3-8-21

None of the following is investment advice. In fact, most of the following is postulation, even more so than normal.

Parallels can be drawn in many ways from Picasso’s Guernica (1937) to today. Chaos, panic, and misfortune directly traceable to government policy. Unlike 1937 Spain, our burgeoning civil war is without weaponry.

This memo discusses our current market state. While many indicators are flashing warning signs, many others are flashing optimism, and knowing which indicators (or intuitions) to abide may mean you can avoid an ending demonstrated by La Guernica (image above). Markets have become increasingly inefficient with the cresting emotion of today – conviction is an investor’s sanctuary. Thankfully, as Twain used to say, “History doesn’t repeat, but it rhymes.” History can teach us much about how to both discover inefficiency and capitalize on it. Please excuse my misanthropy.

To begin, capitalism and its most successful members are unrepentant. Capitalists dogmatically claim that markets are efficient and passive investing is the only way to invest, while curiously we have come to find out that they represent the majority of market participation. This is reference to Ken Griffin, whose firms clear roughly 40% of all US stock market orders alone, and to Jim Simons, who created a market beating algorithm whose derivatives now are responsible for over 90% of all US stock trades. When confronted by such statistics, you not only question efficiency hypotheses, but condemn that they are ever spoken of.

Endless evidence of capitalism abounds, such as a post in January by another prolific capitalist, Chamath Palihapitiya.

“In 2020, I invested $370M of my money in a handful of new positions. As of 12/31 these new investments were worth $2.03B for an IRR of 393% and a MOIC of 5.2X”

Chamath comes across as someone you’ll want to listen to. He’s calm, he’s full of contrarian ideas, he interned in Silicon Valley, and he’s been very successful. In other words, he sells himself extremely well to a crowd of customers.

“Customers” in capitalism are the ones that lose out on trades. Ironically, Chamath’s brazen post was received in adulation by the retail population, exactly who were, are, and will be, on the other side of Chamath’s trades. “Like selling salt to a slug”, the vast majority of his returns likely derived from SPAC formations, where he could turn 1000%+ profits easily with a willing customer base. Capitalism is unrepentant

Hard questions of the moment –

• When will those customers realize they are losing so badly and things begin to resemble La Guernica?
• Will they end up blaming themselves, or blame capitalists*?
• Will leverage destroy 25% of market participants (i.e. retail investors) in a vicious cycle?

*My belief is that people need to become passionate about winning on their own. This is the ultimate theory of capitalism – competitive forces…

With the 10 year treasury rate at 1.60%, we can be relatively sure that all these SPACs and high-flying tech stocks will drop significantly from where they are today. Such indigestion may result in a simple burp, or it could lead to Endoscopic surgery (yield curve control). 1.6% is probably not a sustainable interest rate for today’s economy, meaning participants are worried. Yet another hard question leaving us looking through history for an answer.

How about watching The Matrix instead?

Let’s give those people two pills, one red and one blue. Take the red pill and interest rates keep rising and the US becomes another Weimar Republic (1930’s Germany), the US Dollar dies and a modern version of the Third Reich takes power.

Take the blue pill and you have faith that the US government can and will rescue the economy from that fate, just as they have for centuries. Here, many readers should consider Warren Buffett’s timeless axiom – “Never bet against America”.

So, you can speculate on either one of these events. You can speculate (as the market currently seems to be) that rates will continue to rise, or that America will survive. Current narratives display two extremes, meaning that markets are extremely inefficient at this moment in time.

The case is substantial that when main street markets open up, input costs will be sky high – will college graduates ever be able to buy a home again on wages from yesteryear? Standards of Living, just as in Weimar, have skyrocketed already. This will probably get worse. Infrastructure legislation will help – will the government be forced employ more people as a percentage of total workers?

My theory is that we will not become a new-age Weimar. Addressing World War 1 debts that had accrued required no hard work or increase in Real GDP, only papering over that debt with new debt. Of course, that sounds exactly like what America has done for the past 13 years… but one problem in Weimar was specifically that there was not enough demand for the German Mark to meet the newly created supply. The capacity wasn’t comparable to today’s dollar; Weimar did not have the world’s Reserve Currency. The US Dollar is used in 75% of global transactions as the World’s Reserve. Good enough for me. Supply probably will always be absorbed.

As I noted in previous memos, people are still depressed with everything going on and the wealth divide growing larger every day around the world. As T.S. Eliot said, “History is Now.” This is the time when we have borrowed so much from our futures, that the only way to continue building is to borrow even more. Simultaneously, the treasury yields indicate 4 interest rate hikes over the next three years. Can the government increase yields after 40 years of shamelessly borrowing from our future? Answer – yes, but not likely.

Elon Musk often says governments are giant corporations. By rising rates at the same time as increasing US Dollar supply by 70% in the last 12 months, we see a very confused board of directors. This is tantamount to selling a massive amount of debt in order to attract new investors by paying an unsustainable dividend. Why raise the dividend if we will only be raising debt every year to pay it out?

For these reasons, Treasury yields are probably too high. We need more debt to keep going forward, and higher interest rates discourage debt. And yet, I dislike how high standard of living costs have and will become.

If I’m correct, short term pain will manifest as participants internalize this. Playing this probability will require conviction to get through that pain period. “Diamond Hands” will quickly turn into “Paper Hands” for most. I certainly hope that this doesn’t happen, although I am prepared for such an event.

There aren’t places to escape the pain period, as rates might stay high and all asset classes will drop. In times like these, Rick Rieder (of Blackrock) says to buy income. To paraphrase Rick – buy risk when assets are cheap, buy income when assets are expensive. Thanks Rick.

The Big Short

History rhymes – today’s SPACs are 2007s MBS and 2000s dotcom IPOs. Ahh, the promises of a new way of doing things…. Exciting, functional for a brief time, but eternally doomed. Industries built around these products were and will probably be decimated, such as Momentum Investing (i.e. Cathie Wood’s Ark Funds), Bridge Lending, and of course, SPACs. These are all clandestine perpetuations of capitalism as well, a zero sum game. Winners and losers. Illustratively, only last week, Chamath sold 34% of his stake in SPCE (the original SPAC) for a gain of nearly $200 Million. Kudos to him.

Want another example of inefficiency? Great, let’s look at AeroGrow (AERO). In 2020, the majority shareholder (Scotts) strong-armed a takeover offer at a very low price, causing damages to minority shareholders. Legislation is underway currently.

Last month, the a contact involved in the case texted me, telling me to buy it. I looked it up and the situation was classic arbitrage. Basically, the merger would go through at $3 but the stock only traded at $3.06. Since the case is so clear, my contact and I agreed that the takeover should have been for no less than $6 based on fundamentals. Thus, the lawsuit seeks damages of around $3 per share for breach of fiduciary duties (I bought bathtubs full). All information was public.

So, hold the stock for two or three weeks, get your $3 at the completion of the merger, and become a part of the class action lawsuit. We think each share will fetch at least $1 in settlement, meaning that we paid $0.06 for $1, and maybe up to $3**.

This arbitrage is evidence that inefficiencies exist all over the place for people who care to look. Best thing about arbitrage, in particular, is that it isn’t cyclical, meaning that the inefficiency isn’t correlated with market forces.

**If you are a client of mine, you had a position in AERO and you can reasonably expect a settlement check in a year or so.

How do you take advantage of inefficiencies when you see them?

Warren Buffett also said, “I make no attempt to forecast the market- my efforts are devoted to finding undervalued securities.” This one quote speaks volumes about what all investors should be doing. Years ago, working at large companies, I was expected to be a salesman and the business was getting new assets in the door. This is an awful suggestion for society and is an unsustainable business practice. If you are in finance, you should dedicate yourself to becoming a more confident, competent investor on behalf of clients, because any other way you cut it, you will not be working in their best interests.

Spending all day growing conviction in businesses we own is a worthwhile task, and one that pays off for us. More people should do it. I realized after my corporate experiences that if you are better at owning assets and you improve recognition ability, that is so much more impactful than being a salesman or understanding the tax code or legal system.

Why not tax or legal professions?

• There are infinite assets public and private for investors, with any one of them able to mint a new millionaire in a relatively short period of time.
• Tax and legal systems are finite and rigid, without the creativity of owning assets. Creative ownership structures are an advantage of the savvy investor.
• The competition in owning assets is high, just as the competition in understanding tax and legal, but anyone can own assets – no certification required. And if you are good at it, you rise quicker than if you are good at tax planning or the legal system.
• It’s much easier to show a prospective investor your returns over 5 years than it is to illustrate tax/legal/insurance results. Results are much more concrete.
• Tax/legal isn’t scalable, since it all depends on the client’s situation. Asset ownership is scalable and capital is capital is capital, no matter who puts it up. Much less constrained, and often the only client is a pool of money (“fund”).

So inefficiencies exist in choosing a career, too.

Earlier, I described the market as capitulating between two extremes. If you can solve which extreme the market will move toward from here, you will need to have incredible conviction. Conviction is the skill that is acquired over decades of investing, and gets stronger because the intelligent investor is always gaining knowledge.

To re-emphasize Buffett’s quote, market forces shouldn’t deter an investor who has conviction. Buffett would take as long as a year to acquire a stake in a small cap company. Small caps outperform large caps very obviously.

• Market forces don’t affect small caps like large caps.
• It’s easier to move the needle when small.
• Large buys/sells of stock tend to move the market significantly, instantly creating buy or sell opportunities for current shareholders.
• ‘Pump and Dump’ schemes prey on investors without conviction, meaning that those investors are very likely to not know what they have. Where 10% drops are common, strong investors find upside inefficiencies, weak investors find downside inefficiencies.
• More likely to find arbitrage situations
• The list goes on

The resolution becomes that small cap going concerns will generally outperform large cap corporations. However, picking the right one is MUCH harder, and you could lose MUCH more money doing it. Because of all these tenets, small caps represent the ultimate inefficiencies. I have been researching small caps more and more each day, and I believe this year will be a great year to invest in them over large caps, which could experience pernicious market forces.

Importantly, if a small cap is obviously a great investment (i.e. one-foot hurdle), a large drop in price (which is VERY common) signals a great buying opportunity. In the event that low prices persist, leaving a bear market with a huge stake (>5%) of a small corporation for the rest of my life sounds like a dream come true for me.

In summary, things will probably advance higher over the next 12 months. Here, you read about inefficiencies that are due from market forces, arbitrage, and market caps. As noted, these inefficiencies are almost always uncorrelated. Knowing this should provide you with more conviction.

Beware SPACs like SPCE and Nikola…. These companies (and the promoters of them) are destroying the market. Such destruction cannot and will not continue. The operating losses they suffer will ultimately come out of taxpayers pockets as they suffer heavy losses over time. Stay the course on an investment strategy and search for great companies that will outperform in any market. Inefficiencies exist today in a magnitude at which has never existed. Best of luck.

On an unrelated note, Bitcoin seems to be receiving more corporate attention.