Dear Valued Clients and Friends,
I wrote last week about a small amount of rather large economic principles that are too often forgotten in contemporary thought, and in many cases were never learned in today’s financial advisory community. I promised a part II this week where we focused more on the application of these principles, and there is no way I would disappoint you after that powerful cliffhanger.
I will point out before we dive into the Dividend Cafe that I hosted a fireside chat with Bahnsen Group economic and policy advisor, Larry Kudlow, this week. You can find that whole video replay here if you are so inclined.
Today’s Dividend Cafe is short and sweet but does focus entirely on the promised mission – putting into practice for investors what the theories of economic wisdom look like. Off we go …
Investing in Human Action
Last week’s Dividend Cafe sought to remind you of the single most basic truth in all of economics, the one I centered so much of my new book around – that economics is the study of human action around the allocation of scarce resources. The humanity of economics is not merely a way to make this study more touchy-feely. The core of understanding economics is understanding the human person, and economists serious about their craft would be wise to view this for all its factors and considerations.
For investors, we can lose sight of the created realities of the human person – the key actor in any economic transaction (both the producer and the consumer are, in fact, human beings). Those realities do not merely include various spiritual, transcendent, and moral components (though they do include those, too), but they include the characteristics of mankind which serve as the framework for thinking about human activity.
Humans do act, and they do so with remarkable instinct, impulse, and freedom. The self-preservation drive in humanity is quite impressive, but so is the aspiration drive. Self-interest is not something that has to be imputed into mankind after birth – it was well-placed into humanity’s very nature (though a proper moral education goes a long way to restrain vices and ill-begotten instincts out of that self-interest).
The realities of the human person impact my view of investing in so much as I never want to lose access to the rationality, creativity, and innovation that is embedded in the human spirit. Too much investing today is agnostic about human action, and falls for the misnomer that profit-making activities can be captured separately from these conditions and characteristics. What do I refer to?
The more one falls for financial engineering as a strategy for return on investment, the less they have tapped human action.
The more one looks to raw materials as a source for return without regard to the human touch that will extract value therewith, the less they have tapped human action.
The same goes for real estate – the ability to see optimal returns from brick, mortar, and land without consideration for the human endeavors required to give it value, the less they have tapped human action.
A spreadsheet merely trying to capture obscure price patterns and potential arbitrage opportunities in price anomalies may or may not prove to be successful as algorithms go, but pattern-driven strategies can never account for human action – which is not merely rational, creative, and innovative, but is also adaptive, flexible, and at times, unpredictable.
What am I getting at here?
We have a strong bias towards capturing the true essence of human action in our investment portfolios, which are most directly and efficiently expressed in the profit-making activities of, well, human beings (sometimes in very cooperative contexts, other times more solo-visionary). When we buy stock of individual companies, we want to capture the profit-making activities of those companies – not merely “play” for a “momentum trade.” Chart action and model-driven hocus pocus is transitory; human nature is evergreen.
The resilience of the human spirit is not investible in a more direct way than in human enterprise. So when one invests in small-cap equities, in emerging markets, in private equity, in dividend growth publicly traded companies – all asset classes we are heavily invested in – we want to be invested in a real story of real people carrying out a real mission with a real strategy and a real culture for real results out of real execution. We want all those real things to create real profits. Yes, the liquidity characteristics of different asset classes mentioned in these paragraphs may offer different pros and cons to different investors. Yes, the risk/reward trade-offs may vary. Yes, the expected volatility is different in each case. But the point I am making is that in all cases the research must be driven around the activities that make humans human, and that can be studied, analyzed, and assessed as such. We determine investment conclusions in these spaces not around inhuman elements of equity markets, but human elements. And in this case, tap the essence of “bottom-up” investing.
Specific to bottom-up investing, I simply must add that buying the entire S&P 500 does give access to some of the great companies and brands in the world, but it also does so with the most bureaucracy, the least subsidiarity, and the most top-down characteristics. If the “knowledge problem” is giving large centralized bodies control over decisions that they have imperfect knowledge to make, the decentralization of, say, private equity companies, may prove more opportunistic. There are fewer decisions made on widely dispersed knowledge which lack optics in more localized and decentralized businesses. Can huge companies also enjoy benefits that others do not, such as scale, brand, balance sheet, and moats? Of course. But we want to make sure that as companies scale their strengths they do not also scale their weaknesses, and size often exacerbates the knowledge problem.
This is pivotal to our investment process, and one of the reasons we favor brands in our mega-cap businesses versus mere bureaucracies.
We look to companies that have the ability to produce goods and services that create growth, prosperity, value, and change. Worrying about the consumer’s appetite to consume, and saying things like “70% of the economy is consumption” is to miss the economic reality that consumption is a given; it is production that requires incentive. No human has ever needed to be told to eat good food or take good vacations – they like consuming good products and enjoying good experiences, without incentive (and sometimes, even without the responsible means of affording such).
Rather than obsessing with the demand side, we want our investment portfolios to be focused on production. On creating goods and services that create their own demand. On driving innovation and activity that builds wealth. Companies that tap into existing motivations or seek new ones are more investible than the idea of trying to figure out how humans will eat more candy bars. When marginal incentives to produce increase, there is investible opportunity.
This impacts not just what we root for (though it does that, too), but what we search for. Where are incentives coming to produce that will harness mankind’s capability? That is where we want to be.
Minimizing the fog
The monetary policy aspects that I wrote about last week are the final component. If we believe the present monetary regime that seeks to distort the true cost of capital is at risk of distorting capital allocation decisions, we want to have as little reliance on the mere cost of capital as possible.
Now, we cannot avoid this entirely. No one can. If asset prices are distorted, and marginal mal-investment takes place in a monetary regime such as this, every risk asset investor is exposed. All we are talking about is mitigation.
Again, what does this mean?
Risk mitigation, period. It means evaluating how much of the attractiveness of an expected return is a by-product of distorted capital cost. It means modeling the potential of a business in different liquidity conditions. It means pricing in the potential of adjustments that impact some companies more than others. So in real life, this means:
(1) Avoiding zombies (who has a perpetual business model of mediocrity or worse that only stays alive because of low capital cost)
(2) Avoiding valuation reaches (whose investment thesis is predicated merely on what is super over-priced becoming super-duper over-priced)
(3) Avoiding yield grabs (who is risking 10% of principal to pick up 1% of yield)
Money gets left on the table in the good times in periods like this. But if you believe, as I do, that the Fed has allowed some asset bubbles to get to a point where they cannot let them burst, it means other mathematical and scientific forces will have to play. Our investment application here means being most-positioned around quality, good pricing, and defensive businesses that have some degrees of separation from mere Fed excess and reliance.
Quote of the Week
“In the dust of defeat as well as the laurels of victory there is a glory to be found if one has done his best.”
― Eric Liddell
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I hit submit on this from New York City, having just arrived on a red-eye. The 47 degrees temperature is what I have been waiting for. That 70 degrees sunshine in Newport Beach yesterday is great but a crisp morning in NYC? Can’t wait.
Reach out as always and enjoy your weekends!! I intend to.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet