04.01.13

What to Build (or Buy) in Today’s Opportunity Set

Capital Investment Decisions:

When making the decision to prospect for oil by drilling a well, one must estimate the likely cost of extracting the oil and compare that to one’s expectation of the market price of oil over the useful life of the well.  If the extraction costs are sufficiently below oil price expectations, then oil exploration makes sense.  The cost of retrieving oil in Saudi Arabia, for example, is very inexpensive at around $5/barrel.  Unfortunately, the world does not have a lot of places where oil can be extracted for $5/barrel.  The cost of some deep water drilling is over $50/barrel.  If one has a high expectation for the price of oil over the next ten years, one would begin a lot of exploration in places that offer the prospect of $50/barrel oil extraction.  Conversely, someone with a low price expectation would not begin the same higher cost projects.

A characteristic of many capital expenditures such as this is that much of the cost is upfront, and the marginal costs after the initial investment are relatively low.  So if one successfully finds oil in a higher cost location, even if prices fall precipitously, one will rationally continue to pump as long as the price is higher than one’s marginal costs because the initial investment cost is sunk.  If prices remain elevated for an extended period of time, many higher cost projects will commence.  As these wells begin production, the market prices for crude oil might overshoot the full costs of extraction to the downside for an extended period of time.

The capital employed in these marginal projects now earns a poor rate of return, but that capital cannot easily be redeployed to a higher and better use.  For example, an off-shore platform in the Gulf of Mexico cannot readily be converted into a tractor in Iowa should farming now appear ripe for investment.  In other words, capital is heterogeneous, and the value of the capital poorly deployed in this case is permanently damaged.  So it follows that prices, or at least the entrepreneur’s expectations of future prices, are incredibly important to the decision-making process for capital investment.  When prices poorly signal to market participants the real prospects for investment returns, capital is deployed inefficiently.  For instance, the gross mispricing of the internet bubble in the late ‘90’s probably permanently impaired $500 billion in capital for the world.  Because of such malinvestment, both labor and capital are worse off in the long run.

Time Preference:

Inherent in the human condition is a positive time preference; that is, in general people would rather consume today than in the future.  The degree of time preference varies based on personality, age, income, wealth, culture, etc.  If you place a marshmallow within reach of Richard’s five-year-old son, you will have to promise him a lot of marshmallows tomorrow to convince him to defer consumption of the one within reach.  We recently tested him.  If you promise him four marshmallows tomorrow in lieu of the one sitting in front of him, he declines the exchange.  If you promise him five, he agrees to not eat the one today, so he can have the bigger batch tomorrow.  So, his marginal rate of substitution, the point at which he is indifferent between consuming today or tomorrow, is one marshmallow today for 4.5 marshmallows tomorrow.  That is a mere 127,750% annualized!  Virtually everyone older will have a lower time preference than he does, but a positive time preference to some degree or another is inescapable.

The marginal rate of substitution for consumption deferral for an entire economy is the real interest rate.  Given a positive time preference, on average and over time this real interest rate must be greater than zero.  Various studies have tried to estimate this rate during human history, and we would probably settle on 3-4% as the long-run, real interest rate.  So humans are indifferent between consuming today versus next year if they have a reasonable expectation to consume 3% to 4% “more” at that time.  Accordingly, investing can be simply defined as deferring consumption today in exchange for the expectation of increased consumption later.   If a farmer invests in a tractor to improve the efficiency of his production, he is deferring some current consumption (the purchase price of the tractor cannot be used for consumption) for the anticipated higher crop yields he will receive over the useful life of this piece of capital.  No matter which asset class you invest in, your expectation should be for a real rate of return plus inflation.  Some capital projects will work out much better while others will fare much worse than this expectation, but averaged out over centuries, this nominal rate of interest is the expected return from investing.

Current Market Interest Rates & Phantom Capital:

As we write, one-year US Treasury bills are yielding 0.11%.  The trailing twelve months consumer price index indicates that the US has experienced about 2% inflation in the last year, and we believe that is a reasonable expectation for the next twelve months.  So, starting with a nominal rate of 0.11% and then subtracting 2% in inflation implies a negative real interest rate of -1.89%.  This rate is 5-6% below the aforementioned historical norms, and the current rate structure means, on average, an investor must pay to consume later rather than now.

As with all things in macroeconomics, it is hard to say definitively how we got into a situation where interest rates are significantly negative on a real basis, even way out on the yield curve.  But we would offer that the primary reason is the aggressive purchasing of debt by the world’s major central banks, including the Federal Reserve, the European Central Bank, and the Bank of Japan.  Our job is not to administer fiscal and monetary policy, but the prospects for investment returns are heavily influenced by such interventions.  No one acts “macroeconomically,” so it is instructive to walk through the incentives being offered on the microeconomic level.

With negative real interest rates, individuals are being aggressively prodded to consume now instead of deferring consumption (saving) because they are losing real money to inflation even in long-dated, high-quality fixed income assets.  Additionally, in longer duration assets such as thirty-year Treasury bonds, real estate investments, or low dividend stocks, implied intrinsic values grow exponentially as nominal interest rates approach zero^[1].  This increase in perceived wealth can also have a spillover effect of further increasing current consumption – the wealth effect.  On the investment side, low interest rates encourage investors to deploy capital into lower credit quality opportunities and into situations where the evidence of success is longer delayed.  In other words, they are encouraged to take on additional risk in a chase for higher current returns.  Notice that no increase in real savings has pushed down interest rates (the price paid to savers).

The first-order effects of such an interest rate policy are fairly easy to see.  Low interest rates favor debtors over creditors.  Existing debt becomes cheaper as borrowers refinance existing obligations at lower rates.  Lots of groups suffer under such a policy, too.  Obvious examples include: (i) retirees on fixed incomes who cannot earn adequate returns on safe bond investments and are forced to consume principal to make up the difference, (ii) life insurance companies that sold either fixed annuities or annuities with floors on the return and who now cannot earn enough on their assets to pay their obligations to the purchasers of these products, and (iii) pension funds of all stripes that find themselves with much greater future liabilities and much diminished ability to earn returns on plan assets.  By definition artificially lowered rates cause a huge transfer of wealth from savers to borrowers, which means that the world’s central banks are implicitly picking winners and losers.

Second-order effects are largely unseen in the short run, but they are no less important.  Medium to long-term interest rates are the most important price in an economy because they signal to entrepreneurs whether a potential investment is likely to be profitable AND how long they should be willing to borrow and/or tie up capital.  The price of future money thusly conditions investment decisions.  The term structure of interest rates (the yield curve) provides the roadmap for the likely terms of payback.  And low long-term rates signal to entrepreneurs that real savings exist to fund long-term investment at low hurdle rates of return.  In fact, only credit has been created by the central bank.  Somehow in the future, real savings must replace this credit in order to fund these long-tailed investments, but the savings simply do not exist to fund all of the projects undertaken and still consume the goods and services produced.  Current central bank policies that skew rates lower have simultaneously caused potential savers to consume while encouraging entrepreneurs to invest phantom capital.  These actions are mutually exclusive in the long run, and many unwise investments will have to be liquidated or restructured, causing real capital loss.

Market Prices for Money & Our Portfolio:

So what does all of this mean for you and us as investors in the fund?  Based on the historic real rates of return of 3-4% discussed above and adding inflation expectations of 2-3%, long-term nominal rates of returns on assets are adequate in the 5-7% range.  Historically, we have used those assumptions as a base and then insisted on a margin of safety by buying assets at a substantial discount to their intrinsic values.  Our goal with this approach is to earn positive returns even when we make mistakes and achieve outsized returns (i.e. above 5-7%) when we are correct.  An investment with a prospective return in the 10-14% range has been our minimum satisfactory expectation (i.e. a hurdle rate) before we will put capital at risk.  Future returns on investments are a function of the prices paid for them, so asset prices inflated by interventions of the world’s central banks have pushed down expected returns across the board.  As a result, we believe there are a lot of businesses where a 5-7% return is likely, but we do not see many where our historic expectation of 10-14% seems likely or even probable.

This conundrum begs a critical question:  should we lower our standards, be happy locking in less attractive returns, and accept our fate as the losers from the central banks’ current policy, or should we simply hold cash in the short run in the absence of compelling investment options?  We are taking a measured approach with today’s opportunity set.  Specifically, we are continuing to buy a couple of businesses as our capital base grows where we think an expected return above 10% still exists.  We are also holding onto some appreciated securities where our future returns are almost certain to be less than 10% per annum, but the prospects for this group of businesses is quite stable and the downside more limited.  The balance of the fund’s capital is in cash, which we are prepared to deploy quickly whenever a market dislocation occurs that offers qualified opportunities with adequate future returns.  The likely short-term result of this approach will be to underperform our benchmarks as long as markets continue to rise at a rapid pace.  We will not, however, respond to the markets’ current incentives by “paying up” for inflated assets.  Instead, we will continue only to invest in businesses where an appropriate margin of safety is present, as permanent capital losses remain the greatest enemy of our goal to maximize the long-term value of your assets.