Ignore the Crowds


How Overvaluation Swindles the Closed-Eye Investor



In the bustling town of Socialmerica lived an equity investor named Social. Social was known for his sharp mind and keen investment strategies, and many people followed him.



He owned shares in leading growth corporations, whose stocks had recently provided a strong return (which helped his popularity). However, lurking in the background was an economic phenomenon that would quietly undermine his and his followers’ holdings (yet again): valuation, inflation, and taxes.



The Initial Investment



Social initially invested $100,000 in leading growth corporations. His expectation was straightforward: a higher annual return than the general stock market since he was, after all, buying “leading” companies, and his investments would surely grow more significantly over the years. However, he did not account for the stealthy eroding power of inflation, taxes, and overvaluation at the time of his purchases.



Just like bonds or fixed-income investments, stocks and the stock market (the S&P 500) have a stated “yield” upon their purchases that bright-eyed analysts understand. While it is true that over a 100-year holding period, a pre-tax pre-inflation 10% return is likely, in 10-to-15-year cycles, however, that “10% return” in general equities is elusive, and it may be much lower or higher depending on when one’s entrance into “the market” transpires.



The return one receives in general equities is predicated on three variables: the ratio between the underlying book value or discounted cash value to the market value, the tax rate, and inflation.



From the 1940s through the 1970s, the internal economics of publicly traded businesses averaged about a 12% return on equity capital (ROE) over the entire period, but the investors’ return varied widely. This is because the 12% return on book value isn’t the stated “yield” the investor gets on his purchase price; the “yield” to the investor is determined by the premium to book or the discount to book that he is willing to pay at any given time.



Despite the extremely consistent 12% return on equity over those four decades from 1940 to 1980 (the internal economics of businesses), the investor’s return was indeed either very good or terrible, depending on the “equity coupon” the investor bought in at. A company or “the market” can simply have great internal economics and growth in earnings, but it can be bought at unsensible prices.



In the mid-1940s through the 1950s, an investor could have bought into the markets with an “equity coupon” that essentially paid them close to 12%, because investors had yet bid up the book value of companies to a premium to their net asset values. After the 1930s—a disappointing decade for the general stock market—people generally disliked U.S. equities going into the 1940s, even though they had become mouth-watering buys.



The return on equity capital was 12% (which is what companies were earning on their shareholders’ equity) in 1940, and the book value was priced in the market at par (100 and sometimes lower), so a return of 12% could have very well been expected in those years, and that is nearly precisely what investors got in those fortuitous days of the 1940s and 1950s for those bold enough to have “bought” in like Warren Buffett.



However, as that era unfolded, and by the late 1960s to early 1970s, investors became nearly convinced, like Social in Socialmerica today, that it seemed like some kind of natural given law that 10% to 12% equity returns are somehow baked into the cake no matter what the three variables might be (valuation, taxes, and inflation).



This belief created extremely happy prices in the markets in the late ’60s, and thus investors willingly paid premium prices for equities as they mimicked one another. In fact, the mantra going into the 1970s was to just buy the leading U.S. growth companies, “The Nifty Fifty,” as it were, at any price, because “you couldn’t go wrong” in the best businesses in the world.



As luck, unfortunately, turned out for those closed-eyed investors to the three economic variables, the book value of general equities had shot well over 200% of book by this time, and the “coupon yield” investors were getting in the 1940s and the 1950s of 12% were now cut in over half by the late 1960s: 12% on book value at par or 100 is 12%. 12% at a premium to book value of 200% is a 6% “coupon yield” to investors.



With a “coupon yield” of under 6% going into the late 1960s, investors were paying very “happy” prices for those “leading growth companies,” but they paid the ultimate price, and their returns would suffer for over a decade. It doesn’t take much of a hit to “earnings” to bring down book value when one has paid dear prices for a world priced for perfection (good earnings, low inflation, and taxes).



The moral of the story is that returns are ultimately decided by the price one pays and where one is in the energy cycle (of all things).



The “Equity Coupon” and the Price for “Leading Growth” Companies Today



While leading companies in the late 1960s shot up well over 200% of book value and “investors” ultimately paid the price for it with poor results, the S&P 500 in 2024 is selling at 471% of book value, and leading growth corporations have a much higher book value than that.



It’s true that today’s leading companies generally require less capital employed in them to generate their respective earnings. They are what we call capital-light businesses (low-capital needs and high profitability). However, like any rule of economics, there are limits to reason.



As companies are unquestionably more efficient today with a higher turnover ratio than in the past (the ratio between sales and total assets employed in the business), the relatively efficient market has priced these economics in with a happy disposition already, and it has for a few years now.



It’s why, for example, the leading “Growth Fund of America,” considered one of the best funds in American history, has had a negative total return over the last 3+ years.



The “coupon yield” for investors today in the “general market,” or the S&P 500, is less than what it was at the beginning of 1970, despite their much higher internal returns on equity. The “coupon yield” today sits barely over 5% in the S&P 500, and Social, who is invested in leading growth companies in Socialmerica, could very well end up as disappointed as investors ended up in the 1970s (or 1930s, or the period from 2000-2011). I’ll circle back to those poor decades for the S&P 500 in a minute, and, more importantly, what worked. 



This “coupon yield,” by the way, is pre-tax and pre-inflation. It doesn’t factor in the long-term capital gains tax rate sitting around 20% or the 3% inflation rate. Today, there is little difference between the 10-year United States Treasury bond after-tax total yield and that of the S&P 500 or the QQQ.



The good news for our Social investor is that with the much higher returns on the equity capital employed in the typical business today, book value growth shouldn’t take as long as it did in the 1970s to catch up to happy prices.



For the real estate investor, FMT estimates that the cap rate, or investor’s yield, is even worse and has negative yields in many cases.



With the general indexes (S&P 500 and QQQ) providing low “equity coupons” along with real estate, the question is: what looks good in the markets?



The short answer is the same assets that roared in the 1930s decade, the 1970s, and the 2000-2011 era even when general stock market was a horrific place to be due to overvaluation, are once again ready to soar.



The Rapid Depreciation of Currency



Fortunately, for eyes-wide-open savers-investors, the choices for allocation indeed aren’t limited to “leading companies or large general equity indexes,” or real estate, for that matter, that have woefully low “coupon yields” priced for perfection. Excess savings traditionally rotate to the highest use case that is priced the most optimally (where money is treated the best).



After all, capital needs to be invested “somewhere” because of the relentless grind of global currency creation. Over the last 100 years, M2 money supply has grown at a 6.5% clip.



Worse yet for savers, M0 is global base money (the total of all fiat currency that is in the system). Since 1970, global base money has grown at a 13% per year clip. 

As a side note, the 13%-year growth in M0 is all but assured over time—the only way for governments to service all existing debt in the system is to create ever more debt, and therefore, MO currency debasement is nearly guaranteed to continue. If I weren’t a regulated fiduciary, I’d probably just say it is, in fact, guaranteed.



With 6.5% annual M2 broad money supply growth over the last century, and M0 global base money inflation averaging 13% per year since 1970, excess capital simply can’t afford to sit around indefinitely in non-interest-paying fiat currencies with that kind of relentless depreciation of one’s capital. It simply wipes out purchasing power in real terms in no time at all.



So, with general equity indices yielding an underwhelming 5%, broad money supply deflating that yield by 6.5% per year along with taxation, and M0 deflating idle savings currency (nation-state cash) by 13% a year where should a shrewd investor rotate capital to?



The Undervalued Trends for Savers Today



In an environment where currencies are steadily losing value due to debasement and said debasement is set to re-accelerate again after a pause (the Federal Reserve has been destroying base money since 2022, which can only be temporary due to government indebtedness), investors must start to take note in a big way. While leading companies and real estate are less attractive due to their low “coupon yields,” other asset classes offer substantial opportunities.



Bitcoin: Bitcoin has gained enormous traction as an alternative to traditional assets and savings vehicles like gold. Although highly volatile, Bitcoin has shown strong historical predictability through Power Laws, a discovery by astrophysicist Giovanni Santosstasi, Ph.D.

One of the stellar things about the Bitcoin Power Laws, among many, is it is the “Fat Protocols” thesis quantified, and it is an extraordinary revelation. It’s worth re-reading my piece, “Dominance 30x,” under Trending Reports on the website to review the network effects of Bitcoin and it’s Fat Protocol value accrual.  Since then, the moat, network, and everything else continues to head in a stellar direction. 



I’ll have a lot more to share at a later date on the entire thesis.



Commodities and Precious Metals: As currencies depreciate, commodities—such as oil and natural gas producers—can serve as a hedge against inflation, especially since they are undervalued and could be a large source of the future inflation (energy spot prices rising).



Silver, in particular, has historically maintained its value over long periods, providing a store of value when fiat currencies falter. It also offers a unique hedge against Bitcoin positions in portfolios. Both should do quite well.



Emerging Markets: Investing in emerging markets provides exposure to faster-growing economies, which may offer better returns compared to developed markets given their undervalued fundamentals. These markets often have higher growth rates and can benefit from a growing middle class and increasing industrialization in regions like India and Brazil.



A huge catalyst could be a change of administrations, where a weak dollar policy will unquestionably be part of the plan — to re-shore supply chains and manufacturing, and try to cut into our trade deficts. 



Small-Mid Companies: Within the equity space, numerous smaller companies have become extremely undervalued compared to the large-cap leading companies and indices. Additionally, in a liquidity cycle, next-generation Internet companies could perform very well.



Conclusion: Navigating the Investment Landscape



In the complex world of investing, understanding the interplay between valuation, inflation, and taxes is crucial. As the story of Social in Socialmerica illustrates, blindly following herds without considering these factors can lead to disappointing returns. Investors must remain vigilant, diversify their portfolios into more attractively priced opportunities, and adapt to changing economic conditions to protect and grow their wealth.



By staying informed and making thoughtful investment choices, investors can navigate the challenges of overvaluation, inflation, and currency depreciation, ensuring they do not fall victim to the swindle of closed-eye investing.



Our eyes are wide-open at FMT.
 


Best regards,

Nicholas Green, CIO and Fiduciary