#121 - Matt McLennan: Resilient Wealth Creation, Patience, Gold

25:40and in fact you know we talked before about the difference between statistical risk and uncertainty if you think the world can be modeled with a standard normal distribution people make the argument well you only need 25 to 30 investments to be diversified but if you have the humility to respect that markets are more likely driven by uncertainty than just model statistically specifically definable risk, then the number of positions you should own is probably a multiple of 25 to 30. And so typically our portfolios are plus or minus 100 securities, not 25 to 30. And our big investments might be 1 % or 2 % of the portfolio as opposed to 5 % or 10 % of the portfolio.

26:24And so position sizing is another way that you can embed humility in a portfolio. And then to our discussion earlier, having the flexibility to have ballast in the portfolio, whether it's cash or gold, it's no different from a bank. A bank wants to deploy most of its assets in productive loans, but it knows if it's going to survive unexpected twists and turns, it needs a decent amount of tier one capital. It might be 10 % or 15 % in tier one capital. So being willing to travel the road with some surplus capital positions you actually to be a predator in times of uncertainty and to survive that uncertainty without having to have the ability to forecast in advance.

27:09Matt McLennan:One interesting observation when I talk to people who have been investing for four or five decades versus those that are younger in their careers, it's a little counterintuitive. but those that have been around a long time tend to be more humble because they've had the opportunity to be wrong more often as opposed to the ones who are earlier in their careers. It's so true. And being wrong in markets is an interesting one because you may find that over a decade, you end up being right, owning a security, but sentiment can differ from fundamentals for years at a time. And I remember the late 1990s when we went through the dot-com boom.

27:51And it was just a very painful time as an investor. I was running small and mid-cap value funds with some talented individuals on the team. And we did a lot of fundamental work and we'd identified companies that really were attractive at decent valuations. And yet, the markets were not rewarding them. The markets were focused on concepts, not cash flow. And the disparity in valuation became quite extreme and took years to remedy itself. And that is its own humbling lesson. And I have a friend who was a very talented exotic options trader. And he said to me once, after he retired, he said, I learned the hard way that markets in some ways exist to deliver the greatest amount of pain to the greatest number of participants before prices finally arrive at their correct destination.

28:46And I think the longer you spend in markets, the more you realize that the price and fundamentals can decouple for extended periods of time. Ultimately, arithmetic wins, but you have to position yourself to endure a disconnect between price and fundamentals. And in a sense, we ought to be also grateful for that because if it weren't for that, you wouldn't have the opportunity to buy good businesses at good prices. And so the source of resilient wealth creation opportunities is also the source of pain in the journey.

29:23Matt McLennan:And you have to accept both realities. And this is another reason why timing can be very challenging because even if you're ultimately right, you could look like you're wrong for years and years and years. It's very true. And that's why I think when you invest in a certain way, you have to invest in a manner that's purposeful. Because if the reason that you're underperforming at a certain point in time is because you're focused on entrenched companies that are being prudently run at prudent prices and the market's focused on other sort of conceptual stocks, that gives you the conviction to patiently wait for arithmetic to play out.

30:06On the other hand, if you're just trying to time markets top down, that's a tough business to be in because you're not grounded necessarily in a bottom-up reality that makes sense. And you end up second-guessing yourself and then closing out your calls at the wrong point in time. And so I think what gives you the ability to endure the inevitable cycles in markets is having a grounded sense of purpose in terms of what you're looking at, looking for at least one stock at a time.

30:37Matt McLennan:You talked about top down. And obviously, we live in a highly uncertain economic and geopolitical environment. And you're obviously a bottom-up investor, but you still spend time thinking about the macro environment. Well, where does macro fit in your decision-making without overwhelming security selection? We are primarily business buyers, bottom-up. I mean, that's where the rubber meets the road for us. But it's fair to say that we've always been willing to cast a wary eye as to what can go wrong. And often that's in a top-down way. And I think that people often look at the top-down and through the wrong filter, they're trying to predict the next recession.

31:21and yet the history of economics, and in fact, there's a great book out recently by Tyler Goodspeed called Recession, and it sort of shows that the vast majority of recessions were created by price shocks in one form or another, oil shocks, locust plagues that diminished the production on the farm and led to food price shocks, wars, things of this nature, things that are inherently unpredictable. And yet the greatest amount of time I see people spending on macro matters is trying to predict the precise timing of the next recession. And so the first thing I'll sort of say is that our efforts are not, when we think about what can go wrong, are less about trying to outguess the market on what's going to happen next.

32:08Who would have predicted COVID in November of 2019? You could have a lot of smart economists with views on the economy, but then COVID comes along. No, for us, it's more about sources of valuation risk. So where do we see extreme expectations in the market? And just making sure that we're not caught up in that is important, not being in Japan in the late 80s or in tech in the late 90s or financials in 2007. And also being attuned to slower release toxins. And by that, I would refer to the fiscal dynamic of the world or monetary policy decisions that are off base, because that can illuminate risks that are lurking beneath the surface for vulnerable capital structures or people's expectations more broadly.

33:01So focusing on stuff that's perhaps more linked to how risk is perceived as opposed to trying to forecast the next recession is the way I'd sort of talk about how we think about keeping an eye on what could go wrong.

33:15Matt McLennan:You just touched on this, but we have massive fiscal deficits during a strong economic period, which is historically unusual. Why does that concern you and what long-term risk does it introduce? It does concern me because you can't truly have independent monetary policy if you don't have sound fiscal policy. And fiscal risk is a kind of an invidious one because as deficits go from being modest to being on a structural basis larger, the initial effect of it feels good, right? Right. You know, if you if you did a sort of a mental thought experiment of an economy, if you had a closed economy and all of a sudden the government starts running big deficits to finance extra expenditures or income transfers, it produces a surplus in the in the private sector.

34:10And so big deficits have helped corporate margins be better than they otherwise would be. And in a sense, government debt, if there's no credible promise to repay it over time, if it just gets grandfathered, is nothing else other than a promise to print more money in the future. There's an economist, John Cochran, who talks about the fiscal theory of the price level and basically says, look, if you just keep running large fiscal deficits, the ultimate consequence of that is going to be higher inflation because you're basically, you have a government that has a certain real asset. And the government's real asset is the optimal ability to tax the economy.

34:51If you tax too much, you will destroy the productivity in the economy. If you tax too little, you won't have social stability. So there's an optimal point of taxation and that's like a royalty on the economy. But the problem is if you're running large fiscal deficits, you're issuing more paper claims on that real asset at a faster and faster clip. So the real value of those paper claims has to go down. And the way in which the real value of government debt goes down is the price of everything else goes up relative to it. That's inflation. And so the risk of running big deficits on a structural basis is either bond markets freak out at some point and force fiscal adjustment.

35:35And you remember the recessions that we had in Europe in the wake of the global financial crisis when the Greeks, the Spanish, and the Irish had to tighten fiscal policy because the bond markets capitulated. So if big deficits were a source of stimulus, if you take them away, it's deflation rate. The other risk is if you don't have those episodes and you keep running them, you end up with more inflation. And the 1970s is a good example of that, where you had the confluence of a couple of oil shocks and structurally too easy fiscal policy. And you had a decade of stagflation. And that was not good for risk assets.

36:15The equity market went from trading at close to 20 times earnings to trading below 10 times earnings. And so big fiscal deficits are a kind of a slow release toxin. Nothing seems to happen for a long time. and then a lot of change can be telescoped into a moment.

36:31Matt McLennan:And I suppose that's another reason to potentially hold gold as a contra currency. You're 100 % right. I mean, in a sense, gold is unique as a real asset. And in fact, we've tried to find alternatives that are cheaper. But if you look at a periodic table, gold has certain chemical elements that make it uniquely suitable to being a kind of real monetary asset the first of which is it's chemically inert which which means that it lasts forever it's like a natural perpetuity and that also incidentally contributes to having it having a steadier supply growth than other commodities because if you produce gold and it lasts forever, one year's incremental mining supply is only about 1.5 % of all the existing gold above ground.

37:27And so of all the real assets, it has amongst the most stable supply character because it lasts forever. And the second thing is because it's inert, it's not primarily produced for use in the industrial system. So unlike oil or copper or aluminum, it doesn't have a beta. And it's naturally a low beta or low economic sensitivity asset. And gold is often being criticized by many great investors as being useless. But the paradox of gold is its utility as a monetary reserve asset is its uselessness as a commodity. It's a zero beta perpetuity. And to put that in plain language, it's basically a perpetual asset that doesn't tend to trade in line with the economy.

38:11me i think of gold almost like being defensive land and it's also very dense if you look at where it is on the periodic table there's not much uh on the periodic table that's denser than gold and the stuff that tends to be denser is often toxic or radioactive uh or or brittle and and not suitable for being money so gold has this kind of unique series of chemical characteristics that I think is the reason why mankind over time has iterated towards it as a store of defensive value. And there's not much of it. It's scarce. There's less than one ounce of gold per capita globally. If you look at all the gold that's in jewelry and central banks and ETFs and private awards, you put that all together, less than one ounce per capita.

38:57And it's so dense that you could fit that all into a tennis court cubed. And so basically you have this defensive mobile land, the size of a cubic tennis court that people will use their other wealth to compete for as a potential hedge. And the value of gold over time tends to be inverse to the quality of man make money. So when people believed in the system, like the late 60s, when we had the nifty 50 or the late 90s in the tech boom, the value of that entire lump of gold, that cubic tennis court, if you looked at all the ounces mined, times the gold price, was less than a quarter of the value of treasuries outstanding.

39:45But when people lost faith in the fiscal dynamic or the monetary dynamic of the leading reserve currency of the world, the US, in the late 70s, early 80s, the value of that lump of gold became more valuable than the level of treasuries outstanding. And today, that pattern replicated itself in a sense in that in 2000, when the gold market troughed, gold price went back to being about a quarter of the value of all treasuries outstanding. and today now that it trades at a fuller and fairer valuation it's not yet exceeding the value of treasuries but it's approaching the value of treasuries outstanding and in fact central banks in the last year now own more gold than treasuries for the first time since the 1990s and so what that means to us at First Eagle as you know as someone who appreciates the role of gold as a real asset that's a potential hedge asset is that we can't get too carried away with the price of gold.

40:52And so as the price of gold has hit new highs over the last year, we've actually trimmed a little bit here and there. Otherwise, it would have become a bigger proportion of our portfolio and our portfolio would have become directionally dependent on the price of gold. And if you think back to what we said before about embedding humility in the process, intentional non-uniformity variegation, that even applies to gold. And so, you know, in some of the windows of strength over the last year, we've used gold at high prices to buy some out-of-favor equities or to replenish some of our cash reserves.

41:28I don't think gold is necessarily overvalued here. I think it's rational what's happened to the value of gold given the fiscal dynamic that we talked about. But it's the prospect for gold. They've got to be more symmetrical now that it's more rationally valued. If we get an enlightened centrist technocrat in power and we improve our fiscal dynamic, gold could become worth less. On the other hand, if the current adverse fiscal trends stay in place, gold could end up being worth a lot more. That's more symmetrical. And so we're mindful of not letting gold become 20 % or 30 % of our portfolios when we want other sources of scarcity value in the portfolio.

42:09Matt McLennan:Is gold primarily about inflation protection, currency debasement, sovereign risk, or something broader? All of those things are actually related. Sovereign risk is basically that you create paper money at too fast a clip relative to the real asset that underlies the sovereign, which is its taxing capacity. If you do that, you end up with either inflation or one form of monetary crisis or another. And I guess the symmetry of that too is just the underlying capital cycle for risk assets. Gold has tended to be most valuable in two states of the world, either when you've got a broken sovereign system or when the private sector breaks.

42:53So if you look at the last 120 years of history, if you were to reconstruct the S &P 500 as Schiller did going all the way back to 1900, a fairly clear pattern emerges, not just in terms of the value of gold relative to treasuries, but gold relative to the S &P 500. And that is that in windows of extreme systemic confidence, like the end of the 1920s, the roaring 20s, or the late 60s, we talked about the nifty 50 or the late 1990s with the tech boom, the first internet boom, in all of those periods, the value of the S &P 500 was more expensive than an ounce of gold. On the other hand, when we're at the peaks of systemic despair, like well into the 1930s with the Great Depression, or well into the 1970s and the early 80s with stagflation, or in the wake of the global financial crisis, the value of gold per ounce was more than the S &P 500.

43:57And so when you think about why we own gold as a long-term investment, it's because it's tended to have its peak values when equities were most depressed or when sovereign dynamics were most distressed. And that is when we would want to take that gold and buy bargain equities, if that makes sense.

44:23Matt McLennan:Yes, as opposed to cash, that doesn't really move around very much. It doesn't move around as much. And secondly, even though it's steady in nominal terms, the yield on cash over time has not kept pace with the rate of growth in government debt. So you've been diluted. If I was going to pitch you a stock that had a 4 % dividend yield, but where management was issuing 6 % new shares a year, you would say that's probably not a great deal. That's what cash is. Now, short-term cash can have option value, as we discussed beforehand. But if you never deploy the cash, then it becomes a slow release form of capital impairment in real terms.

45:06Matt McLennan:One interesting aspect of gold that many may not be aware of is, and it's because people think of it as a defensive asset and it has no real productive use and no yield or cash flow. So its return should be low cash-like. But if you go back to when we came off the gold standard in 1971, gold's return since then until now is very competitive with equities. And so you can think of that as not necessarily gold up, but confidence in paper money going down. That's exactly what it is. It's not that gold is going up in value. It's just that the real value of paper money has gone down. Ultimately, over a long period of time, if you think about gold being this defensive land that's mobile, the cubic tennis court, even though it's not an income-producing asset, its value over time is going to be proportionate to the nominal value of everything else because people will want a certain amount of their wealth in that ultimate defensive real asset.

46:09And so gold has participated indirectly in the march of mankind. But it's tended to be most valuable when there's been either systemic distress in risk assets or sovereign distress. And so over any given point-to-point period, the return of gold will be a function of the drift in human potential in nominal terms and whether we've gone from a high risk to a low risk or a low risk to a high risk moment and so um it's worth bearing in mind that gold has suffered big drawdowns over time um you know if you bought gold in the early 80s at 700 an ounce it was trading at less than half of that 20 years later um uh when it troughed and um the The reason being that even though the nominal wealth of humankind went up during that period, at the beginning of that period in the early 80s, confidence in the system was very low.

47:08So the value was high for gold. I mentioned before the stock of gold was worth more than the level of U.S. treasuries. By the end of the 90s, people had a huge faith in the system. The Berlin Wall had fallen. We had the dot-com boom. You know, the U.S. Treasury notes were offering 6 % and the government was running a budget surplus. So gold was trading at a very depressed value because people had faith in the human-made system. And so gold had a big drawdown. But then that ended up being a great time to buy gold because, you know, over time, paper money tends to erode itself.

47:44Matt McLennan:Let me ask you a different question. How do you factor in the implicit Fed put when assessing risk and long-term capital impairment? It's a little like Pavlov's dogs. That experiment where the dogs became accustomed to a certain shock or whatnot, they stopped eating the food. Investors, in the opposite way, have bit up the value of risk assets because they think the Fed will always come to the rescue. But the Fed put, by definition, can't be an ironclad rule of economics. There is no free lunch in economics. And so, ultimately, there are states of nature where the Fed doesn't exist. And typically, the independence of the Fed presupposes stable long-term fiscal dynamic.

48:36When the fiscal situation gets out of control, then the Fed has less degrees of freedom. And we've seen this in many emerging markets. Just think of the history of Argentina, for example, or Turkish monetary economics. But it can even happen in the U.S. So think of this most recent shock with the Iran war. The price of oil spikes, the stock market's down, and market expectations for policy rates go up, not down. Because of the fiscal dynamic and because of the existing inflation, we never really got inflation back below 2%. And all of a sudden, the Fed's feeling constrained in what it can do because it's afraid that inflation expectations will get out of control.

49:23We've seen other examples like the early 1920s where there was a big market correction and the Fed didn't come running to the rescue. And so I think the Fed put is a bit of a dangerous illusion for investors, particularly when you have exogenous price shocks like the oil price shock or you have fiscal dynamics that are going to complicate the inflation tradeoff or other forces at work. And sometimes the Fed put has negative second order consequences in the medium term. Money wasn't supposed to be free, Jean-Marie always used to say. and that period we had of low and sustained zero interest rates, I think fueled a lot of speculative VC investing, SPACs, all sorts of other meme stocks and things like that, that in many cases, unwound painfully later on.

50:17And so even though something might help you in the short term, like a subsidized cost of money, it can come back to for you in the medium term.

50:24Matt McLennan:And also just the concept of Fed put, the fact that it exists and it's known influences the price of assets and at the same time increases the odds of a negative surprise should the Fed put not actually transpire. I couldn't agree more. You think about where we were going into this Iran war. Credit spreads, option-adjusted credit spreads in the high-yield market were as low as they've been since 2007, in part because the market was expecting future Fed rate cuts. and so the promise of the fed put and the hope that you know trump wants a new head of the fed who's going to be more dovish leads the market to price less risk and and therefore when risk happens it's unexpected there's an asymmetric payoff function if the risk goes away well you're already priced for goldilocks if the risk stays with us for longer than expected then we're not priced for that.

51:25And the Fed may not be able to do anything about it.

51:27Matt McLennan:When an investment hasn't worked for an extended period of time, how do you distinguish between patience, which we talked about earlier, and a potentially flawed thesis? As a team, we're big believers in having an annual offsite where we sit down and we analyze what went right for the last decade, what went wrong for the last decade. And I think one of the lessons in there is that often stocks go into what what I call the gray zone where you buy it, fundamentals end up being a little bit worse than you expected, but the price has gone down by more than that. And so you feel committed to own it.

52:05And I think the key tell of whether something's been a value trap or your patience has yet to be rewarded is how the fundamentals of the business performed relative to what you thought at the time you initiated the investment. We talked before about some of the longer-term risks, whether it's substitution risk, whether it's management agency risk diluted reinvestment of capital. I think you have to be honest with yourself. Has the business not kept pace with nominal activity in a way that you expect that it did? Or have management done things with the capital that have been deleterious to intrinsic value?

52:45I think you have to ask yourself those questions relative to what you expected at the time of the investment. Has the market share of the business shrunk relative to what you would have thought? And those questions take a certain amount of humility and self-honesty and a willingness to sort of realize that no one has a perfect crystal ball. The primary goal is not to be right because you can't be right in a world of uncertainty all the time. The primary goal is to preserve capital. And so to be honest with yourself about how the business is paced relative to what you expected, independent of the price of the stock.

53:22Matt McLennan:So when you have those periods of reflection and you're looking back on what went right and what went wrong, what kinds of mistakes have you found are the most costly over a full market cycle? As I was mentioning earlier, I think it's really the substitution risk when a business becomes just less relevant. And that can happen gradually. It happens, actually. And sometimes from out of left field, people start spending money on something else. Sometimes it's more obvious. So the extreme example is imagine you own shares in a bookstore chain and then Amazon comes along. People buy their books a different way.

53:56Sometimes it's more in your face. Other times it's more subtle. Other times it's just a changing pattern of consumer preferences where people want to spend their wallet on something else.

54:08Matt McLennan:What do you think most investors potentially misunderstand about long-term investing and possibly because they're too focused on short-term signals? I think the thing that they most misunderstand is that if they're focused on short-term signals, is that the more you focus on the short term, the more shifts in sentiment impact prices. Does a company beat the quarter or does the Fed raise rates more than people expect or does it not. Sentiment shifts and fundamental surprise in the short-term dominate short-term returns. But as you lengthen your time horizon, arithmetic becomes more important. There's a certain ineluctable force to what is the cash flow yield of the business and what has been a trained growth rate of the business.

54:58Over time, the rate of return will converge on the yield and the growth of the business. But in the short term, it's going to be driven by sentiment shifts. And I think for people who are used to focusing on trading the short term, where they often get tripped up is when you get beyond that window of sentiment surprise and arithmetic starts to dominate outcomes. If you haven't done the work on the arithmetic, that's where you can be surprised.

55:25Matt McLennan:Well, Matt, this has been a fascinating conversation. I appreciate you sharing all your insights. You have a great way of articulating the core concepts. So I enjoyed it, and I hope our listeners did as well. Thank you. Thank you so much for having me on. It's always a pleasure to have the opportunity to kick these ideas around. And we have an expression on our team, no one has a monopoly on the truth. We certainly don't have a monopoly on the right way of thinking, but the fund has been around since 1979 and the philosophy. And along the way, we've had to learn the hard way how to think about markets and how to position ourselves to endure the unexpected and thus our philosophy of resilient wealth creation.

56:07Great. Thank you, Matt. Thank you.

56:10Matt McLennan:Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening. Important information. This podcast is provided for informational purposes only and should not be considered legal, tax, investment, or business advice. It is not a solicitation, recommendation, or endorsement.

56:50Matt McLennan:All opinions expressed by participants are their own and do not necessarily reflect the views of the Evoque Advisors Division of MAI Capital Management, LLC, or Evoque, its affiliates, or any companies mentioned. Information shared has not been independently verified by MAI or its affiliates. MAI Capital Management, LLC, or MAI, is registered with the U.S. Securities and Exchange Commission, SEC, which does not imply any particular level of skill or training. Certain information contained herein has been obtained from third-party sources and such information has not been independently verified.

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