Why did I just listen to a nine hour audio book of Warren Buffet’s “Ground Rules”?
Get Your Mind Ready
Living in Steamboat Springs, CO, I have seen my fair share of elite winter athletes mentally preparing for the ski course ahead. They are standing at the top of the course, eyes closed, in the moment of perfect memory, virtually skiing the gates ahead of them. I find myself, doing the same now as I believe the markets are approaching the “start” of a profoundly different market environment that will differ from what many have accepted as permanent leadership.
In preparation, I thought it would be helpful to step into the metaverse of those great money managers of all time who were at their peak in the early 50’s through the 1970’s. Hint there really aren’t many still alive, beyond Buffet. My takeaway after digesting “Ground Rules” was that Buffet really was (is) an exceptional money manager. His boldness as a 20-year-old was just shocking but in a calculating, educated, disciplined way that is nearly the polar opposite of a lot of the behavior I see today. “Ground Rules” is a long walk through Buffet’s annual investor letters in which he openly talks through his own journey and evolution in identifying unique investment opportunities different strategies within his own skill set, never reaching beyond his own ability nor forgetting his own rules for margin of safety with investor capital. Buffet was the protege of Benjamin Graham, The Godfather of qualitative value investing and a survivor (winner) during the Great Depression. That mentorship certainly forged a lifetime bias in Buffet as a value investor that served he and his investors incredibly well for over 7 decades to date.
The Start
In the last update, I described what I am excited about. This is an extension of that commentary but want to focus more specifically on the developing opportunity to accumulate stock in companies, sectors and asset classes that are selling at historically cheap valuations. I believe this is the start of a secular move where value dramatically outperforms growth as we quickly and not so quietly, graduate from a world dominated by a just a few mega cap growth names. I realize this is now a well-worn story in the financial news, but remarkably, investors are not acting on this opportunity in any scale (yet). Bear with me as I walk through the evidence and set some expectations for our clients heading into 2022.
Why Value Now?
- Valuations – I know that’s sort of silly to say. Let’s buy Value because it’s “valuable” ! They say, a stock’s valuation doesn’t matter until it does. Now is the time when valuations matter. Today we have a market that is dominated by growth names selling at absurdly high valuations by any measurement (P/E, Price to Sales, Price to Book, Price to Earnings Growth, Earnings Yield… take your pick). Meanwhile, I am now seeing a small but growing number of companies with expanding earnings, high dividends, low debt to equity selling at prices that are approaching their liquidation values. I presented some of these ideas last week with my commentary about Ford vs Tesla. In full disclosure, we sold the last of our TSLA shares in our New Power strategy above $1200 last week. Apologies for realizing the gain for those with taxable accounts. We will continue to add to Ford on pullbacks. Buffet has got to be excited with the prospects for Berkshire Hathaway which is probably why they just executed an enormous buyback of their own shares this week. There are other “Fords” out there for those brave enough to act with discipline and avoid caving to conventional thinking.
- Inflation – You know my thoughts on inflation. It is not temporary unless temporary is 3-4 years for you. Please reread any of the posts in the last 12 months as to why inflation is not temporary. We are now approaching the end of year 1 and it is just now becoming something of a headline. Inflation is the enemy of companies that are owned for their growth prospects. Why? Because inflation makes FUTURE earnings less valuable than earnings (or dividends) paid in today’s dollars. Growth companies reward investors for FUTURE earnings while today’s value-oriented companies reward investors with earnings and dividends TODAY. Recognition that inflation is real and persistent should drive investors into the value sector and out of growth. This is a special moment in time, right here, right now for those looking to reposition their portfolios as the relationship between growth and value is stretched to a historic extreme. If the past is our guide, we would not be surprised to see value investments continue much higher even as the growth side of the market experiences bear market type losses.
- The Fed is Trapped – Powell is going to lose his job because President Biden doesn’t like the sound of “Bidenflation”. There was a lot of chatter leading up to the last Fed meeting about how they were going to taper their purchases of bonds in the coming months. Yes, they are tapering their bond purchases, but this is not tightening in any way, it’s just less accommodation. In fact, statistically, the Fed will be purchasing another $400 Billion in credit and bond securities before they are finished next year according to plan. Raising interest rates is something that will happen later, maybe much later, or maybe never considering the Fed’s new laser focus on employment. They know that raising rates and the cost of borrowing will yield higher unemployment and will do nothing to curb inflation. Remember, raising rates only restricts an economy that is stretched on credit. Today, households and corporations are sitting on more savings and cash, respectively, than any time in modern history. We have too much money chasing too few goods with very low labor participation rates. Raising rates will do nothing to curb these inflationary realities.
- Gambling Not Investing – I’ve seen this movie before. It happens when not so smart and inexperienced investors chase anything that moves fast. It doesn’t really matter what “it” is, just that it’s going to the moon! Gambling culture has moved from Vegas to DraftKings to Robinhood and now to the general stock market. I am admittedly a terrible gambler. The entire notion of betting big on something that offers a low probability of return is simply against my DNA. Gamblers always think they have an edge of some sort that makes their bets a high probability. Ask any Crypto maniac and they will tell about their insights and skill. Don’t confuse brains with a self-fulfilling crowd inspired price frenzy. Those of us who have been doing this for a while have seen speculative markets like these when whispers turn into 30% single day gains. When companies like Rivian come to market with an IPO valuation larger than Ford or GM without having delivered a vehicle yet. When small lot options trading becomes a hobby for home gamers. When things like SPACs and NFTs go mainstream. These are the days. What a great time to reinvent yourself as an investor in real value, real things, paying real dividends and providing real shareholder yield.
Strategy Orientation for 2022
This section is speaking to our current clients in an effort to tell you where we are going with your money and our general orientation toward the markets going into 2022. We are acting on these ideas now, because the opportunities described above are now.
In short, the environment we see looking forward, is one of contrast. The odds strongly favor a move toward a new environment with big winners and big losers and away from the current phenomenon where all things seem to rise in unison (a very rare condition. Strategies that can judiciously accumulate shares of deeply discounted shares now with the intent of holding them for years will stand apart from the broad market and those portfolios that remain locked into yesterday’s winners.
In our all-stock strategies like Worldwide Sectors and New Power, you should expect to see more individual stock names. Our intention here is to accumulate shares here and now, while value is still present and hold these names for longer than we have traditionally in the past adding some tax efficiency, lower trading frequency and more concentrated positions to these strategies. Our approach shifts a bit in the process, with less of a focus on momentum approach seeking leadership and more attention to fundamentals and valuations. Volatility in these programs will necessarily increase as we carry more individual stock holdings.
In our dynamic models like All Season and Gain Keeper Annuity, we will orient our strategies toward oversold asset classes, styles and sizes where value hides. Today, those are in small caps (esp small cap value), internationals and emerging markets, commodities, dividend payers, and inflation beneficiaries like gold, silver, and agriculture. We expect to continue holding just a minimum allocation to bonds as per our guidelines and avoid large cap growth altogether until we see a more attractive set up to reinvest. Volatility should remain roughly the same here.
MASS Income will remain invested in our current near equal allocations to dividend paying stocks (1), high yielding REITS and inflation beneficiaries (2) and credit bonds (3). If rates begin to move higher, we are likely to skew away from bonds.
Our newer Constant Exposure strategies (Wealth Beacon and Direct Indexing) won’t do anything different. Constant exposure is constant exposure. If there is a larger market decline in 2022, these strategies will take advantage by realizing losses, creating some tax credits against future realized gains, while remaining fully invested. Our “tilt” toward small caps, value and internationals remains going into 2022 across all Constant Exposure strategies.
Both of our Income models (Retirement Income and Freeway High Income) will work hard to preserve capital and clip as much income as we can. Admittedly, this is an uphill battle against the tide of inflation. The good news is that once interest rates finally sync up with real inflation, our income models will ride again, generating very stable high single digit returns as they have done under more normal economic conditions. Until then, Income allocations should be looked at as a ballast to any equity investments to control portfolio volatility or a source of cash to cover living expenses rather than a means of creating wealth. Special note – You will always have something in your portfolio that is less productive than other investments. Anything invested in bonds fits this role now. But it’s important to consider the very purpose of your fixed income investments in your portfolio now. Why do you have any fixed income ever? Growth of capital has never been the answer of course. If the lure of higher returns found in stocks is nagging at you, make sure to let us help you evaluate the importance of this piece of your portfolio first. Maybe you don’t need it and maybe you really need it! Everyone’s situation is unique.
The Point
One of our jobs as your advisor and asset manager is to set expectations as best we can. We are your guide with all things financial including the mix of strategies within your total portfolio. When there are significant changes in outlook, strategy holdings or perspectives, we want you to know what we’re thinking. That’s all 🙂 There is no action needed on your part and we look forward to seeing you on your next review.
Cheers
Sam Jones
