Podcast: Battle-Tested Assets for All Regimes

I recently enjoyed joining Jack Forehand, CFA, and Justin Carbonneau on the Excess Returns podcast for an engaging discussion. Our conversation touched on a range of topics, including my background in due diligence and a comparison between the situations faced by Paul Volcker and Jerome Powell in their respective tenures as Federal Reserve Chair (Spoiler Alert: Volcker's situation was more manageable).

Below are some highlights from our conversation:

• The Value of a Background in Due Diligence and Selecting a Fund Manager
• The Journey to Quantitative Investing
• Adapting to An Inflationary Regime: Investment Options
• Adjusting for Inflationary Conditions
• Comparing Volcker and Powell
• Microsoft and Exxon Mobil: A Tale of the Cyclical Nature of Growth and Value
• The Most Important Lessons for Investors Today

The Value of a Background in Due Diligence and Selecting a Fund Manager

A background in due diligence offers a unique opportunity to engage with accomplished fund managers with impressive track records. Conversations with these successful investment professionals can be invaluable as you can absorb valuable insights and strategies to help shape your own investment philosophies and personal style.

One key aspect to consider when evaluating a fund manager is their long-term track record of success, which demonstrates a sound investment philosophy and a strong investment process.

The Journey to Quantitative Investing

The blend of art and science in portfolio management can be seen in the balance between quantitative and fundamental strategies. Quantitative investing, which involves a market historian's perspective, allows studying past market performance to understand current trends better and predict future movements.

Quantitative strategies have the advantage of removing the emotional pitfalls that discretionary managers face, as they can sometimes be dogmatic. Merging the informational and behavioral benefits of quantitative investing with the common sense and experience of fundamental investing can create a powerful approach. Understanding that human discretion is always involved in some capacity is essential in recognizing the balance between the two methods.

Adapting to An Inflationary Regime: Investment Options

Inflation has been a concern for us for some time and the current high levels are expected to persist for an extended period. Historically, once high inflation emerges, it is difficult to resolve. Inflation may experience peaks and troughs, but the average level of inflation over time is critical to consider. The current environment may not be conducive to fighting inflation due to factors such as commodity shortages, ongoing conflicts, and a lack of political willpower.

Dealing with elevated inflation requires a change in investment strategies. While investors can manage 4 to 5% inflation, anything higher is disruptive. As we enter a new inflationary period, investors must adapt their strategies and consider assets that will perform well in this environment. With the Federal Reserve's efforts to bring inflation down, it is crucial to recognize that other factors are at play, such as global economic conditions and the current state of the commodity market. It is not solely the Fed's actions that will determine the success of investments moving forward.

Investors have various options when investing in assets that may perform well during inflationary times. Some of these include commodities, gold, certain stocks, and real estate. After extensive research on this topic, we believe these are the best assets to invest in during this period:

1. Resource Assets: Commodities and Natural Resource Equities

Commodities respond quickly to supply-demand imbalances, and due to the transition from traditional energy to renewables, structural shortages are expected in the commodity complex. This could lead to elevated commodity prices for an extended period of time.

Natural resource equities, such as oil services companies and those involved in extracting, producing, and distributing commodities, are also expected to perform well. These companies benefit from higher commodity prices and have shown discipline in capital allocation.

2. Financial Assets: Gold Bullion and Gold Equities

Another recommended investment is gold bullion and gold equities. Gold does not have the utility of other commodities, so people must seek it out as a store of value asset for it to work as an investment. In an inflationary environment, gold becomes an attractive option for investors looking to preserve wealth. Historically, gold has performed well during periods of inflation, as seen in the 1970s and mid-2000s. As we move later in the cycle, gold is expected to rally significantly, even independent of interest rates.

3. Income Assets: Income-Generating Real Assets

Finally, income-generating real assets such as infrastructure companies, REITs, and MLPs should be considered. These investments can pass along inflation to their customers while maintaining profit margins, making them more attractive in an inflationary environment.

Adjusting for Inflationary Conditions

Investors should aim to have assets in their portfolios that can perform in various economic environments, including high growth, low growth, high inflation, and low inflation. A balanced portfolio should include an allocation to resource assets, although this allocation should be smaller than the allocation to stocks and bonds.

The traditional 60/40 portfolio of stocks and bonds may not be sufficient to protect against inflationary risks. Investors should consider allocating around 15% of their portfolio to diversified real assets, which can provide a buffer during periods of high inflation while still allowing for growth during periods of low inflation.

In periods of ultra-high inflation, it may be prudent for investors to adjust their portfolio allocations to favor assets particularly effective at protecting against inflation, such as commodities. Strategies like the VanEck Inflation Allocation ETF (RAAX) invest in a mix of resource assets, income-generating real assets, and financial assets while biasing the portfolio towards assets expected to lead the market higher during periods of inflation.

However, during periods of extended low inflation, it may be more appropriate to increase allocations to REITs and infrastructure real assets, which can perform independently of the inflation cycle. While adjusting your portfolio based on inflationary conditions is important, it's equally important not to make drastic changes based on short-term economic forecasts.

Comparing Volcker and Powell

The current situation is very different from what former Federal Reserve (Fed) Chairman Paul Volcker faced during his tenure. Volcker had the advantage of disinflationary forces like fallen commodity prices and no wars working in his favor. In contrast, current Chair Jerome Powell has these same forces working against him. This makes it challenging for Powell to maintain low inflation while also dealing with the consequences of de-globalization.

Microsoft and Exxon Mobil: A Tale of the Cyclical Nature of Growth and Value

To better understand the dynamics of free cash flow yields and company performance, examining the contrasting stories of Microsoft and Exxon Mobil is useful. Microsoft has outperformed the S&P 500 for the decade leading up to this point, while Exxon Mobil has remained relatively flat. This difference can be attributed to the significant disparity in free cash flow yields during various economic regimes.

However, expanding the analysis beyond the last decade reveals a period when Exxon Mobil significantly outperformed Microsoft. This historical context highlights the cyclical nature of growth and value investing.

Both growth and value managers have often claimed that the other investment style is "dead” at some point. However, the truth is that growth and value investing work in cycles that typically last five to ten years. We are likely in a continued value environment that will benefit those exposed to commodities.

At present, the free cash flow yields for Exxon Mobil are remarkably high. Historically, such high yields have led to above-market returns. The expectation is that this trend will continue for some time. As more investors recognize the potential in these assets, we'll likely see significant price appreciation in the coming years.

The Most Important Lessons for Investors Today

When it comes to investing, there is a wealth of research and experience to draw from. However, if we had to distill all of that knowledge into just one critical lesson for the average investor, it would be this: asset allocation is the most important decision you'll make. To navigate the ever-changing economic landscape, you must understand the four major categories of economic environments – high inflation, low inflation, high growth, and low growth – and build a stable asset allocation mix that can handle each of these regimes.

While it's natural to feel the urge to move in and out of asset classes as market conditions change, avoiding being too aggressive with tactical shifts is crucial. Making careless errors in this area can increase the time you'll need to work before achieving your financial goals. The key is to stay strategic, making only minor adjustments at the margins when necessary. Doing so can better position yourself for long-term success in the markets.

One of the most challenging aspects of investing is managing emotions during market volatility. However, it's essential to recognize that volatility is a normal investment process. Rather than being frightened by it and rushing to sell your assets, try to see volatile periods as opportunities for growth. By sticking to your strategic asset allocation and riding through these storms, you'll be better equipped to capitalize on market fluctuations and ultimately achieve your financial goals.

Watch the full podcast episode here.

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