Tackling Hot Topics

The last few months have turned up several interesting debates within the investing community. Some topics are economic, some touch on the role of the government, some about the link between the economy and the market, and yet others about the perennial debate between active and passive investing. These are interesting debates that go into the heart of the future of investing, and we’re going to weigh in. This is partly because we think these are important discussions, but also because the nerdy part of us can’t resist. To make sure this post isn’t purely an intellectual debate with an imaginary opponent, we’ll try to add some practical advice at the end of each section.

Topic 1) The role of the Government in Private Industry:

We’re using the term “private industry” as this is less talked about than the role of the government in the market in general. This is simply to stay away from the topic of the Federal Reserve’s (or central banks in general) role in the market, which is evident. Instead, we’re focusing on the government ‘bailout’ of industries. There has been a lot of discomfort in the US about the potential for the government to step in and bailout the airlines, which have taken a jumbo-sized (pun intended) sized hit during the coronavirus outbreak.  The TSA numbers below should make this point clearly.

Now some of the opposition is, on the surface, understandable. People clearly remember the government bailing out banks during the 2008/09 crisis, and then went on to see those banks pay out billions of dollars in bonuses to employees. With regards to Airlines, we have all seen the headlines illustrating that the amount of bailout money they are set to receive is equivalent of the buybacks and dividends they’ve done over the last decade. The details behind these numbers are very nuanced and skewed, but for the sake of argument, let’s assume it’s true. However if we dig a little deeper, we think that some of the arguments are probably not applicable to the current situation.

• Role of the Government and Exogenous shocks: Free-market economists will tell you that the government should do very little in the private domain, and should let the markets ‘do their thing’. However this same logic is used by opponents of bailouts when they say governments should just let the airlines fail. Thus we must take a look at when it is appropriate for the government to step into the private sector. There are some common and well established reasons for this such as in the cases of externalities, criminal activity, and monopolies that hurt the consumer, etc. However, the question becomes about what happens if there’s an exogenous shock that had nothing to do with the industry per se? Unlike the banks who sowed the seeds of their own destruction (via CDOs), Airlines did not create the coronavirus. They were what you might call ‘innocent bystanders’ and society and governments have a history of bailing out those who fall on tough times due to no fault of their own. Now one could argue that it doesn’t matter, and if the Airlines weren’t prepared for all eventualities they should fail anyway, but the complete and long-lasting shutdown of the airline industry would wreak more havoc on the world economy than the coronavirus has (tourism dead, visiting family overseas a non-starter, business travel over, cost of moving goods shoot through the roof).

• The fault of the buybacks – Hang on you might say, but the Airline industry is at fault! Look at all the money that they spent on buybacks and dividends. Had they not, there would be no need for the bailouts! The problem with this argument is that it fails to take into the dynamics of the Airline industry. It’s extremely competitive, with the dumbest player in the market having the ability to ruin unit economics for all the rest (by cutting prices). While there is overall growth in air traffic (3-4% a year), pricing is always under pressure due to budget airlines and general passenger demands. Had airlines not been smart about their capital allocation, (or in this case, redemption) they wouldn’t have been able to attract investors. Even if any single airline wanted to retain that capital, they couldn’t do so as they would lose out to other Airlines. Further, Airlines, especially in the US, were actually quite well managed. Take Southwest Airlines as an example; it has had 20+ continuous years of profit, billions of dollars in annual free cash-flow, and a very conservative debt/equity ratio. It, like other airlines, just never foresaw a zero revenue environment.

Going forward, we think that what happened to the banks could/should happen to the Airlines (or really any industry too important to fail), where if there is a bailout all the major players take on capital and have to keep some amount in reserve for rainy days. If it’s mandated that all airlines must do this, then it will bring back investor confidence to the industry as a whole, and no one airline risks being the loser in the hypothetical prisoner’s dilemma.

Practical advice: There are always winners and losers in situations when the government becomes a stakeholder – but some companies really do better than others. Taking banking as an example, JPM and Bank of America were outliers in the pack post-GFC. While we haven’t tread in these waters yet, there could be interesting opportunities to invest in some of the stronger airlines (although we would stick to the US market where a semi-oligopoly exists).

Topic 2) The market is not the economy

We’ve often talked about this rally (especially in US markets) being the newest iteration of the “most hated rally” ever and when market participants justify the rally we hear the phrase “The market is not the economy.” We disagree with this. The market is the economy; it’s just not the current economy. If we break it up into its parts, the stock market is made up of the market capitalization of its constituents which in turn is driven by the price of the individual constituent stocks multiplied by the number of shares outstanding. Or put it another way, the price is driven by dividing the value of the company by number of shares outstanding. Thus the question becomes what drives the “value of the company.” While there are many ways to skin this cat, most people would agree that the value of a company is the present value of its future earnings. The key word here is future. The market is forward looking, and if this is true, there is no way it is going to reflect the economy as it is now. If you concede the market is forward looking, it’s not too hard to understand this rally. While the coronavirus was not man made (move along, conspiracy theorists!), the global shutdown and the subsequent incapacitation of the economy was. Thus with global economies reopening by reversing man made action, the market sees the future brighter than the present, and prices reflect that optimism. To take this a bit further, if we look at countries that have reopened or are reopening soon versus those who are taking longer to reopen, we can see a difference in stock performance.

Another way to look at the rally is to judge what the environment was at 23rd March (the current bottom of the stock market during this pandemic). On that day we were faced with an extreme health crisis and an economic crisis as global economies went from alive and thriving to stopping in their tracks. To a certain extent we’re getting past the worst of the health crisis in many countries (as curve flattening has occurred), and now the focus is more on the economic impact (which has also eased after re-opening), so it’s easy to understand why markets where economies are getting steadily past both issues faster have seen their stock markets rebounding more rapidly then economies that are behind the curve.   

Now you might ask – should the markets like the S&P 500 be this high? Perhaps not, and Fed reserve action may have something to do with that, but certainly the future is much brighter now than it was on 23rd March, and markets are reflective of that optimism.

Practical Advice: There are quite a few countries, companies, and industries that have not participated in this rally. If you think the future looks brighter than the present for them, then accessing them via long-dated call options could be a way to go. In our personal portfolios we’ve done very well buying call options (2022 expiry) on QSR restaurants, entertainment companies that have physical assets, and cruise lines (please note this is not investment advice, please do your own research. Call options carry the risk of permanent capital loss).

Topic 3) Passive versus Active Investing

This blog post is already running a bit long, so we’ll make this section a bit short and expand on it in a subsequent post. In general, we very much understand and appreciate the benefit of passive investing via ETFs or Robo-Advisors. This is especially true for people who do not have the time to manage their own money, and want it to compound without much effort. However, we do believe that if passive investors think that huge gains will come quickly, we think they are in for a rude surprise. Stock markets can go an entire decade without making gains (US market in 1970s and 2000), or can actually make losses (Japan in the 1990s). Thus if you invest passively, you have to make sure that your time horizon is in the decades. For example, in our personal portfolio we do have an allocation to passive funds, but this is predominantly our retirement money (which we won’t touch for 30+ years).

The second part of this debate is that passive investing is preferable as active investors do not outperform. While the data on this is quite damning, the odds of you picking an outperforming advisor do get better from time to time.  As you can see from the table below, the odds of out performance do tend to get better in decades where the index trades flat.

Because of this, we do think it is prudent to have at least some of your portfolio actively managed. Whether you do this yourself or outsource this to a fund is really down to your own skill, interest, and risk appetite.

Practical Advice: Picking a fund that will outperform in the future is a difficult task, but we’ve found success here focusing on funds that are smaller (less than $1 billion), have concentrated positions, and an investor-friendly fee structure.

We hope the above gives you both food for thought and some practical advice! Happy investing all.