We feel we should be clear: there is volatility to be worried about. An article on “accounting for survivorship” sought to explain the survivorship bias in looking at US international dominance when measuring “country-specific real equity market returns” from 1900 to 2019. As the Morningstar article points out, in 1900 the United Kingdom dominated the world equity market with a 25% share, while Germany, France and the United States held roughly 15% shares each. As we pointed out last quarter (see QMP Summer 2020), by 2020 the United States accounted for almost 55% of the world equity market itself. The authors of the article rightly point out that for equity markets in Germany, Russia and Japan, “being on the losing side of a world war or two, the overthrowing of capitalism or just prolonged poor market performance would have wiped out the capital investors.” Certainly.
Not seeking to be flip, but standard investment advice is good only if a conflagration doesn’t start in the South China Sea and expand from there. On their time scale, the authors point out that “lower volatility,” as measured by the standard deviation of investment returns, seems to relate to higher “compound annual returns” by country. To state the obvious, the volatility of Germany was “extreme” and it negatively affected returns on capital.
Hard Versus Manufactured Volatility
We’d call this “hard” volatility. On the other hand, without some volatility, Wall Street can’t make money trading financial instruments. Manufactured or incidental volatility is something that long-term investors can weather and survive. It is why we believe that volatility does not equal risk, most of the time. We’d differentiate between “hard” and “manufactured” volatility, however.
As one of our own portfolio managers has pointed out, if US equity investors can expect a long-term, inflation-adjusted return of 7-8% per year and the prior ten years yielded a 13% annualized return, a regression to the mean may require less than a 7-8% return for the next ten years to balance out. Investors may search for other investment vehicles to boost their return. We are familiar with other areas of investment focus such as private equity, frontier and emerging markets, inflation hedging with energy and metals investments, hedge funds and even investments in rare earths elements. (The trick to remember with the latter is that rare earths elements are not rare.) Someone will always be promoting an alternative to US stocks, so we keep watching and reading.
One item that caught our eye was the news that Harvard University’s endowment is undergoing a refocus from teams of in-house professionals managing their different classes of investments to having most of them managed by outside professionals. The latest group to exit in-house status was the natural resources group, which includes timberland, vineyards with accompanying water rights, soybean plantations and olive oil pressing. These assets are typically very hard to value, so how accurate could an annual return calculation on these assets be? When Harvard’s present endowment chief arrived in 2016, he took a few months and then “wrote down the natural resources portfolio’s value by roughly $1 billion, the portfolio’s biggest loss since its 1997 inception.” The chief took a “more bearish view,” probably accurately, but he didn’t look up values in the Wall Street Journal.
He may have recognized what a letter writer to the WSJ realized. The writer listed the “keys to trading” in the agricultural markets as follows: 1. you must understand the fundamentals of your market; 2. your information flow must be equal to or better than the competition; 3. you must be able to recognize the underlying reasons for what is happening in the market; 4. it is very helpful to trade a large book, so that you can both hold a core position and then trade smaller amounts either offensively or defensively around the core position to defeat the algorithms; and 5. patience: algorithms are stubborn, and sometimes it takes several days or a week before a trade can be reversed “in the money.” 
For US investors in foreign and emerging markets, a major concern is currency risk. A recent WSJ article sought to explain why more risk didn’t mean more return in emerging markets and found that “since most companies operating in a particular country have a good portion of their earnings coming to them in their local currency, this leaves any US dollar-based” investor in them “exposed to fluctuations in the local exchange rate,” which affected returns negatively. The solution is not easy; perhaps purchasing currency to move with, or against “the US dollar’s fluctuations against the currency in question.”
Up until recently, protecting a portfolio from the “cruelest tax,” inflation, meant purchasing exposure to energy and metals. Bonds carry a special risk when emerging from a low interest rate environment: loss of capital if not held to maturity. However, the two sectors of energy and materials “now make up 5% of the S&P 500 – about half their share from five years ago” – for a variety of reasons. The downward pressure on these values may be alleviated by inflation, but when and how are very relevant here and not obvious.
So here we sit, after ten very good years, surveying the alternatives. We prefer to spend our time understanding “complexity” by reviewing the approximately 100 companies we’re interested in for their present situations, plans for the future, and their managements’ ability. The complexities of valuation, currency effects and hedging for other assets classes seem to outweigh analyzing an individual company’s attributes, perhaps not to the benefit of the investor.
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William H. Darling, Chairman & CEO
Adrian G. Davies, President