Q1 Note & Commentary

By Jason Lesh, Managing Principal


The first three months of the year have reminded everyone that volatility is not just a myth: it actually exists. January opened the year on a tear, only to erase nearly all the gains in February. March saw the S&P 500 turn negative on the year.

This quarter, Nick goes wildlife tracking. In addition to searching for the proverbial lion in the grass, he’s noticed some subtleties in the investment environment that have shown themselves in the evolution of our portfolios. We are feeling great about our current stance and highlight how a conventional 60/40 portfolio with US growth stocks and interest-rate sensitive bonds is actually incredibly risky.

If conventional wisdom and traditional allocations are risky, what do we like? International and emerging markets. Commodities. And astute investors with fortress like balance sheets. And it has served us well as of late.

Warmest regards,

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Jason Lesh




Quarterly Commentary: The Lion in the Grass

By Nick Fisher, Portfolio Manager

One of the things I love about the work I do is the association with deep thinkers and phenomenal people (not just Rick and Jason). One such person is Patrick O’Shaugnessy whose “Invest Like the Best” podcast discusses finance and investing and routinely explores unrelated influential ideas. In a recent podcast, Patrick featured Boyd Varty who discussed the idea of “wildlife tracking” on the Londolozi Game Reserve in South Africa, as a metaphor for an approach to life. You can listen to the fascinating and thought-provoking conversation here.

“Look deep into nature and then you will understand everything better.”
–Albert Einstein

I would submit that wildlife tracking is equally as applicable to investing and offers some unique perspectives in this uncertain environment. Tracking is not as simple as following the tracks of an animal, just as investing is not as simple as buying an index fund and leaving it alone. Economist John Mauldin has referred to the idea of how to spot the lion in the grass if you want to avoid being eaten.

“If you actually are listening…if you’re actually aware…if you take the time to learn about the wilderness…it talks to you. It doesn’t want to tear you up…if you learn the language it can actually be a very very safe environment.”
-Boyd Varty

Good trackers and good investors pay attention to the environment and the subtleties of what’s happening around them, the direction of the wind, the movement, sounds, and disposition of other animals, the narrative of what the animal senses or the situation in which the animal finds itself. On the African plains, if you miss these subtleties and bumble through the grass, you may be eaten. In the investment world it can be equally as dangerous, if you’re not paying attention.

Here are some of the subtleties that I see in the investment environment that could amount to the lion in the grass:

  1. Stock Market valuations: By every valuation measure that I am aware of, the US stock market is the first or second most expensive market in the world. When we have seen this discrepancy in the past, it has led to poor long-term returns going forward.
  2. Monetary Policy: We have discussed the tail winds of monetary policy at length. The shift in investor appetite to higher returns is widely known at this point. Investors have favored marginally more risky assets to avoid ever-lower bond returns. As the Fed increases interest rates and starts quantitative tightening (the opposite of quantitative easing), investors will see less liquidity and capital will become scarce which will reverse this risk-seeking trend. This transition will create significant volatility in all assets.
  3. Typically when the treasury yield curve inverts, (ie. you make more yield from a 5 yr Treasury bond than a 10 yr or 30 yr bond) it does not bode well for stocks. Five years ago, the difference between the 5yr and 30yr was 2.2%. Today it is 0.33%!
  4. The infallibility of big tech (think FANG stocks): In the last few years if you haven’t owned Facebook, Amazon, Netflix and Google, you have looked like a fool. Investors are changing the way we think about valuing stocks to justify the domination of these stocks. We have seen this before (see Nifty Fifty, Dot Coms, etc.) and it never ends well. Over the long-term, capitalism, innovation or regulation will reduce their dominance, valuations will no longer be justified, and many years will pass before prices recover.
  5. Intraday trading: Recently as much as 25 percent of all trading volume during the day is taking place during the last 30 minutes of trading. In 2017 markets were consistently rallying in this last period of trading, which signals broad based buying among institutional investors. Recently this has reversed itself and many days have started positive and sold off. The not so subtle message: a lot of institutional selling is taking place.

All these subtleties of change suggest that our stance should be cautious. 


Conventional Wisdom

We absolutely despise the traditional 60% stocks and 40% bonds portfolio. We believe that this over allocation to US growth stocks and interest-rate sensitive bonds and credit will lead to disappointing returns. These returns will surely leave investors short of their retirement goals. That seems very risky.

Meb Faber recently backtested many different asset allocation scenarios and even in the “safest” scenario, real returns after inflation have hardly been safe with a 25% peak to trough decline. That is to say, adding cash, or bank CDs or guaranteed government treasury bills did not keep your portfolio 100% “safe.” We must be prepared for this type of “volatility” and risk.

Jeremy Grantham, who may be the greatest asset allocation investor of all time, has detailed the predicament that investors find themselves in. He has outlined three scenarios: 1) An environment where we see significant inflation and a return to the long-term trend of interest rates. 2) An environment where we have a major economic slow down and deflation rears its head (again) with the Fed dropping rates to zero or lower. 3) An environment where we just muddle along with very low returns but no significant volatility or market decline either. None of these scenarios are ideal for the traditional 60/40 portfolio and will likely lead to disappointing returns.

To us it seems riskier to accept the highly probable lower returns of the assets that are considered traditionally safer. In order to achieve an acceptable return, as we have detailed in the past, an unconventional exposure to assets often thought of as more “risky” may be required. These include:

  1. International and Emerging markets while volatile, have not been any more volatile recently than the S&P 500. This may be surprising, but the fact that they are so substantially cheaper in valuation give them a much better risk/return profile than normal. See our previous discussion here.
  2. Commodities will provide an inflation adjusted “hedge” against our safe assets like cash and short-term treasuries. By nature, late in the economic cycle, inflation is much more likely. This is often the cause of rising rates, ie. inflation causes the Fed to raise rates and slow down the circulation of capital within the economy. Agriculture, industrial metals, precious metals and energy should all do well versus the dollar.
  3. Putting money in the hands of astute value investors is a great bet in environments such as this. Berkshire Hathaway and Fairfax Financial fit this bill. With their fortress like balance sheet and ability to be decisive when opportunities present themselves it makes them more valuable in the uncertain times we find ourselves in.

As volatility plays out, we often have the opportunity to take advantage of specific situations that are more idiosyncratic in nature. We especially like it when an entire industry is left for dead and expectations have swung so low that results are likely to surprise higher. Canadian energy companies fit this bill currently, with many of them selling at 5x cash flow.

It’s important to realize that we like it when assets meet all 3 objectives above, the trifecta. That is to say: a) they are relatively cheap among a sector, but b) absolutely cheap relative to our thoughts around global economic stability and commodity inflation and finally c) they are run by management teams that act as astute investors/capital allocators.

To summarize, we are cautious as a whole, but humbly confident in our ability to navigate the uncertainty of this African savannah. By using all of the tools as “trackers” we will achieve satisfactory returns and avoid being eaten.

Best regards,

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Nick Fisher