Hedging for Armageddon
January 16th, 2011Note: this piece is NOT about precious metals. To each his own, but this author prefers assets with a yield (whether distributed or not); gold, silver and their shiny friends generate no yield, so we don’t own or advocate them. The following is adapted from the January 2010 edition of Spinoff & Reorg Profiles, but remains at least as relevant today.
There has been talk since late 2009 among value investment managers about shorting long-dated Treasuries — especially after well-regarded value investor Charles de Vaulx (manager of the International Value Advisors funds, protegé of SoGen Funds manager Jean-Marie Eveillard, and a self-described lifelong long-only investor) revealed he had 1% of his IVA Funds in ProShares Ultrashort 20+ Year Treasury (TBT).
The speculation makes sense — the Fed must eventually wind down intervention in that market — but it is disconcerting to see value investors stray so far, buying instruments with no measurable book value or direct yield, and which hedge poorly against “armageddon,” in that they depend upon financial counterparties that may fail under just the extreme conditions in which they should pay best.
This illustrates the box into which investment managers — especially bigger ones — are painted. Demand, prices, credit and currency exchange rates all remain unusually unstable and unpredictable, compared to the pre-2007 world. The S&P’s price ratios are again at the high end of their historical range, with yet little evidence of sustained industrial recovery.
Moreover, value investors continue fear a macro wipeout: hyperinflation, protracted deflation, stagflation, currency collapse, etc. No one agrees which one, and it is difficult to judge conditions by public data when the global financial system is increasingly intertwined with government (for example, how do we judge the residential mortgage market when nearly all new loans are federally subsidized?). Under such conditions, the fundamentals respond as much to political necessity as to economic logic.
This almost unprecedented uncertainty over macro conditions greatly amplifies the usual investor uncertainty about specific choices. Almost no tactic is simultaneously robust to inflation, deflation, currency fluctuation, broker collapse, credit crisis, etc. Even determining what to do with cash has been complicated — it now yields nothing, or less, yet is exposed to whatever currency it is denominated in, and to whatever financial institution to which it is entrusted.
For the investor convinced of an impending wipeout, but unsure which terrifying portent will prove true, one path through the minefield — surer than cash under some scenarios — is a stable, unencumbered, yielding asset whose yield is denominated in utility (in the economist’s sense), rather than currency. This may sound too general to be actionable, but actually describes the requirements fairly clearly:
- Low debt, so that yield is immune to shocks in the cost of capital.
- Low capital requirements, so that yield is immune to shocks in the price of plant & equipment.
- Stable demand, so that yield is immune to shocks in general economic activity.
- Sustainable competitive advantage, so costs can be passed on to buyers, rendering yield immune to wild swings in input prices.
It’s difficult to simultaneously satisfy all of these constraints except with a portfolio. Still, we keep coming back to tobacco firms — Lorillard (LO), Altria (MO), Philip Morris International (PM), etc. — as a good fit. While they are no longer cheap, and while debt is not as low as we would like, they do satisfy all requirements pretty well, and remain priced below the market’s long-run average P/E ratio.
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As long as menthols don’t get banned, which is about 80% of LO’s revenue
Yes, owning 100% LO would just trade one potential armageddon for another.