On Target Newsletter
2020.11.07

In this issue:

  • Behavioural finance

  • Hydrogen: fuel for the future

  • Beyond the American elections

  • New global supercycle

  • SID report

  • Coal

Impact of Human Behaviour on Moneycraft

One of the most radical changes I’ve seen in the more than half-a-century I’ve been writing about personal finance is acceptance that understanding investment is much more than a study of facts and figures – it has to take into account the way those who drive the markets think and act.

It’s a study called behavioural finance: How psychological influences shape decisions what to buy and sell, and when to do so. It encompasses concepts such as herd behaviour (mimicking what others are doing), decisionmaking driven by emotional extremes or over-confidence in oneself, and anchoring (dependence on an initial piece of information).

How can you recognize these and use them to manage your moneycraft, even doing so well enough to become wealthy? Morgan Housel, the award-winning American writer, provides a handy guide in his new book The Psychology of Money published by Harriman House.

“In the real world people don’t make financial decisions on a spreadsheet,” he says. “They make them at the dinner table, or in a meeting room, where personal history, your own unique view of the world, ego, pride, marketing and odd incentives are scrambled together.

”Financial success is not a hard science – it’s a soft skill where how you behave is more important than what you know. Ordinary folks with no financial education can be wealthy if they have a handful of behavioural skills that have nothing to do with formal measures of intelligence.”

Here are some of Housel’s most interesting insights…

► Luck and risk are both realities that every outcome in life is guided by forces other than your individual effort. The world is too complex for you to have complete control over what happens to you. But if you respect the power of luck and risk you’ll have better chances of focusing on things that you can control.

To contain their impact, look for actionable examples. Avoid seeking to copy extreme examples such as what billionaires do, Look for broad patterns of success or failure. The more common the pattern, the more applicable it might be to your life.

Bill Gates once said: “Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” Failure can be a lousy teacher, too. It seduces smart

people into thinking their decisions were terrible when sometimes they just reflect the unforgiving realities of risk.

When things are going extremely well, remember you are not invincible. Acknowledge that luck brought you success. To guard against the risks of failure brought about by bad luck, arrange your financial life so that a bad investment won’t wipe you out.

Limit your exposure to risk to what you can be comfortable with. Manage your money in a way that helps you sleep at night. That’s the best approach to all financial decisions.

► The hardest skill is getting your goalposts to stop moving. If expectations rise with results, there is no logic in striving for more because you’ll feel no better after putting in the extra effort. Life isn’t any fun without a sense of ENOUGH.

There are many things never worth risking no matter the potential gain: Reputation, freedom and independence, family and friends, being loved, happiness. Your best shot at keeping these things is knowing when it’s time to stop taking risks that might harm them.

► Good investing isn’t necessarily about earning higher returns. It’s more about having the patience to stick with investments and allowing them to compound. The longer the better. Warren Buffett’s extraordinary wealth of $84½ billion is not because he’s been a phenomenal investor but because he’s been a good one for such a long time: three-quarters of a century.

Compounding makes little things grow big. It only works if you can give an asset years and years to grow. Increasing time horizon is the single most important thing you can do to do better as an investor.

However, getting and keeping the extraordinary growth that compounding can eventually deliver requires surviving all the unpredictable ups and downs that everyone inevitably experiences over time.

Getting rich and staying that way calls for opposing skills

► The only way to stay wealthy is some combination of frugality and paranoia. Getting money requires taking risks, being optimistic, and putting yourself out. But keeping money requires the opposite of taking risks. It requires fear of loss, frugality, and an acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely.

► Become OK with a lot of things going wrong. You can be wrong half the time and still make a fortune because it’s the small minority of things that go right that account for the majority of positive returns. It’s fine to have a large chunk of investments in your portfolio that turn out to be poor if there are a few outstanding ones.

► Leverage – taking on debt to make your money go further – pushes routine risks into something capable of producing ruin. The danger is that optimism, which is rational enough most of the time, masks the odds of ruin some of the time. The result is that we systematically underestimate risk.

► The more you want something to be true, the more likely you are to believe a story that overestimates the odds of its being true.

Investing is one of the only fields that offers daily opportunities for extreme rewards. Dial back your expectations. The bigger the gap between what you want to be true, and what you need to be true to have an acceptable outcome, the more you are protecting yourself from falling victim to an appealing financial fiction.

► Financial and investment planning are critical because they let you know whether your current actions are within the realm of reasonable. But few plans of any kind survive your first encounter with the real world. A good plan embraces the reality of unknowns and emphasizes room for error.

Providing a margin of safety is one of the most under-appreciated forces in finance. It comes in many forms. For example a frugal budget, flexible thinking, a loose timeline – anything that lets you live happily with a range of outcomes.

It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic — the higher your margin of safety, the smaller your edge needs to be to achieve a favourable outcome.

It’s vital to have a barbelled personality – be optimistic about the future, but paranoid about what will prevent your getting to that future.

Simple boring strategies are key

► A few things account for most success in investing. Spending your time chasing the one-in-a-thousand or one-in-a-million event that delivers a spectacular profit is not one of them. Simple, boring strategies are the ones to pursue such as saving even a small amount but continuing to do so no matter how bad the news. Housel gives the example of how investing just one dollar in the US stockmarket every month from 1900 to 2019 would have accumulated to $435,551.

Building wealth has little to do with your income or investment returns but lots to do with your rate of savings.

► We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.

Daniel Kahneman says that both in explaining the past and predicting the future we focus on the causal role of skill and neglect the role of luck. We focus on what we know and neglect what we do not know, which makes us over-confident in our beliefs.

► You can plan for every risk except the things that are too crazy to cross your mind. It’s those crazy things that do the most harm because they happen more often than you think and you have no plan how to deal with them.

The one way to guard against the damage they do is to avoid single points of failure. With money it’s sole reliance on a pay cheque to fund short-term spending needs. The answer is to have enough savings readily available that are far greater than you expect to need.

► The prophets of doom are very popular – but usually wrong. Markets adapt. Setbacks happen too suddenly to ignore, but progress happens all the time… quietly. Destruction is driven by single points of failure. Growth is driven by compounding, which always takes time. Natural disasters can kill thousands instantly, but progress in medicine is so powerful that half-a-million Americans don’t die every year because of the decline in heart disease since 1965.

► History can be a misleading guide to the future of the economy and stock market because it doesn’t account for structural changes that are relevant to today’s world. When you try to apply some of the formulas presented in Benjamin Graham’s classic book The Intelligent Investor, few of them actually work. Graham himself constantly experimented, re-tested and replaced his formulas with new ones.

He is known for his margin of safety concept: Allowing room for error or redundancy is the only safe way to navigate a world that is governed by odds, not certainties.

Housel says that in his personal planning he assumes that the future returns in his lifetime will be one-third below what have been the historical averages.

Hydrogen: the Fuel for the Future

By Gareth Spring

Governments around the world are committed to combat greenhouse gases by promoting “renewable” alternatives to fossil fuels such solar and wind energy. However, those have huge disadvantages, in particular intermittency – they can’t deliver power when the sun doesn’t shine or winds don’t blow.

One solution is battery farms, which capture and store electricity to bridge periods of lack of supply. Trouble is, batteries are weighty, inefficient, have a short life-span, and are expensive to maintain. This makes them unsuitable for many purposes.

The alternative in which there is now much interest is using fuel cells to drive electric motors. These don’t store electricity like batteries but generate it without combustion or gas emissions. There are several kinds of fuel they can use, but the one about which there is growing interest is hydrogen.

Hydrogen, a gas, is the most abundant element on earth. It is found in hydrocarbons such as natural gas, but can be recovered from water by electrolysis.

When this process is carried out using electricity from renewable sources, it’s a carbon-free fuel and it’s called Green Hydrogen, as different from versions dubbed Grey or Blue. Those are made from natural gas using electricity from conventional power stations. Chemically, they’re no different. They’re just political categories, but the unfavoured ones are much cheaper to produce. Green hydrogen typically costs six to ten times as much as Grey hydrogen.

It’s planned to reduce the expense of Green hydrogen by producing it on a huge scale. In Australia there’s a $16 billion plan to build the world’s biggest power station in the remote Pilbara region covering 6,500 square kilometres of land with solar panels and wind turbines. The power will be used to extract Green hydrogen and another carbon-free fuel, ammonia, from water.  

Fuel-cell vehicles are similar to traditional petrol and diesel powered ones as they have similar ranges to a tank of fuel and can refuel in minutes.

Car, truck, train, aeroplane and shipping manufacturers are making strides in developing hydrogen powered vehicles as they seek to go green. Tiny aircraft have already flown; Airbus is developing big zero emission jets that it predicts to take flight by 2035. Mitsubishi Shipping has already developed a multi fuel ship powered using hydrogen. Germany has been running hydrogen powered trains since 2016. There are already some hydrogen powered public transport buses in operation. Toyota, Hyundai and BMW have been developing and running hydrogen powered cars and trucks.

Big engineering and steel manufacturing are also developing the technology to fuel their factories and processes. Energy suppliers are looking at using hydrogen fuel cells to store and harness traditional oversupply of renewable energy to re-send to the grid in peak demand periods, as well as hydrogen gas powered electricity turbines. Industry has started to use fuel cells to supply constant electricity for hospitals, data centres, telecoms towers, emergency response systems and military applications for national defence.

The heating of buildings, water and industry accounts for half of global energy use. In Europe heating and hot water accounts for 79 per cent of household energy consumption, with the vast majority of homes relying on natural gas boilers for heat. Hydrogen offers an alternative to fossil fuels.

This creates long term stock investment opportunity in the many players in the industry. Fossil fuel suppliers like Shell are converting existing plants to accommodate, produce and supply hydrogen. Vehicle manufacturers like Airbus, Mitsubishi, Toyota, BMW and Hyundai are developing hydrogen vehicles. Big steel, cement and glass producers are converting to hydrogen-fuelled technologies.

As its viability continues to improve, as costs of Green hydrogen lower, and as investment in supply networks develops, the likelihood of hydrogen becoming a major player in future energy supply and distribution seems certain.

Looking Beyond the Election

Iain Little of the Swiss-based thematic investment specialist P&C Global Wealth Managers says investors should ignore political guesswork and focus on the seismic societal and technological changes that Covid-19 has accelerated.

“These shifts are infinitely more reliable, stable and investable than the promises of fickle politicians. When human beings start to behave differently – iPhones, working from home, plugging in their cars at night, measuring daily steps, washing their hands -– that’s when you get the most sustainable economic changes. It looks like they’re changing right now.”

The growth sectors that will continue to lead markets higher are technology, healthcare and e-commerce.

In a zero-interest rate, depression-filled world, growth should be highly valued. P&C’s technology adviser Charles Elliott defines a growth stock as one with top line revenue growth exceeding 15 per cent in a zero-interest rate world.

People will continue to “overpay” for 15-plus per cent growth because — assuming it leads to 20/25 per cent earnings growth — it drives down a 40x Price Earnings Ratio into low double digits in under five years. The real question for an investor is not “is the company’s PER too high to buy it?” but rather “will the competitive position of this growth company persist for three to five years?”

Distributed working, 5G, growing internet diffusion, Internet of Things, augmented reality, electric or hydrogen cell vehicles, ageing populations… these sectors and themes have saved portfolios this year. Such themes are more sustainable change-drivers than either a Biden or a Trump presidency

In March P&C said Covid-19 would accelerate these trends. In June it advised against leaving these safer “growth” shores for more cyclical and beaten down “value” sectors like cyclicals, industrials, traditional energy and —  “the kiss of death” — hospitality or airlines.

This shift and emphasis won’t last forever. But it’s got longer to run, at least until central banks achieve their targets of 2 per cent inflation by over-shooting it via a combination of fiscal reflation and Modern Monetary Theory.

A New Global Supercycle Has Started

The predominantly pessimistic view of the outlook for the world economy is “a rear-view-influenced belief,” say analysts at the EM Capital Advisors consultancy. In fact the outlook for the future “is far brighter than most can imagine.” Indeed, “a brand new global supercycle was born last quarter.”

World output bottomed at an annual level of $77 trillion in the June quarter. It should grow at 8 to 10 per cent a year in nominal dollar terms for the next few years. This view is based on a few key assumptions:

► In real terms growth will continue about 3 per cent a year, as it has done the past 20, after normalizing to pre-Covid levels in real terms by 2022.

► The global deflator (inflation adjustment) will stay elevated in the 2 to 4 per cent range for the next few years.

► The dollar will weaken 3 to 4 per cent a year for the next few years. The Chinese yuan will do the heavy lifting on the other side.

This will translate into a globally synchronized reflationary environment – a positive tailwind for businesses.

Contrary to what is generally believed, global trade integration will continue. There will be new all-time highs in the US-China trade deficit, although there will be some shifts away from China at the margin. Vietnam, Bangladesh and India will be beneficiaries.

Global integration will continue through acceleration in the data and services sectors. Countries with large pools of skilled capital will see their incomes grow faster. India in particular will be a big beneficiary.

What are the implications for businesses?

The analysts expect returns to recover markedly in the current quarter and head back towards previous highs within the next couple of years. The extremely difficult period experienced this year has stress-tested companies’ abilities. But quality firms will soon be able to put fresh capital to work.

The analysts advise investors to stick with equities, but particularly those of the emerging markets as transmission of the new boom plays out of the next 18 to 24 months. Consumer discretionary, non-capex industrials and financials are good places to be. Those of emerging markets and especially those of Asia “are well-positioned,” as are those of very cyclical industrial economies like those of Europe.

The analysts are very positive about the Class 8 trucks segment in the US and the global supply chains feeding into it. Another recommendation is high quality financial franchises, which are set to do well out of a new leveraging cycle. Globalization in services gives competitive advantage to countries like India and the Philippines where there is strong service-oriented cultural bias.

Risks to the new supercycle thesis are that Covid-related challenges worsen; that US elections or other developments torpedo current easy-money policies; or that some significant geopolitical event such as an armed clash in the South China Sea disrupts global trade

Gloomy Forecast for the Dollar

Expect the dollar to crash soon and lose up to 35 per cent of its value by the end of the coming… year says Stephen Roach, senior lecturer at the Yale School of Management and former chief economist investment bank Morgan Stanley.

He says this will happen because of a “lethal interplay” between a collapse in American savings and a gaping current account deficit.

In the second quarter net domestic saving – depreciation-adjusted saving of households, businesses and government – plunged into deficit. The pandemic was partly responsible, but savings have been falling for a long time. With the politicians now in competition to make huge spending boosts, the federal deficit will run to 8.6 per cent of GDP next year, taking the US net saving rate far deeper into negative territory than it did during the global financial crisis.

The foreign trade deficit also ballooned in the second quarter and will also “only deepen.” Massive external financing will be needed, but foreign lenders are likely to demand better terms. As the Federal Reserve is committed to keeping its interest rates near zero for several years, current account adjustment will be forced through a weaker dollar.

The July agreement for a Next Generation European Union Fund will strengthen the euro. Other alternatives to the dollar are the renminbi, gold and cryptocurrencies. The US currency “is now far more vulnerable to a sharp correction – a crash is looming.”

SID Report

Latest interesting news items about the Self-Inflicted Disaster and the pandemic are…

▶ China is using the deadly virus it originated to advance its national interests. It’s promising preferential access to the Covid-19 vaccines it’s developing to countries across Asia, Africa and Latin America. Foreign minister Wang Yi, who is spearheading the promotional effort, has told Malaysia, Thailand, Cambodia and Laos that they will be among the “priority” recipients of Chinese vaccines once they’re approved for distribution.  China has four products in phase three trials, the final stage of approving safety and effectiveness.

So far the Americans, who have several vaccines in final stages of development, have made no similar commitments to other countries for access to them.

▶ The World Health Organization has changed its mind about using shutdowns to fight the pandemic.  Dr David Nabarro, its special envoy on Covid-19, now says: “We do not advocate lockdowns as the primary means of control of this virus.” The only time they’re justified is to buy time to reorganize, regroup, rebalance resources and protect health workers who are exhausted, “but by and large, we’d rather not do it.”

Tailpieces

Coal: There is no environmental benefit to be gained from complying with investors’ demands that mining companies sell or spin off their coal mines says Ivan Glasenberg, chief executive of Glencore, one of the world’s largest producers.

He says the company was better off running down its coal mines and using them as a source of cash to expand production of raw materials such as nickel, copper and cobalt that will be needed as the world shifts towards other forms of energy.

Pressure from the carbonatic lobby is switching control of collieries into other players – principally the Chinese – who have no intention of cutting carbon emissions. If anything, it gives them a free hand to produce more.

Big mining companies are under pressure from investors and banks to divest their coal mines and align their businesses with targets set by the Paris climate change agreement. The largest, BHP, has pledged to withdraw from mining thermal coal (the grade burned in power stations); Rio Tinto sold its last colliery in 2018; South32 is selling its South African coal mines.

Real estate: The sector of the market now heading for trouble is residential apartment buildings, the FT’s Joe Rennison reports. An end to US government stimulus programmes, coming with the moratoriums in many states on landlords’ tenant evictions, will lead to severe losses for investors.

Tenants are finding it harder to pay rent; landlords in turn will have less income to pay their mortgages. Moratoriums prevent landlords’ booting out tenants who can’t pay their rent. Eventually reduced payments will hit investors who ultimately finance properties through the commercial property mortgage-backed securities market.

So far the proportion of tenants defaulting on rent is very small, but it’s forecast that is about to end.

 

Inflation coming: Central banks have no choice but to pursue inflation with every tool they have available to them, says Eoin Treacy of FullerTreacyMoney. Not only has the pandemic unleashed deflationary forces, but governments have no plan for how the debt taken on to combat it will be repaid.

We have been through a decade where various efforts at fiscal austerity have been attempted. All they succeeded in doing was creating demand for more spending, and the rise of populism. The solution is therefore to abandon fiscal discipline and attempt to stimulate our way out of trouble, with a good dose of inflation mixed in for insurance. That conclusion is wending its way around the world. It suggests there is likely to be a boom over the next couple of years.

Offshore detention centre: The UK government is considering using Ascension or St Helena, British islands in the South Atlantic, as a place to keep asylum seekers seeking entry into Britain while their applications are considered – a process that normally takes many months.

This year record numbers of migrants have been using small boats to cross the English Channel for illegal entry. The minister responsible for immigration control, Priti Patel, thinks the prospect of being detained 6,000 kms away from Britain could discourage illegals. An opinion poll shows that 40 per cent of Brits agree.

Australia has been using detention centres on remote Pacific islands very successfully to deter illegal immigration since the 1980s.

Chinese censorship: A museum in France has decried what it calls “censorship” by the Chinese government, after pressure from Beijing prompted the institution to postpone a planned exhibit about the Mongol emperor Genghis Khan.

The Château des Ducs de Bretagne history museum in the city of Nantes, western France, scrapped its Mongol Empire exhibition rather than comply with a demand by Chinese authorities that it remove certain words from the show. These included “Genghis Khan,” “Empire” and “Mongol.” The Chinese authorities also requested control over the exhibition’s brochure, legends and maps. The museum also refused to do that.

A recovery stock: Eoin Treacy, who recently tipped London-listed Rolls-Royce Group, says: “I bought it as an investment on the assumption we are at the peak of coronavirus hysteria. If that conclusion is correct, then it can only get better from here.

“I believe there will be widespread availability of treatments and vaccines within six months. As the travel sector comes back, Rolls-Royce is a play on miles flown, due to its service contracts.” [The company doesn’t make much money out of selling the engines fitted to airliners, but does so out of servicing those engines over their long lives].

Renewables: Australia, which has huge export businesses in coal and natural gas, plans to diversify away from fossil fuels. Its Sun Cable project in the Northern Territory involves developing the world’s largest solar farm to generate electricity for Singapore. The $22 billion scheme is designed to transmit electricity using high voltage direct current 750 km to Darwin then 4,500 km via submarine cable to Singapore to supply 20 per cent of the island’s energy needs.

Income investments: With interest rates close to zero in the advanced economies, and with the global total of bonds trading on negative yields approaching an all-time high of $17 trillion, it’s become impossible for savers to earn an income or outpace inflation with a bank deposit account or invest in a bond without significant risk.

Increasingly this drives those seeking an income into investing in shares they can cash in for capital gain. Or into emerging-market bonds.

Used cars: There has been an upsurge in demand for them in Britain, with two or three being sold by dealers for every one new vehicle. The biggest surprise is a strong switch towards conventional petrol and diesel motors and away from electric and hybrid machines.

Batteries: Because they are a key to overcoming the disadvantages of renewables, huge amounts are now being invested in technologies to improve their efficiency and therefore lower their cost. The average time it takes to double their energy density is now less than five years.

 

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