“Three things ruin people: drugs, liquor and leverage”.
There are so many excellent quotes and so much wisdom from Charlie Munger one the great value investors. He appreciated that investing is the intersection of psychology and valuation. I personally loved that he criticised investment banking spin right to the end. “Every time you hear EBITDA, just substitute it with bull…t.” He was an absolute legend. From our own humble perch, it has always been important to have value as an anchor, rather than adopting a forecasting-based approach. However, value is conditional on cash flows, profits, and balance sheets. As we noted in our “non-predictions” we attempt to take on expanded risk premium when expectations or beliefs have shifted rapidly and have become focused on an implausible outcome. Stated simply, it is about getting the valuation odds on your side.
An irony of the great man’s incredible performance over a long period of time is that “value” equity has underperformed “growth” equity since 2007 and especially over the phase of zero rates and quantitative easing (chart 1). Of course, as we noted above, “conditional” elements or having a quality bias have been important, especially when the discount rate or the cost of capital started to rise in 2022 following the end of the “super-abundant” liquidity phase. Historically, rate hike cycles when capital and liquidity become scarce have often triggered or contributed to greater differentiation within equities. Growth companies with expected cash flows well into the future also tend to be longer duration and sensitive (from a Net-Present-Value) perspective to an increase in the discount rate. As a result, value tends to outperform growth following a rise in the discount rate.
As we have noted in the past, the price determination mechanism is also more complex than taking news (information) and using a valuation model to forecast price. Rather, price is also influenced by perceptions of risk and the required rate of return in a self-reinforcing feedback loop. Put another way, the valuation multiple and risk premium are often pro-cyclical. Valuations tend to expand when investors are more confident and contract when they are pessimistic about future returns and fundamentals. Perversely, investors ought to take the opposite approach from a psychological or behavioural point of view. The best returns are made when you are deeply uncomfortable, not when confidence is high, and the risk premium is narrow. Of course, from a single stock perspective there is also a question of the business model itself and sustainable returns (profits) relative to consensus beliefs.
In the current episode, the context is that equity earnings yield on the S&P500 is rather narrow relative to the yield on Treasuries. However, underneath the surface valuations are depressed on a range of stocks outside the top 10. That is especially true outside the United States. In sympathy with Charlie’s observation, if you want to know where the risk is: follow the leverage. In the cycle, the leverage has been in government debt and the misallocation has been the “volatility laundering” in private assets. The forward-looking risk is that private assets eventually get marked at more realistic valuations and that creates a potential episode for the pension funds and endowments that have allocated too much capital into unlisted assets.
While the great man might not have allocated a lot of capital based on observations about macro conditions, single stock opportunities tend to be greater in phases of dislocation and discrimination, not during phases of super-abundant liquidity. That tends to occur after the Fed has hiked the funds rate. Great companies and business models ought to be able to perform through-the-cycle not simply when capital is cheap, plentiful and investors are euphoric. Rest in Peace Charlie.