Eric Peters: Today’s Opportunities Include Negative Convexity, Complexity, Illiquidity, Leverage, Or All The Above
From the latest Weekend Notes by Eric Peters, CIO of One River Asset Management
“What are the odds we come across an opportunity in the coming 4yrs to earn 20%?” the investor asked his team.
“High,” they answered. “The odds are 100%,” he said, having seen this movie a few times. “So our cost of capital is 5% per year (20% divided by 4yrs), plus the 1% we earn on cash,” he said. His team nodded.
“Under no circumstances should we deploy capital unless it earns well more than 6% per year from here on out.” It made sense.
“What do we see that earns more than this hurdle?” he asked. His team’s list was as short today as it was long in 2016, 2011, 2009, 2003, 1998, 1997, 1994, 1992, 1990, 1987, etc. Today’s few opportunities have much in common with previous peaks: negative convexity, complexity, illiquidity, leverage, and/or all the above.
“Investors confuse a 7.5% average annualized return target with a 7.5% annual return target,” he explained. “They’re entirely different things.”
Targeting average annualized returns allows you to accept what the market gives you, while targeting annual returns forces you to leverage investments near peak valuations to hit your bogey. “Typical pension and endowment boards want incoming investment returns to consistently exceed outgoing flows.”
So most investors attempt to produce the highest return every year, no matter what it takes. “But that’s the wrong objective. Never underestimate the value of cash and patience in achieving the real goal; superior returns over the complete cycle,” he explained.
“Markets tell you what to do if you listen,” he said. “Near the highs, few opportunities exist to earn substantial returns, so you should take little risk. Near the lows, opportunities to earn attractive returns are abundant.” You should take a lot of risk. “This sounds simple because it is. It’s obvious. But obvious is not easy.”