Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quote

“Happiness is simply the absence of desire... Happiness is not about the achievement of pleasure (which is joy or satisfaction), but about the lack of desire. It arrives when you have no urge to feel differently. Happiness is the state you enter when you no longer want to change your state.”

— James Clear (Author of ‘Atomic Habits’)

Tweet

Glenn Kelman, CEO of residential real estate brokerage Redfin, shared interesting insights on the U.S. housing market, which may surprise some given the backdrop of higher interest rates and ongoing recession fears. The market appears to have begun recovering from the weakness his firm had witnessed since March 2022.

What appears different about this downturn (so far) is that inventory did not rise meaningfully and is still at half the levels it was back in 2016. Kelman highlights that “less than 2% of homeowners are underwater on a mortgage, compared to 30+% in 2008” although, that could just be a function of where we are in the cycle.

The big question is whether this will be a short-lived improvement or if we will see more sustained correction in house prices. Of course, time will tell.

Chart

Over the last few weeks, technology stocks have roared back to life after a particularly painful 12 months+, especially for companies that are unprofitable. Some investors are now asking whether this means the equity bear market is over and if they should buy this particular group of stocks.

Let’s take a brief trip down memory lane by looking at Juniper Networks, a prior technology darling during the dotcom bubble. Less than 3 months into 2000, the stock peaked at around $145, along with the Nasdaq Composite Index. The stock having more than halved in value by May, subsequently rallied over 250% to a new all-time high of $245 by October, having smashed analyst earnings expectations. Over this period, the Nasdaq did not recover to its prior high.

During the following 12 months, Juniper Networks proceeded to lose 96% of its value. Incredibly, 22+ years later, the stock has yet to regain those prior highs.

The lessons seem obvious:

1. Buying companies with extremely elevated valuations is rarely worth the risks.

2. Anything can happen.

Investor Report

FundSmith’s annual letter written by the founder and CEO Terry Smith is typically a great read and the 2022 letter does not disappoint.

Smith covers a wide range of topics, including the end of quantitative easing, Japan’s bubble in the 1980s and the implications of some fundamental headwinds for the technology sector.

Our favourite section is the part that discusses how a number of listed companies are treating stock-based compensation in non-GAAP (General Accepted Accounting Principals) profit figures. Here is a snippet that will hopefully encourage you to read the rest of the piece:

“Among the 75 companies in the Technology Select Sector Index mentioned above, 45 of them remove share-based compensation from non-GAAP versions of their earnings per share, operating income, or both — in plain English they remove the amount of the debit for share-based compensation which boosts their profits. That is about $26bn of expenses that have been adjusted out in reporting the 2021 profits in the non-GAAP results of these 45 companies. This amounts to about an average of $600m of share-based compensation for each company which is excluded or added back in reaching their non-GAAP earnings. You will find it as no surprise that all of the companies in the index whose share-based compensation represents greater than 5% of revenue remove share-based compensation from non-GAAP measures.”

Articles

Charlie Munger: Why America should ban crypto

A concise piece published on the WSJ, Munger makes it clear why crypto needs to be banned as soon as possible: ”Such wretched excess has gone on because there is a gap in regulation. A cryptocurrency is not a currency, not a commodity, and not a security. Instead, it’s a gambling contract with a nearly 100% edge for the house.”

Crypto-focused Silvergate bank loaded up on $4.3 billion in Home Loan bank advances

As depositors yanked their money out of Silvergate following the collapse of cryptocurrency exchange FTX, the California bank oddly shored up its capital by tapping a quasi-government agency, the Federal Home Loan Bank of San Francisco. The bank now holds $4.6 billion in cash on its balance sheet, according to metrics the bank recently released.

Auto loan performance deteriorated further in December

Subprime severe delinquency rate in particular rose to the highest level in the data series which goes back to 2006, according to Autodealer.

Meanwhile, the value of used cars declined the most in the history of the Manheim Used Vehicle Value Index - this shouldn’t be too surprising given the temporary covid-induced supply chain bottlenecks that significantly boosted demand for used cars.

People’s Bank of China (PBOC), banking regulator urge banks to step up support to real economy

The PBOC and the China Banking and Insurance Regulatory Commission (CBIRC) pushed banks to step up financial support to the real economy and front-load loan issuance, according to a statement released by the central bank.

Microsoft announces multi-billion dollar investment in ChatGPT stake

OpenAI launched ChatGPT to the public free of charge in November 2022, with the program quickly surging in popularity as many users were surprised by how well the bot modeled human speech. Microsoft has now announced that it has boosted its stake in the company having previously invested $1 billion in OpenAI back in 2019.

This week, Microsoft integrated ChatGPT into its Teams videoconferencing software, enabling it to automate tasks such as note taking, recommending tasks, and personalizing meeting highlights for individuals. The tool can also translate meetings into different languages in real time, with captions for participants who don't know the language being spoken.

Earnings commentary insights

Chevron: 2023 production is expected to be flat to up 3% at $80 Brent

CEO on oil supply: “We expect production to grow, led by the Permian and other shale and tight assets.”

On European gas supply: “The successful build of inventories for this year and the reduction of industrial demand have both resulted in an outlook that is less dire for the European economies, than it may have looked like several months ago.”

On dividends: “We haven't cut the dividend since the great depression. […] we've increased the payout 36 years in a row now.”

Schlumberger: Despite concerns for potential economic slowdown in certain regions, oil and gas demand growth remains resilient

CEO: “Markets will remain tightly supplied with modest production increases offset by the end of SPR release and well productivity declines in certain regions, most notably in North America”

Freeport-McMoRan: Demand remains strikingly strong, supply question marks remain

President on copper demand: “Physical market continues to be healthy…. we are selling everything we can produce. If we could produce more, our customers would want it.”

CEO on copper supply: “40% of the world's copper comes from Chile and Peru. And with what went on in their most recent presidential elections, the uncertainties that came out from that and things continue to change in Peru, the government has been in turmoil. […] And then, Chile had the situation where there was a negative vote on the proposed constitutional amendment, which changed the targets there. And you can see what's happening to greenfield projects being delayed in the United States...”

Until next time...

Thank you for reading this week’s issue.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quotes

“If you count the current events, we have now had three economic and financial crises this century and it is still in its first quarter. This would seem to illustrate that attempts to expunge volatility from the financial system are actually producing the opposite of the desired effect.”

— Terry Smith (FundSmith Founder and Chief Executive Officer)

"… defence is ten times more important than offence. The wealth you have can be so ephemeral; you have to be very focused on the downside at all times."

— Paul Tudor Jones (Hedge fund manager)

Charts

Year in review

2022 was a tough year for long-only investors as most major central banks exited loose monetary policies (aka ‘easy money’) and interest rates rose around the world. Both equities and bonds declined, in many cases into the double digit territory.

With that backdrop in mind and higher oil prices, it is perhaps unsurprising to see energy equities as the only positive performing sector within the S&P 500 index:

U.K. household’s spend 35% of their earnings on rent

In the UK, rents continued to soar throughout most of 2022 and despite rising wages, Zoopla finds that households are paying a larger share of their incomes on rents.

The Guardian wrote a great piece on the affordability challenges facing the U.K. housing market, highlighting that some are paying as much as 50% of their combined household wages on rents alone.

According to The Guardian, the average advertised rent in Greater London approached £2,343 and is “16.1% higher than a year ago, the highest rate of growth of any region on record”. Interestingly, other towns and cities in the U.K. have faced even larger annual increases: 22.2% in Newbury, 20.5% in Manchester, 19.6% in Cardiff, 18% in Edinburgh and 17.6% in Birmingham.

The continued rise in rental costs is believed to be largely driven by the lack of additional supply of rental homes in the country:

Unsurprisingly, the U.K. is not alone. Many developed countries have seen house price-to-rent ratios and house price-to-income ratios jump significantly over the last 10 years, as illustrated by the following chart:

In the U.K. for example, as of August 2022, the price of an average house is over 9 times average wages, up from around 7 times 10 years ago and around 4 times in the early 1980s.

In the U.S. the housing picture is not much brighter, with affordability levels lower than during the housing bubble that preceded the global financial crisis back in 2007/08.

It will be fascinating to see how higher interest rates and inflationary pressures impact these ratios going forward, given their implications for mortgage costs and house prices.

Earnings commentary insights

BlackRock highlights the attractive yields available to investors today

CEO: “For the first time in years, investors can actually earn very attractive yields without taking much duration or credit risk. Just a year ago, the U.S. 2-year treasury note was yielding approximately 90 basis points [0.9%], and today, they’re earning over 4% with corporate bonds earning over 5 and high-yield earning 8[%].”

Wells Fargo starting to see some impact of higher rates on consumer spending

CEO: "We are starting to see the impact on consumer spend, credit, housing, and demands for goods and services, but at this point, the impact of consumers and businesses has been manageable…. the rate of impact we see in our customer base is not materially accelerating…. Our customers have remained resilient with deposit balances, consumer spending and credit quality still stronger than pre-pandemic levels."

J.P. Morgan sees consumer strength continuing with balance sheets in good shape

CEO: “The consumer is still strong. Their balance sheets are in good shape. They’re spending 10% more than pre-covid. They have more in their checking accounts. Companies are in good shape, and that’s driving a strong economy.”

Pioneer Natural Resources emphasises that the rapid growth of shale is over

CEO: “The aggressive growth era of US shale is over. The shale model definitely is no longer a swing producer.”

Articles

Saudi Arabia says it is open to settling oil trade in other currencies

The country’s finance minster, Mohammed Al-Jadaan, said “There are no issues with discussing how we settle our trade arrangements, whether it is in the US dollar, whether it is the euro, whether it is the Saudi riyal”. This comes a month after China and Saudi Arabia upgraded their relations to a strategic partnership during Chinese President Xi Jinping’s visit to Riyadh.

China’s population shrank for the first time in 60 years

Official results highlight how China’s demographic challenges continue to deepen. Women had 9.56 million babies last year, a 10% drop from 10.62 million in 2021, according to the National Bureau of Statistics. The national birth rate fell to a record low of 6.77 births for every 1,000 people in 2022, down from 7.52 in 2021, marking the lowest rate since records began in 1949.

BlackRock halts withdrawals from £3.5 billion UK property fund

The company has suspended withdrawal requests from investors in the fund. Investors in the fund include pension funds and other institutional investors.

Until next time...

Thank you for reading this week’s issue.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

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Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

Twitter, which ran our prior newsletter platform, has decided to shut it down. It turns out that the half of their workforce that they laid off did do some work after all. Joking aside, we have had to migrate to a new platform as a result, which you will probably have noticed by now.

If you missed our prior issue, you can find it here.

Quotes

“Humans have a strong desire to be part of a group. That desire makes us susceptible to fads, fashions and idea contagions.”

— Michael Mauboussin (Head of Consilient Research at Morgan Stanley)

“The trees that are slow to grow bear the best fruit.” 

— Molière (French playwright / actor)

Charts

Decline in U.S. government 30-year bonds

This fascinating chart, put together by Bank of America, illustrates drawdowns since 1987 for the 30-year U.S. treasury. As is evident, the 40%+ decline in 2022 has been particularly painful for long-duration bond investors.

This raises interesting questions such as: if interest rates are unlikely to go back to zero any time soon and investors’ bond portfolios have taken a double digit hit this year, will they choose (or perhaps be forced) to sell other assets to rebalance their portfolios? If so, what will they sell?

Financial market liquidity

Since the global financial crisis, the mantra “don’t fight the fed” had been regularly repeated. It referred to the notion that you did not want to bet against the major central banks, which from 2009-2021 kept interest rates low and were pumping liquidity into global markets, therefore supportive of higher asset prices.

Since March 2022 however, central bankers have reversed course, raising rates and begun to drain liquidity to fight inflation and slow an overheated economy (known as “tightening” monetary policy).

Now it seems, some investors have decided to ignore the relevance of the aforementioned mantra. These investors are hoping for a quick “fed pivot” or in other words, seeing the fed and other central bankers returning to their previous stimulative policies.

To illustrate the importance of liquidity to asset prices, Morgan Stanley put together this great chart which shows that when liquidity is rising (defined as growth in the federal reserve’s balance sheet, reduction in the treasury general account and reduction in the reverse repurchase facilities), S&P500 returns tended to be positive, with the opposite true when liquidity is shrinking. Simply: liquidity drives returns.

It’s worth briefly looking at each of these individual components which define liquidity in the chart above.

Federal reserve balance sheet

Since late-2008, the federal reserve has kept interest rates low and embarked on several ‘quantitative easing’ rounds, essentially a form of money printing.

During the onset of the covid-19 pandemic, it aggressively expanded its balance sheet, buying treasuries and mortgage-backed securities (MBS), resulting in its total assets growing from around $4 trillion in March 2020 to $9 trillion at its peak in April 2022. By acquiring these assets from investors, the central bank added significant liquidity to the financial system.

The Fed began to raise rates in March 2022 and in June it stopped replacing some of the bonds it owned that matured, a process referred to as ‘quantitative tightening’, which reduces market liquidity. In September, this process swung into full gear with the Fed permitting up to $60 billion a month in Treasury debt and $35 billion per month in MBS to mature and therefore reducing the size of its balance sheet.

Since its peak in 2022, this has declined by around $0.5 trillion, withdrawing market liquidity.

Treasury general account

The second variable in the Morgan Stanley chart is the ‘treasury general account’ (TGA). This is basically the U.S. government’s current account. All disbursements are made from this account, while tax receipts and sales of treasury debt are paid into it.

From a liquidity stand point, when the balance in this account declines, as has been the case since its peak back in May this year, liquidity is injected into the financial system. Interestingly, we are fast approaching the 2010-2022 average balance (the red line), suggesting this mechanism will soon turn neutral or potentially even start to pull liquidity out of the system, especially if the Treasury decides to replenish the account with new debt issuance (which takes cash out of investors’ hands).

Note: The U.S. Congress passed a $1.7 trillion spending bill on December 23rd that will need to be financed.

Since the start of 2022, the TGA has increased by $0.2 trillion, withdrawing market liquidity.

Overnight reverse repurchase agreements

The final element is the overnight reverse repurchase “repo” agreements. This account tracks temporary open market operations that are designed to temporarily add or drain reserves in the banking system, and therefore add or subtract liquidity. Simply, when this account’s balance rises, it indicates liquidity is being removed from the financial system.

The chart illustrates the rapid rise in excess banking reserves (over $2.2 trillion) that the fed has had to drain since 2021. While this has recently declined somewhat, it hardly suggests a shortage in banking reserves.

On November 30th, Federal Reserve chairman Jerome Powell said "it's really a public benefit to have plenty of reserves, plenty of liquidity in the markets and in the banking system, in the financial system generally." Given its importance, we should probably keep at least one eye on it, especially in moments like today where the fed is looking to slow the economy and maintain (or perhaps regain) credibility with regards to its 2% inflation target.

Since the start of 2022, reverse repos have increased by $0.6 trillion, withdrawing market liquidity.

In summary, when combining these three elements, the federal reserve has effectively tightened monetary policy by draining around $1.3 trillion out of markets since the start of 2022 (so far).

Earnings commentary insights

Micron Technology: On “solid footing” to navigate the near-term environment

CEO: “In the last several months, we have seen a dramatic drop in demand. Micron has responded quickly to reduce our CapEx and supply output, and we are taking strong enterprise-wide actions to control our expenses… we currently expect second half fiscal 2023 revenue to improve from the first half.”

FedEx: Industrial economy is slowing around the world with Europe being the hardest hit

CEO: At the same time, “there is an e-commerce reset", therefore the company will accelerate progress on “cost actions, helping to offset continued global volume softness.” Regarding China, “we haven’t seen any fundamental change in volume profile one way or the other in the last few weeks.”

Nike: Consumer demand for its portfolio of brands continues to drive strong business momentum

CEO: “Our growth was broad-based and was driven by our expanding digital leadership and brand strength”.

Reflection of the month

The ‘The Tail End’ by Tim Urban is worth reading at least once every few years. It’s a short, creative and fitting read as we catch-up with family/friends and reflect during the holiday season, reminding us about our short time on this planet.

Urban’s piece encourages us to reflect and be more thoughtful about how we spend our time. Below is an excerpt and graphic which will hopefully encourage you to read the whole piece:

I’ve been thinking about my parents, who are in their mid-60s. During my first 18 years, I spent some time with my parents during at least 90% of my days. But since heading off to college and then later moving out of Boston, I’ve probably seen them an average of only five times a year each, for an average of maybe two days each time. 10 days a year. About 3% of the days I spent with them each year of my childhood.

Being in their mid-60s, let’s continue to be super optimistic and say I’m one of the incredibly lucky people to have both parents alive into my 60s. That would give us about 30 more years of coexistence. If the ten days a year thing holds, that’s 300 days left to hang with mom and dad. Less time than I spent with them in any one of my 18 childhood years.

When you look at that reality, you realize that despite not being at the end of your life, you may very well be nearing the end of your time with some of the most important people in your life. If I lay out the total days I’ll ever spend with each of my parents—assuming I’m as lucky as can be—this becomes starkly clear:

You can read Tim Urban’s full article by clicking here.

Until next time...

Thank you for reading this week’s issue.

Do you have any questions or thoughts? Please feel free to reach out.

We wish you and your loved ones a merry Christmas and a happy new year!

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quotes

“In the real world, things fluctuate between pretty good and not so hot. In the market, they fluctuate between flawless and hopeless. We’re not at hopeless. Hopeless is October 2009 or March 2020. But at least we’re not flawless anymore.”

— Howard Marks (Co-founder and co-chairman of Oaktree Capital Management)

"Someone with half your IQ is making 10x as you because they aren't smart enough to doubt themselves."

— Ed Latimore (Writer and former heavyweight boxer)

Tweet

As ever, Nassim Taleb did not mince his words in his tweet.

Taleb highlights that venture capital funding is down ~55% year-on-year as of the third quarter, while deal count is down 20%. He believes investors have still not accepted this new regime of higher interest rates and its consequences, including its impact on companies that are unable to generate positive free cash flow.

In 2021, start-ups with a valuation of $1 billion+ (known as 'unicorns') were being created at a rate of more than two per business day, according to CB Insights. More start-ups hit unicorn status in 2021 than in the previous five years combined.

Charts

Analyst projections for the S&P500 in 2023

Every December, analysts from most the major wall street firms publish their macroeconomic and market forecasts for the coming year or two. Interestingly, for the first time in 22-years, analysts are forecasting a down year (2024) for their S&P500 annual change projections.

Now before you run off and spend hours reading what they have to say, note this: these projections have little to no predictive power.

Case in point: while analysts had projected positive returns for the S&P500 over the last 22 years, the index experienced seven negative years, including the bear market of 2000-02, down 10.2%, 13.0% and 23.4% respectively, and the 2008 drawdown of 38.5%.

With the benefit of hindsight, if you'd like to read what analysts had predicted for 2022, here is Bloomberg's 2022 summary of analyst projections.

If you are [somehow] still curious to read what analysts are predicting for 2023, see Yahoo Finance's summary here.

So what does matter? I highly recommend reading Howard Marks' memo appropriately titled "What really matters?".

Articles

UK government is considering whether to relax the ring-fencing of banks to free "trapped capital"

Ring-fencing, which requires banking groups to separate their retail banking operations from their investment banking activities, was brought into place following the global financial crisis in 2008. Fundamentally, it was designed to protect UK customer deposits. Bloomberg reports that the government is now planning to relax these rules to make the country a "better place to be a bank".

The hope is that deregulating the City of London would result in a "big bang" out of Brexit [we should perhaps be careful what we wish for?].

Saudi central bank accelerates efforts to boost liquidity

The bank intervened via open market operations, enabling it to provide short-term liquidity in exchange for securities from lenders. This helped stabilise the interest rate banks charge one another for loans however, it remains near a record high.

The funding shortfall is reportedly due to the rapid rise in lending in the country as part of the ongoing construction boom, which has not been matched by deposit growth. Saudi Arabia's construction pipeline is estimated to be $1 trillion over the next eight years, aimed at diversifying the economy beyond oil.

Meanwhile, the government is expected to run its first budget surplus in about a decade after seeing revenues jump on the back of higher oil prices.

Private equity: the new conglomerates?

Marc Rubinstein writes a thought-provoking piece, asking whether private equity firms, which generated strong returns initially by purchasing unloved assets from conglomerates, have now become so large that the firms and the portfolios they manage now resemble conglomerates themselves.

Clearly, there are differences: portfolio companies remain independent and are acquired through termed fund structures with the goal of selling them at a profit and returning capital to the fund's investors.

Despite this, Rubinstein argues that they are run by "the same firms, the same partners, and housed in the same portfolios.".

Using his example of Blackstone: in mid-2021, the firm controlled 250 companies across a range of industries, in which they employ more than half a million people.

Blackstone runs an internal "portfolio operations" team to provide functional support across its portfolio companies, helping company management with a wide range of areas such as brand strategy, data science, technology, M&A, procurement and recruitment. This team comprised of over 70 people in 2018 and has grown since, delivering $600 million of savings in the last full year. These can be compared to the "synergies" promised by conglomerates of old.

Adding to the similarities is the fact that many private equity firms now invest ever-larger sum of their own capital into deals.

Image of the month

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quotes

“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is, the first two he just added because they started with ‘L’ – It’s leverage.”

— Warren Buffett (Berkshire Hathaway Chairman and CEO)

"We act as though comfort and luxury were the chief requirements of life, when all that we need to make us happy is something to be enthusiastic about."

— Charles Kingsley (Priest and novelist)

Charts

Rising rates and the potential for more bankruptcies

Between 2004 and 2006, the U.S. central bank raised interest rates 17 times from 1.0% to 5.25% to curb inflation and cool off an overheated economy.

Today, the fed is again looking to address uncomfortably high inflation and high levels of demand relative to supply. During the current hiking cycle, the federal reserve has raised interest rates from 0.0% to 3.75% in as little as 9 months, with another increase expected in December to take base interest rates above 4.0%.

With the cost of financing on the rise globally, and in many developed countries at the highest levels in over a decade, attention will soon shift to default rates and bankruptcies.

One measure of bankruptcies, the Bloomberg Bankruptcy Index, remains near the lowest levels since 2007, just before the global financial crisis began.

Metals and mining

This fascinating chart highlights how relatively 'cheap' the metals and mining sector currently is when looking back 20 years. It goes without saying that something cheap can become even cheaper. Nonetheless, it may be worth exploring this segment of the market more closely given the structural shortages we are likely to face in some metals if demand holds up and/or rises (see the prior BTU issue where we highlighted copper as an example).

Articles

Billions in capital calls have the potential to wreak havoc on public markets

Since the global financial crisis, central banks have pumped a significant amount of money into the financial system. A large amount of this cash found its way into unlisted assets, as investors sought higher returns in a low interest rate environment. This segment of the market grew to $10 trillion globally by September 2021, a fivefold increase from 2007 according to Preqin.

Early signs of trouble are starting to show up: capital calls now exceed distributions in aggregate across these private-market partnerships, according to data from the Burgiss Group.

Big pensions and endowments are expected to have sufficient cash flows to meet these capital calls however, there are concerns that other types of investors will have to offload liquid equity and debt assets to meet their commitments. As a last resort, they could try to sell their illiquid assets at steep discounts to secondary buyers.

“We see cause for concern,” Burgiss analysts Patrick Warren and Luis O’Shea wrote in a note last month. “Venture capital’s net distributions are now at a multi-decade low, and senior and distressed debt are also calling capital on net.”

Exacerbating matters is that fact that some institutions have broken past their private market concentration limits within their portfolios.

Following the latest crypto-related collapse, Charlie Munger labels cryptocurrencies as "good for kidnappers"

The Berkshire Hathaway Vice Chairman, who has almost seen it all at the age of 98, did not mince his words: "You are seeing a lot of delusion. Partly fraud and partly delusion. That’s a bad combination." He adds: "Good ideas, carried to wretched excess, become bad ideas. Nobody’s gonna say I got some s*** that I want to sell you. They say – it’s blockchain!”

Things that make you go hmm...

Venture capital funding

Peter Thiel's Founders Fund believes that venture capital is no longer funding companies that will drive significant improvement to humanity's way of living.

For example: in 2021, global VCs allocated almost 5.5 times more capital to companies that speed up grocery deliveries versus companies developing the potential of nuclear power technology to address our evergrowing energy needs and our dependence on fossil fuels.

"Venture capital has ceased to be the funder of the future, and instead has become a funder of features, widgets, irrelevances."

— Founders Fund

Global fossil fuel consumption

The following powerful chart (pun intended) demonstrates our ever increasing global need for energy produced by fossil fuels. Does society really want to cut investments in this critical-to-life sector before we have a truly sustainable and scalable alternative in place?

Investor Report

Elliot Management, one of the largest activist funds in the world, recently wrote a deeply pessimistic letter to their investors, flagging a range of areas they are concerned about, starting with the boom in asset prices:

"The cumulative rise in home prices from 2019 to July 2022 is around 45%. This, together with mortgage interest rates more than doubling in that period, has created the fastest and largest rise in home unaffordability in history. America’s experience in this regard is mimicked in a number of other countries. We think it is highly likely that home prices will retrace part or all of the boom surge."

"Complementary to the rise in the price of homes is the rise in S&P 500 stocks from 2020 to 2021 (47%), the rise in money supply in 2020 to 2021 (40%), and the rise in U.S. federal spending from 2020 to 2021 (53%). This suggests to us that a 22% drawdown in global stock prices may not be “enough” to reflect the magnitude of the boom that is being forcefully reversed by central bankers. What does it suggest to you?"

The letter goes into detail on what drove the liability-driven investment (LDI) blow-up in U.K. pension funds:

"The problem with these derivatives is that the plans only posted a small proportion of the purchase price in cash, and the “rest” has been used to buy stocks and other more risky (and putatively profitable) securities. Moreover, the pension plans that engaged in these strategies actually received cash “mark-to-market” payments as interest rates declined. This had the effect of providing or reserving additional cash that the plans used to purchase additional stocks and other risky assets. When the interest-rate universe reversed, at a time when the stocks and other investment assets were themselves providing mark-to-market losses, the variation margin of the derivatives turned negative. At a certain point, given the speed of the interest rate moves, plans ran out of cash to meet margin calls and had to sell their derivatives or bonds into a declining (in price) market, thus punching down on the prices, and up on the rates, in a “death spiral.”"

Elliot Management essentially suggested to their investors to "buy the umbrella":

"The time to be shoring up risk protections is when you have time and space to do so, when the sky is bright."

"Our job is the same as always: To try not to lose money no matter what — no excuses. This is a noble goal, a difficult goal, and incredibly useful as a path and guideline."

Investors' buy the dip mentality remains uncomfortably prevalent:

"One of the most dominant strains of investor thinking currently about stocks, bonds and real estate is the confidence that market adversity is always temporary, that there is no permanent impairment of asset values on the landscape in a timeframe that matters, and that drawdowns can basically be ignored."

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quote

"I think one of the things people might be getting wrong is the assumption that disruption is new, or that the scale of it is greater than in the past. We are very prone to recency bias."

— Terry Smith (Fundsmith CEO & CIO)

Charts

US equity market valuations

If we look at the US equity market capitalisation as a whole, relative to GDP, we are now re-testing the prior peak during the technology bubble in March 2000. Probabilistically, how likely is it that the market would bottom at a prior bubble high?

World Container Index (WCI) rapidly declining for some routes

The media has extensively covered supply chain challenges and shipping constraints over the last 2 years. During this time, the WCI Shanghai to LA container freight benchmark increased to over $12,000 per 40 foot box. Since then, costs have declined close to their prior decade range.

The reverse route, LA to Shanghai, has seen meaningful declines too however, shipping costs are still 114% higher than February 2020 levels. Likewise, Shanghai to New York costs remain 122% higher.

Hong Kong emigration accelerates

Strict covid-19 controls and an uncompromising new national security regime have driven a reversal in Hong Kong's net migration flows since 2019.

Many of the 113,000 residents who left in the first half of 2022 were higher earning professionals, resulting in further pressure on the local housing market, where prices are now down 11% from their August 2021 peak.

Population dynamics in Hong Kong are being exacerbated by the declining birth rate (black line) and the rising death rate (orange line). The death rate has now exceeded the birth rate for over 2 years.

Adding to Hong Kong's troubles is the ongoing strengthening U.S. dollar as a result of the Federal Reserve's drive to stamp down inflation by raising interest rates.

The Hong Kong Monetary Authority (HKMA) has to follow the fed in raising rates if it wants to maintain the Hong Kong dollar's long-standing peg to the U.S. dollar. The HKMA is trying to follow a more gradual increase in interest rates to reduce the burden on property owners and the wider local economy.

Back in July, Financial Secretary Paul Chan said the city's "huge" reserves are enough to maintain the linked exchange rate, despite capital outflows. These outflows are a result of investors seeking to earn higher interest rate returns offered by the U.S. dollar. The exchange reserves balance is currently down 16% since the start of 2022.

Despite all the bearish factors highlighted above, there has not (yet?) been a significant surge in bearish wagers against the currency:

Articles

Uber expands advertising business globally, targeting $1 billion in ad revenue

Uber’s CEO Dara Khosrowshahi said the company was targeting $1 billion in gross ad bookings by 2024, on an annualised basis. As of Q2, the existing ad business had an annual gross bookings run rate of $350 million.

The business unit formed earlier this year and run by former Amazon advertising executive Mark Grether, plans to display promotions within its apps, on top of its cars and on the back of seats. Brands will also be able to have emails sent to Uber's 122 million active users.

Self-driving cars: $100 billion to go no-where

For the last 10+ years, we have seen exciting demonstrations from companies including Alphabet's Waymo, GM's Cruise, Ford, Tesla, and Zoox that have promised cars capable of piloting themselves without any human input or oversight. Repeated promises and timelines have lapsed, with the goal of transforming the $2 trillion global automotive industry. According to Bloomberg, it seems like there is still a long way to go.

Anthony Levondowski, the engineer who co-founded Waymo and then Ottomotto, stated that “You’d be hard-pressed to find another industry that’s invested so many dollars in R&D and that has delivered so little". He goes a step further: “Forget about profits—what’s the combined revenue of all the robo-taxi, robo-truck, robo-whatever companies? Is it a million dollars? Maybe. I think it’s more like zero.”

Trafigura warns global copper inventories have fallen to perilously low levels

Speaking at an FT conference, Kostas Bintas, Trafigura's co-head of metals and minerals trading, said the copper market is currently running with inventories that cover 4.9 days of global consumption and is expected to end the year at 2.7 days. Copper inventories are typically counted in the weeks.

“While there is so much attention being paid to the weakness in the real estate sector in China, quietly, the demand for infrastructure, electric vehicle-related copper demand, more than makes up for it,” Bintas said. “It actually not only cancels completely the real estate weakness, but also adds to their consumption growth increase.”

Earnings Commentary Insights

Freeport-McMoRan: Physical copper market is strikingly tight, globally

CEO: "Higher prices will be required to bring on new suppliers, much higher prices than we have now. Simply because the current price is not sufficient to incent new supply development on the scale that will be required to meet this increasing demand [driven by the ongoing global electrification and the energy transition]."

Hermes: Will hike prices by 5-10% in 2023, no signs of any slowdown

EVP of Finance: "For the moment, we don't see any sign of slowdown in any of our markets". The company plans to accelerate a hiring drive, after adding 800 people in the first six months of the year and increased salaries for all European employees in July.

J.P. Morgan: Loan performance remains solid

CFO: "We just don't see anything that you could realistically describe as a crack, in any of our actual credit performance. [...] but we've done some fairly detailed analysis about different cohorts and early delinquency bucket entry rates and stuff like that. And we do see in some cases some tiny increases, but generally in almost all cases, we think that's normalization and it's even slower than we expect, so."

ASML: Semiconductor demand continues to be strong

CEO: "Growth in semiconductor end markets & increasing lithography intensity are driving demand for our products & services... Based on market developments we are looking... [at] further increasing our capacity beyond what we presented during our Sept 2021 Investor Day."

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things we’ve been reading and thinking about during the week.

If you missed our prior issue, you can find it here.

Quote

"Lucky opportunities tend to be stumbled upon, not handed out.

If you're waiting for someone to hand deliver an excellent opportunity to you, it's unlikely to happen. But if you are exploring and moving—if you're in the mix and engaged—then you'll stumble upon many opportunities.

The active mind comes across a lot. Keep tilling the soil and you will occasionally unearth something wonderful."

— James Clear

Charts

China's non-performing real estate loans on the rise

Citi Research put together an incredible chart that demonstrates the depth of the Chinese property crisis focusing on non-performing loans (NPLs).

A NPL is borrowed money whose scheduled payments have not been made by the debtor for a period of time – typically 90 or 180 days.

Citi's estimates show that 47.8% of loans held by privately-owned developers are non-performing. This contrasts with 14.8% of state-owned developers' loan books. Both are up significantly from their respective 2020 levels.

U.S. union membership numbers at historical lows, whilst sentiment towards labour unions on the rise

The U.S. Bureau of Labour Statistics reported that in 2021, the union memberships fell to 10.3%, or 14.0 million workers. To provide some context, this contrasts with 20.1% in 1983, the first year for which comparable union data are available.

Nevertheless, union petitions are up over 58% so far in 2022 relative to 2021 according to the National Labour Relations Board (NLRB).

Interestingly, a Gallup poll shows that positive sentiment towards labour unions has been rising since 2010 and now matches levels last seen during the 1960s.

Articles

Westinghouse to be sold for $7.9bn in sign of nuclear power revival

Westinghouse Electric, a US nuclear power company, is being bought by a private equity-backed consortium in a $7.9 billion deal, four years after it emerged from bankruptcy. Westinghouse Electric makes technology used in about half the world’s 449 nuclear reactors. The company is currentlyo owned by Brookfield Asset Management's private equity division.

The FT reports that Westinghouse Electric will be purchased by Brookfield Renewable Partners and Cameco, a supplier of uranium fuel. Cameco announced a $650 million stock sale to help finance its portion of the deal.

The International Energy Agency believes nuclear generation needs to double by 2050 to hit net zero targets.

Investigation into U.S. congress representatives' stock trading

From 2019 to 2021, 183 current senators or representatives reported a trade of a stock or another financial asset by themselves or an immediate family member. Incredibly, more than half of them sat on congressional committees that potentially gave them insight into the companies whose shares they reported buying or selling, detailed analysis by the New York Times has found.

The thin line between bold and reckless

The Collaborative Fund wrote a fascinating piece on the dangers of judging a process purely by its outcome:

The hardest thing about studying businesses and investors is that many traits that fuelled their success could have just as easily triggered failure. But we rarely think about it that way when learning from specific outcomes.

The key takeaways are:

• Focus less on case studies and more on broad patterns

• Accept that strategies expire

• There is a lot to learn from people who accidentally stepped over the line and lived to tell the tale

The piece links well with what we wrote in BTU issue #17:

What good poker players and good decision-makers have in common is their comfort with the world being an uncertain and unpredictable place. What makes a great decision is not that it has a great outcome, it is “the result of a good process”. That process must include an attempt to accurately represent our own state of knowledge.

Good process is critical to successful investing over the long-term.

Podcast

The big shift with fund manager Jacob de Tusch-Lec

This 20-minute podcast is a worthwhile listen as de Tusch-Lec succinctly highlights some of the key changes to global trends and ways investors can take advantage.

Interesting takeaways:

• 10+ years of low interest rates and a roaring bull market in long-duration 'growth' assets have resulted in malign investments

• The longer you have excess liquidity in the financial system, the longer you allow money to flow to speculative areas (cash flow absorbing versus cash flow generating)

• As yields rise, time horizons shorten due to the opportunity cost increasing - we have witnessed this with stocks of unprofitable technology companies' which have been hit the hardest

• Just because 'growth' investments have done so well over the last 10-years, does not necessarily imply 'value' will do well for the subsequent 10-years

• There has been underinvestment in the real economy relative to the digital economy, resulting in the world becoming structurally short of multiple commodities such as energy, copper and wheat

• War in Ukraine accelerated many of the trends like inflation

• Higher rates will not drive more supply of whatever is driving higher inflation

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

If you missed the prior issue, you can find it here.

Quotes

“In this game the determined tortoise will always beat the excitable hare.”

— Peter Seilern

"It all depends on how we look at things, and not how they are in themselves."

― Carl Jung

Charts

U.S. private sector financial assets as a percentage of GDP

In BTU #36 we showed the degree of outperformance of bonds and stocks relative to commodities and real estate since the end of the last war on inflation in the 1970s and early 1980s.

Bank of America put together another fascinating chart, showing US private sector financial assets as a percentage of gross domestic product (GDP). The chart speaks for itself really.

What are the odds that this continues? We believe this is largely a function of interest rates and given the rise in global yields, this ratio is likely to have peaked.

How quickly can inflation be brought down?

With economists and central bankers continuing to believe that inflation can be brought down rapidly to 2%, it is worth looking at historical periods where inflation was above 5% in advanced economies.

Unfortunately, history suggests it takes on average 10 years for inflation to come down to the current target. The shortest period was 3 years.

Jeffery Gundlach from Doubleline raises a valid question: if inflation does indeed come down rapidly from its current 8.3% rate due to the federal reserve and other central bankers' actions, what are the odds it stops declining at their target level of 2% and then staying there?

To us, it seems wildly optimistic (although admittedly, not impossible) to assume that central bankers can achieve such precession.

Emerging markets underperformance since the global financial crisis

Emerging markets, which some believe are historically cheap, have continued to underperform the U.S. equity markets since 2010. The last peak, following the dotcom bubble in 1999/2000, saw emerging markets outperform on a relative basis for a decade.

U.K. government borrowing costs jump

Following the recent "mini-budget" by the new British government, the Sterling has taken a tumble, at one point reaching a record low against the dollar. Investors viewed the mini-budget tax cuts as unsustainable due to the size of the government's budget deficit and overall financial position. As a result, U.K. government bonds also declined with yields hitting the highest levels in at least a decade (bond prices and yields have an inverse relationship).

The chart below illustrates the size of the move in 10-year U.K. government bonds yield and the level at which they now trade:

At the end of 2020, the U.K. government was able to borrow for 10-years at a cost of less than 0.5% in interest. As of writing, yields for the same duration are now as high as 4.5%.

On Wednesday, the Bank of England (BoE) responded by announcing that it was "temporarily" stepping in and buying unlimited long-dated bonds to stabilize the market. If this is the start of the BoE putting a ceiling on government bond yields (known as yield curve control), the Sterling is likely to continue to weaken further relative to the U.S. dollar, as we have already witnessed with the Japanese Yen (the BoJ has already enacted yield curve control).

Following the BoE's emergency response, Bloomberg reported that the Biden Administration is 'alarmed' by the developments in the U.K. due to the potential of spillovers to the broader economy.

U.S. Commerce Secretary Gina Raimondo pointed out that cutting taxes and boosting spending won't help cool inflation nor "put you in good stead for longer-term economic growth". The International Monetary Fund, where the U.S. is the largest shareholder, pressured the U.K. government to "re-evaluate the tax measures".

Chinese renminbi breaks out above 7.00

With many investors talking about the British Pound's recent historic decline against the dollar, the Chinese Renminbi (off shore) has weakened beyond the key 7.00 level despite the Chinese government trying to support it from weakening further.

Other emerging market economies are also struggling with the strong dollar, such as the Indian Rupee which hit another record low.

The significant moves in currencies and bonds are likely to have significant knock on effects on financial stability over the next few weeks and months.

Articles

'The Great Transition' - from interest low rates to high anxiety

Sander Gerber and Jason Cuttler wrote a great piece highlighting the interest transition occurring, after nearly two generations of declines.

"Every OECD country (besides Japan and Switzerland) is running inflation above 4%. Wages are growing at 5.5% and inflation is broad-based with virtually all worker categories earning pay increases of 4% or more. [...] Despite Wall Street predictions of inflation moderating, uncomfortable levels are here to stay."

"Unlike some, we don't doubt the Fed's conviction..."

"Even with mounting evidence to the contrary, derivative markets price a mere 8% chance of 10-year yields being above 5% one year from now."

"Finally, virtually all asset classes — from property to private equity — benefited from falling bond yields and the low cost of capital. Most worrisome, the impact of higher yields is correlated across most holdings, overwhelming any delusion that diversification (or an algorithm) is sufficient defense against the great transition. [...] There are very few assets that truly hedge inflation risk."

Goldman's Apple Card business has a surprising subprime problem

The investment bank, which began its foray into consumer finance in 2016 to diversify from its traditional strengths of Wall Street trading and advisory activities, is currently struggling with its credit card business.

The bank's loss rate on credit card loans is the worst among big U.S. card issuers and “well above subprime lenders” at 2.93%, according to a note from JPMorgan.

A record number of British pensioners are working

According to the ONS, there are now almost 1.5 million Britons over the age of 65 in employment, driven by rises in part-time work.

The increase in people working past the UK’s state pension age could reflect rising cost of living pressures, forcing some out of retirement. The U.S. is seeing similar trends.

China reins in belt and road program, $1 trillion later

China's Belt and Road infrastructure program was designed to expand its influence across Asia, Africa and Latin America. One trillion dollars later, Beijing is working on an overhaul of the troubled initiative. A slowing global economy, rising interest rates and higher inflation have left countries struggling to repay their debts to China, as reported by the WSJ.

Transcripts

FedEx CEO Raj Subramaniam is prioritising cost cutting:

"Getting cost out rapidly is my priority...We saw a decline in our volumes during Q1, which accelerated in the final weeks. Our softening volumes in Asia & US were predominantly due to the economy while the shortfall in Europe was both economic & service related."

J.P. Morgan Chase CEO Jamie Dimon points out that the ESG agenda is hurting the American economy and that more oil and natural gas production is needed to reduce CO2 emissions:

“The world needs effectively 100 million barrels of oil and gas every day, and we need it for 10 years. To do that, we need proper investing in the oil and gas complex.

Investing in the oil and gas complex is good for reducing CO2, because as we have all seen, because of the high price of oil and gas, particularly for the rest of the world, you’ve seen everyone going back to coal. Not just poor nations like India, Indonesia and Vietnam, but wealthy nations like Germany, France and the Netherlands."

Things that make you go hmm...

The WSJ says that oil leases on Federal land have slowed to a trickle under the Biden administration. In his first 19 months in office he has leased out just 126,228 acres for drilling.

Since Nixon, no president has leased fewer than 4.4m acres at the same stage in their presidency. Harry Truman was the last to lease fewer acres at just 65,658 in 1945/6 when offshore drilling was just beginning.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

If you missed last week’s issue, you can find it here.

Quotes

"Set your life on fire. Seek those who fan your flames."

— Jalāl al-Dīn Muḥammad Rūmī

"In economics, interest rates act as gravity behaves in the physical world."

— Warren Buffett

Tweet

Eddie Fishman's twitter thread goes into some of the objectives of the recently announced G7 price cap on Russian oil sales, how it will be enforced through sanctions, why China and India will probably comply and the likely challenge.

The objective is fairly simple: the G7 would like pressure Russia's oil revenues, the lifeblood of Russia's economy.

There will actually be *three* price caps: one for crude oil, one for high-value refined products, and one for low-value refined products. The refined product caps will debut on February 5, 2023. Implementation day for crude oil will be December 5 of this year, when the EU maritime insurance ban is set to begin and US GL-8C expires.

How it will be enforced and why China and India will probably comply:

This threat of sanctions is the "stick." But the success of this policy will hinge even more on the "carrot"—the opportunities for China, India, and others to buy Russian oil at even larger discounts than they do today.

The challenge:

The Kremlin has already threatened not to sell oil to anyone that complies with the price cap.

Any supply cuts by Russia could push up global oil prices, which could undermine the price caps. Also, what stops an entity buying the oil at the cap and then selling it at the market price once it is no longer classified as "Russian oil"?

Charts

Headwinds for operating margins and corporate tax rates

In BTU issue #3 we highlighted that towards the end of 2021, S&P 500 companies' operating margins were at the highest level since 1990. We asked whether one could prudently continue to bet on operating margins expanding.

In similar vein, today we ask whether it is likely that corporate tax rates will continue to fall from here? The chart below shows that tax rates have almost consistently declined since their highs during the 1950s.

If we can agree that the odds are tilted towards operating margins declining and taxes rising, then it seems sensible to assume that this would act as a further headwind for corporate profits and in turn equity markets, not to mention the ongoing increases in the discount rate (due to rising interest rates).

Venture capital dollar volumes decline in the second quarter

Much of the media's attention continues to be on public markets however, private markets have also been hit since the end of 2021.

For example, venture capital volumes have declined by 27% as of June according to Crunchbase. Declining inflows will likely continue to drive a reset in valuations and, in the worst case scenario, starve some start-ups of capital as investors look to cut their losses.

The 'Warren Buffett' Indicator

In a brilliant piece for Fortune Magazine in 2001, Warren Buffett spoke about the various equity market backdrops over the preceding century, the resulting market performance and the psychology of investors. Buffett also made an insightful comment on interest rates, which is highly relevant for investors today:

"At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you're going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%."

Buffett also spoke of periods of extreme market irrationality:

"The tour we've taken through the last century proves that market irrationality of an extreme kind periodically erupts--and compellingly suggests that investors wanting to do well had better learn how to deal with the next outbreak. What's needed is an antidote, and in my opinion that's quantification. If you quantify, you won't necessarily rise to brilliance, but neither will you sink into craziness."

Subsequently, he introduced a simple chart which he believed to "probably [be] the best single measure of where valuations stand at any given moment". This chart, now referred to as the 'Buffett Indicator', is shown below.

“For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire.”

Average photovoltaic grade polysilicon spot prices continue to rally

Solar costs, which had been declining for at least a decade, have seen spot prices for average PV grade polysilicon rally 510% since the middle of 2020. As a result, solar power equipment makers have continued to lift prices.

Polysilicon, a material that is currently largely sourced from China, is facing supply shortages. Last week, the Chinese Ministry of Industry and Information Technology, the State Administration for Market Regulation, and the National Energy Administration asked regional authorities to take action to halt price increases in the industry.

The Xinjiang region in western China supplies nearly 50% of the world’s supply of polysilicon and is currently in the spotlight due to credible allegations of forced labor.

Articles

South Korea plans to scale down its reliance on traditional renewable energy sources and boost nuclear generation

A new draft of the nations' long-term power supply plan targets 21.5% generation capacity from renewable energy sources by the end of the decade. This is down from 30.2% under the previous version. Most of the gap would be met by nuclear while coal and gas are little changed from the prior proposal.

The proposal will go through government discussions, parliament and public hearing before it’s finalized, according to the energy ministry.

Tencent turns from buyer to seller in investment pivot

Tencent, the Chinese internet firm, is pivoting from years of aggressive stake building to a focus on divestments as it comes under pressure from investors and Beijing’s recent antipathy towards Big Tech.

The company has outlined a soft target of divesting about $14.5 billion of its $88 billion listed equity portfolio this year, depending on market conditions and internal profit targets.

Things that make you go hmm...

California asks electric vehicle owners to limit their charging

Heading into one of the busiest holiday travel weekends in the United States, and just a week after approving an ironic plan to ban the sale of new gasoline cars, California asked electric vehicle owners to limit when they plug in to charge their vehicles.

This notice was issued due to a heat wave hitting the state, pushing up the demand for energy to power air-conditioners. Unfortunately, this is not the first time extreme heat has affected drivers of electric vehicles. Last month, a heat wave in China also caused problems for EV drivers as the government prioritized "more critical daily electricity needs". 

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

If you missed last week’s issue, you can find it here.

Quotes

"The things that will destroy America are prosperity at any price, peace at any price, safety first instead of duty first, and love of soft living and the get-rich-quick theory of life.”

— Theodore Roosevelt (26th U.S. President)

"You can't stop a fever by putting an icepack over your head. You've got to get to the cause of the fever."

— Lyndon B. Johnson (36th U.S. President)

Charts

UK energy bills set to soar once again, exceeding £6,000

A typical annual energy bill is currently £1,971. Ofgem has announced that its price cap will rise to £3,549 on 1 October and will be adjusted every 3 months thereafter.

New forecasts suggest that energy bills could rise well over £6,000 a year from April 2023, pressuring the government to urgently support those struggling or unable to pay.

Note: the price cap puts a maximum per unit price on energy that reflects what it costs to buy energy on the wholesale market and supply it to UK homes. In addition, it sets a "strict and modest" profit rate that energy suppliers can make from domestic sales.

European energy crisis subsidies mount

European governments have now allocated approximately $280 billion in funding to cushion the impact of the energy crisis on households and businesses. Subsidies however do not solve the underlying drivers behind the energy crisis, i.e. the world is currently in short supply of critical commodities due to unhelpful supply-side policies in the west.

Germany's $2 trillion of value-add depends on $20 billion of gas from Russia - that is 100-times leverage

Credit Suisse put together a fascinating chart that shows Germany's reliance on Russia's gas to power its economy. It imports around $27 billion from Russia, mostly natural gas, which in turn enables Germany to power its manufacturing base that creates approximately $2 trillion in value. This would equate to 100-times leverage, an incredible risk for any individual business, let alone an economic powerhouse.

Articles

Zoltan Pozsar: War and industrial policy likely to result in continued inflationary pressures

Credit Suisse' Pozsar wrote a brilliant and thought-provoking piece on why current escalating geopolitics and eroding trust are unlikely to push inflation down in a hurry.

Two snippets that will hopefully encourage you to read the rest of the article:

"In 2007-08, big banks ran on “just-in-time” liquidity: the dominant form of liquidity was market liquidity, for which you could always sell assets into a deep market without moving prices, so you did not have to have liquidity reserves at the central bank. Similarly, big corporations today run “just-in-time” supply chains for which they assume that they can always source what they need without moving the price."

The West will have to pour trillions into four types of projects starting “yesterday ”: (1) re-arm (to defend the world order) (2) re-shore (to get around blockades) (3) re-stock and invest (commodities) (4) re-wire the grid (energy transition).

American Airlines announced an agreement to purchase Boom's supersonic passenger aircraft

American Airlines and Boom Supersonic announced an agreement to purchase up to 20 supersonic passenger aircrafts, with an option for an additional 40. The airlines has paid a non-refundable deposit on the initial 20 aircraft.

The aircraft, named Overture, is expected to carry passengers at twice the speed of today’s fastest commercial aircraft.

India's big industrial states plan massive coal imports to stave off shortages, cover residential and industrial needs for the next three years

The Indian states, which cumulatively accounted for nearly a third of India's electricity demand in 2021, plan to import 10.5 million tonnes of coal in coming months as officials "scramble to arrest widespread power cuts" according to Reuters.

This will likely push global coal prices to new highs and add further pressure on energy prices. It is worth noting that India is the world's second largest coal importer.

Blackstone to stop buying homes in 38 U.S. regional housing markets

The pandemic housing boom looks like it has come to a stop, or perhaps a pause, as existing home sales and new home sales are down 20.2% and 29.6% respectively on a year-on-year basis.

The announcement by Blackstone-owned Home Partners of America comes as several firms are realizing that the intensifying housing correction could translate into falling home prices.

BlackRock, BNP Paribas, UBS among firms named energy boycotters by Texas

Texas has banned ten finance firms from working with the state after concluding that they are hostile to the energy industry.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm when they are typically in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

If you missed last week's issue, you can find it here.

Quotes

"A smooth sea never made a skilled sailor".

— Franklin D. Roosevelt

“Far more money has been lost by investors trying to anticipate corrections than has been lost in all the corrections combined.”

— Peter Lynch

Chart

Total return performance year-to-date

Deutsche Bank put together this helpful chart that illustrates the returns in 2022 up to the end of July. Only three assets are up for the year: Brent crude oil, WTI crude oil and the Commodity Research Bureau Index (the CRB index includes 19 commodities, with a 41% weighting towards agriculture and 39% weighting towards energy commodities).

Investor Letter

Brookfield Asset Management, a publicly listed global alternative asset manager with over $750 billion of assets under management, has positioned itself to benefit from the recent market adjustments to higher inflation and interest rates.

In particular, their infrastructure, renewables and real estate assets are benefiting from inflation due to the way their cash flows are structured and the increasing replacement cost of assets they own.

In the second quarter shareholders letter, Brookfield's CEO Bruce Flatt points out that despite the recent increases, interest rates are expected to remain favourable to businesses as they are likely to stay low relative to historical levels:

"Despite two historic Fed rate increases—with probably more to come—short rates are only at 2.5% and long rates are less than 3%. Once this period of adjustment passes, rates are expected to settle at historically “low-ish” levels, which should still be very conducive to business."

In addition, Flatt adds that even if the U.S. falls into a recession, balance sheets are fairly strong:

"Whether this causes a recession is not important in our view, as balance sheets for individuals and companies are in a good position to withstand this shift, and before we know it, we expect to be in a recovery."

Price and value are rarely the same

The goal of the value investor is to take advantage of the gap between price and the true intrinsic value of those assets. Over the longer term, the price of a security will gravitate towards its value.

"Value investing is, in essence, the arbitrage between 'Price' and 'Value'."

Over the short term there are multiple reasons for why the price of an asset would not equal to the value of a business.

"Assets prices are usually dependent on the supply of and demand for capital, which in turn is heavily influenced by investor sentiment. In robust markets, there is generally more capital than there are assets. This forces Price higher, even to the point where it far exceeds Value." There is no doubt that, in hindsight, this described many technology and “growth” stocks in 2020/2021. On the other hand, in stressed markets, if a sale has to be made, the Price received for an asset can be far below its Value. We are starting to see some of these situations emerge. In summary, Price is often influenced by the news of the day, market sentiment, the availability of capital, and other factors that may or may not have any relevance to the Value of a specific security.

How is the value calculated? It is the net present value of the future cash flows of a business or asset, based on assumptions for future growth discounted at an appropriate rate for that particular investment.

The difficulty in ascertaining Value is that there is no absolute value for anything, so there will always be a wide range of views over an asset’s growth profile, profitability, and the appropriate discount rate.

Thoughts on global infrastructure

Brookfield believe there is an incredible investment opportunity in the sort of assets they invest in due to the massive buildout of global infrastructure needed.

From a demand perspective, global infrastructure is aging, and less public capital has been invested than is required to keep up with the pace of population growth. In addition, there are major tailwinds for investors in the form of the tens of trillions of dollars needed for the backbone of the Internet and Mobile Infrastructure; Energy Transition; Reshoring of Critical Infrastructure; and the Rewiring of European Energy.

Given the size of this expected buildout, it will require requiring tens of trillions of dollars, 20 years and will produce an incredible investment boom. The record debt-to-GDP for most developed nations will require their governments to lean on private capital providers to fund much of this infrastructure.

For example, U.S. and European semiconductor buildout programs, initiated by their respective governments, require upwards of $100 billion to localize production.

Earnings Commentary Insights

Softbank posted its largest-ever quarterly loss of $23.4 billion following their big tech sector bets

Masayoshi Son, Softbank's Chairman and CEO admitted that "When we were turning out big profits, I became somewhat delirious and looking back at myself now, I am quite embarrassed and remorseful".

Interestingly, the company has now systematized its investment decisions and empowered experts, rather than relying on Son's hunches.

Softbank's Vision Funds presentation is worth a read given their size and reach. They also separately disclosed that they had sold their Uber stake for a $5.6 billon gain.

Articles

Wall street faces billion-dollar losses on private equity buyout debt

Investment banks are believed to be sitting $80 billion of commitments backing leveraged buyouts that they may have to unload at a discount. Deals include Citrix, Twitter, Morrisons and Jetblue.

The Financial Times notes that Deutsche Bank had to sell its high-yield bonds backing the buyout of packaging firm Intertape Polymer Group at just 82 cents on the dollar, one of the steepest discounts in two decades for a new junk-bond issuance. By dropping the price, the overall yield on offer (a bond's price moves in the opposite direction to its yield) rose to more than 14%.

China's youth unemployment rate rises to 19.9%

This represents the fourth consequent month of rising unemployment for youth in the country.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

Quotes

“Thinking is the hardest work there is, which is the probable reason why so few people engage in it.”

— Henry Ford

"If you have knowledge, let others light their candles in it."

— Margaret Fuller 

Chart

Real assets relative to financial assets hit a new low

This fascinating chart, put together by Bank of America's global investment strategy team, illustrates the degree of outperformance of bonds and stocks relative to commodities and real estate. This is particularly evident since the end of the last war on inflation in the 1970s and early 1980s.

If inflation ends up being sticky, could that result in real assets making up (at least some) lost ground over the next decade?

Investor Memo

Howard Marks published another brilliant and must-read memo for investors titled "I Beg to Differ".

The topic of the memo is one of BTU's favourite: how do investors achieve superior returns and how should they position themselves if they want to continue to do so?

Marks covers a few key areas: conventional versus unconventional behaviour, superior second-level thinking, contrarianism and willingness to be wrong alone.

Below are a few great passages that should hopefully encourage you to read the entire memo or at the very least aid your own investment processes.

"If your behavior and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if the behavior is unconventional is your performance likely to be unconventional ...and only if the judgments are superior is your performance likely to be above average."

Investors who are happy with average returns can simply invest in a broad index fund or exchange traded fund (ETF) whose exposure represents that asset class, geography or sector.

On the other hand, if investors want to generate above average returns, they have to do something different to consensus, which opens the door to below average performance.

Marks points out that in order to outperform, an investor's thinking has to be different and better:

"First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple."

Their outperformance has to come from their superior ability to do one or more of the following:

- Better understand the significance of the published numbers

- Better assess the qualitative aspects of a company

- Better predict the future

"Readily available quantitative information with regard to the present cannot be the source of superior performance.” 

On contrarianism:

During periods of extremes (i.e. excessive optimism or pessimism), then it’s valuable to leave the crowd and be a contrarian, i.e. diverging from the crowd:

"At the extremes, which are created by what “most people” believe, most people are wrong."

"Most great investments begin in discomfort. The things most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive, and the outlook is rosy – are unlikely to be available at bargain prices. Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late."

Earnings Commentary Insights

LVMH reports strong performance, despite the difficult macroeconomic backdrop

Jean-Jacques Guiony, LVMH's CFO, stated very clearly the strength of the business: "I will mention the double-digit revenue growth in all business groups and in all geographies, except obviously Asia".

Mastercard continues to see persistent inflationary pressures but highlights several positives: strong labour market, rising wages and high consumer savings

The CEO, Michael Miebach, states that "with this backdrop, consumer spending and particularly travel-related spending remains strong."

US retail spending in particular remains healthy. According to their 'MasterCard SpendingPulse' which is based on all payment types including cash and check, "US retail sales ex-auto, ex-gas, were up 6% in the second quarter versus a year ago. In Europe, spending trends are positive although the risks related to both the supply of natural gas and higher interest rates remain headwinds".

Schindler seeing economic growth cool

The elevator and escalator manufacturer's CFO stated that "our industry market is severely dropping by more than 15%", with credit tightening becoming evident and "many developers are in real difficulties".

On China, the CEO highlighted the credit crunch in the property market is not getting better at all.

S&P Global experiences issuance declines in every category

The CEO stated that "This is the first time that I can recall seeing [issuance] declines in every category in every region since I’ve been doing earnings calls", highlighting the challenging market conditions so far in 2022.

Articles

Crypto collapse has flooded the market with Rolex and Patek watches

Online-watch trading platform Chrono24 believes the pullback in crypto prices "has directly impacted pricing of luxury watches from brands like Rolex and Patek Philippe". The German company has more than half a million watches listed for sale on its website.

Copper worth around half a billion dollars has gone missing in China

The onshore depot in Hebei (northern China) has 200,000 tons less than it was supposed to be holding resulting in an investigation by its financiers, most of whom are state-backed Chinese companies. The storage site was found to be holding just one third of the inventory it claimed it had.

UK braces for black-outs this winter

Under the UK government’s latest “reasonable worst case scenario” warns that the UK could experience blackouts for several days in January, if cold weather combines with gas shortages to leave the country short of power.

Concerns over a power supplies shortfall have grown despite government sources insisting are highly unlikely to materialize. The shortfall could total about a sixth of peak demand even if emergency plans to fire up retiring coal power plants are enacted.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week and enjoy your summer.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

Quotes

"Raise your ambitions. Lower your expectations. The higher your ambitions, the bolder your actions. The lower your expectations, the greater your satisfaction. Achieve more and be happy along the way."

— James Clear

"You can't connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future."

— Steve Jobs

Charts

Federal reserve policy and inflation expectations

The Federal Reserve raised interest rates by 0.75% on Wednesday, following a similar sized move in June. We are currently witnessing the fastest tightening of monetary policy since former fed chair Paul Volcker battled double-digit inflation in the 1980s.

Interestingly, the fed was seen to be less hawkish following comments from fed chair Jerome Powell, which spurred hopes for a slower hiking path. As a consequence, inflation expectations spiked, highlighting the difficult challenge the central bank currently faces between ensuring inflation expectations revert towards their 2% goal, while maintaining market stability.

Working age population trends

Apollo put together this fascinating chart that shows the four largest economies' working age population over the next 80 years. The U.S. appears to be in the best position as the other three economies are expected to face a decline, unless immigration policy is adjusted within the latter to counter these trends.

The UN believes that the global population is growing at its slowest rate since 1950, having fallen to less than 1% in 2020. It predicts that the world's population will hit eight billion in November 2022.

Margin debt declines as markets fall into bear market territory

The latest FINRA data illustrates the deleveraging taking place across equity markets as investors become more cautious. This contrasts to the approximately 80% growth during the elevated bullish mood last year.

Emerging market sovereigns in distress or default at record high

With interest rates, energy and food prices rising globally, emerging market governments are struggling to refinance their existing debt and as a result have fallen into distress or default.

According to Bloomberg, a quarter-trillion dollar pile of distressed debt is threatening to drag the developing world into default. In particular, it appears that El Salvador, Ghana, Egypt, Tunisia and Pakistan are vulnerable.

Earnings Commentary Insights

Walmart disappointed investors this week, stating that food inflation is "double digits and higher than at the end of Q1" and is hurting its business

Management highlighted that this is affecting customers’ ability "to spend on general merchandise categories and requiring more markdowns to move through the inventory, particularly apparel". The CEO expects more pressure on general merchandise in the second half of 2022.

AT&T and Verizon are experiencing contrasting payment patterns by their customers

AT&T CEO: "Customers are stretching out their payments a bit. We expect they will continue to pay their bills, but they're taking longer to do it. That's not atypical in an economic cycle."

Verizon CEO: "We haven’t seen any noticeable change in the payment patterns from customers, continues to be very good, very much in line with what we were seeing pre-COVID, in fact, slightly better than that time period."

Articles

Germany's industrial companies hit by higher energy costs

The German Chambers of Industry and Commerce (DIHK) said a number of German industrial companies are cutting production in reaction to the burden of high energy prices. A survey of 3,500 companies found that 16% are scaling back production or partially discontinuing business operations.

Last week London came remarkably close to a blackout

The city managed to avoid a blackout last week by paying a record high £9,724.54 per MWh, more than 5,000% higher than the typical price, to briefly import electricity from Belgium due to a combination of surging demand and bottlenecks in the power grid.

CMOC's Congo mine suspends copper and cobalt exports

Congo is the world’s largest producer of cobalt and Africa’s leading copper miner. The country accounted for more than 70% of worldwide cobalt mine production in 2021, which is used in electric batteries.

Congo's government announced last August that it had formed a commission to reassess reserve levels, an interesting development given the rarity of Congolese authorities challenging the Chinese companies that dominate its mining sector. The latest move marks a major escalation from the government.

Average rent in Manhattan was a record $5,000 in June

The average apartment rent in June was an incredible $5,058, the highest on record, according to data gathered by Miller Samuel and Douglas Elliman. Average rental prices were up 29% over last year, while median rent was up by 25% to $4,050 a month.

UAE's ADNOC acquires Zakher Marine International

Abu Dhabi National Oil Company's Logistics and Services (L&S) subsidiary has bought the privately-owned company as it looks to bolster its offshore oil, natural gas and wind businesses with ZMI's offshore support vessels.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

Quotes

"People base their actions not on reality but on their view of the world, and the two are not identical. [...] Myths about the past have a bearing on the future."

— George Soros

"Power tends to produce overconfidence and the idea that you can make your own rules, and these consequences of having power often cause people to behave in ways that cost them their power and their position."

— Jeffrey Pfeffer

Charts

The humbling process of inflation

Some believe that investment decisions can be made based on inflation forecasts. However, trying to predict the future rate of inflation is like trying to forecast the weather. While it may seem simple, it is all-but impossible to do, especially if you are trying to forecast it several months or years out.

Over the last 12 months, inflation has become one of those inescapable topics. It is important to note that neither the bond markets nor economists have a great track record at forecasting inflation. Even the Federal Reserve, which has over 400 Ph.D economists, got it wrong, believing (or perhaps wishing) strong inflation was "transitory" (i.e. short-lived).

What makes inflation (like the weather) so difficult to try to predict is the sheer number and complexity of the variables involved, not to mention their volatile interdependencies. My favourite way of illustrating the difficulty of predicting inflation's path is by looking back at history.

The graph below shows inflation during the infamous inflationary period of the 1970s and early 1980s. Who could have predicted the following behaviour of inflation?

You will see that by summer of 1972, it seemed like inflation was well under control and reverting to the 1960s range. Instead, it U-turned and took off, this time surpassing its prior high. Four years later, it looked like inflation was again coming back down. Of course, it fooled everyone and took off once more and hit another new high.

What is the relevance of this given how different the world is today? Simply put, while economic conditions may differ, inflation's dynamics have not changed. Inflation is still highly unpredictable and as with most macroeconomic forecasts, a very humbling futile process for those who continuously try to predict it.

Pakistan's bond yields rally as pressures mount

In BTU issue #30, we covered Pakistan's woes. Pressure on the country has further increased with the government's 2027 USD bond trading at a yield north of 19%.

On 13th July, the IMF announced that they have reached a staff-level agreement (SLA) with the Pakistani government. If approved by the IMF's Executive Board, its Extended Fund Facility (EFF) will release ~$1.2 billion in funding, bringing the total disbursements under the program to ~$4.2 billion. The IMF is considering to extend the EFF until end of June 2023 while raising the total available funding to $7 billion, given Pakistan's higher financing needs and eroded reserve buffers.

The IMF's announcement shares further detail on the policy priorities of the program that they believe will help stabilize the economy. Strikingly, inflation in Pakistan exceeded 21% in June, hitting those on the lowest incomes particularly hard.

Venture capital extends losses, wipes out covid-19 gains

The Refinitiv VC index, which tracks US-based start-ups, is now down 57% and wiping out gains since the onset of covid-19.

VC funds are currently in the process of preparing their second quarter financial statements, raising interesting questions about how they will value their portfolios and what sort of markdowns they will be willing to show their investors.

Articles

TSMC sees resilient semiconductor chip sales, yet cuts capital investment plans

The world's largest chipmaker reported record profits, calming near term fears over headwinds for the industry. Notably, the company raised its 2022 revenue forecast however trimmed its capital investment plans by as much as 9% from its initial guidance.

China's property market trouble continues

Chinese authorities held emergency meetings with banks this week after growing alarmed that an increasing number of homebuyers across the country are refusing to pay mortgages on stalled projects. Homebuyers have stopped mortgage payments on at least 100 projects in more than 50 cities as of Wednesday 13th July.

Germany begins rationing hot water, dims its street lights and closes swimming pools

The energy crunch in Germany has begun to spread from the industrial parts of the economy to offices, leisure centres and homes. Europe’s biggest economy has plunged into its worst energy crisis since the oil price shock of 1973.

On Monday 11th July, Russia shut down its main pipeline to Germany, Nord Stream 1, for 10 days due to "scheduled maintenance". Some fear it will never reopen.

Europe is racing to reduce its heavy reliance on Russian energy supplies. The region received 45% of its natural gas imports from Russia last year, and it is currently rushing to refill storage facilities ahead of winter.

Tesla loses its top AI executive who led the 'Autopilot' vision team

After a four-month leave of absence, Andrej Karpathy announced that he is leaving the company. This follows news that Tesla was laying off 229 data annotation employees.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

Quote

"If you care too much about being praised, in the end you will not accomplish anything serious. [...] Let the judgments of others be the consequence of your deeds, not their purpose."

— Leo Tolstoy

Tweet

Nassim Taleb, most known for his 2007 book 'The Black Swan', minces no words. His tweet highlights the challenge that faces markets today, with rising interest rates bringing free/cheap money to an end.

As Taleb points out, with the changing backdrop, cash flows become the key focus point once again for most investors (rather than just some investors). It will be interesting to see how these developments will impact companies that rapidly burn cash, especially those that were funded by venture capitalists at elevated valuations over the last few years.

Charts

Softbank's 5-year Credit Default Swap hits highest level since global financial crisis

This week, Japanese bank Softbank's Credit Default Swap (CDS) hit the highest level since the 2007/08 global financial crisis as investors worried about its financial position, due to its significant exposure to unprofitable and highly valued technology companies.

CDS refers to a financial derivative that allows a lender to offset their credit exposure to a particular entity. For example, a lender of Softbank could swap the risk of default by buying a CDS on Softbank from another investor who agrees to reimburse the lender if the borrower defaults. Investors can also buy a CDS contract if they want to bet on a company defaulting on its borrowings.

Softbank, which led Klarna's $639 million funding round last year at a valuation of $45.6 billion, was hit by more bad news this week. The buy-now-pay-later company is expected to raise a $650 million round at a valuation of $6.5 billion, a fraction of its prior round. This will likely cause some pain at Softbank's second Vision fund, which manages $56 billion. In Q1 2022, the fund reported $800 million in investment gains. This will now mostly be wiped out by Klarna's write-down.

Some may remember that two years ago, Softbank was hit by a massive valuation reset at WeWork, whose valuation in 2019 hit a high of $47 billion and subsequently was slashed to $2.9 billion. Softbank had invested a reported $18.5 billion in the company. Now publicly listed, WeWork is valued at $3.6 billion.

Given the track record of the first Vision fund which manages $100 billion, Softbank struggled to convince investors to invest in a second fund and as a result, Softbank is believed to be the only investor in Vision fund II.

In 2021, Softbank was overtaken as the "world's busiest venture capitalist" by Tiger Global Management, according to Bloomberg.

Update: Hours before publishing, Rajeev Misra announced he was stepping back from his main roles at Softbank Group. This marks the exit of one of the key architects that drove the conglomerate's evolution into one of the largest technology investors in the world.

Credit Suisse 5-year CDS hits highest level since 2009

Credit Suisse CDS hit an alarming level not seen since the global financial crisis. The bank has been scaling back its leverage exposure but continues to get caught up in various scandals. The bank has vowed to push ahead with its risk management and compliance overhaul while navigating what the CEO described as a "challenging" environment.

Articles

SEC rejects Grayscale's application to convert its Bitcoin trust into an ETF

The U.S. Securities and Exchange Commission (SEC) put together an 86-page rejection document, detailing that "the record does not support a finding that the Exchange has demonstrated that the bitcoin market as a whole or the relevant underlying bitcoin market is uniquely and inherently resistant to fraud and manipulation".

The commission's possible sources of fraud and manipulation in the spot bitcoin market include (page 73):

• "Wash" trading (i.e. buying through one broker while simultaneously selling through another broker)

• "Persons with a dominant position in bitcoin manipulating bitcoin pricing"

• Hacking of the bitcoin network and trading platforms

• Malicious control of the bitcoin network

• "Trading based on material, non-public information" or based on "the dissemination of false and misleading information" (example: plans of market participants to significantly add or reduce their holdings in bitcoin, how a bitcoin-based investment vehicle will respond to a "fork" in the blockchain)

• "Manipulative activity involving purported "stablecoins" including Tether (USDT)" [it is interesting that they specifically mention Tether - we wrote about Tether in BTU Issue #8]

• Fraud and manipulation at bitcoin trading platforms

The SEC has now rejected over a dozen spot bitcoin ETF applications during the past year, while approving several bitcoin futures-based ETFs.

Five countries seek to delay EU fossil fuel car phase-out

The current energy crisis gripping Europe is pushing some countries to re-visit their energy transition plans. Italy, Portugal, Slovakia, Bulgaria and Romania want to delay an EU plan to effectively ban the sale of new petrol and diesel cars from 2035 by five years, according to Reuters.

Brussels believes the 2035 date is critical due to the fact that the average lifespan of a new car is 15 years, enabling the EU to reach net zero emissions by 2050.

Interestingly, Germany's finance minister broke ranks by stating that he does not support his own government's agreed position.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of ‘Buy the Umbrella’, a short list of interesting things I’ve been reading and thinking about during the week.

Quote

“Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” 

— John Kenneth Galbraith

Charts

Australian residential land value hits a new high

As a percentage of GDP, Australian residential land is now worth more than residential land in Japan at the peak of the epic 1990s bubble.

Australian households are amongst the most indebted in the world, which is potentially problematic now that the country's central bank has begun to raise interest rates to fight inflation.

Data from the Bank of International Settlements showed total credit to Australian households amounted to ~120% of GDP, trailing only to Switzerland’s 130% and was far higher than the average of ~75% for developed economies.

Initial jobless claims as an indicator of market lows

Jefferies put together a chart showing that the S&P500 tends to bottom when jobless claims reach a peak and begins to steadily move downwards. Based on their historical analysis, excluding the anomaly of the mandatory lockdowns and re-openings, it has taken anywhere from five months to three years for the initial jobless claims to peak.

Of course this sort of analysis is easier to do with hindsight, as the unanswerable question is: how do we know when jobless claims have peaked? Peaks and troughs in any time series are only obvious when looking backwards in time.

Articles

Denmark urges its citizens to take shorter showers and dry clothes outside

Europe's energy crisis has hit a new level of severity, with no sign that the region's gas price gains are abating. Households account for ~29% of Denmark's gas usage, therefore the government is trying to pull levers to lower demand.

Denmark is amongst a handful of nations that has had its gas taps switched off by Russia, after it refused to pay for the fuel in Russian rubles. The country is due to get a supply boost from Norway through the new Baltic Pipe in October. 

Macron tells Biden that Saudi Arabia and the UAE unable to boost supply significantly

The French President reportedly was told that Saudi Arabia and the UAE are unable to raise oil output significantly. Following the media reports, the UAE Energy Minister released a statement clarifying that "the UAE is producing near to our maximum production capacity based on its current OPEC+ production baseline".

Podcast

The thought-provoking podcast titled "Making Sense of the Market" with Aswath Damodaran, a Professor of Finance at NYU’s Stern School of Business, interviewed by Patrick O'Shaughnessy is a worthwhile listen (podcast and the transcript can be found here).

Here are some of the fascinating takeaways:

Inflation

Damodaran breaks down inflation into two components:

• Expected inflation (the more "benign" part of inflation)

• Unexpected inflation (the more "deadly" part for investors)

Why is expected inflation considered benign? Investors can build it into their financial assets. Using a simplistic example, let's say there's a bond yielding 8%. If you expect inflation to be 5%, you may feel you are adequately compensated. On the other hand, if unexpectedly you end up with inflation at 9%, the bond's price falls and if you were to hold the bond until maturity, you will have generated a real return of -1%. This is why unexpected inflation is considered deadly.

The 1970s were particularly painful as unexpected inflation regularly came in above expectations and had a significant negative impact on financial assets. In contrast, while inflation was high during the 1980s, investors began to price sufficiently high inflation expectations into financial assets, hence when inflation came in lower than expected, markets rallied.

"My concern with what's been happening in 2021 and 2022 was seeing a pattern that we saw in the seventies, which is people's expectations are set by what they've lived through [...] if you look at the investors in the market in 2021, enter the market in the last 10, 15, 20 years. For those people, the only inflation they've known is low and stable inflation. It takes a while, and this is the behavioural component, for people to adjust their expectations."

The question driving markets is, if we can agree that inflation is unlikely to soon go back down to last decade's trend of 1-1.5% level, where will inflation land between that and the current rate of 8-9%? Inflation is like the genie in a bottle. Once out, it is difficult to put back in place.

Discretionary versus non-discretionary matters in an inflationary environment

For non-discretionary purchases like groceries, retailers can pass on the increase in costs by raising prices. Today, the challenge investors face is that society spends money on a wide range of things that didn't exist during the last inflationary period. For example, we do not know how discretionary or non-discretionary a Netflix subscription is, or how critical it is to upgrade your iPhone when prices are rising by double digits. It looks like we are going to find out soon.

"With Apple, the problem is you've essentially built a $3 trillion, $2.5 trillion company now on a single product."

Inequality

The government is stuck between a rock and a hard place:

"If you had concerns about income inequality coming into this process, it's going to get exacerbated by whatever inflation does, at least at the lowest end of the weight spectrum."

To fight inflation, governments have to reduce demand by pushing the economy into a recession, which hurts exactly the same people.

Real estate

Real assets generally hold up against inflation better than financial assets. It is believed to be the reason why real estate did well during the 1970s.

"The only problem is we screwed up real estate as a physical asset by securitizing it. What's happened as we've securitized real estate is it started to behave more like stocks and bonds."

Misalignment driven by poorly designed incentives

The way the industry ranks investment managers encourages them to not just be risk takers, but reckless risk takers because that is how you end up at the top of the "alpha" list.

"The Hippocratic oath of doing no harm should really be first, front and centre for anybody managing other people's money."

"It's amazing how as human beings when we succeed, we attribute it to our skills. And when we fail, it's always bad luck."

"There are many people who claim to be investors, but they're really playing the momentum game. It's amazing how their top ten stocks happen to be the ten stocks that have gone up the most over the last two years. It's amazing that your value approach gave you those same ten stocks. Traders masquerading as investors."

Interest rates are set by markets

"Interest rates ultimately are not set by the fed, and this is I think the delusion that's driven a lot of bad investing choice over the last fourteen years, is the fed can keep rates at whatever it wants to, no matter what happens."

Damodaran believes investors have been spoiled by a decade of low interest rates which is why inflation is going to be such a painful adjustment process.

Merits of more disclosures

"Have you read the risk section in any prospectus? 50 pages of garbage. [...] Companies have learned to play the game. They've discovered that if you disclose everything, it's like disclosing nothing, you lose perspective. They don't know the big thing versus the small things."

ESG

"I've become more and more convinced that the reason it's [ESG] taken off is it's become a money machine for the people involved."

He believes these people include the asset managers, the investment banks, the consultants, the "experts" and the academics.

"It's [ESG] a feel good scam [...] Your definition of good and my definition of good are going to be very different. [...] They're going to come up with some other buzzword to replace it. Because that is the history of businesses, what was ESG was called SRI and CSR."

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of 'Buy the Umbrella', a short list of interesting things I’ve been reading and thinking about during the week.

Quotes

“If opportunity doesn’t knock, build a door.”

— Milton Berle

Chart

Energy transition will require extraordinary supply increase in key commodities to meet targets

Politicians and environmental activists continue to push for a sustainable energy transition, citing climate change and irreversible harm to our planet. Interestingly, few go into the logistical details and highlight the amount of commodities that we will need to extract in order to accomplish this so-called green transition.

Wil VanLoh, founder & CEO at Quantum Energy Partners, put together this fascinating chart illustrating the current demand for the key minerals versus the expected demand to make this shift happen by the 2030 global target. According to VanLoh, we have never been able to increase the global supply of any extractive industry by 300-500% in a decade, which is what is required.

Looking at the chart makes us wonder: can extracting such huge quantities of these minerals really be considered environmentally friendly?

Article

Apollo and Carlyle see private equity buyout fundraising slowdown

With market volatility remaining high, Apollo, which expected to raise a $25 billion fund in one close by year-end has been forced to adjust its timetable according to Bloomberg. The firm is now preparing to have an initial close at half the original goal. Apollo's CEO Marc Rowan stated that “there’s no way anyone will raise money on the schedule they’ve initially envisioned".

Similarly, Carlyle is also behind schedule for its flagship fund as pension funds and other large institutions face a challenging market backdrop, making them reluctant about locking up more money in illiquid funds. Carlyle's CEO believes that "there is an overcrowding" in private equity.

If the larger and more established players are experiencing a more challenging fundraising environment, it is likely that the smaller players and newer funds are in a difficult spot too?

Working paper

Lawrence Summers recalculated historical inflation readings, allows for apples-to-apples comparison

Some of us may be aware of the highly inflationary environment of the 1970s, when headline inflation eventually peaked at 14.8% in March 1980 and fell to 2.5% by July 1983, following aggressive policy decisions by the Federal Reserve Board under Chairman Paul Volcker.

Last week, the U.S.' Bureau of Labor Statistics reported the official inflation rate hit 8.6% in May. While this may still seem a long way off the inflationary 1970s and early 1980s, it is important to point out that the U.S. government has made meaningful changes to the way it calculates the consumer price index (CPI), a.k.a. the inflation rate, over the decades.

Given today's elevated price pressures, a group of economists, including former treasury secretary Lawrence Summers, published a working paper that recalculated historical readings for the CPI to apply modern-day spending patterns and allows for an apples-to-apples comparison.

Interestingly (perhaps unsurprisingly to some), they found that the current level of inflation is much closer to past inflation peaks than the official series would suggest. The adjusted inflation peak in 1980 ran at 9.1%, half a percentage point above May 2022's level.

In addition, they found that the rate of core CPI disinflation caused by Volcker-era policies is "significantly lower when measured using today’s treatment of housing: only 5 percentage points of decline instead of 11 percentage points in the official CPI statistics". This suggests that to return to 2% core CPI inflation today "will thus require nearly the same amount of disinflation as achieved under Chairman Volcker".

Volcker’s monetary tightening sent the federal funds rate up about 10%, to a peak of 20% in the early 1980s. The current federal funds target range is 1.5%-1.75%.

Video

Stanley Druckenmiller masterclass

Stripe co-founder John Collison interviewed legendary investor Stanley Druckenmiller at the Sohn 2022 conference and unsurprisingly, it is a must-watch for all investors.

Druckenmiller once managed George Soros’ Quantum Fund and shot to fame after helping make a $10 billion bet against the British pound in 1992. He later oversaw $12 billion as president of Duquesne Capital Management before closing his firm in 2010, and turning Duquesne into his family office.

His current macroeconomic view:

“The probabilities of being a soft landing [for the economy] are pretty remote. Historically, I think we’ve only pulled off two or three in history....there’s so much wood to chop. And there’s been such a broad asset bubble going into it.”

“Once inflation has got above 5%... it’s never been tamed without a recession. So if you’re predicting a soft landing, you’re going against decades of history.”

“Given the extent of the asset bubble and the destruction in the markets, given what’s going on in Ukraine, giving zero Covid policy in China, I don’t take a lot of comfort from that.”

“So I assume, and pretty strongly, soon we’re going to have a recession sometime in 2023.”

"My best guess, and this business is about guessing, there are no certainties: we are six months into a bear market that has some room to run."

"Think about the fact that we have had virtually no bankruptcies, this is probably the most disruptive period since the 1890s... if you look across the landscape, there should have been many many bankruptcies but they have been buried by QE..."

Druckenmiller has consistently outperformed the federal reserve in terms of macroeconomic forecasts over the last 20 to 30 years, here's how:

"I don't use what traditional economists use to predict the economy, things like employment and a bunch of top down macro statistics... over time I learned that the inside of the stock market has a very very prescient message about future economic activity. For whatever reason, stocks tend to lead the fundamentals by 6-12 months. Can even go beyond that by looking at industries that lead the economy and industries that lag the economy. The obvious one that everyone knows about is housing, is traditionally been looked at as a leading industry, retail has slightly, capital goods lag. Historically, we do the macro by a compilation of listening to companies and doing a bottoms-up analysis of industries that lead the economy and industries that lag the economy. If the leading industries are turning up or turning down, that's a signal. That has worked beautifully historically."

What the stock market is currently indicating:

"Homebuilders, with supposedly good fundamentals, have all declined 50% from their highs. Trucking industry is down 40%, despite the fact they are reporting record earnings. An industry which is not that much of a leader but is more of a leader than a laggard is the retail industry... a little tainted as retail went to 100% of the wallet [spend] from 85% because we weren't going outside and travelling... but even then, taking that into account retail appears to be much weaker than it should be given what the so-called GDP numbers are printing. Right now there is a signal, albeit early, that there may be trouble ahead... a lot of these things have longer lead times like six months to a year."

On the bond market:

Unfortunately, the last 10 to 11 years, the bond market has not signalled anything because the central banks took it upon themselves to manipulate bond prices. To me, the 10-year [U.S.] treasury is the most important price in the world.

During the interview, Druckenmiller's passion for the investment business shines through. He even addresses the topic directly:

It makes everybody think I'm a hard worker because I'm attracted to the game. There's a life lesson. I've seen young people who looked like they were lazy. When they find their passion, they become very driven. I just happen to be passionate about this particular discipline. I don't know whether I have a hard work ethic. But that's the end result of my passion."

His key advice to new investors:

"Do not invest in the present. The present is not what moves stock prices. Change moves them. I want you to try and envision a different world in a year and a half from now.”

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone who would enjoy it.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of 'Buy the Umbrella', a short list of interesting things I’ve been reading and thinking about during the week.

Book of the month

Richer, Wiser, Happier is a brilliant book by financial journalist William Green. Interviewing some of the smartest investors in the world, Green helps us uncover a range of insights such as how the investors maximize their odds of long-term success in markets, what we can draw from their life lessons and how we can improve our own thinking.

The list of investors includes Mohnish Pabrai, Sir John Templeton, Howard Marks, Jean-Marie Eveillard, Joel Greenblatt, Will Danoff, Nick Sleep, Qais Zakaria, Tom Gayner, Charlie Munger, Ed Thorp and Bill Miller.

As Green finds out, "the best investors tend to be open-minded pragmatists who search relentlessly for ways to improve their thinking".

Quote

“The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of the country.”

— Milton Friedman

Chart

U.S. households savings rate drops, credit card loans at record highs

During the early stages of the covid-19 pandemic, the U.S. government handed out three separate checks to eligible individuals: $1,200 in April 2020, $600 in December 2020/January 2021 and $1,400 in March 2021.

These handouts were the primary drivers behind a significant boost to the household savings rate (blue line, right axis) and the resultant reduction in credit card and other revolving loans (red line, left axis).

Since the end of these programs, and the consequent inflationary pressures, households now have the lowest savings rate since the global financial crisis and have had to turn to more short-term loans than ever before. The combination has resulted in subprime borrowers missing loan payments faster-than-normal, raising eyebrows given the expected interest rate increases to come over the next few months.

Articles

Pakistan Rupee drops past 200 a dollar with IMF bailout uncertain

On May 19, Pakistan’s currency fell past 200 a dollar for the first time ever as a shortage of dollars threatened to spiral into a full-blown crisis. The country's foreign-exchange reserves now cover less than two months of imports. 

Policy makers are in talks with the International Monetary Fund (IMF) to revive a stalled $6 billion loan program. Key conditions would require Prime Minister Shehbaz Sharif to raise fuel and electricity prices, which risks public backlash given inflation is already at 13%. Meanwhile, ousted PM Imran Khan has threatened to add fuel to the fire (no pun intended) by leading street protests calling for early elections.

On May 28, the currency saw some respite which has proven temporary, as the government duly obliged to one of the IMF preconditions by raising fuel prices, paving the way for the release of $1 billion. Further price hikes are expected, in addition to the removal of subsidies on electricity rates.

Separately, the Pakistani government is currently in talks with the Chinese government over the rollover of a $2.3 billion syndicated Chinese loan it paid back in March.

UAE Energy Minister: We are nowhere near peak oil prices

With Brent crude over $123 a barrel, Suhail Al-Mazrouei believes we are "nowhere near" peak oil prices given the expected rebound in Chinese demand, adding further pressure to an already tight oil supply backdrop. The UAE is a key OPEC+ member.

The Energy Minister added that without more global investment in oil and gas, OPEC+ cannot guarantee sufficient supplies as demand continues to rise. Aside from 2-3 members, the rest of OPEC+ members are maxed out in terms of the supply they can bring online. What will happen when the other members run out of spare capacity?

Al-Mazrouei pointed out that prices can reach "unseen" levels if Russian oil and gas is completely taken off the market given we are already "lagging by almost 2.6 million barrels a day, and that’s a lot”.

Note that OPEC+ production has consistently missed their own supply targets, despite every economic incentive to do the opposite and will likely struggle to deliver on recent pledged increases.

Hedge fund D1 which borrowed $2 billion to buy stakes in private companies, braces for plunging valuations

At BTU, we have been concerned about the elevated valuations and the amount of money chasing private companies, particularly within the tech sector. In Issue #13, we raised the fact that exits continue to be a small fraction of deal count, hovering around 10% even during the 10+ year equity bull market.

We are now starting to learn that some hedge funds bet heavily on exciting yet money-losing start-ups. Hedge funds are the least capable of withstanding major valuation shocks given their liquidity mismatch (investors can typically redeem their money within 1-12 months, but are investing in illiquid start-ups with low exit probabilities). This can result in fire sales or worse, a "run on the bank" type scenario.

Bloomberg reported that the industry is "bracing for a reckoning". Hedge funds improved their returns by investing in start-ups (while times were good) and simultaneously lowered their perceived volatility as private companies are revalued less frequently (in industry lingo, this improved their "information ratio"). D1 is certainly not the only hedge fund that followed this strategy. Bloomberg highlights that Tiger Global, Lone Pine Capital, Coatue Management and Viking Global Investors are also the "most active buyers of those assets". Unsurprisingly, Tiger Global has enacted a redemption plan.

China technology stocks rally as optimism builds over regulatory crackdown easing

Investors in Chinese technology stocks have struggled since the government crackdown began towards the end of 2020. This week, there were encouraging signs that the regulatory pressure on the sector may be abating, after the government approved a new batch of video games and regulators ended their year-long probe on Didi, enabling the company to return to domestic app stores after being removed due to national security concerns.

It is expected that Didi will receive a large fine, and may have to offer a 1% equity stake to the state as well as hand over more direct control, following the path of Weibo and Beijing ByteDance Technology, the company behind Douyin and TikTok.

Separately, China is considering reviving Jack Ma's Ant Group IPO which it halted in November 2020. The company is expected to soon receive a long-awaited license that would result in it being regulated more like a bank.

Podcast

Tim Ferriss recently interviewed legendary investor Edward Thorp. The podcast (found here) is a wonderful listen, full of thought-provoking content and wisdom. If you prefer to read the transcript, it is available here.

Here are some of our favourite parts:

Thorp, a mathematician, got into investing having made money at blackjack and from book royalties. When it comes to investing, he believes that most people should simply invest in index funds, rather than try to manage their own portfolios. He does make an exception for those that are really interested in investing:

If you really are interested in investing, it’s worth educating yourself and trying to do it because you will learn a lot about investing. You might actually find a way to win and you’ll learn about how the world works and a lot about life too. The things you learn from what seems like a narrow, specialized field, generalizes very widely to all kinds of things if you’re the kind of person who can take a lesson in one part of life and transport it to another part of life.

Thorp considers himself "very risk averse" despite his track record of very high returns:

If you lose most of your capital, it’s very hard to climb back out. For instance, if you lose 90 percent of your capital, you’ve got to multiply what’s left by 10 in order to get back to even, which means you’ve got to make 900 percent to offset that 90 percent loss. That’s not going to be easy to do. It takes a long time. So you want to avoid really bad outcomes.

He emphasises the importance of learning how to think, not what to think:

If you think fast, it’s kind of emotionally from the gut, responding without really reflecting. You will make a lot of mistakes. Sometimes though it’s a way of saving your life. For example, somebody yells fire, you’re at the door of the theatre, you run out the door immediately, before you find out whether there is a fire.

Some words of wisdom:

What’s important in life, I think is the journey and the people you know and you spend your time with and how you spend your time otherwise also.

One of the things that makes you independent is to accumulate capital because then the capital can grow on its own if it’s simply invested as I described before, in, for example, an index fund. And once you have capital, then you have the chance of independence. If you have enough capital, it will support you indefinitely. So when you’ve achieved that goal, there’s no point in spending time doing anything you don’t like doing if you can help it. I have to do some things you don’t like, like gather all your tax information together every year, or go in for routine medical appointments.

Edward Thorp leaves us with a powerful story and some food for thought:

Joseph Heller wrote his famous book, Catch-22, of which they made a movie way back maybe 50 years ago. I’m not sure exactly when. But it was very well known and famous at the time. And Kurt Vonnegut is well known too for a variety of books. And Joseph Heller died, I’m not sure when, maybe early 2000s. And Kurt Vonnegut was writing in The New Yorker about him. And he said, “Joseph Heller and I were at a hedge fund mogul’s house.” I’m not sure if it was hedge fund mogul, but somebody very, very rich in New York. “And I said to Joseph Heller, ‘You’ve made a lot of money out of Catch-22. This guy makes as much money in a day as you’re ever going to make. He’s got penthouses and yachts and jets and villas and models falling off his arm and so on.'” And Joseph Heller looked back and said, “I have something he’ll never have.” Kurt Vonnegut was puzzled and he said, “What’s that?” Heller said, “I have enough.” And that’s something that people who endlessly chase money to the end don’t figure out: that you can have enough and it’s better than not having enough.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone like-minded.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of “Buy the Umbrella”, a short list of interesting things I’ve been reading and thinking about during the week.

Quote

“Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.”

— Albert Einstein

Charts

Private sector sensitivity to rising interest rates

In BTU issue #12 we shared a chart of U.S. households' transition towards fixed-rate mortgages and away from adjustable-rate mortgages, helping cushion households from rising interest rates.

Furthermore, corporates and households' direct sensitivity to higher interest rates should be relatively low given the loan-to-deposit ratio at US banks is at a 50+ year low. In fact, the private sector currently sits on $5.8 trillion of gross savings therefore, all else equal, 200 basis points increase in interest rates on these assets would add $116 billion per year to gross income. Of course, other variables will not remain constant. Nonetheless, could a rate hike perversely stimulate demand? More importantly, will we therefore need more rate hikes in order to tame spending and bring down inflation?

We must not forget that monetary policy acts with a long and unpredictable lag. The Fed believes it can take anywhere from 3-24 months to impact the economy, and the effects on inflation "tend to involve even longer lags, perhaps one to three years, or more".

Oil market structure continues to be bullish

The International Energy Agency's (IEA) chief believes that the current energy crisis is "much bigger" than the oil shocks of the 1970s and that it would also last longer.

This is illustrated by U.S. inventories which continue to decline and are currently below the 5-year average. The U.S. Energy Information Administration (EIA) currently believes this will begin to resolve itself during the second half of this year and into 2023. The EIA has so far persistently underestimated the strength of oil demand - what happens if demand continues to outpace supply?

In addition, the IEA chief believes that Europe could face fuel shortages this summer due to tight oil markets. Demonstrating the global squeeze, oil markets are currently in backwardation (i.e. oil sold and delivered today is more expensive than oil stored and delivered in the future), which historically has been bullish for oil prices as per the chart below:

Saudi Aramco, which produced 13 million barrels of oil equivalent per day in Q1 2022, highlighted the need for substantial new investments to compensate for the decline in existing fields. In the graph below, the dark green area shows the global supply at natural decline with no new investment, while the lightest green shows the additional level of investment needed on top of what is already planned to ensure oil supply can meet 2030 demand.

Management believe at least $400 billion per year in capital investment is needed to meet current demand, yet upstream investment continues to be materially below that level, as highlighted by the bar chart. This suggests higher oil prices are likely to be with us for a while.

Food prices continue their two-year-long upward trajectory

In nominal terms, the World Bank's Food Commodity Price Index hit a record high in April 2022. These developments are being closely tracked by the World Bank and discussed in a chart-filled blog post which is helpful read to understand what got us to this point. The World Bank expects food prices to rise ~20% this year before easing in 2023, although it is not clear what will drive the easing.

In the U.K., the Office for National Statistics (ONS) has found a "substantial range of price movement" for the lowest-cost grocery items:

Article

Dubai saw the biggest increase in high-end property prices globally

In 2021, Dubai's prime real-estate prices rose 56%, according to Knight Frank. This is believed to be a result of the government’s nimble response to the coronavirus which boosted investor confidence and pulled in money from around the world. Incredibly, the move topped every other major city and far exceeded increases of 1.3% in London, 3.6% in New York and 19% in San Francisco.  

Investor report

Bridgewater have published a 10-page update from their CIOs titled "What was coming is now upon us" and is a worthwhile read.

A few interesting takeaways:

• While we have had two federal reserve interest rate hikes and a series of further hikes are priced in, Bridgewater note that the market is discounting a high likelihood of easing following the hikes, which is atypical.

• "The yield curve is flat from three years to thirty years, discounting either no risk premium in bonds or a significant easing after a moderate tightening cycle".

• A big supply/demand "hole" is developing in the bond market, given the fed is expected to start unwinding its balance sheet, foreigners are selling and the U.S. government is issuing more bonds. Who will step in to bridge the gap?

• Discounted earnings have "not changed much" despite a clear present value effect on equities for the most liquidity-sensitive, longer-duration cash flow companies.

• Nominal GDP growth continues to be "well above" levels of interest rates, which "supports the self-reinforcing nature of nominal spending, income, and credit growth". This difference in the U.S. is as wide as any time in the past six decades.

• Nominal growth rates are high and have "a lot of momentum" however, real growth is weakening as economies approach capacity constraints. As a result, "increasingly high nominal spending is being absorbed by prices, so you get less real stuff for your money". Low growth and high inflation (aka stagflation) is challenging for central bankers as they are "forced to choose between two undesirable outcomes: tighten to control inflation at the cost of an economic downturn, or don't tighten and allow a higher level of inflation".

Things that make you go hmm...

Frothy valuations have driven median venture capital Series A post-money valuations higher by 92% over the last two years alone according to Pitchbook data. It is likely that venture capitalists who "won" deals based solely on paying the highest price will probably have a tough time going forward.

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone like-minded.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to ‘buy the umbrella’ before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.

Here is your latest dose of “Buy the Umbrella”, a short list of interesting things I’ve been reading and thinking about during the week.

Quote

“The history of the stock market shows many periods of twenty years or more when stock prices ended up precisely where they began.”

— Peter Bernstein

Charts

Equity allocations remain high despite declining U.S. consumer sentiment

U.S. equity market exposure continues to be at an elevated level according to the latest AAII survey, despite a rapid deterioration in consumer sentiment. In fact, consumer sentiment is already near the levels hit during the Global Financial Crisis in 2007-2008.

Given the close relationship these two variables have had over the last thirty years, could it be possible that a further sell off by institutional investors is lurking? Or will consumer sentiment rebound rapidly? A divergence this extreme is unlikely to hold up for long.

Inflation expectations continue to move higher

Since 2020, economists have had to push their US inflation expectations higher every few months. Despite this, they continue to believe that inflation will rapidly revert to approximately 2%.

The chart below is a helpful reminder to keep an open mind with regards to the future as no-one has a crystal ball, whether they are economists or even central bankers as per this tweet.

Short-interest at 1999/2000 lows

Goldman Sachs put together an incredible chart, showing that bearish bets against S&P500 stocks is at a low last seen as the dotcom bubble was about to deflate. Remember the saying: "history doesn't repeat itself but it often rhymes".

Breaking down current bearish wagers by sector is equally fascinating, with information technology at 0% quintile ranking versus history, despite elevated valuations.

Articles

Snap plunges 40%+ after CEO warning

This week Snap, the social media company behind SnapChat, warned that the macroeconomic environment has deteriorated "further and faster" than they expected when they issued their quarterly guidance just last month.

The CEO, Evan Spiegel, added “as a result, while our revenue continues to grow year-over-year, it is growing more slowly than we expected at this time” and as a result the company will slow its pace of hiring for the rest of the year.

India to limit sugar exports, adding to global food prices pressure

Bloomberg reported that India is set to restrict sugar exports as a precautionary measure to safeguard its own food supplies, another act of protectionism after banning wheat exports just over a week ago.

The move could be announced in the coming days, according to Bloomberg's sources. Critically, India was the world’s biggest sugar exporter after Brazil last year, and counts Bangladesh, Indonesia, Malaysia and U.A.E. among its top customers. 

UK being warned of ‘apocalyptic’ food price rises

A quarter of Britons have resorted to skipping meals as inflationary pressures and a worsening food crisis combine in what the Bank of England recently dubbed an “apocalyptic” outlook for consumers.

A major British caterer commented that schools were now facing “difficult decisions” as to whether to reduce meal sizes or use lower quality ingredients amid surging prices.

Video

How to think about risk

Howard Marks' presentation on risk at Wharton is brilliant and thought provoking (full video at the bottom), addressing the most important question for all investors: how should we think about risk?

Marks makes a great point that many overlook: investor returns only tell you one part of the story. Performance has to be viewed in risk-adjusted terms. How much risk did the investor bare to get this return? What would returns have looked like if markets were hostile?

"Risk is the ultimate test of investment skill:

- It is not hard to achieve investment return

- That's especially true when the market rises, which it usually does

- The real achievement is achieving return with less-than-proportionate risk

Achieving an above average return with average risk is a significant accomplishment. Achieving an average return with below average risk is an equally significant accomplishment, albeit easily overlooked."

To demonstrate this Marks look at two scenarios:

A) the market generates returns of +10% and B) the market returns -10%. He then looks at the returns of several investors in both scenarios to figure out whether they are adding value or not.

Investor A generates returns in line with the market, with market equivalent risk. Investor B meanwhile generates 2x market returns for 2x market equivalent risk (i.e. she is more aggressive). Investor C generates 0.5x market returns for 0.5x market risk (i.e. she is more conservative). Howard Marks points out that all three do not generate any real alpha (no skill) when taking into account their risk levels.

Now consider Investor D who adds value by generating asymmetry in returns: +15% in the first market scenario and -10% in the second. This suggests that she participates in the gains to a greater extent than the losses. Likewise, Investor E participates in the market returns in scenario A but loses less than the market in scenario B, highlighting that there are different ways skilful investors can add value.

Critically, Marks emphasises risk is not volatility although it can be an indicator of the presence of risk (a symptom). Otherwise, wouldn't venture capital and private equity be one of the least risky asset classes given they are not priced daily, weekly or even monthly and therefore appear to have less volatile returns? Of course, we know that is not the case.

So what is risk?

There are several types of risks to consider however, the most important one is the probability of permanent loss. This is followed by the risk of missing out on opportunities that drive a serious performance shortcoming, and the risk of being forced to sell at the market lows due to margin calls, loss of confidence or the need for cash. Unfortunately, risk cannot be quantified in advance or even in hindsight and is "a matter of opinion. A variety of experts will view it and quantify it differently".

Risk is largely a matter of price: "risk is not a function of asset quality: a high-quality asset can be priced so high that it's risky".

Consider this: most investors believe that to generate higher returns, you have to take higher risks. If high risk investments could be counted on to produce high returns, then they would not be risky. In reality, riskier investments have a wider range of outcomes, i.e. they are far from certain to deliver on their promise of high returns, as illustrated in the chart below:

Risk is something that should be dealt with constantly, not sporadically.

Highly skilled investors assemble portfolios that will produce "good returns if things go well and resist decline if things go poorly". Keep in mind: this is a hidden accomplishment most of the time as "risk only turns into loss occasionally... when the tide goes out".

“Only when the tide goes out do you discover who's been swimming naked.” — Warren Buffett

Ultimately, we should not expect to make money without bearing risk, but we also "should not expect to make money just for bearing risk".

Outstanding investors are "outstanding because they have a superior sense for the probability distribution that governs future events, and for whether the potential returns compensate for the risks that lurk in the distribution's negative left-hand tail. This enables them to achieve the asymmetry that characterizes them".

Until next time...

Thank you for reading this week’s issue. If you found it interesting, consider sharing it with someone like-minded.

Do you have any questions or thoughts? Please feel free to reach out.

Have a wonderful week.

Why ‘Buy the Umbrella’?

Individuals, many of whom also run businesses and governments, tend to not think of the downside when the present is stable, and the future is looking positive (usually when we feel most in control).

Just because it is currently sunny, does not mean it will never rain. If we are not prepared, once it does begin to rain, we will end up running around looking for an umbrella in the middle of a storm, when they tend to be in short supply. We therefore need to 'buy the umbrella' before it rains.

Simultaneously, we cannot allow our awareness of risk to make us fearful, pessimistic, or paranoid, as this too works against us over the long-term.

Having the right mindset in advance is critical. The challenge is getting the right balance between being optimistic about the future and being able to not only withstand future crises, but in fact grow stronger due to the opportunities they tend to present.

It is not enough just to be conservative. One needs to be willing to put our cash to work when others feel least comfortable doing it. To do that with confidence, we need to have a foundational understanding of history, business, markets and human psychology.

Our mission at BTU is to learn as much about the world as possible, and in doing so, to try to find investment opportunities with favourable risk/reward characteristics. These should, over the long term, help build sustainable wealth.