The U.S. economy felt like a balloon in search of a needle

Interview with Robert Mark - Part II

As we move deeper and deeper into this covid crisis, more and more people under-stand that there’s a lot more to fear besides the disease itself. As the economic impact and the full scale of the damage caused by the lockdowns and the shutdowns become undeniable, there are too many questions lacking any sort of convincing answer and the future for so many employees, business owners, investors and ordinary savers seems bleak and uncertain. The one thing that is obvious to all of us by now, is that this crisis is not the like the ones that came before it. The same is true of the government and central bank responses to it and their unprecedented stimulus measures.

It thus inevitable, for seasoned investors and for ordinary citizens alike, to become overwhelmed by this climate of uncertainty, fear, and self-contradictory messages from supposed “leaders” and “experts”. To add to the confusion, the signals directly from the markets seem to be painting a picture that is increasingly surreal: in the midst of the worst economic crisis in modern history, US equities are breaking new record highs. 

To shed some light on these current challenges and to get his perspective on how one might deal with them, I turned to Robert Mark. Robert is an old and dear friend and he is the kind of man that focuses his energy on adding value in what he can directly im-pact, in safeguarding other peoples’ assets, and he refuses to participate in today’s media circus. It is therefore a great pleasure that he graciously accepted my request for, as he put it, his “first and only interview” so far. His extensive experience and par-ticular insights really help separate the signal from the noise and allow us to look at the current situation much more clearly, through the lens of value investing. 

Based in Dallas, Texas, Robert Mark’s firm manages an equity strategy for institutional clients based on the timeless principles of patience and fundamental analysis.

Claudio Grass (CG): The covid crisis and the scale of the economic damage caused by the lockdowns globally are unlike anything we’ve seen before. Howev-er, it can be argued that a recession was inevitable, with or without covid, as we were already seeing serious cracks in many major economies before the virus ever emerged. Do you agree with that view? Did you already see red flags before the start of the year?

Robert Mark (RM): I agree with that viewpoint. The U.S. economy felt like a balloon in search of a needle. We never addressed the root causes of the 2008 financial credit crisis—easy access to cheap capital increased the probability of capital misallocations. We solved a debt problem by creating more debt. A quote from Jeremy Grantham of GMO comes to mind. When asked in an interview what lessons were learned from the 2008 financial crisis, Grantham stated: “In the short term a lot, in the medium term a little, in the long term, nothing at all.” Monetary and fiscal authorities treat the symp-toms, just not the underlying illness.

CG: The monetary and fiscal interventions that we’ve seen so far are as extreme and unprecedented as the shutdown policies themselves. Do you think they’ll be enough to keep the economy afloat though, or is a deep and long recession simply inevitable?

RM: As I survey the current disconnect between asset markets and the underlying economy, I simply conclude that the older I am, the less that I know. I never expected this level of intervention and yet here we are now. At this point, I simply cannot quantify the level of malinvestment that permeates our economy – I see it everywhere that I look. A recession should be a normal occurrence. When the business cycle contracts, there is a general decline in economic activity. A recession cleans out the excesses created during the last economic cycle. At some point along the way, ‘recession’ be-came a bad word. Now, when a recession begins to unfold, the monetary and fiscal au-thorities immediately employ all means necessary to stop the recession before it cleans out the prior economic cycle’s poor capital allocation.

CG: Considering the extent of the economic damage of the covid crisis and the scale of the monetary and fiscal responses, it would seem there are two massive and opposing forces at work. Where do you stand on the “inflation vs deflation” debate, and what do you think is the likeliest outcome?

RM: Everyone struggles with this question. On a personal basis, as a consumer with no debt, I have no problem with lower prices. However, if I borrowed a tremendous amount of money, I would be terrified if I had to repay that debt with depreciating dollars. From a broader perspective, I follow the Austrian School, which defines inflation as an in-crease in the quantity of money and credit. Therefore, one would conclude that there is inflation.

By contrast, governments prefer to define inflation as rising prices—just not rising asset prices. Government statistics and jargon confuses the effect for the cause. Some argue rather convincingly that the burden of the current and growing level of debt is deflation-ary because it weighs on the economy. The economy’s easy access to capital creates too much capacity which results in a lack of pricing power—the U.S. shale energy in-dustry comes to mind. In short, I see both sides of the argument, but I am not smart enough to argue convincingly for one side or the other. However, I suspect that at some point, wage and price inflation are inevitable.

CG: We’ve seen an incredible shift in central bank policies over the last decade, starting with the massive balance sheet expansion after the last recession. To-day, we see “unlimited QE” and new, very aggressive interventions being part of the “new normal”, fueling an artificial rally in stocks that seems increasingly di-vorced from reality. Do you think this “decoupling” between the real economic and the market can be sustained or is another, much more severe correction on the way?

RM: Peter Lynch, former fund manager of the Fidelity Magellan Fund, once said that “I spend about fifteen minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture.” I have no material insight that I can share that one could not readily deduce from casual observation. In fact, I find that one can easily experience ‘paralysis by analysis’ when investing top-down from a macroeconomic viewpoint. Anyone with a detached perspective of the U.S. stock mar-ket will instinctively note that ‘trees do not grow to the sky.’ But when one surveys the current fiscal, monetary and market distortions, one realizes that these distortions can persist far longer than one ever expected. In any market, at its basic level, there are buyers and sellers. The interaction by individuals in the market determines prices. Un-fortunately, central banks distort market behavior. I would recommend reading Sahil Bloom’s simple analogy he posted on Twitter that wonderfully summarizes the central bank’s actions on market behavior.

CG: Over the last few months, we started to see a significant increase in bank-ruptcies in the U.S. Do you think this is just a result of the covid crisis flushing out a few problematic companies or is it just the tip of the iceberg, and we should expect to see a lot more filings going forward?

RM: I think that the issue is really the struggle between liquidity versus insolvency. Many companies are in danger of insolvency, but liquidity in the financial system keeps them alive—a distressed company can continue to restructure or rollover their existing debt. 

Think about the issue of forest fires in the United States, particularly in the western half of the country. Prescribed burns are based on the idea that forests historically burned on a frequent basis. They burned when lightning struck, when campfires jumped, or when Indian tribes wanted to drive game or clear land. The fires cleaned up the forest floor, so when new fires started, they burned cooler, smaller and caused less damage. 

About a century ago, the U.S. government created the Forest Service. The Forest Ser-vice once operated under a policy of immediately extinguishing fires whenever possible. In time, these actions created their own problem—too many dead trees led to bigger and more dangerous fires, which made the Forest Service even more determined to suppress fires. After about a century of fire suppression, researchers realized that fire played a role in maintaining healthy forests. At some point, central banks and politicians might also understand that recessions perform an important function for healthy econ-omies.

Claudio Grass (CG): In this surreal policy environment, how has the role and the investment process of the value investor evolved, especially over the last dec-ade?  How can one still identify value in a world of subsidized binge borrowing, extreme indebtedness, and stock buybacks?

Robert Mark (RM): The patriarch of value investing, Ben Graham, once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.”  As markets have evolved into modern, global electronic exchanges, Graham’s analogy remains true.  Short-term, stock markets are beauty pageants. Speculators continue to vote for the Wall Street darlings. On the other end sits the weighing machine which measures the future earnings of a business. As a value investor, my role is to focus on the weighing machine despite the party over at the voting machine. Binge borrowing, extreme indebtedness, and stock buybacks all feed into the emotions of the voting ma-chine. Value does exist in certain pockets of the market, but one must simply step aside and operate at their own pace. 

CG: Many mainstream analysts and commentators have rushed to declare value investing obsolete, especially following the recent losses suffered by value giant Warren Buffet. Could it be that the markets have become too distorted by central bank policies and by algorithms to identify value or is this assessment simply too simplistic and naive?

RM: Warren Buffett and his company Berkshire Hathaway have come in for criticism from those sitting in the bleacher seats—”too big, too slow, too old-fashioned". Buffett had his worst performance versus the S&P 500 in 2019, and 2020 is looking just as bad. Instead of highlighting Berkshire’s fortress-like balance sheet, critics argue that Buffett needs to fundamentally rethink his mix of businesses and investments. Berk-shire Hathaway’s cash position has increased to about $140 billion, but to the surprise of many, Buffett did not deploy any of that dry powder during the market’s plunge in March. He did not see “anything attractive.”

In short, yes-central bank policies, passive investing, algorithms, and any number of factors are distorting the markets and will continue to distort markets. We cannot choose the game to play, but we can play the game by our own rules. Buffett’s job is to remain focused on the weighing machine, not the voting machine… which is exactly what one would expect from a value investor. Buffett built Berkshire Hathaway to re-ward investors over time, but not on time. Investing always involves making decisions under uncertainty. We never know what the market will do in the near term, but value investors understand that if they vote for assets rather than patiently weighing their po-tential investments, they run the real risk of permanently destroying their investment capital.

CG: Aside from the obvious economic concerns, we’re also seeing a lot of turbu-lence in the geopolitical and social fronts, from US-China relations to internal social unrest in much of the western world. Do you see real risks there too and did you have to adjust your own investment approach to account for them?

RM: It boils down to three simple words: margin of safety. Our psychology is critical to the investment process. For example, if an investor loses confidence and has made too many mistakes recently, it becomes very easy to say, “I can’t stand being down more than this.” Therefore, we believe in being conservative all the time—by being both a patient buyer and a disciplined seller. If we do so, we ensure a margin of safety in our investments. We frequently reference another quote from Benjamin Graham in every presentation we make: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these re-quirements are speculative.” We do not speculate, we invest. And when we invest, we demand a margin of safety. 

Back in 2002, Secretary of Defense Donald Rumsfeld used the phrase "There are known unknowns and unknown unknowns" during a news briefing about the lack of evi-dence linking the government of Iraq with the supply of weapons of mass destruction to terrorist groups. A lot of people sort of scratched their head at these linguistic gymnas-tics. Known unknowns are risks you are aware of, while unknown unknowns are risks that come from situations that are so unexpected that they are not even considered. We always see very real risks when investing but try to account for these risks in the quality of the companies we select and the margin of safety we apply to our estimate of fair value.

CG: A lot has been said and written about the rally in precious metals and the reasons behind it. What do you think is driving it and what is your view on the role of gold in an investment portfolio?

RM: One can readily point to any number of reasons as to why gold is moving ‘higher’ over short periods of time, beginning with a loss of confidence in central banks or the soundness of one’s currency or negative real interest rates. However, we forget that over time, gold is not moving higher but rather our currencies are losing value against gold. Or at least that is how I view the situation. As for the role of gold in one’s invest-ment portfolio, you are preaching to the choir. So yes, I absolutely believe in the value gold provides to one’s asset allocation. Personally, I first started buying physical gold in the summer of 2000, when I walked into a local jewelry store and asked the owner if he sold gold coins. He laughed and said that he did sell gold coins, but it had been about ten years since he last sold any coins. As a natural contrarian, I found the jeweler’s re-sponse interesting.

CG: In the last few years, we’ve witnessed the rise of the amateur investor, facili-tated by popular apps and zero-commission brokers, and this trend was drasti-cally accelerated during the lockdowns. Are you concerned about this wave of inexperienced investors entering the market en masse and making bets they don’t really understand, with money they can’t afford to lose?  Do think this has the potential to have a wider impact on the markets?

RM: There is little doubt in my mind that the advent of Robinhood and zero commis-sions at the online brokerage firms like Charles Schwab has certainly generated a lot of excitement. A new generation of retail investors are at the voting booth and chasing the prettiest candidates that Wall Street has to offer. I watched in shocked amusement when a U.S. federal judge approved plans for bankrupt rental car company Hertz to sell $1 billion in stock AFTER the company filed for bankruptcy and HTZ stock increased tenfold.  Another example that comes to mind was when a small Chinese real estate company in one day jumped 1300% on no news. The company’s name is Fangdd Net-work Group, which is similar to the popular acronym “FAANG,” representing Facebook, Apple, Amazon, Netflix, and Google. FAANG shares were up that day; therefore, I guess that a number of new traders somehow believed that Fangdd should trade higher as well.   

I have no issue with new retail traders. In time, they will learn their own lessons and draw their own conclusions as to how one should best allocate their investment capital. The one group that I would single out are the professional "paid-to-play" active manag-ers desperately trying to keep up with their respective benchmarks. I suspect that many are actively trading these FAANG names in order to catch up to their benchmark. One wonders if they really believe that they are doing the right thing for their clients or are they focusing on retaining and growing assets under management? These professional managers know the game: clients will fire them if they underperform their benchmark. Therefore, they constantly try to closely track their index, fearful of being too cautious in a rising market and straying from their target benchmark performance. I can under-stand the retail investor who is trading and taking risk with their own capital. I do not forgive the professional who knows better and yet goes ahead and puts his clients’ capi-tal at great risk.

CG: Looking ahead, and given the uncertainty and the legitimate fears that are on many investors’ and ordinary savers’ minds, what would be your advice for those who wish to preserve and protect their wealth during this crisis?

RM: I suggest that one takes a serious look at the investment philosophy behind the ‘permanent portfolio’ allocation. Libertarian Harry Browne first proposed this concept in the book Fail Safe Investing.  To summarize, the permanent portfolio is an investment portfolio designed to perform well in all economic conditions… Remember, there are unknown unknowns! 

The permanent portfolio is composed of an equal allocation to stocks, bonds, gold and cash. Browne believed that a portfolio equally split between stocks, precious metals, government bonds and US Treasury bills would be an ideal investment mixture for in-vestors seeking safety and growth. Browne argued that the portfolio mix would be prof-itable in all types of economic situations: stocks would prosper in expansionary markets, precious metals in inflationary markets, bonds in recessions and Treasury bills in de-pressions.

The biggest potential problem with this investment strategy is that sitting through long periods of underperformance can be very difficult, if not impossible... The price action in Tesla and Apple after they recently announced stock splits is far more exciting than re-balancing a simple asset mix each year. However, the goal of the strategy is not to out-perform, but to generate long-term investment returns that exceed inflation while pro-tecting your investment capital. To borrow an American baseball analogy, your likeli-hood of long-term success is far greater if you consistently hit singles rather than swing for homeruns.

Claudio Grass, Hünenberg See, Switzerland

Source: © Unsplash/Ehud Neuhaus, Amy Shamblen