Thinking About Investing and the Economy Post-Pandemic
As I wrote a few days ago, the return to normalcy has begun in California just as it has in many other parts of the world. Case in point: Walt Disney World in Orlando, Florida has submitted a plan to begin reopening in July. Keeping an eye on numerous individual companies, as well as a broad array of economic data, I am far more optimistic about the next ten years than I was this time last month.
My thoughts on the topic are expansive and it is difficult, if not impossible, to encapsulate them in a brief blog post. At best, my hope is this gives you some idea as to the partial lens through which I see the world right now. Before we get started, I want to expressly state that nothing in this post, or anywhere on my personal site, including any responses I may write in the comments section, is, or is intended to be, investment advice even if you are an existing client of our fiduciary wealth management firm, Kennon-Green & Co. (In the latter case, those will occur through our direct conversations at the office on the telephone, in private client letters, and in Timeline posts published on the restricted blog within the private client portal where we discuss specific companies and, sometimes, specific valuations and weightings as to why we are doing things.) Instead, this is a broader scale, academic discussion outside of my work like one I might have over coffee with friends.
Also, please keep in mind that this post is written based upon present-known factors. Conditions have been changing rapidly. It is entirely possible there may be a new development, such as the virus mutating to become much more or less lethal, a war breaking out between superpowers, an innovation coming along that revitalizes GDP growth, etc. As such, the conversation is limited, by its very nature, to a specific snapshot in time. If facts and circumstances change, my opinion on a given matter may accordingly change and cause me to make decisions that would appear to be at odds with what I wrote here at the time of original publication.
That said, let’s dive into it. What are my thoughts on investing and the economy in general over the coming quarters, months, and decade?
The Odds of Suffering a “Greater Depression” Have Plummeted in Recent Weeks
If you asked me to ballpark it, I’d say the odds of the United States collapsing into a “Greater Depression” have imploded from 15% to 20% to around 3% to 5%. It could still happen – there are just enough moving parts that with the wrong roll of the dice, it’s possible – but it isn’t very likely for a variety of reasons as numerous political, cultural, and economic forces align against it. Instead, this country will face other challenges, some of them substantial, that are likely to manifest over the coming 120 months.
Our Baseline Economic Scenario Going Forward
While we hope things work out more favorably, in order to better protect our wealth and the wealth entrusted to us, our current baseline economic scenario is that:
- The United States experiences a deep, and painful, recession that may not end until December 2021. It is going to be worse for other countries as we have several things going in our favor, including a much better capitalized banking system than nearly the whole of Europe.
- Unemployment will remain elevated at over 10% for quite awhile. It may take years, perhaps even much of the next decade, to recover the jobs that were lost; a pace slowed, in part, because the nature of this pandemic is going to accelerate automation that minimizes human contact if and when desirable, reducing the need for employees.
- The enormous increase in debt-to-GDP at the Federal level, along with various other factors, must be paid for in some way. Unless we suffer a duplication of the “lost generation” phenomenon seen in Japan, this will either mean substantial middle class tax hikes at some point in the future (taxing the rich won’t be enough) and/or a noticeable uptick in inflation with nominal prices rising at a rate people haven’t experienced in decades.
- Weakened state and local municipality budgets are going to cause forced austerity absent Federal intervention, which could slow the rate of recovery by suppressing demand.
- Global passive income distributions, including dividends on common stocks, are going to be slashed dramatically and take years to recover. In some cases, this will be the wisest course of action for the best long-term outcomes. For example, I mentioned Disney earlier. The Walt Disney Company is one of our largest family holdings. Both Aaron and I completely, totally support the board’s decision to suspend dividend payments to preserve cash until the theme parks are re-opened. Had we been on the board, we would have voted for it in a heartbeat, if not have been the first to suggest it. The business is a goldmine that can compound for generations despite the significant volatility in its common stock. No other enterprise on Earth has the same breadth and quality of intellectual property. Keeping it safe so that it gets through a challenging, but temporary, situation caused by exogenous forces is what matters.
- There will be no nation-wide second wave of lockdowns that are in any way comparable to the first. Given the economic damage that has been done, and how close we came to the brink, I truly believe that if such lockdowns were enacted, legislators and governors would be gunned down in broad daylight by people with nothing left to lose. Based upon my current back-of-the-envelope estimates, we’re probably already at the point that 1 out of 2 families earning less than $40,000 have lost most if not all of their income; the main reason this isn’t causing riots being the temporary generous unemployment benefits that are not likely to be extended past this summer. If that income disappears, and healthy people at low risk of death are told they can’t go back to work, politicians, as well as average citizens attempting to enforce quarantine, will be assassinated or killed. There is a reason empires throughout history were brought down due to a lack of bread. People have shown a remarkable ability to suffer oppression provided they are well-fed and constantly entertained. If you take those things away, all bets are off. Call it what you will but we have effectively transitioned to a herd immunity strategy with the very real possibility 500,000 to 1,000,000 out of roughly 331,000,000 Americans die earlier than they otherwise might have died (despite lowered estimates projecting 100,000 to 200,000 deaths).
On that second-to-last note, I’ve always found it interesting that more companies haven’t adopted what I would refer to as an “Entrepreneurial Dividend Policy” in which they pair a relatively small base dividend considered sacrosanct with semi-annual discretionary dividend payments that fluctuate with the economic fortunes of the enterprise precisely how a private business owner is likely to declare distributions from his or her small business. Sometimes, you get special dividends like this but they tend to be few and far between. For example, Brown-Forman Corporation, one of the largest holdings at Kennon-Green & Co., declared a five-for-four stock split, an increase in its base dividend per share level, and a special one-time windfall per share cash dividend because earnings were skyrocketing at the bourbon distilleries. I like that system better because it gives management more ability to react to changing conditions and opportunities. I mean, if my family owned 100% of, say, Exxon Mobil, I’d want the dividend taken to zero right now so I could sit on as much liquidity as possible, watching the rest of the oil sector go bankrupt in order to rush in and buy up those holdings for pennies on the dollar. I think Royal Dutch Shell was wise for what they did, rebasing their dividend to a lower level (which, frankly, took a lot of courage as I thought a return to the scrip dividend was more likely given the political pressure they faced to maintain payouts).
The Types of Assets and Securities We Want to Own in This Economic Environment
This particular combination of potentialities caused us to write the private clients at our firm nearly a month ago via the restricted Timeline blog within the private client portal, explaining that the types of assets we wanted to own were likely to be disproportionately focused on those that could meet four conditions.
Condition #1: In the event of a severe economic recession or depression, the net product of per unit consumption and/or average price per unit is not likely to materially decline or, if it does, is likely to decline at a rate that is notably slower than the typical enterprise, resulting in greater stability of cash flows than a run-of-the-mill operation.
Condition #2: In the event of significant inflation five or ten years from present, the inherent pricing structure of the industry is sufficient to allow the enterprise to pass on most nominal increases in input costs to the end consumer, preserving real economic returns for owners.
Condition #3: The balance sheet must be strong enough that most reasonable observers would conclude the enterprise could be expected to survive all but the most extreme economic environments.
Condition #4: The price remains reasonable in relation to intrinsic value.
The Types of Assets and Securities We Don’t Want to Own in This Economic Environment
This means what we don’t buy is just as important as what we do acquire. For example, we are eschewing entire industries for the most part while focusing on others pretty heavily. Case in point: We have little to no interest at this time in building direct, major positions in banks as the combination of heightened default risk with unprecedented intervention by the Federal Reserve has created an environment in which profitability is likely to face significant headwinds for many years, none of which is the fault of the banks themselves. Our interest could change if, holding all else equal, prices were half of what they are now but we don’t feel present market quotations offer the best risk-reward trade-off, especially compared to certain other industries that meet the criteria set forth in the above list. Stated another way, prices are not low enough for at-risk enterprises such as the major banks to justify the potential downside to intrinsic value if the wrong roll of the dice comes up over the next few rounds.
Likewise, most long-term, fixed-rate annuities issued in this environment are likely to be horrific investments despite appearing to be stable in the short-term. Interest rates are at near all-time lows, annuities typically have hidden fees that can run as high as 6% to 8% up-front plus several percentage points per annum thereafter that the annuity recipient doesn’t even realizes they are paying because those expenses are carefully obscured, inflation risk threatens to strip away purchasing power materially over the coming decades, and any heirs would lose the principal as a source of inheritance absent certain rider provisions that might offer some protection on that matter for at least a certain period of time. To be fair, Aaron and I, along with effectively all of the private clients of the firm as well as many of you reading this, own shares of Berkshire Hathaway, Inc., which is one of the largest insurance companies in the world. Berkshire Hathaway has a good-sized annuity business so we, our clients, and you are all making money, indirectly through the Omaha-based conglomerate, selling these products to people even though I refuse to sell them directly at Kennon-Green & Co. because I don’t feel it can be done in the best interest of the client as a fiduciary. Annuities are just … such a bad deal for people if they have any financial sense at all. Worse, it offers the appearance of safety despite having astronomically high purchasing power loss risk, preying on those who want to be more conservative but who don’t understand the complexities of the underlying product. To put it bluntly, there is almost no scenario in which I would recommend an annuity to my friends, family, or private clients of the firm right now. It’d take a fairly unique alignment of the stars, including unlikely provisions within a specific annuity contract, to get me to change my mind on that. It’s not even close to the line.
We have little to no interest in weak credits in the corporate debt markets. It would be better to earn no nominal return, and hang on to cash, than to accept the exposures some of them require as they could get really ugly were economic conditions to deteriorate further and/or inflation pick up several years from now.
Important Strategies and Behaviors Going Forward, as Well as Other Thoughts
I’ve only mentioned general thoughts on allocation but all of this is predicated upon an individual, family, or institution doing several things.
Keeping plenty of spare cash on hand outside of the investment portfolio, even building their liquidity reserves further if already established, to serve as a buffer in the event income suffers a material deterioration or cessation of income.
Reducing fixed costs as much as reasonably possible while planning for contingency scenarios in which other costs are cut on short notice should it become necessary.
Finding ways to generate alternative cash flow streams if the primary or secondary streams are threatened. For example, I can tell you without a doubt that if Aaron and I still owned our sporting goods businesses, several months ago we would have found a way to design and manufacture face masks and other supplies within 7 to 10 days. We simply wouldn’t have slept until it was done because there would have been a window in time when providing an essential product at a reasonable price could have led to an influx of cash flow to bolster reserves. Our access to the expertise and machinery necessary to gain a head start would have allowed us to get to market faster than many others.
The reason: We remember the lesson of the railroads. For generations, railroads were the primary gilt-edged fixed-income securities for bond investors as well as the most attractive blue chip common stock investment for equity owners. Yet, the railroads suffered incalculable costs of omission because they made the mistake of thinking of themselves as being in the business of railroads instead of realizing their operating model should be transporting goods and people; that railroads were merely a means to an end not the objective itself. The railroads should have had investments in the car companies. The railroads should have been UPS or FedEx. They made the mistake of confusing the how for the what and why. A lot of executives, managers, and business owners commit this transgression.
Among the most important things to keep in mind is that you must not confuse volatility with real changes in long-term intrinsic value. It is ridiculous the number of people, including journalists and media commentators, who are surprised the stock market is rising when second quarter financials can’t be predicted. Yes, there is some speculation but the plainly obvious answer is that long-term business owners are looking at the net present value of discounted cash flows.
Let’s use an example of a real-world blue chip, The Coca-Cola Company, which is part of the Dow Jones Industrial Average. Most investors have exposure to it directly or indirectly. I’ve owned shares for years (and, in fact, own more today than I did at this time last year). Over the past 52 weeks, the beverage giant’s ownership has traded between a high of $60.13 per share and a low of $36.27, the latter figure only briefly materializing for a moment in time during the height of the uncertainty surrounding the pandemic. The stock has since recovered to $46.73 and offers a dividend yield of 3.51%.
The idea that somehow the recovery from $36.27 to $46.73, an increase of 28.8%, was totally irrational is not well-reasoned. For a long-term owner thinking in decades, despite its recent rise, Coke is trading for much lower than it was and now stands at a modest discount to its intrinsic value while offering much greater stability in the underlying business than the typical corporation. For someone using non-borrowed money with a multi-decade horizon, even if Coke were trading at a 50% loss from present levels five years from now, it will probably turn out to be a good buy if one holds long enough because it’s likely to produce a satisfactory risk-adjusted result compared to many alternatives. Sure, if the pandemic suddenly ends because a vaccine is found, people flock back to hotels, and travel companies skyrocket, equities in the hospitality industry might outperform Coke shares. So what? Regardless of whether such a miracle does or does not come to fruition is not relevant as under either scenario, Coke is probably going to be fine. I can’t guarantee it – even Coca-Cola could go bankrupt under some presently unthinkable set of conditions – but acting like people buying it at this price is similar to, or as irrational as, purchasing at 50x normalized earnings during the 1990s is asinine. All it tells you is the person making the assertion can’t value a business nor do they understand what stocks are or how they work. Are there more attractive long-term investments? Individually, on a component vs. component basis, no doubt there will prove to be. However, as part of constructing an overall compounding machine, companies like Coke have a vital role. Staying rich is as important, if not more important, than trying to amass a second or fifth fortune. Sometimes you need workhorses that do their job, come rain or shine, when the rest of the world is burning.
Really, it comes down to keeping cash on hand, selectively picking up companies that disproportionately meet the list of conditions I set forth earlier, finding ways to protect your income stream(s), and going about your life as best you can. The virus is here to stay and a lot more people are going to die. Stocks may crash, or they may not. If you are running your household, career, and portfolio intelligently so you can make it through almost any scenario, and underlying intrinsic value has not been materially impaired, it shouldn’t matter to you. The idea of buying, or not buying, stocks because they have gone up or down over a certain period of time without discussing underlying components and intrinsic value is speculating, not investing. It’s hard to get ahead, and stay ahead, that way as you are trading what is knowable and actionable for probability factors beyond your control and analysis.
Finally, I expect that the seeds being planted now are going to cause enormous political ramifications in the coming years and decades. Just one example: I’ll be surprised if the emergency powers of various governors aren’t modified to automatically expire unless renewed with the consent of the legislature or some other limiting mechanism that makes it impossible for a single elected politician to destroy the lives of millions of citizens without so much as a public hearing.