2022: A Year to Remember

While nonprofits face many near-term challenges in the financial markets and in bettering society as a whole, longer-term trends are encouraging. In fact, I expect 10 years from now we will be marveling how much life has changed for the better. Researchers and scientists, for example, are making progress both in terms of protection of the environment and understanding of human diseases. While our entrepreneurial spirit might be fatigued from overstimulation the past few years, it remains intact, and new businesses are being created every day to capitalize on technology to improve our productivity and welfare.

Despite that optimism, after a year like 2022 it is easy to dwell on what went wrong. Sometimes we learn the most from difficult years, and last year was no exception, even for experienced investors. Although 2022 was definitely “a year to remember,” it is helpful to remember that things are not as gloomy as current markets may indicate.

2022 was a year in which stocks and bonds fell together in the face of higher interest rates and global inflation (see chart). Market dynamics prompted many thought pieces on whether the 60/40 portfolio and other forms of diversified portfolios were dead. The role of fixed income as ballast during a market crisis was called into question. We do not believe it is appropriate to extrapolate a trend or conclude we are in a new paradigm based on something that has happened only once since 1928. Instead, our base case is mean reversion, and our hypothesis is that diversified portfolios with fixed income serving as a buffer to protect against difficult equity environments are likely to work in the future.

Stocks and Bonds Performance by Year Since 1928

While we caution against overreacting to a year like 2022, many of the lessons learned have sown the seeds for strong potential future returns. In this, the first issue of our quarterly Endowment & Foundation Perspectives, these lessons provide the basis for many of our medium-term predictions, which we believe will have an impact on nonprofits and the communities they serve.

A Look into the Future: Five Predictions

Yogi Berra was right about predictions. And it is especially difficult to make predictions over a one-year horizon, so let us focus on what I believe will be the more secular trends likely to manifest over the next five to seven years. An emphasis on these trends helps keep endowment and foundation investment portfolios focused on the bigger picture and avoid being swept up in the short-term market narratives of the moment. While aligning portfolios with my intermediate-term views, I tend to keep tactical shifts quite modest relative to long-term asset allocation strategies.

Let us take a high-level tour of what I believe are the five most important predictions and the tactical positioning such views imply.

Prediction 1: The price of U.S. exceptionalism reverts to the mean

Over the past century, the U.S. has been a major player on the global stage — some might even say exceptional — with the advantages of 1) a strong rule of law and property rights, 2) flexible labor markets, 3) entrepreneurial spirit and innovation in technology and biotechnology, 4) good infrastructure, 5) the global reserve currency and 6) a dominant military compared to the rest of the developed world. These advantages have, in part, led U.S. equity markets to have a higher price-to-earnings multiple relative to the rest of the world’s markets. Over the next couple of years, U.S. equities are likely to continue to trade at a premium; however, we expect that premium to contract, leaving equities in the rest of the world more attractive on a relative basis.

Prediction 2: European and China fears are oversold in the market and offer attractive returns

When market participants arrive at a consensus view around a negative scenario, they often overweight the negative future scenario into the price of securities. There are two such markets today — China and Europe — where it seems the extremely negative cases have been priced into the future, leaving little room for positive surprises. While we might be past the peak of these fears and off the lowest prices, historically these types of situations tend to outperform for an extended period.

The war between Russia and Ukraine has been incredibly costly to Europe, pushing energy prices to excessive levels. In addition, European markets have underperformed the U.S. over the past decade by a significant margin. Compounding these effects was the dramatic rise of the U.S. dollar relative to European currencies. These and other factors have left many investors bearish on Europe, and the resulting valuations are attractive relative to the U.S.

Despite a recent uptick following the abrupt termination of zero-COVID policies, sentiment around China has deteriorated significantly, reaching a point where many investors consider the country “uninvestable.” China is a large and complex country with a different set of priorities than most developed economies and a political system that is unlike any purely capitalistic developed economy. However, China’s desire to play on the world stage requires a level of rational economic behavior that is likely to limit the more extreme outcomes. We believe Chinese assets are at attractive valuations, and the inefficiency of the markets should allow skilled investment managers to generate excess returns.

Prediction 3: Biotechnology represents innovation at a discount

Biotechnology stocks have dropped precipitously, and investor interest has dried up as markets have moved into “risk-off” mode. The eventual success of biotech stocks depends on scientific and regulatory outcomes requiring deep technical knowledge. Drug trials are expensive to run and can take more than a decade, over which time a company may require multiple funding rounds to offset significant cash burn. These companies are hard to value given negative cash flows awaiting these binary outcomes. All this complexity creates opportunity for dedicated specialists. Further, we expect the biotech industry will create significant value as it continues to make progress in treatments that increase quality of life and longevity. This could be an opportune time to buy innovation at a discount, and we believe the returns to funding biotech research over the next three years has the potential to be higher than usual.

Prediction 4: Investors will have a renewed focus on the cost of capital and profitability

As interest rates have increased, we have left the world of TINA (there is no alternative), which drove many investors to reduce fixed income allocations and focus on long-tailed unprofitable growth. When the cost of capital was near zero, it was relatively easy for companies to raise unlimited amounts of cash without having to show profits. This behavior created a difficult environment for fundamentally oriented investment managers that focused on buying companies with an ability to grow profitably. For the hedge fund industry, it made shorting stocks treacherous as the more money a company lost at scale, the higher the valuation. When you add to the mix a difficult backdrop of swings in meme stocks and the extreme concentration of performance in a small number of large cap growth stocks, traditional active investment managers were left with no way to outperform the market. We believe this trend has reversed and therefore recommend tilting the portfolio to overweight hedge funds and long-only active managers that can identify cash flow positive companies trading at reasonable multiples with profitable growth opportunities.

Prediction 5: Energy is a growth industry

As the global economy continues to grow, so too will the demand for energy. We believe that over the next decade the U.S. will make significant progress toward moving more energy production from fossil fuel to renewable energy sources. Building on the technological advances of the past decade and those likely to come, we see opportunities to invest in technologies that will accelerate the rate of change from fossil fuels to renewable sources. While we are all-in with investing in renewable energy technologies, we also believe traditional sources of energy will continue to offer strong returns as they provide energy security and serve as a bridge to sources from intermittent renewable energy.

Over the intermediate term, the demand for energy continues to grow faster than the ability of renewable energy to create new sources. The risk of stranded fossil fuel assets¹ is real, but still a ways off as peak fossil fuel consumption is predicted in the 2030s and thereafter decreasing at an uncertain rate. Building electric cars, windmills, solar panels, batteries, the electrical grid and other technologies related to renewables is commodity intensive. Providing the natural resources necessary (such as copper, lithium, cobalt, rare earths) is incredibly important and potentially profitable.

A Look into the Future: Three Cautions

Caution 1: More relative pain in store for high flying unprofitable growth stocks

Over the past two years, values of high-flying unprofitable public growth stocks have dropped precipitously, some by 80% or more. Toward the end of 2022, some technology companies started laying off employees to reduce cash burn rates as it became difficult to raise new money at desired valuations. What we have not seen to date are 1) a significant number of liquidations of marginal companies as they run out of cash, 2) a sufficient number of “down rounds”² and 3) an adequate number of companies reducing top-line growth strategies to refocus on growth with profitability.

Down rounds have two negative effects: They force current investors to write down the value of their investment and make employee recruiting and retention more difficult as these private companies tend to pay a significant percentage of compensation in stock. We are currently observing a seemingly desperate attempt in some private markets to avoid down rounds. While there have been some notable down rounds, more commonly companies are issuing new shares at the same valuation level as prior rounds. However, in addition to shares, new investors are receiving significant optionality through additional rights (e.g., preferences, warrants, first call on profitability or revenues). The options granted to new investors have significant economic value. As the overall company’s valuation has not changed, that value is being transferred directly from current shareholders to new investors. Given this reduction in value, shares issued in prior rounds should reflect this loss of value. However, given the complexity of valuing these options, we are instead seeing previous investors keeping their valuations unchanged rather than marking them down to reflect the new economic reality. Until companies and investors come to terms with the new valuation environment, it is unlikely a new healthy bull market can begin.

Caution 2: Investors feel pain from unaligned private investments and the return of the illiquidity premium

While we remain near our long-term target private investment allocations, there are two trends in private investing that warrant extreme caution:

• To increase alignment between the investor and the investment manager, investors in the private investment industry historically required investment managers to invest in funds alongside investors. This investment assures that when things go poorly, the investment manager shares in the downside experience and is motivated to manage through difficult situations. Many funds today include “management fee waivers” in their legal documents. That is, the investment manager “waives” the management fee, and the investor uses the waived fee to fund the manager’s investment in the fund. In addition, given the dramatic increase in fund sizes over the past couple of years and high management fees (typically 2%), revenue has grown at a much faster rate than costs. The annual increase in profitability is often larger than the required investment of the manager alongside investors. At the end of the day, the manager’s investment in the fund is coming 100% from investors’ pockets. This creates the following misaligned outcomes: • The investor does well, the manager becomes rich. • The investor does ok, the manager becomes rich. • The investor losses money, the manager becomes rich.

In most situations, instead of pushing back on misalignment, investors seem eager to gain access to these funds. The only option left for investors focused on alignment is to not invest in funds where alignment has become skewed by industry norms.

• When investors set their capital market assumptions, they typically embed a fixed assumption that there will always be an illiquidity premium for private equity. By definition, the reason the illiquidity premium exists is that investors should be willing to pay a lower price for a private asset because they demand a higher return for losing the option to sell. After a decade of strong returns in private equity, investors have come to view the illiquidity premium as a fixed and invariant feature of the market. In a market where people assume all private assets have an illiquidity premium and are willing to pay ever higher prices to access the illiquidity premium, the act of paying higher prices actually turns the premium into a cost, thereby leading to lower future returns. Our working hypothesis is that strong investor demand and enthusiasm for private equity demonstrates that investors are willingly paying a premium for illiquid assets relative to public assets. If the illiquidity premium were to be re-established near historical levels, then the value of private assets will need to fall more (or rise slower) than public markets. This underscores the importance of being selective with private investments, investing in opportunities where capital is somewhat constrained, and ensuring that incentive structures and management fees align with investors’ best interests.

Caution 3: U.S. debt reckoning becomes an unpredictable headwind

Much of the economic activity over the past two decades was fueled by a significant increase of economy-wide debt as a percentage of GDP. Deficits that fund increased investment in productive capacity typically lead to growth in the economy that exceeds the increase in debt. Conversely, deficits that fund consumption shift future aggregate demand to the present. This type of debt does not increase GDP permanently and, at some point, might be expected to weigh on future consumption and GDP as this debt is serviced. As an economy accumulates consumptive debt, the marginal increase in GDP resulting from each marginal unit of incremental borrowing tends to fall. As long as consumptive debt is accumulating it creates a liquidity tailwind pushing up asset prices. In 2022, the Federal Reserve increased rates from 0.25% to 4.25% and pivoted from quantitative easing to quantitative tightening. Tailwinds from the accumulation of debt turn into headwinds as the accumulated debt is serviced. The strength and duration of these headwinds are unpredictable. However, the unprecedented experiment the Federal Reserve ran with quantitative easing post-global financial crisis could have equally unprecedented results when shifted into reverse. It may create opportunities for investors to own debt at multidecade levels of interest rates.

Though these cautions are quite downbeat, we do not draw any broad conclusions on the basis of these or act on any of them in isolation. It is as much our responsibility to pursue underappreciated opportunities as it is to avoid uncompensated risks. I would like to leave you where we started: I am encouraged about the future. Longer-term trends are on balance positive. And history teaches us that optimism typically prevails.