Alec Cutler: it feels like the 1970s – what should you buy?

By MoneyWeek

published 18 February 2022

in Features

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Alec: It started out great and we rotated. We were actually a fairly growthy fund for the beginning, for the first few years. It’s a ten-year-old fund now. And I rotated towards value and then deeper value and deeper value as it underperformed. So up until last year, we struggled, 2018-2019 and half of 20. And since the bottom of the Covid sell-off, which just happened to be the day the recession started and ended, we’ve done quite well. So we bounced back quite strongly.

Merryn: Excellent. So my guess is that you’re moving into an environment that is really going to suit you at the moment. Now, we’re talking just as the latest CPI numbers have come out for the US. Quite shocking, and it’s beginning to look like… no, it definitely looks like anyone who at any point over the last year said that inflation is transient was completely wrong. In fact, it’s beginning to feel a little bit 1970s out here.

It reminds me of when I first when to Japan to work there in the early 1990s. And the bull market had fairly decisively ended. But nonetheless, most of the brokers still believed that that huge bull/bubble market was the norm and they expected it to return. They all said to me, you’re here at just the right time. It’s about to take off again. It never did, of course. But it’s interesting how long that idea that normal is what just happened. It carries on.

And I suspect, if you flip over to the Federal Reserve and the central bankers, they were the lead cheerleaders. There was no inflation. Then it was transitory. Then it was, we’ll be back to 2% by the end of 2022. That was Powell in December. And now he's, we’ll be back to 2.4% at the end of 2022. And I suspect after this latest inflation reading, he might be talking about 2.6% by the end of 2022. So it’s a sort of cross this line and I’ll kill you type denial.

The anger will come. If this is the real deal, the anger will come towards the Fed. And that will manifest itself in a complete lack of confidence. And as you know, inflation is a confidence game, so once you have a loss of confidence that anyone has control over inflation, then inflation just starts compounding and feeding on itself as people go into inflation behaviour. Buy today what’s going to be more expensive tomorrow. Ask for a raise, which is why the Bank of England governor is telling people not to ask for a raise, as tone deaf as that sounds.

Alec: Exactly. But what it tells you, more alarmingly than a tone deaf ivory tower attitude, is that if you listen to the central bankers, in order for them to maintain confidence, they say along the lines of, we’ve got this, don’t worry, this isn’t the 70s, we have a much better toolkit now. Powell is into toolkits. And if this, if trying to get people to not ask for a raise, is the toolkit, is the new toolkit, we’re in big trouble.

Alec: I primarily studied the 70s period as an instructive tool to talk to the investors within Orbis not to use the last ten years as your model for the next ten years. So it’s really just to drag people off that “past is prologue” heuristic and to look at and think about periods in the past that might also share some characteristics with the environment we’re heading into. The 70s was a terrible, awful period. The 2000 TMT bubble crash, that was an awful environment for everyone but value investors, by the way.

Merryn: Oh, it wasn’t an awful environment for everyone, was it? Because it was a slightly different time in that, for starters, not everybody was an investor at the time. Many more people are investors now, particularly in the UK, now we have an auto-enrolment system. And it was only really a small part of the market. It wasn’t the same all-round crisis that affected lots of people. It was a bit different, wasn’t it?

Alec: And I said, what’s going on? And he said, can I talk to you about my portfolio? And he showed me his portfolio and it was all the go-go stocks from the late 90s that had cracked 30%, 40%, 50%, 70%. And he said, I invested in the 70s. I vowed never to invest again. And all my doctor friends were making so much money in the late 90s that I had to get in. And I gave, I’m not going to tell the name of the brokerage firm, my savings and it’s now down 70%.

Alec: No, and of the top five names in 2000, the largest names in the US were Cisco, Intel, Microsoft, General Electric and Walmart. Of those names, the only one that’s in the top five today is Microsoft. And in the medium term, between those two points in time, we were buying Microsoft at ten times earnings. We sold it far too early, and it’s a fantastic company. But to say that that can’t happen again is kind of idiotic because it has happened twice. And this is just the type of environment that makes that happen.

Merryn: OK. So what do you think is going to drive the inflation that might bring us back to this 1970s scenario? We know that energy prices have been rising. We know that there’s a supply chain crunch, etc. But all those things are possibly reversible. I keep being told that there are signs the supply chain is easing up already and it may be that energy prices stop here, in which case, they need to keep rising for inflation to keep rising, right? So what do you think is going to make inflation come in at these 7% numbers for more than a couple of months more?

Alec: Yes. Inflation is an amazing beast in that it doesn’t matter what sparks it, it’s what comes next. It is does it compound? How is the PMM behaviour reacting to it? So in the 70s, the misnomer is that inflation was caused by the oil embargo in 1973/74, and then again in the Iranian Revolution in 1979. In studying it, inflation was ramping hard before the oil embargo, and prices of raw materials, in particular, but also wage inflation.

And so then you say, well, what caused that? And the cause of that… And again, this is a strong parallel to today. The root cause of that was the US going off the Gold Standard. The Bretton Woods Agreement put tight guardrails on money supply. It really restricted what the central banks could do. And when Nixon pulled us off the Gold Standard in 1971, it allowed the Federal Reserve to crank up money supply. Cranking up money supply beyond those guardrails started inflation.

So the ten-year Treasury was yielding 4% at the end of the 60s. It’s yielding now one… It just popped up to 2% today, yesterday. Now it’s a bit below. But we were as low as 0.5 on the US ten-year and we were negative on the Bund until last week. Quantitative easing is a complete experiment that makes going off the Gold Standard look like child’s play from a level of difficulty and trying to understand where this thing is going to go.

The wealth gap now is miles bigger than the wealth gap… There wasn’t much of a wealth gap at all, in fact, in the late 60s. Coming out of the war, everyone started the same and you didn’t have this big gradient between the richest and everyone else, and labour was very strong. A third of workers were in unions in the 70s. 6% in the US, and I think it’s around 8% in the UK of workers are in unions today. But the popularity, the public sentiment around unions is as high as it was in the early 70s.

Alec: You’ve had this huge shift. Yes. You’ve had this huge shift. And I think it relates to the thing prior. The wealth gap is so high. And in particular, if you look at everything from the GFC through jaundiced eyes, it looks like everything the Fed has done, everything the government has done is to protect the wealthy. It’s caused massive financial inflation, financial asset inflation, which the 99 don’t really participate in though we’d like them to, and it’s just made the rich richer and richer and richer.

Merryn: And it also protects the old. That’s one of the interesting things about this whole dynamic is obviously the old tend to be wealthier than the young. They’ve had more time to build the wealth. And a lot of the things that we have done with quantitative easing, etc., forcing up asset prices, has been to benefit the old to the detriment of the young. And, of course, that’s something we’ve seen during the pandemic as well. You’ve asked the young to give up everything to protect the old.

And I keep looking at this. I was thinking about this this morning. It’s such a strange dynamic at a time when fertility rates have collapsed across the Western world and populations outside seven or eight core countries around Africa, etc. are going to start falling relatively soon. We have a falling number of young people, both relative to old people and also actually in many countries in absolute terms.

You would think that with that scarcity of the young, we would want to take care of them beautifully, we would want to look after them even better than we’d want to look after our old. But you only have to look at things, the weird dynamics of making children wear masks when adults don’t have to and focusing entirely on protecting the wealth of the old at the expense of the young to think, this is really bizarre.

Alec: Have been getting hammered. Their cost of living increase has been nil, which is awful for them because the reality is their cost of living has been skyrocketing. The cost of living from a medicine standpoint, at least in the US, that’s not as highly regulated as it is in the UK, but old people are really struggling with this low/no rate environment. So they’ll at least get some benefit.

So the positive difference is supposed to be, if you listen to the central bank mouthpieces, that they have these great, new tools.. They all studied the 70s. I went back. In looking at literature, trying to find out and learn about the 70s, all the literature, all the academic literature is written by the people at the central bank. That’s what they did in grad school. So they know it really, really well. And I think it’s given them confidence, perhaps over-confidence, that they’re not going to make those same mistakes.

Merryn: Yes. Interesting. Is it possible that central banks don’t really have any tools at all to control inflation in that over the last 20 years or so, when they’ve thought that it has been them controlling inflation and we hear about their targets and their special tools for doing this, etc., inflation has just been low anyway because of globalisation, because of the opening up of labour markets in Eastern Europe, China entering the world economy, etc. All these things kept inflation low automatically, regardless of what central banks did.

Alec: You’re welcome to have it. So I think they’re in big trouble. I think that when they did their academic papers, they didn’t think that this would be the set-up. But it’s just very hard. And if you’re ever going to listen to the very old people, the old people that still get asked to go on podcasts and TV, who want to talk about this, if you see what they’re talking about now, it’s this. They can’t see how we get out of this alive, I guess alive referring to economic health and stability. And I think it might be a good time to listen to old people.

The government can. The government could incent people to go drill for oil and gas. They have in the past. This government doesn’t seem to want to, at least in the US. And in fact, no government in the world wants to. But energy would be the first place to look, in that if that’s going to be the prime mover, the spark that causes this rolling inflation, then your safest place to be is in those that produce the inflating commodity that starts it and keeps it rolling.

And we were able to buy into these names at very low valuations because the zeitgeist drove the valuations down so low and stopped production to the point where you could easily see supply-demand getting out of whack and you could easily see governments following the logic and saying, in the end, we need these. And you’re seeing that in the EU. You’re seeing that in the UK. And you’re seeing that in the US. And we’re welcoming it.

And telling BP and Shell that they have to divest, they have to stop producing energy does two things. One, it’s not like it’s not going to get produced. When they leave… When BP left Iraq, Sinopec comes right in. The Chinese and the Russians come right in and they help pump oil with abandon. And I don’t know, if you’re a better, whether you want to bet that BP is going to do a better job for the environment or a Chinese or Russian state-owned enterprise. But I’ll be willing to bet anyone who listens to the podcast my standard bet, and I’ll take BP and Shell.

Alec: That leaves you with natural gas. And so at the same time the supply of natural gas went down because people forced it down, people power, including taking Shell to court in the Netherlands, so people cannot wipe their hands of this and say it wasn’t us, it was us, to now go after those companies and say that they’re making super profits and it’s their fault because they didn’t produce enough and we’re going to go after them and tax them more, well, what happens when you tax somebody more? You produce less, or you go elsewhere.

Merryn: It’s interesting, isn’t it? And John and I, John, the Executive Editor of the magazine, we talk quite a lot about this bizarre hatred that people have in the UK and globally for these oil giants. They treat them like the enemy. Whereas, in fact, and I think you said that in a couple of years, we’ll probably look at these companies as our great national champions as opposed to our enemies.

I can’t think… I thought that the energy issue, the natural gas issue was the epitome of shooting yourself in the foot. But now, particularly in light of what we’re seeing in the Ukraine and in the South China Sea, telling your indigenous defence manufacturing base that we don’t like you anymore really isn’t a smart thing to do. And while you can buy oil from the Chinese and the Russians and the Middle East, I just don’t see England buying…

So just thinking about a stagflation playbook, number one would be energy names. So we’re loaded with BP, Shell, Schlumberger, California Resources, Woodside in Australia, Impax in Japan. There’s great energy opportunities all over the place. And these all, almost universally, sell at double-digit free cash flow yields. Gold you mentioned. So we’ve got 10% of the portfolio in gold, in gold miners. At heart…

Then the last area, and this is where the Orbises of the world tend to really shine, is in idiosyncratics. So in the 70s, there was a whole pocket of names that worked because they were either so darn cheap and hated, that there was nowhere to go but up, as long as they just muddled along, or names that have drivers that have nothing to do with economic activity or do better when economic activity is getting worse.

So in the names that everyone hates that are super-cheap category, I get eye rolls when I even mention the name, Bayer, the purveyor of Roundup and genetically modified seeds. They do all these evil things. But you don’t have to like a company to need a company. Without Bayer, world hunger would just go off the charts. You can’t feed the world without the ag chemicals and the genetically modified seeds that the Bayers of the world produce.

And because no one likes it and because they’ve had to pay out for a Roundup lawsuit, which they never should’ve lost, in my opinion, and it’s been appealed to the Supreme Court who is thinking about taking it on, you leave those things aside, Bayer is selling at six to eight times earnings and pays a very nice dividend. So while everything else is going down, Bayer can just hold up. It can be a huge winner.

Burford Capital is a fantastic, very interesting company. They invented the space that’s now called litigation finance. They look at people who are suing other people, or entities, who are running out of money and can’t afford to keep the lawsuit going, which is the number one tactic of a big company, just outlast the resources of someone who is trying to sue you, and they come in and they offer to pick up the tab. And offering to pick up the tab, they get half the winnings if they win.

Alec: And they bring a lot to the table as well. They know the judges. They know the venues. They know what court it would be best to bring this to. And they know suits and they know probabilities. So just as I’m a manager of stocks and I need to figure out the risk-reward of a stock or a bond, they and a reinsurance company in Bermuda, where I am, needs to figure out the risk-reward of a risk, a risk of loss.

These guys figure out the risk and reward of cases. That’s where they bring their value add. And it’s not them going out and finding it. It’s not them going out and chasing widows and orphans and saying, let us handle your case. They’re not ambulance chasers. Those widows and orphans are finding them and saying, I can’t afford to keep doing this. And then they look at the merits of the case. They make a determination on the probability of success. And then they make a decision as to whether they’re going to pick that up or not.

And they pick up about 20% of the cases that come to them. And their return in invested capital is astronomical. They’re really, really good at this, and they’re one of the very few companies who are good at it. Some people try to come in and just can’t do it. But this sells at a single-digit multiple and we think it’s obviously completely idiosyncratic, would’ve been a fantastic name to own in the 70s.

Alec: Exactly. And there’s a lot of litigation coming from Covid-19 as well. Now, the other category are these energy transition names that are currently considered to be bad and evil and do nasty things. But we can see, we have line of sight or logic says, no, they’re one of the good guys, where we can go and invest in that gradient, buy on the cheap when it’s considered to be evil, and ride that gradient up.

And they’re taking… I know it's boilerplate and I know that the single-issue entities will find a picture of a log that looks rather straight and they’ll say, no, they’re cutting down perfectly good, round trees. They really aren’t. They are taking the scraps from the lumberyard, they’re taking the scraps from the telephone pole yards, they’re taking the scraps from the paper pulp mills, they’re taking the diseased trees, and they’re grinding them up, smashing them into pellets and they’re bringing them to the UK.

And none of these forests are cutting down… All these forests that are managed are net growers. So yes, they’re cutting down trees that are 22 years old. It takes 22 years to grow a tree to maturity, and they’re cutting down 90% of those trees. So the forests are actually growing and capturing more. They are not stumping them. They’re not pulling the stumps out. So that carbon is going back into the soil.

They really are trying to do a good job. They’ve got bad PR right now. That PR Is going to go away. So I’ll place another bet. That bad PR is going to go away when they add the second phase, which is carbon capture. So when they burn the wood pellets and capture the carbon from the flue gas and transport it into the North Sea and sequester it three miles down into depleted wells, that will be the only energy source that is carbon negative.

And just as in the 70s, when push came to shove and the governments really studied what the most effective way to conserve energy was, and they wound up subsidising light bulbs, that’s what Europe is about to do. And you’re going to see a big boom in demand for LED light bulbs and office efficiency and it’s going to be a wonderful period for Signify. And while we wait, it sells at a double-digit free cash flow yield. They just crank out cash.

Alec: I think that’s pretty fun. But they can go to orbis.co.uk and they can find it very simply there. But I do encourage people to learn about what’s in the fund, to read the quarterly reports, to get Investing for Dummies to understand what they’re looking at, and decide whether they agree or disagree with what’s in the fund. And I think it’s so important now, when you have all these labelling issues. And I look at some of these funds that just slap sustainable on the names of their funds, and I think it’s criminal, what’s in them. And people really need to look under the hood.

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