Q4 2020 Letter

NZS Capital Fourth Quarter 2020 Update

January 11th, 2021

PDF

The NZS Capital Global Growth Strategy returned 23.41% (23.22% net) in the fourth quarter of 2020 and 63.51% (62.44% net) in the year ending December 31st, 2020 compared to the Morningstar Global Target Market Exposure Index returns of 14.75% and 15.83% for the same periods. The NZS Capital Global Select strategy returned 22.06% (21.88% net) in the fourth quarter of 2020 and 67.08% (65.98% net) in the year ending December 31st, 2020.

For A Table of Performance Please Download the Letter PDF

Market Commentary

The fourth quarter progressed through a backdrop of uncertainty and volatility toward potential light at the end of the tunnel with the approval of several promising vaccines. A small group of highly valued companies has been leading the market higher since the beginning of the global pandemic. The market dynamics are a striking echo to behavior during the dotcom bubble, with the important exception that today, companies with ballooning valuations, represent a much smaller part of the overall market.

You cannot invoke the term bubble without concurrently discussing time horizons and hurdle rates. The idea of a bubble in the present time implies that valuations will correct down over the short term. High starting points for valuations also imply that long-term returns will be lower. However, if your expectation of equity returns over the next decade is lower than historical figures, then even valuations on some stocks today are not high when measured against a 3-5% hurdle rate. Most of us, however, strive to do much better than single digit returns on equities, and, therefore, many stocks today become uninvestable even on a five- to ten-year time horizon. Low interest rates are of course at play when any investor considers their hurdle rate for long-term returns. And, the lower rates drop, the more short-term valuations are sensitive to small changes in interest rates.

When we think about valuation and position sizing in the portfolio, especially in the context of an equity bubble, we focus primarily on whether the range of outcomes is widening or narrowing (a concept we covered in more detail in our Third Quarter 2020 Letter: “If you let a winner run even though the range of outcomes is still very wide, then you are explicitly making a large bet on a narrow prediction about the future, which means all you have done is increase the risk in the portfolio. And, in turn, you are starving resources for new Optionality positions.”). To never sell or trim a stock simply due to a high valuation, no matter how large the opportunity might appear, would be a misunderstanding of risk at the portfolio level – at some point that strategy becomes gambling rather than investing. As always, we remain vigilant about the range of outcomes and implied returns across our strategies. With the world still in the early stages of the global economic transition from analog to digital, many sectors are still presenting good investment opportunities for long-term growth.

The research process at NZS Capital is always guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited to the current state of the markets. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions underpinning their success and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy. 

In the Year 2030...

When volatility is high in the short term, it’s best to imagine yourself far into the future: what will your day look like in 2030? Let’s assume the pandemic is over by then, and that, optimistically, the world is perhaps a little more stable. In 2030, it will have been about fifty years since interest rates began their steady decline, fifty years since inequality began rising as real wages began stagnating, and fifty years since the personal computer revolution began the Information Age in earnest – driving decades of deflationary pressures that enabled those declining rates while significantly expanding asset prices. What will be the same in 2030? What will be different? What will the path to the year 2030 look like?

These questions of course are not answerable with any level of precision, but at NZS Capital we are optimists, believing that conditions will improve no matter how bad they might seem in the present. That optimism is one of the few predictions we are comfortable holding on to when we think about the possible futures we might find ourselves in. Focusing too much on the present and the near future is what gets many investors into trouble. Loch Kelly quotes contemporary Tibetan Buddhist teacher Mingyur Rinpoche as saying: “If you examine even the present moment carefully, you find that it also is made up of earlier and later moments. In the end, if you keep examining the present moment, you find that there is no present moment that exists either”. The past seems to have slipped away, the present is elusive, and the future is unknown. What’s an investor to do? 

Coming back to the questions of what will and won’t change in the next decade can be a useful starting point. So, let’s return to the speculation of what a day might look like in 2030. After a night of restful sleep – thanks to analysis and advice from smart health monitors (including wearable and radar-based sensors on your nightstand) – your smart assistant might wake you up at the opportune time for feeling rested. Your temperature-controlled mattress will contribute to better sleep and health. Overall, wearables will be generating an enormous amount of data in 2030, enabling a shift from a broken healthcare system focused on treating disease to one focused on preventing disease from taking root in the first place. Healthcare will be very different in 2030.

Will you work from home in ten years? Surely the ability for some to work remotely helped in 2020, and increased location flexibility going forward will be an equalizer that creates opportunities. However, the loss of ad hoc randomness from isolation may send humans back to group settings. Or, perhaps augmented reality glasses will bring lifelike interaction to the virtual world. Augmented reality will likely be a large part of daily life in 2030, with ambient audio, video, communication, and gaming woven into everything.

In many ways, technology will continue to remove friction from the economy as we transition from a world where less than 10% of transactions are digital to one where nearly every transaction and interaction is digital in some way. In the banking industry, for example, there remains an enormous amount of friction, but, if I am still writing paper checks and putting them in envelopes to mail in 2030, I may lose my optimism! Fintech is breaking down walls one at a time in the legacy banking system, and blockchain has a chance at creating a digital transactional currency and asset ownership system that could one day underpin much of the economy; however, 2030 might be just a little early for that revolution.

Will you have an autonomous vehicle? What percent of new and existing cars will be electric? Will we be far down the path to creating a green, distributed power system around the planet? These questions are difficult and complex, but the direction seems clear for energy and transportation – if not 2030, then 2040 or 2050.

What are the foundational platforms, both hardware and software, that will enable a better, more digital future in every sector of the economy? Will they be the same platforms we have today? If not, why? What would be a better foundation? The primary element that we believe will create the platforms of the future is non-zero sum, e.g., win-win, or generating more value for your constituents than you take for yourself. The higher the ratio of give to take, the more likely a technology will transform and take off with ever-increasing returns and network effects. Technology that creates value should disappear into the background to the point where you don’t even realize it’s there.

We can speculate endlessly about the enabling technologies of the future, but they can only be great if they are available to everyone on the planet, and if they make the planet better. The deflationary trends of technology are just beginning, and, as we enter the AI age, they will accelerate to a pace heretofore unseen (for more discussion of deflation see the ‘Can We Harness Technology’s Deflationary Pressure?’ at the end of newsletter SITALWeek #258). Technology’s growing impact on the economy can make humans feel less useful, a feeling which could grow even larger with the rise of AI. This disenfranchisement, combined with the decades of increasing inequality, has created a backdrop for fear, nationalism, and, in some cases, hate. If managed correctly, the balance of deflationary technology trends with fiscal and monetary programs around the world could ensure everyone has access to the sustainable, technology-driven improvements to life and wellbeing. It’s a Goldilocks meets Pollyanna scenario, but, like we said, we’re optimistic. Our job at NZS Capital is to create the landscape for luck to come knocking, and the best way to do that is to keep an open mind, always look for new ways to connect dots, and focus on the distant future. 

Performance Discussion

The following fourth quarter performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors. Technology remained our largest weighting at 60.68%. Our technology investments were up 25.56% compared to the technology component of the benchmark, which rose 14.78% in the quarter. Other significant contributors to performance in the quarter were our stock selection in consumer discretionary and communication services in addition to owning fewer healthcare and consumer staples investments. In the fourth quarter, our top contributors were semiconductor companies Microchip, Lam Research, and Taiwan Semiconductor along with software companies Sailpoint and Zendesk. Financials, industrials, and energy stocks did well in the fourth quarter, and our lower weights in those sectors detracted from performance. Our bottom five contributors in the fourth quarter were Salesforce, Nvidia, Crown Castle, Moderna, and Air Products.

For the full year ending December 31st, 2020, our top performing sectors were a combination of weighting and stock selection in technology, followed by consumer discretionary, communication services, financials, and real estate. Owning fewer industrial and healthcare investments weighed on performance relative to the market. Our top five contributors to 2020 were Nvidia, Tesla, Sailpoint, Cadence, and Amazon. Performance across our top 20 was well-balanced between a mix of both Resilience and Optionality positions. Our bottom five contributors for the year were Comcast, ViacomCBS, Walt Disney, Lyft, and Heico.

Thank you for your continued trust, interest, and support.

There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

Net returns are calculated by subtracting the highest applicable management fee (1.00% annually, or .0833% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.

Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.

Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.

An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.

Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.

Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. 

NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”).  The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN

Q3 2020 Letter

NZS Capital Third Quarter 2020 Update

October 14th, 2020

PDF

The NZS Capital Global Growth Strategy returned 14.71% (14.52% net) in the third quarter of 2020 and 32.50% (31.83% net) year to date compared to the Morningstar Global Markets GR Index returns of 7.95% and .94% for the same periods. The NZS Capital Global Select strategy returned 19.10% (18.9% net) in the third quarter of 2020 and 36.88% (36.19% net) year to date.

For A Table of Performance Please Download the Letter PDF

The third quarter was marked by ongoing uncertainty and volatility due to the pandemic and geopolitical events. The research process at NZS Capital is guided by the unpredictability of the world around us. Our lens on the world, which does not rely on narrow predictions of the future, is ideally suited to the current state of the markets. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.

The following year-to-date performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors. Technology remained our largest weighting year to date at 62.58%. Our technology investments were up 34.82% compared to the technology component of the benchmark which rose 29.03% year to date. Other significant contributors to performance in the period were our stock selection in consumer discretionary and real estate (REITs) along with our underweights in energy and financials. In the third quarter our top contributors were Nvidia, Sailpoint, Taiwan Semiconductor Manufacturing, Salesforce.com, and Tesla. Detractors from performance included Micron, Microchip, American Tower, Guidewire, and Thor Industries.

Commentary

The following is adapted from our weekly newsletter #259:

At NZS Capital, we are always reminding ourselves that no one can predict the future, even with perfect information. That notion can feel uncomfortable, and even a bit paralyzing. We do, however, know that there are certain elements of a company’s culture and products that afford better odds of future success. Chief among those are a company’s adaptability and the level of NZS, or non-zero sum, they provide – the more value they create for others, the more value they will ultimately create for themselves down the road. One way to frame a hypothesis regarding a future outcome, without having to rely too much on a crystal ball, is like this: “In five to ten years I think blank will happen, but I don’t know how it will happen, what it will look like, or who will win.” Example: In five to ten years, people will watch more video content, but I don’t know what types of devices it will be on (screens or AR/VR glasses?), what type of content it will be (scripted Hollywood, interactive life streaming, immersive metaverse gaming, casual games, etc.), or who will be making more of the content. 

We can separate these statements into broad predictions, which are more likely to happen in various futures, and narrow predictions, which are difficult to know ahead of time. Some of the broad predictions would be: 1) semiconductors and connectivity will be in more demand; 2) creativity and storytelling will always be important; 3) data – and smart use of it – will be important; 4) if interactive content rises, gaming engines will be more important in creation of content; 5) cloud computing and AI will be important; 6) people’s tastes will always be fickle and personal, and thus hard to predict. These broad predictions create a landscape in which to plant various narrow predictions and monitor growth and outcomes. Many factors will determine which predictions grow stronger and which wither and die, including, first and foremost, adaptability and NZS, but also network effects, innovation, platform dynamics, etc. If we were to look today at, for example, what content is the most adaptable and highest NZS for consumers, it’s probably video games and life sharing/streaming via social networks or YouTube. These forms of content can change their storytelling easily, provide the largest amount of content per dollar spent, and generally create win-win for all constituents. Some views will be Resilient – fairly broad and safe predictions (e.g., semiconductors will do well), and some will be Optional – narrow predictions (e.g., specific content/video game will gain share). This process is at the heart of our investing strategy and is detailed in our paper, Complexity Investing, which provides a framework for identifying winning companies and constructing a portfolio that balances Resilience and Optionality.

As you objectively assess new information, you can water and prune this landscape of broad and narrow predictions. It’s important not to let the narrow predictions become giant weeds. Letting your narrow prediction winners run is a false narrative that feeds off a set of cognitive biases (bias traps are also addressed in our Complexity Investing paper). At NZS, we tend to let our Optionality (narrow prediction) positions grow in the portfolio only if the range of outcomes is becoming more narrow – meaning that the prediction itself is becoming more broad (see figure at the end of this letter). If the range of outcomes has remained the same, but a company’s market value is up, then letting the position grow in the portfolio is akin to doubling down at every spin of the roulette wheel without taking any chips off the table (an obvious and risky mistake given the very narrow chance of future payout). Further, when you prune an Optionality position, you use the excess to seed new Optionality positions and/or water the ones that are experiencing a narrowing range of outcomes. This strategy allows you to maintain the overall asymmetry of the portfolio while not concentrating risk. If you let a winner run even though the range of outcomes is still very wide, then you are explicitly making a large bet on a narrow prediction about the future, which means all you have done is increase the risk in the portfolio. And, in turn, you are starving resources for new Optionality positions. Complex adaptive systems teach us that very narrow predictions are overwhelmingly likely to be wrong. Some Optionality positions end up being giant, adaptable oaks that last decades; however, the majority – including most/all of your cherished favorites – end up as weeds.

Thank you for your continued trust, interest, and support.

Optionality positions, which have a wide range of outcomes, should only graduate to larger positions if that range is narrowing, and the predictions are becoming safer. For more see Redefining Margin of Safety.

There is no guarantee that the information presented is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

Net returns are calculated by subtracting the highest applicable management fee (1.00% annually, or .0833% monthly) from the gross return. The management fee includes all charges for trading costs, portfolio management, custody and other administrative fees. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The fees are available on request and may be found in Form ADV Part 2A. Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.

Any projections, market outlooks, or estimates in this presentation are forward-looking statements and are based upon certain assumptions. No forecasts can be guaranteed. Other events that were not taken into account may occur and may significantly affect the returns or performance. Any projections, outlooks, or assumptions should not be construed to be indicative of the actual events which will occur.

Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.

An investor should not construe the contents of this newsletter as legal, tax, investment, or other advice.

Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.

Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. 

NZS strategies are not sponsored, endorsed, sold or promoted by Morningstar, Inc. or any of its affiliates (all such entities, collectively, “Morningstar Entities”).  The Morningstar Entities make no representation or warranty, express or implied, to the owners who invest in the strategy or any member of the public regarding the advisability of investing in the strategy y or to any member of the public regarding the advisability of investing in equity securities generally or in the strategy in particular, or the ability of the strategy to track the Morningstar Global Target Market Exposure Index or the Morningstar Developed Markets Technology Index or the equity markets in general. THE MORNINGSTAR ENTITIES DO NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE STRATEGIES OR ANY DATA INCLUDED THEREIN AND MORNINGSTAR ENTITIES SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN

Q2 2020 Letter

NZS Capital Mid-Year Update

July 5th, 2020

PDF

Our disciplined, Resilience and Optionality portfolio construction process posted year-to-date returns of 15.51% (14.12% net) for the NZS Global Growth strategy and 14.93% (14.54% net) for the NZS Global Select concentrated strategy compared to the -6.69% decline of the Morningstar Global Target Market Exposure NR USD index. For the second quarter of 2020, the NZS Global Growth strategy was up 38.64% (38.43% net) and the NZS Global Select concentrated strategy was up 40.86% (40.65% net). The NZS Global Technology strategy, which launched in March 2020, was up 38.68% (38.48% net) in Q2 2020.

For A Table of Performance Please Download the Letter PDF

The research process at NZS Capital is guided by the unpredictability of the world around us. We believe companies that maximize non-zero-sum outcomes for all of their constituents, including employees, customers, suppliers, society, and the environment, will also maximize long-term outcomes for investors. Our view of the world informs our portfolio construction process, which combines a relatively small number of Resilient companies with a long tail of Optionality companies. Resilient businesses have very few predictions and a narrow range of outcomes, while Optionality businesses have a wider range of outcomes and their success hinges upon a more specific view of the future playing out. This combination of long-duration growth with asymmetric upside is well suited to navigating the increasing pace of change throughout the global economy.

The following year-to-date performance discussion references the NZS Global Growth strategy, which represents our broadest approach in terms of number of names and sectors. 

The market experienced a significant decline in Q1 2020; however, technology led a rebound in Q2 2020. Our technology sector weight for the first half of 2020 was 62.44% of the strategy, which was up 18.54%. We outperformed the technology component of the index by 4.56 percentage points. At NZS Capital, we believe volatility is not risk; rather, it represents opportunity. As such, we took advantage of the market conditions in Q1 to shift a portion of the portfolio from Resilience to Optionality. Both components of the portfolio contributed to performance in the period; notably, in the Resilient portion, Nvidia, Amazon, Microsoft, and Zendesk outperformed as the pandemic raised interest in accelerated cloud migration for enterprise IT departments. Optionality was also well represented in top performers by Tesla, Shopify, Peloton, Redfin, and Adyen. From a sector perspective, the portfolio outperformed in technology (as previously mentioned), consumer discretionary, and real estate (REITs), and benefited from not owning stocks in the financial and energy sectors.

Among the detractors were media companies Viacom and Disney, which underperformed due to their advertising exposure, and, in the case of Disney, theme park shutdowns. We view these pressures as short term in nature and continue to own these investments. Several semiconductor companies weighed on performance due to slower economic demand including Amphenol, Soitec SA, and On Semiconductor. Semiconductors and related industries remain the largest portion of the portfolio given our long-term optimism for the sector. Constellium, a provider of rolled and extruded aluminum products for the automotive, aerospace, and beverage can market, detracted from performance as well. We added to the position based on the long-term outlook for the business. HEICO was negatively impacted by travel demand, and we exited the position given the risk of longer-term travel disruptions. 

We brought on three new employees to NZS Capital in the first half of 2020. Jon Bathgate and Joe Furmanski joined co-founders Brinton Johns and Brad Slingerlend on the investment team. Jon and Joe spent 12 and 14 years, respectively, at Janus Henderson Investors in Denver, working with Brinton and Brad for much of that period. Adam Schor, former Director of Global Equity Strategies at Janus Henderson Investors, joined as President and Chief Risk Officer. Jim Goff, former Director of Research at Janus, became a Senior Advisor to NZS Capital. We were pleased that a large endowment and a noted sovereign wealth fund selected us to manage a portion of their portfolios in the first half of 2020. We will succeed as a firm only if we meet and exceed the objectives of these and future clients. 

Market Commentary

The following is adapted in part from our weekly newsletters:

Well, that was an interesting 181 days. The COVID-19 pandemic and protests following George Floyd’s murder placed an even bigger spotlight on inequality. Capitalism worked for centuries to lift more people up from poverty than any other system over the same period. But, in its later days, the experiment has left far too many behind – vulnerable, and unjustly harmed. The last six months highlighted the hypocrisy of the tech platforms that have dominated our lives for the last two decades, as well as the ineptitude of our governments. And yet, in the West, freedom of expression and speech rose up to shine an even brighter light – hope for the future and a path forward. As we often say, cynicism sounds smart, but it’s never right in the long run. Optimism always wins over time, and at NZS Capital we are optimistic about the future for companies that create more value for society than for themselves. We strive to build our portfolios out of companies working toward a more positive future, and we see no shortage of opportunities today.

There is much speculation in the markets that the markets have too much speculation. However, the current positive impacts from fiscal and monetary stimulus, combined with the negative impact of the short- and long-term effects of COVID-19, make it hard to know if the market is underpricing or overpricing risk. Before the global meltdown, “risk-free” long-term US government bond rates had around 2%-3% yields, corporate bond yields were a bit higher, and the market multiple was ~20x forward earnings. Absent the drop in interest rates and the fiscal stimulus, which has so far guaranteed almost all assets are “risk free” (as the central banks continue to purchase nearly anything to provide liquidity and stabilization), the shallow correction in equities seems to underprice the risk of multiple years of rolling shut downs and the fat-tail fallout from the pandemic. However, the penalty of holding cash at zero (or in some countries negative) rates is strong motivation to bid up riskier assets with higher return potential. Therefore, with zero rates and fiscal stimulus, the market might be unexpectedly overpricing the risk of the pandemic, (particularly given the reasons for low rates discussed in more detail below), which brings us to valuations. 

The starting point when you buy or own a stock matters. A high starting point forces you to try to peer further into the future, requiring very narrow predictions about how the far future will unfold in order to be correct in the present. Conversely, a low starting point allows for broader predictions, and does not require that crystal ball to be nearly as accurate. We know from complex systems that attempting to precisely and accurately predict the future is of little use. Therefore, there are two responses to a high starting point: 1) the more narrow your prediction(s), the smaller the position size should be (and vice versa); and 2) keep an eye on the totality of those small position sizes, such that you aren't making a portfolio level narrow prediction about valuations. It’s fairly easy when you simplify it: match the breadth of prediction to position size and monitor the total exposure of narrow predictions across the portfolio. None of this argues for selling a position entirely if the outcome asymmetry is still high; instead, it argues for thoughtful position sizing and portfolio construction – a good idea no matter what the starting point is.

Which Came First, Low Rates or Increased Debt?

Back in May, Warren Buffett sat by himself in an empty, 19,000-seat arena and wondered aloud: if rates can stay low forever, then why didn't civilization figure that out 2000 years ago? Over the last 20 years, there has been a persistent fear that ever-rising credit cycles will create ever-bigger crashes, as we saw in 2009. One might expect a major shock to the global economy to pop a credit bubble created by artificially low rates; this spring we got the biggest shock of them all, yet it appears the economy could eventually exit the pandemic reasonably intact. However, the unevenness of the recovery – with inequality rising even more as a result of the pandemic – remains to be addressed (a point we’ll return to shortly). 

Do low rates and seemingly infinite government monetary and fiscal stimulus perversely mean that shocks make the economy stronger? But, what about inflation!? Surely the flood of money will drive up prices and cause rates to jump higher, thus popping the giant credit bubble. But this hasn’t been the case, despite being decades into the steadily declining rate trend and monetary stimulus. Related to this, NZS Capital’s President and resident finance Lecturer, Adam Schor, points to the collapse 49 years ago of Bretton Woods, the post-WWII global agreement to tie currencies to gold. Following the extreme inflation of the 1970s, rates began a steady, 40-year, downward march – which the termination of Bretton Woods likely facilitated. No longer tied to gold, central banks can increase monetary supply and interest rates with much more flexibility. 

Did low rates increase debt, or did debt demand low rates? As an economy grows and debt increases, the borrowers – those people who need to make the interest payments and eventually return the principle – tend to be disproportionately less-wealthy, while the people who lend money out and make a return on it tend to be wealthier. As time goes on, the wealth of the wealthier is more and more tied to the interest payments from the less wealthy – one person’s indebtedness is another person’s asset. And, as inequality marches higher, the less wealthy have an ever-rising debt burden that can only be maintained by perpetually lowering interest rates. It’s in the best interest of the lenders to lend at lower and lower rates to preserve their assets. This explanation is somewhat at odds with the general narrative – that lower rates are the driving force behind rising debt. Certainly lower rates allow rising debt; however, the common view misses the crucial point that increasing debt necessitates lower rates – which actually has mathematical support. 

As well as allowing rising financial inequality to go unaddressed and unchecked, decreasing rates have been one of the hidden deflationary forces in the economy, along with the shift from an asset-heavy Industrial Age to a data-heavy Information Age. Indeed, with a large number of people with rising indebtedness and stagnant incomes operating in an economy with technology-driven deflation, it’s hard to imagine what could create sustainable inflation. 

Now, if this trend of falling rates and rising debt persists into perpetuity, the result would be infinitely negative rates and, in the end, one person would have 100% of the wealth while everyone else would be indebted to them. Thus, we find ourselves back in that empty, dark arena in Omaha, kindred spirits with Buffett in our puzzlement. Perhaps there is a solution to this quandary – one that almost seems demanded by the current, pandemic-exacerbated inequality in the world – redistribution. Economist and SFI External Professor Brian Arthur calls our economy today the “distributive era”. To paraphrase: we have created a lot of wealth in the global economy; now, it’s time to focus on increasing who has access to it. Distributing money to more people who are on less-certain financial footing is going to stabilize, or possibly reverse, the deflationary trend. However, it’s important to avoid excessive inflation and rising rates that would further burden the borrowers who are helped by redistribution. 

It seems like a hard needle to thread, but it is not impossible. Why? The deflationary pressure from the technology sector is going to step up dramatically as we move into the “AI Age” over the next century, and every part of the economy becomes tech enabled, starting from less than 10% digital today. So, we probably have a wide berth to drive a little inflationary pressure and maintain low rates.

That’s a neat and tidy story, right? It’s one possible explanation, and, moreover, it suggests that redistribution could be a way out of our current socio-economic quandary. But, we live in a world dominated by complex adaptive systems, which means that predicting the future isn’t so neat and tidy. Or, as Jim Goff said in one of our recent team meetings, “Just when you think you have something figured out, that’s when the market kicks you in the teeth”. The theory relies on smart redistribution by governments, and, if we’ve learned anything from the last few years, then we probably shouldn’t bank on smart decisions by governments around the world. And, the economy remains extremely vulnerable to inflationary shocks, although they remain elusive for the time being.

While this mid-year update has focused on macroeconomic issues, we actually spend comparatively little time thinking about macro events from an investment perspective. As a whole, however, the recent turbulence serves to highlight the frequency of fat-tail events inherent to complex systems – and reinforces our philosophy of finding adaptable companies that are creating the new digital operating system for the economy. The pandemic of 2020 has accelerated the decades-long shift from the Industrial Age to the Information Age. Companies that are long-term focused, innovative, and maximizing non-zero-sum outcomes will disproportionately benefit. Our process is built to find these companies and craft a portfolio that balances Resilience and Optionality for our clients. Thank you for your continued trust, interest, and support.

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Morningstar Global Target Market Exposure NR USD is a rules based, float market capitalization-weighted index designed to cover 85% of the equity float-adjusted market capitalization of the Global equity markets.

Morningstar Developed Markets Technology NR USD measures the performance of companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. 

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