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

When Winning Is Not Losing

Good Morning,
 

Stocks rallied Friday, but still posted their first losing week in six amid heightened inflation fears. The major averages closed the week lower after the hottest inflation report in 30 years. The Dow fell 0.6%, the S&P 500 dipped 0.3% and the Nasdaq Composite inched down about 0.7% on the week.

Consumer sentiment in early November dropped to its lowest level in a decade, the University of Michigan reported Friday. Plunging consumer sentiment prompted hope among traders that the Federal Reserve would delay any interest rate hikes. Many survey respondents cited inflation concerns, according to the report.

Meanwhile, workers left their jobs in record numbers in September with 4.43 million people quitting, the Labor Department reported Friday. The exodus occurred as the U.S. had 10.44 million employment openings that month, according to the report.


Our Take 

Inflation is looking a lot less "transitory" after CPI numbers for October showed that consumer prices jumped 6.2% from a year ago, while notching the fifth straight month of a figure higher than 5%. It's also the fastest rate since 1990, and while that might cause some worry in the general population, Wall Street appears to be discounting the effects. Many continue to argue that the Fed won't get too aggressive, inflation could moderate next year, while some think stocks could even benefit along with a rise in asset prices.

Politicians are certainly taking notice: "Inflation hurts Americans pocketbooks, and reversing this trend is a top priority for me. With the [infrastructure] bill we passed last week, and the steps we're taking to reduce bottlenecks at home and abroad, we're set to make significant progress," President Biden said in a statement. "Very soon we're gonna see the supply chain start catching up with demand, so not only will we see more record-breaking job growth, we'll see lower prices, faster deliveries as well. This work is going to be critical as we implement the infrastructure bill and as we continue to build the economy from the bottom up and the middle out by passing the Build Back Better plan."

On the other hand, in the face of persistent inflation, central bankers around the world are increasingly looking like they are caught between a rock and a hard place. The only way to keep the economy afloat and the expansion continuing was (and is) to keep rates near zero. 

Yet the medicine used to solve the problem of jumpstarting the economy created two new problems: asset bubbles in just about everything, spiralling cost living and an economy that has become addicted to the stimulus drug. 

As John De Goey has pointed out, stimulus can be conceptualized as a form of economic antibiotics: antibiotics stop infections caused by bacteria; stimulus stops economic illness caused by slow growth. No one would ever recommend staying on antibiotics indefinitely. Yet given that any change to the status quo risks triggering a financial meltdown, central banks are stuck. 

Thus, what appears most likely is that there will be no significant tapering or normalization of any kind until we are faced with the harsh no-win economic ultimatum to do something about inflation that is without a doubt non-transitory. 

We haven’t reached that moment yet and there is a compelling argument that we may never reach it as with each passing day the status quo (and associated addiction) becomes more entrenched.


 Musings

Observing most of the major indexes, asset classes, economic output and inflation hit record highs, while consumer sentiment hits ten year lows, has prompted us to shift focus away from the “build wealth” side of the coin to the “preserve wealth” side. 

Market participants appear to have discarded caution, worry and fear of loss and instead obsess about the risk of missing opportunity. Worry appears to be in short supply as most investors who have stayed the course over the last decade have done exceedingly well. Despite the fact that about half the U.S. population does not have a significant stake in the stock market, U.S. household net worth has hit record highs led by real estate values and stock prices.

Stocks have surged to record highs, and low borrowing costs have supported a flurry of home buying, and ultimately home price appreciation. Massive support provided by the government and the Fed has bolstered Americans’ wealth. 

Gains are so considerable that data suggests they may be fuelling the labor shortage (U.S. workers quitting their jobs just hit record highs) as people exit low-paying work to trade stocks and risky digital assets. Too much money is chasing the risky and the new, driving up asset prices and driving down prospective returns and safety. 

What should we make of all of this? In our view what is occurring today appears to be a modern permutation of a classic behaviour. As Mark Twain famously remarked: “History doesn't repeat itself, but it often rhymes.”

Economies, like life, are sine waves with attitudes and behaviour oscillating between peaks and troughs. When it comes to markets, declines can occur because many people’s goal is to become so successful (wealthy) that they can relax (think top of the sine wave), and relaxing leads to complacency (worry is in short supply) which sows the seeds of future decline (and back to the bottom of the sine wave we go).
 

I’ll always remember a conversation I had with a mentor of mine years ago when he noticed me “over celebrating” a win. He saw celebration as something sloppy, something dangerous, a self-indulgent act that could derail one's focus. He told me “if you have arrived, then what is there left to do?”

Most people’s career goal is to work hard so that one day they can stop working. Our economies are set up around this concept. If we can just get to retirement then we can relax.

The problem is that if enough people adopt this mentality simultaneously and feel that they can“relax”, relaxation is compounded into complacency. Think about the uncertainty and hardship brought on by COVID-19. Perhaps the incredible recent asset price gains and associated investor behaviour can be better understood through this lens. 

Becoming financially successful typically requires years of hard, stressful and unglamorous work. It’s understandable that once a certain level of financial success is achieved some feel justified to slow down, kick back, and let their guard down – especially when their assets are rising in value almost daily. 

People today understandably need a break from what has been an incredibly taxing and uncertain last two years. Desire for comfort and confidence is high. Bandwidth for skepticism, fear of loss and risk aversion is low. 
 

Investors long for the feeling that they are finally “getting ahead” despite the gravitational pull of inequality/class stagnation and spiralling costs of living. Yet as my mentor so aptly pointed out, there is usually a cost to such indulgence. A cost for casting skepticism aside and replacing reticence with eagerness. Success has an odd way of increasing confidence more than ability. The longer it lasts, and the more it was tied to some degree of luck, the truer that becomes. 

Recognizing this pattern and identifying it is key for investment survival as building wealth and preserving it are two different skills. 

On the one hand building wealth requires taking risks, being optimistic and swinging the bat. On the other, preserving wealth requires frugality, humility and a healthy dose of skepticism. It also requires an understanding that what you have can be taken away from you just as fast in addition to an acceptance that at least some of what you have can be attributable to luck. 

For us, the past two years and the current moment of rapid asset appreciation and high risk tolerance have made us think a lot about longevity and survival. Few gains are worth permanent capital loss and to experience the power of compounding in life and in markets, one must survive the unpredictable dips along the way. 

What does thinking about survival and longevity mean for us today in light of the above? 

For us it means increasing room for error by focusing on increasing our “margin of safety”. What measures can be taken to raise the odds of success at a given level of risk by increasing our chances of survival: 

-Reducing financial leverage 

-Flexibility of strategy and worldview

-Increasing willingness to commit capital to investments when risk is obviously being well priced, such as late 2008, 2009 or March 2020 and being less willing when risk is not being as well priced like 1999, 2007 and perhaps today

-Adopting an attitude of patience, humility and skeptical optimism about the future

-Having clarity on one’s investment time horizon

-Focusing on avoidance of accidents and permanent losses - recovering from disaster is difficult if one loses 50% on an ill-considered investment as a 100% gain is needed just to get back to where you started

-Respecting uncertainty by not assuming that the period ahead will resemble the period one most recently experienced 

-Avoiding faddish and vogue investments 

-Avoiding business models that are particularly vulnerable to technological change as well as those with opaque balance sheets or too much financial leverage

-Focusing on businesses that are less vulnerable to competitive forces - think DHR, WST, MSFT, CRL

With a focus on increasing our “margin of safety” we can increase our odds of hitting the ball out of the park without ever swinging for the fences. During “go go” times like these in which investor behaviour evidences a widespread belief that risk is low, winning becomes about not losing...

Charts of the Month


When looking at the sheer volume of money flowing into the market, it's easier to understand today's price action. Whether it's the record flow of speculative options volumes, or the torrential downpour of cash flooding into the broader equity markets, we've simply never seen anything like this:

Traders are nearing the all-time speculative blow-off peak from February, with the smallest of traders spending 53% of their volume on buying calls to open. That ranks as the 4th-most out of the 1,141 weeks since January 2000. It's even more extreme among large traders. 

Among all traders on all U.S. exchanges, net speculative volume is equal to the peak during the week ending February 12. There's no point showing the complete history because extremes over the past year are so far beyond anything seen in the prior 20 years that it completely distorts a chart.

Investing capital when prices are exceedingly above the underlying growth trend repeatedly had poor outcomes. Investing money at peak deviations led to very long periods of ZERO returns on capital.

The S&P 500 ended October with a return greater than 20%, and when that's the case the index has never been lower - neither in the month of November, nor in the months of November and December, combined.

Heading into November with the S&P 500 up 20%+ for the year means that the average returns investors may expect are 3.7% for November and 6.2% until year-end. That's significantly higher than the average year's returns of 1.7% and 3.2%, respectively.

Over the last month, investors pushed the stock market to extremely overbought, extended, and deviated levels. Currently, the deviation from the long-term bullish monthly moving average is at the most extreme since 1997. Furthermore, the stock market is now highly overbought, which has typically preceded more significant market corrections.

For nearly 5 decades, the NFIB Small Business Cost of Labor index has been a good barometer, especially for extended cycles. Based on this gauge, it took 19 months (on average) for the US economy to be in recession once the reading >=8. 

FYI: The most recent reading is 12... (needless to say this is an all-time high and this index has never failed).

The path out of the pandemic continues to defy straight-line forecasts. The hope was that getting the virus under control by vaccinating a large percentage of the population would turbocharge an economic recovery. Now we know it’s not that simple. As the chart below shows, countries with pre-pandemic challenges haven’t escaped them.

Focus on what you can control. There are always reasons to sell.

Time horizon is everything.

Logos LP October 2021 Performance

October 2021 Return: 5.14%

2021 YTD (October) Return: 17.97%

Trailing Twelve Month Return: 56.43%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 25.04%

 

Thought of the Month

“The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future." -Benjamin Graham

Articles and Ideas of Interest

• The best market indicator over the last 34 years. Interesting article by Ralph Wakerly which looks at six major market indicators and their track record in navigating the last seven bull/bear market cycles. Investment advisor sentiment has the best track record. CAPE has little value as a short-term timing tool, but is powerful in forecasting future long-term market returns. CAPE is currently near historical highs, signaling weak returns over the next ten years. Technical analysis is controversial and murky. Contrary to many academic studies and proponents of efficient markets, some technical indicators have proven useful. But their effectiveness varies with time. And most technicians don’t rely on any single indicator.
  
   

• Generation lockdown: Where youth unemployment has surged. Young people around the world have found themselves shut out of the labor market—and the consequences could linger for years to come. Niall O’Higgins, one of the authors of the ILO report, warns of the consequences of being shut out of the labor market for an extended time. “Clearly there is a serious danger that young people being out of work for a long period is likely to damage both the individual’s earnings prospects and the society’s productivity and long-term earnings potential.” The damaging effects go beyond economics. In countries with relatively young populations, having a large number of out-of-work youth can contribute to criminality and political instability.

• There's a massive chasm between government policy and our energy reality. Eric Nuttall suggests that it is epically frustrating that in Canada, a country blessed with some of the most abundant energy resources in the world, the majority of the population suffers from profound energy ignorance: the lack of knowledge of how hydrocarbons are used, how critical they are to our daily lives, and the realistic timeline to replace them with a “renewable” alternative. Without oil and natural gas, we would literally be back in the Stone Age, experiencing a fraction of our current standard of living. So how did we get here, where the average Canadian thinks the end of oil is at hand, politicians contemplate the necessity of limiting production growth, and where we have lost sight of how blessed we are as a nation to be gifted with such valuable energy resources produced in one of the most ethically and cleanest manners anywhere in the world? Joe Oliver also ​​reminds us that although Canada represents only 1.6 per cent of total emissions and cannot make a difference to global climate, we have a moral obligation to do our part in a worldwide effort. A common-sense approach would be to optimize our contribution while limiting damage to the economy. Instead, we seem determined to minimize our effectiveness and maximize self-harm.
  
   

• America needs a new scientific revolution. A repurposed antidepressant might help treat COVID-19, a remarkable study found. The way this research was funded highlights a big problem-and bigger opportunity-in American science. The Atlantic diagnoses several paradoxes in the current U.S. system.
  
  

• The bio revolution: innovations transforming economies, societies, and our lives. Mckinsey suggests that a confluence of advances in biological science and accelerating development of computing, automation, and artificial intelligence fueling a new wave of innovation. This Bio Revolution could have significant impact on economies and our lives, from health and agriculture to consumer goods, and energy and materials. We believe this is one of the best investment themes for the next decade. We like IONQ, KZIA, WST, CRL, RGEN, BDSX.
  
   

• AI is no match for the quirks of human intelligence. We may sometimes behave like computers, but more often, we are creative, irrational, and not always too bright.
  
   

• I’m a life coach, you’re a life coach: the rise of an unregulated industry. Fascinating piece in the Guardian charting the rapid rise of an unregulated industry at a time when the demand for mental health services is outpacing supply. Operating in the murky realm of “empowerment”, where personal development and financial success blur together, Life coaching Schools are having their moment yet are they empowering their largely female client base with the tools and support they need? Or selling them an unattainable fantasy?

• No One Cares! Our fears about what other people think of us are overblown and rarely worth fretting over. Arthur C. Brooks for the Atlantic suggests that we are wired to care about what others think of us. As the Roman Stoic philosopher Marcus Aurelius observed almost 2,000 years ago, “We all love ourselves more than other people, but care more about their opinion than our own,” whether they are friends, strangers, or enemies. This tendency may be natural, but it can drive us around the bend if we let it. If we were perfectly logical beings, we would understand that our fears about what other people think are overblown and rarely worth fretting over. But many of us have been indulging this bad habit for as long as we can remember, so we need to take deliberate steps to change our minds.
  

• The metaverse will mostly be for work. Stanford professor Jeremy Bailenson has been thinking about virtual reality and the metaverse for decades. As of 2020, he even teaches in it (more on that in a moment). For all of the chatter from Facebook/Meta, Nvidia, and other companies about building the metaverse, though, he thinks the metaverse will be mostly empty. That is to say, there won’t necessarily be a lot of things to do in this immersive version of the internet.

• Unions are on the rise, but so are the robots. U.S. manufacturers hired 60,000 people in October, double economists’ estimates and the most since June of last year. It was a robust showing, led by automakers. But payrolls in the sector are still down by almost 300,000 since the end of 2019, even as many large industrial companies are reporting sales above pre-pandemic levels. Last month’s recruitment success will only make a modest dent in the nearly 900,000 open manufacturing positions as of the end of August. The tight labor market has created a moment for unions: Deere & Co. workers this week felt so confident in their value to the company that they voted down a revised contract proposal that included substantial wage increases and enhanced retirement benefits. It’s also creating a moment for robots.

Our best wishes for a month filled with joy 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

Laugh Now Cry Later

Image Source: From Drake's Laugh Now Cry Later music video, 2020.Courtesy of UMG / Republic / OVO

Good Morning,
 

Stocks rose on Friday, lifted by strong U.S. economic data, to end a week that saw the broader market reach a record level. 

The bull market was strong before the virus and it has now regained its stride. This week's price action confirmed that. A 55% move off the lows in five months is the quickest and strongest recovery after a BEAR market low. The comeback rally appears to be the beginning of a new bull market. 

On Friday the Nasdaq hit its 35th new high in 2020 while the S&P recorded its 15th high with a close at 3,397. Both of those indices posted their fourth straight week of gains. The Dow 30 and the Dow Transports were both unchanged on the week, while the small caps as measured by the Russell 2000 fell 1.5%. 

This week, concerns over a new coronavirus stimulus bill kept the market’s gains in check as party representatives appeared unable to come to an agreement on the terms of a package. 

Washington continues to bicker while markets hit fresh record highs as we experience the strongest start to any month of August in 20 years. 

What to make of the haters who are still singing the “too much complacency” / “a total disconnect from the real economy” / “only a handful of stocks are rising” tune?

Our Take
 

Below I will get into why we, as investors, are predisposed to looking out for dangers that may upset our investment plans, but first I want to point out what is being lost in neverending gloom and doom of the popular financial media. 

For those who wonder why we are hitting new highs or who fear that the risk-reward is most certainly now skewed to the downside I would recall the following FACTS:

-Retail Sales hit a record high last week, and now Housing Starts and Building Permits are back to pre-pandemic levels.

-Airline passenger traffic has continued to improve off its lows from April, and the seven-day average traffic is the strongest since March 22nd.

-Adjusted for seasonal factors, the IHS Markit Flash U.S. Composite PMI Output Index posted 54.7 in August, up from 50.3 at the start of the third quarter, and signaled a strong increase in output (18-month high). Moreover, it marked the sharpest upturn in private sector business activity since February 2019.

-U.S. Services Business Activity Index at 54.8 (50.0 in July). 17-month high.

-U.S. Manufacturing PMI at 53.6 (50.9 in July). 19-month high.

-U.S. Manufacturing Output Index at 53.9 (51.7 in July). 19-month high.

Siân Jones, Economist at IHS Markit noted a strong expansion in U.S. private sector output in August:

"August data pointed to a further improvement in business conditions across the private sector as client demand picked up among both manufacturers and service providers. Notably, the renewed increase in sales among service sector firms was welcome news following five months of declines."

"Encouragingly, firms signalled an accelerated rise in hiring, as greater new business inflows led to increased pressure on capacity. Some also mentioned that time taken to establish safe businesses practices had now allowed them to expand their workforce numbers."

"However, expectations regarding output over the coming year dipped slightly from July due to uncertainty stemming from the pandemic and the upcoming election. Meanwhile, cost burdens surged higher amid reports of greater raw material prices. Although manufacturers increased their selling prices at a faster rate to help compensate, service sector firms noted that competitive pressures and discounting to attract customers had stymied their overall pricing power."
 

Furthermore when we move from the macro backdrop to the company level we see similar green shoots: 

-We continue to see extremely strong beat rates, especially for bottom-line EPS numbers. Overall, 82% of companies have reported earnings better than expected with an aggregate earnings surprise of ~22%.

-Forward guidance continues to be as positive as investors have ever seen it, but not many analysts are talking about it. 

Today, the haters state that technology stocks are in a new bubble, but the data may suggest otherwise. When compared to other sectors,  the Technology sector easily has the strongest EPS beat rate this season at 87%. Industrials, Consumer Staples, and Materials have the next strongest beat rates, while Energy and Real Estate have the weakest beat rates in the 50s. Do these numbers suggest that the market is irrational?

What of the claim that technology is doing ALL of the heavy lifting and this can’t go on? Is this even accurate? 

This may sound hard to believe, but the Technology sector ETF is just the sixth best performing sector in the third quarter and underperforming the S&P 500.

Industrials, Consumer Discretionary, Materials, and Communication Services are all posting double-digit percentage gains this quarter. With Consumer staples posting a 9+% gain, that is also higher than the 8.8% gain for the Technology sector in Q3.

The S&P is also up 9+% for the quarter. Let's not forget that Small Cap Growth, Small Cap Value, and Mid Cap value are also posting double-digit percentage gains in Q3 as well…

What about the general claim that the market is overpriced? The S&P 500 is trading at 10% above its 200-day moving average, similar to where it traded in February and at other previous market highs so there isn’t much new to see here yet what of the claim that the market is overvalued?

This appears to be a popular opinion as cash on the sidelines continues to to hit record highs. The double dip narrative appears to be gaining steam with every new fresh record high. Are stocks overvalued? The following tweet offers some insight:

Barry’s tweet is a reminder that classic “quick and dirty” valuation tools such as PE multiple should be relied upon with caution. What “expert” truly has any idea how high the PE multiple should be with an unlimited level of monetary stimulus and backstop of credit from the Fed? What investor has been here before? 

At minimum, it isn’t unreasonable to assume that the multiple should NOT be in line with historical norms. Therefore, the overvaluation “models” many investors and classical “value investors” cling to simply cannot hold the same weight they did with the 10-year Treasury at 0.68% when the historical norm is well above 5.0% (see Morgan Housel’s article below on Expiring Skills vs. Permanent Skills).

In fact, Kai Wu of Sparkline capital has put together an interesting research report which suggests that classical “value investing” has a long and distinguished pedigree but is currently in a deep thirteen-year drawdown as its “models” have rotated such investors into a massive losing bet against technological disruption. 
 

This is not the time for dogma. The old playbooks should at minimum be questioned. More than ever before, espousing a flexible approach is required. Inspiration from the old and appreciation for the new is a must as the “New” economy becomes THE economy.  

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Musings

I recently heard Drake’s new hit single “Laugh Now Cry Later,” on which Drake and Lil Durk rap about the high-life they live hoping to live in the moment and deal with pain and troubles later. As usual, Drake has aptly captured the spirit of the moment at a time when it appears that governments and central banks around the world are engaging in ever increasing monetary and fiscal stimulus that favors immediate pleasure, pushing pain and troubles to some future date for some future generation. 

The deficit spending for the U.S. is over $3 trillion so far this year and for Canada, close to $75 billion. While the costs are clear, the benefits are less so. Financial relief for millions of Americans and Canadians furloughed or unemployed has certainly been a short-term humanitarian gift but what about the future? 

As both governments in the USA and Canada look to additional government spending they must acknowledge the fact that monetary and fiscal spending have not generated ​significant growth ​over the past decade. 

As Michael Farr suggests, “our current efforts continue to make the same mistakes.  There are two primary mistakes: one, while surges of liquidity can stave off economic collapse​, and provide needed relief, they have little ability to stimulate ​sustained growth.  When growth doesn’t come, policy makers add more stimulus.  Two, cheap money has increased supply and done little to increase demand.”

The injections over the past ten years of QE haven’t created any multiplier effect. A trillion dollar injection results in a one-time trillion dollar surge and another trillion in debt because the U.S. doesn’t have an extra trillion lying around somewhere (the USA hasn’t run a surplus since the 1990s). 

Instead, the dollars should be funnelled to things that will grow and create jobs and increase over time. In short, there needs to be a clear ROI on future spending beyond the payment of another month’s rent or mortgage. This is the kind of investment that successful private industry and individuals would make. 

Unfortunately, policy makers have chosen to continue on a kind of willfully blind panglossian adventure in which they take the recipients of stimulus to an amusement park only to have them return to their same old same old. While at the park they feel pretty good. They temporarily forget their struggles and pain as they live the highlife only to return out another trillion in cash. When the high fades, a weak business pre-pandemic is still a weak business, a poor/precarious skill set/job is still a poor/precarious skill set/job. 

Instead, policy makers will need to have the courage to confront the harsh realities of this “Laugh Now Cry Later” economy. The rapid adoption of remote work and automation is accelerating inequalities which were in place well before the pandemic. The resulting ‘K’ shaped recovery has been and will continue to be good for professionals with the right skills who are largely back to work, with stock portfolios approaching new highs—and bad for everyone else.

The stimulus dollars as they are currently being deployed are not addressing this reality. Over the past ten years to today, the economy has no longer been creating steady jobs for low-skilled, low-wage workers as fast as it once was. Things will not go back to the way they were. No amount of protectionism or taxation of the hyper-rich will make it so. 

Alternatively, if policy makers are to have a chance at stimulating the kind of sustained growth we need, they will need to acknowledge that not all skills, jobs and businesses are created equal. Certain uses of capital and certain skills have higher ROIs than others. 

They will need to be more discerning capital allocators if they wish to stimulate a generation of producers, earners, consumers, tax payers, creative innovators and problem solvers that would better the future for generations to come. 

Sadly, looking at the sorry state of the current political discourse, such courage appears to be in short supply. 

After all, perhaps given how uncertain the future now looks and how much harder it will be for most to make a buck, many may be satisfied with what they can get. Even if it’s just a free trip to Wonderland…

Charts of the Month

After slowing to a trickle in March, public listings roared back and are now on pace to reach their highest levels since the peak of the dot-com boom in 2000.

Robot subsidy: Payroll and related taxes have held steady over the past 40 years, but the effective tax rate on automation has fallen. Translation: Economists argue we are now subsidizing the replacement of humans with robots, even when robots aren't as productive.  

Logos LP July 2020 Performance

 
July 2020 Return: 4.77%
 

2020 YTD (July) Return: 51.44%
 

Trailing Twelve Month Return: 59.30%
 

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: +21.91%
 

Thought of the Month

"“The worst loneliness is to not be comfortable with yourself.”– Mark Twain

Articles and Ideas of Interest

 

• Even a global pandemic can’t slow the US IPO market down. After slowing to a trickle in March, public listings roared back and are now on pace to reach their highest levels since the peak of the dot-com boom in 2000.

• After tapping the bond market at a record-shattering pace in recent months, Corporate America is more indebted today than ever before. And while much of that fresh cash -- more than $1.6 trillion in total -- helped scores of companies stay afloat during the pandemic lockdown, it now threatens to curb an economic recovery that was already showing signs of sputtering. Many companies will have to divert even more cash to repaying these obligations at the same time that their profits sink, leaving them with less to spend on expanding payrolls or upgrading facilities in months ahead. Leverage ratios have never been higher for U.S. companies.

• Scientists discover a major lasting benefit of growing up outside the city. As the recession is predicted to slam cities and many rush to leave them, the data seems to support the move. Using data from 3,585 people collected across four cities in Europe, scientists from the Barcelona Institute for Global Health (also called IS Global) report a strong relationship between growing up away from the natural world and mental health in adulthood. Overall, they found a strong correlation between low exposure to nature during childhood and higher levels of of nervousness and feelings of depression in adulthood. Co-author Mark Nieuwenhuijsen, Ph.D., director of IS Global’s urban planning, environment and health initiative, tells Inverse that the relationship between nature and mental health remained strong, even when he adjusted for confounding factors.

• What if we could live for a million years? Past generations used to say that even though we cannot postpone natural death, we can control how we live. They also believed that there is “nothing new under the sun.” Both statements are inaccurate from our current perspective. With advances in bioscience and technology, one can imagine a post-COVID-19 future when most diseases are cured and our life span will increase substantially. If that happens, how would our goals change, and how would this shape our lives? Fascinating article in the Scientific American outlining what a post-death world could look like.

• Is inflation really what we should be worrying about? With many pundits pushing gold as their investment of choice, deflation remains the bigger danger from the collapse in global demand, rather than a surge in inflation.

• Delisting Chinese Firms: A cure likely worse than the disease. Interesting article by Jesse Friend suggesting that if the proposed legislation becomes law, its cure could be worse than the disease. Both Chinese controlling shareholders and the Chinese government are likely to exploit such a trading ban to further their own objectives, at the expense of Americans holding shares in these firms.

• The unstoppable Damian Lillard is the NBA superstar we deserve. He’s lifted his game to new heights inside the NBA bubble, but what sets the Trail Blazers’ point guard apart is the fierce loyalty and outsider spirit that’s driven him from the start. His unwillingness to run from “the Grind” is an inspiration.

• The unravelling of America. Interesting perspective (albeit a bit depressing) on America by anthropologist Wade Davis in the Rolling Stone in which he suggests that COVID has reduced to tatters the illusion of American exceptionalism. At the height of the crisis, with more than 2,000 dying each day, Americans found themselves members of a failed state, ruled by a dysfunctional and incompetent government largely responsible for death rates that added a tragic coda to America’s claim to supremacy in the world. Using compelling data and the historical context of other great empires, he paints a picture of a country in decline. Nothing lasts forever - perhaps America’s best days are behind it?

• Expiring vs. Permanent Skills.  Morgan Housel knocks it out of the park with this one in which he explains that every field has two kinds of skills: Expiring skills, which are vital at a given time but prone to diminishing as technology improves and a field evolves. Permanent skills, which were as essential 100 years ago as they are today, and will still be 100 years from now. Both are important. But they’re treated differently. Expiring skills tend to get more attention. They’re more likely to be the cool new thing, and a key driver of an industry’s short-term performance. They’re what employers value and employees flaunt. Permanent skills are different. They’ve been around a long time, which makes them look stale and basic. They can be hard to define and quantify, which gives the impression of fortune-cookie wisdom vs. a hard skill. But permanent skills compound over time, which gives them quiet importance. Morgan provides an excellent list of certain key permanent skills applicable to many fields.

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

Logos LP