Feature Stories | Jul 03 2006
By Greg Peel
GaveKal Research is an independent economic research house and consultancy created in 1999 in the US by Charles Gave and partners. GaveKal has a reputation for "original thinking". The following feature series is drawn from a GaveKal publication of 2005 entitled: Our Brave New World. This is Part VII, the final part.
The Brave New World – that of The Third Wave, or more specifically the platform company – seems a whole new challenge for investors. If the paradigm has shifted, what use are previously regarded investment criteria? Do we start again?
One possible response is for the unskilled investor to throw their hands up and say: I think I’ll just give my money to an index fund and be done with it. That would be a big mistake.
An index fund is one which invests for return on capital based on an index. The most obvious example is an index-tracking stock market fund. These funds merely allocate investor’s money based on the capital weighting of the stocks in the index such as, for example, the S&P/ASX 200.
The evidence is actually in favour of index funds. Its shows that, over time, active management (ie stock picking) rarely outperforms the index. It may do so in certain periods, and there will always be the odd genius who gets it right a lot, but the further into time one goes the more active management will be rebalanced back to the index. Eventually everyone will have a bad run.
However, active managers are necessary for the market. If everyone was an index-tracker, then everyone would attempt to hold the same portfolio and the "market" would cease to exist. It is a necessary function of a capitalistic system that there are winners and there are losers.
Over the decades of the 80s and 90s, active management was prevalent, and a failure. The 80s witnessed one of the greatest bull rallies in history only to crash. When a bear market looked like digging in fortunes were revived by the Gulf War. The 90s were a rocky road featuring emerging market booms and busts (eg Asian tigers, Russian debt markets), the fall of Barings, spectacular hedge fund collapses (eg LTCM) and finally a tech boom that ended in tears.
Active managers had a hell of a time.
The result was an enforced move away from active management. Not enforced by managers themselves, but by the accountants and risk managers. Conservatism became fundamental and overnight what were once active funds became "closet" indexers.
Thus a bear market was ushered in. (Note: The US has been in a bear market since the tech boom peak. Australia never experienced much of a tech boom/bust, but still suffered a bear market in 2000-03 before the commodity boom).
The reason a bear market eventuated is because indexing became a victim of its own success. If everyone steers well clear of risk, then no one is going to spark a momentum rally. Furthermore, the fundamental problem with index-tracking is that allocations are made purely on size. This is actually counterproductive.
Think about it. If most of the money goes into the biggest company in the index (eg BHP) then that company’s share price will rise which in turn sparks more allocation because capitalisation increases. Thus the price of BHP feeds on itself, at least until some trigger causes a price drop (eg the current correction) and money then has to be removed, which causes the price to fall further. In other words, risk-averse indexation causes volatility – the sort of volatility that hurts because you are always on the wrong side of the market. It’s pretty hard to make money that way.
Indexation has its place, but the recent boom in investment has been hedge funds. One of the major reasons so many hedge funds have sprung up lately is not just because of excess global liquidity, but because of all the active managers who vacated their positions when the accountants moved in.
While hedge funds have thrived, large pension funds have faltered. This is not just because hedge funds offer more diversified risk investments. It is because under the platform company model, companies now no longer employ vast numbers of blue-collar workers, nor vast numbers of any lowered paid employees. This has sounded the death knell for large company retirement funds, which have joined the large government employee funds which have become redundant due to privatisation of industry.
More and more workers in the Western world are becoming responsible for their own superannuation. From this has grown a plethora of new-style funds – whether you want to call them hedge funds or not – which offer a balance of indexing and active management. We have seen the birth of such animals as the "individually managed account".
It is important to understand at this point that there are many who do not understand hedge funds. Firstly, the name is a furphy – it arose from the early use of derivative instruments by small funds for the actual purpose of hedging. (One Australian fund manger became a legend overnight because he bought index futures puts ahead of the ’87 crash and thus lost no money when everyone else lost 25%. That was a hedge).
Since then some hedge funds (eg again, LTCM) have given the industry a bad name by using derivatives to actually increase risk through leverage and then falling over. This has created the stigma. It is only the feeble-minded who still associate "hedge fund" with imminent danger and "derivative" with risk by default. The reality is that hedge funds provide for all sorts of risk/reward profiles and those who get caught out are only the same gamblers and worshippers of greed that have existed in markets since the beginning of time. Nothing has changed.
It is these feeble-minded who will immediately rail against anything hedge fund just like their ancestors who burned "witches" at the stake. These are sad people who think anything they don’t understand must be evil, and the problem is made worse because they will likely never understand. It is perfectly fair to regulate in order to protect investors from "dodgy" practitioners. It is ludicrous to regulate against financial market risk. Risk is fundamental. Those who get burnt are usually burnt not by the instruments they invest in, but by their own greed.
(Take the NAB "rogue" traders as an example. Who are the culprits here? The foreign exchange options market, or a handful of criminals? Actually, the real culprits were NAB management. There are none so blind as those who will not see.)
Having said my piece on hedge funds (that was me, not Gavekal) consider that hedge fund strategies fall under three basic categories.
The first is the "return to mean" strategy, where assets are bought or sold based on perceptions of under- or overvaluation. Warren Buffet is the pin-up boy here.
The second is "momentum-based" strategies. Here you will find the trend-followers and the technical analysts. The idea is to ride the wave while you can but get off before it breaks. This category is based more on human psychology than any fundamental analysis.
The third is the "carry trade", where managers play the yield curve by borrowing at low rates and lending at higher rates, or by investing in assets with higher returns. This category is very much in focus at present, as excess global liquidity has given rise to extensive carry positions but global interest rate rises will likely see them unwound.
Most hedge funds will play any or all of these strategies at any given time. As more and more smaller hedge fund strategies replace cumbersome index strategies the extraordinary return opportunities will become less and less. This is already apparent in financial markets where levels of actual volatility have been dropping for a long time. The less volatility, the less opportunity. This might be comfort for the risk averse, but it makes it hard to make money.
So if index funds are not an option, and hedge fund returns are diminishing, where do we put our money under the platform company model?
First option: give it to the consumer. Under the platform company model outsourcing has grown, leading to higher and more stable returns on invested capital, lower volatility in the economic cycle, higher productivity and higher disposable incomes for consumers. Thus the obvious choice is to overweight consumer plays – retail, consumer finance etc. However, in the more mature platform company economies (US, UK, Australia) the likelihood is that the benefits are already priced in. Hence the trick is to find countries that aren’t so mature (Japan, Singapore, Sweden perhaps?).
Second option: Buy scarce assets. Under the platform company model the poor get richer through falling prices, low interest rates and rising disposable incomes. The rich get insanely richer by capturing entire markets with zero marginal cost (Microsoft, E*bay, Google, IKEA). Thus one might turn to real estate, art, wine or anything the rich would covet. Again the problem is how much is already priced in.
Third option: emerging markets. As emerging markets expand and economies grow there are golden opportunities. There is also extreme volatility.
Final option: buy platform companies everywhere. You thought this would be the obvious conclusion, didn’t you. Platform companies offer higher more stable returns and thus should outperform over time. But again, how much is priced in already? The trick here is to invest in companies which are in the process of moving towards a platform company model (outsourcing production, maintenance, call centres etc) such that, in due time, their movement from the old business world to the new business world will eventuate in a re-rating.
But remember – platform companies don’t need capital. This is evidenced by the spate of capital initiatives, share buybacks, special dividends and so forth. It is actually not too much of a stretch to think that the days of listing a company for the purpose of raising capital may be numbered. What we might find is that instead of endless IPOs there will be complete management buy-outs. That would rid a company of those pesky shareholders.
It doesn’t sound all that inspiring, does it, and there you were expecting a key to the meaning of life in the Brave New World.
The fundamentals of investing have not changed. The trick is still to look for the highest returns but the trap is those returns may already have been priced in by investors ahead of you. Remember, the secret is also as much about avoiding losers as it is about picking winners. And it is still fundamental to hedge against risk.
How to hedge against risk? (1) Diversify – this is a golden rule in any investment model; (2) Insure – if you have a lot of your money in, for example, the stock market, talk to your broker about index put options. These can be employed as a trailing stop-loss that allows you to always sleep at night; (3) Hedge often – when things are going very well then it’s a good idea to spend some of that gain by locking in part of it. That doesn’t just mean selling, it means investing in other instruments – derivative or otherwise – that will perform well if your star performers falter. The best scenario is that you always lose on your hedge, but at some point a hedge will ultimately come into play.
At the end of the day, investment success is inexorably linked with economic growth. But just because economies are growing, it doesn’t have to follow that prices are growing too. Consider that there are four investment scenarios.
The first scenario is the "inflationary boom". This is the scenario that has been most prevalent since the Second World War, and hence the scenario that drives most investment strategies today. In an inflationary boom sales accelerate, prices rise and margins rise as well. Such booms usually occur when central banks pump too much money into the system with the intention of stimulating economic activity.
In this scenario the winners are emerging markets and commodities. Does this sound familiar? Inflation has crept into the system once more and the world has experienced a boom in emerging markets and commodities recently. The problem is that once inflation takes hold there is a chance of…
The second scenario is the "inflationary bust" or "stagflation". This was the theme for the 70s. This scenario is usually triggered by excessive government spending and growth in money supply, and in the case of the 70s an oil price spike. Many economists warn of stagflation right now, because inflation is rising but economies are slowing. Most, however, see inflation abating. In the meantime, the inflationary bust tactic is to buy gold.
The worst scenario of all is the "deflationary bust". This is a scenario in which everything goes down in price, except government bonds. A deflationary bust is born from excessive government intervention that might involve increased taxation, increased regulation, protectionism, or a war.
By a process of elimination, it follows that the fourth scenario must be the "deflationary boom". The concept of a deflationary boom may seem almost contradictory, but only because there is a misplaced association between the words "deflation" and "depression". Deflation simply means the level of inflation is declining. There is another word, "disinflation" which actually means inflation is negative, and again it is confused with deflation. Depression means negative economic growth, and hence is not associated with a deflationary "boom".
Not only is it quite possible for prices to fall while the economy is booming, there have been many such cycles in history. What is important to a business in a time of falling prices is that sales are increasing. If both are falling then its game over. The reason the oil and metals commodity price spikes have not sparked immediate global inflation nightmares has been because of the deflationary boom going on in China. Exports from China have been growing but prices have been falling (take electronic goods, computers etc as examples).
The consultants at Gavekal believe the deflationary boom is the natural state of capitalism. This state will often be interrupted by any of the other three scenarios over periods of time, but the deflationary boom will prevail.
They believe that after 25 years featuring inflationary bust (1972-1982), inflationary boom (1983-2000) and the occasional deflationary bust (Japan since 1990, Asia 1997 and 2003) we are entering a global phase of deflationary boom. The problem is no one much alive knows how to invest in a deflationary boom.
Evidence from the nineteenth century, and also from the US (and Australian) experience from the mid-90s to 2005 when the Gavekal treatise was written, shows that the winners are the currency, the local consumer, local financial companies (especially banks), real estate (particularly at the high end) and any producer of goods with high elasticity (sees volumes rising faster than prices fall).
At the moment it appears, as suggested, that we may suffer a very brief inflationary bust as current inflation fears are worked through. However, this does not override Gavekal’s greater theory.
Gavekal’s advice for portfolio selection under a deflationary boom is to invest in platform companies, emerging markets and commodities, and to hedge against the mistakes of governments and central banks by holding gold or cash and high quality government bonds. The consultants suggest one could split between these four and go to the beach, rebalancing once a year, and be surprised how good the longer term performance turns out to be.
For those who back themselves that they can move money around more actively for a better result then portfolio shifts between the four asset classes is the way to go.
Gavekal believes the odds of a real inflationary bust are small, and the odds of a deflationary boom are high. Thus it makes sense that an overweight position in platform companies makes sense in a brave new world.
The ideas and examples put forward in this series are the work of Gave, Kaletsky & Gave: Our Brave New World, self-published, 2005. The writer has added observations as well.
That wraps up FN Arena’s Brave New World feature series. The complete series will shortly be made available in a single PDF file. We hope you found the ideas put forward as evocative as we did.
