Reuben Beelders – Chief Investment Officer
Megan Fraser – BD & Marketing
The veteran investor, Charlie Munger, maintains that one should always fully understand the alternate hypothesis. Processing information and forming a lucid and proficient opinion takes energy and hard work. In the investment industry there is undoubtedly no shortage of either information or the worker bees expending enormous amounts of energy on processing and understanding all the available information. Perhaps the most confounding aspect of this industry, however, is that two investment specialists can look at the same information and come to very different opinions. And this is where the dilemma comes in – generally speaking, most investors’ approach is somewhat binary. Either you’re invested with the crowd or you’re not. The tendency for humans to take comfort in hiding in a herd is tacitly accepted; most people would rather stick with the crowd than wander down the road less travelled.
While we acknowledge our view is very often somewhat contrarian to that of our peers, particularly in a bear market, what matters more to us is that we consciously and rigorously interrogate our position in order to ensure that any blinkers we may have do not become blinders. We don’t get up in the morning with the objective of being contrary, but we have found ourselves in that position as a result of diligently following our rules-based approach. Fully subscribing to our rules-based philosophy means that our investment team constantly endeavours to ensure that we maintain perspicacity and resist any comfort of overconfidence.
What this means is that we must have clear sight of the alternative hypothesis; we must endeavour to understand the appeal and opportunuity that results in our peers investing as they do – how it is that they have arrived at the investment they have?
I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.
— Charlie Munger
Whenever intelligent, erudite inspiration is required, a reliable go-to is always Shane Parrish’s Farnham Street. In considering the subject of forming an opinion, he offers insightful perspective on the grunt and grind required.
“While we all hold an opinion on almost everything, how many of us actually do the work required to have an opinion? The work is the hard part, that’s why people avoid it. You have to do the reading. You have to talk to competent people and understand their arguments. You have to think about the key variables and how they interact over time. You have to listen and chase down arguments that run counter to your views. You have to think about how you might be fooling yourself. You have to see the issue from multiple perspectives. You have to think. You need to become your most intelligent critic and have the intellectual honesty to kill some of your best-loved ideas. Doing the work required to hold an opinion means you can argue against yourself better than others can. Only then can you say, “I can hold this view because I can’t find anyone else who can argue better against my view”.
Currently (and it feels like more so now than ever), investors sit on the horns of a dilemma. And, more than ever (it seems), we are are aware of disparate views that are essentially based on the same available information. In order to try and assist with a useful perspective, we thought we’d share some insights on the major areas impacting investment decisions, namely: inflation, company earnings, interest rates and global markets.
The table below offers a synopsis of these elements as well as the headlines opposing views on each of them:
This table is obviously a very high level overview of the data – we will gladly go through a detailed presentation with anyone interested in the details but we include some of our thoughts below:
Inflation is a phenomenon that has not warranted much attention by financial markets for the last 40 years and the investment community has understandably become complacent about its dangers. Investors should be prepared to pay for real growth, not nominal growth, and inflation can obscure the distinction between the two.
Considering the data since 1960, the relationship between inflation and the Price Earnings Ratio of the S&P500 reflects that generally, when inflation is low, PEs are high, and vice versa. Investors are more likely to enjoy real growth when inflation is low and benign, i.e. not volatile.
Even if inflation falls to 4% next year, that is still double the 2% target level of the FED, and this could result in PEs being closer to 15% rather than the recent range of north of 20%.
Should earnings hold at current levels, this could result in a decline in equity markets of around 25%.
While inflation in and of itself is not the problem; delivering real growth is the problem. Considering the two elements of inflation – flexible inflation and sticky inflation – the former appears to have adjusted downwards satisfactorily, but it’s sticky inflation that is the cause for concern. Flexible inflation comprises fuel and transport costs while sticky inflation includes wages and shelter costs. (For those interested, the Atlanta Federal Reserve website offers useful information and detail.)
Our overarching concern regarding earnings is that they are unlikely to remain at current levels. Margins are at elevated levels. Inflation is likely to increase operating costs for many companies, putting pressure on margins. Labour costs are of particular concern. Companies may not be able to pass these inflationary cost increases onto their customers because of competition and/or substitute products being available. In the past, whenever economies entered a period of sub-par growth or recession, corporate profits suffered. We do not believe this time will be any different.
Interest rates have supported company profits in various ways:
- Low interest rates have allowed consumers to spend more on goods and services, rather than servicing debt.
- Companies, likewise, have enjoyed the lower cost of debt, enabling them more gearing or a lower cost of debt and thus higher returns to shareholders.
- Companies have also used debt to finance share buy-backs. This has resulted in growth in earnings per share. With interest rates at higher levels, this avenue for growing earnings per share is no longer available to companies.
Investors should be aware of the degree to which equity markets have (or have not yet) priced in the impact of inflation and higher interest rates. The full impact of recent rate hikes by global central bankers is likely to unfold into the future and possibly result in an environment which is less supportive of growth (economic and earnings) than has been the case in the past.
Since 2008/9, Central Bankers have practiced quantitative easing which has resulted in liquidity (read debt) being available at very low cost. With the recent rise in interest rates, cash is offering returns that are a viable alternative to either bonds or equities.
Previously, the oft-quoted mantra ‘There is no Alternative’ (TINA) to bonds and equities was supported by the fact that cash rates were kept at zero by global central bankers (ZIRP =Zero Interest Rate Policy). However, inflation has spoiled this party.
Investors would do well to recognize that cash seldom results in negative returns and currently delivers decent yield. Prospective returns and the associated volatility of all alternate asset classes should therefore be compared to cash.
The ability to destroy your ideas rapidly instead of slowly when the occasion is right is one of the most valuable things. You have to work hard on it. Ask yourself, what are the arguments on the other side. It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental discipline.
— Charlie Munger
Our objective in sharing these insights is not to establish our view as being the correct one; it’s not a question of being right or wrong – it’s a question of being aware of the risks, considering the consequences and scrutinising all options available. Gryphon’s preference is for the risk-adjusted return that will serve investors best. It’s critical for us that our investors understand our investment philosophy and hope that these insights assist in understanding and appreciating how their multi asset investment with us will behave given current market conditions.
One of the questions most commonly asked of us recently is: did we miss the last equity run? Our answer is a very simple one: our indicators did not get us into the market – it’s not a question of choice. Remaining true to our philosophy is sacrosanct for two main reasons: if we blink and make an asset allocation without the support of the indicators, our credibility and integrity is shattered, and secondly, if we get into markets of our own accord, we can’t expect our indicators to inform the next asset allocation move – we’ve broken our system.
How this plays out in the relative ranking tables is a capricious and moving target and is possibly the data that we pay least attention to – we are comfortable to stand alone and firm in our view rather than have the comfort and cost of hiding with the crowd, particularly if what we do results in our multi asset funds delivering consistent, inflation-beating returns over the longer term.
“The moment you doubt whether you can fly, you cease forever to be able to do it.”