"Margin of Safety" Investment Stack

The three most important words for investing are "margin of safety." Benjamin Graham, who coined this phrase was essentially focused on the investment itself. For example, he liked an stock investment which cost less than the actual net cash of the underlying investment. This "tangible" value approach to investing was a way to preserve value through such disruptions as the Great Depression. Since then, the world has evolved away from "tangibles" to "intangibles" but the underlying principle has not changed.

Yet within investing there are several layers which create an "investment stack." The investment stack at the most fundamental is the business itself. There are a wide variety of estimating the the values, but the principle is to pay less than the value of the investment by a "margin of safety." In today's world, this is increasingly difficult and requires some conviction about the ability for rates to stay lower for longer.

The next level within the investment stack is at the portfolio level. This involves an asset class decision, such as an appropriate amount of cash, bonds and stocks. At this level, the portfolio has to exhibit a "margin of safety" so that the volatility of the portfolio performs adequately against required draw rates.

The final level within the investment stack is at the investor level. The investor is likely to experience changed requirements, such as those related to healthcare or other issues, as well as psychological issues during periods of extreme duress. If an investor is likely to get caught up in larger societal reactivity, the investor needs a "margin of safety" to address this. Reason does not win when faced with the overwhelming power of emotions. Here Socrates gave the two most important words "know thyself." 

When a "margin of safety" is the principle of construction at each level of the stack, the investment process is likely to be enjoyable as well as profitable.

India's Economy Buried by Gold?

For years, I have wondered how India has been the home of spiritual, material, aesthetic and architectural highs (not to mention gorgeous women) but managed to evidence such extreme poverty. When I asked about it growing up, my rural Midwestern community's answer was "they don't eat their cattle." Another great example of our frame of reference driving perceptions. More recently, many of the public traded companies that I follow are lead by Indians. And it's not just leadership as apparently per capita income exceeds any other identifiable American group. So what in going on?

Later, I was reading a book on the history of India. The historian discussed a common perception from the Roman writings. India was already the go-to place for fabrics, art, jewelry, building materials and all things man-made. However, the Romans found that the Indians desired nothing but gold in return. Indians could care less about weaponry, swords and shields - only gold did the trading trick.

In reading BRK's 2011 annual report, a light went on. It states "Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond."

It's sad to think about. Indians have tied their national wealth up with an inert object rather than focus on productive assets. The tragic result is that gold is the likely cause for poverty in India as gold ownership really became a form of high social consumption (for dowries etc) rather than capital as an investment for productivity and employment. 

Big Tech is really Digital Real Estate

I have gone to Aspen Colorado for over 25 years. It's a lovely place with beautiful scenery, mild winds and attractive infrastructure. The buildings are from the Silver Boom in the late 19th century and provide a wonderful Western flair. As a coffee junkie, I initially fell in love with a shop called Zele. Soon enough, I found what happens with many shops. The business was so successful that the owner of the real estate kicked them out and put in one of their own. It turns out that this phenomenon has a name: wholesale transfer pricing.

Wholesale transfer pricing is the bargaining power of company A that supplies a unique product XYZ to Company B which may enable company A to take the profits of company B by increasing the wholesale price of XYZ. In this case, the Aspen real estate owner supplied Zele with a perfect location that ultimately the real estate owner could take by either jacking up rents or kicking out the business. Nothing evil here, but it's a crushing dynamic if you're on the wrong end.

As current suits stack up against Google, Facebook, Apple and Microsoft, it just reminds me of the Aspen Zele dynamic. These Big Tech companies have simply created and own the critical real estate. Businesses can come in and build very successful businesses on top of that real estate, but to quote the labor union at UPS, Big Tech can simply say to those businesses "you make more, we take more." Rules of the road. The critical part is not to be invested to heavily that relies on another company with such bargaining power.

Value Redefined?

Historically, a "value" manager was in a category that adhered to a numerical basis for the valuation of an investment. This process was typically balance sheet-driven in which assets were purchased for less than their valuation. The positive estimate between the value received and the price paid constituted a "margin of safety." The results were driven by downside protection and some percentage of upside capture.

In contrast, a "growth" manager was in a category that followed structural disciplines in which indicators of growth were identified. This indicators might vary from gaining market share from cost or disruptive technology all the way to simply price movements. The results were driven by capturing the gains of expansion followed by a quick exit if any signs of maturity or decline set in.

Seasonally, value and growth managers alternated leadership with the best in each category generating superior results to market averages. However, for the past ten years (excepting the past two quarters), "growth" has trounced "value." While many pundits argue for a "reversion to the mean," I think that something else may be at work. 

Generally speaking, an investment does well if there is scarcity of supply relative to demand. After the vigorous efforts to restore markets damaged by the Great Recession of 2008-9, capital became abundant. Rates were low. This trend accelerated during the Great Infection of 2020. With government fiscal spending and central bank monetary support strongly committed, this abundance of capital could thwart the "reversion to the mean" thesis.

Business cycles are characterized by cycles in profits. When profits sink, unproductive assets drop in value, capacity is closed and capital is withdrawn. Later when profits recover, capital flows back into assets, capacity is expanded and assets increase in value. Critical to this cycle is scarcity of capital. If capital is abundant, then as profits drop, capital is not withdrawn and capacity is not closed, but instead continues to compete at lower levels of profitability. As a result of capital abundance, industries may experience prolonged competition and a decreased ability to cyclically get to "the good old days."

If this is so, then "value" managers may still capture results numerically, but need to focus on income statement items in which reasonable assumptions of growth are secured by some durable competitive advantage. Durable competitive advantages offset the impact of capital abundance. By discounting future earnings of such companies at today's lowered rates, value managers may discover a "margin of safety" through growing earnings rather than recovering assets. Such an approach may not yield the same combination of downside protection and upside capture, but it may generate superior results due to owning assets less subject to commoditization.

The Eyes of the Market

The eyes of the market are focused on inflation. This is appropriate, given that a sustainable dynamic of inflation would completely change the current dynamics of our economy. The reasoning is simple. If the Federal Reserve removed inflation under Paul Volker's leadership in the early 80s by tightening rates and shrinking the Fed's balance sheet, why wouldn't the opposite actions do the opposite? With the Fed's balance sheet ballooning to nearly $8 trillion shouldn't we be concerned that a view of benign inflation is simply a form of "fighting the Fed"?

This reasoning process is sound but fails to take into account the asymmetrical impact that Fed support has. This impact has been called "pushing on a string," articulating the powerful nature of a string to restrain but its limitations to support. Fed policy is difficult to disentangle from the other powerful force of fiscal policy. To use a model of disentangling, look at the current situation in Europe.

The ECB’s benchmark deposit rate sits at minus 50 basis points, with the seventh anniversary of sub-zero borrowing costs coming up next month, while total assets on the ECB balance sheet were €7.6 trillion ($9.3 trillion) as of last week, equivalent to 57% of pre-pandemic nominal GDP in 2019.  That compares to $7.9 trillion in assets held by the Federal Reserve, equivalent to 37% of 2019 output. Here is a situation of more significant central bank support that is not muddied by the aggressive fiscal stimulus in the US.

Of course, inflation could rise on a sustainable level, but the Fed's role will not be key. The Fed's actions have provided liquidity to the markets as well as a valuation lift. Every asset owner has received a "stimulus check" in the form of this support. Clearly the Fed will withdraw this support at a future date, but not until other forces have successfully driven sustainable inflation. So far those forces seem temporary.

Ignorance as Value-Added

John Bogle described the biggest cost of investing - an investor's reactivity causing selling at lows and buying at highs. This cost is well over 2% per year - a cost that towers over other investment costs. Is there a way to avoid these costs? Apparently so.

Large institutional investors have often proved themselves the worst in terms of reactivity, confirming Warren Buffett's comment that an IQ of over 120 is a wasted asset in investing. These large scale investors have been pouring money into private equity and venture capital. When zombie funds and survivorship bias and cash flow returns are calculated appropriately, private equity and venture capital returns do not exceed those of public markets. So what's the benefit?

Ask any money manager if she or he would be happy to pay for a statement that would revalue assets no more than one time a year and they would gladly sign up. Client investors read statements and invariably react the opposite of their best interest - inclined to buy high and sell low. Perhaps a product could be created that would allow static valuations of the portfolio with a liquidity option. The latest example of ignorance bearing fruit? SPACs.

Super Powers: Inevitable Conflict for AAFG?

Headlines about regulations affecting the business models of Amazon, Apple, Facebook and Google (AAFG) do not really concern me. History is devoid of government intervention truly damaging the fortunes of a successful business enterprise. The fall of a company like IBM was not fundamentally affected by the government's breaking it into smaller components. Rather, it was the company's focus on hardware rather than software. Companies are damaged either by their own arrogance or the innovations of others.

As the radio station owner declares in Brother where art thou, "Competition is bad for business," the challenges for great businesses often lie in competition. As a result, businesses spend great energies maintaining their positioning and thwarting the efforts of others. The laws around anti-trust are designed to prohibit activities that hurt competition and, thus, negatively affect consumers. The result is a set of laws designed with a standard of damage to consumers.

Today's monopolists have no problem with this standards. In fact, scale and aggregation of supply and demand allow for an increase in the quality of the product for consumers. In the past, oil companies like Standard Oil or phone companies like AT&T were broken up because the increased fragmentation led to lower pricing and thus increased benefits for consumers. But in the frictionless world of the internet, this structure is turned upside down as the consumers benefit at the expense of intermediaries and suppliers. If consumers are not hurt, should a restructuring occur?

Twenty years ago, the same issue came up for the explosive retailing force of Walmart. Competitors and labor unions complained about shutting down small towns as well as low wages. However, no real action occurred because the benefit to the consumers was compelling as Walmart increased the purchasing power of low and middle income Americans who were already struggling with the wage impact of globalization. Of course, Walmart was not welcome into major cities, but wealthier consumers were not Walmart's natural target. 

Today AAFG face the same issue. The services provided by each company are continuously increasing in quality and or appeal. In the case of Facebook and Google, the services are free. For that reason, antitrust issues will be difficult to apply in any way that does not simply further entrench them. In addition, taxes to supply "neutral" news services can be applied, but again this does not disrupt. So I spend my nights thinking about what could.

Lately I've been reflecting on the dominance that England, France and Germany had in the late nineteenth century. The three together dominated in science, math, industry, travel, leisure and on about any other standard relative to the rest of the world.  Yet, they managed to take the next fifty years completely self-destructing from a fear that somehow each would be displaced by the others. Each country, like the AAFG companies, brought unique cultural and structural advantages, but were not content to exploit those. Fear brought them to attempt the destruction of the others, only to destroy themselves.

As I read about the various attempts of each of the AAFG to outcompete the others, I watch closely for signs that might resemble early 1914 when the superpowers of that time thought their conflicts would be brief and insignificant. The current challenges of once almighty Intel are a lesson in the rapidity of a downfall.