Fellow Partners,
The present investing environment is an interesting one. Large indices are near all-time highs whilst there is a bloodbath in smaller stocks and especially growth stocks. No one can quite agree whether digital assets are dramatically undervalued or overvalued, or how closely they will move with other risk assets over the longer term. Inflation predictions are in vogue, and the Fed keeps playing with the punchbowl. Volatility is high and markets are moving quickly.
The present investing environment is wonderful for long-term investors applying practical wisdom and first principles reasoning to patiently compound capital, such as this partnership. Opportunities abound. I encourage partners to increase their positions in the partnership to take advantage of them, and potential partners to reach out.
This letter provides context to this environment and how we are navigating through it.
In summary:
- In our present environment first principles reasoning is critical (as always). I have included a summary of our writing series on topic, with links to all the essays published thus far.
- Inflation is a battle of demographics and technology vs. money for nothing1. While inflation remains impossible to predict in the short-term (so we should stop trying), it is possible to understand the longer-term forces that will influence it.
- Our global supply chain can be visualized as a snow globe. Pre-Covid the snow was gently oscillating about. It now receives regular, violent shakes. This exacerbates the challenges inherent in managing inflation and understanding asset prices.
- There have been many signs of froth in the market over the past 12 months. This has led to high volatility, particularly in smaller stocks and growth stocks.
- Indices are not companies — there are both overvalued indices and undervalued companies in the present market. The aggregate of the above factors has created buying opportunities we are taking advantage of.
[1] First principles reasoning
Our writing focus in 2021 was our First Principles Reasoning Series.
Our present investing environment is a superb example of the importance of those focal points (all links go to the essays in the series):
- History can’t tell you what to do
- Priorities are critical — ours must be focusing on the business and building better businesses
- To do so we must seek to understand the fabric pattern of reality and pursue simplicity on the far side of complexity
- We must know why we own what we own and know what we’re looking for
- And, whatever we do, we must not compete with robots
[2] Demographics and technology vs. money for nothing
This has been called the chart of the century. Spend a few minutes thinking it through:
It sheds light on many current debates, e.g.:
- Have real (inflation-adjusted) prices really risen?
- Are younger generations better-off or worse-off financially than older ones?
- Have home prices risen faster than inflation?
In general, this data highlights the difference in price changes of goods (e.g., TVs, cars) vs. services (e.g., healthcare, education).
As with all data, what is happening underneath the surface is critical. Segment. Always segment. Quality often has a premium and can rise in cost far faster than inflation (e.g., home price growth in highly desirable areas vs. the overall market).
I may publish a longer piece on inflation and deflation in the coming months, but here’s the short version:
- The lower birthrate of younger generations vs. older generations means that there will be relatively fewer consumers over the coming decades to consume goods and services. This is a longer-term deflationary force.
- By contrast, elderly populations that are larger than working age populations will require more from each worker for support. This is a shorter-term inflationary force.
- As seen in the chart above, areas that have embraced technological disruption (cars, phones, computers, TVs, etc.) have seen declines in relative cost. This is a deflationary force.
- Areas that have been slow to embrace technological disruption are in a doom loop. For example, rising costs of healthcare and education have led to additional government intervention and subsidies which in turn have allowed even higher costs. This is an inflationary force.
- Consuming digital bits — such as digital software and entertainment — are deflationary. If you are reading this essay on a phone, tablet or computer, your present actions are deflationary as you are consuming bits, and bits are infinitely replicable with zero marginal cost.
- Consuming atoms (physical items) is inflationary. We all require a certain amount of physical goods and services such as housing and food. Too many people chasing too few items is the definition of inflation. Massive amounts of government stimulus since the start of Covid have exacerbated this.
In the short-run the effects of these largely demand-side considerations have been exacerbated by supply chain disruptions.
[3] Supply chain disruptions
We have been experiencing a somewhat perfect storm of rising demand amidst severely disrupted supply for well over a year.
Demand for goods and services is high due largely to massive government stimulus since the start of Covid, which led to high levels of household savings and sharply rising wages against a backdrop of pent-up consumer demand seeking outlets. Shifts in consumption mix (e.g., buying a big TV instead of going to the movies, or upgrading one’s home instead of going on vacation) make this even tougher.
Supply of goods and services is severely disrupted due to massively global supply chains and a myriad of changing variables (e.g., China’s zero Covid policy creating rapid, regular, and unpredictable shutdowns of major ports and factories that are linchpins in global manufacturing and distribution).
Pre-Covid global supply chains were so optimized that purchasing managers were carrying what we would now consider to be surprisingly low stocks.
A capable purchasing manager’s role is to [a] minimize stock (thereby minimizing working capital) while [b] ensuring stock never runs out. The relatively calm decade leading up to Covid meant that stock-minimization was, well, maximized. It was not uncommon to carry only a few weeks of inventory even if replenishing such inventory relied on global sourcing, assembly, and distribution (for example, iPhones contain components from 43 countries across six continents).
Pre-Covid the developed world had a very, very refined global supply chain and little reason to carry extra stock to handle supply shocks. Initial reactions to Covid exacerbated the low-stock problem. For example, at the start of Covid auto manufacturers cancelled orders for semiconductors in anticipation of a prolonged demand slump. Due to long manufacturing lead times, when demand returned faster than expected auto manufacturers found themselves with insufficient stock of semiconductors and months-long wait times to restock them. The effects of these decisions are still being felt in the market for new and used autos 18+ months later.
Of course, much of the above has been in the news for months. But the degree and duration of these factors remains under-appreciated.
Imagine our global supply chain as a snow globe. Pre-Covid snow generally fell gently and predictably. Now it blusters randomly and chaotically, and when the environment starts to calm down it gets another violent shake. That’s a decent metaphor for what we are currently experiencing, and why we should expect continued oddities in the availability and prices of goods and services well into 2022.
All that said, demand for and supply of goods and services is massively complex, behaving as a complex adaptive system with emergent, unpredictable behavior. It is useless to try to guess where this all goes in the short run, including whether it permits continued inflation. Forecasting is hard (see image below).
What we do know is that in the short-term supply/demand imbalances lead to volatile prices.
This has led to signs of froth.
[4] Signs of froth
In the past twelve months we’ve seen2:
The biggest IPO of 2021 — with a trading debut valuation over $100 billion — was a company with a wonderful product but no revenue.
After years of vocally criticizing himself for missing the rise of wonderful internet-native companies, Charlie Munger invested heavily in Alibaba.
Howard Marks, a famed skeptic of new-new things, was finally willing to discuss blockchain technology, and ultimately accepted it as an innovation platform.
An ETF was launched to invest in a theme we are yet to clearly define.
Facebook changed their name to Meta Platforms to signal their seriousness about said theme, and committed to spending $10 billion annually to develop it.
Very high levels of insider selling.
Shopify, the company “arming the rebels” to compete with Amazon, started working on Non-Fungible Tokens.
Elon Musk pumped cryptocurrency on SNL.
My barber recommended investing in digital assets (yes, this happened).
Matt Damon in those endless crypto.com commercials.
Stuff like this:
And this:
Ramneek @iramneek“I think he’s the new Buffett, uhh… Chamath.” ~Josh Brown, Jan 13, 2021
And this:
Alex Rampell @arampell1/ Why is “Buy Now, Pay Later” (BNPL) an early threat to trillions of dollars of market cap - Visa (almost $500B), MasterCard ($350B), card issuing banks, acquiring banks/services (Fiserv, FIS, Global Payments, etc)?
The aftermath of froth creates buying opportunities.
[5] Buying opportunities
Over the past few months we’ve had a tale of two markets.
Major indices are at or near all-time highs, including those with modest value and growth tilts (see below blue, teal, and orange lines).
This is not true in two areas: smaller stocks (yellow line) and especially smaller growth stocks (purple line).
In aggregate, smaller stocks and smaller growth stocks were volatile but overall about flat in 2021 until mid-November, when fears of rising interest rates as a response to heightened inflation began to take hold. In December the Fed signaled tightening and rate increases in 2022, and recently released minutes from their December meeting suggested even more stringent moves than previously suspected. Higher interest rates mean profits years into the future are less valuable in the present. Selloffs ensued and as of the time of this writing are still taking place.
Why do indices remain near their all-time highs? The prospect of rising interest rates means that bond prices will inevitably decrease, making bonds a poor option for a flight to safety. Instead, investors are rotating within equities — buying financials, commodities, cyclicals and other sectors — while selling positions more reliant on profits years into the future. This in essence is shifting funds from one pocket of an index to another, whilst maintaining the overall level of the index.
How is this impacting our portfolio?
We are zigging while others zag.
We have begun buying or increasing our positions in high quality companies that are currently well out of favor, often able to purchase shares at 30-60% discounts to recent prices — prices last seen months or years ago — for businesses whose performance is much better today vs. the time these prices were last offered.
We have funded these activities through selling positions that have held up well but done so at the cost of future growth prospects (relatively higher prices now results in relatively lower price appreciation down the road).
Our intention is to hold these companies for years. Short-term volatility doesn’t matter much in the long run, but purchase price directly impacts our future profits. We hold through periods of volatility and use drawdowns as opportunities to increase our holdings. This is our main focus: owning quality businesses and not overpaying. If we do both, we should be happy with the long-term results.
Another zig: our current portfolio consists of 17 positions, only one of which is in the S&P 500.
I remain very optimistic about the long-term future of our portfolio and encourage partners who are considering investing additional capital to reach out (as well as potential partners interested in joining).
Thank you to those of you who have already contributed capital. I believe we will be envious of some of the prices we are seeing today when we look back in five years’ time.
Closing thoughts
I was grateful to see most partners in-person in 2021 and hope the same again in 2022. As always, I enjoy hearing from you. Please reach out any time.
All the best for a strong start to 2022!
John
Founder and Managing Partner
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Thanks to Andrew G. for this wonderful phrase.
Thanks to this excellent thread for compiling much of this list.