Inflation Assets, Investing & Managing Equity Duration
Note: Video Presentation is at the top of the transcript
By way of preview I’m going to try and compress the views explained in some of our more technical research into a very quick 10-15 minute presentation.
Summarily what I can say is the following:
- We have seen people far brighter than us assemble incredibly compelling arguments for inflation and deflation
- Both groups do a phenomenal job marshalling a tremendous amount of data to support their views
- If you would like a fantastic summary of what we believe is one of the best displays of the “pro” and “con” views on inflation, a newsletter published by Grant Williams recently put out a remarkably helpful summary of both views
- Our research team appreciates that how the inflation and deflation argument plays out will have a huge impact on stock prices
- People who pick the correct side and invest accordingly will make stunning amounts of money
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Inflation and Stocks
For fundamental stock-pickers like us who base our views on historical context we believe the pricing structure in the stock market today has immense information value, and that is where this piece will conclude.
The path to those conclusions around today’s pricing structure will follow three broad constructs:
- What can history teach us?
- Where is equity duration in aggregate today and relative to history?
- Where are the outliers and how can we use that information to improve portfolio construction through stock selection?
Inflation Assets Presentation Video
70s Inflation & Sector Outcomes
We are going to start off here. One of the most interesting things we have seen is a large amount of studies and data around what worked and did not work well based on rising interest rates and rising consumer prices over the last ten years.
In our minds the last decade, where the Fed Funds rate has hovered between 25bps and 2.5%, might be a misleading place to make inferential conclusions about stocks and their relationship with raising interest rates, much less their performance in an inflationary environment.
After doing a fair bit of reading we thought it made sense to go back to the last time in history rising prices became an economic headwind. If you’d like the list of individuals, investors and institutions that set this ball rolling they can be found on page one of our report.
This slide shows what worked and didn’t work over the high inflation of the 1970s which soared into the double digits. What is sort of remarkable about this slide is that over this period inflation almost perfectly matched the S&P 500 equity index.
So we put the slide up here to show the real returns of the sectors over the inflationary period but think it is worth noting that right there in the middle is the S&P. Over 15 years you made exactly nothing in real terms and these bars are therefore showing real returns as well as returns relative to the S&P.
The summary takeaway here foots with intuition in our mind. When inflation breaks out people have less real purchasing power and companies that make the necessities of life, do better than companies that make stuff you want.
Here are real bond yields over history. We avoid asset classes outside our area of expertise and claim no skill in bond investing. In our paper we bracket every page and exhibit with a quote or two from Buffett.
On this one we closed the page out with his statement in his review of Berkshire’s 2020 results. He wrote: And bonds are not the place to be these days. Can you believe that the income recently available from a 10 Year US Treasury bond – the yield was 0.93% at year end – had fallen 94% from the 15.8% yield available in 1981? Fixed-income investors worldwide – whether pension funds, insurance companies or retirees, face a bleak future.
We bring that up because, as we show in the paper, Buffett openly contemplated the returns and trade-offs that bond and equity investors faced in 1980. We wonder if Buffett would be interested in treasury inflation protected securities “tips” considering the federal reserve’s conduct and the soaring consumer price index.
Equity & Bond Returns Through a Long Period Including Difficult Economic Growth
So what did Buffett say in 1980 and how did he do? Let’s remember that bonds in 1980 yielded 12.4%. Here is his quote.
The buyer of money to be used between 1980 and 2020 has been able to obtain a firm price now for each year of its use while the buyer of auto insurance, medical services, newsprint, office space – or just about any other product or service – would be greeted with laughter if he were to request a firm price now to apply through 1985...
…our unwillingness to fix a price now for a pound of See’s candy … to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.” -Warren Buffett, 1980
Pretty incredible Buffett was talking about 2020 in 1980. Even more incredible that his view worked out. To be clear: our research does not rest on Warren Buffett’s statements then or now.
Moving on to the next slide, let’s just look at equity valuations going into the 1970s with its annual inflation rises and wage and price controls.
Good Stocks for Inflation Were Inexpensive (We Omit Real Estate Investment Trusts)
This slide shows valuation multiples by sector. Like the first slide it is sorted by best to worst performing sector over the Great Inflation. The navy blue squares are the price to sales ratios at the beginning of the period and the light blue diamonds are the ending multiples.
The feature that is common to all sectors is multiple compression.
This is a whole different animal that has an entire literature dedicated to it. How inflations crush equity multiples. In our paper we list out some great starting points and if you’d like some supplemental reading.
Inflation Increases & The Risks to High Multiples
This slide is the exact same one as the prior one except we added the red dots which are where the sectors are now. A couple things stand out to us.
The first is that tech stocks today, over on the far right, are almost unbelievably expensive. That’s an entirely different animal and we have several papers you can read about the history of manias and the interplay with IT stocks.
But looking at the rest of the sectors it is interesting to us that every single one of them is more expensive than in 1969 EXCEPT for energy and healthcare – two of the sectors that performed best in the 1970s. So we are at the zero bound on rates, Treasuries offer negative real yields and some of the best inflation hedges based on history are at discounts.
Oil prices are not things we can predict but there may be something to be said for investing in sellers of real assets like oil that are integral to the economy.
This slide shows us that valuations alone seem to be an almost structural bet against inflation. One could suggest that an S&P 500 index fund has a massive structural bet against inflation.
The next slides we jump into our equity duration tool which is more complex and for use to aid in portfolio construction.
Equity Duration and Inflation Sensitivity at the Index Level
This is our estimate of equity duration. The technical underpinnings of this work were and continue to be a non-trivial undertaking. For folks interested in the math please reach out to someone at Concepts and we will happily walk you through it.
Equities are at record duration. The picture looks an awful lot like 2000. The major problem is, per our prior slides, bonds no longer offer any reasonable income or safe harbor.
This issue is all the more pressing in our mind as both asset allocators, pensions and our society at large are facing a demographic turning point. We are at the point where 10,000 Americans are hitting retirement age every single day.
We have a massive, politically and financially powerful cohort looking to find safe investments and reasonable income. Yet that same block of individuals, which has never been larger, has to choose off a menu rife with poor choices. No wonder Janet Yellen believes inflation would be good for the US economy!
Before we move forward and validate the claim that our duration tool has some efficacy let me say the following:
I understand most of you are used to people who get up in front of you and pound the table of certainty. What I can say about our equity duration tool is that we believe it is a massive improvement over guesswork.
The Equity Duration tool we offer is roughly correct if, at times on certain specific stocks with unusual accounting, precisely wrong.
Did our Equity Duration Tool Fare Well in the 1970s?
What we did here was quintile stocks based on our equity duration tool and sorted stocks from the lowest to highest duration. It did a phenomenal job identifying the stocks that would do the best over the great inflation and identifying those that left investors exposed.
Moving from left to right you can see that the 20% of stocks our tool said were the lowest duration rose 404% over the inflationary period studied. The third bar. That is the return hurdle to simply maintain your purchasing power over this 15 year period.
The three bars to the right of inflation breakeven were all groups of stocks that failed to maintain purchasing power over the inflationary period under review.
Our equity duration tool is not built like many quantitative tools. It does not look at historical data, and then use regressions. The tool is fundamental in construction.
If you look at our demo of the tool you will see it is a conceptual neighbor of a DCF. The reason that matters is the tool has no idea what happened in the 1970s much less today. It is a bottoms up fundamental method that has no history involved in its construction.
So looking at the left-most bar in particular and the three bars on the right show that it did a great job separating the winners and losers from inflation.
Best Stocks During Inflation and Deflation
Here is how the tool did from December of 2016 through February of 2021 when we saw 10 year bond yields collapse from ~3% to below 1%. If you had or have a macro tool on rates, this tool can help you build winning portfolios.
We find stuff like this sort of incredible in that it is another dimension to the portfolio construction process that has probably never been more important and more talked about that has lacked any sort of credible framework for measurement.
And that is, in short, the purpose of these pieces of research and this tool.
Good Stocks For Inflation: The Low vs. High Equity Duration Cohorts
Here we show the duration of the 20% of firms in the S&P with the lowest and highest duration today. To the degree you are looking for firms that might hedge your rate exposure this tool can help you very efficiently cut your macro duration risk quickly by adding stocks from either of the tails.
Stocks to Buy for Inflation
So this is our final slide where we show the characteristics of the lowest and highest duration stocks. The first box shows the 20% with the highest duration on average, in 1969 right before the great inflation and in 1984 when the 10 year finally fell below 10% and the market realized that Volker, moving the Fed Funds to 20% in June of 1981, was not messing around and the cycle of relentless disinflation began and then, of course, today.
What we think is most interesting about this data set is that while valuations are indeed higher in the “high duration” group, our model is not just a simple expression of “expensive stocks are high duration and cheap stocks are low duration.” There are reasonably priced stocks on both tails.
We have a substantial value bias in our research process and it has been an eye opening exercise seeing the impact of high and low growth rates on the implied duration this tool generates. The tool has forced us to look hard at some of the value stocks in our portfolio that are shrinking and challenge our assumptions and think through “is there a stock of slightly higher quality that can be substituted with lower macro exposure?”
Similarly, some of the growthier stocks in our portfolios that we have sort of been leaning more and more on the “quality” in a market that has been relentlessly re-rating, we have had to think through just what does this company need to do to justify the valuation because even under generous assumptions the thing is bringing a lot of external macro risk to the portfolio.
And with that, I think I’m going to reiterate my thanks for your time and open this up to any questions. I’d like to just repeat that for regulatory reasons we will not be discussing any individual stocks. Please see our upcoming piece for those interested in GARP research and securities.