2021 – The year that changed the world
2021 ushered in a rise in consumer price inflation (CPI). Demand rebounding from the lull in consumption during the COVID pandemic found supply chains short of capacity. Excess demand was exacerbated by government stimulus cheques to help supplement incomes of those whose livelihoods had been adversely affected by the pandemic.
Businesses that had taken precautions to limit production and inventory during the pandemic found themselves scrambling to turn on the taps again. This stoked inflation where consumers outbid each other to secure goods in short supply. Central Banks around the world responded by raising interest rates to stop prices from spiraling higher – effectively curtailing consumer demand.
The battle against inflation saw no respite as Russia invaded Ukraine in February 2022 and much of the Western world imposed sanctions on Russian oil and gas. Ukraine, the largest producer of wheat, also could not export the staple. These disruptions added to supply shortages relative to demand. CPI breached 7% in the US and crept closer to double digits in the UK.
Central Banks responded by continuing to raise interest rates. The bleak outlook on inflation and interest rates decimated the markets. The economically sensitive Nasdaq tumbled 33%. Who would have imagined though that in 2023, the same index would get off to a roaring start despite worsening inflation and interest rate figures? As I write this article, the Nasdaq is up 25% year to date.
2023 – the bounce back for certain market segments
This recovery is amazing given that the 10yr US Gov bond yields peaked at 5% in October, above the long-term median of 4% going back to 1871.
The surge in 10yr US Gov bond yields took off in earnest from the June quarter end, at which time the yield was 3.8%. The 10yr yield is what auto loans, credit cards, and other long-term debt is priced off. As yields rose, the Nasdaq fell 11% from July 19 to October the 27th. It has since rebounded 8% from October to today, November 13th, in sympathy with US Gov bond yields that have retraced lower from a high of 5% to their current 4.6%.
But is short-term market behaviour really consequential?
Why are we regaling you with this story? Because investors waste their time trying to impute these movements into their valuations of businesses. They buy and sell shares based on the movements in inflation, interest rates, GDP growth and other macro-economic factors.
Competitive advantage can be assessed and valued
Against this, we believe that companies should be owned or disowned based on their relative competitive advantages and our valuation framework must account for differences in competitive advantage. We are obsessed with competitive advantages because they are solely responsible for compounding of shareholder value. It behooves us to identify and value competitive advantages in a business if we wish to arbitrage the cyclical nature of macro-economic factors. One should never forget that some of the best businesses the world has ever seen were listed at times when the US Gov 10yr bond was above 6%:
Great businesses demonstrate resilience through the toughest of times
These businesses lived through a peak of 14% in the US Govt Bond yield to be what they are today. One may argue that they were disruptive, and their long-term prospects unknown due to significant risks to product penetration. You may even argue that it’s less risk for incumbents to cede “first mover advantage” to a disrupter and be a “fast follower” instead. Please allow us to provide our retort by quoting Andrew McAfee, digital innovation research scientist at MIT Sloan School of Business:
“Opting to be a fast follower is a recipe for long term decline. Every risk that you can point to that prevents you from being a first mover is real. But if you are behind on learning about them, then you are behind on the learning curve. Then you are behind on the experience curve, and you are behind on the productivity curve. The risks are real but manageable. You can imagine how insulting the disrupter is going to make it for you to copy them. Your prize will simply be staying alive.”
Great businesses are often difficult to value
The reason we focus on companies that provide us with the best options to compound shareholder returns is that it is as hard for competition to beat them as it is for us to accurately compute their valuation. In fact, it is mathematically impossible to handicap the valuation of a moat that is widening. Think about it, an analyst would have to keep increasing her valuation as Coca Cola went from colouring and flavouring 0% of the world’s fresh water to 2%. We use the anecdote of the “Chessboard Problem” to illustrate the difficulties with accurately valuing a business with a flywheel of value creation well in motion.
The chessboard problem
Since returns from compounding are non-linear, that is, do not go up in a straight line, investors often surmise that a bird in hand (from mean reverting, macro-factor induced returns) is better than two in the bush. Psychologists use a story of an ancient Indian Minister, Sessa, who supposedly invented chess, to illustrate the power of compounding over time.
As a reward for inventing the game of chess, The Minister requested the ruler to give him grains of wheat according to the squares on a chessboard. He asked the ruler to double the wheat grains with every one of the 64 squares on the chess board. The ruler laughed it off as a meager prize for a brilliant invention, only to have court treasurers report the unexpectedly huge number of wheat grains – the sum of the grains on the chess board would be eighteen quintillion, four hundred forty six quadrillion, seven hundred forty four trillion, seventy three billion, seven hundred nine million, five hundred fifty one thousand, six hundred fifteen, or over 1.4trillion metric tons which is over 2000 times annual wheat production today. Naturally, this would outstrip the ruler’s resources.
A modern day example of compounding
Updated to modern times, the same hypothetical question is used to ask, “would you rather take $1m right upfront or a penny on day one, doubled every day until day 30?” Doubling every day for 30 days would yield $10m while doubling every day would yield $1m in 27 days. So, taking $1m upfront would make you look like a hero for 27 days! However, you would rue your lack of patience to net yourself $10m in the last three days of the month.
Lessons from this piece
Understanding a company’s competitive advantage (moat) and having the structures in place to value this advantage, is critical to generating market beating returns. We believe this is a more sustainable method of generating wealth for clients than attempting to guess economic cycles or responding to short-term economic noise.
Great businesses compound returns and can create outsized returns for investors – the art is recognizing which businesses might do this.
Temperament has an exponential impact on investment outcomes (compared to other means of alpha generation, namely, analytical, and informational advantages). Temperament allows us to forgo upfront gains (quarterly and even annual gains) in favour of compounding outcomes that may only show up further out on the horizon of adverse macro-economic factors.