Tag Archives: ESG

Robertson: When “Stuff” Gets Real

We all can be tempted to follow the path of least resistance and in a competitive world there are always incentives to get the most bang for the buck. Often this means taking shortcuts to gain some advantage. In a forgiving world, the penalties for such transgressions tend to be small but the rewards can be significant. When conditions are extremely forgiving, shortcuts can become so pervasive that failing to take them can be a competitive disadvantage.

In a less forgiving world, however, the deal gets completely flipped around and penalties can be significant for those who take shortcuts. This will be important for investors to keep in mind as rapidly weakening economic fundamentals and increasing stress in financial markets make for far less forgiving conditions. When things get real, competence and merit matter again – and this is a crucial lesson for investors.

Leaders of companies and organizations normally receive a lot of attention and rightly so; their decisions and behaviors affect a lot people. In the best of situations, leaders can distinguish themselves by creatively finding a “third” way to resolve difficult challenges. In other situations, however, leaders can reveal all-too-human weakness by taking shortcuts, cheating, and acting excessively in their own self-interest.

One of the situations in which these weaknesses can be spotted is in whistleblower incidents. For example, the Financial Times reported on the illuminating experiences of one HR director who in successive jobs was requested to break rules by a boss:

“Told by a senior manager at a FTSE 100 business to rig a pay review to favour his allies, she refused. ‘After that, he did everything to make my life absolute hell,’ she says. Then, at the first opportunity, he fired her, claiming that she was underperforming. Warned that the company would use its resources to fight her all the way if she took legal action, she accepted a pay-off and left’.” 

“Her next employer asked her to manipulate the numbers for a statutory reporting requirement to make its performance look better. She refused, signed another non-disclosure agreement and resigned.”

As unfortunate as these experiences were, they were not isolated events. The HR director described such incidents as happening “left, right and centre”. The fact that such cases are extremely hard to prosecute in any meaningful way helps explain why they are so pervasive. Columbia law professor John Coffee describes: “It’s extremely difficult to make a case against the senior executives because they don’t get Involved in operational issues. But they can put extreme pressure on the lower echelons to cut costs or hit targets.”

Company employees aren’t the only ones who risk facing hostility for standing for what they believe is right. Anjana Ahuja reports in the FT that scientists can fall victim to the same abuses. As she points out, “Some are targeted by industry or fringe groups; others, as the Scholars at Risk network points out, by their own governments. The academic freedom to tell inconvenient truths is being eroded even in supposed strong holds of democracy.”

Ahuja noted that the Canadian pharmacist and blogger, Olivier Bernard, was chastised for “interrogating the claim that vitamin C injections can treat cancer.”  As a consequence of his efforts, “He endured death threats” and “opponents demanded his sacking.”

In yet another example, Greece’s former chief statistician Andreas Georgiou “has been repeatedly convicted, and acquitted on appeal, of manipulating data.” The rationale for such a harsh response has nothing to do with merit: “statisticians worldwide insist that Mr Georgiou has been victimised for refusing to massage fiscal numbers.” It is simply a higher profile case of refusing to be complicit in wrongdoing.

The lessons from these anecdotes also play out across the broader population. The FT reports:

“According to the [CIPD human resources survey], 28 per cent of HR personnel perceive a conflict between their professional judgment and what their organisation expects of them; the same proportion feel ‘it’s often necessary to compromise ethical values to succeed in their organisation’.”

Employees are all-too familiar with the reality that such compromises may be required simply to survive in an organization and to continue getting health insurance: “Most HR directors know colleagues who have been fired for standing their ground.”

Yet another arena in which expertise and values get compromised is politics. While political rhetoric nearly always involves exaggerations and simplifications, the cost of such manipulations becomes apparent when important issues of public policy are at stake. Bill Blain highlighted this point on Zerohedge:

“It’s as clear as a bell that Trump had no plan to address the Coronavirus before he was finally forced to say something Monday [March 9, 2020]. Until then it was a ‘fake-news’ distraction. He made a political gamble: that the virus would recede before it became a crisis, making him look smart and a market genius for calling it.”

Blain’s assessment illustrates a point that is common to all these examples: Each involves a calculation as to whether it is worth it or not to do the right thing based on merit or to take a shortcut. Each involves an intentional effort to reject/deny/attack positions that are real and valid. Evidence, expertise and professional judgment are foresworn and replaced by narrative, heuristics, and misinformation. While such tactics undermine the long-term success of organizations and societies, they can yield tremendous personal advantages. The good of the whole is sacrificed for the good of the few.

Another point is that these efforts are absolutely pervasive. They can be found across companies, academia, politics, and beyond. They can also be found in countries all across the world. In an important sense, we have been living in an environment of pervasive tolerance of such decisions.

A third point, and the most important one, is that now it is starting to matter. It appears that the real human impact of the coronavirus has shaken many people out of complacency. The types of narratives and misinformation regarding the market that had been accepted suddenly seem woefully out of place when dealing with a real threat to public health. As Janan Ganesh reports in the FT, “This year provides a far less hospitable atmosphere for such hokum than 2016”. He concludes, “Overnight, competence matters.”

True enough, but Ganesh could have gone further. Suddenly, additional traits such as courage, good judgment, and ethical behavior also matter. Overnight, carelessness and complacency have become much more costly.

All these things will become extremely important for investors as well. For example, information sources are crucial for early identification of potential problems and for proper diagnosis. Most mainstream news outlets were slow to report on the threat of the coronavirus even though it was clearly a problem in China in January. By far the best sources on this issue have been a handful of independent researchers and bloggers who have shared their insights publicly.

One form of news that will be interesting to monitor is upcoming earnings reports and conference calls. These events can provide an opportunity to learn about companies as well as to learn about management’s philosophy and decision-making.

Which companies are busily responding to the crisis by scrutinizing their supply chains and developing HR policies to ensure the safety of their employees? Which companies already had these measures in place and are simply executing on them now? Which companies are withdrawing guidance while they frantically try to figure out what’s going on? These responses will reveal a great deal about management teams and business models.

In addition, a much higher premium on merit will also place much higher premia on security analysis, valuation, and risk management. Alluring stories about stocks and narratives about the market can be fun to follow and even compelling. At the end of the day, however, what really matters is streams of cash flows.

Finally, a higher premium on merit is likely to significantly re-order the ranks of advisors and money managers. Those ridiculed as “overly cautious” and “perma bears” will emerge as valuable protectors of capital. Conversely, those arguing that there is no alternative (TINA) to equities will be spending a lot of time trying to pacify (and retain) angry clients who suffer big losses. Further, things like education, training, and experience will re-emerge as necessary credentials for investment professionals.

As the coronavirus continues to spread across the US, things are starting to get real for many investors. Suddenly, the world is appearing less forgiving as it is becoming clear that economic growth will slow substantially for some period of time. This especially exposes the many companies who have binged on debt while rates have been so low. Further, it is becoming increasingly obvious that there is very little the Fed can do with monetary policy to stimulate demand.

While the coronavirus will eventually dissipate, the increasing premium on merit is likely to hang around. The bad news is that in many cases it will be too late to avoid the harm caused by leaders and managers and advisors who exploited favorable conditions for personal advantage. The good news is that there are very competent people out there to make the best of things going forward.

Robertson: One Is The Loneliest Number

With passive funds continuing to grow share at the expense of actively managed funds and markets on a roll since late 2018, analyzing individual stocks can seem like a quaint if not downright outdated exercise. Indeed, many investors and advisors have become so deeply habituated to passive investing that they don’t even consider other alternatives. As a result, the exercise of analyzing individual stocks has become a fairly lonely pursuit.

This reality, however, also spells opportunity. While the rising tide of easy monetary policy lifted most equity boats for many years, the beneficial effects now are being shared by a decreasing number of the largest stocks. In addition, as the share of active management declines, so too do analytical efforts that keep market inefficiencies in check. A key consequence is that some much more interesting stock ideas are beginning to emerge for investors who are willing and able to rummage around in less visible parts of the market.

In a sense, it shouldn’t be surprising that individual stock opportunities are creeping up. After all, there are only a relatively few stocks with the size and liquidity requisite to be constituents in a broad array of passive funds. Pretty much by definition then, most stocks do not benefit so disproportionately from large flows of funds from price-insensitive investors. It also follows that without such support, most individual stocks are still vulnerable to eroding fundamentals to a greater or lesser extent.

And eroding fundamentals there are. Weak economic growth across the globe and repeated flirtations with yield curve inversion provide plenty of fodder to beat up on stocks with economic exposure. Companies across the energy sector have been hit, but so have those in transportation, shipping, retail, and plenty of other industries.

While poor economic news (and plenty of other uncertainty) is negative for stock prospects, it does come with a bit of a silver lining. Such clear detrimental forces induce investors to react, and in doing so, they often overreact. These types of situations are the bread and butter of valuation-based stock picking.

This also relates to another point that seems nearly forgotten. It wasn’t all that long ago that investment research was dominated by company-specific work. Before the financial crisis in 2008, Wall Street research emphasized company analyses. Investment platforms such as Motley Fool and Seeking Alpha (among others) emerged to address the widespread appetite for company-specific insights. Even casual conversations often revolved around stock tips.

While much of that activity was overdone and not especially useful, the key tenets of equity analysis remain as valid as ever. With the opportunity set beginning to open up again, now is a good time to either refresh those skills or develop them anew. More specifically, the thrust of such efforts is to identify the degree to which situational factors affect a company’s cash flow stream and then to determine if the market’s reaction is excessive.

As an example, one of the stocks I have found interesting is a small-mid cap supplier to the food and beverage industry. It has been around for a long time and sells all over the world; less than half of its revenues are in the US. Because it sells to the food and beverage industry, its revenues are fairly stable. While they don’t go up a whole lot, they don’t go down a whole lot either.

This particular company is also a leader in its industry. It dominates market share and as such, it provides significant logistical and reliability advantages to its customers. On top of all this, it is also a technology leader and finds various ways to monetize its position.

The company does have debt, but the debt level is manageable given the stability of the business and its prodigious generation of cash flow.

Based upon this description of fundamentals, how would you expect the stock to have performed? By way of comparison, the S&P 500 produced a total return of 31.5% in 2019 and finished with a trailing price/earnings multiple of 21.75. Would it be up by half as much as the S&P500? Flat? Maybe down a bit?

The reality was far harsher. Not only did the stock fail to keep up with the S&P 500 last year, it crashed on the order of 50% after a negative earnings surprise. This was interesting for two reasons. First, it was left with a price/earnings multiple in the mid-single digit range which is nearly unheard of in such overvalued markets. Second, the stock fell to a level below its lows during the Great Financial Crisis over ten years ago, despite being in a far more benign economic environment. To value buyers, this starts to sound interesting.

Obviously, not all cheap stocks will outperform and there are plenty of other factors that can come into play. Further, if economic conditions continue to erode, a number of companies will be negatively affected and could run into serious trouble. This is certainly happening in the energy industry right now.

But that’s not the point. The main point here is to recognize the world of individual stocks is becoming increasingly bifurcated. On one side is the glossy veneer of index averages regularly pushing higher. These are driven be a relatively few mega cap tech names that seem to be nearly impervious to negative news.

On the other side is a growing group of stocks that are not only vulnerable but seem to be hypersensitive to such factors. This is a different environment than a few years ago when it was extremely difficult to find any stock that was cheap. Something has changed.

This opens up new challenges and opportunities for investors. A big challenge is that the mega cap tech leaders today are unlikely to remain impervious to bad news forever. One of the great lessons of the internet boom in the late 1990s is that tech companies are not immune from economic pressures.

Many will be surprised to find out this is still true. Whether it comes in the form of reduced capital spending by companies, lower discretionary spending by consumers, or lower advertising spend as corporate budgets get squeezed, technology businesses are still very much affected by economic conditions. As it turns out, these conditions affect all their customers.

Another big challenge is that with major indexes near all-time highs and with little earnings growth to support those prices, common passive strategies are set up to deliver exceptionally poor returns over the next several years. As a result, the returns from passive investing may very well be insufficient for many investors to reach their goals. The ride over the last ten years has been terrific, but the next ten will likely be very different.

There is also opportunity, however. The best chance investors will get to realize the kinds of returns that can really help them is to return to the hard work of uncovering undervalued companies. Such an endeavor is the bread and butter of active investors and focuses on identifying cash flows and determining how sustainable they might be. Competitive advantages are important and often come in the form of less tangible attributes such as an organization’s capacity to learn and adapt. It takes a lot of work, but the opportunities exist.

While the work of toiling on individual company analyses can be a lonely endeavor, especially while passive strategies remain in the spotlight, it is also a valid way to extract decent returns from an otherwise overvalued universe of options. Indeed, such efforts may be the last best hope to realize attractive returns for some time to come.

Robertson: Only Time Will Tell

A great way to learn more about any phenomenon is to gain perspective by examining it from different angles. While it is certainly true that a great deal is known about stock returns, it is also true that a broader understanding of the subject has been hampered by overly simplified narratives and recency bias.

What is needed is a fresh perspective and a fairly recent (2018) study provides just that. The study helps to better understand the proposition of investing in stocks and in doing so, provides valuable insights for long-term investors.

The study in question was conducted by Hendrik Bessembinder from the W.P. Carey School of Business at Arizona State University (h/t Steve Bregman from Horizon Kinetics by way of his interview with Real Vision). A key difference in Bessembinder’s approach is that rather than looking at returns from broadly diversified stock portfolios, he focuses his attention on “returns to individual common stocks.”

More specifically, he looks at the excess market value created from holding a stock over the value of simply holding a one-month Treasury bill. Drawing on data from the Center for Research in Securities Prices (CRSP) database, he analyzes the series of one month returns of each stock relative to a T-bill from 1926 to 2016. His finding is somewhat surprising at first look:

“More than half of CRSP common stocks deliver negative lifetime returns. The single most frequent outcome (when returns are rounded to the nearest 5%) observed for individual common stocks over their full lifetimes is a loss of 100%.”

He goes on to explain how this happens: “These results highlight the important role of positive skewness in the distribution of individual stock returns.” In other words, stocks have very asymmetric returns. Most stocks don’t create value relative to Treasuries (over their lifetimes), but a small subset of stocks create vast amounts of value. Bessembinder’s work highlights just how lopsided the contributions are:

“When stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.”

Importantly, the poor performance record for most individual stocks casts a very different light on both active and passive management and therefore has important implications for investors.

For active investors, it highlights both a challenge and an opportunity. Since only a relatively few stocks drive all of the wealth creation, failure to have adequate exposure to those few will severely impair portfolio performance. This can be seen quite clearly in the comparison of median and mean buy-and-hold returns for the universe:

“The mean annual buy-and-hold return is 14.74%, while the median is 5.23%. The divergence is more notable for the decade horizon, where the mean buy-and-hold return is 106.8%, compared to a median of 16.1%.”

The key challenge of active management, then, is to establish sufficient exposure to the relatively few disproportionate value creating stocks. If a manager has no special capability to single out these types of stocks, active returns are more likely to be close to the median than the mean.

This reality also creates opportunities, however. Insofar as a manager does have research and analytical processes that create an edge in identifying value creating stocks, the chances of outperforming a passive index are pretty decent. Bessembinder notes, “Investors with long investment horizons who particularly value positive return skewness” can significantly increase their chances of outperforming. The reason is that such an effort can focus on the types of stocks that create disproportionate wealth and concentrate them in a portfolio.

Active management also creates other opportunities. Bessembinder’s study focuses on buy-and-hold returns which excludes the universe of stocks that create value for some period of time before losing that capacity. Active management allows managers to reap the benefits of value creation for part of a company’s life cycle and then to eliminate exposure if evidence of erosion arises. Further, when active managers focus on value creating stocks, there is far less need to offset the performance drag caused by the majority of stocks in the universe.

Of course, the implications for passive investing are just opposite side of the same coin. While passive funds are often lauded for their low costs, little attention is paid to their investment merits. Bessembinder reveals the investment proposition of broad index funds fairly clearly – and the main advantage is diversity. More specifically, owning a piece of everything ensures that you get exposure to the relatively few stocks that create excess wealth.

Along with that benefit, however, comes the baggage of exposure to a lot of stocks that do not create any value. Further, such funds also necessarily include exposure to stocks that are visibly overvalued with no inherent mechanism to hedge that exposure. Stocks that create value for some period of time but then lose out to competition and fade away are included on the way up – and on the way down.

This highlights another point, “Individual common stocks tend to have rather short lives” with a median of seven-and-a-half years. This means that long-term investors in broad market passive funds will churn through several generations of failed companies through the course of their investment horizons.

Based on these insights, we can characterize passive investing more by what it is NOT, than what it is. A broad market passive fund is NOT a collection of mostly value creating securities (over their lifetimes) nor is it an efficient way to gain exposure to businesses that do create long-term value.

Yet another useful lesson from Bessembinder’s study is that it lends historical perspective to individual stock returns by illustrating some important changes over time. For instance, “the percentage of stocks that generate lifetime returns less than those on Treasury bills is larger for stocks that entered the CRSP database in recent decades.” So, as skewed as the returns have been, they have become even more so over time. This progression is evidenced by the fact that “the median lifetime return is negative for stocks entering the database in every decade since 1977.”

Not surprisingly, the worsening trend in performance also coincides with “a sharp decline in survival rates for newly listed firms after 1980.” While a number of potential causes are at play,  prominent ones feature the increased prevalence of stocks “with high asset growth but low profitability”. History suggests this combination leads to lower survival rates.

This history is especially interesting because it contrasts so sharply with today’s market ethos. For example, many of the current market darlings such as Netflix and Tesla not only exhibit high growth and low profitability, but also embrace and promote those attributes. History suggests such companies are overfit for very specific business conditions that are unlikely to persist and therefore are unlikely to survive more challenging conditions.

The issue of resilience is one that Nassim Taleb captured well in his book, Antifragile. For example, he described how he only drinks wine, water, and coffee based on the logic that liquids that are at least a thousand years old have been adequately tested for fitness. While Taleb’s standards of fitness for beverages may be extreme, the point is still a valid one: With such a long history, these beverages have proven themselves safe over a wide variety of conditions.

The concept of resilience is also critical for long-term investors. Part of the reason is that companies that regularly operate at (or beyond) the thresholds of prudence are completely beholden to the graces of a favorable environment. Just as soon as things become even modestly more difficult for whatever reason, they do not have the wherewithal to survive.

This matters because for firms to be able to create a great deal of wealth, they must be able to generate excess returns, and also to do so repeatedly so returns can compound. That means survivability is also a precondition for significant wealth creation.

It really helps for long-term investors to keep this in mind. When stocks keep running up and the news is positive, it is easy to get caught up and lose perspective. Bessembinder’s study provides a striking reminder that the vast majority of these price moves do not reflect lasting value creation. In order to track lasting value creation, it takes company and industry research along with detailed analysis of economic returns and sustainable growth rates.

Finally, one of the great benefits of studying history is that it expands understanding well beyond our own personal experiences. Bessembinder’s study provides useful historical context but also much more. By uncovering the net returns of individual stocks over Treasuries, he also creates a much richer understanding from which to evaluate active and passive approaches to investing. Time will tell which approach is more useful for investors with long time horizons.

Robertson: The Fed’s Monetary Magic

Given the strong performance of stocks over the past year and the past decade, investors might be forgiven for enjoying a sense of calm. Regardless of what one might believe about underlying fundamentals and valuation, it is hard to dispute that whenever markets have run into trouble, central banks have provided ample liquidity to get them back on track. Although maintaining exposure to risk assets in such an environment can hardly be called investing in any conventional sense, it has been profitable to do so.

The main problem with such a benign outlook is that it rests on the assumption that central bankers will be both willing and able to protect markets by way of monetary policy. The bad news is that when all the ongoing challenges are considered together, it becomes clear just how complicated and difficult the task will be to keep markets afloat with monetary magic. The good news is that it is easy to identify those challenges by just reflecting on the last year and a half or so.

One big challenge that shows up on the radar is China. In September 2018 I wrote that Chinese residential real estate is “The most important asset class in the world.” Much like in the US in the mid-2000s, a housing boom in China has been fueled by cheap and easily available credit. The only major difference is that the excesses in China’s real estate market have not yet been resolved.

While the pattern of resolution is likely to be different in China for a variety of reasons, the implications are very similar. The main one is that the process is deflationary. The reason is that the resolution of bad debts both reduces money supply and tends to put downward pressure on prices until excess supply gets worked off.

Importantly, these deflationary pressures are unlikely to be neatly contained within China’s borders. Given China’s disproportionate influence on incremental global economic growth, any declines will be felt broadly. The persistent weakness in copper prices is one important indicator.

Another big challenge will be contending with the structurally lower demand for Treasuries outside of the US. I highlighted Russell Napier’s thesis in “Dollars and nonsense, Part 2” which explains that the halcyon days of persistently rising foreign exchange reserves, forced buying of US Treasuries from abroad, and artificially subdued interest rates are over.

Going forward, US savers will bear a much greater burden to buy Treasuries, and that burden will be made even greater yet by fiscal policy that allows massive deficits. The result is that US savers will need to either sell other assets or save more in order to fund growing government debts. This in turn will impede economic growth and significantly complicate monetary policy.

Yet another factor that threatens to complicate monetary policy is the Eurodollar system. I noted in “Dollars and nonsense, Part 1” that shadow banking in general, and the Eurodollar system in particular, create all kinds of headaches for policy makers. In this system, money supply is a function of capital markets and falls outside the regulatory purview of central banks. In addition, money created through the Eurodollar system is largely a function of global trade and therefore vulnerable to geopolitical risk. As a result, the Fed has virtually no control over this money and only vague ideas as to its quantity. 

In addition, a factor that can present serious challenges is the potential for severe capital controls to be implemented in a major emerging market. Although such measures are typically reserved for only the most extreme monetary challenges, they are always a policy option. Such controls can create immediate liquidity challenges which can spread quickly and widely.

The set of unhelpful consequences of monetary policy itself is yet another complicating factor. While policy prescriptions like low rates and asset purchases may provide some short-term benefits, they also come with longer-term costs. After ten years, the costs are accumulating, and the clock is ticking. Low and negative rates in Europe and Japan have destroyed the profitability of banks and eroded their ability to build strong capital bases. This can’t go on forever.

In addition, low rates induce companies (and consumers) to take on more debt. Increased burdens substantially reduce the margin of error by which companies operate. Any modest decrease in revenue, increase in interest costs, or increase in other costs (e.g. labor) can erode operating profits. With such fragile conditions for success, corporate financial health can decline quickly.

Indeed, such pressures are already being felt in a number of industries. For example, bankruptcies have been rising in the energy sector through 2019 and new capital is all but unavailable to these companies. Transportation companies are also feeling the pinch. Thus far financial stress has remained fairly localized, but the pressures are mounting.

With all these factors fresh in mind, it is easier to see just how complicated the task will be for central bankers. Because many of the issues are global in scope, the Fed will need to coordinate successfully with other major central banks, even as their objectives and priorities increasingly come into conflict.

At the same time, central bankers will need to maintain a balancing act between providing just enough stimulus to keep markets afloat but not so much as to further increase the risks of financial instability. Low rates undermine bank profitability and encourage over-consumption of debt. Excess liquidity encourages risk-taking. All these measures have costs and those costs are coming due.

If these aren’t problems enough, the ability of monetary policy to keep markets afloat is largely dependent on investors’ perceptions. In this symbiotic relationship, the ability of monetary policy to calm markets is at least partly determined by the belief of investors that it will work. In other words, maintaining this belief system takes on even more importance than fixing problems.

Unfixed problems can only persist for so long, however, before people start to notice and protect their wealth accordingly. When this happens, the power of central banks can unravel quickly. Importantly, a number of these unfixed problems are already revealing themselves in the forms of increasing bankruptcies, greater deflationary pressures in China, and the risk of a big bank in Europe or Japan failing.

Finally, the belief that stocks will keep going up because central banks will keep supporting them is based largely on the simple belief that since it has worked for ten years, it will continue to work. This, of course, is a fallacy and a misread of statistical probabilities. Such harmful, but common, tendencies are why the investment warning that “past performance is no guarantee of future results” has become so familiar.

Will the monetary magic wear out this year? It is impossible to say with certainty, but we do know a few things. One is that central banks cannot continue to implement policies with short-term benefits and long-term costs forever. Another is that the balancing act is getting increasingly difficult. Yet another is that we are closer to the end of the road this year than last year. So, if investors want to join (or remain in) the stock rally, they should do so with the full knowledge that they are playing with fire.

Robertson: Ain’t Nobody Home

One of the great challenges of financial markets is that certain important events only happen infrequently – which makes it all the easier to overlook them during intervening periods. One of those important situations is when it becomes extremely difficult, if not impossible, to sell an investment because too few people are both willing and able to buy it.

Through the course of a cycle the phenomenon of illiquidity occurs periodically but is normally contained to very specific situations and does not affect broader markets. Increasingly, however, there are signs that liquidity could be a problem in the foreseeable future, so it is a good time to review the risks.

To start with, there is nothing inherently wrong with illiquid investments. In fact, illiquid investments can produce higher returns for investors who don’t need immediate liquidity. As a result, they can make great sense for long term investors like pension funds and endowments. Indeed, David Swensen has made famously good use of this characteristic with the endowment at Yale.

Of course, many other investors who might need the liquidity are also attracted to those incremental returns, and especially so in an environment of exceptionally low yields. As a result, many investors have succumbed to the temptation by plowing into private equity, venture capital, real estate, structured credit, fixed income ETFs and all kinds of other investments for which liquidity can be a problem.

As investors pursue this course of action, however, a couple of things happen along the way. One is that the prices of illiquid investments get bid up and therefore the prospective returns come down. Another is that as progressively more money flows into investment vehicles that can be difficult to exit, systemic risk increases. I described these phenomena in “A formula for losing money“.

As the risk of systemic illiquidity increases it can challenge, and overtake, the risk of slowing economic growth as a key risk factor. This change manifests itself in a subtle way. Unlike in 2017 when markets rose in a climate remarkably devoid of volatility, this year there are a number of rumblings underneath the calm veneer of market index performance. The Financial Times reports:

“Yet, through all of this, the sanctity around the market price has remained. Most don’t question whether basic formation of market prices is faulty. What if market gyrations are less to do with shifts in expectations on the economy or company performance, and more to do with participants coming to terms with a less well-functioning market?”

It is now time to add another worry to the list: the unravelling of the market liquidity illusion.

The “unraveling of the market liquidity illusion” is both a worthy consideration, and increasingly, a timely one. Further, there is a growing body of evidence to support the hypothesis. As the FT spells out, increasing bond market volatility is a signal:

“’It’s impossible to know the catalyst, and this market is good at shrugging off bad news. [But] bond market volatility is a good sign of the fragility,’ Mr Croce said. ‘We’ve seen steadily rising bond volatility this autumn, and that will eventually have an impact on asset prices’.

Auctions in fixed income markets have also been highlighted by Zerohedge:

“The number of high yield credits trading at spreads over a thousand basis points over treasuries has been rising all year long. Also, you’re seeing a lot more volatility in the leveraged lending space. Credit Investors increasingly are firing first, and ask questions later.”

Russell Clarke provided similar foreshadowing in a Realvision interview dated September 18, 2019:

“Like I said, the weird classic macro indicators are diverging radically from what equities are doing. That does happen sometimes. Usually, the macro indicators are right.” 

In addition, another signal can come from broader market factors. Since the relationship of supply to demand for securities is relative, whenever sellers overwhelm prospective buyers, deficiencies in liquidity can arise. This phenomenon often occurs when investors chase a common theme, as the FT describes:

But Marko Kolanovic, head of quantitative strategy at JPMorgan, says there is still ‘extreme crowding’ in the more defensive, bond-like parts of the stock market, as well as in stocks enjoying positive momentum. He said this was evidence of the ‘prevalence of groupthink … across investment strategies’.”

With several signs all pointing in the same direction, the chances of some kind of liquidity event appear to be increasing. Importantly, many of the warning signs are virtually invisible to investors and advisors who rely primarily on market indexes for information content.

Lest investors forget what happens when liquidity dries up, Russell Clarke provides a useful refresher:

Speaking of the Lehman bankruptcy in 2008, Clarke described: “Then suddenly, and it was very weird, didn’t make a lot of sense. Then suddenly, it broke in way. That’s typically how markets work. They force everyone into an asset at exactly the wrong time and then liquidity just disappears, and you are stuck in it.

The notion of suddenly being “stuck in it” was also crystallized by the FT in a recent report. The UK Mexican restaurant chain Chilango issued mini-bonds and intentionally lured investors with an attractive yield: “Free food for four years! Plus 8 per cent APR!”

The only problem was, just months after its last mini-bond offering, the company’s solvency came into question and it was forced to hire restructuring advisers. While Chilango is reminiscent of WeWork’s bond offering to sophisticated investors, there was one major difference:

“While red-faced hedge fund managers can sell their WeWork bonds at a loss and move on, Chilango’s bonds are explicitly non-transferable. The doors are locked.”

Unfortunately, retail investors are learning another lesson from institutional debt markets the hard way: liquidity matters.

In simple terms, there is no way for investors to get their money out of Chilango’s mini-bonds. They are stuck. This is exactly what can happen when liquidity vanishes for whatever reason. Although there may be some recovery down the road, there will be no access to those funds for the indefinite future.

This leads to a few important lessons regarding liquidity risk. One is that it is an insidious risk. It gathers gradually, over time, without revealing at what point it might strike. Indeed, markets can be most alluring at the most dangerous times. As Clarke notes, “They [markets] force everyone into an asset at exactly the wrong time.”

Liquidity is also nonlinear – and this is very hard for many investors to fully appreciate. It is easily available for long periods of time and then suddenly vanishes. When investors start running for the proverbial exits, many end up getting trapped inside. While it is true that this happens only infrequently, it is also true that there are no do-overs – the damage can be permanent.

Finally, when liquidity shuts down, it can be contagious. When it becomes impossible to exit illiquid investments, investors have only one choice if they need cash – and that is to sell what they can – and that is usually more liquid assets. As a result, problems in a relatively small niche of illiquid investments can easily infect a much broader realm of assets. This was an important dynamic in the financial crisis of 2008 when problems with subprime mortgages started surfacing. It is a lesson that still applies today.

An important takeaway is that investors should not be unduly focused on a market crash as the worst possible outcome. Crashes happen but can be recovered from. However, if investors urgently need liquidity and cannot access it, they can suffer permanent harm. Indeed, insufficient access to cash, not a market crash itself, many be the greater risk for many investors.

The risk of losing liquidity is a real one for investors, but it is often underappreciated. B.B. King illustrates the same basic point in his classic song, “Ain’t nobody home”, in a way that is both personal and memorable.

He describes how he once fawned over a girl and followed her “wherever you’d [she’d] lead me” and in the process, endured some “pain and misery”. After he finally decides he’s had enough, she begs him to come back. By then, he is no longer in a forgiving mood and lets her know, “Ain’t nobody home.”

In a similar way, liquidity can seem so ample and forthcoming at times that it is easy to take for granted. When the tables turn, however, investors had better beware. Just when they need it most, there might not be anyone home.

David Robertson: “Best Used By”

Most people have had an experience or two with something that is out of date. Whether gulping down some spoiled milk, biting into some moldy bread, or sipping a glass of wine that has turned to vinegar, the experience tends to be shocking, unpleasant, and memorable, all at the same time. The lesson quickly learned is that you need to pay attention to how “fresh” certain things are to avoid an unpleasant experience.

The same thing happens with social norms, albeit with a longer time frame. xxsome can adapt, but others either cannot or do not. Since business success depends on resonating with customers, employees and investors, it matters when belief systems get stale.

For better and worse, the financial news has been rife with examples of rich and powerful people being discredited by their statements and/or behaviors. This has happened to such a degree that it looks like a pattern. The cases are too numerous to dismiss as anomalous.

One of the more recent incidents involved Ken Fisher, who runs a firm with over $100 billion and is worth $3.6 billion himself. At a financial conference, zerohedge reported, he “shocked attendees when he compared gaining a client’s trust to ‘trying to get into a girl’s pants’.”

Those comments alone might have been easy to pass over. Offensive, sure. But they could have been dramatized, or taken out of context, or just not that important. Fisher, however, decided to eliminate any possible doubt that he really meant what he said when he added:

I have given a lot of talks, a lot of times, in a lot of places and said stuff like this and never gotten that type of response.

As such, the comments were revealing in a couple of ways. First, the absence of any real contrition indicated he stood behind what he said. He did, however, seem disappointed that he had lost the respect of a lot of people.

Most importantly, he seemed genuinely surprised that anyone might take issue with his comments. That surprise was most likely caused by having fallen dangerously out of date with social norms, and that says something about Fisher.

In a very different example, Jorge Paolo Lemann, head of the private equity firm 3G Capital made comments at a conference last year that also demonstrated a disconnect with the real world, albeit in a very different way. The Financial Times reported Lemann’s comments at the time:

I’ve been living in this cosy world of old brands, big volumes, nothing changing very much,” he said. “You can just focus on being efficient and you’ll do OK. And, all of a sudden, we’re being disrupted in all ways.

The idea that food and beverage products are “not changing very much” seems almost laughably out of touch. Anyone who ever eats out, goes to restaurants or bars, goes to the grocery store, watches tv, follows social media, or interacts with other people is overwhelmed by the amount of change in the food and beverage industry. It is no secret that younger customers want different things.

It is also no secret that these changes have been developing for many years, as has disruption in the food and beverage industry. As a result, Lemann’s perception that disruption happened “all of a sudden” says more about him than about the market. Specifically, his beliefs about the “cosy world of old brands” had become seriously outdated.

To Lemann’s credit, he admitted that he felt like “a dinosaur”, so at least he eventually came around to realizing this. It did not come easily, however. It took a shocking rejection of his underlying assumptions about the market, in the form of poor financial results, for him to eventually change his views. Rather than observing gradual change over time, it was more like getting hit with a 2×4 upside the head.

Yet another example is that of Christine Lagarde, the new head of the European Central Bank. Shortly before her term began, the FT reported on comments made primarily to a European audience. In particular, she declared:

We should be happier to have a job than to have our savings protected.

In one sense, it is understandable that Lagarde might want to establish continuity with ECB policy, even if it is problematic in many respects. In proclaiming what people should prefer, rather than listening to what people actually do prefer, however, she also revealed a degree of arrogance and condescension that come across as passé in today’s more egalitarian ethos.

It may be tempting to write off these examples as just some innocuous bits of disappointing behavior. It’s not like it is illegal to have outdated beliefs, and there are certainly plenty of scandals involving illegal activities among the wealthy and powerful class to grab our attention. Further, outdated beliefs can even be a bit humorous when revealed unintentionally.

It would be a mistake to dismiss such incidents, however. For one, these are not isolated incidents but rather are emblematic of widespread behaviors and belief systems. The incidents reported are indicative of similar instances that happen every day. The FT describes the landscape:

In decades prior, Mr Fisher’s remarks may have elicited a warm hum of laughter from the usual greying, male crowd. He may even have impressed some would-be allocator in charge of a family office or endowment with his maverick touch. Not so today. Instead, this has ended up being a costly mistake.

Another problem is that many leaders seem unaware of how completely their personal belief systems fail to comport with those of society as a whole. To be fair, the belief systems of a society are moving targets; they change over time.

The Economist explains,

Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart.” A key factor is that the composition of society changes due to demographics. The Economist explains, “many socially conservative old people have died, and their places in the polling samples have been taken by liberal millennials.” 

While there have always been generational differences, part of what makes today’s differences so interesting is the magnitude and breadth of those differences. The generation of Millennials is much more diverse than the Baby Boom or Silent generations. Millennials, as a group, are also far better educated. It’s no wonder that significant political differences exist.

As a result, some social beliefs are changing quickly. The Economist illustrates with the example of gay marriage:

“As recently as the late 1980s, most Americans thought gay sex was not only immoral but also something that ought to be illegal. Yet by 2015, when the Supreme Court legalised same-sex marriage, there were only faint murmurs of protest. Today two-thirds of Americans support it, and even those who frown on it make no serious effort to criminalise it.”

One important consequence is that this rapid change in social beliefs is exposing a number of leaders and managers as being distinctly out of touch. Whether it be Fisher making vulgar comments to a group of financial professionals, Lemann professing how stable big food brands are, or Lagarde telling people they should prefer jobs over savings, each of these figures revealed that they have completely missed important changes happening across society.

In a sense, it is a bit sad when leaders reveal such striking shortcomings. They can seem like beached whales; potentially majestic but so desperately out of their element. One day they were swimming in a set of beliefs that they fully understood and the next, they were stranded and helpless.

This phenomenon is not harmless, however, and can affect investors in a myriad of different ways. One important way is through the boardroom. Board members are normally chosen for their business acumen, contacts, and decision-making ability, among other things. Because these qualities often tend to improve with age, most board members are more experienced.

While all those qualities are valuable, all of that experience can also engender certain belief systems that are not helpful at all. Indeed, “experience” can also engender a great number of lessons learned in past environments that are unlikely to recur in future ones. 

This can create a real problem. Whether intentionally or not, the behaviors and beliefs of board members get propagated through the entire company. This point was made clear by the Economist in summarizing Ben Horowitz’ new book: “Leaders set the tone. If they lie, shout or swear, then others will do the same.” Likewise, if they make lewd comments, ignore rapidly changing consumer preferences, or treat people as “subjects”, others will also do the same. It usually doesn’t take long for such behavior to thoroughly permeate an organization.

An excellent example of this was Uber. Back in the summer of 2017, when Uber’s board was trying to deal with the unseemly behavior of Travis Kalanick, board member David Bonderman made things worse. As the FT reported, “it took less than seven minutes before Mr Bonderman … interrupted fellow board member Arianna Huffington. As Ms Huffington was telling staff that research showed boards with one female director were more likely to appoint a second, Mr Bonderman interjected: ‘Actually what it shows is that it’s much more likely to be more talking’.” Is it any wonder that Uber had a “corporate culture known for being aggressive and sexist”?

Although many forego the opportunity, there are things investors can do to reduce such risks. Proxy statements reveal a number of “tells” that indicate which boards and which companies may be especially prone to outdated belief systems, most of which revolve around an element of insularity. For example, low board turnover, concentrated power among a few long-serving members, and boards that are “captive” to a powerful CEO/chairman are all indications of potential problems.

Another investment consequence of outdated belief systems involves the competition for talent. Perhaps no business is more affected by the clash of conflicting belief systems than that of business schools themselves.

Nitin Nohria of Harvard Business School notes in the Economist that “younger alumni and incoming classes want ‘the place of work to reflect purpose and values’.” Jonathan Levin of Stanford’s Graduate School of Business (gsb) highlights the responsibility of business schools “to recognise the societal consequences of corporate actions.” Simply put, a lot of tomorrow’s managers and leaders don’t want to work within the belief systems of some of today’s managers and leaders.

Of course, stale belief systems are not solely the purview of leaders and managers. Since belief systems tend not to change much at the individual level, once they become stale, they tend to remain stale. As the Economist notes. “It is hard to beat bias out of individuals …”

When this happens on a large scale, it can create systemic risk. For example, a lot of people have experienced enormous appreciation in financial assets over their careers. Given this powerful experience, it is easy for one to believe that it always makes sense to invest in financial assets.

This creates consequences for all investors. Price discovery becomes much more a reflection of an entrenched belief system and much less an ongoing analytical exercise. Prices become disconnected from fundamental reality.

What can cause things to change? Certainly, beliefs can change. It is possible that investors stop believing that central banks can, and will, continue to support financial asset prices. It is also possible that investors start getting more squeamish about valuations.

Sooner or later, however, the thing that will definitely cause change is demographic replacement. Older generations that have fared extremely well by owning financial assets are gradually being replaced by younger generations that have had far less positive experiences. When a tipping point is reached, attitudes towards stocks are likely to change just as quickly, and permanently, as they did with gay marriage.

In sum, outdated belief systems are a fact of life and are often harmless. The main lesson though, is that there are absolutely situations in which stale beliefs can cause extremely unpleasant experiences. Fortunately, there are ways for investors to identify the risk and manage it before it becomes a problem.

Impact Investing- Is It Right For You?

Over the last 30 years, the popularity of impact investing and a desire to ‘do good’ with investment portfolios has blossomed. In April 2019, The Global Impact Investing Network estimated the global impact investing market was $502 billion. While impressive, it represents less than 1% of the investing universe.

Impact investors, looking to have a positive social and environmental influence, tend to analyze factors not typically on the radar of traditional investors. In particular, ESG, an acronym for environmental, social, and corporate governance, is a framework for investors to assess investments within three broad factors.  

We all want to make the world a better place, but are investment portfolios the right tool to do that?

To answer the question it is important to step back from impact investing and explore investment goals and how wealth grows fastest to help answer the question.

As a wealth fiduciary, our mission is managing our client’s portfolios in a risk-appropriate manner to meet their financial goals. Whether a client is ultra-conservative or uber-aggressive, the principle of compounding underlies every strategy we employ.  Compounding, dubbed the “eighth wonder of the world” by Albert Einstein, is an incredibly important factor in wealth management.

Wealth compounding is achieved through consistency. Targeting steady growth while avoiding large drawdowns is the key.  To do this, we develop an aggregation of diversified investment ideas.

Investment diversification is well-touted but not well understood. Commonly it is believed that portfolio diversification is about adding exposure to many different investments within many different asset classes. True portfolio diversification is best created by owning a variety of assets with unique, uncorrelated cash flows that each individually, offer a promising risk and return trade-off.

To demonstrate the importance of drawdown avoidance, we compare two portfolios. Both average 5% annual growth. Portfolio A grows by a very dependable 5% every year. Portfolio B is a more typical portfolio with larger growth rates but occasional drawdowns. Portfolio B grows 10% a year for four years but experiences a 15% drawdown every fifth year. Despite earning 5% a year less in four of five years, portfolio A avoids losses and grows at an increasing rate to portfolio B as highlighted below.

Consistent, steady returns and no drawdowns build wealth in the most efficient manner. The more investment options we have, the better we can diversify and minimize portfolio drawdowns. When options are limited, our ability to manage risk is limited.

Is doing ‘good,’ good for you?

The cost of impact investing is two-fold. First, by limiting the purchase of certain companies and industries, you forego the potential to buy assets offering a better risk-return tradeoff than other assets in the market.  Second, due to the smaller size of your investable pool, your ability to diversify is hampered. The combination of these costs show up as more volatile returns which results in a lessened ability to compound.  

While impossible to quantify, this cost is hopefully more than offset by the feeling of having a positive impact on the world.

Inclusion or Exclusion

To invest with purpose, there are some things you may or may not have considered. Foremost on the list is the question, “Where are your investment dollars truly going?”  Most investments in stocks and bonds are in securities that were issued in the past. The company behind those stocks or bonds already raised capital and is using it to achieve their mission. We may avoid buying stocks in coal miners or tobacco companies, but the funds from a market transaction go to another investor, not the company. This holds equally true if we buy stocks or bonds of a company we deem has a positive social or environmental impact.

That does not mean our investment decisions are fruitless. Our participation affects the perceived health of a company via the liquidity we’ve provided or taken from the company’s securities. When equity prices decline and/or bond yields rise, a company will find it harder and more costly to raise new capital.

Bill Gates has some interesting views to help us understand our potential role in social impact investing. 

In a recent Financial Times article, Fossil fuel divestment has ‘zero’ climate impact, says Bill Gates, the billionaire philanthropist argues environmental change is achieved via investing in disruptive and innovative companies that tackle environmental problems, not divesting from those that do not.

Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline,” he said. “I don’t know the mechanism of action where divestment [keeps] emissions [from] going up every year. I’m just too damn numeric.”

If you are interested in impact investing, we ask you to consider Bill Gates advice of inclusion not exclusion. Use the entire menu of investment opportunities and rigorous analysis to determine which assets are worthy. If the “disrupters” qualify under your investment protocol, include them in your portfolio and perhaps favor them. However, be cognizant of the cost of shunning companies that are doing things you don’t like.

A well-diversified portfolio with a positive risk/return structure will provide more stability and limit drawdowns. By growing your wealth as efficiently as possible, you will be able to invest more into companies that are having a positive social impact and have more wealth which you can donate in more direct, impactful ways.  

The Bursting Bubble Of “B.S.”

On the surface, middle of the road performance for stocks in the quarter indicated relative calm. Especially coming off strong performance in the first half of the year, there was little cause for concern.

Performance was choppy in the quarter, however, as steady, modest gains were repeatedly undermined by significant losses. In addition, a quant quake came out of nowhere and led to massive outperformance of value over growth for a short period of time. Also, out of nowhere overnight repo rates spiked higher until the Fed intervened. Gold prices rose steadily. Under the surface, something seems to be amiss. What is that something and what does it mean for investors?

For a growing number of investors, the answer is a short one: Stocks have overshot their fundamentals and a market crash is imminent. Such concerns are serious partly because they come from some highly respected players and partly because if true, there would be serious consequences for investors. However, stocks have been highly valued for a long time and for the past ten years bumps in the road have always been smoothed over by central banks. Is anything different this time?

It helps to establish some perspective. One of the more prominent themes over the last ten years has been the outperformance of growth stocks relative to value stocks. Rick Friedman of GMO points out that “Over the past 12 years … value stocks have underperformed”. 

John Pease, Friedman’s colleague at GMO adds, “All in all, it has been a harrowing decade for those who have sought cheap stocks.”

This recent underperformance of value provides a notable break from its historical pattern. Friedman continues:

“Historically, buying companies with low price multiples has delivered substantially better returns than the overall market, with the added benefit of lower absolute volatility. From the inception of the Russell 3000 Value index through 2006, value stocks outperformed the broad market in the U.S. by 1.1% per year starting in 1978.”

Dan Rasmussen, founder and portfolio manager of Verdad Capital Management, described just how unusual this performance has been in the September 20, 2019 edition of Grant’s Interest Rate Observer:

“What has been abnormal … is the remarkable performance of growth stocks. That has really been driven by the very largecap tech companies, which have had this amazing combination of high growth, high profitability, high and sustained growth, high and sustained profitability (and starting to actually dividend out money). That historically is very, very anomalous. You don’t typically see the largest stocks grow the fastest.”

Indeed, Friedman explains that the reason value stocks tend to outperform is because they offer an attractive tradeoff:

“While value companies did in fact under-grow the market, their cheaper valuations, higher yields, and a number of other factors more than made up for their weaker fundamentals.”

The “engine of returns behind value portfolios is ‘the replacement process, whereby a formerly disappointing company sees its fortunes change and its prices respond (à la General Electric in the 80s).’

Investors systematically underestimate the ability of weaker and distressed companies to mean revert to profitability and reasonable growth levels. Instead, they overpay for growth by extrapolating relatively strong growth too far into the future.” notes Friedman.

Pease notes, “In the last 13 years,” however, “rebalancing has disappointed somewhat,” and with it, the primary mechanism by which value tends to outperform. Friedman adds that factors that typically inhibit the most outlandish expectations for growth have been unusually weak:

Of late, expensive stocks have remained expensive for longer than usual. Typically, high growth companies are unable to sustain excessive growth rates for long periods. In the last decade, however, the growth universe has been more retentive than in the past.

So, one thing that is amiss is exaggerated expectations for growth. One exercise I regularly perform is to identify market-implied growth rates by matching discounted cash flows with current market prices. A couple of patterns are clear. One is that the prices of a lot of companies assume growth rates that are much higher than those that can be sustained by internally generated cash flows. In other words, the company’s growth is entirely dependent on access to outside capital.

Another pattern that is evident is that many implied growth rates are so high as to defy all practical constraints on growth. Historical experience, competitive response, industry size, economic growth, regulatory response, input costs, input availability, discretionary income, changing tastes and preferences, and real cash flows (as opposed to non-gaap earnings) all provide practical limits on growth for various businesses. It usually doesn’t take a ton of math to identify a ballpark range of growth estimates that is reasonable for a company.

As it turns out, the top-down evidence of unrealistic growth expectations corroborates the bottom-up observations. Rasmussen notes:

“You’re at this point … where the spread between the valuations of growth stocks and the valuations of value stocks is near all-time highs. The two times it has been this high in the past 50 years are 2000—the height of the tech bubble—and 1973—the height of the Nifty Fifty boom.”

One implication for investors, then, is the risk of exposure to exaggerated growth expectations is high right now. That risk may well be greatest in the IPO arena. Grant’s surveys the “abnormal” IPO landscape by way of statistics from Jay R. Ritter, chaired professor at the Warrington College of Business at the University of Florida:

81% of firms that went public in 2018 showed GAAP losses. To date in 2019, 74% of companies debuting in the public-equity market have been similarly loss-making. Each figure is substantially higher than the 39% average of profitless new public companies that IPO-ed between 1980 and 2018.”  

While these numbers portray an exceptional level of enthusiasm for IPOs, cracks have been emerging. The high-profile offerings of Uber and Lyft have both performed poorly and more recently, Peloton fell immediately from its offering price and has remained weak. Obviously, something has changed. Richard Waters from the Financial Times ascribes such weakness to a diminishing desire to believe “airy promises”. In other words, the market finally seems to be pushing back on exaggerated claims for growth.

“Airy promises” are not the only thing amiss in the IPO market, however. As Waters also notes, the easy cash available for many IPOs “has bred bad habits.”

The poster child for bad habits is WeWork. When WeWork started the IPO process, its valuation was targeted at $47 billion. After a great deal of pushback ahead of the roadshow and several price cuts, the IPO was finally pulled.

Not only is the company not going public, however, now it is in serious risk of going bankrupt. The FT reports, “Last week rating agency Fitch downgraded WeWork’s credit rating to CCC+, a level at which ‘default is a real possibility’. It said ‘the risk that the company is unable to restructure itself successfully has increased materially’.” How in the world can a company go from hot IPO prospect to bankruptcy candidate in a couple of months?

While WeWork provides plenty of entertaining drama, it also provides instructive lessons for the broader market. Importantly, all the information necessary to assess WeWork as a fragile financial proposition and a low-grade credit was available for all to see prior to its aborted IPO. There were no surprising revelations at the company. The only thing that changed was how people chose to evaluate the same body of information.

An important part of that body of information, as is the case with many younger companies, is the founder, Adam Neumann. Well known for his quirkiness, outlandish proclamations, and use of recreational drugs, Neumann also successfully crafted himself as a visionary. The balance between visionary and crackpot, however,  is often a very tenuous one as Scott Galloway describes:

“Since people want abnormal results, they try to find abnormal thinkers. But no one should be shocked when people who think about the world in unique ways you like also think about the world in unique ways you don’t like. If you want the party, you also get the hangover. Big, bold, visions are important and should be celebrated. But they have to be matched with stable, reality-based operators who have equal power if those visions are to have a fighting chance at surviving outside incubation.”

He elaborated on this tenuous balance in a separate interview in which he was blunter in his assessment:

The lines between vision, bullsh*t, and fraud are pretty narrow.

Galloway’s evaluation is not just that of some aggrieved tech investor who lost money either. He was actually a CEO during the internet boom of the 1990s and saw all-too-well what can happen when self-indulgence and fantasy are not only not constrained, but actively encouraged. As he puts it,

“If you tell a 30-year-old male he’s Jesus Christ, he’s inclined to believe you.”

Ostensibly, the task of constraining leaders who are naturally inclined to push limits is at least partly that of the board. Among the reasons to have a board is to ensure good decision making and to maintain corporate decorum. That didn’t happen with WeWork. According to Galloway:

“It’s safe to assume that board members already knew all of the details about Neumann’s antics … his hard partying and yoga babble were seen as features, not bugs, until the market threw up on it. Now, all of a sudden, the board is acting shocked. The board didn’t fire this guy; the board enabled him … Basically, as long as people were willing to buy into this charade, they [the board members] kept it going as long as the music kept playing.” 

Two other elements come into play in facilitating such excesses. One is the cyclical view towards charismatic leaders. There are times when dynamic founders are replaced by more experienced managers to run a business as it matures. Recently, however, founders have been allowed more latitude to stay in power longer.

The excesses are also partly a function of the marketplace as Galloway explains:

It’s frothy, and there’s more capital than operators. Any operator who has a vision and can promise the potential and convince people they can be the next Google or Facebook can attract billions of dollars right now. The reality is there’s more money out there.”

All of this provides useful context from which to evaluate market conditions. First, there are clear analogies with the subprime crisis. As long as things are working, the vast majority of actors are making money. As long as people are making money, there is little incentive to change things. Positive feedback loops ensure the good times run longer than they should.

This creates an interesting possibility. What if the thing that is amiss is simply an increasingly sober evaluation of existing conditions? What if investors have become less willing to dismiss math as some kind of weird science and more inclined to seriously apply it to growth expectations? What if, in the context of weakening growth, investors are less willing to believe in “vision” and “airy promises” and more inclined to manage downside risk?

What if a bubble is bursting, but it is not one of stocks per se, but one of bullsh*t?

This would have major implications for investors. First and foremost, any exposure to bold visions, airy promises, and barely credible growth expectations would need to be re-evaluated and re-calibrated. How many of those growth estimates are realistic? How many are off by a long shot? How many are not even possible? How many are only possible if funded indefinitely with free capital? Such scrutiny is even more likely to increase as earnings growth declines, global growth slows, geopolitical tensions rise, and as the credibility of central bankers fades. The result is likely to be a major rotation from growth into value.

Such a rotation would affect more than just growth investors; it would also have a disproportionate impact on broad index investors. Since capitalization weighted indexes overweight stocks that are overpriced and underweight stocks that are underpriced, broad indexes have become increasingly comprised of inflated growth stocks. That exposure becomes especially painful when the process reverses.

To the extent the primacy of bullsh*t diminishes or even vanishes as a determinant of stock prices, it will also have a significant impact on strategies for investors and advisers. When BS is ascendant, investors need only follow the same trends that everyone else does; it is no more complicated than that. Valuation, however, is a fundamentally different exercise. Determination of reasonable growth estimates is subject to all kinds of research, analysis, and judgment. This will create new opportunities for stock selection, but in doing so, will also leave a lot of people bereft of necessary analytical and investment tools.

Finally, the bursting bubble of BS also has implications for risk management. When the inflated expectations facilitated by BS are the norm, there is little reason to worry about how inflated the expectations are. Rather, the main concern is regarding the catalyst that could change things. The current environment provides many good examples including trade wars, election outcomes and the potential for a recession.

Focusing on a catalyst is a poor way to manage risk for a number of reasons, however. It is very hard to imagine all possible catalysts. Often, catalysts have a different effect than supposed. Thing can happen randomly. Further, the world is a complex place; oftentimes there is no particular, recognizable catalyst at all.

The thing that can usually be judged with far greater confidence than a catalyst is downside risk. You usually have a pretty good idea of what you can lose if things go bad. With that in mind, imagine playing a game of Russian roulette with your investment portfolio. You have one chamber of a gun loaded that you know can destroy your savings. Why would you focus on what might cause the barrel to stop spinning at the filled chamber rather than avoiding the inherent risk of the situation altogether? In other words, if stocks are significantly overvalued, why accept so much risk?

In sum, it is fair to say that something is amiss in the investment landscape. If that something is a bubble in BS rather than a bubble in stocks, the fallout will likely be different. Rather than one big, sudden crash, it will be more like a process of individual balloons popping over time as particular manifestations of BS get called out and re-calibrated.

As this happens, it will create a great deal of pain for sure, but there will be opportunities. The best vantage point will be that from security-specific analysis.

ESG Investing & The Quest For Sustainability

Almost anywhere you look there is commentary on sustainability. What used to be known fairly narrowly as “socially responsible investing” has now grown into a broad effort captured by the acronym “ESG” (environmental, social, governance). These issues range from climate change to sustainable food production to better versions of capitalism.

It is easy to infer from all this coverage that sustainability is something we should be talking about. It is far less clear, however, what we should actually be doing about it. The bad news is that some sustainable efforts are ineffective and even harmful. The good news is that the dialogue on sustainability is maturing in meaningful ways.

In August the Business Roundtable made waves when it released a statement indicating that the purpose of a corporation is to benefit all stakeholders, including customers, employees, suppliers, communities and shareholders. Signed by 181 CEOs, this statement marked a break from the past and made a lot of headlines.

Interestingly, several other organizations have also recently upped the ante on highlighting various sustainability issues. The Economist recently published its “Climate” issue under the pretense that “Climate change touches everything this newspaper reports on.” The Financial Times recently heralded a “New Agenda” which explicitly responds to the fact that the “liberal capitalist model” has “come under strain.” Advisor Perspectives recently sent out its “most read commentaries on ESG, SRI and impact investing.”

As if there weren’t already enough dots to connect, Ben Hunt and Rusty Guinn from Epsilon Theory recently identified the top six articles from the past 24 hours [as of September 23, 2019] that were the “most on-narrative (i.e. interconnected and central) stories in financial media. Those articles were: 

  • “Danish pensions to put $50 billion into green investments” [Reuters] 
  • “Gender diversity pays off: A new Stanford study finds equitable hiring boosts companies’ stock prices” [Business Insider] 
  • “Aluminium industry must commit to carbon reductions” [Business Insider] 
  • “Daughter of Ebony founder resigns from spot on magazine’s board” [Chicago Tribune] 
  • “At Amazon, workers push climate policy; Bezos sets net-zero carbon emission goals, but employees want more urgent action.” [Vox]
  • “General Motors Shares Extend Declines As Nationwide UAW Strike Hits Day Five” [The Street]

The narrative is clear: Sustainability issues are front-and-center. Guinn offers a couple of hypotheses as to why this is happening now: 

“We have commented before that ESG specifically tends to follow the fortunes of the market. It usually becomes a cohesive, high attention narrative when times are good and investors feel confident. When markets decline and perceived risk rises, ESG issues tend to fade from investors’ attention.

Independent of ESG investing as a topic in itself, however, the politics of climate, inequality and identity that we have shown to be dominant in electoral coverage are becoming similarly prominent in financial markets coverage.”

Another hypothesis seems to suggest, shall we say, a more sustainable explanation. An FT report on “The limits of the pursuit of profit” notes:

“Prof Ioannou’s latest research, with George Serafeim of Harvard Business School, shows the adoption of common sustainability practices is increasingly a survival issue. ‘The ones that fall behind in adopting best practices are the ones whose performance gets hit in the long run,’ he says.” The article continues, “Chief executives face the threat that if they fail — or if they only apply a veneer of stakeholder concern — they will be accused of ‘purpose-washing’, leading to further cynicism about their motives.”

While this research is encouraging, the reality on the ground is often less straightforward. The very same FT article, which highlighted Danone as a positive example of sustainable approaches, admitted,

It is shareholders, not other stakeholders, who are most in need of convincing with regard to Danone’s good intentions.

The FT also noted the challenge of “persuading asset owners to approach investment differently” when it reported, What is blindingly obvious is that it is very hard for company bosses to take such steps if investors are pulling very strongly in the opposite direction.

What is also blindingly obvious is that many efforts to address sustainability simply do not work. The FT identified Vanguard funds that were designed to “invest in companies with strong environmental, social and governance records” but which also happened to own “A private prison operator, a gun manufacturer and Rupert Murdoch’s media groups.” Vanguard claimed, “the companies were included ‘erroneously’ in an ESG index designed by FTSE Russell”, but regardless of the cause, the funds failed to do the one thing they were designed to do.

Nor have quantitative efforts produced much headway. The FT reports on efforts to “find a so-called ESG ‘factor’ — a systematic, repeatable way of identifying such stocks which rivals would find hard to copy.” Despite the potential that “The rewards for the fund managers could be huge”, the truth is that “It’s extremely hard to find that factor”.

The silver lining in such failures is that they are leading to more robust and constructive discussions around the relevant issues. “The limits of the pursuit of profit” story in the FT, for example, highlights the fundamental definitional issues of sustainable investing. While a wealthy individual may care relatively more about the “impact” of an investment than the ultimate financial returns, a pension fund has an obligation to produce adequate returns for their beneficiaries. Paul Singer, founder of activist hedge fund Elliott Management, said that earning a rate of return for pension funds and charities “is itself a social good — a very high one”. He’s right.

Not only can the “investment” aspect be understated in ESG efforts, but the “sustainable” element can be overstated. The story also reveals the potentially negative consequences of simple ESG ratings which can be “based on incomplete information, public shaming and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion”. The worst part is that the consequences of such misguided efforts “ultimately fall on real people”.

Bill Gates also recently chimed in on the debate by challenging a common practice among sustainability practitioners. He criticized efforts at divestment saying they “won’t change anything“. Gates explained, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline.” As a result, Gates concluded, “Climate activists are wasting their time lobbying investors to ditch fossil fuel stocks.”

Helpfully, he offers an alternative approach that he thinks has greater potential to make a difference:

“Those who want to change the world would do better to put their money and energy behind the disruptive technologies that slow carbon emissions and help people adapt to a warming world”.

Indeed, Gates is among a cadre of wealthy businesspeople who are thoughtfully considering what types of actions can really promote sustainability and really make money. The Economist’s “Climate” issue describes them as people who are “putting serious money into climate-friendly investments – and expect serious returns”. According to the piece, “All want to do good by the planet. Most expect to do well for themselves.”

In addition, Sarah Kaplan of Toronto’s Rotman School of Management describes a model by which business leaders can succeed with sustainable investment.

“One way to survive,” she says, “is for companies that have already pursued the business case for responsible action, to ‘innovate around trade-offs’.”

“One example is how Nike, attacked over its suppliers’ working conditions in the 1990s, not only improved standards but developed an entirely new manufacturing process to take pressure off the old supply chain. The US sportswear company’s Flyknit ‘woven’ shoe was one result.”

This course is a noticeable break from the modus operandi of many global companies. When confronted with such challenges it is frequently the case that the problem is solved by some combination of moving to a jurisdiction with less scrutiny, leveraging the company’s power and authority, and simply paying penalties if they are not excessive. In other words, a lot of people get paid good money to dodge the spirit, if not the letter, of the law.

Looking across the realm of sustainable investing today reveals some striking features. One is that a lot of shortcomings regarding sustainability are related to deficiencies in enforcement. Why would a company spend a lot of money upfront to avoid penalties if the penalties are so small as to be trivial and the chances of being penalized are slim? It is a real business tradeoff.

Further, it is often the case that rules don’t even need to be broken if regulations can be cleverly arbitraged. Too often, regulators and enforcement authorities are no match for their corporate counterparts. Sustainability could be greatly improved simply by leveling this playing field. Penalties and enforcement reflect society’s values. If they are substantive enough, they will incentivize compliance.

Another striking aspect of the sustainability movement is just how noncommittal many consumers are. Many people express opinions, and many people take some action, but actual consumer behavior is not matching the sustainability preferences being expressed.

A recent article in The Economist provides a possible explanation, “Many consumers neither read nor understand the contracts they sign”, even when it is clearly in their interest to do so. While the research was conducted primarily in regard to the “terms and conditions” of apps and online services, the behavioral phenomenon is broadly applicable. Many consumers simply don’t want to exert the effort to ensure better outcomes.

Researchers “concluded that savers doubted the benefits of shopping around and were put off by the perceived inconvenience.” The Economist suggested, “‘Caveat emptor’, it seems, may apply in principle but not in practice.”

This results in any number of interesting paradoxes. For example, if a big beverage company packages soda in a can with a liner containing BPA, that company is often targeted for its unfriendly business practices. If, however, a local craft brewer packages its products in the same can, is lauded for its “sustainable” practices and the BPA is conveniently overlooked. Nobody even asks the question even though it is exactly the same practice.

In addition to paradoxes, the incomplete engagement by consumers creates a real hurdle for well-intentioned sustainability efforts to overcome. You may have great ideas and you may be right it the long run, but if consumers don’t vote for you by way of their purchase decisions, none of it really matters. 

This is a shame because the threats of unsustainable practices are becoming very real. Gillian Tett reports in the FT that an information asymmetry regarding climate change appears to be widening. 

Jupiter, a climate advisory group that provides modelling for banks and insurance companies, “forecasts a tripling of losses from flood damage in the next couple of decades.” The company arrives at its conclusion by evaluating the type of residential mortgage exposure of a real bank. This is consistent with work done by McKinsey:

“Coastal regions such as Florida … could deliver asset price shocks for lenders, insurers and homeowners. So, too, in places such as Spain, southern France, Greece and Italy which are projected to see eye-popping increases in drought.”

Further, when the information asymmetry narrows, it could be punishing for many homeowners: “while American households typically use 30-year mortgages to buy properties, the price of insurance is reset annually.”

The same information asymmetries exist in the markets for financial assets as well. According to the entity Principles for Responsible Investment (which is supported by the UN), “financial markets today have not adequately priced-in the likely near-term policy response to climate change”. Tett voices her concern about the likely consequences:

“History shows that extreme information asymmetries produce market shocks. That’s what happened in the subprime mortgage saga. It is hard to believe it will be any different with climate change.”

Given such risks, what can investors, leaders, and consumers do to overcome inertia and narrow the information asymmetries? Dave Stangis, ESG expert and former CSO of Campbell Soup, provides a useful perspective:

“I always sense the macro challenge is trying to find the right language to describe what so many people are talking/writing about.  I do believe the expectations of good business have shifted and we see many examples of business done right (not just activities or initiatives) can deliver measurable benefit to shareowners, execs, other employees and customers/consumers.  The debate seems centered around what is that called when it works and how do we describe when it misses the mark – or when it is something else (negative screening).”

In other words, don’t get hung up on the language and miss the forest for the trees. Sure, there are frivolous and virtue signaling sustainability efforts, and sure, there are business practices that extract disproportionate benefits from society. But those can all be identified as such and avoided.

On the other hand, there are real efforts to innovate around tradeoffs. Properly considered, these can be characterized as something like continuous improvement in capitalism. It takes ongoing effort, thought, and research to differentiate between “business done right” and business “missing the mark”, but expectations are shifting and the benefits can be substantial. Conversely, the costs of failing to do so are rising every day.