Regarding… Vol 3 no 33 – Ode to the Cockroach

Dear Fellow Investors and Friends,

Welcome to another edition of my newsletter, where I share my efforts to understand markets and the world around me.

I do appreciate you taking the time to read this. Feedback is welcome; feel free to drop me a line. It’s great to start conversations.

Today is Thursday, September 11th, the 247th day of the year. There are 118 days until the end of the year. I am presenting at the BizNews conference in Hermanus today, so I thought I would share my talk – mainly because in preparing for it, I ran out of time to write my letter in the regular format.

Normal service will resume next week.

With that, here’s my talk:

Most of you sitting in this room have a problem. Your problem is that you have accumulated some level of wealth through applying your skills in the real world. However, now you need to look after that wealth and ensure it retains its purchasing power over time – preferably in hard currency terms. Trying to do this makes people nervous.

Do I buy equity? Onshore or offshore? But what if markets crash? What if the politicians steal all our money? Should I buy bonds? Onshore or offshore? But what if the United States experiences hyperinflation? Should I buy gold? How do I buy gold? What about Bitcoin?

And so on…

Today, I want to present you with a solution. The solution is a cockroach. Most people would not imagine a cockroach to be a solution to a problem!! But if your goal is to survive and thrive over time, no matter what the circumstances, the cockroach is precisely what you should try to emulate.

But how does this work?

To explain, let me tell you a story about how I came to invest like a cockroach. When I started RECM in 2003, the first fund I launched was the RECM Global Flexible fund. I believed that investors needed a globally diversified portfolio. But I wasn’t very imaginative, and to compound matters, I believed that I was smart. Smart enough to see around corners. Simultaneously, I was also dumb enough to think the fund should look like just the competition’s funds – just better. And to be better, I would simply analyse harder and forecast better.

After all, that’s what I grew up believing a portfolio manager’s job was.

My assumptions proved costly. A 60/40 equity/bond portfolio with 25% (then, now 40%) offshore exposure just didn’t cut it. Initially, it went well, but I was just lucky. Eventually, my luck ran out, and performance started regressing to the mean. Then I got unlucky, and my performance really started to crater.

By the time of the Covid panic-induced crash in 2020, the fund’s performance was shocking. I was ashamed.

It was time for change.

But before we examine the changes I made, let’s establish some investing facts first. Facts that I learned firsthand.

Firstly, let’s just accept that we know nothing, especially about the future. As Munger sub-quoted Socrates: “The dawning of wisdom is when we realise that we don’t know anything”.

Now, to fill this void, market practitioners – such as myself until 2020 – developed elaborate measures of risk, as risk is measurable and thus quantifiable.

To explain, what is the risk that you lose on the first roll of the dice in craps? Well, craps are 2, 3 or 12 on a come-out roll. There are 4 ways to do so (2 one-way, 3 two-way, and 12 one-way) out of a possible 36, i.e. the risk of rolling craps is 4/36 or 11.1%.

But that’s not how markets work. I mean, what is the risk of the market going down 20% tomorrow? No one knows. In markets, we live in an uncertain world, not a risky world. Uncertainty is unquantifiable; nor is it measurable, despite the financial industry’s best efforts.

So they have come up with nonsense metrics like VAR and CAPM. Without going into the weeds, these types of calculations assume returns are normally distributed and independent; however, financial markets typically exhibit fat tails, skewness, bursts of volatility, and high autocorrelations – especially during crises.

Standard measurements of market risk are simply extrapolations of what has happened in the past.

During the Second World War, indigenous populations on some Pacific islands observed planes flying overhead and dropping cargo, filled with food and drink. They were dropping it to the soldiers stationed on the island. Sometimes the drop would miss and fall into the hands of the locals. When the war was over, the soldiers left the island, and the locals started missing the cargo drops. So, they built makeshift airstrips and towers from bamboo to resemble wartime air bases, hoping to attract cargo planes, as they had seen during the war, even though they lacked any technology or real understanding. They simply hoped these makeshift simulacra would attract the real thing to drop some more cargo on them.

This is what financial risk management is – cargo cult science – an extrapolation of the past, hoping for a similar outcome.

Robin Williams was a genius who understood how the world works better than most. He was also a terrible student. During a macroeconomic class at College of Marin, Williams’ final paper contained a single sentence to his professor: “I really don’t know, sir.”

He failed the class. But if you ask me, his answer is the highest level of economic wisdom.

But this is overwhelming! We don’t know anything, and even the things we think we know something about are fraught with uncertainty and can’t be adequately measured.

What to do?

Okay, let’s start with three things we do know for sure:

1. Long-term returns come from staying in the game. Over the past 100 years, the S&P 500 index has returned around 10.5% p.a, or 7% above inflation. That is an outstanding return. And it was achieved despite two major world wars, the Great Depression, a huge bout of inflation in the 1970s and 1980s and crashes in 1929, 1973, 1987, 2000, 2008, and 2020. If you had sold every time one of these events happened and waited to get back in when things seemed “safe”, your returns would have been much worse! The same goes for the SA market. If you had sold after the Sharpeville massacre, Verwoerd’s assassination, the oil crisis in the 70’s, during our debt default in the 80’s, the crashes of ‘87, ‘98, 2008 and 2020, and only bought back when it was “safe”, you would not have come close to earning the 14% p.a. – 7.5% in real terms – that the JSE provided. Morgan Housel said it best when he said, “Average returns sustained for an above-average period of time leads to extraordinary returns.”
2. Harry Markowitz once said, “Diversification is one of the few free lunches in finance” – you can have lower risk coupled with a higher return. But this depends on diversifying among assets with negative correlation. This leads directly to the corollary: you are not adequately diversified if none of your assets causes you at least some discomfort at any point.
3. All else equal, the more volatile a sequence of returns, the worse the compound returns are over the long term. In Yosemite National Park, there is a famous mountain called Half-Dome, which is exactly that, a half-dome: vertical in the front, and dome-shaped at the back. Climbing the face of the Half-Dome can take up to three days. Climbing uses about 700 calories per hour. Assuming you climb for 8 hours per day, you will use approximately 16,500 calories. There is an alternative route, however. You can walk up the back way, which takes around 12 hours. Hiking expends around 500 calories per hour, so to reach the same place – the top of the mountain – you will use around 6,000 calories. With both routes, you end up in the same place: at the summit. However, one path is perilous and requires a great deal of energy. The other is easier and requires significantly less energy. In trying to achieve our investment goals, our preferred route is up the back way!

To relate this to investing, the energy you spend going up and down a mountain is volatility. If you instead use that energy to travel horizontally across the ground, you cover far more ground – and that is compounding. All else being equal, the more volatile a return stream, the worse the long-term returns.

To illustrate, think of two funds. One achieves 30% in year one, while the other achieves 10%. Next year, fund one does 30% again, while the other fund continues to chug along at 10%. Of course, the first fund now has advertising all over the airport and all the DFMs – based on their rigorous analysis of the fund’s historical returns – think it is the best thing since sliced bread. So, it attracts all the flow. The other fund is like the wallflower at the dance – no one is interested. In year three, the first fund goes down by 30% – after all, to achieve high returns, you must take significant risks, which works both ways. The second fund is still stuck doing 10% p.a. If you add up the returns (30% plus 30% minus 30% AND 10% plus 10% plus 10%), on the face of it, both funds have done the same. But compounding is not additive; it is multiplicative. On a compound annual growth rate, which is what we as investors care about, the second fund did 10% p.a. while the other fund – full of client money – only achieved 5.8% p.a.

So, how can we use these certainties in our efforts to achieve our goals?

At this point, we should first remind ourselves of our goals:

1. We want our assets to grow more than inflation in hard currency terms, to maintain the purchasing power of our wealth over time.
2. Our assets must be available in liquid form at any point if we need them.

We need to achieve this, knowing that stats will not help us. Even if we could calculate it, we can’t get the prospective average return of the market. The expected return of a 50% gain and a 50% loss is zero. Except that we won’t get that expected return of zero –  we will get what we get, which is either 50% more or 50% less.

Another way to think about this is that 5 out of 6 – i.e. 83% – of players who are offered a million rand to play Russian Roulette think it’s a great game. The expected return from playing is R830k. But the 6th player disagrees. That person is beyond caring about the stats.

Neither you nor your portfolio can ever afford to be the 6th player. You just do not achieve the” expected” market return, so discard that concept where it belongs.

So, what you want to own is not necessarily the best asset – i.e., the asset with the highest expected return over time, like a game of Russian Roulette. What you want to own is the best combination of assets – in other words, the combination that preserves your capital during bad times and grows it in the good times – the combination of assets that avoids significant losses.

Fortunately, Gavekal has helped us in this regard. They came up with the 4-quadrant approach. It basically describes 4 types of economic environments:

1. Inflationary boom
2. Deflationary boom
3. Inflationary bust
4. Deflationary bust

If prices are increasing – along the vertical axis – you want to own hedges against inflation, or tangible assets. Generally, you want to stay away from contractual assets like bonds or property.

• In a bust, this can be cash or any anti-fragile asset. An anti-fragile asset benefits from things going wrong. Anti-fragile assets benefit from higher volatility. Such an asset would be gold, or a short position in stocks, or a position that is effectively long volatility, such as owning options.
• In a boom, you want to own growth assets that are sensitive to price, like commodity producers or other cyclical assets. Contrarian assets could also work, such as owning value stocks when everyone else owns growth stocks or owning Chinese stocks when everyone else owns American stocks, and so on.

If prices are decreasing i.e. below the horizontal line, you generally want to be in nominal, or contractual assets.

• In a bust, cash is a defensive asset, while bonds can be anti-fragile.
• In a boom, you want to own growth assets that are sensitive to volume growth, like tech stocks – the Mag 7, etc. Bonds and cash provide resilient income in this environment.

Now, of course, all we need to do is to predict in which quadrant we will be going forward, and align our portfolio with that, right?

No!

Remember – the cockroach survives not because it is smart and can forecast, but because it is dumb and robust to any situation.

What we need to do, then, is not just predict, but also prepare for any eventuality. And how do we prepare? By building a portfolio that has equal exposure to all 4 quadrants, i.e. 25% each in:

• Cash (deferred purchasing power)
• Bonds (contractual assets)
• Equity (growth/fragile assets)
• Hard assets (anti-fragile assets)

In so doing, we will have a mix of assets in our portfolio that can survive a catastrophe and that can thrive when the all-clear is given, just like a cockroach. Importantly, the assets we own in this portfolio are negatively correlated, which reduces the volatility.

An essential aspect of this allocation is its ability to play defence. Defence wins championships, and our goal is to win the wealth preservation and growth championship, not every game. In the previous Rugby Union World Cup, the teams that won the semis and the final were the teams that had less possession, kicked more and made more tackles. The stronger defensive team won.

As someone famously said to a portfolio manager who was pontificating on what he thought the client should be doing (much like I am doing now!): “Don’t tell me what you think, tell me what’s in your portfolio!”

So, here’s what the MWI Worldwide Flexible Fund looks like:

• 25% in cash – mainly US$ (15%) plus 7% JPY and 3% ZAR
• 25% in bonds – mainly SA govt bonds, but also an increasing allocation to EM bonds ETFs. No developed market bonds.
• 25% in equity. Here I am building a portfolio of equities I call my “10 stocks forever”. These are 10 stocks, global businesses that:
  • are high-quality businesses (i.e. high margins, high ROE);
  • have been around for over 50 years, i.e. they are Lindy;
  • have a strong culture; and
  • have low debt levels, making them less vulnerable to a market downturn.

I have been building this portfolio over the past 18 months, and so far, I have bought shares in Nestle, Estee Lauder, LSE Group, Berkshire Hathaway, and Disney. I have not yet bought shares in Hermes, Nintendo, Amazon, Microsoft, and Investor AB. I will do so over the next 18 months as and when appropriate.

• 25% in hard assets. This is primarily held in physical gold through an ETF, but it also owns energy assets, as well as small allocations to Bitcoin, land, and platinum.

As you can see, this is a highly diversified portfolio – in fact, I would even call it aggressively diversified.

What returns should you expect from such a fund?

• Cash should return 1% more than inflation.
• Bonds should give you 2% above inflation.
• Equity should give you inflation plus 4% to 6%
• Gold / hard assets should give you inflation plus 4 to 8%

Overall, that equates to an expected return of inflation plus 4%.

But what has the fund done historically?

Since August 2020, when I implemented the cockroach process, the fund has returned 9.7% p.a. in ZAR – 5.1% above local inflation. Measured in US dollars (my preferred method of measuring the outcome), it has returned 8.8% annually, 4.5% more than US inflation.

Importantly, it has done so with low volatility (the 2nd lowest out of 89 funds in its sector), low downside risk (also 2nd lowest in the industry). Its Sharpe and Sortino ratios are above 1, which indicates solid returns for the level of risk undertaken.

To sum up, what is the cockroach all about?

• It’s simple – you can do it yourself or entrust the job to me.
• It’s liquid – you can always access your funds quickly in an emergency.
• It doesn’t require any forecasting.
• It doesn’t rely on a genius fund manager.
• Its low volatility provides us with low stress levels, keeping us in the game.
• Rebalancing utilises the cash allocation to buy assets at a low price – which is almost the exact opposite of what most investors end up doing.
• It maintains and grows the real value of your hard-earned asset base in hard currency terms, despite anything the politicians will throw at us.

But don’t expect the DFMs or investment consultants ever to recommend this process!

Thank you.