Seasons Pt. 2: How We Got Here
First Principles Reasoning Series
This is the second entry in a 3-part series. Part 1 defines a useful mental model. Part 2 covers the seasons leading up to our current economic realities. Part 3 describes where we may be headed.
Fellow Partners,
As discussed in Seasons Pt. 1: A Better Mental Model, individuals, groups, markets and businesses are best understood through the lens of seasons as opposed to artificial increments of time such as months and quarters.
Pre-Pandemic Seasons
Prior to the Covid-19 pandemic we had seasons dominated by cheap money, monetary debasement, and global economic stability. This created an enormous amount of capital with opposing timelines. Some used cheap money to pursue projects that would require 10+ years of low-cost financing (e.g., e-commerce, the sharing economy, and space exploration). Others used the enormous amount of capital to play increasingly short-term games in public markets leading to capital markets dominated by momentum trading and short time horizons. Rapidly expanding globalization including hyper-global supply chains and just-in-time production flourished as well, all undergirded by:
Monetary expansion. Money was cheap and plentiful thanks to the world’s major central banks providing low interest rates and injections of capital into monetary systems through vehicles such as quantitative easing. This created a tide that lifted all boats through availability of capital. Home buyers could afford ever-pricier homes through ever-lower mortgage rates. Companies could choose to be unprofitable for years and still retain high valuations because the discount factor was low.
Maximum globalization. Geopolitical stability thanks to growing global wealth and some unsung heroes such as the US Navy which secured global shipping lanes meant that the relentless pursuit of lower prices and higher profits reached many corners of the earth. As an example, an iPhone contains components from suppliers in 43 countries across six continents, Apple tends to carry just a few weeks or months of iPhone stock, and yet they rarely run out. That is a modern-day miracle and not a natural state of economic order. But it persisted for so long that we got used to it.
Geopolitical stability. While far from perfect, peace reigned in most of the world, and the perception of peace was dominant. This allowed the expansion of globalization, including investors willing to make substantial capital investments throughout the world confident that their assets would remain safe (BP's stake in Russia’s state-controlled oil company Rosneft — acquired in 2012 and recently written down from $25.5 billion to $0 — is a prime example.)
These seasons were the predominant context in which assets were evaluated and prices set for most of the 2009 - 2019 decade. One proxy for valuations: the 2014-2019 median revenue multiple for software-as-a-service businesses was 8x. Remember that figure.
Pandemic Seasons
The Covid-19 pandemic induced rapid changes to these powerful seasons, accelerating the momentum of monetary policy whilst destabilizing the global economic order:
Monetary expansion accelerated at a stunning pace. Money got even cheaper as the world's major central banks injected enormous amounts of capital into their monetary systems and interest rates were taken to 0% (quite literally, free money). Here's a stark illustration: home prices in the US have grown 8% year on year for the past decade; the US-dollar money supply has also grown 8% year on year for the past decade, much of which occurred in 2020 and 2021. This aggressive monetary expansion accelerated the growth of asset prices. Are we actually wealthier, or have the numbers just gotten bigger? Millionaires aren't what they used to be.
Globalization began reversing. The enormous uncertainty created by the Covid-19 virus and subsequent government, business and social responses created a rapid "me first" ethos that played out about as one would expect. The rich world developed vaccines and received them first. Vaccines were utilized for political and diplomatic ends, which is why we presently have a glut of available vaccines in the world but still have large populations unvaccinated or vaccinated with less effective vaccines (e.g., China's population and others that used the Sinovac vaccine remain much more vulnerable to Covid-19). These realities woke us up to other vulnerabilities. Semi-conductors are critical to everyone, but disruption in Taiwan could set the world back years due to the immense volume of silicon produced on that single small island and the immense cost and time required to build alternative sources.
Geopolitical stability began wobbling. Global policy responses to Covid-19 woke us up to just how different the world can be. I remain surprised and deeply saddened that the world proved largely unable to look at scientific data and draw reasonable conclusions. Covid-19 was horrible. But it is not the only factor in the world, though much of the world still acts as though it is and are making unsophisticated or politically motivated trade-offs that severely lag our understanding of the virus and how we can live with its reality. This bled into other areas as we learned just how authoritarian some governments can be and how much nations will serve themselves before serving others. The underlying growth of post-modernism accelerated these factors and created the conditions for people to look at the same set of facts and draw wildly different conclusions. This eroded trust, which eroded stability.
In the context of history these were rapid seasons that persisted for most of 2020 and 2021. The effects of unprecedented monetary expansion quickly wound their way into markets. Inflation — defined as too much money chasing too few goods — arrived. The average price of a used car in the US, which hovered around $20,000 for years, quickly shot up to $29,000. The cost of homes, airline tickets, and many other assets grew as well. The median revenue multiple for software-as-a-service businesses doubled from 8x to 16x.
Post-Pandemic Seasons
We are now in a period in which the longer-term effects of these prior seasons are working through global economies, markets, businesses, and households. An excess of cheap money, Covid-induced changes to consumer demand, and supply chain issues have collided to produce inflation, which is being fought by some of the world’s central banks and has created substantial price uncertainty.
A great example: single-serve coffee creamer has been difficult to stock for months because the metal foil for the lid is manufactured in China, which has had frequent factory shutdowns and shipping disruptions as it enforces its Zero Covid policy. This is part of why IHOP and other heavy users of the stuff have had to raise prices.
Our seasons have rapidly shifted again as the world has begun accepting that Covid-19 is a reality we must learn to live with, globalization is not a de-facto reality, and peace is something we must not take for granted. These seasons are marked by:
Monetary contraction. When money remains too cheap and too plentiful for too long its value erodes and with that, trust. The world’s major central banks know this, of course, and some have set the stage to pull money out of their systems and raise interest rates (i.e., move away from free money). The anticipation of these movements has sent the price of financial assets plummeting as risk has been re-priced under new assumptions that money will have a cost (what a novel idea...) and the proverbial central bank printing presses may stop. Higher interest rates decrease the present value of future cash flows — a reasonable rule of thumb: every 1% rise in 10-year government debt reduces revenue multiples for long duration equities by 15-20% — and thus decrease the value of businesses, especially those that expect to earn relatively more profits in the future vs. the present. Higher interest rates also increase the cost of borrowing, which reduces appetite for investment and expansion.
Deglobalization. The stark realization of our global dependencies has refocused the world on securing their own supplies, including re-shoring manufacturing capabilities and reducing dependencies for critical infrastructure (the massive recent support for US-based semi-conductor manufacturing is a good example). A decade of purchasing manager behavior that had reduced working capital down to just-in-time inventory has realized the vulnerability and pain from running out of stock (e.g., Apple has estimated they will lose $4 - $8 billion in sales this coming year due to shortages in their supply chain). This has changed behavior from an elegant snow globe to stockpiling of inventory, larger-than-needed orders for future inventory, and efforts to secure multiple and alternative means of supply. In aggregate this has reduced the effectiveness of price signals, reduced the economic efficiency of globalization, and reduced trust within its systems.
Geopolitical instability. Russia's invasion of Ukraine made most matters worse. The pile of lies leading up to the invasion and the sheer and swift brutality of the Russian army's invasion helped us realize that peace is not a natural state, and war is hell. NATO nations' support to Ukraine and Russia's saber-rattling of their nuclear stockpile helped us realize the immense stakes at play. Europe's unwise dependence on Russian hydrocarbons and the world's dependence on Ukraine and Russian breadbaskets and fertilizers revealed painful vulnerabilities of massive globalization. The West's rapid and unprecedented decisions to freeze Russian global reserves and stop doing business in Russia made nations realize how globally vulnerable they are to the decisions of a few key players. This conflict catalyzed action, and highlighted deep geopolitical and economic fragilities.
These seasons emerged in 2021 and early 2022 and are now the predominant context in which financial assets are evaluated and prices set. At present, median revenue multiples for software-as-a-service businesses have fallen by 70% from 16x to 5x.
Inflation, monetary contraction, erosion of trust, impairment of price signals, deglobalization, and geopolitical instability mean substantial uncertainty in the price and supply of money, the economic tailwinds of globalization, and geopolitical backdrop supportive of economic prosperity. For investors with short time horizons, rational business prices have imploded. “Sell, sell, sell" has been an unsurprising conclusion.
Part 3
This causes us to question the future direction of travel and forthcoming seasons that will impact the prices of our investments. This is the subject of the third and final entry in this series.
All the best,
John
Founder and Managing Partner