The Rational Cloning: Weekly Ideas #60
Elliott Management Letter on Inflation, Energy, Globalization, China, and More; Todd Combs Interview; Substacks/Blogs & Tweets That Make You Go… Hmm 🤔
Welcome to the 60th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Elliott Management Investor Letter
What we have been anticipating for some time is now here. It is the other side of
the bubble mountain: Serious inflation due to policy mistakes, interest rates rising
from their lows and stock and real estate prices falling from their Olympian
heights. While rallies are to be expected (financial markets do not usually trade in
straight lines), it does appear (and not only because stock prices are down
substantially year-to-date) that a period of real adversity is taking shapeSo far, the decline in stock prices is a matter of price-to-earnings ratios (and
multiples of EBITDA) shrinking. Corporate earnings have mostly held up, but they
may be close to degrading, perhaps significantly, in any version of the widely-
expected recession. A prolonged or deep recession would probably reduce inflation
substantially and at least temporarily relieve the pressure of the hiking cycle in
interest rates. But it could also be a dangerous development in a vastly over-
leveraged global financial system, causing significant credit issues and giving
central bankers and treasury officials an “excuse” for new rounds of inflationary
stimulus.Inflation
Consumer and producer inflation, in a long declining trend since the early 1980s,
kept bumping along at low levels (under 2% annually) post-GFC despite the
extraordinary amount of continuous monetary and fiscal stimulus, which lasted all
through the 2010s. This, along with new monetary theories, must have convinced
policymakers that inflation was dead for all time, and that the tool of Zero-Interest-
Rate Policy (ZIRP) and unlimited money printing (QE and the lot) would be a
fabulous all-purpose, all-the-time cure-all, devoid of negative consequences.Now the smug and absurdly confident smiles have been wiped off the faces of the
policymakers. Their attempts at self-reinforcing messaging (Transitory! Supply
Chains! Putin! Tapering! Inflation can be killed in 15 minutes!) have been
followed by the current tough-guy rhetoric (“We will do whatever it takes...”).
We don’t understand why investors and citizens have not completely lost
confidence in policymakers and the gobs of money that they print willy-nilly, but
maybe it is just a matter of time. What is true is that (i) these policymakers do not
know much about the nature and causes of inflation, (ii) they will likely not have
the staying power to crush it, (iii) it is likely to come down sharply only in a
recession, and (iv) during the recession central bankers and treasury officials are
likely to go right back to their ZIRP/NIRP/QE playbook, together with massive
over-spending.As one final example, policymakers state their determination to tame inflation, but
QE has not truly reversed. Mortgages on central-bank balance sheets are not being
sold. They are raising interest rates like crazy, and the natural way for inflation to
go from 10% to 2% is through a serious recession. There is still $30 trillion on
central banks’ balance sheets. So what happens when the recession is in full force?
Do the central bank balance sheets go to $50 trillion?
The world is on the path to hyperinflation, which is the direct route to global
societal collapse and civil or international strife. It is not baked, but that is the path
that we are treading. Uplifting, right?Energy
It seems to have only recently become apparent to leaders of the Western
democracies that replacing hydrocarbons — which supply ~85% of the most
important input into the global economic system — with something greener was
not going to happen overnight, and maybe not going to happen at all, or at least not
anytime soon.“Sustainable energy,” the favored choice of developed countries, is much more
costly than its supporters claim, for two principal reasons. The first is that the
advertised cost ignores the necessary reserve infrastructure that is required to
produce “all the time” power in a world in which intermittent energy sources (solar
and wind, even supported by batteries that do not yet exist at scale) are preferred.
The second is that a significant increase in solar and wind from their current ~5%
share of global energy will put tremendous pressure on the supply (and price of the
supply) of materials that are essential in the production of solar and wind.
In a steep recession, we can expect that oil, gas and coal prices will decrease. But
currently, policies that suppress supply and enhance demand are enabling people to
ignore price signals. Market-based prices ration consumption (demand) much more
efficiently than money printing and price controls.Instead of increasing the supply of energy from all sources, governments around
the world are writing checks and printing money to mask the high prices of solar,
wind and hydrocarbons and to avoid making unpopular decisions to encourage and
facilitate oil, gas and coal production. It is true that some policymakers are
thinking more fondly of nuclear energy these days, translating into a combination
of keeping existing facilities open and initiating new projects, but the lead-time on
new nuclear projects is long.Globalization
Over decades, globalization lowered prices, increased efficiency, enhanced global
growth and was widely considered a win-win for rich and poor countries alike. De-
globalization is the reversal of those elements, driven by the physical supply chain
issues unleashed by COVID-19 as well as the realization that countries which
control important products, metals, minerals, and elements may not be reliably
“friendly” toward the U.S. or other developed countries. Rather, they may actually
be adversaries or enemies, and the low prices and reliable supply from such
countries come with serious and possibly unaffordable costs, which may not only
be measured in money.All of these factors go under the heading of sudden realizations. Obliviousness in
these matters is yesterday’s newspaper. Realism is advancing. But make no
mistake: De-globalization is inflationary and growth-suppressive. This direction of
travel is not reversing back to “normal” any time soon, if ever.China
We do not know quite what to make of the fact that China has experienced the
world’s greatest real estate boom and has the world’s largest pile of bank loans,
including the largest ratio of bank loans to GDP. Nobody knows how this
combination will work out, but the size of it all beggars belief. On the numbers, a
severe economic downturn in China would seem to be a likely occurrence, rather
than a fleeting possibility. However, we are reticent to make such a prediction
because for decades, outsiders have been predicting a crash in China, or at least in
China’s real estate sector, and these predictions have yet to pan out.The dollar
For decades, the U.S. dollar has been said to be “cruising for a bruising,” the U.S.
being ground zero for financial excess. However, currencies are “graded on a
curve,” and “Depreciation against what?” was always a good question. Given the
military incapability of Europe, even as a serious war threatens the continent,
together with the refusal of a number of countries to develop their own energy
resources (even though the U.S. is not optimizing its own energy resources), is
there any “safe haven” other than the U.S. and U.S. assets? Apparently, many around the world believe the answer to that question is “no.Lately, the dollar has risen rapidly against practically everything else. This
dynamic enhances the “safe-haven” status of the dollar and the desire of companies
and countries to settle deals in dollars. It also creates a deflationary bias in America
(and a commensurate inflationary impulse elsewhere). Yet, just as the dollar
strengthened quickly to a value that may or may not be “appropriate,” the dollar
could easily quickly weaken should global feelings of what is “appropriate” adjust.
This would be inflationary in the U.S. and no doubt appreciated by countries
buying key goods denominated in dollars; however, a rapidly fluctuating global
currency inherently brings instability, as volatility and unpredictability are not
what you want to see in something so critical for long-term investment and other
decisions.Labor
Presently, labor is tight. Unemployment rates are low, and worker power is
advancing. However, in a recession, will there still be an increase in the power of
labor compared to capital? Regardless of whether moves to restore or augment the
power of labor are organized, the fact is that they will run right into tremendous,
and in some cases astonishing, advances in robotics and automation. As we look
outside the window and see an autonomous lawnmower programmed to respect the
boundaries of grass to the inch, wandering around dawn to dusk without a
complaint, we start to understand the scope of the complex tasks that can be
performed by reliable, cheap and hard-working machines.Corporate profit margins and global risk
Profit margins are at an all-time high. Operating leverage coming out of COVID-
19 was extreme (if your costs are not going up too much, who is to know the right
selling price, and if you raise prices, well, that is to be expected in a period of
inflation), as was the imbalance between corporate and worker power. However,
most forces related to corporate profitability are turning down or are about to turn
down.Recap
To recap, we have: threats of nuclear war by a country that has more nuclear
weapons than any other; a deliberate suppression of the supply of the world’s most
important resources; the developed world drowning in ever-growing indebtedness
and unrepayable entitlement obligations; the world’s greatest real estate and stock-market booms; the developed world’s greatest fall in bond prices; and a likely
permanent negative inflection point in globalization. And as discussed thus far, this
is only one part of the current landscape for global risk.
(2) Graham & Dodd Annual Breakfast 2022 [Guest Speaker: Todd Combs, Moderator: Michael Mauboussin]
Combs opened his discussion on investing by equating it to Einstein’s theory of intelligence, which he said ranges from smart, intelligent, brilliant, genius to simple. Combs states that while investing is simple, it is not easy.
98% of what Buffett and Combs discuss is qualitative. If something is 30x earnings you can calculate what it will have to do to get to run rate earnings. The worst business grows and needs infinite capital with declining returns. The best business grows exponentially with no capital.
Combs goes to Buffett’s house on many Saturdays to talk, and here’s a litmus test they frequently use. Warren asks “How many names in the S&P are going to be 15x earnings in the next 12 months? How many are going to earn more in five years (using a 90% confidence interval), and how many will compound at 7% (using a 50% confidence interval)?” In this exercise, you are solving for cyclicality, compounding, and initial price. Combs said that this rubric was used to find Apple, since at the time the same 3-5 names kept coming up.
Businesses are run by people, and Buffett says he likes taking the cash flow and removing it from managers and investing it himself. There’s a known adage, when looking to buy a business: look to buy a business a dummy can run, because eventually a dummy will run it.
Charlie famously says you get what you incentivize. If a management is incentivized to appeal to Wall Street, it might behave in a value destructive way. Combs said that it’s a red flag if a company is too focused on external relations.
A big signaling effect for Combs is when management changes the key performance indicators for which it will get compensated by, presumably because management won’t get compensated if the KPIs are left as is.
Categorically, founder led businesses outperform because the founders are the fiduciary, and they have a longer time horizon.
Tweets That Make You Go… Hmm 🤔
thanks for the effort