conservative in my valuations and I try to buy them at discounts to even my conservative valuations.
I do think there are a few things worth taking into consideration here though.
Because bonds now yield a real return, there is an alternative to equities. The days of TINA are over. This will likely reduce multiples of equities going forward.
I have no idea what this will look like. It could be a decline in prices. It could be a sideways market with stable prices, but growing earnings, resulting in lower PE multiples. It could be something completely different.
I could also be totally wrong.
The days of free money are also over. This will likely reduce economic growth moving forward. Take this into consideration when projecting growth of companies.
The longer the period you’re projecting growth over, the more sensitive the ultimate value will be to small changes in growth rates.
For a long time, I saw no reason to own bonds. Now that yields are above historical (and current) inflation levels, some allocation to fixed-income is worth considering for many investors.
None of this is meant to be an overly-bearish stance. It is not a warning to sell all your stock and get out of the market. Pessimism does not make money the vast majority of the time. When I find a great company at a great price, I’m more than happy to buy it.
I do think it’s worth stepping back to look at what you already own and determine if it’s likely to do well in the environment moving forward.