Image Source: Pixabay

Recently I read a book called Richer, Wiser, Happier by William Green. One of the readers of this letter suggested it to me a few months ago. The author draws on his experience interviewing great investors for publications such as Fortune, Forbes, Money, and Time. Some of the people profiled included Charlie Munger, Mohnish Pabrai, Bill Ruane, Irving Kahn, Bill Miller, Peter Lynch, John Templeton, Jean-Marie Eveillard, and Arnold Van Den Berg, among others.

What makes this book interesting is it doesn’t focus on the investment techniques or seek to uncover arcane secrets but instead seeks to understand the psychology, temperament, and habits that contributed to these investors’ success. In some cases, these investors had unique temperaments that were practically wired into them from birth. In other cases, the investors struggled to overcome psychological limitations through a process of continuous learning.

In the case of Arthur Van Den Berg of Century Management, I’d known of his record and the decades-long success he had as a long-term investor, but knowing his backstory made it even more impressive. Arthur was a small boy when the Nazis occupied his hometown of Amsterdam. Since his family was Jewish, they went into hiding in the house of a non-Jewish family a few blocks from where Anne Frank was hiding. His parents became concerned that he and his brother would die if they were caught, so they arranged for the Dutch Underground to take him to an orphanage for the rest of the war.

His parents did end up getting discovered and taken to Auschwitz. Fortunately, they were among the survivors. When his father came to the orphanage to pick him up, they found Arthur malnourished and skeletal. He didn’t even remember who his parents were.

The family ended up in America, settling in East Los Angeles, where Arthur was bullied constantly for being small and foreign. He ended up getting bad grades and never went to college, not seeing the point of doing it because he thought he was not smart enough. In fact, school psychologists thought his mind had been permanently damaged because of the malnutrition he had experienced at a young age and the trauma of the Holocaust.

Working various jobs to support himself, he started selling insurance and then mutual funds. This led to a fascination with why some did better than others and he began reading works of Benjamin Graham, such as The Intelligent Investor and Security Analysis. He also engaged in a self-improvement program inspired by From Poverty to Power by James Allen, including things such as affirmations, visualization, and daily study. Arthur realized that his anger at what he had experienced and self-doubts were limiting his success and he sought to reprogram his mind.

Over the next decades, he succeeded in transforming himself, doing well for clients and growing a money management practice.

I highly recommend the book for the many stories on the human side of great investors, such as the one above.

One thing a lot of the investors had in common was a desire for true independence, where they could control their own time and make decisions they thought were best for clients without the interference of a committee or bureaucracy. Having achieved the financial independence necessary for that, few of these investors ever retired until forced to by failing health. The oldest, Irving Kahn, continued working until shortly before his death at 109 years old.

Key Wealth Principles

• Spend less than your income
• Invest in quality businesses at an attractive price
• Build a portfolio of good businesses in different industries
• Maintain appropriate reserves and income sources
• Consider your financial circumstances, goals, and risk exposure

Winners and Losers: Revenge of the Rising Rates

The combination of inflation being more persistent than Wall Street expected and the economy holding up better than expected in the face of rising interest rates had led to adjusted expectations that the Federal Reserve will continue raising short-term interest rates, perhaps to as high as 6% sometime this year, though that will likely change with the recent events at several banks.

These higher interest rate expectations pushed down the value of assets across the board, from stocks to bonds to real estate. Riskier sectors and sectors dependent on borrowing, such as consumer discretionary, retail, real estate, and media & telecom, were particularly hard hit. Long-term bonds, including government bonds, were also hit hard as their prices are directly related to interest rates (their value falls when interest rates rise).

 

Equities: Holding Up, But Signs of Cracking

Source: FactSet as of 3/3/2023.

Source: FactSet as of 3/3/2023. Dividend Yield is an estimate based on the weighted average of all companies in the category (by market cap). Earnings Yield, Earnings Growth, and Return on Equity are estimates based on the median profitable company. The % Losing Money statistic represents the percent of stocks with negative earnings in the preceding 12-month period. Large Cap stocks are defined here as the stocks in the S&P 500, according to FactSet. Small Cap stocks are defined here as U.S. stocks ranked 1,001 to 3,000 in market capitalization. International Stocks are defined here as the 1,000 largest stocks traded on international exchanges, by market capitalization.
 

There is an interesting dynamic in the marketplace in that companies are still showing good earnings growth overall-in fact, the average earnings growth rate estimate increased last month—but certain sectors are showing weakness. The percentage of companies losing money has increased among large cap stocks from less than 5% to 8%. The tech industry and Wall Street have announced layoffs. Real estate transactions have slowed dramatically given high mortgage rates.

Despite concerns in these important sectors, other areas seem to be doing okay, turning in solid growth figures. I think it is appropriate to be somewhat cautious, minimize debt, and maintain adequate safety reserves. But I am still seeing plenty of good quality companies trading at 5-7% earnings yields and offering expected earnings growth of around 7-10% a year. At those earnings yields and growth rates, I am happy to invest for the long-term.

* “Earnings yield” is an investor’s share of earnings for every dollar invested (i.e., earnings per share / price per share). It’s the same as the more famous Price / Earnings (P/E) ratio, but expressed as a yield rather than as a multiple. I use it to compare stocks more clearly with bonds and other asset classes.“Equity Risk Premium” equals the Earnings Yield minus the 10-year Treasury Inflation Protected Securities yield.

 

A Treasury Bond From 1979

Source: WikiMedia.org.

Income: Return of the Savers

Source: Interest rates from Raymond James’ Weekly Interest Rate Monitor as of 2/27/2023 and The Wall Street Journal as of 3/4/2023. Source for the Dividend Yields is from FactSet as of 3/3/2023. Common Stocks uses the estimated weighted average dividend yield for the S&P 500. The top 25% yield is the median yield of the top quartile of dividend-paying stocks out of the largest 1,000 stocks. The next 25% yield is the median of the second quartile. Preferred Stocks is the median dividend yield of the 100 largest traded preferred stocks (by dollar volume, per FactSet). REIT and Utilities dividend yields are the median of those sector stocks included in the 1,000 largest common stocks.
 

I probably sound like a broken record to regular readers, but I believe that Wall Street has been mispricing inflation risk for some time. This corrected somewhat last month as 10-year inflation expectations bumped up from 2.3% to 2.4%*, but I still think the probability of inflation coming in higher than that is greater than the probability of inflation coming in lower.

Regardless of outlook, short-term rates have become quite attractive from the perspective of savers and conservative investors. Treasury securities in the 6-12 month maturity range are yielding around 5% and money market funds are yielding 4-5%. Realistically, many investors are happy earning 4-5% in government obligations, so it is an attractive environment for conservative investors.

* Implied inflation expectations are derived from taking the 10-Year Treasury rate and subtracting the 10-Year Treasury Inflation Protected Securities (TIPS) rate. For example, if the yield on 10-year treasuries is 2.8% and the yield on 10-year TIPS is 0.4%, they are roughly equivalent investments if inflation comes in at the difference (2.8% - 0.4% = 2.4%).
 

Quote

“I keep six honest serving-men
  (They taught me all I knew);
Their names are What and Why and When
   And How and Where and Who.
 

—Rudyard Kipling

The Long View

For the last 20, 30, and 100 years, stocks have averaged around an 8-10% return, driven by dividend yield, reinvestment of earnings, and earnings growth. Long-term bonds have yielded about 5% on average over the last century while inflation has been about 3%.

Throughout this period, there have been major upheavals, such as the Great Depression, World War II, The Korean War, The Vietnam War, dropping the gold standard, 1970s high inflation, 1987’s Black Monday Crash, the Dot.com bust, the 9/11 terror attacks, the Global Financial Crisis, and the Covid Crash, among others.

These events led to severe market downturns about once every decade, with a median price decline of 33% and a median time to recover back to the previous high of 3.5 years. If we were to include dividends, the recovery to previous highs is actually a little faster.

Meanwhile, a 3% inflation rate results in a 59% decline in the value of a dollar over 30 years. Meaning that people who retire at 60 years old on a fixed income face a high risk of a lower quality of life as they get further into retirement.
 

Source: Morningstar Direct via cfainstitute.org, FactSet. Past performance is not necessarily indicative of future performance. Depreciation of the dollar: $1 / (1 + 3%)^30 = $0.41 real value 30 years later.

Market Outlook

Now I’ll put on my “Nostradamus Hat” and make some predictions, for whatever they’re worth:

• Inflation will average 3-4% over the next 10 years. Inflation currently exceeds this range but core inflation has fallen below 6% recently.
• Interest rates will fall in the 3-5% range for 10yr Treasuries over the next several years, in line with inflation and historical experience.
• The economy will grow 2-3% in real terms over the next several years, though we will probably slip into a recession this year.
• Stocks will average an 8-10% return over the next 10+ years. After subtracting inflation, this will translate into about a 5% real return. There is likely to be at least one big decline every decade or so.

From the standpoint of where you and your family will be in 30 years, none of this matters. What matters is finding good quality investments that are likely to grow over the decades. For this reason, I largely ignore my own general market forecast and invest whenever I find a business that I am confident in and that trades at an attractive valuation.

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