Yes, the times they are a-changin’

In the allegory of the cave, Plato talks about a group of people who live chained to the wall of a cave. They watch shadows projected on the wall ahead of them, from objects passing in front of a fire behind them. They then give names to these shadows.

The shadows are the prisoners’ reality, but they are not accurate representations of the real world. Now, 2,500 years later, the allegory is an apt one for most investors, who have experienced two major trends for their whole career.

Their reality is: 40 years of increasing profitability at major Western corporations, and 40 years of increasing valuations of these corporations

Since 1981 interest rates around the world, led by the US, have been on an inexorable downtrend. As interest rates have declined, p:e multiples have expanded. It is basic maths to show that the value of a stream of cash flows into the future is worth more today if interest rates are low than when they are high.

And since 2008, in an attempt to avoid economic pain, central banks have been printing lots of money. So money is cheap and plentiful.

It’s no wonder the share prices of growth stocks — stocks with expectations of huge earnings in the distant future — have exploded. Not to speak of the venture capital (VC) world, where easy money has caused valuations in early-round financings to explode.

A unicorn is an imaginary animal, “scarce” to the point of being nonexistent in the real world. In the VC world, a unicorn is an early-stage business with a valuation of more than $1bn. Today, after the deluge of cheap money, in the cave of the venture capitalists there are more “unicorns” than donkeys.

For a long time, investors have deserted value stocks — shares with low earnings expectations. If you are discounting cash flows that are not in the distant imagination of 35-year-old fund managers, but in the immediate future, then changes in interest rates make no difference. But it’s not only distorted valuations being applied in the cave of today’s investors, it is also the level of earnings these valuations are being applied to which are subject to misinterpretation. Corporate earnings have been inflated by (at least) three factors.

The first is the deflation exported by China to the West after it gained “most favoured nation status” in 1980 (more than 40 years ago!)

The second is energy. An important input into the cost structure of most businesses, oil peaked at $135 a barrel in 1980. Today, we think the oil price is high at $90.

The third is technology, which has driven huge efficiencies. The worldwide web was first used in the late 1980s.

Increased earnings have been rewarded with higher multiples, leading to a long-term bull market in growth stocks — compounded by free money, available at a central bank near you since the global financial crisis of 2008.

Venture capitalists, and growth investors generally, rule the roost. This is our lived experience, the way the world

If someone were to argue that tomorrow’s reality might not correspond with this vision, ridicule would follow

works. As with Plato’s prisoners, it’s really hard to imagine anything else.

So if someone were to argue that tomorrow’s reality might not correspond with this vision, today’s prisoners would regard such a person as part of the “lunatic fringe”. Ridicule would follow in short order. Value investors understand this dynamic only too well.

Bearing in mind that we can never see what the people saw who built the fires in the first place, I believe change is afoot. As a value investor and a fiduciary, here is how I interpret the flickering shadows on the cave wall: inflationary pressures are increasing; corporate profitability will come under pressure; and eventually interest rates will rise. Commodity prices face upward pressure due to supply shortages. Our determined friends in the environmental, social and governance lobby will see to that. And they have the political cover — ask Shell or Hosken Consolidated Investments.

The volume of money printing will reduce its purchasing power. US Federal Reserve chair Jay Powell and his unelected partners in crime will see to it. And they have political cover. Paying back debt with dollars that are worth less is the easy way out. Austerity doesn’t get you the vote.

“History shows … inflation is often a collective behavioural phenomenon, with all the nonlinear dynamics that implies. A confidence crisis occurs suddenly, rather than in a predictable, mechanistic manner. Think tipping points,” says Jeremy Grantham, cofounder of investment firm GMO.

Bob Dylan’s The Times They Are AChangin’ also comes to mind. More than 40 years ago, he wrote:

“Keep your eyes wide,

The chance won’t come again

And don’t speak too soon

For the wheel’s still in spin

And there’s no tellin’ who

That it’s namin’

For the loser now

Will be later to win.”

Tipping points are hard to discern after a lifetime of interpreting flickering flames against the wall you are chained to. But they’re coming.