WINDHORSE
Top of Mind — Q4 2016
David A. Salem, Chairman and Chief Investment Officer
Imperfect Prologue. Given the relative stasis of financial markets in the months preceding its publication, the
last installment in this series focused not on recent market developments but rather on an admittedly bookish
discussion of two disciplines that have helped me lots in deploying capital: history and physics. Applying a key concept
from the latter, namely phase transitions, to the recent triumph of an unusual candidate for the US presidency, it
behooves stewards of long-term capital to ponder whether America’s recent election heralds a phase transition
destined to produce a material and sustained re-pricing of financial assets in general and US equities in particular. Why
focus on US equities? Why not? After all, they dominate the equity portions of most portfolios owned by US-based
investors, institutional or individual; they’ve outperformed non-US equities over most multi-year time periods, ranging
from just a few years to a century or more; they’re available on a passive or indexed basis at vanishingly low costs; and
they’ll produce delightfully high real returns if Mr. Trump’s pending tenure as US president proves as bountiful for US
stock investors as did the tenure of an earlier Republican chief executive to whom America’s president-elect has been
compared by some observers, Ronald Reagan. Will it prove so bountiful? The better question would be, can it? Possibly,
but I doubt it — not with starting valuations on US stocks as a group fairly described as the polar opposite of those
prevailing when Mr. Reagan was elected in 1980, i.e., very high now, very low then. To this all-important difference
between 1980 and today one could add several others of acute importance to long-term investors, including an
asymmetrical set-up for future moves in interest rates and inflation — asymmetrical because both have been hovering
until quite recently at levels as anomalously low as they were anomalously high when Mr. Reagan’s presidential tenure
commenced.
Opportunity Knocks. Determined as I am to keep all such quarterly notes including this one tolerably brief, I’ll leave
for private conversations my further thoughts on Mr. Trump’s character, such as it is, and the probable path of
Trumponomics, such as it is (sic) or may become. That said, having telegraphed above skepticism that Mr. Trump’s
election and all that may flow from it will spawn a material and sustained advance in the real or inflation-adjusted
prices of US stocks as a group, I’ll note that I’m more optimistic than most of my professional peers respecting
achievable real returns on appropriately diversified portfolios over the next decade. The operative word in the prior
sentence is “appropriately,” which in this context means an array of assets likely to perform satisfactorily under all
plausible scenarios and uncommonly well under conditions to which we at Windhorse assign higher probabilities than
investors as a group. As will be obvious, our own modeling work coupled with qualitative analysis cause us to project
lower real returns on US stocks over the next decade than most strategists of which we’re aware. Such thinking is
reflected in the following update of this publication’s standard compendium of noteworthy investment opportunities
and perils — a compendium whose self-imposed brevity precludes mention of numerous other opportunities and perils
on which we’ve acted or stand poised to act. Differently put, Windhorse is already walking the talk outlined below, via
means we’d be pleased to discuss and that we’re increasingly equipped to make available to qualified parties on a
comprehensive or specialized basis.
Open-Minded. Though I'm a member of the bar and did a brief stint in the early 1980s helping President Reagan's
White House Counsel help his boss stay out of legal trouble — an experience that informs crucially my own decidedly
mixed expectations for a Trump presidency — I've never argued a case in court. I mention this because I admire skilled
litigators' capacities to anticipate potential arguments from their opponents. Applying this mindset to my own work as
a CIO, I'm pondering carefully probable returns on the non-US stocks that Windhorse holds or may acquire assuming
US stocks as measured by the S&P 500 do indeed produce robust real returns over the 7-10 year time horizon that
animates capital deployment here at Windhorse. My bottom line, which I'm quick to highlight when pushed to defend
material allocations to non-US stocks over the horizon just specified: if indeed the S&P 500 performs really well over
this horizon, many if not most non-US stocks will perform as well if not better. Why? Because the S&P 500 can't deliver
as such without the global economy doing very well, thereby lifting all boats including many non-US stocks that are
cheap relative to US stocks at present.
Top of Mind
2
Q4 2016
Noteworthy Investment Perils ( - ) and Opportunities (+) circa 4Q 2016
- US stocks as a group. Pockets of value exist in most markets at most times, but as hinted on the prior page US stocks
as a group are priced at present for robust revenue and profits growth in coming years and beyond. Such expectations
might get met, but the probabilities are high they won’t. So too are the odds that interest rates will normalize, putting
downward pressure on price/earnings ratios.
- Stocks of domestic-oriented European companies. Brexit was likely the first of several anti-centrist shoes to drop in
the EU, portending big changes in relations among EU member-states. Between now and mid-2017, voters in five such
nations go to the polls. As with the Brexit vote itself, an anti-centrist wave of balloting in the EU could put stocks of
Europe-domiciled firms with EU-focused operations on the path to higher valuations over time. Alternatively, such
balloting could heighten longstanding concerns respecting the future socio-economic and political viability of numerous
EU members, especially those with high aggregate debt loads, rapidly aging populations, and shrinking work forces.
Think Italy, and watch carefully what happens not immediately but as the European winter unfolds if Italian voters
repudiate their prime minister in a referendum slated for December 4. While watching, keep in mind that the first but
perhaps not last nation opting to leave the EU since the Eurozone came into being in 1999 has its own currency — the
British pound. So too does the second nation in which anti-centrist sentiments ran high in recent balloting: the US.
Stating the obvious, Italy doesn't have a currency relief valve through which a re-pricing of Italian assets (real or
corporate) can get at least partly consummated if Italians vote no on December 4.
- Conventional asset mixes. Like the Vermont farmer’s answer to a city slicker’s request for directions to Maine
— “Ya can’t get theah from heah” — asset mixes that have generally served investors well of late are unlikely to get
them to where they want to go over the next decade. Why? Because major central banks have kept pedal to the metal
since the Global Financial Crisis commenced, boosting private sector capital expenditures far less than they’d hoped
and existing assets’ prices far more than they’d imagined. Show me policy portfolios adopted toward the end of the
prior decade that’ve produced pleasing returns for faithful users of them since then, and I’ll show you asset mixes likely
to disappoint their votaries over the next decade. Is there a better way? Yes, if one has (1) the right amount of
investable wealth (neither too much nor too little), (2) robust deal flow in relatively inaccessible corners of the global
capital market, and (3) the skills and experience needed to separate wheat from chaff when processing such flow.
+ Nifty niches. Though Trump’s election has spawned much talk of Dodd-Frank’s potential repeal, it’ll take some time
for the hoped-for renaissance of community banking in the US to achieve full flower, if indeed it ever does. Meantime,
there’s ample opportunity for nimble capitalists to pocket robust risk-adjusted yields by originating or buying on
secondary markets loans to small and medium-sized businesses, developers, and owners of residential realty, whether
single or multi-family. Other niches replete with opportunities to pocket plump yields with limited downside, especially
if and when stock prices are slumping, include royalty streams from intellectual property, customized reinsurance
contracts, and litigation financing.
+ Closely held companies. The large fraction of private equity (PE) “exits” comprising sales by one PE firm to another is
proof positive that PE managers employing traditional fund models have as a group too much money to deploy.
Contrast this with the handful (so far as we know) of PE pros able to deploy capital on a potentially indefinite basis —
a fine fit for the many family-controlled companies that seek to stay that way but want or need equity capital. Efforts
at Windhorse to partner with such companies are well underway. So too are efforts to acquire shares of firms that are
public in a de jure sense but private in a de facto sense: managed by founders or their legatees with the aim of remaining
independent indefinitely. Windhorse already owns stakes in family-controlled firms domiciled outside the US, not
directly but via sub-advisors we know well and trust to deploy capital responsibly, an opportunity we’d be pleased to
discuss in detail.