ET Note: Every Shot Must Have A Purpose

My latest note for Epsilon Theory is a golf lesson we can apply to our portfolios.

The most grievous portfolio construction issues I see inevitably seem to center on basic issues of strategy and commitment. Particularly around whether a portfolio should be built to seek alpha or simply harvest beta(s).

You don’t have to shape your shots every which way and put crazy backspin on the ball to break 90 in golf. Likewise, not every portfolio needs to, or even should, strive for alpha generation.

There are few things more destructive (or ridiculous) you can witness on a golf course than a 20 handicap trying to play like a 5 handicap. And it’s the same with portfolios. For example, burying a highly concentrated, high conviction manager in a 25 manager portfolio at a 4% weight. Or adding a low volatility, market neutral strategy to an otherwise high volatility equity allocation at a 2% weight.

Click through to Epsilon Theory to read the whole thing.

vandevelde.PNG

1Q19 Expected Returns Update

This is a quick post to share an update of this running model of expected S&P 500 returns using Federal Reserve data. As of March 31, the model predicted an 8.12% annualized return over the next 10 years. This has likely come down a bit further since then as the market rallied. As of today, we might be somewhere in the 6-7% range.

1q19sp500er
Data Source: Federal Reserve

Given there’s so much wailing and gnashing of teeth over macro risks these days it’s worth emphasizing a couple points.

First, this model is useless as a short-term timing signal. Don’t try and use it that way. If you’re looking for short-term signals you need to be looking at trend following systems and such.

Where I think there’s some utility here is as a data point you can use to help set longer-term return expectations and guide strategic asset allocation decisions (particularly when used alongside other indicators like credit spreads). When the aggregate equity allocation is close to 40% or above, it signals lower expected returns and argues for taking down US equity risk. Between 30% and 40% it signals “meh.” Probably not worth making any adjustments in this range. At least not on the basis of this model. At or below 30%, however, the model argues for adding equity risk.

Also, what I like about this model is that unlike indicators such as the CAPE or market cap/GDP what you are really measuring here is the aggregate investor preference for fixed income versus equities. When investors are very comfortable owning equities they bid up prices and expected returns fall. When investors are not comfortable owning equities they sell, prices fall and expected returns rise.

That’s the ball game.

No macro forecasting is required.

You don’t have to make any judgment calls on valuations, either.

What I would love to do eventually is run this for countries outside the US. What I suspect is that the ex-US models would show similar efficacy but with different “preferred” bands of equity exposure based on the culture of equity ownership in each country and whether or not there’s a significant impact from “hot money” flows from foreign investors.

I’m not aware of a straightforward way to find the data needed to do this. But if anyone has suggestions, please drop me a line.

The Permanent Portfolio In Action

May afforded an interesting opportunity to test the leveraged permanent portfolio strategy out of sample. (For previous posts on the permanent portfolio, see here and here) Below is data showing the results for two different leveraged permanent portfolio implementations, compared to the Vanguard Balanced Index Fund (an investable proxy for a 60/40 portfolio) and SPY. You can do a deeper dive into the data here.

LeveredPP052019Portfolios
Source: Portfolio Visualizer
LeveredPP052019Monthly
Source: Portfolio Visualizer

NTSX’s laddered Treasuries provided better downside protection than the StocksPLUS bond portfolio here. But the gold exposure was also a major help, with GLD returning +1.76%. Obviously this is just a single month of performance, but the results are consistent with what you might expect based on backtests of the strategy.

Notice that the performance pattern is similar during the 4Q18 drawdown. In each case, the drawdowns are less severe than even those experienced in the 60/40 portfolio due to the diversifying impact of the gold. Because again, where the leveraged permanent portfolio shines is downside protection. You aren’t capturing all the upside of a 100% SPY allocation, but you’re capturing only a fraction of the downside.

Since December 2004, the PSPAX/GLD portfolio has captured 60% of the upside of SPY but only 43% of the downside. The asymmetry means PSPAX/GLD slightly outperforms SPY over this time period, but with less volatility. More importantly, the max drawdown is only a little more than half as bad.

Still, in my view the biggest problem the leveraged permanent portfolio presents for investors is precisely that its outperformance comes in down markets. This isn’t a sexy way to make money. It’s not the kind of thing that impresses people at cocktail parties. The behavioral challenges this presents should not be underestimated.

But personally, I’ll take a 10.62% safe withdrawal rate over cocktail chatter any day.

Correlation And Meaning

We’re all familiar with the old saw: “correlation is not causation.” Correlation is merely a statistical measure of the strength of the linear relationship between two variables. Correlations can change over time. The fancy stats word for this instability is “nonstationarity.”

Anyway, what I want to suggest in this post is that correlations can often be interpreted as markers of meaning.

For example, stocks and Treasury bonds have been negatively correlated since the financial crisis. The reason is that the meaning of Treasuries to investors, broadly speaking, is “safe haven asset.” A Treasury allocation is an allocation that will perform well in a deflationary environment. And deflation, broadly construed, has topped the list of investor fears for many years now.

A big mistake many investors (particularly younger investors) may make is assuming Treasuries will always be negatively correlated with stocks. This has not always been true historically and will not necessarily be the case in the future. Why? In a highly inflationary environment, both stocks and Treasuries will perform poorly. The two assets classes will become positively correlated.

Another example of this is gold. Traditionally, gold has been viewed as an inflation hedge and has been positively correlated with inflation expectations. These days, however, gold is liable to trade up on deflation fears as well as inflation fears. Why the change in correlation? The meaning of gold has changed. Gold has shifted from a pure inflation hedge to an insurance policy against economic chaos more generally. Gold is now a hedge against policy mistakes by our economic elites (our Ever Wise and Benevolent Central Bankers in particular).

What I’m driving at here is that if you want to better understand the nonstationarity of correlations, you ought to spend some time thinking about narrative.

A stable correlation is a correlation where objective meaning dominates. Objective statements can be proven true or false in a straightforward way. Unstable correlations are correlations where subjective meaning dominates. Subjective statements cannot be proven true or false in a straightforward way.  Subjective statements are reflexive.

George Soros described it this way:

Consider the statement, “it is raining.” That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, “This is a revolutionary moment.” That statement is reflexive, and its truth value depends on the impact it makes.

There’s not much subjective judgement required to evaluate a Treasury bond as an investment. It’s a mostly objective process that more or less boils down to your views on the future path of inflation and interest rates.

Now, your views on inflation and interest rates may make Treasury bonds seem relatively more or less attractive to you at any given point in time. But there’s never any real question in anyone’s mind as to how Treasury bonds will perform in a deflationary environment versus an inflationary environment. This is what I’m driving at when I say the meaning of a Treasury bond for your portfolio is going to remain pretty stable over time. A Treasury bond is protection from deflation.

Credit is a bit more subjective than Treasury bonds because now you’ve got defaults and recoveries in the mix. And equity valuation is far more subjective than credit valuation because the timing and amounts of the cash flows associated with equities are highly variable.

The value of gold is an order of magnitude more subjective than even equities because there aren’t any cash flows associated with gold. Gold is a purely speculative asset. Gold has value because, for whatever reason, human beings have arrived at the collective consensus that it’s a store of value over tens of thousands of years.

At the extreme end of this spectrum you have something like Bitcoin. Bitcoin, of course, has no cash flows. On top of that, there’s no broad consensus regarding what Bitcoin means. Sometimes it’s a currency. Sometimes it’s a speculative risk asset. Sometimes it’s a store of value or even a safe haven asset.

You ought to be extremely skeptical of any MPT-style analysis of Bitcoin’s role in a portfolio at this point. You simply can’t know if, when or how its correlation with other portfolio assets is going to stabilize over time. Just because Bitcoin is uncorrelated today doesn’t mean it will continue to be uncorrelated in the future.

Another practical application of all this relates to factor investing.

Patterns of correlations are the building blocks for factor-based investment strategies (they are literally what the math going on under the hood is measuring). It’s well-known that factor strategies go through extended periods of outperformance and underperformance that are difficult, if not impossible, to time. Factor performance comes and goes in irregular regimes. Regimes are driven by a mixture of objective and subjective factors that influence one another in feedback loops.

Regime_Graphic

If you’re trying to figure out when the relative underperformance of value stocks will end, you need to be thinking about what in the zeitgeist and market regime needs to change so that investors will want to buy stocks with “value” characteristics (how you choose to define “value” is important here). For example, in late 2016 the election of Donald Trump triggered a massive rally in cyclical industrial and financial services stocks. If you’re a long-suffering, old-school value investor who owns a lot of these stocks, what you want at a high level is higher growth, (modestly) higher inflation and (modestly) higher long-term interest rates.

If you’re a growth-oriented investor, such as a VC, who owns unprofitable, high-growth businesses that will not generate free cash flows for many years, what you want is a regime with solid growth but even more importantly with low inflation. More specifically, low interest rates. The value of your equity ownership is extremely sensitive to the cost of capital because your investments are very long duration. Much like a zero coupon bond, their cash flows lie far out in the future.

So anyway, when you’re considering factors such as value and growth what you want to be thinking about when evaluating their potential persistence over time are the drivers of the underlying patterns of correlation. And if you go through this exercise enough, I think you’ll find you keep coming back to investor preferences for different cash flow profiles.

As my friend Rusty Guinn once wrote:

Investment returns are always and everywhere a behavioral phenomenon.

Because, in the words of Marty Whitman, we’re pretty much always looking for a “cash bailout” when it comes to our investments. And our ability to exit an investment almost always ends up depending on a sale to another party. Marty wrote a wonderful explanation of this in an old investor letter (I’ll end on this note because I think it’s a fitting conclusion for this post):

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.

Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.

Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market

Value + Catalyst

Gazprom_Balloon

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.

While I increasingly work to expand my investing horizons, I have no illusions about my truest investing self.

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 to assign 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)

OGZPY_FinSnapshot
Source: Morningstar (currency values in in RUB)

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.

The Skinner Box

Skinner_box_scheme_01
Source: Wikpedia

A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.

Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.

The financial markets, too, are a kind of Skinner box.

Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?

LOL.

We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.

Below is what an operant schedule of reinforcement looks like.

Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)

Bet on Momentum Factor -> SMALL REWARD (MAYBE)

Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)

1Q19_Rolling_Factors
Data Source: Ken French’s Data Library
1Q19_Trailing_Factors
Data Source: Ken French’s Data Library

The “lesson” here is very clear:

BETA IS ALL THAT MATTERS

BETA IS ALL THAT WORKS

This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.

Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).

The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.

Regime_Graphic

This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.

Reality Check

This is a short-and-sweet post meant to get some thoughts down and possibly provide a (small) public service. In my line of work I’m involved in a bit of direct private equity investing. The typical acquisition target is a Main Street USA business with EBITDA somewhere between $500,000 and $2,000,000. These are profitable businesses but slow growers. We’re talking mid-single digit revenue growth here.

These businesses are worth something like 3x to 5x EBITDA (subject to negotiation, of course). It’s rare that the seller is financially sophisticated. The sale of the business is probably the only such transaction he or she will complete in a lifetime. So setting realistic expectations around pricing is one of the most important things to cover early in the process. If someone thinks he’s going to get a 10x multiple on one of these things it’s best to walk away early rather than waste everyone’s time and energy.

There’s a common argument unsophisticated sellers trot out to make the case for a higher valuation. It’s this:

What about my IP and intangible assets? Surely they’re worth something. You should be assigning more value to those things!

No purchaser takes this argument seriously. The fact of the matter is that value has been assigned to the IP and intangible assets. It’s in the earning power of the business.

Put another way, when you buy an operating business you don’t buy the tangible assets (property and equipment) separately from everything else. Same with intangibles. The costs and benefits associated with both tangible and intangible assets are loaded into the cash flow profile of the business. You don’t double-count them.