Noteworthy ideas & observations from our Chairman and Chief Investment Officer Murray Stahl
Devil's Advocate -- Trends in Healthcare
Health Care spending continues to grow as a share of GDP, while spending per capita in the U.S. well exceeds that of most other nations, sometimes startlingly so. Yet metrics such as life expectancy do not appear to be materially better in the U.S. than in many nations with far more modest health care expenditures. Continued expansion of the health care sector at the current rate would require ever greater interaction of much of the populace with the medical system. Current valuations and growth projections for the sector seem to assume that will occur. This presumes that the population will not require a change to the U.S. medical system, despite its far higher costs, but comparable outcomes, to other countries’ systems. There are implications for the relative valuations and future returns of the different components of the healthcare sector, such as the divide between pharmaceuticals and healthcare equipment, or between those technologies and services that can reduce vs. those that serve to maximize interaction time with the system and treatment costs.
European Contrarian: Wealth and Crisis: The Role of Diamonds in Asset Allocation
Civil war is more frequent and of longer duration than many in the Western world realize. Most such conflicts are not covered by the media, and when they are, the investment impacts are not the focus. But they represent a real risk to all investors, warranting inclusion in one’s portfolio of assets that should maintain or even increase in value in such an event. Though gold and silver are the most obvious assets, diamonds are a more attractive choice, due to their high value density (the physical quantity required to afford protection is lower than gold or silver), ease of transport and now, fungibility and a transparent trading market.
Contrarian -- Diamonds as an Investment
Though diamonds have long been prized for their individual value, that uniqueness has prevented the establishment of diamonds as a fungible, physical store of value and as an investment class. The modern diamond industry has been changing rapidly though, beginning with the successful challenge to the effective monopoly long held by DeBeers, and the consequent establishment of multiple diamond exchanges. This has quite recently enabled the most dramatic change in the diamond market: advances in computational technology that allow the creation of packets of diamonds with standardized, identical values, such as $5,000 and $50,000 ‘coins’ and ‘bars’, leading to the development of a tradeable diamond asset class.
Devil's Advocate -- Bitcoin vs. Bonds
Fixed income investing has traditionally been viewed as conservative and low risk. But an updated look at the historical record tells a different story and even generates questions about the nature of the asset class itself: in the past two decades, bonds provided a negative after-tax real return. And, moreover, during a bond bull market defined by 20 years of declining interest rates and low inflation. Logically, one must rethink one’s approach to bond investing. Bitcoin, on the other hand, is considered by most to be very risky—understandable, considering its early stage of adoption and significant volatility. Yet, if a holder of $1 million of the iShares Core U.S. Aggregate Bond ETF were to have made the most marginal possible change to the asset allocation plan by investing merely 1 basis point annually into bitcoin, the 12-year annualized after-tax return would have risen from 1.79%, for a $1.237 million value, to at least $39.8 million, a 36% annualized return. From this point forward, of the many considerations surrounding bitcoin is that its market capitalization is still worth less than 7/10ths of 1% of the U.S. publicly traded bond market. The future bitcoin return should be genuinely extraordinary if, at some point, the investment community ever concludes that bitcoin will better protect against inflation than the bond asset class, which appears to provide no such protection.
Spin-Off -- The Importance of the Oil Service Industry
Oil services companies are crucial to the functioning of the oil and gas production companies. But although the energy sector cannot operate without them, oil services companies are barely a rounding error in the S&P 500 Index. Yet, or because of this, they also hold the potential for very high returns. The oil service sector has experienced about four decades of excess oil service supply and endured enormous losses and operating asset reductions in order to establish sufficiently low break-even operating levels that they are actually profitable. This makes it a very interesting sector from an investment perspective: it is the only industry currently aligned operationally to endure a depression, simply because it has already done so. Both the energy producers and the service companies have been disinvesting in their businesses—reserves replacement and equipment manufacturing capacity, respectively—for a great many years. Meanwhile, there is persistent evidence of a developing energy shortage due to this underinvestment. There will come a time when, merely to maintain production levels, much less increase them, the oil producers will turn to the energy service companies—which will lack the requisite manufacturing production capacity. The profit potential and equity revaluation potential could be quite substantial.
Inflation and Economic Thought
It is interesting to note that the great economists have rarely written about inflation, while historians have frequently, and generally as the root of the demise of an empire. When economists do discuss it, they have generally referred to inflation in the context of a policy tool to moderate economic growth, not with respect to its ruinous effects. The lack of writings on the topic does not lessen its importance to the economy and to individuals. The impact of inflation differs from person to person. For those living on a fixed income, for example, the effect can be devastating. Investors have sought a variety of ways to hedge against inflation. Some have invested in gold, though its actual benefits in this regard have been highly variable. A far preferable method would be via precious metals royalty companies, a business structure that is consistently profitable. Leverage is another hedge – and given the current degree of leverage in the world, inflation is the most likely route out, since it permits the repayment of loans in cheaper currency. So, many will be supportive of the debasement of money. Inflation hedges, therefore, have never been more important to an investor’s portfolio.
The Achievement of Diversification
Does the S&P 500 provide diversification? More than half of the S&P 500 constituents have such low weights that they cannot be considered relevant to the performance of the Index, so investors are getting a concentrated, not a diversified portfolio. What is also clear is that the S&P 500 does not provide diversified exposure to the economy. Rather, the market-capitalization-based weighting biases the index toward businesses with the highest valuations, which are not necessarily those with the largest role in the economy. The companies relegated to rounding errors are actually more representative, on a scale basis, of the broad economy. The problem is equally pronounced in country indexes, which are dominated by a handful of companies that generate the vast majority of their revenues outside of their borders; their local businesses, which would be reflective of their economies, lack the trading liquidity to form an investable index product.
Though such index concentration has rewarded investors during this period of declining interest rates and increasing globalization, should these conditions change, index products would likely need to change as well.
The Transformation of the Fixed Income Asset Class
Fixed income is an investment that is a type of loan. A borrower is obligated to make payments of a predetermined amount, and the principal must be paid on the maturity date. The legal predetermination of the payments is the origin of the term fixed. In other words, fixed means predetermined. This legal definition will not change. An exceedingly low level of interest rates changes the character of this type of investment in extraordinary and not so obvious ways.