Paying The Piper

Good Morning,
 

Stocks slumped on Friday as increased tensions between Ukraine and Russia sent oil spiking and led investors to dump risky assets like equities. Shares were mostly flat on the day until Ukraine-related headlines in afternoon trading caused traders to dump stocks and buy Treasuries.

With about 2 hours left in the trading day, U.S. National Security Advisor Jake Sullivan said at a White House briefing that there were signs of Russian escalation at the Ukraine border and that it was possible that an invasion could take place during the Olympics, despite speculation to the contrary.

Both the U.S. and U.K. have called for their citizens to leave Ukraine as soon as possible. Sullivan noted that the U.S. is not certain that Russian President Vladimir Putin has made a final decision to invade Ukraine. But “it may well happen soon,” 

This week’s volatility in the bond market started after a hotter-than-expected inflation reading on Thursday, which prompted St. Louis Fed President James Bullard to call for accelerating rate hikes — a full percentage point increase by the start of July.

Goldman Sachs shifted its expectations for the Fed this year, calling for seven rate hikes in an effort to cool an economy that has generated inflation far more persistent than policymakers had anticipated.

Our Take 

What a difficult environment. It’s as if with every passing day the macro environment deteriorates and the outlook for 2022 grows more fragile. 

We believe that investors should avoid wasting time on things that are unknowable and unimportant and focus primarily on things that are knowable and important. Nevertheless, some unknowable questions such as the direction of interest rates, how high inflation will go and where the economy is headed are important.

Yet how do we confront their importance if they are unknowable? To study such questions, we practice looking at facts and deriving probabilistic statements. Not whether we will be right or wrong but rather: “What is the probability of this scenario versus another, and how does this information affect my assessment of value?”

When it comes to the unknowable yet important macro questions above, we believe as we stated back in November, that governments and central banks are caught between a rock and a hard place. They face persistent above trend inflation that is poorly understood while their economies’ fundamentals weaken, dependence on loose monetary policy becomes entrenched, debt burdens continue to rise, and politicians have gone all in on anti-growth/anti-business populism.

We still maintain this view, yet even after the historic selling which kicked off 2022, we see the potential for more downside as the piper collects his due. Both the Fed and Joe Biden’s credibility are now on the line as too many people are suffering from the effects of stubbornly “non-transitory” inflation. The issue is now political and with 40% of American voters holding no stake in asset markets, the Fed will find it very hard to pivot away from established tightening expectations.
 

The Fed will be tightening into fading cyclical growth momentum at peak valuations, significantly raising the probability of additional drawdowns. 

Core to the slowing growth view are peak/declining readings on various well-known inputs like ISM New Orders, US Consumer Confidence, trade weighted US$, US BBB credit spreads, and Global Manufacturing PMIs. Bond markets seem to agree as the gap between the 2-year and 10-year Treasury yields has sunk to its lowest since late 2020.

Unfortunately, the Fed looks poised to tighten for the wrong reasons (slowing runaway inflation in an economy with a backdrop of weak fundamentals) rather than for the right reasons (slowing runaway inflation in an economy with a backdrop of strong fundamentals). It should also be noted that investors underestimated how much the Fed would raise rates in the last three tightening cycles, so there is a risk that the Fed may tighten more than expected this time around.

Bottom line, the probability of profit growth momentum peaking and slowing through 2022 and even into 2023 is high. With 4Q earnings underway, the slowdown is already apparent. The pace of positive surprise has slowed meaningfully in 4Q21 with fewer positive revisions to subsequent quarter forecasts and corporate guidance has returned to its mildly negative average. The slowing rate of change is how weakness begins…

China is also an important leading indicator (typically as goes China, goes the West) and their central bank has already begun an easing blitz with fresh rate cuts. A serious Chinese economic downturn would endanger growth everywhere.

Despite the above, we must stress that this environment is fluid. As a result, we will remain defensive yet will not hesitate to shift to offense if the pendulum swings too far towards extreme fear.

This is a challenging environment with the worst start to the year since January 2009, but for the long-term investor, there is always opportunity amidst volatility. The long-term investor’s portfolio is not, nor should it be, immune to rough patches. After all, to enjoy the benefits of compounding, such patches must be endured.

The long-term investor should remain focused on allocating capital to assets based on well-reasoned estimates of their potential and remain confident that with patience, the storm will pass as it always does.

“To make money in stocks, you need to have vision to see them, courage to buy them and patience to hold them. Patience is the rarest of the three.” -Thomas Phelps

Musings

 

Looking back on 2021 at Logos LP with an eye to 2022 we’ve put most of our energy into honing the definition of our “circle of competence”.

“I’m no genius, but I’m smart in spots, and I stay around those spots.” -Tom Watson Sr.

As liquidity is drained and capital becomes more discerning, the ability to correctly evaluate “select” businesses is paramount. As opportunity sets improve, the importance of knowing our sweet spots increases.

At its core, our circle of competence includes durable, high-quality (growth security and deliverability) businesses that are trading at reasonable (or cheap) valuations relative to their long-term earnings power. If we are able to develop a deep understanding of these businesses and establish confidence in their long-term business results, we will build meaningful stakes.

No single strategy works in every kind of market yet we believe that long term, having a concentrated portfolio composed of such businesses will offer the best odds of outperformance.

As the Fed moves down a tightening path and elevated market volatility compresses multiples, dislocations are beginning to create attractive opportunity sets in our sphere of competence. One sector in which we are seeing the most attractive opportunity set of relative value per unit of fundamentals is healthcare/life sciences.

At present, the healthcare sector typifies the “quality value” factor trading at a roughly double discount relative to the broader market. This sector offers well above market FCF yield, double digit sales growth and low volatility of sales. Relative earnings for the sector (vs. other sectors) also appear to be poised for improvement which can support outperformance. This is before considering the secular forces of aging populations, growing demand for health and wellness as well as treatments for complex and chronic diseases. Such factors also underpin the secular trends currently fueling investment in healthcare sub-sectors including healthcare services, infrastructure, and research globally.

We believe these sub-sectors hold some of the most important innovations of our lifetime, in addition to possessing some of the most durable tailwinds we have seen in a post-Covid world. According to EvaluatePharma, by 2026, global pharmaceutical R&D spend is expected to reach $233 billion coinciding with US national healthcare expenditures increasing at a 5.5% CAGR between 2019 and 2028. These secular tailwinds should continue to drive greater demand for diagnostics and novel therapeutics, addressing the world's most complex and onerous disease threats, such as cancer, Alzheimer’s, and other life-altering diseases.

There are currently more compounds in Phases 1-3 of clinical trials than in any other period in history (Figure 1). Additionally, the number of biotech formations and catalysts (these are measured by FDA approvals, audits, readings, or patient output) has declined to 9-year lows due to: 1. Covid delays; 2. No FDA head for the 9 months prior to October 2021; 3. Fluctuating lockdowns impacting clinical trials (Figure 2). This has led to one of the lowest valuation troughs for the small-to-mid cap biotech sector over the past 20 years (Figure 3) and the longest (and largest) drawdowns for the XBI vs. the SPY in history (Figure 4).

Figure 1:

Source: Pharmaprojects 2020

Figure 2:

Source: Evaluate Pharma; Bloomberg; Wedbush Securities, Inc. Research

Figure 3:

Source: Wells Fargo Securities

Figure 4:

Source: Wells Fargo Securities

Additionally, the biotech sector is well capitalized with high quality assets during a period in which cash rich big pharma will likely look to M&A as they face imminent patent cliffs.

Within the complex described above, we believe the optimal approach is to look at the ‘compounder’ businesses that are less cyclical, possess oligopolistic characteristics, very strong pricing power and are comfortable with share buybacks. 

We are currently focusing on a few businesses that meet these criteria including:

1. Charles Rivers Laboratories (CRL) – Provides CRO services to roughly 80% of all FDA approved compounds.

2. West Pharmaceuticals (WST) – Holds 70% market share in drug packaging and has been involved in 90% of all biologics delivery since 2019.

3. Repligen (RGEN) – Has a virtual monopoly on ligand A proteins, a key ingredient for any FDA approved vaccine or therapeutic.

Given the make-up of the economy in a post-Covid world, we believe this rare breed of business is well positioned to take advantage of certain secular tailwinds that will likely be present over the next decade and will provide attractive long-term IRRs. Furthermore, this view is supported by peaking cyclical growth as well as a slowing pace of earnings growth as 2022 progresses (see above). Slowing growth elsewhere will favor the growth security and deliverability of such businesses in the healthcare/life sciences sector.

Charts of the Month

The gap between 5- and 30-year yields narrowed to less than 40 basis points, the smallest since the Fed was at the end of its last rate-hike campaign in 2018. That signals speculation that economic growth will slow as the Fed tightens monetary policy.

History doesn't repeat but it sure does rhyme. Tightening tantrum followed by growth correction…

Earnings revisions and outlook views tend to begin with a trickle and then the downward revisions lead to a change in the consensus outlook…

Historical look at core goods minus core services inflation with recessions … spread is more negative now than at any point going back to late-1950s.

The S&P 500’s real earnings yield continues to plunge; now at -3.2% (an all-time low). We are living in the upside down…

When if ever will China take the number one spot? Maybe never..

Mid term years can be ugly…

Logos LP December 2021 Performance

December 2021 Return: -9.46%

2021 YTD (December) Return: 4.82%

Trailing Twelve Month Return: 4.82%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 22.58%

 

Thought of the Month


“People who arbitrage time will almost always outperform. The first order thought of instant gratification is a crowded path, ensuring mediocre results at best. Delayed gratification, which requires second order thinking, is less crowded and more likely to get results.” — Shane Parrish

Articles and Ideas of Interest

• Does the national debt matter? For decades now, there have been many over-simplistic views on government debt. Some people were acting as though it would be a near-term catastrophe thirty years ago, and it never was. On the other hand, there are people who say it barely matters at all, ironically when it’s probably starting to actually matter. As with most things in life, the truth is somewhat more nuanced. This article by Lyn Alden dives into some of the details as far as the available data are concerned.
  
   

• The great climate backslide: How governments are regressing worldwide. From the U.S. to China, harsh economic realities mean the political will for painful choices is evaporating fast. In 2022, a toxic combination of political intransigence, an energy crisis and pandemic-driven economic realities has cast doubt on the progress made. If 2021 was marked by optimism that the biggest polluters were finally willing to set ambitious net-zero targets, 2022 already threatens to be the year of global backsliding. 

• When will China be the world’s biggest economy? Maybe never. When will China outstrip the U.S. to claim the top spot in the world economic rankings? For Beijing, it would be convenient if everyone viewed that transition as inevitable and imminent. The reality is as Bloomberg outlines, it’s anything but. A debt crisis, demographic drag, and international isolation could all keep China stuck in perpetual second place.

• Are we cultivating a generation of failed startup founders? Are we driving innovation, or instilling false hope in wannabe entrepreneurs? Medium’s largest publication is The Startup, with more than 700,000 followers. Hundreds of thousands of people who are curious about startups, have created one themselves or plan to build one in the future. More and more people are joining the conversation. More and more people are starting their own side hustles or full-time ventures because they’re hoping that it will lead them to success. Can all these people make it? Can so many people change the world in a million different ways? Or might we be better off encouraging these people to search for secure jobs, so they contribute to the economy in a safe and predictable way? Very interesting article examining the implications of the cult of the “startup”.

• The big question: how long can private market multiples stay elevated while young public companies compress? The median ARKK holding traded for 33x sales in early ’21. Today it’s 9x and going lower by the day. There is almost certainly a tipping point, but Michael Batnick thinks this dichotomy can last longer than most people think. There’s too much money chasing too few deals in private markets, and an interest rate hike or two may not change that.
  
   

• The lockdown catastrophe. Where are the public health benefits to justify Covid-era shutdowns and spending? Government disease doctors and politicians around the world panicked in the face of Covid and began shutting down societies in early 2020. The accounting has hardly begun on the impact of isolating human beings, denying them opportunities, education and experiences—not to mention disrupting non-Covid medical treatments and myriad other valuable services—and then attempting to simulate the benefits of a functioning society by printing fiat money. It will take years to understand the full cost of this man-made catastrophe, But emerging research suggests that on the other side of the ledger, public health benefits were extremely small, if they can be verified at all. The WSJ digs into the results of a new study on the effects of lockdowns by Johns Hopkins economist Steve Hanke and colleagues from Denmark and Sweden.
  
   

• Some good observations from Michael Batnick about 2021. What makes this game fun and exciting is that there is no handbook where we can observe the rule changes. All we have are numbers on a screen. When something that worked for 30 years stops working, how long before we pick up on the shift? My favourite: avoid extremes.

• The capital sponge. Why have US stock outperformed for so long? Lyn Alden suggests that the US put in place a set of policies over the past four decades that pulled a lot of domestic and global capital into its stock market. This naturally had some pros and cons associated with it. Each country generally has a set of political priorities, and those priorities can change over time. Compared to other developed nations, the US has favored its corporate sector above most else since the early 1980s, which made the US stock market an attractive sponge to absorb capital from everywhere. As a result, the US stock market capitalization currently represents 61% of the global stock market capitalization, despite the fact that US GDP is only 23% of global GDP. Are the factors behind this trend running out of steam?
   

Our best wishes for a year filled with discovery and contentment,

Logos LP

Tilting the Odds in Our Favor

Good Morning,
 

Stocks gyrated between gains and losses Friday to end a volatile week on Wall Street, as investors appeared content to consolidate positions after worries over Evergrande and a slowing global economy prompted traders to pull $28.6 billion from U.S. equity funds over the first three days of the week, the most since February 2018. But stocks then staged a two-day rally after the Federal Reserve signaled no removal of its easy money policy, at least for now. 

Tech stocks trailed Friday after a crackdown on bitcoin by China overnight hurt sentiment in the sector, but financial stocks rose as the 10-year U.S. Treasury yield reached its highest since July. "What is clear is that inflation is likely to be the determining factor for liftoff and the pace of rate hikes," Deutsche Bank Chief U.S. Economist Matthew Luzzetti wrote in a note. "If inflation is at or below the Fed's current forecast next year of 2.3% core PCE, liftoff is likely to come in 2023, consistent with our view. However, if inflation proves to be higher with inflation expectations continuing to rise, the first rate increase could well migrate into 2022."

Meanwhile Nike confirmed investor concerns about the pandemic wreaking havoc with supply chains and raising costs for companies, especially multinationals. Nike shares fell 6.2% after the sneaker giant lowered its fiscal 2022 outlook because of a prolonged production shutdown in Vietnam, labor shortages and lengthy transit times.

Our Take 

Skepticism on Wall Street is widespread with most of the major investment firms calling for a 10-20% market correction. Furthermore, the popular narrative for the rest of the year appears to be falling Covid cases globally and economic acceleration favouring cyclical stocks in the energy, financial, industrial and travel sectors. For us the data is noisy. Economic acceleration could very well occur but we also believe as we have stated in the past, that there are equally compelling reasons to infer significant economic deceleration. 

At present we believe policy error in the form of excessive government intervention in the economy to be the largest risk to growth estimates. Several countries closely regulate industries, labor, and markets, set monetary policy, and provide subsidies to help boost their economies yet many countries are veering towards giving the government a level of control that would allow it to steer the economy and industry along a path of its exact choosing channeling additional private resources into strengthening state power.

The big risk for these countries is that the push winds up suppressing much of the entrepreneurial energy and incentives that have powered their boom, years of innovation and improving standards of living.

From a market standpoint, we continue to believe that as pandemic-era programs to bolster the economy are lifted there will be an easing of market conditions which favor the indexes and tech megacaps. The era of narrow stock leadership -- powered by the explosive growth in passive funds -- may be beginning to unwind. Less aggressive monetary easing ahead should expand the number of market winners favoring active management. PanAgora Asset Management’s research suggests that a cap-weighted strategy thrives as concentration rises, but delivers “significantly” lower returns when the macro climate shifts in favor of higher rates. 

The removal of policy supports could mean the fundamentals of individual companies come to the fore replacing what has been a wall of stimulus money hitting the indexes. We see much opportunity for outperformance ahead...


 Musings
 

Over the past month, as I’ve watched politicians worldwide flounder around on everything from public health, housing, the economy, taxation to capitalism itself I’ve found myself thinking more about my framework for viewing life and investing. The future is becoming more and more uncertain as the world is changing rapidly while those in power appear less and less capable of leading with grace and conviction. It is possible we are at the dawn of the period of greatest change for the past few centuries and the range of potential outcomes when pondering the coming decade or two spans from “dystopia to Renaissance”. 

In Canada and across the border in the USA, our democracies appear to be in the hands of statists who believe that government justifiably holds near-absolute power. During the recent Canadian election and the ongoing Democrat proposed 3.5T spending discussions there is little sense that there are or should be limits on the power of democratically elected governments. Such limits still exist in constitutional form, but they are being overwhelmed in spirit if not in law. A tax on wealth and capital? Previously unimaginable spending and deficits? Restrictions on the right to buy and sell property? Restrictions on speech, employment, movement and association based on “woke” ideological purity? Break up corporations? State led discriminatory attacks on certain corporations and individuals based on their ability to make profits? No worries. Big brother knows best and more government intervention and control is warranted. 

The overall ideological thread today has been that governments have the power and the right to do whatever they want — a trend that COVID-19 appears to have entrenched globally. 

Authoritarianism is on the rise around the world with governments becoming less transparent and losing the people's trust. The latest report 'Freedom in the World 2021' by Freedom House is sobering. The report, which is an annual country-by-country assessment of political rights and civil liberties, downgraded the freedom scores of 73 countries, representing 75 per cent of the global population. Democracy has eroded in the United States as well, the report noted.
 

While still considered 'free', the United States has experienced further democratic decline. The US score in 'Freedom in the World' has dropped by 11 points over the past decade, and fell by three points in 2020 alone. 

How much of the above is in our control? The rules of the game keep shifting as the state increasingly imposes its will on markets, society and culture. Watching this distressing reality unfold, largely out of my control, has prompted me to think more deeply about my framework for viewing life and investing. 

As a starting point, William Green in his fantastic new book suggests that it’s helpful to view investing and life as games in which we must consciously and consistently seek to maximize our odds of success. The rules are slippery and the outcomes unpredictable yet there are intelligent ways to play as well as stupid ones. 

How can we avoid swimming upstream and instead be carried with the current? How do we tilt the odds in our favor regardless of the environment or “playing field”? 

When it comes to investing, much ink has been spilt on this. Without diving too deeply we could distill the common “get an edge” formula into the following principles:

Be patient and selective exploiting neglected and misunderstood market niches. 

Say no to almost everything. 

Exploit the market’s bipolar mood swings. 

Buy companies at a discount to their intrinsic value. 

Stay within your circle of competence. 

Filter out the noise, keep things simple and avoid anything too complex. 

Make a small number of bets with minimal downside and high upside. 

Control your emotions and be patient. 

Simple but not always easy to follow. But my goal here isn’t to review the core principles that most investors likely already know, or should know. 

Instead, faced with the increasingly frustrating and downright depressing global macro political environment I tried to think about the times in my investing career I was best able to follow the above principles. 

What I found was that essentially all of the moments I had achieved some sort of “high performance” or “success” occurred in periods of time in my life in which I was joyous. Periods of time when I was particularly happy.  

Interestingly, perhaps the most consistent way we can maximize our odds of success is adopting an optimistic and positive attitude. Shawn Achor in his fascinating book “The Happiness Advantage” explains that “waiting to be happy limits our brain’s potential for success, whereas cultivating positive brains makes us more motivated, efficient, resilient, creative, and productive, which drives performance upward.”

New research in psychology and neuroscience demonstrates that we become more successful when we are happier and more positive. In his book, Achor outlines that: “doctors put in a positive mood before making a diagnosis show almost three times more intelligence and creativity than doctors in a neutral state, and they make accurate diagnoses 19 percent faster. Optimistic salespeople outsell their pessimistic counterparts by 56 percent. Students primed to feel happy before taking math achievement tests far outperform their neutral peers.” 

Unfortunately, for most of us, we are conditioned from birth to believe that once we become successful then we will be happy. Success is conceptualized as a necessary condition for happiness. If we get the promotion/raise/car/return [insert success/external validation], we will be happy. But with each victory the goals shift and the happiness gets pushed further out. 

Instead, in the face of an increasingly precarious future including its associated “FUD: Fear, Uncertainty and Doubt” I think that focusing on happiness as a precursor to success rather than simply its result is game changing. This kind of relationship with happiness is the ultimate way we can tilt the odds in our favor in investing and perhaps more importantly in life. 

Anytime you get a truth that much of humanity doesn’t understand, that’s a large competitive advantage. Intelligent people are easily seduced by complexity while underestimating the importance of simple ideas that carry enormous weight. When you consistently apply a powerful idea such as the happiness advantage with thoughtful diligence, the effects may astonish you...

Charts of the Month

According to the Fed's Z.1 report, U.S. Household net worth rose at a solid 18.4% rate in Q2 to $142 Trillion, after gains of 16.7% in Q1 and 28.5% in Q4 '20. The "Wealth Effect" is one of the most important statistics we can use to measure how American households are faring. This measurement leads to the "feel good" effect that adds to the confidence to go out and spend. It is comical that this report never makes a headline. Then again the popular rhetoric is still concentrating on how BAD things are out there. The data on consumers doesn’t seem to support that outlook...

Men are falling behind remarkably fast, abandoning higher education in such numbers that they now trail female college students by record numbers. No one is talking about it.

Logos LP August 2021 Performance

August 2021 Return: 10.23%

2021 YTD (August) Return: 18.26%

Trailing Twelve Month Return: 57.07%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 25.71%

 
Thought of the Month

“The very purpose of religion is to control yourself, not to criticize others. Rather, we must criticize ourselves. How much am I doing about my anger? About my attachment, about my hatred, about my pride, my jealousy? These are the things that we must check in daily life.” -Dalai Lama.

Articles and Ideas of Interest

• ESG is inflationary. As the global economy rebounds, the likelihood of inflation has become the dominant economic story. You can’t watch the financial news for long without hearing about inflation. At the same time, environmental, social, and governance (ESG) initiatives continue on an inexorable march to greater public perception. However, despite both issues occupying ever more column inches, one consideration has been underexplored; ESG will add to inflationary pressures. TwentyFour Asset Management suggests that yes, ESG is a new source of inflation that was not so present in the previous cycle and cannot be overlooked when forming a view on this cycle’s inflation outlook. How willing will consumers be to shoulder such rapidly increasing costs? There's arguably a point at which a preponderance of inflationary pressures may backfire, with people suddenly demanding governments do something (anything!) to ensure access to cheaper energy (never mind whether it's dirty or not)...Britain looks set to bump up against this reality as some customers are facing a 50% increase in their energy bills…
   

• Replicating private equity with liquid public securities. According to a Harvard Business School study, it is possible to replicate private equity returns with liquid public securities. “A passive portfolio of small, low EBITDA (earnings before interest, taxes, depreciation, and amortization – a commonly used measure of cash flow) multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index.” Accelerate in a fascinating report believes that Harvard has it right, despite claims from private equity executives insisting otherwise.

• Lie Flat’ if you want, but be ready to pay the price. ​​The new “lie flat” social protest movement seems to be catching on. It started among overworked Chinese factory workers burned out from grueling 12-hour, six-day work weeks, and the unrelenting pressure from the government and society to climb the economic ladder. So some Chinese millennials formed an underground movement to opt out of work and the pressures of society. Never ones to miss a chance to cry “hardship,” upper-middle-class, well-educated young Americans are also getting in on the action, claiming they, too, are burned out and quitting their jobs to do nothing. What this trend will mean for China is unclear, but Allison Schrager suggests that Americans who choose to lay down in lieu of work may end up worse off than they think.
  
   

• The ‘melancholic joy’ of living in our brutal, beautiful world. Brian Treanor writes that it’s a challenging time to be an optimist. Climate change is widespread, rapid and intensifying. The threat of nuclear war is more complex and unpredictable than ever. Authoritarianism is resurgent. And these dangers were present even before we were beset by a historic pandemic. The data clearly show that based on certain objective measures of wellbeing we are living in the best of times – yet many people feel dissatisfied. In some places, including the US, self-reported happiness has actually been on the decline. So how should we view the state of the world: with optimism or pessimism? In answering, Treanor suggests that we must contemplate the broad sweep of both the world’s goodness and its evils.
  
   

• The everything bubble and TINA 2.0. FTX research does an fantastic job of exploring that common statement that “We are in an everything bubble” reviewing the data and going asset by asset. Worth the read. Spoiler: There’s most certainly pockets of excess in nearly every corner of the financial markets, but there’s also ample opportunity.
   

• Why is gold not rising? Interesting take on the shiny metal (albeit from a gold bug) via GoldSwitzerland.
  
   

• Silicon Valley is searching for the fountain of youth in a bill. Human aging is the latest and greatest field being disrupted by technology. The big picture: Work on therapeutics that could slow or even prevent the aging process is moving out of the fringes and into the mainstream, fueled by funding from tech billionaires who have one thing left to conquer: death.

• What if people don’t want a career? Charlie Warzel, a reporter on the future of work has found an interesting and potentially profound trend: the growing skepticism around ‘careers.’ ‘Careerist’ has long been a dirty word in the working world — usually it’s meant to signify a cynical, ladder climbing mentality. A careerist isn’t a team player. They care more about the job title and advancement than the work. The current brand of career skepticism he is talking about is different, more absolute. It’s not a rejection of how somebody navigates the game, it’s a rejection of the game itself. The idea isn’t limited to a specific age group, but the best articulation of it comes from younger Millennials and working age Gen Zers. Many of them are fed up with their jobs and they’re quitting in droves. Even those with jobs are reevaluating their options. What comes next?
   

• You are living in the Golden Age of stupidity. The convergence of many seemingly unrelated elements has produced an explosion of brainlessness. Interesting take by Lance Morrow suggesting that stupidity dominates in our time because of a convergence of seemingly unrelated elements (the death of manners and privacy) that - mixed together at one moment, in our cultural beaker - have produced a fatal explosion.

• Why you need to protect your sense of wonder - especially now. As the pandemic era goes on, more than ever we need ways to refresh our energies, calm our anxieties, and nurse our well-being. The cultivation of experiences of awe can bring these benefits and has been attracting increased attention due to more rigorous research. At its core, awe has an element of vastness that makes us feel small; this tends to decrease our mental chatter and worries and helps us think about ideas, issues, and people outside of ourselves, improving creativity and collaboration as well as energy. David Fessell and Karen Reivich, a physician and a psychologist, have facilitated hundreds of resilience and well-being workshops; they suggest for HBR a number of awe interventions for individual professionals as well as groups. 

Our best wishes for a month filled with joy and contentment,

Logos LP

The Nature Of Long-Term Shareholding

Good Morning,
 

The Dow Jones Industrial Average jumped to another record high on Friday as reopening optimism continued to encourage the rotation into cyclical stocks. Meanwhile, surging bond yields rekindled valuation fears and took the comeback momentum out of high-growth, high multiple names.

The 10-year Treasury yield jumped another 10 basis points to 1.64% at its session high Friday, hitting its highest level since February 2020. The benchmark rate started 2021 at around 0.92%.

The rapid rise in bond yields prompted investors to dump the high-growth, high-multiple long-duration Nasdaq (QQQ) names again after a brief rebound earlier this week. Sharp increases in interest rates can put outsized pressure on such high-growth long-duration stocks as they reduce the relative value of future profits.

February and March saw the biggest market sell-off since September 2020. The recent sell-off predominantly affected the QQQ with a rotation out of high-growth, high-multiple technology companies and into businesses that have taken a beating throughout the pandemic (energy, banks, live events, brick-and-mortar retailers, hotels or travel to name a few). 

For those in more traditional S&P 500 (SPY) components, with little exposure to the high-growth complex, the “sell-off” was barely noticeable. Whereas, for those with significant exposure to such long duration assets, the drawdown was more pronounced than the move in the index would suggest, with many names reaching extremely oversold levels (average drawdowns of 30%-40% across the board):

Many analysts and so-called market pundits have since rushed in and declared that the bubble is popping. That the high-growth technology trade is dead. The refrain is now: 

“I think the story is becoming very, very clear in the tech sector. We have incredibly high valuations and yields that have tripled from the low last year,” said Robert Conzo, CEO of The Wealth Alliance. “You are going to see a lot of volatility in the tech sector. There’s a better trade out there in the cyclicals.”

Or even more bold calls such as:


“2020 marked the secular low point for inflation and interest rates; new central bank mandates, excess fiscal stimulus including UBI, less globalization, fading deflation from disruption, demographics, debt…we believe inflation rises in the 2020s and the 40-year bull market in bonds is over… BofA Global Research’s Inflation Survey shows 61% of analysts saw their companies raise prices in recent months. AA [asset allocation] implications bullish real assets, commodities, volatility, small cap value, and bearish bonds, US$, large cap growth.”

There is no doubt that the rapid sharp increase in U.S. government-bond yields is pressuring certain pockets of the stock market and forcing investors to confront the implications of both rising inflation and interest rates.

Yet the rotation referenced above has been playing out for at least 6 months now as energy, financials, industrials and materials (stocks whose fortunes are closely tied to economic growth) have greatly outperformed technology:

Same goes for growth vs. value with traditional value stocks (those which trade at low multiples of their book value, or net worth) beating growth stocks by the widest margin in TWO DECADES! 

This year, the Russell 1000 Value Index is up 11% and the Russell 1000 Growth Index has edged up 0.2%.

That gap is the largest lead for value stocks at this time of year since 2001, according to Dow Jones Market Data, when the bursting of the tech bubble led to a resurgence in value shares. At this point last year, during the coronavirus-induced downturn, growth stocks held a wide lead.

Oh what a difference a few months can make...

Our Take

So, should one abandon high-growth technology/innovation and chase the hot hand, piling into cyclicals/value names even as they reach new highs? Should one chase the trend and shift to low quality, high volatility, weak balance sheet names with little profitability? 

What should we make of the rotation?

Value investing and growth investing are two different investing styles.Traditionally, value stocks are thought of as an opportunity to buy shares below their actual value (although most investing can be conceptualized this way), and growth stocks exhibit above-average revenue and earnings growth potential.

Wall Street attempts to categorize stocks neatly as either growth or value stocks. The truth is a bit more complicated, as some stocks have elements of both value and growth. Nevertheless, to answer the questions posed above, it is important to step back and think about what’s going on and how investors should approach the current market. 

The pandemic has caused a massive acceleration for digital/innovation businesses. This isn’t likely to be temporary. The pandemic has now lasted long enough for consumers and companies to form new habits and ways of doing business, many of which will last even as the pandemic fades into history.

The digital/innovation acceleration is real. The long-term implications are likely larger than currently envisioned by even the most optimistic forecasters. Yet as we have warned before, many stocks leveraged to these trends, especially those that appear to be pure plays, were likely overvalued coming into 2021 and remain overvalued now. Mistaking such individual investments as a "no-brainer" way to capture long-term mega trends like digital acceleration, AI, solar, cloud, blockchain, EV is fraught with risk as stock price moves in such names can be extreme. 

At a high level, as long-term investors (more on this below), we believe that although the declines discussed above can be painful given their speed and unpredictability, investors must be willing to pay this price in the pursuit of above-average long-term returns. 

Such drawdowns should not be a catalyst for panicked portfolio rebalancing, as well as significant rotations/reallocations towards the “investment theme du jour”. Instead, they should prompt diligent reflection on one’s portfolio:  

1. How do I understand market, sector and company risk? 

2. How much drawdown can I cope with?

3. Do I have the cash I need and a cash deployment strategy?

4. Does my portfolio fit my risk profile?

5. Do I have a list of stocks I want to buy and a strategy for allocating to them?

6. Do I have a strategy that is written down?

In addition to this, the recent drawdowns in high-growth/high-innovation names should remind us that it isn’t enough to recognize a big innovation/investment trend and throw money at it. 

As QQQ names were melting down earlier this month, there was real fear that this could be a Dot Com moment. The knife could continue to fall. 

Intrinsic Investing reminds us that if we look at the Dot Com crash for guidance we can find at least two important lessons: 1) people at the time were too conservative about their big mega trend outlooks and; 2) they were too optimistic in how they expressed those views in individual stock selection. 

Despite the internet being vast, only a handful of the companies capitalized on the mega trends of the times. Some of the biggest winners of the internet age weren’t even public (i.e. Google) or founded yet (i.e. Facebook) until well after the Dot Com bubble crashed.

The Dot Com bubble and crash teaches us not to get out of the market when speculative activity surges as it is today. Rather, the takeaway is to “avoid those specific stocks that are speculatively valued and to be highly skeptical of unproven businesses that claim they are sure to capitalize on exciting new trends.” It is during periods like these - and where we find ourselves today - that stock selection (knowing what you own) becomes extremely important. The last few weeks have been a stark reminder of this principle. 

So, as we manage our portfolio at a time when speculative activity is rampant, we will do our best to keep an open mind when it comes to the significance of the big fundamental changes at play, while remaining very skeptical about which companies will capture those trends and the valuation of those companies we believe will be the long-term winners. In short, we will not be rotating into low quality, high volatility, weak balance sheet names with little profitability. 

Musings

It’s important to realize that as an investor in an increasingly digital world in which investment information is ubiquitous, no matter what innovations we see in the financial industry, patience will always be the great equalizer in the financial markets. In fact, one of the biggest advantages investors have over the pros and even the machines is the ability to be patient. 

Charlie Munger nailed it when he remarked: 

“We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses.

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.”

Individual investors have the luxury of thinking (and hopefully acting) in terms of decades which is virtually impossible on Wall Street. A buy and hold strategy is by no means perfect, yet for it to work, you need to do both the buying and the holding during a drawdown. Of late, it has been much easier to do the buying and holding when markets are rising. Yet we must remember that on the journey to making large returns, there will be detours accompanied by poor returns.  

For example, Morgan Housel looked at one of the best-performing stocks of the last 20 years (Monster Beverage) and found that it spent the majority of that time with returns that would make make most investors hit the sell button. 

Housel looked at the 10 best stocks to own over the past 20 years which were all cherry-picked for their stellar returns, and would represent the stocks you would probably choose to own if you had a time machine. On average they increased more than 28,000%.

But they all spent a majority of the time well below their previous high mark. They all had multiple declines of 50% or more. A few had multiple 70% drops.

Investors underestimate how common and severe volatility is, especially among individual stocks. If stocks with the cherry-picked best returns spend a third of their time down at least 30%, you can imagine what the long-term losers look like. 

In 2009, Charlie Munger was asked how concerned he was that Berkshire Hathaway shares — which made up most of his net worth — dropped more than 50%. He quickly interrupted the interviewer and responded:

“Zero. This is the third time that Warren [Buffett] and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it's in the nature of long-term shareholding that the normal vicissitudes in markets means that the long-term holder has the quoted value of his stocks go down by, say, 50%.

In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who can be more philosophical about these market fluctuations.”

Investing is work. Stock picking is work. There are no shortcuts that provide easy money for an extended period of time.
 

For long-term investors like us, there is no scenario where we will be meaningfully selling out of high quality businesses in order to buy and hold low-quality businesses or sit in cash. Why not now?

1. We don’t know how to time the market: We don't know when the market will crash or even correct. It could be next week; it could be a decade from now. Unpredictable geopolitical, environmental, and biological events, coupled with people's emotional response to them, will determine this. 

2. What matters is time in the markets: If you wait for ideal conditions before investing, you never will. Time in the market is what is important. Productively and diligently allocating capital creates far more wealth than timing its allocation perfectly.

3. Stocks are a wonderful hedge against inflation: Since 1928, the U.S. stock market is up 9.8% per year while inflation has averaged 3% per year. So stocks have grown at nearly 7% more than the rate of inflation. One of the reasons for this is the fact that earnings and dividends also grow at a healthy clip above inflation. Over the past 93 years, earnings have grown at roughly 5% per year. Stocks also have perhaps the greatest income stream of any asset. Dividends have grown at roughly 5% per year. So earnings and dividends both have a history of growing above the rate of inflation.

4. Real interest rates are likely to remain negative over the long term: We aren’t economists, yet we believe that the rise in inflation and interest rates will be a temporary diversion from a clear downward trend. The fiscal stimulus is all transitory and the economic effects on demand will be short-lived. Zombie firms (those that cannot cover their fixed expenses with operating income and thus continuously rely on the capital markets to survive) are proliferating all over the developed world causing disinflation. We are also going through a productivity boost (technology) at a time when real wage growth is depressed and that is no prescription for durable inflation from a unit-labour cost perspective. In addition, aging demographics and a catastrophic collapse in birth rate (which no one is talking about) across the developed world are disinflationary, while governments are arguably the most anti free-market and least business friendly ever. How will the investor holding a portfolio of low quality, high volatility, weak balance sheet names with little profitability fare if the reflation thesis flames out? 

There will always be another narrative to worry about. A reason to sell your holdings or rotate into the “investment theme du jour”. A good long-term investment strategy will not produce desired returns year in and year out. 

Rather, it will be tested as it makes progress toward some long-term goal over time as winning years more than offset losing years. Investors who keep their investment strategy consistent regardless of volatility set themselves up for success over the long-term. 

Embrace the grind. How can you know what your investment strategy is made of if its never been tested? 

Charts of the Month


How does the market perform when interest rates rise?

Back drop: Why the big picture is critical – especially now:

(1) Three YEARS of non-stop Stock selling.

(2) All the money went into Bonds.

If the rally continues, where does the money go? Is the current equities market a bubble? This chart offers some perspective. Look at where money has been invested since the March 2009 bottom. The bets on equity funds and ETFs are dwarfed by the inflow for bonds.

Where are the jobs? Where is the growth?

The big boost China experienced post Covid-19 looks like it has already come to an end. China's economy was the first to recover from the Covid-19 collapse due to trillions of credit pumped into the economy at home, as well as Americans rushing out to buy imported goods using stimulus money. With China again showing signs of economic weakness, the story that it takes more and more stimulus to create the same kick each time we play this game is playing out. Will the story somehow be different for America or Canada?

Zombies are taking over the world.

If you think that is a lot, consider the entire globe. An International Monetary Fund report from October 2019, fretted that global zombie debt could soon rise to $19 trillion and amount to 40% of all corporate debt in major economies...

Logos LP February 2021 Performance

February 2021 Return: 2.89%

2021 YTD (February) Return: 14.95%

Trailing Twelve Month Return: 133%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 27.29%

 

Thought of the Month

“I judge you unfortunate because you have never lived through misfortune. You have passed through life without an opponent- no one can ever know what you are capable of, not even you.” -Seneca

Logos LP Services


Looking for help with your investments? Unsure about how to achieve your financial goals? We would be happy to chat. Please book an intro call here.



Articles and Ideas of Interest

• The Gig Economy Is Coming for Millions of American Jobs. California’s vote to classify Uber and Lyft drivers as contractors has emboldened other employers to eliminate salaried positions—and has become a cornerstone of bigger plans to “Uberize” the U.S. workforce. This while Long-term unemployment is close to a Great Recession record and the unemployment rate for the bottom quartile of Americans is 23%.

• Canada's balance sheet is deteriorating and the consequences could be significant for investors. Canada is spending in places that may not directly repair the damage that has been done by the virus. No wonder a job in the public sector has never looked better. The long-running rivalry between the two services — public versus private — has been settled by COVID-19. Why would anyone risk the dangers and uncertainty of free enterprise when they could have the safety and security of a large and ever-expanding government? The bottom line is that the cachet that once went with private employment has gone the way of the Dodo bird, which coincidentally never had a government to protect it either. Public pay is better, the benefits top-of-line, it’s almost impossible to be fired, you know the date you can retire, and the amount you’ll be paid. If you don’t get along with your manager you can call the union and grieve 13 ways from Sunday. You don’t have to worry about the business going under, and can live in confidence that terror-stricken politicians will opt to buy peace at contract time, rather than challenge the latest set of demands. This reality is a major problem for the future of Canada’s economy.

• Move over GameStop, hockey cards are emerging as the hottest bull market on the planet: Blame it on the pandemic, but cards are seeing a 'parabolic boom' with values up 300% to 400%. All this while people are paying millions for video clips that can be viewed for free. Welcome to the world of ‘NFTs’.
  
   

• Microdosing study shows placebo effect of taking psychedelics. UK research into LSD consumption reveals expectation of improved wellbeing drives transformation rather than the drug itself. The mind is more powerful than the sword. 
  
   

• YOLO investing still appears healthy. 37% of Americans in a recent online survey say they've made trades based on an Elon Musk tweet and half of respondents in a recent survey between 25 and 34 years old plan to spend 50% of their stimulus payments on stocks. Bless their hearts.

• The long-term economic costs of lost schooling. Students who are falling behind now because of Covid restrictions may never catch up in their skills, job prospects and income.
  
   

• SPACs are becoming less of a sure thing as the deals get stranger, shares roll over. Faced with intense competition, deadline pressure and a volatile market, some SPACs had to settle for less ideal targets, and in some cases, throw their entire blueprint out the window.The proprietary CNBC SPAC 50 index, which tracks the 50 largest U.S.-based pre-merger blank-check deals by market cap, dropped more than 15% in the past two weeks, giving up all of its 2021 gains. Most are problematic, but there is one we find attractive: IonQ (DMYI) which promises to be the leader in quantum computing. 

• What happened to gold? If you went into a laboratory to build a gold price optimizer, you would want a couple of things: A falling dollar, Rising inflation expectations, Money printing, Central bank balance sheets expanding, Fiscal deficits increasing and Political turmoil. All of these things were in place over the last few months, and yet gold has done the opposite of what you expected it to do. It’s down 9% over the last 6 months, and it’s 15% below its highs in August. Gold could rally on any one of the items I mentioned. All six were in place at the same time, and it couldn’t get out of its own way. Michael Batnick digs in.  
  
   

• How Much Longer Can This Era Of Political Gridlock Last? Democrats may have a narrow majority in both the House and the Senate for the next two years, but it’s nothing near the margin they hoped for. And the likelihood that Democrats keep both the House and the Senate in 2022 are low, as the president’s party almost always loses seats in the midterm elections. That means more divided government is probably imminent, and the electoral pattern we’ve become all too familiar with — a pendulum swinging back and forth between unified control of government and divided government — is doomed to repeat, with increasingly dangerous consequences for our democracy.

Our best wishes for a month filled with joy and contentment,

Logos LP

How did we do in 2019? Sell in 2020?

Good Morning,
 

Stocks rose slightly on Friday as Wall Street wrapped up a nice weekly performance that featured new record highs for the major indexes amid strong global economic data and a solid start to the earnings season. 

Friday’s gains came after Chinese industrial data for December topped expectations overnight, with production rising 6.9% on a year-over-year basis. The overall Chinese economy grew by 6.1% in 2019, matching expectations. 

In the U.S., housing starts soared nearly 17% in December and reached a 13-year high. That data follows Thursday’s release of better-than-forecast weekly jobless claims and strong business activity numbers from the Philadelphia Federal Reserve.

Stocks are gaining to start the year with bullish investor sentiment on the rise and the naysayers in sync with calls of an “overbought” market “ripe” for a fall (more than three months have gone by since the S&P 500's last decline of 1% or more back on October 9th).

Meanwhile hedge fund billionaires David Tepper and Stanley Druckenmiller are confident in the current bull run. 

Tepper told CNBC’s Joe Kernen in an email: “I love riding a horse that’s running.” Tepper, meanwhile, told Kernen in a separate email he is still bullish in the “intermediate term” in part because of the Federal Reserve’s current monetary policy stance.

A solid start to the corporate earnings season has also provided a supportive backdrop to the market as more than 8% of the S&P 500 have reported quarterly results thus far and of those companies, 72% of companies gave posted better-than-expected earnings.

Our Take

With indexes trading at record highs, the S&P 500 up 13 of the past 15 sessions and with stocks trading at historically high levels versus earnings, expected profits and sales, it is understandable that investors might feel uncomfortable putting more money to work. 

Furthermore, as Nick Maggiulli reminds us, investors are faced with the common refrain that markets are “due” for a pullback. The reality is that markets are never “due” for anything. After studying the historical data Nick demonstrates that there is little to no relationship between prior 10-year returns and growth over the next 10 years.

For example, if you look at how the S&P 500 performed over its prior 10-years (starting in 1936) and then look at how it grew in the future, you won’t see much of a pattern. 

Interestingly, Nick demonstrates that “while the prior 10 years show little to no relationship with future returns, this is not necessarily true if we look at returns over the last 20 years.  Typically, if U.S. markets did well over the prior 20 years, they did poorly in the next 10 years, and vice versa.”  

Nick’s research suggests that if history were to repeat itself in some meaningful way, the S&P 500 would be 4x higher by 2030 than where it is today. 

Is this such an outrageous prediction given where we stand with persistently low borrowing costs and inflation? 

Sarah Ponczek in a recent piece in Bloomberg explored this “new regime for stocks” and found that stock prices have the potential to rise a lot more before reaching valuations that are justified by bond rates. Some suggest as high as 30 times earnings on the S&P. 

Near 3,330, the S&P 500 currently trades at 22 times recorded earnings. Getting to 30 times would place the benchmark close to 4,500, a gain of more than 35%.

There is no doubt that buying a quality asset at a low/reasonable price is more attractive than purchasing it a higher price. Yet the more interesting point to be gleaned from the above is that divesting or not investing at all based on the simple adage that ‘The market’s expensive therefore I’m a seller’ rarely works. The market historically has been rewarded with higher valuations when interest rates and inflation are subdued. 

Although there are no laws which guarantee the market will follow this historical trend and/or for how long, it is interesting to consider that those predicting a poor decade for stocks ahead may not have the data/evidence on their side…


Stock Ideas
 

For some of our picks for 2020 please find them on Yahoo Finance here.

Musings

For our thoughts about 2019, our portfolio composition headed into 2020, and our outlook for 2020 please find a copy of our 4Q annual letter to our partners on ValueWalk accessible here. 

Charts of the Month

Logos LP December 2019 Performance
 

December 2019 Return: -0.06%
 

2019 YTD (December) Return: 37.62%
 

Trailing Twelve Month Return: 37.62%
 

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: +15.77%

Thought of the Month


 "The world is ruled by letting things take their course.” – Lao-Tzu


Articles and Ideas of Interest

 

• Banks that shun risky borrowers offer rosy view of the U.S. Consumer. With most U.S. households spending more and paying their bills on time, their creditors are feeling more confident than ever. To hear the CEOs of the nation’s largest banks tell it this week, rarely has the American consumer been in better shape. Nevertheless, these banks may reflect the fact that banks have focused more on the wealthy and those with excellent credit as Nationwide, four in 10 adults don’t have the cash to cover an unexpected $400 expense, according to a 2018 survey by the Federal Reserve.

• Ten charts that tell the story of 2019. The power of a good chart or map lies in its ability to inform the debates and decisions that lie ahead. Here are 10 graphics published by the Financial Times in 2019 where the real story is often about what happens next — in the years, decades and centuries to follow.

• 19 big predictions about 2020, from Trump’s reelection to Brexit. Will Biden win the nomination? Will Netanyahu hang on in Israel? Will global poverty see a decline? The staff of Future Perfect forecasts the year ahead. The future perfect team at Vox weighs in.

• The pressing need for everyone to quiet their egos. Scott Barry Kaufman for the Scientific American suggests why quieting the ego strengthens your best self. We are more divided than ever as a species with anxiety and depression at record highs. What is the answer? The quiet ego approach. The goal of the quiet ego approach is to arrive at a less defensive, and more integrative stance toward the self and others, not lose your sense of self or deny your need for the esteem from others. You can very much cultivate an authentic identity that incorporates others without losing the self, or feeling the need for narcissistic displays of winning. A quiet ego is an indication of a healthy self-esteem, one that acknowledges one’s own limitations, doesn’t need to constantly resort to defensiveness whenever the ego is threatened, and yet has a firm sense of self-worth and competence.

• Why doing good makes it easier to be bad. In an age where corporate “do-goodism” / “corporate social responsibility” is en vogue, you might wonder how people who seem so good in public could be so bad in private. The theory of moral licensing could help explain why: When humans are good, it says, we give ourselves license to be bad.

• What makes a good life? Lessons from the longest study on happiness. What keeps us happy and healthy as we go through life? If you think it's fame and money, you're not alone – but, according to psychiatrist Robert Waldinger in this TED talk, you're mistaken. As the director of a 75-year-old study on adult development, Waldinger has unprecedented access to data on true happiness and satisfaction. In this talk, he shares three important lessons learned from the study as well as some practical, old-as-the-hills wisdom on how to build a fulfilling, long life.
  
   

• Why you will marry the wrong person. Alain de Botton for the NYT suggests that though we believe ourselves to be seeking happiness in marriage, it isn’t that simple. What we really seek is familiarity — which may well complicate any plans we might have had for happiness.
  
   

• Reports of value’s death may be greatly exaggerated. Many investors are reexamining their exposure to the value style given the extraordinary span—over 12 years—of underperformance relative to growth investing. Given the long historical record of value investing, and its solid economic foundations (dating back to the 1930s and, less formally, dating back centuries), it is unlikely that the period up to 2007 was a result of overfitting. The three other explanations, however, deserve a deeper examination. It is likely that no one story accounts for the underperformance; it is probably a combination of all three. Rob Arnott for Research Affiliates digs in.  

Our best wishes for a fulfilling January,

Logos LP

Haters Gonna Hate

Good Morning,
 

The Dow Jones Industrial Average fell sharply on Friday, weighed down by steep losses in Boeing and Johnson & Johnson. The broader market was also pressured by a decline in Netflix shares that led other Big Tech stocks lower.

The 30-stock index ended the day down 255.68 points, or 0.95% to close at 26,770.20. Boeing dropped 6.8% — its biggest one-day drop since February 2016 — on news that company instant messages suggest the aerospace giant misled regulators over the safety systems of the 737 Max. Johnson & Johnson slid 6.2% after the company recalled some baby powder upon finding traces of asbestos.

Friday’s losses wiped out the Dow’s gains for the week. The index closed down 0.2% week to date. 

Meanwhile, S&P 500 pulled back 0.4% to end the day at 2,986.20 while the Nasdaq Composite slid 0.8% to 8,089.54. Netflix shares dropped more than 6%. Facebook, meanwhile, slid 2.2% while Amazon fell 1.6%. Alphabet shares pulled back 0.4%.

Both indexes were able to post solid gains for the week despite Friday’s decline. The S&P 500 rose 0.5% week to date while the Nasdaq gained 0.4% as enthusiasm around the first batch of corporate earnings lifted market sentiment.

More than 70 S&P 500 companies reported calendar third-quarter earnings this week. Of those companies, 81% posted better-than-expected results, FactSet data shows.

It was also a brutal week for the software/cloud technology sector. The worst in recent memory. 

Our Take

We are currently in the middle of deflationary period for many once popular software stocks which began in late July/early August and certain names have dropped anywhere from 40-60% in a matter of months. Investing can be a popularity contest and the most dangerous thing is to buy something at the peak of its popularity. As such, we are now evaluating this group as the safest and most potentially profitable thing is to buy something no one likes.

What can be made of this selloff? There are likely a variety of reasons for this repricing tied to the overall pessimistic “macro” narrative that continues to dominate “popular” discourse (more on this below) yet a more simple explanation is that their valuations have gotten ahead of themselves in a market that is maturing.  

A quick review of the charts of several cloud computing and software focused ETFs suggest incredible outperformance vs. the S&P 500 since around 2016 until about August of this year with many popular software names (Okta (OKTA), Veeva (VEEV), ServiceNow (NOW), Twilio (TWLO), Coupa (COUP)) still up between 20-100% for the year. To boot, most of the cloud computing and software focused ETFs are still up between 15-25% for the year despite the selloff.

Not exactly a “blood bath”. Instead, we see this repricing as perhaps a welcome reversion to the mean as well as a maturation of the sector. A swinging of the pendulum back to reality as all new great growth stories tend to do. The reality is that many of these businesses are more economically sensitive than once thought and many are running out of runway. Competition is now fierce and so the multiples must come down. Look at history and this is nothing new.

Many of these names continue to generate impressive amounts of recurring revenue, maintaining breathtaking rates of growth while solving real problems for customers.  All things considered, the weakness in the space along with the weakness in demand for such issue in the IPO market (think WeWork, AirBnB, Uber, Lyft, SmileDirect, Slack etc.) all point to the other side of the “can’t lose investment idea” coin.

This is healthy and rational. The greater fool theory works only until it doesn’t (think WeWork). Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.

"Attractive at any price” in relation to the sector is steadily morphing into simply “attractive” on a more company specific basis. This is why we are beginning to get excited about opportunities in the space and have begun considering increasing our portfolio weighting in software and technology related services. Our focus has been on companies in the sector in the small to mid-cap arena with strong secular growth stories with real free cash flow. As such, we have started to initiate positions in companies like the following:

1. New Relic (NEWR): Company provides analytic and data monitoring software for DevOps teams. Company is trading a little over 6x sales with ~80% gross margin. Stock is down 47% from 2018 and FCF has nearly quintupled since then. New Relic has more FCF than companies like Zscaler with a similar growth profile is trading at nearly half the market cap.

2. Zuora (ZUO): Company provides software to utilities, industrials and other technology firms that are developing subscription services. Trading under 5.99x sales with growth in enterprise accounts over 100k at 20% and overall growth at over 40% since 2018, the company blew past quarterly earnings and raised guidance last quarter. Stock is down 61% since 2018.

3. Upland Software (UPLD): Marked as the U.S. version of Constellation Software, the company trades at 14x next year’s earnings, a little over 4x sales with FCF quadrupling since 2016. Company has been on an acquisition spree and has raised full year guidance. This is a name that may become a core.

Not all technology stocks or software stocks are created equal. We believe the market has unfairly treated many SaaS providers with strong growth and cash flows by lumping in real software companies at reasonable valuations with companies that are either tremendously overvalued or that are not even technology focused to begin with. Why should Okta, which is an Oauth replacement trading at over 24x sales, be in the same conversation with some of these other high growth sticky software companies trading below 15x sales? Why is Slack, which seems to have its hands full with MSFT Teams, trading at 26x sales? 

While some professional investors may have an answer to these questions, we prefer to wait for compelling valuations to match compelling growth stories. In the meantime, we welcome further multiple compression among highly recurring software businesses as they will provide for interesting upside in the future. Let the baby get thrown out with the bathwater…

Musings

Pessimism and frustration are the words that best describe the popular sentiment at present. It has become necessary for the majority (the "Haters Gonna Hate" crowd) to portray every data point and every headline as negative, in the hopes of confirming their views. The facts are that we are roughly 2% off of record highs YTD for the S&P 500. These majority views thus haven’t proven to be particularly profitable.

It has been said that there are four phases in every bull market: 1) Despair 2) Disbelief (of initial rally) 3) Acceptance 4) Euphoria. We think it is safe to say that we have been through the despair phase. Next we have the disbelief phase in which a few begin to believe that things will get better but most question everything and maintain a pessimistic view holding large swathes of their portfolio in bonds, gold, utilities, non-cyclicals and even cash. Have we really moved out of this phase to acceptance?

What pundit can you think of that is optimistic? There isn’t a day that goes by without David Rosenberg at Gluskin Sheff calling for a recession. Don’t forget Ray Dalio at Bridgewater suggesting that we are headed for the 1930s all over again. What person do you know who loves stocks right now and is suggesting that you buy? At a recent Thanksgiving celebration we were informed by most at the party that they had completely exited the markets as a recession was “right around the corner”.  We couldn't help but think that at least if these views prove to be incorrect one wouldn’t be lonely... 

This is not indicative of acceptance or euphoria. Instead, we believe the door to the acceptance phase began to open in 2017. For some, there was renewed optimism with a pro-business agenda in play. That crack in the door has been abruptly shut. Negativism is back en vogue and is pervasive anywhere you look.

Just last week The American Association of Individual Investors who runs a weekly sentiment poll where participants express their view on which direction the U.S. stock market will be headed over the next six months reported that 20.3% were bullish, 35.7% were neutral and 44% were bearish. Roughly 80% of market participants are not bullish…This is a huge number. 

In other news, investors are flocking to the relative safety of money market funds at the highest level since the financial crisis-era collapse of Lehman Brothers in 2008. The industry has pulled in $322 billion over the past six months, the fastest pace since the second half of 2008, bringing assets to nearly $3.5 trillion, according to data from FactSet and Bank of America Merrill Lynch. Total money market assets are now at their highest level since September 2009! 

Today, it’s all about what is going wrong, and the positives are nowhere to be found. The negative rhetoric coming from ALL political candidates across the spectrum is shocking. Watching the Democratic primary debates on TV, listening to Trump at his rallies or on Twitter or watching the Canadian Federal election debates is enough to make you lose hope for the future. Any positive data is being thrown under the rug and the person/party that can say the most shocking and negative thing appears to be the one that gets the most attention. 

Quite frankly the political discourse is so uninspirational that we feel confident in saying that the disbelief phase is still in progress today, and the “haters gonna hate” sentiment presented week after week confirms that. The fearful have been joined by the frustrated, and that angry mob has grown to proportions seen during times of crisis. 

What to do? We have chosen to accept this market for what it is: it hasn’t gone anywhere for almost 2 years, “safety assets” are leading the market, US household financial burdens today are lower than at any time since the early 1980s, US household leverage (total liabilities as a % of total assets) has declined almost 35% since the mid 1980s, the five largest money center banks in the USA have beaten earnings estimates this quarter, the commentary from just about every Bank CEO was that: "The consumer is ''strong”, the S&P 500 earnings yield stands at +5.90%, growth remains at a moderate pace, inflation is tame, the Fed is dovish and so we will stay the course looking out for opportunities during the acceptance and euphoria phases.

At the end of the day, if this cycle is anything like the others, the currently hyper-valued defensive stalwarts like consumer staples, interest rate sensitive investments, including REITs and utilities, and the heavily embraced bond market, are all poised to underperform dramatically, as a historic capital rotation occurs. As such, looking out into the final 2 phases of the bull market, embracing shunned economically-sensitive assets, when almost all market participants are bidding up the price of “quality”/“safe” assets preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity. As history has taught us, there is no such thing as a good investment regardless of price…

Charts of the Month

Apparently many think we have another 2008 situation brewing as cash has become king now.

Logos LP September 2019 Performance

September 2019 Return: -5.13%
 

2019 YTD (September) Return: 24.62%
 

Trailing Twelve Month Return: 4.67%
 

Compound Annual Growth Rate (CAGR) since inception March 26, 2014:+14.48%

Thought of the Month

"When the thumb of fear lifts we are so alive.” – Mary Oliver

Articles and Ideas of Interest

• Why many smart women support president Trump. Interesting piece in the WSJ. "I, too, am a college-educated, suburban woman. I am retired, and during President Trump’s term my retirement fund has increased. I live in a heavily populated border state and am happy to see he is addressing the overabundance of people living here illegally. He has reduced my taxes, reduced government regulations thereby improving the business environment and giving my children and grandchildren more access to better, high-paying jobs, and he is protecting my health plan from a government takeover."

• The 'Glass Floor' is keeping America's richest idiots at the top. Elites are finding more ways to ensure that their children never run out of chances to fail. In 2014, Zach Dell launched a dating app called Thread. It was nearly identical to Tinder: Users created a profile, uploaded photos and swiped through potential matches. The only twist on the formula was that Thread was restricted to university students and explicitly designed to produce relationships rather than hookups. The app’s tagline was “Stay Classy.” Zach Dell is the son of billionaire tech magnate Michael Dell. Though he told reporters that he wasn’t relying on family money, Thread’s early investors included a number of his father’s friends, including Salesforce CEO Marc Benioff. The app failed almost instantly. Perhaps the number of monogamy-seeking students just wasn’t large enough, or capping users at 10 matches per day limited the app’s addictiveness. It could also have been the mismatch between Thread’s chaste motto and its user experience. Users got just 70 characters to describe themselves on their profiles. Most of them resorted to catchphrases like “Hook ’em” and “Netflix is life.” After Thread went bust, Dell moved into philanthropy with a startup called Sqwatt, which promised to deliver “low-cost sanitation solutions for the developing world.” Aside from an empty website and a promotional video with fewer than 100 views, the effort seems to have disappeared.And yet, despite helming two failed ventures and having little work experience beyond an internship at a financial services company created to manage his father’s fortune, things seem to be working out for Zach Dell. According to his LinkedIn profile, he is now an analyst for the private equity firm Blackstone. He is 22.

• Why are rich people so mean? Call it Rich Asshole Syndrome—the tendency to distance yourself from people with whom you have a large wealth differential.

• Not all millennials are woke. In Europe, young people’s political views have shifted right rather than left. Under-30s in Europe are more disposed than their parents are to view poverty as a result of an individual’s choice.

• Australia’s three rate cuts are making consumers even gloomier. Australian consumers are feeling their gloomiest in more than four years, signaling that the Reserve Bank’s three recent interest-rate cuts are having the reverse intended effect. Consumer confidence dropped 5.5% to 92.8 in October, with pessimists again outweighing optimists in the monthly Westpac Banking Corp. survey. The index sunk to its lowest level since July 2015 and is down 8.4% since the central bank started cutting rates in June. “This result will be of some concern to the monetary authorities,” said Westpac Chief Economist Bill Evans. “Typically, an interest-rate cut boosts confidence, particularly around consumers’ expectations for and assessments of their own finances. In this survey, these components of the index fell by 3.7% and 4.9% respectively.” Maybe politicians will eventually realize that they will have to make some hard decisions as monetary policy has run its course and fiscal policy will need to be relied upon.
   

• You now need to make $350,000 a year to live a middle-class lifestyle in a big city. Here’s a sad breakdown of why. 
  
   

• Empty hair salons can’t be saved by a central bank. Struggling businesses in rural Japan show the limits of the BOJ’s massive easing. There’s a lesson for other economies facing demographic decline.

• Time can make you happier than money. It’s true for all ages and stages - even for recent college grads according to a new study. “People who value time make decisions based on meaning versus money,” says study leader Ashley Whillans, an assistant professor of business administration at Harvard Business School. “They choose to do things because they want to, not because they have to.”

• VC Withering? Aggregate valuations of venture-backed companies are still at an all-time high.  But CB insights quarterly deep dive MoneyTree report — created in partnership with PwC — shows deals and funding down almost across the board (in the geographical and industry-specific sense). Looks like the money and dealmaking is pulling back. What does it mean? 

  Our best wishes for a fulfilling October,

  Logos LP