The Line of Best Fit
The Line of Best Fit
Like any analysis, regression analysis has strengths and weaknesses in its predictive power. While being easy to understand and implement, spurious correlations abound, particularly being a problem in larger datasets. Of course, there are caveats such as using adjusted R2, checking the T-stat and the residuals. But more than that, one should employ the scientific method and have a hypothesis, a priori about the likely relationship between variables before the analysis commences.
Over the past 25-odd years, a regression analysis between bonds and equities would need to include data on central bank balance sheet growth, as an input. Among many other dynamics that distinguish this era from all others has been the unprecedented role of governments and central banks in the operation of the free markets. While each economic era has its own distinctive set of traits, this most recent era saw very different interactions between stakeholders. International trade expanded at an extraordinary rate, and the role of central banks in buffeting against periodical crises saw a great reluctance on their part to test the resilience of markets and economies alike, more than in any other era.
But one thing that all markets and economies have in common is their biological structure. Businesses rise and fall, technology disrupts and the creative destruction of the capitalist system sees the economy and financial system evolves as a complex adaptive system where only the fittest survive.
Or at least that was the situation before the increasingly larger role played by central banks over the past 25 years. Over this time, central bank largesse has seen zombie companies rise and live in a half-world, on the life support of artificially cheap funding.
Going back further, if it were possible to draw a line of best fit on the global economy since World War II, it would reveal a long period of growth in the financial services sector as a component of the global economy, as well as the many efficiencies attained in capital allocation and costs that were derived from a super cycle of disintermediation.
Around this long line of best fit were deflationary eras, inflationary episodes, wars, periods of deregulation and re-regulation. But as the global financial system evolved through all of this, management became increasingly incentivized by short-run return on equity, driven by markets buttressed by central banks and less incentivized on long-term capital expenditure reaping long-term returns.
This had two particular impacts over the past 25 years. Businesses became less resilient, and competition for return on equity became pronounced, meaning capital planning to withstand inevitable crises took a back seat. This played out through share buybacks periodically occurring at market peaks, and share issuance taking place in market troughs, and debt-funded dividends in many cases.
So, if the world is transitioning from one era to another, as seems likely, what might an investment line of best fit look like going forward?
It is ordinarily foolhardy to predict the future. However, constructing a line of best fit can have the advantage of helping investors be broadly right rather than precisely wrong across constantly changing conditions. It is about seeking to identify vulnerabilities in investment thinking and strategies. Government policies change, central bank policies change, as do trade and economic conditions.
But we know enough about the past 25 years to know the importance of long-term strategic planning in a world that values monthly and quarterly performance. Charlie Munger recently observed that he had seen three 50% share price declines in his Berkshire Hathaway stock, without ever feeling the need to respond, reflecting his confidence in Berkshire’s long-term prospects.
One of the great tailwinds of this recent era has been the secular declining trend in interest rates and bond yields. This has typically unfolded as long periods of low volatility punctuated by periodical spikes in volatility.
But what happens if a rising interest rate and bond yield environment creates the opposite effect?
By definition, surviving increased volatility requires increased resilience. If indeed that is how things will play out going forward, what type of business “moat” could be more attractive to investors seeking resilience from their exposures?
Perhaps it is capital intensity – the opposite of the past 25 years.
Capital intensive businesses do not have the luxury of running lean balance sheets. To do so consigns them to obsolescence, or at best the risk of being overtaken by competitors with deeper capital pockets.
It is easy to forget how many car manufacturers existed in the US during the early twentieth century, although the remains of the Packard plant in Detroit give a stark reminder of how capital intensive industries evolve. The strong get stronger and the weak either go out of business or are acquired by the strong. And in the end, the real moat around such businesses lies in the difficulty for a new competitor to enter the market and replicate such a capital intensive architecture.
As an industry, Japanese car manufacturers were able to achieve this in the 1970s and 1980s, aided and assisted by Detroit manufacturers not responding to higher oil prices, and focussing on more fuel efficient cars. Then over time, Japanese manufacturers climbed up the value chain by supplying increasingly high quality cars, while Detroit had to find ways to manage their capital in more optimal ways in order to increase their resilience. Twenty years ago, the second most expensive component of a car made in Detroit was the health care benefits paid to workers. This capital structure gave Japanese manufacturers comparatively additional resources for innovation.
Another benefit of capital intensive businesses is that they generally have a degree of pricing power - think infrastructure and energy producers.
That said, there are clearly competitive pressures in any industry, irrespective of the level of capital intensity.
But just as there are sectors and industries that benefit from times that favor leaner capital management, there are economic times and conditions that favor greater capital resilience.
In times of increased volatility and interest rates, this would seem to be the line of best fit.