I sold my Gazprom ADRs yesterday. The shares popped nearly 22% after the company proposed a 60% increase in its 2018 dividend. If you are unfamiliar with Gazprom, it is Russia’s state-owned natural gas behemoth. It is also probably one of the cheapest non-distressed stocks in the world on an absolute basis.
My truest investing self is a Ben Graham-style bottom-feeder who is happiest scooping up feared and loathed investments at significant discounts to book value. This is stuff that’s gotten so cheap all you need is for things not to deteriorate too significantly and you will make some money. Meanwhile, if things break even a little bit your way you stand to make a lot of money. It is the kind of stuff that sometimes actually makes people angry when you tell them you own it.
There are not many places in the world today where you can find non-distressed businesses trading at massive discounts to book value or on 5x earnings or whatever.
But you can find them in Russia.
To me, it is beyond question that Gazprom trades at a massive discount to the value of its net assets. You don’t exactly have to be an accounting wonk to understand that. Gazprom controls almost 20% of global natural gas reserves and supplies nearly 40% of Europe’s natural gas. It trades at 0.3x book value.
The problem you have is that the market has to believe there is a realistic path to unlocking that value in order for the stock to trade up.
Read that again. Slowly.
It is critical to understand Gazprom doesn’t have to actually unlock any value for the stock to work. The market just has to believe it will. In fact, if the market begins toassign even a modest probability to management unlocking value, the stock will start to work.
This is still not straightforward for a company like Gazprom, where it’s pretty obvious the company is being looted and the Russian state is at a minimum complicit in the looting, if not itself the architect of the looting. There was a Sberbank equity analyst, Alexander Fak, who made a compelling case Gazprom is being looted primarily via its capex. (A bit too compelling a case, apparently, as Mr. Fak was fired soon after issuing his report)
Which brings me to the reason I am content to sell my Gazprom ADRs now, despite the fact they may trade up further in the short-term. Because of all its capex, Gazprom is free cash flow negative. By my calculation, management is proposing paying out something like RUB 380 billion of dividends for 2018. Fine and dandy on a net income of RUB 1,456 billion but not so much on free cash flow of RUB -22 billion.
My take on this is that the Russian state is engaged in some first-class financial engineering: loot the company via capex and plug any holes with borrowing. Dividend Recap: SOE Edition!
As an investor, it’s never a good idea to rely on fat dividends that aren’t backed by robust free cash flow to support an investment case. Us bottom-feeders tend to learn this the hard way early on in our investing, by averaging down value traps.
Could Gazprom play this financial shell game forever? Sure. The company is a quasi-sovereign entity. But there is a price above which I am less and less thrilled about entrusting the fate of my investment to the amity and goodwill of the Russian state and for me that threshold was about $5.65 per ADR.
Maybe some day Gazprom’s capex will come down and the financials will make a bit more sense. If so, I may happily own it again. But for now this is one of those cases where “money talks and bullshit walks.”
My Larger Point
For those of you who are also Ben Graham-style bottom feeders, I cannot emphasize the importance of catalysts for these types of investments enough. In this day and age, stuff that gets this cheap tends to be cheap for a reason. To the extent you’re not looking at a value trap you are almost certainly looking at something where there is a major impediment to value realization.
One of the things I spend more and more time thinking about on the up-front now is how those impediments might be cleared. I must admit I didn’t spend enough time thinking about this with Gazprom when I initially invested.
Shareholder activism is one obvious solution. If an activist is involved, congratulations! You’ve got a catalyst. Whether the activist’s agenda is aligned with your own, and whether the activist will succeed in implementing that agenda, are different things all together. But you’re not dead in the water.
Another potential solution is a management team that’s good at capital allocation. Management teams that are thoughtful about capital allocation will take action to close obvious value gaps. In Gazprom’s case, what a thoughtful management team not involved in looting the company would be doing would be cutting back on capex to whatever extent possible and buying back stock hand over fist.
Be wary of situations where a stock is cheap but management is entrenched and is engaged in looting the business. Gazprom is an example of this in Russia. Biglari Holdings is a great example in the US.
Then again, to paraphrase Seth Klarman, everything’s a sell at one price and a buy at another. So maybe sometimes take your chances.
Last week’s permanent portfolio post generated some great questions and feedback, so I wanted to do a follow-up post addressing some of the most common issues raised.
That’s a big allocation to gold. What about using REITs instead of gold?
Admittedly, gold has a lot of issues as an asset. The biggest issue with gold is that it’s a negative carry asset. Not only is there no yield on gold, but there are also costs associated with storing it (fun fact: your primary residence is also a negative carry asset unless you rent out a room or two).
In theory, it would make a lot of sense to allocate to REITs in place of gold. In an inflationary environment, the real value of the properties would increase while the real value of any debt on them would decrease.
I was able to pull US Equity REIT return data from NAREIT back to 1972 and run a new backtest looking at two different approaches to a REIT allocation. (h/t to @IrvingFisher15 for pointing me to this data on Twitter) The first portfolio swaps half the gold allocation for REITs. The second portfolio swaps half the US equity exposure for a dedicated allocation to REITS. I compared both to a 100% US Equity allocation.
By swapping some gold for REITs you improve the portfolio’s return and volatility profile but at the cost of greater drawdowns and greater correlation with the US equity market.
To me, a decision on this comes down to each investor’s preferred risk exposures.
In a barbell approach to portfolio construction such as the one that I favor, I would opt not to replace gold with REITs, because the whole point is to mitigate drawdowns in the “core” sleeve of the portfolio. The opportunistic sleeve of the portfolio will necessarily contain a significant amount of equity risk. This may include real estate exposure.
Someone who is implementing the permanent portfolio as a standalone portfolio, however, would likely prefer the return profile where REITs replace some of the gold.
In the basic permanent portfolio, there’s not enough equity exposure.
Usually I find when people say “there’s not enough equity exposure” what they’re really saying is “the CAGR is too low relative to my return hurdle.” We’ve been conditioned to believe that when CAGRs are too low the only solution is to take more equity risk. But that’s not necessarily true.
This is where the leveraged permanent portfolio concept comes into play. To illustrate what this might look like for a DIY investor, I backtested a simple implementation of a leveraged permanent portfolio.
Portfolio #1 is a 50/50 allocation to PIMCO StocksPLUS and GLD. The PIMCO fund uses a bond portfolio to collateralize a 100% net long exposure to S&P 500 futures for 200% notional exposure. So, at the portfolio level, this portfolio is 50% bonds, 50% stocks and 50% gold for 150% notional exposure.
Portfolio #2 is a 100% allocation to SPY as an investable proxy for the S&P 500.
Vanguard Balanced Index is included as an investable proxy benchmark for a traditional 60/40 allocation.
Below are the results.
While this is a relatively short time period, I find the results quite compelling. The leverage allows you to increase portfolio returns without adding equity exposure. While the addition of leverage does increase portfolio drawdowns, you’ve gotten a slightly better return than a 100% SPY portfolio with drawdown characteristics similar to a 60/40 portfolio. And again, in the bargain you’re much better protected from an inflationary regime than you would be using either of the alternatives.
One of the most significant shifts in my thinking around asset allocation over time has been to embrace the use of a modest amount of leverage to build more diversified portfolios that are still capable of meeting investors’ return hurdles. I guess I am slowly but surely transforming into a risk parity guy. Of course, the REIT-for-gold switch discussed earlier in this post is also a form of levering a portfolio (REITs are leveraged assets).
Anyway, I’d be remiss to move on without commenting on what I believe is the biggest issue with implementing a permanent portfolio, either levered or unlevered, for an actual client. Particularly a retail advisory client. The issue is that the portfolio massively underperforms equity markets in strong bull markets. So it’s absolutely critical a permanent portfolio investor remain focused on absolute returns in these types of environments. Otherwise, envy will lead to FOMO and FOMO to bailing out of the strategy at EXACTLY the wrong time.
The permanent portfolio truly shines when equity markets are getting hammered, either due to inflation or deflation. It’s not a sexy way to generate returns. The behavioral challenges this presents for investors should not be underestimated.
And for what it’s worth, I don’t think there’s a “solution” for this. Either people are willing to accept the potential opportunity costs of the strategy and cultivate the discipline necessary to stick with it through thick and thin, or they’re not.
What about replacing the gold allocation with trend following or Bitcoin or other uncorrelated alternatives?
By all means! Knock yourselves out. Gold was merely the easiest uncorrelated alternative for me to backtest, and also (probably) the easiest for the DIY investor or retail financial advisor to actually implement at this time. Furthermore, it doesn’t require the investor to bet on a specific investment manager to implement.
But I think it’s perfectly valid to replace the gold allocation with other uncorrelated alternatives. A word of caution, however: in my view the use of other alternatives should be biased toward strategies that perform well specifically in inflationary market regimes. That’s the whole point of owning gold here.
Why no credit exposure?
As alluded to above, this exercise was based on the K.I.S.S principle (Keep It Simple, Stupid). I have mixed feelings about how best to integrate credit in a permanent portfolio. Investment grade credit probably has a home in the bond bucket, though it will introduce a bit more equity-like sensitivity to deflationary conditions.
The lower down the credit quality spectrum you go, or the more you get into hybrid securities like preferred stocks, the more you take on equity-like risk. So to the extent assets such as high-yield debt and bank loans and preferred stocks have a place in the permanent portfolio, it’s actually in the equity bucket.
The permanent portfolio is all about balancing risk exposures in light of their potential patterns of correlation across different macroeconomic and financial market regimes. Asset classes get sorted into buckets based on their historical sensitivities to those regimes and (hopefully) how robust those relationships may prove to be in the future.
This is precisely the same intuition that underlies most flavors of risk parity, including Bridgewater’s famous All-Weather portfolio. The advantage Bridgewater and other large investors have here is that they have access to the full toolbox of financial instruments for portfolio construction. Smaller investors have to hack something together based on the investments they can access.
If you’ve read this blog for any length of time it’ll come as no surprise to hear that I’m rather disillusioned with the prevailing wisdom around asset allocation. It goes something like this:
Adjust a 60/40 split based on your age and risk tolerance and close your eyes for 40 years or so and the world will probably be a better place when you finally open them again. Here are some charts showing “long term” equity returns to make you feel better about enduring 50% drawdowns.
Here are my key issues with the prevailing wisdom:
Prevailing wisdom is biased heavily toward equities based on historical experience. This is the market Skinner box in action. There are no physical laws requiring future equity returns to look like past equity returns over any particular length of time.
Equity risk drives outcomes within most portfolios, despite these portfolios appearing more diverse when visualized in a pie chart.
The notion of “the long term” is at best squishy. “Long term,” we’re all dead. No one’s investment time horizon is infinite. We ignore sequence risk at our peril.
Prevailing wisdom is robust to neither inflationary nor deflationary busts. Which are really the conditions that ought to keep us up at night. Particularly inflationary busts. Because other than a few cranks no one is prepared to invest in a highly inflationary environment these days. (What? You think the inflation of the early 1970s or 1980s can’t happen again? LOL. Just Google MMT )
So this is going to be a post about the permanent portfolio, which is where I’ve landed as an alternative to the prevailing wisdom. This post should absolutely not be taken as investment advice. There are opportunity costs involved here and they may be significant. Particularly if your inclination would otherwise be to allocate 60/40 to US stocks/bonds and US equity continues its run of strong returns for an extended period of time. See my disclaimer for more on why making investment decisions based on random blog posts is an incredibly stupid thing to do.
Fundamental Assumptions & Principles
There are some key assumptions underlying my views on all this. I want to lay them out explicitly up front, because many of these can be debated endlessly. I’m not trying to argue all of this is capital-t Truth. This is simply the framework I’m operating within.* So for example, if you’re a guy or gal who wants to own five stocks forever, I’m not trying to convince you to do it differently. And you’re probably not going to agree with any of this. That’s fine.
We should build portfolios as regret minimizers and not utility maximizers. Note that regret minimization is subjective. We can regret both realized losses AND foregone gains. The exact “regret function” will vary with each individual. The first sentence of this bullet is in bold because it’s the foundation for everything else. I’d hypothesize that human beings in general tend more toward regret minimization than utility maximization. But I can’t prove that.
The starting point for any portfolio should be wealth allocation. A wealth allocation consists of at most three buckets. It is possible and sometimes even desirable to have fewer. Wealth allocation is consistent with regret minimization.
Equity ownership is absolutely essential for preserving and growing purchasing power over long time periods. However, equities can go through substantial and lengthy drawdowns. Major drawdowns are problematic in a number of ways:
They create sequence of returns risk for the portfolio (e.g. massive drawdown immediately prior to retirement)
They may encourage poor investor behavior (buying high and selling low)
The portfolio will have the least liquidity and buying power when expected returns are highest (e.g. at the trough of a major drawdown), preventing opportunistic purchases of assets subject to forced selling, etc.
Reliably forecasting economic cycles for the purpose of tactical asset allocation is impossible.
Traditional methods of hedging tail risk are frequently expensive and can be a significant drag on returns if utilized in meaningful size. They can also be extremely challenging, if not impossible, for individual investors to implement.
Ideally what we want is a core allocation capable of delivering approximately 5% real returns while minimizing drawdowns across different market regimes. The regimes that are of particular concern are:
The goal of this exercise is not to build an Armageddon-proof portfolio. In the case of extreme tail events (nuclear war, zombie apocalypse, socialist revolution) your portfolio is going to be the last thing you’re worried about. And anyway, what you’ll really need in those situations are food, medicine and bullets.
The Permanent Portfolio
I think the permanent portfolio offers a solution. The investment analyst Harry Browne devised it specifically for robust performance across a range of different economic conditions. In its original form the permanent portfolio consisted of:
25% US Stocks
25% Long-Term Treasuries
The underlying intuition is a model of parsimony. This is a combination of assets where “something should always be working,” regardless of the macroeconomic environment. Long-term Treasuries and gold are less correlated and often negatively correlated with equities. Long-term Treasuries do well in deflationary busts. Gold does well in periods of high inflation.
I do have some quibbles with the permanent portfolio in its original form:
It holds too much cash.
It is under-allocated to equities.
It is strongly biased toward the US.
But perhaps we can address these issues through portfolio construction.
Analyzing The Permanent Portfolio
I used Portfolio Visualizer to run some analysis using historical data. I compared two different permanent portfolio implementations with a 60/40 allocation to US Stocks/US Treasuries. I set the portfolios to rebalance any time an asset class reached +/- 10% of its target weight.
I’ll walk through a couple observations in this post but if you’d like to explore the analysis yourself here is the link to exactly what I ran. (aside: I can’t recommend Portfolio Visualizer enough as a free analytical tool) Below are my three portfolios.
I was able to backtest these allocations back to 1986 with the available data. Unfortunately, the periods where the permanent portfolio really shines versus 60/40–the stagflation of the 1970s and the high inflation and interest rates of the early 1980s–lie outside this time period. If you drop the international equities you can capture the late 1970s and early 1980s, however.
Starting in 1986, Portfolio 1 rebalanced 7 times. Portfolio 2 rebalanced 9 times. Below is a growth chart comparison.
This 30-year period has been truly extraordinary for US stocks and long-dated Treasuries. It comes as no surprise that the permanent portfolios have lagged a 60/40 allocation. And, of course, the permanent portfolio with ex-US equity exposure lagged even more.
But you’re still getting your 5% annualized real returns, with milder drawdowns than the 60/40 portfolio. And in the bargain, you’re better protected from an inflationary regime than you would be with a 60/40 portfolio.
Obviously, if you don’t believe in allocating to ex-US equity you will prefer Portfolio 2 over Portfolio 1. I don’t share that belief, personally. But I certainly can’t prove US equity returns won’t continue to dominate going forward.
We can also look at returns over rolling periods, which paint a similar picture.
If you’re willing to use volatility as a quantitative proxy for risk, you can see the permanent portfolios are significantly more diversified in their sources of risk and return than the 60/40. Equity risk dominates the 60/40 allocation. Imagine the extent to which it dominates in a 70/30 or 80/20 split.
The tradeoff here is simple: give up some upside for a more attractive risk profile.
But what if you could juice the returns a bit?
Because this strategy is robust across market regimes it should also be fairly amenable to leverage. In an ideal world I’d take the more diversified flavor (Portfolio 1) and lever it something like 1.25x to 1.50x. This is the intuition behind risk parity: take a well-diversified portfolio with the risk exposures you want, then lever them to reach your target return. So instead of being limited to 33%/33%/33% you would be allocated maybe 45%/45%/45% for 135% notional exposure.
Unfortunately, as an individual investor it’s not straightforward to lever a portfolio. So, there are some implementation issues to work around. The simplest solution appears to be to use mutual funds or ETFs that apply leverage via either equity or Treasury futures.** This essentially allows you to “bolt on” gold and/or other alternative strategies without having to cut back on your equity or fixed income exposure. I may do a follow-up on this analysis exploring this form of implementation in more detail.
The Permanent Portfolio In A Barbell Portfolio
There are a couple less obvious, ancillary benefits to the permanent portfolio structure I want to mention in closing.
First, because of the attractive drawdown characteristics, it may obviate the need for large cash allocations (e.g. “emergency funds” or “cash buckets” for individuals). There are significant opportunity costs associated with large cash allocations, particularly in real terms.
Second, in keeping with the above, the permanent portfolio provides an excellent stable core around which to build a satellite portfolio of opportunistic investments. For example, at the wealth allocation level you could implement a structure where 70% of the portfolio is permanent portfolio, and the remaining 30% of capital is allocated to private market investments, or high risk/high return single hedge fund investments, or concentrated single stock positions. From a wealth allocation perspective you would be looking at something like 0% Protect Lifestyle / 70% Maintain Lifestyle / 30% Enhance Lifestyle.
In the above configuration, you would also likely be able to use the permanent portfolio as a source of liquidity during major market dislocations, to fund opportunistic investments at precisely the times when expected future returns are highest.
In my view, this strikes a nice balance between staying rich, maybe getting a bit richer but without dying trying.
Essentially, what you’re doing here is building a barbell portfolio. You’re using the permanent portfolio to set a floor for the value of the overall portfolio. You’re then taking the “excess” capital and buying call options with it.
There are other ways for individuals to implement a barbell portfolio structure. You could just use cash to create the floor. Except that’s an extremely inefficient use of capital, in my view. You could also use an annuity.
My quibbles with the annuity approach:
A fixed annuity with a modest inflation escalator leaves you vulnerable to inflationary booms and busts.
I am deeply suspicious of variable annuities–in fact, any insurance product with bells and whistles designed to “protect” you from various risks. The pricing of the bells and whistles is usually opaque and therefore not a good deal for the buyer. It is a timeless truth of economics that opaque pricing always and everywhere obscures profitability (see: healthcare; college).
No matter what route you go the insurance company will extract its pound of flesh.
You give up the ability to opportunistically redeploy capital from the annuitized core of your portfolio.
That said, I think buying a simple fixed annuity with an inflation escalator is a straightforward option for individuals who want to implement a barbell portfolio, and who are unable or unwilling to go the permanent portfolio route.
*I’d encourage everyone reading this to spend some time writing out your investment framework as explicitly as you can. This is your Investing Code. Once you’ve written down your Code, compare it to your actual portfolio and see if they match. The results of this exercise may surprise you. Incidentally, my friend Rusty Guinn wrote a phenomenal series of articles on Investing Codes and portfolio construction, called Things That Matter/Don’t Matter. I can’t recommend it enough. It touches on the issues discussed in this post as well as many, many more.
** Thanks to @choffstein and @EconomPic for their help conceptualizing this via Twitter.