Quarterly Report 3Q2021

Sidestepping the nominal asset trap, part I

Unprecedented programs of money creation by the world’s major central banks have been in place starting with the US subprime crisis in 2007/8. One unintended effect, we believe, has been a somewhat confused picture among traders and investors about what constitutes those equity investments that represent enduring value and others that largely move up or down in price based on the hunches, moods and whims of the market. For simplicity, the former category we would call “real assets” and the latter “nominal assets.”

It should come as no surprise that, ideally, our aim is to have the fund’s portfolio positioned with a minimum in “nominal” assets and a maximum in “real” ones. We will begin with what types of equities we want to avoid for the fund, deferring the discussion of our preferred assets on the “real vs. nominal” scale separately to a future installment of this letter.

First, it should be evident that we try to minimize cash holdings and money market instruments, whether in the form of “hard” or “soft” fiat currencies, as they render a negative yield given the current short-term interest rates available. Needlessly to say, we won’t even consider novel ways to hold liquidity such as virtual currencies; in our view, they also exhibit “nominal” rather than “real” qualities. Fortunately, we are in a comfortable position to hold a fully invested portfolio given the abundant and excellent opportunities available in inexpensive equities embodying “real asset” characteristics.

Second, we believe that equities treated with fixed-income characteristics by the market—the so-called “bond-proxies” (e.g., stable, steadily growing “blue-chip” consumer staple, health care and high-tech companies)—in general don’t provide good value at present as their future earnings streams are currently being discounted by the market at unduly low hurdle rates.

Third, we are very cautious towards firms with much of their implicit value tied up in goodwill in the form of acquisition premia, brand names and other hard-to-assess accounting items. Takeover premia, for their part, become ever more elevated given the cheap financing sources available. These “book values” will have to be amortized over time or eventually written down if they fail obligatory impairment tests at future measurement dates. As far as brand values are concerned, they are oftentimes overhyped by company managements and investment analysts alike. Hence, especially in times of abundant liquidity, they tend to become overpriced by the markets.

Fourth, with cheap money abound it has always been the case that too many firms with decidedly shallow long-term business cases have gone public, some featuring not much more than a catchy story or concept, taking advantage of trendy and fashionable yet unproven ideas built on shaky competitive foundations. In fact, the recent boom in special purpose acquisition companies (SPACs) goes yet a step further and symbolizes the point. Their sponsors are able to raise money upfront merely in the form of empty vehicles with the implicit promise to place the proceeds in a hopefully successful business venture afterwards.

And fifth, we also detect pockets of unattractive valuations attributed to firms benefitting from excessively cheap terms for the consumer to finance them (e.g., residential real estate in popular locations, luxury goods and even art and collectibles). Here, by the way, we can see that the issue of “real” vs. “nominal” for us goes beyond favoring “tangibles” over “intangibles;” even hard assets can become significantly overvalued when monetary policies are heavily accommodative over extended periods of time.

We cannot predict what consequences the prolonged ultra-loose monetary conditions will eventually have for the global economy. However, what we can do is to stay alert and prepare for a future where again a fair and proper price will have to be paid for money that adequately reflects real, inflation-adjusted conditions.

Sincerely,