Interview

«We’re Dealing With a Very Different Animal»

Kevin Duffy, head of hedge fund Bearing Asset Management and editor of «The Coffee Can Portfolio», thinks the shakeout in financial markets has only just begun. The contrarian investor says what may be coming next for the stock market and where price dislocations are opening up opportunities for a prudent investment strategy.

Christoph Gisiger
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Deutsche Version

Rarely has the landscape of the financial markets been as challenging as it is today. With inflation rising sharply, stocks and bonds have suffered significant losses this year. Increasing fears of a global recession are now also hitting the commodities sector.

«I think we just had a classic bubble bursting,» says contrarian investor Kevin Duffy. «The Fed’s hands are tied. They’re not able to reflate the bubble. If anything, they’re accelerating the unwind», he adds.

Duffy knows what he’s talking about. Few know speculative excesses and manias better than founder of hedge fund Bearing Asset Management and editor of the investment bulletin «The Coffee Can Portfolio.» Last summer, in an interview with The Market, he warned that the next bear market had already secretly started.

In this in-depth interview with The Market NZZ, the straight-talking American explains what makes the current bear market particularly dangerous in a historical comparison, what one should pay particular attention to right now, and where opportunities open up for a prudent investment strategy.

«Simply front running the Fed and getting ahead of the monetary inflation has been the key to investing over the past couple of decades, but that game is not going to work anymore»: Kevin Duffy.

«Simply front running the Fed and getting ahead of the monetary inflation has been the key to investing over the past couple of decades, but that game is not going to work anymore»: Kevin Duffy.

Mr. Duffy, the climate in the financial markets remains tough with inflation the highest in 41 years. The S&P 500 has corrected by more than 20%. As a long-term investor and contrarian, what does the view look like from 10,000 meters?

This is a really interesting time. If you go back over the last fifty years, we’ve experienced a series of bubbles. We can start with the Nifty Fifty bubble in 1972, followed by crude oil in the late 70s and early 80s, personal computers in 1983, then the massive Japan bubble in the late 1980s, coinciding with a frenzy in U.S. takeover stocks. In 1996, there was a craze for adding semiconductor capacity. Around that time, you also had the first wave of the internet boom with the Netscape IPO which culminated in the late 90s dot-com and technology bubble. That was replaced by a housing and credit bubble, followed by the latest iteration which reached its speculative peak in February of last year.

And what is the conclusion of fifty years marked by excesses and manias?

The most important lesson is that bubbles spawn anti-bubbles. These are places to hide and plant seeds for the next bull market. Let’s take the Japan bubble in the late 1980s. It was fueled by the idea of the visionary bureaucrat: a partnership between business and government. This was called «industrial policy» and perceived as an improvement over the free market system. The anti-bubble was the more laissez faire American model, essentially Silicon Valley. The conventional wisdom was that America lacked competitiveness and its technology sector could not compete without government help. At that time, we actually invested in Dell, then named Dell Computer, trading for 10-12 times earnings. Michael Dell started the company in his dorm room and dropped out of college as business took off. It was one of our largest holdings and turned out quite well.

So Dell was an investment in the anti-bubble?

Exactly. If you can identify this pattern, you will constantly be avoiding risk (the bubble) and chasing opportunity (the anti-bubble). You may not experience all the excitement of the speculative blow-offs, but you’ll certainly achieve above-average returns over time.

How can this pattern be applied to today’s situation?

If you look at these past bubbles, they’ve all been somewhat narrow. During the energy bubble in the late 70s and early 80s, for instance, Houston was booming and Dallas was doing pretty well. But the rest of the country was one giant anti-bubble, mired in gas lines and people moving to Texas. The tech bubbles of 1983 and 2000 were confined to one sector. The housing and credit bubble was definitely much bigger, much broader. It sucked in a lot more people and got the big banks in trouble, but it wasn’t as crazy in some ways. We didn’t have a red-hot IPO market, for example. But this time, we’ve experienced a bubble for the ages, the so-called everything bubble. It’s unique in a number of ways. We’ve never seen anything like this in terms of size and scope. We’ve never seen bubbles in housing, in stocks, in bonds all happening at once.

What are the consequences of this phenomenon?

Investors were spoiled by forty years of tailwinds from rising bond prices. In the past, bonds were a diversifier, but today they are leading the way down. In fact, bonds are at the epicenter of the everything bubble. We’re dealing with a very different animal.

What will happen next?

When things turn, you typically get a warning crack. So far, the unraveling has been like a slow-moving train wreck in some ways. The decline in the S&P 500 has been very orderly, but I think that’s masking far more damage below the surface. According to Deutsche Bank, the U.S. ten year Treasury note just suffered its worst six month decline since 1788. That’s a major warning crack. We also had a warning crack in all of these money losing technology companies, IPOs, SPACs and cryptocurrencies. A lot of the craziest stuff has gotten absolutely destroyed, but the big popular averages have stayed above the fray. Investors are not really connecting the dots. So it seems to me we’re still early in this process.

Where do we go from here in this process?

As I said, I think we just had a classic bubble bursting. The Fed’s hands are tied. They’re not able to reflate the bubble. If anything, they’re accelerating the unwind. Regardless of what the Fed does, I think we’re going into a recession, if we’re not there already. This is going to destroy a lot of demand and that’s going to put pressure on commodities. 10 out of the 19 commodities I track are actually down year-to-date. The internals are breaking down and that’s telling us that the next act in this play - however long it lasts - will probably be deflationary. In that kind of environment, cash should do well, but the key question is, «how long does it last?» If I knew the answer, I’d own my own island.

How can investors navigate their way through this difficult environment?

I don’t think putting all your money in cash right now is an option, not when the world’s central bankers still have a license to print money. There’s always something interesting: an overreaction, an entrepreneur solving a problem, a company riding a secular wave, eventually even another bull market. I like Seth Klarman’s advice: «worry macro, invest micro.» We can worry about all the macro factors, but at the end of the day we need to translate that into action. If we’re going into a recession, look at defensive businesses providing basic necessities: food, healthcare, even energy to a certain extent. You have to turn over a lot of rocks, rolling up your sleeves and trying to figure out who will be able to withstand a harsh economic environment and how much bad news is discounted in the stock price. The good news is that there are a ton of cheap stocks. At the micro level, I’m more excited today than I have been in a long time. But at the macro level, I’m kind of terrified.

Where might opportunities open up in this context?

You have to think like a contrarian and ask yourself, «what’s on everybody’s mind?» «What are the big fears?» Besides inflation, it’s supply chains and certainly the geopolitical environment - not just with Ukraine and Russia, but also China. And now, recession is a growing fear. Fred Hickey, editor of The High-Tech Strategist, taught me to think about this like a food chain. Those companies facing the consumer are at the front; they feel the pain first. At the back of the chain are companies like the semiconductor and semiconductor equipment manufacturers; they feel it later. Consumer discretionary stocks are the worst performing sector this year. They’re down even more than technology.

And how do you go about this food chain strategically?

Look at the front of the food chain for what’s really been beaten up. Also, look at the bottom of the economic ladder, because it’s obvious that the lower income consumer has been hit first and the hardest. To me, that is discounted in stock prices, whereas a long bear market in stocks and bonds is going to hit higher income people. And I don’t think that is reflected as much, at least not yet.

What kind of companies offer potential in this regard?

A lot depends on valuations. Even though I haven’t recommended Target yet, it’s been hit with a lot of negative news and the valuation looks reasonable. Walmart is still a bit pricey, but it was actually one of the few stocks that held up well in the 2008-09 bear market. One stock in this space that looks interesting is Big Lots.

Why?

The company has been hit by all the things I just described: exposure to the lower income consumer, broken supply chains and a brutal environment for purchasing managers trying to forecast demand. The stock’s been pounded this year, cut in half. Big Lots is a deep discounter, providing a treasure hunt experience. They benefit from close outs, and when there is stress in the system, they have more opportunities to sell things, to improve the quality of their merchandise. They also benefit from higher income consumers looking for bargains and trading down. This company doesn’t grow very quickly, but if you go back to 2008-09, they did fine. I’m not suggesting this recession is going to look exactly like the last one: it’s probably going to be deeper and longer. Because of inventory miscues, Big Lots is expected to lose money this year, but if they can get their operating income back to pre-pandemic levels, they can easily earn $8 a share.

Do you spot other opportunities in the retail area?

I’m a big fan of Skechers U.S.A. long-term with its global footprint, omni-channel model and focus on value and comfort. This is the third largest casual footwear brand in the world. It’s well-positioned in China where there has been a tremendous amount of negativity lately. But that’s where the growth opportunities are. Skechers also has exposure to India which I don’t think is reflected in the valuation. It’s an inexpensive stock with high insider ownership run by a founder taking the long view. If I look out five or ten years, Skechers should be a bigger, more profitable company.

Another segment that has suffered a massive setback is growth stocks. From a value perspective, is it time to take a closer look at these companies?

Certainly, there have been some serious hits taken in the growth area, and well deserved. These stocks were trading at ridiculous levels. Valuations have come way down, but are not universally cheap. There are still way too many money losing companies that were propped up by the past decade of easy money going into pie-in-the-sky business plans where everybody expected to become the next Amazon. We’re in a new environment where companies will be forced to become profitable much sooner. Some will make it while others, like Peloton, may never turn the corner.

We are talking here about price declines of around 70 to 90%. Are there any companies in this area that look really cheap now?

I wouldn’t go as far as cheap, but there are some that look reasonably priced. I like companies positioned in front of megatrends, for example location independence. This was a slow, steady trend that got a huge boost from Covid. Remote work is here to stay: we’re not all going back to physical offices. Zoom is an obvious beneficiary. It is a very profitable company and the founder, Eric Yuan, has plenty of skin in the game with about $5 billion at the current price.

Are there any other growth companies worth taking a closer look at?

Another example is Airbnb. The three co-founders are young and own 32% of the stock worth $19 billion. They’ve been battle tested by the recent adversity of Covid. CEO Brian Chesky has a clear vision and the company is profitable. It’s an open question of how much they are going to be impacted by the slowdown in the economy. I imagine they will, so it may be a bumpy ride over the next six to twelve months, but I’m looking beyond that. Different parts of the portfolio play different roles. With these growth stocks, I’m investing for the next bull market. It’s like planting a garden. I’m probably early in the process, but excited. Eighteen months ago, I looked at these companies and thought, «this is an interesting business, but it’s outrageously expensive.» Now, it’s a lot more fun.

It’s impossible to time the market, but are there any signs investors should look for to know when the bear market is nearing its end?

Everything should get cheap, including growth stocks and large cap stocks. I’d like to see an intense focus on profitability. Margin debt needs to come way down from record levels. And, of course, the more bearish investors get, the better. All bubbles are built on a key rationalization that gets discredited at the end. For the 1983 personal computer bubble and 2000 dot-com bubble, it was first mover advantage. For the 2005-07 housing and credit bubble, it was that real estate always goes up. For the everything bubble, I think the key rationalization was that government is the solution to all problems. This is not just financial, it’s ideological. This is an all-encompassing detachment from reality that extends to culture, foreign policy, even saving the planet from climate change. These bubbles are all connected by the same theme and are beginning to run into the brick wall of reality, but we’re still early.

What does this mean for the construction of a robust portfolio?

As an investor, you need to understand this new world we’re going into. Simply front running the Fed and getting ahead of the monetary inflation has been the key to investing over the past couple of decades, but that game is not going to work anymore. Also, from a foreign policy standpoint, we’re going into a multipolar world. The United States is no longer the world’s policeman. Ultimately, that will lead to a more stable world, but the transition will be bumpy and uncertain. The bursting of these bubbles is healthy, but the process is messy.

How can investors protect themselves during this messy process?

I think you want to look for companies that will be able to navigate this new world. They provide vital goods and services. They are self-funding and don’t rely on government subsidies. They are run by founders or owner-operators who take a long view. They try to remain apolitical. To me, the biggest risks lie in companies that suck up to the government and end up doing destructive things to shareholders. Nike for instance is trying to push certain official narratives that are going to alienate their customers in China. Yum Brands is unloading its chain of 1,000 KFC restaurants in Russia that took two decades to build. Those types of stocks are more likely to show up in the S&P 500 where everybody is positioned. If I’m right, the kinds of independent businesses I’m looking for will be seen as ports in the storm and trade at a premium.

What kind of companies are you referring to exactly?

You have to be willing to be politically incorrect. It takes a certain amount of courage to do that, and most people aren’t wired that way. The green energy lobby has basically been trying to put fossil fuels out of business, but that’s the type of industry that interests me. Oil and gas companies provide a vital commodity in which supply is severely constrained by ideology and politics. Reality is starting to sink in that we can’t just cancel fossil fuels and that this was always a delusion. So even though many commodity prices will go down, energy prices should be a lot stickier.

Are there other segments in the commodity space that look promising?

Even though gold has held up ok, gold stocks have been dragged down with the rest of the market. All-in costs are around $1100 an ounce, so even at a gold price of $1700 or $1750, these companies are still generating plenty of free cash flow. The stocks are too cheap to pass up. In this case, I like to take a diversified approach, owning a basket of senior and junior miners, plus streaming and royalty companies.

Any final thoughts?

At the risk of sounding overly optimistic, this is not the time to crawl under a rock. Do your homework and plant seeds. As legendary investor John Templeton used to say, «for those properly prepared, a bear market is not a calamity but an opportunity.»

Kevin Duffy

Kevin Duffy is a battle-proven contrarian investor and veteran in the risky business of short selling. He is the editor of The Coffee Can Portfolio and the Notable and Quotable blog. Mr. Duffy co-founded Bearing Asset Management in 2002. He was a vocal critic of the 2007 credit bubble, successfully shorting many of its most aggressive players including Countrywide Financial and Bear Stearns. Prior to Bearing, he co-founded Lighthouse Capital Management and served as Director of Research from 1988 to 1999. He chronicled the excesses of the Japan and technology bubbles of the late 1980s and the late 1990s. Kevin Duffy bought his first stock at the age of 13. He has a passion for Austrian economics.
Kevin Duffy is a battle-proven contrarian investor and veteran in the risky business of short selling. He is the editor of The Coffee Can Portfolio and the Notable and Quotable blog. Mr. Duffy co-founded Bearing Asset Management in 2002. He was a vocal critic of the 2007 credit bubble, successfully shorting many of its most aggressive players including Countrywide Financial and Bear Stearns. Prior to Bearing, he co-founded Lighthouse Capital Management and served as Director of Research from 1988 to 1999. He chronicled the excesses of the Japan and technology bubbles of the late 1980s and the late 1990s. Kevin Duffy bought his first stock at the age of 13. He has a passion for Austrian economics.