While getting rich may help make you happy, it does so only once. The key then becomes finding the best way to keep what you have, or, better yet, grow your money. Over time maintaining your purchasing power is really the issue. Bearing in mind that some of the predictions I might have made when I entered the money management business in 1991 would have missed the mark, the thoughts that follow are what I advise my family today.
The Corrosive Effects of Inflation
Inflation can greatly reduce how much you can buy, unless your money grows at a rate at least commensurate with inflation. As John Templeton aptly put it in considering the problem of inflation: “[T]here is no safety without preserving purchasing power.” Lots of wealthy Americans in the late 1960s had not lost their principal by the mid-1980s, but they had seen much of their purchasing power disappear. Jay Leno had it about right when he said: “Congress wants to replace the dollar bill with a coin. They’ve already done it: It's called a nickel.”
As we know, money printing by governments has accelerated dramatically due to the coronavirus. We agree this money creation is the right approach during this time of crisis, as the social implications otherwise are so dire. Despite the rapidly increasing money supply, to date interest rates have remained low or negative while inflation has been minimal. Yet, as Warren Buffett said recently: “If the world turns into a world where you can issue more and more money and have negative interest rates over time, I’d have to see it to believe it, but I’ve seen a little bit of it. I’ve been surprised, so I’ve been wrong so far. I would say this – if you can have negative interest rates and pour out money and incur more and more debt relative to productive capacity, you’d think the world would have discovered it in the first couple thousand years rather than just coming on it now [our emphasis].”1 Mr. Buffett also pointed out: “This is a very good time to borrow money, which means it may not be such a great time to lend money.”
We do not know if we’ll see meaningful inflation in six months, one year or ten years, but we do expect there will ultimately be inflation from all this money creation.
In addition to inflation risk,
investors seeking to sustain their wealth also have to
think about credit risk. Like the U.S. Treasury, lots of
companies and state and local governments have issued
large amounts of debt, as have foreign countries, who
issue debt in currencies other than their own. But
unlike the U.S. federal government, these parties cannot
manage their debt load by printing new money. 2 My young
son likes to ask for scoops of ice cream, often “five
scoops please.” Debt is like ice cream; some can be
tasty, but too much causes indigestion. We expect all
this debt issuance to cause some indigestion in the form
of some defaults, with investors left holding the bag.
With this in mind, we choose to own stock in well-run businesses over bonds. To us, it makes no sense to sign up for a half a percent yield for ten years when you can invest in businesses earning far more with the likelihood of growing their earnings over time. But choosing equities over bonds isn’t all that’s required to sustain wealth. Sustaining wealth requires committing to a strategy that is simple but well-informed, not clouded by hubris or driven by fear, and that acknowledges the past without being beholden to it.
“Out of clutter, find simplicity. From discord, find harmony.
In the middle of difficulty, lies opportunity.” – Albert Einstein
A key ingredient in successful investing is to read a lot. Reading is like compounding your knowledge. Businesses have retained earnings; money management done right has retained learnings which enable the investor to spot the rare investment opportunity that others may miss. But valuing information does not mean valuing complexity. To us, wise investing should be simple and easy to understand. If you cannot write in a sentence or two on a cocktail napkin why an investment makes sense, then you should pass on the investment. As Einstein said: “If you can’t explain it to a six-year old, you don’t understand it yourself.” You should know what you own and why you own it.
Our investment philosophy can be simply
stated. We look for high-quality, productive businesses
that make money over time and generate great free cash
flows going forward.
Avoiding Hubris and Fear
“It’s amazing to think how intelligent it is just to spend some time sitting.
A lot of people are way too active.” – Charlie Munger
We have yet to meet the expert who can confidently and consistently predict moves in the stock market. As Yogi Berra quipped “predictions are difficult, especially when they are made about the future,” and we agree. Given the stock markets’ gyrations this year, we find it amazing anyone can take the various prognosticators and pundits in the media seriously. Entertainment is quite different from investing, which, as Mr. Munger says, is “not supposed to be easy. Anyone who finds it easy is stupid.” 3
Yet people continue to think they can tap dance in
and out of the stock market, even though Mr. Buffett has
said of market timing: “I don’t know anybody who has
done it successfully and consistently. I don’t even know
anybody who knows anybody who has.” That statement
should make anyone, even those with vast experience and
knowledge pause and consider the wisdom of buying and
selling with an aim towards “timing the market.” We
think a core reason folks attempt to time the market is
what psychologists call the Dunning-Kruger effect – the
cognitive bias in which people with a low ability at a
task overestimate their ability. Most people
consistently underestimate the complexity of what they
are looking at. All of us need to be careful to
understand our limits. Fat, easy pitches are what we
want. For this reason, and out of respect for the
benefits of simplicity, I keep this “Too Hard Pile” bin
on my desk:
Just as it is important not to let our investment judgment be clouded by hubris, so too, is it important not to let our decisions be driven by fear. We have great trouble separating the physiology of fear, which is so important to our survival, from the thought processes we need in modern life generally and specifically for investment success. The coronavirus as it relates to investing plays right into humans’ innate and “hard wired” response to danger – the reflex to flee from danger is triggered automatically and stress impairs rational thought. In fact, as investing is the intersection of economics, business, and psychology, the pandemic is in a way a perfect storm for human emotions as we have market volatility, which activates a flight response we must control, driven by a real threat to our health, which magnifies the emotional impact. The problem is compounded when we are exposed to large amounts of information that we must sift through to determine what is important and what is superfluous.
All of this gives rise to what the famed Nobel-Prize-winning psychologist and behavioral economist Daniel Kahneman calls “fast thinking,” or a type of thinking that is quick, effortless, intuitive, emotional, often fear-based (think fight or flight) and often wrong. 4
While the current environment presents many daunting
problems, we believe that the best way to make wise
investment decisions—and, thus, the best way to sustain
wealth—is by “slow thinking” with the right information.
That is exactly what we strive to provide to our
clients. And we do this while keeping the past in the
Learning From the Past Without Being Beholden to It
“History never repeats itself, but man always does.” – Voltaire
“The idea of the future being different from the past is
so repugnant to our
conventional mode of thought and behavior that we, most of us, have a
Great resistance to acting on it in practice.” – Mark Twain
We believe if people read more history, they would be far less eager today to invest in overly levered companies and governments. While concerns about inflation and creditworthiness are being underplayed now, many businesses are being propped up by various Federal Reserve policies. Also, since central banks often operate as a pack, similar policies have created a “money is free” aspect in many other countries. Even before the coronavirus flared up, the Wall Street Journal reported that “35% of NYSE and Nasdaq stocks can be called unprofitable.” 5 We think this percentage has likely increased a lot. Even worse, many companies and governments do not have enough cash flow to cover their interest payments and get by through repeatedly taking on more debt. As Paul Volcker said: “It’s the leverage stupid.”
Of course, while it is important to understand history, it is equally important not to get mired in it. Investors often fixate on the rear-view mirror and have trouble understanding how the future may differ from the recent past. We feel many investors are anchoring themselves in the present and on the history of an almost 40-year bond bull market, when interest rates peaked in 1981. No doubt the road to money-creation-induced inflation in the U.S. could be by way of negative interest rates like those in some other developed countries. However, we think investing based on an expectation of negative interest rates at this point of quite low rates is akin to jumping in front of a speeding train to pick up a coin – the risk/reward ratio is just not good.
Again, thinking of long-term bonds with very low interest rates—or even worse “negative interest rates”—as a “safe investment” seems to rely on a very fearful view of what lies ahead. But consider this, as of September 8th the Swiss government 50-year bond issued 2014 due 2064 had a -0.32% yield to maturity. To us, though, it is obvious that people buying negative yielding bonds today will at some point hit their head and think “whoops I could’ve had a positive yield.” Perhaps an easy way to understand how complacent investors have become about potential inflation is to consider the yields to maturity of the 100 year bonds issued by where I studied finance, Georgetown, and by the University of Virginia, where I graduated law school. As of September 8th, Georgetown’s 100-year bonds due 2119 had a yield to maturity of 3.768% and the University of Virginia’s 100-year bonds due 2117 had a yield to maturity of 2.99%. We think we are in a bond yield bubble, but there are a lot of frogs believing in the bubble as the water (a.k.a. money printing) heats up. I think it would have been inconceivable to anyone in my Georgetown or U.V.A. Law classes that the schools could issue 100-year bonds at such low rates, but we think it is a wonderful deal for the universities!
We believe that failure to keep history in its proper perspective has created a dichotomy in the current market. On the one hand, lots of low-quality and levered businesses have overly high valuations. (Why so many folks want to own some of these stocks baffles us.) At the same time, though, we feel there are great businesses “spinning” cash that are becoming better and better with long runways ahead of them, with optimistic prospects not fully recognized by investors. In addition—and we want to preface this statement by emphasizing that the human toll of the pandemic is just terrible—there are companies that directly benefit from the coronavirus such as Amazon and Costco. Indeed, changes in the economy that might have occurred over a several years are now happening in a few months. Also, technology continues to drive more profitability in many businesses. Likewise, the rise in value of intangible assets, such as design and R&D, compared to tangible assets like buildings and machinery, can really increase profitability.
where do these lessons lead us? To value investing, we
The Benefits of Value Investing
“Through the vicissitudes of wars, panics and depressions, investment in America’s
growth and development has never proven a mistake.” – Malcolm Forbes
“Value investing is simple to understand,
but difficult to implement. The hard part
is discipline, patience and judgement.” -Seth Klarman
We have tremendous optimism in the entrepreneurship, innovation, and the overall economic engine that America possesses today, which has driven our remarkable prosperity since the 1600s. Sure, the fortunes of different regions of our country wax and wane – in the mid-1800s probably the wealthiest place in America was the whaling town of New Bedford, and in the late-1800s it was likely the then technology leader, Scranton. Likewise, we do not think anyone can consistently predict which future technologies will drive growth. For example, who would have guessed that Einstein’s curved theory of time would, many decades later, enable all our iPhones to work?
Perhaps the best way to visualize the power of the American economic engine is to do what Alan Greenspan did in his book Capitalism in America: An Economic History of the United States:
that a version of the World Economic Forum was held at
Davos in 1620 … The subject of the conference is who
will dominate the world in the coming centuries?
Everyone wants to make a case for their corner of the
planet. You rush from panel discussion to panel
discussion (and then stumble from after-party to
after-party) to absorb the Davos wisdom … In all of the
arguing in Davos, one region goes unmentioned: North
America. The region is nothing more than an empty space
on the map – a vast wilderness sitting above Latin
America, with its precious metals, and between the
Atlantic and Pacific oceans, with their trading routes
and treasure troves of fish … The entire North American
continent produces less wealth than the smallest German
Yet by the time of the start of the American Revolution, per capita income in America had surpassed that of England. Today, with all due respect to pundits suggesting putting money into emerging markets from which you may not emerge if there are problems or into other developed markets, the United States continues to have robust advantages compared to other countries. Just to choose two powerful American comparative advantages out of a very long list, by giving women more opportunities than they have available in many other countries (and let us hasten to add our country can and should do more in this area), we effectively double our economic potential. It is impossible to read books like Broad Band: The Untold Story of the Women Who Made the Internet by Claire Evans and draw any conclusion other than there are just as many female as male Einsteins and Franklins. Another major help to our economy can be summed up by a story in the Financial Times titled “A lot of rich people in China cannot sleep well.” Our rule of law makes a massive positive difference.
While we have been
surprised by our government’s missteps handling the
coronavirus, there is absolutely nothing in the current
public health situation that makes our optimism in
America falter. We believe owning a number well run
businesses for the long-term and benefitting from the
powerful American tailwind has been and will be the best
strategy. As Aesop said: “It’s as easy as that, and as
hard as that.”
In Sum . . . .
If ever there were a market that highlights the point of Rudyard Kipling’s famous poem “If,” it is the market in 2020 so far. Kipling’s poem begins, “If you can keep your head when all about you are losing theirs,” to which we would add, good things are likely to then happen for your investments [our emphasis]. Jeff Bezos summed up the coronavirus well by saying: “Reflect on this from Dr. Seuss: ‘When something bad happens you have three choices. You can either let it define you, let it destroy you, or you can let it strengthen you.’ I am very optimistic as to which of these civilization is going to choose.”
As always, please call or email
us with any questions or comments that you have.
2. Modern Monetary Theory or MMT has been dubbed the magical money tree. We think for the U.S. Treasury some degree of debt monetization – the effective reduction of liabilities by inflation – is the likely outcome.