'Buy the Umbrella' - Issue #43
Hi there!
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."
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.