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Mental models are an oft-discussed topic in investing circles. Charlie Munger, Warren Buffett’s long-time partner who passed away in November at age 99, spoke at length about mental models as essential for investors to develop and use to synthesize the endless amounts of information faced daily. James Clear, author of the bestselling book Atomic Habits, describes mental models as “concepts, frameworks or worldviews that you carry around in your mind to help you interpret the world and understand the relationship between things. They are thinking tools that you use to understand life, make decisions and solve problems.” Munger suggested that a person should adopt a “latticework” of models to use systematically to process information in the world.
A frequently cited mental model in investing is Daniel Kahneman’s “Fast versus Slow” thinking, which was popularized in his 2011 best-selling book Thinking, Fast and Slow. This model attempts to overcome the biases that the human brain has when making decisions under uncertainty. Kahneman and his colleague Amos Tversky won the Nobel Prize for their work identifying several of these biases. Many assessments humans make under uncertainty involve estimating probabilities of one thing versus another. In their seminal 1974 paper “Judgment under Uncertainty: Heuristics and Biases,” Kahneman and Tversky highlight a person’s tendency to overweight new information when assessing probabilities, often to the exclusion of base-rate probabilities which they do not even factor into their assessment. Kahneman and Tversky demonstrated this tendency by presenting the following riddle to sample groups:
An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” Is Steve more likely to be a librarian or a farmer?”
The instinct of most who hear this riddle is to use the descriptive information given to assume that Steve would most certainly be a librarian, since the description fits the stereotype of a librarian. However, what actually has the largest impact on the statistical probability of whether Steve is a librarian or a farmer is the mere fact that in America, there are 20 farmers for every one librarian. So even though the description of Steve fits our stereotypical view of the qualities of a librarian, Steve is actually far more likely to be a farmer than a librarian. What is most interesting about this exercise is that the average person doesn’t even consider the preponderance of farmers versus librarians when answering the question. This illustrates the human tendency to overweight the most recent information, often to the exclusion of the largest factor ultimately impacting an outcome.
We believe this “fast thinking” judgment bias first highlighted by Kahneman and Tversky’s work is still alive and well in the current debate about inflation and interest rates. The prevailing narrative in the financial press is described simplistically as this:
It is January 2024 and America has recently experienced a period of high inflation, which peaked one and a half years ago with annualized rates of increase in price levels as measured by the Consumer Price Index that exceeded 9%. Since then, the Federal Reserve has increased overnight interest rates at a rapid pace to slow the economy. Subsequently, annualized rates of increase in the Consumer Price Index have declined in 15 of the last 17 months. Many economists forecast a “soft landing” where the economy slows but a recession is avoided. From this point, should investors be concerned about inflation?
The consensus view articulated in the financial press seems to answer this question with a resounding “No!” The simplistic conclusion made is that inflation risk is no longer a concern for investors because rates of inflation have fallen, so therefore the Federal Reserve will soon begin to cut interest rates. The consensus opinion exiting 2023 was that the Federal Reserve will cut interest rates six times in 2024. Many believed this would end the higher inflation and higher interest rate regime we have been in since 2022. As you might not be surprised to hear, we beg to differ. It is our opinion that such a simplistic conclusion overlooks the factors that will most determine inflation’s future impact to portfolios: the insidious nature of purchasing power reductions and the historical tendency for overly indebted nations to use inflation as a means of debt reduction.
Part of the reason for our differentiated perspective is that our time horizon is different than the average market forecaster. Our clients have hired us to manage their capital for achieving their long-term goals. Investors today are so focused on inflation’s reduction from 9% annually to 3% annually that they seem to be overlooking the fact that inflation at any level is a risk worth protecting against in long-term portfolios. Inflation represents a loss of purchasing power over time. Even the Federal Reserve’s stated 2% inflation goal is a gradual tax on your ability to spend – every dollar an investor has today would be worth ~2% less every year if the Federal Reserve achieved its stated inflation goal. With annual compounding, inflation at the Fed’s goal of 2%, every dollar today would buy ~18% less after 10 years. At today’s 3% annualized inflation, every dollar our client has today will buy ~26% less in 10 years. The nearby illustration from Visual Capitalist demonstrates the compounded impact of this phenomena over the last 100 years, during which time the United States Dollar has lost just over 96% of its purchasing power, averaging around ~3% annually.
Equally importantly, we suspect that it might be obvious in retrospect that the United States has now entered a new regime of lower growth, higher inflation and higher interest rates. The growing federal indebtedness in this country introduces increasing instability to our financial system. The United States government debt continues to expand at a rapid pace, outpacing the growth in GDP so that government debt as a percentage of GDP hovers near its highest ever level at 119% as of September 2023. The prior peak in this ratio had only been following World War II, which required an abundance of expenditure in short order. We now have what veteran bond investor Jeffrey Gundlach calls “institutionalized $2 trillion budget deficits” that are regularly around 5-6% of GDP even in strong economic times. If something seems unable to continue forever, it usually will not.
An analysis of economic history reveals a remarkably consistent pattern among heavily indebted nations both advanced and emerging: high levels of debt ultimately begin to impede economic growth. Because heavily indebted nations need this growth to sustain the highly indebted position they are in, many have succumbed to the temptation to use inflation as a means of debasing their currencies, which allows them to repay debts in currency that is less valuable than what they originally borrowed. As stated in their book This Time is Different, Carmen Reinhart and Kenneth Rogoff’s seminal history of financial crises: “inflation has long been the weapon of choice in sovereign defaults on domestic debt.” As they further concluded in a 2013 NY Times op-ed on the subject, “Resolving these [sovereign] debt burdens usually involves a transfer, often painful, from savers to borrowers.” Our clients are the savers, and doing what we can to protect them from the tool most used to affect this likely inevitable transfer (i.e inflation) is a very important aim of ours.
Finally, we also consider it presumptuous to assume that if inflation stays lower, then interest rates will automatically drop. The belief that the Federal Reserve is a grand puppet master in sole charge of determining the exact level of long-term interest rates is an increasingly fragile assumption. Credit is a nebulous thing. The ownership of newly issued US Treasuries is changing rapidly. The Federal Reserve is currently reducing its US Treasury portfolio at a rate of $60 billion per month, China is letting their US Treasury bond holdings run off and other central bank purchases have been declining. These changes are happening concurrent with our aforementioned ~$2 Trillion (or higher if a recession were to hit) of additional treasury debt that will need to be issued every year. We suspect that the Federal Reserve could have a harder time controlling the interest rate on long-term treasury issuances. As Reinhart and Rogoff say: “Excessive debt accumulation poses greater systemic risks than it seems during a boom.”
Over the short term, this inflation and resulting rates discussion is causing volatility in market prices. But over the long-term horizon for which our clients hired us to focus, we still believe inflation is a risk to our clients. Read on for how we believe we can best protect you against this risk.
Why We Remain Bullish on Common Stock Ownership
We believe that owning operating businesses through common stocks, bought for prices below their intrinsic value, has the best chance to protect our clients against the unrelenting risk of inflation. Firstly, common stocks have annualized at an average return that is double that of bonds (11.2% annualized for stocks since 1950 versus 5.5% annualized for bonds over the same period). For any capital our clients won’t need in the next few years, we believe common stocks offer the best potential inflation-adjusted return. Though stocks are more volatile in the short run, the longer an investor’s time horizon, the more consistently stocks have had strong performance with fairly low variation as evidenced in the chart below from J.P. Morgan.
Secondly, we believe our 33-year track record demonstrates that disciplined, fundamentals-based value investing has the potential to further improve upon the broad market returns. As surprising as it sounds in a highly valued stock market environment, we are as optimistic today about the portfolio we have assembled for you as we have been in years. Our equity composite cash balance is at its lowest point since 2016. Our stock portfolio trades at 12.9 times trailing earnings, which is 10 percentage points below the 22.9x earnings multiple of the broad market as measured by the S&P 500.
It bears repeating that the reason low valuations make us so optimistic is because there is a direct correlation between current valuation levels and future returns, as evidenced by the chart below from Bank of America. This chart shows annualized future 10-year returns for the S&P 500 given the Price to Earnings (P/E) ratio in a given year.
As you might expect, the conclusion from the data is intuitive: paying higher prices is no recipe for strong future investment success. But paying low prices – now that is another story. This leads back to our optimism today. In our annual reviews we are discussing with clients just how overvalued the broad market is, driven in large part by the “Magnificent Seven” tech stocks - Apple, Amazon, Google, Meta (Facebook), Microsoft, Nvidia and Tesla. As of the end of 2023, these stocks trade for nearly 37x their annual earnings. Subsequent 10-year annualized returns in the stock market at levels that extreme have been somewhere around -8% to -10%. Our portfolio, on the other hand, trades for 12.9x earnings. Subsequent 10-year annualized returns in the stock market at levels that attractive have been in the mid-teens range. While we never know the future and can never promise any future return, we believe that consistently paying attractive prices for good companies is a good way to maximize our odds of future investment success.
Consolidation in the Oil Patch
The last few years have been busy ones for the oil and gas industry. Bigger is not necessarily better, but in the case of several large acquisitions announced by two of our largest oil and gas holdings, we believe it will prove to be. Exxon announced in October that they will be purchasing Pioneer Natural Resources, a dominant low-cost producer in the shale-rich Permian basin of west Texas. Just over a week later, Chevron announced it would buy Hess Energy, gaining exposure to the recent oil discoveries offshore from the South American countries of Guyana and Suriname. We are constructive on both acquisitions. Exxon paid a particularly fair price for Pioneer, less than 10x trailing earnings, and makes them the largest producer in this prolific oil basin. Exxon’s oil discovery in the offshore Guyana and Suriname region was one of the first major oil fields discovered in over 30 years. We already own exposure to this new discovery through Exxon’s 45% ownership and operating interest, but now with Chevron’s purchase of Hess we gain exposure to their 30% share of the block. We believe these acquisitions will further lower their cost of capital, increase the discipline in their production growth, and improve the efficiency of their drilling and infrastructure spending by applying the scale and technology of the oil majors to their newly purchased reserves. All of these improvements should increase the already incredible amounts of free cash flow being generated by the energy sector. The companies are using this cash flow not only to make acquisitions but also to reward shareholders with buybacks and dividends. Our current oil and gas holdings have raised their dividends a cumulative 51% since 2020. Overall, our dividend yield on today’s market value of our energy positions has increased from 2.47% at the end of 2020 to 3.74% today. We have discussed at length our view that global energy demand, for all forms of energy, will continue to grow as developing nations increase their standard of living. We remain optimistic shareholders of energy businesses.
Donor Advised Funds
We want to bring your attention to a charitable offering that might be of interest to some of our clients. All of our primary custodians offer donor advised funds through their respective charitable entities. A donor-advised fund is a tax-efficient way to pre-fund charitable giving where a donor can contribute appreciated securities or cash to the donor advised fund sponsor, receive an immediate tax deduction for the entirety of the charitable contribution but then retain control of how much, when and to whom to donate the funds in the future. For Schwab and Fidelity-custodied donor advised funds in excess of $100,000 initial contribution, we can serve as investment advisor for the account until the client chooses to donate the funds. We manage a number of donor-advised funds for clients and have found our custodians’ donor-advised fund offerings to have very competitive fees and very favorable donor flexibility regarding investment choices and donating timeline. We are happy to discuss in more detail should you like to explore a donor advised fund for your charitable giving.
2023 Milestones
From a performance perspective, we believe the last two years are significant in that they encompass the first look in more than a decade at what value investing can provide in a world without artificially suppressed interest rates. Admittedly, we widely under-performed the equity market this past year. As we have discussed throughout the year, much of the market performance was provided by seven stocks that had unprecedented valuations at year-end. That said, cumulatively across the last two years of higher interest rates our net of fee performance has beaten the broad market (as measured by the S&P 500) handily. (Please do reach out if you would like to see our 33-year performance track record.) We continue to have a very strong buy list and are finding opportunities up and down the size spectrum. We continued to enjoy very good fixed income performance in 2023 and are recovering lost ground that we experienced when rates were so low.
On the FRM news front, when compared to 2022, it was a fairly uneventful year. They did not quite beat the end of the year, but Sarah Hill Bruner (daughter of our beloved former colleague, Tom Hill) and her husband Kyle announced the birth of their son, William (Will) Dwain Bruner on January 3, 2024. Will weighed seven pounds and eight ounces and was twenty inches long. We are hoping that Will has a fly rod in his hands before too long. Congratulations, Sarah and Kyle!
One thing you might like to know is that the State of Arkansas instituted (mandated) a twelve-hour continuing education program for all investment adviser representatives in 2023, regardless whether they are federally (SEC) regulated, as we are, or not. The mandate included six hours of ethics. Thus, you can now feel very good about the ethics of the people that are managing your money (hopefully you are reading this as tongue-in-cheek). We continue to be confronted with ever-increasing regulatory requirements such as this. Abby McKelvy, our CFO and Chief Compliance Officer and Lauren Sanders, our Portfolio Accounting Manager and Controller, do a wonderful job at helping us navigate the ever-growing regulatory jungle that we must navigate. Rounding out our administrative staff are Stephanie Hills and Trina Boyd. They both do a marvelous job helping us interface with your custodian, among many other tasks. You have probably spoken with one or both in the past. This place would not run without them.
Know that you are always welcome to our offices. We would love to introduce some of the folks you may have not yet met. In saying farewell to another year, our thoughts always turn to how blessed we are to work for you and your families. FRM may not be the biggest, but we would put the quality of our clients up against any. Thank you for the privilege of serving you.
Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. “FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.