Notes from the Diamond #7: Hittin ‘Em Where They Ain’t (Part 2)


David A. Salem
Email: [email protected]
Twitter: @dsaleminvestor

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Part 2: Addition By Subtraction

Trivia Question #7 of 108.  Taken as a group, the 51 countries or dependencies comprising Asia are home to a bit more than half of the world’s 44,000 or so listed companies.  What is the median number of sell side research analysts following the roughly 22,000 Asia-based firms just referenced?  Hint: the correct answer equals the number of no-hitters pitchers in Major League Baseball (MLB) have thrown on their birthdays, which itself equals the number of times two batters on the same team have “hit for the cycle” (single, double, triple, home run) in the same game.  As regular readers know, approximately 220,000 MLB games have been played since big league competition commenced in the 1870s.  Answer appears below.

Pre-Game Jitters.  Tired of waiting for the best MLB player of this and perhaps any generation — 27 year old Angels outfielder Mike Trout — to make his next appearance in MLB’s best ballpark?  Me too.  Frustrated it’s taken me so long to take this swing at the curveball I left hanging in Part 1 of this post when it got published several weeks ago? Me too.  Skeptical I can smack the curveball just referenced — i.e., outline investment policies conducive to the achievement of plump real returns over the next few decades of Trout’s blessed existence — or indeed convey useful thoughts of any kind via sentences comprising fewer words than the number of times Trout reached first base on walks in 2018 (a stunning 122 times in 608 plate appearances)?  Can’t blame you: as a guy who’s spectated many games in the ballpark alluded to above without wishing any would end sooner than they did, I have a natural if unfortunate tendency to craft sentences that run longer than most readers presumably prefer.[1]

Mike Trout

Obviously, there’s nothing I can do to accelerate Trout’s next appearance at Fenway (on August 8).  But I can scratch the other itches hinted at above — codifying concisely policies conducive to long-term wealth enhancement — and do so below via a series of tenets, none of which comprises more words than Trout’s age when he and the Angels inked recently the largest contract ever awarded a pro athlete: a deal that’ll pay Trout a total of $432 million pre-tax from 2019 through his age 38 season in 2030. 

Of course, since no one knows for sure how the economy and inflation let alone tax rates will evolve between now and 2030, no one knows for sure what goods and services the roughly $17 million per year in after-tax dollars Trout stands poised to earn under current tax schedules will buy him over the course of his newly-signed 12-year contract.  If, for example, inflation over the next dozen years runs as hot as it did during the most inflationary 12-year span in US history (1970 – 1981), the $17 million in after-tax income Trout is slated to pocket in 2030 will buy him the equivalent of a mere $7 million in goods and services if purchased today, CPI inflation having eroded the dollar’s purchasing power by roughly 60% over the 12 years ending  1981.[2]

Adding insult to potential injury, quite apart from potential surtaxes on certain outlays a highly compensated pro like Trout might reasonably be expected to make from time to time (e.g., hefty levies on fuel for private jet travel), wealth taxes of the sort proposed by certain politicians of late could prevent Trout from amassing even as remotely as much real wealth over the next 12 years as he would if the dominant zeitgeist for this interval were to resemble that of the 12 years beginning in 1981, i.e., disinflation and generally reduced tax rates.[3]    

Similar anxieties confront most individuals, families and indeed institutions that have already amassed substantial wealth as 2019 unfolds, including well-endowed non-profits that IMHO would be unwise to assume their investable wealth or current income produced by same will remain untaxed indefinitely. 

Indeed, even if the wealth just referenced is subjected to little or no explicit taxation in coming years and beyond, it could as noted above be subject to the implicit tax known as inflation: to currency debasement of the sort that, along with other ugly and corollary trends, led ultimately to the appointment of the investment maven on which Part 1 of this two-part paean to Hittin ‘Em Where They Ain’t focused: Yale CIO David Swensen.  (Part 1 focused as well on a baseball maven discussed further below: Branch Rickey.)  Other observers may disagree, but I doubt Yale would’ve hired a 30-something finance geek with no investment experience to run its endowment in 1985 if it hadn’t suffered a 60+% erosion in endowment purchasing power over the prior 35 years. 

What Trout Needs.  Like all investment home runs of which I’m aware, the riches that Yale has garnered by tapping Swensen as its CIO 30-odd years ago constitute just if not inevitable recompense for deducing correctly that the perceived risks of such a move exceeded the actual risks.  This isn’t to say that the latter were non-existent: Swensen might have proven inept in crafting investment policies responsive to Yale’s presumed needs, or the policies he ultimately devised might have proven infertile if the investment zeitgeist that subsequently unfolded had been different.  To Swensen’s credit, and Yale’s great and good fortune, the investment model he built embodied nicely if somewhat unwittingly an attribute inherent in all sound approaches to conscious risk-taking: asymmetry

“Heads I win, tails I don’t lose.”  That’s the ticket, we’d all agree, as reflected among other happy investor tales in this arresting fact: for more than a quarter century following Swensen’s assumption of his current post, a key tenet of his model essentially proved fallacious, with high quality bonds of the sort Swensen’s model disfavored producing returns roughly equal to marketable stocks as a group.  Of course, Swensen didn’t invest in the broad stock market during the quarter century in question (1985 – 2010), nor has he done so since.  Rather, he’s employed more or less exclusively active equity strategies, with a hugely profitable tilt toward privately-traded equities, including venture capital. 

The undeniable fact that such strategies bent but never quite broke Yale nor Swensen when they produced large unrealized losses in 2008 – 2009 merely reinforces the point made above respecting asymmetry: wittingly or not, Swensen has deployed Yale’s endowment in a manner that’s caused its unitized as well as total value to grow materially in real terms since 2009 under conditions resembling in certain ways those that caused such values to shrink materially in real terms over the 30-odd years preceding Swensen’s appointment as CIO, i.e., “guns and butter” fiscal policies coupled with large dollops of central bank largesse. 

Where would Yale’s finances and in turn Swensen’s reputation be today if such largesse hadn’t materialized over the last decade?  Reasonable people can reasonably disagree in answering that counterfactual question.  Ditto for a question that’s top of mind for me if not also you and should certainly be top of mind for investment pros fortunate enough to be advising Trout on the deployment of his investable wealth: will the dominant investment zeitgeist over the multi-decade horizon under discussion here be marked by the continuance of such largesse on a more or less globalized basis?  I  doubt it, but I wouldn’t bet the ranch against it.  Rather, I’d do what all fiduciaries worthy of the name try earnestly to do when engaged in policy-making: craft policies likely to produce tolerable results at worst across the widest plausible range of market scenarios and pleasing results at a minimum if the scenario or zeitgeist deemed most probable does indeed unfold.

Less is More.  What zeitgeist did I deem most probable in formulating the policies commended below — an investment model if you will intended to function effectively over a time horizon rivaling the span that’s elapsed since Swensen activated “the Yale model” many years ago?  Truth be told, I didn’t spend much time crafting a best guess or base case scenario for the global economy and capital markets when building the model below — not because scenario planning isn’t valuable if done astutely but rather because ET’s co-founders have shown convincingly in their writings that less is almost certainly more for investors seeking to divine economic and market trends in coming years and beyond.

Indeed, so convinced or more precisely humbled am I by Ben Hunt’s core message in Three Body Problem — “there is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns” — that I’ve adopted a base case scenario even leaner than that sketched by Ben in his masterful notes on zeitgeists entitled You Are Here and This is Water.

Specifically, while not questioning Ben’s perspicacity in divining all four phenomena flagged in the nearby box, the worldwide and necessarily long-term prism through which I ponder policy options makes me wary of policies premised on a fully globalized and sustained flowering of the first three trends. 

This isn’t to say that I think the trends Ben espies will peter out or reverse in the foreseeable future.  Indeed, I think such trends could very well accelerate, especially in the US and Old Europe, and more particularly if Rusty Guinn’s forebodings in Free Range Kids / Free Range Capitalism prove prescient; as Rusty notes, if taken too far, the ongoing transformation of capital markets into utilities could render investors as a group “utterly incapable of determining whether we should provide capital to a business or government venture, and under what terms.”

As for the fourth element of Ben’s perceived zeitgeist as summarized above — the displacement of cooperative games by interminably competitive ones — I’ve assigned a high probability to this condition in crafting the policies outlined below.  Fortunately and crucially, the less sound this premise actually proves in coming years and decades, the better I would expect the investment program sketched below to perform.  That may seem delusional — most attempts to exploit perceived asymmetries in capital markets produce strikeouts or singles rather than extra base hits or homers — so the onus is on me to defend the assertion just made.  I try to do just that as the modeling exercise below unfolds — one that begins logically (for a series exploring parallels between investing and baseball) with a favorite example of less being more in baseball.

Addition by Subtraction.  As regular readers will recall, Note #1 in this series opened with a trivia question concerning a Hall of Famer catcher who posted a 75-3 record as a pitcher in high school.  The rocket arm that made Johnny Bench (MLB 1967 – 83) nearly invincible as a high school hurler spawned ultimately a seemingly odd stat for Bench as a big league catcher: a relatively low number of runners nabbed stealing bases via throws from Bench.  The throws themselves were unfailingly swift and accurate, as one might expect from an athlete who’d practiced them countless times as a youngster albeit over twice the 127’ span between home plate and second base on a regulation diamond.  (Bench’s father and first baseball tutor knew well how to show young Johnny tough love.)  In fact, Bench’s arm strength became so widely respected in MLB circles that managers of opposing teams nixed base stealing attempts by all but their swiftest players when doing battle against Bench’s Cincinatti Reds.

Though such circumspection by Cincy’s opponents didn’t prevent the “Big Red Machine” from winning six divisional titles plus four league and two world championships during Bench’s 17-year playing career, it did boost opponents’ odds of beating the mighty Reds.  Addition by subtraction, one might call it: achieving more by doing less — by shunning endeavors in which one lacks a reliable edge or would otherwise confront unattractive odds.[4]

Edge and Odds.  I haven’t canvassed creatures fortunate enough to inhabit Little River Farm to ask how often Farmer Ben mutters “edge and odds” as he tends to their needs, but judging from how often Dr. Hunt chants that mantra in human interactions I’m guessing they’ve heard it many times indeed.  With good reason: in addition to pursuit of attractively asymmetric returns — the stated if sometimes unachieved aim of active managers and the only legitimate reason to invest in broadly diversified indexes like the S&P 500 on a buy-and-hold basis — savvy investors logically seek to focus their energies on opportunity sets in which they have an actionable edge in exploiting favorable or mispriced odds.[5]     

Millions of words having been written or spoken about “edge” in investing, I’ll say nothing about it here except that I’m defining it for purposes of this model-building gambit as know-how useful to the generation of above-market net returns if and when applied in an effective manner.  As noted above — and this is crucial to the model commended below — “edge” as just defined is most productively applied to markets in which an investor enjoys favorable or mispriced odds. 

Successful examples of such productivity include the two mavericks on whom Part 1 of this post focused.  As the first MLB GM to add black and Latino players to the talent pool from which his teams drew, Branch Rickey enhanced hugely his odds of assembling world-beating rosters; and while MLB franchises not headed by Rickey weren’t long in expanding imitatively their own talent pools, by the time they took such steps Rickey and his subordinates had developed a valuable edge in discerning which players of color most merited pro contracts. 

Similarly, David Swensen has enhanced Yale’s odds of partnering with market-beating managers by tilting Yale’s portfolio toward asset classes in which manager returns tend to be most dispersed; and while other allocators (big and small) weren’t long in expanding their own portfolios to include such holdings after Swensen showed the way, by the time they ramped up allocations to private equity, venture capital and other size-constrained niches favored by Yale, Swensen and his subordinates had developed a big edge in discerning which PE and VC managers most merited funding.  Fortunately for Swensen, and regrettably for allocators keen to be “like Yale”, this edge compounds over time, with Yale being a coveted client for managers seeking to maximize time spent investing by minimizing time spent fundraising.  Ain’t no better way to do that at present than to have Yale serve as one’s bell cow.

Pinpointing the Problem. And there ain’t no better way to convert a big fortune like the one Trout is poised to amass into a small one than to invest in volatile but potentially high returning assets without knowing them well enough to avoid ill-considered sales during inevitable bouts of punishingly poor returns.  What might Trout do to avoid such impoverishment?  Presuming as I do that he lacks the time if not also peculiar personal qualities needed to gain and hold an edge in investing, Trout should do what most individuals, families and institutions logically do when deploying substantial wealth: delegate the task to trustworthy pros who walk the talk set forth above — who focus their mental bandwidth and in turn clients’ capital on opportunity sets in which they have or can develop an actionable edge exploiting favorable or mispriced odds.

Tautologically, no opportunity set or selection universe meeting the criterion just specified can be boundless, because no pro’s or team of pros’ circle of competence is boundless (Herb Washington’s diverse talents notwithstanding).  Conversely, no person’s or team’s investment edge in a given asset class or sub-class is so acute that they can safely be relied upon to achieve the ambitious aims conjectured here (5+% annualized real returns over a multi-decade span) without doing one or both of two things: (1) deploying at least some capital outside their chief hunting ground or (2) violating liquidity and volatility constraints typically applied in the stewardship of substantial fortunes. 

Accordingly, when crafting limits on how capital under their ultimate control might be deployed, thoughtful principals strike a sensible balance between edge and odds, preserving needed flexibility while also keeping the breadth of assets or strategies deemed eligible for use within bounds consistent with the time-tested principle of knowing what you own and owning what you know.  After all, the seemingly boundless skills of an all-star allocator like Swensen or an all-star baseballer like Trout notwithstanding, in investing as in athletics, no one knows it all — not even Bo. [6]

Even Bo Don’t Know It All
Mike Trout (MLB 2011 – present, at left) and Bo Jackson (MLB 1986 – 94) earning their pay as centerfielders.  Jackson starred in “Bo Knows”, Nike’s wildly popular ad campaign for cross-training shoes circa 1989-90 that depicted Bo excelling at multiple sports and other pursuits including guitar-picking and musical theatre. The on-field plays pictured here both ended in catches by the players shown, natch.

Admiring Tackling the Problem.  Assuming the long wind-up above hasn’t caused Rusty ET faithful to dismiss me as a charlatan for merely Admiring the Problem, I’ll tackle the challenge conjectured here by outlining as concisely as I can the game plan I’d propose if Mike Trout or other well-endowed principals sought my best thinking on means of achieving 5+% real returns over the next few decades. 

As promised at the outset of this note, none of the tenets comprising my game plan contains more words than Trout’s current age of 27.  Nor do any of these tenets address directly the concern most commonly raised when I’ve shared the blueprint below with US-domiciled principals seeking my counsel, such as it is: shouldn’t investors who pay their bills in US dollars invest primarily in dollar-denominated assets?  My answer, in a nutshell: not necessarily — not if one assesses currency risk as we all should on a rigorously look-through basis, dissecting all anticipated liabilities to reveal the currencies underlying such potential outlays while dissecting similarly the currencies underlying assets available for investment.  Of course, the latter task is often easier said than done, with the true attributes of even seemingly straightforward assets like dollar denominated S&P 500 index funds differing greatly from their perceived attributes due to the geographic breadth of constituent firms’ operations.

Hold that thought — and the corollary thought that currency shifts tend to be accompanied over time by offsetting valuation shifts — as I outline my preferred investment analog to the convention-busting views on baseball that Rickey felt compelled to serve up in the Life magazine piece celebrated in Part 1 of this note.  Like Rickey, and indeed like Swensen when he submitted his preferred approach to capital deployment to Yale’s trustees for their initial approval back in the day, I recognize that what follows might be “most disconcerting” to many allocators; like Rickey — from whose Life piece I drew the self-aware red flag just quoted plus the following phrasing — I’ve “come upon [a method for deploying capital] that has compelled me to put different values on some of my oldest and most cherished theories.”  As will be seen, the game plan I’ve devised owes much to contemporary thinkers and doers who’ve displayed Rickeyesque cheek in challenging what Rickey referred to unflatteringly as “considered opinion”.  Here’s the plan, with its key tenets listed from most general to most specific and with noteworthy premises underlying such tenets appearing beneath each:

Tenet 1 – Create and maintain a sub-portfolio comprising cash, or liquid investments reducible thereto, in proportions equal to at least three years’ net cash needs under worst case conditions.

In theory, cash is a drag on returns of equity-oriented portfolios like the one commended here.  So too is an all-purpose hedge viewed even more skeptically by most allocators: gold.  Unwilling as I am to deem impossible over the multi-decade planning horizon conjectured here either of the disasters that can befall equity-oriented portfolios — depression-induced deflation or very high rates of unanticipated inflation — I deem it imprudent to “park” less than the equivalent of three years’ net cash needs in the “low returning” assets just mentioned, with a bias toward high quality debt instruments whose currency profile resembles closely that of the net cash needs such hedges seek to defray.

Tenet 2 – Favor ownership over creditorship, with the maximum feasible bias toward the only type of equities worth owning on an indefinite basis: stocks of owner-operated companies (OOCs).

Though further research on this all-important topic remains to be done, studies done by Steve Bregman and his colleagues at Horizon Kinetics  (HK) suggest that more than 100% of the vaunted “equity risk premium” that Yale’s equity-centric approach to endowment management presupposes is attributable to OOCs.[7] You read that right: exclude OOCs for purposes of comparing stocks’ long term rewards to bonds’ and the latter take the crown.  Needless to say, as has happened with every verifiably superior investment (or baseball!) gambit ever devised, the excess returns or “alpha” derivable from OOCs will likely get arbitraged away in due course.  That caveat having been filed, there are parts of the world where the supply of OOCs (listed as well as private) continues to expand invitingly — geographies that the investment model commended here rather fancies, as will be revealed shortly.

Tenet 3 – Maintain a very high bar for private investments, accepting long-term lock ups only when doing so provides exposures to specific forms of capitalistic activity not obtainable via other means. 

Venture investments occasionally clear this bar, though less frequently than most allocators currently clamoring for such exposures surmise.  As discussed in prior notes in this series (here and here), private equity (PE) investments clear the bar under discussion here even less frequently — a dirty little secret about the current apple of many an allocator’s eye that’s becoming less secretive by the minute as a young investment pro with Rickeyesque gifts for clear thinking and writing intensifies his assault on “considered opinions” respecting PE.  If you’re among the rapidly shrinking universe of allocators not yet exposed to Dan Rasmussen’s admirable assaults on such opinions, you’d do well to get acquainted with same via the musings posted on his firm’s website, including especially Dan’s fine essay in the Spring 2018 edition of American Affairs

To be sure, the company attributes that Dan and his team have come to fancy, including small market caps, limit how much capital he or other investors using similar screens can deploy without causing potential returns to sink below tolerable levels.   Since these screens, like the OOC-focused (and partially overlapping) screens that Bregman et al at HK employ, work at least as well outside the US as within it, Verdad deploys capital on a global basis — just as HK does, and just as Rickey did when populating his innovative farm system for the St. Louis Cardinals nearly a century ago.

Tenet 4 – Favor equity investments in companies employing or serving primarily people with abundance as distinct from scarcity mindsets.

For reasons flagged in multiple works by another Rickeyesque researcher — demographer par excellence Neil Howe —the US and major European economies generally flunk the test just articulated:  like not a few “rich” families with which I’ve had the pain privilege of interacting, the world’s “richest” nations at present (measured by GDP per capita) comprise an overabundance of individuals who lack the skills or drive needed to generate fresh wealth commensurate with their appetites and social ambitions. Small surprise then that the “widening gyre” and related societal maladies that Howe as well as Ben and Rusty discuss so arrestingly in their writings are most conspicuously manifest in corners of the global economy characterized by (1) relatively but perhaps unsustainably high per capita incomes (2) rising dependency ratios (i.e.,  retirees relative to working stiffs like me if not also you) and (3) relatively high debt ratios (i.e., unpaid bills for goods and services consumed previously). 

Add to the potentially toxic mix just described such intractable problems as the Eurozone’s fatally flawed currency union, America’s unsustainably undemocratic approach to self-government, and corporate America’s unsustainable addiction to the “financialization” whereof Ben speaks unlovingly, and it’s tough for any investment pro worthy of that label to defend non-zero policy allocations to US stocks as a group or to their European counterparts.[8] 

N.B.: I’d include non-zero allocations to Japanese stocks in the list of dubious policy fixtures just furnished but my own studies of evolving business and societal norms in Japan plus insights into same provided by my go-to guy on such matters (Andrew McDermott of Mission Value Partners) suggest that abundance trumps scarcity in most Japanese mindsets, i.e., expectations are low relative to most plausible outcomes (however unexciting such outcomes might be).  

Tenet 5 – Apply the tenets set forth above to the narrowest universe of eligible investments that gets the job done.

Having test-driven the investment model now unfolding with several savvy principals before finalizing this note for publication, I know that while Tenet 5 might appeal to my arborist friend Ben (for reasons outlined here), it won’t sit well with many readers.  After all, diversification being the “only free lunch” available to investors — or so financial economists would have us believe — why would thoughtful principals view less as more respecting assets eligible for purchase? 

They’d do so because, presuming sensible cash flow planning of the sort embodied in Tenet 1 and asset selection consistent with Tenets 2 – 4, the chief if not sole risk of the investment program sketched here is the potential jettisoning of inherently sound strategies during their inevitable bouts of disappointingly low returns (a/k/a whipsaw).  Such bad spells are inevitable because plump net real returns of the sort targeted here (5+% annualized over meaningfully long horizons) can’t realistically be achieved without potentially prolonged periods of below-target returns.[9] 

The most reliable means of guarding against whipsaw is to know what you own and own what you know.  As previously noted, the only reliable means of meeting such standards is to limit one’s universe of eligible investments to the maximum feasible extent.  By my lights, the optimal universe for deployment of the total return-oriented or non-hedging part of the portfolio contemplated by the framework extolled here is one hinted at in Trivia Question #7 posed at the outset of this note: Asian equities.  Leaving aside Asian nations that are off limits to western investors, or have too few or too thinly capitalized public companies to merit inclusion here, the median number of sell-side analysts following the ~22,000 stocks of Asia-domiciled companies alluded to in TQ #7 is zero.  This compares to the corresponding median of seven analysts for the roughly 4,000 listed companies in the US at present (down from roughly 8,000 since I sank into money management in the early ‘80s).

How many of the ~22,000 Asian stocks referenced above meet all of the criteria embodied in the tenets propounded above?  I don’t have a verifiably accurate answer to this question, for two reasons: first, because the criteria are somewhat subjective, with Tenet 4 (favoring abundance mindsets) serving as the poster child for such subjectivity; second, because I know what I don’t know (yet), namely many things I need to know about Asia in order to gain and hold an edge deploying capital in that region.  Strike that: taking Tenet 5 to a logical and IMHO entirely justified extreme, if granted unfettered discretion to shape the universe of assets eligible for purchase within the total return segments of long-term portfolios of the sort conjectured here, I’d enhance my odds of both avoiding whipsaw and gaining an edge relative to other investors by focusing my attention and capital on private as well as publicly-traded companies domiciled in but a dozen of Asia’s 51 nations and dependencies, as follows:

Sources: Worldometers; IMF.  Figures rounded for presentation purposes.  Readers inclined to @me for swallowing seemingly the demographic kool-aid served up by promoters of investment schemes focused on “emerging markets” (EM) should take due note of Japan’s inclusion in the opportunity set furnished above.  Like Ben, who bashed demography-driven EM schema during his ET Live! chat with Rusty on April 2 (premium subscription required), I’m inclined to short rather than go long on investment schema premised primarily on rapid population growth.   

Surrendering Preconceived Ideas.  “If the baseball world is to accept this new system,” Rickey noted in the heretical essay on baseball stratagem referenced repeatedly in this post, “it must first give up preconceived ideas.  I had to.  The [system] outrages certain standards that experienced baseball people have sworn by all their lives.”  The investment paradigm sketched above will outrage some readers, methinks, especially those who view the world’s biggest national economy at present [the U.S.] as the “safest” place to deploy capital and, as a corollary, the biggest economy making the above cut as an unsafe place to deploy capital. 

Truth be told, I myself generally view China as such, due largely to its suspect fidelity to the rule of law.  That said, the scarcity mindset growing increasingly prevalent in the US and Old Europe poses different but clear and present dangers to the rule of law! in such geographies, with the meme just mentioned (rule of law!) serving as shorthand for the intricately woven but increasingly frayed fabric of legal, commercial, social and political norms on which investors in US- and Europe-domiciled companies have customarily relied to safeguard and indeed nurture their ownership stakes.  All of which is to say that, while I’m as opposed to non-zero fixed or policy allocations to Chinese stocks as I am to such rigidities respecting US or European equities, I certainly wouldn’t exclude Chinese stocks from my hoped-for circle of competence (defined broadly to include Asia- or China-focused managers deploying capital entrusted to me). 

Nor would I pursue policies entailing unduly high bars to the ownership of equities denominated in currencies issued by any of the countries comprising my self-selected opportunity set, China not excepted.  Indeed, convinced as I am that Ben has divined rightly that “competitive and single-play games” have displaced “cooperative and multi-play [ones]” in international politics and economics, I’d assign better-than-even odds to the US dollar’s displacement as the world’s dominant reserve currency within the next quarter century or so.  I doubt the Chinese yuan or indeed any other currency excepting possibly gold will ascend to the throne that USD seems destined to vacate, of necessity or choice.  But I’m reasonably confident that by the time Mike Trout takes his rightful place in baseball’s Hall of Fame a decade or two from now, the global economy will be divided into three major currency blocs, with China, Germany and the US each spearheading the bloc in which their national currencies sit. 

I’m reasonably confident too that the scarcity mindset increasingly manifest in American politics and economics will produce ultimately a material downward revision in the US dollar’s value relative to both gold and a sensibly weighted basket of its “trading” partners’ currencies, with “trading” defined broadly to include services as well as goods.  Obviously and perhaps sadly for Americans lacking overseas holdings or other means of profiting from dollar debasement, USD devaluation to the degree divined here would generally flatter the Asia-centric investment program delineated above, spawning as it likely would currency-related gains on non-US stocks even after factoring in valuation shifts commonly associated with major currency moves. 

(If you’re unfamiliar with how and why such shifts occur, you should be especially wary of any raccoons investment pros seeking to manage your money for a fee while assuring you they have everything under control.  “Investing is simple,” one often hears, “but not easy.”  In fact, effective investing is neither simple nor easy, least of all for investment pros forced unavoidably and unendingly to balance their own pecuniary needs against their clients’ wants and needs.)    

Finally and not obviously, in the unlikely event that America scores decisive victories in the “competitive and single-play games” in which it seems destined to participate in coming years and beyond, I’d expect the Asia-centric investment program endorsed here to produce long term returns not merely matching but likely besting those produced by US-centric alternatives.  Why?  Because the restoration of Pax Americana that such victories would both presuppose and promote would almost surely put strong and steady winds into the sails of the Asian economies identified in the table above, including especially India (my single favorite target for capital deployment in coming decades) as well as smaller Asian nations likely to fare better on balance if Uncle Sam’s traditional values of liberty and justice for all triumph ultimately over Uncle Xi’s evolving ethics, such as they are.  Heads I win, tails I don’t lose.  That’s the ticket, we’d all agree — even if we can’t agree on the surest means of dialing such asymmetry into capital allocation protocols. 

Indeed, mindful as I am that the policy prescriptions proffered here may create a “widening gyre” (to quote Ben quoting Yeats) of opinions within the ET Pack respecting prudent approaches to capital deployment, I’ll try in my next note to inject centripetal forces into the mix by presenting to the Pack the single best metric known to me for gauging long term investment success.  By my lights, it’s as relevant today as it was when its principal modern proponent first drew it to my and other investment wonks’ attention in 2005.  Mike Trout was a young teenager playing baseball for free back then; and the so-called sabermetrics revolution that’s changed materially the metrics baseball cognoscenti employ for gauging ballplayers’ worth had only recently commenced.  As will be seen, just as sabermetrics is rooted in methods devised many years earlier by the great and good Branch Rickey, the money metric I’ll discuss approvingly in Note #8 is rooted in methods of gauging financial abundance devised long before the first MLB game was played 143 springtimes ago.

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On Deck

In search of excellence when gauging excellence

[1] Many lovers of sport including some lovers of baseball think MLB games have become too long and devoid of action since computer-based analytics came to the fore in pro baseball several years ago.  I share such concerns, with a carve out for games unfolding glacially at Fenway, and plan to discuss them plus potential remedial measures in a future note.

[2] You can check my math here, applying to Trout’s newly contracted pay package the 52% effective tax rate I’ve assumed here or whatever alternate rate you deem sensible given the idiosyncratic manner in which salary payments received by peripatetic entertainers like Trout get taxed.  Like rock stars on tour — which Trout essentially is — MLB players pay state-level income taxes pro rated to the number of days they play in a given state each season, taking credits against their home state’s levies.  As a New Jersey resident for tax purposes, Trout is poised to fork over a minimum of at least 9% of his pay in state taxes, with half or more of his salary being subjected to the ~13% tax extracted by the state in which Trout and his Angels teammates play half of their regularly scheduled games each season: California. 

[3] As Ben Hunt wrote when elevating the term to its rightful place as a key concept in Epsilon Theory (here), “zeitgeist” “is the macro scale of our social lives as investors and citizens.”

[4] Bench’s extraordinary gifts as a ballplayer are captured nicely in the brief profile posted here.

[5] Though capitalization weighting stocks for passive investment purposes is demonstrably inferior to other portfolio construction methods on a pre-tax basis, even a cap-weighted index like the S&P 500 has displayed historically and will likely continue displaying asymmetry of the sort alluded to here: the longer one lengthens the time periods over which returns are examined, the higher the percentage of positive outcomes rises.  Hence, even if the odds of investing in broadly diversified portfolios like the S&P 500 aren’t mispriced (and good luck diving inflection points in such mispricing), they are unarguably favorable in positive payoff terms for truly long-term investors.  The defects of cap-weighted portfolios are catalogued cleverly in a 2006 paper by Jason Hsu posted here and in a 2018 research note by Jason and his former Research Affiliates colleagues Rob Arnott and Vital Kalesnik posted here.

[6] Using the least-worst available metric for gauging baseballers’ on-field contributions to their team’s success (a cumulative measure known as Wins Above Replacement or WAR), Trout’s achievements as both a batsman and outfielder since his big league career commenced at age 19 in 2011 have already elevated him to a Top 150 spot in MLB’s all-time list of players ranked by WAR: when his ninth season as a big leaguer commenced in March 2019, Trout had compiled a lifetime WAR of 64, which is roughly equal to the median WAR for the 261 players (including four 2019 inductees) comprising baseball’s Hall of Fame.  Think Trout will join their ranks eventually?  Me too, especially since he’s already 16th in WAR all-time among center fielders, ahead of nine of the 19 such players who’ve been elected to the Hall.    

[7] As noted in its white paper on OOCs, HK defines an “owner-operator” as “a principal or an owner — often a founder — who is directly involved in the management of a corporation in which he or she maintains a significant portion — ideally the majority — of his or her wealth.”

[8] “Unsustainably undemocratic” as used here refers to the inevitable reformation of arrangements that today give roughly 30% of the American electorate a de facto veto (via the US Senate) over laws governing the residual 70%.  Of course, the same imbalance is manifest in US presidential elections decided ultimately by the electoral college — an artifact of logrolling by America’s founding fathers whose eventual elimination could and likely will entail political if not also social unrest inimical to the interests of passive investors in broadly diversified portfolios of US stocks.

[9] Ping me via [email protected] if you’d like to review data supporting this assertion.  Alternatively, take a look at the characteristically fine Wall Street Journal piece that my pal Jason Zweig crafted after he laid hands on the data in question.


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1 year ago

“I have a natural if unfortunate tendency to craft sentences that run longer than most readers presumably prefer”.

Ya think? Lol, good stuff.

1 year ago
Reply to  Ampf

Just to clarify, I found the piece to be very interesting and informative. My simple brain isn’t used to reading such highly complex and structurally challenging writing. It may take me awhile, but I know it’s worth it.

Sean Garman
1 year ago

Can you explain a bit more what you meant by including Germany in the three currency blocs you expect to be around in the 2030s? Do you mean that because Germany is the Eurozone’s economic powerhouse and it effectively holds the pursestrings that the Euro is driven by Germany? Or are you saying that the Euro will unravel and Germany will return to the DM?

Sean Garman
1 year ago
Reply to  dsalem

Thanks for the response, David. I am not in the camp that the Euro will disappear despite the imbalances and incompleteness of the Eurozone system. There is too much political will and in many countries there is too much memory of life pre-Euro to disentangle without political and social agreement.

If individual nations did leave or if Germany decided to leave, then either the rumpEuro or newDB will appreciate in value and be a “big country” equivalent of the Swiss franc. In short, I can imagine that type of currency being more willingly used as a reserve currency notwithstanding reduced liquidity.

Still, from my perch in London I struggle to see positive structural factors in the Eurozone and am more positively inclined towards North America & Asia.

And it was good to see Vlad Jnr’s debut & the BlueJay support for him.

1 year ago

Great post! I have to say, it’s taking me a little while to wrap my head around all these concepts. Is the gist of this that the US political and corporate environment has trended away from investment that increases the productivity / competitiveness of our economy. Therefore, when the global cooperative games change, our “free lunch” of immigration and globalization will run out. When we take this situation, combined with inflation and a move away from the USD as the reserve currency, a primarily US based investment thesis carries a much higher risk of “tails you loose”?

1 year ago

I agree that there is little coverage in US media on Asian public listed companies ( Tencent’s excepted ) ;
But the large Asian cultures – Indian, Chinese , Indonesian – all operate on a scarcity mentality. All of them….they may have fancy modern buildings – but the mindset, particularly of the Governments , is still locked up in the Feudal Farmer stage of Human development. Tight control by bureaucrats is considered the only acceptable form of administration.
As to MMT, the Chinese are way ahead of the US ; that is one of the key reasons why they are unable or unwilling to float the Yuan. The RMB is even more of a ‘fiat’ currency than the US$. Totally and only backed by authoritarian Government power.
“Power grows out of the barrel of a gun” – Mao Zedong.
Of the big three , only Indonesia, a commodity and resource economy , has a free floating currency regime.

1 year ago
Reply to  dsalem

Hi David,
Thank you for replying. Actually, I am glad you brought up the issue of the ‘Scarcity Mentality “ because in my humble opinion, having been born, and lived most of my life in Asia, this is the single biggest issue holding back the progress of the large Asian cultures. & one that nobody talks about…..
Now, if it changes with the new generations, then yes, we shall have great economic progress and concurrent investment opportunities.
The late Peter Drucker shares your opinion –“The dominance of the U.S. is already over. What is emerging is a world economy of blocs represented by NAFTA, the European Union, ASEAN. There’s no one center in this world economy. India is becoming a powerhouse very fast”
That is from a 2004 interview with Fortune magazine.
My old college roommate from NYC went back to India and founded what is now the largest student loan financial institution there.
We still write back and forth about Asian development issues.
I wrote a couple of essays, one for him on India, another for a close Singapore based friend, on the similarities between Mainland China & Singapore. I would be happy to email them to you if you would like to read them, but they are about 7-8 pages each ….
Thanks again

1 year ago

Okay, the mistake I made was setting aside only a half hour to read this (and glad to see others making comments share this view) highly intricate piece; hence, I read it in several parts and need (and will) go back to read it again, this time, in one sitting.

I have too many question owing to that – and it’s not fair to burden others or David with my confusion – but thought I’d ask one question: David, you describe one of the “intractable problems” as being –

“America’s unsustainably undemocratic approach to self-government.”

Are you referencing the intentionally designed undemocratic structures built into our constitution – electoral college, the need for super majorities for some legislative actions, etc., – or something else?

Thank you for an incredible piece that I know I will value even more when I’ve reread/studied it (a few times, at least) so that I actually understand it (and can not just half fake my way through a discussion of it).

1 year ago
Reply to  dsalem

Thank you for the comprehensive answer. My humble, undergraduate-degree-only view is that I hope those controls stay in place. I didn’t vote for T or H – to me, it’s not about “this moment” in our politics, but what is good for the long-term health of our Republic.

That said, I think you are right as the big sweep seems to be moving in the direction of more direct democracy as the measured, long-term views the Founders held either aren’t taught to or haven’t stuck with younger generations. We will know a lot more in 2020 only if the Dems win – then, we’ll learn if they were tactical frustrations (and dropped) or a real generational passion (and advanced).

Thank you again for the response and the very impressive piece.

Victor K
1 year ago

How do you effectively diversify representation in Tenet 1 before worst case conditions for worst case conditions?

Victor K
1 year ago
Reply to  dsalem

I have >three years of liquidity. Currently, it is represented digitally in several IRA brokerage cash accounts (supposedly not money markets). That is not diversified. I have cryptos elsewhere, still digitally represented. Physical gold is a joke; ask any jeweler how to divide it up, and you still have a verification problem! Physical currency is like bearer bonds: secure at your own risk, and which ones: US paper or coins, Euros, Swiss Francs…???
Without going full Rickards or prepper, but respecting the “reset” of Mauldin or Stockton, how would you diversify the way your 3 years of liquidity is represented to prepare for a variety of worst case conditions?
And finally, don’t you think Warren Buffett would have been an opposite field hitter except when he knew it was going to be a hanging curve?
Thanks for taking the time for any reply!

Victor K
1 year ago
Reply to  dsalem

Most excellent – thank you! USTs and FDIC CDs it is, and I’m keeping all my nickels and copperish pennies!

1 year ago

Great write – up !!! ….will need time to digest it properly.
I would be very wary of China, but I am biased, living here in Hong Kong where we’re protesting the dumbass extradition law sponsored by Beijing.

An anecdote for you – in 2014 I was living in Shanghai, and my partners – two well-off locals – were buying stocks during that short-lived boom. Like all smart moneyed Mainlanders, they had already parked their wives and families and some wealth overseas – Australia in the case of these two – & were living it up in Shanghai. I asked the junior guy , who seemed to be killing it at the time , how he knew what stocks to buy …what metrics to evaluate….his reply : “Don’t waste your time on that, even I don’t know what businesses they are in. Its all fake. The big fish decide what stock they want to ‘fry’ and you buy on the rumors….that’s all. None of the companies’ business models are real anyway. The big money in China has to partner with the communist party, there is no other way”.
We would joke that he’d made a 911 the past quarter….ie enough money to buy a Porsche; then it became two 911s, then 3 , followed by the bust when we counted his losses in 911’s as well…..

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