To Infinity and Beyond – and the Usual New Year Review Stuff
January 2022 — Every year has plenty of lessons when looking backward in December. Our mindset is that if you are not wiser at the end of the year, then shame on you. At CSC we try to make new and interesting mistakes each year rather than repeat the old ones, a process anyone who is 110% presently invested in a balanced portfolio of cryptocurrency, meme stocks, and NFTs (non-fungible tokens) of vintage Julius Erving pictures might find hard to appreciate.
We are going to divide this Letter into three parts: (1) relevant and repetitive thoughts for 2022; (2) a recap of Cove Street Capital firm thinking and structure; and (3) a bulleted list of 2021 thought to clear out our brain for 2022 fresh thinking. To reiterate, our blog at CoveStreetCapital.com/Thoughts has our comments on the world at large. These musings tend to lean more towards bite-sized chunks, as we have heard rumors that TL;DR is a virus more prevalent than COVID variants. (Feel free to Google that—I had to when confronted with feedback on our last Strategy Letter.)
But some things are worth repeating in a valiant attempt to be vindicated within one’s lifetime. So here is our 2022 outlook in a nutshell:
- Near-zero interest rates since 2010 have put most asset classes “off the charts” in terms of any historical sense of valuation regardless of your metric. High current valuation and recent asset appreciation suck blood from future returns, as world productivity and underlying wealth creation en masse are simply not compounding at double-digit rates. They also create volatility as it takes less news to wobble the asset perched on the top of a step ladder. The future and its arrival remain elusive—but there are a lot of truly ridiculous “investment” assets that still need to come down hard to roost properly if survive at all.
- We don’t fear rising rates per se, but we fear a complacency in the “expert opinion” running the Federal Reserve. The risk in 2022 is human error in dealing with truly new circumstances with extra zeroes at hand. There is something about the last two years that makes one question the “we are just following the data” pitch from the Federal Reserve. The risk is in how the Fed approaches inflation expectations as much as it is in the actual print of inflation.
- “Be fearful when others are greedy” is really hard to employ with other people’s institutional money. Conservatism has not paid off in any fashion for many years. Like “climate,” it is easy to confuse your own sense of reason and timing within a sample set that may simply be much longer than that which many of those around you consider. Think Keynes and death. We enter 2022 in good health and remain conservative.
- “Simple, profitable, and bird in the hand” remains an extraordinary relative trade versus a lot of extraordinarily speculative nonsense. The current period is not 2000—it’s dumber. But the absolute valuation of small cap today is not as cheap as it was in 2000, a fact that makes it harder to claim that assets like small cap and value can/will outperform the S&P by thousands of basis points because “reasonable” was simply revalued to reasonable and “silly” was marked closer to zero. So we will go with “hundreds of basis points.” But directionally we are there. Our misgivings about bigger themes seem to be matched by more than enough reasonable opportunities. For instance, we have barely scratched the surface of a record year of now or soon to be failing IPOs and SPACs—future gifts for public investors after the insider wealth transfer is complete.
- Yes, 2022 will be the year that the deflationary trade will prove transitory—albeit 37 years was a pretty solid trend on which to climb aboard. Taking capital risk—crypto lending, toothless credit lending, leveraging low-rated instruments to achieve a higher desired “fixed” return, etc.—to goose income generation has always ended up as a sad story. This one just seems as interminably long as is the new Matrix movie. And it’s not just the level of interest rates on which things change; it’s the willingness of credit to be extended. Historically speaking, the two issues are a lot more correlated than many investors think.