Investing

I regularly read a website about overpriced West Coast real estate called Dr. Housing Bubble.  The site had an interesting exchange in the comments section of one of its recent posts.  One commenter encouraged people to contact their congressional representative and ask him (or her) to ban the foreign purchase of U.S. real estate.  A regular commenter then responded with this:

First of all I think any law like that would be thrown out by [the] courts. If Trump can’t ban radical Muslims from entering the country, good luck banning rich Chinese from buying homes.

Second, it is ridiculous to tell foreign people who want to bring money and invest it here “sorry we don’t want your money”. Actually ridiculous isn’t the right word…downright insane is a better description.

I wanted to highlight this quote because I feel it is emblematic of one of the greatest investing conceits of our age – a complete failure of investment imagination.  Investors gripped by this dread disease cannot fathom the possibility of a world that is significantly different than the one we currently inhabit.  To them we have reached the end of investment history, where current investing trends, tax laws and economic policies must inevitably persist forever.

But a failure of investment imagination can be hazardous to your wealth.  In fact, we are already beginning to see the slow disintegration of the old financial regime as economic pressure ratchets ever higher.

For example, in August 2016, the Canadian city of Vancouver instituted a 15% transaction tax on foreign real estate buyers.  In April 2017, the entire province of Ontario followed suit with a similar surcharge.  New Zealand has just instituted an even more radical policy than Canada, by completely banning the sale of existing homes to foreigners.

To believe that California real estate is somehow immune from these global developments is unrealistic.  Yet this Dr. Housing Bubble commenter, along with hordes of property buyers, thinks that U.S. real estate policies cannot possibly change.  And while this particular failure of investment imagination is about real estate, it is obvious that a similar mindset is ensconced in all asset classes.

In some ways this is a very natural, very human reaction to the post-Great Financial Crisis investing landscape.  For the last decade, markets of every description – stocks, bonds, real estate – have gone nowhere but up.  This has made investors complacent and entitled.  They cannot imagine a different world, because today’s world is the one they are getting rich in.  And they never want to stop getting rich.

The future, however, is likely to be far less forgiving than the present, particularly in capital markets.  The metaphorical ground underneath our collective economic feet is likely to shift in a profound, and possibly disturbing, way.  Due to a widespread failure of investment imagination, few people are prepared for this brave new world.

What changes will take place in the economy over the next few years?  To be honest, nobody knows.  The world’s central bankers are currently conducting the largest, most ambitious monetary experiment in human history.  As a result, we are in completely uncharted economic territory, and anybody who says otherwise has an agenda.  However, I do think there are a few events that we can reasonably assert will happen in one form or another.

First, I think it is highly likely that what has worked for investors over the past 10 years will stop working rather suddenly.  Risk-oriented paper assets, like stocks, REITs and high-yield bonds, which have marched relentlessly higher over the past decade, will abruptly lose favor.  This will be a tremendous shock to professional money managers and financial advisors, who have built their portfolios around these traditional investment classes.

Second, it is clear that the world will become increasingly localized as globalization at least partially reverses.  Money and goods will not flow across borders as easily as they once did, and, in certain situations, they may not flow across borders at all.  Neither major corporations nor mom and pop investors are prepared in the least for this eventuality.  I detail this concern at greater length in an article titled “Hard Assets in a World of Capital Controls“.

Finally, I believe the future will see a wave of corporate defaults as over-levered companies finally hit the limits of financial market credulity.  This will undoubtedly catch large numbers of sanguine investors off-guard.  Losses will be steep and the damage will be distributed across a wide range of historically “safe” investment strategies.

The flip side of today’s ubiquitous failure of investment imagination is that alternative assets, like bullion, fine art and antiques, have generally been overlooked.  The recent performance of these tangible assets has been rather modest compared to market darlings like crypto-currencies and technology stocks.  But then again, you won’t wake up one random Monday morning to discover that half the value of your bullion stash has been wiped out over the weekend.

This nightmare scenario, where the bid for stocks and bonds dries up suddenly, is called a discontinuous market.  And it could cause the major market indices to gap down by 10%, 20% or even more in a very short period of time – perhaps minutes.  Stop-loss or trailing stop-loss orders which would normally protect your brokerage portfolio would actually be detrimental in this situation, as they would force you to sell into the teeth of the panic.

These dark circumstances in which the previously unthinkable suddenly becomes fact, are, unfortunately, not just possible, but probable.  They are the natural side effects of highly distorting central bank policies that have gutted the middle class while simultaneously creating a new gilded age for the ultra-wealthy.  As frightening as this bleak future sounds, there is a way to protect yourself.  Undervalued hard assets represent a great opportunity to hedge market risks.  Don’t let a failure of investment imagination hobble your portfolio.

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Most of us are looking to invest our retirement funds in asset classes that stand the test of time.  When we access our money 10, 20 or 30 years in the future, we not only expect it to still be there, but to have also grown.  In other words, we want to buy perpetual assets.  This investment philosophy is best summed up by the famous Warren Buffett quote, “Our favorite holding period is forever.”

In order to achieve this end, Warren Buffett invested primarily in common stocks.  And an entire generation of investors eagerly followed his lead without really understanding the mechanics behind it.  Both Wall Street and the general public have completely embraced the idea of “stocks for the long run.” As a result, we are currently overrun with stock-oriented mutual funds, ETFs and hedge funds.  In fact, there is a very good chance that your workplace 401-k plan is dominated by equity funds, with only a single money market fund and maybe one or two bond funds as alternatives.

But the idea that you can robotically dump your retirement savings into stocks and expect eternal 10% returns as if it were a fundamental law of nature is hopelessly misguided.  The sad truth is that a great deal of the success of stock-based investing over the course of the 20th century is attributable to an accident of timing.  Simply put, the mid 20th century was a great time to buy the broad U.S. stock market.  Valuations were modest and the country had many decades of strong economic growth ahead of it.  This combination of variables essentially assured the stellar stock market returns we have seen over the last several decades.

But, unfortunately, stocks are not the perpetual assets that most of us were hoping for.  The Dow Jones Industrial Average lays bare this truth.  Founded in 1896 by Charles Dow, the DJIA is one of America’s oldest and most venerable stock indices.  Of its original 12 components, only one, GE, is still in the index today.  All the rest of the original DJIA companies have either been acquired as their business prospects declined or gone bankrupt.  In fact, the DJIA’s constituents have changed 51 times since the index’s inception.

The DJIA’s high turnover isn’t exceptional either.  Stocks in the S&P 500 index only have an average lifespan of around 15 years today, a massive decline from the 67 year average lifespan of a listed U.S. company in the 1920s.  And there have been a parade of bankruptcies over the past 30 years involving formerly iconic American companies, including Eastman Kodak, General Motors and Texaco.  And this list excludes the slew of storied financial firms that disappeared during the Great Recession of 2008-2009.  The idea of treating stocks as perpetual assets suddenly doesn’t look so smart anymore.

However, there is an asset class that doesn’t face the prospect of bankruptcy.  It has been treasured and coveted by the elite of society for hundreds of years.  This asset class has been a reliable store of value for the wealthy and powerful for century after century.  I am talking about real perpetual assets – fine art and antiques.

The famous Sancy Diamond illustrates this point superbly.  This faintly-yellow gem of just over 55 carats was most likely mined at the renowned Golconda diamond mines in medieval India, although its true origins are lost to the mists of time.  It’s first recorded historical appearance was in 1570, when the diamond came into the possession of its namesake, the French diplomat Nicolas de Harlay, seigneur de Sancy.

Over the centuries the glittering Sancy Diamond has passed through the hands of much of Europe’s royalty, while simultaneously escalating in value.  It sold for £25,000 in 1657, £80,000 in 1828 and £100,000 in 1865 before finally being sold to the Louvre Museum for $1,000,000 in 1978.

The gem’s long term performance is made all the more impressive by the fact that the British Pound suffered almost no inflation between the early 18th century and the 1930s.  In addition, I strongly suspect that the diamond’s final sale price of $1,000,000 might have been discounted as a gift to the most famous museum in the world!  In any case, as perpetual assets go, the Sancy Diamond has an impeccable 400 year long (and counting) investment track record!

Of course, less expensive antiques and fine art also enjoy all the benefits of perpetual assets.  Ultra-rare pattern coins, antique silver cigarette cases, and vintage fountain pens are just a sampling of the fine antiques that are accessible to savvy investors right now at reasonable prices.  Once purchased, these perpetual assets will continue to accrue value for decades and decades to come.

Although it is little recognized in the investment world, fine art and antiques behave a lot like zero coupon bonds.  A zero coupon bond makes no interest payments during its life, but is issued at a discount to its face value.  The difference between its discounted purchase price and the bond’s ultimate redemption at full face value is the investor’s profit.

Antiques replicate this zero coupon bond effect, albeit without any explicit face value.  Investment grade art and antiques have a tendency to gradually and steadily rise in value over long periods of time.  This means that an antique purchased today will most likely sell for a higher price tomorrow.  And the longer you hold an item, the higher its eventual sale price will probably be.  As an added bonus, fine art and antiques also possess implicit inflation protection – a vital attribute when looking for perpetual assets to invest in.

Whether we realize it or not, most of us are looking to place perpetual assets in our investment accounts.  Most people don’t want to be bothered with having to constantly check on their investments to make sure they haven’t spontaneously combusted.  And, unfortunately, spontaneous combustion, otherwise known as bankruptcy, is an unsettlingly common feature of the modern stock market.  The Sancy diamond might be forever, but publicly listed companies are decidedly not.  Fortunately, you can avoid the modern-day stock market casino by investing in fine art and antiques.

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Thousands of years ago, small bands of humans used to sit around the campfire and exchange tales of bravery, passion and vengeance.  In some ways, humanity never outgrew those mythical accounts and ancient epic poems.  This is rarely more evident than when observing how investors in today’s equity markets flock to story stocks.

A story stock is a publicly traded company with a compelling narrative that explains why it is growing quickly.  The very best story stocks leverage this plot into capital market access, where they issue billions of dollars worth of stocks and bonds to fuel their corporate ambitions.  Right now Amazon, Netflix and Tesla are excellent examples of some of the most irresistible story stocks of our time.  But while the sizzle is always great with story stocks, oftentimes the steak is missing.

When people invest in equities, what they are really doing is buying future cash flows in the form of earnings and dividends.  Even though the narrative surrounding each individual story stock might be unique, the end product that all investors want – cold, hard cash – is actually a commodity.  Ultimately, it doesn’t matter whether an investor gets future stock market earnings from the latest and hottest technology company or from distinctly unsexy stocks in the trucking, mining or utility industry.  To any rational investor, a dollar’s worth of cash flows is a dollar’s worth of cash flows, regardless of where it originates.

What usually happens when investors get suckered into buying story stocks is that the fabled companies fail to live up to their own mythology.  This is especially the case during stock market bubbles, when investors’ greed-filled imaginations run wild.  Bubbles are exactly the time when story stocks are not only at their most seductive, but also at their most dangerous.

For example, during the original 1999 internet bubble there was a company called Juniper Networks.  This company was one of the classic story stocks of the era.  Its business centered on the production of networking hardware and software – critical tools used to power the early internet.  According to the prevailing zeitgeist of the time, the future belonged to these internet infrastructure companies.  And Wall Street enthusiastically agreed with this assessment.  Juniper Networks nearly tripled from its IPO price on its first day of trading and was often treated as one of a select group of “must own” stocks for any savvy, forward-looking investor.

Although the fantasy spun around the company was a good one, it wasn’t enough to keep this story stock afloat.  Juniper Networks’ stock price peaked at $232 on October 20, 2000.  Today, in January 2018, Juniper Networks stock trades at a meager $28 per share.  The company’s price-earnings ratio declined from a nosebleed 473 at its 2000 high, to a rather pedestrian 16.6 currently.  Investors who chose Juniper networks as one of their story stocks are still sitting on 87.9% losses to this day, 17 years later!

This is the omnipresent danger with story stocks.  The fantasy might be alluring, but at the end of the day, all investors really want is for their investments to spin off lots of cash.  And cash flows simply don’t care about the story.

Now I’m not opposed to a good tale.  After all, much of human identity and society is driven by myths, legends and sagas.  But as an investor, I think it is imperative to know when to embrace the narrative and when to demand cold, hard facts.  When dealing with the stock market, I very much lean toward facts rather than pleasant fictions.

However, there is one class of assets where history, anecdote and adventure are not just acceptable, but truly desirable.  I’m speaking, of course, about fine art and antiques.  These alternative assets have been pursued, hoarded and coveted by the wealthy and powerful for centuries.  And this is because they fulfill deep-seated psychological needs, including the need for a good story.

Edvard Munch’s famously unsettling painting, The Scream, is a good example of how a story can enhance a work of art, propelling it to the status of a cult classic.  According to Munch, his inspiration for painting this masterpiece was as follows:

“One evening I was walking along a path, the city was on one side and the fjord below. I felt tired and ill. I stopped and looked out over the fjord – the sun was setting, and the clouds turning blood red. I sensed a scream passing through nature; it seemed to me that I heard the scream. I painted this picture, painted the clouds as actual blood. The color shrieked. This became The Scream.”

That is powerful commentary!  It is easy to see how this description builds a compelling myth around The Scream, elevating the painting to a status that it probably wouldn’t hold otherwise.

Of course, it isn’t just priceless artworks that benefit from a good origin story.  Far more affordable art and antiques also become more interesting and desirable when their history, provenance and legends are known.

For instance, in 1954 between 200 and 300 gold Brazilian 12 guilder coins were restruck at the Sao Paulo Exposition Numismatic in commemoration of the city’s 400th anniversary.  The original coins are steeped in history, having been minted in 1645/46 in the Dutch-occupied, Brazilian port city of Recife.  At this time, the Dutch West India Company had seized a large portion of the Portuguese colony of Brazil for its sugarcane resources.  These beautiful gold coin restrikes deftly position the tumultuous history of 17 century Brazil and early-modern European colonialism against a mid 20th century Latin American backdrop.

It is a great story, and one that should be compelling to any coin collector or investor.  Yet, these pieces of Brazilian-Dutch numismatic history currently sell for ridiculously low prices right now – a mere $604 in this case.  And almost half of that price is attributable to the gold content of the coin!

However, I don’t expect this situation to persist forever.  Eventually this romantic tale will gain a wider audience.  And when it does, prices for Brazilian 12 guilder restrikes (and probably the originals as well) will inevitably rise.

I like stories.  But I think investors need to be very careful about investing in them.  There are some asset classes where stories make sense and others where they don’t.  There’s a reason you’ve never heard of the term “story bonds”; likewise, story stocks rarely make much sense for long-term investors.  All too often, those fabulous tales of perpetual and limitless future growth end up being disappointing mirages.

Happily, more narrative-oriented investors can always rely on fine art and antiques.  Their history and myth builds a foundation of desirability that appeals to even the most hard-nosed connoisseur.  Fine art and antiques are one of the few asset classes where a good tale is worth the price of admission!

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