8/25/20

None of the below is investment advice. I am/we are currently long AerCap Holdings bonds.

And the world kind of just.. kept spinning. Virtually everybody expected the opposite – that the world would stop and succumb to COVID 19. We certainly did. Instead, many people had a magnificent year.

Only the strongest investors mentally could understand that the market as we knew it had died and a new paradigm took force. You could almost feel the desperation behind market moves as we came to grips with massive waves of inflation. 

It wasn’t traditional inflation, which measures standards of basic living, but inflation of standards of wealth. The demeanor around what I tell you in this letter is both exacting and omniscient, but during the first half of the year, I was neither of those. Boy, I made some bonehead mistakes, but those were the best things to ever happen to me and our firm. Those mistakes allowed us to outperform benchmarks every year since that year.

Despite the mistakes in 2020, our firm made strong returns, but we had trouble rationalizing to others what we had just learned. When our friends and families couldn’t participate in the massive rally, we looked inward – we couldn’t reach enough of them.

This was very painful for me, personally. I loved the night air and the sound of the waves crashing outside my beachfront window, but nothing could save me from insomnia – many nights I obsessed about things we couldn’t control. We all felt what was coming, but nobody could do anything about it.

So what happened?

The three tenets behind markets – taxes, interest rates, and money printing – all converged behind the greatest technological tailwind of all time and more investors entering the market every day. The largest companies proliferated to unbelievable heights, propelled not because of operational results, but because they became a storehold of wealth (i.e. inflation hedges). This was the first time that owning a tech stock – any tech stock – was safer than owning US Dollars well into the future. A primary reason was that much of tech was weaved into everyday life and ‘non-cyclical’. The tech not only was easier to use than alternatives, but it was cheaper too. 

The gargantuan values people put on those companies were antagonized by headlines and talking heads, so the majority of America capitulated around the media coverage and stayed in cash. Every day was something new, but then again, nothing was new. Those three tenets (all fiscal and monetary policies) were being loosened all the way through the year, and yet many prominent investors were more concerned about the presidential election. 

It was the first time we saw that the market was not a democracy – that fiscal and monetary policies were things world citizens had virtually no control over. And those policies in turn influenced virtually all markets globally. For the first time, our firm saw elections and headlines as not so subtle equivocations. 

As an aside, we saw the actions of the government and those policies as probably necessary given what was known, meaning that if the three tenets weren’t loosened, the system would have crashed.

So the market was fundamentally changed by those policies, but most didn’t know what that meant or how to survive it, much less profit from it. The greatest question during any time period – What is a ‘safe asset’?

Something yielding a consistent, relatively durable long-term return will always beat cash. What people had trouble understanding was that the yields in tech companies were more consistent and durable than ever before, which fundamentally caused them to be a better investment than cash and apotheotic inflation hedges during 2020. We understand this to be true today, but that was a first for the world – that tech would outperform every industry, asset class, and currency for years to come.

This caused massive wealth inflation – the smartest investors piled into those companies with consistent returns while others stayed in cash. Thus, the returns on the stock market during 2020 were not borne out of incrementally better operational results, but out of consistent results. While people bought those stocks they simultaneously shorted the dollar, which made all the sense in the world. 

History showed before 2020 that stocks gained based on incremental operational gains, but with the government now able to lower taxes, lower interest rates, and print money at seemingly any time, the market was not synchronized with history. There was no comparison whatsoever to any historical trends. In fact, the only way to determine market returns was predicting monetary and fiscal policies, which was in turn based on policy makers’ judgments. Markets were largely at the mercy of judgment calls. 

Of course, population growth and more market participants have correlations with markets, but those correlations are not as strong as those three tenets. There are many correlations in markets, but none more reliable than those three tenets.

Keep in mind that these are generalizations to help you better understand what professional investors thought at the time, which are mostly basic and obvious today, but these ideas were borderline heresy for most folks at the time.

It took months to convince even myself and during that period, our firm made some serious mistakes, mostly on cutting winners too soon. What we know now is that if a company’s revenues are poised to grow in any environment, you should hold onto it no matter what happens to policies. The vast majority of my positions at the beginning of the year turned out to be extremely successful investments… after we sold them. 

So in 2020, we came to the conclusion that to own a company meant a long term commitment of being patient. Even in the face of changing monetary and fiscal policies (which are completely unpredictable), you have to stick with consistent revenues. Many will argue that ETFs are the way to go in all environments, which is often true, but when opportunities present themselves over and over again like they did in 2020, you need to rethink that strategy. Very few people have gotten wealthy on ETFs, but many have gotten wealthy on one or two very good ideas.

Okay, got it.

When those three tenets change, stocks will invariably rise and fall, but determining operational results is easier than predicting policy makers’ judgments. Why? Operational results spell out all risks, numbers, and are audited for shareholders’ review. Often, if something isn’t right, shareholders can speak up and can change the way the company is organized and operated. None of this can happen around monetary and fiscal policy, so the best equity investors only look at operational results. All else equal, investing in companies based on bottom up fundamentals probably beats macro strategies in the long term.

To recap equity investments, tech got a giant boost from the loosening of those three tenets, but investors were really only looking for long-term operational consistency. When the drop in equities came, very few realized that those tenets would virtually guarantee operational consistency, so the market rebounded quicker then anyone imagined… and then kept going.

2020 was the first year that the three tenets converged immediately and indiscriminately. While tech stocks gained, so did my knowledge around bonds. Up to that point in my career, nobody had told us how lucrative individual bond selection could be, so we bought ETFs before 2020.

Most people we knew didn’t buy individual bonds like they bought individual stocks, because the minimum investment was much higher then than it is now. Those minimums kept out the majority of the retail world and thereby caused more of an edge for those that had the capital. We often found it easier to profit from bonds over stocks, because the results of an investment were much more determinable. While stock returns in the short term will always be massively determined by the three tenets, bond returns have higher correlations with cash flows and solvency measures. So any drops in bonds are much safer to buy than drops in stocks.

Bonds were a strong play in 2020 because

  • The Federal Reserve allowed more money to flow in, creating more solvency for existing bond issues
  • All industries had bonds, so tech wasn’t the only play as it mostly was in equity
  • Volatility created many opportunities that yielded safe >5% annual returns in a 0% environment

In the scenario of a bond, you are buying a company’s solvency until the bond matures and simultaneously directly shorting US Dollars. Money markets are virtually the opposite, which ultimately brought the FDIC into question, but that’s another story. 

Bonds rode the same tailwind that stocks did – the declining dollar made them rise – but the demand for safe investments also created their frenzied rise. We saw so many bonds of highly solvent companies get demolished in unloved industries. Furthermore, the demand for bonds in unloved industries forced many highly solvent companies to issue bonds at high interest rates to attract buyers, such as myself.

The first place we thought to look was sovereign debt, which is theoretically the safest form of bonds. For the same reason that investing in equities involves looking at operational results, so too with bonds. Bondholders of companies have the same luxuries – the risks, numbers, and so many other items are spelled out, under the auspices of an audit. You also couldn’t buy individual sovereign bond issues as easily as corporates, eliminating key optionality.

Treasury and sovereign investments, on the other hand, are mostly guesses and blind trust, which of course doesn’t translate to us not trusting government issuers, but we felt the leap of faith wasn’t worth such paltry returns. In the middle of July, 2020, for instance, a 5 year bond yielded about 0.3% per year, while a 5 year air lessor bond yielded over 6%.

So we bought Air Lessor bonds. Air lessors are ultimately skeleton operations that make money when times were good, and don’t spend money when times were bad. Fundamentally, that meant solvency in all environments, but the 2020 market priced the bonds for relative insolvency. Bonds that matured in June 2025 were issued at $100 and carried a 6.5% interest rate. People weren’t traveling, so everything in the airline industry was decimated, and while the equity value of air lessors amounted to ownership of fleets of planes of questionable net value for decades into the future, bonds represented the solvency of the companies within the next few years.

When we bought those bonds, we got some clients asking a lot of questions. We had to explain to dozens of people how bonds worked, and many may still not fully understand. Everything rested on the abilities of the company to make their interest payments and the return of capital at the end: in this case, 2025.

That meant if the air lessor had free cash flow, all of it could and would be used to pay back bonds. If they didn’t have free cash flow, they could sell more bonds to raise money to make full payments on the 2025 bonds or they could sell airplanes/other assets to raise the money. The risk rested on the ability to generate those cash flows and the risk that the company could find a market of buyers for new bond issues. However, these risks were offset by massive cash positions that could also be used to pay back bonds, so the true risks were minimized and the returns were virtually guaranteed.

Even though we made money in 2020, it was obvious to us that the economy had reached a tipping point of sorts.

I took a trip in August to Telluride, Colorado to kayak and mountain bike. Never before have I been to a place of such unencumbered wealth! I got pitched two different real estate deals my first day there, just sitting in the plaza – and the deals were massively overpriced. While I was thrilled that people were still so ebullient (like our firm was), I couldn’t help wondering how much of the wealth in Telluride was either buoyed or catapulted by the cheap money. Back in San Diego, a non-profit I was a part of was discussing Universal Basic Income (UBI). This was a perfect manifestation of the wealth divide, which itself was completely unapologetic.

The dichotomy is impossible to underestimate, and of course rested on the theme in my first letter – that the leadership around what was best for the country was not as strong as it should have been, given that policies were looser than ever.

We had all the tools, but there was no direction, or at least no communication of direction. On one hand, people thought the government would award the millions of unemployed people UBI for life, while in Telluride, people thought government policy was allowing them virtually free money to buy dream homes at nosebleed prices. Ultimately, of course, we believed that the government would never support UBI consistently – there was just no infrastructure for it and people were basically sublime without it anyway. Besides, for those people in Telluride to turn around and willingly be taxed to support the millions of unemployed was an unfathonable request. It’s the same reason why the Coty corporation threw money around haphazardly instead of putting it toward societal advancement.

So the market just kept rising for years and the dollar just kept losing value. The people stuck with US Dollars spent years in confusion trying to determine what had happened in 2020 and why the massive rally just wouldn’t end. The psychological effects on those people and those people who had lost jobs were often insurmountable.

However, some of them became our clients, and while they probably still don’t understand why we were so optimistic at the time, they are better off for collaborating with us. Many great financial leaders of the time who had a vision for how people could still reach their goals safely while the economy floundered, and we all participated in a very bright future that we still are enjoying today.

We emphasized empowerment and confident entrepreneurialism, we still do, and we always will. The government created a new paradigm around saving the system in spite of itself, and the experiment will always work, to an extent. The strongest parts of the economy get stronger, and the weaker parts get weaker. As investors, our job is to understand these big, somewhat obvious patterns (often through painful lessons) and then collaborate with other thoughtful people to really move society forward.

2020 was a year of hardship, pain, innovation, and collaboration for us. We were so blessed for everything that happened, good and bad, and I share these things with you so that you can improve your own life, both financial and otherwise.

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