From Bill Smead at Smead Capital Management, September 6:
Inflation Expectations
Dear fellow investors,
As the chart below shows, investors are demanding as much protection against inflation today as they did in 2011. We will review what investors were thinking in 2011 and explain why their expectations were in error. Then, we will compare today’s circumstances and talk about how we can seek to take the most advantage of the circumstances like we did back then.
In 2010, I was on CNBC’s Worldwide Exchange debating Jimmy Rogers on the subject of inflation. He was convinced that the massive liquidity injected by the Federal Reserve into the U.S. economy during the Financial Crisis would trigger explosive inflation. The extra spread of 2% above inflation on the 30-year TIPS exemplified the consensus at that moment.
Why did that former liquidity from the financial crisis not cause inflation? First, as the money supply grew, the velocity of money declined. Second, we were in a home building depression, which normally would have boomed in a low interest rate environment. Third, the emerging large cohort of adults (millennials) were about to delay adulthood by about seven years compared to prior generations and would postpone household formation. At the same time, the Gen X group was much smaller in size than the prior group (boomers).
The result was the most anemic economic growth following a recession in U.S. history. We argued that the economy was like a game of Monopoly where you doubled the amount of money in the bank. Since they didn’t give the players any more to start the game or more for passing go or more for landing on free parking, it didn’t cause inflation. At Smead Capital Management, we took full advantage of our view and beat the S&P 500 Index in our strategy five years in a row. We did it through buying cheap mature growth stocks that could grow despite the anemic economic growth.
Fast forward to today. The 30-year TIPS are set for high inflation expectations after the most massive, monetized liquidity since World War II. After taking interest rates to nearly zero, the U.S. Government, in two presidential administrations, monetized nine trillion dollars of liquidity and injected it into the economy. In case that wasn’t enough, they did another on the misnamed Inflation Reduction Act.
Back to the Monopoly analogy. This time, they gave the players way more than $2,000 to start the game, paid way more for passing Go and dramatically loaded up the free parking. Stimmy checks, PPP money and forgiven student loan payments might have retarded the behavior of millions of 15–30-year-old Americans in the process. We believe that just to be sure that inflation will be a problem they threw one trillion dollars at uneconomic clean energy projects through what we call the Inflation Creation Act!
Therefore, the inflation protection sought through the 30-year TIPS will pay off in a big way this time, in our opinion! We are loaded with inflation beneficiary stocks like oil and gas stocks and useful real estate. We are banking on the economic activity of that same slow-starting Millennial group to translate into an inflation-driven home building boom as too many people with too much monetized debt chase too few homes. The classic definition of inflation....
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Smead are value, sometimes deep value investors and have been beating the oil&gas drum for the last few years. As noted in a link to another of their missives (November 2022):
The Sum-of-the-Parts Argument For Volkswagen Longs
Caveats up front:1) Much of the value in VW is contingent on the correct evaluation of Porsche (this is where financial engineering in the form of a pair trade [it is not an arb, it is not an arb] might be of some value)
2) It can sometimes take a very long time for the market to come around to your way of thinking, you have to understand this going in or you are apt to get bored/lazy/scared and sell before the perceived value has manifested out of your head and into the price, to get a bit new-agey....
....For fund managers, assuming the analysis is correct, it all comes down to "How long does it take to play our" or in the words of a very wealthy investor I was talking to as he laughed about the latest 89-page investment thesis he had been sent: "I don't want all this, I want the answers to three questions: What's the upside? What's the downside? What's the time frame?".
The issue for the deep value investor is that you are waiting for the market to come around to your way of thinking which raises three issues you had better understand before you venture in:
1) Is your analysis of the underlying business correct? You have to get this right because:
2) It might take a while, which will raise the odds of adverse exogenous events buffeting the market's perception of your little gem. You cannot risk having a bankruptcy or even a downturn in the company's prospects during your holding period. Quality management and quality financials go a long way toward mitigating the risk inherent in being exposed to the wider market vicissitudes.
3) You have to be psychologically girded against internalizing the fact that you are going to look like both an idiot and a genius. You're neither.
The timing on this missive, January 25 2022 could have led one to believe the genius fallacy:
The Lack Of Prospects For ESG (at the moment)
And in the months immediately following Russia's invasion of Ukraine folks who had been accumulating O&G names were riding pretty high:
Oil & Gas Equities: "Love Is In The Air" (CLR; OXY)
As oil prices declined after the spike (and the O'Biden - Harris administration hastened things along by draining the Strategic Petroleum Reserve) investors in oil & gas got hammered. It is at that point you need a touchstone, and in mid-October 2022 we saw one, prefaced by a bit of history:
Something Very Important Happened In The Oil & Gas Business This Week
When generalizing from specifics to overarching themes, especially in business and markets, you have to continually ask yourself if you are trying to force your square peg of an observation into the round hole of a template for action.
The classic examples are the books titled "Business Secrets of Machiavelli" or "Trade like Genghis Khan" or suchlike. The author may (if you are being charitable) have an insight or two but when they try to stretch it out for a couple hundred pages, well, I believe it is called 'padding' in the writing business.
So, in the instant case, here is the template for action which we will attempt to justify with an observation.
Action: Follow insiders. They know more about their industry than you do.
Observation: On May 7, 2006 Herb and Marion Sandler sold their family business, Golden West Financial. At the time they had built Golden West to be the 2nd largest Savings & Loan in the U.S.
It was also the largest originator of sub-prime mortgages in the country.
Sell of Golden West Financial to Wachovia signifies burst of housing bubble
The decision to sell Golden West Financial to Wachovia for about $25 billion in mostly stock and some cash may turn out to be a harbinger of the end of the housing bubble....
That is the single most remarkable bit of inference/analysis I have ever seen....MORE
